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The median voter moving to the left has spurred paradigm shifts. These new regimes are giving way to transformational leaders who seek change by breaking convention. As they test their constraints and pursue their preferences, a cautious stance towards risk assets is warranted. In this Monthly Report, BCA's Geopolitical Strategy discusses Trump's recent comeback, rising EM political risk, and Italy's upcoming constitutional referendum.

The populist backlash, if left unchecked, could spiral out of control, leading to severe losses for investors. Concerns about lax financial regulation, rising inequality, unfettered globalization, and fiscal austerity are understandable. Addressing these grievances will hurt corporate profits short-term, but could lead to a more resilient economy longer-term. Investors should position for modestly higher inflation and steepening yield curves. Near-term, equities are technically overbought, but will benefit from the shift to more stimulative fiscal and monetary policies.

Highlights The U.K. has a new Prime Minister - former Home Secretary Theresa May - who has committed her cabinet to pursue a divorce from the EU. With the government in London now falling inline with the mantra that "Brexit means Brexit," is there no hope for a reversal of the June 23 referendum results? Feature In this Brexit Update, we tackle three questions: What is the big picture relevance of Brexit? Have the "next steps" of the Brexit saga become any clearer? What does the U.K. want and can it get it from the EU? The global relevance of Brexit is that it will signal to the markets that stimulative fiscal policy is around the corner. To be clear, Brexit will not cause fiscal stimulus (at least not outside the U.K.). Rather both Brexit and government spending are symptoms of the same disease: low growth, deflationary, environment in the context of two decades of stagnating wages and high household debt levels. This dynamic is politically pernicious and thus unsustainable, inevitably leading policymakers to reach for the fiscal lever, as BCA's Geopolitical Strategy has argued for some time.1 Here Comes G Voters in the U.K. rejected EU membership for a number of reasons. However, data shows that the best predictor for Brexit support was a level of education (Chart 1), suggesting that voters ultimately decided based on their own personal level of competitiveness in a globalized economy. Theresa May is a shrewd politician who understands that the Brexit referendum was about more than just the EU, British sovereignty, and overbearing Brussels' bureaucrats. Only London, as far as England is concerned, voted to remain in the union. London's denizens are neither threatened by changes to the British economy wrought by globalization, nor bothered by Eastern European immigrants working primarily in the service industry. For the U.K. Conservative Party, which draws its support almost exclusively from England, the referendum is a massive wake up call. The Tories who do not heed the alarm-bells, will be left without a job. For investors trying to make sense of this post-Brexit Britain, May's first speech may serve as a useful guide. The Prime Minister promised to fight "against the burning injustice that if you're born poor you will die on average nine years earlier than others." She added that for an "ordinary working class family, life is much harder than many people in Westminster realize. When it comes to opportunity, we won't entrench the advantages of the fortunate few, we will do everything we can to help anybody, whatever your background, to go as far as your talents will take you."2 There were no promises of corporate tax cuts, business-friendly policies, or free-trade deals with India and China.3 And we suspect that May's government, with new Chancellor of the Exchequer Philip Hammond at the head, will do away with austerity and look to counter any Brexit-induced recession with fiscal stimulus in the fall. Chart 1Brexit: A Protest Vote##br##By Those Left Behind Brexit Update: Does Brexit Really Mean Brexit? Brexit Update: Does Brexit Really Mean Brexit? Chart 2Here Comes G bca.gps_sr_2016_07_15_c2 bca.gps_sr_2016_07_15_c2 If Britain's Tories can move towards the left-of-spectrum on economic policy, then almost any center-right party can. A low-growth environment is politically pernicious in a context where median wages have stagnated for decades and households are laden with debt. The median voter in developed economies is moving to the left, which means that political parties will either follow or become uncompetitive.4 As such, investors should not think of Brexit as the cause for inflationary fiscal policies. Rather, both Brexit and government spending are the symptoms of the same disease. Bottom Line: When the political and geopolitical intrigue of Brexit is removed, investors are left with one key takeaway: popular anger in developed economies will end austerity. We expect to see a positive fiscal thrust from most major economies by the end of 2017 (Chart 2). In the long term, however, investors will lament the erosion of political support for laissez-faire economics. With demand-side policies coming back into vogue, investors should prepare for inflation to make a comeback. The Next Steps Our rule of thumb with flow-charts and decision-trees is simple: If they become unintelligible when one squints at them, then they are a sign that the author does not really know what is going on (Diagram 1). Diagram 1Next Steps: It's Complicated Brexit Update: Does Brexit Really Mean Brexit? Brexit Update: Does Brexit Really Mean Brexit? We admit that we have little conviction with the next steps laid out in our decision-tree diagram. But we know one thing with a high degree of certainty: nobody else does either. There are three questions that our decision-tree diagram immediately brings to mind: Is a new election necessary? Not at all. There is no constitutional reason why May would call a new election. She was a key member of David Cameron's cabinet, heading a high-profile ministry. As such, she can rightly say that she represents a continuation of the Conservative Party democratic mandate, received with the last election. We do not expect May to call an election. Does invoking Article 50 require parliamentary approval? The governments says no, many constitutional law experts in Britain say yes.5 We suspect that May will not seek parliamentary approval, given that she has already empowered Brexit-advocate David Davis to pursue negotiations with the EU via a new ministry solely dedicated to exiting the EU. Will exiting the EU require parliamentary approval? We have a high conviction view that Westminster will ultimately have to decide whether the U.K. leaves the EU.6 This is because the act of leaving the EU is not just related to invoking Article 50, which handles London's relationship with the EU. In order to formally abrogate the supremacy of Brussels-made laws, the U.K. will have to repeal the European Communities Act (1972). What do our answers mean for investors? First, May and her "Brexit Minister" Davis have hinted that Article 50 would only be invoked by January. This suggests that May still wants to have a "cooling off" period ahead of negotiations with the EU despite her surprising early victory (in addition, it further suggests that Brexit proponents truly have no plan as to how to pursue exit). While May continues to repeat her election pledge that "Brexit means Brexit," she did support the "Stay" side and may be trying to allow economic and political consequences of Brexit to hit home with voters. Second, we do not see Article 50 as a doomsday clock that begins ticking once negotiations for exit with the EU begin. Given that May would likely ask Westminster to formalize EU exit in parliament, say some time in 6-18 months, political realities of that moment would decide the vote. As such, investors should carefully watch opinion polls, particularly party performance (Chart 3) for any sign of "Bremorse." Chart 3Watch The Opinion Polls##br##For Signs Of Bremorse bca.gps_sr_2016_07_15_c3 bca.gps_sr_2016_07_15_c3 Third, May has appointed a number of prominent Brexit supporters in her cabinet, with Davis heading the new "Brexit Ministry" and Boris Johnson installed as the Foreign Secretary. What message should investors take from this move? On one hand, it could mean that May has come to terms with the referendum and is committed to Brexit. On the other, she may be setting up her potential rivals for failure when the public turns on Brexit and its proponents. Either way, she remains above the fray and able to manoeuvre out of Brexit if needed. Fourth, we believe that a second referendum is possible, despite May's firm statement that there would be no second referendum on "EU membership." That may be true, but there could be a referendum on whatever kind of a deal - or more precisely, outlines of a deal - the U.K. negotiators produce with Brussels. Bottom Line: May has undoubtedly started her premiership with a commitment to executing an exit from the EU. However, the probability of Brexit is still a coin-toss. It will depend on how the U.K. economy and politics evolve over the course of its negotiations with the EU. By putting Eurosceptics in charge of the negotiations with the EU, May is absolving herself of any poorly negotiated Brexit terms, a cunning political move if there ever was one. Introducing The Brexit Trilemma The U.K. is caught in a Brexit Trilemma. London wants to retain access to the common market and maintain "passporting" rights for its services industry (particularly the City's financial firms), while preventing EU citizens from accessing its labor market. According to Brussels and Berlin, the U.K. cannot get all three. London believes that it can ultimately threaten market access for German car manufacturers and use it to get all that it wants in negotiations. At least, that is what Davis, the "Brexit Minister" has publicly stated on a number of occasions. In our view, this is a poor negotiating strategy. First, German car exports are highly competitive globally, regardless of trade arrangements. If BMW and Mercedes-Benz can sell cars in China, we're pretty sure a post-EU U.K. will not be a challenge. Second, the U.K. is a significant market for German exports, at 7% of all exports destined for Britain. However, the EU is a far greater destination for British exports, with 55% of all exports going to the bloc.7 Third, the U.K. may have a deficit with the EU in goods and thus wouldn't mind if severing of links with the bloc improved its trade balance, but it has a surplus in services (Chart 4). In a post-WTO environment, it is difficult to be protectionist with trade in manufactured goods, but it is relatively easy to protect one's domestic services market via non-tariff barriers to trade. In fact, one of the biggest complaints out of London in relation to its EU membership has been the slow implementation of the 2006 EU's Services Directive, which would have enhanced cross-EU trade in services. The directive was transposed by all member states, but has only been implemented half-heartedly, and at times not at all, since coming into force in 2009.8 Now that the U.K. is preparing to exit the bloc, it is likely that it would see a reversal in whatever small steps the EU had made towards a "services union." Taking these constraints into consideration, the U.K. has a decision to make on its future relationship with the EU. There are three options: WTO option: no trade deal, U.K.-EU relationship falls to the level of two WTO-signatories. Bespoke option: A "bespoke" trade deal is one akin to the Swiss-EU relationship - which is in fact a large number of smaller bilateral deals - or one that the EU negotiated with Canada, and that took seven years to conclude. This is essentially as unappetizing as the WTO option as it would leave the U.K. in limbo for years. EEA: Members of the European Economic Area (EEA) retain full access to the Single Market. This also includes "passporting" for various services industries. It is therefore the optimal option for the U.K. from a trade perspective. However, the U.K. would have to continue paying a somewhat reduced membership fee and give EU citizens access to its labor market. The EEA option does provide for "safeguard measures" to be enacted on any part of the agreement, including on migration, in cases of "serious economic, societal or environmental difficulties of a sectoral or regional nature."9 These measures can be retaliated against by other EEA members, but only "in kind." This would mean that U.K. citizens would be barred access to the EU labor market, which would be an acceptable cost for U.K. policymakers. As such, the EEA option may be acceptable to all sides. Ultimately, the main question is whether Brussels and Berlin will allow the U.K. to limit EU migration. From a perspective of national interest, we do not see why EU member states would insist on forcing the U.K. to take on EU immigrants. After all, does it not serve Germany's interests that Eastern European EU nationals lose the option of migrating to the U.K. and instead have to choose Germany as their destination? However, from the perspective of EU-wide interests, it does make sense that the U.K. is made to jump through hoops so as to discourage other member states from seeking their own à la carte deals. Bottom Line: Brexit vote was very clearly motivated by the influx of migrants from "EU accession countries. (Chart 5)"10 There is no flexibility on this issue for U.K. politicians, unless Bremorse sets in and the British public changes its mind. We suspect that various EU member states are more flexible on the issue of migration, but may want to make the U.K. suffer nonetheless, in order to prevent further exits down the line. Chart 4Brexit: Bad For The U.K.##br##Services-Dominated Economy bca.gps_sr_2016_07_15_c4 bca.gps_sr_2016_07_15_c4 Chart 5Brexit Sends A Clear##br##Signal On Immigrants bca.gps_sr_2016_07_15_c5 bca.gps_sr_2016_07_15_c5 A happy medium may ultimately be possible. One where the U.K. gets limits to free movement of people, but pays for the privilege to "shoot its economy in the foot" through a trade-deal that favors the EU. Why do we put it that way? Because immigrants from EU accession countries account for a quarter of the U.K. potential GDP growth rate. As such, the U.K. will be made to pay for the right to limit its own potential GDP growth rate. Marko Papic, Managing Editor marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation), dated July 13, 2016, "Introducing: The Median Voter Theory," dated June 8, 2016, "Nuthin' But A G Thang," dated August 12, 2015, "Is Abenomics The Future?," dated February 11 2015, "The Apex Of Globalization - All Downhill From Here," November 12, 2014, "The Return Of 'G?'" dated November 13, 2013, "Austerity Is Kaputt," dated May 8, 2013, all available at gps.bcaresearch.com. 2 Please see BBC, "Boris Johnson made foreign secretary by Theresa May," dated July 13, 2016, available at BBC.com. 3 One of the main arguments in favor of Brexit was that it would allow the U.K. to negotiate free trade deals with the entire world once it became unencumbered by protectionist EU member states such as France and Italy. The problem with this idea is that it assumes that the voters who rejected EU membership will then support a doubling-down on free trade, with countries such as India and China no less! Our view? Not a chance. 4 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 5 Please see Nick Barber et al, "Pulling the Article 50 'Trigger:' Parliament's Indispensable Role," dated June 27, 2016, available at ukconstitutionallaw.org. 6 Please see BCA Geopolitical Strategy Special Report, "The Coming EXITentialist Crisis," dated June 24, 2016, available at gps.bcaresearch.com. 7 This is not a coincidence. The whole point of the EU is that it is the world's richest consumer market. As such, it has a massive negotiating leverage with all trade partners. As a side note, this throws into doubt the logic that the U.K. can get better trade deals by leaving the bloc. First test of that premise will be its negotiations with the EU itself. 8 Please see EU Commission, "Implementation of the Services Directive," available at ec.europa.eu. 9 Please see EEA Treaty Articles 112-114. 10 Countries which were admitted to the EU in the 1990s and are mostly located in Eastern Europe. This includes Bulgaria, Croatia, Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Romania, Slovakia, and Slovenia.

Signs that the median voter is moving to the left are everywhere. Markets will cheer the move as it means more government spending. In the long term, it depends if policymakers stop at fiscal stimulus. In this <i>Monthly Report</i>, BCA's <i>Geopolitical Strategy</i> reviews prospects for "Bremorse," latest in the U.S. election, Italian political crisis, tensions in South China Sea, and the long-term future of Europe.

Signs that the median voter is moving to the left are everywhere. Markets will cheer the move as it means more government spending. In the long term, it depends if policymakers stop at fiscal stimulus. In this <i>Monthly Report</i>, BCA's <i>Geopolitical Strategy</i> reviews prospects for "Bremorse," latest in the U.S. election, Italian political crisis, tensions in South China Sea, and the long-term future of Europe.

The only certainty regarding the next steps in the Brexit Saga is uncertainty. In the attached report, BCA's Geopolitical Strategy presents the BREXIT Decision Tree and reviews the possible next steps. We also collate all of the BCA investment views and strategies - tactical and strategic - that relate to the ongoing saga.

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

The 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.

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

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.