Turkey

Highlights EM currencies are fairly valued at the moment - they are neither cheap nor expensive. Unit labor cost-based REER is a superior currency valuation measure to those based on consumer and producer prices. Based on this measure, the U.S. dollar is not expensive - rather its valuation is neutral. When valuations are neutral, directional market indicators are more imperative than valuations. We expect directional indicators to favor the U.S. dollar and the euro versus EM currencies. In Turkey, inflation is breaking out - the currency, stocks and bonds will be under assault (page 9). The Philippines economy is overheating warranting policy tightening. Share prices are at risk (page 16). Feature EM currencies have recently begun to sell off. Does this represent a major reversal, or just a pause in a bull market? Our bias is that it is the former. In this week's report, we discuss the valuation aspect of foreign exchange markets. One of the oft-cited bullish arguments for EM currencies is that they are cheap. Similarly, the contention goes that the U.S. dollar is expensive. Our exchange rate valuation measures do not support these claims. According to our most favored currency valuation measure - the real effective exchange rate (REER) based on unit labor costs - the U.S. dollar is currently fairly valued (Chart I-1). More specifically, the greenback is not cheap, per se, but it is not expensive either. Meanwhile, the euro is at its fair value and the yen is undervalued (Chart I-2). The source of this data is the IMF. Below we elaborate in detail why we believe the unit labor cost-based REER valuation measure is superior to those based on consumer or producer prices. Chart I-1The U.S. Dollar Is Neither Cheap Nor Expensive Chart I-2The Euro Is Fairly Valued, The Yen Is Cheap As to EM currencies, there is no data on REER based on unit labor costs across all EM countries. The IMF and OECD have data for only a few developing countries, shown in Chart I-3A and Chart I-3B. With the exception of the Mexican peso and the Polish zloty, EM currencies shown in these charts are not cheap. Chart I-3AEM Currencies Are Not Universally Cheap Chart I-3BEM Currencies Are Not Universally Cheap In the absence of unit labor cost-based REER for EM, we deduce EM currency valuations in a number of ways: First, if the U.S. dollar, the euro and yen are not expensive, EM currencies by definition cannot be cheap. Second, provided exchange rates of commodities-producing advanced countries such as Australia, New Zealand, Canada and Norway are still expensive, according to unit labor cost-based REER (Chart I-4A and Chart I-4B), it is fair to argue that currencies of commodities-producing EM economies probably are not cheap as well given they move in tandem with their advanced countries peers. Chart I-4ACAD Is At Fair Value, NOK Is Slightly Expensive Chart I-4BAUD & NZD Are Expensive Third, Chart I-5 illustrates consumer and producer prices-based REER for EM. Excluding China, Korea and Taiwan, the equity market cap-weighted EM REER based on the average of consumer and producer prices is at its historical mean (Chart I-5). This denotes that EM currencies are by and large fairly valued. Notably, the BRL is slightly above its fair value, according to the REER based on average of consumer and producer prices (Chart I-6, top panel). Similarly, the same measure for the RUB and ZAR is no longer depressed after the appreciation witnessed in both currencies over the past 18 months (Chart I-6, middle and bottom panels). Chart I-5EM Ex-China, Korea And Taiwan: ##br##Exchange Rates Valuations Are Neutral Chart I-6EM High-Yielding ##br##Currencies Are Not Cheap All in all, we conclude that EM currencies are fairly valued at the moment - they are neither cheap nor expensive. This message is also corroborated by current account profiles across EM economies. In many developing countries, current account balances have improved, but are still in deficit. Consistently, the U.S. current account deficit excluding oil is at 1.75%, and with oil is at 2.4% of GDP - not wide at all. So, the current account does not presage that the greenback is expensive. Importantly, when valuations are neutral, they do not necessarily prevent the market from either rallying or selling off. Neutral valuations in any market have little impact on the market outlook. Thereby, we conclude that valuations are not an impediment for both EM currencies and the U.S. dollar to move in any given direction. When valuations are neutral, directional market indicators are more imperative than valuations. The best directional indicators for EM currencies have been commodities prices and the EM business cycle. Chart I-7 illustrates the EM aggregate currency index has historically correlated with commodities prices and EM industrial production. If commodities prices relapse and the EM business cycle slows down, as we expect, EM currencies will depreciate. As to U.S. bond yields and the greenback, we believe U.S. interest rate expectations will rise and the U.S. dollar will strengthen, at least, relative to EM currencies. That said, there has been no historical correlation between high-yielding exchange rates such as the BRL and ZAR and their interest rate differential over the U.S. (Chart I-8). Chart I-7These Factors Drive ##br##EM Exchange Rates Chart I-8Interest Rate Differential And ##br##Exchange Rates: No Correlation The euro and European currencies have the least downside versus the U.S. dollar. Hence, we expect EM currencies to weaken materially versus both the dollar and the euro (Chart I-9). Bottom Line: EM currencies are neither cheap nor expensive. We expect commodities prices to relapse and U.S. interest rate expectations to rise. This warrants a material down leg in EM currencies. We continue recommending a short position in a basket of the following currencies: ZAR, TRY, BRL, MYR and IDR versus the U.S. dollar. Investors, who are not comfortable being long the U.S. dollar, can short these same EM currencies versus the euro. Our overweights within the EM currency space are the TWD, THB, RMB, RUB, MXN, PLN and CZK. The Superior Currency Valuation Measure Unit labor cost-based REER is a superior currency valuation measure to those based on consumer and producer prices. The key idea behind currency valuation measures in general is to gauge competitiveness. Rising consumer and producer prices relative to trading partners signifies deteriorating competitiveness, and usually entails more expensive currency valuations. However, nowadays, labor costs in many economies, especially advanced ones, represent the largest cost component, even for manufacturing businesses. Therefore, it makes sense to compare wages across trading partners, not consumer and producer prices. However, rising wages in a country relative to its trading partners do not always signify worsening competitiveness. Wages might be rising, but productivity of employees may well be growing faster than wages. Therefore, true labor costs for businesses are not wages, but unit labor costs. Unit labor costs equal wages divided by productivity. They show the labor cost per unit of output. To estimate an economy's true competitiveness, one should compare its unit labor costs relative to its trading partners. REER based on unit labor cost does that. Hence, this measure captures two critical variables to competitiveness: wages and productivity. On the whole, unit labor costs measure competitiveness better than consumer and producer prices. Therefore, we argue that REER based on unit labor costs is superior to those based on consumer and producer prices. For comparison purposes, Chart I-10 illustrates the two REER measures for the U.S. dollar. Chart I-9EM Currencies Versus The USD And Euro Chart I-10U.S. Dollar: Two Valuation Measures Based on the above analysis, we conclude that the greenback and the euro are fairly valued, while the Japanese yen is cheap. In addition, EM currency valuations are neutral and currencies of commodities producing advanced countries are modestly expensive. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Turkey: Ride The Sell-Off Turkish stocks were among the best performing equity markets worldwide in the January-August period of this year before relapsing by 16% in U.S. dollar terms since September 1st (Chart II-1). We remain bearish/underweight Turkish financial markets. A Genuine Inflation Breakout Despite the currency being stable since the beginning of the year, inflation has been rising. Core consumer price inflation has surpassed 10% for the first time in the past 14 years (Chart II-2). Chart II-1Turkish Stocks Have More Downside Chart II-2Turkey: Inflation Is Breaking Out The country's double-digit wage growth is not supported by productivity gains. The latter has been stagnant (Chart II-3, top panel). Consequently, unit labor costs have surged in both the manufacturing and services sectors (Chart II-3, bottom panel). This combination of strong wage growth paired with low productivity growth depresses companies' profit margins. This in turn will force businesses to raise prices. Provided stimulus-propelled domestic demand is robust, businesses will succeed in raising their prices leading to escalating inflation. Typically, when a country is witnessing heightening inflationary pressures, the natural policy response should be monetary and/or fiscal tightening. However, Turkish authorities have been doing the opposite - running loose monetary and fiscal policies: Government expenditure excluding interest payments have accelerated significantly (Chart II-4). The rise in government spending has been partially funded by commercial banks - the latter's holdings of government bonds have been growing, boosting money supply, as a result. Chart II-3Turkey: Surging Unit Labor Costs Chart II-4Turkey: Fiscal Expenditures Are Booming This year the Turkish authorities have been able to generate growth through the recapitalization of the Credit Guarantee Fund. The aim of this fund is to incentivize banks to lend by essentially assuming credit risk on loans extended to small and medium enterprises. Under this scheme, the government has effectively given a green light to flood the economy with credit, in turn, boosting economic growth. So far, the scheme has been responsible for the creation of TRY 200 billion, or 7% of GDP, worth of new credit out of the TRY 250 billion limit. This TRY 250 billion is considerable as it compares with a total of TRY 367 billion worth of loan origination by commercial banks last year. Turkey's banking system has been relying on enormous amounts of liquidity provisions by the central bank (Chart II-5, top panel) to sustain its ongoing credit boom and strong economic growth. On the whole, the central bank's net liquidity injections into the banking system continue to increase rapidly. Interestingly, the nature of the central bank's funding of commercial banks has increasingly shifted away from open market operations and more towards direct lending to banks (Chart II-5, bottom panel). Adding all the liquidity facilities - the intraday, overnight and late window facilities - the Central Bank Of Turkey's outstanding funding to banks is TRY 86 billion, or 3% of GDP, abnormally elevated relative to the data series' history. This entails that monetary policy is loose even though the price of liquidity provided by the central bank to banks has been rising. Consistently, local currency bank loan growth stands at 25% (Chart II-6, top panel). Chart II-5Central Bank Of Turkey's Liquidity Injections Chart II-6Turkey Is Experiencing A Credit Binge On the whole, commercial banks are requiring more and more liquidity, and the CBT is continuously supplying it. These injections maintain liquidity in the banking system to a sufficiently high level that allow money/credit creation by commercial banks to continue mushrooming (Chart II-6, bottom panel). Fiscal and monetary policies are overly simulative and the country's twin - fiscal and current account - deficit is widening (Chart II-7). The widening current account deficit - which is a form of hidden inflation - substantiates the case of an inflation outbreak in Turkey. Remarkably, despite extremely strong exports due to the robust growth in the Euro Area, Turkey's current account deficit has been unable to narrow at all. This confirms excessive growth in domestic demand. In regard to currency valuation, Chart II-8 demonstrates that the lira is not cheap, especially according to unit labor cost-based REER. It is therefore questionable how long Turkish exports can remain competitive if unit labor costs continue mushrooming at a rapid pace. Chart II-7Turkey: Widening Twin Deficit Chart II-8The Lira Is Not Cheap Bottom Line: Despite high inflation, the Turkish authorities have opted to stimulate the economy further, aiming to boost short-term growth at all costs. The outcome will be an inevitable inflation outbreak. The Monetary Regime And Exchange Rate Chart II-9Excessive Money Printing Is Bearish For Lira The monetary regime in Turkey will lead to a major lira depreciation: The money multiplier - calculated as broad local currency money divided by banks' excess reserves at the central bank - has been rising sharply since 2012 (Chart II-9, top panel). This measure illustrates the degree of leverage banks have assumed. Also, the money multiplier reveals how much broad money/purchasing power banks have created per unit of liquidity provided by the central bank. To put into perspective the vast amount of money that has been created, the bottom panel of Chart II-9 demonstrates that the current net level of foreign exchange reserves (currently US$ 32 billion) covers only 11% of broad local currency money M3. Not only is excessive money creation bearish for the currency but it is also highly inflationary. As inflation rises, residents' desire to convert their deposits from local to foreign currency will increase, further exerting downward pressure on the lira. In fact, this is already happening - households' foreign currency deposits - measured in U.S. dollars - are growing at rapid annual pace of 13%. Given this inflationary backdrop and the risk of further depreciation, interest rates will have to rise. This will inevitably trigger another NPL cycle. Banks are very under-provisioned for non-performing loans (NPL). NPLs have not risen, and NPL provisions are also very low (Chart II-10). Both are set to rise considerably, and banks' capital and ability to expand credit will be severely undermined. Lastly, higher interest rates will be negative for loan growth and bank's profitability. Bank stocks are starting to roll-over. Given the extent to which they have decoupled from interest rates, we believe there is much more downside (Chart II-11). Chart II-10Turkey: A New NPL Cycle Will Start Chart II-11Turkish Bank Stocks Have Considerable Downside The current monetary policy stance is unsustainable. Inflation is breaking out and this is bearish for Turkish financial markets. Box 1 on page 15 addresses the geopolitical dimension of Turkey's recent spat with the U.S. Investment Conclusions We expect policy makers to remain behind the curve amid rising inflation and this will weigh on the lira. As such, we suggest currency traders who are not shorting the lira to do so at this time. We remain short the lira versus the U.S. dollar but the lira will continue to plummet versus the euro too. A weaker lira will undermine U.S. dollar and euro returns on Turkish stocks and domestic bonds. Dedicated EM equity investors as well as those overseeing EM fixed income and credit portfolios should continue to underweight Turkish assets within their respective EM universes. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com BOX 1 Turkey's Unstable Geopolitical Position On the political front, the recent spat with the U.S. over visas is just another sign of how far Turkey has descended into the geopolitical unknown. The U.S. has closed its visa offices as a response to the detention of a Turkish national working for the U.S. consulate in Istanbul by the local authorities. The arrest was made over alleged links to Fethullah Gulen, the cleric that Turkish authorities blame for the July 2016 botched coup. That Gulen remains the obsession of Turkish authorities is a clear sign that President Recep Tayyip Erdogan continues to feel threatened. Whether the Gulen threat is real or imagined is not for us to determine. But it is clear that Turkey remains a deeply divided country. The April 2017 constitutional referendum giving the president greater powers barely passed, despite numerous reports of irregularities. As BCA's Geopolitical Strategy posited following the vote, the referendum did nothing to reinforce Erdogan's power or reduce domestic tensions.1 It would only deepen his instinct to use "rally-around-the-flag" strategy by emphasizing external threats to quell domestic opposition. Now Turkey finds itself at the crossroad on three different fronts: Iraq: Neighboring Kurdistan Regional Government (KRG) has just held an independence referendum, prompting Erdogan to threaten military action against the Iraqi Kurds. Although no regional or global power overtly supports KRG's moves towards independence, Turkey is under pressure to respond in order to snuff out any secessionist ambitions by the Kurds in Turkey and Syria. Syria: President Erdogan has also threatened invasion of the self-declared Kurdish canton of Afrin in northwestern Syria. The enclave is held by the U.S.-allied People's Protection Units (YPG), which fought against the Islamic State in Syria. According to various news reports, Turkish troops are amassing on the border with Syria for the intervention. This could put the Turkish military in direct contact with Russian troops, which have a presence in Afrin. The West: Relations with the West, with whom Turkey remains in a formal military alliance (NATO) remain in the doldrums. Aside from the visa spat with the U.S., Turkey's relations with Europe, and Germany in particular, are at their lowest point in years. Bottom Line: In a month's time, Turkey may have invaded both Syria and Iraq while simultaneously hitting a low point in its relationship with traditional Western allies. At the very least, this complicated geopolitical environment will make it difficult for Ankara to focus on the economy. At its greatest, it is a recipe for geopolitical overreach, military disaster, domestic crisis, or any combination of all three. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "What About Emerging Markets?," dated May 3, 2017, available at gps.bcaresearch.com. The Philippines: An Overheating Economy Requires Policy Tightening Since early 2016, the Philippine stock market has been massively lagging the EM benchmark (Chart III-1, top panel). Similarly, the Philippine peso has been extremely weak, recording new lows versus the U.S. dollar, despite the broad-based EM currency rally (Chart III-1, bottom panel). In fact, the symptoms of this economy and its financial markets are consistent with an overheating economy that is expanding above potential, and where inflationary pressures are heightening. Going forward, inflation will keep rising and the central bank will have to tighten monetary policy meaningfully. These developments will weigh on Philippine growth and financial markets. Consumer price inflation, both headline and core, are rising briskly and currently stand at 3% - in the middle of the central bank's 2-4% target (Chart III-2). With the policy rate at 3%, this entails that real rates have dropped to zero. Chart III-1Philippine Stocks Relative ##br##To EM Have Underperformed Chart III-2Philippine Inflation ##br##Is Creeping Higher The Central Bank of the Philippines (BSP) has kept monetary policy too easy for too long. It injected liquidity into the banking system on various occasions in 2013-2014 and 2016-2017 via its banking liquidity management tool - the Special Deposit Account (Chart III-3, top panel). These liquidity injections incentivized commercial banks to create enormous amounts of credit in the economy (Chart III-3, middle and bottom panels). Booming credit growth in turn is creating excessive purchasing power in the economy, resulting in a current account deficit for the first time since 2000. In addition, the fiscal deficit is now widening (Chart III-4). Chart III-3Credit Growth Is Rampant Chart III-4Philippines Twin Deficit On the wage front, non-agriculture workers' salaries are accelerating, pushing unit labor costs higher (Chart III-5). Remarkably, despite real GDP growth of about 6.5% since 2014, consumer staples EPS growth is on the verge of contracting. It seems that costs (including wages) have been mushrooming while productivity gains have been lagging. This also corroborates the overheating thesis. With Philippines' inflationary dynamics intensifying, the BSP will have to tighten monetary policy. In fact, the top panel of Chart III-3 shows that the BSP has already begun its tightening cycle by withdrawing some banking liquidity via its Special Deposit Account. In addition, interest rate hikes by the central bank are also an option. Monetary tightening amid very strong loan growth will lead a meaningful slowdown in the economy. Loan growth deceleration will affect primarily capital spending and the property market. Both segments are cooling off (Chart III-6). Chart III-5Philippines: Wages Are Accelerating Chart III-6Cyclical Slowdown On The Horizon Importantly, banks' net interest margins have been falling - a trend that will likely continue due to potential liquidity tightening and higher policy rates (Chart III-7, top panel). This, along with slow loan growth and rising NPL provisions, will intensify banks' EPS contraction (Chart III-7, bottom panel). Chart III-8 illustrates that both NPL and NPL provisions as a percent of total loans are at their lowest level since 1997. Higher borrowing costs following a decade-long lending boom, necessitates higher NPL provisions. Chart III-7Banks' Interest Rate Margins And Profits Chart III-8Bank NPLs To Rise Along With Provisions NPLs are likely to emanate from the real estate and construction sectors. Loans to these two sectors account for 20% of total bank loans. Hence, higher interest rates are negative for banks and real estate stocks which, together, account for 40% of the Philippines MSCI index market cap. If the central bank decides not to tighten, however, the economy will continue to overheat and bond yields - as well as the currency - will sell-off. Such a scenario is equally bearish for the equity market. Philippines equity valuations are elevated and, hence, are not priced for any of these scenarios. For dedicated EM equity investors, we continue recommending a neutral allocation to this bourse. We are reluctant to underweight this stock market because the Philippines remains less leveraged to China and the commodities cycle vis-à-vis other emerging markets (EM). Besides, it has already considerably underperformed the EM equity benchmark. Therefore, it might not underperform substantially relative to other EM countries - if and when commodities start selling off as a result of a growth slowdown in China. Within ASEAN, we favor Thailand, underweight Malaysia and are neutral on the Philippines, Indonesia, and India relative to the EM equity benchmark. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Feature Turkey's banking system has in recent years relied on enormous liquidity provisions by the central bank (Chart I-1) to sustain its ongoing credit boom, and hence economic growth. Since early this year, the authorities have doubled down: they have also begun using fiscal policy to prop up growth. Chart I-1Turkey: Central Bank Large Liquidity Injections On the whole, this combination of colossal credit and fiscal stimulus is indisputably bearish for the currency. Despite strong performance by Turkish stocks this year, we are maintaining our bearish call on the lira. The lira is set to depreciate by 20-25% in the next 12 months or so versus both an equally-weighted basket of the U.S. dollar and the euro. Bringing Fiscal Stimulus Into Play The Turkish authorities have recently begun using fiscal means to stimulate growth: Last summer, a sovereign wealth fund was set up by presidential decree to pool shares in companies owned by the government and use them as collateral to raise debt and initiate spending on various infrastructure projects. The target size of the fund is US$ 200 billion, compared with the government non-interest expenditure of US$ 165 billion in the last 12 months. This would effectively allow the government to issue debt and increase expenditures off-balance sheet. In addition, this past March, the government decided to recapitalize the Credit Guarantee Fund. This initiative allowed it to underwrite US$ 50 billion, or 7% of GDP, worth of credit to Turkish companies. This is considerable as it compares with US$ 93 billion worth of loan origination by commercial banks last year. By assuming credit risk on these loans, the government is effectively encouraging banks to lend, in turn boosting economic growth. In effect, this has lowered lending standards and given a green light to banks to flood the economy with credit. Even though interest rates have risen since last November, credit growth has accelerated as banks have provided loans covered by government guarantees (Chart I-2). On top of this quasi-fiscal stimulus, government expenditures excluding interest payments have accelerated (Chart I-3). Chart I-2Bank Loan Growth Has Accelerated ##br##Despite Higher Interest Rates Chart I-3Turkey: Fiscal Spending Has Surged Such a rise in government spending has been financed by commercial banks whose holdings of government bonds have risen sharply. Essentially, government spending has also been funded by commercial banks' money creation. In short, fiscal and credit stimulus have boosted domestic demand, thereby widening the country's current account deficit once again (Chart I-4A and Chart I-4B). Chart I-4AWidening Twin Deficit Chart I-4BWidening Twin Deficit Given that the starting point of the government's fiscal position is good - public debt stands at only 28% of GDP - the authorities have ample room to rely on fiscal levers to promote growth. However, a widening fiscal deficit will be bearish for the currency. Bottom Line: Widening twin (current account and fiscal) deficits (Chart I-4A and Chart I-4B) are a bad omen for the lira. Monetary Tightening? What Monetary Tightening? Chart I-5Turkey: Money/Credit Growth Is Too Strong Although interbank and lending rates have risen in recent months, money and credit growth have been booming (Chart I-5). This does not support the idea that monetary policy is tight. On the contrary, thriving money and credit growth suggest that the policy stance is very easy. The Central Bank of Turkey (CBT) raised various policy rates and capped the overnight liquidity facility at the beginning of this year. However, commercial banks' usage of the late liquidity window facility - the one facility that has been left uncapped - has literally gone exponential - it has risen from zero to TRY 70 billion in the past 8 months. On the whole, the central bank’s net liquidity injections into the banking system continue to make new highs, even though the price of liquidity has been rising. Adding all the liquidity facilities – the intraday, overnight and late window facilities – the CBT's outstanding funding to banks is 90 billion TRY, or 3% of GDP, more than ever recorded (Chart 1, bottom panel). This entails that monetary policy is loose rather than tight. On the whole, commercial banks are requiring more and more liquidity, and the CBT is continuously supplying it. These injections maintain liquidity in the banking system to a sufficiently high level to allow aggressive money/credit creation among commercial banks. Bottom Line: The CBT is facilitating/accommodating an economy-wide credit binge by providing copious amounts of liquidity to commercial banks. The Victim Is The Lira The lira will inevitably depreciate in the months ahead: Chart I-6Turkey: Central Bank's Foreign ##br##Reserves Have Been Depleted The lira's exchange rate versus an equally-weighted basket of the U.S. dollar and the euro has been mostly flat year-to-date, despite the CBT intervening in the market to support the lira by selling U.S. dollars. Aggressive selling of CBT foreign exchange reserves has so far prevented much steeper lira depreciation in Turkey. However at this stage, the central bank is literally running out of reserves and will soon lose its ability to support the currency (Chart I-6). A developing country with foreign exchange reserves worth less than three months' imports is considered vulnerable. Therefore, at 0.5 months of imports coverage, or US$ 9.7 billion, the CBT has little capacity to continue supporting the currency via interventions. Economic growth has recovered: export volumes are very strong, driven by shipments to Europe, while loan growth is supporting private domestic demand and government expenditures have mushroomed. The ongoing economic recovery will boost inflation, and strong domestic demand will assure the current account deficit widens. This will weigh on the exchange rate. Core inflation measures have subsided from 10% to 7%, but remain well above the central bank's target of 5%. Provided inflation is a lagging variable, the acceleration in money growth and domestic demand this year will lead to higher inflation in the months ahead. Wage growth remains high and our profit margin proxy for both manufacturing and service industries - calculated as core CPI divided by unit labor costs - has relapsed signifying deteriorating corporate profitability (Chart I-7). This in turn will force businesses to raise prices. Provided demand is strong, companies will likely succeed in passing through higher prices to customers. In brief, odds are that inflation will rise significantly soon. Escalating unit labor costs also offsets the benefit of nominal currency depreciation. Chart I-8 illustrates that the real effective exchange rate is not cheap based on consumer prices, or unit labor costs. Chart I-7Companies Profit Margins Are Shrinking Chart I-8The Lira Is Not Cheap At All As inflation rises, residents' desire to convert their deposits from local to foreign currency will increase. In fact, this is already happening - households' foreign currency deposit growth is accelerating. In short, lingering high inflation will continue to weigh on the currency's value. Bottom Line: The authorities have doubled down on fiscal and credit stimulus, warranting a doubling down on bearish bets on the lira. Investment Implications On the whole, the authorities will continue resorting to fiscal and monetary stimulus to sustain economic growth. According to the Impossible Trinity theory, in countries with an open capital account structure, the authorities can control either interest rates or the exchange rate, but not both simultaneously. Chart I-9Bank Stocks Have Rallied Despite ##br##Shrinking Net Interest Margins In Turkey, policymakers will eventually opt to control interest rates, meaning they will not have much control over the exchange rate. We suggest currency traders who are not shorting the lira do so at this time. We remain short the lira versus the U.S. dollar. A weaker lira will undermine U.S. dollar returns on Turkish stocks and domestic bonds. Dedicated EM equity investors as well as those overseeing EM fixed income and credit portfolios should continue to underweight Turkish assets within their respective EM universes. Bank stocks have rallied strongly, and have decoupled from interest rates (Chart I-9). This reflects the recent credit binge, where banks are making profits on loan originations while the government is holding responsibility for bad loans. These dynamics could persist for a while. However, both loan growth and banks' profitability will be hurt if the credit guarantee scheme is not renewed. So far, it is estimated that TRY 200 billion of an announced TRY 250 billion of this credit guarantee scheme has been utilized. Continuous credit guarantee schemes and accumulation of off-balance-sheet liabilities by the government will widen sovereign credit spreads. In many EM countries, including Turkey, bank share prices have historically correlated with sovereign spreads. Hence, rising sovereign risk will weigh on banks stocks too. Finally, as the lira begins to depreciate and inflation rises, local interest rates will have to climb. This will also weigh on bank share prices. In brief, we are reiterating our negative/underweight stance on Turkish banks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Chart 1European Policy Uncertainty Down Macron remains on target to win the French election, but Italy looms as a risk ahead; Fade any relief rally after South Korean elections; Russia is not a major source of geopolitical risk at present; Stay underweight Turkey and Indonesia within the EM universe. Feature The supposed pushback against populism is emerging as a theme in the financial industry. The expected defeat of nationalist-populist Marine Le Pen in the second round of the French election on May 7 has reduced Europe's economic policy uncertainty, despite continued elevated levels globally (Chart 1). We are not surprised by this outcome. A year ago, ahead of both the Brexit referendum and the U.S. election, we cautioned investors that it was the Anglo-Saxon world, not continental Europe, which would experience the greatest populist earthquake.1 The middle class in the U.S. and the U.K. lacks the socialist protections of large welfare states (Chart 2), leading to frustrating outcomes in terms of equality and social mobility (Chart 3). In other words, the gains of globalization have not been redistributed in the two laissez-faire economies. Hence the Anglo-Saxon world got Trump and Brexit while the continent got market-positive outcomes like Rajoy, Van der Bellen, Rutte, and (probably) Macron. Chart 2Given The Qualities Of The##br## Anglo-Saxon Economy ... Chart 3...Brexit And Trump ##br##Should Not Be A Surprise Looking forward, we agree with the consensus that Marine Le Pen will lose, as we have been stressing with high conviction since November.2 Despite a poor start to the campaign, Macron remains 20% ahead of Marine Le Pen with only four days left to the election (Chart 4). Could the polls be wrong? No. And not just because they were right in the first round. Polls are likely to be right because French polls have an exemplary track record (Chart 5) and there is no Electoral College to throw off the math. Chart 4Le Pen Unlikely To Bridge This Gap Chart 5French Polls Have Strong Track Record As we go to press, the two candidates are set to face off in an important televised debate. Given Le Pen's post-debate polling performance in the first round (Chart 6), we doubt she will perform well enough to make a change. Next week, we will review the second round and its implications for the legislative elections in June and French politics beyond. Overall, we think Europe's policy uncertainty dip is temporary, as the all-important Italian election risk looms just ahead in 2018.3 For now, we are sticking with our bullish European risk asset view, but will look to pare it back later in the year. Chart 6Debates Have Not Helped Le Pen Chart 7Commodity Currencies Suggest Global Trade Is At Risk... What about emerging markets? With investors laser-focused on developed market political risks - Trump's policies and protectionism, European elections, Brexit, etc - have EM political risks fallen by the wayside? Chart 8...And Commodities Are At Risk Too Chart 9China's Growth To Decelerate Again We don't think so. According to BCA's Emerging Market Strategy, the recent performance of the commodity currency index (an equally weighted average of AUD, NZD, and CAD) augurs a deceleration of global growth in the second half of this year (Chart 7) and a top in the commodity complex (Chart 8).4 At the heart of the reversal is the slowdown in China's credit and fiscal spending impulse (Chart 9).5 Given China's critical importance as the main source of EM final demand (Chart 10), the slowdown in money and credit growth is a significant risk to EM growth in the latter part of the year (Chart 11).6 Chart 10EM Is Leveraged To China Much More Than DM Chart 11China: Money/Credit Growth Is Slowing At the heart of China's credit slowdown are efforts by policymakers to cautiously introduce some discipline in the financial sector. Chinese interbank rates have risen noticeably, which should have a material impact on credit growth (Chart 12). Given that the all-important nineteenth National Party Congress is six-to-seven months away, we doubt that the tightening efforts will be severe. But they may foreshadow a much tighter policy in 2018, following the conclusion of the Congress, when President Xi has full reign and the ability to redouble his initial efforts at reform, namely to control the risks of excessive leverage to the state's stability. With both the Fed and PBoC looking to tighten over the next 12-18 months, in part to respond to improvements in global inflation expectations (Chart 13), highly leveraged EM economies may face a triple-whammy of USD appreciation, Chinese growth plateauing, and easing commodity demand. In isolation, none is critical, but as a combination, they could be challenging. Chart 12Chinese Policymakers End The Credit Party? Chart 13Global Tightening Upon Us? In this weekly report, we take an around-the-world look at several emerging economies that we believe are either defying the odds of political crisis or particularly vulnerable to growth slowdown. South Korea: Here Comes The Sunshine Policy, Part II South Korea's early election will be held on May 9. The victory of a left-wing candidate has been likely since April 2016, when the two main left-wing parties, the Democratic Party and the People's Party, won a majority of the 300-seat National Assembly. It has been inevitable since the impeachment of outgoing President Park Geun-hye in December - whose removal was deemed legal by the Constitutional Court in March - for a corruption scandal that split the main center-right party and decimated its popular support after ten years of ruling the country.7 The only question was whether Moon Jae-in, leader of the Democratic Party and erstwhile chief of staff of former President Roh Moo-hyun, would finally get his turn as president, or whether Ahn Cheol-soo, an entrepreneurial politician who broke from the Democratic Party to form the People's Party, would defeat him. At the moment, Moon has a significant lead in the polls, while Ahn has lost the bump in support he received after other candidates were eliminated through the primary process (Chart 14). Moon's lead has grown throughout the recent spike in saber-rattling between the United States and North Korea, which suggests that Moon is most likely to win the race. The debates have also hurt Ahn. Moon leads in every region, among blue collar and white collar voters, and among centrists as well as progressives. Also, the pollster Gallup Korea has a solid track record for presidential elections going back to 1987, with a margin of error of about 3%, so Moon is highly likely to win if polls do not change in Ahn's or Hong's favor. The key difference between Moon and Ahn boils down to this: Moon is the established left-wing candidate and has mainstream Democratic Party machinery backing him, a clear platform, and experience running the country from 2003-8. Ahn does not have experience in the executive branch (Blue House) and his policy platform is less clear. His party is a progressive offshoot of the Democratic Party, yet he is bidding for disenchanted center-right voters, a contradiction that has at times given him the appearance of flip-flopping on important issues. Thus Ahn's election would bring greater economic policy uncertainty than Moon's, though Ahn is more business-friendly by preference. Regardless, the new president will have to work with the opposing left-wing party in the National Assembly if he intends to get anything accomplished. The combined left-wing vote is 164, yielding only a 13-seat majority if the two parties work together. Differences between them will cause problems in passing legislation. It would be easier for Moon to legislate with his party's 119-seat base than for Ahn with his party's 40-seat base, unless Ahn can steer his party to cooperate with the center right like he is trying to do in the presidential campaign. Markets may celebrate the election regardless of the victor because it sets the country back on the path of stable government. The Kospi bottomed in November when the political crisis reached a fever pitch and has rallied since December 5, when it became clear that the conservatives in the assembly would vote for Park's impeachment. This suggested an early government change to restore political and economic leadership. The market rallied again when the Constitutional Court removed Park, which pulled the presidential elections forward to May and cut short what would otherwise have been another year of uncertainty until the original election date in December 2017 (Chart 15). Chart 14South Korea: Moon In The Lead Chart 15Korean Stocks Cheered Impeachment Investors can reasonably look forward to an increase in fiscal thrust after the election, particularly if Moon is elected. Table 1 compares the key policy initiatives of the top three candidates - both Moon and Ahn are pledging increases in government spending. Note that South Korean fiscal thrust expanded in the first two years of the last left-leaning government, i.e. the Roh Moo-hyun administration (Chart 16). Table 1South Korean Presidential Candidates And Their Policy Proposals Chart 16Left-Wing Leaders Drive Up Fiscal Spending Beyond any initial relief rally, however, investors may experience some buyer's remorse. South Korea is experiencing a leftward swing of the political pendulum that is not conducive to higher growth in corporate earnings. This is the implication of the April legislative elections and the collapse of President Park's support prior to the corruption scandal; it will also be the takeaway of either Moon's or Ahn's election win over a discredited conservative status quo (both fiscal and corporate). The leftward shift is motivated by structural factors, not mere political optics. Average growth rates have fallen since the Great Recession, yet South Korea lacks the social amenities of a slower-growing developed economy. The social safety net is comparable to Turkey's or Mexico's and wages have been suppressed to maintain competitiveness (Chart 17). Inequality has grown dramatically (Chart 18). Chart 17Keeping Labor Cheap Chart 18Fueling The Populist Fire Therefore the policies to come will emphasize redistribution, job security, and social benefits. Moon's policies, in particular, are aggressive. He has pledged to require the public sector to increase employment by 5% per year and add 810,000 jobs by 2022, and to expand welfare for the elderly regardless of their income level. This will swell the budget deficit and public debt, especially over time, given South Korea's demographic profile, which is rapidly graying (Chart 19). Moon also intends nearly to double the minimum wage, require private companies to hire 3-5% more workers each year, depending on company size, and give substantial subsidies to SMEs that hire more workers. He supports a hike in corporate taxes, though the details of any tax changes have yet to be disclosed. Chart 19Society Turning Gray Ahn's policy preferences are more focused on productivity improvements than social welfare. While Moon panders to middle-aged workers concerned about job security - among whom he leads Ahn by 30 percentage points - Ahn panders to the youth, who are currently battling an unemployment rate of 11%. He would pay subsidies to young workers while they look for jobs immediately after graduation ($266 per month) and for the first two years of their employment at an SME ($532 per month). He would direct budgetary funds to research and development, high-tech industries, and job training. The SME policies speak to the general dissatisfaction with the cozy relationship between large, export-oriented industrial giants - the chaebol - and the political elite. Both Moon and Ahn will attempt to remove subsidies and privileges from the chaebol, potentially forcing them to sell or spin-off branches that are unrelated to their core business, and will seek to incentivize SMEs. Chaebol reform is a long-running theme in South Korean politics with very little record of success, but the one thing investors can be sure of on this front is greater uncertainty regarding policies toward the country's multinationals. Bottom Line: South Korea is experiencing a swing of the political pendulum to the left regardless of who wins the presidential race on May 9. What About Geopolitics? Internationally, Moon, if he wins, will attempt to improve relations with China and North Korea at the expense of the U.S. and Japan. His voter base came of age during the democracy movement of the 1980s and is friendlier toward China and less hostile toward North Korea than other age groups (Chart 20 A&B). Ahn may attempt a similar foreign policy adjustment, but he is less willing to confront the United States. His attempt to woo the youth will constrain any engagement with Pyongyang, since young South Koreans feel the least connection with their ethnic brethren to the north. Given that a Moon presidency would be paired with that of Trump, it would likely precipitate tensions in the U.S.-Korean relationship. News headlines will announce that South Korea is "pivoting" toward China, much in the way that U.S. ally the Philippines was perceived as shifting toward China after President Rodrigo Duterte's election in 2016. This will be an exaggeration, since Koreans still generally prefer the U.S. to China and view North Korea as an enemy (Chart 21). Nevertheless, there is potential for real, market-relevant disagreements. Chart 20Moon's Middle-Aged Constituency Chart 21Constraints On The Sunshine Policy In the short term, the risk is to trade, given the South Korean Left's strain of opposition to the U.S.-Korea free trade agreement (KORUS) and Trump's intention to renegotiate it, or even impose tariffs. Trump is bringing a protectionist tilt to U.S. trade policy - at very least - and he is relatively unconstrained on trade so we consider this a high-level risk over his four-year term in office. Trade tensions could become consequential if South Korea breaks with the U.S. over North Korea, angering the Trump administration. At the same time, South Korea's trade with China (Chart 22) is a risk due to China's secular slowdown, protectionism, and intention to move up the value chain and compete with South Korea in global markets. Chart 22South Korea's Twin Trade Risks In the short and long term, Moon's attempt to revamp Kim Dae-jung's "Sunshine Policy" of economic engagement and denuclearization talks with North Korea could create serious frictions with the U.S. What Moon is proposing is to promote economic integration so that South Korea has more leverage over the North, which is increasingly reliant on China, and also to reduce military tensions via negotiations toward a peace treaty (the 1950-3 war ended with an armistice only). The idea is to launch a five-year plan toward an inter-Korean "economic union." This would begin by re-opening shuttered cooperative projects like the Kaesong Industrial Complex and Mount Kumgang tours and later establish duty-free agreements, free trade zones, and multilateral infrastructure projects that include Russia and China.8 The problem is that any new Sunshine Policy - which is ostensibly a boon for the region's security - will clash with the Trump administration's attempt to rally a new international coalition to tighten sanctions on North Korea to force it to freeze its nuclear and ballistic missile programs. North Korea will want to divide the allies and thus will be receptive to China's and South Korea's offers of negotiations; the U.S. and Japan will not want to allow any additional economic aid to the North without a halt to tests and tokens of eventual denuclearization. How will this tension be resolved? Trump is preparing for negotiations and over the next couple of years the U.S. and Japan are highly likely to give diplomacy at least one last chance, as we have argued in recent reports.9 Eventually, if the U.S. becomes convinced of total collaboration between China and South Korea with the North (i.e. skirting sanctions and granting economic benefits), while the North continues testing capabilities that would enable it to strike the U.S. homeland with a nuclear weapon, some kind of confrontation is inevitable. But first the U.S. will try another round of talks. The "arc of diplomacy" could extend for several years, as it did with Iran (Chart 23), if the North delays its missile progress or appears to do so. Chart 23The 'Arc Of Diplomacy' Can Last For Several Years Despite our belief that the North Korean situation will calm down as diplomacy gets under way, South Korea is seeing rising geopolitical headwinds for the following reasons: Sino-American tensions: U.S.-China competition is growing over time, notwithstanding the apparently friendly start between the Trump and Xi administrations.10 Trump's North Korea policy: The Trump administration has signaled that the U.S. does not accept a nuclear-armed North Korea and the need to maintain the credibility of the military option will keep tensions at a higher level than in recent memory.11 Japanese re-armament: Japanese tensions with China and both Koreas are rising as Japan increases military expenditures and maritime defenses and moves to revise its constitution to legitimize military action.12 The costs of peace: If diplomacy prevails, South Korean engagement with the North still poses massive uncertainties about the future of the relationship, the North's internal stability amid liberalization, whether the transition to greater economic integration will be smooth, and whether the South Korean economy (and public finances) can absorb the associated costs. This is not even to mention eventual unification. Bottom Line: The current saber-rattling around the Korean peninsula is not over yet, but tensions are soon to fall as international negotiations get under way. Still, geopolitical risks for South Korea are rising over the long run. Investment Conclusions The currency will be the first to react to the election results and will send a signal about whether the fall in policy uncertainty is deemed more beneficial than the impending rise in pro-labor policies. Beyond that, the won has been strong relative to South Korea's neighbors and competitors (Chart 24). The Korean central bank is considering cutting rates at a time when fiscal policy is set to expand substantially, a negative for the currency. Chart 24Won Strength, Yen Weakness Therefore we remain short KRW / long THB. Thailand, another U.S. ally, is running huge current account surpluses, is more insulated from U.S.-China geopolitical conflicts, and has navigated tensions between the two relatively well. We expect a relief rally in stocks due to resolution of the campaign and the likelihood of an easing in trade tensions with China. However, this is the only reason we are not yet ready to join our colleagues in the Emerging Markets Strategy in shorting Korean stocks versus Japanese. We will look to put on this trade in future. We do not have high hopes for Korean stocks over the long run due to the headwinds listed above. As for bonds, both Moon's and Ahn's agendas, particularly Moon's, will be bond bearish because they will increase deficits and debt. At the short end of the curve, yields may have reason to fall; but the long end should reflect looser fiscal policy, the worsening debt and demographic profile, and increasing geopolitical risk, whether from conflicts with the U.S. and North Korea, or from the rising odds of a greater future burden from subsidizing (or even merging with) North Korea. Therefore we recommend going long 2-year government bonds / short 10-year government bonds. Russia: Defying Odds Of A Political Crisis Russia has emerged from the oil-price shocks scathed, but unbowed.13 Its textbook macro policy amid a severe recession over the past two years has been exemplary: The government has maintained constant nominal expenditure growth and substantially cut spending in real terms (Chart 25). The fiscal deficit is still large at 3.7%, but it typically lags oil prices (Chart 26). Hence, the recovery in oil prices over the past year should lead to a notable improvement in the budget balance. For 2017, the budget is conservative, as it assumes $40/bbl Urals crude. Chart 25Russia Has Undergone##br## Through Real Fiscal Squeeze... Chart 26...Which Is##br## Now Over Early this year, the Ministry of Finance adopted a new fiscal rule where it will buy foreign currency when the price of oil is above the set target level of 2700 RUB per barrel (the price of oil in rubles at the $40 bbl Urals) and sell foreign exchange when the oil price is below that level (Chart 27). The objective of this policy is to create a counter-cyclical ballast that will limit fluctuations in the ruble caused by swings in oil prices. Chart 27Oil Price Threshold For New Fiscal Rule Chart 28Forex Reserves Have Stabilized The recovery of oil prices and strict macroeconomic policy has allowed Russia to stabilize its foreign exchange reserves (Chart 28), although they remain at a critical level as a percent of broad money supply. However, the GDP growth recovery will be tepid and fall far short of the high growth rates of the early part of the decade (Chart 29). Chart 29Russia: ##br##Recovery Is At Hand Chart 30Inventories Remain Far ##br##Above Average Levels Russian policymakers should be cautiously optimistic. On one hand, they have been able to withstand a massive decline in oil prices. On the other, the situation is still precarious and warrants caution given the delicate situation in oil markets. OECD oil inventories remain elevated and could precipitate an oil-price collapse without OPEC's active oil-production management (Chart 30). From this macroeconomic context, we would conclude that: Russia will abide by the OPEC 2.0 production-cut agreement: While the new budget rule will go a long way in insulating the ruble from swings in oil prices, Russia is still an energy exporter. As such, we expect Russia to play ball with Saudi Arabia and continue to abide by the conditions of the OPEC deal. Thus far, Russia has been less enthusiastic in cutting production than the Saudis, but still going along (Chart 31). Russia will not destabilize the Middle East: While Russia will continue to support President Bashar al-Assad of Syria, its involvement in the civil war will abate. Moscow already began to officially withdraw from the conflict in January. While part of its forces will remain in order to secure Assad's government, Russia has no intention of provoking its newfound OPEC allies with geopolitical tensions. Russia will talk tough, but carry a small stick: Shows of force will continue in the Baltics and the Arctic, but investors should fade any rise in the geopolitical risk premium (Chart 32). It is one thing to fly strategic bombers close to Alaska or conduct military exercises near the Baltic States; it is quite another to act on these threats. In fact, Russia has been doing both since about 2004 and its bluster has amounted to very little with respect to NATO proper. This is because Russia depends on Europe for almost all of its FDI and export demand and it is only in the very early innings of replacing European demand with Chinese (Chart 33). As long as Russia lacks the pipeline infrastructure to export the majority of its energy production to China, it will be reluctant to confront Europe. Chart 31Moscow Will Play ##br##Ball With OPEC Chart 32Fade Any Spike ##br##In Geopolitical Risk Chart 33Russia Relies On Europe;##br## China Not A Replacement As we have posited in the past, energy exporters are emboldened to be aggressive when oil prices are high.14 When oil prices collapse, energy exporters become far more compliant. Nowhere is this dynamic more true than with Russia, whose military interventions in foreign countries have served as a sure sign that the top of the oil bull market is at hand! Bottom Line: We do not expect any serious geopolitical risk to emanate from Russia, despite the supposed souring of relations between the Trump and Putin administrations due to the U.S. cruise-missile strike against Syria.15 And we also do not expect President Putin to manufacture a geopolitical crisis ahead of Russia's March 2018 presidential elections, given that his popularity remains high and that the opposition is in complete disarray. While Russia may continue to talk tough on a number of fronts, investors should fade the rhetoric as it is purely for domestic consumption. Turkey: Deceitful Stability Turkey held a constitutional referendum that dramatically expands the powers of the presidency on April 16.16 The proposed 18 amendments passed with a 51.41% majority and a high turnout of 85%. As with all recent Turkish referenda and elections, the results reveal a sharply divided country between the Aegean coastal regions and the Anatolian heartland, the latter being a stronghold of President Recep Tayyip Erdogan. Is Turkey Now A Dictatorship? First, some facts. Turkey has not become a dictatorship, as some Western press allege. Yes, presidential powers have expanded. In particular, we note that: The president is now both head of state and government and has the power to appoint government ministers; The president can issue decrees; however, the parliament has the ability to abrogate them through the legislative process; The president can call for new elections; however, he needs three-fifths of the parliament to agree to the new election; The president has wide powers to appoint judges. What the media is not reporting is that the parliament can remove or modify any state of emergency enacted by the president. In addition, overriding a presidential veto appears to be exceedingly easy, with only an absolute majority (not a super-majority) of votes needed. As such, our review of the constitutional changes is that Turkey is most definitely not a dictatorship. Yes, President Erdogan has bestowed upon the presidency much wider powers than the current ceremonial position possesses. However, the amendments also create a trap for future presidents. If the president should face a parliament ruled by an opposition party, he would lose much of his ability to govern. The changes therefore approximate the current French constitution, which is a semi-presidential system. Under the French system, the president has to cohabitate with the parliament. This appears to be the case with the Turkish constitution as well. Bottom Line: Turkish constitutional referendum has expanded the powers of the presidency, but considerable checks remain. If the ruling Justice and Development Party (AKP) were ever to lose parliamentary control, President Erdogan would become entrapped by the very constitution he just passed. Is Turkey Now Stable? The market reacted to the results of the referendum with a muted cheer. First, we disagree with the market consensus that President Erdogan will feel empowered and confident following the constitutional referendum that gives him more power. This is for several reasons. For one, the referendum passed with a slim majority. Even if we assume (generously) that it was a clean win for the government, the fact remains that the AKP has struggled to win over 50% of the vote in any election it has contested since coming to power in 2002 (Chart 34). Turkey is a deeply divided country and a narrow win in a constitutional referendum is not going to change this. Chart 34Turkey's Ruling Party Struggles To Get Over 50% Of The Vote Second, Erdogan is making a strategic mistake by giving himself more power. It will focus the criticism of the public on the presidency and himself if the economy and geopolitical situation surrounding Turkey gets worse. If the buck now stops with Erdogan, it means that all the blame will go to him in hard times. We therefore do not expect Erdogan to push away from populist economic and monetary policies. In fact, we could see him double down on unorthodox fiscal and monetary policies as protests mount against his rule. While he has expanded control over the army, judiciary, and police, he has not won over the major cities on the Aegean coast, which not only voted against his constitutional referendum but also consistently vote against AKP rule. Events in Turkey since the referendum have already confirmed our view. Despite rumors that the state of emergency would be lifted following the referendum, the parliament in fact moved to expand it by another three months. Furthermore, just a week following the plebiscite, the government suspended over 9,000 police officials and arrested 1,120 suspects of the attempted coup last summer, with another 3,224 at large. This now puts the total number of people arrested at around 47,000. Investors are confusing lack of opposition to stability. Yes, the opposition to AKP remains in disarray. As such, there is no political avenue for opposition to Erdogan. The problem is that such an arrangement raises the probability that the opposition takes the form of a social movement and protest. We would therefore caution investors that a repeat of the Gezi Park protests from 2013 could be likely, especially if the economy stumbles. Bottom Line: The referendum has not changed the facts on the ground. Turkey remains a deeply divided country. Erdogan will continue to feel threatened by the general sentiment on the ground and thus continue to avoid taking any painful structural reforms. We believe that economic populism will remain the name of the game. What To Watch? We would first and foremost watch for any sign of protest over the next several weeks. Any Gezi Park-style unrest would hurt Erdogan's credibility. May Day protests saw police scuffle with protesters in Istanbul, for example. Given his penchant for equating any dissent with terrorism, President Erdogan is very likely to overreact to any sign that a social movement is rising in Turkey to oppose him. It is not our baseline case that the constitutional referendum will motivate protests, but it is a risk investors should be concerned with. Next election is set for November 2019 and the constitutional changes will only become effective at that point (save for provisions on the judiciary). Investors should watch for any sign that Erdogan's or the AKP's popularity is waning in the interim. A failure to secure a majority in parliament could entrap Erdogan in an institutional fight with the legislature that creates a constitutional crisis. Chart 35Turkey Constrained By European Ties Relations with the EU remain an issue as well. Erdogan will likely further deepen divisions in the country if he goes ahead and makes a formal break with the EU, either by reinstituting the death penalty or holding a referendum on the EU accession process. Erdogan's hostile position towards the EU should be seen from the perspective of his own insecurity as a leader: he needs an external enemy in order to rally support around his leadership. We would recommend that clients ignore the rhetoric. Turkey depends on Europe far more than any other trade or investment partner (Chart 35). If Turkey were to lash out at the EU by encouraging migration into Europe, for example, the subsequent economic sanctions, which we are certain the EU would impose, would devastate the Turkish economy and collapse its currency. Nonetheless, Ankara's brinkmanship and anti-EU rhetoric will likely continue. It is further evidence of the regime's insecurity at home. Bottom Line: The more that Erdogan captures power within the institutions he controls, the greater his insecurities will become. This is for two reasons. First, he will increase the risk of a return of social movement protests like the Gezi Park event in 2013. Second, he will become solely responsible for everything that happens in Turkey, closing off the possibility to "pass the buck" to the parliament or the opposition when the economy slows down or a geopolitical crisis emerges. As such, we see no opening for genuine structural reform or orthodox policymaking. Turkey will continue to be run along a populist paradigm. Investment Conclusions BCA's Emerging Market Strategy recommends that clients re-instate short positions on Turkish assets, specifically going short TRY versus the U.S. dollar and shorting Turkish bank stocks. The central bank's net liquidity injections into the banking system have recently been expanded again (Chart 36). This is a form of quantitative easing and warrants a weaker currency. To be more specific, even though the overnight liquidity injections have tumbled, the use of the late liquidity money market window has gone vertical. This is largely attributed to the fact that the late liquidity window is the only money market facility that has not been capped by the authorities in their attempt to tighten liquidity when the lira was collapsing in January. The fact remains that Turkish commercial banks are requiring continuous liquidity and the Central Bank of Turkey (CBT) is supplying it. Commercial banks demand liquidity because they continue growing their loan books rapidly. Bank loan and money growth remains very strong at 18-20% (Chart 37). Such extremely strong loan growth means that credit excesses continue to be built. Chart 36Liquidity Injections Reaccelerating Chart 37Money And Credit Growth Strong Besides, wages are growing briskly - wages in manufacturing and service sector are rising at 18-20% from a year ago (Chart 38, top panel). Meanwhile, productivity growth has been very muted. This entails that unit labor costs are mushrooming and inflationary pressures are more entrenched than suggested by headline and core consumer price inflation. It seems Turkey is suffering from outright stagflation: rampant inflationary pressures with a skyrocketing unemployment rate (Chart 38, bottom panel). The upshot of strong credit/money and wage growth as well as higher inflationary pressures is currency depreciation. Excessive credit and income/wage growth are supporting import demand at a time when the current account deficit is already wide. This will maintain downward pressure on the exchange rate. The currency has been mostly flat year-to-date despite the CBT intervening in the market to support the lira by selling U.S. dollars (Chart 39). Without this support from the CBT, the lira would be much weaker than it currently is. That said, the CBT's net foreign exchange rates (excluding commercial banks' foreign currency deposits at the CBT) are very low - they stand at US$ 12 billion and are equal to 1 month of imports. Therefore, the central bank has little capacity to defend the lira by selling its own U.S. dollar. Chart 38Turkish Stagflation Chart 39Turkey Props Up The Lira We also believe there is an opportunity to short Turkish banks outright. The currency depreciation will force interbank rates higher (Chart 40, top panel). Chart 40Weak Lira Will Push Interbank Rates Higher Historically, currency depreciation has always been negative for banks' stock prices as net interest margins will shrink (Chart 40, bottom panel). Surprisingly, bank share prices in local currency terms have lately rallied despite the headwinds from higher interbank rates and the rollover in net interest rate margin. This creates an attractive opportunity to go short again. Bottom Line: We are already short the lira relative to the Mexican peso. In addition, we are recommending two new trades based on the recommendations of BCA's Emerging Market Strategy: long USD/TRY and short Turkish bank stocks. Dedicated EM equity as well as fixed-income and credit portfolios should continue underweighting Turkish assets within their respective EM universes. Indonesia: A Brief Word On Jakarta Elections President Joko "Jokowi" Widodo saw his ally, Basuki Tjahaja Purnama (nicknamed "Ahok"), badly defeated in the second round of a contentious gubernatorial election on April 19. Preliminary results suggest that Ahok received 42% against 58% for his contender, Anies Baswedan, a technocrat and defector from Jokowi's camp whose own party only expected him to receive 52% of the vote. This was a significant setback. Jokowi's loss of the Jakarta government is a rebuke from his own political base, a loss of prestige (since he campaigned to help Ahok), and a boost to the nationalist opposition party Gerindra and other opponents of Jokowi's reform agenda. Ahok is a Christian and ethnic Chinese, which makes him a double-minority in Muslim-majority Indonesia, which has seen anti-Chinese communal violence periodically and has also witnessed a swelling of Islamist politics since the decline of the oppressive secular Suharto regime in 1998. Ahok fell under popular scrutiny and later criminal charges for allegedly insulting the Koran in September 2016 by casting doubt on verses suggesting that Muslims should not be governed by infidels. Mass Islamist protests ensued in November. Gerindra exploited them, as did political forces behind the previous government of Susilo Bambang Yudhoyono and trade unions opposed to the Jokowi administration's attempt to regularize minimum wage increases.17 Ahok's sound defeat shows that the opposition succeeded in making the race a referendum on him versus Islam. Despite the blow, Jokowi's popularity remains intact (Chart 41). The latest reliable polling is months out of date but puts Jokowi 24% above Prabowo Subianto, leader of Gerindra, whom he has consistently led since defeating him in the 2014 election. Jokowi remains personally popular, maintains a large coalition in the assembly, and is still the likeliest candidate to win the 2019 election. Jokowi's approval ratings in the mid-60 percentile are comparable to those of former President Yudhoyono at this time in 2007, and the latter was re-elected for a second term. Moreover Yudhoyono slumped at this point in his first term down to the mid-40 percentile in 2008 before recovering dramatically in 2009, despite the global recession, to win re-election. In other words, according to recent precedent, Jokowi could fall much farther in the public eye and still recover in time for the election. However, Jokowi will now have to shore up his support among voters with a strong Muslim identity, which is a serious weak spot of his, as indicated in the regional electoral data in Table 2. Jokowi relies on two key Islamist parties in the National Assembly. He cannot afford to let opposition grow among Muslim voters at large (notwithstanding Gerindra's own problems working with Islamist parties). Chart 41Jokowi Still Likely To Be Re-Elected In 2019 Table 2Islamist Politics A Real Risk For Jokowi He clearly faces a tougher re-election bid now than he did before. Risks to China and EM growth on the two-year horizon are therefore even more threatening than they were. And since a Prabowo victory would mark the rise of a revanchist and nationalist government in Indonesia that would upset markets for fear of unorthodox economic policies, the political dynamic will be all the more important to monitor. These election risks also suggest that traditional interest-group patronage is likely to rise at the expense of structural economic reform over the next two years. Bottom Line: We remain bearish on Indonesian assets. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Client Note, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 4 Please see BCA Emerging Markets Strategy Weekly Report, "Signs Of An EM/China Growth Reversal," dated April 12, 2017, available at ems.bcaresearch.com. 5 Please see BCA Emerging Markets Strategy Weekly Report, "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com. 6 Please see BCA Emerging Markets Strategy Weekly Report, "Toward A Desynchronized World?" dated April 26, 2017, available at ems.bcaresearch.com. 7 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016; Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017; and Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, all available at gps.bcaresearch.com. 8 Please see "Moon Jae-in's initiative for 'Inter-Korean Economic Union," National Committee on North Korea, dated August 17, 2012, available at www.ncnk.org. 9 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 10 For our latest feature update on what is one of our major themes, please see BCA Geopolitical Strategy and EM Equity Sector Strategy, "The South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 11 Please see footnote 7 above. 12 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 13 Please see BCA Emerging Markets Strategy and Geopolitical Strategy Special Report, "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat'," dated April 7, 2017, available at gps.bcaresearch.com. 16 An original version of this analysis of Turkey appeared in BCA Emerging Market Strategy Weekly Report, "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com. 17 Please see "Indonesia: Beware Of Excessive Wage Inflation" in BCA Emerging Markets Strategy Special Report, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, available at ems.bcaresearch.com.

Highlights The sequential improvement in global trade is less pronounced than the annual growth rates in the Asian trade data imply. China has been instrumental to the recovery in global trade but mainland's credit and fiscal spending impulse has rolled over decisively pointing to a relapse its growth in general and imports in particular. This will hurt meaningfully countries and sectors selling to China. Commodities prices are set to tumble. In Turkey, reinstate the short TRY versus U.S. dollar and short bank stocks trades. Feature Economic data from China and Asian trade data have been strong of late. However, when one looks ahead, China's growth and imports are set to roll over decisively in the second half of the year, based on the credit and fiscal spending impulse (Chart I-1). This will hurt countries and industries that sell to China. This is why we believe commodities prices are in a broad topping-out phase. Commodities producers and Asian economies will again suffer materially. Any possible strength in U.S. and European growth will not offset the drag on EM growth emanating from China and lower commodities prices. As a result, having priced in a lot of good news, EM risk assets are at major risk of a selloff in absolute terms and are poised to underperform their DM counterparts over the next six months. Beware Of The Low Base Effect Asian trade data have been strong, but the magnitude of recovery has not been as large as implied by annual growth rates: Annual growth rates of export values in U.S. dollar terms have surged everywhere - in Korea, Taiwan, Japan and China (Chart I-2A). Chart I-1China's Growth To Decelerate Again Chart I-2AHigh Annual Growth Rates Are Due To... Chart I-2B...Low Base In Early 2016 Chart I-2B depicts the level of export values in U.S. dollar terms. It is clear that dollar values of shipments remain well below their peak of several years ago. Looking at the annual rate of change is reasonable since it removes seasonality from the series. However, investors should be aware of the low base effect of late 2015 and early 2016 that has made these annual growth rates extraordinarily elevated in recent months. As for export volumes, Chart I-3 illustrates that volumes held up better than U.S. dollar values in late 2015, which is why they are now expanding at a moderate rate (i.e. they are not surging). In short, in the past 12 months there has been a major discrepancy between dollar values and volumes of Asian exports. Indeed, the V-shaped profile of Asian export growth rates has been partially due to price swings in tradable goods. Prices for steel and other metals as well as for petrochemical products and semiconductors dropped substantially in late 2015 and early 2016, and have rebounded materially from that low base since. Correspondingly, Asian export prices have rebounded considerably in percentage terms (Chart I-4). Chart I-3Export Volume Recovery Has Been Moderate Chart I-4Export Values Are Inflated By Rising Prices In the U.S., the low base effect from a year ago is also present in manufacturing and railroad shipments. Both intermodal (container) and carload shipment volumes excluding petroleum and coal plunged in early 2016 and recovered considerably on an annual rate-of-change basis, from a low base (Chart I-5). Chart I-5U.S. Railroad Shipments ##br##Also Had Low Base In Early 2016 All told, the skyrocketing annual rate of change of Asian export values and other global trade series is exaggerated by the fact that global trade volume was sluggish and various tradable goods/commodities prices fell precipitously in the last quarter of 2015 and first quarter of 2016, thereby creating a base effect. We are not implying that there has been no genuine recovery in global trade. Indeed, there has been reasonable sequential recovery in global demand and trade. The point is that the sequential improvement in global trade is less pronounced than the annual growth rates in the trade data imply. Importantly, China has been instrumental to the recovery in global trade and the rebound in commodities prices. Hence, the outlook for China holds the key. Looking Ahead Looking forward, there are few reasons to worry about U.S. growth. Consumer spending is robust and core capital goods orders are recovering following a multi-year slump (Chart I-6). Nevertheless, BCA's Emerging Markets Strategy team's view is that global trade growth will decelerate again because China's one-off stimulus-driven recovery will soon reverse, causing the rest of EM to also suffer: In particular, the credit and fiscal spending impulse has rolled over decisively; the indicator typically leads nominal GDP growth and mainland imports by six months, as exhibited in Chart I-1 on page 1. As Chinese import volume relapses again, economies and sectors selling to China will suffer. Chart I-7 demonstrates China's credit and fiscal spending impulses separately. Chart I-6U.S. Final Demand: No Major Risk Chart I-7China: Fiscal And Credit Impulses The credit impulse is the second derivative of outstanding corporate and household credit.1 It does not take much of a slowdown in credit growth for the second derivative, credit impulse, to roll over and then turn negative. Remarkably, narrow (M1) and broad (M2) money as well as banks' RMB loan growth have all slowed in recent months (Chart I-8). Non-bank (shadow banking) credit growth remains stable (Chart I-8, bottom panel). Yet given that the PBoC's recent tightening has targeted shadow banking activities, it is a matter of time before shadow banking credit also decelerates meaningfully. To assess real-time strength in China's economic activity, we monitor prices of various commodities trading in China. Chart I-9 demonstrates that these commodities prices have lately plunged. Chart I-8China: Money/Credit Growth Is Slowing Chart I-9Plunging Commodities Prices To be sure, commodities prices are influenced not only by final demand but also by other factors such as supply, inventory swings and investor/trader positioning. We use these data as one among many inputs in our analysis. Bottom Line: Money/credit growth has rolled over and will continue to downshift, causing the current recovery underway in China to falter. This will hurt meaningfully countries and sectors selling to China. Commodities prices are set to tumble. Market-Based Indicators Financial asset prices often lead economic data. Therefore, one cannot rely on economic data releases to time turning points in financial markets. We watch and bring to investors' attention price signals from various segments of financial markets to corroborate our investment themes and economic analysis. Presently, there are several indicators flashing warning signals for EM risk assets: The plunge in iron ore prices warrants attention as it has historically correlated with EM equities and industrial metals prices (the LMEX index) (Chart I-10). The commodities currencies index - an equal-weighted average of CAD, AUD and NZD - also points to an end of the rally in EM share prices (Chart I-11). Chart I-10Is Iron Ore A Canary In A Coal Mine? Chart I-11EM Stocks Have Defied ##br##Rollover In Commodities Currencies It appears these long-term correlations have broken down in the past several weeks. We suspect this is due to hefty fund flows into EM. In the short term, the flows could overwhelm fundamentals and prompt financial variables that have historically been correlated to temporarily diverge. However, flows can refute fundamentals for a time, but not forever. It is impossible to time a reversal or magnitude of flows as there is no comprehensive set of data on global investor positioning across various financial markets. The message of a potential relapse in Chinese imports is being reinforced by commodities currencies that lead global export volume growth, and are pointing to weakness in global trade in the second half of this year (Chart I-12). The latest erosion in the commodities currencies has occurred even though the U.S. dollar has been soft and U.S. TIPS yields have not risen at all. This makes this price signal even more important. Oil prices have recovered to their recent highs, but share prices of global oil companies have not confirmed the rebound (Chart I-13). When such a divergence occurs between spot commodities prices and respective equity sectors, the spot prices typically converge toward the equity market. This leads us to argue that oil prices will head south pretty soon. Chart I-12Commodities Currencies ##br##Lead Global Trade Cycles Chart I-13Oil Stocks Have Not Confirmed ##br##The Latest Rebound In Oil Prices The average stock (an equally-weighted equity index) is underperforming the market cap-weighted index in both the EM universe and the U.S. equity market (Chart I-14). Chart I-14Narrowing Breadth Of Equity Rally This usually occurs in two instances: (1) the rally is losing steam and narrowing to large market-cap stocks; and/or (2) the rally is being fueled by flows into ETFs that must allocate money based on market cap. Narrowing breadth of the rally is a warning signal of a top, albeit the precise timing is tricky. Bottom Line: There are several market-based indicators that herald an imminent top in EM share prices, commodities prices and other risk assets. Stay put. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Turkey: Deceitful Stability Turkey held a constitutional referendum that dramatically expands the powers of the presidency on April 16. The proposed 18 amendments passed with a 51.41% majority and a high turnout of 85%. As with all recent Turkish referenda and elections, the results reveal a sharply divided country between the Aegean coastal regions and the Anatolian heartland, the latter being a stronghold of President Recep Tayyip Erdogan. Is Turkey Now A Dictatorship? First, some facts. Turkey has not become a dictatorship, as some Western press alleged. Yes, presidential powers have expanded. In particular, we note that: The president is now both a head of state and government and has the power to appoint government ministers; The president can issue decrees, however, the parliament has the ability to abrogate them through the legislative process; The president can call for new elections, however, they need three-fifths of the parliament to agree to the new election; The president has wide powers to appoint judges. What the media is not reporting is that the parliament can remove or modify any state of emergency enacted by the president. In addition, removing a presidential veto appears to be exceedingly easy, with only an absolute majority (not a super-majority) of votes needed. As such, our review of the constitutional changes is that Turkey is most definitely not a dictatorship. Yes, President Erdogan has bestowed upon the presidency much wider powers than the current ceremonial position possesses. However, the amendments also create a trap for future presidents. If the president should face a parliament ruled by an opposition party, they would lose much of their ability to govern. The changes therefore approximate the current French constitution, which is a semi-presidential system. Under the French system, the president has to cohabitate with the parliament. This appears to be the case with the Turkish constitution as well. Bottom Line: Turkish constitutional referendum has expanded the powers of the presidency, but considerable checks remain. If the ruling Justice and Development Party (AKP) were ever to lose parliamentary control, President Erdogan would become entrapped by the very constitution he just passed. Is Turkey Now Stable? The market reacted to the results of the referendum with a muted cheer. First, we disagree with the market consensus that President Erdogan will feel empowered and confident following the constitutional referendum. This is for several reasons. For one, the referendum passed with a slim majority. Even if we assume (generously) that it was a clean win for the government, the fact remains that the AKP has struggled to win over 50% of the vote in any election it has contested since coming to power in 2002 (Chart II-1). Turkey is a deeply divided country and a narrow win in a constitutional referendum is not going to change this. Chart II-1AKP Versus Other Parties In Turkish Elections Second, Erdogan is making a strategic mistake by giving himself more power. It will also focus the criticism of the public on the presidency and himself if the economy and geopolitical situation surrounding Turkey gets worse. If the buck now stops with Erdogan, it also means that all the blame will go to him as well. We therefore do not expect Erdogan to push away from populist economic and monetary policies. In fact, we could see him double down on unorthodox fiscal and monetary policies as protests mount against his rule. While he has expanded control over the army, judiciary, and police, he has not won over support of the major cities on the Aegean coast, which not only voted against his constitutional referendum but also consistently vote against AKP rule. That said, opposition to AKP remains in disarray. As such, there is no political avenue for opposition to Erdogan. The problem is that such an arrangement raises the probability that the opposition takes the form of a social movement and protest. We would therefore caution investors that a repeat of the Gezi Park protests from 2013 could be likely, especially if the economy takes a stumble. Bottom Line: The referendum has not changed the facts on the ground. Turkey remains a deeply divided country. Erdogan will continue to feel threatened by the general sentiment on the ground and thus continue to avoid taking any painful structural reforms. We believe that economic populism will remain the name of the game. What To Watch? We would first and foremost watch for any sign of protest over the next several weeks. Gezi Park style unrest would hurt Erdogan's credibility. Given his penchant to equate any dissent with terrorism, President Erdogan is very likely to overreact to any sign of a social movement rising in Turkey to oppose him. It is not our baseline case that the constitutional referendum will motivate protests, but it is a risk investors should be concerned with. Next election is set for November 2019 and the constitutional changes will only become effective at that point (save for provisions on the judiciary). Investors should watch for any sign that Erdogan or AKP's popularity is waning in the interim. A failure to secure a majority in parliament could entrap Erdogan in an institutional fight with the legislature that creates a constitutional crisis. Chart II-2Turkey Depends On Europe Turkey ##br##Is Very Reliant On Europe Economically Relations with the EU remain an issue as well. Erdogan will likely further deepen divisions in the country if he goes ahead and makes a formal break with the EU, either by reinstituting the death penalty or holding a referendum on EU accession process. Erdogan's hostile position towards the EU should be seen from the perspective of his own insecurity as a leader: he needs an external enemy in order to rally support around his leadership. We would recommend that clients ignore the rhetoric. Turkey depends on Europe far more than any other trade or investment partner (Chart II-2). If Turkey were to lash out at the EU by encouraging migration into Europe, for example, the subsequent economic sanctions would devastate the Turkish economy and collapse its currency. Nonetheless, Ankara's brinkmanship and anti-EU rhetoric will likely continue. It is further evidence of the regime's insecurity at home. Bottom Line: The more that Erdogan captures power within the institutions he controls, the greater his insecurities will become. This is for two reasons. First, he will increase the risk of a return of social movement protests like the Gezi Park event in 2013. Second, he will become solely responsible for everything that happens in Turkey, closing off the possibility to "pass the buck" to the parliament or the opposition when the economy slows down or a geopolitical crisis emerges. As such, we see no opening for genuine structural reform or orthodox policymaking. Turkey will continue to be run along a populist paradigm. Investment Strategy On January 25th 2017, we recommended that clients take profits on the short positions in Turkish financial assets. Today, we recommend re-instating these short positions, specifically going short TRY versus the U.S. dollar and shorting Turkish bank stocks. The central bank's net liquidity injections into the banking system have recently been expanded again (Chart II-3). As we have argued in past,2 this is a form of quantitative easing and warrants a weaker currency. To be more specific, even though the overnight liquidity injections have tumbled, the use of the late liquidity money market window has gone vertical. This is largely attributed to the fact that the late liquidity window is the only money market facility that has not been capped by the authorities in their attempt to tighten liquidity when the lira was collapsing in January. The fact remains that Turkish commercial banks are requiring continuous liquidity and the Central Bank of Turkey (CBT) is supplying it. Commercial banks demand liquidity because they continue growing their loan books rapidly. Bank loan and money growth remains very strong at 18-20% (Chart II-4). Such extremely strong loan growth means that credit excesses continue to be built. Chart II-3Turkey: Central Bank ##br##Renewed Liquidity Injections Chart II-4Turkey: Money/Credit ##br##Growth Is Too Strong Besides, wages are growing briskly - wages in manufacturing and service sector are rising at 18-20% from a year ago (Chart II-5, top panel). Meanwhile, productivity growth has been very muted. This entails that unit labor costs are mushrooming and inflationary pressures are more entrenched than suggested by headline and core consumer price inflation. It seems Turkey is suffering from outright stagflation: rampant inflationary pressures with a skyrocketing unemployment rate (Chart II-5, bottom panel) The upshot of strong credit/money and wage growth as well as higher inflationary pressures is currency depreciation. Excessive credit and income/wage growth are supporting import demand at a time when the current account deficit is already wide. This will maintain downward pressure on the exchange rate. The currency has been mostly flat year-to-date despite the CBT intervening in the market to support the lira by selling U.S. dollars (Chart II-6). Without this support from the CBT, the lira would be much weaker than it currently is. Chart II-5Turkey: Stagflation? Chart II-6Turkey: Central Bank's Net FX ##br##Reserves Are Being Depleted That said, the CBT's net foreign exchange rates (excluding commercial banks' foreign currency deposits at the CBT) are very low - they stand at US$ 12 billion and are equal to 1 month of imports. Therefore, the central bank has little capacity to defend the lira by selling its own U.S. dollar. Chart II-7Short Turkish Bank Stocks We also believe there is an opportunity to short Turkish banks outright. The currency depreciation will force interbank rates higher (Chart II-7, top panel). Historically, this has always been negative for banks' stock prices as net interest margins will shrink (Chart II-7, bottom panel). Surprisingly, bank share prices in local currency terms have lately rallied despite the headwinds from higher interbank rates and the rollover in net interest rate margin. This creates an attractive opportunity to go short again. Bottom Line: Re-instate a short position in the currency. In addition, short Turkish bank stocks. Dedicated EM equity as well as fixed-income and credit portfolios should continue underweighting Turkish assets within their respective EM universes. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Gauging EM/China Credit Impulses", dated August 30, 2016, link available on page 19. 2 Please refer to the Emerging Markets Strategy Special Report titled, "Turkey's Monetary Demagoguery", dated June 1, 2016, link available on page 19. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Trump's agenda has not derailed ... at least not yet; Europe remains a red herring ... as the Dutch showed; Turkey cannot restart Europe's immigration crisis; Supply-side reforms are still likely in France; The ECB will remain dovish for longer than expected; EUR/USD may rise in the short term, but it will relapse. Feature In this Weekly Report, we focus on the key questions regarding continental European politics. To begin, however, we will briefly address the U.S., since investors are starting to worry about whether President Donald Trump can get his legislative agenda through, given the recent testimony of FBI Director James Comey on the alleged interference of Russia in the U.S. election. There are three points to focus on in the U.S.: Chart 1Trump Not Dead To Republicans Yet The GOP base supports Trump: President Trump was always going to be a controversial president. Anyone who is surprised by it today clearly was not paying attention last year. In the long term, Trump's extraordinarily low popularity will be an albatross around his neck, draining his political capital. However, until the mid-term elections, his popularity with Republican voters is all that matters, and it remains strong (Chart 1). House Republicans have to worry that they could face pro-Trump challengers in primary elections in the summer ahead of the 2018 midterms. As such, as long as the Republican voters support Trump, he still has political capital. Republicans in Congress want tax reform: Budget-busting tax reform is not only a Trump policy, it is a Republican policy. We have already received plenty of signals from fiscal hawks in Congress that they intend to use "dynamic scoring," macroeconomic modeling that takes into account revenue-positive effects of tax cuts when assessing the impact on the budget, in order to justify cuts as revenue-neutral. Republicans are also looking at the repatriation of corporate earnings and a border adjustment tax to raise revenue. Obamacare delay may not mean much: We already pointed out before that the GOP intention to focus on Obamacare first, tax reform second, would get them in trouble.1 This is now playing out. Opposing the Obamacare replacement may make sense to small-government Tea Party members. Repeal, alone, is why they are in Congress in the first place, given the 2010 wave election. But opposing tax cuts - once justified by dynamic scoring as revenue neutral - will be much more difficult. The Tea Party is "small government" first, fiscal restraint second. In other words, if tax reform cuts taxes and reduces revenue available to Washington D.C., "temporary" budget deficits will be easy to swallow. This is not to say that the recent events have not hurt the chances of whopping tax cuts and infrastructure spending. In particular, we think that Congressional GOP members may take over the agenda if Trump loses any more political capital. And this will mean less budget-busting than Trump would have done. Also, tax reform was always going to be difficult as special interests and lobbyists were bound to get involved. Chart 2French Spreads Are Overstated In addition, the probability of an eventual Trump impeachment - were Republicans to lose the House, or grassroots Republicans to abandon him in droves - has risen. Investors can no longer ignore this issue, even though it was initially a liberal fantasy. However, all of these risks to the Trump agenda will likely spur the GOP in the House to focus on passing tax reform while they still have a majority in Congress and control of the White House. We still expect tax reform to be done this year - within the fiscal year 2018 reconciliation bill - as time now may truly be running out for Republicans. Europe, meanwhile remains a focal point in client meetings. Our view that Europe will be a geopolitical red herring in 2017 - and thus an investment opportunity - remains controversial. We will address Brexit and the new Scottish independence referendum in our report next week, to coincide with London's formal invocation of Article 50 of the Lisbon Treaty to initiate the exit proceedings. Popular support for independence in Scotland has been one of our measures of "Bregret" since last summer and it has just sprung back to life, which adds a new source of risk for investors. On the continent, investors are particularly concerned that the upcoming French election will follow the populist script from the U.K. and the U.S. last year. This worry has pushed French bond yield spreads over German bonds to the highest level since 2011, bringing French bonds into the same trend as peripheral bonds (Chart 2). Since the outbreak of the euro area's sovereign debt crisis, a tight correlation between French and Italian/Spanish bonds has signified systemic political risk. We disagree that political events represent a systemic risk to the euro area in 2017. This week, we address five critical questions inspired by challenges to our view presented by our clients in meetings and conference calls. Question 1: Is The Dutch Election Result Important? Few clients have asked for a post-mortem on the March 15 Dutch election, but many asked about the vote beforehand. It has come and gone with little fanfare. Financial media have brushed it aside as it does not fit the neat script of rising Euroskepticism on the continent. To recap, the Euroskeptic and populist Party for Freedom (PVV), led by Geert Wilders, gained five seats in the election (13% of the votes cast), bringing its total support to 20 in the 150-seat parliament. Despite the gains, however, the election was an unmitigated disaster for Wilders, as the PVV was polling strong for most of the campaign and was expected to win between 30 and 35 seats (Chart 3). In terms of its share of total votes, the PVV's performance in 2017 trails its performance in the 2010 general election and the 2009 and 2014 European Parliament elections. Not only did the PVV underperform the past year's polls, but also they only managed to eke out their fourth-best performance ever. Chart 3Dutch Euroskeptics Were Always Overrated Chart 4Austria Leans Euroskeptic... Chart 5...Yet Chose A Europhile President It is a mistake to ignore these results. They teach us three valuable lessons: Trend reversal: In April of last year we warned clients that the upcoming Brexit referendum and U.S. elections had a much higher chance of populist outcomes than the European elections in 2017.2 The basis for our controversial claim was the notion that European social-welfare states dampened the pain of globalization for the middle class. We now have two elections that confirm our view that European voters are just not as angry as their Anglo-Saxon counterparts. Aside from the Dutch, there is also the lesson from the similarly ignored Austrian presidential election last December. Despite Austria's baseline as a relatively Euroskeptic country (Chart 4), the right wing, populist candidate lost his solid lead in the last few weeks ahead of the election (Chart 5). Clients should not ignore Austria and the Netherlands, since both countries have a long tradition of Euroskepticism and their populist, anti-immigration parties are well established and highly competitive. If Euroskeptics cannot win here, where can they win? It's immigration, stupid: Investors should make a distinction between anti-immigrant and anti-euro sentiment. In both the Netherlands and Austria, it was anti-immigrant sentiment that propelled populist parties in the polls. However, as the migration crisis abated, their polling collapsed. This was clearest in the Netherlands, where asylum applications to the EU - advanced by six months - tracked closely with PVV polling (Chart 6). The distinction is highly relevant as it means that even if the populists had taken power, they would not necessarily have had enough political support to take their country out of the euro area. This is particularly the case in the Netherlands, where support for the euro remains high (Chart 7). Brexit is not helping: Much ink has been spilt in the media suggesting that Brexit would encourage voters in Europe to hold similar popular referendums. We disagreed with this assertion and now the evidence from Austria and the Netherlands supports our view.3 Chart 3 shows that the decline in the PVV's support sped up around the time of the U.K. referendum, suggesting that Brexit may even have discouraged voters from voting for the populist option. Geert Wilders was temporarily buoyed by the kangaroo court accusing him of racial insensitivity. But the sympathy vote quickly dissipated and PVV polling reverted back to the post-Brexit trend.4 Chart 6Dutch Populists Linked To Immigration Chart 7The Dutch Approve Of The Euro Bottom Line: The election in the Netherlands provides an important data point that should not be ignored. The populist PVV not only failed to meet polling expectations, it failed to repeat its result from seven years ago. Investors are ignoring how important the abating of the migration crisis truly was for European politics. Question 2: Can Turkey Restart The Immigration Crisis? The end of the migration crisis in Europe clearly played a major role in dampening support for the Dutch and Austrian populists. We expected this in September 2015, when we argued with high conviction that the migration crisis would prove ephemeral (Chart 8).5 How did we make the right call at the height of the influx of asylum seekers into Europe? Three insights guided us: Civil wars end: No civil war can last forever. Eventually, battle lines ossify into de facto borders between warring factions and hostilities draw to a close. The Syrian Civil War is still going, but its most vicious phase has ended. Civilians have either moved into safer zones or, tragically, have perished. Enforcement increases: The influx of 220,000 asylum seekers per month - the height of the crisis in October 2015 - was unsustainable. Eventually, enforcement tightens. This happened to the "Balkan route" as countries reinforced their borders and Hungary built a fence. Liberal attitudes wane: European attitudes towards migrants soured quickly as the crisis escalated. After the highly publicized welcoming message from Chancellor Angela Merkel, the tone shifted to one of quiet hostility. This significantly changed the cost-benefit calculus of the economic migrants most likely to be deported. Given that roughly half of asylum seekers in 2015 were not fleeing war, but merely looking for a better life, the change in attitude in Europe was important. Many of our clients are today worried that Turkey might deliberately restart the migration crisis as a way to punish Europe amidst ongoing Euro-Turkish disputes. The rhetoric from Ankara supports this concern: Turkish officials have threatened economic sanctions against the Netherlands, and accused Germany of supporting the July 2016 coup and the U.S. of funding the Islamic State. We call Turkey's bluff on this threat. First, the number of migrants crossing the Mediterranean collapsed well before the EU-Turkey deal was negotiated in March 2016. This puts into doubt Turkey's role in dampening the flow in the first place. Second, unlike in 2015, Turkey is now officially involved in the Syrian conflict, having invaded the country last August. By participating directly, Turkey can no longer tolerate the unfettered flow of migrants through its territory to Europe, a luxury in 2015 when it was a "passive" bystander. Today, migrants flowing through its territory are even more likely to be parties active in the Syrian war looking to strike Turkish targets for strategic reasons. Third, the Turkish economy is reliant on Europe for both FDI and export demand (Chart 9). If Turkey were to lash out by encouraging migration into Europe, the subsequent economic sanctions would devastate the Turkish economy and collapse its currency. Investment and trade with Europe make up the vast majority of its current account deficit. Chart 8Migration Crisis Well Past Its Peak Chart 9Turkey Depends On Europe Bottom Line: Turkey can make Europe's life difficult. However, the migration crisis did not end because of Turkey and therefore will not restart because of Turkey. Furthermore, Ankara has its own security to consider and will continue to keep its border with Syria closed and closely monitored. Question 3: Is A Supply-Side Revolution Still Possible In France? In February, we posited that a supply-side revolution was afoot in France.6 Since then, the Thatcherite candidate for presidency - François Fillon - has suffered an ignominious fall in the polls due to ongoing corruption scandals. This somewhat dampens our enthusiasm, given that Fillon's program was by far the most aggressive in proposing cuts to the size of the French state. Still, the new leading candidate Emmanuel Macron (Chart 10) is quite possibly the most right-wing of left-wing candidates that France has ever fielded. He quit the Socialist Party and has received endorsements across the ideological spectrum. In addition, his governing program is largely pro-market: Public expenditure will go down to 50% of GDP (from 57%) by 2022; Corporate taxes will be reduced from 33.3% to 25%; Regulation will be simplified for small and medium-sized businesses; Productive investment will be exempt from the wealth tax, which will focus solely on real estate; Exceptions to the 35-hour work week will be allowed at the company level. More important than Macron's campaign promises is the evidence that the French "median voter" is shifting. Polls suggest that a "silent majority" in France favors structural reform (Chart 11). Chart 10Macron's Huge Lead Over Le Pen Chart 11France: 'Silent Majority' Wants Reform As such, France may be ready for reforms and Emmanuel Macron could be France's Gerhard Schröder, a centrist reformer capable of pulling the left-wing towards pro-market reforms. What about the fears that Macron will not be able to command a majority in France's National Assembly? Macron's party En Marche! was founded less than a year ago and is unlikely to be competitive in the upcoming June legislative elections (a two-round election to be held on June 10 and 17). This will force Macron, should he win, to "cohabitate" with a prime minister from another party. Most likely, this will mean a prime minister from the center-right Republicans. For investors, this could be very positive. The French constitution gives the National Assembly most power over domestic affairs when the president cannot command a majority. This means that a center-right prime minister who receives his mandate from Macron will be in charge of domestic reforms. We see no reason why Macron would not be able to work with such a prime minister. In fact, the worse En Marche! does in the parliamentary election, the more likely that Macron will be perceived as non-threatening to the center-right Republicans. What if no party wins a majority in parliament? We think that Macron would excel in this situation. He would be able to get support from the right-wing of the Socialist Party and the centrist elements of the Republicans. And if the National Assembly fails to support his program, he could always call for a new parliamentary election in a year's time, given his presidential powers. In other words, investors may be unduly pessimistic about the prospect of reforms under Macron. Several prominent center-right figures - including Alain Juppé and Manuel Valls - have already distanced themselves from Fillon, perhaps opening up the possibility of a premiership under Macron. In addition, Macron himself has refused to accuse Fillon of corruption, a smart strategy given that he will need his endorsement in the second round against Le Pen and that he will likely need to cohabitate with the Republicans to govern. What of Marine Le Pen's probability of winning? At this point, polling does not look good for her. Not only is she trailing Macron by 22% in the second round, but she is even trailing Fillon by 11%. Nonetheless, we suspect that she will close the gap over the next month. Election momentum works in cycles and she should be able to bounce back, giving investors another scare ahead of the election. Bottom Line: Concerns over Emmanuel Macron's ability to pursue structural reforms are overstated. Yes, he is less ideal of a candidate than Fillon from the market's perspective, but no, we do not doubt that he would be able to cohabitate with a center-right parliament. That said, we cannot pass definitive judgment until the parliamentary election takes place in June. Question 4: Will Germans Want A Hawk In 2019? An Austrian member of the ECB Governing Council, Ewald Nowotny, spooked the markets by suggesting that Bundesbank President Jens Weidmann would be one of the two most likely candidates to replace Mario Draghi in 2019. Weidmann is a noted hawk who has opposed the ECB's easy monetary policy and even testified against Angela Merkel's government during the court case assessing the constitutionality of the ECB's Outright Monetary Transactions (OMT). The prospect of a Weidmann ECB presidency fits the narrative that Germans will want a hawk to replace Mario Draghi in 2019. The idea is that by 2019, inflation will be close to the ECB's target of 2% and Germans would be itching to beat it down. We have heard this view from colleagues and clients for some time. And we have disagreed with it for quite some time as well! As we pointed out in 2012, it was a German political decision to shift the ECB towards a dovish outlook.7 This is not to say that the ECB takes its orders from Berlin. Rather, it is that Chancellor Merkel had plenty of opportunities via personnel decisions to ensure that the ECB followed a more monetarist and hawkish line. For example, she could have signed off on former Bundesbank President Axel Weber, who was the leading candidate for the job in 2011. She refused when Weber signaled his opposition to the ECB's initial bond-buying program (the Securities Market Program). Mario Draghi was quickly tapped as the alternative candidate suitable to Berlin. Later in 2011, ECB Executive Board member Jürgen Stark resigned over opposition to the same ECB bond-buying program. Since Stark was the German member of the Executive Board, convention held that Berlin would propose his replacement. In other words, while Merkel had her pick of Germany's foremost economists, she picked her finance minister's deputy, Jörg Asmussen. Neither Draghi nor Asmussen have a strand of monetarist or inflation-hawk DNA between the two of them. ECB policy has not been dovish by accident but by design. While it is true that the ECB will inhabit a different macro environment in 2017-19 from the crisis of 2011-12, nevertheless we suspect that dovishness will continue beyond 2019 for two key reasons: German domestic politics: Germans are not becoming Euroskeptic, they are turning rabidly Europhile! If the polls are to be believed, Germans are now the most pro-euro people in Europe (Chart 12). Martin Schulz, chancellor-candidate of the center-left Social Democratic Party (SPD), is campaigning on an aggressive anti-populist, pro-EU platform. He has accused Merkel of being too reticent and of providing Europe's Euroskeptics with a tailwind due to her policies. The SPD's recent climb in the polls is stunning (Chart 13). But even if Schulz fails to win, Merkel will have to take into account his brand of politics if she intends to reconstitute the Grand Coalition with the SPD. It is highly unlikely that Schulz will sign off on a hawkish ECB president (or on the return of Finance Minister Wolfgang Schäuble for that matter). Italian risks: While we have been sanguine about this year's political risks, the Italian election slated for February 2018 is set for genuine fireworks. Euroskeptic parties have now taken a lead in the polls (Chart 14). While the election is still too close to call, and a lot of things can happen between now and then, we expect it to be a risk catalyst in Europe. The problem with Italy is that the election is unlikely to provide any clarity. A hung parliament will likely produce a weak, potentially minority government. Given Italy's potential GDP growth rate of about 0%, this means that a weak government will at some point have to deal with a recession, heightening political risks beyond 2018. Chart 12Germans Love The Euro Chart 13Pro-Europe Sentiment Drives SPD Revival Chart 14Italian Elections: The Big Risk Bottom Line: Italy will hang over Europe like a Sword of Damocles for quite some time. The ECB will therefore be forced to remain dovish a lot longer than investors think. We see no evidence that Berlin will seek to reverse this policy. In fact, given the political paradigm shift in Germany itself, we suspect that Berlin will turn more Europhile over the next several years. Question 5: What Is The Big Picture For Europe? What explains the dogged persistence of support for European integration on the continent? Even in the case of Italy - where Euroskepticism is clearly on the rise - we would bet on voters supporting euro area and EU membership in a referendum (albeit with a low conviction). Why? In 2011, at the height of the euro area sovereign debt crisis, we elucidated our view on the long-term trajectory of European integration.8 We highly recommend that our clients re-read this analysis, as it continues to inform our net assessment of Europe. Our assertion in 2011 was that Europe is integrating out of weakness, not out of misplaced hope of strength. Much of the analysis in the financial community and media does not understand this point. It therefore rejects the wisdom of integration on the basis that Europhile policymakers are blinded by ambition. In our view, they are driven by necessity. As Chart 15 suggests, the average "hard power" of the five largest economies in the euro area (the EMU-5) is much lower than the average "hard power" of the BRIC states.9 European integration is therefore an attempt to asymptotically approach the aggregate, rather than the average, "hard power" of the EMU-5. Europe will never achieve the aggregate figure, as that will require a level of integration that is impossible. But the effort lies beneath European policymakers' goal of an "ever closer union." The truth of the matter is that European nation-states - as individual sovereign states - simply do not matter anymore. Their economic weight, demographics, and military strength relative to other nations are a far cry from when Europe dominated the world (Chart 16). Chart 15European Integration Is About Geopolitics... Chart 16...And Global Relevance If European countries seek to shape their geopolitical and macroeconomic environment, they have to act in unison. This is not a normative statement, it is an empirical fact. This means that everything from Russian assertiveness and immigration crises to energy policy and trade negotiations have to be handled as a bloc. But is this not an elitist view? To what extent do European voters think in such grand geopolitical terms? According to polling, they think this way more than most analysts are willing to admit! Chart 17 shows that most Europeans - other than the British and Italians - are "in it" for geopolitical relevance and security, and only secondarily for economic growth. Even in Italy, geopolitical concerns are more important than economic performance, although levels of both suggest that Italy is again the critical risk for Europe. We suspect that it is this commitment to the non-economic goals of European integration that sustains the political commitment of both elites and the general public to the European project. As Chart 18 suggests, European voters continue to doubt that their future will be brighter outside of the bloc. Chart 17Voters Grasp The EU's Purpose ... Chart 18...And Most Want To Stay In It Bottom Line: European integration is not just an economic project. Voters understand this - not in all countries, but in enough to sustain integration beyond the immediate risks. Given this assessment, it is not clear to us that the project would collapse even if Italy left. Investment Implications Given our political assessment, we continue to support the recommendation of our colleague Peter Berezin that investors overweight euro area equities in a global portfolio.10 As Peter recently elucidated, capital goods orders continue to trend higher, which is a positive for investment spending on a cyclical horizon - helping euro area assets (Chart 19). Furthermore, private-sector credit growth remains robust, despite political risks (Chart 20). Chart 19European Economy Looking Up Chart 20Credit Growing Well Despite Election Risk Over the next 6-12 months, we see EUR/USD rising, especially as the ECB contemplates tapering its bond purchases. We recommend a tactical long EUR/USD trade as a result. The euro could rise higher if the Trump administration disappoints the market on tax reform and infrastructure spending, policies that were supposed to supercharge the U.S. economy and prompt further Fed hawkishness. Over the long term, however, we doubt that the ECB will have the luxury of hawkishness. And we highly doubt that Berlin will rebel against dovish monetary policy. In fact, investors may be using the wrong mental map if they are equating Mario Draghi's taper with that of Ben Bernanke. While Bernanke intended to signal eventual tightening, Draghi will likely do everything in his power to dissuade the market from believing that interest rate hikes are inevitably coming soon. Therefore, we suspect that EUR/USD will eventually hit parity, after a potential rally in 2017. While this long-term depreciation may make sense from a political and macroeconomic perspective for Europe, it will likely set the stage for a geopolitical confrontation between the Trump Administration and Europe sometime next year. Marko Papic, Senior Vice President marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy," dated April 13, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 4 The media has suggested that the PVV merely suffered because of the Turkey-Netherlands spat over Turkish political campaigning in the Netherlands. We see no evidence of this. First, the PVV's collapse in the polls predates the crisis by several weeks. Second, the crisis had all the hallmarks of a trap for the establishment. It is not the fault of incumbent Prime Minister Mark Rutte for adeptly capitalizing on the situation. 5 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 7 Please see "Draghi And Asmussen, Not The OMT, Are A Game Changer," in BCA Geopolitical Strategy Monthly Report "Fortuna And Policymakers," dated October 10, 2012, available at gps.bcaresearch.com. 8 Please see BCA Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at bca.bcaresearch.com. 9 As measured by the BCA Geopolitical Power Index. 10 Please see BCA Global Investment Strategy Weekly Report, "Three Battles That Will Determine The Euro Area's Destiny," dated March 10, 2017, available at gis.bcaresearch.com.

Highlights Mexico and China are not the only countries that could suffer from U.S. trade protectionism. Malaysia, Korea, Taiwan and Thailand are also at risk. The global inflationary versus deflationary impact of U.S. trade protectionism will depend on the magnitude of exchange rate adjustments. Currencies will adjust to redistribute the inflationary and deflationary impact of U.S. tariffs and Border Adjustment Taxes between the U.S. and the rest of the world. Go long three-month volatility in the KRW, the MYR and the THB. The Turkish lira has approached our target of TRY/USD 3.9. Investors should book profits for now and reinstate short if the lira rebounds to 3.5 Feature Chart I-1Are Share Prices Discounting ##br##U.S. Trade Protectionism? The odds of a considerable rise in U.S. trade protectionism have ratcheted up since President Donald Trump's victory in early November, yet global share prices have been sanguine about it. Equities have instead focused on the positives of Trump's agenda such as fiscal stimulus and deregulation. Does this mean that the marketplace is overly complacent? One can argue that potential trade wars are a well-known risk, and as such are already discounted in share prices. It is also possible to argue that the equity markets did not fall at all ahead of and following Trump's victory to discount potential negatives from trade protectionism. The only market that has reacted to discount looming trade restrictions is Mexico, specifically the peso and its fixed-income markets. However, the ramifications of U.S. trade protectionism will reverberate well beyond Mexico. Global ex-U.S. share prices have not corrected at all to discount the potential negatives (Chart I-1). Unless the U.S. dollar surges, U.S. manufacturers will likely benefit from protectionist measures. However, U.S inflation and interest rates will rise in this scenario, weighing on equity valuation multiples. Overall, the majority of America's trade partners are at risk. In this week's report, we assess the vulnerability of various EM countries to the U.S. trade assault. U.S. trade restrictions will take the form of either import tariffs, a Border Adjustment Tax (BAT),1 or a mix of both. We conclude that buying volatility of select EM currencies is one way to profit from budding U.S. protectionism. Vulnerability To A U.S. Trade Assault Below we analyze which EM economies are most at risk from U.S. import tariffs and BAT. Given it is impossible to know whether the U.S. will adopt import tariffs, a BAT, or some combination of the two, we evaluate the impact on developing countries from both measures. Import tariffs: To assess each country's exposure to potential import tariffs, we examine the size of export shipments to America relative to that country's GDP. Table I-1 shows that Mexico, Canada, Malaysia, Taiwan and Thailand have the largest exports to the U.S. as a share of their economy. For Mexico, Canada and Malaysia, we exclude oil shipments to the U.S., as it is not clear whether oil will be subject to import tariffs. BAT: The principal variable gauging a country's vulnerability to a BAT is its trade balance with the U.S. This is because a BAT is both a penalty on imports into the U.S. as well as a subsidy on American exports. Hence, this analysis has to take into consideration not only a country's shipments to the U.S. but also American producers' exports to that country. Table I-2 shows the size of each country's trade balance with the U.S. as a share of its GDP. Table I-1Vulnerability To U.S. Import Tariffs Table I-2Vulnerability To BATs Again, for Mexico, Canada and Malaysia, we exclude the oil trade balance with the U.S. from the calculation. 3. Combined vulnerability ranking. Lack of clarity on trade policy specifics the U.S. is going to adopt means that we may need to synthesize the above analysis, combining the vulnerability ranking on both measures into one. Chart I-2 plots trade balances on the X axis and exports to the U.S. on the Y axis. It appears Malaysia, Mexico, Taiwan and Thailand are the most vulnerable, based on both criteria. Chart I-2Vulnerability To U.S. Import Tariffs And Border Adjustment Taxes Another way to generate a vulnerability ranking is to calculate an aggregate score based on Tables I-1 and I-2 because either import tariffs, a BAT or some combination of the two will be adopted by the U.S. The aggregate vulnerability score is presented in Chart I-3. Chart I-3U.S. Trade Protectionism Vulnerability Ranking According to the overall vulnerability score, Mexico, Malaysia, Taiwan, Thailand and Korea are the most exposed to potential U.S. trade protectionism measures. By contrast, Turkey, Brazil and Chile are the least exposed. Bottom Line: Mexico and China are not the only countries that could suffer from U.S. trade protectionism. Malaysia, Korea, Taiwan and Thailand are also at risk. On the flip side, Turkey and Brazil are the least exposed to a U.S. trade assault. We remain short many EM exchange rates versus the U.S. dollar including the Malaysian, Korean and Colombian currencies, and reiterate these positions today. Traders who are not positioned this way or have been stopped out should consider reinstating these trades (the full list of our currency recommendations). As for the Mexican peso, it has undershot relative to other EM currencies. We have not been bullish on the MXN versus the USD, though in recent months have recommended going long the MXN versus the BRL and ZAR. These trades have so far produced large losses, but we expect the MXN to recover some of those losses on its crosses. Are Trade Barriers Inflationary Or Deflationary? We consider three scenarios: Chart I-4U.S.: Rising Unit Labor Costs ##br##Warrant Higher Core Inflation 1. Without an exchange rate adjustment (U.S. dollar appreciation), import tariffs and BATs will be inflationary for the U.S. and deflationary for the rest of the world. In this scenario, the prices of imported goods will rise in U.S. dollars and U.S. consumers will end up paying for the tariff/border taxes or exporters will see their U.S. dollar revenues plummet or some combination of the two. U.S. manufacturers will become competitive with higher prices of imported goods, and U.S. employment and resource utilization will mount, heightening domestic inflationary pressures. Even though non-energy imports make up only 11% of U.S. GDP, the inflationary impact of trade protectionism will be pervasive. The reason being that it will tighten the resource utilization in the American economy in general, and the labor market in particular. Currently, the U.S. labor market is tight, wages are accelerating and unit labor costs are rising (Chart I-4). Further strength in demand due to potential fiscal stimulus, import substitution, and a further revival of confidence, will lead to even higher wage inflation and an acceleration in unit labor costs. This, along with rising prices for imported goods, will produce higher inflation. That said, it is likely that American consumers cannot handle a drastic price hike in imported goods, so higher selling prices will entail less demand. For the rest of the world, the same scenario will be very deflationary. Countries with large exports to the U.S. will experience a plunge in their shipments to America, income/profit growth will tank, and domestic demand will dwindle. In aggregate, this scenario will be inflationary for the U.S. and deflationary for the rest of the world - there will be meaningful losses in global output. 2. With "full" exchange rate adjustments, the import tariffs and BATs will be neutral for the U.S. and the rest of the world. But for this to occur, the U.S. dollar has to overshoot. Chart I-5Exchange Rates Have##br## Made A Difference In this scenario, imported goods prices in U.S. dollars will remain the same, given tariffs/BATs are entirely offset by a strong dollar. For exporters, their U.S. dollar revenues will plunge but their currency depreciation will restore the value of shipments to the U.S. in local currency terms (Chart I-5). In brief, the "full" currency depreciation will reflate exporter economies in local currency terms. Given that the rate of tariffs or BATs will likely exceed 15-20%, potential U.S. dollar appreciation will need to be dramatic to produce this scenario. In turn, the considerable dollar appreciation will cap inflationary pressures in the U.S. There will be little, if any, impact on global output. 3. With "partial" exchange rate adjustment (moderate dollar appreciation), the impact of tariffs or BATs will be split between U.S. consumers facing somewhat higher prices for imports and exporters who will suffer declines in revenues in local currency terms, though not as much as in the case of no currency deprecation. Consequently, this scenario will be mildly inflationary for the U.S. and modestly deflationary for the rest of the world. Yet, there will also be a small loss of global output - i.e., global GDP growth will be negatively impacted. Odds favor scenarios two and three - i.e., the greenback is set to appreciate, but it is not clear whether it will rise enough to entirely offset the impact of import tariffs or BATs and preclude decline in global growth. Bottom Line: The inflationary versus deflationary impact of U.S. trade protectionism will depend on exchange rate adjustments and their magnitude - i.e., currencies will move to redistribute the inflationary and deflationary impact of U.S. tariffs and BATs. Overall, the U.S. dollar is set to appreciate meaningfully and probably overshoot before topping out. Go Long EM FX Volatility Given central banks outside the U.S. - both in DM ex-U.S. and EM - are attempting to keep interest rates low, odds favor considerable appreciation in the U.S. dollar, or at least a material rise in exchange rate implied volatility. When monetary authorities control interest rates, the entire burden of adjustment falls on exchange rates. In brief, exchange rates have to move a lot - the U.S. dollar would have to overshoot - to prevent a hit to global output. Investors should consider betting on higher exchange rate volatility. In spite of rising odds of U.S. trade protectionism, EM and DM currency volatility has so far remained surprisingly tame (Chart I-6). We feel there is a trade opportunity here, and today we recommend investors go long select EM exchange rate volatilities. Chart I-7 plots the U.S. trade vulnerability score on the X axis, and exchange rate volatility - more specifically, the standardized 3-month implied currency volatility - on the Y axis. According to Chart I-7, it appears that by historical standards, the current level of volatility of MYR, THB and KRW are low when considering these countries' vulnerability to U.S. trade protectionism. Therefore, investors should go long 3-month implied volatility for the KRW, the MYR and the THB. Chart I-6Exchange Rate Volatility In ##br##Historical Perspective Chart I-7Go Long Currency VOLs in Korea, ##br##Malaysia, And Thailand In addition, the volatility in these Asian currencies will rise and the RMB depreciate further. Bottom Line: To capitalize on a potential rise in global currency volatility, traders should go long three-month volatility in the KRW, the MYR and the THB. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Taking Profits On Turkish Shorts For Now In our December 7, 2016 Special Report 2 we argued that the odds of the lira being vigorously defended by the authorities or some sort of capital controls being implemented in Turkey would increase as the exchange rate approached USD/TRY 3.9. Given the exchange rate has come close to that level, we recommend that traders book profits on our Turkish short positions. The idea is to protect profits and capital in the case of capital controls. It is impossible to know whether the Turkish authorities will opt for capital controls, as it is a political decision. Yet, the risk is non-trivial. Furthermore, the rhetoric from Turkish President Recep Tayyip Erdogan suggests3 he views foreign investors as the main culprits for the nation's current financial debacle. President Erdogan will not shy away from hurting foreign investors via the introduction of capital controls and create the perception of financial stability. The central bank has been very active in recent weeks. Apart from hiking the overnight lending rate this week, it has recently curtailed liquidity injections into the banking system: Chart II-1Turkey: A Decline in Liquidity Provision On January 10, the Central Bank of Turkey (CBT) announced that it will place borrowing limits of TRY $22 billion in the Interbank Money Market, effectively limiting the volume of liquidity the central bank provides to commercial banks. Given the lira continued to slide, three days later, the CBT decided to move the interbank money market borrowing limit even lower at TRY $11 billion, effective January 16. That said, since January 10, the CBT has injected TRY $9.5 billion, on average per day, via the overnight window, and TRY $27 billion via the late liquidity window, albeit at higher interest rates than at the overnight window. Hence, the CBT has still injected a meaningful amount of liquidity into the banking system, but it has done so at higher interest rates. All in all, the CBT has curtailed liquidity injections in order to avoid further lira depreciation (Chart II-1, top panel). As a result, interest rates have risen sharply (Chart II-1, bottom panel). Yet, it is not certain that the central bank has tightened liquidity enough. Going forward, there are two main risks: either the CBT's liquidity tightening will be too little, and therefore the lira will continue to plunge, or, there will be considerable liquidity tightening, which will stabilize the exchange rate, but cascade the economy into major recession. Both scenarios are bearish for foreign investors holding Turkish stocks and credit. As we have discussed at length in previous reports, monetary authorities can control either the exchange rate or interest rates, but not both simultaneously. The CBT has been trying unsuccessfully to exercise control over both. To stabilize the exchange rate, the CBT has to drastically curtail its injections of local currency liquidity into the system. In such a case, however, interest rates will surge. Continued attempts to cap interest rates entail a further collapse in the lira's value. The only other option is to introduce capital control (i.e. close the capital account) in order to get control over both interest rates and the currency. Higher interest rates are not politically acceptable, as they will push the economy into deep recession. The reason being that domestic credit growth has been enormous in recent years, and higher interest rates will suffocate the economy. Yet not hiking the policy rate, or allowing interbank interest rates to rise, will all but ensure a deeper crash in the exchange rate. With the industrial sector already showing signs of weakness and the consumer sector flat, a decrease in loan growth will send the already weak economy into recession (Chart II-2). Yet, mushrooming money and credit growth, along with very high inflation in Turkey, justify higher interest rates: Local currency money and credit growth is too strong (Chart II-3). Unless these slow down, the lira will continue to decline. Chart II-2Turkey: Economy Is Heading##br## Into Recession Chart II-3Money/Credit Creation ##br##Has Been Too Rampant Genuine inflationary pressures are too ubiquitous: manufacturing and service sector wages have grown by about 20% over the past 12 months (Chart II-4). In brief, such genuinely high inflation, coupled with still low rates, are bearish for the currency. Robust credit and income/wage growth are supporting import demand, and the current account deficit is wide. This is another bearish factor for the exchange rate. In short, the lira has further room to fall. Remarkably, according to the real effective exchange rates based on unit labor costs as well as consumer prices, the lira is still not very cheap, making it vulnerable to further depreciation (Chart II-5) Chart II-4Turkey: 20% Wage Inflation Chart II-5The Turkish Lira Can Get Cheaper Even more surprising, despite a more than 20% depreciation against the U.S. dollar last year, foreign investors' holdings of Turkish equities and government bonds has not dropped significantly (Chart II-6). Finally, bank share prices in local currency terms have risen despite the spike in interest rates (Chart II-7). This entails that this bourse, which is dominated by bank stocks, is not pricing in risks from higher interest rates. Chart II-6Will Foreigners Capitulate On Turkish Assets? Chart II-7Bank Share Prices Have Held Up So Far Investment Recommendations: Currency and fixed income traders should take profits on our short TRY / long USD trade, as well as our short 2-year Turkish bond trade. These have returned a 24% and a 20%, respectively, since January 17, 2011 and June 1, 2016. That said, investors should consider shorting the lira versus the U.S. dollar again if the exchange rate rebounds to TRY/USD 3.5. We recommend equity traders book profits on our short Turkish banks position, which has registered a return of 60% since June 4, 2013. Dedicated EM equity and fixed income investors (both credit and local-currency bonds) should continue to underweight Turkey. Absolute-return and non-dedicated EM investors should minimize their exposure to Turkish financial markets. Stephan Gabillard, Research Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Global Investment Strategy Special Report, titled "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017", dated January 20, 2017, available at www.gis.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Report, titled "Turkey: Military Adventurism And Capital Controls", dated December 7, 2016 available at ems.bcaresearch.com 3 President Erdogan, speaking at the 34th meeting with village chiefs at the Presidential Palace in Ankara, said "Everyone already sees and knows the attacks that Turkey has been subjected to also have an economic aspect. There is no difference between a terrorist who has a weapon or bomb in his hand and a terrorist who has dollars, euros and interest in terms of aim. The aim is to bring Turkey to its knees, to take over Turkey and to distance Turkey from its goals. They are using the foreign exchange rate as a weapon". Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Dear Client, I am visiting clients in Saudi Arabia, Abu Dhabi, and India this week, and as such there will be no regular Weekly Report. Instead, we are sending you a Special Report written by my colleague Marko Papic, Senior Vice President, BCA's Geopolitical Strategy service. Marko argues that the Middle East has reached a stable equilibrium, as much as is possible, and will not drive the news or markets in 2017. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights The Middle East is not a major geopolitical risk in 2017. Saudi-Iranian and Russo-Turkish tensions will de-escalate, for now. The OPEC production cut will go through; oil prices will average $55/bbl in 2017. Geopolitical risk continues to rotate to the Asia Pacific region. Trump, Iranian elections, and Iraqi instability pose risks to the view. Feature The Middle East has dominated the news flow for the past five years, for good reason. The carnage in Syria and Iraq is tragic and reprehensible. However, the investment relevance of the various regional conflicts is dubious. For all the attention paid to the rise of the Islamic State, we would remind clients that the group's conquest of Iraq's second-largest city Mosul in June 2014 did not cause a spike in oil prices but rather marked the end of the bull market (Chart 1)! From an investment perspective, the only dynamic worth watching in the Middle East is the "Great Game" between regional actors, which have been looking to fill the vacuum left by America's dramatic geopolitical deleveraging (Chart 2). The U.S. strategy is permanent and driven by global interests, namely the rise of China and the need to shift resources towards East Asia. Given the incoming Trump administration's laser focus on China, we expect that the U.S. will remain aloof from the Middle East. Chart 1Ironically, Worry About The Fall Of ISIS Chart 2While The U.S. Military Deleverages... Does the recent détente between Russia and Turkey in Syria, and between Iran and Saudi Arabia over OPEC production cuts, signal that the Middle East has finally found geopolitical equilibrium? We tentatively think the answer is yes. This will reduce the importance of the region as the primary source of geopolitical risk premia, which BCA's geopolitical strategists have expected to shift to Asia for some time.1 Saudi-Iranian Tensions Are On Ice Chart 3...The Saudi Arabian Military Leverages Up Since the U.S. decision to deleverage from the region in 2011, Saudi Arabia has leveraged up, becoming one of the world's largest arms purchasers and involving itself overtly and covertly in several regional conflicts in the process (Chart 3). Saudi insecurity deepened following President Barack Obama's decision to leave no troops in Iraq. The last U.S. soldier of the main occupation force left Iraq on December 18, 2011. The very next day, on December 19, Iraq's Shia Prime Minister Nuri al-Maliki, a close ally of Iran, issued an order for the arrest of the Sunni Vice-President Tariq al-Hashimi. The move by al-Maliki set off what essentially became a civil war in the country, with the Sunni minority eventually turning to ever-more radicalized militant groups for protection. From the Saudi perspective, Iraq is a vital piece of real estate as it is a natural buffer between itself and its Shia rival Iran. While the Fifth Fleet of the U.S. Navy, based in Bahrain, continues to guard against any Iranian incursion via the Persian Gulf, there is very little space between the Saudi oil fields and Iran if Iraq falls into Iran's orbit. The subsequent five years saw Iran and Saudi Arabia fight several proxy wars in Iraq, Syria, and Yemen. These included direct military action by Iran in Iraq and Syria against Saudi-backed militants and by Saudi Arabia in Yemen against Iranian-backed militants. It also included oil politics, with Saudi Arabia announcing in November 2014 that it was ending years of its price-setting strategy. These strategies ultimately proved to be unsustainable and BCA's Geopolitical Strategy called the peak in Saudi-Iranian tensions in February 2016.2 Why? First, because oil prices collapsed! Geopolitical adventurism is a luxury afforded to those with the means to pursue adventures. The combination of low oil prices, domestic social outlays, and an expensive war in Yemen forced Saudi Arabia to burn through $220 billion of its foreign reserves between July 2014 and December 2016, equivalent to 30% of its central-bank holdings!3 There is a relationship between high oil prices and aggressive foreign policy in oil-producing states (Chart 4). Political science research shows that the relationship is not spurious. As Chart 5 illustrates, petrol states led by revolutionary leaders are much more likely to engage in militarized international disputes.4 This relationship is particularly pronounced when oil sells at above $70 per barrel. At that price, oil producing states become more prone to disputes than non-oil states, regardless of leadership qualities. Second, Saudi Arabia's military campaign in Yemen proved to be a disaster. The kingdom intervened in March 2015 to reinstate the democratically elected President Abdrabbuh Mansour Hadi, who had been removed from power by Iranian-linked Houthi rebels. The real reason for the intervention was for the Saudis to gauge their war-making capabilities, test their recently purchased military equipment, and put a check on Iranian influence in the region. A quick, successful war in Yemen would have been a template for future interventions in Iraq and Syria on behalf of Sunni allies, and would have cemented Saudi Arabia's position as a regional power in the wake of the U.S. withdrawal. As BCA's Geopolitical Strategy warned, however, defeating the experienced Houthis would not be easy and Saudi Arabia would ultimately hesitate to commit to a land war.5 The intervention has resulted in disaster for Saudi Arabia on several levels: Houthis remain in control of the capital Sana'a and largely the same territory that encompassed the former Yemen Arab Republic (North Yemen); The Saudis, desperate for a ground-force presence, have turned a blind eye to Al Qaeda's and ISIS's control of almost a third of the country in the south and coastal regions; Saudi forces have taken considerable losses, including some high-tech and high-priced items; The conflict has exposed severe military deficiencies, from the low level of strategic and tactical planning of senior staff, to the poor communication of units at the middle level, to the pervasive low morale and training of the rank-and-file. The biggest loss for Saudi Arabia has been that of leadership. What began as a pan-Sunni intervention led by Riyadh, with considerable involvement by the UAE and Egypt, has seen the Saudis lose almost all their allies. The UAE removed its troops in mid-2016 (in somewhat of a diplomatic spat with Riyadh) and Egypt has subsequently held military exercises with Russia, a Saudi rival in the region, and decided in December to provide military advisors to the Syrian Arab Army. All the talk about a "Sunni NATO" is over. Saudi Arabia's experience in Yemen, combined with the decline in its currency reserves, forced it to come to terms with reality, and eventually agree to an oil production cut with Russia and Iran. Thus it took Saudi Arabia exactly five years, from the U.S. withdrawal in Iraq in 2011, to realize the limits of its regional power. Bob Ryan, Senior Vice President of BCA's Commodity & Energy Strategy, correctly forecast the OPEC cut and expects the deal to be successfully implemented in 2017.6 One reason Bob is confident is that both Saudi Arabia and Russia are looking to privatize their energy sector significantly by 2018. Russia has sold 19.5% of Rosneft and the Saudis want to conduct an IPO of 5% of their state-owned oil company Aramco. It makes no sense to do this IPO in an environment of low oil prices. Furthermore, sovereign debt issuance to cover budget deficits will become cheaper when oil prices are higher. Geopolitics are aligning with Bob's view as well. Saudi Arabia's attempt to counter Iranian influence in the region has failed both militarily and via oil politics. Riyadh is focusing inwards, on its "Vision 2030" reforms, which will entail considerable domestic upheaval as a result of its comprehensive effort to remove the ultra-conservative religious establishment from power.7 This is now coming to light, with Deputy Crown Prince Mohammed bin Salman recently announcing harsh punitive measures for any cleric who incites or resorts to violence against the reform agenda. Bottom Line: Saudi Arabia's bid for regional hegemony is over, at least for now. The country is focusing inwards, on long-term political and social reforms and economic diversification. Its efforts to bring Iran to heel with low oil prices and with direct military confrontation in Yemen have failed. The oil production-cut deal between Saudi Arabia, Iran, and Russia should hold as a result of the de-escalation of Saudi-Iranian tensions and the socio-economic priorities of all three states. BCA's Commodity & Energy Strategy service is overweight energy relative to other commodities as a result.8 Is The Russia-Turkey Détente Sustainable? Turkey and Russia have concluded a political and military détente in Syria with surprising speed. This has made one of our major geopolitical risks for 2017 - a Turkish-Russian confrontation over Syria - already obsolete. Much as with Saudi Arabia, Turkey has had a bite of regional hegemony, did not like the bitter taste, and has decided to make a deal with its rivals instead. For Turkey, the real concern over the past five years has been American inaction in Syria. President Recep Tayyip Erdogan has spent a lot of political capital opposing Syrian President Bashar al-Assad. He had hoped that a successful revolution would create a new client state for Turkey, yielding Turkey overland access to Persian Gulf energy sources. Erdogan was therefore beyond dismayed when President Barack Obama failed to intervene in Syria in 2013 following Assad's use of chemical weapons. The chronology of what happened next is important: Russia intervened two years later, in September 2015, to stem the progress of anti-Assad rebels and save the regime from collapse. Two months later, a Russian Sukhoi Su-24 was shot down by Turkish F-16s in the Turkey-Syria border area. Turkey and Russia broke relations for a while, but tensions did not escalate. Ankara faced a coup attempt in mid-July 2016, which the ruling party linked to the U.S.-based Islamist preacher Fethullah Gülen. The Obama administration refused to extradite Gülen without concrete evidence of his involvement. By late July, Turkish officials were calling Russia a "friendly neighbor" and a "strategic partner." In early August, Erdogan met Russian President Vladimir Putin in St. Petersburg, after issuing a letter with an apology to the family of the shot-down pilot. Then, on August 24, Turkey invaded Syria. The military intervention, dubbed "Operation Euphrates Shield," was officially launched to fight the Islamic State, a common pretext these past three years. Erdogan officially stated that he also aimed to fight Assad's regime, but this appeared to put Ankara and Moscow back on collision course, and statements from the Turkish side have since been "corrected." The real reason for the intervention was not to fight ISIS or Assad, but rather to curb the gains made by the various Kurdish militias on the ground in Iraq and Syria. In particular, Ankara intervened to prevent the Kurdish People's Protection Units (YPG) - the armed wing of the Syrian Democratic Union Party, which is affiliated with the Turkey-based Kurdistan Workers' Party - from linking up with its now vast territory held in the north of Syria (Map 1). The territory, which our map shows has expanded considerably as the YPG has claimed mostly Islamic State-held areas, is split between Rojava, the main territory east of the Euphrates river, and the Afrin enclave near the Mediterranean Sea. For Turkey, the proximity of such a vast Kurdish-held territory so close to its own Kurdish southeastern region presents a national-security nightmare. The operation's strategic goal was to capture Al-Bab, the stronghold of the Islamic State in northern Syria and a strategic point between the two YPG-held swaths of territory. However, it has taught the Turks that they have no experience fighting a prolonged battle, especially against local insurgents and militants who know the region. Since the first attack on Al-Bab's western part, the Turkish army has suffered three defeats and retreated to initial positions. With Turkey stuck in Al-Bab, the Russian air force has now begun to bomb Islamic State positions to help their tentative new ally. This level of operational coordination is notable and important. It suggests that Turkey, a NATO member state, is now reliant on Russian air strikes for ground support rather than on American sorties flying out of NATO's air base in Incirlik, Turkey. Turkey even claims that U.S. presence in Incirlik is obsolete if it receives no help from the U.S. Air Force around Al-Bab. How sustainable is the Turkey-Russia détente? We suspect it will be quite sustainable, at least in the short term. Ankara has moved away from demands for Assad to step down, with the Deputy Prime Minister, Numan Kurtulmus, recently stating that Turkey would not "impose any decision" on the Syrian people regarding future leadership. The assassination of the Russian ambassador in Turkey also failed to derail Russo-Turkish cooperation. Beyond the short term, however, the question remains what Turkey intends to do about Kurdish gains, which are considerable in both Syria and Iraq. The town of Manbij, for instance, is strategically located west of the Euphrates and was supposed to be ceded to Turkey by the Kurds. The situation could grow even more complicated for Turkey as the Kurdistan Regional Government (KRG) in Iraq may proclaim independence after the Islamic State stronghold of Mosul is liberated in early 2017.9 The YPG in Syria could then ask to join their fellow Kurds in Iraq in forming a unitary state. Although unlikely, this scenario is probably on Turkey's mind, as it would mean that the Kurds inside Turkey may intensify their anti-government insurgency. Note, however, that this scenario does not bother Russia. As far as Moscow is concerned, it has succeeded in keeping Assad in power, its Syrian naval base in Tartus is secure, and it has proven its ability to project power outside of its immediate sphere of influence (Ukraine, Crimea, Georgia, and the Caucasus), thus advertising its "Great Power" status. Bottom Line: For the time being, the Russian-Turkish détente will hold. The real risk is not a Turkish-Russian confrontation, but rather a wider Turkish engagement in both Syria and Iraq against the Kurds sometime in the future. We suspect that the Turkish military experience in Syria may make the Turks think twice about engaging in a large-scale war against the Kurds across three states. But given the erratic policymaking out of Ankara in recent years, it is difficult to say this with any confidence. The geopolitical risk of Turkish imperial overreach will continue to weigh on Turkish assets in 2017. Risks To The Sanguine View There are many reasons why investors should stay up at night in 2017, but the Middle East is not one of them. The process of U.S. deleveraging from the region has been painful and costly (from a human perspective especially), but it has ultimately forced regional powers to figure out how to carve out the leftover space between them. There are a few questions left to answer, starting with the Kurdish question. But, for the most part, we do not expect to see the major players - Iran, Saudi Arabia, Turkey, Russia, Egypt, or Israel - come to blows with each other. There are three major risks to this sanguine view. The U.S. Is Back! The current semi-stable equilibrium will definitely be thrown off track if the Trump administration decides to sink its teeth fully into the Middle East. We expect President-elect Donald Trump to authorize greater military action against the Islamic State, including more intense air strikes. However, this is not a qualitative reversal of Obama's deleveraging policy. A real reversal would be if Trump decided to follow the advice of Iran hawks in his government - of whom there are several - and increase tensions with Tehran. This is unlikely, given Trump's focus on China and his willingness to improve ties with Russia, a nominal ally of Iran. In fact, there has been almost no talk of Iran from either President-elect Trump or any of his advisors since the election. Furthermore, while U.S. oil imports from OPEC are no longer declining, they are still massively down since their peak in the mid-2000s (Chart 6). It is unlikely that Trump will commit resources to a region of diminishing importance to U.S. interests. Change Of Guard In Tehran. While the risk of Washington saber-rattling with Iran is overstated, what happens if the moderate President Hassan Rouhani is defeated in the upcoming May election? Hardliners are arguing that the nuclear deal with the West has done nothing for the economy, the main pillar of Rouhani's 2013 platform. This is not true. Headline inflation ticked up in late 2016, but remains well off the 40% levels in 2013, while GDP growth has been in the black throughout Rouhani's term, and net exports have bottomed (Chart 7). However, the flow of FDI into the country has been tepid, probably due to ongoing uncertainty with the government transition in the U.S. Both European and Asian businesses are waiting to see if the incoming Trump administration wants to revive sanctions. Meanwhile, skirmishes between U.S. and Iranian vessels - purportedly controlled by the hardline Islamic Revolutionary Guard Corps - have increased in the Persian Gulf. Perhaps the hardliners in Tehran are hoping that they can bait the hardliners in D.C. into a pre-election confrontation that sinks Rouhani. Iraqi Instability. Although the Iraqi government is set to take over Mosul from the Islamic State some time in Q1 2017, the fact remains that the country is bitterly divided between Sunnis and Shia amidst sluggish oil revenues. While the production cut deal will raise revenues marginally, revenues will still be well below their highs (Chart 8). Defeating the Islamic State militarily is one thing, but the real challenge is for Baghdad to reintegrate the Sunni population, which largely lives in territory devoid of oil production. A renewal of civil strife and terrorism targeting Iraqi civilians, which could happen as the Islamic State militants blend back into the wider population, may be a risk in 2017. Chart 6U.S. Imports From OPEC Remain Low Chart 7Iranian Economy Improves Under Reformist Rule Chart 8Iraqi Oil Revenues Still Down From Highs A word on Israel may also be in order. Israel has not played a major geopolitical role in the region for the past five years and we suspect it will not in the next five. It is secure from its neighbours, who cannot match it in terms of military capability, and remains preoccupied with domestic politics and internal security. Meanwhile, the days when the region unified against Israel are over. Sectarian and ethnic conflicts have gutted Israel's traditional enemies. And former foes, particularly Egypt and Saudi Arabia, are now close allies. The one geopolitical threat that remains is Iran. However, that threat remains dormant as long as Israel maintains nuclear supremacy over Iran and as long as the U.S. remains a security guarantor for Israel. We do not see either changing any time soon. Investment Implications The main investment implication of our thesis that the Middle East has found a new equilibrium is that the region will not dominate the news flow in 2017. Short of a major Turkish blunder in Syria and Iraq, we see the current status quo largely frozen in place. Saudi Arabia appears to have conceded, for now at least, its inferior place in the geopolitical pecking order. Investors have plenty of things to worry about in 2017, such as general de-globalization, a potential Sino-American trade war, geopolitical tensions in East Asia, and elections in four of the five largest euro-area economies. Our geopolitical team's long-standing thesis that geopolitical risk is rotating out of the Middle East and into East Asia is therefore fully playing out.10 Chart 9KSA-Russia Production ##br##Pact Aims at Lowering Inventories In the near term, the geopolitical equilibrium should allow Saudi Arabia, Iran, and Russia to maintain their six-month agreement to cut production by up to 1.8 million b/d. The stated volumes to be cut are comprised of 1.2 million b/d from OPEC, 300,000 b/d from Russia, and another 300,000 b/d from other non-OPEC producers. The goal of this agreement is to reduce global oil inventories to more normal levels, which our commodity strategists believe will happen by the end of 2017 (Chart 9). Bob Ryan, of the Commodity & Energy Strategy, forecasts U.S. benchmark WTI crude prices to average $55/bbl in 2017. The incoming Trump administration will focus its Middle East policy on cooperating with regional actors against the Islamic State. Investors should expect to see more American "muscle" dedicated to the fight, perhaps at the risk of causing civilian casualties (which the Obama White House was careful to avoid). The downside of this strategy is that as the Islamic State loses its territory and ceases to be a caliphate, it will revert to being a more conventional terrorist organization. Its foreign fighters may return home to Europe, Russia, and elsewhere, while home-grown militants will seek to sow further Sunni-Shia discord, especially in Iraq. Unfortunately, this trend will keep our thesis of "A Bull Market For Terror" intact, which lends support to U.S. defense stocks.11 Marko Papic, Senior Vice President marko@bcaresearch.com Oleg Babanov, Editor/Strategist obabanov@bcaresearch.co.uk 1 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 2 Please see "Middle East: Saudi-Iran Tensions Have Peaked," in BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 3 According to the estimates of BCA's Commodity & Energy Strategy, "Tactical Focus Again Required In 2017," dated January 5, 2017, available at ces.bcaresearch.com. 4 Please see Cullen S. Hendrix, "Oil Prices and Interstate Conflict Behavior," Peterson Institute for International Economics, dated July 2014, available at iie.com. According to Hendrix, revolutionary leaders are "leaders who come to power by force and attempt to transform preexisting political and economic relationships, both domestically and abroad." The definition is broad and includes leaders who used force in order to gain prominence. 5 Please see BCA Geopolitical Strategy Client Note, "Does Yemen Matter?" dated March 26, 2015, available at gps.bcaresearch.com. 6 Please see BCA Commodity & Energy Strategy Weekly Report, "2017 Commodity Outlook: Energy," December 8, 2016, available at ces.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Saudi Arabia's Choice: Modernity Or Bust," dated May 11, 2016, available at gps.bcaresearch.com. See also Emerging Market Equity Sector Strategy, "MENA: Rise Early, Work Hard, Strike Oil," dated October 4, 2016, available at emes.bcaresearch.com. 8 Please see BCA Commodity & Energy Strategy, "Tactical Focus Again Required In 2017," dated January 5, 2017, available at ces.bcaresearch.com. 9 Please see P. Ronzheimer, C. Weinmann, and K. Mössbauer, "Kurden Brauchen Mehr Deutsche Abwehrraketen," Bild, dated October 28, 2016, available at http://www.bild.de/politik/ausland/mossul/kurden-brauchen-dringend-milan-systeme-48495330.bild.html. 10 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013, available at gps.bcaresearch.com. 11 Please see BCA Global Investment Strategy and Geopolitical Strategy Special Report, "A Bull Market For Terror," dated August 5, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Multipolarity will peak in 2017 - geopolitical risks are spiking; Globalization is giving way to zero-sum mercantilism; U.S.-China relations are the chief risk to global stability; Turkey is the most likely state to get in a shooting war; Position for an inflation comeback; Go long defense, USD/EUR, and U.S. small caps vs. large caps. Feature Before the world grew mad, the Somme was a placid stream of Picardy, flowing gently through a broad and winding valley northwards to the English Channel. It watered a country of simple beauty. A. D. Gristwood, British soldier, later novelist. The twentieth century did not begin on January 1, 1900. Not as far as geopolitics is concerned. It began 100 years ago, on July 1, 1916. That day, 35,000 soldiers of the British Empire, Germany, and France died fighting over a couple of miles of territory in a single day. The 1916 Anglo-French offensive, also known as the Battle of the Somme, ultimately cost the three great European powers over a million and a half men in total casualties, of which 310,862 were killed in action over the four months of fighting. British historian A. J. P. Taylor put it aptly: idealism perished on the Somme. How did that happen? Nineteenth-century geopolitical, economic, and social institutions - carefully nurtured by a century of British hegemony - broke on the banks of the Somme in waves of human slaughter. What does this have to do with asset allocation? Calendars are human constructs devised to keep track of time. But an epoch is a period with a distinctive set of norms, institutions, and rules that order human activity. This "order of things" matters to investors because we take it for granted. It is a set of "Newtonian Laws" we assume will not change, allowing us to extrapolate the historical record into future returns.1 Since inception, BCA's Geopolitical Strategy has argued that the standard assumptions about our epoch no longer apply.2 Social orders are not linear, they are complex systems. And we are at the end of an epoch, one that defined the twentieth century by globalization, the spread of democracy, and American hegemony. Because the system is not linear, its break will cause non-linear outcomes. Since joining BCA's Editorial Team in 2011, we have argued that twentieth-century institutions are undergoing regime shifts. Our most critical themes have been: The rise of global multipolarity;3 The end of Sino-American symbiosis;4 The apex of globalization;5 The breakdown of laissez-faire economics;6 The passing of the emerging markets' "Goldilocks" era.7 Our view is that the world now stands at the dawn of the twenty-first century. The transition is not going to be pretty. Investors must stop talking themselves out of left-tail events by referring to twentieth-century institutions. Yes, the U.S. and China really could go to war in the next five years. No, their trade relationship will not prevent it. Was the slaughter at the Somme prevented by the U.K.-German economic relationship? In fact, our own strategy service may no longer make sense in the new epoch. "Geopolitics" is not some add-on to investor's asset-allocation process. It is as much a part of that process as are valuations, momentum, bottom-up analysis, and macroeconomics. To modify the infamous Milton Friedman quip, "We are all geopolitical strategists now." Five Decade Themes: We begin this Strategic Outlook by updating our old decade themes and introducing a few new ones. These will inform our strategic views over the next half-decade. Below, we also explain how they will impact investors in 2017. From Multipolarity To ... Making America Great Again Our central theme of global multipolarity will reach its dangerous apex in 2017. Multipolarity is the idea that the world has two or more "poles" of power - great nations - that pursue their interests independently. It heightens the risk of conflict. Since we identified this trend in 2012, the number of global conflicts has risen from 10 to 21, confirming our expectations (Chart 1). Political science theory is clear: a world without geopolitical leadership produces hegemonic instability. America's "hard power," declining in relative terms, created a vacuum that was filled by regional powers looking to pursue their own spheres of influence. Chart 1Frequency Of Geopolitical Conflicts Increases Under Multipolarity The investment implications of a multipolar world? The higher frequency of geopolitical crises has provided a tailwind to safe-haven assets such as U.S. Treasurys.8 Ironically, the relative decline of U.S. power is positive for U.S. assets.9 Although its geopolitical power has been in relative decline since 1990, the U.S. bond market has become more, not less, appealing over the same timeframe (Chart 2) Counterintuitively, it was American hegemony - i.e. global unipolarity after the Soviet collapse - that made the rise of China and other emerging markets possible. This created the conditions for globalization to flourish and for investors to leave the shores of developed markets in search of yield. It is the stated objective of President-elect Donald Trump, and a trend initiated under President Barack Obama, to reduce the United States' hegemonic responsibilities. As the U.S. withdraws, it leaves regional instability and geopolitical disequilibria in its wake, enhancing the value-proposition of holding on to low-beta American assets. We are now coming to the critical moment in this process, with neo-isolationist Trump doubling down on President Obama's aloof foreign policy. In 2017, therefore, multipolarity will reach its apex, leading several regional powers - from China to Turkey - to overextend themselves as they challenge the status quo. Chaos will ensue. (See below for more!) The inward shift in American policy will sow the seeds for the eventual reversal of multipolarity. America has always profited from geopolitical chaos. It benefits from being surrounded by two massive oceans, Canada, and the Sonora-Chihuahuan deserts. Following both the First and Second World Wars, the U.S.'s relative geopolitical power skyrocketed (Chart 3). Chart 2America Is A Safe-Haven,##br## Despite (Because Of?) Relative Decline Chart 3America Is Chaos-Proof Over the next 12-24 months, we expect the chief investment implications of multipolarity - volatility, tailwind to safe-haven assets, emerging-market underperformance, and de-globalization - to continue to bear fruit. However, as the U.S. comes to terms with multipolarity and withdraws support for critical twentieth-century institutions, it will create conditions that will ultimately reverse its relative decline and lead to a more unipolar tendency (or possibly bipolar, with China). Therefore, Donald Trump's curious mix of isolationism, anti-trade rhetoric, and domestic populism may, in the end, Make America Great Again. But not for the reasons he has promised-- not because the U.S. will outperform the rest of the world in an absolute sense. Rather, America will become great again in a relative sense, as the rest of the world drifts towards a much scarier, darker place without American hegemony. Bottom Line: For long-term investors, the apex of multipolarity means that investing in China and broader EM is generally a mistake. Europe and Japan make sense in the interim due to overstated political risks, relatively easy monetary policy, and valuations, but even there risks will mount due to their high-beta qualities. The U.S. will own the twenty-first century. From Globalization To ... Mercantilism "The industrial glory of England is departing, and England does not know it. There are spasmodic outcries against foreign competition, but the impression they leave is fleeting and vague ... German manufacturers ... are undeniably superiour to those produced by British houses. It is very dangerous for men to ignore facts that they may the better vaunt their theories ... This is poor patriotism." Ernest Edwin Williams, Made in Germany (1896) The seventy years of British hegemony that followed the 1815 Treaty of Paris ending the Napoleonic Wars were marked by an unprecedented level of global stability. Britain's cajoled enemies and budding rivals swallowed their wounded pride and geopolitical appetites and took advantage of the peace to focus inwards, industrialize, and eventually catch up to the U.K.'s economy. Britain, by providing expensive global public goods - security of sea lanes, off-shore balancing,10 a reserve currency, and financial capital - resolved the global collective-action dilemma and ushered in an era of dramatic economic globalization. Sound familiar? It should. As Chart 4 shows, we are at the conclusion of a similar period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. There are other forces at work, such as pernicious wage deflation that has soured the West's middle class on free trade and immigration. But the main threat to globalization is at heart geopolitical. The breakdown of twentieth-century institutions, norms, and rules will encourage regional powers to set up their own spheres of influence and to see the global economy as a zero-sum game instead of a cooperative one.11 Chart 4Multipolarity And De-Globalization Go Hand-In-Hand At the heart of this geopolitical process is the end of Sino-American symbiosis. We posited in February that Charts 5 and 6 are geopolitically unsustainable.12 China cannot keep capturing an ever-increasing global market share for exports while exporting deflation; particularly now that its exports are rising in complexity and encroaching on the markets of developed economies (Chart 7). China's economic policy might have been acceptable in an era of robust global growth and American geopolitical confidence, but we live in a world that is, for the time being, devoid of both. Chart 5China's Share Of Global##br## Exports Has Skyrocketed... Chart 6And Now China ##br##Is Exporting Deflation China and the U.S. are no longer in a symbiotic relationship. The close embrace between U.S. household leverage and Chinese export-led growth is over (Chart 8). Today the Chinese economy is domestically driven, with government stimulus and skyrocketing leverage playing a much more important role than external demand. Exports make up only 19% of China's GDP and 12% of U.S. GDP. The two leading economies are far less leveraged to globalization than the conventional wisdom would have it. Chart 7China's Steady Climb Up ##br##The Value Ladder Continues Chart 8Sino-American ##br##Symbiosis Is Over Chinese policymakers have a choice. They can double down on globalization and use competition and creative destruction to drive up productivity growth, moving the economy up the value chain. Or they can use protectionism - particularly non-tariff barriers, as they have been doing - to defend their domestic market from competition.13 We expect that they will do the latter, especially in an environment where anti-globalization rhetoric is rising in the West and protectionism is already on the march (Chart 9). Chart 9Protectionism On The March The problem with this likely choice, however, is that it breaks up the post-1979 quid-pro-quo between Washington and Beijing. The "quid" was the Chinese entry into the international economic order (including the WTO in 2001), which the U.S. supported; the "quo" was that Beijing would open its economy as it became wealthy. Today, 45% of China's population is middle-class, which makes China potentially the world's second-largest market after the EU. If China decides not to share its middle class with the rest of the world, then the world will quickly move towards mercantilism - particularly with regard to Chinese imports. Mercantilism was a long-dominant economic theory, in Europe and elsewhere, that perceived global trade to be a zero-sum game and economic policy to be an extension of the geopolitical "Great Game" between major powers. As such, net export growth was the only way to prosperity and spheres of influence were jealously guarded via trade barriers and gunboat diplomacy. What should investors do if mercantilism is back? In a recent joint report with the BCA's Global Alpha Sector Strategy, we argued that investors should pursue three broad strategies: Buy small caps (or microcaps) at the expense of large caps (or mega caps) across equity markets as the former are almost universally domestically focused; Favor closed economies levered on domestic consumption, both within DM and EM universes; Stay long global defense stocks; mercantilism will lead to more geopolitical risk (Chart 10). Chart 10Defense Stocks Are A No-Brainer Investors should also expect a more inflationary environment over the next decade. De-globalization will mean marginally less trade, less migration, and less free movement of capital across borders. These are all inflationary. Bottom Line: Mercantilism is back. Sino-American tensions and peak multipolarity will impair coordination. It will harden the zero-sum game that erodes globalization and deepens geopolitical tensions between the world's two largest economies.14 One way to play this theme is to go long domestic sectors and domestically-oriented economies relative to export sectors and globally-exposed economies. The real risk of mercantilism is that it is bedfellows with nationalism and jingoism. We began this section with a quote from an 1896 pamphlet titled "Made in Germany." In it, British writer E.E. Williams argued that the U.K. should abandon free trade policies due to industrial competition from Germany. Twenty years later, 350,000 men died in the inferno of the Somme. From Legal To ... Charismatic Authority Legal authority, the bedrock of modern democracy, is a critical pillar of civilization that investors take for granted. The concept was defined in 1922 by German sociologist Max Weber. Weber's seminal essay, "The Three Types of Legitimate Rule," argues that legal-rational authority flows from the institutions and laws that define it, not the individuals holding the office.15 This form of authority is investor-friendly because it reduces uncertainty. Investors can predict the behavior of policymakers and business leaders by learning the laws that govern their behavior. Developed markets are almost universally made up of countries with such norms of "good governance." Investors can largely ignore day-to-day politics in these systems, other than the occasional policy shift or regulatory push that affects sector performance. Weber's original essay outlined three forms of authority, however. The other two were "traditional" and "charismatic."16 Today we are witnessing the revival of charismatic authority, which is derived from the extraordinary characteristics of an individual. From Russia and the U.S. to Turkey, Hungary, the Philippines, and soon perhaps Italy, politicians are winning elections on the back of their messianic qualities. The reason for the decline of legal-rational authority is threefold: Elites that manage governing institutions have been discredited by the 2008 Great Recession and subsequent low-growth recovery. Discontent with governing institutions is widespread in the developed world (Chart 11). Elite corruption is on the rise. Francis Fukuyama, perhaps America's greatest political theorist, argues that American political institutions have devolved into a "system of legalized gift exchange, in which politicians respond to organized interest groups that are collectively unrepresentative of the public as a whole."17 Political gridlock across developed and emerging markets has forced legal-rational policymakers to perform like charismatic ones. European policymakers have broken laws throughout the euro-area crisis, with the intention of keeping the currency union alive. President Obama has issued numerous executive orders due to congressional gridlock. While the numbers of executive orders have declined under Obama, their economic significance has increased (Chart 12). Each time these policymakers reached around established rules and institutions in the name of contingencies and crises, they opened the door wider for future charismatic leaders to eschew the institutions entirely. Chart 11As Institutional Trust Declines, ##br##Voters Turn To Charismatic Leaders Chart 12Obama ##br##The Regulator Furthermore, a generational shift is underway. Millennials do not understand the value of legal-rational institutions and are beginning to doubt the benefits of democracy itself (Chart 13). The trend appears to be the most pronounced in the U.S. and U.K., perhaps because neither experienced the disastrous effects of populism and extremism of the 1930s. In fact, millennials in China appear to view democracy as more essential to the "good life" than their Anglo-Saxon peers. Chart 13Who Needs Democracy When You Have Tinder? Charismatic leaders can certainly outperform expectations. Donald Trump may end up being FDR. The problem for investors is that it is much more difficult to predict the behavior of a charismatic authority than a legal-rational one.18 For example, President-elect Trump has said that he will intervene in the U.S. economy throughout his four-year term, as he did with Carrier in Indiana. Whether these deals are good or bad, in a normative sense, is irrelevant. The point is that bottom-up investment analysis becomes useless when analysts must consider Trump's tweets, as well as company fundamentals, in their earnings projections! We suspect that the revival of charismatic leadership - and the danger that it might succeed in upcoming European elections - at least partly explains the record high levels of global policy uncertainty (Chart 14). Markets do not seem to have priced in the danger fully yet. Global bond spreads are particularely muted despite the high levels of uncertainty. This is unsustainable. Chart 14Are Assets Fully Pricing In Global Uncertainty? Bottom Line: The twenty-first century is witnessing the return of charismatic authority and erosion of legal-rational authority. This should be synonymous with uncertainty and market volatility over the next decade. In 2017, expect a rise in EuroStoxx volatility. From Laissez-Faire To ... Dirigisme The two economic pillars of the late twentieth century have been globalization and laissez-faire capitalism, or neo-liberalism. The collapse of the Soviet Union ended the communist challenge, anointing the U.S.-led "Washington Consensus" as the global "law of the land." The tenets of this epoch are free trade, fiscal discipline, low tax burden, and withdrawal of the state from the free market. Not all countries approached the new "order of things" with equal zeal, but most of them at least rhetorically committed themselves to asymptotically approaching the American ideal. Chart 15Debt Replaced Wages##br## In Laissez-Faire Economies The 2008 Great Recession put an end to the bull market in neo-liberal ideology. The main culprit has been the low-growth recovery, but that is not the full story. Tepid growth would have been digested without a political crisis had it not followed decades of stagnating wages. With no wage growth, households in the most laissez-faire economies of the West gorged themselves on debt (Chart 15) to keep up with rising cost of housing, education, healthcare, and childcare -- all staples of a middle-class lifestyle. As such, the low-growth context after 2008 has combined with a deflationary environment to produce the most pernicious of economic conditions: debt-deflation, which Irving Fisher warned of in 1933.19 It is unsurprising that globalization became the target of middle-class angst in this context. Globalization was one of the greatest supply-side shocks in recent history: it exerted a strong deflationary force on wages (Chart 16). While it certainly lifted hundreds of millions of people out of poverty in developing nations, globalization undermined those low-income and middle-class workers in the developed world whose jobs were most easily exported. World Bank economist Branko Milanovic's infamous "elephant trunk" shows the stagnation of real incomes since 1988 for the 75-95 percentile of the global income distribution - essentially the West's middle class (Chart 17).20 It is this section of the elephant trunk that increasingly supports populism and anti-globalization policies, while eschewing laissez faire liberalism. In our April report, "The End Of The Anglo-Saxon Economy," we posited that the pivot away from laissez-faire capitalism would be most pronounced in the economies of its greatest adherents, the U.S. and U.K. We warned that Brexit and the candidacy of Donald Trump should be taken seriously, while the populist movements in Europe would surprise to the downside. Why the gap between Europe and the U.S. and U.K.? Because Europe's cumbersome, expensive, inefficient, and onerous social-welfare state finally came through when it mattered: it mitigated the pernicious effects of globalization and redistributed enough of the gains to temper populist angst. Chart 16Globalization: A Deflationary Shock Chart 17Globalization: No Friend To DM Middle Class This view was prescient in 2016. The U.K. voted to leave the EU, Trump triumphed, while European populists stumbled in both the Spanish and Austrian elections. The Anglo-Saxon median voter has essentially moved to the left of the economic spectrum (Diagram 1).21 The Median Voter Theorem holds that policymakers will follow the shift to the left in order to capture as many voters as possible under the proverbial curve. In other words, Donald Trump and Bernie Sanders are not political price-makers but price-takers. Diagram 1The Median Voter Is Moving To The Left In The U.S. And U.K. How does laissez-faire capitalism end? In socialism or communism? No, the institutions that underpin capitalism in the West - private property, rule of law, representative government, and enforcement of contracts - remain strong. Instead, we expect to see more dirigisme, a form of capitalism where the state adopts a "directing" rather than merely regulatory role. In the U.S., Donald Trump unabashedly campaigned on dirigisme. We do not expand on the investment implications of American dirigisme in this report (we encourage clients to read our post-election treatment of Trump's domestic politics).22 But investors can clearly see the writing on the wall: a late-cycle fiscal stimulus will be positive for economic growth in the short term, but most likely more positive for inflation in the long term. Donald Trump's policies therefore are a risk to bonds, positive for equities (in the near term), and potentially negative for both in the long term if stagflation results from late-cycle stimulus. What about Europe? Is it not already quite dirigiste? It is! But in Europe, we see a marginal change towards the right, not the left. In Spain, the supply-side reforms of Prime Minister Mariano Rajoy will remain in place, as he won a second term this year. In France, right-wing reformer - and self-professed "Thatcherite" - François Fillon is likely to emerge victorious in the April-May presidential election. And in Germany, the status-quo Grand Coalition will likely prevail. Only in Italy are there risks, but even there we expect financial markets to force the country - kicking and screaming - down the path of reforms. Bottom Line: In 2017, the market will be shocked to find itself face-to-face with a marginally more laissez-faire Europe and a marginally more dirigiste America and Britain. Investors should overweight European assets in a global portfolio given valuations, relative monetary policy (which will remain accommodative in Europe), a weak euro, and economic fundamentals (Chart 18), and upcoming political surprises. For clients with low tolerance of risk and volatility, a better entry point may exist following the French presidential elections in the spring. From Bias To ... Conspiracies As with the printing press, the radio, film, and television before it, the Internet has created a super-cyclical boom in the supply and dissemination of information. The result of the sudden surge is that quality and accountability are declining. The mainstream media has dubbed this the "fake news" phenomenon, no doubt to differentiate the conspiracy theories coursing through Facebook and Twitter from the "real news" of CNN and MSNBC. The reality is that mainstream media has fallen far short of its own vaunted journalistic standards (Chart 19). Chart 18Europe's Economy Is Holding Up Chart 19 We are not interested in this debate, nor are we buying the media narrative that "fake news" delivered Trump the presidency. Instead, we are focused on how geopolitical and political information is disseminated to voters, investors, and ultimately priced by the market. We fear that markets will struggle to price information correctly due to three factors: Low barriers to entry: The Internet makes publishing easy. Information entrepreneurs - i.e. hack writers - and non-traditional publications ("rags") are proliferating. The result is greater output but a decrease in quality control. For example, Facebook is now the second most trusted source of news for Americans (Chart 20). Cost-cutting: The boom in supply has squeezed the media industry's finances. Newspapers have died in droves; news websites and social-media giants have mushroomed (Chart 21). News companies are pulling back on things like investigative reporting, editorial oversight, and foreign correspondent desks. Foreign meddling: In this context, governments have gained a new advantage because they can bring superior financial resources and command-and-control to an industry that is chaotic and cash-strapped. Russian news outlets like RT and Sputnik have mastered this game - attracting "clicks" around the world from users who are not aware they are reading Russian propaganda. China has also raised its media profile through Western-accessible propaganda like the Global Times, but more importantly it has grown more aggressive at monitoring, censoring, and manipulating foreign and domestic media. Chart 20Facebook Is The New Cronkite? Chart 21The Internet Has Killed Journalism The above points would be disruptive enough alone. But we know that technology is not the root cause of today's disruptions. Income inequality, the plight of the middle class, elite corruption, unchecked migration, and misguided foreign policy have combined to create a toxic mix of distrust and angst. In the West, the decline of the middle class has produced a lack of socio-political consensus that is fueling demand for media of a kind that traditional outlets can no longer satisfy. Media producers are scrambling to meet this demand while struggling with intense competition from all the new entrants and new platforms. What is missing is investment in downstream refining and processing to convert the oversupply of crude information into valuable product for voters and investors.23 Otherwise, the public loses access to "transparent" or baseline information. Obviously the baseline was never perfect. Both the Vietnam and Iraq wars began as gross impositions on the public's credulity: the Gulf of Tonkin Incident and Saddam Hussein's weapons of mass destruction. But there was a shared reference point across society. The difference today, as we see it, is that mass opinion will swing even more wildly during a crisis as a result of the poor quality of information that spreads online and mobilizes social networks more rapidly than ever before. We could have "flash mobs" in the voting booth - or on the steps of the Supreme Court - just like "flash crashes" in financial markets, i.e. mass movements borne of passing misconceptions rather than persistent misrule. Election results are more likely to strain the limits of the margin of error, while anti-establishment candidates are more likely to remain viable despite dubious platforms. What does this mean for investors? Fundamental analysis of a country's political and geopolitical risk is now an essential tool in the investor toolkit. If investors rely on the media, and the market prices what the media reports, then the same investors will continue to get blindsided by misleading probabilities, as with Brexit and Trump (Chart 22). While we did not predict these final outcomes, we consistently advised clients, for months in advance, that the market probabilities were too low and serious hedging was necessary. Those who heeded our advice cheered their returns, even as some lamented the electoral returns. Chart 22Get Used To Tail-Risk Events Bottom Line: Keep reading BCA's Geopolitical Strategy! Final Thoughts On The Next Decade The nineteenth century ended in the human carnage that was the Battle of the Somme. The First World War ushered in social, economic, political, geopolitical, demographic, and technological changes that drove the evolution of twentieth-century institutions, rules, and norms. It created the "order of things" that we all take for granted today. The coming decade will be the dawn of the new geopolitical century. We can begin to discern the ordering of this new epoch. It will see peak multipolarity lead to global conflict and disequilibrium, with globalization and laissez-faire economic consensus giving way to mercantilism and dirigisme. Investors will see