Austria

Overweight Selected Companies Dear Client, This week I am away visiting clients in Australia, so we are sending you this report written by my colleague Oleg Babanov (Emerging Market Equity Sector Strategy). Oleg identifies select companies in Austria as excellent conduits to emerging market growth whilst maintaining high standards of corporate governance. Oleg also has a list of top stocks in Poland, Russia and Turkey. Please contact us if you would like to see those additional picks. Dhaval Joshi Highlights We are recommending an overweight position in select Austrian companies on a long-term (one year-plus) time horizon. Austrian-listed companies traditionally have high exposure to Central and Eastern Europe (CEE) and other Emerging Markets (EM), while offering superior corporate governance standards, which secures a premium to EM peers. At the same time, geographically diversified revenues stemming from developed and emerging markets support less-volatile earnings growth and outperformance over the long-term. Table 1Single-Stock Statistics On Select Austrian Companies* Austria: High EM Exposure And Corporate Governance Standards Austria: High EM Exposure And Corporate Governance Standards Austrian Companies - EM Focused... Companies in Austria have traditionally been active in both Western Europe, with a main focus in Austria and Germany, as well as in the CEE region, providing investors with a unique access to both kind of markets. Sectors with high exposure include financials, with around 56% in emerging markets, consumer discretionary, with 46%, and materials with 45%. Furthermore, in terms of company count, pretty much every listed company in the materials as well as the real estate sector has exposure to emerging markets (Chart I-1A, Chart I-1B, Chart I-1C, Chart I-1D, Chart I-1E, Chart I-1F). Chart I-1AGeographical Revenue Breakdown Austria: ##br##Consumer Discretionary Austria: High EM Exposure And Corporate Governance Standards Austria: High EM Exposure And Corporate Governance Standards Chart I-1BGeographical Revenue Breakdown Austria: ##br##Financials Austria: High EM Exposure And Corporate Governance Standards Austria: High EM Exposure And Corporate Governance Standards Chart I-1CGeographical Revenue Breakdown Austria:##br## IT Austria: High EM Exposure And Corporate Governance Standards Austria: High EM Exposure And Corporate Governance Standards Chart I-1DGeographical Revenue Breakdown Austria:##br## Materials Austria: High EM Exposure And Corporate Governance Standards Austria: High EM Exposure And Corporate Governance Standards Chart I-1EGeographical Revenue Breakdown Austria: ##br##Real Estate Austria: High EM Exposure And Corporate Governance Standards Austria: High EM Exposure And Corporate Governance Standards Chat I-1FGeographical Revenue Breakdown Austria:##br## Utilities Austria: High EM Exposure And Corporate Governance Standards Austria: High EM Exposure And Corporate Governance Standards ...And With High Corporate Governance Standards The Austrian ATX equity index has significantly outperformed the MSCI EM index on both a long-term (+21% over five years and +27% over three years) and short-term time horizon (+12%) (Chart I-2A & Chart 1-2B). Chart I-2AFive-Year Performance: ##br##Austrian ATX Index Vs. MXEF Index Five-Year Performance: Austrian ATX Index Vs. MXEF Index Five-Year Performance: Austrian ATX Index Vs. MXEF Index Chart I-2BYTD Performance:##br## Austrian ATX Index Vs. MXEF Index YTD Performance: Austrian ATX Index Vs. MXEF Index YTD Performance: Austrian ATX Index Vs. MXEF Index We believe part of this outperformance is warranted by better corporate governance standards of Austrian companies, which score highly compared to their emerging market peers on all metrics, with the exception of environmental disclosure (Chart I-3A, Chart I-3B, Chart I-3C, Chart I-3D).1 Effectively such companies are offering investors access to emerging markets with less corporate risk, and better management and disclosure standards. Chart I-3AESG Disclosure Comparison Austria: High EM Exposure And Corporate Governance Standards Austria: High EM Exposure And Corporate Governance Standards Chart I-3BSocial Disclosure Comparison Austria: High EM Exposure And Corporate Governance Standards Austria: High EM Exposure And Corporate Governance Standards Chart I-3CEnvironment Disclosure Comparison Austria: High EM Exposure And Corporate Governance Standards Austria: High EM Exposure And Corporate Governance Standards Chart I-3DGovernance Disclosure Comparison Austria: High EM Exposure And Corporate Governance Standards Austria: High EM Exposure And Corporate Governance Standards Based on the findings above, we have created a portfolio of six companies from the consumer discretionary, financials, real estate and industrials sectors, combining exposure to emerging markets with a high ESG score and sound operational and financial performance (Table I-2). Table I-2Select Overweight Companies And ##br##12-Month Beta Vs. MSCI EM Austria: High EM Exposure And Corporate Governance Standards Austria: High EM Exposure And Corporate Governance Standards Sector Specifics Price performance over the past five years has been strong, with our overweight basket outperforming the broad MSCI EM index by 53% (Chart I-4). Valuations between Austrian banks and companies from other sectors are diverging. While non-bank companies are trading at a 16% premium to EM peers on a P/E basis, Austrian banks are trading at a 14% discount to the EM Banks Index on a price-to-book comparison (Chart I-5). Chart I-4Select Austrian Companies Outperforming##br## MSCI EM Index Select Austrian Companies Outperforming MSCI EM Index Select Austrian Companies Outperforming MSCI EM Index Chart I-5Valuations Are Diverging##br## Depending On Sector Valuations Are Diverging Depending On Sector Valuations Are Diverging Depending On Sector Nevertheless, Austrian companies display better bottom-line growth dynamics, helped by recovering performance on an operational level, translating into slightly higher profitability (Chart I-6A, Chart I-6B, Chart I-6C). Chart I-6AA Recovery In Operating Margins Of ##br##Austrian Companies In Late 2015... A Recovery In Operating Margins Of Austrian Companies In Late 2015... A Recovery In Operating Margins Of Austrian Companies In Late 2015... Chart I-6B...Has Helped EPS Growth To Outstrip EM ##br##Companies Since The End Of 2015... ...Has Helped EPS Growth To Outstrip EM Companies Since The End Of 2015... ...Has Helped EPS Growth To Outstrip EM Companies Since The End Of 2015... Chart I-6C...While Profitability Is Close ##br##To The EM Average ...While Profitability Is Close To The EM Average ...While Profitability Is Close To The EM Average Chart I-7ACash Flow Generation Is Subdued##br## Among Austrian Companies... Cash Flow Generation Is Subdued Among Austrian Companies... Cash Flow Generation Is Subdued Among Austrian Companies... Furthermore, despite negative cash flow generation for the select basket, Austrian companies have comfortable debt levels, and are paying out higher dividends than EM companies (Chart I-7A, Chart I-7B, Chart I-7C). Chart I-7B...With Debt Levels Close To The EM Average... ...With Debt Levels Close To The EM Average... ...With Debt Levels Close To The EM Average... Chart I-7C...And Dividend Yields Higher Than EM Peers ...And Dividend Yields Higher Than EM Peers ...And Dividend Yields Higher Than EM Peers The Overweight Basket Erste Group Bank (EBS AV) Austria: High EM Exposure And Corporate Governance Standards Austria: High EM Exposure And Corporate Governance Standards Erste Group Bank (EBS AV) (Chart I-8). Chart I-8Performance Since October 2016: ##br##Erste Group Bank vs. MSCI EM Performance Since October 2016: Erste Group Bank vs. MSCI EM Performance Since October 2016: Erste Group Bank vs. MSCI EM Erste Group Bank (EBS AV) reported better-than-expected third-quarter 2017 financial results on November 3. Net interest income stabilized, ticking up 1% year over year, mainly driven by the integration of Citigroup's consumer banking business in Hungary. Net interest margin was still under pressure, down 4 basis points year over year to 2.39%. Net fee and commission income expanded by 4%, supported by fee income, but was offset by trading income deterioration. Operating expenses grew by 3% year over year due to regulatory and IT project costs. With the decrease in provisions offsetting declining operating results, the bottom line rose by 8% year over year. Asset quality showed improvement, with the NPL ratio shrinking by a significant 111 basis points year over year to 4.3%. The company's tier-1 ratio grew by 2 basis points year over year to 13.4%. The market is estimating a 0.2% EPS CAGR over the next four years. We believe operating expenses should grow at a slower pace in the coming quarters, positively affected by decelerating regulatory and IT project investments. At the same time, we expect net interest income to continue to expand, driven by strong macro performance in the CEE region and countercyclical measures by the corresponding central banks. Raiffeisen Bank (RBI AV) Austria: High EM Exposure And Corporate Governance Standards Austria: High EM Exposure And Corporate Governance Standards Raiffeisen Bank (RBI AV) (Chart I-9). Chart I-9Performance Since October 2016:##br## Raiffeisen Bank vs. MSCI EM Performance Since October 2016: Raiffeisen Bank vs. MSCI EM Performance Since October 2016: Raiffeisen Bank vs. MSCI EM Raiffeisen Bank International (RBI AV) reported remarkable third-quarter 2017 financial results on November 14, solidly beating market expectations. Net interest income advanced by 4% year over year, with net interest margin up 4 basis points to 2.47%. Net fee and commission income climbed by 8% year over year, boosted by the bank's payment transfer business but offset by sluggish trading income as well as a one-off litigation cost in Slovakia. However, pre-provisional profit surged by 35% thanks to disciplined cost management. As a result, net income soared 46% year over year, substantially beating market expectations. Asset quality improvement was another positive. The NPL ratio came in at 6.7%, down 200 basis points year over year, aided by slower NPL formation and write-offs. The tier-1 capital ratio expanded by 100 basis points year over year to 13.4%. The market is estimating an 18% EPS CAGR over the next four years. We welcome the bank's digital transformation strategy in Romania. We believe the new version of the banking platform to be launched in 2018 will better support customers' needs and optimize the bank's transaction business. Andritz AG (ANDR AV) Austria: High EM Exposure And Corporate Governance Standards Austria: High EM Exposure And Corporate Governance Standards Andritz AG (ANDR AV) (Chart I-10). Chart I-10Performance Since October 2016:##br## Andritz vs. MSCI EM Performance Since October 2016: Andritz vs. MSCI EM Performance Since October 2016: Andritz vs. MSCI EM Andritz AG (ANDR AV) reported weak third-quarter 2017 financial results on November 3. Revenue contracted by 8% year over year, weaker across all business segments, especially in pulp and paper (-13%). This was reflected by a shrinkage in overall order intakes, down 9% year over year. In terms of geographic exposure, Andritz continues its sales expansion in Europe (+6%) and China (+25%). EBITDA fell 9% year over year, mainly dragged down by the materials business, despite this being moderately compensated by the separation business segment. EBITDA margin was also disappointing across the board, down 20 basis points year over year to 7.2%, except for the hydro segment (+154%). As a result, the bottom line declined by 20% year over year, missing market expectations. Andritz is trading at a forward P/E of 16.5x, while the market is estimating a 4.7% EPS CAGR over the next four years. Despite lower-than-expected third-quarter earnings, we remain bullish on the company, given its strong track record of business growth in difficult environments. Earlier this month, the company won a contract from SaskPower to refurbish a hydroelectric power station in Canada, with a total contract value of more than US$104 million. CA Immobilien Anlagen (CAI AV) Austria: High EM Exposure And Corporate Governance Standards Austria: High EM Exposure And Corporate Governance Standards CA Immobilien Anlagen (CAI AV) (Chart I-11). Chart I-11Performance Since October 2016: ##br##CA Immobilien Anlagen vs. MSCI EM Performance Since October 2016: CA Immobilien Anlagen vs. MSCI EM Performance Since October 2016: CA Immobilien Anlagen vs. MSCI EM CA Immobilien Anlagen AG (CAI AV) reported better-than-expected third-quarter 2017 financial results on November 22. Revenue increased by 5.6% year over year, helped by a 10% increase in rental income, as occupancy rates increased in all three major regions (Germany, Austria and CEE). On the operating side, expenses fell by 5% year over year, while income jumped by 21.4% year over year, pushing operating margin higher to 45.8% from 39.8% for the same period last year. The EBITDA grew 11% year over year. As a result of strong top line performance and a further decline in costs, bottom line expanded by 25% year over year on adjusted basis. CA Immo is trading at a forward P/E of 19.5x, while the market is estimating a 6% EPS CAGR over the next three years. Among some of the highlights of this quarter was the successful reduction in financing cost (-22% compared to the first quarter 2017). The new property additions in Budapest and Prague have already positively contributed to the results, and focus is now shifting to the future pipeline, which is heavily tilted towards Germany (in terms of projects). We expect the positive earnings momentum to continue in 2018. UBM Development (UBS AV) Austria: High EM Exposure And Corporate Governance Standards Austria: High EM Exposure And Corporate Governance Standards UBM Development (UBS AV) (Chart I-12). Chart I-12Performance Since October 2016:##br## UBM Development vs. MSCI EM Performance Since October 2016: UBM Development vs. MSCI EM Performance Since October 2016: UBM Development vs. MSCI EM UBM Development reported better-than-expected third quarter 2017 financial results on November 28. Quarterly revenue fell by 66.5% year over year, but nine-month output volume stood 18% higher, while operating expenses contracted by 66.7% year over year, helped by lower material costs. Nevertheless, operating income decreased by 70% compared to the same period last year, while operating margin finished 70 basis points lower at 7.9%. Pretax income was helped by a one off gain from affiliates, as a result, net profit climbed 10% compared to last year, and 24% for the first three quarters. On adjusted basis bottom line finished the quarter in negative territory. UBM Development is currently trading at a forward P/E of 10x, while the market is forecasting an EPS CAGR of 6.5% over the next three years. The company came close to reaching its debt reduction target of EUR 550 million, despite EUR 164 million of investments in the first half of the year. Improvements on the balance sheet should provide the company with cheaper financing in 2018. Furthermore, sales are on track, with another EUR 120 million of cash sales secured after the third quarter reporting period, bringing UBM close to its full achieving its full-year guidance. DO & CO (DOC AV) Austria: High EM Exposure And Corporate Governance Standards Austria: High EM Exposure And Corporate Governance Standards DO & CO (DOC AV) (Chart I-13). Chart I-13Performance Since October 2016: ##br##DO & CO vs. MSCI EM Performance Since October 2016: DO & CO vs. MSCI EM Performance Since October 2016: DO & CO vs. MSCI EM DO & CO (DOC AV) announced first-half year financial results on November 16. Revenues dropped by 10% year over year, primarily dragged down by the international event catering segment. EBITDA contracted accordingly, down 13% year over year. However, EBITDA margin remained stable in the international event catering as well as the restaurants and lounges segments. The bottom line came in shy of expectations, shrinking by 18% year over year. We believe the inclusion of a new customer - Juventus soccer club - will boost the margin further in the second-half of the year. DO & CO is trading at a forward P/E of 17.5x, while the market is estimating a 7.2% EPS CAGR over the next four years. The company is fairly valued compared to its five-year average, but trades at up to a 30% discount to its international peers. We believe that DO & CO should be able to crystalize the effects of a strong 2018 pipeline, with new clients in the airline segment (e.g. Lufthansa, and Air China) and the opening of new locations in Los Angeles and Paris (and expansions in London and New York). On a longer-term perspective, the positive outcome on possible construction of a third airport in Turkey would also boost performance. How To Trade? The EMES team recommends gaining exposure to this theme through a basket of listed equities consisting of six overweight recommendations. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index-hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Erste Group Bank (EBS AV); Raiffeisen Bank (RBI AV); Andritz AG (ANDR AV); CA Immobilien Anlagen (CAI AV); UBM Development (UBS AV); DO & CO (DOC AV). ETFs: iShares Austria Capped ETF (EWO US) provides exposure to all described companies. Funds: Pioneer Funds Austria (VIENTPF AV); 3 Banken Osterrrech-Fonds (3BKOESI AV); Raiffeisen-Oesterreich-Aktien (OSTAKTT AV). Please note this trade recommendation is long term (1Y+) and based on an overweight trade. We do not see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equal-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case On a macro level, we see the main risks stemming from possible asset-purchase tapering by the European Central Bank, which could slow GDP growth in Eastern Europe as well as trigger FX weakness and a slowdown in property markets. Taking into account that exposure to this region is high, such a scenario would most likely cause earnings headwinds for the selected companies, especially in the banking sector. Separately, some of the companies have high exposure to Russia and Turkey. Both countries are prone to geopolitical turbulence, as seen in the past, which in turn can negatively affect economic development and negatively affect companies. Company specific risks include higher rates of projects under construction in the real estate sector, with risks of delays and higher input costs inflating budgets. For Andritz, we see the main risk in the slowdown of capex in the European auto segment (which it seems already happened in the second quarter), and the possible need for additional restructuring in the auto division. We also see some regulatory risk for the banking segment from adverse regulations, such as the bank tax introduction already seen in Hungary, or possible increases in bank taxes in Austria. Oleg Babanov, Associate Vice President obabanov@bcaresearch.co.uk Billy Zicheng Huang, Research Analyst billyh@bcaresearch.com 1 BCA Estimates and Bloomberg Data

Highlights The centrist consensus is breaking down across the developed world; In its place is rising political plurality, with non-centrist and anti-establishment parties gathering support; This trend is not to be feared by the markets; Political systems that encourage political plurality - such as those of continental Europe - are more stable in the long run than those promoting political duopoly; Establishment parties in Europe can neuter single-issue parties by selectively adopting their agenda; Emergence of a third party in the U.S. would be positive for both the markets and the economy in the long run. Feature Chart 1European Border Enforcement Is Effective European Border Enforcement Is Effective European Border Enforcement Is Effective Germany's Social Democratic Party (SPD) signaled on November 23 a willingness to entertain another Grand Coalition with its rival the Christian Democratic Union (CDU). If coalition talks reproduce the centrist coalition that has ruled Germany since 2013, the risk of a new election will be averted. While European markets breathe a sigh of relief, there is much to be concerned about. First, the left-leaning, liberal Socialists will likely force Chancellor Angela Merkel to accept that family reunification for asylum claimants will remain an eligible migration route into the country. This means that the 1.3 million asylum seekers that have entered Germany since 2015 will be able to apply for family members to join them, swelling the numbers of migrants from Africa and the Middle East. This could raise tensions inside Germany and increase support for anti-establishment parties. This risk is overstated, as asylum seekers to Germany have collapsed since the EU stepped up enforcement of its borders after the 2015 crisis (Chart 1). Nonetheless, the perception that Merkel is soft on migrants will hound her for the remainder of what we believe will be her last term in power. Second, the SPD performed terribly in the September election, garnering only 20.5% of the popular vote, its worst performance since March 1933 (Chart 2).1 If the German Socialists enter another Grand Coalition, it will leave the anti-establishment, anti-immigrant, and anti-EU Alternative für Deutschland (AfD) in the ceremonial role of the leader of the opposition.2 Chart 2The Center-Left Has Collapsed In Germany Should Investors Fear Political Plurality? Should Investors Fear Political Plurality? This brings up the larger concern for investors: collapse of the centrist monopoly on political power in the West writ large. Germany is hardly the only country that is facing centrifugal forces that are eroding the hold on power by the center-left and center-right establishment parties. Across a number of critical economies, the center-left and center-right political behemoths are giving way to new entrants into the political system. This political plurality means that post-World War Two era centrist duopolies are breaking down as new parties, many of them anti-establishment and populist, enter the scene. Should investors fear this development? The consensus says yes. We disagree. Even in the United States, we doubt that a "third party" would be a negative development. Introducing The Political Concentration Index Chart 3 shows the developed economy measure of our BCA Political Concentration Index (PCI), which we constructed using the Herfindahl-Hirschman index normally used to measure the level of monopoly in a particular industry.3 Our modified index measures political - rather than economic - monopoly. We replace "firms" with "parties" and "industry" with "political system" (i.e., country). A country with a single ruling party would register a 1 on the index, while a country with 10, equal-sized parties in its parliament would register a 0.1. Chart 3Political Plurality Is On The Rise In The Developed World Should Investors Fear Political Plurality? Should Investors Fear Political Plurality? As Chart 3 illustrates, the developed economy concentration of political power has declined considerably. Power is concentrated in the hands of more and more political parties. Chart 4 shows the PCI of ten major western economies, illustrating that the culprits for the overall collapse of political monopoly are Australia, Canada, Germany, Spain, Sweden, and the Netherlands. Our indicator would illustrate an even greater decline of political concentration if we excluded the U.S. and the U.K. Somewhat surprisingly, Italy is actually holding up well, with current levels of political concentration in line with the post-World War Two era and higher than the free-wheeling 1990s. Chart 4Political Concentration Is On The Decline Across The Developed World Should Investors Fear Political Plurality? Should Investors Fear Political Plurality? France also surprisingly illustrates rising political concentration, at least relative to the 1980-1990s. However, this result also reveals the weakness of our index. Our measure is ignorant of the rise and fall of major parties. As such, it has failed to take into account the massive political earthquake that has occurred in France, where President Emmanuel Macron's La République En Marche! (REM) has completely replaced the Socialist Party as the main center-left French party. This shift is not picked up by the index as the degree of concentration of political power in the French National Assembly remains unaltered. Overall, the data confirm the suspicions of many of our clients that the political consensus is breaking down across the western world. There are likely three culprits: The economic dimension is eroding in relevance: The post-World War Two organization of western political parties across the left-right economic spectrum echoed the late-nineteenth and early-twentieth century cleavages between the conservative bourgeoisie and revolutionary proletariat. The Industrial Revolution created immense wealth across Europe and North America, but also immense inequalities. As the urban proletariat grew in size, it demanded political and economic rights. For example, the German SPD remained committed to a radical proletariat revolution almost right up until the First World War. While the question of economic redistribution remains relevant today, the left-right economic axis is not as cogent in a world where living standards have risen massively since the turn of the last century. Culture wars: With the vast majority of western voters no longer responding to basic, Malthusian needs, identity issues are rising in prominence and drawing votes away from the centrist parties arrayed along the left-right economic spectrum. Several single-issue parties have found a permanent foothold in the political system, from the German Greens (since 1980) to the U.K. Independence Party (since 1993). A number of young and old parties have found particular success focusing on immigration, most prominently the Dutch Party for Freedom (founded in 2006), the Swedish Democrats (founded in 1988), the AfD (founded in 2013), and the New Zealand First party (founded in 1993). Generational cleavages: Voters born after the Cold War are particularly drawn to new and anti-establishment parties. Spain's Podemos and Italy's Five Star Movement (M5S) have had particular success appealing to young voters. Similarly, parties with a strong anti-immigration and anti-globalization focus have found success recruiting older voters. There is no single unifying theory that explains the erosion of the left-right economic spectrum as the defining political cleavage in the West. For example, France's Front National - anti-establishment, Euroskeptic, and anti-immigration - is particularly successful in recruiting young French voters, whereas its populist peers generally have not. Each country has its own set of idiosyncratic variables that explain how the political system is evolving. These range from endogenous factors (political system, demographics, ethnic makeup) to exogenous factors (economic crisis, membership in the EU, geopolitical risk, etc.). Even in the case of the U.S. - which shows no decline in political concentration (Chart 4), as Republicans and Democrats so far maintain a grip on their duopoly - numerous cleavages are evolving. Primary elections, particularly in the Republican Party, are pitting anti-establishment candidates - often ideologically aligned with the small government "Tea Party" - against establishment centrists. While these anti-establishment policymakers are officially aligned with the GOP, they often operate as an independent bloc in the House of Representatives. Bottom Line: For a number of reasons, different in each political system, the left-right economic spectrum is no longer driving voter preferences. Hence it should no longer serve as a starting point of analysis. Politicians who realize this - such as President Donald Trump or President Emmanuel Macron, both of whom challenged left-right orthodoxies on economic policy - are rewarded with surprising upsets. Our Political Concentration Index suggests that a trend is underway. Should investors fear the trend? The short answer is no. Political Plurality Is Stabilizing Political plurality should not be feared. True, in the short term, political plurality will produce political volatility. Aside from the ongoing German coalition talks, investors may remember the recent Spanish and Greek elections. Both countries had to hold two elections before producing a relatively stable political equilibrium due to the breakdown in what were traditionally two-party systems.4 Our PCI obviously suggests that similar outcomes are likely and to be expected. Germany could still become a case in point and Italy looms ominously in Q1 2018. However, there are three reasons why risks of more political plurality are overstated. The first is obvious. Chart 5 is the same as our Chart 3, but we have grafted onto it average GDP growth and unemployment rates. There is no clear difference in economic performance between periods of rising and falling political concentration. Chart 5The Economy Does Not Drive Political Concentration Should Investors Fear Political Plurality? Should Investors Fear Political Plurality? The second is also obvious from Chart 5. There appears to be a pattern in the rise and fall of political concentration. In other words, investors should not necessarily extrapolate today's low concentration into the future. We suspect that the reason for the natural oscillation in our index is also the third reason that more political plurality is not a risk to the markets and the economy. A field of multiple parties allows establishment, centrist politicians to steal certain popular aspects of the electoral platform of the anti-establishment parties. Over time - what appears to be a roughly 7-year interval, or two electoral cycles on our chart - the establishment simply swallows the most competitive portions of the anti-establishment platform, repackages it in a way that is palatable for the median voter, and rebrands it as an establishment policy. The recent Austrian election is a perfect case study. Austria held a general election this year in October and the anti-establishment Freedom Party (FPÖ) came in third with 26% of the vote, a 5.5% increase from its 2013 outcome. It was not, however, the best performance for the FPÖ, as it had several strong performances in the late 1990s (Chart 6). Furthermore, investors often make the mistake of only comparing the performance of a party to the last election. In case of Austria, that means that analysts are ignoring four years' worth of polling data. In the particular case of the FPÖ, that means ignoring that the party's 26% performance was an absolute crushing collapse. As Chart 7 shows, the FPÖ went from leading in the polls for much of 2016, at one point reaching 35% support, to coming in third. Why? Chart 6Austrian Populists Have Been Here Before Should Investors Fear Political Plurality? Should Investors Fear Political Plurality? Chart 7The Establishment Stole FPO's Thunder Should Investors Fear Political Plurality? Should Investors Fear Political Plurality? As we illustrate in Chart 7, the Austrian establishment was not stupid. The center-right People’s Party (ÖVP) appointed 31-year-old Sebastian Kurz as its leader in May 2017. Kurz promptly shifted the ÖVP towards the FPÖ’s policy on immigration while retaining centrist views on literally everything else. From that point until the election, the centrist ÖVP crushed the FPÖ in the polls (the ultimate vote swing was nearly 15%). What the Austrian example shows is that a plural political system allows establishment, centrist parties to co-opt portions of the anti-establishment agenda without bringing them on board. In the long term, single-issue parties that focus on anti-globalization, immigration, the environment, or low-income families could see their support erode as the establishment parties adopt portions of their electoral manifesto, without setting-off major political earthquakes. Our forecast is that anti-immigration, populist parties in Europe have likely seen their peak in 2017. Other center-right parties will observe Kurz's success.5 There is simply no reason for them to stand in favor of open borders for asylum seekers in Europe going forward, particularly since newly arrived immigrants cannot vote. As such, it is far more likely that Kurz becomes a model for conservatives rather than, say, Angela Merkel. We concede that Merkel may be the last conservative holdover on immigration. She appears to be stuck defending her decision made in 2015 and is unable to pivot away from that episode. Our strong conviction view is that her successor as head of the CDU will have no such qualms and that the next conservative Chancellor of Germany will close all non-European immigration avenues to the country. Bottom Line: BCA's Political Concentration Index illustrates that political pluralism abates every seven years, or two electoral cycles. This is because single-issue and anti-establishment parties introduce new ideas and policies into the political marketplace, allowing the establishment players to co-opt some of those ideas and win elections without causing a dramatic - and market shattering - break with the past. Beware Of Political Duopolies Is there nothing that investors should fear in our data? No, they should fear persistent political monopolies and duopolies. Take the U.S. and the U.K. It is interesting that the two countries that have experienced the most populist political outcomes in the past two years - Brexit, Trump - are also consistently rated as having the highest political concentration (see Chart 4 on page 4). Why? We suspect that it is because the establishment parties in both political systems try to be catch-all, "big tent" conglomerates that capture a wide array of ideological views on several issues.6 By trying to capture diverse positions, including some fringe ones, they are in danger of becoming entrapped by them. One of the reasons for the "big tent" nature of Anglo-Saxon parties is the "first-past-the-post" electoral system of individual electoral districts. Unlike proportional representation systems favored on the European continent, first-past-the-post electoral systems radically reduce the incentives for small parties to launch independent campaigns.7 For example, UKIP captured 12.7% of the vote in the 2015 election, but it was awarded only one seat in the House of Commons. Such a record of failure is difficult to maintain for any political entity over a long period of time. Eventually, small parties are swallowed whole by their big tent counterparts. The problem with swallowing the whole party, instead of merely biting off an anti-establishment issue here and there, is that the big tent parties often swallow more than they can chew. In the case of the U.K.'s Conservative Party (which has almost wholly swallowed the anti-establishment UKIP), it has been forced to push forward with Brexit, which is dragging on the economy and making it difficult to govern. In the case of the Republican Party in the U.S., the Republicans absorbed the anti-establishment Tea Party, but the two wings of the party are at risk of descending into open warfare. The particular danger for U.S. parties is that their primary elections are normally poorly attended, particularly in midterm election years that lack the star-power of presidential candidates. This means that a candidate representing the far-left or far-right fringe can often win a candidacy with merely 4%-7% of the electorate in each district (the average turnout for primary elections in a midterm year).8 They then can easily proceed to be elected to the House of Representatives due to the fact that so few American electoral districts are truly competitive (Chart 8). As these anti-establishment voices gather force in Congress - 41 members of the GOP belong to the Tea Party-aligned Freedom Caucus for example - they can heighten already considerable polarization by preventing compromise (Chart 9). Chart 8No Competitive Districts Left In The U.S. No Competitive Districts Left In The U.S. No Competitive Districts Left In The U.S. Chart 9Polarization In The U.S. Is Historically High Polarization In The U.S. Is Historically High Polarization In The U.S. Is Historically High A heightened state of political polarization, which persists throughout the term in office, is far more market-relevant than heightened volatility around an election produced by more political plurality. For the most part, Europe's political systems have weathered a severe double-dip recession (triple-dip in Italy's case!), a massive loss of political confidence in European institutions, and a Biblical migration crisis with relatively few early elections (Table 1). In this turbulent period, many European governments have pushed through draconian austerity measures, far-reaching economic structural reforms, and agreed to fund or receive costly bailout programs. When anti-establishment parties came to power - as they legitimately did in Greece - they quickly migrated to the middle in order to govern, needing the votes of other parties. Table 1Europe: Less Volatile Relative To Context Should Investors Fear Political Plurality? Should Investors Fear Political Plurality? Empirically speaking, there is no evidence that low political concentration is therefore inferior to the perceived stability of high political concentration exhibited in the U.S. and the U.K. The American and British economies both have seen generally better economic performances since 2008, yet they are struggling with dramatic bouts of populism in 2016.9 In the U.K.'s case, Brexit will reduce potential GDP. In the U.S.'s case, Trump's tax cuts will be inflationary, could hasten the next recession, and will likely exacerbate income inequality. We do not have a view on whether a third party will emerge in the U.S. Political polarization is a powerful trend at present, and since by definition it promotes the existence of two opposing ideological camps, it reinforces the two-party system. Republicans want to maintain control of the conservative base and hence cannot afford to let the Tea Party split off, while Democrats want to control the liberal base and cannot afford to let the progressive wing split off. If either party fractures, the other benefits. Nevertheless, there is nothing unique about the U.S. electoral system that would prevent a breakdown of the American political duopoly: other first-past-the-post systems exhibit political plurality, most notably in Canada. If a third party does emerge, we would wager that it would increase, not decrease, political stability; and reduce, not increase, political polarization. For example, if Tea Party policymakers were to run as independent candidates, it would free up both Tea Partiers and centrist Republicans to pursue their preferred policies in Congress. Centrist Republicans could vote with the Tea Party on matters of common concern and vote with the Democrats on issues where the Tea Party is deemed to be on the fringe. The basic ability to pass a budget would not be hindered by the Tea Party's single-mindedness on government spending, yet voters demanding tighter budgets would not be denied representation. Alternatively, if a new single-issue party emerged, say one favoring tighter immigration policy, Republicans would be free to co-opt aspects of its view on immigration and neutralize the threat of losing votes. They would not be forced to absorb the entire party and pursue hardline policies that would cause gridlock with Democrats. Bottom Line: Empirical evidence since the 2008 Great Financial Crisis does not support the conventional wisdom that low political concentration (i.e., political plurality) is less favorable for investors than high political concentration. Both the U.S. and the U.K., which score the highest on our PCI, have produced highly volatile political outcomes. Investment Implications Investors should not worry about the emergence of new parties in Europe. Particularly harmless are single-issue parties, specifically those focusing on tighter immigration controls. Conservative parties across Europe have already adopted more stringent immigration policies while still sounding sane, a potent electoral mix relative to some of the populist anti-immigrant parties currently vying for the votes of concerned citizens on the continent. Meanwhile, we do not fear the emergence of a third, or fourth, party in the U.S. In fact, such a development could play a role in reducing historically high political polarization in the country. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Yes. That 1933 election. 2 There is no official "leader of the opposition" in Germany and as such the AfD leadership is merely ceremonial. The left-wing Die Linke was in the same position from 2013-2017 with little effect. In fact, Die Linke saw only an incremental increase in its support (0.6%) between the two elections. 3 Regular readers of Geopolitical Strategy will know that we are big fans of the Herfindahl-Hirschman index. We have applied it before to measure geopolitical hegemony. Originally, the index was designed to assist in competition law and antitrust cases as it is an indicator of the amount of competition between firms in a particular sector. The formula for the index is shown below, where si is the market share of firm i in the market, and the N is the number of firms; Should Investors Fear Political Plurality? Should Investors Fear Political Plurality? 4 Spain held an election in December 2015 and another in June 2016. The latter produced a minority government led by the center-right People's Party that is essentially supported by the Spanish Socialists Workers' Party (PSOE). Greece similarly held two elections, one in January 2015 and another in September of that year. 5 The German, establishment, Free Democratic Party (FDP) did so in the most recent election, copying ÖVP's focus on tight immigration policy. It has seen its support rise to 10.7%, a substantive increase from 2013. 6 We admit that the case for the U.K. as a political duopoly is harder to make given that there are third (and fourth) parties; although both the Labour Party and the Conservative Party have cleavages on the economy, globalization, and European integration that few European peers have. This is largely due to both parties' attempt to capture a diverse coalition of views. 7 First-past-the-post refers to an electoral system where the country is divided into electoral districts. In each electoral district, the party that wins the most votes generally sends its candidate to the legislature. While there are some variations on this model, and some mixed systems, this electoral system tends to favor political duopolies. In political science, this tendency has often been referred to as Duverger's law (named after the French sociologist Maurice Duverger who first observed this phenomenon). 8 Please see Elaine C. Kamarck, "Increasing Turnout In Congressional Primaries," Center for Effective Public Management at Brookings, dated July 2014, available at brookings.edu. 9 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com.

Highlights Macron has won in France; Economic reforms are forthcoming; Euroskeptic parties are moving to the center; Yet Italy remains a real risk; Stick to long French industrials versus German; stay long EUR/USD for now. Feature "A chair, a table, or a bench would be elected rather than her [Le Pen] in this country." - Jean-Luc Mélenchon Third-party candidate Emmanuel Macron is the new president of France following his win over populist and nationalist Marine Le Pen (Table 1). The victory was resounding, with polls underestimating support for the centrist, and vociferously Europhile, Macron (Chart 1). Macron's victory was all the more impressive given the low turnout, which should have favored Le Pen. Table 1Results Of French Presidential Election Stick To The Macro(n) Picture Stick To The Macro(n) Picture Chart 1Underestimating Emmanuel Underestimating Emmanuel Underestimating Emmanuel There are numerous narratives competing to make sense of the election in France. Our conclusion is simple: Marine Le Pen got trounced by a 39-year old political neophyte with no party organization and an investment-banking background. Le Pen wasn't so much defeated as she was routed, in a veritable Battle of Sedan for the European populists. What does this mean for investors? First, European assets are about to "rip." Second, the EUR/USD may have some more upside in the short term. Third, investors remain overly complacent about Italy, which we think has a good chance of breaking the trend of victories for the centrist forces in Europe. However, this is a story for 2018 and thus off the radar screen for investors at the moment. Le Pen Loses More Than Macron Wins Left-wing firebrand, and surprise first-round performer, Jean-Luc Mélenchon forecast in April that "a chair, a table, or a bench" would defeat Le Pen head-to-head. Naturally, the comment was self-serving for Mélenchon as he was trying to convince swing voters to support his campaign. Nonetheless, we fully agree with his assessment! Not only did Le Pen lose, but she lost to a political neophyte with investment banking on his resume. In France... In 2017... Chart 2Le Pen's Flaw Is The Euro Le Pen's Ceiling Is Support For The Euro Le Pen's Ceiling Is Support For The Euro So what happened? It is not a coincidence that Le Pen got precisely the same proportion of voters as the percent of the French public that does not support the euro, around 30-35%. Le Pen's popularity has in fact closely mirrored French Euroskepticism for years, peaking in 2013. Chart 2 essentially illustrates that Le Pen's ceiling is determined by the Euroskeptic mood of the country. We have stressed to clients since the December 2015 regional elections that Le Pen's Euroskpeticism is a major handicap to her political fortunes. In that election, her Front National (FN) was massacred in the second round despite a highly favorable context for an anti-establishment, nationalist party. The election took place on the heels of an epic migration crisis and a massive terrorist attack (which occurred just 23 days before the election).1 The Front National was defeated in all 13 mainland French regions, despite leading in six following the first round. As such, investors should ignore both the positive and negative hype surrounding the media coverage of Macron. The main lesson of the French election is that Euroskepticism does not pay political dividends, not that Le Pen still has a chance in the next election or that Macron has pulled off an extraordinary victory. The upcoming legislative elections - set for two rounds on June 11 and 18 - will cement our call on Le Pen and FN. Polls are sparse, but what we have thus far suggests that Macron's En Marche and the center-right Les Républicains will capture the vast majority of seats in the legislature (Table 2). We do not have enough polling data to gauge the reliability of this forecast, but it does make sense given FN's previously weak electoral performances in legislative and regional elections. In fact, following Macron's strong performance on May 7, we would be surprised if FN gets more than 15-20 seats in the National Assembly. Table 2Macron May Have To Work With The Republicans Stick To The Macro(n) Picture Stick To The Macro(n) Picture What matters for investors is the likely strong performance in the legislative elections for the center-right Les Républicains. Its presidential candidate François Fillon was the leading centrist candidate to get into the second round for most of early 2017 and only faded due to his corruption scandal (Chart 3). His primary challenger - Bordeaux mayor and former conservative Prime Minister Alain Juppé - in fact was comfortably leading all candidates before he was bested by Fillon in late November in party primaries (Chart 4). Chart 3Scandal, Not Policies, Killed Fillon Scandal, Not Policies, Killed Fillon Scandal, Not Policies, Killed Fillon Chart 4Juppe Led The Race Before Fillon Took Over Juppé Led The Race (Prior To Fillon) Juppé Led The Race (Prior To Fillon) A Macron presidency supported by Les Républicains in the National Assembly could be the best outcome for investors. On the international stage - where the president has no constraints - France will be led by a committed Europhile willing to push Germany towards a more proactive - rather than merely reactive - policy. On the domestic stage - where the National Assembly dominates - Macron's cautiously pro-growth agenda will be pushed further to the right by Les Républicains. In our view, the best outcome would be either genuine "cohabitation," where Macron's En Marche does not get a majority and he is forced to cohabitate with a center-right prime minister, or an En Marche sweep. The worst outcome would be a hung parliament, where Les Républicains refuse to cooperate with En Marche so as not to give Macron any further political wins. We continue to believe that the context is ripe for genuine structural reforms. We expanded on this topic in a February report titled "The French Revolution" and will not repeat the arguments here.2 Suffice it to say that a "silent majority" in France appears ready to incur the pain of reforms (Chart 5). As a play on the reform theme, we have been long French industrial equities / short German industrial equities on a long-term horizon (Chart 6). The idea is that French reforms should suppress wage growth and make French exports more competitive vis-à-vis their main competitor, Germany (Chart 7). Chart 5"Silent Majority" Wants Reform Stick To The Macro(n) Picture Stick To The Macro(n) Picture Chart 6France Will Revive, Germany Is Peaking France Will Revive, Germany Is Peaking France Will Revive, Germany Is Peaking Chart 7Reforms Could Close This Gap Reforms Could Close This Gap Reforms Could Close This Gap Bottom Line: As we have expected for years, Marine Le Pen is unelectable due to her opposition to European integration. At the minimum, this should allay the fears of many investors that Frexit is a possibility. It has never even been close.3 At its most optimistic, Macron's victory will usher in a period of economic reforms in France. The Big Picture: Europe's Populists Defeated In April 2016 - ahead of the U.K. EU referendum and the U.S. general election - we made a controversial call: Anglo-Saxon populists would surprise to the upside in the upcoming plebiscites, whereas continental European would underperform.4 The U.K. has subsequently chosen Brexit and the U.S. electorate has chosen Donald Trump, both outcomes that we noted were more likely than the consensus expected. On the other side of the ledger, populists were defeated in two Spanish elections (December 2015 and June 2016), the Austrian presidential election in December 2016, and the Dutch general election in April 2017. The latest defeat for the anti-globalization populists is surprising because it happened in France, a country with a long tradition of both. One cannot blame relative economic performance for the outcome, as France has clearly underperformed the U.S. on both the growth and employment fronts (Chart 8). Nor can it be blamed on a more sanguine security situation: since 2015, France has experienced far more tragedy due to terrorist attacks than the U.S. and has been in a state of emergency since the November 2015 terror attack (Chart 9). And while France has largely avoided the 2015 European migration crisis, it was at least far more threatened by it than the U.S. due to mere geography. Chart 8Economic Woes Not Lacking In France... Economic Woes Not Lacking In France... Economic Woes Not Lacking In France... Chart 9... Nor Is Threat Of Terrorism Stick To The Macro(n) Picture Stick To The Macro(n) Picture In our view, the long-term socio-economic context is more important than the day-to-day economic and security situation in explaining the success of populists. The French social welfare state - which is onerous, inefficient, and clearly in need of reform (Chart 10) - has nonetheless played a crucial role in tempering the appeal of anti-establishment politics. Chart 10France: Welfare State Needs Reform Stick To The Macro(n) Picture Stick To The Macro(n) Picture Chart 11Anti-Establishment Candidates Win... The Median Voter Has Lost In America... The Median Voter Has Lost In America... Unlike the U.S. - which has seen the real median household income decline over the past two decades and grow much slower than the economy (Chart 11) - European countries have redistributed the gains of globalization in such a way as to ensure that more people benefit from it (Chart 12). Income inequality has grown in Europe regardless, but to a much lower level - and by a lower magnitude - than in the U.S. (Chart 13). This is perhaps most pronounced in France, where the top 10% of households by income retain much the same share of the economy as they did in 1950 (Chart 14). Chart 12Redistributing Globalization's Gains ...And Won In Europe ...And Won In Europe Chart 13U.S. & U.K.: Outliers On Inequality Stick To The Macro(n) Picture Stick To The Macro(n) Picture Chart 14France: Inequality Flat For 70 Years France: Inequality Flat For 70 Years France: Inequality Flat For 70 Years Many of our clients in the U.S. and the U.K. have reacted negatively to our view above. Our analysis is not meant to endorse French levels of social welfare spending. In fact, we are bullish on France precisely because we expect Emmanuel Macron to reduce French state largesse over time. We merely point out that the political effect of a redistributive socio-economic system is greater stability and centrism of the voting public in the midst of a painful socio-economic context. The median voter in Europe is simply not as angry as the median voter in the U.S. This is not by chance, but rather by design. Europe's "socialism" is a relatively modern development and a product of Europe's disastrous inter-war period, which instilled a fear of a populist backlash against failed economic policies of the time. The inter-war period saw the rise of both left- and right-wing extremism, which fed on each other with increasing intensity. These included a failed communist revolution in Germany (1918-1919), a failed Nazi coup in Germany (1923), a fascist takeover of Italy (1925), a Nazi takeover in Germany (1933), far-right unrest in France (1934), and the Spanish Civil War (1936-1939). These political upheavals were a product of both the Great Depression and the First World War. But they were also colored by Europe's socio-economic context at the time: very high wealth inequality at the beginning of the twentieth century. In fact, Europe had a much higher starting level of wealth concentration than the U.S., resulting in a much sharper correction during the inter-war period (Chart 15). What most commentators who forecast Europe's doom after the Great Recession missed is that the socio-economic context matters. It is the reality through which voters filter contemporary events. In Europe's case, the median voter was in a much better place to deal with the post-2008 economic and financial crises because Europe's "socialism" had dampened the negative consequences of globalization. In the U.S., and we would argue in the U.K. to a much lesser extent, the median voter was far more exposed to the vagaries of globalization and thus was (and remains) more open to anti-establishment political outcomes. This is the great paradox of the past 18 months: that the two best performing economies in the developed world - the U.S. and the U.K. - experienced the greatest level of populism. To us, it is not much of a paradox. Economic performance is by nature a study of the mean performance, whereas political forecasting deals with the median outcomes. This is not to say that the French are not angry with elites. After all, nearly 50% of the votes cast in the first round of the election went to anti-establishment candidates (Chart 16). However, French voters are not angry enough to want a dramatic reordering of their society, particularly in terms of their support for European institutions. What about other countries in Europe? A trend is emerging across the continent where anti-establishment parties are retaining their commitment to economic redistribution, anti-immigrant sentiment, or unorthodox foreign policy, but abandoning their Euroskepticism for the sake of competitiveness. The best examples of this trend are Spain's Podemos and Greece's SYRIZA, which have evolved in a short period of time into mainstream left-wing parties. Meanwhile, parties that retain an official strategy of Euroskepticism are increasingly finding out that the "Euroskeptic ceiling" is real. As such, these parties are struggling between remaining politically competitive and staying true to their Euroskeptic ideals: Germany: The German Euroskeptic Alternative Für Deutschland (AfD) party has been beset by massive internal conflict and identity crisis. Ousted leader Frauke Petry tried to move the party towards the center, but was rebuked at an April party congress. The AfD is still polling just under 10% (Chart 17), and will therefore enter the Bundestag in the September 24 election, but its leadership is torn between openly embracing the German alt-right and setting a course as a conservative alternative to Angela Merkel's Christian Democratic Union. We would expect the party to enter the Bundestag, but only just, in the upcoming election. Chart 15U.S. And France: Different ##br##Starting Points Of Inequality... Stick To The Macro(n) Picture Stick To The Macro(n) Picture Chart 16French Voters##br## Are Angry French Voters Are Angry And Anti-Establishment Feeling High French Voters Are Angry And Anti-Establishment Feeling High Chart 17German Euroskeptics To ##br##Squeak Into Bundestag, At Best German Euroskeptics To Squeak Into Bundestag, At Best German Euroskeptics To Squeak Into Bundestag, At Best Austria: The presidential candidate of the anti-establishment Freedom Party of Austria (FPO), Norbert Hofer, tried mightily to soften his Euroskepticism ahead of the December 2016 elections. He failed and lost the election despite a solid lead in the polls for much of the year. Austria is set to hold general elections by October 2018 and support for the FPO has clearly peaked (Chart 18). Given that all other parties in Austria are pro-EU, the FPO is likely to remain isolated. Finland: The "True Finns," since rebranded as just "The Finns," were once the only competitive Euroskeptic party in northern Europe. They did very well in the 2015 general election and entered the governing coalition. To do so, they compromised on their Euroskeptic positions and became largely irrelevant, with a big dip in support (Chart 19). April municipal elections went terribly for The Finns, with the Europhile Green League emerging as the big winner. An upcoming party congress in June will determine the future of the party and whether it swings towards populism or centrism. Chart 18Austrian Anti-Establishment Has Peaked Stick To The Macro(n) Picture Stick To The Macro(n) Picture Chart 19Finnish Anti-Establishment Has Peaked Stick To The Macro(n) Picture Stick To The Macro(n) Picture Italy: The one party to watch over the next several months is Italy's Five Star Movement (5SM). There is evidence that 5SM is itself riven by internal conflict over how far to take its Euroskepticism. And several moves by party leadership - including attempting to leave the legislative alliance with UKIP at the European Parliament level - appear designed to pursue the political center. The problem, however, is that there is little evidence that the Italian median voter is as committed to European integration. This remains the key risk for Europe going forward. Bottom Line: Populism has underperformed in continental Europe, much to the surprise of most commentators. Europe's economic redistribution has dampened demands for anti-establishment outcomes. Evidence suggests that Euroskeptic parties will continue to migrate to the center, at least as far as European integration is concerned, in the near future. One outlier to this view is Italy, which we elaborate on below. Investment Implications European risk assets should continue to outperform the U.S. in the coming months. The European economy continues to fire on all cylinders, whereas the U.S. appears to have hit a soft patch, according to the sharply divergent Economic Surprise Indexes (Chart 20).5 The euro may benefit from the reduction in risk premia for the time being. We will retain our long EUR/USD for now, but look to close it over the summer as we doubt the ECB's commitment to a hawkish turn in monetary policy ahead of critical risks in 2018. At the forefront of those risks is the upcoming Italian election. As we have argued repeatedly for two years, the Italy's Euroskeptic turn is real and underpinned by data. Whereas the median European has been far less Euroskeptic than the conventional wisdom has held, the median Italian is becoming more Euroskeptic. We spent a week in Europe warning clients in London, Paris, and Zurich of the upcoming Italian risks. There was little appetite for our bearish view. Even clients in the U.K. who previously held deeply skeptical views of the Euro Area's ability to survive have changed their view on Italy. Why such complacency? The oft-repeated refrain was that Italian politics have always been a mess. The election, which is highly likely to produce either a weak coalition or a hung parliament, will therefore not produce a definitive outcome worthy of risk premia. We highly disagree with this view. Our concern with Italy is not the current polling of Euroskeptic parties, but rather the underlying turn in the Italian electorate towards greater acceptance of a future outside of Europe (Chart 21). If the median voter is more willing to entertain Euroskeptic outcomes, than the Euroskeptic parties will not be forced to adopt a centrist position, as they have done in the rest of Europe. Chart 20U.S. Economy Hits A Soft Patch U.S. Economy Hits A Soft Patch U.S. Economy Hits A Soft Patch Chart 21Italy: The Real Risk To Euro Area Italy: The Real Risk To Euro Area Italy: The Real Risk To Euro Area Nonetheless, investor complacency tells us that European asset outperformance could last well into late 2017. There will be no immediate risk rotation from the French election to the Italian one. The market will have to be shocked into pricing greater odds of Euro Area dissolution when Italy comes back into focus, likely in Q1 2018. Until then, the party will continue. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy, "Strategic Outlook 2016: Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 5 Please see BCA Global Alpha Sector Strategy Weekly Report, "Buy The Breakout," dated May 5, 2017, available at gss.bcaresearch.com.

If the U.K. ultimately exits the EU, it will be a major break in the 70 years of European integration. Multipolarity will be reinforced, increasing global geopolitical risk. We expect global risk assets to start taking cues from Europe, not the Fed and China. However, risks of N-Exit - that other EU member states follow suit - may be overstated.

Highlight Even alarmists like us have been surprised by the referendum outcome; The referendum is a major break in the 70 years of European integration; It will reinforce multipolarity and increase global geopolitical risk; The U.K., however, is an outlier in terms of Euroskepticism; No other EU country is likely to vote to leave the EU, though tail risks are up; Watch for the "Who is Next" premium to be applied to European assets, and the "reflation trade" is likely over for the time being. Feature "Since they will overload my shoulders," quoth John, "I shall throw down the burden with a squash amongst them, take it up who dares." - John Arbuthnot, complaining about Europe's treatment of Britain, The History of John Bull (1712) Chart 1So Much For Crowd Wisdom bca.bcasr_sr_2016_06_24_c1 bca.bcasr_sr_2016_06_24_c1 British voters have chosen to leave the European Union. The outcome caught most forecasters by surprise, including the "smart money" of the betting markets (Chart 1). We are not as surprised, since we raised the possibility that the conventional view was wrong as early as March and called the referendum "too close to call" in our last missive.1 However, we also thought that the narrow polling would push voters towards the status quo in the last minute. In this analysis, we offer our view on three questions: What is next for the U.K.? Who is next in the EU? Is a risk premium even appropriate? What does this mean for broader global stability? We conclude with investment implications. What Next For The U.K.? In our report last week, "Break Glass To Brexit," we outlined some of the likeliest next steps after Brexit. These have not changed: Cameron's Fate and the Tories: Leaders who stake their credibility on a referendum typically resign if they lose the vote, as with Jacques Parizeau in Quebec or Alex Salmond in Scotland. Cameron has similarly stated that he will resign by October. This introduces greater political risk into British politics. In particular, any economic risks emanating from the referendum will be blamed on the Tories. The Labour Party stands to benefit. Under Jeremy Corbyn it has turned more left-wing than any opposition party since the 1980s. But Labour MPs could also ditch Corbyn in an effort to capitalize on Tory disintegration. British politics will be a rollercoaster for quite some time. The last time the Conservative Party imploded over Europe, a Tony Blair-led Labour waited in the wings. This is not the case today. Article 50 of the Lisbon Treaty: The process of leaving the EU requires the departing member-state to invoke this article, which provides for a two-year period to negotiate an exit that should take account of the state's obligations and future relations with the union. No country has done this before so it is not clear how exactly it will happen. A meeting of the European Council next week provides an opportunity for Cameron to announce the country's intentions. But the government has an incentive to wait before initiating the two-year countdown process until it has formed a negotiation plan, since the EU is likely to take a hard line on the U.K.'s access to the common market. It should be noted that the two-year negotiation timeframe is not firm - the U.K. could withdraw precipitously, or, with approval from all member states, it could negotiate for more than two years. Another Referendum: Yes, it is possible for another referendum to be held. In fact, the likely successor to David Cameron, and "Leave" vote champion, former Mayor of London Boris Johnson, raised the possibility of a second referendum when he announced his support for exit. In other words, even the likely new prime minister and pro-Brexit leader is open to another referendum. Perhaps one could be held after the U.K. ends its negotiations with the EU. The problem is that we doubt the EU will concede much, since that could lead to a chain reaction in Europe. As such, it will depend on the U.K.'s political circumstances whether a new referendum is held. An Act of Parliament: Formal withdrawal will require an act of parliament, since, for instance, the 1972 European Communities Act ensures that the U.K. automatically incorporates EU directives into law and has hitherto been interpreted as establishing the priority of EU law where it contradicts British law. That is a key motivation of the sovereignty argument behind Brexit; the law will have to be replaced if Britain leaves. Notably, the referendum itself does not have any legal consequences. It is a dead letter without a government decision to enact it. That decision should be forthcoming in a mature democracy where the result is clear and uncontested. However, the political aftermath could lead to a parliamentary dissolution, with some groups hoping to delay the country's exit or hold a second referendum. Chart 2Scottish Independence:##br##A Yearning Not Yet Laid To Rest bca.bcasr_sr_2016_06_24_c2 bca.bcasr_sr_2016_06_24_c2 Scottish Referendum: Scots voted 62% to stay in the EU, versus England's 53% to leave, which throws into stark relief the differences in points of view between the two countries. The U.K. vote has reinvigorated calls for independence almost immediately, with the First Minister Nicola Sturgeon already calling for a new referendum. The failure of the Scottish independence referendum in 2014 has not extinguished the desire to leave (Chart 2), although we suspect the collapse of oil prices may at least raise the economic bar of independence. The Scottish National Party has swept into almost total control of the Scots parliament since the referendum failed. Scotland, by comparison with the U.K., is a disproportionate beneficiary of EU transfers. During the 2014 referendum, the EU pushed against Scots independence, but it may not do so the second time. The loss of Scotland would jeopardize British energy and naval advantages as well as create various internal political risks across the British Isles for the future. Tensions in Ireland: Northern Ireland, like Scotland, benefits from EU funds (like farm subsidies) and voted 56% to remain. It too has groups aggravated by England's vote carrying the day. Any separation of Scotland would motivate forces both in Northern Ireland and in the Republic of Ireland to push for a unified Irish island state. That will aggravate political and sectarian tensions that have only quieted down since 1998 and were even showing a few signs of heating back up before Brexit. Thus Brexit will force Westminster to devote greater attention and resources to re-establishing the U.K.'s compact with its constituent countries. Bottom Line: Political uncertainty will rise across the U.K. due to Brexit. If the decision to leave the EU stays, we believe that the U.K. may cease to exist as a unitary state. However, the referendum may not be the last word on EU membership. The likely next prime minister, Boris Johnson himself, has floated the option of a second referendum and thus the idea that the just-concluded referendum is part of a negotiation strategy. Who Is Next? The immediate question investors are asking is, Who is next to try to leave the EU?" Already, the "Who Is Next Premium" is infecting the Mediterranean European bond markets, with peripheral spreads up across the board (Chart 3). Chart 3The 'Who Is Next?' Premium The "Who Is Next?" Premium The "Who Is Next?" Premium To simplify the answer to this forecasting challenge, we developed an EU Dependency Index (Chart 4).2 We combine six economic and financial factors to determine which member states have a high bar to clear in order to leave the EU. Chart 4Constraints To Leaving The EU The Coming EXITentialist Crisis The Coming EXITentialist Crisis As with all indexes, one should take its conclusions with a grain of salt. But generally speaking, the results are helpful. For instance, Hungary is more constrained in leaving the EU than Sweden. Hungary's trade is almost exclusively with EU member states, its interest payments as a percent of GDP are high (and would become higher post-EU exit), and it benefits the most from structural funds from the EU. Leaving the bloc would be a painful decision for Budapest that would undoubtedly leave the country worse off. One set of factors that our index does not measure is geopolitics. Central and Eastern Europe, as well as Cyprus, are members of the EU for more than just economic benefits. In the case of countries like Romania and Poland, the EU is seen as another layer - on top of NATO membership - of security guarantees vis-à-vis Russia. (For Cyprus, the EU is a form of security arrangement against Turkey.) In the oft-cited 2016 Pew Research poll showing a decline of support for the EU, Poland remains the most supportive with a 72% favorable rate (Chart 5). Hungary is not far behind. Both countries are led by rhetorically Euroskeptic right-of-center parties, but the reality is that they will not contemplate exit. By focusing on the lower end of the dependency index, we can isolate the countries that are the least constrained economically in pursuing a break with the union. We will therefore focus on the Netherlands, Austria, Greece, Spain, Italy, Finland, Germany, Denmark, France, and Sweden. This is not to say that the other countries on the index do not have Euroskeptic movements, but only that we do not take them seriously. How do our selected EU member states stack up against the U.K.? First, as we argued earlier this year, the U.K. stands out for Euroskepticism. In our view, it has the lowest political, economic, financial, and geographic constraints to exiting the bloc. This is born out in data. In particular: Identity: The British have never felt comfortable defining themselves as European (Chart 6). Meanwhile, the sense of "Europeanness" has actually risen in the rest of Europe since 2010. Chart 5Falling Support For The EU bca.bcasr_sr_2016_06_24_c5 bca.bcasr_sr_2016_06_24_c5 Chart 6British Identity Has Always Stood Apart bca.bcasr_sr_2016_06_24_c6 bca.bcasr_sr_2016_06_24_c6 EU Immigration: In our view, the issue of intra-EU immigration carried the day for "Leave" on June 23. Polling data revealed that this issue, perhaps more than any other, was a source of consternation among U.K. voters (Chart 7). The feeling is not mutual across Europe (Chart 8), although France and Italy are similarly split on the issue. Chart 7EU Emigration: A Concern In Britain bca.bcasr_sr_2016_06_24_c7 bca.bcasr_sr_2016_06_24_c7 Chart 8Not Everyone In Europe Is Concerned About EU Emigration The Coming EXITentialist Crisis The Coming EXITentialist Crisis Geopolitics: Europeans do not see the EU as a vehicle towards "economic prosperity," but rather a project for "peace" and a "stronger say in the world" (Chart 9). Therefore, for much of the EU, the bloc has a geopolitical component that gives the EU a "geopolitical imperative for integration," as we argued in 2011.3 This is not the case in the U.K., which is the world's fifth largest economy, a nuclear power, a permanent UN Security Council member, and a geographically isolated island. It needs the EU the least in the geopolitical sense. Chart 9The U.K. Does Not Perceive The EU As A Geopolitical Project The Coming EXITentialist Crisis The Coming EXITentialist Crisis Confidence: British voters do not see a life outside the EU as a big threat, perhaps revealing why the "Stay" campaign strategy of emphasizing the economic costs of exit was a mistake. When asked whether they thought "their country could better face the future outside the EU," British respondents have consistently answered in the affirmative (Chart 10). This is not the case for any other country in Europe. It is an important point because holding a negative view of the EU is not the same as wanting to leave it. Greece is a good example. While 38% of Greeks see the EU in a negative light, 56% do not think the country would do better outside of it (Chart 11). Denmark, Sweden, Finland, and the Netherlands - all frequently cited as "Euroskeptic" candidates for a future EU-exit - also score surprisingly low on confidence that they would be successful outside of the EU. However, Italian confidence in a future sans Europe appears to be growing, and Austrian confidence has always been high. Chart 10AThe U.K. Is Confident About ##br##Life Outside The EU bca.bcasr_sr_2016_06_24_c10a bca.bcasr_sr_2016_06_24_c10a Chart 10BThe U.K. Is Confident About ##br##Life Outside The EU bca.bcasr_sr_2016_06_24_c10b bca.bcasr_sr_2016_06_24_c10b Chart 11Not Everyone Who Is Angry##br## Wants A Divorce The Coming EXITentialist Crisis The Coming EXITentialist Crisis Currency: The U.K. is not a member of the euro area and therefore does not have to deal with the redenomination risk of exit. For countries in the Mediterranean, such a risk would see household wealth redenominated into pesetas, lira, and francs. For Germany, it would mean a 20-30% deutschmark appreciation and a devastating blow to its export-driven economy. Support for membership in the euro area remains surprisingly high in the countries that are members of the currency union (Chart 12). In fact, support for the euro is at or near its highest levels ever in Finland, France, Germany, the Netherlands, Spain, and even Greece! Again, Italy stands as a dangerous outlier. Chart 12ASupport For The Euro Remains Strong bca.bcasr_sr_2016_06_24_c12a bca.bcasr_sr_2016_06_24_c12a Chart 12BSupport For The Euro Remains Strong bca.bcasr_sr_2016_06_24_c12b bca.bcasr_sr_2016_06_24_c12b From the polling data we can conclude that the U.K. stands alone in consistently lying on the Euroskeptic side of each political category. However, we can also make five general observations: Italy has clearly seen a significant rise in Euroskepticism over the past decade; Austria has always lacked enthusiasm for the EU, although its support of the euro remains high; Concerns over the Nordic countries are overstated, there is no evidence that they are Euroskeptics; France is mixed, scoring high on Euroskepticism when it comes to immigration, but low on other issues. Germany is committed to European institutions. So, who is next? With great respect to the history made on June 23 and to the growing anti-establishment sentiment around the world, we suspect that nobody will follow in the U.K.'s footsteps and actually vote to leave. In fact, European policymakers are likely to push against the June 23 vote with a new treaty that takes into account many of the grievances of Euroskeptics around the continent. But the point is that the economic, financial, political, and geopolitical costs of exit are much higher for every other EU member state. Nevertheless, given the success of the U.K.'s referendum, the probability that another vote on EU membership will be held has increased. That alone will be enough for the markets to apply a "Who is Next" premium to European assets, which explains the European asset sell-off the day after the referendum. We are in particular focused on five countries: Chart 13Italian Politics: A Rising Risk bca.bcasr_sr_2016_06_24_c13 bca.bcasr_sr_2016_06_24_c13 Italy: Unlike its Mediterranean peer Spain, Italy has not seen any improvement in competitiveness and remains embroiled in sub-par growth. The constitutional referendum in October - on streamlining governance, a necessary step before embarking on painful structural reforms - could fail, leading to an early election late this year or early next. At the moment, the anti-establishment Five Star Movement (5SM) is closing in on the ruling Democratic Party in the polls (Chart 13). Its leader, Beppe Grillo, has called for an EU referendum, but its rising political star - and new mayor of Rome - Virginia Raggi has rejected Euroskepticism. If an early election this or next year produces a 5SM government, a political crisis will ensue. The Netherlands: According to the survey data we reviewed in this analysis, the Netherlands would not vote to leave the EU. That is our high conviction view. However, the Euroskeptic Party for Freedom is leading in the polls for the upcoming Dutch general election, set to be held no later than March 15, 2017. Its leader Geert Wilders has said that he would call for an EU membership referendum if he were to win the election. Austria: According to the data reviewed in this analysis, Austrian Euroskepticism is on the rise. The next general election is set for the end of 2018 and will likely see the Euroskeptic Freedom Party win the largest share of the vote. This leaves the possibility of an EU membership referendum open for 2019. France: Presidential elections in France are set for April and May 2017 (two rounds). Marine Le Pen appears to have peaked in popularity in 2013 and thus has very little chance of winning (Chart 14). However, her likely progress into the second round could put French Euroskepticism in the spotlight. Investors should remember that French Euroskepticism is not at all a novel concept, so greater changes would need to be forthcoming (Chart 15). Chart 14Has Marine Le Pen Peaked? Has Marine Le Pen Peaked? Has Marine Le Pen Peaked? Chart 15France Has A Tradition of Euroskepticism The Coming EXITentialist Crisis The Coming EXITentialist Crisis Germany: No, we do not think there is any chance of a referendum on the EU or euro membership in Germany. If there was one, it would fail to produce an exit on both accounts. However, Germany is the key country to watch because the future of the EU depends on it. Without a shift from Berlin on the bloc's adherence to strict budget discipline, the EU may not survive. Germans have crossed their "red lines" numerous times in order to preserve the euro area, suggesting that they are quite flexible (Table 1). However, it has always taken a major crisis for them to move. Table 1Europe: The Hurdle To Heterodoxy Is Low The Coming EXITentialist Crisis The Coming EXITentialist Crisis Another important notice here is that the European migration crisis likely had an influence on the U.K. referendum result. But the numbers show that the crisis has not only abated, but that it has effectively ended. The overall figures show that migration flows peaked at 220,000 in October 2015, whereas they were only 9,354 in June (Chart 16). Breaking down the flows by destination (Greece vs. Italy) does not reveal any new information (Chart 17). The migration flows have therefore not shifted from the Balkan route to the Italian one. Chart 16The Migration Crisis Is Over!##br## (Did Anyone Tell The Voters?) bca.bcasr_sr_2016_06_24_c16 bca.bcasr_sr_2016_06_24_c16 Chart 17Migrants Are Not ##br##Coming Via Libya bca.bcasr_sr_2016_06_24_c17 bca.bcasr_sr_2016_06_24_c17 As such, it is possible that by the time an Austrian, Dutch, or Italian referendum on EU membership is called, the issue of migration may no longer be front-and-center on voters' minds. In fact, EU efforts to intercept refugee flows at the bloc's external borders could be seen as successful by that point. Bottom Line: A "Who is Next" premium will undoubtedly be applied to European assets now that the U.K. has voted to leave the EU. However, it will likely overstate the risks of other countries following suit. The U.K. has the least political, economic, financial, and geopolitical constraints to exiting the bloc. Broad Political And Geopolitical Implications The decision by the U.K. electorate to leave the EU is going to increase both political and geopolitical volatility. It strikes at the stability of the European Union, which is one of the core post-World War Two institutions that have kept peace in the Western world for the past seventy years. As such, its implications - if London goes ahead with Brexit - will be profound. The U.K. referendum will have implications for multipolarity, a major theme of BCA's Geopolitical Strategy. The world lacks global leadership as the U.S. wanes in relative geopolitical power. From an investor's perspective, this is a negative process as multipolarity is empirically and theoretically proven to be a harbinger of inter-state conflict. Today, this process has largely been assuaged by the existence of Cold War-era institutions that allow the U.S. to amplify its power. The EU, NATO, and financial institutions such as the IMF and the World Bank are such entities. By leaving the EU, the U.K. does not necessarily undermine this global order, but it does show that a 43 year-old geopolitical relationship can end. It will weaken the EU as a global player, given the U.K.'s obvious hard power, and aid Europe's geopolitical rivals. And if it further leads to disintegration of the EU, which is not our base case, it will massively increase global geopolitical risk. We suspect our clients will have to brush up on obscure geographical references - such as Alsace-Lorraine, Silesia, and South Tyrol - by the time this process is over, if it ever begins. This is a profoundly negative outcome, if it were to occur. Generations that thought they would never see another armed conflict on the European Peninsula may be in for a surprise. On the domestic political front, the rise of the anti-establishment - particularly in the U.S. and U.K. - has been one of the most talked-about themes in the financial community in 2016. However, it is unclear how to price the risk, if any, of non-centrists coming to power. In part, the reason is that investors have had widespread disbelief that populism could win any major election in any major economy. That has now changed with the U.K. choosing to exit the EU. Chart 18Debt Replaced Income Debt Replaced Income Debt Replaced Income We suspect that the focus over the next several months - in terms of assigning risk premia - will remain on Europe. However, the reality is that middle class malaise may be the most advanced in the laissez-faire economies of the U.S. and the U.K., especially now that the debt supercycle is no longer available to assuage the pain of decade-long stagnant wages (Chart 18). In a way, anti-globalization policies are merely the politically right-of-center approach to redistributing income. The last three decades of free trade and laissez-faire policies have led to growing income inequality as winners of globalization captured most of the gains and losers were left to face the consequences, and the painful adjustment, without much redistribution. Take the vote on EU membership, which saw all of England vote to leave except for the financial capital of the world, London. For Bernie Sanders and Jeremy Corbyn - as well as Podemos in Spain and SYRIZA in Greece - the answer is to dial up the redistribution. For Donald Trump, UKIP, and Marine Le Pen in France, the answer is to wall off their economies and hope to stave off redistribution by shifting the blame for tepid growth to the outside world. Both policies will be equally bad for equity markets and risk assets, as they will erode profit margins one way or another. The 1990s consensus on deregulation, privatization, low taxes, budgetary discipline, and free trade is over. The median voter is shifting to the left-of-center and demanding economic policies that are in contravention of the 1990s "Third Way" consensus (Diagram 1). According to the median voter theory, policymakers will shift with the median voter to a new center and will not shift back to the old center once they capture power.4 Thus, even if the establishment wins in the U.S. this year and France and Germany next year, it will have moved away from the laissez-faire and globalization consensus. Diagram 1Median Voter Theorem The Coming EXITentialist Crisis The Coming EXITentialist Crisis This is bad news for emerging markets. It is also bad news for the shares of global companies who have benefited tremendously from the steady dismantling of barriers to the free flow of goods, capital, and labor. In the long run, the decline of globalization will also usher in higher inflation. Globalization has effectively produced the largest supply-side shock in the history of mankind. As such, it is a major deflationary force. But if policymakers respond to populism with protectionism and fiscal expenditure, then the deflationary forces of globalization will reverse. Perhaps sooner than the market expects. Bottom Line: The Goldilocks era for investors - in terms of the economic policy consensus - is over. When combined with the hegemonic instability of a multipolar order, Brexit means that politics and geopolitics will become an ever more relevant analytical lens for investors. The apex of globalization has come and gone.5 Investment Implications At BCA, we have long maintained that at times such as this, it makes sense to take a cold shower and resist making any rushed investment decision. Brexit, if it were to go ahead as currently planned, has the potential to change the world, but it is not clear precisely how. The current market sell-off offers a buying opportunity, at least in the short term. Policymakers are already responding with renewed stimulus. The G7 communique issued on the heels of the referendum has essentially given a green light to Japan and Europe to intervene in the currency markets. The Fed funds rate futures are now pricing in a 15% probability of a U.S. rate cut by the end of the year, whereas the probability was zero just one day ago. Nevertheless, the damage has been done. Peter Berezin, Chief Strategist of BCA's Global Investment Strategy, fears that the "reflation trade" that began in February may be over. Certainly the data out of China is becoming more difficult to square, with declining credit growth and leading indicators (like excavator sales) taking a plunge. Reflation by policymakers may eventually combine with the pervasive "search for yield" to buoy risk assets. At the moment, however, all eyes will be turned to Europe and the "Who is Next" premium likely to creep into assets. We suspect that global assets will take cues not from the Fed or China in the short term, but Europe and the usual bellwether of the continent's future: Mediterranean economies. In terms of U.K. assets, several immediate investment strategies exist: Currency: BCA's Foreign Exchange Strategy recommends buying the GBP/USD at 1.32. Short FTSE 250/FTSE 100: The FTSE 250 has outperformed the FTSE 100 since 2000 (Chart 19), closely reflecting the performance of the U.K. economy relative to the euro area. Uncertainty caused by a vote in favor of Brexit will weigh on consumer and business confidence in the U.K., hurting the FTSE 250's performance, while a weaker GBP/USD should give a boost to the globally-oriented FTSE 100. Long FTSE 100 "exporters" / FTSE 100 "financials": While negative for the pound, Brexit should represent a boon to export-oriented industries. British real net exports increased during the period of sterling weakness following "Black Wednesday" - the pound's exit from the European Exchange Rate Mechanism (ERM) in September 1992 - reaching a level that they have been unable to regain since (Chart 20). Meanwhile, the greatest uncertainty would surround the financial sector, which would face both the potential loss of market access in the euro area and negative political consequences. Chart 19Go Long U.K. Exporters bca.bcasr_sr_2016_06_24_c19 bca.bcasr_sr_2016_06_24_c19 Chart 20Weak Pound Is Good For Exports Weak Pound Is Good For Exports Weak Pound Is Good For Exports Buy inflation protection: We favor getting long 10-year U.K. CPI swaps / short 10-year U.S. CPI swaps (Chart 21). BCA's Global Fixed Income Strategy team argues that inflation could surprise to the upside in the U.K. First, the labor market is tightening and firms are having increasing difficulty recruiting (Chart 22). A weaker pound will also lead to higher inflation through higher import prices. To counter the negative economic effects, the Bank of England will now likely cut interest rates, and perhaps even engage in renewed quantitative easing, which means that monetary policy will not curb but feed the inflationary impulses of Brexit. Chart 21Buy Inflation Protection bca.bcasr_sr_2016_06_24_c21 bca.bcasr_sr_2016_06_24_c21 Chart 22U.K. Labor Market Is Tightening U.K. Labor Market Is Tightening U.K. Labor Market Is Tightening Play the corporate bond market: The U.K. corporate bond market has not priced in Brexit (Chart 23). Investors should underweight U.K. financials versus euro area financials and/or underweight U.K. financials versus U.K. industrials. Ahead of the referendum, U.K. financial spreads had only widened mildly versus peers in the U.S. and the euro area. They were not even showing signs of stress against U.K. industrials. The Brexit vote will likely push these spreads wider. Play the yield curve: If Brexit happens, the yield curve will most likely steepen. As more interest rate cuts are priced in the short end of the curve, inflationary pressures will bubble up and push the longer part of the curve higher. The belly of the curve will profit from these conditions (Chart 24). Chart 23Corporate Bond Market ##br##Has Not Priced In Brexit Corporate Bond Market Has Not Priced In Brexit Corporate Bond Market Has Not Priced In Brexit Chart 24Long Bullet Vs. ##br##The Wings bca.bcasr_sr_2016_06_24_c24 bca.bcasr_sr_2016_06_24_c24 Marko Papic, Managing Editor marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com 1 Please see BCA Special Report, "Break Glass To Brexit: A Fact Sheet," dated June 17, 2016, and BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 2 The six factors are trade balance with the EU, exports as percent of GDP, debt interest payments, gross government debt, foreign direct investment, and net transfers to the EU. 3 Please see BCA's The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated October 19, 2011, available at bca.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.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.

The reflation rally continues. Despite our bearish outlook for the year, we think the risks of the current rally lie to the upside given China's redoubling of stimulus at the expense of reform. Populist troubles are picking up in Europe, but we maintain our positive structural view and note that the migration crisis is slackening. Rather, the greatest risks of populism continue to flourish in the Anglo-Saxon world with Brexit and Trump.