DM Asia Pacific

Highlights Multipolarity will peak in 2017 - geopolitical risks are spiking; Globalization is giving way to zero-sum mercantilism; U.S.-China relations are the chief risk to global stability; Turkey is the most likely state to get in a shooting war; Position for an inflation comeback; Go long defense, USD/EUR, and U.S. small caps vs. large caps. Feature Before the world grew mad, the Somme was a placid stream of Picardy, flowing gently through a broad and winding valley northwards to the English Channel. It watered a country of simple beauty. A. D. Gristwood, British soldier, later novelist. The twentieth century did not begin on January 1, 1900. Not as far as geopolitics is concerned. It began 100 years ago, on July 1, 1916. That day, 35,000 soldiers of the British Empire, Germany, and France died fighting over a couple of miles of territory in a single day. The 1916 Anglo-French offensive, also known as the Battle of the Somme, ultimately cost the three great European powers over a million and a half men in total casualties, of which 310,862 were killed in action over the four months of fighting. British historian A. J. P. Taylor put it aptly: idealism perished on the Somme. How did that happen? Nineteenth-century geopolitical, economic, and social institutions - carefully nurtured by a century of British hegemony - broke on the banks of the Somme in waves of human slaughter. What does this have to do with asset allocation? Calendars are human constructs devised to keep track of time. But an epoch is a period with a distinctive set of norms, institutions, and rules that order human activity. This "order of things" matters to investors because we take it for granted. It is a set of "Newtonian Laws" we assume will not change, allowing us to extrapolate the historical record into future returns.1 Since inception, BCA's Geopolitical Strategy has argued that the standard assumptions about our epoch no longer apply.2 Social orders are not linear, they are complex systems. And we are at the end of an epoch, one that defined the twentieth century by globalization, the spread of democracy, and American hegemony. Because the system is not linear, its break will cause non-linear outcomes. Since joining BCA's Editorial Team in 2011, we have argued that twentieth-century institutions are undergoing regime shifts. Our most critical themes have been: The rise of global multipolarity;3 The end of Sino-American symbiosis;4 The apex of globalization;5 The breakdown of laissez-faire economics;6 The passing of the emerging markets' "Goldilocks" era.7 Our view is that the world now stands at the dawn of the twenty-first century. The transition is not going to be pretty. Investors must stop talking themselves out of left-tail events by referring to twentieth-century institutions. Yes, the U.S. and China really could go to war in the next five years. No, their trade relationship will not prevent it. Was the slaughter at the Somme prevented by the U.K.-German economic relationship? In fact, our own strategy service may no longer make sense in the new epoch. "Geopolitics" is not some add-on to investor's asset-allocation process. It is as much a part of that process as are valuations, momentum, bottom-up analysis, and macroeconomics. To modify the infamous Milton Friedman quip, "We are all geopolitical strategists now." Five Decade Themes: We begin this Strategic Outlook by updating our old decade themes and introducing a few new ones. These will inform our strategic views over the next half-decade. Below, we also explain how they will impact investors in 2017. From Multipolarity To ... Making America Great Again Our central theme of global multipolarity will reach its dangerous apex in 2017. Multipolarity is the idea that the world has two or more "poles" of power - great nations - that pursue their interests independently. It heightens the risk of conflict. Since we identified this trend in 2012, the number of global conflicts has risen from 10 to 21, confirming our expectations (Chart 1). Political science theory is clear: a world without geopolitical leadership produces hegemonic instability. America's "hard power," declining in relative terms, created a vacuum that was filled by regional powers looking to pursue their own spheres of influence. Chart 1Frequency Of Geopolitical Conflicts Increases Under Multipolarity Frequency Of Geopolitical Conflicts Increases Under Multipolarity Frequency Of Geopolitical Conflicts Increases Under Multipolarity The investment implications of a multipolar world? The higher frequency of geopolitical crises has provided a tailwind to safe-haven assets such as U.S. Treasurys.8 Ironically, the relative decline of U.S. power is positive for U.S. assets.9 Although its geopolitical power has been in relative decline since 1990, the U.S. bond market has become more, not less, appealing over the same timeframe (Chart 2) Counterintuitively, it was American hegemony - i.e. global unipolarity after the Soviet collapse - that made the rise of China and other emerging markets possible. This created the conditions for globalization to flourish and for investors to leave the shores of developed markets in search of yield. It is the stated objective of President-elect Donald Trump, and a trend initiated under President Barack Obama, to reduce the United States' hegemonic responsibilities. As the U.S. withdraws, it leaves regional instability and geopolitical disequilibria in its wake, enhancing the value-proposition of holding on to low-beta American assets. We are now coming to the critical moment in this process, with neo-isolationist Trump doubling down on President Obama's aloof foreign policy. In 2017, therefore, multipolarity will reach its apex, leading several regional powers - from China to Turkey - to overextend themselves as they challenge the status quo. Chaos will ensue. (See below for more!) The inward shift in American policy will sow the seeds for the eventual reversal of multipolarity. America has always profited from geopolitical chaos. It benefits from being surrounded by two massive oceans, Canada, and the Sonora-Chihuahuan deserts. Following both the First and Second World Wars, the U.S.'s relative geopolitical power skyrocketed (Chart 3). Chart 2America Is A Safe-Haven,##br## Despite (Because Of?) Relative Decline America Is A Safe-Haven, Despite (Because Of?) Relative Decline America Is A Safe-Haven, Despite (Because Of?) Relative Decline Chart 3America Is Chaos-Proof bca.gps_so_2016_12_14_c3 bca.gps_so_2016_12_14_c3 Over the next 12-24 months, we expect the chief investment implications of multipolarity - volatility, tailwind to safe-haven assets, emerging-market underperformance, and de-globalization - to continue to bear fruit. However, as the U.S. comes to terms with multipolarity and withdraws support for critical twentieth-century institutions, it will create conditions that will ultimately reverse its relative decline and lead to a more unipolar tendency (or possibly bipolar, with China). Therefore, Donald Trump's curious mix of isolationism, anti-trade rhetoric, and domestic populism may, in the end, Make America Great Again. But not for the reasons he has promised-- not because the U.S. will outperform the rest of the world in an absolute sense. Rather, America will become great again in a relative sense, as the rest of the world drifts towards a much scarier, darker place without American hegemony. Bottom Line: For long-term investors, the apex of multipolarity means that investing in China and broader EM is generally a mistake. Europe and Japan make sense in the interim due to overstated political risks, relatively easy monetary policy, and valuations, but even there risks will mount due to their high-beta qualities. The U.S. will own the twenty-first century. From Globalization To ... Mercantilism "The industrial glory of England is departing, and England does not know it. There are spasmodic outcries against foreign competition, but the impression they leave is fleeting and vague ... German manufacturers ... are undeniably superiour to those produced by British houses. It is very dangerous for men to ignore facts that they may the better vaunt their theories ... This is poor patriotism." Ernest Edwin Williams, Made in Germany (1896) The seventy years of British hegemony that followed the 1815 Treaty of Paris ending the Napoleonic Wars were marked by an unprecedented level of global stability. Britain's cajoled enemies and budding rivals swallowed their wounded pride and geopolitical appetites and took advantage of the peace to focus inwards, industrialize, and eventually catch up to the U.K.'s economy. Britain, by providing expensive global public goods - security of sea lanes, off-shore balancing,10 a reserve currency, and financial capital - resolved the global collective-action dilemma and ushered in an era of dramatic economic globalization. Sound familiar? It should. As Chart 4 shows, we are at the conclusion of a similar period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. There are other forces at work, such as pernicious wage deflation that has soured the West's middle class on free trade and immigration. But the main threat to globalization is at heart geopolitical. The breakdown of twentieth-century institutions, norms, and rules will encourage regional powers to set up their own spheres of influence and to see the global economy as a zero-sum game instead of a cooperative one.11 Chart 4Multipolarity And De-Globalization Go Hand-In-Hand bca.gps_so_2016_12_14_c4 bca.gps_so_2016_12_14_c4 At the heart of this geopolitical process is the end of Sino-American symbiosis. We posited in February that Charts 5 and 6 are geopolitically unsustainable.12 China cannot keep capturing an ever-increasing global market share for exports while exporting deflation; particularly now that its exports are rising in complexity and encroaching on the markets of developed economies (Chart 7). China's economic policy might have been acceptable in an era of robust global growth and American geopolitical confidence, but we live in a world that is, for the time being, devoid of both. Chart 5China's Share Of Global##br## Exports Has Skyrocketed... bca.gps_so_2016_12_14_c5 bca.gps_so_2016_12_14_c5 Chart 6And Now China ##br##Is Exporting Deflation bca.gps_so_2016_12_14_c6 bca.gps_so_2016_12_14_c6 China and the U.S. are no longer in a symbiotic relationship. The close embrace between U.S. household leverage and Chinese export-led growth is over (Chart 8). Today the Chinese economy is domestically driven, with government stimulus and skyrocketing leverage playing a much more important role than external demand. Exports make up only 19% of China's GDP and 12% of U.S. GDP. The two leading economies are far less leveraged to globalization than the conventional wisdom would have it. Chart 7China's Steady Climb Up ##br##The Value Ladder Continues Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 8Sino-American ##br##Symbiosis Is Over bca.gps_so_2016_12_14_c8 bca.gps_so_2016_12_14_c8 Chinese policymakers have a choice. They can double down on globalization and use competition and creative destruction to drive up productivity growth, moving the economy up the value chain. Or they can use protectionism - particularly non-tariff barriers, as they have been doing - to defend their domestic market from competition.13 We expect that they will do the latter, especially in an environment where anti-globalization rhetoric is rising in the West and protectionism is already on the march (Chart 9). Chart 9Protectionism On The March Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The problem with this likely choice, however, is that it breaks up the post-1979 quid-pro-quo between Washington and Beijing. The "quid" was the Chinese entry into the international economic order (including the WTO in 2001), which the U.S. supported; the "quo" was that Beijing would open its economy as it became wealthy. Today, 45% of China's population is middle-class, which makes China potentially the world's second-largest market after the EU. If China decides not to share its middle class with the rest of the world, then the world will quickly move towards mercantilism - particularly with regard to Chinese imports. Mercantilism was a long-dominant economic theory, in Europe and elsewhere, that perceived global trade to be a zero-sum game and economic policy to be an extension of the geopolitical "Great Game" between major powers. As such, net export growth was the only way to prosperity and spheres of influence were jealously guarded via trade barriers and gunboat diplomacy. What should investors do if mercantilism is back? In a recent joint report with the BCA's Global Alpha Sector Strategy, we argued that investors should pursue three broad strategies: Buy small caps (or microcaps) at the expense of large caps (or mega caps) across equity markets as the former are almost universally domestically focused; Favor closed economies levered on domestic consumption, both within DM and EM universes; Stay long global defense stocks; mercantilism will lead to more geopolitical risk (Chart 10). Chart 10Defense Stocks Are A No-Brainer Defense Stocks Are A No-Brainer Defense Stocks Are A No-Brainer Investors should also expect a more inflationary environment over the next decade. De-globalization will mean marginally less trade, less migration, and less free movement of capital across borders. These are all inflationary. Bottom Line: Mercantilism is back. Sino-American tensions and peak multipolarity will impair coordination. It will harden the zero-sum game that erodes globalization and deepens geopolitical tensions between the world's two largest economies.14 One way to play this theme is to go long domestic sectors and domestically-oriented economies relative to export sectors and globally-exposed economies. The real risk of mercantilism is that it is bedfellows with nationalism and jingoism. We began this section with a quote from an 1896 pamphlet titled "Made in Germany." In it, British writer E.E. Williams argued that the U.K. should abandon free trade policies due to industrial competition from Germany. Twenty years later, 350,000 men died in the inferno of the Somme. From Legal To ... Charismatic Authority Legal authority, the bedrock of modern democracy, is a critical pillar of civilization that investors take for granted. The concept was defined in 1922 by German sociologist Max Weber. Weber's seminal essay, "The Three Types of Legitimate Rule," argues that legal-rational authority flows from the institutions and laws that define it, not the individuals holding the office.15 This form of authority is investor-friendly because it reduces uncertainty. Investors can predict the behavior of policymakers and business leaders by learning the laws that govern their behavior. Developed markets are almost universally made up of countries with such norms of "good governance." Investors can largely ignore day-to-day politics in these systems, other than the occasional policy shift or regulatory push that affects sector performance. Weber's original essay outlined three forms of authority, however. The other two were "traditional" and "charismatic."16 Today we are witnessing the revival of charismatic authority, which is derived from the extraordinary characteristics of an individual. From Russia and the U.S. to Turkey, Hungary, the Philippines, and soon perhaps Italy, politicians are winning elections on the back of their messianic qualities. The reason for the decline of legal-rational authority is threefold: Elites that manage governing institutions have been discredited by the 2008 Great Recession and subsequent low-growth recovery. Discontent with governing institutions is widespread in the developed world (Chart 11). Elite corruption is on the rise. Francis Fukuyama, perhaps America's greatest political theorist, argues that American political institutions have devolved into a "system of legalized gift exchange, in which politicians respond to organized interest groups that are collectively unrepresentative of the public as a whole."17 Political gridlock across developed and emerging markets has forced legal-rational policymakers to perform like charismatic ones. European policymakers have broken laws throughout the euro-area crisis, with the intention of keeping the currency union alive. President Obama has issued numerous executive orders due to congressional gridlock. While the numbers of executive orders have declined under Obama, their economic significance has increased (Chart 12). Each time these policymakers reached around established rules and institutions in the name of contingencies and crises, they opened the door wider for future charismatic leaders to eschew the institutions entirely. Chart 11As Institutional Trust Declines, ##br##Voters Turn To Charismatic Leaders As Institutional Trust Declines, Voters Turn To Charismatic Leaders As Institutional Trust Declines, Voters Turn To Charismatic Leaders Chart 12Obama ##br##The Regulator Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Furthermore, a generational shift is underway. Millennials do not understand the value of legal-rational institutions and are beginning to doubt the benefits of democracy itself (Chart 13). The trend appears to be the most pronounced in the U.S. and U.K., perhaps because neither experienced the disastrous effects of populism and extremism of the 1930s. In fact, millennials in China appear to view democracy as more essential to the "good life" than their Anglo-Saxon peers. Chart 13Who Needs Democracy When You Have Tinder? Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Charismatic leaders can certainly outperform expectations. Donald Trump may end up being FDR. The problem for investors is that it is much more difficult to predict the behavior of a charismatic authority than a legal-rational one.18 For example, President-elect Trump has said that he will intervene in the U.S. economy throughout his four-year term, as he did with Carrier in Indiana. Whether these deals are good or bad, in a normative sense, is irrelevant. The point is that bottom-up investment analysis becomes useless when analysts must consider Trump's tweets, as well as company fundamentals, in their earnings projections! We suspect that the revival of charismatic leadership - and the danger that it might succeed in upcoming European elections - at least partly explains the record high levels of global policy uncertainty (Chart 14). Markets do not seem to have priced in the danger fully yet. Global bond spreads are particularely muted despite the high levels of uncertainty. This is unsustainable. Chart 14Are Assets Fully Pricing In Global Uncertainty? Are Assets Fully Pricing In Global Uncertainty? Are Assets Fully Pricing In Global Uncertainty? Bottom Line: The twenty-first century is witnessing the return of charismatic authority and erosion of legal-rational authority. This should be synonymous with uncertainty and market volatility over the next decade. In 2017, expect a rise in EuroStoxx volatility. From Laissez-Faire To ... Dirigisme The two economic pillars of the late twentieth century have been globalization and laissez-faire capitalism, or neo-liberalism. The collapse of the Soviet Union ended the communist challenge, anointing the U.S.-led "Washington Consensus" as the global "law of the land." The tenets of this epoch are free trade, fiscal discipline, low tax burden, and withdrawal of the state from the free market. Not all countries approached the new "order of things" with equal zeal, but most of them at least rhetorically committed themselves to asymptotically approaching the American ideal. Chart 15Debt Replaced Wages##br## In Laissez-Faire Economies Debt Replaced Wages In Laissez-Faire Economies Debt Replaced Wages In Laissez-Faire Economies The 2008 Great Recession put an end to the bull market in neo-liberal ideology. The main culprit has been the low-growth recovery, but that is not the full story. Tepid growth would have been digested without a political crisis had it not followed decades of stagnating wages. With no wage growth, households in the most laissez-faire economies of the West gorged themselves on debt (Chart 15) to keep up with rising cost of housing, education, healthcare, and childcare -- all staples of a middle-class lifestyle. As such, the low-growth context after 2008 has combined with a deflationary environment to produce the most pernicious of economic conditions: debt-deflation, which Irving Fisher warned of in 1933.19 It is unsurprising that globalization became the target of middle-class angst in this context. Globalization was one of the greatest supply-side shocks in recent history: it exerted a strong deflationary force on wages (Chart 16). While it certainly lifted hundreds of millions of people out of poverty in developing nations, globalization undermined those low-income and middle-class workers in the developed world whose jobs were most easily exported. World Bank economist Branko Milanovic's infamous "elephant trunk" shows the stagnation of real incomes since 1988 for the 75-95 percentile of the global income distribution - essentially the West's middle class (Chart 17).20 It is this section of the elephant trunk that increasingly supports populism and anti-globalization policies, while eschewing laissez faire liberalism. In our April report, "The End Of The Anglo-Saxon Economy," we posited that the pivot away from laissez-faire capitalism would be most pronounced in the economies of its greatest adherents, the U.S. and U.K. We warned that Brexit and the candidacy of Donald Trump should be taken seriously, while the populist movements in Europe would surprise to the downside. Why the gap between Europe and the U.S. and U.K.? Because Europe's cumbersome, expensive, inefficient, and onerous social-welfare state finally came through when it mattered: it mitigated the pernicious effects of globalization and redistributed enough of the gains to temper populist angst. Chart 16Globalization: A Deflationary Shock Globalization: A Deflationary Shock Globalization: A Deflationary Shock Chart 17Globalization: No Friend To DM Middle Class Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now This view was prescient in 2016. The U.K. voted to leave the EU, Trump triumphed, while European populists stumbled in both the Spanish and Austrian elections. The Anglo-Saxon median voter has essentially moved to the left of the economic spectrum (Diagram 1).21 The Median Voter Theorem holds that policymakers will follow the shift to the left in order to capture as many voters as possible under the proverbial curve. In other words, Donald Trump and Bernie Sanders are not political price-makers but price-takers. Diagram 1The Median Voter Is Moving To The Left In The U.S. And U.K. Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now How does laissez-faire capitalism end? In socialism or communism? No, the institutions that underpin capitalism in the West - private property, rule of law, representative government, and enforcement of contracts - remain strong. Instead, we expect to see more dirigisme, a form of capitalism where the state adopts a "directing" rather than merely regulatory role. In the U.S., Donald Trump unabashedly campaigned on dirigisme. We do not expand on the investment implications of American dirigisme in this report (we encourage clients to read our post-election treatment of Trump's domestic politics).22 But investors can clearly see the writing on the wall: a late-cycle fiscal stimulus will be positive for economic growth in the short term, but most likely more positive for inflation in the long term. Donald Trump's policies therefore are a risk to bonds, positive for equities (in the near term), and potentially negative for both in the long term if stagflation results from late-cycle stimulus. What about Europe? Is it not already quite dirigiste? It is! But in Europe, we see a marginal change towards the right, not the left. In Spain, the supply-side reforms of Prime Minister Mariano Rajoy will remain in place, as he won a second term this year. In France, right-wing reformer - and self-professed "Thatcherite" - François Fillon is likely to emerge victorious in the April-May presidential election. And in Germany, the status-quo Grand Coalition will likely prevail. Only in Italy are there risks, but even there we expect financial markets to force the country - kicking and screaming - down the path of reforms. Bottom Line: In 2017, the market will be shocked to find itself face-to-face with a marginally more laissez-faire Europe and a marginally more dirigiste America and Britain. Investors should overweight European assets in a global portfolio given valuations, relative monetary policy (which will remain accommodative in Europe), a weak euro, and economic fundamentals (Chart 18), and upcoming political surprises. For clients with low tolerance of risk and volatility, a better entry point may exist following the French presidential elections in the spring. From Bias To ... Conspiracies As with the printing press, the radio, film, and television before it, the Internet has created a super-cyclical boom in the supply and dissemination of information. The result of the sudden surge is that quality and accountability are declining. The mainstream media has dubbed this the "fake news" phenomenon, no doubt to differentiate the conspiracy theories coursing through Facebook and Twitter from the "real news" of CNN and MSNBC. The reality is that mainstream media has fallen far short of its own vaunted journalistic standards (Chart 19). Chart 18Europe's Economy Is Holding Up Europe's Economy Is Holding Up Europe's Economy Is Holding Up Chart 19 "Mainstream Media" Is A Dirty Word For Many "Mainstream Media" Is A Dirty Word For Many We are not interested in this debate, nor are we buying the media narrative that "fake news" delivered Trump the presidency. Instead, we are focused on how geopolitical and political information is disseminated to voters, investors, and ultimately priced by the market. We fear that markets will struggle to price information correctly due to three factors: Low barriers to entry: The Internet makes publishing easy. Information entrepreneurs - i.e. hack writers - and non-traditional publications ("rags") are proliferating. The result is greater output but a decrease in quality control. For example, Facebook is now the second most trusted source of news for Americans (Chart 20). Cost-cutting: The boom in supply has squeezed the media industry's finances. Newspapers have died in droves; news websites and social-media giants have mushroomed (Chart 21). News companies are pulling back on things like investigative reporting, editorial oversight, and foreign correspondent desks. Foreign meddling: In this context, governments have gained a new advantage because they can bring superior financial resources and command-and-control to an industry that is chaotic and cash-strapped. Russian news outlets like RT and Sputnik have mastered this game - attracting "clicks" around the world from users who are not aware they are reading Russian propaganda. China has also raised its media profile through Western-accessible propaganda like the Global Times, but more importantly it has grown more aggressive at monitoring, censoring, and manipulating foreign and domestic media. Chart 20Facebook Is The New Cronkite? Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 21The Internet Has Killed Journalism Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The above points would be disruptive enough alone. But we know that technology is not the root cause of today's disruptions. Income inequality, the plight of the middle class, elite corruption, unchecked migration, and misguided foreign policy have combined to create a toxic mix of distrust and angst. In the West, the decline of the middle class has produced a lack of socio-political consensus that is fueling demand for media of a kind that traditional outlets can no longer satisfy. Media producers are scrambling to meet this demand while struggling with intense competition from all the new entrants and new platforms. What is missing is investment in downstream refining and processing to convert the oversupply of crude information into valuable product for voters and investors.23 Otherwise, the public loses access to "transparent" or baseline information. Obviously the baseline was never perfect. Both the Vietnam and Iraq wars began as gross impositions on the public's credulity: the Gulf of Tonkin Incident and Saddam Hussein's weapons of mass destruction. But there was a shared reference point across society. The difference today, as we see it, is that mass opinion will swing even more wildly during a crisis as a result of the poor quality of information that spreads online and mobilizes social networks more rapidly than ever before. We could have "flash mobs" in the voting booth - or on the steps of the Supreme Court - just like "flash crashes" in financial markets, i.e. mass movements borne of passing misconceptions rather than persistent misrule. Election results are more likely to strain the limits of the margin of error, while anti-establishment candidates are more likely to remain viable despite dubious platforms. What does this mean for investors? Fundamental analysis of a country's political and geopolitical risk is now an essential tool in the investor toolkit. If investors rely on the media, and the market prices what the media reports, then the same investors will continue to get blindsided by misleading probabilities, as with Brexit and Trump (Chart 22). While we did not predict these final outcomes, we consistently advised clients, for months in advance, that the market probabilities were too low and serious hedging was necessary. Those who heeded our advice cheered their returns, even as some lamented the electoral returns. Chart 22Get Used To Tail-Risk Events Get Used To Tail-Risk Events Get Used To Tail-Risk Events Bottom Line: Keep reading BCA's Geopolitical Strategy! Final Thoughts On The Next Decade The nineteenth century ended in the human carnage that was the Battle of the Somme. The First World War ushered in social, economic, political, geopolitical, demographic, and technological changes that drove the evolution of twentieth-century institutions, rules, and norms. It created the "order of things" that we all take for granted today. The coming decade will be the dawn of the new geopolitical century. We can begin to discern the ordering of this new epoch. It will see peak multipolarity lead to global conflict and disequilibrium, with globalization and laissez-faire economic consensus giving way to mercantilism and dirigisme. Investors will see the benevolent deflationary impulse of globalization evolve into state intervention in the domestic economy and the return of inflation. Globally oriented economies and sectors will underperform domestic ones. Developed markets will continue to outperform emerging markets, particularly as populism spreads to developing economies that fail to meet expectations of their rising middle classes. Over the next ten years, these changes will leave the U.S. as the most powerful country in the world. China and wider EM will struggle to adapt to a less globalized world, while Europe and Japan will focus inward. The U.S. is essentially a low-beta Great Power: its economy, markets, demographics, natural resources, and security are the least exposed to the vagaries of the rest of the world. As such, when the rest of the world descends into chaos, the U.S. will hide behind its Oceans, and Canada, and the deserts of Mexico, and flourish. Five Themes For 2017: Our decade themes inform our view of cyclical geopolitical events and crises, such as elections and geopolitical tensions. As such, they form our "net assessment" of the world and provide a prism through which we refract geopolitical events. Below we address five geopolitical themes that we expect to drive the news flow, and thus the markets, in 2017. Some themes are Red Herrings (overstated risks) and thus present investment opportunities, others are Black Swans (understated risks) and are therefore genuine risks. Europe In 2017: A Trophy Red Herring? Europe's electoral calendar is ominously packed (Table 1). Four of the euro area's five largest economies are likely to have elections in 2017. Another election could occur if Spain's shaky minority government collapses. Table 1 Europe In 2017 Will Be A Headline Risk Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now We expect market volatility to be elevated throughout the year due to the busy calendar. In this context, we advise readers to follow our colleague Dhaval Joshi at BCA's European Investment Strategy. Dhaval recommends that BCA clients combine every €1 of equity exposure with 40 cents of exposure to VIX term-structure, which means going long the nearest-month VIX futures and equally short the subsequent month's contract. The logic is that the term structure will invert sharply if risks spike.24 While we expect elevated uncertainty and lots of headline risk, we do not believe the elections in 2017 will transform Europe's future. As we have posited since 2011, global multipolarity increases the logic for European integration.25 Crises driven by Russian assertiveness, Islamic terrorism, and the migration wave are not dealt with more effectively or easily by nation states acting on their own. Thus far, it appears that Europeans agree with this assessment: polling suggests that few are genuinely antagonistic towards the euro (Chart 23) or the EU (Chart 24). In our July report called "After BREXIT, N-EXIT?" we posited that the euro area will likely persevere over at least the next five years.26 Chart 23Support For The Euro Remains Stable Support For The Euro Remains Stable Support For The Euro Remains Stable Chart 24Few Europeans Want Out Of The EU Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Take the Spanish and Austrian elections in 2016. In Spain, Mariano Rajoy's right-wing People's Party managed to hold onto power despite four years of painful internal devaluations and supply-side reforms. In Austria, the establishment candidate for president, Alexander Van der Bellen, won the election despite Austria's elevated level of Euroskepticism (Chart 24), its central role in the migration crisis, and the almost comically unenthusiastic campaign of the out-of-touch Van der Bellen. In both cases, the centrist candidates survived because voters hesitated when confronted with an anti-establishment choice. Next year, we expect more of the same in three crucial elections: The Netherlands: The anti-establishment and Euroskeptic Party for Freedom (PVV) will likely perform better than it did in the last election, perhaps even doubling its 15% result in 2012. However, it has no chance of forming a government, given that all the other parties contesting the election are centrist and opposed to its Euroskeptic agenda (Chart 25). Furthermore, support for the euro remains at a very high level in the country (Chart 26). This is a reality that the PVV will have to confront if it wants to rule the Netherlands. Chart 25No Government For Dutch Euroskeptics Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 26The Netherlands & Euro: Love Affair The Netherlands & Euro: Love Affair The Netherlands & Euro: Love Affair France: Our high conviction view is that Marine Le Pen, leader of the Euroskeptic National Front (FN), will be defeated in the second round of the presidential election.27 Despite three major terrorist attacks in the country, unchecked migration crisis, and tepid economic growth, Le Pen's popularity peaked in 2013 (Chart 27). She continues to poll poorly against her most likely opponents in the second round, François Fillon and Emmanuel Macron (Chart 28). Investors who doubt the polls should consider the FN's poor performance in the December 2015 regional elections, a critical case study for Le Pen's viability in 2017.28 Chart 27Le Pen's Polling: ##br##Head And Shoulder Formation? Le Pen's Polling: Head And Shoulder Formation? Le Pen's Polling: Head And Shoulder Formation? Chart 28Le Pen Will Not Be##br## Next French President Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Germany: Chancellor Angela Merkel's popularity is holding up (Chart 29), the migration crisis has abated (Chart 30), and there remains a lot of daylight between the German establishment and populist parties (Chart 31). The anti-establishment Alternative für Deutschland will enter parliament, but remain isolated. Chart 29Merkel's Approval Rating Has Stabilized Merkel's Approval Rating Has Stabilized Merkel's Approval Rating Has Stabilized Chart 30Migration Crisis Is Abating bca.gps_so_2016_12_14_c30 bca.gps_so_2016_12_14_c30 Chart 31There Is A Lot Of Daylight... bca.gps_so_2016_12_14_c31 bca.gps_so_2016_12_14_c31 The real risk in 2017 remains Italy. The country has failed to enact any structural reforms, being a laggard behind the reform poster-child Spain (Chart 32). Meanwhile, support for the euro remains in the high 50s, which is low compared to the euro-area average (Chart 33). Polls show that if elections were held today, the ruling Democratic Party would gain a narrow victory (Chart 34). However, it is not clear what electoral laws would apply to the contest. The reformed electoral system for the Chamber of Deputies remains under review by the Constitutional Court until at least February. This will make all the difference between further gridlock and a viable government. Chart 32Italy Is Europe's bca.gps_so_2016_12_14_c32 bca.gps_so_2016_12_14_c32 Chart 33Italy Lags Peers On Euro Support bca.gps_so_2016_12_14_c33 bca.gps_so_2016_12_14_c33 Chart 34Italy's Next Election Is Too Close To Call bca.gps_so_2016_12_14_c34 bca.gps_so_2016_12_14_c34 Investors should consider three factors when thinking about Italy in 2017: The December constitutional referendum was not a vote on the euro and thus cannot serve as a proxy for a future referendum.29 The market will punish Italy the moment it sniffs out even a whiff of a potential Itexit referendum. This will bring forward the future pain of redenomination, influencing voter choices. Benefits of the EU membership for Italy are considerable, especially as they allow the country to integrate its unproductive, poor, and expensive southern regions.30 Sans Europe, the Mezzogiorno (Southern Italy) is Rome's problem, and it is a big one. The larger question is whether the rest of Italy's euro-area peers will allow the country to remain mired in its unsustainable status quo. We think the answer is yes. First, Italy is too big to fail given the size of its economy and sovereign debt market. Second, how unsustainable is the Italian status quo? OECD projections for Italy's debt-to-GDP ratio are not ominous. Chart 35 shows four scenarios, the most likely one charting Italy's debt-to-GDP rise from 133% today to about 150% by 2060. Italy's GDP growth would essentially approximate 0%, but its impressive budget discipline would ensure that its debt load would only rise marginally (Chart 36). Chart 35So What If Italy's Debt-To-GDP Ends Up At 170%? bca.gps_so_2016_12_14_c35 bca.gps_so_2016_12_14_c35 Chart 36Italy Has Learned To Live With Its Debt Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now This may seem like a dire prospect for Italy, but it ensures that the ECB has to maintain its accommodative stance in Europe even as the Fed continues its tightening cycle, a boon for euro-area equities as a whole. In other words, Italy's predicament would be unsustainable if the country were on its own. Its "sick man" status would be terminal if left to its own devices. But as a patient in the euro-area hospital, it can survive. And what happens to the euro area beyond our five-year forecasting horizon? We are not sure. Defeat of anti-establishment forces in 2017 will give centrist policymakers another electoral cycle to resolve the currency union's built-in flaws. If the Germans do not budge on greater fiscal integration over the next half-decade, then the future of the currency union will become murkier. Bottom Line: Remain long the nearest-month VIX futures and equally short the subsequent month's contract. We have held this position since September 14 and it has returned -0.84%. The advantage of this strategy is that it is a near-perfect hedge when risk assets sell off, but pays a low price for insurance. Investors with high risk tolerance who can stomach some volatility should take the plunge and overweight euro-area equities in a global equity portfolio. Solid global growth prospects, accommodative monetary policy, euro weakness, and valuations augur a solid year for euro-area equities. Politics will be a red herring as euro-area stocks climb the proverbial wall of worry in 2017. U.S.-Russia Détente: A Genuine Investment Opportunity Trump's election is good news for Russia. Over the past 16 years, Russia has methodically attempted to collect the pieces from the Soviet collapse. Putin sought to defend the Russian sphere of influence from outside powers (Ukraine and Belarus, the Caucasus, Central Asia). Putin also needed to rally popular support at various times by distracting the public. We view Ukraine and Syria through this prism. Lastly, Russia acted aggressively because it needed to reassure its allies that it would stand up for them.31 And yet the U.S. can live with a "strong" Russia. It can make a deal if the Trump administration recognizes some core interests (e.g. Crimea) and calls off the promotion of democracy in Russia's sphere, which Putin considers an attempt to undermine his rule. As we argued during the Ukraine invasion, it is the U.S., not Russia, which poses the greatest risk of destabilization.32 The U.S. lacks constraints in this theater. It can be aggressive towards Russia and face zero consequences: it has no economic relationship with Russia and does not stand directly in the way of any Russian reprisals, unlike Europe. That is why we think Trump and Putin will reset relations. Trump's team may be comfortable with Russia having a sphere of influence, unlike the Obama administration, which explicitly rejected this idea. The U.S. could even pledge not to expand NATO further, given that it has already expanded as far as it can feasibly and credibly go. Note, however, that a Russo-American truce may not last long. George W. Bush famously "looked into Putin's eyes and ... saw his soul," but relations soured nonetheless. Obama went further with his "Russian reset," removing European missile defense plans from Poland and the Czech Republic. These are avowed NATO allies, and this occurred merely one year after Russian troops marched on Georgia. And yet Moscow and Washington ended up rattling sabers and meddling in each other's internal affairs anyway. Chart 37Thaw In Russian-West##br## Cold War Is Bullish Europe bca.gps_so_2016_12_14_c37 bca.gps_so_2016_12_14_c37 Ultimately, U.S. resets fail because Russia is in structural decline and attempting to hold onto a very large sphere of influence whose citizens are not entirely willing participants.33 Because Moscow must often use blunt force to prevent the revolt of its vassal states (e.g. Georgia in 2008, Ukraine in 2014), it periodically revives tensions with the West. Unless Russia strengthens significantly in the next few years, which we do not expect, then the cycle of tensions will continue. On the horizon may be Ukraine-like incidents in neighboring Belarus and Kazakhstan, both key components of the Russian sphere of influence. Bottom Line: Russia will get a reprieve from U.S. pressure. While we expect Europe to extend sanctions through 2017, a rapprochement with Washington will ultimately thaw relations between Europe and Russia by the end of that year. Europe will benefit from resuming business as usual. It will face less of a risk of Russian provocations via the Middle East and cybersecurity. The ebbing of the Russian geopolitical risk premium will have a positive effect on Europe, given its close correlation with European risk assets since the crisis in Ukraine (Chart 37). Investors who want exposure to Russia may consider overweighing Russian equities to Malaysian. BCA's Emerging Market Strategy has initiated this position for a 55.6% gain since March 2016 and our EM strategists believe there is more room to run for this trade. We recommend that investors simply go long Russia relative to the broad basket of EM equities. The rally in oil prices, easing of the geopolitical risk premium, and hints of pro-market reforms from the Kremlin will buoy Russian equities further in 2017. Middle East: ISIS Defeat Is A Black Swan In February 2016, we made two bold predictions about the Middle East: Iran-Saudi tensions had peaked;34 The defeat of ISIS would entice Turkey to intervene militarily in both Iraq and Syria.35 The first prediction was based on a simple maxim: sustained geopolitical conflict requires resources and thus Saudi military expenditures are unsustainable when a barrel of oil costs less than $100. Saudi Arabia overtook Russia in 2015 as the globe's third-largest defense spender (Chart 38)! Chart 38Saudi Arabia: Lock And Load Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The mini-détente between Iran and Saudi Arabia concluded in 2016 with the announced OPEC production cut and freeze. While we continue to see the OPEC deal as more of a recognition of the status quo than an actual cut (because OPEC production has most likely reached its limits), nevertheless it is significant as it will slightly hasten the pace of oil-market rebalancing. On the margin, the OPEC deal is therefore bullish for oil prices. Our second prediction, that ISIS is more of a risk to the region in defeat than in glory, was highly controversial. However, it has since become consensus, with several Western intelligence agencies essentially making the same claim. But while our peers in the intelligence community have focused on the risk posed by returning militants to Europe and elsewhere, our focus remains on the Middle East. In particular, we fear that Turkey will become embroiled in conflicts in Syria and Iraq, potentially in a proxy war with Iran and Russia. The reason for this concern is that the defeat of the Islamic State will create a vacuum in the Middle East that the Syrian and Iraqi Kurds are most likely to fill. This is unacceptable to Turkey, which has intervened militarily to counter Kurdish gains and may do so in the future. We are particularly concerned about three potential dynamics: Direct intervention in Syria and Iraq: The Turkish military entered Syria in August, launching operation "Euphrates Shield." Turkey also reinforced a small military base in Bashiqa, Iraq, only 15 kilometers north of Mosul. Both operations were ostensibly undertaken against the Islamic State, but the real intention is to limit the Syrian and Iraqi Kurds. As Map 1 illustrates, Kurds have expanded their territorial control in both countries. Map 1Kurdish Gains In Syria & Iraq Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Conflict with Russia and Iran: President Recep Erdogan has stated that Turkey's objective in Syria is to remove President Bashar al-Assad from power.36 Yet Russia and Iran are both involved militarily in the country - the latter with regular ground troops - to keep Assad in power. Russia and Turkey did manage to cool tensions recently. Yet the Turkish ground incursion into Syria increases the probability that tensions will re-emerge. Meanwhile, in Iraq, Erdogan has cast himself as a defender of Sunni Arabs and has suggested that Turkey still has a territorial claim to northern Iraq. This stance would put Ankara in direct confrontation with the Shia-dominated Iraqi government, allied with Iran. Turkey-NATO/EU tensions: Tensions have increased between Turkey and the EU over the migration deal they signed in March 2016. Turkey claims that the deal has stemmed the flow of migrants to Europe, which is dubious given that the flow abated well before the deal was struck. Since then, Turkey has threatened to open the spigot and let millions of Syrian refugees into Europe. This is likely a bluff as Turkey depends on European tourists, import demand, and FDI for hard currency (Chart 39). If Erdogan acted on his threat and unleashed Syrian refugees into Europe, the EU could abrogate the 1995 EU-Turkey customs union agreement and impose economic sanctions. The Turkish foray into the Middle East poses the chief risk of a "shooting war" that could impact global investors in 2017. While there are much greater geopolitical games afoot - such as increasing Sino-American tensions - this one is the most likely to produce military conflict between serious powers. It would be disastrous for Turkey. The broader point is that the redrawing of the Middle East map is not yet complete. As the Islamic State is defeated, the Sunni population of Iraq and Syria will remain at risk of Shia domination. As such, countries like Turkey and Saudi Arabia could be drawn into renewed proxy conflicts to prevent complete marginalization of the Sunni population. While tensions between Turkey, Russia, and Iran will not spill over into oil-producing regions of the Middle East, they may cloud Iraq's future. Since 2010, Iraq has increased oil production by 1.6 million barrels per day. This is about half of the U.S. shale production increase over the same time frame. As such, Iraq's production "surprise" has been a major contributor to the 2014-2015 oil-supply glut. However, Iraq needs a steady inflow of FDI in order to boost production further (Chart 40). Proxy warfare between Turkey, Russia, and Iran - all major conventional military powers - on its territory will go a long way to sour potential investors interested in Iraqi production. Chart 39Turkey Is Heavily Dependent On The EU Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 40Iraq Is The Big, And Cheap, Hope bca.gps_so_2016_12_14_c40 bca.gps_so_2016_12_14_c40 This is a real problem for global oil supply. The International Energy Agency sees Iraq as a critical source of future global oil production. Chart 41 shows that Iraq is expected to contribute the second-largest increase in oil production by 2020. And given Iraq's low breakeven production cost, it may be the last piece of real estate - along with Iran - where the world can get a brand-new barrel of oil for under $13. In addition to the risk of expanding Turkish involvement in the region, investors will also have to deal with the headline risk of a hawkish U.S. administration pursuing diplomatic brinkmanship against Iran. We do not expect the Trump administration to abrogate the Iran nuclear deal due to several constraints. First, American allies will not go along with new sanctions. Second, Trump's focus is squarely on China. Third, the U.S. does not have alternatives to diplomacy, since bombing Iran would be an exceedingly complex operation that would bog down American forces in the Middle East. When we put all the risks together, a geopolitical risk premium will likely seep into oil markets in 2017. BCA's Commodity & Energy Strategy argues that the physical oil market is already balanced (Chart 42) and that the OPEC deal will help draw down bloated inventories in 2017. This means that global oil spare capacity will be very low next year, with essentially no margin of safety in case of a major supply loss. Given the political risks of major oil producers like Nigeria and Venezuela, this is a precarious situation for the oil markets. Chart 41Iraq Really Matters For Global Oil Production Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 42Oil Supply Glut Is Gone In 2017 bca.gps_so_2016_12_14_c42 bca.gps_so_2016_12_14_c42 Bottom Line: Given our geopolitical view of risks in the Middle East, balanced oil markets, lack of global spare capacity, the OPEC production cut, and ongoing capex reductions, we recommend clients to follow BCA's Commodity & Energy Strategy view of expecting widening backwardation in the new year.37 U.S.-China: From Rivalry To Proxy Wars President-elect Trump has called into question the U.S.'s adherence to the "One China policy," which holds that "there is but one China and Taiwan is part of China" and that the U.S. recognizes only the People's Republic of China as the legitimate Chinese government. There is widespread alarm about Trump's willingness to use this policy, the very premise of U.S.-China relations since 1978, as a negotiating tool. And indeed, Sino-U.S. relations are very alarming, as we have warned our readers since 2012.38 Trump is a dramatic new agent reinforcing this trend. Trump's suggestion that the policy could be discarded - and his break with convention in speaking to the Taiwanese president - are very deliberate. Observe that in the same diplomatic document that establishes the One China policy, the United States and China also agreed that "neither should seek hegemony in the Asia-Pacific region or in any other region." Trump is initiating a change in U.S. policy by which the U.S. accuses China of seeking hegemony in Asia, a violation of the foundation of their relationship. The U.S. is not seeking unilaterally to cancel the One China policy, but asking China to give new and durable assurances that it does not seek hegemony and will play by international rules. Otherwise, the U.S. is saying, the entire relationship will have to be revisited and nothing (not even Taiwan) will be off limits. The assurances that China is expected to give relate not only to trade, but also, as Trump signaled, to the South China Sea and North Korea. Therefore we are entering a new era in U.S-China relations. China Is Toast Asia Pacific is a region of frozen conflicts. Russia and Japan never signed a peace treaty. Nor did China and Taiwan. Nor did the Koreas. Why have these conflicts lain dormant over the past seventy years? Need we ask? Japan, South Korea, Taiwan, and Hong Kong have seen their GDP per capita rise 14 times since 1950. China has seen its own rise 21 times (Chart 43). Since the wars in Vietnam over forty years ago, no manner of conflict, terrorism, or geopolitical crisis has fundamentally disrupted this manifestly beneficial status quo. As a result, Asia has been a region synonymous with economics - not geopolitics. It developed this reputation because its various large economies all followed Japan's path of dirigisme: export-oriented, state-backed, investment-led capitalism. This era of stability is over. The region has become the chief source of geopolitical risk and potential "Black Swan" events.39 The reason is deteriorating U.S.-China relations and the decline in China's integration with other economies. The Asian state-led economic model was underpinned by the Pax Americana. Two factors were foundational: America's commitment to free trade and its military supremacy. China was not technically an ally, like Japan and Korea, but after 1979 it sure looked like one in terms of trade surpluses and military spending (Chart 44).40 For the sake of containing the Soviet Union, the U.S. wrapped East Asia under its aegis. Chart 43The Twentieth Century Was Kind To East Asia Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 44Asia Sells, America Rules bca.gps_so_2016_12_14_c44 bca.gps_so_2016_12_14_c44 It is well known, however, that Japan's economic model led it smack into a confrontation with the U.S. in the 1980s over its suppressed currency and giant trade surpluses. President Ronald Reagan's economic team forced Japan to reform, but the result was ultimately financial crisis as the artificial supports of its economic model fell away (Chart 45). Astute investors have always suspected that a similar fate awaited China. It is unsustainable for China to seize ever greater market share and drive down manufacturing prices without reforming its economy to match G7 standards, especially if it denies the U.S. access to its vast consumer market. Today there are signs that the time for confrontation is upon us: Since the Great Recession, U.S. household debt and Chinese exports have declined as a share of GDP, falling harder in the latter than the former, in a sign of shattered symbiosis (see Chart 8 above). Chinese holdings of U.S. Treasurys have begun to decline (Chart 46). China's exports to the U.S., both as a share of total exports and of GDP, have rolled over, and are at levels comparable to Japan's 1980s peaks (Chart 47). China is wading into high-tech and advanced industries, threatening the core advantages of the developed markets. The U.S. just elected a populist president whose platform included aggressive trade protectionism against China. Protectionist "Rust Belt" voters were pivotal to Trump's win and will remain so in future elections. China is apparently reneging on every major economic promise it has made in recent years: the RMB is depreciating, not appreciating, whatever the reason; China is closing, not opening, its capital account; it is reinforcing, not reforming, its state-owned companies; and it is shutting, not widening, access to its domestic market (Chart 48). Chart 45Japan's Crisis Followed Currency Spike bca.gps_so_2016_12_14_c45 bca.gps_so_2016_12_14_c45 Chart 46China Backing Away From U.S. Treasuries bca.gps_so_2016_12_14_c46 bca.gps_so_2016_12_14_c46 There is a critical difference between the "Japan bashing" of the 1980s-90s and the increasingly potent "China bashing" of today. Japan and the U.S. had established a strategic hierarchy in World War II. That is not the case for the U.S. and China in 2017. Unlike Japan, Korea, or any of the other Asian tigers, China cannot trust the United States to preserve its security. Far from it - China has no greater security threat than the United States. The American navy threatens Chinese access to critical commodities and export markets via the South China Sea. In a world that is evolving into a zero-sum game, these things suddenly matter. Chart 47The U.S. Will Get Tougher On China Trade bca.gps_so_2016_12_14_c47 bca.gps_so_2016_12_14_c47 Chart 48China Is De-Globalizing bca.gps_so_2016_12_14_c48 bca.gps_so_2016_12_14_c48 That means that when the Trump administration tries to "get tough" on longstanding American demands, these demands will not be taken as well-intentioned or trustworthy. We see Sino-American rivalry as the chief geopolitical risk to investors in 2017: Trump will initiate a more assertive U.S. policy toward China;41 It will begin with symbolic or minor punitive actions - a "shot across the bow" like charging China with currency manipulation or imposing duties on specific goods.42 It will be critical to see whether Trump acts arbitrarily through executive power, or systematically through procedures laid out by Congress. The two countries will proceed to a series of high-level, bilateral negotiations through which the Trump administration will aim to get a "better deal" from the Xi administration on trade, investment, and other issues. The key to the negotiations will be whether the Trump team settles for technical concessions or instead demands progress on long-delayed structural issues that are more difficult and risky for China to undertake. Too much pressure on the latter could trigger a confrontation and broader economic instability. Chart 49China's Demographic Dividend Is Gone bca.gps_so_2016_12_14_c49 bca.gps_so_2016_12_14_c49 The coming year may see U.S.-China relations start with a bang and end with a whimper, as Trump's initial combativeness gives way to talks. But make no mistake: Sino-U.S. rivalry and distrust will worsen over the long run. That is because China faces a confluence of negative trends: The U.S. is turning against it. Geopolitical problems with its periphery are worsening. It is at high risk of a financial crisis due to excessive leverage. The middle class is a growing political constraint on the regime. Demographics are now a long-term headwind (Chart 49). The Chinese regime will be especially sensitive to these trends because the Xi administration will want stability in the lead up to the CCP's National Party Congress in the fall, which promises to see at least some factional trouble.43 It no longer appears as if the rotation of party leaders will leave Xi in the minority on the Politburo Standing Committee for 2017-22, as it did in 2012.44 More likely, he will solidify power within the highest decision-making body. This removes an impediment to his policy agenda in 2017-22, though any reforms will still take a back seat to stability, since leadership changes and policy debates will absorb a great deal of policymakers' attention at all levels for most of the year.45 Xi will also put in place his successors for 2022, putting a cap on rumors that he intends to eschew informal term limits. Failing this, market uncertainty over China's future will explode upward. The midterm party congress will thus reaffirm the fact that China's ruling party and regime are relatively unified and centralized, and hence that China has relatively strong political capabilities for dealing with crises. Evidence does not support the popular belief that China massively stimulates the economy prior to five-year party congresses (Chart 50), but we would expect all means to be employed to prevent a major downturn. Chart 50Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses bca.gps_so_2016_12_14_c50 bca.gps_so_2016_12_14_c50 What this means is that the real risks of the U.S.-China relationship in 2017 will emanate from China's periphery. Asia's Frozen Conflicts Are Thawing Today the Trump administration seems willing to allow China to carve a sphere of influence - but it is entirely unclear whether and where existing boundaries would be redrawn. Here are the key regional dynamics:46 The Koreas: The U.S. and Japan are increasingly concerned about North Korea's missile advances but will find their attempts to deal with the problem blocked by China and likely by the new government in South Korea.47 U.S. threats of sanctioning China over North Korea will increase market uncertainty, as will South Korea's political turmoil and (likely) souring relations with the U.S. Taiwan: Taiwan's ruling party has very few domestic political constraints and therefore could make a mistake, especially when emboldened by an audacious U.S. leadership.48 The same combination could convince China that it has to abandon the post-2000 policy of playing "nice" with Taiwan.49 China will employ discrete sanctions against Taiwan. Hong Kong: Mainland forces will bring down the hammer on the pro-independence movement. The election of a new chief executive will appear to reinforce the status quo but in reality Beijing will tighten its legal, political, and security grip. Large protests are likely; political uncertainty will remain high.50 Japan: Japan will effectively receive a waiver from Trump's protectionism and will benefit from U.S. stimulus efforts; it will continue reflating at home in order to generate enough popular support to pass constitutional revisions in 2018; and it will not shy away from regional confrontations, since these will enhance the need for the hawkish defense component of the same revisions. Vietnam: The above issues may provide Vietnam with a chance to improve its strategic position at China's expense, whether by courting U.S. market access or improving its position in the South China Sea. But the absence of an alliance with the U.S. leaves it highly exposed to Chinese reprisals if it pushes too far. Russia: Russia will become more important to the region because its relations with the U.S. are improving and it may forge a peace deal with Japan, giving it more leverage in energy negotiations with China.51 This may also reinforce the view in Beijing that the U.S. is circling the wagons around China. What these dynamics have in common is the emergence of U.S.-China proxy conflicts. China has long suspected that the Obama administration's "Pivot to Asia" was a Cold War "containment" strategy. The fear is well-grounded but the reality takes time to materialize, which is what we will see playing out in the coming years. The reason we say "proxy wars" is because several American allies are conspicuously warming up to China: Thailand, the Philippines, and soon South Korea. They are not abandoning the U.S. but keeping their options open. The other ASEAN states also stand to benefit as the U.S. seeks economic substitutes for China while the latter courts their allegiance.52 The problem is that as U.S.-China tensions rise, these small states run greater risks in playing both sides. Bottom Line: The overarching investment implications of U.S.-China proxy wars all derive from de-globalization. China was by far the biggest winner of globalization and will suffer accordingly (Chart 51). But it will not be the biggest loser, since it is politically unified, its economy is domestically driven, and it has room to maneuver on policy. Hong Kong, Taiwan, South Korea, and Singapore are all chiefly at risk from de-globalization over the long run. Chart 51Globalization's Winners Will Be De-Globalization's Losers Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Japan is best situated to prosper in 2017. We have argued since well before the Bank of Japan's September monetary policy shift that unconventional reflation will continue, with geopolitics as the primary motivation for the country's "pedal to the metal" strategy.53 We will look to re-initiate our long Japanese equities position in early 2017. ASEAN countries offer an opportunity, though country-by-country fundamentals are essential. Brexit: The Three Kingdoms The striking thing about the Brexit vote's aftermath is that no recession followed the spike in uncertainty, no infighting debilitated the Tory party, and no reversal occurred in popular opinion. The authorities stimulated the economy, the people rallied around the flag (and ruling party), and the media's "Bregret" narrative flopped. That said, Brexit also hasn't happened yet.54 Formal negotiations with Europe begin in March, which means uncertainty will persist for much of the year as the U.K. and EU posture around their demands for a post-exit deal. However, improving growth prospects for Britain, Europe, and the U.S. all suggest that the negotiations are less likely to take place in an atmosphere of crisis. That does not mean that EU negotiators will be soft. With each successive electoral victory for the political establishment in 2017, the European negotiating position will harden. This will create a collision of Triumphant Tories and Triumphant Brussels. Still, the tide is not turning much further against the U.K. than was already the case, given how badly the U.K. needs a decent deal. Tightercontrol over the movement of people will be the core demand of Westminster, but it is not necessarily mutually exclusive with access to the common market. The major EU states have an incentive to compromise on immigration with the U.K. because they would benefit from tighter immigration controls that send highly qualified EU nationals away from the U.K. labor market and into their own. But the EU will exact a steep price for granting the U.K. the gist of what it wants on immigration and market access. This could be a hefty fee or - more troublingly for Britain - curbs on British financial-service access to euro markets. Though other EU states are not likely to exit, the European Council will not want to leave any doubt about the pain of doing so. The Tories may have to accept this outcome. Tory strength is now the Brexit voter base. That base is uncompromising on cutting immigration, and it is indifferent, or even hostile, to the City. So it stands to reason that Prime Minister Theresa May will sacrifice the U.K.'s financial sector in the coming negotiations. The bigger question is what happens to the U.K. economy in the medium and long term. First, it is unclear how the U.K. will revive productivity as lower labor-force growth and FDI, and higher inflation, take shape. Government "guidance" of the economy - dirigisme again - is clearly the Tory answer. But it remains to be seen how effectively it will be done. Second, what happens to the United Kingdom as a nation? Another Scottish independence referendum is likely after the contours of the exit deal take shape, especially as oil prices gin up Scottish courage to revisit the issue. The entire question of Scotland and Northern Ireland (both of which voted to stay in the EU) puts deeper constitutional and governmental restructuring on the horizon. Westminster is facing a situation where it drastically loses influence on the global stage as it not only exits the European "superstate" but also struggles to maintain a semblance of order among the "three kingdoms." Bottom Line: The two-year timeframe for exit negotiations ensures that posturing will ratchet up tensions and uncertainty throughout the year - invoking the abyss of a no-deal exit - but our optimistic outlook on the end-game (eventual "soft Brexit") suggests that investors should fade the various crisis points. That said, the pound is no longer a buy as it rises to around 1.30. Investment Views De-globalization, dirigisme, and the ascendancy of charismatic authority will all prove to be inflationary. On the margin, we expect less trade, less free movement of people, and more direct intervention in the economy. Given that these are all marginally more inflationary, it makes sense to expect the "End Of The 35-Year Bond Bull Market," as our colleague Peter Berezin argued in July.55 That said, Peter does not expect the bond bull market to end in a crash - and neither do we. There are many macroeconomic factors that will continue to suppress global yields: the savings glut, search for yield, and economic secular stagnation. In addition, we expect peak multipolarity in 2017 and thus a rise in geopolitical conflict. This geopolitical context will keep the U.S. Treasury market well bid. However, clients may want to begin switching their safe-haven exposure to gold. In a recent research report on safe havens, we showed that gold and Treasurys have changed places as safe havens in the past.56 Only after 2000 did Treasurys start providing a good hedge to equity corrections due to geopolitical and financial risks. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but has since become correlated with S&P 500 total returns. As deflationary risks abate in the future, we suspect that gold will return to its safe-haven status. In addition to safe havens, U.S. and global defense stocks will be well bid due to global multipolarity. We recommend that clients go long S&P 500 aerospace and defense relative to global equities on a strategic basis. We are also sticking with our tactical trade of long U.S. defense / short U.S. aerospace. On the equity front, we have closed our post-election bullish trade of long S&P 500 / short gold position for an 11.53% gain in just 22 days of trading. We are also closing our long S&P 600 / short S&P 100 position - a play on de-globalization - for an 8.4% gain. Instead, we are initiating a strategic long U.S. small caps / short U.S. large caps, recommended jointly with our colleague Anastasios Avgeriou of the BCA Global Alpha Sector Strategy. We are keeping our EuroStoxx VIX term-structure hedge due to mounting political risk in Europe. However, we are looking for an opening into European stocks in early 2017. For now, we are maintaining our long USD/EUR - return 4.2% since July - and long USD/SEK - return 2.25% since November. The first is a strategic play on our view that the ECB has to remain accommodative due to political risks in the European periphery. The latter is a way to articulate de-globalization via currencies, given that Sweden is one of the most open economies in the world. We are converting it from a tactical to a strategic recommendation. Finally, we are keeping our RMB short in place - via 12-month NDF. We do not think that Beijing will "blink" and defend its currency more aggressively just because Donald Trump is in charge of America. China is a much more powerful country than in the past, and cannot allow RMB appreciation at America's bidding. Our trade has returned 7.14% since December 2015. With the dollar bull market expected to continue and RMB depreciating, the biggest loser will be emerging markets. We are therefore keeping our strategic long DM / short EM recommendation, which has returned 56.5% since November 2012. We are particularly fond of shorting Brazilian and Turkish equities and are keeping both trades in place. However, we are initiating a long Russian equities / short EM equities. As an oil producer, Russia will benefit from the OPEC deal and the ongoing risks to Iraqi stability. In addition, we expect that removing sanctions against Russia will be on table for 2017. Europe will likely extend the sanctions for another six months, but beyond that the unity of the European position will be in question. And the United States is looking at a different approach. We wish our clients all the best in health, family, and investing in 2017. Thank you for your confidence in BCA's Geopolitical Strategy. Marko Papic Senior Vice President Matt Gertken Associate Editor Jesse Anak Kurri Research Analyst 1 In Michel Foucault's famous The Order of Things (1966), he argues that each period of human history has its own "episteme," or set of ordering conditions that define that epoch's "truth" and discourse. The premise is comparable to Thomas Kuhn's notion of "paradigms," which we have referenced in previous Strategic Outlooks. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2012," dated January 27, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2013," dated January 16, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com and Global Investment Strategy Special Report, "Underestimating Sino-American Tensions," dated November 6, 2015, available at gis.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, and "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2014 - Stay The Course: EM Risk - DM Reward," dated January 23, 2014, and Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 8 Please see BCA The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 10 A military-security strategy necessary for British self-defense that also preserved peace on the European continent by undermining potential aggressors. 11 Please see BCA Global Investment Strategy Special Report, "Trump And Trade," dated December 8, 2016, available at gis.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see Max Weber, "The Three Types Of Legitimate Rule," Berkeley Publications in Society and Institutions 4 (1): 1-11 (1958). Translated by Hans Gerth. Originally published in German in the journal Preussische Jahrbücher 182, 1-2 (1922). 16 We do not concern ourselves with traditional authority here, but the obvious examples are Persian Gulf monarchies. 17 Please see Francis Fukuyama, Political Order And Political Decay (New York: Farrar, Straus and Giroux, 2014). See also our review of this book, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 19 Please see Irving Fisher, "The Debt-deflation Theory of Great Depressions," Econometrica 1(4) (1933): 337-357, available at fraser.stlouisfed.org. 20 Please see Milanovic, Branko, "Global Income Inequality by the Numbers: in History and Now," dated November 2012, Policy Research Working Paper 6250, World Bank, available at worldbank.org. 21 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," June 8, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 23 In some way, BCA's Geopolitical Strategy was designed precisely to fill this role. It is difficult to see what would be the point of this service if our clients could get unbiased, investment-relevant, prescient, high-quality geopolitical news and analysis from the press. 24 Please see BCA European Investment Strategy Weekly Report, "Roller Coaster," dated March 31, 2016, available at eis.bcaresearch.com. 25 Please see The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at bca.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Client Note, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 28 Despite winning an extraordinary six of the 13 continental regions in France in the first round, FN ended up winning zero in the second round. This even though the election occurred after the November 13 terrorist attack that ought to have buoyed the anti-migration, law and order, anti-establishment FN. The regional election is an instructive case of how the French two-round electoral system enables the establishment to remain in power. 29 Please see BCA European Investment Strategy Weekly Report, "Italy: Asking The Wrong Question," dated December 1, 2016, available at eis.bcaresearch.com. 30 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 31 Please see BCA Geopolitical Strategy Special Report, "Cold War Redux?" dated March 12, 2014, and Geopolitical Strategy Special Report, "Russia: To Buy Or Not To Buy?" dated March 20, 2015, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Russia-West Showdown: The West, Not Putin, Is The 'Wild Card,'" dated July 31, 2014, available at gps.bcaresearch.com. 33 Please see BCA's Emerging Markets Strategy Special Report, "Russia's Trilemma And The Coming Power Paralysis," dated February 21, 2012, available at ems.bcaresearch.com. 34 Please see BCA Geopolitical Strategy, "Middle East: Saudi-Iranian Tensions Have Peaked," in Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 35 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 36 President Erdogan, speaking at the first Inter-Parliamentary Jerusalem Platform Symposium in Istanbul in November 2016, said that Turkey "entered [Syria] to end the rule of the tyrant al-Assad who terrorizes with state terror... We do not have an eye on Syrian soil. The issue is to provide lands to their real owners. That is to say we are there for the establishment of justice." 37 Please see BCA Commodity & Energy Strategy Weekly Report, "2017 Commodity Outlook: Energy," dated December 8, 2016, available at ces.bcaresearch.com. 38 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 39 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 40 In recent years, however, China's "official" defense budget statistics have understated its real spending, possibly by as much as half. 41 Please see "U.S. Election Update: Trump, Presidential Powers, And Investment Implications" in BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 42 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 43 Please see BCA Geopolitical Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 44 Please see BCA Geopolitical Strategy Monthly Report, "China: Two Factions, One Party - Part II," dated September 2012, available at gps.bcaresearch.com. 45 The National Financial Work Conference will be one key event to watch for an updated reform agenda. 46 Please see "East Asia: Tensions Simmer ... Will They Boil?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 47 Please see "North Korea: A Red Herring No More?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 48 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, and "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 49 The Trump administration has signaled a policy shift through Trump's phone conversation with Taiwanese President Tsai Ing-wen. The "One China policy" is the foundation of China-Taiwan relations, and U.S.-China relations depend on Washington's acceptance of it. The risk, then, is not so much an overt change to One China, a sure path to conflict, but the dynamic described above. 50 Please see BCA China Investment Strategy Weekly Report, "Hong Kong: From Politics To Political Economy," dated September 8, 2016, available at cis.bcaresearch.com. 51 Please see BCA Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 52 Please see "Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW" in BCA Emerging Markets Strategy Weekly Report, "The EM Rally: Running Out Of Steam?" dated October 19, 2016, and Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 53 Please see BCA Geopolitical Strategy Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, and "Unleash The Kraken: Debt Monetization And Politics," dated September 26, 2016, available at gps.bcaresearch.com. 54 Please see BCA Geopolitical Strategy Special Report, "BREXIT Update: Brexit Means Brexit, Until Brexit," dated September 16, 2016, available at gps.bcaresearch.com. 55 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 56 Please see Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 15, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

Hillary Clinton has a 65% chance of winning the election; she receives 334 electoral college votes according to our model. Trump still requires an exogenous shock to win. Meanwhile, the USD is poised to rally - and leftward-moving policymakers will applaud its redistributive effects while MNCs suffer the consequences.

Investors are overstating the legal and political constraints to "helicopter money"; The BoJ and BoE have few legal hurdles, whereas the ECB would have to get creative to stay within the existing law; Inflation-phobia in Germany will wane if the choice becomes euro survival; The BoJ has already laid the framework for debt monetization with its Sept. 21 decision; The risk is that debt monetization is a difficult policy to restrain once unleashed; Our long-term bet is bullish on an inflation comeback and Japanese risk assets. The helicopters are coming. The global appetite for outright debt monetization, i.e. "helicopter money," appears small today. However, the research philosophy at BCA's Geopolitical Strategy holds that policymakers respond readily to constraints and rarely get to pursue their preferences. As such, we approach every issue from the perspective of what policymakers have to do, not what they want to do. That is why we perked up when the Bank of Japan announced a new monetary policy framework on Sept. 21. The central bank says it will target the yield curve rather than the monetary base in its quest to increase inflation, reduce real interest rates, spur growth, and catapult Japan out of its long-lived liquidity trap. Assuming the policy evolves, as is typically the case, and comes to be accompanied by more ambitious fiscal spending, as we think will happen, it helps clear the way to debt monetization in all but name.1 Our colleague Peter Berezin, Chief Strategist of BCA's Global Investment Strategy, has shown how policymakers may end up dining at the trough of "money printing" (Charts 1 and 2).2 Chart 1As Long As Credit##br## Expands Faster Than Income ... bca.gps_sr_2016_09_26_c1 bca.gps_sr_2016_09_26_c1 Chart 2... Debt Burdens Will Remain High bca.gps_sr_2016_09_26_c2 bca.gps_sr_2016_09_26_c2 To summarize, Peter argues that: The BoJ and the ECB may find themselves in a situation where they have no choice but to implement heterodox monetary policy, and that may happen relatively soon. Negative interest rate policy (NIRP) has failed to increase inflation and demand, leaving intact the global deflationary tail risk and forcing policymakers and investors to ask, "What next?" Japan is stuck in a liquidity trap. Therefore orthodox monetary policy will not increase inflation and demand. Fiscal policy is needed (Charts 3 and 4). There are high political and economic constraints to raising tax rates in Japan. Hence there is little scope for fiscal stimulus that does not increase indebtedness. In the euro area, a return of the sovereign debt crisis cannot be discounted, once the lagged effects of the massive decline in bond yields and credit spreads, a weaker euro, and lower oil prices dissipate in the future. Helicopter money may become politically appealing as a way in which to boost inflation and demand in order to assuage the political costs of painful structural reforms. Chart 3Japan Is In##br## A Liquidity Trap Japan Is In A Liquidity Trap Japan Is In A Liquidity Trap Chart 4Fiscal Stimulus Will Not Drive Up##br## Interest Rates In A Liquidity Trap Unleash The Kraken: Debt Monetization And Politics Unleash The Kraken: Debt Monetization And Politics We agree - and yet the politics can be tricky. In this analysis, we ask, What are the legal and political hurdles to debt monetization, and what are the political risks of pursuing such a policy? We believe that investors may be overstating the constraints to ultra-unorthodox monetary policy. However, we also share the view of our colleague Martin Barnes that debt monetization would entail significant "mischief," including higher political and geopolitical risks.3 Helicopter Shopping Monetary financing (i.e. "helicopter money") can be implemented in various ways.4 Whatever option is chosen, the chief advantage is that "Ricardian Equivalence" does not apply.5 This means that even as the government issues new debt, households and corporates will not restrict their spending and investing on the expectation that taxes will eventually have to go up. Debt monetization avoids this demand-suppressing phenomenon because central bank money is irredeemable, which leads to a permanent increase in the monetary base and should therefore lead to higher inflation and demand. Helicopter money is fiscal stimulus financed by monetary means (hence the term "monetary financing"). Even handing cash directly to households is ultimately a form of fiscal stimulus, equivalent to a tax cut. Critically, and unlike the latter, helicopter money does not involve any increase in government debt levels. There are several forms of monetary financing worth expanding on: Perpetual QE: The government issues government bonds and sells them to financial market participants in order to increase public expenditures or cut taxes. Beforehand, the central bank assures the public that it will buy the same amount of debt in the open market and will never sell it back again. Since bonds are normally redeemable, Ricardian Equivalence is avoided only if the central bank can credibly commit itself never to sell the purchased bonds to the open market. Then it does not matter whether the central bank cancels these bonds or rolls them over when they mature.6 Haircut on existing debt: Central banks could take a haircut on their existing holdings of government bonds, letting a large part of the public debt disappear and giving governments more scope for fiscal stimulus. This would result in a loss on the central bank balance sheet, which it would obviate by creating money out of thin air. Direct lending to government: Governments could issue perpetual zero-coupon bonds and sell them directly to the central bank. This would allow for fiscal stimulus financed by a permanent increase in the monetary base without a balance sheet loss for the central bank. Lending to a public institution: Instead of direct lending, governments could sell perpetual zero-coupon bonds to a public institution (like an infrastructure bank). The central bank would then purchase those bonds from this public institution on the secondary market. This would avoid legal prohibitions, such as those in the euro area, against direct financing of government expenditure. "Trillion dollar coin": Governments could mint a high-value coin and sell it to the central bank. This measure was discussed during the United States fiscal cliff negotiations in 2012 as a way for the president to avoid a debt crisis caused by political brinkmanship with the legislature. "Citizenship credit": Governments could issue "citizenship credits" to all households, which the central bank would then buy for a set price. This fictitious asset swap would result in increased household wealth and could thus have a larger effect on demand than the above measures.7 The evidence from past tax cuts and stimulus measures suggests that households will spend at least 20 cents of every dollar received.8 Pure helicopter drops: The most radical solution would be to print money and distribute it directly to households. In theory, this would lead to a balance sheet loss on part of the central bank because no asset would be received in return. But, in reality, as Peter Berezin points out, from the central bank's point of view "money" is merely a bond which never matures and pays no interest. By definition, such a bond has a present value of zero. From the perspective of the household receiving the money, a one-dollar bill has a present value of $1. The use of actual helicopters to deliver the cash is optional. Legal Constraints One of our guiding principles during the euro area sovereign debt crisis was to ignore any argument that relied purely on the legal architecture at hand. "Laws are meant to be broken," particularly by those who penned them in the first place. Nonetheless, legal architecture is important in so far as it suggests which type of monetary financing is more or less likely in which economy. Table 1 examines the legal constraints that major central banks face when trying to adopt the aforementioned strategies. Based on our subjective read of the "strictness" of the respective institutional constraints, we assign each central bank a number between one and four. The higher the number, the more difficult it is to implement helicopter money legally. Table 1Legal Constraints To Debt Monetization In Developed Markets Unleash The Kraken: Debt Monetization And Politics Unleash The Kraken: Debt Monetization And Politics Only direct lending to the government is strictly prohibited by most major central banks. For the Bank of Japan and the Bank of England not even this is the case, resulting in a very low legal constraint index score. In Japan, central bank governor Haruhiko Kuroda has recently said that "directly underwriting government bonds and monetizing fiscal deficits" is either illegal or "should not be done."9 However, the legal constraints seem relatively slight. Article 5 of Japan's Public Finance Law stipulates that "in special circumstances the BoJ shall be able to lend money within the amount approved by the Diet resolution." Articles 38.1 and 43.1 of the Bank of Japan Act allow the BoJ, in effect, to do whatever it deems necessary so long as it obtains the authorization of the prime minister and minister of finance. Hence, it is appropriate to conclude that legal constraints for the BoJ are minimal and that helicopter money could be implemented. This view is supported by the BoJ's Sept. 21 decision. The same conclusion can be drawn for the U.K. The existing "ways and means" facility is nothing other than direct government borrowing from the BoE. Even EU rules allow this facility, so the option remains open even if Brexit should ultimately fail to take place.10 The euro area is a more complicated case. Regarding the prohibition of debt monetization, Article 132.1 of the Treaty of Lisbon is very strict. However, Article 132.2 (the very next paragraph) provides a possible loophole, since it allows lending to a publicly owned credit institution.11 Therefore, a "European infrastructure fund" could be set up that would have access to the ECB's monetary financing and could deploy fiscal stimulus throughout the currency union. The ECB's Emergency Liquidity Assistance (ELA) facility - which provides funding to solvent euro area credit institutions facing liquidity problems - could be another way to avoid prohibitions against direct monetary financing by the ECB.12 The responsibility for the supply of ELA funding lies with national central banks, not the ECB. The ECB can only stop an ELA facility already under way with a two-thirds majority vote in its Governing Council. The ECB has argued in previous opinions that the ELA cannot be used to subvert the Article 123 prohibition against monetary financing, but circumstances may eventually alter those opinions.13 Most critically, national central banks provide liquidity under the ELA in exchange for collateral whose terms they set themselves (such as haircuts based on quality). As such, the national central bank could provide its financial institutions - including, say, a public infrastructure bank - with printed money in exchange for snow globes and comic books. And the ECB could stand aside and watch it all happen, with the Austrian and German members of the ECB Board feigning opposition with token votes against the Governing Council. Another possible loophole for the ECB arises from its Targeted Long Term Refinancing Operations (TLTRO). Under the guise of TLTRO, the ECB could provide perpetual zero-coupon loans to private banks while contractually binding them to extend these loans to any euro area citizen. Economist Eric Lonergan refers to this measure as cash transfers to households intermediated by banks.14 Finally, Article 20 of the Statutes of the ECB allows the Governing Council, by a two-thirds majority, to decide upon other operational methods of monetary control (besides the ones explicitly mentioned) in order to achieve price stability. In other words, if the ECB deems that its price stability mandate is threatened, it could vote itself the power to use helicopters. The alternative to stretching the existing law is to change it.15 Hence we will now assess the ease by which central bank rules can be changed. The possibility to amend the law is what earned the Fed a low legal constraint index in Table 1 above, since the key article has been amended several times in history. Furthermore, the proviso under which the Fed was allowed to purchase bonds directly from the Treasury was only ruled out in 1979.16 Far more difficult to change is the relevant part of the Lisbon Treaty, since that would require unanimity in the European Council and ratification by all member states, which would involve their domestic politics.17 This could be a major obstacle regarding any amendments to Article 132, as we elucidate below. Europeans will likely have to work within the rules available to them, which we think are quite malleable anyway. Finally, Sweden, unlike the United Kingdom, is bound to the Lisbon Treaty and receives no exception for direct lending to the government. Furthermore, the prohibition of monetary financing is also stated in the Sveriges Riksbank Act, making it even more complex to amend the law. The other two options - distributing cash to households and minting a high-value coin - are also of dubious legality in the Swedish case. Therefore, the Riksbank has in our view the highest legal constraints to helicopter money. Bottom Line: Legal constraints to debt monetization are far smaller than one would initially think. This is especially the case for the BoJ and BoE. The ECB would have to get creative in order to work within the law, but its statutes have wide enough holes for any helicopter to fly through. In addition, if one takes into account the raft of controversial, unconventional monetary and fiscal policies undertaken in the euro area in the recent past (Table 2), one is tempted to say, "Where there's a will, there's a way"! Table 2Europe: The Hurdle To Heterodoxy Is Low Unleash The Kraken: Debt Monetization And Politics Unleash The Kraken: Debt Monetization And Politics Political Constraints A policy as controversial as debt monetization requires political capital for implementation. In economies where legal and political constraints exist, a crisis will be necessary to overcome them. As such, we agree with our colleague Martin Barnes, who has argued that debt monetization is step three of a process where step two is a deep economic crisis.18 The constraints are not uniform across economies. Countries where households mostly struggle with the twin ills of debt and deflation would welcome higher inflation, but those where households are mostly savers would naturally not. On the other hand, even savers who depend on interest-bearing income for retirement would likely favor unorthodox monetary policy that allows interest rates to rise eventually. We therefore look at three broad factors when assessing the political constraints to monetary financing: Overall trust in monetary institutions; Household savings rate; Financial asset composition of households. Japan The two main factors that led to high saving rates in Japan, i.e. sharply rising incomes and favorable demography, have vanished (Chart 5). Japanese household savings rates have declined dramatically since the 1980s (Chart 6).19 Of course, Charts 7 and 8 show that the financial net worth of households is still massive and hence Japanese households may still prefer low inflation rates.20 But the population's aversion to inflation may not be as great as is assumed by conventional wisdom. Chart 5Japan's Demographic Dividend Is Over ... Japan's Demographic Dividend Is Over ... Japan's Demographic Dividend Is Over ... Chart 6... Leading To A Savings Rate Decline bca.gps_sr_2016_09_26_c6 bca.gps_sr_2016_09_26_c6 Chart 7Japanese Households Are Still Wealthy Unleash The Kraken: Debt Monetization And Politics Unleash The Kraken: Debt Monetization And Politics Chart 8Japan: Public Debt Vs. Private Wealth bca.gps_sr_2016_09_26_c8 bca.gps_sr_2016_09_26_c8 After all, Japanese households suffer in a low interest-rate environment because their financial assets are mainly composed of rate-sensitive products (Chart 9). Moreover, high government debt levels risk imperiling future entitlement spending. As such, the public may support policies that inflate away government debt so that the public sector can pay out pensions in future. Chart 9Only American Pensioners Are Ambivalent About The Pain Of Low Interest Rates Unleash The Kraken: Debt Monetization And Politics Unleash The Kraken: Debt Monetization And Politics For the past four years, policies to boost inflation in Japan have received strong popular support. How else can we explain the continued political success of Prime Minister Shinzo Abe and his government, the most impressive run in twenty-first century Japan (Chart 10)? The inflation goal of Abenomics is clearly stated, not obfuscated by technocratic jargon, so it cannot simply be said that the public has been deceived. At the very least it suggests that the public understands the tradeoffs between inflation and deflation and is starting to favor the former over the latter as the household sector draws closer and closer to net debtor status. Europe The economies of the euro area have substantially different household saving rates. As such, political constraints to monetary financing are not equal across the currency union. Households in countries like Germany and France save a large fraction of their disposable income. In Spain and Italy, only a fraction of income is saved, whereas Greek and Portuguese households are net borrowers (Chart 11). Unsurprisingly, German trust in the ECB seems to be highly negatively correlated with increases in money supply (Chart 12). On the other hand, trust in the ECB in the peripheral states has recovered somewhat since the various efforts by the central bank to support their economies (Chart 13) through non-conventional monetary policy. Chart 10If Abenomics Is So Unpopular,##br## Why Is Abe Popular? bca.gps_sr_2016_09_26_c10 bca.gps_sr_2016_09_26_c10 Chart 11Discrepancy In Savings##br## Rates In The Euro Area Unleash The Kraken: Debt Monetization And Politics Unleash The Kraken: Debt Monetization And Politics Chart 12Germans Fret About Easy Money bca.gps_sr_2016_09_26_c12 bca.gps_sr_2016_09_26_c12 Chart 13Trust In ECB Recovering bca.gps_sr_2016_09_26_c13 bca.gps_sr_2016_09_26_c13 Many pundits and commentators have also pointed out that Germans will not accept higher inflation rates due to traumatic history. The 1922-23 hyperinflation is often blamed for the eventual collapse of the Weimar Republic. But this is a false narrative. The Weimar Republic did not suffer hyperinflation because of money printing but because its manufacturing base was destroyed by the First World War. This massive supply loss was exacerbated by the French and Belgian occupation of the Ruhr in January 1923 as punishment for unpaid reparations. This was a German industrial region where much of its surviving capacity was located. The cumulative loss of supply caused a price shock that the central bank attempted to assuage with money printing. Money printing was therefore primarily a consequence of a massive decline in supply, leading to rampant price inflation. In fact, it was the austerity policies of Chancellor Heinrich Brüning following the Great Depression that led to the rise of populism in Germany, not the money printing undertaken a decade earlier. At the moment, this narrative may not be the dominant one in Germany. But historical interpretations can change on a dime when circumstances demand it. The fact remains that the ECB has effectively pursued an activist monetary policy despite the supposed resistance of Germany. How do we explain this? First, EU integration remains a geopolitical priority for Germany, as well as other European states. Individual European countries are no longer capable of exerting a significant global influence independently and have sought to aggregate geopolitical power as a result.21 Whether the project will succeed may be debatable, but the reality that it has sound geopolitical logic is not. Second, Germany's export-oriented economy is particularly vulnerable to protectionism and competitive currency devaluation by its top trade partners. These policies are precisely what Berlin would suffer if it were to abandon its currency-union peers by choosing "exit" over the printing press. Italy and France would immediately devalue their currencies against the new Deutschmark, and would likely impose outright trade barriers and tariffs subsequently. In short, if Germany will not help sustain the low financing costs of France and Italy through currency union, then it will be denied access to their markets. Founders of the EU understood this dynamic, which is why multiple (unsuccessful) attempts were made to peg European currencies, first to the U.S. dollar, and later to the Deutschmark, prior to the advent of the euro. We suspect that if the euro area's sovereign-debt crisis were to arise anew, German policymakers would have to explain the tradeoff between staying true to historical narratives on hyperinflation and sustaining Germany's export-addicted economy to their public. The contest is not even close. Historical revisions would be revised. In addition, German households are, much like their Japanese peers, dependent on high interest rates for saving (see Chart 9 above). As such, they may eventually relent to a set of unorthodox policies that raises interest rates in future. Nevertheless, regardless of German history and geopolitics, the reality is that the German public is not ready for monetary financing today. As such, we suspect that the ECB will only fire up the helicopters once the integrity of the euro area is threatened anew. Thankfully for ECB policymakers, Japan will likely have already undertaken such heterodox monetary policy by that time, allowing the ECB to piggyback on BoJ efforts. The U.S. In contrast to Japan and the euro area, deflation is not as much of a risk in the United States and interest rates have not been pushed into negative territory (Chart 14). Therefore, the case for debt monetization is much weaker. In addition, U.S. households are increasingly preferring saving instead of spending (Chart 15), a dynamic that may impede the transmission mechanism of helicopter drops, which ultimately rely on household spending. Chart 14Inflation Remains Low, But Has Bottomed Inflation Remains Low, But Has Bottomed Inflation Remains Low, But Has Bottomed Chart 15U.S. Households Prefer To Save bca.gps_sr_2016_09_26_c15 bca.gps_sr_2016_09_26_c15 Despite their preferences for more savings, however, the actual savings rate for the bottom 90% households in terms of wealth is essentially zero. In fact, most U.S. households are concerned about poor job prospects, low wage growth, and high debt levels. How else can we explain the support for Donald Trump and Bernie Sanders?22 As such, the aggregate household savings rate may not be the best measure of political constraints to monetary financing in the U.S. It may overstate the preferences of the minority of the population that actually saves. The United Kingdom Chart 16Public Is Satisfied With BoE bca.gps_sr_2016_09_26_c16 bca.gps_sr_2016_09_26_c16 As in the U.S., interest rates remain positive in the U.K. In addition, growth is tolerable and the unemployment rate is near the BoE's definition of full employment (5%). Therefore, pressure for drastic measures is weak, albeit higher after the Brexit referendum shock than before. According to Chart 16, individuals are satisfied with the BoE and trust the bank to take the appropriate measures to achieve the inflation target, thus giving the BoE high political capital. British households would suffer under lower interest rates because they are heavily reliant on pension funds and life insurance for income (see Chart 9 above). Therefore, one could argue that they would rather support helicopter money than negative interest rates. Mark Carney, the BoE governor, has ruled out helicopter money even since the Brexit vote, arguing that the available stimulus tools are sufficient and "there's not a need for such flights of fancy here in the UK."23 Hence the chances of debt monetization may be low for now, assuming that the likely post-referendum recession is not very deep. However, they would increase if a shock were to hit the British economy. Just such a shock could occur after the U.K. formally exits the EU, which may still be two years away. Switzerland Swiss households save a high fraction of their net income (see Chart 6 above). In addition, the Swiss government's debt-to-GDP ratio is very low (34% as of 2015). Therefore, the current deflation is not as much of a burden for Switzerland as it would be for indebted countries. On the other hand, negative interest rates weigh heavily on pension funds, which account for a large fraction of households' financial assets (see Chart 9 above). Moreover, the overvalued Swiss franc drags on the Swiss economy. Instead of buying euros to stabilize the EUR/CHF exchange rate, the SNB could distribute this money to households. Swiss Trade, a powerful union representing the interests of 3,800 retail companies and over 10% of the Swiss labor force, has made this demand. So far, however, this kind of pressure from domestic interest groups has not made any difference. The situation could change if another sovereign-debt crisis were to hit the euro area and put further upside pressure on the Swiss franc, a safe haven asset. Sweden The Swedish population has great trust in national institutions, especially in the Riksbank.24 Its political capital is therefore large. Nevertheless, since there is no danger of deflation and the economy is doing well, it would be hard to justify such extreme policy measures. Moreover, Swedish households increased their savings rate drastically in the last few years (see Chart 6 above), making them more averse to inflation than they were a decade ago. In addition, there is no pressure for higher interest rates, since households are heavily invested in equities (see Chart 9 above), which profit from low interest rates. Political constraints are thus very high. Bottom Line: Our analysis shows that Japan has the lowest legal and political constraints to debt monetization, and recent events suggest it has begun laying the framework. In addition, if another euro crisis were to occur, the ECB and the SNB might be forced to join the BoJ in mustering the helicopters. On the other hand, it would be rather surprising in the short and medium term if the Fed, BoE, or Riksbank took concrete steps toward debt monetization. Uncharted Waters? Would helicopter money mark a dangerous voyage into uncharted waters? Not really. Western governments used debt monetization several times in the twentieth century. During the Second World War, various countries printed money to finance war costs. In the U.S., debt monetization continued after the war with the Fed purchasing government bonds directly from the Treasury from time to time. It was only in April 1979 that these purchases ceased.25 An even more striking example is Italy, which monetized its debt down to 1981: the Bank of Italy was actually forced by law to purchase all public debt not taken up by the market.26 In Canada, the Bank of Canada financed public debt down to the 1970s. Between 1935 and 1939, the BoC funded a remarkable two thirds of public debt and, during the Second World War, fiscal and monetary policy effectively merged. Inflation never exceeded 5% until the early 1970s, indicating that monetary financing can contribute to positive non-inflationary economic outcomes if conditions (and management) are right.27 Another example of a successful implementation of helicopter money is the expansionary policy undertaken by former Japanese Finance Minister Takahashi Korekiyo between 1932 and 1936. His debt monetization program is said to be the prime reason why Japan recovered so quickly from the Great Depression. At the same time, the example is instructive about the risks of helicopter money: Takahashi was ultimately assassinated by the military when he changed course on debt monetization, and the whole episode fed into Japan's slide into fascism.28 To these substantial risks, we will now turn. Bottom Line: Helicopter money is not merely theoretical. Major economies - including responsible ones like Canada and Italy - used debt monetization into the late twentieth century. Dangers Of Releasing The Kraken Chart 17Unlimited Resources ##br## Undermine Democracy Unleash The Kraken: Debt Monetization And Politics Unleash The Kraken: Debt Monetization And Politics Democracy is a process by which various interest groups and segments of the population bargain over limited resources. Democracies are successful because they institutionalize the bargaining process so that it legitimizes the decisions over who gets what. Countries with unlimited resources tend to be authoritarian regimes (Chart 17). This phenomenon is referred to as the "resource curse" and is well documented in political science. Essentially, countries that are endowed by massive natural resources can distribute the wealth to all interest groups and all segments of the population, thus obviating the need to institutionalize any part of their bargaining process. The ruling elite stays in power because it can keep buying off the population and stave off demands for representation.29 We are not saying that Japan or Europe would turn fascist because of helicopter money, but rather that it will be difficult to restrain the policy once it is unleashed. When resources become unlimited, how would democratically-elected policymakers manage to limit them? It is easy to tell various interest groups - pensioners, veterans, single mothers, low-income households - that they cannot receive what they want when the resources are limited. But the danger of helicopter money is that once the decision is taken to drop the cash from the air, the decision of who gets money for what will become extremely politicized and polarizing. Proponents argue that just as monetary policy has become independent of government, so too can fiscal policy. For example, the central bank could decide how much fiscal spending is needed to achieve its inflation target and then print the requisite amount, leaving it up to political decision-makers to decide how to divvy out the manna from heaven. The problem is that monetary policy has already become politicized in a number of countries, mainly in the emerging markets, and pressure has been mounting in the developed world. That pressure would become extraordinary once central banks start creating resources from thin air. The essence of representative government - popular control of fiscal powers - would erode. Our colleague Dhaval Joshi, Chief Strategist of European Investment Strategy, has also posited that the population could easily lose trust in institutions, even the currency itself, if the experiment gets out of control.30 This is unlikely in its first iteration, but it could happen if the process becomes politicized, which we think would happen. The other problem is that the effort to print money could become a source of geopolitical conflict if it produces a competitive debt monetization regime. For example, if the BoJ implements helicopter money and weakens the yen, China could counter by devaluing the renminbi. Since there are natural limits to how much money can be printed before inflation takes off, and neither country would want to destroy the value of its currency, the two sides might seek to counter helicopter devaluations via protectionism. Bottom Line: Debt monetization and helicopter money would short-circuit the democratic process itself. The entire point of representative government and democratic institutions is to allow for bargaining over limited resources. Once the option of unlimited resources becomes real, it will be very difficult to decide who gets to benefit. It would take a very strong government indeed - perhaps an authoritarian one - to impose limits. Investment Implications Debt monetization is not going to be fully implemented in any major economy until a serious economic crisis arrives. As such, this research effort is largely exploratory. We have presented a list of legal and political constraints that we believe will determine the sequence and the form of helicopter money in major economies. We agree with our colleague Peter Berezin that Japan may attempt some form of debt monetization in 2017-18. The monetary policy framework is already being laid. In the long term, the world is slowly moving away from its current deflationary paradigm. On the geopolitical front, we are seeing less, not more, globalization. Global multipolarity is a constraint to geopolitical stability, and this is as true today it has been over the past 200 years. We identified this trend in a 2014 Special Report, "The Apex Of Globalization: All Downhill From Here," which we encourage our clients to re-read.31 On a shorter timeline, we are seeing policymakers move away from austerity and towards greater willingness to use fiscal policy. The U.S. presidential election is instructive, as the issues of budget deficits and debt sustainability have been completely ignored throughout the campaign, despite their prominence as recently as 2012. Other major economies, including Europe, are moving away from austerity. More government spending, less globalization, and more unorthodox monetary policy all point to the end of the current deflationary era. As a play on this theme, we would recommend that investors take long positions on Japanese and German inflations swaps. We also think that it is time to turn structurally bullish on gold.32 In addition, we recommend going short JPY/long USD, even though markets will initially test the BoJ and drive the yen higher. We are renewing our strategic long Japanese stocks trade, hedged for currency, to capitalize on the ongoing paradigm shift in Japan that we identified in 2012.33 Nicola Grass, Contributing Author Marko Papic, Managing Editor marko@bcaresearch.com 1 Specifically, the BoJ pledged to keep the 10-year JGB yield at around zero, at least until inflation stabilizes at a rate above 2%. This decision amounts to a commitment to correct past inflation undershoots and to keep 10-year yields at zero regardless of the supply of new debt. Please see "Japan: Don't Count Abenomics Out," in Geopolitical Strategy Monthly Report, "Who's Afraid Of Big Bad Trump," dated August 10, 2016, and Geopolitical Strategy Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, available at gps.bcaresearch.com. 2 Please see Global Investment Strategy Weekly Report, "Helicopter Money" A Semi-Hostile Q&A," dated May 13, 2016, "Escape from the Land of The Rising Yen," dated April 15, 2016, "Japan: On The Road to Debt Monetization," dated February 5, 2016, and Global Investment Strategy Outlook, "Ten Predictions For The Rest Of The Year," dated April 1, 2016, available at gis.bcaresearch.com. In addition, please see Foreign Exchange Strategy Weekly Report, "Down the Rabbit Hole," dated April 15, 2016 available at fes.bcaresearch.com. 3 Please see The Bank Credit Analyst Special Report, "The Case Against More Monetary Mischief," dated August 16, 2016, available at bca.bcaresearch.com. 4 The term helicopter money refers to the statement by Milton Friedman in his 1969 paper "The Optimum Quantity of Money," where he proposes that a central bank could throw money out of a helicopter to increase inflation. 5 The "Ricardian Equivalence" theory suggests that individuals are forward looking and thus will assess that today's tax cuts or fiscal expenditure must be financed by tomorrow's higher tax burden. Since the intertemporal budget constraint is binding, rational individuals will not necessarily increase their current consumption even while benefiting from expansionary fiscal policy. 6 See Willem H. Buiter, "The Simple Analytics of Helicopter Money: Why It Works - Always," Economics E-Journal 8 (2014), pp. 1-38. Available at dx.doi.org. 7 Please see Global Investment Strategy Weekly Report, "Escape from the Land of The Rising Yen," dated April 15, 2016, available at gis.bcaresearch.com. 8 Please see Laura Jaramillo and Alexandre Chailloux, "It's not all Fiscal: Effects of Income, Fiscal Policy, and Wealth on Private Consumption," IMF Working Paper 15/112 (May 2015), available at www.imf.org. 9 Please see Bank of Japan, "'Comprehensive Assessment' of the Monetary Easing: Concept and Approaches," dated September 5, 2016, available at www.boj.or.jp/en. 10 According to Protocol No. 15, Article 10 of the Lisbon Treaty, the "Government of the United Kingdom may maintain its 'ways and means' facility with the Bank of England if and so long as the United Kingdom does not adopt the euro." 11 Article 132.2 of the Treaty of Lisbon: "Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions." 12 ECB, "Emergency liquidity assistance (ELA) and monetary policy," dated 2016, available at www.ecb.europa.eu. 13 Please see ECB, "Opinion of the European Central Bank of 21 November 2008," dated November 21, 2008, https://www.ecb.europa.eu/ecb/legal/pdf/en_con_2008_74_f.pdf. 14 Eric Lonergan, "Legal helicopter drops in the Eurozone,"dated February 24, 2016, available at www.philosophyofmoney.net. 15 Various academics argue that an explicit allowance of monetary financing would not undermine the independence of central banks as long as governments decide how the money will be spent and central banks decide how much money to print. See Buiter (above, note 4) and Adair Turner, "The Case for Monetary Finance - An Essentially Political Issue," 16th Jacques Polak Annual Research Conference (2015), available at www.imf.org. See also "Helicopter Ben" Bernanke, "Some Thoughts on Monetary Policy in Japan," Federal Reserve, Speech at Japan Society of Monetary Economics, dated May 31, 2003, available at www.federalreserve.gov. 16 Please see U.S. Code 355, "Purchase and sale of obligations of National, State, and municipal governments," Legal Information Institute, accessed 2016, available at www.law.cornell.edu. 17 Title 6, Article 48.6 of the Lisbon Treaty. 18 Please see footnote 3 above. 19 The longstanding Japanese household opposition to inflation has been shifting in recent years, as revealed by voter behavior since 2012. Yet some elements of the trend persist, as in the BoJ's public survey in April 2016, in which over 80% of respondents argued that a general price increase would be unfavorable. Please see Martin Feldstein, "Japan's Savings Crisis," Project Syndicate, dated September 24, 2010, available at www.project-syndicate.org. 20 See Bank of Japan, "Results of the 65th Opinion Survey on the General Public's Views and Behavior (March 2016 Survey)," dated April 18, 2016, available at www.boj.or.jp/en. 21 Please see Geopolitical Strategy Special Report, "The Euro And (Geo)politics," dated February 11, 2015, and Geopolitical Strategy Special Report, "Europe's Geopolitical Gambit," dated November 2011, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy," dated April 13, 2016, available at gps.bcaresearch.com. 23 Please see Will Martin, "Carney: We Will Take 'Whatever Action Is Needed,'" Business Insider UK, dated August 4, 2016, available at uk.businessinsider.com, and Jake Cordell, "Mark Carney dismisses helicopter money as a 'compounding Ponzi scheme,'" City AM, dated April 19, 2016, available at www.cityam.com. 24 Please see European Commission, "Introduction Of The Euro In The Member States That Have Not Yet Adopted The Common Currency," Flash Eurobarometer 418 (May 2015), p.44, available at ec.europa.eu. 25 Kenneth Garbade, "Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks," Federal Reserve Bank of New York, Staff Report No.684, 2014, available at www.newyorkfed.org. 26 Guido Tabellini, "Central bank reputation and the monetization of deficits: The 1981 Italian monetary reform," Economic Inquiry 25 (1987), p.185-200, available at onlinelibrary.wiley.com. 27 Josh Ryan-Collins, "Is Monetary Financing Inflationary? A Case Study of the Canadian Economy, 1935-75," Levy Economics Institute, Working Paper No. 848 (2015), available at www.levyinstitute.org. 28 Myung Soo Cha, "Did Korekiyo Takahashi Rescue Japan from the Great Depression?" Hitotsubashi University, Institute of Economic Research Discussion Paper Series No. A395, dated September 30, 2000, available at hermes-ir.lib.hit-u.ac.jp. 29 Please see Jeffrey Sachs and Andrew Warner, "Natural Resource Abundance and Economic Growth," NBER Working Paper 5398 (December 1995), available at www.nber.org. 30 Please see European Investment Strategy Weekly Report, "The Case Against Helicopters," dated May 5, 2016, available at eis.bcaresearch.com. 31 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization: All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 32 Please see footnote 2 above. 33 Please see BCA Geopolitical Strategy Special Report, "Japan's Political Paradigm Shift: Invest Implications," dated December 21, 2012, available at gps.bcaresearch.com.

With 88 days to go until the U.S. presidential election our client meetings are starting to steer towards "all Trump, all the time." In this report we present evidence that Trump's electability is correlated with the chief global safe haven, the 10-year Treasury. Markets may be overreacting, however. Trump has a chance, but Clinton is the clear favorite. We also bust five myths about China's political system, in a continuation of our coverage of rising geopolitical risks in East Asia.

The median voter theory is one of the few genuine theories of political science. It assumes that voters have limited policy priorities and that politicians want power. Therefore the latter will adjust their stances to satisfy the largest swath of voters. The median voter in the Anglo-Saxon world is shifting to the left, and regardless of what happens in the Brexit referendum or the U.S. election, this shift will be the most consequential development for markets.

Clients should forgive us for being too gloomy at the start of the year -- it is difficult to be optimistic in the dead of a Montreal winter. However, with springtime comes the reflation trade, born on the wings of massive Chinese fiscal and credit expansion. In this report, we discuss how long (not very) the trade can go (and how to play it). Our In Focus feature returns to pessimism, with a discussion of why the Anglo-Saxon laissez-faire economic model may be in for a big pendulum swing.