the benevolent deflationary impulse of globalization evolve into state intervention in the domestic economy and the return of inflation. Globally oriented economies and sectors will underperform domestic ones. Developed markets will continue to outperform emerging markets, particularly as populism spreads to developing economies that fail to meet expectations of their rising middle classes. Over the next ten years, these changes will leave the U.S. as the most powerful country in the world. China and wider EM will struggle to adapt to a less globalized world, while Europe and Japan will focus inward. The U.S. is essentially a low-beta Great Power: its economy, markets, demographics, natural resources, and security are the least exposed to the vagaries of the rest of the world. As such, when the rest of the world descends into chaos, the U.S. will hide behind its Oceans, and Canada, and the deserts of Mexico, and flourish. Five Themes For 2017: Our decade themes inform our view of cyclical geopolitical events and crises, such as elections and geopolitical tensions. As such, they form our "net assessment" of the world and provide a prism through which we refract geopolitical events. Below we address five geopolitical themes that we expect to drive the news flow, and thus the markets, in 2017. Some themes are Red Herrings (overstated risks) and thus present investment opportunities, others are Black Swans (understated risks) and are therefore genuine risks. Europe In 2017: A Trophy Red Herring? Europe's electoral calendar is ominously packed (Table 1). Four of the euro area's five largest economies are likely to have elections in 2017. Another election could occur if Spain's shaky minority government collapses. Table 1 Europe In 2017 Will Be A Headline Risk We expect market volatility to be elevated throughout the year due to the busy calendar. In this context, we advise readers to follow our colleague Dhaval Joshi at BCA's European Investment Strategy. Dhaval recommends that BCA clients combine every €1 of equity exposure with 40 cents of exposure to VIX term-structure, which means going long the nearest-month VIX futures and equally short the subsequent month's contract. The logic is that the term structure will invert sharply if risks spike.24 While we expect elevated uncertainty and lots of headline risk, we do not believe the elections in 2017 will transform Europe's future. As we have posited since 2011, global multipolarity increases the logic for European integration.25 Crises driven by Russian assertiveness, Islamic terrorism, and the migration wave are not dealt with more effectively or easily by nation states acting on their own. Thus far, it appears that Europeans agree with this assessment: polling suggests that few are genuinely antagonistic towards the euro (Chart 23) or the EU (Chart 24). In our July report called "After BREXIT, N-EXIT?" we posited that the euro area will likely persevere over at least the next five years.26 Chart 23Support For The Euro Remains Stable Chart 24Few Europeans Want Out Of The EU Take the Spanish and Austrian elections in 2016. In Spain, Mariano Rajoy's right-wing People's Party managed to hold onto power despite four years of painful internal devaluations and supply-side reforms. In Austria, the establishment candidate for president, Alexander Van der Bellen, won the election despite Austria's elevated level of Euroskepticism (Chart 24), its central role in the migration crisis, and the almost comically unenthusiastic campaign of the out-of-touch Van der Bellen. In both cases, the centrist candidates survived because voters hesitated when confronted with an anti-establishment choice. Next year, we expect more of the same in three crucial elections: The Netherlands: The anti-establishment and Euroskeptic Party for Freedom (PVV) will likely perform better than it did in the last election, perhaps even doubling its 15% result in 2012. However, it has no chance of forming a government, given that all the other parties contesting the election are centrist and opposed to its Euroskeptic agenda (Chart 25). Furthermore, support for the euro remains at a very high level in the country (Chart 26). This is a reality that the PVV will have to confront if it wants to rule the Netherlands. Chart 25No Government For Dutch Euroskeptics Chart 26The Netherlands & Euro: Love Affair France: Our high conviction view is that Marine Le Pen, leader of the Euroskeptic National Front (FN), will be defeated in the second round of the presidential election.27 Despite three major terrorist attacks in the country, unchecked migration crisis, and tepid economic growth, Le Pen's popularity peaked in 2013 (Chart 27). She continues to poll poorly against her most likely opponents in the second round, François Fillon and Emmanuel Macron (Chart 28). Investors who doubt the polls should consider the FN's poor performance in the December 2015 regional elections, a critical case study for Le Pen's viability in 2017.28 Chart 27Le Pen's Polling: ##br##Head And Shoulder Formation? Chart 28Le Pen Will Not Be##br## Next French President Germany: Chancellor Angela Merkel's popularity is holding up (Chart 29), the migration crisis has abated (Chart 30), and there remains a lot of daylight between the German establishment and populist parties (Chart 31). The anti-establishment Alternative für Deutschland will enter parliament, but remain isolated. Chart 29Merkel's Approval Rating Has Stabilized Chart 30Migration Crisis Is Abating Chart 31There Is A Lot Of Daylight... The real risk in 2017 remains Italy. The country has failed to enact any structural reforms, being a laggard behind the reform poster-child Spain (Chart 32). Meanwhile, support for the euro remains in the high 50s, which is low compared to the euro-area average (Chart 33). Polls show that if elections were held today, the ruling Democratic Party would gain a narrow victory (Chart 34). However, it is not clear what electoral laws would apply to the contest. The reformed electoral system for the Chamber of Deputies remains under review by the Constitutional Court until at least February. This will make all the difference between further gridlock and a viable government. Chart 32Italy Is Europe's Chart 33Italy Lags Peers On Euro Support Chart 34Italy's Next Election Is Too Close To Call Investors should consider three factors when thinking about Italy in 2017: The December constitutional referendum was not a vote on the euro and thus cannot serve as a proxy for a future referendum.29 The market will punish Italy the moment it sniffs out even a whiff of a potential Itexit referendum. This will bring forward the future pain of redenomination, influencing voter choices. Benefits of the EU membership for Italy are considerable, especially as they allow the country to integrate its unproductive, poor, and expensive southern regions.30 Sans Europe, the Mezzogiorno (Southern Italy) is Rome's problem, and it is a big one. The larger question is whether the rest of Italy's euro-area peers will allow the country to remain mired in its unsustainable status quo. We think the answer is yes. First, Italy is too big to fail given the size of its economy and sovereign debt market. Second, how unsustainable is the Italian status quo? OECD projections for Italy's debt-to-GDP ratio are not ominous. Chart 35 shows four scenarios, the most likely one charting Italy's debt-to-GDP rise from 133% today to about 150% by 2060. Italy's GDP growth would essentially approximate 0%, but its impressive budget discipline would ensure that its debt load would only rise marginally (Chart 36). Chart 35So What If Italy's Debt-To-GDP Ends Up At 170%? Chart 36Italy Has Learned To Live With Its Debt This may seem like a dire prospect for Italy, but it ensures that the ECB has to maintain its accommodative stance in Europe even as the Fed continues its tightening cycle, a boon for euro-area equities as a whole. In other words, Italy's predicament would be unsustainable if the country were on its own. Its "sick man" status would be terminal if left to its own devices. But as a patient in the euro-area hospital, it can survive. And what happens to the euro area beyond our five-year forecasting horizon? We are not sure. Defeat of anti-establishment forces in 2017 will give centrist policymakers another electoral cycle to resolve the currency union's built-in flaws. If the Germans do not budge on greater fiscal integration over the next half-decade, then the future of the currency union will become murkier. Bottom Line: Remain long the nearest-month VIX futures and equally short the subsequent month's contract. We have held this position since September 14 and it has returned -0.84%. The advantage of this strategy is that it is a near-perfect hedge when risk assets sell off, but pays a low price for insurance. Investors with high risk tolerance who can stomach some volatility should take the plunge and overweight euro-area equities in a global equity portfolio. Solid global growth prospects, accommodative monetary policy, euro weakness, and valuations augur a solid year for euro-area equities. Politics will be a red herring as euro-area stocks climb the proverbial wall of worry in 2017. U.S.-Russia Détente: A Genuine Investment Opportunity Trump's election is good news for Russia. Over the past 16 years, Russia has methodically attempted to collect the pieces from the Soviet collapse. Putin sought to defend the Russian sphere of influence from outside powers (Ukraine and Belarus, the Caucasus, Central Asia). Putin also needed to rally popular support at various times by distracting the public. We view Ukraine and Syria through this prism. Lastly, Russia acted aggressively because it needed to reassure its allies that it would stand up for them.31 And yet the U.S. can live with a "strong" Russia. It can make a deal if the Trump administration recognizes some core interests (e.g. Crimea) and calls off the promotion of democracy in Russia's sphere, which Putin considers an attempt to undermine his rule. As we argued during the Ukraine invasion, it is the U.S., not Russia, which poses the greatest risk of destabilization.32 The U.S. lacks constraints in this theater. It can be aggressive towards Russia and face zero consequences: it has no economic relationship with Russia and does not stand directly in the way of any Russian reprisals, unlike Europe. That is why we think Trump and Putin will reset relations. Trump's team may be comfortable with Russia having a sphere of influence, unlike the Obama administration, which explicitly rejected this idea. The U.S. could even pledge not to expand NATO further, given that it has already expanded as far as it can feasibly and credibly go. Note, however, that a Russo-American truce may not last long. George W. Bush famously "looked into Putin's eyes and ... saw his soul," but relations soured nonetheless. Obama went further with his "Russian reset," removing European missile defense plans from Poland and the Czech Republic. These are avowed NATO allies, and this occurred merely one year after Russian troops marched on Georgia. And yet Moscow and Washington ended up rattling sabers and meddling in each other's internal affairs anyway. Chart 37Thaw In Russian-West##br## Cold War Is Bullish Europe Ultimately, U.S. resets fail because Russia is in structural decline and attempting to hold onto a very large sphere of influence whose citizens are not entirely willing participants.33 Because Moscow must often use blunt force to prevent the revolt of its vassal states (e.g. Georgia in 2008, Ukraine in 2014), it periodically revives tensions with the West. Unless Russia strengthens significantly in the next few years, which we do not expect, then the cycle of tensions will continue. On the horizon may be Ukraine-like incidents in neighboring Belarus and Kazakhstan, both key components of the Russian sphere of influence. Bottom Line: Russia will get a reprieve from U.S. pressure. While we expect Europe to extend sanctions through 2017, a rapprochement with Washington will ultimately thaw relations between Europe and Russia by the end of that year. Europe will benefit from resuming business as usual. It will face less of a risk of Russian provocations via the Middle East and cybersecurity. The ebbing of the Russian geopolitical risk premium will have a positive effect on Europe, given its close correlation with European risk assets since the crisis in Ukraine (Chart 37). Investors who want exposure to Russia may consider overweighing Russian equities to Malaysian. BCA's Emerging Market Strategy has initiated this position for a 55.6% gain since March 2016 and our EM strategists believe there is more room to run for this trade. We recommend that investors simply go long Russia relative to the broad basket of EM equities. The rally in oil prices, easing of the geopolitical risk premium, and hints of pro-market reforms from the Kremlin will buoy Russian equities further in 2017. Middle East: ISIS Defeat Is A Black Swan In February 2016, we made two bold predictions about the Middle East: Iran-Saudi tensions had peaked;34 The defeat of ISIS would entice Turkey to intervene militarily in both Iraq and Syria.35 The first prediction was based on a simple maxim: sustained geopolitical conflict requires resources and thus Saudi military expenditures are unsustainable when a barrel of oil costs less than $100. Saudi Arabia overtook Russia in 2015 as the globe's third-largest defense spender (Chart 38)! Chart 38Saudi Arabia: Lock And Load The mini-détente between Iran and Saudi Arabia concluded in 2016 with the announced OPEC production cut and freeze. While we continue to see the OPEC deal as more of a recognition of the status quo than an actual cut (because OPEC production has most likely reached its limits), nevertheless it is significant as it will slightly hasten the pace of oil-market rebalancing. On the margin, the OPEC deal is therefore bullish for oil prices. Our second prediction, that ISIS is more of a risk to the region in defeat than in glory, was highly controversial. However, it has since become consensus, with several Western intelligence agencies essentially making the same claim. But while our peers in the intelligence community have focused on the risk posed by returning militants to Europe and elsewhere, our focus remains on the Middle East. In particular, we fear that Turkey will become embroiled in conflicts in Syria and Iraq, potentially in a proxy war with Iran and Russia. The reason for this concern is that the defeat of the Islamic State will create a vacuum in the Middle East that the Syrian and Iraqi Kurds are most likely to fill. This is unacceptable to Turkey, which has intervened militarily to counter Kurdish gains and may do so in the future. We are particularly concerned about three potential dynamics: Direct intervention in Syria and Iraq: The Turkish military entered Syria in August, launching operation "Euphrates Shield." Turkey also reinforced a small military base in Bashiqa, Iraq, only 15 kilometers north of Mosul. Both operations were ostensibly undertaken against the Islamic State, but the real intention is to limit the Syrian and Iraqi Kurds. As Map 1 illustrates, Kurds have expanded their territorial control in both countries. Map 1Kurdish Gains In Syria & Iraq Conflict with Russia and Iran: President Recep Erdogan has stated that Turkey's objective in Syria is to remove President Bashar al-Assad from power.36 Yet Russia and Iran are both involved militarily in the country - the latter with regular ground troops - to keep Assad in power. Russia and Turkey did manage to cool tensions recently. Yet the Turkish ground incursion into Syria increases the probability that tensions will re-emerge. Meanwhile, in Iraq, Erdogan has cast himself as a defender of Sunni Arabs and has suggested that Turkey still has a territorial claim to northern Iraq. This stance would put Ankara in direct confrontation with the Shia-dominated Iraqi government, allied with Iran. Turkey-NATO/EU tensions: Tensions have increased between Turkey and the EU over the migration deal they signed in March 2016. Turkey claims that the deal has stemmed the flow of migrants to Europe, which is dubious given that the flow abated well before the deal was struck. Since then, Turkey has threatened to open the spigot and let millions of Syrian refugees into Europe. This is likely a bluff as Turkey depends on European tourists, import demand, and FDI for hard currency (Chart 39). If Erdogan acted on his threat and unleashed Syrian refugees into Europe, the EU could abrogate the 1995 EU-Turkey customs union agreement and impose economic sanctions. The Turkish foray into the Middle East poses the chief risk of a "shooting war" that could impact global investors in 2017. While there are much greater geopolitical games afoot - such as increasing Sino-American tensions - this one is the most likely to produce military conflict between serious powers. It would be disastrous for Turkey. The broader point is that the redrawing of the Middle East map is not yet complete. As the Islamic State is defeated, the Sunni population of Iraq and Syria will remain at risk of Shia domination. As such, countries like Turkey and Saudi Arabia could be drawn into renewed proxy conflicts to prevent complete marginalization of the Sunni population. While tensions between Turkey, Russia, and Iran will not spill over into oil-producing regions of the Middle East, they may cloud Iraq's future. Since 2010, Iraq has increased oil production by 1.6 million barrels per day. This is about half of the U.S. shale production increase over the same time frame. As such, Iraq's production "surprise" has been a major contributor to the 2014-2015 oil-supply glut. However, Iraq needs a steady inflow of FDI in order to boost production further (Chart 40). Proxy warfare between Turkey, Russia, and Iran - all major conventional military powers - on its territory will go a long way to sour potential investors interested in Iraqi production. Chart 39Turkey Is Heavily Dependent On The EU Chart 40Iraq Is The Big, And Cheap, Hope This is a real problem for global oil supply. The International Energy Agency sees Iraq as a critical source of future global oil production. Chart 41 shows that Iraq is expected to contribute the second-largest increase in oil production by 2020. And given Iraq's low breakeven production cost, it may be the last piece of real estate - along with Iran - where the world can get a brand-new barrel of oil for under $13. In addition to the risk of expanding Turkish involvement in the region, investors will also have to deal with the headline risk of a hawkish U.S. administration pursuing diplomatic brinkmanship against Iran. We do not expect the Trump administration to abrogate the Iran nuclear deal due to several constraints. First, American allies will not go along with new sanctions. Second, Trump's focus is squarely on China. Third, the U.S. does not have alternatives to diplomacy, since bombing Iran would be an exceedingly complex operation that would bog down American forces in the Middle East. When we put all the risks together, a geopolitical risk premium will likely seep into oil markets in 2017. BCA's Commodity & Energy Strategy argues that the physical oil market is already balanced (Chart 42) and that the OPEC deal will help draw down bloated inventories in 2017. This means that global oil spare capacity will be very low next year, with essentially no margin of safety in case of a major supply loss. Given the political risks of major oil producers like Nigeria and Venezuela, this is a precarious situation for the oil markets. Chart 41Iraq Really Matters For Global Oil Production Chart 42Oil Supply Glut Is Gone In 2017 Bottom Line: Given our geopolitical view of risks in the Middle East, balanced oil markets, lack of global spare capacity, the OPEC production cut, and ongoing capex reductions, we recommend clients to follow BCA's Commodity & Energy Strategy view of expecting widening backwardation in the new year.37 U.S.-China: From Rivalry To Proxy Wars President-elect Trump has called into question the U.S.'s adherence to the "One China policy," which holds that "there is but one China and Taiwan is part of China" and that the U.S. recognizes only the People's Republic of China as the legitimate Chinese government. There is widespread alarm about Trump's willingness to use this policy, the very premise of U.S.-China relations since 1978, as a negotiating tool. And indeed, Sino-U.S. relations are very alarming, as we have warned our readers since 2012.38 Trump is a dramatic new agent reinforcing this trend. Trump's suggestion that the policy could be discarded - and his break with convention in speaking to the Taiwanese president - are very deliberate. Observe that in the same diplomatic document that establishes the One China policy, the United States and China also agreed that "neither should seek hegemony in the Asia-Pacific region or in any other region." Trump is initiating a change in U.S. policy by which the U.S. accuses China of seeking hegemony in Asia, a violation of the foundation of their relationship. The U.S. is not seeking unilaterally to cancel the One China policy, but asking China to give new and durable assurances that it does not seek hegemony and will play by international rules. Otherwise, the U.S. is saying, the entire relationship will have to be revisited and nothing (not even Taiwan) will be off limits. The assurances that China is expected to give relate not only to trade, but also, as Trump signaled, to the South China Sea and North Korea. Therefore we are entering a new era in U.S-China relations. China Is Toast Asia Pacific is a region of frozen conflicts. Russia and Japan never signed a peace treaty. Nor did China and Taiwan. Nor did the Koreas. Why have these conflicts lain dormant over the past seventy years? Need we ask? Japan, South Korea, Taiwan, and Hong Kong have seen their GDP per capita rise 14 times since 1950. China has seen its own rise 21 times (Chart 43). Since the wars in Vietnam over forty years ago, no manner of conflict, terrorism, or geopolitical crisis has fundamentally disrupted this manifestly beneficial status quo. As a result, Asia has been a region synonymous with economics - not geopolitics. It developed this reputation because its various large economies all followed Japan's path of dirigisme: export-oriented, state-backed, investment-led capitalism. This era of stability is over. The region has become the chief source of geopolitical risk and potential "Black Swan" events.39 The reason is deteriorating U.S.-China relations and the decline in China's integration with other economies. The Asian state-led economic model was underpinned by the Pax Americana. Two factors were foundational: America's commitment to free trade and its military supremacy. China was not technically an ally, like Japan and Korea, but after 1979 it sure looked like one in terms of trade surpluses and military spending (Chart 44).40 For the sake of containing the Soviet Union, the U.S. wrapped East Asia under its aegis. Chart 43The Twentieth Century Was Kind To East Asia Chart 44Asia Sells, America Rules It is well known, however, that Japan's economic model led it smack into a confrontation with the U.S. in the 1980s over its suppressed currency and giant trade surpluses. President Ronald Reagan's economic team forced Japan to reform, but the result was ultimately financial crisis as the artificial supports of its economic model fell away (Chart 45). Astute investors have always suspected that a similar fate awaited China. It is unsustainable for China to seize ever greater market share and drive down manufacturing prices without reforming its economy to match G7 standards, especially if it denies the U.S. access to its vast consumer market. Today there are signs that the time for confrontation is upon us: Since the Great Recession, U.S. household debt and Chinese exports have declined as a share of GDP, falling harder in the latter than the former, in a sign of shattered symbiosis (see Chart 8 above). Chinese holdings of U.S. Treasurys have begun to decline (Chart 46). China's exports to the U.S., both as a share of total exports and of GDP, have rolled over, and are at levels comparable to Japan's 1980s peaks (Chart 47). China is wading into high-tech and advanced industries, threatening the core advantages of the developed markets. The U.S. just elected a populist president whose platform included aggressive trade protectionism against China. Protectionist "Rust Belt" voters were pivotal to Trump's win and will remain so in future elections. China is apparently reneging on every major economic promise it has made in recent years: the RMB is depreciating, not appreciating, whatever the reason; China is closing, not opening, its capital account; it is reinforcing, not reforming, its state-owned companies; and it is shutting, not widening, access to its domestic market (Chart 48). Chart 45Japan's Crisis Followed Currency Spike Chart 46China Backing Away From U.S. Treasuries There is a critical difference between the "Japan bashing" of the 1980s-90s and the increasingly potent "China bashing" of today. Japan and the U.S. had established a strategic hierarchy in World War II. That is not the case for the U.S. and China in 2017. Unlike Japan, Korea, or any of the other Asian tigers, China cannot trust the United States to preserve its security. Far from it - China has no greater security threat than the United States. The American navy threatens Chinese access to critical commodities and export markets via the South China Sea. In a world that is evolving into a zero-sum game, these things suddenly matter. Chart 47The U.S. Will Get Tougher On China Trade Chart 48China Is De-Globalizing That means that when the Trump administration tries to "get tough" on longstanding American demands, these demands will not be taken as well-intentioned or trustworthy. We see Sino-American rivalry as the chief geopolitical risk to investors in 2017: Trump will initiate a more assertive U.S. policy toward China;41 It will begin with symbolic or minor punitive actions - a "shot across the bow" like charging China with currency manipulation or imposing duties on specific goods.42 It will be critical to see whether Trump acts arbitrarily through executive power, or systematically through procedures laid out by Congress. The two countries will proceed to a series of high-level, bilateral negotiations through which the Trump administration will aim to get a "better deal" from the Xi administration on trade, investment, and other issues. The key to the negotiations will be whether the Trump team settles for technical concessions or instead demands progress on long-delayed structural issues that are more difficult and risky for China to undertake. Too much pressure on the latter could trigger a confrontation and broader economic instability. Chart 49China's Demographic Dividend Is Gone The coming year may see U.S.-China relations start with a bang and end with a whimper, as Trump's initial combativeness gives way to talks. But make no mistake: Sino-U.S. rivalry and distrust will worsen over the long run. That is because China faces a confluence of negative trends: The U.S. is turning against it. Geopolitical problems with its periphery are worsening. It is at high risk of a financial crisis due to excessive leverage. The middle class is a growing political constraint on the regime. Demographics are now a long-term headwind (Chart 49). The Chinese regime will be especially sensitive to these trends because the Xi administration will want stability in the lead up to the CCP's National Party Congress in the fall, which promises to see at least some factional trouble.43 It no longer appears as if the rotation of party leaders will leave Xi in the minority on the Politburo Standing Committee for 2017-22, as it did in 2012.44 More likely, he will solidify power within the highest decision-making body. This removes an impediment to his policy agenda in 2017-22, though any reforms will still take a back seat to stability, since leadership changes and policy debates will absorb a great deal of policymakers' attention at all levels for most of the year.45 Xi will also put in place his successors for 2022, putting a cap on rumors that he intends to eschew informal term limits. Failing this, market uncertainty over China's future will explode upward. The midterm party congress will thus reaffirm the fact that China's ruling party and regime are relatively unified and centralized, and hence that China has relatively strong political capabilities for dealing with crises. Evidence does not support the popular belief that China massively stimulates the economy prior to five-year party congresses (Chart 50), but we would expect all means to be employed to prevent a major downturn. Chart 50Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses What this means is that the real risks of the U.S.-China relationship in 2017 will emanate from China's periphery. Asia's Frozen Conflicts Are Thawing Today the Trump administration seems willing to allow China to carve a sphere of influence - but it is entirely unclear whether and where existing boundaries would be redrawn. Here are the key regional dynamics:46 The Koreas: The U.S. and Japan are increasingly concerned about North Korea's missile advances but will find their attempts to deal with the problem blocked by China and likely by the new government in South Korea.47 U.S. threats of sanctioning China over North Korea will increase market uncertainty, as will South Korea's political turmoil and (likely) souring relations with the U.S. Taiwan: Taiwan's ruling party has very few domestic political constraints and therefore could make a mistake, especially when emboldened by an audacious U.S. leadership.48 The same combination could convince China that it has to abandon the post-2000 policy of playing "nice" with Taiwan.49 China will employ discrete sanctions against Taiwan. Hong Kong: Mainland forces will bring down the hammer on the pro-independence movement. The election of a new chief executive will appear to reinforce the status quo but in reality Beijing will tighten its legal, political, and security grip. Large protests are likely; political uncertainty will remain high.50 Japan: Japan will effectively receive a waiver from Trump's protectionism and will benefit from U.S. stimulus efforts; it will continue reflating at home in order to generate enough popular support to pass constitutional revisions in 2018; and it will not shy away from regional confrontations, since these will enhance the need for the hawkish defense component of the same revisions. Vietnam: The above issues may provide Vietnam with a chance to improve its strategic position at China's expense, whether by courting U.S. market access or improving its position in the South China Sea. But the absence of an alliance with the U.S. leaves it highly exposed to Chinese reprisals if it pushes too far. Russia: Russia will become more important to the region because its relations with the U.S. are improving and it may forge a peace deal with Japan, giving it more leverage in energy negotiations with China.51 This may also reinforce the view in Beijing that the U.S. is circling the wagons around China. What these dynamics have in common is the emergence of U.S.-China proxy conflicts. China has long suspected that the Obama administration's "Pivot to Asia" was a Cold War "containment" strategy. The fear is well-grounded but the reality takes time to materialize, which is what we will see playing out in the coming years. The reason we say "proxy wars" is because several American allies are conspicuously warming up to China: Thailand, the Philippines, and soon South Korea. They are not abandoning the U.S. but keeping their options open. The other ASEAN states also stand to benefit as the U.S. seeks economic substitutes for China while the latter courts their allegiance.52 The problem is that as U.S.-China tensions rise, these small states run greater risks in playing both sides. Bottom Line: The overarching investment implications of U.S.-China proxy wars all derive from de-globalization. China was by far the biggest winner of globalization and will suffer accordingly (Chart 51). But it will not be the biggest loser, since it is politically unified, its economy is domestically driven, and it has room to maneuver on policy. Hong Kong, Taiwan, South Korea, and Singapore are all chiefly at risk from de-globalization over the long run. Chart 51Globalization's Winners Will Be De-Globalization's Losers Japan is best situated to prosper in 2017. We have argued since well before the Bank of Japan's September monetary policy shift that unconventional reflation will continue, with geopolitics as the primary motivation for the country's "pedal to the metal" strategy.53 We will look to re-initiate our long Japanese equities position in early 2017. ASEAN countries offer an opportunity, though country-by-country fundamentals are essential. Brexit: The Three Kingdoms The striking thing about the Brexit vote's aftermath is that no recession followed the spike in uncertainty, no infighting debilitated the Tory party, and no reversal occurred in popular opinion. The authorities stimulated the economy, the people rallied around the flag (and ruling party), and the media's "Bregret" narrative flopped. That said, Brexit also hasn't happened yet.54 Formal negotiations with Europe begin in March, which means uncertainty will persist for much of the year as the U.K. and EU posture around their demands for a post-exit deal. However, improving growth prospects for Britain, Europe, and the U.S. all suggest that the negotiations are less likely to take place in an atmosphere of crisis. That does not mean that EU negotiators will be soft. With each successive electoral victory for the political establishment in 2017, the European negotiating position will harden. This will create a collision of Triumphant Tories and Triumphant Brussels. Still, the tide is not turning much further against the U.K. than was already the case, given how badly the U.K. needs a decent deal. Tightercontrol over the movement of people will be the core demand of Westminster, but it is not necessarily mutually exclusive with access to the common market. The major EU states have an incentive to compromise on immigration with the U.K. because they would benefit from tighter immigration controls that send highly qualified EU nationals away from the U.K. labor market and into their own. But the EU will exact a steep price for granting the U.K. the gist of what it wants on immigration and market access. This could be a hefty fee or - more troublingly for Britain - curbs on British financial-service access to euro markets. Though other EU states are not likely to exit, the European Council will not want to leave any doubt about the pain of doing so. The Tories may have to accept this outcome. Tory strength is now the Brexit voter base. That base is uncompromising on cutting immigration, and it is indifferent, or even hostile, to the City. So it stands to reason that Prime Minister Theresa May will sacrifice the U.K.'s financial sector in the coming negotiations. The bigger question is what happens to the U.K. economy in the medium and long term. First, it is unclear how the U.K. will revive productivity as lower labor-force growth and FDI, and higher inflation, take shape. Government "guidance" of the economy - dirigisme again - is clearly the Tory answer. But it remains to be seen how effectively it will be done. Second, what happens to the United Kingdom as a nation? Another Scottish independence referendum is likely after the contours of the exit deal take shape, especially as oil prices gin up Scottish courage to revisit the issue. The entire question of Scotland and Northern Ireland (both of which voted to stay in the EU) puts deeper constitutional and governmental restructuring on the horizon. Westminster is facing a situation where it drastically loses influence on the global stage as it not only exits the European "superstate" but also struggles to maintain a semblance of order among the "three kingdoms." Bottom Line: The two-year timeframe for exit negotiations ensures that posturing will ratchet up tensions and uncertainty throughout the year - invoking the abyss of a no-deal exit - but our optimistic outlook on the end-game (eventual "soft Brexit") suggests that investors should fade the various crisis points. That said, the pound is no longer a buy as it rises to around 1.30. Investment Views De-globalization, dirigisme, and the ascendancy of charismatic authority will all prove to be inflationary. On the margin, we expect less trade, less free movement of people, and more direct intervention in the economy. Given that these are all marginally more inflationary, it makes sense to expect the "End Of The 35-Year Bond Bull Market," as our colleague Peter Berezin argued in July.55 That said, Peter does not expect the bond bull market to end in a crash - and neither do we. There are many macroeconomic factors that will continue to suppress global yields: the savings glut, search for yield, and economic secular stagnation. In addition, we expect peak multipolarity in 2017 and thus a rise in geopolitical conflict. This geopolitical context will keep the U.S. Treasury market well bid. However, clients may want to begin switching their safe-haven exposure to gold. In a recent research report on safe havens, we showed that gold and Treasurys have changed places as safe havens in the past.56 Only after 2000 did Treasurys start providing a good hedge to equity corrections due to geopolitical and financial risks. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but has since become correlated with S&P 500 total returns. As deflationary risks abate in the future, we suspect that gold will return to its safe-haven status. In addition to safe havens, U.S. and global defense stocks will be well bid due to global multipolarity. We recommend that clients go long S&P 500 aerospace and defense relative to global equities on a strategic basis. We are also sticking with our tactical trade of long U.S. defense / short U.S. aerospace. On the equity front, we have closed our post-election bullish trade of long S&P 500 / short gold position for an 11.53% gain in just 22 days of trading. We are also closing our long S&P 600 / short S&P 100 position - a play on de-globalization - for an 8.4% gain. Instead, we are initiating a strategic long U.S. small caps / short U.S. large caps, recommended jointly with our colleague Anastasios Avgeriou of the BCA Global Alpha Sector Strategy. We are keeping our EuroStoxx VIX term-structure hedge due to mounting political risk in Europe. However, we are looking for an opening into European stocks in early 2017. For now, we are maintaining our long USD/EUR - return 4.2% since July - and long USD/SEK - return 2.25% since November. The first is a strategic play on our view that the ECB has to remain accommodative due to political risks in the European periphery. The latter is a way to articulate de-globalization via currencies, given that Sweden is one of the most open economies in the world. We are converting it from a tactical to a strategic recommendation. Finally, we are keeping our RMB short in place - via 12-month NDF. We do not think that Beijing will "blink" and defend its currency more aggressively just because Donald Trump is in charge of America. China is a much more powerful country than in the past, and cannot allow RMB appreciation at America's bidding. Our trade has returned 7.14% since December 2015. With the dollar bull market expected to continue and RMB depreciating, the biggest loser will be emerging markets. We are therefore keeping our strategic long DM / short EM recommendation, which has returned 56.5% since November 2012. We are particularly fond of shorting Brazilian and Turkish equities and are keeping both trades in place. However, we are initiating a long Russian equities / short EM equities. As an oil producer, Russia will benefit from the OPEC deal and the ongoing risks to Iraqi stability. In addition, we expect that removing sanctions against Russia will be on table for 2017. Europe will likely extend the sanctions for another six months, but beyond that the unity of the European position will be in question. And the United States is looking at a different approach. We wish our clients all the best in health, family, and investing in 2017. Thank you for your confidence in BCA's Geopolitical Strategy. Marko Papic Senior Vice President Matt Gertken Associate Editor Jesse Anak Kurri Research Analyst 1 In Michel Foucault's famous The Order of Things (1966), he argues that each period of human history has its own "episteme," or set of ordering conditions that define that epoch's "truth" and discourse. The premise is comparable to Thomas Kuhn's notion of "paradigms," which we have referenced in previous Strategic Outlooks. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2012," dated January 27, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2013," dated January 16, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com and Global Investment Strategy Special Report, "Underestimating Sino-American Tensions," dated November 6, 2015, available at gis.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, and "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2014 - Stay The Course: EM Risk - DM Reward," dated January 23, 2014, and Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 8 Please see BCA The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 10 A military-security strategy necessary for British self-defense that also preserved peace on the European continent by undermining potential aggressors. 11 Please see BCA Global Investment Strategy Special Report, "Trump And Trade," dated December 8, 2016, available at gis.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see Max Weber, "The Three Types Of Legitimate Rule," Berkeley Publications in Society and Institutions 4 (1): 1-11 (1958). Translated by Hans Gerth. Originally published in German in the journal Preussische Jahrbücher 182, 1-2 (1922). 16 We do not concern ourselves with traditional authority here, but the obvious examples are Persian Gulf monarchies. 17 Please see Francis Fukuyama, Political Order And Political Decay (New York: Farrar, Straus and Giroux, 2014). See also our review of this book, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 19 Please see Irving Fisher, "The Debt-deflation Theory of Great Depressions," Econometrica 1(4) (1933): 337-357, available at fraser.stlouisfed.org. 20 Please see Milanovic, Branko, "Global Income Inequality by the Numbers: in History and Now," dated November 2012, Policy Research Working Paper 6250, World Bank, available at worldbank.org. 21 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," June 8, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 23 In some way, BCA's Geopolitical Strategy was designed precisely to fill this role. It is difficult to see what would be the point of this service if our clients could get unbiased, investment-relevant, prescient, high-quality geopolitical news and analysis from the press. 24 Please see BCA European Investment Strategy Weekly Report, "Roller Coaster," dated March 31, 2016, available at eis.bcaresearch.com. 25 Please see The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at bca.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Client Note, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 28 Despite winning an extraordinary six of the 13 continental regions in France in the first round, FN ended up winning zero in the second round. This even though the election occurred after the November 13 terrorist attack that ought to have buoyed the anti-migration, law and order, anti-establishment FN. The regional election is an instructive case of how the French two-round electoral system enables the establishment to remain in power. 29 Please see BCA European Investment Strategy Weekly Report, "Italy: Asking The Wrong Question," dated December 1, 2016, available at eis.bcaresearch.com. 30 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 31 Please see BCA Geopolitical Strategy Special Report, "Cold War Redux?" dated March 12, 2014, and Geopolitical Strategy Special Report, "Russia: To Buy Or Not To Buy?" dated March 20, 2015, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Russia-West Showdown: The West, Not Putin, Is The 'Wild Card,'" dated July 31, 2014, available at gps.bcaresearch.com. 33 Please see BCA's Emerging Markets Strategy Special Report, "Russia's Trilemma And The Coming Power Paralysis," dated February 21, 2012, available at ems.bcaresearch.com. 34 Please see BCA Geopolitical Strategy, "Middle East: Saudi-Iranian Tensions Have Peaked," in Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 35 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 36 President Erdogan, speaking at the first Inter-Parliamentary Jerusalem Platform Symposium in Istanbul in November 2016, said that Turkey "entered [Syria] to end the rule of the tyrant al-Assad who terrorizes with state terror... We do not have an eye on Syrian soil. The issue is to provide lands to their real owners. That is to say we are there for the establishment of justice." 37 Please see BCA Commodity & Energy Strategy Weekly Report, "2017 Commodity Outlook: Energy," dated December 8, 2016, available at ces.bcaresearch.com. 38 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 39 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 40 In recent years, however, China's "official" defense budget statistics have understated its real spending, possibly by as much as half. 41 Please see "U.S. Election Update: Trump, Presidential Powers, And Investment Implications" in BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 42 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 43 Please see BCA Geopolitical Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 44 Please see BCA Geopolitical Strategy Monthly Report, "China: Two Factions, One Party - Part II," dated September 2012, available at gps.bcaresearch.com. 45 The National Financial Work Conference will be one key event to watch for an updated reform agenda. 46 Please see "East Asia: Tensions Simmer ... Will They Boil?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 47 Please see "North Korea: A Red Herring No More?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 48 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, and "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 49 The Trump administration has signaled a policy shift through Trump's phone conversation with Taiwanese President Tsai Ing-wen. The "One China policy" is the foundation of China-Taiwan relations, and U.S.-China relations depend on Washington's acceptance of it. The risk, then, is not so much an overt change to One China, a sure path to conflict, but the dynamic described above. 50 Please see BCA China Investment Strategy Weekly Report, "Hong Kong: From Politics To Political Economy," dated September 8, 2016, available at cis.bcaresearch.com. 51 Please see BCA Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 52 Please see "Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW" in BCA Emerging Markets Strategy Weekly Report, "The EM Rally: Running Out Of Steam?" dated October 19, 2016, and Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 53 Please see BCA Geopolitical Strategy Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, and "Unleash The Kraken: Debt Monetization And Politics," dated September 26, 2016, available at gps.bcaresearch.com. 54 Please see BCA Geopolitical Strategy Special Report, "BREXIT Update: Brexit Means Brexit, Until Brexit," dated September 16, 2016, available at gps.bcaresearch.com. 55 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 56 Please see Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 15, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

Special Report

Highlights There are rising odds that Turkey will undertake military action in the Middle East. When and if this occurs, it will severely undermine already fragile investor confidence, and foreign capital inflows will evaporate. Feature As foreign capital inflows dry up, the lira will continue to plunge, pushing up borrowing costs. Yet the authorities' tolerance for higher interest rates is extremely low. The only way to gain control over interest rates and prevent them from shooting up when the currency plunges will be to impose capital controls. The imposition of capital controls would be a political decision, and hence it is impossible to forecast its form or timing with any precision. That said, investors should be mindful of growing odds of capital controls being imposed, and incorporate it into their strategic decision-making. Rising risks of capital controls entail not only closing long positions and taking capital out of the country but also closing short positions because, capital controls, if enacted, mean any capital will be stuck in liras, which will likely depreciate a lot. Turkey's "Two-Level Game" BCA's Geopolitical Strategy's main geopolitical theme since 2012 has been American hegemonic deleveraging.1 This process ushered in an era of multipolarity, a distribution of power where more than one or two countries can pursue their national interests independently. We know from history and formal modeling in political science that a multipolar context is the one most likely to produce military conflict.2 Turkey is today a perfect example of why multipolarity is volatile. Once a staunch U.S. ally and model democracy for the region, Turkey largely toed the American line for the post-World War II era. Over the past five years, however, Turkish policymakers have experienced both the risks and rewards of multipolarity. On the one hand, multipolarity means that Turkey can finally pursue its own interests in the Middle East. On the other, it means that it cannot rely on the U.S. for protection when it does so. Turkey is today the most unpredictable major power. With its foreign policy outsourced to the U.S. for so many decades, Ankara is going through a trial-and-error process of what it can and cannot do on its own. This process is fraught with political risks. Complicating the situation further, President Recep Tayyip Erdogan is playing a "two-level game" between international and domestic policy. Since the anti-government protests in 2013, Erdogan has exploited domestic and international crises to rally the people "around the flag" and increase support for his ruling Justice and Development Party (AKP) and its planned constitutional reforms. Geopolitical Risks In February 2016, BCA's Geopolitical Strategy noted that direct Turkish involvement in Iraq and Syria could be one of the five "Black Swans" of the year.3 It was clear to us that the days of the Islamic State's pseudo-Caliphate were numbered, and that both Syrian Kurds and Iraqi Kurds stood to gain the most from the terrorist group's defeat. This was unacceptable to Turkey, which therefore intervened militarily to counter Kurdish gains, and may intervene further in the near future. We are particularly concerned about three potential dynamics: Direct intervention in Syria and Iraq: The Turkish military entered Syria in August, launching operation "Euphrates Shield." Turkey also reinforced a small military base in Bashiqa, Iraq, only 15 kilometers north of Mosul. Both operations were ostensibly undertaken against the Islamic State, but the real intention is to limit the Syrian and Iraqi Kurds, who benefit from the collapse of the Islamic State. Map I-1 shows the extent to which Kurds have expanded their control in Syria and Iraq. In Syria, Turkish forces are attempting to prevent Syrian Kurds from connecting their territory in the north of the country, which would create a Kurdish mini-state right next to the Turkish border. In Iraq, it is unclear what Turkish intentions are. Map I-1Kurdish Gains In Syria & Iraq Conflict with Russia and Iran: Syrian and Iraqi Kurds are staunch American allies. As such, Turkey's direct military intervention in both states will anger Washington. However, the real risk to Turkey is not from its NATO ally, but rather from Russia and Iran. Consider that in Syria, Erdogan's stated objective is to remove President Bashar al-Assad from power.4 Yet Russia and Iran are both involved militarily in the country - the latter with its regular ground troops - to keep Assad in power. True, Russia and Turkey cooled tensions recently. Yet the Turkish ground incursion into Syria increases the probability that tensions will re-emerge. Meanwhile, in Iraq, Erdogan has cast himself as a defender of Sunni Arabs and has suggested that Turkey still has a territorial claim to northern Iraq. This stance would put Ankara in direct confrontation with the Shia-dominated Iraqi government, allied with Iran. Turkey-NATO/EU tensions: Turkey is a member of NATO, a collective self-defense alliance. However, the cornerstone Article 5 of the NATO Treaty specifically limits the alliance to attacks that occur in Europe or North America. As such, Turkey would have no recourse to the Treaty's self-defense clause if it were to get into a war with Russia and Iran in the Middle East.5 Furthermore, tensions have increased between Turkey and the EU over the migration deal they signed in March 2016. Turkey claims that the deal has stemmed the flow of migrants to Europe, which is dubious given that the flow abated well before the deal was struck (Chart I-1). Since then, Turkey has threatened to open the spigot and let millions of Syrian refugees into Europe. This is likely a bluff as Turkey depends on European tourists, import demand, and FDI for hard currency (more on Turkey's foreign capital dependence in the sections below) (Chart I-2). If Erdogan acted on his threat and unleashed Syrian refugees into Europe, the EU could abrogate the 1995 EU-Turkey customs union agreement and impose economic sanctions. Chart I-1Turkey's Migration Threat Is Not Credible Chart I-2Turkey Is Heavily Dependent On The EU The Turkish foray into the Middle East poses the chief risk of a "shooting war" that could impact global investors in 2017. While there are much greater geopolitical games afoot - such as increasing Sino-American tensions6 - this one is the most likely to produce military conflict between serious powers. It would be disastrous for Turkey. First, it is not clear what state the Turkish military is in. President Erdogan has purged the military of hundreds of generals and thousands of lower level officers since the July 2016 coup d'état. Second, Turkey would be directly challenging Russia and Iran when both have prepositioned troops and air assets in the Middle East. Third, any Turkish military aggression will further distance Ankara from its Western allies. The U.S. and Europe could impose an arms embargo on Turkey, which would severely limit its ability to prosecute a long military campaign (given its reliance on NATO-compliant armament). Bottom Line: Turkey's increasing involvement in the geopolitical morass that is the Middle East is a clear and definite risk. It has no upside. So why is President Erdogan contemplating it? Domestic Political Risk President Erdogan has used geopolitical and security crises to bolster his popularity and hold on power. We therefore see Erdogan's geopolitical assertiveness as a reflection of his domestic political insecurity. This insecurity began with the mid-2013 Gezi Park protests, which came as a shock to Erdogan. We noted at the time that political volatility has been the norm for Turkey since the Second World War. The anomaly was the decade of tranquility under the AKP rule.7 The anti-government protests came amidst a slumping economy and as Erdogan was trying to enact multiple constitutional changes. The first change was to turn the presidency into a democratically elected position, which Erdogan subsequently contested and won in August 2014 (albeit with only 52% of the vote). The second change, to turn Turkey into a presidential republic and give Erdogan sweeping powers at the expense of the parliament, required a two-thirds majority in the legislature and thus a big win at the scheduled 2015 elections. From that critical moment in mid-2013, Erdogan faced multiple setbacks on the domestic front that stalled his constitutional reforms: December 2013: A corruption scandal embroiled several key members of government, including family members of ministers. June 2015: The ruling AKP failed to win a majority in parliamentary elections, with the pro-Kurdish and liberal People's Democratic Party (HDP) winning an extraordinary 80 seats. July 2015: June elections were immediately followed with renewed violence between Turkish armed forces and the Kurdistan Workers' Party (PKK), a Kurdish militant group based in Turkey. November 2015: Erdogan campaigned on a law and order platform, charging pro-Kurdish HDP with responsibility for renewed violence. The incumbent AKP won a majority, but fell short of the two-thirds needed to turn the country into a presidential republic. We expect Erdogan to call a constitutional referendum in the spring of 2017, given that his AKP, plus nationalists in parliament, have 60% of the seats needed to call for one. Polls are unreliable, but if we combine public support for AKP and nationalists in the November 2015 election as a proxy for support for a presidential republic, it suggests Erdogan will win the plebiscite. To gain support from nationalists for constitutional amendment, Erdogan will have to agree to their demands that the constitution reaffirm Turkish ethnic identity as the basis for citizenship, as well other anti-Kurdish demands. The referendum could therefore rekindle tensions between the government and Kurds, a conflict that could gain an international dimension with the Kurds in Syria and Iraq ascendant. Erdogan may continue to use geopolitical crises to rally support. Domestic politics is messy in Turkey as the country has competitive and largely free elections. If the liberal, coastal opposition were to unite with the Kurdish population behind a single candidate, Erdogan could conceivably be defeated in a future election. As such, external and internal geopolitical and security crises are useful as they give a popular boost to the president while giving the security apparatus a reason to target political opponents. Unfortunately, this dynamic is likely to increase domestic political risk and encourage Erdogan to sacrifice Turkey's political and economic institutions - including the country's adherence to the principals of the free market - for short-term political gain. It is highly unlikely that this political and geopolitical context will create an environment conducive to difficult, pro-market, choices. Instead, we expect the government to double down on populist policies that boost wages, increase liquidity in the banking system, and erode central bank independence. Bottom Line: President Erdogan is playing a "two-level game," with domestic political insecurity motivating geopolitical assertiveness. This is dangerous as the game could get out of hand. Populist policies will continue. Financial And Economic Constraints Foreign financing has been and remains a major constraint. Turkey is dependent on foreign capital flows to finance its still-large current account deficit of $32 billion, or 4% of GDP (Chart I-3). Therefore Turkish policymakers should, in theory, conduct credible monetary and fiscal policies, as well as provide an investor-friendly political and economic backdrop to attract foreign capital. Yet, in reality, the exact opposite is happening. Macro policies, and monetary policy in particular, have been completely unorthodox. On the one hand, the central bank has been intervening in the foreign exchange market, depleting its already extremely low level of foreign exchange reserves. On the other, it has been injecting liquidity into the financial system via lending to banks and other means (Chart I-4). The central bank's overnight lending to commercial banks has surged (Chart I-4, bottom panel). Chart I-3Turkey: Large Current Account Deficit = ##br##Reliance On Foreign Capital Chart I-4The Central Bank Is Injecting Enormous ##br##Liquidity Into The System In short, the Central Bank of Turkey (CBT) has been conducting "reverse sterilization" by injecting liras into circulation. It is doing so to avoid a rise in market-based interest rates, since rates typically rise when a central bank sells foreign currency and buys (i.e. withdraws) local currency from the system. In addition, the CBT cut interest rates 6 times from March to September. Remarkably, this combination of liquidity expansion and rate cuts has taken place while wages have been skyrocketing - 20% in nominal terms and 10% in real (inflation-adjusted) terms (Chart I-5). Money and credit growth have also boomed at 15-20% (Chart I-6). Wages and unit labor costs are the most critical factors in generating genuine inflation in any economy. We can very confidently state that in recent years Turkey had extremely high inflation. Chart I-5Turkish Wage Inflation Is Explosive Chart I-6Turkey: Money Supply Is Booming In a country where inflationary forces are genuine and intense and the central bank is running very loose monetary policy - i.e. well behind the curve - the currency typically depreciates a lot. Chart I-7Turkey's Net Foreign ##br##Reserves Are Running Low Hence, it is not surprising that the lira has plunged. In fact, without central bank intervention through foreign currency sales, the lira would have plunged much more. The CBT's net international reserves have dropped to a mere $20 billion from $46 billion in 2010 (Chart I-7). Net foreign exchange reserves exclude commercial banks' deposits at the central bank. The often-quoted number by the central bank of $100 billion is gross foreign exchange reserves, which includes commercial banks' foreign currency deposits at the central bank. These are liabilities of the central bank, and they do not belong to the monetary authorities. Net foreign currency reserves are currently equal to only one month of imports, and odds are that the CBT will run out of its own foreign exchange reserves very soon. In such a case, the monetary authorities could choose to use banks' foreign currency deposits to defend the lira, but the CBT would then become liable to commercial banks. Since the government owns the central bank, this would ultimately become the government's liability. Although the monetary authorities could use commercial banks' foreign exchange reserves deposited at the CBT, the act of doing so would further undermine investor confidence, and foreign capital inflows would dry up and probably turn negative. This would also remove the buffer that prevents bank runs on foreign currency deposits from occurring. Furthermore, Table I-1 illustrates the current profile of Turkey's external debt. The high level of external and foreign exchange-denominated debt, as well as elevated foreign funding requirements - $150 billion or 21% of GDP over the next 12 months - mean that debtors and the overall economy have limited tolerance for further currency depreciation. Yet the only credible way to stem the currency's plunge is to hike interest rates. That, in turn, would produce a full-blown credit downturn, pushing the economy into recession. Hiking interest rates is precisely what Turkey did many times in the past when faced with unsustainable exchange-rate levels. However, that was back when the credit-to-GDP ratio was low (Chart I-8) and policymakers were more orthodox and followed IMF prescriptions. Table I-1Turkish External Debt By Sector Chart I-8Turkey's Credit-To-GDP ##br##Ratio Has Risen Considerably At the moment, President Erdogan is not only bashing orthodox monetary policies and blaming foreign speculators for his country's troubles,8 but also pursuing a geopolitical strategy that contradicts that of both the U.S. and the EU, as outlined above. Overall, having no appetite for higher interest rates and a recession, the Turkish authorities will ultimately have no choice but to opt for capital controls to diminish the lira's decline. Bottom Line: To prevent currency depreciation from causing a surge in interest rates and an economic implosion, policymakers will likely end up introducing capital controls. Is The Lira Cheap? Although the nominal exchange rate has depreciated a lot, the lira is not yet very cheap. This is because wages have been skyrocketing in local currency terms, while productivity has been stagnant (Chart I-9). This means Turkey's unit labor costs have swelled (Chart I-9, bottom panel). Consequently, the lira's real effective exchange rate is not yet very cheap (Chart I-10). When expressed in euros, unit labor costs in Turkey have not declined at all, and have not yet improved compared to those of central European countries (Chart I-11). Chart I-9Turkey: Low Productivity, ##br##High Unit Labor Costs Chart I-10Lira Is Not Cheap Chart I-11Turkish Manufacturing ##br##Is Not Competitive... Consistently, Turkey has lagged central European countries in penetrating European markets. Since 2006, Turkey's market share in non-energy European imports has been mostly flat, while it has significantly increased for central European countries (Chart I-12). Even though the rising export penetration of central European countries can also be attributable to factors beyond currency competitiveness, the point remains that Turkey needs further currency depreciation to boost exports. Consistent with the fact that the lira is not yet very cheap, Turkish manufacturing is struggling (Chart I-13) and the country's current account balance, excluding oil, has been deteriorating. Chart I-12...And Is Losing EU Market Share Chart I-13Turkish Industry Needs ##br##A Much Weaker Currency Bottom Line: The lira is not very cheap. It has to depreciate more to boost Turkey's competitiveness and ameliorate the current account deficit. Investment Recommendations Chart I-14Stay Underweight Turkish ##br##Stocks Versus The EM Benchmark Over the past several years, we have been recommending shorting/underweight Turkish assets on the grounds of a dire economic and financial outlook as well as uneasy geopolitics. We have repeatedly warned that the Turkish central bank cannot defy the Impossible Trinity - trying to control the exchange rate and interest rates simultaneously when the country has an open capital account. It seems a final showdown in policymakers' fight to control both the exchange rate and interest rates is looming: the odds of some sort of capital controls being implemented are rising. Dedicated EM equity and fixed-income portfolios (both credit and local-currency bonds) should continue underweighting Turkey (Chart I-14). Absolute-return and non-dedicated EM investors should limit their investments in Turkish financial markets. BCA's Emerging Markets Strategy service's trade of shorting the TRY versus the USD remains intact. However, we recommend investors book profits as the exchange rate approaches USD/TRY 3.9. Similarly, traders should take profits on our trade of shorting 2-year bonds and bank stocks when the lira's exchange rate gets closer to USD/TRY 3.9. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Stephan Gabillard, Research Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Indonesia: Beware Of Excessive Wage Inflation In the very near term, Indonesia, like other EM countries with current account deficits and high equity valuations, is vulnerable to rising U.S. bond yields, an associated relapse in EM currencies, and a simultaneous rise in local bond yields. Heading into 2017, Indonesian financial markets will likely come under pressure from a renewed decline in commodities prices and rising domestic inflation. While the country's structural fundamentals are much better than those of Turkey, South Africa, Brazil, and Malaysia, Indonesia's financial markets are quite vulnerable due to elevated valuations and foreign investor positioning. Indonesia has been one of the darlings of EM investors over the past several years, and any selloff in EM risk assets could trigger an exodus of capital. With foreigners holding some 40% of outstanding domestic bonds, Indonesia is vulnerable to capital outflows. Furthermore, the equity market has formed a major top and a breakdown is likely (Chart II-1). High Wage Inflation Is Bearish For The Rupiah And Local Rates The inflation outlook is deteriorating in Indonesia: Wages are rising briskly across most industries (Chart II-2). Even in recession-hit sectors such as mining, wages grew by a stunning 20% between February 2015 and February 2016. Given the general rise in commodities prices this year, labor will demand even higher wage growth in 2017. Chart II-1Indonesian Equities Formed A Major Top Chart II-2Indonesia's Wage Growth Is High The central government's October 2015 minimum wage regulation - which sets minimum wage increases at the level of nominal GDP growth - is unlikely to be successful in restraining wage growth. Labor unions are extremely powerful in Indonesia, and they are currently staging numerous protests demanding minimum wage increases on the order of 25% in 2017. We therefore believe average wage growth will continue to be higher than nominal GDP growth. Odds are that wage growth will be in the double digits, while nominal GDP is currently 8.4%. Please refer to Box II-1 for more details on the issue of unions and strikes. BOX II-1 Union Protests Against Wage Indexation Labor unions across the Indonesian archipelago are highly dissatisfied with the announced 2017 minimum wage level. As a result of the government's minimum wage reforms adopted last year, pushback by unions was inevitable. The new rules will tie minimum wages to nominal GDP instead of letting it be decided at the district level by unions, businesses, and local governments. Since the unions are now at risk of losing significant influence, they are staging protests: The North Sumatran administration announced an 8.3% increase in 2017 minimum wages, but the region's labor union fiercely objected to it. The latter is now planning major protests and threatening to paralyze the industrial sector if the authorities do not comply. The region is Indonesia's fourth-most populated. Similarly, in East Java, Indonesia's second-most populous province, labor unions are not satisfied by the announced wage rise and are demanding revisions. Meanwhile, the administration in South Sulawesi raised minimum wages for 2017 by 11.1% - above the central government's assigned level - and the business community has voiced major concerns. The provincial administration has nevertheless publicly denied it has violated the central government's policy. The Confederation of Indonesian Workers Unions (KSPI) has grown dissatisfied with the announced increase in Jakarta's minimum wage (8.25%). As a result, the KSPI decided to latch on to Islamist-led protests on December 2, demanding the ousting of Jakarta's Governor "Ahok" (Basuki Tjahaja Purnama). This highlights that labor unions are willing to tap into growing religious tensions in order to make their demands more potent. This could end up being a serious issue, requiring the central government to negotiate a compromise that waters down efforts to reform minimum wages. Strong wage growth has outpaced productivity gains, and will continue to do so. While strong wage gains are good for consumption, mushrooming unit labor costs (Chart II-3) are compressing corporate profit margins and damaging Indonesia's competitiveness. Companies faced with rising wages/labor costs will have to either hike prices or squeeze margins. Both scenarios are bearish for share prices. The central bank has been extremely dovish and has, so far, disregarded rampant wage growth. Odds are that it will be late in addressing rising inflationary pressures. Typically, the exchange rate of a country where its central bank is behind the inflation curve depreciates. We expect the Indonesian rupiah to weaken significantly as Bank Indonesia (BI) will be late to raise interest rates. Although the policy rate and domestic bonds yields appear attractive when compared with the inflation rate,9 interest rates are very low compared with wage growth. We believe wages, and more specifically unit labor costs, are more genuine indicators of underlying inflation dynamics than food or energy prices - even though the latter have large weights in Indonesia's consumer price index basket. In short, interest rates are too low when compared to wage growth. Notably, over the past year or so households and businesses shifted their deposits away from foreign currency and into local currency. It seems the trend is now reversing (Chart II-4). Growing demand for U.S. dollars from residents will also weigh on the rupiah. Chart II-3Unit-Labor Costs Are Soaring Chart II-4Indonesian Residents Will Start Buying Dollars A weaker currency will push up interest rates. Higher interest rates in turn will curtail credit growth. Chart II-5 shows that the local-currency loan impulse is already rolling over and will drag economic growth lower. Indonesian commercial banks are saddled with rising non-performing loans (NPLs). Banks will be forced to increase provisioning for bad assets, leading to slower profit and loan growth. For a detailed analysis on Indonesian banks, please refer to our May 18 Weekly Report.10 Finally, narrow (M1) money growth has rolled over decisively. Historically, this has coincided with a relapse in share prices (Chart II-6). Higher interest rates will ensure a further slowdown in M1, escalating downside risks in share prices. Chart II-5Indonesia: Loan Impulse Is Turning Chart II-6M1 Money Impulse: ##br##A Worrying Signal For Stocks External Vulnerability Next year, we expect commodities prices (especially, industrial metals and coal prices) to decline due to renewed weakness in Chinese demand. This negative terms-of-trade shock will further depress the rupiah, push up interest rates, and extend the equity market selloff. Chart II-7 shows that China's imports of coal from Indonesia have surged. There has been some improvement in final demand for coal and other commodities, but supply cutbacks in China as well as financial demand (investor speculation) explain most of the exponential rise in prices. This vertical move is unsustainable, and prices will drop next year. Importantly, Chinese demand will likely weaken. China's fiscal spending and credit impulses have rolled over, warranting less industrial demand for electricity (Chart II-8). Besides, property construction will contract anew following policy tightening, high leverage among developers and hidden inventories (Chart II-8, second panel). Coal and base metals account for about 15% of Indonesia's total exports. Palm oil makes up another 9%. Given that Indonesia is running both current account and fiscal deficits (Chart II-9), lower commodities prices will weigh on the exchange rate. Chart II-7Positive Terms Of Trade##br## Boost Unsustainable Chart II-8China Growth Relapse In 2017? Chart II-9Indonesia's Twin Deficits Bottom Line: Indonesian share prices and domestic bonds are expensive and over-owned by EM investors. We recommend underweighting/shorting Indonesia relative to EM equity, local bond and sovereign credit benchmarks, respectively. We are also maintaining short positions in the IDR versus the U.S. dollar and the HUF. Ayman Kawtharani, Research Analyst aymank@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see BCA Special Report, "Geopolitical Strategic Outlook 2012," dated January 27, 2012, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 4 President Erdogan, speaking at the first Inter-Parliamentary Jerusalem Platform Symposium in Istanbul in November 2016, said that Turkey "entered [Syria] to end the rule of the tyrant al-Assad who terrorizes with state terror... We do not have an eye on Syrian soil. The issue is to provide lands to their real owners. That is to say we are there for the establishment of justice." 5 A risk does exist, however, of Russia retaliating against Turkish actions in the Middle East by attacking Turkey itself. At that point, it would be a legal question whether Article 5 still applied. We are certain that Europe and the U.S. would not come to Turkey's aid, particularly if Turkey was the aggressor in Syria or Iraq. 6 Please see BCA Global Investment Strategy and Geopolitical Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Monthly Report, "Turkey: Canary In The EM Coal Mine?" in "The Coming Political Recapitalization Rally," dated June 13, 2013, available at gps.bcaresearch.com. 8 President Erdogan, speaking at a Borsa Istanbul ceremony on November 23, said "We are heirs to the Ottoman Empire, which had been exploited since 1854 when it took its first external loan by banks, bankers and loan sharks. Some years tax revenues could not cover the interest payment. However, I can't consent to wasting what rightfully belongs to my people through high real interest rate." 9 This is why Indonesia scores as one of the most attractive EM local bond markets in our analysis published in last week. Please refer to our Emerging Markets Strategy Weekly Report, titled "Will The Carnage In EM Local Bonds Persist?" dated November 30, 2016; the link to the report is available on page 23. 10 Please see Emerging Markets Strategy Weekly Report, titled "EM Bonds: Unloved And Under-Owned?" dated May 18, 2016; available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights Trump's foreign policy proposals will exacerbate geopolitical risks. Sino-American relations are the chief risk - they will determine global stability. A Russian reset will benefit Europe, especially outside the Russian periphery. Trump will retain the gist of the Iran nuclear deal. Turkey and North Korea are wildcards. Feature Chart 1Market Rally Redoubled After Trump's Win Financial markets rallied sharply after the election of Donald Trump and the resulting prospect of lower taxes, fewer regulations, and greater fiscal thrust (Chart 1). But is the euphoria justified in light of Trump's unorthodox views on U.S. foreign policy and trade? Is Trump's "normalization" amid the transition to the White House a reliable indicator that the geopolitical status quo will largely be preserved? We believe Trump's election marks a substantial increase in geopolitical risk that is being understated by markets.1 This is not because of his personality, though that is not particularly reassuring, but rather because of his policy proposals. If acted on, Trump's geopolitical agenda would exacerbate global trends that are already underway: Waning U.S. Dominance: American power, relative to other nations, has been declining in recent years as a result of the emergence of new economic and military powers like China and India (Chart 2). If Trump allows himself to be sucked into another conflict despite his campaign promises - say, by overturning the nuclear deal with Iran - he could embroil the U.S. at a time when it is relatively weak. Multipolarity: America's relative decline has emboldened various other nations to pursue their interests independently, increasing global friction and creating a world with multiple "poles" of influence.2 If Trump keeps his word on reducing foreign commitments he will speed along this historically dangerous process. Lesser powers like Russia and Turkey will try to fill vacuums created by the U.S. with their own ambitions, with competition for spheres of influence potentially sparking conflict. Multipolarity has already increased the incidence of global conflicts (Chart 3). De-Globalization: The greatest risk of the incoming administration is protectionism. Trump ran on an overtly protectionist platform. Democratic-leaning economic patriots in the American "Rust Belt" handed him the victory (Chart 4), and he will enact policies to maintain these pivotal supporters in 2018 and 2020 elections. This will hasten the decline of trade globalization, which we signaled was peaking back in 2014.3 It does not help that multipolarity and collapse of globalization have tended to go hand in hand in the past. And historically speaking, big reversals in global trade do not end well (Chart 5). Chart 2U.S. Power Eroding In A Relative Sense Chart 3Multipolarity Increases Conflict Frequency Chart 5Declines In Global Trade Preceded World Wars In what follows we assess what we think are likely to be the most important geopolitical effects of Trump's "America First" policies. We see Russia and Europe as the chief beneficiaries, and China and Iran as the chief risks. A tougher stance on China, in particular, will feed broader strategic distrust; the combination of internal and external pressures on China will ensure that the latter will not be as flexible as in the past. For the past five years, BCA's Geopolitical Strategy has stressed that the deterioration in Sino-American cooperation is the greatest geopolitical risk for investors - and the world. Trump's election will accelerate this process. Trump And Eurasia Trump's election is clearly a boon for Russia. Over the past 16 years, Russia has methodically attempted to collect the pieces from the Soviet collapse. The purpose of Putin's assertiveness has been to defend the Russian sphere of influence (namely Ukraine and Belarus in Europe, the Caucasus, and Central Asia) from outside powers: the U.S. and NATO seemed eager to "move in for the kill" after Russia emerged from the ashes. Putin also needed to rally popular support at various times by distracting the public with "rally around the flag" operations. We view Ukraine and Syria through this analytical prism. Lastly, Russia acted aggressively because it needed to reassure its allies that it would stand up for them.4 And yet the U.S. can live with a "strong" Russia. It can make a deal with Russia if the Trump administration recognizes some core interests (e.g. Crimea) and calls off the "democracy promotion" activities that Putin considers to be directly aimed at the Kremlin. As we argued during the Ukraine invasion, it is the U.S., not Russia, which poses the greatest risk of destabilization.5 That is because the U.S. lacks constraints. It can be aggressive towards Russia and face zero consequences: it has no economic relationship with Russia (Chart 6) and does not stand directly in the way of any retaliation, as Europe does. That is why we think Trump and Putin will manage to reset relations. The U.S. can step back and allow Russia to control its sphere of influence. Trump's team may be comfortable with the concept, unlike the Obama administration, whose Vice-President Joe Biden famously pronounced that America "will not recognize any nation having a sphere of influence." We could even see the U.S. pledging not to expand NATO from this point onwards, given that it has already expanded as far as it can feasibly and credibly go. Note, however, that a Russo-American truce may not last long. George W. Bush famously "looked into Putin's eyes and ... saw his soul," but relations soured nonetheless. Obama went further with his "Russian reset," removing European missile defense plans from avowed NATO allies Poland and Czech Republic merely one year after Russian troops invaded Georgia. And yet Moscow and Washington ended up rattling sabers and meddling in each other's internal affairs. Ultimately, U.S. resets fail because Russia is in a structural decline as a great power and is attempting to hold on to a very large sphere of influence whose denizens are not entirely willing participants.6 Because Moscow often must use blunt force to prevent the revolt of its vassal states (e.g. Georgia in 2008, Ukraine in 2014), it renews tensions with the West. Unless Russia strengthens significantly in the next few years, we would expect the cycle to continue. On the horizon may be Ukraine-like incidents in neighboring Belarus and Kazakhstan, both key components of the Russian sphere of influence. Bottom Line: Russia will get a reprieve from U.S. pressure under Trump. While we expect Europe to extend sanctions through the end of 2017, a rapprochement with Washington could ultimately thaw relations by the end of next year. Europe stands to benefit, being able to resume business as usual with Russia and face less of a risk of Russian provocations via the Middle East, like in Syria. The recent decline in refugee flows will be made permanent with Russia's cooperation. The losers will be states in the Russian periphery that will feel less secure about American, EU and NATO backing, particularly Ukraine, but also Turkey. Countries like Belarus, which enjoyed playing Moscow against the West in the past, will lose the ability to do so. Once the U.S. abandons plans to prop up pro-West regimes in the Russian sphere of influence, Europeans will drop their designs to do the same as well. Trump And The Middle East Trump's "America First" foreign policy promises to be Obama's "geopolitical deleveraging" on steroids. He is opposed to American adventurism and laser-focused on counter-terrorism and U.S. domestic security. He also wants to deregulate the U.S. energy sector aggressively to encourage even greater energy independence (Chart 7). The chief difference from Obama - and a major risk to global stability - is Iran, where Trump could overturn the Obama administration's 2015 nuclear deal, potentially setting the two countries back onto the path of confrontation. Nevertheless, this deal never depended on Obama's preferences but was rooted in a strategic logic that still holds:7 Iraqi stability: The U.S. needed to withdraw troops from Iraq without creating a power vacuum that would open up a regional war or vast terrorist safe haven. With the advent of the Islamic State, this plan clearly failed. However, Iran did provide a Shia-led central government that has maintained security for investments and oil outflows (Chart 8). Iranian defenses: Bombing Iran is extremely difficult logistically, and the U.S. did not want to force the country into a corner where asymmetric warfare, like cutting off shipping in the Straits of Hormuz, seemed necessary. Despite growing American oil production, the U.S. will always care about the transit of oil through the Straits of Hormuz, as this impacts global oil prices.8 China's emergence: Strategic threats grew rapidly in Asia while the U.S. was preoccupied in Iraq and Afghanistan. China has emerged as a more technologically advanced and assertive global power that threatens to establish hegemony in the region. The deal with Iran was therefore a crucial piece of President Obama's "Pivot to Asia" strategy. Chart 7U.S. Becoming More Energy Independent Chart 8U.S. Policy Boosts Iraqi And Iranian Oil None of the above will change with Obama's moving on. Nor will the other powers that participated in sanctioning Iran (Germany, France, the U.K., Russia, and China) be convinced to re-impose sanctions now, just as they gain access to Iranian resources and markets. It is also not clear why Trump would seek confrontation with Iran in light of his desire to improve relations with Russia and concentrate U.S. firepower on ISIS - both objectives make Iran the ideal and obvious partner. Trump will therefore begrudgingly agree to the détente with Iran, perhaps after tweaking some aspects of the deal to save face. Meanwhile, it will serve the hawks in both countries if they can go back to calling each other "Satan." Iran itself is comfortable with the current situation, so it does not have an incentive to reverse the deal. It controls almost half of Iraq (and specifically the portion of Iraq that produces oil), its ally Hezbollah is safe in Lebanon, its ally Bashar Assad will win in Syria (more so with Trump in charge!), and its allies in Yemen (Houthi rebels) are a status quo power secure in a mountain fortress in the north of the country. It is hard to see where Trump would dislodge Iranian influence if he sought to do so. The U.S. is a powerful country that could put a lot of resources into rolling back Iranian influence, but the logic for such a move simply does not exist. Trump will also maintain Obama's aloof policy toward Saudi Arabia, which keeps it constrained (Chart 9).9 The country is in some ways the stereotype of the "ungrateful ally" that Trump wants to downgrade. For instance, Trump supported the law allowing victims of the September 11 attacks to sue the kingdom (a law that Obama tried unsuccessfully to veto). He has blamed the Saudis for the rise of ISIS and the failure to take care of Syrian refugees. His primary focus is on preventing terrorists from striking the U.S., and to that end he wants to cooperate with Russia and stabilize the region's regimes. This entails the relative neglect of Sunni groups under Shia rule in Syria and Iraq. Indeed, the few issues where the Saudis will welcome Trump - opposition to the Iran nuclear deal, support for Egypt's military ruler Abdel Fattah el-Sisi, and opposition to aggressive democracy promotion - are so far rhetorical, not concrete, commitments. Chart 9Saudi Arabia Sees The U.S. Stepping Back Will Trump get sucked into the region to intervene against ISIS? We do not think so. A bigger risk is Turkey.10 President Recep Erdogan may think that Trump will either be too complacent about Turkish interests in Syria, or that Trump is in fact a "kindred nationalist spirit" who will not prevent Turkey from pursuing its own sphere of influence in Syria and northern Iraq. Trump's foreign policy of "offshore balancing" would call for the U.S. to prevent Turkey from resurrecting any kind of regional empire, especially if it risks a war with Russia and Iran or comes at the cost of regional influence for American allies like the Kurds.11 Turkey will also be starkly at odds on Syria and ISIS. This means Turkey and the U.S. could see already tense relations get substantially worse in 2017. We would not be surprised to see President Trump threaten Erdogan with expulsion from NATO within his first term. Bottom Line: The biggest risk to our view is that Trump rejects the consensus of the intelligence and defense establishment and pushes Iran too far, leading to conflict. We do not think this will happen, but his rhetoric on the nuclear deal has been consistently negative and he seems likely to favor "Middle East hands" for top cabinet positions. He could involve the country in new Middle East entanglements if he does not show discipline in adhering to his non-interventionist preferences - particularly if he overreacts to an attack. Nonetheless, we believe that America's policy of geopolitical deleveraging from the Middle East will continue. Trump may have a mandate to be tough on terrorism from his voters, but he definitely does not have a free hand to commit military resources to the region. Trump And Asia Trump criticized China furiously during the campaign, declaring that he would name China a currency manipulator on his first day in office and threatening to impose a 45% tariff on Chinese imports. However, there is a familiar pattern of China bashing in U.S. presidential elections that leads to no sharp changes in policy.12 Will Trump be different? Some would argue that relations may actually improve, given how bad they already are. First, Trump's chief concern is to fire up the U.S. economy's animal spirits, and that would support China's ailing economy as long as he does not couple his tax cuts and fiscal stimulus with aggressive protectionist measures (Chart 10). Proponents of this view would point out that Trump's tougher measures may be called off when he realizes that the Chinese current account surplus has fallen sharply in recent years (Chart 11), and that the PBoC is propping up the RMB, not suppressing it. Similarly, Trump's China-bashing trade advisor, the former steel executive Dan DiMicco, may not get much traction given that the U.S. has largely shifted to Brazilian steel imports (Chart 12). In short, the U.S. could take a somewhat tougher stance on specific trade spats without provoking a vicious spiral of discriminatory actions. The fact that the U.S. is more exposed than ever to trade with emerging markets only reinforces the idea that it does not want to spark a real trade war (Chart 13). Chart 10A Trump Boom, Sans Protectionism, Would Lift Chinese Growth Chart 11China's Economy Rebalancing Chart 12China Already Lost The Chart 13A Reason To Eschew Protectionism Second, the Obama administration's "Pivot to Asia" and attempts to undermine China's economic influence in the region through the Trans-Pacific Partnership (TPP) have aggravated China with little substantive gain. By contrast, Trump may emphasize American business access to China over Chinese citizens' freedoms - which could reduce the risk of conflict. He may not go beyond symbolic protectionist moves, like the currency manipulation charge, and meanwhile canceling the never-ratified TPP would be a net gain for China.13 In essence, Trump, despite his populist rhetoric, could prove both pragmatic and willing to inherit the traditional Republican stance of business-oriented positive engagement with China. This is a compelling argument and we take it seriously. But it is not our baseline case. Rather, we think Trump will eventually take concrete populist steps that will mark a departure from U.S. policy in recent memory. As mentioned, it was protectionist blue-collar voters in the Midwest who gave Trump the White House, and he will need to retain their loyalty in coming elections. Moreover, the secular flatlining of American wages and the growth of income inequality have moved the median U.S. voter to the left of the economic spectrum, as we have argued.14 Neo-liberal economic policy has fewer powerful proponents than in the recent past. Thus, in the long run, we expect the grand renegotiation with China to fall short of market hopes, and Sino-American tensions to resume their upward trajectory.15 Why are we so pessimistic? Three main reasons: The "Thucydides Trap": Sino-U.S. tensions are fundamentally driven not by trade disputes but by the U.S.'s fear of China's growing capability and ambition.16 Great conflicts in history have often occurred when a new economic and military power emerged and tried to alter the regional political arrangements set up by the dominant power. This was as true in late nineteenth-century Europe, with the rise of Germany vis-à-vis the U.K. and France (Chart 14), as it was in ancient Greece. The rise of Japan in the first half of the twentieth century had a similar effect in Asia (Chart 15). Trump could, of course, endorse Xi's idea of a "new type of great power relations," which is supposed to avoid this problem. But nobody knows what that would look like, and greater trade openness is the only conceivable foundation for it. Chart 15AThe Disruptive Rise Of Germany Chart 15BThe Disruptive Rise Of Japan China's economic imbalances: A caustic dose of trade remedies from the Trump administration will compound internal economic pressures in China resulting from rampant credit expansion, misallocation of capital, excessive money printing, and capital outflows (Chart 16).17 The combination of internal and external pressures is potentially fatal and China's leaders will fight it. Otherwise, they risk either the fate of the Soviets or of the Asian strongman regimes that succumbed to democracy after embracing capitalism fully. Instead, China will avoid rushing its structural reforms (it is, after all, currently closing its capital account), and protect its consumer market, which it hopes to be the growth engine going forward. This is not a strong basis for the "better deal" that Trump will demand. President Trump will want China to open up further to U.S. manufacturing, tech, and service exports. Economics and the security dilemma: China and the U.S. will not be able to prevent economic tensions from spilling over into broader strategic tensions. Compare the spike in trade tensions with Japan in the 1980s, when Japanese exports to the U.S. peaked and the U.S. strong-armed Japan into appreciating its currency (Chart 17). The U.S. had nurtured Japan and South Korea out of their post-war devastation by running large trade deficits and enabling them to focus on manufacturing exports while minimizing spending on defense. China joined this system in the 1980s and has largely resembled the formal U.S. allies (Chart 18). Given that China has largely followed Japan's path, it was inevitable that the U.S. would eventually lose patience and become more competitive with China. China has seized a greater share of the U.S. market than Japan had done at that time, and its exports are even more important to the U.S. as a share of GDP (Chart 19). Comparing the exchange rates then and now, the Trump administration will be able to argue that China's currency is overdue for appreciation (Chart 20). However, in the 1980s, the U.S. and Japan faced no risk of military conflict - their strategic hierarchy was entirely settled in 1945. The U.S. and China have no such understanding. There is no way of assuring China that U.S. economic pressure is not about strategic dominance. In fact, it is about that. So while China may be cajoled into promising faster reforms - given that its trade surplus with the U.S. is the only thing that stands between it and current account deficits (Chart 21) - nevertheless it will tend to dilute and postpone these reforms for the sake of its own security, putting Trump's resolve to the test. Chart 16Flashing Red Light On China's Economy Chart 17The U.S. Forced Structural Changes On Japan Chart 18Asia Sells, America Rules Chart 19The U.S. Will Get Tougher On China Trade Chart 20China Drags Its Feet On RMB Appreciation Chart 21A Reason For China To Kowtow Trump's victory may also heighten Beijing's fears that it is being surrounded by the U.S. and its partners. That is because Trump will make the following developments more likely: Better Russian relations: From a bird's eye view, Trump's thaw with Putin could mark an inversion of Nixon's thaw with Mao. China is the only power today that can stand a comparison with the Soviet Union during the Cold War. The U.S. at least needs to make sure the Sino-Russian relationship does not become too warm (Chart 22).18 Russo-Japanese peace treaty: The two sides are already working on a treaty, never signed after World War II. Aside from their historic territorial dispute, the U.S. has been the main impediment by demanding Japan help penalize Russia after the invasion of Ukraine. Yet negotiations have advanced regardless, and Japanese air force scrambles against Russia have fallen while those against China have continued to spike (Chart 23). The best chance for a deal since the 1950s is now, with Abe and Putin both solidly in power until 2018. This would reduce Russian dependency on China for energy markets and capital investment, and free up Japan's security establishment to focus on China and North Korea. American allies are not defecting: The United States armed forces are deeply embedded in the Asia Pacific region and setbacks to the "pivot" policy should not be mistaken for setbacks to U.S. power in the absolute.19 U.S. allies like Thailand, the Philippines, and (soon) South Korea are in the headlines for seeking to warm up ties with China, but there is no hard evidence that they will turn away from the U.S. security umbrella. Rather, the pivot reassured them of U.S. commitment, giving them the flexibility to focus on boosting their economies, which means sending emissaries to Beijing. The problem is that Beijing knows this and will therefore still suspect that a "containment" strategy is underfoot over time. Better Indian relations: The Bush administration made considerable progress in improving ties with India. Trump also seems India-friendly, which would be supported by better ties with Russia and Iran. India could therefore become a greater obstacle to China's influence in South and Southeast Asia. Chart 22Energy A Solid Foundation For Sino-Russian Ties Chart 23Japan's Strategic Predicament From the above, we can draw three main conclusions: The U.S. role in the Pacific will determine global geopolitical stability under the Trump administration. The primary question is whether China is willing and able to accede to enough of Trump's demands to ensure that the U.S. and China have at least "one more fling," a further extension to the post-1979 trade relationship. It is possible that China is simply unable to do so and in the face of any concrete sanctions by Trump, will batten down the hatches, rally people around the flag, and shore up the state-led economy. There may be a tactical U.S.-China "improvement" over the next year - relative to the worst fears of trade war under Trump - but it will not be durable. The year 2017 will be the year of Trump's "honeymoon," while Xi Jinping will be focused on internal politics ahead of the Communist Party's crucial National Party Congress in the fall.20 Thus, after Trump gives China a "shot across the bow," like charging it with currency manipulation, the two sides will likely settle down at the negotiating table and send positive signals to the world about their time-tried ability to manage tensions. Financial markets will see through Trump's initially symbolic actions and begin to behave as if nothing has changed in U.S.-China relations. However, this calm will be deceiving, since economic and security tensions will eventually rise to the surface again, likely in a more disruptive way than ever before. China's periphery will be decisive, especially the Korean peninsula. The Koreas could become the locus of East Asia tensions for two reasons. First, North Korea's nuclear weaponization has reached a level that is truly alarming to the U.S. and Japan.21 New sanctions, if enforced, have real teeth because they target commodity exports (Chart 24). The problem is that China is unlikely to enforce them and South Korean politics are likely to turn more China-friendly and more pacific toward the North with the impending change of ruling parties. This will leave the U.S. and Japan with legitimate security grievances but less of an ability to change the outcome through non-military means. That is an arrangement ripe for confrontation. Separately, China's worsening relations with Taiwan, Vietnam's resistance to China's power-grab in the South China Sea, and conflicts between India and Pakistan will be key barometers of regional stability vis-à-vis China. Chart 24Will China Cut Imports From Here? The risk to this view, again, is that a Middle East crisis could distract the Trump administration. This would mark an excellent opportunity for China to build on its growing regional sway, and it would delay our baseline view that the Asia Pacific is now the chief source of geopolitical risk in the world. Investment Conclusions There is no geopolitical risk premium associated with Sino-American tensions. Our clients, colleagues, and friends in the industry are at a loss when we ask how one should hedge tensions in the region. This is a major risk for investors as the market will have to price emerging tensions quickly. Broadly speaking, Sino-American tensions will reinforce the ongoing de-globalization. If the top two global economies are at geopolitical loggerheads, they are more likely to see their geopolitical tensions spill over to the economic sphere. Unwinding globalization implies that inflation will make a comeback, as the reduction in flows of goods, services, capital, and people gradually increases supply constraints. This is primarily bad for bonds, which have enjoyed a bull market for the past three decades that we see reversing.22 At the same time, these trends suggest that investors should favor consumer-oriented sectors and countries relative to their export-reliant counterparts, and small-to-medium sized businesses over externally-exposed multinationals. BCA Geopolitical Strategy's long S&P 600 / short S&P 100 trade is up 7.4% since inceptionon November 9. Finally, these trends, combined with the associated geopolitical risks of various powers struggling for elbow room, warrant a continuation of the Geopolitical Strategy theme of favoring Developed Markets over Emerging Markets, which has made a 45.5% return since inception in November 2012. The centrality of China risk only reinforces this view. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 Please see our initial discussion of Trump's foreign policy, "U.S. Election Update: Trump, Presidential Powers, And Investment Implications," in BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization: All Downhill From Here," dated November 12, 2014, and, more recently, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 4 Please see "In Focus - Cold War Redux?" in BCA Geopolitical Strategy Monthly Report, "It's A Long Way Down From The 'Wall Of Worry,'" dated March 2014, and Geopolitical Strategy Special Report, "Russia: To Buy Or Not To Buy?" dated March 20, 2015, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Russia-West Showdown: The West, Not Putin, Is The 'Wild Card,'" dated July 31, 2014, available at gps.bcaresearch.com. 6 Please see BCA's Emerging Markets Strategy Special Report, "Russia's Trilemma And The Coming Power Paralysis," dated February 21, 2012, available at ems.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "End Of An Era For Oil And The Middle East," dated April 8, 2015, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "Saudi Arabia's Choice: Modernity Or Bust," dated May 11, 2016, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "Turkey: Strategy After The Attempted Coup," dated July 18, 2016, available at gps.bcaresearch.com. 11 Please see John J. Meirsheimer and Stephen M. Walt, "The Case For Offshore Balancing: A Superior U.S. Grand Strategy," Foreign Affairs, July/August 2016, available at www.foreignaffairs.com. 12 Please see BCA China Investment Strategy, "China As A Currency Manipulator?" dated November 24, 2016, available at cis.bcaresearch.com. 13 One of his foreign policy advisors, former CIA head James Woolsey, has floated the idea that the U.S. could turn positive about Chinese initiatives like the Asian Infrastructure Investment Bank and the One Belt One Road program to link Eurasian economies. Please see Woolsey, "Under Donald Trump, the US will accept China's rise - as long as it doesn't challenge the status quo," South China Morning Post, dated November 10, 2016, available at www.scmp.com. 14 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy and Global Investment Strategy Joint Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 16 Please see Graham Allison, "The Thucydides Trap: Are The U.S. And China Headed For War?" The Atlantic, September 24, 2015, available at www.theatlantic.com. 17 Please see BCA Emerging Markets Strategy Special Report, "China's Money Creation Redux And The RMB," dated November 23, 2016, available at ems.bcaresearch.com. 18 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 21 Please see "North Korea: A Red Herring No More?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 22 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com.