Geopolitical Regions

Highlights So What? Investors should look to European assets for considerable upside. Why? In the Euro Area, investors have constantly overestimated the angst of the median voter towards the currency union. The European Parliament has few real powers, so a fractured European Parliament does not really matter. Europe’s high-beta economy should benefit from a Chinese and global rebound. Stronger European growth will translate into more credit demand and lower non-performing loans, which will boost bank earnings. Go long European banks as a tactical trade, and long European equities versus Chinese equities as a strategic play. We will also consider going long EUR/USD as a strategic play once we get clarity on potential tariffs. Feature Chart 1 Europe’s economy and asset markets continue to underperform in 2019 despite a global policy pivot away from tightening monetary policy and a solid quarter of Chinese credit growth. Investors are broadly unattracted to continental Europe, regularly voicing fears that it is beset by a combination of hazards: from a no-deal Brexit to the ballooning Target 2 imbalances. According to the latest Bank of America Merrill Lynch survey of fund managers, the most crowded trade remains “short European equities” (Chart 1). The doom and gloom are intriguing considering that China is stimulating its economy and will continue to do so as long as trade tensions are elevated. “Higher beta” equities, including Europe and EM, should benefit from this stimulus (Chart 2). Exports, a key growth engine for the currency union, are closely linked to Chinese credit growth (Chart 3). Chart 2Chinese Stimulus Good For "High Beta" Economies Chinese Stimulus Good For "High Beta" Economies Chinese Stimulus Good For "High Beta" Economies Chart 3Europe Will Benefit From Improving Chinese Growth Europe Will Benefit From Improving Chinese Growth Europe Will Benefit From Improving Chinese Growth And yet Europe remains unloved. Given that most client questions focus on the political situation – and that many ask about the upcoming May 23 European Parliament (EP) elections – we focus on both in this analysis. First, we review the latest survey data on the collective sentiment towards Europe and integration. Second, we give our insights regarding the upcoming EP elections. Our broad conclusion is simple. If our house view that global growth is about to bottom is correct, and barring a collapse in U.S.-China trade talks, European assets – primarily equities and the euro – should be the top performers this year.   What Does The European Median Voter Want? The Median Voter Theory is a critical concept for investors. At BCA Research Geopolitical Strategy, we believe that the median voter – not the policymaker – is the price maker in the political market place. Politicians, especially in democracies, are price takers. They are bound by constraints, of which the preferences of the median voter are the most concrete impediments to action. This concept is simple to understand, but difficult to implement. It is far easier to get lost in rumor intelligence-driven analysis of political consultants and journalists who pass on the cocktail party chatter insights gathered through speaking with policymakers. These insights focus on the preferences of the people in power. But their preferences are secondary to those of the median voter. Trust in the EU remains below 50%, but this is in line with or better than the usual trust most governments achieve. Chart 4Support For The Euro Has Been Trending Upwards Support For The Euro Has Been Trending Upwards Support For The Euro Has Been Trending Upwards In the Euro Area, investors have constantly overestimated the angst of the median voter towards the currency union. This has led many investors to keep their money off the table, or take active short positions, even when it was prudent to remain invested. The prime example is the sentiment towards the common currency itself. Support for the euro hit a low in 2013 but has shot up since then across the continent (Chart 4). Even in Italy, the support for the euro is now at an eight-year high. Many investors have remained blind to this empirical fact. Not only has the support for the currency rebounded, but it has done so by converting doubters. Chart 5 shows that the increased support for the common currency – particularly in Spain, Germany, the Netherlands, and Italy – has occurred at the same time as the opposition has fallen. In other words, it is not the “undecideds” that are switching into supporters of the euro, rather it is the opponents who are relenting. Chart 5ASupport For The Common Currency Rising... Support For The Common Currency Rising... Support For The Common Currency Rising... Chart 5B...As Doubters Convert ...As Doubters Convert ...As Doubters Convert Chart 6Support For The EU Also On The Rise Support For The EU Also On The Rise Support For The EU Also On The Rise What of the support for the EU broadly defined? Latest Pew Research polling also shows a strong rebound in support among the public in the largest member states (Chart 6). The last time we published the data – in the summer of 2016 following Brexit – the figures were much lower. Given that for many Europeans the EU is merely another layer of bureaucracy and government, the support level is impressive when put in the international context. Chart 7 shows that the trust in the EU, compared to the trust Europeans have in their own governments, falls somewhere squarely in the middle. When compared to non-European countries, Europeans have considerably more trust in the EU than Americans have in their own government and in line with the sentiment of Japanese towards their own government. In other words, the trust in the EU remains below 50%, but this is in line with or better than the usual trust most governments achieve.   Chart 7 Why has the median voter remained supportive of European institutions despite mixed economic performance? For one, investors – particularly outside continental Europe – continue to overstate how much emphasis Europeans put on “economic prosperity” as a key goal of the integrationist process. Sure, everyone wants a humming economy, but Chart 8 shows that for most large European economies, “peace” and a “stronger say in the world” are more cogent explanations for the EU’s raison d’être than economic performance. Chart 8 Now, a skeptic might argue that this is because the EU has failed to deliver on the promise of prosperity. Nonetheless, the data suggest that Europeans today no longer expect European institutions to focus primarily on economic matters. Geopolitics, particularly security and foreign policy, are not just concerns of the shadowy elites and bureaucrats in Brussels. The median voter is concerned with these matters as well. The one worrying aspect of Chart 8 is that voters in Italy and Spain don’t think the EU means much to them at all. That level of nihilism might be compatible with continued European integration today. However, it also means that both countries, particularly Italy, remain a risk whenever a recession hits. The second reason for the improvement in median voter support of European institutions is that the migration crisis of 2015 – which peaked in October 2015, merely eight months ahead of the fateful referendum in the U.K. – is done and gone (Chart 9). Illegal immigration is an issue of concern, but it has been for over half a century. In fact, every decade has seen a turn against immigration, usually following a recession. It is a recurring problem that will remain a major policy issue for the rest of the century. The path from a “policy problem” to “the end of European integration” is neither direct nor immediate. Third, terrorism has abated as an existential threat to Europe. Chart 10 shows that we have seen the end of the “bull market in terror” in Europe. Unfortunately, the data for that chart only goes to 2017, otherwise it would show an even more jarring collapse in both attacks and casualties. Chart 9The Migration Crisis Is No Longer A Crisis The Migration Crisis Is No Longer A Crisis The Migration Crisis Is No Longer A Crisis Chart 10The "Bull Market In Terror" Is Over The "Bull Market In Terror" Is Over The "Bull Market In Terror" Is Over   The chart is also useful in putting the latest bout of terrorism – mainly of the radical Islamic variety – in its proper historical context. Europe has been riven with far left and nationalist terror (often both) since the late 1960s. The number of casualties per year in the 1970s was nearly two times greater than the peak of the recent bout of radical Islamic terror. This is largely the case even excluding the Troubles in Ireland and Northern Ireland. There is simply no evidence that the European median voter is moving towards Euroskepticism. Although it is difficult to make the connection, we would go on to posit that the abating of the migration crisis and bull market in radical Islamic terror has allowed the median voter in Europe to assess whether breaking apart the EU would truly resolve these crises. Elements of European integration, particularly the common labor market and Schengen Agreement – which is part and parcel of the integrationist evolution – definitely make it easier for migrants and terrorists to cross borders. However, the geopolitical forces that breed both are at least partly, if not completely, non-European in origin. As such, it is not clear how individual European countries that lack any hard power would deal with these events on their own. Thus European integration is not a policy born of strength but of weakness. Chart 11 illustrates this concept empirically. It shows the percent of respondents who think their country could better face the future outside the EU. The dotted line represents the pessimistic view. An astounding 87% of Dutch responders, for example, are pessimistic about the country’s future outside the EU. We pick on the Dutch because they have tended to vote for Euroskeptic parties. Similarly, a very high number of Germans, Finns, Swedes, French, and Spaniards are lacking confidence in “national sovereignty.” Only the Italians are flirting with “going it alone,” although even in their case the momentum for sovereignty appears to have stalled, as it has in traditionally Euroskeptic Austria. Chart 11AEuropeans Lack Confidence In National Sovereignty... Europeans Lack Confidence In National Sovereignty... Europeans Lack Confidence In National Sovereignty... Chart 11B...And Believe They Are Better Off Sticking Together ...And Believe They Are Better Off Sticking Together ...And Believe They Are Better Off Sticking Together Many investors approach European integration with an ideological slant. But charts don’t lie. Since we founded BCA Research Geopolitical Strategy, we have used Euro Area perseverance as the premier example of how an empirically-driven approach to political analysis can generate alpha. There is simply no evidence that the European median voter is moving towards Euroskepticism. A broad trend has existed since 2013 of rising support for the common currency, the euro. And a mini up-cycle in support for broader European institutions appears to be present since 2016, probably due to the combination of Brexit, an abating migration crisis, and the end of the bull market in terror. Bottom Line: The median voter supports both the euro and broad European integration. This is an empirical fact. But … Euroskeptics Are Winning Seats! Chart 12Anti-Establishment Parties Are Gaining Seats Anti-Establishment Parties Are Gaining Seats Anti-Establishment Parties Are Gaining Seats Despite the comfort of our empirical data, the reality is that anti-establishment parties continue to increase their share of parliamentary seats across the continent (Chart 12). In the recent Spanish election, for example, the populist Vox managed to win 10.3% of the vote. Headlines immediately picked up on the extraordinary performance, noting that Euroskeptics have finally established a foothold in Spain. Spanish Prime Minister Pedro Sánchez, the leader of the victorious Socialist Party, has welcomed the characterization as a foil to his program, promising to build a pro-European bloc with other left-leaning parties. Sánchez is playing politics. He understands how broadly European integration is supported in Spain and is trying to paint his opponents – who disagree with him on many issues, but not on Spain’s membership in the EU and EMU – as being on the other side of the median voter’s preferences. In reality, Vox is not a hard Euroskeptic party. It is right wing on immigration, multiculturalism, and the centralization of the Spanish state, but on Europe Vox merely wants less integration from the current, already highly integrated level. Anti-establishment parties are realizing that the median voter does not want to abandon European integration. As such, the right-leaning anti-establishment parties are focusing on anti-immigrant and anti-multicultural policies, while the left-leaning are focusing on anti-austerity politics. But there appears to be an emerging truce on integration. We forecast this transition in our 2016 report titled “After Brexit, N-Exit?” We posited that anti-establishment parties would increasingly focus on anti-immigration policies, while reducing the emphasis on Euroskepticism, in order to remain competitive. We now have a number of examples of this process, from Italy’s Lega to Finland’s the Finns Party. Which brings us to the election at hand: the EP election on May 23. Chart 13 Ironically, the EP election gives Euroskeptics the best chance at winning seats. First, the turnout has been falling for decades (Chart 13) given the dubious relevance of the legislative body (more on that below). Second, Euroskeptic voters tend to be highly motivated during EP elections as they get to vote “against Europe.” Third, ironically, EP elections allow Euroskeptics to build pan-European coalitions with their fellow skeptics. Despite the hype, the latest seat projections give Euroskeptics merely 26% of the seat total in the body, or just under 200 seats in the 750-seat body (Diagram 1). Chart 14 shows that the support for Euroskeptics has actually taken a serious dip following the Brexit referendum, with the overall continent-wide support remaining around 20%. This is broadly the same level at which the support was five years ago, giving Euroskeptic parties no gain in half a decade. Diagram 1Euroskeptics Expected To Hold Only A Quarter Of The Seats European Parliament Election: Much Ado About A Moderately Relevant Event European Parliament Election: Much Ado About A Moderately Relevant Event Chart 14 All that said, if a fifth of Europe’s electorate is voting for anti-integrationist parties in the midst of the most important European-wide election, that must be a bad sign for Europe. Right? Wrong. The media rarely unpacks the Euroskeptics beyond citing their overall support figures. However, we have gone beyond merely citing the three leading Euroskeptic blocs. Instead, we have separated the individual Members of European Parliament (MEPs) from across the three Euroskeptic blocs into four camps: Eastern European Camp – These are MEPs from EU member states that are former members of the Warsaw Pact or former Republics of the Soviet Union. Hardcore Camp – These are committed Euroskeptics who genuinely want their countries to leave European institutions. The Dutch Party for Freedom wants to see the Netherlands leave both the EU and the EMU. However, parties such as the Swedish Democrats and the Finns Party are more nuanced. Nonetheless, we erred on the side of apocalypse and added them all to the hardcore camp. Classical Camp – These are MEPs who would have fit the Euroskeptic definition back in the 1990s. They generally do not have a problem with the EU, but tend to be skeptical of the EMU and definitely do not want to see any further integration (although some would welcome integration on the military front). Italy’s Lega belongs to this camp, at least since the 2017 election, given the reorientation of the party’s policy away from criticizing the EMU and toward anti-immigrant policies.  On The Way Out Camp – The U.K. MEPs will eventually be forced to exit the EP given the eventual departure of the U.K. from the EU. In this camp, we have thrown all the U.K. MEPs who sit in Euroskeptic groupings, which includes both UKIP MEPs and Conservative Party members – even those who are not actually anti-EU. Diagram 2Almost Three Quarters Of Euroskeptic MEPs Are Bluffing European Parliament Election: Much Ado About A Moderately Relevant Event European Parliament Election: Much Ado About A Moderately Relevant Event Diagram 2 shows the distribution of the currently 311 Euroskeptic MEPs. The largest portion, by far, are Eastern European MEPs. The second-largest portion are MEPs from the U.K., who are either on their way out or about to become the “lamest ducks” in the history of any legislature. What does this mean? First, that almost three quarters of the Euroskeptic MEPs are essentially bluffing. Eastern European Euroskepticism is a geopolitical oxymoron. Investors should ignore any Euroskeptic rhetoric from Eastern Europe for two reasons. First, many Eastern European economies remain highly dependent on the EU for structural funding (Chart 15). But even that crude measure does not illustrate the benefit of EU membership. If Eastern and Central European countries were to leave the EU, they would lose access to the common market, a huge economic cost given their close integration with the German manufacturing supply chain. Second, and perhaps more importantly, the EU is a critical geopolitical anchor for the former Warsaw Pact member states. As much as the Polish and Hungarian Euroskeptic MEPs like to speak of the “tyranny of Brussels,” they all remember all too clearly the actual tyranny of Moscow. As such, Eastern Europe’s Euroskepticism is a bluff, a rhetorical political tool to blame the ills of poor governance on Brussels for the sake of domestic political gains. It holds no actual threat to European integration or its institutions given that the alternative to Brussels is… Moscow. Chart 15 This is why the three Euroskeptic blocs will find it difficult to cooperate in the future. The Eastern European-heavy European Conservatives and Reformists (ECR) are highly skeptical of Russia, as the largest party in the bloc is the Polish Law and Justice (PiS) Party. The PiS is highly critical of Moscow’s foreign policy and is the ruling party of Poland. Its rhetoric is on occasion illiberal and anti-EU, but it has also changed domestic policy when pressured by Brussels. The ECR is expected to be the smallest Euroskeptic party, with 55 MEPs. The genuinely hard-core Euroskeptic bloc is the Europe of Nations and Freedom (ENF). It is expected to win 58 MEPs and is dominated by genuine, long-time, anti-EU parties such as Marine Le Pen’s National Rally of France (formerly the National Front) and the Dutch Party for Freedom. However, its latest iteration is likely to be dominated by Matteo Salvini’s Lega, which is Italy’s ruling party and has taken a decided turn towards soft Euroskepticism. Finally, the moderately Euroskeptic Europe of Freedom and Direct Democracy (EFDD) is expected to win 57 seats. However, its largest bloc are the ruling Italian Five Star Movement (M5S) and an assortment of Euroskeptic British MEPs, including Niger Farage. Italy’s M5S has already toned down its Euroskeptic rhetoric given that it now sits in Rome and runs the EMU’s third-largest economy. Meanwhile, U.K. MEPs will be largely irrelevant, raising the question of whether EFDD should even be classified as Euroskeptic in the next EP. Bottom Line: When all is said and done, the European Parliament election is a much-hyped non-event. By our count, only about 60 out of approximately 190 Euroskeptic MEPs will be actual hard-core Euroskeptics (or, just 8% of the entire EP). The rest are either reformed centrists – the two major Italian parties, Lega and M5S – on their way out – U.K. Euroskeptics – or are just bluffing – all Eastern European MEPs. That said, the EP seat distribution will reflect the polarization and fracturing observed in most national parliaments across of Europe. It is likely that neither the center-left nor the center-right will have enough seats to select the European Commission President. Does Any Of This Even Matter? Does the EP election even matter? To answer this question, we first have to assess whether the European Parliament itself matters. Both the proponents and opponents of the EU overstate the bloc’s supranational institutions: the EP and the Commission. A fractured European Parliament does not really matter ... In fact, the European Parliament has few real powers. The true power in the EU is vested in the European Council. The European Council could be conceived of as an upper chamber of a combined EU legislature, the Senate to the European Parliament’s House of Representatives (to put into U.S. context). It is comprised of the heads of government of EU member states and is therefore elected on the national, not supranational, level. It is, by far, where most power resides in the EU. The Commission, on the other hand, is the EU’s technocratic executive. Its members are not democratically elected, but are chosen by the European Council and approved by both the Council and the EP.1  The EU Commission President is elected according to the Spitzenkandidat system. The party grouping that secures a majority governing coalition in the EP gets to name their leader as the candidate for the European Commission President. This system is not enshrined in EU law, it is merely a convention. In fact, it was designed to try to boost the voting turnout for the EP elections. The idea being that Europe’s voters would turn out to vote if it meant that their votes would ultimately determine who gets to head the European Commission. At the end of the day, the European Council has to approve the Spitzenkandidat. And, according to the letter of the law, the European Council can ultimately even ignore the Spitzenkandidat suggestions of the European Parliament and propose their own head of the European Commission. As such, the fact that Diagram 1 suggests a fractured European Parliament does not really matter. The European Council could, in the end, simply find a consensus candidate and have national governments instruct their MEPs to vote for that candidate in the EP. In fact, the European Parliament has few real powers. It is one of the only legislatures in the world with no actual legislative initiative (i.e., it cannot produce laws!). It gets to hold a ceremonial vote on new EU treaties – the treaties that act as a constitution of the bloc – but cannot veto them. On most important matters – including the EU budget – the Parliament cannot overrule the European Council (the heads of national governments), which means that it cannot subvert the sovereignty of the EU member states. In the political construct that is the EU, it is the upper-chamber that holds all the power (if we are to extend the analogy of the European Council as the “Senate”). Another important thing to remember is that MEPs are rarely unaffiliated. The vast majority are members of national parties on the national level. Few, if any, are actual supranational agents. In fact, most MEPs fall into two categories. They are either young up-and-comers being groomed for a successful career on the national level – the level that actually matters – or they are past-their-expiration-date elders looking for a cushy retirement posting that includes frequent, taxpayer-funded, trips between Brussels and Strasbourg.  Bottom Line: The importance of the EP is vastly overstated by both Europhiles and Euroskeptics. Its role within the EU legislative process has been increasing through treaty evolution and convention. However, the true power in the EU still rests with the national governments and the EP can be sidelined if the European capitals so desire. Furthermore, while the EP is a supranational body with supranational powers, its soul is very much national. This is because most of its MEPs either have an eye on returning to domestic politics or are emeriti of domestic politics looking for one last bout of relevance. Investment Implications Given our sanguine view of European politics, and the BCA House View that global growth should bottom (Chart 16), investors should look to European assets for considerable upside. This is particularly the case if the U.S. and China overcome their cold feet and conclude a trade deal. Our colleague Peter Berezin, BCA’s Chief Investment Strategist, has proposed that investors go long European banks as a tactical trade. Peter has pointed out that banks are now trading at distressed valuations (Chart 17).2  Given a Chinese and global rebound, and barring a total relapse into trade war, Europe’s high-beta economy should benefit, leading to higher bond yields in core European markets.This has tended to help European bank stocks in the past (Chart 18). Stronger economic growth will also translate into more credit demand and lower non-performing loans. This will boost bank earnings (Chart 19). Chart 16Growth Is Recovering In The U.S. And China Growth Is Recovering In The U.S. And China Growth Is Recovering In The U.S. And China Chart 17European Banks: A Good Value Play European Banks: A Good Value Play European Banks: A Good Value Play Chart 18Euro Area: Higher Bond Yields Bode Well For Bank Stocks Euro Area: Higher Bond Yields Bode Well For Bank Stocks Euro Area: Higher Bond Yields Bode Well For Bank Stocks Chart 19More Credit, Fatter Bank Earnings More Credit, Fatter Bank Earnings More Credit, Fatter Bank Earnings In addition, U.S. dollar outperformance is long-in-the-tooth. If global growth is truly bottoming, and assuming a trade deal is done,  then the policy divergence that has favored the greenback should be over (Chart 20). As such, we will consider going long EUR/USD as a strategic play once we get clarity on China tariffs and potential tariffs on U.S. auto imports (the latter risk is rising from 35% to 50% given Trump’s willingness to take risks this year). Chart 20If Trade War Subsides, Dollar May Fall If Trade War Subsides, Dollar May Fall If Trade War Subsides, Dollar May Fall Chart 21A Reversal In Tech Outperformance Supports Long Europe/China A Reversal In Tech Outperformance Supports Long Europe/China A Reversal In Tech Outperformance Supports Long Europe/China Finally, Dhaval Joshi, BCA’s Chief European Strategist, believes that Europe is a clear tactical overweight to China.3 Part of the reason is that the two markets are mirror opposites of each other in terms of sector skews. China is overweight technology and underweight healthcare, while Europe is overweight healthcare and underweight technology. The year-to-date outperformance by global technology stocks relative to healthcare is long in the tooth and ripe for a correction (Chart 21). Given our positive structural assessment of European political risk, we recommend going long European equities and short China as a strategic play.   Marko Papic Consulting Editor marko@bcaresearch.com Footnotes 1      For the American context, the Commission would be what the various U.S. Departments would look like if they were serving at the pleasure of the U.S. Senate. While the analogy is not perfect, it does capture the fact that the EU’s executive is controlled by the European Council. 2      Please see BCA Global Investment Strategy Weekly Report, “King Dollar Is Due For A Breather,” dated April 26, 2019, available at gis.bcaresearch.com. 3      Please see BCA Research European Investment Strategy Weekly Report, “Suffering Market Vertigo,” dated May 2, 2019, available at eis.bcaresearch.com.  

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

Highlights So what? Egyptian assets will benefit from improving fundamentals. Why?   March credit data confirm China’s stimulus, supporting the commodity/EM complex. Oil price risks are also to the upside. In Egypt, investors will welcome constitutional changes that reinforce the regime and overall stability. Egypt is beginning to reap the rewards of painful IMF reforms enacted in late 2016. A large, under-invested labor market is a key structural risk that will weigh on Egypt’s long-term investment potential. We recommend an overweight stance in Egyptian sovereign (USD) bonds relative to EM. Feature Egypt is the world’s most populous Arab country and a geopolitical fulcrum at the critical juncture between Africa, Europe, and Asia. Its stability is particularly important at a time of rapid geopolitical change. The U.S. is deleveraging from the Middle East and regional powers are scrambling to fill the void. Popular discontent is toppling rigid authoritarian leaders, most recently in Algeria and Sudan. Displaced peoples have spilled into Europe in the recent past and could do so again if more regimes fail (Chart 1). In this week’s Special Report we take a close look at Egypt and show how its continued stabilization is a rare positive trend for the region and one that presents an investment opportunity in its own right. China’s March Credit data confirm that stimulus is surprising to the upside this year. Before proceeding, however, we make note of some key developments on the global front, especially our oil view: China’s Stimulus: China’s March credit data confirm that stimulus is surprising to the upside this year (Chart 2). The data will help galvanize expectations of firming global growth, supporting commodity prices and EM risk assets. We are long Chinese equities, Indonesian and Thai equities, and EM energy producer equities relative to the EM benchmark.    Chart 1Asylum Seekers May Rise Amid Mideast Instability Asylum Seekers May Rise Amid Mideast Instability Asylum Seekers May Rise Amid Mideast Instability Chart 2Chinese Credit Supports Economic Outlook Chinese Credit Supports Economic Outlook Chinese Credit Supports Economic Outlook Iranian Sanctions: The Trump administration is increasing the pressure on Iran again and threatening to enforce sanctions strictly on oil exports. Exports have recovered somewhat since Trump issued waivers for key importers last fall and this means that 1.3mm bpd are still at risk if enforcement intensifies (Chart 3). Chart 3 Libyan War: Libyan National Army leader, General Khalifa Haftar, has made a move for Tripoli after sweeping across the country’s south, jeopardizing the roughly 300,000 barrels per day exported from Zawiya, west of Tripoli. Egypt is one of Haftar’s geopolitical backers, along with the UAE, so Egypt’s improving domestic situation, discussed below, is a factor supporting Haftar’s ability to extend his control across western Libya, which poses a risk of unplanned oil outages this year. The combination of these factors will put upward pressure on oil prices in an environment where supplies are already limited. As a result, Bob Ryan, the head of BCA’s Commodity & Energy Strategy, believes that OPEC 2.0 will eventually follow Russia’s preferred path at this juncture and increase production. Russia and Saudi Arabia are comfortable with Brent crude above $70 per barrel, but will get nervous once prices rise above $80 and threaten to kill demand in emerging markets. An alteration of slated production cuts has not yet been agreed and prices remain well supported in the meantime, with Brent on track to average $75 per barrel in 2019 and $80 in 2020.1  We do not expect President Trump to impose “maximum pressure” on Iran in this context. We have long assumed the worst of Venezuelan production, i.e. that it will at least be cut in half to 500,000 bpd by end of year, and possibly fall to zero. Libyan outages could theoretically rise to the full 900,000 bpd, though the likely cap is 300,000 bpd. The removal of 1.3mm bpd of Iranian barrels would bring the combined production losses close to OPEC 2.0’s spare capacity of around 2.1mm bpd. Moreover, the Iranians have the ability to retaliate, which jeopardizes other output across the Middle East. The United States has a valuable tool in the Strategic Petroleum Reserve.2 But President Trump would still be taking an enormous risk with the economy in advance of an election year to enforce the maximum sanctions on Iran. So we maintain that he will largely keep the waivers in place on May 2. The real danger, from our point of view, comes if Trump is re-elected, as then he will be less constrained both politically (no chance of reelection) and economically (U.S. production going up) in pursuing his hawkish foreign policy against Iran. But that is a story for 2021. With that, we turn to Egypt.  A Dream Deferred Earlier this year, the Egyptian parliament voted in favor of a series of proposed constitutional amendments that will further consolidate President Abdel Fattah al-Sisi’s power. Among the changes are the extension of the president’s term, allowing him in principle to rule for another 15 years. The proposed amendments will also expand the role of the military, enshrining a political role for it, thus solidifying its already preeminent position in Egyptian politics.3 These proposed changes bring the de facto Egyptian political environment close to its pre-2011 state – that is, the state of affairs before an estimated two million Egyptians rose in protest at Tahrir Square and removed President Hosni Mubarak from power, setting in motion a tumultuous decade. Sisi supporters argue that these changes will guarantee much needed stability and policy continuity to the Egyptian economy, allowing it to regain its footing. With GDP growth expected to near 6% by the middle of next year – the strongest since the 2011 revolution – it is no surprise that the aspirations of Egypt’s revolutionaries have become a dream deferred. Chart 4Improving Fundamentals Bode Well For Egyptian Equities Improving Fundamentals Bode Well For Egyptian Equities Improving Fundamentals Bode Well For Egyptian Equities Instead, policymakers and ordinary citizens alike have focused on making ends meet – both in terms of the fiscal purse and the household bank account. Policy continuity is what is required for Egypt at this point in time: It is finally beginning to reap the rewards of the painful reforms enacted in late 2016 as part of the IMF program. Sisi’s own position is reinforced by the fact that he oversaw this process and has come out on the other side. While the proposed constitutional amendments will pass, and will be characterized as a step back into authoritarian rule, the stability will be favorable for investors, as it will support a more predictable near-term trajectory for the Egyptian economy. Egyptian assets have already started to reflect this reality, signaling that Egypt is transitioning into a new era that portends a more attractive investment climate. As such, Egyptian equities have picked up and have outperformed the broader EM index since December (Chart 4). Bottom Line: “Stability” is the catch-phrase of the Sisi regime. Constitutional amendments allowing the Egyptian president and military to amass far-reaching powers are likely to pass. While they mark a return to Egypt’s traditional authoritarian system, this will be welcomed by foreign investors who were otherwise hesitant to re-enter the Egyptian market during the turbulent aftermath of 2011 Egypt’s 2016-2019 Policy Mantra: No Pain, No Gain Since the 2011 revolution, the Egyptian economy has been defined by years of turmoil. The popular uprising and ensuing loss of security drove away tourists and foreign investors – key sources of hard currency – causing the central bank to chew through its foreign exchange reserves as it scrambled to stabilize confidence and the currency. High rates of poverty, unemployment, and inequality amid a growing public sector wage bill, over reliance on food imports and an overvalued currency were a recipe for an economic disaster. Public debt ballooned while the black market for foreign exchange thrived. Thus, the structural reforms (Box 1) that accompanied the November 2016 $12bn IMF loan – while painful – were necessary to transition the economy onto a more sustainable trajectory.   Box 1 Structural Reforms Implemented Since 2016 The reforms that accompanied the IMF program are designed to improve fiscal consolidation, liberalize the foreign exchange market, and create a more business friendly investment climate. They include the following measures: The floating of the currency in November 2016 which resulted in the Egyptian pound losing half its value relative to the dollar. Given that Egyptians rely on imports for a large chunk of their consumption, the impact on household budgets and consumer prices have been massive (Chart 5). However, the inflation rate has since slowed to 14.4%, with the Central Bank of Egypt (CBE) targeting single-digit inflation by the end of next year. Similarly, it has stabilized the EGP/USD.4 Reductions to fuel subsidies have weighed on consumer expenditures. The target is full-cost recovery by the end of 2018-19 for almost all fuel products (except LPG and fuel oil used in bakeries and electricity generation). The introduction of a value-added tax (VAT) of 13% in 2016, which subsequently rose to 14%. The VAT will help generate revenue, by replacing the distortionary sales tax and broadening the tax base. Basic goods and services are exempt from the VAT in order to shield the poor from rising living costs. A reduction in utility subsidies to reduce state spending and instead channel funds to more productive uses. Authorities target the full elimination of electricity subsidies by 2020-21. Similarly, water and sewage subsidies have been cut. As of December 2018, Egypt ended a discounted customs exchange rate for non-essential imports. The monthly fixed customs exchange rate was introduced in 2017, following the 2016 currency devaluation, offering a favorable exchange rate to importers. In the second half of last year, the customs exchange rate was set at 16 EGP/USD while the market rate was EGP/USD 17.82-17.96. The non-essential imports include tobacco products, alcohol, pet food, and cosmetics. Other goods that will also be subject to the market rate include mobile phones, computers, furniture, shoes, cars, and motorbikes. The elimination of the repatriation mechanism for new inflows. The repatriation mechanism guaranteed the availability of foreign exchange for capital repatriation to portfolio investors that chose to sell foreign exchange to the central bank. Its elimination means that cash inflows and outflows by foreign portfolio investors will now impact the supply and demand of foreign currencies in the market. A new investment law was enacted in July 2017, which aims to promote domestic foreign investments by offering incentives and reducing bureaucracy. A new bankruptcy law was enacted in January 2018. Egypt ranks 101 out of 168 in the “Resolving Insolvency Index” of the Doing Business report. The law simplifies post-bankruptcy procedures and aims to reduce the need for companies to resort to courts in the case of bankruptcy. It also removes investment risk by abolishing imprisonment in bankruptcy cases. Chart 5FX Reform Was Inflationary FX Reform Was Inflationary FX Reform Was Inflationary     To mitigate the impact of these changes, especially on the lower and lower-middle income brackets, social programs have been expanded and improved, including: Takaful and Karama: An expansion of the cash transfer program, which now targets more than 10 million people, or ~10% of the population. Forsa: A program that helps create job opportunities for underprivileged youth by focusing on employment training. Mastoura: A program that lifts living standards and provides economic empowerment for Egyptian women by supplying microloans to fund projects. Sakan Karim: A program that aims to improve housing conditions of the poor by promoting access to clean drinking water and sanitation. Together, the structural reforms and targeted social programs will support the Egyptian economy by strengthening the business climate, attracting investment, and increasing employment. Since the beginning of the program, the country’s fiscal arithmetic has improved, inflation has been contained, and foreign exchange is no longer scarce. As a result, investor confidence has picked up. With the final $2bn tranche of the loan expected to be dispersed in the middle of 2019, the onus now lies on Egyptian policymakers to keep up the momentum. Bottom Line: With the IMF program now winding down, the continuity of reform implementation is squarely on the back of policymakers. With further structural policies in the pipeline, we expect policymakers to build on the macroeconomic gains of the past few years. Reaping The Rewards The most evident improvement following the reforms is seen in the fiscal purse. For the first time in over a decade, the primary balance is in surplus (Chart 6). The improvement reflects lower government spending commitments on the back of fiscal consolidation (Chart 7). Nevertheless, revenues remain weak, despite the implementation of the VAT, implying a need to improve tax collection and boost aggregate demand to raise taxable revenues. Chart 6Improving In Fiscal Arithmetic... Improving In Fiscal Arithmetic... Improving In Fiscal Arithmetic... Chart 7...On Back Of Fiscal Consolidation ...On Back Of Fiscal Consolidation ...On Back Of Fiscal Consolidation As policymakers continue reforming budgetary allocations, we expect the primary surplus to remain intact. This will alleviate some of the pressure on the overall budget, which, while still in deficit, has improved substantially. With the final $2bn tranche of the loan expected to be dispersed in the middle of 2019, the onus now lies on Egyptian policymakers to keep up the momentum. Nevertheless, the stock of public debt – whilst declining – remains elevated and will continue weighing on the overall budget (Chart 8). This is especially problematic for fiscal arithmetic since domestic interest rates are in the double digits and interest payments will tie down roughly half of government revenues. A combination of improving potential GDP, falling domestic interest rates, and continued prudence on debt is needed to stabilize Egypt’s debt dynamics. In fact, with the decline in both headline and core inflation, the Central Bank of Egypt has already embarked on a monetary easing cycle, cutting rates by 300 basis points since the beginning of last year (Chart 9). Although interest rates remain extremely high, lower borrowing costs will not only improve debt dynamics on the margin, but also encourage private sector credit, thus raising aggregate output and revitalizing domestic investment. Chart 8Debt Remains A Burden Debt Remains A Burden Debt Remains A Burden Chart 9Continued Easing Will Boost Outlook Continued Easing Will Boost Outlook Continued Easing Will Boost Outlook While inflation may accelerate in the coming months – on the back of a seasonal uptick in food prices during the month of Ramadan and the further removal of subsidies – we expect further cuts by the CBE in 2H2019 and 2020. Falling real wages due to fiscal consolidation also point to lower inflationary pressures (Chart 10). Unless Egypt manages to stabilize its debt dynamics, it will once again be forced to resort to debt monetization, which bodes ill for the currency as well as for inflation. The evidence to date points to an improvement (Chart 11). Chart 10Inflationary Pressures Are Contained Inflationary Pressures Are Contained Inflationary Pressures Are Contained Along with the improvement in the fiscal account, Egypt’s external deficit has also narrowed on the back of the improvement in the macroeconomic climate (Chart 12). The contraction in the current account deficit has been bolstered by an expansion in exports, which grew more than 10% in 2018. Chart 11Authorities Resisting Urge To Monetize Debt Authorities Resisting Urge To Monetize Debt Authorities Resisting Urge To Monetize Debt Chart 12External Deficit Contracting External Deficit Contracting External Deficit Contracting Chart 13Natural Gas Exports Will be Supportive Natural Gas Exports Will be Supportive Natural Gas Exports Will be Supportive   Notably, the energy trade balance has benefitted from an increase in Egypt’s natural gas potential (Chart 13). The giant Zohr field – the largest gas discovery ever made in the Mediterranean – came on stream in December 2017, and will support Egypt’s self-sufficiency in gas after falling domestic production forced Egypt to cut most LNG exports in 2014. The location of the gas field also presents opportunities for Egypt to become a natural gas export hub in the region. The Zohr field is close to other major fields in Israel and Cyprus, which means economies of scale can be utilized in developing regional export infrastructure. Egypt’s LNG export plants in Damietta and Idku have a capacity of 19 billion cubic meters (bcm) per year, which have been mostly idle in recent years. Already, an agreement between Egypt and Cyprus this past December committed to the construction of a pipeline connecting the Aphrodite gas field to Egypt’s LNG facilities. Similarly, a rebound in revenues from tourism to near-pre-crisis levels has helped improve the external account (Chart 14). Going forward, we expect the decline in terrorism to support the rebound of foreign inflows from tourism (Chart 15). This will be a non-negligible source of cash as tourism now accounts for roughly half of all service receipts, up from less than a quarter just three years ago. However, given that the security situation is unpredictable, this sector remains vulnerable to downside risks. Chart 14Rebound In Tourism... Rebound In Tourism... Rebound In Tourism... Chart 15 Another supportive source of inflows has been remittances from Egyptians living abroad. These continue to grow at a double-digit rate (Chart 16). Chart 16Recovery In Remittance Inflows Recovery In Remittance Inflows Recovery In Remittance Inflows Chart 17Foreign Investment Will Be Supported... Foreign Investment Will Be Supported... Foreign Investment Will Be Supported...   However, the financial account has taken a hit recently as inflows from portfolio investments have come down quite sharply on the back of investor aversion to emerging markets last year (Chart 17). Given the Fed’s pause, China’s stimulus, and other factors, we expect a pickup in portfolio investment. What’s more, Egyptian authorities have been working on improving the business environment, reflected in Egypt’s rising rank in the ease of doing business and global competitiveness surveys (Chart 18). This should improve foreign direct investment, which remains relatively weak so far. Chart 18 Chart 19Build Up In Central Bank Reserves Build Up In Central Bank Reserves Build Up In Central Bank Reserves Of course, despite these improvements, Egypt still ranks relatively low on these measures. Thus continued efforts to improve the business environment will be necessary to make Egypt an attractive destination for businesses. Yet Egypt’s foreign reserves have picked up considerably, and more importantly its net reserves – which exclude the CBE’s foreign borrowings – have once again turned positive (Chart 19). Bottom Line: The rewards from Egypt’s structural reforms are evident in the improvements to its twin deficits. While continued policy prudence is necessary to maintain the momentum of these policies, we expect the EGP/USD to remain flattish for the remainder of the year. We expect continued policy easing as the CBE cuts rates at least one more time in the second half of the year on the back of slowing inflation. Ghosts Of Futures Past Political stability and an improvement in macroeconomic indicators will no doubt be supportive of the Egyptian economy and assets in the near term. However, several structural risks remain, and could derail its performance down the road. For one, Egypt remains heavily reliant on its external environment. This environment has been largely cooperative throughout Sisi’s term in office, but a global or EM downturn could cause investment to collapse. Meanwhile the cyclical rise in oil prices will weigh on the import bill and raise headline inflation. Improvements in the business environment should attract foreign directinvestment. Second, a rising dependency ratio will pose a burden on Egypt in the coming years (Chart 20). Furthermore, elevated female and youth unemployment keep the output gap wide. True, the current improvement in the overall labor market will help the country weather the demographic headwind. However, another chronic problem is the quality of the Egyptian labor market. The latest data from the World Bank shows that government spending on education is significantly lower than it is among EM peers (Chart 21). Similarly, health expenditure per capita has not picked up much in recent years and has actually fallen as a share of GDP. Chart 20Demographic Challenges Remain Demographic Challenges Remain Demographic Challenges Remain Chart 21   This has manifested in relatively low labor productivity and highlights the need for investment in human capital to improve potential GDP and the necessity for funds to be channeled to these sectors. Fortunately, the reforms have freed up badly needed fiscal space for now. Another key concern is the bloated economic role of the state and military. This is a double whammy to the Egyptian economy as it reduces fiscal funds available for other uses, such as healthcare and education while constraining the private sector. The crowding out of the private sector is evident from the recipients of bank credit: loans to the government – beyond purchases of government securities – are growing at by nearly 50% y/y, while lending to other sectors is expanding at less than 15% y/y (Chart 22). Once again, however, there is evidence of improvement: bank investments in government securities have come down from their peak and now represent roughly a third of total bank assets (Chart 23). Accordingly, credit to the private sector has likely bottomed. Chart 22Private Sector Crowding Out Remains... Private Sector Crowding Out Remains... Private Sector Crowding Out Remains... Chart 23...But Signs Of Improvement ...But Signs Of Improvement ...But Signs Of Improvement One structural concern that is here to stay is the fact that the Egyptian military occupies an oversized share of the economy. Given that all companies of the Egyptian armed forces are exempt from taxes, they have an unfair advantage over the private sector. The military has an especially large presence in Egypt’s recent infrastructure mega-projects. These include $8.2 billion invested in an expansion of the Suez Canal as well as the construction of a new administrative capital, 45 km to the east of Cairo. The military budget is secret and connected industries are not subject to auditing. Preferential treatment in assigning government contracts and the ability to offer services at a cheaper rate have further expanded the military’s role in the economy. Bottom Line: Risks to our optimistic outlook on Egypt mostly come from any deterioration in the external environment. The Egyptian economy is also weakened by structural weaknesses such as a large, under-invested labor market. These structural risks are considerable and will weigh on the long term investment potential of Egypt. In the short term, however, Egypt appears to be a lucrative trade opportunity. Investment Implications Egyptian sovereign spreads will likely contract going forward on the back of an improvement in the economic outlook (Chart 24). Thus, we recommend an overweight stance in Egyptian sovereign bonds within the EM space. Chart 24Improved Fundamentals A Positive For Sovereign Bonds Improved Fundamentals A Positive For Sovereign Bonds Improved Fundamentals A Positive For Sovereign Bonds Chart 25Equities Still Attractive Equities Still Attractive Equities Still Attractive   In the equities space, Egypt’s valuations look attractive relative to their Emerging Market and Frontier Market peers (Chart 25), despite the recent rally in recognition of the stability we outline here.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Marko Papic Consulting Editor marko@bcaresearch.com Footnotes 1      Please see BCA Commodity & Energy Strategy Weekly Report, “Sussing Out OPEC 2.0’s Production Cuts, U.S. Waivers On Iran Sanctions,” April 11, 2019, available at www.bcaresearch.com. 2      The U.S. Strategic Petroleum Reserve (SPR) was created in 1975, in the wake of the Arab oil embargo, to protect the U.S. from supply disruptions. Faced with a “severe energy supply interruption” the U.S. president can authorize a maximum drawdown of 30 million barrels within a 60-day period, beginning 13 days after the decision. Notably, the SPR was tapped for 21 million barrels in 1990-91, during the Iraqi invasion of Kuwait, and for 30 million barrels in 2011, when Libyan production fell to zero amid the revolution. The current inventory is 649 million barrels of sweet and sour crude, which could last the U.S. 114 days of crude imports. As U.S. net oil imports decrease, the length of time that the SPR could substitute for net imports rises. 3      The Egyptian parliament voted in favor of the proposed changes on April 16. The changes will be put to a public referendum – as early as next week – before taking effect. The amendments seek to (1) extend presidential terms from four to six years, (2) permit President Sisi to run again after his current term ends in 2022 – as an exceptional case, (3) allow the president to select the heads of judicial bodies and to oversee a new council responsible for judicial affairs, and (4) enshrine in the constitution a political role for the army to preserve the constitution, democracy and – ironically – the civilian nature of the country. 4      The most recent appreciation this year raised fears that the CBE is once again intervening in the currency market through state-owned banks.  

Highlights So what? The U.S.-China deal is not shaping up as well as the consensus holds. Why? The odds of reaching a deal by June are rising, but no higher than 50%. Unemployment is a constraint on the Chinese side but stimulus reduces urgency. Structural concessions on currency and foreign investment are limited in scope. Strategic concessions are limited to North Korea; Taiwan risks are rising. Stay overweight U.S. and Chinese equities on a relative basis at least until the deal is signed.   Feature Once again investors are faced with a stream of headlines suggesting that a U.S.-China trade deal is all but finished, only to find critical caveats buried on page six. For instance, President Donald Trump and President Xi Jinping have not yet scheduled a summit to sign a trade agreement, though Trump insists a summit is necessary. Chief U.S. negotiator Robert Lighthizer says that he is “hoping but not necessarily hopeful.”1 There is still room for U.S. and Chinese bourses to outperform on a relative basis while negotiations continue. Still, the news flow is encouraging. Trump has said “we’ve agreed to far more than we have left to agree to,” while Xi Jinping has called for an “early conclusion of negotiations.” The other negotiators are also making positive sounds, with Vice Premier Liu He saying that a “new consensus” has been reached on a text of the trade agreement. National Economic Council Director Larry Kudlow says that key structural issues are on the table and that negotiations are continuing by videoconference after two successful rounds of direct talks in Beijing and Washington. Even the notorious China hawk, Peter Navarro, Director of the U.S. National Trade Council, has begrudgingly admitted that the two sides are in the final stage of the talks, saying, “the last mile of the marathon is actually the longest and the hardest.”2 Readers know that we take a pessimistic view of U.S.-China relations over the long run. We were skeptical about the possibility of a tariff truce on December 1. However, the signs are stacking up in favor of a deal. While we would not be surprised if talks extended to the June 28-29 G20 summit in Osaka, Japan, President Trump has suggested that a summit could come as early as May 5-19. Chart 1Still Some Room To Run Still Some Room To Run Still Some Room To Run Judging by the performance of U.S. and Chinese equities relative to the rest of the world since the first tariffs were imposed on June 14, 2018, there is still room for these two bourses to outperform on a relative basis while negotiations continue. Relative to global equities excluding China and U.S., Chinese stocks have retraced 78% of the ground they lost, while U.S. stocks have not surpassed the high points reached at the peak of the global economic divergence in 2018 (Chart 1). Once a deal is reached, will investors that bought equities on the rumor sell the news? We would buy, though equity leadership should rotate away from the U.S. and China depending on the timing and external conditions discussed below. As a House we are overweight global equities on a 12-month horizon. Xi Is Not Mao China’s economic stimulus is a key swing factor for global growth and the corporate earnings outlook this year. Our China Investment Strategy has highlighted that the BCA Activity Indicator has now fully registered the negative impact of trade tariffs as well as the broader slowdown (Chart 2). Chart 2Slowdown Fully Priced In Slowdown Fully Priced In Slowdown Fully Priced In Previously it was more buoyant than our leading indicator suggested it should be, largely because companies placed orders throughout the second half of 2018 to front-run Trump’s tariffs and this artificially boosted China’s exports and manufacturing activity. Now that this front-running is over, any improvement or deterioration in underlying monetary conditions, money supply, and lending should be reflected in the BCA Activity Indicator itself. Hence a stout credit number for March will cause an uptick that will confirm that China’s economy is recovering. We expect this to occur because, to be blunt, President Xi Jinping is not truly a modern-day Chairman Mao Zedong. While he has revived aspects of Maoism, he has responded pragmatically, rather than ideologically, to the Communist Party’s Number one political constraint: the tradeoff between productivity and employment. When Xi consolidated power in 2017, he launched a deleveraging campaign and doubled down on various structural reforms in order to make progress in rebalancing China’s economy. The result was renewed weakness in the labor market as the stimulus measures of 2015-16 wore off (Chart 3). Labor “incidents,” or protests, particularly those sparked by the relocation of workers from closed factories, began to rise again (Chart 4). Significantly, the number of bankruptcies also increased, demonstrating that the government was willing to tolerate some economic pain in order to make the allocation of capital more efficient (Chart 5). Chart 3A Key Constraint On Xi Jinping A Key Constraint On Xi Jinping A Key Constraint On Xi Jinping Chart 4Labor Incidents On The Rise Labor Incidents On The Rise Labor Incidents On The Rise Chart 5 China’s policymakers pursued these reforms while believing that President Trump’s threat of a trade war was largely bluster. But when Trump proceeded to impose tariffs, confidence collapsed and China’s private sector found itself sandwiched between stricter government at home and an impending squeeze of demand abroad. The labor and business indicators in Charts 3-5 suffered further deterioration in 2018 as animal spirits evaporated across the economy. President Xi’s response could have been to close China’s doors to trade and to the West and undertake an even more aggressive purge of “capitalist roaders.” The possibility is inherent in his cult of personality, aggressive anti-corruption campaign, and cyber-security state apparatus. This would have meant a dramatic reckoning with the country's economic and financial imbalances, but it would have given the hardliners in the Communist Party an opportunity to establish absolute control and national “self-sufficiency.” Instead, Xi entered into talks with Trump and launched supply-side, tax-and-tape-cutting measures to stimulate private economic activity, and boosted fiscal spending. He chose reflation rather than revolution. Chinese stimulus does not make a trade deal more likely in itself, as it gives President Xi more leverage in negotiations. But without a trade deal, private sector sentiment and animal spirits will remain depressed and stimulus measures will eventually falter. So it makes sense that Xi wants a deal. China will be the center of two market-positive outcomes in the near term: more domestic reflation and less conflict with the United States. To put this into context: if China’s credit impulse turns positive it will push the overall fiscal-and-credit impulse higher than 2% of GDP (Chart 6), foreshadowing a rebound in Chinese imports and global growth and enabling China’s own corporate earnings to recover. Our China Investment Strategy estimates that if the past three months’ rate of credit growth continues, while manufacturing sentiment improves on a trade deal and the renminbi remains flat, then the probability of an earnings recession on the MSCI China Index falls from 92% to 21%, as shown in Chart 7. From a policy perspective this looks conservative, as the actual rate of credit growth will probably be faster than that of the past three months. Chart 6Credit Will Add To Fiscal Boost Credit Will Add To Fiscal Boost Credit Will Add To Fiscal Boost Chart 7Earnings Unlikely To Contract Earnings Unlikely To Contract Earnings Unlikely To Contract Of course, President Trump has even more acute political constraints than President Xi urging him toward a deal. A deterioration in the U.S. manufacturing sector is a serious liability, especially in the Midwestern battleground states (Chart 8), and Trump has apparently calculated that a tailored infusion of Chinese cash and promises is a better reelection strategy than a continuation of trade war amid a slowdown.   Chart 8A Key Constraint On Donald Trump A Key Constraint On Donald Trump A Key Constraint On Donald Trump The implication of all of the above is that China will be the center of two market-positive outcomes in the near term: more domestic reflation and less conflict with the United States. The former is not yet consensus, while the latter is lacking in specifics. Yet both are beneficial for Chinese equities on an absolute and relative basis. And once there is a concluded trade deal and clarity over stimulus, emerging markets can also outperform their developed market counterparts. Note that we do not expect China to launch a massive 2008-09-style stimulus unless the tariff war reignites. Such an outcome would only be bullish for some EMs, since beneath the initial surge in Chinese imports would lie the disruption of the global supply chain and broader de-globalization. Bottom Line: Unemployment is a key political constraint suggesting both that China’s stimulus will surprise to the upside and that a trade deal is forthcoming. We are reducing the odds of an extension of trade talks beyond June from 35% to 20%, leaving a 50% chance for some kind of trade deal to emerge by the end of that month (Table 1). Table 1Updated Trade War Probabilities (April 2019) U.S.-China Conflict: The End Of The Beginning U.S.-China Conflict: The End Of The Beginning Trump Is Not Nixon If Xi is not Mao, then Trump is not Nixon. Despite a likely trade deal, we are not on the verge of a historic 1972-esque “grand compromise” that will usher in a new era of U.S.-China engagement. This should temper enthusiasm regarding the long-term durability of the trade truce, highlighting that China’s credit data is the more important factor for the 12-month horizon, though the trade issue is an impediment that needs to be removed for a sustainable rally. China may be increasingly willing to embrace structural concessions, but the depth of the structural change should be doubted until the details of the trade deal prove otherwise. For example, at the moment there is still no agreement on tariff levels. And there can be no “enforcement mechanism” to satisfy the U.S. side other than the perpetual threat of tariffs, which erodes trust and discourages Chinese implementation of structural changes. Two structural issues highlight the conundrum: currency and foreign investment. First, while the details of the currency agreement are unknown, the U.S. will definitely not get anything comparable to what it got from Japan after the Plaza Accord in 1985. The Japanese were a subordinate ally to the U.S. in the midst of the Cold War; they did not negotiate with the suspicion that the U.S. secretly wanted to destroy their economy. China has neither the security guarantee nor the economic trust. The implication is that the CNY-USD may rise by about 10% or so from current levels (Chart 9), as opposed to the 54% that the JPY-USD witnessed from 1985-88. The upside for the U.S. is that Trump may get some yuan appreciation, while the upside for China is that limited appreciation means no excessively deflationary impact. Chart 9Currency Agreement: Far From A Plaza Accord Currency Agreement: Far From A Plaza Accord Currency Agreement: Far From A Plaza Accord Second, China’s new foreign investment law, which received a rubber stamp from the legislature in March, is not an unqualified success for American negotiators. We have illustrated this in Table 2 by denoting white flags for aspects of the law that are genuine concessions and red flags for aspects that will raise new suspicions about China’s foreign investment framework. It is a mixed bag. Moreover, the law itself has no power and will depend entirely on the central government’s dedication to imposing strict adherence down through the local layers of government, where forced technology transfer actually takes place. Table 2New Foreign Investment Law: A Mixed Bag U.S.-China Conflict: The End Of The Beginning U.S.-China Conflict: The End Of The Beginning American negotiators will also want bilateral agreements on tech transfer and intellectual property protection since otherwise they will not receive any particular benefit from a law that applies equally to all foreign investors (e.g. Europeans). But it is not yet clear that they will get anything more concrete. The upside for the U.S. is that it will have some means of redress for forced tech transfer and intellectual property theft, while the upside for China is that foreign direct investment should improve. The strategic conflicts between the U.S. and China are even less likely to be dealt with than the economic issues. How can we be sure? Peer Competition: The U.S.-China détente under Nixon occurred at a time when a vast asymmetry between U.S. and Chinese national power existed, whereas today China’s power increasingly rivals that of the U.S., making it easier for China to write its own rules for global interactions and to resist U.S. pressure (Chart 10). Unilateralism: Trump did not leverage American alliances and partnerships across the world to create a “coalition of the willing” to confront China over its mercantilist trade and investment practices. There is some cooperation but it has been inconsistent and tentative, even on deep national security concerns like Huawei’s involvement in 5G networks and the Internet of Things. Had the U.S. created such a coalition and then set out to prosecute its claims, the threat to China’s economy would have been so immense that much greater structural changes could be expected than is the case today (Chart 11). Chart 10The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over Chart 11Trump Eschewed A Coalition Of The Willing Trump Eschewed A Coalition Of The Willing Trump Eschewed A Coalition Of The Willing Core Interests: The trade talks only nominally address dangerous conflicts in China’s near abroad. China’s enforcement of sanctions on North Korea has produced limited results so far but we ultimately expect diplomacy to bear fruit (Chart 12). However, Taiwan is more rather than less likely to be the site of conflict. This is not because of pro-independence sentiment, which is actually on decline in public opinion relative to pro-unification sentiment (Chart 12, second panel). It is because the lame duck Tsai Ing-wen administration may attempt to secure last-minute benefits from the U.S., while an unexpected primary election challenge could lead to the nomination of Lai Ching-te (William Lai), a more outspoken pro-independence candidate, on April 24. Either could provoke Beijing. There is zero chance that any trade deal in the coming months will reduce the threat of reunification of Taiwan by force. Underlying distrust will remain. Chart 12Geopolitical Risk Down In Korea But Up In Taiwan Geopolitical Risk Down In Korea But Up In Taiwan Geopolitical Risk Down In Korea But Up In Taiwan Furthermore, the South China Sea is not a “red herring” but a potential “black swan,” as it is connected to Taiwan’s security and more broadly to U.S. alliance security. After all, 96%-97% of Taiwan’s, South Korea’s, and Japan’s oil imports flow through these sea lanes. Critical supplies become vulnerable if China expands its military’s capabilities there (Diagram 1). The U.S. and China will likely be just as provocative as before in this area after they sign a deal. Technology: The tech conflict is more likely to limit the trade deal than vice versa. The sanctions and embargoes on Chinese companies like ZTE, Fujian Jinghua, and Huawei have operated on a separate track from the trade talks, and it is not at all clear that the U.S. will embrace Huawei as part of any final deal. The initial actions of the newly beefed-up Committee on Foreign Investment in the United States (CFIUS) send warning signals. CFIUS is largely a vehicle for U.S. oversight of China (Table 3) and, if anything, that country-specific focus is intensifying. For instance, the U.S. has deemed Chinese ownership of a gay and lesbian hook-up app, