France

Highlights It is too soon to bottom feed with fears of a global pandemic and “socialist” boom in the United States. China’s government will do “whatever it takes” to stimulate the economy – but animal spirits need to revive for it to work. European political risk and policy uncertainty are clearly on the rise, albeit from low levels. Bernie Sanders could become the presumptive nominee for president on Super Tuesday – if Biden fails to make a comeback. The market is underrating the Sanders risk to US equities – particularly tech and health. Assuming pandemic fears subside, the Fed put, the China put, and the Trump reflation put will fuel risk-on sentiment in H2 2020. Feature Chart 1Risk-Off Mood Dominates Markets... Risk-Off Mood Dominates Markets... Risk-Off Mood Dominates Markets... Financial markets awoke to the confluence of negative news this year on February 20. The S&P 500 has fallen 8.0% from this year’s peak while the 10-year US Treasury yield dove to 1.33%. Gold reached the highest level since 2013. The yield curve inverted again (Chart 1). It is too soon to buy into the equity selloff. Fear of the coronavirus is spreading, not abating, while Vermont Senator Bernie Sanders – a democratic socialist who would turn the regulatory pen against corporations – is running away with the Democratic Party’s nomination for US president. Chart 2...Amid Fears Over Coronavirus And Sanders ...Amid Fears Over Coronavirus And Sanders ...Amid Fears Over Coronavirus And Sanders The market selloff is well correlated with fear of the coronavirus, but there is also some correlation with Sanders’s success (Chart 2). This should intensify if Sanders becomes the presumptive nominee following “Super Tuesday,” March 3, by which time 39% of the Democratic Party delegates will have been chosen. Sanders poses a more systemic risk to corporate profits than the virus as he emblematizes a generationally driven sea change looming over US national policy: a shift from capital to labor. A greater tightening of financial conditions would prompt the Federal Reserve to cut interest rates, possibly as soon as its meeting on March 17-18. But the Fed is not yet signaling cuts. Also, cuts may not pacify the market as easily this time as in the last major pullback in Q4 2018. Tightening monetary policy was the culprit for that selloff and therefore the Fed’s policy reversal on January 4, 2019 gave the market just what it needed to rally. Today the Fed has no control over the causes: virus fears and “socialism.” President Trump is manifestly uneasy as the virus spreads. Anything that weakens the US manufacturing sector is a direct threat to his reelection, regardless of how he spins it. The statewide coincident indicators provided by the Philadelphia Fed show that Pennsylvania’s economy is deteriorating, while a relapse in Michigan will push it into the Democratic camp according to our quantitative election model. This would leave Trump with only Wisconsin standing between him and the shame of a one-term presidency (Chart 3). Chart 3Trump’s Narrow Victory At Risk Of Virus-Induced Slowdown GeoRisk Update: Leap Year, Or Steep Year? GeoRisk Update: Leap Year, Or Steep Year? What can Trump do to feed the markets and economy some good news? Not much. The Democrats control the House of Representatives and will refuse any fiscal stimulus unless a total collapse is occurring, in which case Trump is doomed anyway. Given the strong dollar, the Fed’s reluctance to cut rates, and Trump’s paternalist proclivities, we can fully envision him attempting to strong-arm the Treasury Department into intervening against the dollar. But intervention would have a fleeting impact without Fed cooperation – and again, the economic crisis required for the Fed to intervene decisively would likely seal Trump’s fate regardless. What remains for Trump is his ability to enact surprise “rate cuts” of his own via tariff rollback on China. This is fully within his power. All he has to do is hold a phone conference with Xi Jinping and then declare that China is complying with the “phase one” trade deal in good faith and therefore deserves assistance amid the coronavirus economic shock. But the impact of a positive tariff surprise would be limited. And such rate cuts are likely to be reactive rather than proactive, as with the Fed. We shifted to a cautious, neutral stance on global risk assets on January 24 and we maintain that position. China is stimulating the economy, meaning that the dominant trend in H2 should be a global “risk on.” Thus we are keeping our China and emerging market trades open. But volatility will likely remain elevated through March, at minimum, given the toxic combination of a slowing global economy and an increasingly likely Sanders nomination. China Stimulus: "Whatever It Takes" Chart 4Xi Administration Is Getting Out The Big Guns Xi Administration Is Getting Out The Big Guns Xi Administration Is Getting Out The Big Guns One near certainty of the coronavirus outbreak is that it will catalyze greater economic stimulus in China. Last year we argued that the trade war had derailed Beijing’s financial deleveraging agenda and hence that the risk of a stimulus overshoot was greater than an undershoot. The Xi Jinping administration limited the degree of reflation for most of the year, but by autumn it was incontrovertible: stabilizing growth and the labor market had taken priority over deleveraging. Local government bond issuance picked up and the government relaxed its grip on informal lending and the shadow banks (Chart 4). Now, with the coronavirus outbreak, the Xi administration is getting out the big guns. The People’s Bank of China has cut key interest rates below where they stood in 2015-16, the last major bout of stimulus (Chart 5), as our China Investment Strategy has noted. Beijing officials have announced they will dial up fiscal policy to build infrastructure and boost purchases of homes and cars. President Xi Jinping has personally assured the world that China will meet its economic growth target for the year. Compared with the 6.1% real GDP growth achieved in 2019, our China Investment Strategy believes a conservative estimate is 5.6% for 2020. Assuming China’s real GDP growth slows to 3.5% in Q1 on a year-over-year basis, China would need at least 6.3% average real growth year-over-year for the next three quarters to hit its target. This growth rate would be 0.3 percentage points higher than in the second half of 2019. Credit expansion and government spending in the next six-to-12 months would need to outpace that of last year. Will the government succeed in firing up demand? If getting back to work results in further outbreaks, then China may see greater difficulty in using its old-fashioned stimulus tools. Moreover Chinese households and corporates are more indebted than ever and have suffered a series of blows in recent years that have weighed on animal spirits: a political purge, slowing trend growth, corporate deleveraging, trade war, and now the virus. It is essential for consumer confidence and the velocity of money to keep recovering (Chart 6). Our Emerging Markets Strategy rightly insists that without a revival in animal spirits, stimulus will be pushing on a string. Chart 5Key Chinese Interest Rates Now Below 2015-16 Levels Key Chinese Interest Rates Now Below 2015-16 Levels Key Chinese Interest Rates Now Below 2015-16 Levels Chart 6Animal Spirits A Precondition For Chinese Recovery Animal Spirits A Precondition For Chinese Recovery Animal Spirits A Precondition For Chinese Recovery Yet it is also true that most of the negative shocks were policy decisions, especially deleveraging and trade war. With these decisions reversed – and likely to stay that way for at least this year – there is no reason to assume a priori that animal spirits will remain depressed. Furthermore, we see little room for the Xi administration to revert to tightening measures until a general economic recovery is well advanced. As we highlighted in our annual strategic outlook, it is necessary to stabilize the economy ahead of the 100th anniversary of the Communist Party in 2021 and – more importantly – the leadership reshuffle to take place in 2022. Chinese consumer confidence and the velocity of money need to recover for stimulus to have an impact. On a side note, Hong Kong is also implementing stimulus measures. This is positive for the city-state in the short run but it is unlikely to revive its fortunes over the long run. What made Hong Kong special was its position as a well-governed ally of the West during the heyday of globalization and the backdoor to mainland China during its rapid, catch-up phase of industrialization. Now globalization is slowing, Beijing is tightening central control, and the West has lost the appetite to defend its influence in Hong Kong. This influence is part and parcel with Hong Kong’s freedoms and privileges. This means that while the country’s equities can see a cyclical improvement we are structurally negative. Bottom Line: We are maintaining our cyclically constructive outlook on global growth and risk assets, as our view on China’s “Socialism Put” has been reinforced. We are keeping open our China Play Index and other EM trades. However, near-term risks are extremely elevated and our cyclical view could change quickly if the virus fear factor proves insurmountable for China and the global economy. China Sneezes, Europe Catches A Cold … And Its Immune System Is Weak Chart 7Our European GeoRisk Indicators Are Springing Back Our European GeoRisk Indicators Are Springing Back Our European GeoRisk Indicators Are Springing Back The European economy was on track to rebound in 2020 prior to the coronavirus, but only tentatively, as sentiment and manufacturing were fragile. The virus struck at the heart of demand for European exports, China, and now is hitting European demand directly via the outbreak in Italy and across the continent. As fear of the virus spreads country by country, households and corporations will cut back on activity. It could take weeks or even months to resume business as usual. And it will take 6-12 months for China’s stimulus to kick in fully and lift demand for European goods. European political risk is thus no longer slated to remain subdued. Our indicators already show it is springing back. The most significant player is Germany, but Italy is the weakest link in the Euro Area, and non-negligible risks are affecting France, Spain, and the United Kingdom (Chart 7). German political risk will be highly market-relevant between now and the federal election slated for October 2021. De-globalization is a structural headwind for the German economy and Chancellor Angela Merkel’s attempt to stage manage a smooth succession has collapsed. The Christian Democratic Union is now plunging into a truly competitive leadership contest that will keep uncertainty elevated, at least until the aftermath of the election. Friedrich Merz is the leading contender (Chart 8) and is attempting to rope more conservative voters back into the Christian Democratic fold so that they do not stray into the populist Alternative für Deutschland (AfD). While a similar dynamic led the British Conservative Party into Brexit, German politics are less polarized than British politics. The Christian Democrats are nowhere near being overtaken by the far right. First, the CDU is still the most popular party and its closest competitors are the Green Party and the Social Democrats, while the AfD polls at 13.3% support and is opposed by all other parties. The AfD’s popularity, while growing, is still very small. Second, a majority of the public still approves of Merkel (Chart 9), signaling a tailwind for centrists within and without her party. Chart 8Merz Is The Top Contender In Germany’s Leadership Contest GeoRisk Update: Leap Year, Or Steep Year? GeoRisk Update: Leap Year, Or Steep Year? Third, the German public is still the most supportive of the euro and EU, for the obvious reason that its economic success is integrally bound up in the union (Chart 10A). Nor is Germany alone, since the only country that looks truly concerning by these measures is Italy and even Italy’s populists remain engaged in the European project (Chart 10B). Chart 9Merkel's Popularity A Sign Of German Centrism Merkel's Popularity A Sign Of German Centrism Merkel's Popularity A Sign Of German Centrism   Chart 10ASupport For The Euro Still Strong (But Watch Italy) (I) Support For The Euro Still Strong (But Watch Italy) (I) Support For The Euro Still Strong (But Watch Italy) (I) Chart 10BSupport For The EU Still Strong (But Watch Italy) (II) Support For The EU Still Strong (But Watch Italy) (II) Support For The EU Still Strong (But Watch Italy) (II) Immediate economic challenges favor Merz’s bid to lead the party. However, if they do not give way to an economic rebound by fall 2021 (i.e. if Chinese and global growth worsen in the lead-up to the general election), then these challenges will undercut the Christian Democrats’ bid to remain in power regardless of whether Merz or a more dovish chancellor-candidate emerges from Merkel’s exit. The Green Party offers a viable alternative to lead the next government. Chart 11Coronavirus Will Weigh On France's Tourism Sector And Macron's Popularity Coronavirus Will Weigh On France's Tourism Sector And Macron's Popularity Coronavirus Will Weigh On France's Tourism Sector And Macron's Popularity In the short run, Germany can ease fiscal policy marginally to help offset the current slowdown. But a game changer in fiscal policy will require either for the current economy to collapse or a resolution to the succession crisis. Finance Minister Olaf Scholz, of the Social Democrats, has just proposed a significant revision to the schuldenbremse, or “debt brake,” which keeps budget deficits pinned above -0.35% of GDP. He would allow Germany’s state and local governments to suspend the debt brake temporarily so as to boost fiscal spending to mitigate the slowdown. A formal suspension requires a constitutional change that would in turn require a two-thirds vote in both houses of the legislature. There are enough votes in the Bundestag and possibly in the Bundesrat but it requires the economic shock to get bigger first so as to force the conservatives to capitulate and court the help of smaller parties. Otherwise Scholz is making an election gambit to distinguish the Democratic Socialists from the fiscally conservative Christian Democrats. In the meantime, limited moves to loosen the belt are perfectly countenanced by existing law which allows for deviations from the debt brake during recessions and emergencies. France is also seeing a spike in political risk. President Emmanuel Macron has slogged through the massive labor strikes against his pension reform, as we expected. The reform would streamline a complex web of pension programs into a single national program, providing incentives for workers to work longer without making spending cuts. It will likely pass into law through his En Marche party’s control of the National Assembly. However, Macron’s political capital is spent and his party is expected to sustain heavy losses in municipal elections from March 15-22. The service-oriented economy will also suffer a blow from reduced tourism amid the coronavirus scare (Chart 11), further eroding Macron’s already low popularity. The loss of influence at home will reinforce Macron’s pivot to foreign policy. Macron can play the leader of Europe at a time when the UK is leaving and Germany is consumed with a leadership contest. In this role he will clash with the UK over Brexit and the US over trade – but this can only go so far given the need to sustain the French economy. Negotiations with the UK will involve brinkmanship but will result in a delay of the end-of-year deadline, or a deal, given the fragile economic backdrop affecting all players. Economic constraints also imply that negotiations with the US will not spiral into a major confrontation unless and until Trump is reelected. Therefore Macron’s gaze will turn to security and immigration, challenges that have the potential to fuel anti-establishment sentiment that could hurt him in the French election of 2022 and undermine his vision of a more integrated Europe. While terrorism has abated for the time being (Chart 12), the trend cannot be guaranteed. The Middle East is extremely unstable amid the global slowdown, virus, drop in oil prices, and general destabilization emanating from the underlying US-Iran conflict. Immigration is also starting to rise again, particularly along the western North African route into Spain and France that bypasses the fighting in Libya (Chart 13). Chart 12A Pickup In Terrorism Would Fuel Populist Sentiment... A Pickup In Terrorism Would Fuel Populist Sentiment... A Pickup In Terrorism Would Fuel Populist Sentiment... Turkey’s foreign policy confrontation with the West threatens an increase in immigration in the east as well as a Turkish client-state in western Libya that France fears could become a militant safe haven. Chart 13...As Would An Increase In Immigration ...As Would An Increase In Immigration ...As Would An Increase In Immigration France is therefore taking a harder line with Turkey and providing maritime assistance to Greece (see Chart 13 above). The Mediterranean is becoming a geopolitical hot spot that could lead to negative surprises – and not only for Turkish assets. European populism is under control for now but a new wave of immigration would spark a new wave of populism that would increase policy uncertainty and the risk premium in equities. Italy has shifted from being an overstated to an understated political risk. Chart 14Italian Right-Wing Parties Are Gaining Strength Italian Right-Wing Parties Are Gaining Strength Italian Right-Wing Parties Are Gaining Strength Politically, Italy remains the weakest link in Europe – and this long-term risk is now becoming more pressing. Support for the euro and EU is among the weakest (see Chart 10 above). The ruling coalition is rickety and groping toward an election, with a popular referendum on the electoral law dated March 29. The country is poorly equipped to handle the virus outbreak. The virus will also call attention to the porous borders, fueling anti-establishment sentiment – after all the anti-establishment League is still the top party in polls while the right-wing Brothers of Italy’s support is surging (Chart 14). This is the case even though immigration into Italy is under control at the moment, particularly with renewed fighting in Libya discouraging flows through the central North African route. In short a full-fledged recession will unleash the furies in Italian politics and the country has shifted from being an overstated to an understated political risk. Bottom Line: The UK-EU trade talks threaten volatility for the pound this year, on top of the key continental risks: succession crisis in Germany, the potential for Macron’s centrist political movement to falter in France, and the possible election of a right-wing anti-establishment government emerging in Italy. Populist sentiment can emerge from the economic slowdown even if terrorism and immigration remain contained, but the recent uptick in immigration and new sources of instability in the Middle East, North Africa, and the Mediterranean show clouds gathering on the horizon. The Euro Area’s fiscal thrust is expected to be a measly 0.015% of potential GDP in 2020. The trends above suggest that this number could increase substantively, albeit reactively, due to fiscal easing in Germany and several other states along with France’s lack of real cuts in its pension reform. United States: Can A Northern Progressive Win In The South? In February 1980, Democratic presidential contender Jimmy Carter won the New Hampshire primary with 51% of the vote. Carter would go on to become the first Democrat from the Deep South to win the presidency since Woodrow Wilson. His triumph in New Hampshire proved, as he said, “that a progressive southerner can win in the North.” Fast forward to February 2020 and Vermont Senator Bernie Sanders, the most left-wing candidate vying for the nomination, is attempting to perform the equally dazzling feat of winning a primary election in the conservative southern state of South Carolina. If Sanders pulls it off then it will trigger an earthquake. For a progressive who can win in the South is likely to score big on Super Tuesday, March 3, and if Sanders pulls that off then he will become the country’s first “socialist” presumptive nominee for president (Chart 15). This would be a huge upset, primarily for former Vice President Joe Biden, who has long led the opinion polls in South Carolina and recently has even rebounded. Biden expects strong support from the African American community – which is staunchly Democratic, moderate in ideology, and favorable toward Biden due to his close association with former President Barack Obama. The problem is that Biden’s latest rebound in the polls may be too little, too late. He made more gaffes in the debate performance and, most importantly, Sanders’s polling has improved among African Americans (Chart 16). Chart 15A Sanders Win In The South Will Help Him Score Big On Super Tuesday GeoRisk Update: Leap Year, Or Steep Year? GeoRisk Update: Leap Year, Or Steep Year? Chart 16Sanders’s Polling Has Improved Among African-Americans GeoRisk Update: Leap Year, Or Steep Year? GeoRisk Update: Leap Year, Or Steep Year? Sanders performed well with almost every demographic in Nevada – if he can do well among blacks, and in the south as well as the north and west, then his ability to unify the party will be incontrovertible and moderate Democratic primary voters looking for a winner will start to resign themselves to his nomination. What is more likely is that Biden wins in South Carolina, declares himself the “comeback kid,” and prolongs the uncertainty regarding the Democratic nomination. Chart 17A Biden Win In Texas Would Reenergize The Establishment GeoRisk Update: Leap Year, Or Steep Year? GeoRisk Update: Leap Year, Or Steep Year? If South Carolina propels Biden to a strong performance on Super Tuesday, particularly a win in Texas, it could usher in a new phase of the primary election since it would suggest the possibility that the establishment has not lost the nomination and is striking back against Sanders (Chart 17). Failing that, any “Never Sanders” movement will face an uphill battle. After March 3, about 39% of the Democratic Party’s delegates will be “pledged,” or committed, to one of the candidates. Two weeks later, fully 61.5% of delegates will be chosen. Which means that the best chance for a conservative counter-revolution against Sanders comes over the next three weeks. Regardless of South Carolina, Biden’s structural limitation on Super Tuesday is the well-known phenomenon of vote-splitting. Five centrist candidates are dividing the moderate vote, leaving Sanders to engross the 40%-45% of the vote that is progressive all to himself.1 This is a compelling reason to believe that Sanders will continue to amass the most delegates. What would change the equation would be a mustering of the centrists under a single competitive candidate. The latter requires candidates to be forced out of the race through defeat or to drop out of the race willingly for the good of the party. If Mayor Pete Buttigieg or Senator Amy Klobuchar should fall short of the 15% to qualify for delegates in South Carolina, they would need to bow out of the race (they might be persuaded by promises of high appointments). Most importantly, if Biden should squander South Carolina then he would need to take one for the team and drop out, passing the baton to Bloomberg. It will be hard for any one of these politicians to quit unless it is coordinated with the others; he or she would have to forgo any hopes of emerging at the top of the ticket at a contested Democratic National Convention in July. If coordination fails, the centrist vote will become even more fragmented when Mayor Michael Bloomberg finally appears on the ballot on March 3. Last week we argued that if Sanders cannot clinch the nomination by winning a majority of the delegates by June, then he needs to win a commanding plurality of the delegates so that moderate unpledged delegates are forced to capitulate and vote for him at the Democratic National Convention. We argued that for this to happen he needs, at minimum, to improve upon his score in 2016, which was 43% of the popular vote and 40% of the delegate count. Otherwise, a sequential voting procedure among roughly equally weighted blocs will likely lead to his defeat, as the two other factions of the party (establishment Washington insiders like Biden and centrist Washington outsiders like Bloomberg) view Sanders-style socialism as their least preferred option. Is this 40%+ threshold enough? Nobody knows. Clearly it is harder to win the nomination with 40% of the delegates than with 49%, even if you are in first place. But if Sanders leads by double digits in terms of the share of delegates, has captured 43%+ of the popular vote, and has won the big swing state primaries across regions, then it will be hard for Democratic delegates to conclude that he is not the most competitive in the general election. Currently Sanders is slated to win California, Michigan, Wisconsin, Pennsylvania, Ohio, and possibly Texas. This is a strong argument for moderate unpledged delegates to swing behind him. It is even compelling for some of the Democratic Party’s “super delegates,” at least those who are wavering. Otherwise these party elders would break up an enormous amount of momentum in the name of a less popular Democratic candidate – and strengthen Trump. Bottom Line: Super delegates will vote as political actors facing constraints inherent in their situation. If the situation is that Sanders has won 43% of the vote, leads the next candidate by double digits, has won the most primary elections, and has won in the major states, including the swing states, then it will be a compelling constraint on voting against him. Investment Conclusions The daily new cases of the coronavirus outside China continues to surge, creating near-term headwinds for global risk assets. Ultimately the negative shock of the virus may be overstated, but we remain on the sidelines of any near-term equity rally due to the confluence of a global demand shock and a US socialism boom. With manufacturing already vulnerable, the coronavirus, insofar as it causes a harder hit to global and hence American manufacturing, is a threat to Trump’s reelection odds. This is true regardless of who takes the Democratic nomination. It is also true notwithstanding that pandemic risks may ultimately fuel xenophobic sentiment. Trump cannot argue his way out of rising unemployment in the Rust Belt. The market is underrating the Sanders risk to health care and technology stocks. This means that Sanders has a greater chance of winning the White House than the consensus holds. Financial markets should continue to discount his rising odds, at least until it becomes clear either that he is falling short of a strong plurality or that the global economy is shaking off its jitters. As the financial market stumbles Sanders will get more steam than other candidates, while Trump’s odds will suffer, which is a potentially self-reinforcing dynamic. Looking at the correlations between different candidates and US equity sectors, the market is underrating the Sanders risk to health care and technology stocks (Table 1). Sanders poses a threat to regulation in these spheres even if the Democrats do not take a majority in the Senate. And they are likely to take the Senate and have a one-seat majority in the event that they prove capable of ousting Trump (via the vice president). Table 1The Market Is Underrating The Sanders Risk To US Equities GeoRisk Update: Leap Year, Or Steep Year? GeoRisk Update: Leap Year, Or Steep Year? Ultimately Trump’s reelection also represents a threat to the tech sector, due to a “Phase Two” trade war, but the initial market reaction is likely to be risk-on. Assuming our base case that the virus fear eventually subsides, people get back to work, the world economy regains its footing, and monetary and fiscal stimulus get pumping (especially in China), the swing state economies may well be banging by November. In that context, the three pillars of our bullish 12-month view will be restored: the Fed put, the China put, and Trump’s reelection as a “buy the rumor, sell the news” phenomenon.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 This assumes Senator Elizabeth Warren of Massachusetts continues to fall short of the 15% threshold qualifying a candidate to receive pledged delegates to the Democratic National Convention. Appendix Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights China’s economic rebound in Q1 will be delayed due to the coronavirus, which will have a larger negative hit than SARS. New stimulus measures will assist a rebound in demand later this year. Europe remains a geopolitical opportunity rather than a risk. As long as global growth rebounds this year, European equities can outperform their richly valued American counterparts. Emerging markets face a new headwind from the coronavirus. Emerging market performance relative to developed markets will be a key test of whether endogenous growth trends are taking shape. Tactically – over a 12-month horizon – we remain long industrial commodities; long Korean equities versus Taiwanese; and long Malaysian equities relative to emerging markets. Feature Global equities will ultimately push through the coronavirus and the Democratic Party primary election, but risks are elevated and Q1 looks to bring significant volatility. Last week we shifted to a tactically neutral stance on risk assets but we remain cyclically bullish. In this report we update our market-based GeoRisk indicators, which are almost all set to rise from low levels in the coming months as developed market equities and emerging market currencies face higher risk premiums. China: The Year Of The Rat Chart 1Markets Will Rebound Once Toll Of Virus Peaks Markets Will Rebound Once Toll Of Virus Peaks Markets Will Rebound Once Toll Of Virus Peaks The ink had hardly dried on our “Black Swan” report for 2020 when Chinese scientists confirmed human-to-human transmission of the Wuhan coronavirus (2019-nCoV), sending a wave of fear over China and the world. The number of new cases and new deaths is rising and economic activity will suffer as the Chinese New Year is extended, shoppers stay home, and international travel is canceled. The virus is likely to prove more troublesome than stock investors want to admit, at least in the short term. Too little is known to make confident assertions about promptly containing the virus or its impact on global economy and markets. The analogy with the SARS outbreak of 2003 is limited: it is not certain that this virus has a lower death rate, but it is certain that the Chinese economy is more vulnerable to disruption today than at that time – and much more influential on the global economy. The SARS episode is useful, however, in suggesting that the market will not rebound until the number of new cases and deaths turn down (Chart 1). Assuming the virus is ultimately contained – both in China and in neighboring Asian countries whose governments may not be as effective at quarantining the problem – regional consumption and production will bounce back. New stimulus measures will also take effect with a lag. Domestic political risk is structurally understated in China. Stimulus will indeed be the answer. First, the negative shock to consumer demand comes at a time when global trade is still relatively weak, thus presenting a two-pronged threat to China’s economy, which was only just stabilizing after the truce in the trade war. Second, China’s hundredth anniversary of the Communist Party, in 2021, will require the government to stabilize the economy now. The important political leadership reshuffle at the twentieth National Party Congress in 2022 is another imperative to avoid a deepening slump today (Chart 2). Chart 2China Will Stimulate To Avoid A Deepening Slump China Will Stimulate To Avoid A Deepening Slump China Will Stimulate To Avoid A Deepening Slump Beyond 2020, the Wuhan virus highlights our theme that domestic political risk is structurally understated in China. At the centennial celebration, China’s leaders aim to show that the country is a “moderately prosperous society in all respects,” emphasis added. For decades China’s leaders have emphasized industrial production to the detriment of other social and economic goals, such as food safety and a clean and safe environment for households to live in. The emergence of the middle class, writ broadly, as a majority of the population is a persistent source of pressure on leaders, as the limited opinion polling available from China demonstrates (Chart 3). In other emerging markets, a large middle class has led to social and political change when the government failed to meet growing middle class demands (Chart 4). Chart 3Chinese Social And Economic Conditions Are Source Of Pressure GeoRisk Update: The Year Of The Rat GeoRisk Update: The Year Of The Rat Chart 4Consumerism Encourages Democracy Consumerism Encourages Democracy Consumerism Encourages Democracy Chart 5China’s Government Is Behind The Curve GeoRisk Update: The Year Of The Rat GeoRisk Update: The Year Of The Rat Under General Secretary Xi Jinping, the government has cracked down on corruption and pollution as well as poverty, and has attempted to improve consumer safety and the health care system. The party officially aims to shift its policy focus from meeting the basic material needs of the population to improving quality of life. The problem is that China’s government is behind the curve (Chart 5). While it is making rapid progress – for instance, the communicable disease burden has dropped dramatically – and has unique authoritarian tools, acute problems of health, food safety, pollution, and public services will nevertheless persist. The government’s responses will inevitably fall short from time to time and heads will roll. Crisis events create the potential for the market to be surprised by the level of domestic political change or pushback, which will prove disruptive at times. Bottom Line: China’s economic rebound in Q1 will be delayed due to the coronavirus, which will have a larger negative hit than SARS. The SARS episode suggests that Chinese equities will be a tactical buy when the number of new cases and deaths begin falling. New stimulus measures will assist a rebound in demand later this year – underscoring our constructive cyclical view on Chinese and global growth. The episode highlights the challenges China faces in modernizing and improving regulations, health, and safety for the emerging middle class. Domestic political risk is understated. Europe: Political Risks Still Contained China’s near-term hit, and rebound later this year, will echo in Europe, where the economy and equity market are highly reliant on China’s credit cycle and import demand. Politically, however, Europe remains a geopolitical opportunity rather than a risk (Chart 6). Chart 6China's Hit Will Echo In Europe, But Political Risks Are Contained There GeoRisk Update: The Year Of The Rat GeoRisk Update: The Year Of The Rat The final months of last year saw the biggest and most immediate political risk – a disorderly UK exit from the EU – removed. The Trump administration is not likely to slap large-scale tariffs – such as auto tariffs on a national security pretext – because Trump is constrained by the weak manufacturing sector in advance of his election. Meanwhile immigration and terrorism have declined since 2016, draining the fuel of Europe’s anti-establishment parties. Pound weakness during the Brexit transition period is an opportunity for investors to buy. Chart 7Immigration Is Ticking Up, But From Low Levels Immigration Is Ticking Up, But From Low Levels Immigration Is Ticking Up, But From Low Levels Chart 8Refugees Will Favor Western Route Across The Mediterranean Refugees Will Favor Western Route Across The Mediterranean Refugees Will Favor Western Route Across The Mediterranean Chart 9Government Gridlock, Catalonia, And Poor Reform Momentum Will Pull Up Spanish Risk Government Gridlock, Catalonia, And Poor Reform Momentum Will Pull Up Spanish Risk Government Gridlock, Catalonia, And Poor Reform Momentum Will Pull Up Spanish Risk There are some signs of immigration numbers ticking up, but from very low levels (Chart 7). This uptick must be monitored for Spain (and France), as the renewed civil war in Libya is forcing refugees to shift to the western route across the Mediterranean (Chart 8). (Note that even peace in Libya opens the possibility of greater migrant flows as the country then becomes a viable transit route again). Our Spanish risk indicator is already ticking up due to government gridlock, the Catalonian conflict, and a declining commitment to structural economic reform (Chart 9). But this is not a major concern for global investors. The United Kingdom The UK will formally exit the European Union on January 31. The transition period – in which the UK remains fully integrated into the EU single market – expires on December 31, 2020. This is the official deadline for the two sides to negotiate a trade agreement – though it can, and likely will, be delayed. Chart 10British Political Risk Will Revive, But Not Dramatically British Political Risk Will Revive, But Not Dramatically British Political Risk Will Revive, But Not Dramatically The trade agreement is intended to minimize the negative economic impact of Brexit while ensuring that the UK reclaims its sovereignty and the EU retains the integrity of the single market. As negotiations get under way, the pound will face a new round of volatility and British political risk will revive somewhat, but we do not expect a dramatic increase (Chart 10). Ultimately we see pound weakness as an opportunity for investors to buy. The twin risks of no-deal Brexit or a socialist Jeremy Corbyn government have been decisively cast off. The end-of-year deadline can be extended and the two sides can find technical ways to compromise over regulations, tariffs, and border checks. Challenges to global growth only make an amicable solution more obtainable. Italy Our Italian GeoRisk indicator is collapsing as political risks proved yet again to be overstated (Chart 11). Chart 11Italian GeoRisk Indicator Is Collapsing Italian GeoRisk Indicator Is Collapsing Italian GeoRisk Indicator Is Collapsing The local election in Emilia-Romagna was hyped as a major populist risk, in which the chief anti-establishment players, Matteo Salvini and the League, would take power in a region viewed as the symbolic home of the Italian left wing. Instead, the League lost, the ruling Democratic Party won, and the current government coalition will survive. While the populists prevailed at another election in Calabria, this outcome was fully expected. The trend of recent provincial elections does not suggest a swell of Italian populism (Chart 12). Chart 12Recent Local Elections Do Not Suggest A Swell Of Italian Populism GeoRisk Update: The Year Of The Rat GeoRisk Update: The Year Of The Rat Chart 13The Italian Coalition Will Not Rush To Elections The Italian Coalition Will Not Rush To Elections The Italian Coalition Will Not Rush To Elections This local election is not the end of the coalition’s troubles. The left-wing, anti-establishment Five Star Movement is suffering in the polls as a result of its uninspiring, politically expedient pairing with the establishment Democrats. The Democrats may receive a boost from Emilia-Romagna but the Five Star’s leadership change – the resignation of party leader Luigi di Maio – will not be enough to revive its fortunes alone. A new Five Star leader will have to decide whether to collaborate more deeply with the Democrats or try to reclaim the party’s anti-establishment credentials. The latter would push the coalition toward an election before too long. But the Five Star’s weak polling – and the League’s persistent 10 percentage point lead over the Democratic Party in nationwide polling – suggests that the coalition will not rush to elections but will try to prepare by passing a new electoral law (Chart 13). What is clear is that the Five Star Movement will not court elections until they improve their polling. France In France, Emmanuel Macron and his ruling En Marche party have seen their popularity drop to new lows amid the historic labor strikes in opposition to Macron’s pension reforms (Chart 14). Macron’s current trajectory is dangerously close to that of his predecessor, Francois Hollande, and threatens to turn him into a lame duck. We doubt this is the case. Chart 14Macron’s Popularity Is On A Dangerous Trajectory GeoRisk Update: The Year Of The Rat GeoRisk Update: The Year Of The Rat Diagram 1The ‘J-Curve’ Of Structural Reform GeoRisk Update: The Year Of The Rat GeoRisk Update: The Year Of The Rat We view Macron’s decline as another example of the “J-Curve of Structural Reform,” in which a leader’s political capital drops amid controversial reforms (Diagram 1). If the leader avoids an election during the trough of the curve, the danger zone, then his or her political capital may well revive after the benefits of the structural reform are recognized. In this case, the reform is neutral for France’s budget deficit – a cyclical positive – but it encourages an improvement in pension sustainability by incentivizing workers to work longer and postpone retirement – a structural positive. Chart 15France's Economy Is Holding Up France's Economy Is Holding Up France's Economy Is Holding Up Chart 16A Relatively Strong Economy Will Buffer Against Political Risk In France A Relatively Strong Economy Will Buffer Against Political Risk In France A Relatively Strong Economy Will Buffer Against Political Risk In France Municipal elections in March will not go Macron’s way, but the presidential and legislative elections are not until 2022. France’s GDP growth is holding up better than that of its neighbors, wages are rising, and confidence did not collapse amid the Christmas labor strike (Chart 15). Hence we expect the increase in political risk to be manageable (Chart 16), a boon for French equities. Germany German political risk is set to rise from today’s depths (Chart 17). The country faces a major shift: globalization is structurally declining and Chancellor Angela Merkel is stepping down. Merkel’s heir-apparent, Annegret Kramp-Karrenbauer (AKK), is floundering in the opinion polls (Chart 18). Chart 17German Political Risk Will Rise German Political Risk Will Rise German Political Risk Will Rise Chart 18Merkel's Heir-Apparent Is Floundering In The Opinion Polls Merkel's Heir-Apparent Is Floundering In The Opinion Polls Merkel's Heir-Apparent Is Floundering In The Opinion Polls Thus intra-party struggle, and conceivably even a rare early election, could emerge. But the US-China trade ceasefire offers a temporary reprieve. Next year will be different, with elections looming in the fall and the potential for a Trump reelection to trigger a second round of the US-China trade war or to shift to trade war with the EU and tariffs on German cars. The overall political trend in Germany is centrist and pro-Europe, and most of the parties are becoming more willing to upgrade fiscal policy over time. South Korea’s economic problems are priced in, while the market is dismissing Taiwan’s immense political risk. Bottom Line: The US election cycle is the chief source of policy risk and geopolitical risk in 2020, a stark contrast with the EU. European political risk will spike with a full-fledged recession, but for now it is contained. In fact the risks are largely to the upside in the short term as the countries turn slightly more fiscally accommodative. As long as global growth rebounds this year, European equities can outperform their richly valued American counterparts. Emerging Markets: Can They Outperform? With volatility likely in the near-term, Arthur Budaghyan of BCA Research’s Emerging Markets Strategy argues that the key test for emerging markets equities is whether they outperform their developed market counterparts. If they do not, then it suggests that investors still do not see endogenous growth, capital spending and profitability in emerging markets and therefore that they will lag their DM counterparts in the eventual equity upswing. Our long Korea / short Taiwan trade exploded out of the gate but has since fallen back in the face of the new headwind from the coronavirus. We have a high conviction in this trade because the difference in equity valuations faces a looming catalyst in the market’s mispricing of relative geopolitical risk: South Korea’s risk indicator is in a broad upswing while Taiwan’s has collapsed, despite the persistence of the diplomatic track with North Korea and Taiwan’s resounding reelection of both a pro-independence president and legislature (Chart 19). Mainland China will send both risk indicators upward in the near term, but South Korea’s economic problems are priced in and Trump’s diplomacy with North Korea is grounded in well-established constraints on Washington, Beijing, Pyongyang, and Seoul. By contrast the market is entirely dismissing Taiwan’s immense political risk, which does not depend on the outcome of the US election. In the coming 1-3 years, Beijing, Taipei, and Washington are all more likely to take self-interested actions that test the constraints in the Taiwan Strait, upsetting the market, before those constraints are reconfirmed (assuming they are). Beijing is likely to impose economic sanctions as Taipei’s demand for greater freedom and alliance with the US will agitate Chinese leaders who will seek to get the Kuomintang back into power. Brazilian political risk has failed to reach new highs, as anticipated, suggesting that President Jair Bolsonaro’s many problems are not driving investors to sell the real amid underlying indications of rebounding global growth and at least attempts at pro-market reform (Chart 20). Chart 19Markets Are Mispricing Geopolitical Risks In South Korea And Taiwan Markets Are Mispricing Geopolitical Risks In South Korea And Taiwan Markets Are Mispricing Geopolitical Risks In South Korea And Taiwan Chart 20Political Risks Remain Contained In Brazil Political Risks Remain Contained In Brazil Political Risks Remain Contained In Brazil Turkey’s military intervention into Libya’s civil war is another example of the foreign adventurism that we see as an outgrowth of populism and the need to distract the public’s attention from domestic mismanagement. We expect the risk indicator to rise or be flat and would remain short Turkish currency and risk assets. Bottom Line: Emerging markets face a new headwind from the coronavirus. Not only will China’s growth rebound sputter but Asian EMs will be exposed to the virus and may be less capable than China of dealing with it rapidly and effectively. With volatility looming, emerging market performance relative to developed markets will be a key test of whether endogenous growth trends are taking shape. Investment Conclusions Tactically we are closing our long GBP/JPY trade and UK curve steepener for negligible gains. We are also closing our long Egyptian sovereign bond trade for a gain of 5.59%. We remain long industrial commodities; long Korean equities versus Taiwanese; and long Malaysian equities relative to emerging markets. We expect these trades to perform well over a 12-month horizon. Strategically several of our recommendations will benefit from heightened volatility in the near term but face challenges later in the year as growth rebounds and risk sentiment revives. Nevertheless our time horizon is three-to-five years. In that span we remain long gold, long euro, long defense, short US tech, and short CNY-USD.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Germany: GeoRisk Indicator Germany: GeoRisk Indicator Germany: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator UK: GeoRisk Indicator UK: GeoRisk Indicator UK: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea: GeoRisk Indicator Korea: GeoRisk Indicator Korea: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights The US-China trade talks will continue despite Hong Kong. The UK election will not reintroduce no-deal Brexit risk – either in the short run or the long run. European political risk is set to rise from low levels, but Euro Area break-up risk will not. There is no single thread uniting emerging market social unrest. We remain constructive on Brazil. Feature Chart 1Taiwan Indicator To Rise Despite Ceasefire Taiwan Indicator To Rise Despite Ceasefire Taiwan Indicator To Rise Despite Ceasefire President Trump signed the Hong Kong Human Rights and Democracy Act into law on November 27. The signing was by now expected – Trump was not going to veto the bill and invite the Senate to override him with a 67-vote at a time when he is being impeached. He does not want to familiarize the Senate with voting against him in supermajorities. The Hong Kong bill will not wreck the US-China trade talks, but it is a clear example of our argument that strategic tensions will persist and cast doubt on the durability of the “phase one trade deal” being negotiated. It is better to think of it as a ceasefire, as Trump’s electoral constraint is the clear motivation. Trump is embattled at home and will contend an election in 11 months. He will not impose the tariff rate hike scheduled for December 15. A relapse into trade war would kill the green shoots in US and global growth, which partly stem from the perception of easing trade risk. Only if Trump’s approval rating collapses, or China stops cooperating, will he become insensitive to his electoral constraint. Will China abandon the talks and leave Trump in the lurch? This is not our base case but it is a major global risk. So far China is reciprocating. Xi Jinping’s political and financial crackdown at home, combined with the trade war abroad, has led to an economic slowdown and an explosion in China’s policy uncertainty relative to America’s. A trade ceasefire – on top of fiscal easing – is a way to improve the economy without engaging in another credit splurge. The US and China will continue moving toward a trade ceasefire, despite the Hong Kong bill. The move toward a trade ceasefire will probably keep our China GeoRisk Indicator from rising sharply over the next few months. However, our Taiwan indicator, which we have used as a trade war proxy at times, may diverge as it starts pricing in the heightened political risk surrounding Taiwan’s presidential election on January 11, 2020 (Chart 1). Sanctions, tech controls, Hong Kong, Taiwan, North Korea, Iran, the South China Sea, and Xinjiang are all strategic tensions that can flare up. Yes, uncertainty will fall and sentiment will improve on a ceasefire, but only up to a point. China’s domestic policy decisions are ultimately more important than its handling of the trade war. At the upcoming Central Economic Work Conference authorities are expected to stay focused on “deepening supply-side structural reform” and avoiding the use of “irrigation-style” stimulus (blowout credit growth). But this does not mean they will not add more stimulus. Since the third quarter, a more broad-based easing of financial controls and industry regulations is apparent, leading our China Investment Strategy to expect a turning point in the Chinese economy in early 2020. This “China view” – on stimulus and trade – is critical to the outlook for the two regions on which we focus for the rest of this report: Europe and emerging markets. Assuming that China stabilizes, these are the regions where risk assets stand to benefit the most. Europe is a political opportunity; the picture in emerging markets is, as always, mixed. United Kingdom: Will Santa Bring A Lump Of Coal? The Brits will hold their first winter election since 1974 on December 12. Prime Minister Boris Johnson’s Conservative Party has seen a tremendous rally in opinion polls, although it has stalled at a level comparable to its peak ahead of the last election in June 2017 (Chart 2). Another hung parliament or weak Tory coalition is possible. Yet the Tories are better positioned this time given that the opposition Labour Party is less popular than two years ago, while the Liberal Democrats are more capable of stealing Labour votes. The Tories stand to lose in Scotland, but the Brexit Party of Nigel Farage is not contesting seats with them and is thus undercutting Labour in certain Brexit-leaning constituencies. Markets would enjoy a brief relief rally on a single-party Tory majority. This would enable Johnson to get his withdrawal deal over the line and take the UK out of the EU in an orderly manner by January 31. The question would then shift to whether Johnson feels overconfident in negotiating the post-Brexit trade agreement with the EU, which is supposed to be done by December 31, 2020. This date will become the new deadline for tariff increases, but it can be extended. Johnson is as unlikely to fly off the cliff edge next year as he was this year, and this year he demurred. Negotiating a trade agreement is easier when the two economies are already integrated, have a clear (yet flexible) deadline, and face exogenous economic risks. Our political risk indicator will rise but it will not revisit the highs of 2018-19 (Chart 3). The pound’s floor is higher than it was prior to September 2019. Chart 2Tories Look To Be Better Positioned For A Single Party Majority Tories Look To Be Better Positioned For A Single Party Majority Tories Look To Be Better Positioned For A Single Party Majority Chart 3UK Risk Will Rise, But Not To Previous Highs UK Risk Will Rise, But Not To Previous Highs UK Risk Will Rise, But Not To Previous Highs Bottom Line: A hung parliament is the only situation where a no-deal Brexit risk reemerges in advance of the new Brexit day of January 31. The market is underestimating this outcome based on our risk indicator. But Johnson himself prefers the deal he negotiated and wishes to avoid the recession that would likely ensue from crashing out of the EU. And a headless parliament can prevent Johnson from forcing a no-deal exit, as investors witnessed this fall. We remain long GBP-JPY. Germany: The Risk Of An Early Election Germany is wading deeper into a period of political risk surrounding Chancellor Angela Merkel’s “lame duck” phase, doubts over her chosen successor, and uncertainty about Germany’s future in the world. The federal election of 2021 already looms large. Our indicator is only beginning to price this trend which can last for the next two years (Chart 4). On October 27 Germany’s main centrist parties suffered a crushing defeat in the state election of Thuringia. For the first time, the Christian Democratic Union (CDU) not only lost its leadership position, but also secured less vote share than both the Left Party and the right-wing Alternative für Deutschland (AfD) (Chart 5, top panel). Chart 4Germany Is Heading Toward A Period Of Greater Political Risk Germany Is Heading Toward A Period Of Greater Political Risk Germany Is Heading Toward A Period Of Greater Political Risk The AfD successfully positioned itself with the right wing of the electorate and managed to capture more undecided voters than any other party (Chart 5, bottom panel). Chart 5The Right-Wing AfD Outperformed In Thuringia … Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 While the rise of the AfD (and its outperformance over its national polling) may seem alarming, Germany is not being taken over by Euroskeptics. Both support for the euro and German feeling of being “European” is near all-time highs (Chart 6). The question is how the centrist parties respond. Merkel’s approval rating is at its lower range. Support for Annegret Kramp-Karrenbauer (AKK), Merkel’s chosen successor, is plummeting (Chart 7). Since AKK was confirmed as party chief, the CDU suffered big losses in the European Parliament election and in state elections. Several of her foreign policy initiatives were not well received in the party.1 In October 2019, the CDU youth wing openly rejected her nomination as Merkel’s successor. At the annual CDU party conference on November 22-23, she only narrowly managed to avoid rebellion. She is walking on thin ice and will need to recover her approval ratings if she wants to secure the chancellorship. Meanwhile the CDU will lose its united front, increasing Germany’s policy uncertainty. Chart 6... But Euroskeptics Will Not Take Over Germany ... But Euroskeptics Will Not Take Over Germany ... But Euroskeptics Will Not Take Over Germany Germany’s other major party – the Social Democratic Party (SPD) – is also going through a leadership struggle. Chart 7The CDU Party Leader Is Walking On Thin Ice The CDU Party Leader Is Walking On Thin Ice The CDU Party Leader Is Walking On Thin Ice Chart 8A Return To The Polls Would Result In A CDU-Green Coalition Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 In the first round of the leadership vote, Finance Minister Olaf Scholz and Klara Geywitz (member of the Brandenburg Landtag) secured a small plurality of votes with 22.7%, just 1.6% more than Bundestag member Saskia Esken and Norbert Walter-Borjans (finance minister of North Rhine-Westphalia from 2010-17). The latest polling, and Scholz’s backing by the establishment, implies that he will win but this is uncertain. The results of the second round will be published on November 30, after we go to press. What does the SPD’s leadership contest mean for the CDU-SPD coalition? More likely than not, the status quo will continue. Scholz is an establishment candidate and supports remaining in the ruling coalition until 2021. Esken is calling for the SPD to leave the coalition, but Walter-Borjans has not explicitly supported this. An SPD exit from the Grand Coalition would likely lead to a snap election, not a favorable outcome for stability-loving Germans. A return to the polls would benefit the Greens and AfD at the expense of the mainstream parties, and would likely see a CDU-Green coalition emerge (Chart 8). Given that a majority of voters want the SPD to remain in government (Chart 9), and that new elections would damage the SPD’s prospects, we believe that the SPD is likely to stay in government until 2021, even if the less established Esken and Walter-Borjans win. The risk is the uncertainty around Merkel’s exit. October 2021 is a long time for Merkel to drag the coalition along, so the odds of an early election are probably higher than expected. Chart 9Germans Prefer The SPD Remains In Government Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Chart 10Climate Spending Closest Germany Gets To Fiscal Stimulus (For Now) Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Chart 11There Is Room For More Fiscal Stimulus In Germany, If Needed There Is Room For More Fiscal Stimulus In Germany, If Needed There Is Room For More Fiscal Stimulus In Germany, If Needed What would a Scholz win mean for the great debate over whether Germany will step up its fiscal policy? If the establishment duo wins the SPD leadership, the Grand Coalition remains in place, and the economy does not relapse, we are unlikely to see additional fiscal stimulus in the near future. Scholz argues that additional stimulus would not be productive, as the slowdown is due to external factors (i.e. trade war).2 The recently released Climate Action Program 2030 is the closest to fiscal stimulus that we will see. This package will deliver additional spending worth 9bn euro in 2020 and 54bn euro until 2023 (Chart 10). We are unlikely to see additional fiscal stimulus from Germany in the near future. Bottom Line: Germany is wading into a period of rising political uncertainty. In the event of a downward surprise in growth, there is room to add more fiscal stimulus (Chart 11). But there is no change in fiscal policy in the meantime, e.g. no positive surprise. France: Macron Takes Center Stage While Merkel exits, President Emmanuel Macron continues to position himself as Europe’s leader – with a vision for European integration, reform, and political centrism. But in the near term he will remain tied down with his ambitious domestic agenda. France is trudging down the path of fiscal consolidation. After exiting the Excessive Deficit Procedure in 2018, and decreasing real government expenditures by 0.3% of GDP, France’s budget deficit is forecasted to decline further (Chart 12). Macron’s government is moving towards balancing its budget primarily by reducing government expenditures to finance tax cuts and decrease the deficit. Macron’s reform efforts following the Great National Debate – tax cuts for the middle class, bonus exemptions from income tax and social security contributions, and adjustment of pensions for inflation – have paid off.3 His approval rating is beginning to recover from the lows hit during the Yellow Vest protests (Chart 13). These reforms will be financed by lower government expenditures and reduced debt burden as a result of accommodative monetary policy. Chart 12Fiscal Consolidation In France Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Chart 13Macron's Reform Efforts Have Paid Off Macron's Reform Efforts Have Paid Off Macron's Reform Efforts Have Paid Off Overall, France has proven to a very resilient country in light of a general economic slowdown (Chart 14, top panel). Business investment and foreign direct investment, propped up by gradual cuts in the corporate income tax rate, have remained steady, and confidence remains strong (Chart 14, bottom panels). France is consumer driven and hence somewhat protected from storms in global trade. Chart 14French Economy Resilient Despite Global Slowdown French Economy Resilient Despite Global Slowdown French Economy Resilient Despite Global Slowdown Chart 15Ongoing Strikes Will Register In French Risk Indicator Ongoing Strikes Will Register In French Risk Indicator Ongoing Strikes Will Register In French Risk Indicator Bottom Line: France stands out for remaining generally stable despite pursuing structural reforms. Strikes and opposition to reforms will continue, and will register in our risk indicator (Chart 15), but it is Germany where global trends threaten the growth model and political trends threaten greater uncertainty. On the fiscal front France is consolidating rather than stimulating.   Italy: Muddling Through This fall’s budget talks caused very little political trouble, as expected. The new Finance Minister Roberto Gualtieri is an establishment Democratic Party figure and will not seek excessive conflict with Brussels over fiscal policy. Italy’s budget deficit is projected to stay flat over 2019 and 2020. The key development since the mid-year budget revision was the repeal of the Value Added Tax hike scheduled for 2020, a repeal financed primarily by lower interest spending.4 Equity markets have celebrated Italy’s avoidance of political crisis this year with a 5.6% increase. Our own measure of geopolitical risk has dropped off sharply (Chart 16). But of course we expect it to rise next year given that Italy remains the weakest link in the Euro Area over the long run. The left-leaning alliance between the established Democratic Party and the anti-establishment Five Star Movement hurt both parties’ approval ratings. In fact, the only parties that have seen an increase in approval in the last month are the League, the far-right Brothers of Italy, and the new centrist party of former Prime Minister Matteo Renzi, Italia Viva (Chart 17). We expect to see cracks form next year, particularly over immigration, but mutual fear of a new election can motivate cooperation for a time. Chart 16Decline In Italian Risk Will Be Short Lived Decline In Italian Risk Will Be Short Lived Decline In Italian Risk Will Be Short Lived Chart 17The M5S-PD Alliance Damaged Their Approval The M5S-PD Alliance Damaged Their Approval The M5S-PD Alliance Damaged Their Approval Bottom Line: Italy’s new government is running orthodox fiscal policy, which means no boost to growth, but no clashing with Brussels either. Spain: Election Post Mortem Chart 18A Gridlocked Parliament In Spain Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 The Spanish election produced another gridlocked parliament, as expected, with no party gaining a majority and no clear coalition options. The Spanish Socialist Workers’ Party (PSOE) emerged as the clear leader but still lost three seats. The People’s Party recovered somewhat from its April 2019 defeat, gaining 23 seats. The biggest loser of the election was Ciudadanos, which lost 47 seats after its highly criticized shift to the right, forcing its leader Alberto Rivera to resign. The party’s seats were largely captured by the far-right Vox party, which won 15.1% of the popular vote and more than doubled its seats (Chart 18). Socialist leader Pedro Sanchez has arranged a preliminary governing agreement with Podemos leader Pablo Iglesias, but it is unstable. Even with Podemos, Sanchez falls far short of the 176 seats he needs to govern. In fact, there are only three possible scenarios in which the Socialists can reach the required 176 seats and none of these scenarios are easy to negotiate (Chart 19). The first – a coalition with the People’s Party – can already be ruled out. The other two require the support of the smaller pro-independence party, which will be difficult for Sanchez to secure, given that he hardened his stance on Catalonia in the days leading up to the election. Chart 19No Simple Way To A Majority Government Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 The next step for Sanchez is to be confirmed as prime minister in an “investiture” vote, likely on December 16.5 He would need 176 votes in the first round (or a simple majority in the second round) to gain the confidence of Congress. He looks to fall short (Chart 20).6 If he fails to be confirmed, Sanchez will have another two months to form a government or face the possibility of yet another election. Chart 20Sanchez Set To Fall Short In Investiture Vote Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Spain’s indecision is leading to small conflicts with Brussels. Last week, the European Commission placed Spain under the preventative arm of the Stability and Growth Pact, stating that the country had not done enough to reach its medium-term budget objective.7 The European Commission’s outlook on Spain is slightly more pessimistic than that of the Spanish government (Chart 21). Deficit projections could worsen if a left-wing government takes power that includes the anti-austerity Podemos – which means that Spain is the only candidate for a substantial fiscal policy surprise. Chart 21A Fiscal Policy Surprise In Spain? Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Chart 22Spanish Risk Will Keep Rising Spanish Risk Will Keep Rising Spanish Risk Will Keep Rising We expect our Spanish risk indicator to keep rising (Chart 22). The silver lining is that Spain’s turmoil – like Germany’s – poses no systemic risk to the Euro Area. Spain could also see an increase in fiscal thrust. Stay long Italian government bonds and short Spanish bonos. Bottom Line: We remain tactically long Italian government bonds and short Spanish bonos. Italian bonds will sell off less in a risk-on phase and rally more in a risk-off phase, and relative political trends reinforce this trade. Emerging Markets: Global Unrest Civil unrest is unfolding across the world, grabbing the attention of the global news media (Chart 23). The proximate causes vary – ranging from corruption, inequality, governance, and austerity – but the fear of contagion is gaining ground. Chart 23Pickup In Civil Unrest Raising Fear Of Contagion Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 A country’s vulnerability to unrest can be gauged by two main factors: political voice and underlying economic conditions. • Political Voice: The Worldwide Governance Indicators, specifically voice and accountability, corruption, and rule of law, provide proxies for political participation (Chart 24). The aim is to assess whether there is a legitimate channel for discontent to lead to change. Countries with low rankings are especially at risk of experiencing unrest when the economy is unable to deliver. Chart 24Greater Risk Of Unrest Where Political Voice Is Absent Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 • Economic Conditions: Last year’s tightening monetary conditions, the manufacturing and trade slowdown, the US-China trade war, and a strong US dollar have weighed on global growth this year. This is challenging, especially for economies struggling to pick up the pace of growth (Chart 25). It translates to increased job insecurity, in some cases where insecurity is already rife (Chart 26). The likelihood that economic deterioration spurs widespread unrest depends on both the level and change in these variables. The former political factor is a structural condition that becomes more relevant when economic conditions deteriorate. Chart 25The Global Slowdown Weighed On Growth In Regions Already Struggling … Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Chart 26… And Raise Job Insecurity Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Chart 27Brazilian Risk Unlikely To Reach Previous Highs Brazilian Risk Unlikely To Reach Previous Highs Brazilian Risk Unlikely To Reach Previous Highs BCA Research is optimistic on global growth as we enter the end game of this business cycle. Nevertheless risks to this view are elevated and emerging market economies are still reeling from the past year’s slowdown. This makes them especially sensitive to failures on the part of policymakers. As a result, policymakers will be more inclined to ease monetary and fiscal policy and less inclined to execute structural reforms. Brazil is a case in point. Our indicator is flagging a sharp rise in political risk (Chart 27). This reflects the recent breakdown in the real – which can go further as the finance ministry has signaled it is willing to depreciate to revive growth. Meanwhile the administration has postponed its proposals to overhaul the country’s public sector, including measures to freeze wages and reduce public sectors jobs. On the political front, President Jair Bolsonaro’s recent break from the Social Liberal Party and launch of a new party, the Alliance for Brazil, threatens to reduce his ability to get things done. This move comes at a time when Brazil’s political landscape is being shaken up by former president Luiz Inacio Lula da Silva’s release from jail, pending an appeal against his corruption conviction. The former leader of the Worker’s Party lost no time in vowing to revive Brazil’s left. Our risk indicator might overshoot due to currency policy, but we doubt that underlying domestic political instability will reach late-2015 and mid-2018 levels. Brazil has emerged from a deep recession, an epic corruption scandal, and an impeachment that led to the removal of former president Dilma Rousseff. It is not likely to see a crisis of similar stature so soon. Bolsonaro’s approval rating is the lowest of Brazil’s recent leaders, save Michel Temer, but it has not yet collapsed (Chart 28). An opinion poll held in October – prior to Lula’s release – indicates that Bolsonaro is favored to win in a scenario in which he goes head to head against Lula (Chart 29). Justice Minister Sergio Moro, who oversaw the corruption investigation, is the only candidate that would gain more votes when pitted against Bolsonaro. He is working with Bolsonaro at present and is an important pillar of the administration. So it is premature to pronounce Bolsonaro’s presidency finished. Chart 28Bolsonaro’s Approval, While Relatively Low, Has Not Collapsed Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Chart 29Bolsonaro Not Yet Finished Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 The problem, as illustrated in Charts 25 and 26, is that Brazil still suffers from slow growth and an uninspiring job market – longstanding economic grievances. This will induce the administration to take a precautionary stance and slow the reform process. The result should be reflationary in the short run but negative for Brazil’s sustainability over the long run. There is still a positive path forward. Unlike the recently passed pension cuts and the public sector cuts that were just postponed – both of which zap entitlements from Brazilians – the other items on the reform agenda are less controversial. Privatization and tax reform are less politically onerous and will keep the government and economy on a positive trajectory. Meanwhile the pension cuts are unlikely to be a source of discontent as they will be phased in over 12-14 years. Thus, while the recent political events justify a higher level of risk, speculation regarding the likelihood of mass unrest in Brazil – apart from the mobilization of Worker’s Party supporters ahead of the municipal elections next fall – is overdone. Bottom Line: The growth environment in emerging markets is set to improve in 2020. US-China trade risk is falling and China will do at least enough stimulus to be stable. Moreover emerging markets will use monetary and fiscal tools to mitigate social unrest. This will not prevent unrest from continuing to flare. But not every country that has unrest is globally significant. Brazil is a major market that has recently emerged from extreme political turmoil, so a relapse is not our base case. Otherwise one should monitor Hong Kong’s impact on the trade deal, Russia’s internal stability, and the danger that Iranian and Iraqi unrest could cause oil supply disruptions. In the event that the global growth rebound does not materialize we expect Mexico and Thailand – which have better fundamentals – to outperform. Our long Thai equity relative trade is a strategic defensive trade.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Ekaterina Shtrevensky Research Analyst ekaterinas@bcaresearch.com Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 Please see “Merkel’s Successor Splits German Coalition With Rogue Syria Plan,” dated October 22, 2019 and “Merkel's Own Party Wants Outright Huawei Ban From 5G Networks,” dated November 15, 2019, available at bloomberg.com. 2 Please see “Scholz Says No Need for German Stimulus After Dodging Recession,” dated November 14, 2019, available at bloomberg.com. 3 Please see “France: Draft Budgetary Plan For 2020,” dated October 15, 2019, available at ec.europa.eu. 4 Please see “Analysis of the Draft Budgetary Plan of Italy,” dated November 20, 2019, available at ec.europa.eu. 5 Please see “Investiture calendar | Can a government be formed before Christmas?” dated November 14, 2019, available at elpais.com. 6 If Sanchez convinces PNV, BNG, and Teruel Exists to vote in his favor for both rounds of the vote, he would need ERC and Eh Bildu to abstain in order to win. However, given that the PSOE has stated that it will not even negotiate with Eh Bildu, it is likely that this party will vote against Sanchez, giving the opposition 168 votes. In this case, Sanchez would not only need PNV, BNG, and Teruel in his favor, but also the support of either CC or ERC, both unlikely scenarios. 7 Please see “Commission Opinion on the Draft Budgetary Plan of Spain,” dated November 20, 2019, available at ec.europa.eu. Appendix Germany: GeoRisk Indicator Germany: GeoRisk Indicator Germany: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator UK: GeoRisk Indicator UK: GeoRisk Indicator UK: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea: GeoRisk Indicator  Korea: GeoRisk Indicator Korea: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator What's On The Geopolitical Radar? Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Section III: Geopolitical Calendar

Highlights So What? Key geopolitical risks remain unresolved and most of the improvements are transitory. Maintain a cautious tactical stance toward risk assets. Why? U.S.-China relations remain the preeminent geopolitical risk to investors and President Trump remains a wild card on trade. Japan’s rising assertiveness in the region will also produce clashes with the Koreas and possibly also with China. USMCA ratification is not a red herring for investors. We expect USMCA will pass by year’s end but our conviction level is low. Trump’s threat to withdraw from NAFTA cannot be entirely ruled out. Remain long JPY-USD and overweight Thailand relative to EM equities. Feature Chart 1U.S. And Chinese Policy Growing More Simulative U.S. And Chinese Policy Growing More Simulative U.S. And Chinese Policy Growing More Simulative We maintain our cautious tactical stance toward risk assets despite improvements to the cyclical macro outlook. American and Chinese monetary and fiscal policy are growing more stimulative on the margin – an encouraging sign for the global economy and risk assets. We have frequently predicted this combination as a positive factor for the second half of the year and 2020. With the Federal Reserve likely to deliver a 25 basis point interest rate cut on July 31, the market is pricing in positive policy developments (Chart 1). Yet in the U.S., long-term fiscal and regulatory policies are increasingly uncertain as the Democratic Party primary and 2020 election heat up. And in China, the trade war continues to drag on the effectiveness of the government’s stimulus drive. President Trump remains a wild card on trade: the resumption of U.S.-China talks is precarious and will be accompanied by heightened uncertainty surrounding Mexico, Canada, Japan, and Europe in the near term. Even the USMCA’s ratification is not guaranteed, as we discuss below. Even more pressing are the dramatic events taking place in East Asia: Hong Kong, Japan, the Koreas, Taiwan, and the South and East China Seas. These events each entail near-term uncertainty amid the ongoing slowdown in trade and manufacturing. Our long-running theme of geopolitical risk rotation from the Middle East to East Asia has come to fruition, albeit at the moment geopolitical risk is rising in both regions due to the simultaneous showdown between Iran and the United States and United Kingdom. The market recognizes that geopolitical risks are unresolved, according to this month’s update of our currency- and equity-derived GeoRisk Indicators. This is in keeping with the above points. We regard most of the improvements as transitory – especially the drop in risk in the U.K., where Boris Johnson is now officially prime minister. We are therefore sticking with our cautious trade recommendations despite our agreement with the BCA House View that the cyclical outlook is improving and is positive for global risk assets on a 12-month horizon. What Is Happening To East Asian Stability? A raft of crises has struck East Asia, a region known for political stability and ease of doing business throughout the twenty-first century after its successful recovery from the financial crisis of 1997. The thawing of Asia’s frozen post-WWII conflicts is a paradigm shift with significant long-term consequences for investors. The fundamental drivers are as follows: China’s rise is not peaceful: President Xi Jinping has reasserted Communist Party control while pursuing mercantilist trade policy and aggressive foreign policy. The populations of Hong Kong and Taiwan have reacted negatively to Beijing’s tightening grip, exposing the difficulty of resolving serious political disagreements given unclear constitutional frameworks. Recent protests in Hong Kong are even larger than those in 2014 and 1989 (Table 1). Table 1Hong Kong: Recent Protests The Largest Ever East Asia Risks And The USMCA – GeoRisk Indicators Update: July 26, 2019 East Asia Risks And The USMCA – GeoRisk Indicators Update: July 26, 2019 America’s “pivot” is not peaceful: The United States is determined to respond to China’s rise, but political polarization has prevented a coherent strategy. The Democrats took a gradual, multilateral path emphasizing the Trans-Pacific Partnership while the Republicans have taken an abrupt, unilateral path emphasizing sweeping tariffs. Underlying trade policy is the increased use of “hard power” by both parties – freedom of navigation operations, weapons sales, and alliance-maintenance. America is threatening the strategic containment of China, which China will resist through alliances and relations with Russia and others. Japan’s resurgence is not peaceful: Japan’s “lost decades” culminated in the crises and disasters of 2008-11. Since then, Japan’s institutional ruling party – the Liberal Democrats – have embraced a more proactive vision of Japan in which the country casts off the shackles of its WWII settlement. They set about reflating the economy and “normalizing” the country’s strategic and military posture. The result is rising tension with China and the Koreas. Korean “reunion” is not peaceful: North Korea has seen a successful power transition to Kim Jong Un, who is attempting economic reforms to prolong the regime. South Korea has witnessed a collapse among political conservatives and a new push to make peace with the North and improve relations with China. The prospect of peace – or eventual reunification – increases political risk in both Korean regimes and provokes quarrels between erstwhile allies: the North and China, and the South and Japan. Southeast Asia’s rise is not peaceful: Southeast Asia is the prime beneficiary in a world where supply chains move out of China, due to China’s internal development and American trade policy. But it also suffers when China encroaches on its territory or reacts negatively to American overtures. Higher expectations from the U.S. will increase the political risk to Taiwan, South Korea, Vietnam, and the Philippines. This is the critical context for the mass protests in Hong Kong and the miniature trade war between Japan and South Korea, and other regional risks. Which conflicts are market-relevant? How will they play out? The U.S.-China Conflict The most important dynamic is the strategic conflict between the U.S. and China. Its pace and intensity have ramifications for all the other states in the region. Because the Trump administration is seeking a trade agreement with China, it has held off from unduly antagonizing China over Hong Kong and Taiwan. President Trump has not fanned the flames of unrest in Hong Kong and has maintained only a gradual pace of improvements in the Taiwan relationship.1 But if the trade war escalates dramatically, Beijing will face greater economic pressure, growing more sensitive about dissent within Greater China, and Washington may take more provocative actions. Saber-rattling could ensue, as nearly occurred in October 2018. Currently events are moving in a more market-positive direction. Next week, the U.S. and China are expected to resume face-to-face trade negotiations between principal negotiators for the first time since May. China is reportedly preparing to purchase more farm goods – part of the Osaka G20 ceasefire – while the Trump administration has met with U.S. tech companies and is expected to allow Chinese telecoms firm Huawei to continue purchasing American components (at least those not clearly impacting national security). We are upgrading the odds of a trade agreement by November 2020 to 40% from 32% in mid-June. With this resumption of talks, we are upgrading the odds of a trade agreement by November 2020 to 40%, from 32% in mid-June (Diagram 1). Of this 40%, we still give only a 5% chance to a durable, long-term deal that resolves underlying technological and strategic disputes. The remaining 35% goes to a tenuous deal that enables President Trump to declare victory prior to the election and allows President Xi Jinping to staunch the bleeding in the manufacturing sector. Diagram 1U.S.-China Trade War Decision Tree (Updated July 26, 2019) East Asia Risks And The USMCA – GeoRisk Indicators Update: July 26, 2019 East Asia Risks And The USMCA – GeoRisk Indicators Update: July 26, 2019 Note that these odds still leave a 60% chance for an escalation of the trade war by November 2020. Our conviction level is low when it comes to the two moderate scenarios. Ultimately, Presidents Trump and Xi can agree to a trade agreement at the drop of a hat – no one can stop Xi from ordering large imports from the U.S. or Trump from rolling back tariffs. Our conviction level is much higher in assigning only a 5% chance of a grand compromise and a 36% chance of a cold war-style escalation of tensions. We doubt that China will offer any structural concessions deeper than what they have already offered (new foreign investment law, financial sector opening) prior to finding out who wins the U.S. election in 2020. Beijing is stabilizing the economy even though tariffs have gone up. As long as this remains the case, why would it implement additional painful reforms? This would set a precedent of caving to tariff coercion – and yet Trump could renege on a deal anytime, and the Democrats might take over in 2020 anyway. The one exception might be North Korea, where China could do more to bring about a diplomatic agreement favorable to President Trump as part of an overall deal before November 2020 – and this could excuse China from structural concessions affecting its internal economy. The takeaway is that U.S.-China trade issues are still far from resolved and have a high probability of failure – and this will be a source of strategic tension within the region over the next 16 months, particularly with regard to Taiwan, the Koreas, and the South China Sea. Hong Kong And Taiwan Chart 2 August can be a crucial time period for policy changes as Chinese leaders often meet at the seaside resort of Beidaihe to strategize. This year they need to focus on handling the unrest in Hong Kong, and the Taiwanese election in January, as well as the trade war with the United States. Protests in Hong Kong have continued, driven by underlying socio-economic factors as well as Beijing’s encroachment on traditional political liberties. Even the groups that are least sympathetic to the protesters – political moderates, the elderly, low-income groups, and the least educated – are more or less divided over the controversial extradition bill that prompted the unrest (Chart 2). This reveals that the political establishment is weak on this issue. Chief Executive Carrie Lam is clinging to power, as Beijing does not want to give the impression that popular dissent is a viable mechanism for removing leaders. But she has become closely associated with the extradition bill and will likely have to go in order to satiate the protesters and begin the process of healing. As long as Beijing refrains from rolling in the military and using outright force to crush the Hong Kong protests, the unrest should gradually die down, as the political establishment will draw support for its concessions while the general public will grow weary of the protests – especially as violence spreads. Hong Kong has no alternative to Beijing’s sovereignty. The scene of action will soon turn to Taiwan, where the January 2020 election has the potential to spark the next flashpoint in Xi Jinping’s struggle to consolidate power in Greater China. Chart 3 A large majority of Taiwanese people supports the Hong Kong protests – even most supporters of the pro-mainland Kuomintang (KMT) (Chart 3). This dynamic is now affecting the Taiwanese election slated for January 2020. The relatively pro-mainland KMT has been polling neck-and-neck with the ruling Democratic Progressive Party (DPP), which has struggled to gain traction throughout its term given diplomatic and economic headwinds stemming from the mainland. Similarly, while popular feeling is still largely in favor of eventual independence, pro-unification feeling has regained momentum in an apparent rebuke to the pro-independence ruling party (Chart 4). However, the events in Hong Kong have changed things by energizing the democratic and mainland-skeptic elements in Taiwan. President Tsai Ing-wen is now taking a slight lead in the presidential head-to-head opinion polls despite a long period of lackluster polling (Chart 5). Chart 4 Chart 5 A close election increases the risk that policymakers and activists in Taiwan, mainland China, the United States, and elsewhere will take actions attempting to influence the election outcome. Beijing will presumably heed the lesson of the 1996 election and avoid anything too aggressive so as not to drive voters into the arms of the DPP. However, with Hong Kong boiling, and with Beijing having already conducted intimidating military drills encircling Taiwan in recent years, there is a chance that past lessons will be forgotten. The United States could also play a disruptive role, especially if trade talks deteriorate. If the KMT wins, then anti-Beijing activists will eventually begin gearing up for protests themselves, which in subsequent years could overshadow the Sunflower Movement of 2013. If the DPP prevails, Beijing may resort to tougher tactics in the coming years due to its fear of the province’s political direction and the DPP’s policies. In sum, while the Hong Kong saga is far from over and has negative long-run implications for domestic and foreign investors, Taiwan is the greater risk because it has the potential not only to suffer individually but also to become the epicenter of a larger geopolitical confrontation between China and the U.S. and its allies. This would present a more systemic challenge to global investors. Japan And “Peak Abe” Chart 6 Japan’s House of Councillors election on July 21 confirmed our view that Prime Minister Shinzo Abe has reached the peak of his influence. Abe is still popular and is likely to remain so through the Tokyo summer Olympics next year (Chart 6). But make no mistake, the loss of his two-thirds supermajority in the upper house shows that he has moved beyond the high tide of his influence. Having retained a majority in the upper house, and a supermajority in the much more powerful lower house (House of Representatives), Abe’s government still has the ability to pass regular legislation (Chart 7). If he needs to drive through a bill delaying the consumption tax hike on October 1 due to a deterioration in the global economic and political environment, he can still do so with relative ease. While the Hong Kong saga is far from over ... Taiwan is the greater risk. Chart 7 Clearly, the election loss will not impact Abe’s ability to negotiate a trade deal with the United States, which we expect to happen quickly – even before a China deal – albeit with some risk of tariffs on autos in the interim. Chart 8 The problem is that Abe’s final and greatest aim is to revise Japan’s American-written, pacifist constitution for the first time. This requires a two-thirds vote in both houses and a majority vote in a popular referendum. While Abe can still probably cobble together enough votes in the upper house, the election result makes it less certain – and the dent in popular support implies that the national referendum is less likely to pass. Constitutional revision was always going to be a close vote anyway (Chart 8). If Abe falls short of a majority in that referendum, then he will become a lame duck and markets will have to price in greater policy uncertainty. Even if he succeeds – which is still our low-conviction baseline view – then he will have reached the pinnacle of his career and there will be nowhere to go but down. His tenure as party leader expires in September 2021 and the race to succeed him is already under way. Hence, some degree of uncertainty should begin creeping in immediately. Abe’s departure will leave the Liberal Democrats in charge – and hence Japanese policy continuity will be largely preserved. But the entire arc of events, from now through the constitutional revision process to Abe’s succession, will raise fundamental questions about whether Abe’s post-2012 reflation drive can be sustained. We have a high conviction view that it will be, but Japanese assets will challenge that view. What of the miniature trade war between Japan and South Korea? On July 4, Japan imposed export restrictions on goods critical to South Korea’s semiconductor industry in retaliation for a South Korean court ruling that would set a precedent requiring Japanese companies such as Mitsubishi and Nippon Steel to pay reparations for the use of forced Korean labor during Japanese rule from 1910-45. Chart 9Japan Has A Stronger Hand In The Mini Trade War Japan Has A Stronger Hand In The Mini Trade War Japan Has A Stronger Hand In The Mini Trade War Japan has the stronger hand in this dispute from an economic point of view (Chart 9). While the unusually heavy-handed Japanese trade measures partly reveal the influence of President Trump, who has given a license for U.S. allies to weaponize trade, it also reflects Japan’s growing assertiveness. Abe’s government may have believed that a surge of nationalism would help in the upper house election. And the constitutional referendum will be another reason to stir nationalism and a recurring source of tension with both Koreas (as well as with China). Therefore, Japanese-Korean tensions and punitive economic measures could persist well into 2020. Bottom Line: U.S.-China relations remain the preeminent geopolitical risk to investors, especially if the Taiwan election becomes a lightning rod. Japan’s rising assertiveness in the region will also produce clashes with the Koreas and possibly also with China. We are playing these risks by remaining long JPY-USD and overweight Thailand relative to EM equities, as Thailand is more insulated than other East Asian economies to trade and China risks. Keep An Eye On The USMCA Last week we highlighted U.S. budget negotiations and argued that the result would be greater fiscal accommodation. The results of the just-announced budget deal are depicted in Chart 10. One side effect is an increased likelihood of eventual tariffs on Mexico if the latter fails to staunch the influx of immigrants across the U.S. southern border, since President Trump has largely failed to secure funding for his proposed border wall. Chart 10 Meanwhile, the administration’s legislative and trade focus will turn toward ratifying the U.S.-Mexico-Canada trade agreement (USMCA). There is an increased likelihood of eventual U.S. tariffs on Mexico ... since President Trump has largely failed to secure funding for his proposed border wall.  Ratification is not a red herring for investors, since Trump could give notice of withdrawal from NAFTA in order to hasten USMCA approval, which would induce volatility. Moreover, successful ratification could embolden him to take a strong hand in his other trade disputes, while failure could urge him to concede to a quick deal with China. Chart 11Trade Uncertainty Supports The Dollar Trade Uncertainty Supports The Dollar Trade Uncertainty Supports The Dollar Further, trade policy uncertainty in the Trump era has correlated with a rising trade-weighted dollar (Chart 11), so there is a direct channel for trade tensions (or the lack thereof) to influence the global economy at a time when it badly needs a softer dollar – in addition to the negative effects of trade wars on sentiment. The signing of the USMCA trade agreement by American, Mexican, and Canadian leaders last November effectively shifted negotiations from the international stage to the domestic stage. Last month Mexico became the first to ratify the deal. The delay in the U.S. and Canada reflects their more challenging domestic political environments ahead of elections, especially in the United States. Ratification in the U.S. has been stalled by Speaker of the House Nancy Pelosi, who is locked in stalemate with the Trump administration. She is holding off on giving the green light to present the agreement to Congress until Democrats’ concerns are addressed (Diagram 2). Trump, meanwhile, is threatening to withdraw from NAFTA – a declaration that cannot be entirely ruled out, even though we highly doubt he would actually withdraw at the end of the six-month waiting period. Diagram 2Pelosi Is Stalling USMCA Ratification Process East Asia Risks And The USMCA – GeoRisk Indicators Update: July 26, 2019 East Asia Risks And The USMCA – GeoRisk Indicators Update: July 26, 2019 Republicans are looking to secure the USMCA’s passage before the 2020 campaign goes into full force in order to claim victory on one of Trump’s key 2016 campaign promises. The administration’s May 30 submission of the draft Statement of Administrative Action (SAA) to Congress initiated a 30-day waiting period that must pass before the administration can submit the text to Congress. But the administration is unlikely to put the final bill to Congress before ensuring that House Democrats are ready to cooperate.2 House democrats are in a position of maximum leverage and are using the process to their political advantage. House Democrats are in a position of maximum leverage – since they do not need the deal to become law – and are using the process to their political advantage. If the bill is to be ratified through the “fast action” Trade Protection Authority (TPA), which forbids amendments and limits debate in Congress, then now is their only chance to make amendments to the text, which was written without their input. Even in the Democrat-controlled House, there is probably enough support for the USMCA to secure its passage. There are 51 House Democrats who were elected in districts that Trump won or that Republicans held in 2018, and are inclined to pass the deal. Moreover 21 House Democrats have been identified from districts that rely heavily on trade with Canada and Mexico (Chart 12).3 If these Democrats vote along with all 197 Republicans in favor of the bill, it will pass the House. This is a rough calculation, but it shows that passage is achievable. Chart 12 Chart 13 What is more, there is a case to be made for bipartisan support for USMCA. Trump’s trade agenda has some latent sympathy among moderate Democrats, and Democrats within Trump districts, unlike his border wall. Democrats will appear obstructionist if they oppose the bill. Unlike trade with China, American voters are not skeptical of trade with Canada – and the group that thinks Mexico is unfair on trade falls short of a majority (Chart 13). Since enough Democrats have a compelling self-interest in securing the deal, and since Trump and the GOP obviously want it to pass, we expect it to pass eventually. The question is whether it can be done by year’s end. Once the bill is presented to Congress and passes through the TPA process, it will become law within 90 days. Assuming that the bill is presented to the House in early September, when Congress reconvenes after its summer recess, the bill could be ratified before year-end. Otherwise, without the expedited TPA process, the bill will no longer be protected against amendment and filibuster, leaving the timeline of ratification vulnerable to extensive delay. The above timeline may be too late for Canada’s Prime Minister Justin Trudeau, who faces general elections on October 21. The ratification process has already been initiated, as Trudeau would benefit from wrapping up the entire affair prior to the national vote.4 However, the process most recently has been stalled in order to move in tandem with the U.S., so that parliament does not ratify an agreement that the U.S. fails to pass. Canadian Foreign Affairs Minister Chrystia Freeland has indicated that parliament is not likely to be recalled for a vote unless there is progress down south. This leaves the Canadian ratification process at the mercy of progress in the U.S. – and ultimately Speaker Pelosi’s decision. The current government faces few hurdles in getting the bill passed (Chart 14). The next step is a final reading in the House where the bill will either be adopted or rejected. If it is approved, the bill will then proceed to the Senate where it will undergo a similar process. If the bill is passed in the same form in the House and Senate, it will become law. Chart 14 Chart 15...But Trudeau's Party Is At Risk ...But Trudeau's Party Is At Risk ...But Trudeau's Party Is At Risk Failure to ratify the deal before the election means it will be set aside and reintroduced in the next parliament. The Liberal Party is by no means guaranteed to win a majority in the election – our base case has Trudeau forming the next government, but the race is close (Chart 15). A Conservative-led parliament would be likely to pass the bill, but it would likely be delayed to 2021 at that point due to American politics. We suspect that Trudeau will eventually stop delaying and push for Canadian ratification. This would pressure Pelosi and the Democrats to go ahead and ratify, when they are otherwise inclined to reopen negotiations or otherwise delay until after November 2020. If this gambit succeeded, Trudeau would have forced total ratification prior to October 21, which would give him a badly needed boost in the election. He can always go through the frustration of re-ratifying the deal in his second term if the Democrats insist on changes, but not if he does not survive for a second term – so it is worth going forward at home and trying to pressure Pelosi into ratification in September or early October. Bottom Line: In light of Canada’s October election and the U.S. 2020 election cycle, USMCA faces a tight schedule. A delay into next year risks undermining the ratification effort, as we enter a period of hyper-partisan politics amid the 2020 presidential campaigns. This makes the third quarter a sweet spot for USMCA ratification. While we ultimately expect that it will make it through, each passing day raises the odds against it. GeoRisk Indicators Update: July 26, 2019 All ten GeoRisk indicators can be found in the Appendix, with full annotation. Below are the most noteworthy developments this month. U.K.: As expected, Boris Johnson sealed the Conservative party leadership contest. This was largely priced in by the markets and as such did not result in a big shift in our risk indicator. Johnson has stated that he is willing to exit the EU without a deal and it is undeniable that the odds of a no-deal Brexit have increased. Nevertheless, the odds of an election are also rising as Johnson may galvanize Brexit support under the Conservative Party even as Bremain forces are divided between the rising Liberal Democrats and a Labour Party hobbled by Jeremy Corbyn’s leadership. The odds that Johnson is willing to risk his newly cemented position on a snap election – having seen what happened in June 2017 – seem overstated to us, but we place the odds at about 21%. As for a no-deal exit, opinion polling still suggests that the median British voter prefers a soft exit or remaining in the EU. This imposes constraints on Johnson, as he may ultimately be forced to try to push through a plan similar to Theresa May’s, but rebranded with minimal EU concessions to make it more acceptable – or risk a no-confidence vote and potential loss of control. We maintain that GBP will stay weak, gilts will remain well-bid, and risk-off tendencies will be reinforced. France: Our French indicator points toward a significant increase in political risk over the last month. President Macron’s government has recently unveiled the pension system overhaul that he promised during the 2017 campaign. The reform, which is due to take effect in 2025, encourages citizens to work longer, as their full pension will come at the age of 64 – two years later than under current regulations. French reform efforts have historically prompted significant social unrest. Both the 1995 Juppé Plan and the 2006 labor reforms were scrapped as a result of unrest, and the 2010 pension reform strikes forced the government to cut the most controversial parts of the bill. Labor unions have already called for strikes against the current bill in September. However, no pain, no gain. Unrest is a sign that ambitious reforms are being enacted, and Macron’s showdown with protesters thus far is no more dramatic than the unrest faced by the most significant European reform efforts. The 1984-85 U.K. miners’ strike led to over 10,000 arrested and significant violence, but resulted in the closures of most collieries, weakening of trade union power, and allowed the Thatcher government to consolidate its liberal economic program. German labor reforms in the early 2000s led to strikes, but marked a turning point in unemployment and GDP trends (Chart 16), and succeeded in increasing wages and pushing people back into the labor force (Chart 17). And the 2011 Spanish reforms under PM Rajoy led to the rise of Indignados, student protesters occupying public spaces, but ultimately helped kick-start Spain’s recovery. Investors should therefore not fear unrest, and we expect any related uncertainty to abate in the medium term. Chart 16Hartz IV Reforms Were Also Accompanied By Unrest... Hartz IV Reforms Were Also Accompanied By Unrest... Hartz IV Reforms Were Also Accompanied By Unrest... Chart 17...But Were Ultimately Favorable ...But Were Ultimately Favorable ...But Were Ultimately Favorable Note that Macron is doubling down on reforms after the experience of the Yellow Vest protests, just as his favorability has rebounded to pre-protest levels. While Macron’s approval is nearly the lowest compared to other French presidents at this point in their terms (Chart 18), he does not face an election until 2022, so he has the ability to trudge on in hopes that his reform efforts will bear fruit by that time. Chart 18 Spain: Our Spanish indicator is showing signs of increasing tensions as Prime Minister Pedro Sanchez attempts to form a government. After ousting Mariano Rajoy in a vote of no confidence in June 2018, Sanchez struggled to govern with an 84-seat minority in Congress. The Spanish Socialist Workers’ Party’s (PSOE) proposed budget plan was voted down in Congress in February, forcing Sanchez to call a snap election for April 28 in which PSOE secured 123 seats. The PSOE leader failed the first investiture vote on July 23 – and the rerun on July 25 – with less votes in his favor than his predecessor Mariano Rajoy received during the 2015-2016 government formation crisis (Chart 19). In the first investiture vote, Sanchez secured 124 votes out of the 176 he needed to be sworn in as prime minister. This led to a second round of voting in which Sanchez needed a simple majority, which he failed to do with 124 affirmative, 155 opposing votes, and 67 abstentions. Going forward, Sanchez has two months to obtain the confidence of Congress, otherwise the King may dissolve the government, leading to a snap election. Chart 19 Chart 20 The Spanish government is more fragmented today than at any point during the last 30 years (Chart 20). Even if Pedro Sanchez’s PSOE were to successfully negotiate a deal with Podemos and its partner parties, the coalition would still require support from nationalist parties such as Republican Left of Catalonia or Basque Nationalist Party to govern. These will likely require major concessions relating to the handling of Catalonian independence, which, if rejected by PSOE, will result in yet another gridlocked government. The next two months will see a significant increase in political risk, and we assign a non-negligible chance to another election in November, the fourth in four years. Turkey: Investors should avoid becoming complacent on the back of the stream of encouraging news following the Turkey-Russia missile defense system deal. Our indicator is signaling that the market is pricing a decrease in tensions, and President Trump has stated that sanctions will not be immediate. Nevertheless, we would be wary. Congress is taking a much tougher stance on the issue than President Trump: The U.S. administration already excluded Turkey from the F-35 stealth fighter jet program; Senators Scott (R) and Young (R) introduced a resolution calling for sanctions; Senator Menendez (D) stated that merely removing Turkey from the F-35 program would not be enough; The new Defense Secretary nominee Mark Esper said that he was disappointed with Turkey’s “drift from the West”; And U.S. Secretary of State Mike Pompeo expressed confidence that President Trump would impose sanctions. Under CAATSA, a law that targets companies doing business with Russia, the U.S. must impose sanctions on Turkey over the missile deal, but does not have a timeline to do so. The sanctions required are formidable, and the U.S. has already imposed sanctions on China for a similar violation. If President Trump is not going forward with sanctions now, he still could proceed later if Turkey does not improve U.S. relations in some other way. From Turkey’s side, Foreign Minister Mevlut Cavusoglu threatened retaliation if the U.S. were to impose sanctions. Turkey is also facing increasing tensions domestically. Erdogan suffered a stinging rebuke in the re-run of the Istanbul mayoral election. This defeat has left Erdogan even more insecure and unpredictable than before. On July 6, he fired central bank governor Murat Cetinkaya using a presidential decree, which calls the central bank’s independence into question. He may reshuffle his cabinet, which could make matters worse if the appointments are not market-friendly. As domestic tensions continue to escalate, and when the U.S. announces sanctions, we expect the lira to take yet another hit and add to Turkey’s economic woes. Diagram 3Brazil: Pension Reform Timeline East Asia Risks And The USMCA – GeoRisk Indicators Update: July 26, 2019 East Asia Risks And The USMCA – GeoRisk Indicators Update: July 26, 2019 Chart 21Brazil Faces A Fiscal Deficit Despite Pension Reform Brazil Faces A Fiscal Deficit Despite Pension Reform Brazil Faces A Fiscal Deficit Despite Pension Reform Brazil: Brazilian risks are likely to remain elevated as the country faces crunch-time over the controversial pension reform on which its fiscal sustainability depends. Although the Lower House voted overwhelmingly in support of the reform on July 11, the bill needs to make it through another Lower House vote slated for August 6. The bill will then proceed to at least two more rounds of voting in the Senate (by end-September at the earliest), with a three-fifths majority required in each round before being enshrined in Brazil’s constitution (Diagram 3). The whole process will likely be delayed by amendments and negotiations. The estimated savings of the bill in its current form are about 0.9 trillion reals, down from the 1.236 trillion reals originally targeted, which risks undermining the effort to close the fiscal deficit. Our colleagues at BCA’s Emerging Markets Strategy still forecast a primary fiscal deficit in four years’ time (Chart 21).5   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Footnotes 1 For instance, the U.S.’s latest $2.2 billion arms package does not include F-16 fighter jets to Taiwan, and F-35s have entirely been ruled out. The Trump administration sent Paul Ryan, rather than a high-level cabinet member, to inaugurate the new office building of the American Institute in Taiwan for the 40th anniversary of the Taiwan Relations Act. At the same time, the Trump administration is threatening a more substantial upgrade of relations through more frequent arms sales, the Taiwan Travel Act (2018), and the Asia Reassurance Initiative Act (2018). 2 The risk is that history repeats itself. In 2007, then President George W. Bush sent the free-trade agreement with Colombia to Congress prior to securing Pelosi’s approval. She halted the fast-track timeline and the standoff lasted nearly five years. 3 Please see Gary Clyde Hufbauer, “USMCA Needs Democratic Votes: Will They Come Around?” Peterson Institute For International Economics, May 15, 2019, available at piie.com. 4 Bill C-100, as it is known, has already received its second reading in the House of Commons and has been referred to the Standing Committee on International Trade. 5 Please see BCA Research’s Emerging Markets Strategy Weekly Report titled “On Chinese Banks And Brazil,” dated July 18, 2019, available at ems.bcaresearch.com. Appendix Image Image Image Image Image Image Image Image Image Image Image Geopolitical Calendar  

Highlights So what? Quantifying geopolitical risk just got easier. Why?   In this report we introduce 10 proprietary, market-based indicators of country-level political and geopolitical risk. Featured countries include France, U.K., Germany, Italy, Spain, Russia, South Korea, Taiwan, Turkey, and Brazil. Other countries, and refinements to these beta-version indicators, will come in due time. We remain committed to qualitative, constraint-based analysis. Our GeoRisk Indicators will help us determine how the market is pricing key risks, so we can decide whether they are understated or overstated. Feature For the past three months we have been tracking a “Witches’ Brew” of political risks that threaten the late-cycle bull market. Some of these risks have abated for the time being: the Fed is on pause, China’s stimulus has surprised to the upside, and Brexit has been delayed. Other risks we have flagged, however, are heating up: Iran And Oil Market Volatility: Surprisingly the Trump administration has chosen not to extend oil sanction waivers on Iran from May 2, putting 1.3 million barrels per day of oil on schedule to be removed from international markets by an unspecified time.  It remains to be seen how rapidly and resolutely the administration will enforce the sanctions on specific allies and partners (Japan, India, Turkey) as well as rivals (China, others). Because the decision coincides with rising production risks from renewed fighting in Libya and regime failure in Venezuela, we expect President Trump to phase in the new enforcement over a period of months, particularly on China and India. But official rhetoric is draconian. Hence the potential for full and immediate enforcement is greater than we thought. In the short term, individual political leaders, and very powerful nations like the United States, can ignore material economic and political constraints. Since the Trump administration’s decision exemplifies this point, geopolitical tail risks will get fatter this year and next. Global oil price volatility and equity market volatility will increase with sanction enforcement actions and retaliation. We would think that Trump’s odds of reelection will marginally suffer, though for now still above 50%, as any full-fledged confrontation with Iran will raise the chances of an oil price-induced recession. U.S.-EU Trade War: Neither the Trump administration nor the U.S. has a compelling interest in imposing Section 232 tariffs on imports of autos and auto parts. Nevertheless the risk of some tariffs remains high – we put it at 35% – because President Trump is legally unconstrained. The decision is technically due by May 18 but Economic Council Director Larry Kudlow has said Trump may adjust the deadline and decide later. Later would make sense given the economic and financial risks of the administration’s decision to ramp up the pressure on Iran.1 But the risk that tariffs will pile onto a weak German and European economy will hang over investors’ heads. U.S.-China Talks Not A Game Changer: The ostensible demand that China cease Iranian oil imports immediately and the stalling of U.S. diplomacy with North Korea are not conducive to concluding a trade deal in May. We have highlighted many times that strategic tensions will persist even if Beijing and Washington quarantine these issues to agree to a short-term trade truce. The June 28-29 G20 meeting in Japan remains the likeliest date for a summit between Presidents Trump and Xi Jinping, but even this timeframe could be too optimistic. Continued uncertainty or a weak deal will fail to satisfy financial markets expecting a very positive outcome.   With a 70% chance that U.S. tariffs on China will not increase this year and, contingent on a U.S.-China deal, only a 35% chance that the U.S. slaps tariffs on German cars, we sound optimistic to some clients. But the Trump administration’s decision on Iran is highly market-relevant and portends greater volatility. We expect to see a geopolitical risk premium creep higher into oil markets as well as a greater risk of “Black Swan” events in strategically critical or oil-producing parts of the Middle East. There is limited research devoted to quantifying geopolitical risk. We are late in the business cycle and President Trump has emphatically decided to increase rather than decrease geopolitical risk. Quantifying Geopolitical Risk Geopolitical analysis has taken a bigger role in investors’ decision-making over the last decade. Surveys show that geopolitical risks rank among global investors’ top concerns overall. In the oft-cited Bank of America Merrill Lynch survey, geopolitical and related issues have dominated the “top tail risk” responses for the past half-decade (Chart 1). In other surveys, the most worrisome short-term risks are mostly political or geopolitical in nature, ranking above socio-economic and environmental risks (Chart 2). Chart 1 Chart 2 Despite this high level of concern, there is limited research devoted to quantifying geopolitical risk. Isolating and measuring the range of risks under this umbrella term remains a challenge. As such, for many investors, geopolitics remains an ad hoc, exogenous factor that is often mentioned but rarely incorporated into portfolio construction. For the past four decades the predominant ways of measuring political or geopolitical risk have been qualitative or semi-qualitative. The Delphi technique, developed on the basis of low-quality data sets in social sciences, relies on pooled expert opinions.2 Independently selected experts are asked to provide risk assessments and their responses are then interpreted by analysts to create a measure of risk. Another semi-qualitative method of measuring geopolitical risk ranks countries according to a set of political and socio-economic variables. These variables – such as governance, political and social stability, corruption, law and order, or formal and informal policies – are extremely important but inherently difficult to quantify.3 These results are useful but suffer from dependency on expert opinion, data quality, and institutional biases. More importantly, these methods are slow to react to breaking events in a rapidly changing world. The same goes for bottom-up assessments using political intelligence. The weakness of these methods is that it is highly unlikely that they will produce statistically significant estimates of risk. The odds of getting a “silver bullet” insight from a “key insider” are decent for simple political systems, but not in the complex jurisdictions that host the vast majority of global, liquid investments. Quantitative approaches to measuring geopolitical risk have since become more widespread. The most prominent method is based on quantifying the occurrence of words related to political and geopolitical tensions that appear in international newspapers. These word-counts typically include terms like “terrorism,” “crisis,” “war,” “military action,” etc. As a result, the indices reflect incidents of physical violence or other “Black Swan” events that may not have direct relevance to financial markets. Moreover, while news-based indices accurately capture dramatic one-time peaks at the time of a crisis, they are largely flat aside from these, as they rely on popular topics rather than underlying structural trends (Chart 3). They fail to capture geopolitical developments associated with electoral cycles, protest movements, paradigm shifts in economic policy, or other policy changes.4 Notice, for instance, that the fall of the Soviet Union in late 1991 and the resulting chaos in Russia and many other parts of the emerging world hardly register in Chart 3. Chart 3News-Based Indices Only Capture Crisis Peaks, Not Geopolitical Developments News-Based Indices Only Capture Crisis Peaks, Not Geopolitical Developments News-Based Indices Only Capture Crisis Peaks, Not Geopolitical Developments Introducing BCA’s GeoRisk Indicators The past 70 years have taught BCA Research to listen and respect the market. Why would we suddenly follow the media instead? Most quantitative geopolitical indicators begin with the premise that journalists and the news-reading public have accurately emphasized the most relevant risks and uncertainties. They proceed to quantify the terms of these assessments with increasingly sophisticated methods. This approach solves only part of the puzzle. News-based indices ... fail to capture geopolitical developments associated with underlying policy changes. At BCA Geopolitical Strategy, we aim to generate geopolitical alpha.5 This means identifying where financial media and markets overstate or understate geopolitical risks. We do not primarily aim to predict events or crises. As such, traditional news-based indicators that capture only major events, even those ex post facto, are of little relevance to our analysis. What is needed is a better way to quantify how the market is calculating risks. We start with a simple premise: the market is the greatest machine ever created for gauging the wisdom of the crowd. Furthermore, it puts its money where its predictions are, unlike other methods of geopolitical risk quantification which have no “value at risk.” Chart 4USD/RUB Captures Geopolitical Risk In Russia... USD/RUB Captures Geopolitical Risk In Russia... USD/RUB Captures Geopolitical Risk In Russia... To this end, we have introduced market-based indicators over the years that rely on currency movements, which are often the simplest and most immediate means of capturing the process of pricing risk. In 2015, for instance, we introduced an indicator that measures Russia’s geopolitical risk premium (Chart 4). It is constructed using the de-trended residual from a regression of USD/RUB against USD/NOK and Russian CPI relative to U.S. CPI. We can show empirically that it captures geopolitical risk priced into the ruble, as the indicator increases following critical incidents. These include the downing of Malaysian Airlines Flight 17 over eastern Ukraine in 2014; the warnings that Russia aimed to stage a “spring offensive” in Ukraine in 2015; Russian military intervention in the Syrian Civil War later that year; and the poisoning of former intelligence agent Sergei Skripal in the U.K. in 2018 and subsequent tensions. Using similar methods, we created a proxy to capture geopolitical risk in Taiwan, based on USD/JPY and USD/KRW exchange rates and relative Taiwanese/American inflation (Chart 5). The indicator tracks well with previous cross-strait crises. It jumped upon Taiwan’s election of President Tsai Ing-wen and her pro-independence government in January 2016 – and this was well before any tensions actually flared. It even registered a small increase upon her controversial phone call congratulating Donald Trump upon winning the U.S. election. Chart 5...And USD/TWD Captures Geopolitical Risk In Taiwan ...And USD/TWD Captures Geopolitical Risk In Taiwan ...And USD/TWD Captures Geopolitical Risk In Taiwan This year we have expanded on this work, constructing a set of ten standardized GeoRisk Indicators for five developed economies and five emerging economies: U.K., France, Germany, Spain, Italy, Russia, Turkey, Brazil, Korea, and Taiwan. Indicators for the U.S., China, and others will be rolled out in a future report. These indicators attempt to capture risk premiums priced into the various currencies – except for Euro Area countries, where the risk is embedded in equity prices. In each case, we look at whether the relevant assets are decreasing in value at a faster rate than implied by key explanatory variables. The explanatory variables consist of (1) an asset that moves together with the dependent variable while not responding to domestic geopolitical risks, and (2) a variable to capture the state of the economy. This set of indicators differs from our earlier indicators in the following ways: We aim to create a simple methodology that we can apply consistently to all countries, both in the DM and EM universes. We therefore omitted using regression models that can prove to be quite whimsical. Instead, we simply looked at the deviation of the dependent variable from the explanatory variables, all in expanding standardized terms, to create the GeoRisk proxy. We wanted an indicator that would immediately respond to priced-in risks, so we opted for a daily frequency rather than the weekly frequency we used in our initial work. To get as accurate of a signal as possible, we use point-in-time data. Since economic data tends to be released with a one-to-two-month lag, we lagged the economic independent variable to correspond to its release date. All ten indicators are shown in the Appendix. Across all countries, they track well with both short-term events and long-term trends in geopolitical risk. In the case of France, for example, the indicator steadily climbs during the period of domestic tensions and protests in the early 2000s; as the European debt crisis flares up; again during the rise of the anti-establishment Front National and the Russian military intervention in Ukraine; and finally during the U.S. trade tariffs and Yellow Vest protests (Chart 6). Our GeoRisk indicators isolate risks that either originate internally or otherwise affect the country more so than others. Similarly, in Germany, there is a general increase in perceived risk as Chancellor Gerhard Schröder implements structural reforms in the early 2000s; another increase leading up to the leadership change as Angela Merkel is elected Chancellor; another during the global and European financial crises; another during the Ukraine invasion and refugee influx; and finally another with the U.S.-China trade war (Chart 7). Chart 6Our French Indicator Picks Up Domestic And European Unrest Our French Indicator Picks Up Domestic And European Unrest Our French Indicator Picks Up Domestic And European Unrest Chart 7Greater German Risk Amid The Trade War Greater German Risk Amid The Trade War Greater German Risk Amid The Trade War   We have annotated each country’s GeoRisk indicator heavily in the appendix so that readers can see for themselves the correspondence with political events. The indicators are affected by international developments – like the Great Recession – but we have done our best to isolate risks that either originate internally or otherwise affect the country more than other countries. (As a consequence, the Great Recession is muted in some cases.) What are the indicators telling us now? Most obviously, they highlight the extreme risk we have witnessed in the U.K. over the now-delayed March 29 Brexit deadline. We would bet against this risk as the political reality has demonstrated that a “hard Brexit” is very low probability: the U.K. has the ability to back off unilaterally while the EU is willing to extend for the sake of regional stability. In this sense the pound is a tactical buy, which our foreign exchange strategist Chester Ntonifor has highlighted.6 Our U.K. risk indicator has been fairly well correlated with the GBP/USD since the global financial crisis and it suggests that the pound has more room to rally (Chart 8). Chart 8Betting Against A Hard Brexit, the GBP Is A Tactical Buy Betting Against A Hard Brexit, the GBP Is A Tactical Buy Betting Against A Hard Brexit, the GBP Is A Tactical Buy Meanwhile, Spanish risks are overstated while Italy’s are understated. As for the emerging world, Turkish risks should be expected to spike yet again, as divisions emerge within the ruling coalition in the wake of critical losses in local elections and a failure to reassure investors over monetary policy and the currency. Brazilian risks will probably not match the crisis points of the impeachment and the 2018 election, at least not until controversial pension reforms reach a period of peak uncertainty over legislative passage. Both our new Russian indicator and its prototype are collapsing (see Chart 4 above). This captures the fact that we stand at a critical juncture in Russian affairs, where President Putin is attempting to shift focus to domestic stability even as the U.S. and the West maintain pressure on the economy to deter Russia from its aggressive foreign policy. Given that both Putin’s and the government’s approval ratings are low amid rising oil prices, the stage is set for Russia to take a provocative foreign policy action meant to distract the populace from its poor living conditions. Venezuela is the obvious candidate, but there are others. Moscow will want to test Ukraine’s newly elected, inexperienced president; it may also make a show of support for Iran. With Russia equities having rallied on a relative basis over the past year and a half, and with the Iranian waiver decision already boosting oil prices as we go to press, the window of opportunity to buy Russian stocks is starting to close. (We remain overweight relative to EM on a tactical horizon; our Emerging Markets Strategy is also overweight.) Going forward, we will update these risk indicators regularly as needed and publish the full appendix at the end of every month along with our long-running Geopolitical Calendar. We will also fine-tune the indicators as new information comes to light. In other words, here we present only the beta version. We hope that these indicators will help inform investors as to the direction, and even magnitude, of political risks as the market prices them. Our GeoRisk indicators are not predictive, as establishing a trend is not a prediction. The main purpose of this exercise is to answer the critical question, “What is already priced in?” How is the market currently calculating geopolitical risk for a country? After that, it is the geopolitical strategist’s job to unpack this question through qualitative, constraint-based analysis. It is when our qualitative assessments disagree with what is priced in that we can generate geopolitical alpha.    Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Marko Papic Consulting Editor marko@bcaresearch.com Footnotes 1      See Sean Higgins, “Auto tariffs decision could be delayed, Kudlow says,” Washington Examiner, April 3, 2019, www.washingtonexaminer.com. 2      Norman C. Dalkey and Olaf Helmer-Hirschberg, “An Experimental Application of the Delphi Method to the Use of Experts,” Management Science, Vol. 9, Issue: 3 (April 1963) pp. 458- 467. 3      Darryl S. L. Jarvis, “Conceptualizing, Analyzing and Measuring Political Risk: The Evolution of Theory and Method,” Lee Kuan Yew School of Public Policy Research Paper No. LKYSPP08-004 (July 2008).  William D. Coplin and Michael K. O'Leary, "Political Forecast For International Business," Planning Review, Vol. 11 Issue: 3 (1983) pp.14-23. The PRS Group, “Political Risk Services”™ (PRS) or the “Coplin-O’Leary Country Risk Rating System”™ Methodology. Daniel Kaufmann, Aart Kraay, and Massimo Mastruzzi, “The Worldwide Governance Indicators: Methodology and Analytical Issues,” World Bank Policy Research Working Paper No. 5430 (September 2010). 4      Scott R. Baker, Nicholas Bloom, and Steven J. Davis, “Measuring Economic Policy Uncertainty,” The Quarterly Journal of Economics, Volume 131, Issue 4, November 2016 (July 2016) pp.1593–1636. Dario Caldara and Matteo Iacoviello, “Measuring Geopolitical Risk,” Board of Governors of the Federal Reserve Board, Working Paper (January 2018). 5      Please see BCA Research Geopolitical Strategy Special Report, “Five Myths On Geopolitical Forecasting,” dated July 9, 2018, available at gps.bcaresearch.com. 6      Please see BCA Foreign Exchange Strategy Weekly Report, “Not Out Of The Woods Yet,” April 5, 2019, available at www.bcaresearch.com.   Appendix Appendix France France: GeoRisk Indicator France: GeoRisk Indicator Appendix U.K. U.K.: GeoRisk Indicator U.K.: GeoRisk Indicator Appendix Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator Appendix Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Appendix Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Appendix Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator Appendix Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Appendix Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Appendix Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Appendix Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator What’s On The Geopolitical Radar? Chart 19      Geopolitical Calendar

Dear Client, I am travelling this week so this report is a joint effort juxtaposing two contrasting observations about France. The ‘opulence’ part highlights France as the world’s dominant producer of luxury goods, and makes the case that some of the French luxury goods companies should form a core part of a long-term investment portfolio. The ‘rebellion’ part borrows from a recent Special Report on French politics penned by my colleague Jeremie Peloso. It analyses the recent yellow vest protests in France, and assesses whether they are a cause for concern. Best regards, Dhaval Joshi, Chief European Investment Strategist Feature Opulence Made In France Chart I-1 Global luxury goods sales amount to a quarter of a trillion dollars, and Europe dominates in the production of these luxury goods. Measured by the number of companies, the leading luxury goods country is Italy. But on the more important metric of share of total global sales, the undisputed world leader is France. In fact, just four French companies produce a quarter of the world’s luxury goods sales. The four are: LVMH, Kering, L’Oreal, and Hermes1 (Chart of the Week, Chart I-2, and Table I-1). Chart I-2 Chart I- France’s luxury goods sector is an excellent diversifier for investors. This is because, compared to other goods and services, luxuries follow very different laws of economics: The demand for luxuries has a positive elasticity to price. Put more simply, the desirability of a luxury increases as its price goes up. This is opposite to the demand for non-luxuries which has a negative elasticity to price: for non-luxury items, the demand declines as the price goes up. By definition, you cannot compete with a luxury item by undercutting its price. Given that a luxury implies fine-craftsmanship rather than mass production, the sector is highly resilient to the existential threats confronting other European industries that emanate from out-sourcing to lower cost economies and from automation. Luxury demand is also relatively insensitive to exchange rate movements. The barrier to entry into the luxuries sector is extremely high. It takes years, or even decades, for a luxury item to acquire its premium status based on consistent high quality in materials and craftsmanship. This high barrier to entry makes it much harder for other economies to challenge the European and French dominance in providing these luxury products. Despite these attractive characteristics the sector does still require a source of structural demand. Our premise, expounded in our Special Report “Buying European Clothes: An Investment Megatrend”, is that the feminisation of consumer spending, particularly in Europe, is providing a strong structural tailwind to the demand for ‘soft’ luxury goods. A recent industry study by Deloitte corroborates this thesis, pointing out that the strongest growth in the luxury sector is to be found in cosmetics, fragrances, bags and accessories. On this premise, the four leading French companies are big beneficiaries.2,3   Are market valuations already aware of, and fully discounting, the thesis of feminisation of consumer spending? We think not, as most investors are surprised by the thesis and unaware of the on-going dynamics behind it. On this basis, three of the four French luxury companies, trading on forward PE multiples in the 20s or below, still appear reasonably valued for their growth prospects (Table I-2). The exception is Hermes which, on a multiple of 40, does seem richly priced. Chart I- The bottom line is that the three other leading French luxury goods companies – LVMH, Kering, and L’Oreal – do deserve to be a core part of a long-term investment portfolio. Rebellion Made In France The yellow vest protest movement is not a coherent force led by a clear leadership. What started on the social media as a protest against the fuel tax in rural areas has evolved into a movement against President Macron. This transition occurred in part because a large segment of the population believes that Macron’s reforms have mainly benefited the wealthy. 77 percent of respondents in a recent poll view him as the “president of the rich.” The modification of the ‘wealth tax’ – which mostly shifts the focus toward real estate assets instead of financial assets – was highly criticized for favouring the wealthiest households. It resonated strongly with the perception that past governments helped the wealthiest households to accumulate more wealth on the back of the middle class. But it is not clear how intense or durable this popular sentiment will be, given that this type of inequality is not extreme in France and has not been rising (Chart I-3). Chart I-3What Income Inequality? What Income Inequality? What Income Inequality? Public support for the protests has hovered consistently around 70 percent since they started in November 2018 (Chart I-4). However, there are now more respondents who think that the protests should stop as that they should continue (Chart I-5). As a sign of things to come, a demonstration against the yellow vests and in support of Macron and his government – held by the “red scarves” – managed to gather more people on the streets of Paris than the regionally based yellow vests have done in the capital city.4 Chart I-4 Chart I-5 Who are the yellow vests? They are mostly rural, mostly hold a high school degree (or less), and overwhelmingly support anti-establishment political leaders Marine Le Pen (right-wing leader of the National Rally) or Jean-Luc Mélenchon (left-wing leader of La France Insoumise). This suggests that the movement has failed to cross the ideological aisle and win converts from the centre (Diagram I-1). Chart I- How many French people are actually protesting? Although there was a slight pickup in protests at the beginning of January, the numbers countrywide are not high. In fact, they are far from what they were back in November and therefore would have to get much larger for markets to become concerned anew (Chart I-6). If we are to compare these protests to those in 1995 or 2010, the numbers pale in comparison (Table I-3). For instance, the protest of December 1995 brought a million people onto the streets while the demonstrations against the Woerth pension reform in 2010 lasted for seven months and gathered close to nine million protesters across eight different events (Chart I-7). Chart I-6 Chart I- Chart I-7 We would compare the yellow vest protests to the 15-month long Spanish Indignados in 2011, which gathered between six and eight million protesters overall, and the U.S. Occupy Wall Street protests that same year. The two movements were similarly disorganized and combined disparate and often contradictory demands. In both cases, the governments largely ignored the protesters. Thus the yellow vests should not have a major impact on Macron’s reform agenda. As expected, Macron has not mentioned changing course on his most business-friendly reforms, which we see as a signal to investors that, despite the recent chaos, the plan remains the same. There is no strategic reason why Macron would reverse course. His popularity is already in the doldrums. His only chance at another term is to plough ahead and campaign in 2022 on his accomplishments. Nevertheless, to ensure that he does not plough into a rock, Macron will adjust course to calm the protesters. For example, the recent increase in the minimum wage that the government announced in response to the demonstrations was not supposed to be implemented until later in the presidential term. In a similar vein, pension reforms will likely be postponed given the ongoing protests. Macron hoped to introduce a universal, unified pension system by the middle of 2019 to replace an overly complex and fragmented system in which 42 different types of pension coexist, each one having its own rules of calculation. Though protests (both yellow vest and otherwise) have been unimpressive by historical standards, it might be too risky for the government to push the pension reform so close to these events. Such adjustments to the reform agenda should help reduce the protest movement’s fervour or otherwise its support. The bottom line is that the yellow vest protests were to be expected – they are the natural consequence of Emmanuel Macron’s push to reform the French economy and state. However, when compared to previous efforts to derail government reforms, the numbers simply do not stack up. Their disunited and broad objectives are likely to limit the effectiveness of the movement going forward.5   Dhaval Joshi,  Chief European Investment Strategist dhaval@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 In the case of L’Oreal this refers to the L’Oreal Luxe division. 2  Please see the European Investment Strategy “Buying European Clothes: An Investment Megatrend”, dated December 6, 2018 available at eis.bcaresearch.com. 3 Deloitte: Global Powers of Luxury Goods 2018, Shaping the future of the luxury industry 4 According to the government, 10,500 “red scarves” marched in Paris on January 27, 2018. 5 For the full report, please see the Geopolitical Strategy Special Report “France: La March A Suivre?”, dated February 27, 2019, available at gps.bcaresearch.com.  

Highlights Investors are currently too pessimistic on Europe’s growth prospects. In fact, European growth will soon bottom. European growth and inflation are also set to improve relative to the U.S. This should give investors an opportunity to reassess the long-term outlook for European Central Bank policy relative to the Fed. Global growth dynamics are also moving in an increasingly dollar-bearish direction, which should create a tailwind for the euro. Based on the pricing of European assets relative to the U.S., there is scope to see more capital flows into the euro area, implying that more euro buying is forthcoming. The entire European currency complex is a buy relative to the dollar; while the NOK, the SEK, and even the GBP could outperform the euro, the CHF will underperform. EUR/JPY also has upside. Feature The case to sell the euro is easy to make. European growth has been very poor: PMIs, industrial production and even German exports are all pointing to a contraction in output; and economic surprises are testing levels recorded during the euro area crisis. Most importantly, this economic retrenchment is particularly sharp when compared to the U.S., which suggests that real interest rate differentials should continue to hurt EUR/USD (Chart 1). Chart 1Selling The Euro Seems So Easy... Selling The Euro Seems So Easy... Selling The Euro Seems So Easy... The problem with this narrative is that investors are already well aware of Europe’s woes. Could Europe instead recover and the euro rebound against the dollar? After all, in the past, when investor pessimism towards Europe experienced as pronounced a dip as the one just witnessed, EUR/USD invariably rebounded soon after (Chart 2). Chart 2...But Maybe We Should Look The Other Way ...But Maybe We Should Look The Other Way ...But Maybe We Should Look The Other Way In this piece, we explore what could go right for the euro, and argue that the euro is indeed attractive at current levels. European Growth Has Hit A Nadir It is safe to say that the euro area is in a funk today: European real GDP growth dipped to a 1.1% annual rate in the fourth quarter of 2018, while industrial production has plunged by 3.9% on a year-on-year basis. But the markets warned us this would happen: The euro has fallen 9% from its February 2018 top, German bund yields are again flirting with the 0.1% level and European banks plunged by more than 40% between January and December last year. Going forward, for European yields to remain as depressed as they are, for the euro to fall again by a similar margin, or for domestic plays to suffer large declines, European growth will have to slow even further. We are not expecting such a scenario. Instead, we expect European growth to recover significantly this year. First, when it comes to Germany, the locomotive of Europe, the shock from the implementation of the new WLTP auto emission standards is passing: Automobile production is stabilizing, capex is accelerating and inventories have been pared down. Moreover, the slowdown in foreign demand has already percolated through the domestic economy, as domestic manufacturing orders are already experiencing one of their sharpest declines since the Great Financial Crisis (Chart 3, top panel). Chart 3European Growth Is Set To Rebound European Growth Is Set To Rebound European Growth Is Set To Rebound Another source of optimism comes from the credit market. As the middle panel of Chart 3 illustrates, the European 12-month credit impulse has begun to bottom. This points to stronger euro area-wide domestic demand. Moreover, the Chinese credit and fiscal impulse is also bottoming, suggesting the drag from foreign demand could be dissipating (Chart 3, bottom panel). When looking at other specific trouble spots, Italy first springs to mind. In our view, the most recent deceleration in Italy was mainly a consequence of the tightening in financial conditions that resulted from the surge in Italian yields following the budget standoff between Rome and Brussels. However, the Lega Nord / Five Star Movement coalition has folded and is more or less acquiescing to the EU’s demands. Moreover, the rising probability that the European Central Bank will continue to provide long-term liquidity to the eurozone banking system via some form of new LTRO should diminish the funding risk to the Italian banking system, and thus, the risks to Rome’s fiscal sustainability. This implies that the decline in Italian borrowing costs could deepen (Chart 4), further easing Italian financial conditions and improving the growth outlook in the euro area’s third-largest economy. Chart 4Easing Financial Conditions In Italy Easing Financial Conditions In Italy Easing Financial Conditions In Italy France, too, has had its fair share of problems, though it is interesting that its industrial sector is not suffering as much as Germany’s, as highlighted by a French manufacturing PMI above the 50 boom/bust line. Instead, the French service sector is the one contracting (Chart 5). This bifurcation is likely to be a byproduct of the gilets jaunes protests that have lasted since November 2018 and affected retail trade. However, the intensity of the protests is declining and the French population is getting used to this. As a result, we are seeing a rebound in French household confidence, which implies that consumption, the main engine of French growth, is likely to perk up. Chart 5Fade The Gilets Jaunes, Paris In Spring Is Beautiful Fade The Gilets Jaunes, Paris In Spring Is Beautiful Fade The Gilets Jaunes, Paris In Spring Is Beautiful Finally, euro area fiscal policy is set to be loosened this year, with the fiscal thrust moving from 0.05% of GDP to 0.4% of GDP (Chart 6). The response of French President Emmanuel Macron to the gilets jaunes protests could even make the fiscal policy support slightly bigger this year. Chart 6Positive Fiscal Thrust In 2019 Positive Fiscal Thrust In 2019 Positive Fiscal Thrust In 2019 Ultimately, this combination of factors suggests that the large dip in European industrial production is likely to prove transitory, and that European activity will revert back toward the levels implied by the Belgian Business Confidence Index, which has historically been a good leading indicator of European growth (Chart 7). Chart 7European IP To Follow Brussels' Mood European IP To Follow Brussels' Mood European IP To Follow Brussels' Mood Bottom Line: The deterioration in European growth has captured the imagination of investors. However, the performance of European assets last year forewarned that growth would decelerate meaningfully. What matters now is how growth will evolve. Developments from Germany, France, Italy, the credit channel and the fiscal front all suggest that European activity will perk up soon. It’s All Relative While getting a sense of European growth is important when making a call on EUR/USD, economic trends must also be considered relative to the U.S. Surprisingly, despite notorious European growth underperformance, rays of hope are emerging. A major structural negative for EUR/USD has abated: The European debt crisis is behind us, and the aggregate European banking sector has been getting healthier, albeit slowly. This means that the euro area credit growth is not declining anymore against that of the U.S. This is a very long-term force that dictates multi-year cycles in the EUR/USD. As Chart 8 shows, it will be difficult for EUR/USD to move below 1.10 so long as the broad trend in the relative credit growth does not weaken anew. Chart 8Credit Dynamics Suggest That The Worst Is Over For EUR/USD Credit Dynamics Suggest That The Worst Is Over For EUR/USD Credit Dynamics Suggest That The Worst Is Over For EUR/USD More immediately, the euro area leading economic indicator relative to the U.S. is forming a bottom (Chart 9). Since the U.S. is not benefiting from as large a fiscal boost as in 2018, and financial as well as monetary conditions have tightened there relative to Europe, this suggests the improvement in the euro area relative LEI could continue this year. Chart 9Bottoming European LEI Versus U.S. Bottoming European LEI Versus U.S. Bottoming European LEI Versus U.S. Relative labor market slack is also evolving in a euro-friendly fashion. From 2013 to 2018, the euro area suffered from greater labor market slack than the U.S., courtesy of a double-dip recession and generally more-moribund growth. However, thanks to a 4.2-percentage-point fall in the European unemployment rate since 2013 to 7.9%, the euro area unemployment gap has not only closed, it is also below that of the U.S. Historically, when the U.S. unemployment gap leapfrogs that of Europe, EUR/USD tends to appreciate (Chart 10). Chart 10Less Slack Leads To A Stronger EUR/USD Less Slack Leads To A Stronger EUR/USD Less Slack Leads To A Stronger EUR/USD Relative slack does not only have value in itself, it also matters for relative inflation trends, which have been a crucial determinant of EUR/USD. As Chart 11 illustrates, EUR/USD tends to follow how euro area core CPI evolves relative to the U.S. After sharply falling last year, European relative core inflation is trying to rebound, which at a minimum suggests that EUR/USD has limited downside. Moreover, EUR/USD has correlated positively with German market-based inflation expectations (Chart 11, bottom panel). This suggests that actual relative inflation as well as euro area inflation expectations play a key role in determining perceptions among investors of how ECB policy will evolve relative to the Federal Reserve. Chart 11EUR/USD Trades Off Of Inflation Dynamics EUR/USD Trades Off Of Inflation Dynamics EUR/USD Trades Off Of Inflation Dynamics The recent euro decline has matched the decline in inflation expectations. However, inflation expectations have been much weaker than implied by the level of wage growth in Europe (Chart 12). This suggests that European inflation breakevens have scope to improve, a positive for the euro. Moreover, European wage growth is not only picking up steam in isolation, it is also rising relative to the U.S., which highlights that European inflation should not just stabilize vis-à-vis the U.S., but also accelerate. Chart 12European Wages Point To Rising Inflation Expectations European Wages Point To Rising Inflation Expectations European Wages Point To Rising Inflation Expectations This case is made even more saliently by looking at relative financial conditions. Due to the tightening in U.S. financial conditions compared to the euro area, European headline and core inflation is set to accelerate relative to the U.S. (Chart 13). Again, this reinforces the case that maybe the euro has upside this year. Chart 13Relative Euro Area Inflation Will Rise Thanks To Easier FCI Relative Euro Area Inflation Will Rise Thanks To Easier FCI Relative Euro Area Inflation Will Rise Thanks To Easier FCI Ultimately, for the euro to rise, investors will have to begin pricing in some switch in policy spreads between the ECB and the Fed. In the past, we showed that short-term policy expectations are important, but long-term ones can be even more relevant, especially when a central bank is well along the path of lifting rates, as the Fed is, while the other remains at maximum accommodation, like the ECB is today.1  Currently, investors expect euro area short rates to be only 0.5% 5-years from now (Chart 14, top panel). The spread between the eurozone and U.S. 5-year forward 1-month OIS rates remains near all-time lows, which explains the weakness in the euro. Now that European policy is much more accommodative than the U.S.’s, there’s scope for investors to upgrade the path of long-term euro area rates relative to the U.S. This would be bullish for the euro (Chart 14, bottom panel). Recovering relative credit flows and improving relative slack and inflation dynamics could catalyze this change. Chart 14The ECB Is Never Raising Rates The ECB Is Never Raising Rates The ECB Is Never Raising Rates Bottom Line: To make the euro an attractive buy, European growth and inflation conditions cannot just increase, they need to improve relative to the U.S. Since long-term interest rate expectations are very depressed in Europe relative to the U.S., a small improvement in the relative growth profile could be enough to catalyze a repricing of the ECB vis-à-vis the Fed, creating a powerful tailwind behind the euro. Nothing Happens In A Vacuum Ultimately, exchange rates, like other prices in the economy, do not only respond to domestic determinants but are also influenced by much larger, global forces. This is because those global trends percolate through domestic economies, resulting in changing relative expected returns that drive money across borders, leading to currency movements. In the case of the euro, global growth matters a lot, because European growth is much more sensitive to global economic fluctuations than U.S. growth is. This is particularly true if shocks emanate from emerging markets (Chart 15). Today, global cyclical variables are increasingly pointing toward an end to the global growth slowdown. A stabilization and reacceleration in global activity would support the euro. Chart 15 First, Chinese monetary conditions have begun to ease, which historically tends to be linked with improvements in European growth relative to the U.S. (Chart 16). Questions remain surrounding this point: How durable will the rebound in Chinese credit be? By how much will Chinese policymakers nurture this bounce? And will this jump be large enough to lift economic activity in the Middle Kingdom? Nonetheless, a reflationary wind from China has begun to blow, and since investors have already discounted much bad news out of Europe, only small improvements could turn the euro around.   Chart 16If China Is Really Stimulating, Europe Will Rip A Greater Dividend If China Is Really Stimulating, Europe Will Rip A Greater Dividend If China Is Really Stimulating, Europe Will Rip A Greater Dividend Second, as Chart 17 shows, our Nowcast for global industrial activity has decisively stepped down. Yet, the countercyclical dollar has been flat since October 2018. Historically, the performance of EM carry trades funded in yen tends to lead global growth. Currently the performance of these strategies is stabilizing. If EM carry trades funded in yen can rally further, this will spell trouble for the greenback, helping the euro – the anti-dollar – in the process. Chart 17An Early Positive For Global Growth An Early Positive For Global Growth An Early Positive For Global Growth Third, EUR/USD tends to correlate with the relative performance of global cyclical equities (Chart 18). The stabilization in these sectors since 2015 suggests it will be difficult for the euro to fall further from current levels. In fact, if EM carry trades can rebound more, cyclicals have additional scope to outperform, and the euro could rally. Chart 18Cyclical Stocks Pointing To No Real Downside In EUR/USD Cyclical Stocks Pointing To No Real Downside In EUR/USD Cyclical Stocks Pointing To No Real Downside In EUR/USD Fourth, the prospects for the semiconductor sector are improving. Demand for semis is highly pro-cyclical, and the U.S. Chip Stock Timing Model developed by our U.S. Equity Strategy service colleagues is currently sending a bullish signal.2 Since such developments link to improving global growth prospects, they are also associated with a stronger EUR/USD (Chart 19). This is also consistent with a generally weaker dollar and stronger Asian currencies. Chart 19The Outlook For Semiconductors Point Toward A Stronger Euro And A Weaker Dollar The Outlook For Semiconductors Point Toward A Stronger Euro And A Weaker Dollar The Outlook For Semiconductors Point Toward A Stronger Euro And A Weaker Dollar Finally, the breakout in copper prices, the stabilization in the CRB Raw Industrials Index and the rally in gold prices all support an improving global growth outlook that could lift EUR/USD. Bottom Line: Various indicators, such as Chinese monetary conditions, EM carry trades, semiconductor demand determinants and commodity prices are suggesting that global growth may soon bottom. Such a development should hurt the countercyclical dollar, amounting to a macro tailwind for EUR/USD. The Bad News Is Priced In Ultimately, the capacity of EUR/USD to rally rests on how much investors upgrade their outlook for Europe. It is therefore crucial to get a sense of exactly how uninspiring Europe currently is to global market participants. There is no better gauge of relative economic pessimism than the price of euro area financial assets relative to U.S. ones. Essentially, money talks. On this front, markets already seem to have internalized the known bad news from Europe, and there is scope for a contrarian rally in the euro, especially if, as we expect, European economic activity improves. First, on a 12-month forward P/E ratio basis, euro area equities are trading at the kind of deep discount to U.S. stocks normally symptomatic of a trough in relative sentiment toward Europe. Such a discount is often followed by a rally in EUR/USD (Chart 20). Chart 20Stock Valuations: Investors Do Not Like Europe Stock Valuations: Investors Do Not Like Europe Stock Valuations: Investors Do Not Like Europe Second, retailers’ equities can often give a more focused assessment of how investors perceive the comparative outlook for domestic demand between two nations. Currently, euro area retailers trade at a 16-year low versus their U.S. counterparts (Chart 21). Investors are therefore much more ebullient about the prospects for U.S. domestic demand than in Europe. Interestingly, the euro’s gyrations since 2016 have tracked the direction of the relative performance of retailers but have diverged in terms of levels. This suggests some underlying support for the currency. Chart 21Can European Domestic Demand Really Validate Such Pessimistic Expectations? Can European Domestic Demand Really Validate Such Pessimistic Expectations? Can European Domestic Demand Really Validate Such Pessimistic Expectations? Third, the relative stock-to-bond ratio also often provides a good read on investors’ comparative economic euphoria/pessimism towards two nations. In 2018, the annual performance of the euro area stock-to-bond ratio relative to the U.S. collapsed to levels not recorded since the euro area crisis was at its apex (Chart 22). This further confirms that investors were massively depressed on European growth prospects relative to the U.S. While this indicator is rebounding, it is still in negative territory, implying that market participants still have room to upgrade their assessment of the euro area relative to the U.S. Historically, this kind of setup has been associated with a rebound in the EUR/USD. Chart 22The Stock-To-Bond Ratio Points To Some Upside Potential The Stock-To-Bond Ratio Points To Some Upside Potential The Stock-To-Bond Ratio Points To Some Upside Potential Fourth, European net earnings revisions relative to the U.S. have also hit bombed-out levels and are in the process of improving. Since earnings are tightly linked to global growth and reflect the same information that informs capital flows into a country (Chart 23), sell-side analysts becoming more positive on Europe at the margin could indicate that investors are in the process of re-assessing whether to buy European assets. A decision to do so would support EUR/USD. Chart 23When The Sell-Side Move From Deeply To Mildly Bearish, EUR/USD Rallies When The Sell-Side Move From Deeply To Mildly Bearish, EUR/USD Rallies When The Sell-Side Move From Deeply To Mildly Bearish, EUR/USD Rallies Bottom Line: Financial market pricing suggests that investors are displaying deep pessimism toward the euro area’s relative growth prospects. The euro could be a contrarian buy. Most importantly, there are early signs that this growth pricing is starting to move in favor of Europe. If our economic view on Europe and global growth is correct, this trend has further to go, implying that more capital could move into Europe, creating a potent tailwind for EUR/USD. What Else? Three additional factors need to be considered: Currency valuations, balance-of-payment dynamics, and technicals. First, while it is not as cheap as it once was, the real trade-weighted euro is still trading below its historical average (Chart 24). Purchasing-power considerations can rarely be used as a timing tool, but our confidence in the euro’s upside would be greatly dented if the euro were a very expensive currency. It is not even mildly pricey. Chart 24Euro Valuations: No Headwinds There Euro Valuations: No Headwinds There Euro Valuations: No Headwinds There Second, balance-of-payment considerations have become increasingly euro-positive. The euro area runs a current account surplus of 3.3% of GDP, and despite large FDI outflows – a natural consequence of being a savings-rich economy – the basic balance of payments remains in surplus. Moreover, as fixed-income outflows have been dissipating, the aggregate portfolio flows into Europe have also been improving (Chart 25). The end of the ECB’s Asset Purchase Program should solidify this trend. Chart 25The Euro Area Balance Of Payments Is Increasingly Favorable The Euro Area Balance Of Payments Is Increasingly Favorable The Euro Area Balance Of Payments Is Increasingly Favorable Finally, technical oscillators are behaving increasingly well. As Chart 26 shows, not only does our Intermediate-Term Indicator remains oversold, but also, it is has begun to form a positive divergence with the price of EUR/USD. If the economic outlook is becoming more bullish, such a technical setup can often be translated into significant gains. Chart 26EUR/USD: Oversold And A Positive Divergence Is Forming EUR/USD: Oversold And A Positive Divergence Is Forming EUR/USD: Oversold And A Positive Divergence Is Forming Bottom Line: The euro’s valuation is not as attractive as it once was, but it remains cheap. Moreover, the euro area’s balance-of-payment dynamics and the EUR/USD’s technical setup both suggest the timing is increasingly ripe to buy the euro against the dollar. Investment Conclusions A trough in European growth, improving growth and inflation prospects relative to the U.S., green shoots for global growth and deep pessimism toward Europe relative to the U.S. all argue that the timing is right to bet on a euro rebound. At this point, the durability of the euro rebound remains unclear. Investors are under-appreciating the ability of the Fed to raise rates this year, which could help the dollar. On the other hand, they seem even more sanguine toward the ECB ever lifting rates. Ultimately, the capacity of the euro to rebound on a long-term basis against the dollar will be constrained by global growth. This means that China will continue to play a center-stage role for this crucial FX pair. At this point, it is unclear how determined Chinese policymakers are to reflate their economy. Thus, we recommend investors monitor Chinese policy to gauge how long to stay in the euro. For the time being, enough pieces are falling into place to warrant buying EUR/USD for three to six months. However, if the Chinese credit impulse can continue on its recent rebound, the durability of a euro rally could be extended, implying that the euro may be in the process of forming a long-term bottom against the dollar. A strengthening euro should support the entire European currency complex against the dollar. In fact, the NOK, the SEK and the GBP may even outperform the EUR. The NOK is being boosted by rising oil prices, a more hawkish central bank, better valuations and an even healthier balance of payments. The SEK is also supported by a Riksbank that is slightly more hawkish than the ECB, and better valuations; it also benefits from a Swedish economy that is even more pro-cyclical than the euro area’s. The GBP also benefits from a greater valuation discount than the euro, and political developments in the U.K. are beginning to move toward a more clear-cut positive outcome on the Brexit front.3 The countercyclical and expensive CHF will prove the European laggard. Finally, EUR/JPY is also set to continue its rebound that began on January 4th. In fact, it may be one of the best vehicles to express a euro-bullish view because it is less sensitive to what the Fed does than EUR/USD is. Rising bond yields are an unmitigated positive for EUR/JPY, and BCA firmly believes that U.S. Treasury yields have upside, whether or not the Fed goes back to lifting rates. The Fed will mostly impact whether it is the real or inflation component that lifts Treasury yields. Bottom Line: The entire European currency complex is set to rise along with the euro against the greenback. In fact, the NOK, the SEK and the GBP are likely to outperform the euro, while the CHF should underperform. EUR/JPY may in fact offer the best risk-adjusted returns to play a euro rebound. While it is clear that at this moment that buying the euro makes sense, the principal risk lies around how long this rally will last. We are increasingly convinced that the euro has made a low for the cycle and that its long-term outlook is looking increasingly bright.  Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see the EUR/USD: Focus On The Western Shores Of The Atlantic section of the Foreign Exchange Strategy Weekly Report, titled “Canaries In The Coal Mine Alert: EM/JPY Carry Trades”, dated December 1, 2017, available at fes.bcaresearch.com 2 Please see U.S. Equity Strategy Weekly Report, titled “Reflationary Or Recessionary”, dated February 25, 2019, available at uses.bcaresearch.com 3 Please see European Investment Strategy Weekly Report, titled “Why A Catastrophic No-Deal Might Be Good… For The EU”, dated February 28, 2019, available at eis.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades