Domestic Politics

Highlights U.S. Politics: We recommend that investors look through the political noise in D.C., which is unlikely to arrest the current cyclical economic upturn. Maintain a pro-growth asset allocation within fixed income portfolios: below-benchmark duration, favoring corporate credit over government bonds, especially in the U.S. Duration Checklists: An update of our Duration Checklists shows that the backdrop remains conducive to rising Euro Area bond yields, while the upward pressures on U.S. yields have diminished somewhat. The majority of the indicators, however, continue to point to higher U.S. Treasury and German Bund yields. Europe: Reduce European duration exposure, but wait for wider spread levels before moving out of European government bonds into U.S. Treasuries. Feature The Economy Trumps Politics Chart of the WeekHas Anything Really Changed? A whiff of panic swept across global financial markets last week, as the political risk bugaboo came back with a vengeance. In the U.S., the deepening morass surrounding President Trump's decision to fire former FBI Director Comey, and the potential links to the ongoing investigation of the White House's ties to Russia, raised concerns that Trump's ambitious pro-growth policy agenda would never make it out of Congress. Even this year's darling in the Emerging Markets, Brazil, suffered a huge financial rout after news broke of corruption allegations against the current president. Amid growing talk of a potential impeachment of Trump, the market action was a classic risk-off move, with equity markets falling, the VIX finally waking from its slumber and safe-haven assets like gold, U.S. Treasuries and the Japanese yen rallying. The euro climbed to new 2017 highs versus the U.S. dollar, without any changes in expectations about potential policy moves from the European Central Bank (ECB), as the market knocked down the probability of a June Fed rate hike (Chart of the Week). Some creative commentators called these market moves "the Trump fade" - the beginnings of a reversal of the so-called "Trump trade" that has sent U.S. equity prices and bond yields higher since the U.S. election on expectations of a large U.S. fiscal stimulus. We remain skeptical, however, that expectations of tax cuts and increased government spending have been the main drivers of the post-election boost in U.S. stock prices and Treasury yields, as the current cyclical upturn in global growth was already underway before Trump's election victory. Our colleagues at the BCA Geopolitical Strategy service note that, despite Trump's terrible overall approval ratings (Chart 2), his support among his Republican voters remains strong (Chart 3). Thus, an impeachment is only likely if the Republicans were to lose control of the House of Representatives in next year's U.S. midterm elections. Fear of that outcome should motivate the GOP to try and push through tax and healthcare reform well ahead of the 2018 midterms, in order to present a positive economic message to voters.1 Unless the evidence against Trump becomes so damning that even the Republicans in Congress have to focus on impeachment instead of policy, investors should ride out any market volatility associated with worries that the Trump economic agenda is at risk. Chart 2Trump's Support Abysmal Chart 3GOP Not Yet Willing To Impeach Trump Even without a boost to growth from D.C., however, we continue to expect the U.S. economy to grow above 2.5% in 2017. This above-trend pace will keep the Fed in play for at least two additional rate hikes before year-end, as it would give policymakers confidence that U.S. inflation expectations would return back the Fed's 2% target. In addition, as we discuss in the next section, the cyclical upturn in the Euro Area economy is showing no signs of cooling off, which will put more pressure on the ECB to begin preparing the markets for an eventual tapering of its asset purchases. The recent decline in bond yields is unlikely to persist much longer. Bottom Line: We recommend that investors look through the political noise in D.C., which is unlikely to arrest the current cyclical economic upturn. Maintain a pro-growth asset allocation within fixed income portfolios: below-benchmark duration, favoring corporate credit over government bonds, especially in the U.S. Checking In On Our Duration Checklists In a Special Report published back in February, we introduced a list of indicators to follow to assess the likely direction of U.S. Treasury and German Bund yields.2 We called these our "Duration Checklists", incorporating data on economic growth, inflation, investor risk aversion and market technicals to judge whether our bias to maintain a below-benchmark duration stance should be maintained. This week, we provide an update on those Checklists. The current message from the Checklists is that there is reduced upward pressure on bond yields from the overall strength of the global economy than existed four months ago. Domestic forces, however, are still pointing to higher yields in the U.S. and, especially, the Euro Area (Table 1). Specifically: Table 1A More Bond-Bearish Backdrop For Bunds Than USTs Global economic activity indicators have lost some momentum. While the global leading economic indicator (LEI) is still rising, our global LEI diffusion index has fallen sharply and is now below the 50 line, indicating that a more countries now have a falling LEI. In addition, the global ZEW index has drifted a touch lower, global data surprises are no longer positive, and the global credit impulse has ticked downward (Chart 4). Only the rising LEI warrants a "check" in our Checklists (i.e. justifies our current below-benchmark duration stance). U.S. & European domestic economic activity remains in good shape. Consumer and business confidence remains at strong levels on either side of the Atlantic, with corporate profit growth still accelerating (Charts 5 & 6). Only the modest decline in the U.S. manufacturing purchasing managers' index (PMI) is worthy of an "x" in our U.S. Checklist, although the index remains well above 50 and is not pointing to a more serious deterioration in the U.S. economy. Chart 4Global Growth Backdrop Has##BR##Turned Less Bond-Bearish Chart 5U.S. Economic Strength##BR##Still Supports Higher UST Yields Chart 6Euro Area Growth Is##BR##Gaining Upward Momentum Inflation pressures have eased a bit, especially in the U.S. The slowing momentum in global energy prices has taken some of the steam out of headline inflation in both the U.S. and Europe. Wage inflation has eased up a bit in the U.S., even with the labor market running at full employment (Chart 7). Wage growth and core inflation have recently ticked higher in the Euro Area, however, while the unemployment rate there has fallen to within less than a percentage point away from the OECD estimate of the NAIRU (Chart 8).3 The only indicators worthy of a "check" are the unemployment gap in both the U.S. and Euro Area, although we will give a potential "check" (with a question mark) to European wage inflation. If the recent uptick gains additional momentum, the case for the ECB to begin moving to a less accommodative policy stance will be much stronger. Chart 7Inflation Pressures On UST Yields Have Eased Chart 8Core Inflation & Wages Bottoming Out In Europe? There is still a pro-risk bias among global investors. U.S. and Euro Area equity markets are still in bullish trends, trading well above their 200-day moving averages. At the same time, corporate credit spreads remain tight and option-implied equity volatility is very low (even after last week's pop in the U.S. on the Trump drama). All indicators are worthy of a "check", suggesting that easier financial conditions can lead to higher bond yields (Charts 9 & 10). We are, however, giving an "x" to the European Checklist for the deviation of the Stoxx 600 from its moving average, as it is now at the +10% extreme that we defined as being potentially bond-bullish as it could foreshadow a near-term correction of an overheated stock market. Chart 9Still Generally A Risk-Seeking Backdrop In The U.S. Chart 10Strong Risk-Seeking Behavior In Europe Bond markets no longer look technically stretched. The sharp move higher in yields at the end of 2016 left all our indicators of yield momentum at bearish extremes (for bond prices). With bond yields pulling back from 2017 highs, however, the momentum measures all look neutral at the moment and are not an impediment to higher yields (Charts 11 & 12). The same goes for duration positioning in the U.S., with the net longs on 10-year Treasury futures now at the highest level since 2007. All of the technical indicators in our Checklists warrant an "check". Chart 11UST Technicals No##BR##Longer Stretched Chart 12Technicals Are No Impediment##BR##To Higher Yields In Europe Summing it all up, our Duration Checklists show that the majority of indicators are still pointing to higher bond yields in the U.S. and Europe, although not as decisively as when we first published the Checklists in February. There are more "check" on the European side of the ledger, however, suggesting that there is more room for European government bond yields to rise relative to U.S. Treasuries. This would indicate a potential trade opportunity to cut allocations to Europe and raise allocations to the U.S. Chart 13UST-Bund Spread Is Now Too Low The recent decline in U.S. yields, however, has narrowed the U.S. Treasury/German Bund spread to levels that make putting on a tightening trade unattractive on a tactical basis. (Chart 13). The gap between the data surprise indices in the U.S. and Euro Area already reflects the recent soft patch for the U.S. economy (middle panel). That spread in the surprise indices now at historically wide levels, suggesting more potential for Treasury yields to rise if the U.S. data begins to rebound soon, as we expect. Also, the gap between U.S. and Euro Area inflation expectations has narrowed alongside the recent downtick in U.S. core inflation (bottom panel), although we expect the decline in U.S. core inflation to be short-lived given the persistent tightness of the U.S. labor market. Net-net, we would prefer to see a wider Treasury-Bund spread before making switching our country exposure out of Europe and into the U.S. We can, however, listen to the message from our Checklists and reduce our duration exposure in Europe. Specifically, we are cutting our allocations to the longer maturity buckets (5 years out to 30 years) by 50% in our model portfolio for Germany, France and Italy, putting the proceeds into the 1-3 year buckets (see the table on Page 12). This will reduce our overall recommended portfolio duration by just over 1/10th of a year, as well as put an additional bear-steepening curve tilt within our European government allocations. We are comfortable with that bias, given the growing risk that the ECB will soon begin signaling a tapering of asset purchases once the current program expires at the end of the year. Bottom Line: An update of our Duration Checklists shows that the backdrop remains conducive to rising Euro Area bond yields, while the upward pressures on U.S. yields have diminished somewhat. The majority of the indicators, however, continue to point to higher U.S. Treasury and German Bund yields. Reduce European duration exposure, but wait for wider spread levels before moving out of European government bonds into U.S. Treasuries. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment", dated May 17 2017, available at gfis.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15 2017, available at gfis.bcaresearch.com 3 Non-Accelerating Inflation Rate Of Unemployment. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, In addition to this abbreviated Weekly Report, I am sending you a Special Report discussing the signals being sent from recent movements in commodity prices. Best regards, Peter Berezin, Chief Global Strategist Feature You want a friend in Washington? Get a dog! - President Harry S. Truman There are no friends in Washington; only enemies and accomplices. Donald Trump has been finding this out the hard way over the past few months. We won't get into the merits (or lack thereof) of the latest allegations of malfeasance against the president. That's for the talking heads on the cable news shows to debate. We will stick with the markets. For now, we are not too concerned about the growing risk that President Trump will be impeached. The U.S. has experienced three impeachment crises over the past 100 years: The Teapot Dome Scandal (April 1922 to October 1927), Watergate (February 1973 to August 1974), and President Clinton's Lewinsky Affair (January 1998 to February 1999). Only the Watergate crisis was accompanied by a bear market in stocks, and that was largely a function of the fact that the U.S. was going through one of the deepest recessions in the post-war era at the time (Chart 1). Things do not look nearly so grim today. After a weak start to the year, activity has rebounded in the second quarter. The Atlanta Fed's GDPNow model is predicting growth of 4.1% while the NY Fed's Nowcast is calling for 1.9%. The first quarter earnings season was a strong one. Our model predicts continued healthy profit growth for the remainder of the year in the U.S. and abroad (Chart 2). As long as corporate earnings are rising, investors will largely overlook the drama in Washington DC. Chart 1Equities Amid Three U.S. Scandals Chart 2Upbeat U.S. Earnings Model Moreover, we are not convinced that the litany of scandals afflicting the Trump administration will derail large parts of Trump's market-friendly policy agenda. Trump desperately needs a win, and tax reform and deregulation are two key areas where the president and congressional Republicans see eye to eye. We still think that there is a good chance that the contours of an agreement to substantially cut taxes will take shape by the end of the year. The prospect of such a deal should be enough to buoy investor sentiment. Thus, while equities are likely to remain under pressure in the near term, the outlook for the next 9-to-12 months is still reasonably good.1 Our worries are more focused on what happens as next summer approaches. As we discussed last week, U.S. growth may begin to stall out in late-2018 as the economy runs out of spare capacity and the impact of Fed rate hikes becomes more apparent. Politics are also likely to turn even more volatile. A simple majority vote in the House of Representatives is all it takes to impeach a sitting president. There aren't enough votes in the House right now, but there could be if the Democrats make a strong showing in the November 2018 midterm elections - something that current polls suggest is quite likely (Chart 3). If the Democrats end up winning the House, Marko Papic, our chief geopolitical strategist, believes that it is nearly 100% certain that they will vote to begin impeachment proceedings.2 Chart 3Challenging Outlook For Republicans In 2018 Chart 4The GOP Base Still Supports Trump The good news for Trump is that even then, it would take a two-thirds majority vote in the Senate to oust him from office. Realistically, this cannot happen without significant Republican support. The bad news is that there are plenty of Republican senators who would be more than happy to stick a long sharp dagger into Trump's back and replace him with Mike Pence, Trump's more reliable and less drama-prone vice president. What is preventing them from doing so is the fear of a backlash from the white, working-class voters who got Trump elected. The only way this fear will go away is if the Republican base turns against Trump. So far that hasn't happened: Trump still commands the support of 84% of Republican voters (Chart 4). The risk, however, is that his base will desert him as the administration goes from one scandal to the next. Trump knows this, which is why come next year, he is likely to dial up his populist rhetoric. And unlike in the past, confident promises will not be enough. Trump's voters will be looking for concrete actions on hot-button issues like trade and immigration. At a time when growth is likely be slowing of its own accord, the specter of such measures could be enough to pull the rug out from risk assets. 1 We are currently short the S&P 500 as a tactical hedge, reflecting the bearish near-term signals being sent by our Stock Market Timing model. Cyclically, however, the model still points to slightly above-average returns for U.S. stocks. For further details, please see Global Investment Strategy Weekly Report, "The Message From Our Stock Market Timing Model," dated May 5, 2017, available at gis.bcaresearch.com. 2 Please see Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 18, 2017, available at gps.bcaresearch.com. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Tactical Trades Strategic Recommendations Closed Trades

Highlights The political theater in Washington has caused the last inning of the dollar correction to materialize. The U.S. economy remains at full employment, growth will stay above trend, and the Fed will be capable of hiking rates by more than the 66 basis points priced into the OIS curve over the next 24 months. It is time to buy the DXY. Investors are too optimistic on the euro and too negative on the CAD, short EUR/CAD as a tactical bet. The Swedish economy continues to improve. Yet, the SEK has limited upside as the Riksbank continues to find excuses to justify its dovishness. The downside for EUR/SEK is limited to 9.3. Feature Chart I-1Trump Rally Is Gone Four weeks ago, we wrote that the U.S. dollar correction was entering its last inning and recommended investors should wait a few more weeks before betting on renewed dollar strength.1 We think the time to bet on this rebound is now. To begin with, the dollar index has now erased all the gains accumulated since Trump's electoral victory, suggesting that all the hope of fiscal stimulus, deregulation, and tax cuts have now been priced out of the greenback (Chart I-1). In fact, at this point in time we think too many risks have been priced into the dollar. For one, the market is overemphasizing the likelihood of a Trump impeachment. While our Geopolitical Strategy group does think the likelihood of an impeachment procedure is near 100% if the democrats win the House in 2018, the likelihood remains much lower in 2017.2 Simply put, Trump remains a very popular president among republican voters (Chart I-2). Most problematic for many republicans that would like to see Trump out of office, is that his popularity is particularly strong among the "Tea Party" districts and voters (Chart I-3). Chart I-2Trump Still Popular With Republicans Chart I-3Trump Is Popular In Tea Party Territory Second, the chance that tax cuts are part of the upcoming budget negations is high. Tax cuts are espoused by the entire GOP caucus. Additionally, Republicans know that in order to avoid losing the Senate or the House of Representatives, or both, they have to do something popular with voters. Tax cuts definitely fit the bill. This simple political assessment points toward a likely passage of stimulus in the coming quarters despite Trump's personal woes. Finally, if Trump were to be stabbed in the back by the GOP establishment, what would the impact be on the dollar? Would the U.S. default? No. Would the economy enter a recession? No. Would the Fed become dovish? Neither. If anything, a potential removal of Trump from the oval office reduces the risk that he appoints a super-dove at the helm of the Fed, a risk that would have been very negative for our positive dollar cyclical stance. Regarding the economics behind the dollar rally, our positive cyclical stance on the USD predates the election of Trump, and in fact relied on the underlying shifts in the U.S. economy.3 These dynamics are still intact: While wage growth remains anemic, this partly reflects the fact that the long-term determinant of wage growth, productivity growth, is low. When this is taken into account, productivity-adjusted wage growth is in line with levels that in the past have prompted the Fed to tighten policy in order to combat potential inflationary dynamics (Chart I-4). Nonetheless, the risk is that wages begin accelerating going forward. The labor market is at full employment, with the U-3 unemployment rate standing 0.3 percentage points below the Fed's estimate of the neutral unemployment rate. Additionally, hidden labor market slack has also greatly dissipated (Chart I-5), with the U-6 unemployment rate, the number of workers in part-time jobs for economic reasons, and the amount of workers outside of the labor force but that would still like to have a job if economic conditions warranted it all back to levels where historically wage growth has gained momentum. Chart I-4Without Productivity Gains, Current Wage##br## Growth Is Enough For A Tighter Fed Chart I-5U.S. Labor Market##br## Is Tight Moreover, the outlook for consumption remains sturdy. Overall household income growth remains supported by elevated levels of job creation, and our indicator for real household disposable income growth continues to point up. Additionally, Federal income tax withholdings are accelerating, a sign of more robust consumption to come (Chart I-6). With consumer confidence at 17-year highs, positive income developments are likely to be translated into consumption. The outlook for capex is also bright. CEO confidence and capex intentions have all rebounded sharply, moves whose genesis predate Trump's election (Chart I-7). Moreover, elements are in place for these positive feelings to be catalyzed into actual investment. On the back of rebounding revenue growth, thanks to nominal GDP growth exiting levels historically associated with recessions, profit growth will receive a fillip, which should boost capex in the current context (Chart I-8). Chart I-6Income Tax Receipts Points ##br##To Healthy Consumption Chart I-7Capex Intentions Point ##br##To Higher Growth Chart I-8Revenue Growth Exiting ##br##Recessionary Levels Finally, when all major indicators are aggregated, real GDP growth looks set to accelerate. BCA's Beige Book diffusion index, based on the distribution of positive and negative mentions about the state of the economy in the Fed's Beige Book, is pointing to an acceleration in activity (Chart I-9). This suggests that the collapse in U.S. economic surprises may be toward its tail end. With this in mind, we continue to expect the Fed to increase rates more than the 66 basis points currently anticipated in the OIS curve over the next two years, as such, this supports our bullish stance on the dollar. In terms of tactical developments, the recent selloff has brought the DXY toward the levels congruent with the end of the correction.4 Additionally, based on our Intermediate-term timing model, the USD is now cheap enough to justify taking a long bet on the currency. The deeply oversold levels reached by our Intermediate-term momentum oscillator supports this message (Chart I-10). Finally, the Swedish Krona seems to be confirming these signposts. USD/SEK has historically displayed one of the strongest betas to the trade-weighted dollar's movements. The fact that this pair has not been able to break down below a long-term upward slopping trend line put in place since 2014, and that it also managed to stay above its 2015 peaks, gives us more confidence that the dollar correction is likely to have run its course (Chart I-11). Chart I-9BCA's Beige Book Monitor ##br##Improves Growth Will Strengthen Chart I-10Dollar Is ##br##Oversold Chart I-11USD/SEK Giving A Hopeful##br## Signal For DXY Bottom Line: The dollar has taken a beating in the wake of the scandals emerging out of the White House. In our view, these developments were only the catalyst that crystalized the last leg of the USD correction that begun in late 2016/early 2017. Ultimately, the bull case for the dollar predates Trump and rests on the dissipating slack in the U.S. economy. These developments are intact, even with Trump's fiascos in the foreground. Tactically, the dollar is now cheap enough and oversold enough to justify investors buy the DXY again. We are opening a long DXY trade this week. We remain long the dollar against most commodity currencies and EM currencies. The yen may continue to benefit if the budding weaknesses in the EM space gather further momentum. EUR/CAD Is A Short At this juncture, it would be natural for us to begin shorting the EUR against the USD. In fact, we believe the recent spike in the EUR has created a good shorting opportunity against the European currency. While we worry investors are becoming too pessimistic on the U.S., we believe investors are too optimistic regarding the capacity of the ECB to increase rates. Investors moved away from deep short positions on the euro and are now net long this currency. Also, while in July 2016 investors expected the first ECB rate hike to materialize in more than five years' time, they are now expecting the first repo rate hike to happen in just 24 months (Chart I-12). This looks premature. For comparison's sake, in the U.S. we are only seeing the early signs of labor market tightness, despite the last recession ending in the summer of 2009. Europe was victim to a double-dip recession, the last leg of which ended in 2013. This decreases the likelihood of Europe being at full employment today. More concretely, there remains plenty of hidden labor market slack in the euro area. In Europe, the main form of slack exists among workers hired under contracts, contracts that do not offer the same level of benefits and protections as regular employment. The euro area increasingly has a dual labor market, a condition that has weighed on wage growth for more than two decades in Japan. Today, as a result of such dynamics, the level of labor underutilization in Europe is still very elevated, which will continue to limit wage growth going forward (Chart I-13). Hence, core inflation dynamics in Europe are likely to prove disappointing and they will keep the ECB on a more dovish path than investors currently appreciate. Chart I-12Investors Too Optimistic On The ECB Chart I-13Labor Market Slack In The Euro Area Remains High For now we are electing to profit from this view by tactically shorting the euro against the CAD. We do believe there are problems in Canada, a topic we discussed a few weeks ago.5 But at this juncture, these worries seem well digested by markets. The Home Capital Group debacle has been front page news for weeks, but the aggregate banking sector remains strong, especially as loses on the mortgage holdings of Canadian banks will ultimately be passed on to the government through the insurance provided by the Canadian Mortgage and Housing Corporation. Additionally, in the wake of the deepening trade dispute on softwood lumber, the fears of a disintegration of NAFTA have hit Canada especially violently, with the CAD falling 16% against the peso since January 2017. Chart I-14EUR/CAD Is Toppy Tactically, the pieces are falling into place to favor the CAD over the EUR. Our Commodity and Energy group remains positive on the outlook for oil prices. The continuation of the output controls by OPEC and Russia remains binding as oil producers want to further curtail elevated oil inventories. Therefore, oil prices have little downside and may even experience further upside, helping the CAD in the process. Additionally, investor positioning is very skewed. Investors are massively short the CAD, especially when compared to the euro, which historically has provided a signal to short EUR/CAD (Chart I-14). This is re-enforced by our Intermediate-term technical indicator which shows EUR/CAD as massively overbought. Shorter-term momentum measures such as the RSI or the MACD have also been forming negative divergences with actual prices in recent days. Bottom Line: The euro is likely to suffer if the USD correction is indeed finishing. Hidden labor market slack remains a much deeper problem in Europe than in the U.S. and will limit the capacity of the ECB to increase rates in the next two years, as investors are currently expecting. For now, we are electing to short the euro against the CAD instead of against the USD. The Canadian dollar is oversold and oil prices have limited downside from here as supply adjustments remain positive. Moreover, investors are at record shorts on the CAD, especially when compared to the euro. Sweden Is Strong, But The Riksbank Still Haunts The SEK The long-term outlook for both Sweden and the Swedish krona remain bright but the ultra-dovish stance of the Riksbank remains a potent short-term hurdle. To begin with, the SEK offers great value. Not only is it trading at 24% and 8% discounts to its PPP fair value against the USD and the EUR, respectively, but the trade-weight SEK is also trading at a near one-sigma discount against our long-term fair value models (Chart I-15). Chart I-15SEK Is Cheap... But Is It Enough? Additionally, Sweden's net international investment position has moved back in positive territory in 2014, and now stands 16.4% of GDP (Chart I-16). This is not only a reflection of the weakness in the SEK since 2014, but is first and foremost the end-result of more than two decades of accumulated current account surpluses. This development is crucial. Not only does the positive income balance generated by assets in excess of international liabilities put a floor under the current account; historically, currencies with positive and growing net international investment positions tend to exhibit an upward bias. In terms of economic developments, employment growth in Sweden remains steady. Unemployment has been in a protracted downtrend, falling 2.9 percentage points since 2008 (Chart I-17). Yet, despite being well into full employment territory, wage growth has been absent. To a large degree, this reflects entrenched deflationary pressures in the Swedish economy. However, deflationary forces are abating. Chart I-16A Long-Term Driver Pointing North Chart I-17Swedish Labor Market At Full Employment To begin with, Sweden's output gap has recently entered positive territory, which historically has been a reliable indicator of inflationary pressures in this country (Chart I-18). Also, monetary aggregates, M1 in particular, continue to point toward higher inflation in Sweden. This means that with the employment market being at full capacity, the conditions for higher inflation in Sweden are emerging. Our expectation of an upcoming upturn in the Swedish credit impulse - which until now has been contracting and exerting deflationary forces on the economy - reinforces confidence in our inflation view. Credit growth tends to lag industrial activity, but our industrial production model for Sweden is perking up. Improving industrial variables suggest that credit will move from depressing demand back to supporting demand, further rekindling inflationary forces (Chart I-19). Chart I-18Swedish Inflation Is Set To Pick Up Chart I-19Swedish Credit Impulse Will Rebound With this positive backdrop for prices, should investors buy the SEK right now? The Riksbank continues to represent a great hurdle for SEK bulls. The Swedish central bank has one of the strongest dovish biases amongst global monetary guardians. Against expectations, it recently increased the duration of its asset purchase program, giving markets a strong signal that it is unlikely to increase rates soon. This means that the Riksbank is unlikely to tighten policy until it sees the "whites of inflation's eyes". While we are moving in the right direction, we are not there yet. Officially, the Riksbank targets CPIF, which currently clocks in at 2%. Yet, the emphasis of the central bank on domestic price dynamics implies that adjustment away from dovishness will only occur when core inflation itself moves to 2% (Chart I-20). This means that gains in the SEK will be limited. To begin with, EUR/SEK does have downside, and our view that the euro is getting overextended highlights that EUR/SEK could fall toward 9.3. However, beyond this level, gains should prove limited as Sweden is a small open economy and EUR/SEK plays a big role in tightening monetary conditions for that country. As a result, any move in EUR/SEK below 9.3 is likely to be unwelcomed by the Riksbank until core inflation moves closer to 2%. Versus the USD, it will be even more difficult for the SEK to rally. Historically, the SEK has been one of the most sensitive currencies to the dollar's trend, implying that strength in DXY could be magnified in USD/SEK. In fact, the absence of breakdown in USD/SEK in the face of violent dollar selling pressures this week suggests that the SEK could be a serious casualty of a rebounding dollar. Additionally, real rate differentials continue to move in favor of the U.S. dollar, with U.S. 2-year real rates now 180 basis points above that of Sweden (Chart I-21). With the Intermediate-term technical indicator for USD/SEK now hitting oversold levels, the downside for USD/SEK is very limited, further supporting the idea that any rebound in DXY could lead to significant weaknesses in SEK. Chart I-20Core Inflation Needs To Rise Chart I-21Rates Differentials Support A Lower SEK Bottom Line: The Swedish economy has adjusted and several factors are pointing toward a pickup in core inflation in the coming quarters. However, the Riksbank has maintained a strong dovish bias. We need to see an actual pick up in core inflation itself before the central bank moves away from its dovish bias. While EUR/SEK could weaken toward 9.3, more gains for the krona against the euro will prove elusive until the Riksbank sees firmer inflation. USD/SEK is a buy at current levels. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant HaarisA@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled “The Last Innings Of The Dollar Correction”, dated April 21, 2017, available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Special Report titled “Break Glass In Case Of Impeachment”, dated May 17, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report titled “Dollar: The Great Redistributor”, dated October 7, 2016, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report titled “The Last Innings Of The Dollar Correction”, dated April 21, 2017, available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report titled “AUD and CAD: Risky Business”, dated March 10, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The past week has been quite eventful for the greenback, slipping almost 2.3%. Most of the downside is owed to markets revising down rate expectations, on the basis of weak growth numbers and political scandals. The 10-year yield dropped, gold rose, and equities fell. There was also a large sell-off in EM currencies and a sharp appreciation in the yen. Furthermore, the soft patch in U.S. data continued as housing starts and building permits came in especially weak in April: 1.172 million and 1.229 million respectively, both underperforming consensus. Nevertheless, markets calmed after the release of stronger employment numbers with initial and continuing jobless claims beating expectations. The upswing in the Philly Fed index also helped revive sentiment. The dollar picked up Thursday morning following these releases. Interestingly, the DXY is at pre-election levels, which suggests that the dollar is nearing its bottom. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro has enjoyed significant upside as a result of Macron's victory and the dollar's drubbing. Weak data in the U.S. caused markets to revise growth expectations, pressuring the dollar downwards and the euro up. Further lifting the euro were comments by ECB President Mario Draghi, who highlighted that growth in the euro area is performing well. However, he also reiterated that "it is too early to declare success". These forces have lifted the euro to expensive levels on a tactical basis, suggesting the path of least resistance is most likely down as the ECB will find it hard to tighten policy and the dollar resumes its bull market. Data in the euro area has been mixed as of late without too much disappointment, and inflationary pressured remain unchanged. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 After coming slightly above 114, USD/JPY has plunged by more than 3%, as a result of the market pricing increasing odds that president Trump will get impeached. Although we believe that the correction of the dollar has run its course, the end of the Trump trade might have triggered the sell-off we have been expecting in emerging markets. Thus we like to play this risk off period by shorting NZD/JPY. On the data side, news have mostly been negative: Machinery orders contracted by 0.7% YoY, underperforming expectations. Consumer confidence came in lower than last month at 43.2. Bank lending grew by a measly 3% YoY underperforming expectations. However, real GDP for Q1 came in at 0.5% QoQ, beating expectations. This was dampened by the weak GDP deflator, which contracted by tk%. We continue to be yen bears on a cyclical basis, as the fed will raise rates more than the markets expects, while the BoJ will continue anchoring 10-year yields around zero. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K has been mixed: Industrial Production growth came in at 1.4%, underperforming expectations. However retail sales and retail sales ex-fuel growth came in at 4% and 4.5% respectively, both outpacing expectations. Crucially, both core and headline inflation came above expectations at 2.4% and 2.7% respectively. This surge in inflation is important as it raises the odds of a BoE hike this year, especially as the economy remains resilient. Moreover, as long term inflation expectations continue to be well anchored consumption is likely to continue to surprise as households are looking through the inflation caused by the depreciation in the pound. Overall, we continue to be positive on GBP against all other currencies but the U.S. dollar, given that the British economy will likely stay more resilient than investors are anticipating. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The RBA shed some light on the Australian economy through its most recent Minutes, highlighting that monetary policy needs to remain accommodative to support economic trends. It noted the negative hit to terms of trade as a result of Cyclone Debbie curtailing coking coal exports. China's housing market was also identified as a risk to Australia's exports and terms of trade. Nevertheless, this week the AUD was buoyant, helped by a weaker greenback. However, the factors above paint a bleak picture for the AUD's future. The very important employment figures depicted a similar trend to that of last year, with full-time employment in fact contracting while part-time employment picked up. Unemployment also declined by 0.2% to 5.7%, however, wages remain subdued. This corroborates the weaker core CPI measure of 1.5%, while the strong headline figure of 2.1% is likely to be transitory when the recent commodity-prices weakness kicks in. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The RBNZ continues to much more accommodative than warranted. The monetary policy report highlighted that the recent surge in inflation is mainly attributable to tradables, and that non-tradable inflation is bound to increase very gradually. We continue to believe that the RBNZ is understating the inflationary pressures in the economy, as core inflation is already higher than 2%. Additionally, retail sales are growing at 10-year high and nominal GDP growth has skyrocketed to 7.5%, by far the highest in the G10. Right now, the market expects the first rate hike to come in 9 months. We believe that a rate hike at this point would be the bare minimum for the RBNZ to avoid an overheating in the economy. Thus expectations have nowhere to go than up and the NZD now has considerable upside against the AUD. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has been somewhat weaker this past week as oil prices rebounded and the dollar fell. Oil prices are likely to see further upside as OPEC and Russia are likely to agree to another supply cut to support oil prices. Domestically, the economy is improving as unemployment is declining and PMIs are perking up. The BoC also identified the output gap to close earlier than expected in its last meeting. The almost 4% depreciation in the CAD in the past month has made the oil-based currency considerably cheap. When looking at EUR/CAD, the depreciation has been around 7.5%. With the euro now sitting in expensive territory, the ECB is unlikely to change its stance any time soon as inflation has not yet rooted itself, while peripheral economies' inflation remain weak. The CAD, however, is likely to see further upside on the back of increasing oil prices and a strengthening economy. These factors warrant a short EUR/CAD trade. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 And CAD: Risky Business -AUD March 10, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Following the election of Emmanuel Macron as the new president of France EUR/CHF skyrocketed, coming close to hitting 1.1. At this point EUR/CHF is a very attractive short, given that good news for the euro are likely to tapper now that the French election is behind us. When it comes to inflation, the ECB will likely focus on the lowest denominator, because in spite of higher inflation in some countries like Germany or Austria, inflationary pressures remain muted in most other economies. This will prevent the ECB from tightening monetary policy as fast as the market expects. Meanwhile, the possibilities that the SNB takes the floor off EUR/CHF at the end of this year or the beginning of 2018 are rising given that inflation and economic activity are slowly coming back to Switzerland. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has depreciated in the past weeks thanks to the fall in the dollar as well as rising oil prices. Additionally, the fall in inflation is slowing down, with core and headline inflation coming in at 1.7% and 2.2% respectively. Is it time to become bullish on the NOK against the U.S. dollar? We do not believe this is the case. While inflation might be close to bottoming it is unlikely to surpass the Norges Bank target in the coming years, given that inflationary pressures remain muted in Norway. Furthermore, given that USD/NOK is more sensitive to real rate differentials than oil prices, the effect of a dovish Norges Bank on USD/NOK will be much stronger than the impact of rising oil prices. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 We expect the SEK to experience limited upside in the next 3-6 months. The Greenback is bottoming and we expect USD/SEK to pick up on the back of the dollar bull market. Furthermore, EUR/SEK has limited downside as the RIksbank wants to keep monetary conditions easy. Indeed, the Swedish central bank is also planning to officially target CPIF instead of the CPI. While both of these measures are near 2%, the behavior of the Riksbank suggests that it is in fact targeting core inflation. Core inflation itself is still somewhat depressed, as consumer activity remains weak. However, we expect core inflation to pick up on the back of a higher credit impulse and money supply growth, which should help the Riksbank exit its dovish tilt later this year. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Venezuela's economic implosion accelerated with the oil price crash. The petrodollar collapse is suffocating consumption as well as oilfield investment, creating a "death spiral" of falling production. The military has already begun assuming more powers as Maduro becomes increasingly vulnerable, and will likely take over before long. OPEC's cuts may help Maduro delay, but not avoid, deposition. Civil unrest/revolution could cause a disruption in oil production, profoundly impacting oil markets. Feature The wheels on the bus go round and round, Round and round, Round and round ... The story of Venezuela's decline under the revolutionary socialist government of deceased dictator Hugo Chavez is well known. The country went from being one of the richest South American states to one of the poorest and from being reliant on oil exports to being entirely dependent on them (Chart 1). The straw that broke the back of Chavismo was the end of the global commodity bull market in 2014 (Chart 2). Widespread shortages of essential goods, mass protests, opposition political victories, and a slide into overt military dictatorship have ensued.1 Chart 1Venezuela Suffers Under Chavismo Chart 2Commodity Bull Market Ended The acute social unrest at the end of 2016 and beginning of 2017 raises the question of whether Venezuela will cause global oil-supply disruptions that boost prices this year.2 One of the reasons we have been bullish oil prices is the fact that the world has little spare production capacity (Chart 3). This means that political turmoil in Venezuela, Libya, Nigeria, or other oil-producing countries could take enough supply out of the market to accelerate the global rebalancing process and drawdown of inventories, pushing up prices. The longer oil prices stay below the budget break-even levels of the politically unstable petro-states (mostly $80/bbl and above), the more likely some of them will be to fail. Venezuela, with a break-even of $350/bbl, has long been one of our prime candidates (Chart 4).3 Venezuela is on the verge of total regime collapse and a massive oil production shutdown. This is not a low-probability outcome. However, the fact that the military is already taking control of the situation, combined with our belief that OPEC and Russia will continue cutting oil production to shore up prices, suggest that the regime may be able to limp along. Therefore a continuation of the gradual decline in oil output is more likely than a sharp cutoff this year. Investors should stay short Venezuelan 10-year sovereign bonds and be aware of the upside risks to global oil prices. A Brief History Of PDVSA State-owned oil company PDVSA is the lifeblood of Venezuela. It once was a well-run company that allowed foreign investment with a reasonable government take, but now it is shut off from direct foreign investment. In 1996-1997, prior to Chavez being elected in late 1998, Venezuela was a rampant cheater on its OPEC quota, producing 3.1-3.3 MMB/d versus a quota of ~2.4 MMB/d in 1996 and ~2.8 in 1997. The oil-price crash that started in late 1997 and bottomed in early 1999 (remember the Economist's "Drowning In Oil" cover story on March 4, 1999 predicting $5 per barrel crude prices?) was a critical event propelling the rise of Chavez (Chart 5). One of the planks in Chavez's platform was that Venezuela had to stop cheating on OPEC quotas because that strategy had helped cause the oil-price decline and subsequent economic misery. Without the oil-price crash, Chavez would not have had such strong public support in the run-up to the 1998 elections, which he won. Chavez did in fact rein in Venezuela's production to 2.8 MMB/d in 1999, which had a positive impact on oil prices and reinforced OPEC. In 2002 and 2003, there were two labor strikes at PDVSA and a two-day coup that displaced Chavez. When Chavez returned to power, he fired 18,000 experienced workers at PDVSA and replaced them with political loyalists. Since then, the total number of employees at PDVSA has swelled from about 46,000 people in 2002, when PDVSA was producing 3.2 MMB/d, to about 140,000 people today, when it is producing slightly below 2 MMB/d. Average oil revenue per employee was over $500,000/person in 2002 at $20 oil, versus about $100,000/person today at $50 oil. Suffice it to say, PDVSA is stuffed to the gills with political patronage, and a strike or a revolution inside PDVSA against President Nicolas Maduro is unlikely. However, if opposition forces manage to seize control of government, the Chavistas in control of PDVSA may attempt to shut down operations to deprive them of oil revenues and blackmail them into a better deal going forward. Chart 5Oil Bust Catapulted Chavez Venezuela is estimated to have the world's largest proved oil reserves at about 300 billion barrels (Chart 6). In addition, there are 1.2-1.4 trillion barrels estimated to rest in heavy-oil deposits in the Orinoco Petroleum Belt (at the mouth of the Orinoco river) that is difficult to extract and has barely been touched. Chart 7Venezuela Cuts Forced By Economic Disaster These reserves are somewhat similar to Canada's oil sands. It is estimated that 300-500 billion barrels are technically recoverable. In the early 2000s, there were four international consortiums involved in developing these reserves: Petrozuata (COP-50%), Cerro Negro (XOM), Sincor (TOT, STO) and Hamaca (COP-40%). However, Chavez nationalized the Orinoco projects in 2007, paying the international oil companies (IOCs) a pittance. XOM and COP contested the taking and "sued" Venezuela at the World Bank. XOM sought $14.7 billion and won an arbitrated decision for a $1.6 billion settlement in 2014. Venezuela continues to litigate the case and the amount awarded to investors has apparently been reduced by a recent ruling. Over the past decade, as Venezuelan industry declined due to dramatic anti-free market laws, including aggressive fixed exchange rates absurdly out of keeping with black market rates, the government nationalized more and more private assets in order to get the wealth they needed to maintain profligate spending policies. The underlying point of these policies is to garner support from low-income Venezuelans, the Chavista political base. In addition to the Orinoco nationalization, the government appropriated equipment and drilling rigs from several oilfield service companies that had stopped working on account of not being properly paid. In 2009, Petrosucre (a subsidiary of PDVSA) appropriated the ENSCO 69 jackup rig, although the rig was returned in 2010. In 2010, the Venezuelan government seized 11 high-quality land rigs from Helmerich & Payne, resulting in nearly $200MM of losses for the company. These rigs were "easy" for Venezuela to appropriate because they did not require much private-sector expertise to operate. As payment failures continued, relationships with the country's remaining contractors continued to be strained. In 2013, Schlumberger (SLB), the largest energy service company in the world, threatened to stop working for PDVSA due to lack of payment in hard currency. PDVSA paid them in depreciating Venezuelan bolivares, but tightened controls over conversion into U.S. dollars. Some accounts receivables were partially converted into interest-bearing government notes. Promises for payment were made and broken. SLB has taken over $600MM of write-downs for the collapse of the bolivar (Haliburton, HAL, has taken ~$150MM in losses). With accounts receivable balances now stratospherically high at approximately $1.2 billion for SLB, $636 million for HAL (plus $200 million face amount in other notes), and $225 million for Weatherford International, the service companies have already taken write-offs on what they are owed and have refused to extend Venezuela additional credit. Unlike the "dumb iron" of drilling rigs, the service companies provide highly technical proprietary goods and services, from drill bits and fluids to measuring services. The lack of these proprietary technical services diminishes PDVSA's ability to drill new wells and properly maintain its legacy production infrastructure. Venezuela's production started falling in late 2015 - well before OPEC and Russia coordinated their January 2017 production cuts (Chart 7). Drought contributed to the problem in 2016 by causing electricity shortages and forced rationing of electricity (60-70% of Venezuela's electricity generation is hydro); water levels at key dams are still very low, but the condition has eased a bit in 2017. After watching crude oil production fall from 2.4 MMB/d in 2015 to 2.05 MMB/d in 2016, OPEC gave Venezuela a production quota of 1.97 MMB/d for the first half of 2017, which is about what they were expected to be capable of producing. In essence, Venezuela was exempt from production cuts, like other compromised OPEC producers Libya, Nigeria and Iran. So far, Venezuela has produced 1.99 MMB/d in the first quarter, according to EIA. Venezuela's falling production is not cartel behavior but indicative of broader economic and political instability. Venezuela is losing control of oil output, the pillar of regime stability. Bottom Line: The double-edged sword for energy companies is that if the regime utterly fails, the country's 2MM b/d of production may be disrupted. However, if government policy shifts - whether through the political opposition finally gaining de facto power or through the military imposing reforms - Venezuela could ramp up its production, perhaps by 1MMB/d within five years, and more after that if Orinoco is developed. How Long Can Maduro Last? Chavez's model worked like that of Louis XIV, who famously said, "après nous, le déluge." Chavez benefited from high oil prices throughout his reign and died in 2013 just before the country's descent into depression began (Chart 8). He won his last election in 2012 by a margin of 10.8%, while Maduro, his hand-picked successor, won a special election only half a year later by a 1.5% margin, which was contested for all kinds of fraud (Chart 9). Chart 8A Hyperflationary Depression Thus Maduro has suffered from "inept successor" syndrome from the beginning, compounding the fears of the ruling United Socialist Party of Venezuela (PSUV) that the succession would be rocky. Maduro lacked both the political capital and the originality to launch orthodox economic reforms to address the country's mounting inflation and weak productivity, but instead doubled down on Chavez's rapid expansion of money and credit to lift domestic consumption (Chart 10).4 Chart 10Excessive Monetary And Credit Expansion Chart 11Exports Recovered, Reserves Did Not The economic collapse was well under way even before commodities pulled the rug out from under the government.5 Remarkably, the recovery in export revenue since 2010 did not occasion a recovery in foreign exchange reserves - these two decoupled, as Venezuela chewed through its reserves to finance its growing domestic costs (Chart 11). This means Venezuela's ability to recover even in the most optimistic oil scenarios is limited. Another sign that the economic break is irreversible is the fact that, since 2013, private consumption has fallen faster than oil output - a reversal of the populist model that boosted consumption (Chart 12). Chart 12Consumption Falls Faster Than Oil Output Chart 13Oil-Price Crash Hobbles Maduro Critically, the external environment turned against Maduro and PSUV as oil prices declined after June 2014. In November 2014 Saudi Arabia launched its market-share war against Iran and U.S. shale producers, expanding production into a looming global supply overbalance. Brent crude prices collapsed to $29/bbl by early 2016 (Chart 13). This pushed Venezuela over the brink.6 First, hyperinflation: Currency in circulation - already expanding excessively - has exploded upward since 2014. The 100 bolivar note has exploded in usage while notes of lower denominations have dropped out of usage. Total deposits in the banking system are growing at a pace of over 200%, narrow money (M1) at 140%, and consumer price index at 150% (see Chart 10 above). Real interest rates have plunged into an abyss, with devastating results for the financial system. The real effective exchange rate illustrates the annihilation of the currency's value. Monetary authorities have repeatedly devalued the official exchange rate of the bolivar against the dollar (Chart 14). However, the currency remains overvalued, which creates a huge gap between the official rate and the black market rate, which currently stands at about 5,400 bolivares to the dollar. Regime allies have access to hard USD, for which they charge high rents, and the rest suffer. Chart 14Official Forex Devaluations Chart 15Domestic Demand Collapses Second, the real economy has gone from depression to worse: Exports peaked in October 2008, nearly recovered in March 2012, and plummeted thereafter. Imports have fallen faster as domestic demand contracted (Chart 15). Venezuela must import almost everything and the currency collapse means staples are either unavailable or exorbitantly expensive. Venezuelan exports to China reached 20% of total exports in 2012 but have declined to about 14% (Chart 16). This means that Venezuela has lost a precious $10 billion per year. The state has also been trading oil output for loans from China, resulting in an ever higher share of shrinking oil output devoted to paying back the loans, leaving less and less exported production to bring in hard currency needed to pay for production, imports, and debt servicing. Both private and government consumption are shrinking, according to official statistics (Chart 17). Again, the consumption slump removes a key regime support. Chart 16Chinese Demand Is Limited Chart 17Public And Private Consumption Shrink Third, Venezuela is rapidly becoming insolvent: Venezuela's total public debt is high. It stood at 102% of GDP as of August 2014, and GDP has declined by 25%-plus since then. Total external debt, which becomes costlier to service as the currency depreciates, was about $139 billion, or 71% of GDP, in Q3 2015 (Chart 18). It has risen sharply ever since the fall in export revenues post-2011. The destruction of the currency by definition makes the foreign debt burden grow. Chart 18External Debt Soars... Chart 19...While Forex Reserves Dwindle The regime's hard currency reserves are rapidly drying up - they have fallen from nearly $30 billion in 2013 to just $10 billion today (Chart 19). Without hard cash, Venezuela will be unable to meet import costs and external debt payments. In Table 1, we assess the country's ability to make these payments at different oil-price and output levels. Assuming the YTD average Venezuelan crude price of $44/bbl, export revenue should hit about $32 billion this year, while imports should hover around $21 billion, leaving $11 billion for debt servicing costs of roughly $10 billion (combining the state's $8 billion with PDVSA's $2 billion). Thus if global oil prices hold up - as we think they will - the regime may be able to squeak by another year. In short, the regime could have about $11 billion in revenues left at the end of the year if the Venezuela oil basket hovers around $44/bbl and production remains at about 2 MMB/d. That is a "minimum cash" scenario for the regime this year, though it by no means guarantees regime survival amid the widespread economic distress of the population. Chart 20Foreign Asset Sales Will Continue If production drops to 1.25 MMb/d or lower as a result of the economic crisis - or if Venezuelan oil prices settle at $28/bbl or below - the regime will be unable to meet its import costs and debt payments. It will have to sell off more of its international assets as rapidly as it can (Chart 20), restrict imports further, and eventually default. Moreover, the calculation becomes much more negative for Venezuela if we assume, conservatively, $10 billion in capital outflows, which is far from unreasonable. Outflows could easily wipe out any small remainder of foreign reserves. So far, the government has chosen to deprive the populace of imports rather than default on external debt, wagering that the military and other state security forces can suppress domestic opposition for longer than the regime can survive under an international financial embargo. This strategy is fueling mass protests, riots, and clashes with the National Guard and Bolivarian colectivos (militias). An extension of the OPEC-Russia production cuts in late May, which we expect, will bring much-needed relief for Venezuela's budget. Thus, there is a clear path for regime survival through 2017 on a purely fiscal basis, though it is a highly precarious one - the reality is that the state is bound to default sooner or later. Moreover, the socio-political crisis has already spiraled far enough that a modest boost to oil prices this year will probably be too little, too late to save Maduro and the PSUV in its current form. As we discuss below, the question is only whether the military takes greater control to perpetuate the current regime, or the opposition is gradually allowed to take power and renovate the constitutional order. Bottom Line: Even if oil production holds up, and oil prices average above $44/bbl as we expect, the country's leaders will have to take extreme measures to avoid default. Domestic shortages and military-enforced rationing will compound. As economic contraction persists, social unrest will intensify. Will The Military Throw A Coup? Explosive popular discontent this year shows no sign of abating. It is a continuation of the mass protests and sporadic violence since the economic crisis fully erupted in 2014. However, as recession deepens - and food, fuel, and medicine shortages become even more widespread - unrest will spread to a broader geographic and demographic base. Protests since September 2016 have drawn numbers in the upper hundreds of thousands, possibly over a million on two occasions. Security forces have increasingly cracked down on civilians, raising the death toll and provoking a nasty feedback loop with protesters. Reports suggest that the poorest people - the Chavista base - are increasingly joining the protests, which is a new trend and bodes ill for the ruling party's survival. Already the public has turned against the United Socialist Party, as evinced by the December 2015 legislative election results and a range of public opinion polls, which show Maduro's support in the low-20% range. In the 2015 vote, the opposition defeated the Chavistas for the first time since 1998. The Democratic Unity Roundtable won a majority of the popular vote and a supermajority of the seats in the National Assembly. Since then, however, Maduro has used party-controlled civilian institutions like the Supreme Court and National Electoral Council - backed by the military and state security - to prevent the opposition's exercise of its newfound legislative power. Key signposts to watch will be whether Maduro is pressured into restoring the electoral calendar. The opposition has so far been denied local elections (supposedly rescheduled for later this year) and a popular referendum on recalling Maduro. So it has little reason to expect that the government will hold the October 2018 elections on time. The government is likely to keep delaying these votes because it knows it will lose them. In the meantime, the opposition has few choices other than protests and street tactics to try to pressure the government into allowing elections after all. Further, oil prices are low, so the regime is vulnerable, which means that the opposition has every incentive to step up the pressure now. If it waits, higher prices could give Maduro a new infusion of revenues and the ability to prolong his time in power. The question at this point is: will the military defect from the government? The military is the historical arbiter of power in the country. Maduro - who unlike Chavez does not hail from a military background - has only managed to make it this far by granting his top brass more power. Crucially, in July 2016, Maduro handed army chief Vladimir Padrino Lopez control over the country's critical transportation and distribution networks, including for food supplies. He has also carved out large tracts of land for a vast new mining venture, supposed to focus on gold, which the military will oversee and profit from.7 What this means is that the government and military are becoming more, not less, integrated at the moment. The army has a vested interest in the current regime. It is also internally coherent, as recent political science research shows, in the sense that the upper-most and lower-most ranks are devoted to Chavismo.8 Economic sanctions and human rights allegations from the U.S. and international community reinforce this point, making it so that officials have no future outside of the regime and therefore fight harder for the regime to survive.9 Still, there are fractures within the military that could get worse over time. Divisions within the ranks: An analysis of the Arab Spring shows that militaries that defected from the government (Egypt, Tunisia), or split up and made war on each other (Syria, Libya, Yemen), exhibited certain key divisions within their ranks.10 Looking at these variables, Venezuela's military lacks critical ethno-sectarian divisions, but does suffer from important differences between the military branches, between the army and the other state security forces, and between the ideological and socio-economic factions that are entirely devoted to Chavismo versus the rest. Thus, for example, it is possible that Bolivarian militias committing atrocities against unarmed civilians could eventually force the military to change its position to preserve its reputation.11 Popular opinion: Massive protests have approached 1 million people by some counts (of a population of 31 million) and have combined a range of elements within the society - not only young men or violent rebels/anarchists. Also, public opinion surveys suggest that supporters of Maduro have a more favorable view of the army, and opponents have a less favorable view.12 This implies that Maduro's extreme lack of popular support is a liability that will weigh on the military over time. Military funds shrinking: Because of the economic crisis, Maduro has been forced to slash military spending by a roughly estimated 56% over the past year (Chart 21). The military may eventually decide it needs to fix the economy in order to fix its budget. Autonomous military leader: That General Lopez has considerable autonomy is another variable that increases the risk of military defection or fracture. As the country slides out of control Lopez will likely intervene more often. He already did so recently when the Chavista-aligned Supreme Court tried to usurp the National Assembly's legislative function. The attorney general, Luisa Ortega Diaz, broke with party norms by criticizing the court's ruling. Maduro was forced to order the court to reverse it, at least nominally restoring the National Assembly's authority. Lopez supposedly had encouraged Maduro to backtrack in this way, contrary to the advice of two notable Chavistas, Diosdado Cabello and Vice President Tareck El Aissami. Ultimately, military rule for extended periods is common in Venezuelan history. Chavez always deeply integrated the party and military leadership, so the regime could persist through greater military assertion within it, or the military could take over and initiate topical political changes. Finally, if Lopez is ready to stage a coup, he may still wait for oil prices to recover. It makes more sense to let the already discredited ruling party suffer the public consequences of the recession than to seize power when the country is in shambles. Previous coup attempts have occurred not only when oil prices were bottoming but also when they bounded back after bottoming (Chart 22). It would appear that the Venezuelan military is as good at forecasting oil prices as any Wall Street analyst! For oil markets, the military's strong grip over the country suggests that even if Maduro and the PSUV collapse, the party loyalists at PDVSA may not have the option of going on strike. The military will still need the petro dollars to stay in power, and it will have the guns to insist that production keeps up, as long as economic destitution does not force operations to a halt. Bottom Line: There is a high probability that the military will expand its overt control over the country. As long as the leaders avoid fundamental economic reforms, the result of any full-out military coup against Maduro may just mean more of the same, which would be politically and economically unsustainable. Chart 22Coups Can Come After Oil Price Recovers Chart 23Stay Short Venezuelan Sovereign Bonds Investment Implications Any rebound in oil prices as a result of an extension of OPEC's and Russia's production cuts at the OPEC meeting on May 25 will be "too little, too late" in terms of saving Maduro and the PSUV. They may be able to play for time, but their legitimacy has been destroyed - they will only survive as long as the military sustains them. To a great extent, the ruling party has already handed the keys over to the military, and military rule can persist for some time. Hence oil production is more likely to continue its slow decline than experience a sudden shutdown, at least this year. This is because it is likely that military control will tighten, not diminish, when Maduro falls. Incidentally, the military is also more capable than the current weak civilian government of forcing through wrenching policy adjustments that are necessary to begin the process of normalizing economic policy - such as floating the currency and cutting public spending. But any such process would bring even more economic pain and unrest in the short term, and it has not begun yet. Even if the ruling party avoids defaulting on government debts this year - which is possible given our budget calculations - it is on the path to default before long. We remain short Venezuelan 10-year sovereign bonds versus emerging market peers. This trade is down 330 basis points since initiation in June 2015, but Venezuelan bonds have rolled over and the outlook is dim (Chart 23). Within the oil markets, our base case is that global oil producers have benefitted and will benefit from the marginally higher prices derived from Venezuela's slow production deterioration. Should a more sudden and severe production collapse occur, the upward price response would be much more acute. A sustained outage of Venezuelan production would send oil prices quickly towards $80-$100/bbl as a necessary price signal to curb demand growth, creating a meaningful recessionary force around the globe. Oil producers, specifically U.S. shale producers that can react quickly to these price signals, would stand to benefit temporarily from the higher prices, but would again suffer from falling oil prices in the inevitable post-crisis denouement. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com 1 For the military takeover, please see "Venezuelan Debt: The Rally Is Late," in BCA Emerging Markets Strategy, "EM: From Liquidity To Growth?" dated August 24, 2016, available at ems.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "The Energy Spring," dated December 10, 2014, available at gps.bcaresearch.com; BCA Commodity and Energy Strategy Weekly Report, "Tactical Focus Again Required In 2017," dated January 5, 2017, available at ces.bcaresearch.com; and Energy Sector Strategy Weekly Report, "The Other Guys In The Oil Market," dated April 5, 2017, available at nrg.bcaresearch.com. 4 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Venezuelan Chavismo: Life After Death," dated April 2, 2013, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy, "Strategic Outlook 2013," dated January 16, 2013, and Monthly Report, "The Reflation Era," dated December 10, 2014, available at gps.bcaresearch.com. 6 Please see BCA Emerging Markets Strategy Weekly Report, "Assessing Political And Financial Landscapes In Argentina, Venezuela And Brazil," dated January 6, 2016, available at ems.bcaresearch.com. 7 For Lopez's taking control, please see "Venezuelan Debt: The Rally Is Late" in BCA Emerging Markets Strategy Weekly Report, "EM: From Liquidity To Growth?" dated August 24, 2016, available at ems.bcaresearch.com. For the gold mine, please see Edgardo Lander, "The Implosion of Venezuela's Rentier State," Transnational Institute, New Politics Papers 1, September 2016, available at www.tni.org. 8 The junior officers have advanced through special military schools set up by Chavez, while the senior officials have been carefully selected over the years for their loyalty and ideological purity. Please see Brian Fonseca, John Polga-Hecimovich, and Harold A. Trinkunas, "Venezuelan Military Culture," FIU-USSOUTHCOM Military Culture Series, May 2016, available at www.johnpolga.com. 9 Please see David Smilde, "Venezuela: Options for U.S. Policy," Testimony before the United States Senate Committee on Foreign Relations, March 2, 2017, available at www.foreign.senate.gov. 10 Please see Timothy Hazen, "Defect Or Defend? Explaining Military Responses During The Arab Uprisings," doctoral dissertation, Loyola University Chicago, December 2016, available at ecommons.luc.edu. 11 Civilian deaths caused by the National Guard and Chavez's loyalist militias triggered the aborted 2002 military coup. Please see Steven Barracca, "Military coups in the post-cold war era: Pakistan, Ecuador and Venezuela," Third World Quarterly 28: 1 (2007), pp. 137-54. 12 See footnote 8 above.

Highlights Impeachment is a political, not legal, process; The House of Representatives decides what is impeachable; The Senate is judge, jury, and executioner; Democrats will impeach Trump if they take the House in 2018; Republicans will not impeach, unless there is a "smoking gun." Markets will look through impeachment risks to tax cuts, for now. Feature "An impeachable offense is whatever a majority of the House of Representatives considers it to be at a given moment in history; conviction results from whatever offense or offenses two-thirds of the other body considers to be sufficiently serious to require removal of the accused from office." - Representative Gerald Ford, April 15, 1970 Chart 1Trump's Support Abysmal Since the election of President Donald Trump we have been inundated with client questions regarding the probability of impeachment. We have hesitated to put our thoughts on paper due to the fact that the House of Representatives plays a crucial role in impeachment proceedings and that the Republican Party enjoys a comfortable 21-seat majority in that legislative chamber. Since the election, however, President Trump has continued to confound supporters and critics alike with controversial moves. His firing of FBI Director James Comey, reportedly without consulting any of his political advisors, is the latest in a string of unorthodox decisions. Leaks and accusations are swirling in the aftermath. In addition, his overall approval numbers continue to languish at historically abysmal levels for the start of a presidency (Chart 1), which portends a tough midterm election for the Republican Party in the House of Representatives (Chart 2). The American political context remains as polarized as ever, with the quantitative measure of ideological polarization at a record high (Chart 3).1 This dataset treats the North-South division of the Civil War differently from ideological polarization; the current level of ideological polarization is the highest since the post-Civil War period. In this environment, we suspect that, were the Democrats to win a majority in the House of Representatives, the probability of impeachment would be very high. Trump would have to hope that Republican Senators have his back, which at that point is by no means a foregone conclusion.2 Chart 2Republicans Heading For Huge Defeat In 2018 Chart 3Record-High Polarization In U.S. Politics According To Key Quantitative Measure We will not get into the "merits" of a case against President Trump. It suffices to repeat Gerald Ford's quip from the top of this report: "an impeachable offense is whatever a majority of the House of Representatives considers it to be." Given the vitriol and polarization of American politics at the moment, we therefore suspect that impeachment will almost certainly occur if the House falls to the Democrats. Otherwise, for the Republicans to impeach one of their own, even one as loosely allied with the GOP as Trump, would require "smoking gun" evidence of the president's direct hand in a grave scandal. A Guide To Impeaching The President Article II, Section 4 of the Constitution says, "the President, Vice President and all Civil Officers of the United States, shall be removed from Office on Impeachment for, and Conviction of, Treason, Bribery, or other high Crimes and Misdemeanors." This is a low bar for impeachment, not a high bar. "Misdemeanors" is a slippery term and the House of Representatives determines what it means. There is no appeals process and no interjection by the Supreme Court. The most important point about the U.S. impeachment process is that the "House decides." Decides what? Everything. Hence impeachment proceedings can be started by the House for whatever crime the legislative body deems worthy of impeachment proceedings. Once the House approves the "articles of impeachment," the Senate must hold a trial and vote on whether to remove the president from office by a two-thirds majority (67 votes). Historically the first presidential impeachment was that of President Andrew Johnson, who assumed the presidency following the assassination of President Lincoln in 1865. Johnson was a Democrat who ran with Republican President Lincoln on a National Union ticket. Johnson was impeached on the grounds that he violated the Tenure of Office Act (which is no longer applicable) by firing his Secretary of War Edwin Stanton. But the real political backdrop to the proceeding was that Johnson, a Southern Democrat, favored quick restoration of state rights to the rebellious South and was firing members of the Lincoln cabinet whom he deemed too abolitionist. Johnson was ultimately acquitted in the Senate by just one vote. President Bill Clinton was the second U.S. president to be impeached, with the GOP-held House of Representatives largely voting along party lines on the two articles of impeachment: perjury and obstruction of justice. The Senate failed to get the 67 votes required for conviction, with Republican Senators from the Northeast (Rhode Island, Maine, and Vermont) and Pennsylvania siding with the Democrats. Both the Johnson and Clinton impeachment were more about the deeply polarized environment in Washington and the country at large than about actual crimes. Only the impeachment proceedings initiated against President Nixon provide a clear example of high crimes and misdemeanors. However, President Nixon was never actually impeached as he resigned before the House of Representatives could consider the articles of impeachment against him. He had been warned he would not survive, given the "smoking gun" evidence of his direct personal involvement in the Watergate break-in scandal, and he did not want to be the first president to be removed from office. Thus, as far as a U.S. president is concerned, the House of Representatives is the accuser and the Senate is the judge, jury, and the executioner. Because the bar for adopting impeachment articles in the House is so low (simple majority), we are almost certain that a Democratic-held House would find a reason to impeach President Trump. Whether the Senate then removes President Trump would depend on the severity of his alleged crimes, which we have no way to assess at this point in time. One crucial point to note - particularly in the case of President Trump - is that the House of Representatives can vote on articles of impeachment that deal with alleged crimes committed prior to coming to the office. Again, the Supreme Court has ruled that the House decides and there is no appeals process.3 Therefore, if the House decides that the president can be impeached for alleged crimes and misdemeanors committed before or outside of his office, then he can. Bottom Line: Impeachment is an intrinsically political process. As such, the legal merits of the accusations matter less than the political context in which the House considers impeaching the president. Given the historically high level of political polarization in the U.S., the extremely low levels of Trump's popularity, and his unorthodox policymaking process, we expect that there is a high probability that a Democratic-held House would impeach President Trump on some grounds. Whether President Trump would then be removed from office would depend on whether the accusations of the House of Representatives have sufficient merit - both in terms of the weight of the crimes and the political interests - for Senate Republicans to abandon the president. A Guide To A Constitutional Coup D'état Intriguingly, the U.S. Constitution provides for a procedure by which the president can be removed from office even without an impeachment process.4 The 25th Amendment, passed following the assassination of President John F. Kennedy, gives the Vice President and the Cabinet the authority to remove the president from power. Section 4 of Article 25 states: Whenever the Vice President and a majority of either the principal officers of the executive departments [Cabinet members] or of such other body as Congress may by law provide, transmit to the President pro tempore of the Senate and the Speaker of the House of Representatives their written declaration that the President is unable to discharge the powers and duties of his office, the Vice President shall immediately assume the powers and duties of the office as Acting President. If the above paragraph sounds like a constitutional coup d'état, that is because it is one. If the president challenges the argument that he is "unable to discharge the powers and duties of his office," then the issue goes before Congress, where it would require two-thirds of each legislative body to vote to remove the president. As such, the 25th Amendment has a higher hurdle than the impeachment process in Congress, but it could be a quicker way to remove a sitting president who is incapacitated for health reasons, becomes mentally unstable, or broadly-speaking loses touch with reality.5 Chart 4GOP Not Yet Willing To Impeach Trump In the case of President Trump, this process would require a complete loss of confidence in his leadership by Vice President Pence, the Cabinet, and Republican members of Congress. Given Trump's high level of support with Republican voters (Chart 4), we are nowhere close to the risk of the 25th Amendment being invoked. However, if Trump's popularity declines precipitously, his own Cabinet has the ability to eject him from the Oval Office without any accusation of legal misconduct. Presumably Trump would have taken concrete action that proved plainly detrimental to the national interest in order to set this process in motion - at which point any number of earlier erratic behaviors or statements could come into play against him. Bottom Line: Impeachment is not the only process by which a sitting U.S. president can be removed from office. Article 25 of the Constitution, Section 4, offers a constitutional coup d'état process that avoids the messiness of a Senate trial. However, the legislative hurdle for this procedure is even higher than the impeachment process. As such, it would require Donald Trump to completely lose the faith of Republican voters and legislators. Signposts To Impeachment We do not intend to prosecute claims against President Trump in this or any future report. First, we are not legal experts. Second, we do not have access to full information. Third, as we pointed out above, the impeachment process is a highly political process. As such, key triggers are political, and only minimally criminal. First, either Democrats win the House of Representatives, or GOP voters turn against President Trump in large numbers. As such, investors should keep close attention to Chart 4 data, at least until the midterm elections. Second, President Trump has to lose the confidence of Republican legislators, particularly in the Senate. Nonetheless, there are several other, more specific, issues we will watch carefully. Special investigation: In both Nixon's and Clinton's scandals, a special committee investigated executive wrongdoing. In Nixon's case this was the Senate Watergate Committee; in Clinton's case it was the special investigation led by independent counsel Kenneth Starr. Starr's investigation initially focused on the suicide of deputy White House counsel Vince Foster and the Whitewater real estate investments by Bill Clinton. But the trail led elsewhere. Ultimately, the "Starr Report" alleged that Clinton lied under oath regarding his extramarital affair with Monica Lewinsky. Why it matters today? The precedent of special investigations and committees is strong in American politics. It will be difficult for President Trump to deny the public a special investigation of his campaign team's dealing with Russian officials. The Clinton example illustrates the danger of such investigations: what began as an investigation into a suspicious real estate deal concluded with perjury accusations on a completely unrelated matter. In other words, once independent investigators start digging, there is no telling what skeletons they will exhume. Subpoenas: Congressional committees investigating impropriety can subpoena individuals or physical evidence to appear before the committee. Such subpoenas can reveal potential crimes and misconduct only tangentially related to the original investigation. The Watergate Tapes were critical to the eventual resignation of President Nixon. The White House challenged their subpoena, but the Supreme Court ruled in U.S. vs. Nixon, July 1974, that executive privilege did not allow President Nixon to deny the release of the tapes. Why it matters today? Currently, the Senate Intelligence Committee is investigating Russian interference in the 2016 election and has issued a subpoena to former National Security Adviser Michael Flynn for documents regarding his interactions with Russian officials. President Trump will not be able to claim ignorance if sufficient members of his inner circle are found to have colluded with a foreign power. It didn't work for President Nixon. Furthermore, it should worry President Trump that three Republicans on the Senate Intelligence Committee are either former GOP primary opponents (Marco Rubio of Florida) or vocal critics (Susan Collins of Maine and Tom Cotton of Arkansas). Law enforcement: The President, as the head of the executive and as the attorney general's direct superior, is in charge of all U.S. federal law enforcement agencies. He therefore has the constitutional prerogative of summarily firing various members of the Justice Department and law enforcement agencies. However, this does not mean that those same agencies will stay loyal and not collude with the opposition or the press to undermine the president's authority. In the Watergate scandal, Associate Director of the FBI, Mark Felt, was the "Deep Throat" source that fed Washington Post journalists Bob Woodward and Carl Bernstein the information that ultimately led to President Nixon to resign. Felt's actions were by no means selfless. Why it matters today? President Trump has fired FBI Director James Comey under unorthodox circumstances. While the official reason is that Comey mishandled the investigation into Secretary Hillary Clinton's email scandal, sources close to Comey (read: Comey) argue that it was because the FBI Director wanted to expand the agency's investigation into Russian interference in the U.S. election. Trump also seems to have feared that Comey was after him personally. Given the penchant of U.S. intelligence agencies to leak embarrassing information on members of Trump's inner circle - e.g. the transcript of Flynn's conversation with Russian Ambassador Sergey Kislyak - we assume that members of the FBI who remain loyal to Comey could leak further information. In other words, President Trump has from the beginning of his presidency made powerful enemies in U.S. law enforcement agencies. If there is any evidence of wrongdoing on any front, we suspect that it will leak. Bottom Line: Once congressional committees begin investigating, subpoenaing documents and witnesses, there is no telling where or how the process ends. What begins as an investigation into Russian interference in the U.S. election can end up somewhere completely different. Given that the Senate Intelligence Committee is already holding investigations and that President Trump has made powerful enemies in the U.S. law enforcement and intelligence community, we have to accept that there is a high probability that the investigations into impropriety expand. Whether they expand to the point of causing the impeachment preconditions listed above is anyone's guess at this point. Investment Implications Of Impeachment Given the small number of cases, it is difficult to rely on historical precedents to make broader conclusions on how the market would react to impeachment or severe political scandal in the White House. Chart 5 looks at market performance during the Teapot Dome Scandal (April 1922 to October 1927), Watergate (February 1973 to August 1974), and President Clinton's Lewinsky Affair (January 1998 to February 1999). Of the three, Teapot Dome did not result in impeachment proceedings, but only because President Harding died in office in 1923 - and neither his death nor the unfolding scandal prevented the stock market from "roaring" through the mid-1920s.6 Chart 5AEquities Amid Three U.S. Scandals Chart 5BVolatility Amid Three U.S. Scandals The market reaction to the Lewinsky Affair was also highly muted. Like Teapot Dome, it occurred amidst one of the greatest bull markets in U.S. history. Of course, U.S. equities did fall 19% mid-way through the Clinton impeachment process. Watergate appears to have affected both equity markets and volatility. The S&P 500 fell 39% from February 7, 1973 - when the Senate established a select committee to investigate Watergate - to Nixon's resignation on August 9, 1974. That said, the scandal alone did not cause the correction, but rather it was a combination of factors, including the second devaluation of the dollar, rapid increases in price inflation, and a massive insurance fraud. Writing in the summer of 1973, BCA's own Tony Boeckh remarked that a speculative, "Watergate-inspired," attack on the dollar further contributed to a short-term capital outflow, but that the macro-fundamentals of the economy would ultimately persevere: Particularly in recent weeks, the Watergate affair has had an effect on the market much like a slow presidential assassination might... The Watergate affair, while primarily of psychological importance in the short run, clearly has had the effect of sustaining the weakness in the dollar and adding greatly to an already deeply negative psychology. If one can see these basic factors as temporary, then the whipsaw possibilities are obvious.7 Tony's analysis ultimately proved prescient, with stocks rallying briskly from Nixon's resignation in August 1974 and throughout 1975. What would happen this time around? If scandals surrounding Russian interference in the election grow over the next several months, the market may begin to price in a loss of the House in November 2018, which would obviously stall Trump's populist, "pump-priming" agenda. We think that the market could fret if the scandals worsen for three main reasons: Legislative agenda - An embattled White House would be a distracted White House. It is difficult to see how the White House could provide leadership on health and tax reform. The seriousness of the alleged crimes - President Clinton was impeached for having an extra-marital workplace affair and lying about it. If the Russian electoral interference charges stick, the Trump administration would be essentially accused of treason. The White House lashes out - An embattled President Trump could shift gears from domestic to foreign policy, as he faces few constitutional constraints on the latter. President Clinton faced off against Serbian strongman Slobodan Milosevic mid-way through the impeachment process, finally ordering NATO air strikes on the heels of his acquittal by the Senate. President Trump could shift his focus on North Korea, Iran, or "unfair" trading partners. Despite good reasons to worry that impeachment will become a possibility after the midterm elections, we think the market will continue to focus on the prospects for tax reform. And on that front, it is highly unlikely that a growing scandal in the Trump administration would matter. Provided, of course, that there is not some material evidence that accelerates the crisis and forces even a GOP-controlled House to focus on impeachment instead of tax reform. We would therefore largely look through the risks of impeachment - as our predecessors at BCA did amidst the Watergate scandal - at least until the months before November 6, 2018 (midterm election date). In particular, there are three main reasons to fade any near-term equity market volatility: President Mike Pence - Under both impeachment rules and the 25th amendment, the U.S. president would be replaced by the Vice President. Vice President Pence's approval rating largely tracks that of President Trump and is in the 40% area, but investors should note that he once stood at nearly 60% during the campaign (Chart 6). As such, the worst case scenario for investors in case of a post-midterm impeachment is that Trump is replaced by Mike Pence, an orthodox Republican, and that Pence has to deal with a split Congress. It would grind reforms to a halt, but at least tax reform would be out of the way by then. Given the market's focus on tax reforms, it is difficult to see why this tail-risk would have to be priced in over the next 12 months. Midterm Election - If the Trump White House becomes engulfed in scandal, Republicans in the House will fear losing their majority. Yes, the partisan drawing of electoral districts - "gerrymandering" - has reduced the number of competitive U.S. House districts from 164 in 1998 to 56 in 2016 (Chart 7). But the Democrats managed to win the House in 2006 and the Republicans managed to take it back in 2010, so there is no reason the roles cannot be reversed yet again. However, this is not a risk, it is an opportunity. It will motivate the GOP in Congress to lock in tax and healthcare reform well ahead of the midterm elections. Given that they plan to use a FY2018 budget reconciliation bill to pass tax reform, it means that passage by April or May of 2018 is highly likely. Then they can campaign all summer on how they kept their promises to give tax relief and create jobs. Counter Revolution - With Trump embattled and facing impeachment, the market may give a sigh of relief because it would mark a clear defeat of populist politics in the U.S. Much as with electoral outcomes in Europe, investors may want to cheer the defeat of an unorthodox, anti-establishment movement in the U.S.8 Chart 6Could Be Worse Than Pence Chart 7Gerrymandering Reduces ##br##Competitive House Seats As such, we would push against any "Russia scandal"-induced volatility in the U.S. markets, at least until the midterm election. We think the market would digest the volatility and realize that Trump's impeachment, were it to occur post-midterm elections, would not arrest the Republican agenda before the midterms. After all, the GOP has waited over 15 years to make Bush-era tax cuts permanent and the opportunity to do so may evaporate within the next 12 months. The one risk we do not account for here is that a "smoking gun" of Trump campaign collusion with Russia is unearthed well before the midterm election. This could force the GOP in the House to focus on impeachment instead of tax reforms. We do not expect this to happen, but we also have no evidence to support our view. At this point, however, there is absolutely no proof that the Trump campaign colluded with Russia. Do we agree that Trump's impeachment would signal the end of populism? No. As our colleague Peter Berezin has repeatedly said - and our clients ought to listen given that he correctly predicted Trump's victory in September 20159 - American voters voted for "Trumpism," not Trump. As Peter recently pointed out, "either Trump will start delivering on the promises that endeared him to blue-collar workers in states such as Ohio and Pennsylvania, or he will go down in flames in the next election."10 Of course, if Trump "goes down in flames" in an impeachment scenario, Peter's point about blue-collar workers still stands. The next election, in 2020, will still feature populism, especially if the U.S. experiences a recession in the meantime and if Trump's policies do not help the median voter by that time. In that case, the election in 2020 will not feature moderates such as Pence, but rather unorthodox policymakers from both the left and the right. We intend to publish a report on populism in America over the next several weeks and elucidate our pessimistic view of politics, the economy, and the markets after 2017. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 The data for polarization analysis uses "nominate" (nominal three-step estimation), a multidimensional scaling method developed to analyze the preference and choice of legislators based on their roll-call voting record in the U.S. Congress. According to empirical work by political scientists Keith Poole and Howard Rosenthal, polarization in Congress is at its highest level ever. Their research shows that the "primary dimension of polarization," the liberal-conservative spectrum on the basic role of the government in the economy, explains approximately 93% of all roll-call voting choices and that the two parties are drifting further apart on this crucial dimension. Please see Poole, Keith T. and Howard Rosenthal, "D-Nominate After 10 Years: A Comparative Update To Congress: A Political-Economic History Of Roll-Call Voting," Legislative Studies Quarterly, Vol. 26 No. 1 (Feb. 2001), pp. 5-29. 2 Especially when one considers that President Trump's fate may at some point in the near future be in the hands of Senators "Lyin' Ted" and "Little Marco." 3 Please see Nixon v. United States, 506 U.S. 224 (1993), a United States Supreme Court decision that upheld the jurisdiction of the Senate in the impeachment proceedings and confirmed that no judicial appeals process exists. As a side point, the case had nothing to do with former President Richard Nixon, but rather was brought against the Chief Judge for the United States District Court for the Southern District of Mississippi, Walter Nixon. 4 We thank our former colleague, and expert on the U.S. Constitution, Mike Marchio for pointing out this loophole. 5 The only time the Section 4 of the 25th Amendment was seriously contemplated was in 1987, due to President Ronald Reagan's growing "inattentiveness" and "laziness" (probably early signs of Alzheimer disease). Incoming Chief of Staff Howard H. Baker Jr. was asked by his predecessor Donald Regan to carefully examine whether President Reagan was capable of performing his duties. President Reagan passed the test. Please see Jason Linkins, Huffington Post, "Happy 50th Birthday To The 25th Amendment To The Constitution!" dated February 10, 2017, available at huffingtonpost.com. 6 "Teapot Dome" was for decades the largest corruption scandal in U.S. history. It involved President Warren G. Harding, his Secretary of the Interior, other officials, and a number of oil companies that were given extremely favorable leases to drill oil on federal land in Wyoming. Investigations and prosecutions lasted through 1927. 7 Please see The Bank Credit Analyst, "Stock Market And Business Forecast," June 1973 - Vol. XXIV No.12 and July 1973 - Vol. XXV No. 1, copies available on request. 8 Please see BCA Geopolitical Strategy Weekly Report, "Stick To The Macro(n) Picture," dated May 10, 2017, available at gps.bcaresearch.com. 9 Please see BCA Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," dated September 4, 2015, available at gis.bcaresearch.com. 10 Please see BCA Global Investment Strategy Weekly Report, "The Establishment Strikes Back," dated April 28, 2017, available at gis.bcaresearch.com.

Highlights Markets will survive late spring and summer unscathed; Macron will win the French election; Trump's agenda is not going down in flames; U.K. snap polls support our sanguine view on Brexit; Fade the rally in Treasuries and bet against unwinding of Trump reflation; Stay tactically long EUR/USD, long the pound, and long French industrials vs. German. Feature One of the oldest adages of Wall Street is to "sell in May and go away." Data reinforce the conventional wisdom, with a strategy of staying on the sidelines during the summer months clearly outperforming the alternative of staying long every month (Chart 1). Chart 1Sell In May And Go Away Should investors adopt the same approach in 2017? Certainly the risks are skewed to the downside due to investor complacency and a busy political schedule: Complacency: Investor complacency has been spectacularly elevated ahead of Q2 this year. Our colleague Anastasios Avgeriou of BCA's Global Alpha Sector Strategy, who has been flagging warning signs since early February, lists four measures of complacency that peaked in April (Chart 2).1 The SKEW index, controlled for by the VIX, rose above 12 early in April, warning that at least a tactical pullback is at hand. The Yale U.S. one year institutional confidence index hit an all-time high of 98.68% in February. Similarly, the Minneapolis Fed's market-based probability of a 20%+ correction in the S&P 500 dropped to below 10%, a level last seen during the peak of the previous bull market in 2007 (bottom panel).2 Political Schedule: April and May have an unusually high number of high-profile deadlines, meetings, and elections packed into a tight space: April 26: U.S. President Donald Trump is expected to announce key details of his long-awaited tax reform plan; April 28: The U.S. government's stopgap funding measure, the continuing resolution, will expire - leading to a government shutdown if no replacement is passed; April 29: The EU Council will hold its "Brexit Summit" to either approve, amend, or reject Council President Donald Tusk's proposed negotiation guidelines;3 May 7: The second round of the French presidential election will be held; May 9: An extraordinary presidential election will take place in South Korea; Mid-May: U.S. President Donald Trump will present his full budget proposal, including tax plans, spending cuts, and growth projections; May 19: Iran holds its presidential election; May 25: The OPEC meeting in Vienna will determine whether to extend the current production-cut agreement. In this Weekly Report, we focus on the three most immediate risks to the markets: the second-round of French presidential election, U.S. domestic politics, and the upcoming election in the U.K. We will also address downside risk to oil prices in an upcoming joint report, to publish tomorrow, with BCA's Commodity & Energy Strategy. Our conclusion is that while risks are indeed skewed to the downside by the mere combination of investor complacency and volume of potential tail-risks, the market will likely emerge from the summer doldrums unscathed. As such, any market downturns are an opportunity to buy on dips. As we recently warned, however, the real risks will emerge in 2018.4 France: Fin? Centrist Emmanuel Macron has won the first round of the French presidential election with a narrow victory over nationalist Marine Le Pen (Table 1). As expected, the two will now contest the second round on May 7. France will subsequently hold a two-round legislative election on June 11 and 18. Chart 2Complacency At A Peak Table 1France: First-Round Election Results Investors learned three things from the first round of the French presidential election: Polls are right: Repeat after us: polls are not wrong, pundits are.5 Neither the Brexit referendum nor the U.S. presidential election came as a huge surprise to those who read polls objectively. In both cases, the outcome was inside the margin of error. Hopefully, the first round of the French presidential election will set aside the notion that all polls are useless and therefore investors are better off interpreting chicken entrails for election forecasting. In fact, polls in France have not significantly underestimated Marine Le Pen's nationalist party - Front National - since the 2002 election (Chart 3). Le Pen has no momentum: Le Pen consistently polled in the high 20s throughout late 2016 and 2017, but ended with only 21.43% of the vote on April 23 (Chart 4). In fact, she only narrowly improved on her 2012 performance of 17.9%, which is astounding considering everything that has happened in France since then (terrorist attacks in particular). Macron has meanwhile nearly doubled his polling from late 2016. French voters are angry: Protest and anti-establishment candidates came away with 49.62% of the vote (Chart 5). Chart 3FN Rarely Outperforms Its Polling Chart 4Le Pen's Momentum Is Gone Chart 5French Voters Are Angry... What to make of these three lessons? First, if lessons A and B are correct, then Le Pen is toast on May 7 (Chart 6).6 According to a poll conducted from April 17 to 21, Le Pen will struggle to get any voters from Mélenchon and Socialist candidate Benoît Hamon (Chart 7). This should not be surprising to anyone who knows France and its history: the left and the right just do not get along. We construct a "Le Pen best case scenario" out of the data by giving her all the voters who said they would abstain in the second round. Let's say that they were lying and are secret Le Pen supporters. She still loses (Chart 8)! Chart 6...But Not That Angry Chart 7Most Voters Will Swing To Macron Chart 8The No-Shows Can't Win It For Le Pen But surely a major terrorist attack could turn it around for Le Pen, right? Wrong. Macron is not pro-terrorist. Why would the French turn to a Russian-financed nationalist with no clear plan on how to prevent terrorism or stop refugee flows into Europe other than to close French borders?7 (And that description is not fake news!)8 They wouldn't. And there is empirical evidence to prove that French voters see through Le Pen's empty rhetoric. We highly recommend our clients read our February report titled "The French Revolution" where we conducted a careful study of the 2015 December regional elections.9 These elections occurred only 23 days following the November 2015 terrorist attacks in Paris and at the height of that year's migration crisis. It was as if the fates conspired with Le Pen's Front National (FN) to create a perfect storm. And yet the election was a crushing loss for the nationalists who came away with nothing in the second round. Chart 9French Public Supports The EU And Euro But hold on a minute. Are the French really about to elect a former investment banker for president even though 50% of them are "angry," as suggested by our lesson C? Well, yes. The "anger" is complicated. Mélenchon received a lot of the disgruntled Socialist Party voters who jumped the Hamon ship after it sunk during the latter's woefully uninspiring debate performances. These are not hard-core Euroskeptic voters. In fact, both Mélenchon and Le Pen moderated their Euroskepticism in the run up to this election to broaden their base of support. Le Pen promised that she would abide by the results of a referendum on the EU even if it went against her will, as polls currently suggest it would (Chart 9). And Mélenchon suggested that exiting the EU would only be his "Plan B," in case his plan to renegotiate the Treaty of the EU failed. What should investors expect of a Macron presidency? While the "French Thatcherite" François Fillon may have been more welcome to the markets than Macron, we think that a combination of President Macron and right-leaning National Assembly could accomplish some reforms. Polling for the legislative elections in June is scarce, but Le Pen's party is highly unlikely to outperform Le Pen herself. Judging by the December 2015 regional elections and Fillon's pre-scandal polling, the center-right Les Républicains are likely to win at least a plurality of seats in the legislative elections. Several prominent center right figures have already come out in support of Macron, perhaps to throw their name in the ring for the next prime minister.10 This is highly positive for the markets as it means that French economic policy will be run by the center right, with an ultra-Europhile as president. Bottom Line: Nothing is over until it is over. Le Pen obviously still has a chance to win given that she is one of the two people running in the French election. However, given current polling, Macron is highly likely to become the next president of France. Hold tactical long EUR/USD and strategic long French industrial equities / short German industrial equities. But start thinking about closing long euro positions. The U.S.: From Math To Magic There are three reasons for global investors to worry about U.S. politics at the moment: Government shutdown: The U.S. government will face a shutdown on April 28 if the continuing resolution (CR) is not extended (via another CR) or if an omnibus funding bill is not passed. The risk for investors is that Senate Democrats could filibuster an omnibus bill that contains a conservative "poison pill" such as funding the wall on the border with Mexico or defunding Planned Parenthood. This would result in a partial government shutdown. Our view is that there is no time to find a long-term solution and the Republicans will have to extend current spending levels via short-term CRs, possibly until the end of the fiscal year on October 1. Given that the government has already been funded for half of the current fiscal year via short-term CRs, it may be the only way that Republicans can avoid a showdown with Democrats in the Senate. Obamacare repeal and replacement: The Senate and the House passed a budget resolution on January 13 that included "reconciliation instructions" allowing for the repeal of Obamacare in an eventual reconciliation bill.11 The reconciliation procedure allows measures that impact government spending and revenue - budgetary matters - to pass through Congress with a simple majority, i.e. without the need for 60 votes to defeat a filibuster in the Senate.12 These instructions are believed to "expire" at the end of May or thereabouts, giving Republicans one more month to replace Obamacare without causing greater traffic jams down the road.13 There are two hurdles to this process. First, the Tea Party-linked "Freedom Caucus" opposed the original Obamacare proposal and needs to be placated with provisions that may put off centrist Republicans in the Senate. Second, both the original Paul Ryan plan and the soon-to-be-revealed alternative are likely to be challenged by the Democrats under the reconciliation rules.14 Trump at first appeared willing to walk away from repealing Obamacare - which seemed to make sense given that the bill he endorsed imposes a roughly $700 billion burden on U.S. households (Chart 10). However, he has since decided that he needs the bill's roughly $320 billion in savings over ten years in order to pay for the "hyuge" tax cuts he has promised.15 Tax reform: Also coming into focus in April and May is tax reform. The White House is set to release key tax-reform details as we go to publication. Further, Trump has to deliver his full FY2018 budget in mid-May. Unlike the budget Trump released in mid-March, the May edition will include the tax proposals, measures on "mandatory" or entitlement spending, and growth projections. Concurrently, Congress has to start working on its budget resolution for FY2018, which, as mentioned, will enable using reconciliation to pass the tax bill with a mere 51 votes in the Senate. Again, the Freedom Caucus is a potential hurdle. Investors fear they will demand that any tax bill be strictly revenue neutral and thus foul up the legislative process. Chart 10Obamacare Repeal Hits Households Confused yet? You are not alone! We have noticed from client meetings and the financial media a growing obsession with details of upcoming reforms and the arcane congressional rules that will govern the legislative process. This is a mistake. Investors should step back and focus on the big picture: Trump is an economic populist who wants to see a higher rate of nominal GDP growth; Republicans are a party that favors tax cuts; Legislative rules are meant to be broken. As such, the key question is whether President Trump can bend the will of the Freedom Caucus, which plays the role of the antagonist in his efforts to clear all three hurdles listed above. We have no reason to believe that he cannot. In fact, all signs are pointing to the Freedom Caucus playing ball with the White House: Rhetoric has changed: Mark Meadows (R- North Carolina), Chairman of the Freedom Caucus, has confirmed that he is not demanding revenue-neutral tax reform plan and that he is open to a compromise on Obamacare. The Freedom Caucus is reportedly getting closer to accepting a health-care bill that passes the deadly issues to the states, allowing state legislatures to make their own decision on whether to remove the most popular regulatory requirements of Obamacare. Politically, this is a brilliant move. It allows both the Tea Party and moderate Republicans to declare victory by claiming that they upheld "state rights" - a core conservative principle - while giving conservative governors and state legislatures the option of eroding Obamacare at a state level. Moderates in the Senate, the theory goes, will not have to shoot down the new health bill for fear of a popular backlash since they presumably reside in states that will opt to keep the Obamacare measures in question (essential health benefits, community ratings, etc). The bill is by no means guaranteed to pass, but the point is that the Freedom Caucus has changed its tune after having been blamed for failing to repeal Obamacare, when repeal was one of the main reasons they were elected in the first place. Trump retains political capital: President Trump's polling with Republican voters has improved since the strike against Syria (Chart 11). He retains political capital with GOP voters and is therefore still a threat to the Freedom Caucus if he should campaign against them in the 2018 midterm primaries. The electoral threat is real: The Tea Party-favored candidate in Georgia's special election on June 20, Bob Gray, came in third place with just over 10% of the vote.16 Notably, a Trump-linked super PAC fielded campaign ads against Gray, helping propel the moderate candidate - Karen Handel - to the run-off against the Democratic challenger. While the media has obsessed about the surprise performance by Jon Ossoff, the first Democrat to make the district competitive since 1978, we are certain that House Freedom Caucus members have taken notice of Gray's fate. The message from the White House is clear: don't mess with Donald Trump. Trump will use carrots as well as sticks with the Freedom Caucus. To that end, we wish to remind our clients of "dynamic scoring," the macroeconomic modeling tool based on the work of economist Arthur Laffer (of the "Laffer curve" fame). The idea is that the headline government revenue loss of tax cuts fails to take into account the growth-generating consequences ("macroeconomic feedback") of the cuts, consequences that actually add to revenues. In other words, "tax cuts pay for themselves." Republican legislators have been using dynamic scoring to justify deficit-busting tax cuts for decades. And there is some truth to their claim that tax cuts generate revenue. For instance, while it is true that President Bush's White house vastly overestimated the U.S.'s long-term revenue when it oversaw major cuts in 2001-3, nevertheless revenues did ultimately go up over the ten-year period - contrary to the Congressional Budget Office's estimates at the time (Chart 12). Various studies suggest that Republicans could use a variety of growth models to write off about 10% of the cost of their tax cuts (Chart 13). And we are being conservative in those numbers. Chart 11Trump In Line With##br## GOP Predecessors Chart 12Bush Was Right,##br## CBO Was Wrong! Chart 13Dynamic Scoring Will Offset About 10% ##br##Of Revenues Lost To Tax Cuts Treasury Secretary Steven Mnuchin was anything but conservative when he explicitly told investors to expect a tax reform plan paid for largely by dynamic scoring. Speaking on the sidelines of the IMF and World Bank spring meetings in Washington, Mnuchin said, Some of the lowering in (tax) rates is going to be offset by less deductions and simpler taxes, but the majority of it will be made up by what we believe is fundamentally growth and dynamic scoring. We have been arguing since November that investors should expect tax cuts that rely on dynamic scoring to justify their deficit-busting effects.17 Mnuchin's comments, after several hints from other legislators, confirm that this is indeed the plan. For the Freedom Caucus, dynamic scoring provides a defense against the accusation that their tax cuts increase the budget deficit. That said, data clearly shows that voters care less about deficits - their concerns have subsided with the deficits themselves (Chart 14).18 It remains to be seen whether Trump's team expects for dynamic scoring to do all the heavy lifting in justifying tax cuts or whether real tax reforms are still on the agenda. Even assuming Trump rejects the House GOP's border adjustment tax (which is apparently hanging onto life by a thread), he can offset revenue losses by repatriating companies' foreign earnings, moderating tax cuts for high-income earners, and closing loopholes. These offsets would add to whatever he saves from repealing Obamacare and cutting regulations.19 Chart 14Americans Not So Worried About Deficits Now Chart 15Trump Lags Average Predecessor Ultimately, Republicans of all stripes know that if they fail to produce some legislative "wins" then they will be left with nothing to campaign on in the midterm elections except for their affiliation with President Trump's very poor nationwide approval rating (Chart 15). The current polling foreshadows a 36-seat slaughter in the upcoming midterm elections for the Republicans in the House (Chart 16). This would give Democrats a majority. Several clients have asked us if this makes tax reform less likely. We do not think so. It simply means that Republicans have 18 months to pass their most treasured policies - and much less time if they want the economic growth spurt to help them get reelected. They may not have an opportunity like this for decades. Bottom Line: Investors should step back and focus on the big picture: Trump remains popular with GOP voters, the Freedom Caucus understands this threat, and - to quote Pink Floyd - magic makes the world go round. Investors should fade the rally in Treasurys, as our colleague Peter Berezin of BCA's Global Investment Strategy recently recommended. We are sticking with our "Trump reflation" 2-year/30-year Treasury curve steepener and initiating a recommendation that clients go short the January 2018 fed funds futures contract (Chart 17).20 Chart 16Republicans Heading For Huge Defeat In 2018 Chart 17Short Jan '18 Fed Funds Futures Brexit: Early Elections Reinforce Our GBP Call British Prime Minister Theresa May's decision to hold early elections vindicates our view that the political risks of Brexit peaked - and GBP bottomed - in mid-January when May declared that her country would leave the EU's common market (Chart 18).21 At that time, May frontloaded the worst expectations of negotiations while simultaneously removing the most contentious issue: common market access. With the U.K. decisively "out," i.e. not trying to take the EU's market while rejecting its people, the EU had less of a reason to make an example of the U.K. to other countries whose Euroskeptics might think they could pick and choose what they want from the bloc. Now May and the Tories are on track for a big electoral win that will not only confirm her government's strategy but also give her more maneuverability to handle the negotiations: May's Personal Mandate: May is a "takeover" prime minister - she emerged as leader in the party reshuffle after her predecessor David Cameron's resignation following the "Leave" outcome of the referendum. Takeover prime ministers are historically weaker than "elected" prime ministers and do not last as long in office - on average they rule for 3.3 years, as opposed to six for their elected peers (Chart 19). In other words, May's position was tenuous. This was especially likely to be the case as the country entered the rocky period of formal exit in 2019 and general elections in 2020. Her struggles in turn could have threatened the Brexit deal or her party's control. At the same time, May has received a bigger "bounce" in popular opinion after assuming office than other takeover prime ministers have done (Chart 20), partly as a result of the rally-around-the-flag effect after the referendum shock. Thus, it was eminently sensible to seek public approval of her leadership at this time. Chart 18GBP Bottomed When U.K. ##br##Forswore Common Market Chart 19Theresa May Faced##br## A Short Tenure Chart 20May Received ##br##A Brexit Boost A Thin Majority: The Conservative Party has also rallied post-referendum, especially in contrast with the divided Labour Party, under Jeremy Corbyn, that will hit its lowest point since 1918 if it performs according to current polling (Chart 21). Yet the government has a thin majority in parliament of only 17 seats, among the thinnest majorities in recent decades (Chart 22). This is a liability heading into the parliamentary vote on the final exit deal with the EU in 2019, raising the menace of a "Brexit cliff" in which the U.K.'s two-year negotiating period could expire without any EU deal at all. That would be an unmitigated disaster. With a greater majority, May will be able to cow the other parties further and whip her own party's backbenchers into shape. There was also a festering scandal about the Conservative Party's 2015 fundraising that could trigger a number of by-elections jeopardizing the thin majority.22 2022 is better than 2020: The Tories also faced the prospect of running for re-election in 2020, one year after Brexit actually occurs. By that time negative economic effects (not to mention any cyclical downturn) are more likely to be felt by the public than today. The Tories would also have to face the public immediately after any embarrassing compromises in the EU negotiations. Although Labour is currently in free fall - as illustrated by the astounding loss to the Tories in the by-election in Copeland in February23 - the next two years provide opportunities for revival. The negotiations may be messy, the economy will suffer as reality sets in,24 and the union itself may come under threat from a second Scottish referendum.25 Hence the new election timeline will suit the Tories better than the old, giving them till 2022 to cement Brexit itself and address some of the effects of the aftermath before facing voters. Chart 21Labour In The Doldrums Chart 22Tories Want A Bigger Majority To Manage Brexit Few doubt that May's timing is impeccable. There can be backlash from election opportunism and voter fatigue, but May's popular approval and the national atmosphere do not suggest it will be significant. Pollsters project from current opinion polls that she will secure a 100-seat majority or greater, and since 1997 party-preference polling has become more, not less, predictive of parliamentary seats after elections. Moreover our extremely conservative estimate based exclusively on opportunities that the Tories have to snatch seats from rivals at odds with the Brexit referendum suggests that they cannot do worse than to add 11 seats to their majority (Table 2). Table 2Minimal Scenario Gives Tories 11 New Seats For Their Majority In turn, a bigger majority more securely linked to Theresa May's leadership will bring greater maneuverability in the EU talks and assurance that she can get her final deal through parliament - even if it is an ugly one. How do the elections affect the EU? Contrary to the posturing on both sides, the early election will send a further electoral confirmation to the EU that the U.K. is dead-set on leaving and that the EU cannot deliberately negotiate a bad deal in hopes that the U.K. will change its mind. It could hardly hope to overturn domestic politics and elicit a reversal on Brexit after a third national electoral outcome in favor of leaving the union. Yet the EU saw the writing on the wall already. EU Council President Tusk's negotiating guidelines are not vindictive.26 The EU is opening the possibility of a multi-year transition period after the formal 2019 exit date and acknowledging the need under Article 50 of the Lisbon Treaty to take account of the future relationship, i.e. to provide a framework for a trade deal. The City of London stands to lose the most, but the guidelines are so far fairly tame outside of the financial sector. Moreover, we do not expect a harder line to emerge from the EU Council meeting on April 29. Already the Dutch, Irish, and Danish have called for negotiations on a trade agreement to begin promptly, essentially agreeing with Britain's urgent timeline.27 True, the probability that Macron will be the next French president - along with a likely shift toward a more outspoken Europhile stance in Germany after elections in September - presents the prospect of a "clash" with May's triumphant Tories. Macron has called for a "strict approach" to negotiations, has threatened to model his pro-market reforms in France in such a way as to steal "banks, talents, researchers, academics" from the U.K., and has suggested that the U.K. can at best hope for a deal comparable to Canada's Free Trade Agreement with the EU. That would set a low bar for the U.K.'s all-important services exports (Chart 23). However, Macron is an establishment player who will not significantly change France's position in the negotiations from what it would have been otherwise. (A Le Pen presidency obviously would mark a change by throwing the EU into chaos, but it is highly unlikely.) France is going to demand with the rest of the EU that the U.K. pay its dues (namely a 60 billion-euro budget contribution), but it is not in the interest of France or the EU to impose, effectively, a British recession - not while they seek to cultivate their own economic recoveries. Moreover, wreaking vengeance would not necessarily discourage Euroskeptics on the continent. With Le Pen mortally wounded, the significant Euroskeptic threat lies in Italy, where an imperious approach to Brexit from Germany and France may not be well received (Chart 24). Chart 23Services Are Key For The U.K. Chart 24Punishing The U.K. May Not Dissuade Italy Bottom Line: May's early election helps remove additional political risk by giving her party more maneuverability in negotiations and a greater ability to "make do" with what the Europeans give. Though this is highly unlikely to lead to a "soft Brexit" (common market access, customs union membership, subordination to the European Court of Justice), it is much more likely to prevent Britain from sailing off into a "no deal" abyss. To be clear, we can still see scenarios in which a reversal of Brexit is possible, as discussed previously,28 but they are very low probability. The snap election enables May's government to be flexible in the negotiations and accept some difficult truths in the final deal, which will reinforce the existing tendency of the EU to avoid causing a destabilizing "punitive" break. Both sides of the Channel are positioning for a relatively market-friendly outcome. We maintain our view that the pound has bottomed. Our short USD/GBP recommendation is up 2.85% since March 29 and short EUR/GBP is up 0.14% since January 25. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Global Alpha Sector Strategy Weekly Report, "Eerie Calm," dated February 10, 2017, available at gss.bcaresearch.com. 2 Please see BCA Global Alpha Sector Strategy Weekly Report, "Caveat Emptor," dated March 24, 2017, available at gss.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 6 French toast in fact... we'll be here all night folks! 7 The reason this plan does not make sense is because most perpetrators of terrorist attacks in France have been French or European citizens. Le Pen's plan amounts to closing the barn door after the horse has bolted. 8 Please see Bloomberg, "Le Pen Struggling to Fund French Race as Russian Bank Fails," dated December 22, 2016, available at bloomberg.com. 9 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 10 Former conservative prime ministers Jean-Pierre Raffarin and Alain Juppé, as well as other prominent members of Les Républicains have already announced that they would support Macron in the second round. 11 Please see "S. Con. Res. 3 - A concurrent resolution setting forth the congressional budget for the United States Government for fiscal year 2017," United States Congress, available at www.congress.gov. 12 For a great summary of the arcane procedure, please see "Introduction to Budget 'Reconciliation,'" dated November 9, 2016, available at cbpp.org. 13 If Republicans choose to delay beyond May, they will have to delay producing the fiscal year 2018 budget resolution. This is possible but introduces problems for next year's budget appropriations and the tax reform measures which will depend on the yet-to-be-written FY2018 budget resolution's reconciliation instructions. "The reconciliation legislation that the GOP is using to partially repeal and replace the ACA has a half-life. It will expire when Congress begins drafting the fiscal 2018 budget blueprint, which will likely be sometime in May. So if Republicans want to resurrect the AHCA and avoid the need for bipartisan votes in the Senate, they will have to vote on the bill within the next several weeks." Please see Baker and Hostetler LLP, "GOP Struggles To Revive Health Bill," Lexology, April 7, 2017, available at www.lexology.com. 14 In short, reconciliation can only be used to pass bills that impact spending and revenue. As such, any changes to Obamacare that do not impact fiscal matters could be found inadmissible by the Senate parliamentarian and thus could defeat the entire bill. There is of course always the "nuclear option" of simply ignoring the ruling of the Senate parliamentarian, but it is not clear whether the Senate GOP would want to go "Kim Jong-Un" twice in the same year! 15 Please see Congressional Budget Office, "American Health Care Act," March 13, 2017, available at www.cbo.gov. 16 Georgia's sixth congressional district is holding this special election to fill the seat left vacant by Tom Price, the new Secretary of Health and Human Services, as appointed by Trump. 17 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 18 Wouldn't dynamic scoring fail to pass the "smell test" with the CBO? Yes, it would. The CBO will likely ignore Republican "magic" and apply actual "math" to the tax proposal. However, this is not an impediment to passing tax reform as the reconciliation rules can still be used as long as the legislation expires after ten years. This is how President George W. Bush passed tax cuts in 2001. 19 A study by the conservative American Action Forum suggests that Trump's regulatory cuts may save $260 billion over ten years. This is a likely source of savings to justify tax cuts, and Trump is only getting warmed up when it comes to deregulation! For the study, please see Sam Batkins, "Fiscal Benefits Of The CRA, Regulatory Reform," April 20, 2017, available at www.americanactionforum.org. 20 Please see BCA Global Investment Strategy Weekly Report, "Fade The Rally In Treasurys," dated April 21, 2017, available at gis.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 22 Please see "Conservatives fined £70,000 over expenses by election watchdog," Channel 4 News, March 16, 2017, available at www.channel4.com. 23 The Conservatives won the Copeland seat for the first time since 1982 after the Labour MP Jamie Reed's resignation there. 24 Please see 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. 25 Please see BCA Geopolitical Strategy Special Report, "Will Scotland Scotch Brexit?" dated March 29, 2017, available at gps.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 27 Please see "Brexit Shouldn't Delay Trade Talks Too Long, Say Leaders," Bloomberg, April 21, 2017, available at www.bloomberg.com. 28 See note 26 above. Geopolitical Calendar

Highlights Treasury yields have slumped since early March, helping to push down the dollar. Slower U.S. growth in the first quarter of the year, weak inflation readings, uncertainty on tax reform, the prospect of a government shutdown, and rising political risks in Europe have all contributed to the Treasury rally. Looking out, U.S. growth should accelerate while growth abroad will stay reasonably firm. The market is pricing in only 34 basis points in rate hikes over the next 12 months. This seems too low to us. Go short the January 2018 fed funds futures contract. Feature What Explains The Treasury Rally? Global bond yields have swooned since early March. The 10-year Treasury yield fell to as low as 2.18% this week, down from a closing high of 2.62% on March 13th. A number of fundamental factors have contributed to the Treasury rally: Recent "hard data" on the U.S. growth picture has been somewhat disappointing. The Atlanta Fed's model suggests that real GDP expanded by only 0.5% in Q1 (Chart 1). So far this month, hard data on payrolls, housing starts, and auto sales have fallen short of consensus expectations. Credit growth has also decelerated sharply (Chart 2). The prospect of tax cuts this year have faded. Treasury Secretary Steven Mnuchin told the Financial Times on Monday that getting a tax bill through Congress by August was "highly aggressive to not realistic at this point."1 Meanwhile, worries about a government shutdown - possibly coming as early as next week - have escalated. Recent inflation readings have been on the soft side. Core CPI dropped by 0.12% month-over-month in March, the first outright decline since 2010. China's growth outlook remains cloudy. Government officials warned this week that recent measures undertaken to cool the housing sector will begin to bite later this month.2 Concerns that the French election will feature a runoff between the "Alt-Right" candidate, Marine Le Pen, and the "Ctrl-Left" candidate, Jean-Luc Mélenchon, have intensified (Chart 3). Euroskeptic parties also continue to make gains in Italy (Chart 4). Chart 1A Disappointing First Quarter Chart 2Credit Growth Slowdown While none of the things listed above can be easily dismissed, the key question for fixed-income investors is whether bond yields are already adequately discounting these risks. Keep in mind that markets are pricing in only 34 basis points in Fed rate hikes over the next 12 months (Chart 5). This is substantially less than the median "dot" in the Summary of Economic Projections, which implies three more hikes between now and next April. Chart 3French Elections: A Many-Way Race? Chart 4Euroskepticism Is On The Rise In Italy Chart 5Markets Are Too Sanguine About The Fed's Rate Hike Intentions U.S. Economy Still In Reasonably Good Shape Our view on rates for the next year is closer to the Fed's than the market's. Yes, the "hard data" on U.S. growth has been lackluster. However, as we discussed last week, the hard data may be biased down by seasonal adjustment problems.3 Moreover, the hard data tend to lag the soft data, and the latter remain reasonably perky. Reflecting the strength of the soft data, our newly-released Beige Book Monitor points to an improving growth picture across the Fed's 12 districts (Chart 6). Worries about plunging credit growth are also overstated. While the increase in interest rates since last year has likely curbed credit demand, some of the recent deceleration in business lending appears to be due to the improving financial health of energy companies. Higher profits have permitted these firms to pay back old bank loans, while also enabling them to finance new capital expenditures using internally-generated funds. In addition, the rising appetite for corporate debt has also allowed more companies to access the bond market. According to Bloomberg, the U.S. leveraged-loan market saw $434 billion in issuance in Q1, the highest level on record (Chart 7). Chart 6Fed Districts See Things Improving Chart 7More And More Leveraged Loans Looking out, business lending should pick up. The Fed's Senior Loan Officer Survey indicates that banks stopped tightening lending standards to businesses in Q1. This should help boost the supply of credit over the coming months (Chart 8). Meanwhile, the recovery in the manufacturing sector will bolster credit demand. Chart 9 shows that an increase in the ISM manufacturing index leads business lending by 6-to-12 months. Chart 8Bank Lending Standards: Stable For Businesses, Tighter For Consumers Chart 9Manufacturing ISM Points To A Pick Up In Business Lending As far as household credit is concerned, higher interest rates and tighter lending standards for consumer loans (especially auto loans) are both headwinds. Nevertheless, overall household leverage has fallen back to 2003 levels and the household debt-service ratio is at multi-decade lows (Chart 10). And while delinquencies have edged higher, they are still well below their historic average (Chart 11). Chart 10Lower Household Leverage Chart 11Despite Slight Uptick, Delinquency Rates Remain Well Contained A reasonably solid growth picture should help lift inflation over the coming months. Chart 12 shows that inflation tends to accelerate once unemployment falls below its full employment level. The U.S. headline unemployment rate currently stands at 4.5%, below the Fed's estimate of NAIRU. Other measures of labor market slack also point to an economy that is quickly running out of surplus labor (Chart 13). As such, it is not surprising that the Atlanta Fed's wage tracker continues to trend higher, as has the NFIB's labor compensation gauge and most other measures of labor compensation (Chart 14). Chart 12The Phillips Curve Appears To Be Non-Linear Chart 13Disappearing Labor Market Slack Chart 14U.S.: Broad Measures Pointing To Rising Wage Pressures Wage Growth Trending Higher U.S. Political Risks Will Diminish... The political risks which have pushed down Treasury yields since early March should also subside over the coming weeks. Concerns that the Trump administration will be unable to pass tax cuts are overblown. Unlike in the case of health care, there is virtual unanimity among Republicans in favor of cutting taxes.4 Congressional hearings on tax reform are scheduled to begin next week. We expect Trump to move quickly to get a deal done. He needs a political victory and this is his best shot. We are also not especially worried about the prospect of a government shutdown. Congress needs to agree on a bill to extend government funding beyond April 28 when congressional appropriations are set to expire. So far, Republican leaders are pursuing a sensible strategy of keeping controversial items - including funding for a border wall and cuts to Obamacare subsidies - out of the bill in the hopes of attracting enough Democrat support to avoid a filibuster in the Senate. Without the inclusion of these contentious measures, it would be politically difficult for the Democrats to take any action that triggers a government shutdown, as they would be blamed for the outcome. ...As Will Risks In Europe... Chart 15The French Are Not Euroskeptic In the U.K., Prime Minister Theresa May's decision to hold a snap election reduces the risk of a "hard Brexit." The current slim 17-seat majority that the Conservatives hold in Parliament has made May highly dependent on a small band of hardline Tories. These uncompromising MPs would rather see negotiations break down than acquiesce to any of the EU's demands, including that the U.K. pay the remaining £60 billion portion of its contribution to the EU's 2014-20 budget. If the Conservative Party is able to increase its control over Parliament - as current opinion polls suggest is likely - May will have greater flexibility in reaching an agreement with Brussels and will face less of a risk that Parliament shoots down the final deal. Worries about the outcome of French elections should also diminish. Opinion polls continue to signal that Emmanuel Macron will make it to the second round of the presidential contest. If that happens, he would be a shoo-in to win against either Marine Le Pen or the far-left challenger Jean-Luc Mélenchon. Even in the unlikely event that Le Pen or Mélenchon ends up prevailing, their ability to push through their agendas would be severely constrained. Neither candidate is likely to secure a majority in the National Assembly when legislative elections are held in June. French presidents have a lot of leeway over foreign affairs, but need the support of parliament to change taxes, government spending, regulations, or most other aspects of domestic policy.5 Also, keep in mind that France's place in the EU is enshrined in the French constitution. Any modifications to the constitution would require that a referendum be called. Considering that French voters are highly pessimistic of their future outside of the EU, it would require a seismic shift in voter preferences for France to end up following the U.K.'s example (Chart 15). ...And In China Lastly, the risks of a trade war between the U.S. and China have eased following President Trump's summit with President Xi. This should help stem Chinese capital outflows. On the domestic front, the government's efforts to clamp down on property speculation will cool the economy. However, as our China team has pointed out, this may not be such a bad thing, given that recent activity has been strong and parts of the economy are showing signs of overheating. Investment Conclusions Chart 16Bet On The Fed The reflation trade will eventually fizzle out, but our sense is that this will be more of a story for late next year than for 2017. For now, underlying global growth is still strong and the sort of imbalances that usually precipitate recessions are not severe enough. If there is going to be one big surprise in the U.S. fixed-income market this year, it is that the Fed sticks to its guns and keeps raising rates at a pace of roughly once per quarter. With that in mind, we recommend that clients go short the January 2018 fed funds futures contract as a tactical trade (Chart 16). A rebound in U.S. rate expectations will lead to a widening in interest rate differentials between the U.S. and its trading partners. This will produce a stronger dollar. The yen is likely to suffer the most in a rising rate environment, given the Bank of Japan's policy of keeping the 10-year JGB yield pinned close to zero. On the equity side, we continue to recommend a modestly overweight position in global stocks. Investors should favor Japan and the euro area over the U.S. in local-currency terms. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Sam Fleming, Demetri Savastopulo, and Shawn Donnan, "Interview With Steven Mnuchin: Transcript," Financial Times, Monday April 17, 2017. 2 Li Xiang, "Real Estate Investment Likely To Slow Down," Chinadaily.com.cn, April 18, 2017. 3 Please see Global Investment Strategy Weekly Report, "Talk Is Cheap: EUR/USD Is Heading Towards Parity," dated April 14, 2017, available at gis.bcaresearch.com. 4 Please see Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 5 Please see Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

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

Highlights The rally in risk assets appears to have stalled, raising fears that the misnamed "Trump Trade" has ended. Investors are attaching too much importance to the reality show in Washington and not enough to the fundamentals underpinning the acceleration in global growth and corporate earnings. For now, these fundamentals are strong, and should remain so for the next 12 months. Beyond then, the impulse from easier financial conditions will dissipate and policy will turn less friendly, setting the stage for a major slowdown - and possibly a recession - in 2019. Stay overweight global equities and high-yield credit, but be prepared to reduce exposure next spring. Feature Risk Assets Hit The Pause Button After rallying nearly non-stop following the U.S. presidential election, risk assets have stalled since early March (Chart 1). The S&P 500 has fallen by 1.8% after hitting a record high on March 1st. Treasury yields have also backed off their highs and credit spreads have widened modestly. Globally, the picture has been much the same (Chart 2). The yen - a traditionally "risk off" currency - has strengthened, while "risk on" currencies such as the AUD and NZD have faltered. EM currencies have dipped, as have most commodity prices. Only gold has found a bid. Chart 1A Pause In Risk Assets In The U.S.... Chart 2...And Globally The key question for investors is whether all this merely represents a correction in a cyclical bull market for global risk assets, or the start of a more sinister trend. We think it is the former. Global Growth Still Solid For one thing, it would be a mistake to attach too much significance to the unfolding reality show in Washington. As we discussed in last week's Q2 Strategy Outlook,1 the recovery in global growth and corporate earnings began a few months before last year's election and would have likely continued regardless of who won the White House (Chart 3). For now, the global growth picture still looks reasonably bright. Our global Leading Economic Indicator remains in a solid uptrend. Burgeoning animal spirits are powering a recovery in business spending, as evidenced by the jump in factory orders and capex intentions (Chart 4). Consumer confidence is also soaring. If history is any guide, this will translate into stronger consumption growth in the months ahead (Chart 5). Chart 3Recovery Predates President Trump Chart 4Global Growth Backdrop Remains Solid Chart 5Rising Consumer Confidence Will Provide A Boost To Consumption The lagged effects from the easing in financial conditions over the past 12 months should help support activity. Chart 6 shows that the 12-month change in our U.S. Financial Conditions Index leads the business cycle by 6-to-9 months. The current message from the index is that U.S. growth will stay sturdy for the remainder of 2017. Stronger global growth should continue to power an acceleration in corporate earnings over the remainder of the year. Global EPS is expected to expand by 12.5% over the next 12 months. Analysts are usually too bullish when it comes to making earnings forecasts. This time around they may be too bearish. Chart 7 shows that the global earnings revisions ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. Chart 6Easing Financial Conditions Will Support Activity In 2017 Chart 7Global Earnings Picture Looking Brighter Gridlock In Washington? As far as developments in Washington are concerned, it is certainly true that the failure to repeal and replace the Affordable Care Act has cast doubt on the ability of Congress to implement other parts of President Trump's agenda. Despite reassurances from Trump that a new health care bill will pass, we doubt that the GOP can cobble together any legislation that jointly satisfies the hardline views of the Freedom Caucus and the more moderate views of the Republicans in the Senate. Ironically, the failure to jettison Obamacare may turn out to be a blessing in disguise for Trump and the Republican Party. Opinion polls suggest that the GOP would have gone down in flames if the American Health Care Act had been signed into law (Table 1). According to the Congressional Budget Office, the proposed legislation would have caused 24 million fewer Americans to have health insurance in 2026 compared with the status quo. The bill would have also reduced federal government spending on health care by $1.2 trillion over ten years. Sixty-four year-olds with incomes of $26,500 would have seen their annual premiums soar from $1,700 to $14,600. Even if one includes the tax cuts in the proposed bill, the net effect would have been a major tightening in fiscal policy. Now, that would have warranted lower bond yields and a weaker dollar. Table 1Passing The American Health Care Act Could Have Cost The Republicans Dearly Granted, the political fireworks over the past month serve as a reminder that comprehensive tax reform will be more difficult to achieve than many had hoped. However, even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. Worries that tax cuts will lead to larger budget deficits will be brushed aside on the grounds that they will "pay for themselves" through faster growth (dynamic scoring!). Throw some infrastructure spending into the mix, and it will not take much for the "Trump Trade" to return with a vengeance. Trump's Fiscal Fantasy This is not to say that the "Trump Trade" won't fizzle out. It will. But that will be a story for 2018 rather than this year. This is because the disappointment for investors will stem not from the failure to cut taxes, but from the underwhelming effect that tax cuts end up having on the economy. The highly profitable companies that will benefit the most from lower corporate taxes are the ones who least need them. In many cases, these companies have plenty of cash and easy access to external financing. As a consequence, much of the tax cuts will simply be hoarded or used to finance equity buybacks or dividend payments. A large share of personal tax cuts will also be saved, given that they will mostly accrue to higher income earners. Chart 8From Unrealistic To Even More Unrealistic The amount of infrastructure spending that actually takes place will likely be a tiny fraction of the headline amount. This is not just because of the dearth of "shovel ready" projects. It is also because the public-private partnership structure the GOP is touting will severely limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Indeed, the bill could turn out to be little more than a boondoggle for privatizing existing public infrastructure projects, rather than investing in new ones. Meanwhile, the Trump administration is proposing large cuts to nondefense discretionary expenditures that go above and beyond the draconian ones that are already enshrined into current law (Chart 8). In his Special Report on U.S. fiscal policy, my colleague Martin Barnes argues that "it is a FALLACY to describe overall non-defense discretionary spending as massively bloated and out-of-control."2 As such, the risk to the economy beyond the next 12 months is that markets push up the dollar and long-term interest rates in anticipation of continued strong growth and major fiscal stimulus but end up getting neither. Investment Conclusions Risk assets have enjoyed a strong rally since late last year, and a modest correction is long overdue. Still, as long as the global economy continues to grow at a robust pace, the cyclical outlook for risk assets will remain bullish. As such, investors should stay overweight global equities and high-yield credit at the expense of government bonds and cash. We prefer European and Japanese equities over the U.S., currency-hedged (See Appendix). As we discussed in detail last week, global growth is likely to slow in the second half of 2018, with the deceleration intensifying into 2019, possibly culminating in a recession in a number of countries. To what extent markets "sniff out" an economic slowdown before it happens is a matter of debate. U.S. equities did not peak until October 2007, only slightly before the Great Recession began. Commodity prices did not top out until the summer of 2008. Thus, the market's track record for predicting recessions is far from an envious one. Nevertheless, investors should err on the side of safety and start scaling back risk exposure next spring. The 2019 recession will last 6-to-12 months. By historic standards, it will probably be a mild one. However, with memories of the Great Recession still fresh in most people's minds and President Trump up for re-election in 2020, the response could be dramatic. This will set the stage for a period of stagflation in the 2020s. Chart 9 presents a visual representation of how the main asset markets are likely to evolve over the next seven years. Chart 9Market Outlook For Major Asset Classes Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Outlook, "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com 2 Please see BCA Special Report, "U.S. Fiscal Policy: Facts, Fallacies And Fantasies," dated April 5, 2017, available at bca.bcaresearch.com. Appendix Tactical Global Asset Allocation Monthly Update We announced last week that we are making major upgrades to our Tactical Asset Allocation Model. In the meantime, we will send you a concise update of our recommendations every month based on a combination of BCA's proprietary indicators as well as our own seasoned judgement (Appendix Table 1). Appendix Table 2Global Asset Allocation Recommendations (Percent) In a Special Report published last year, we laid out the quantitative factors that have historically predicted stock market returns. Appendix Chart 1 updates the output of that model for the U.S. It currently shows a slightly above-average return profile for the S&P 500 over the next three months. Appendix Chart 1S&P 500: Above Average Returns Over The Next 3 Months Applying this model to the rest of the world yields a somewhat more positive picture for Europe and Japan, given more favorable valuations and easier monetary conditions in those regions. The technical picture has also improved in Europe and Japan. This is especially true with respect to price momentum: After a long period of underperformance, euro area equities have outpaced the U.S. by 11.5% in local-currency terms since last summer’s lows. Japanese stocks have suffered over the past few months, but are still up 12.5% against the U.S. over the same period (Appendix Chart 2). Turning to government bonds, the extreme bearish sentiment and positioning that prevailed in February and early March has been largely reversed, suggesting that the most recent rally in bonds could run out of steam (Appendix Chart 3). Looking ahead, yields are likely to rise anew on the back of strong economic growth and rising inflation. Thus, an underweight allocation to government bonds is warranted, particularly in the U.S. Appendix Chart 2Relative Performance Of Euro Area ##br##And Japanese Equities Troughed Last Summer Appendix Chart 3Rally In Bonds Could Soon Peter Out Clients should consult our Q2 Strategy Outlook for a more detailed discussion of the global investment outlook. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades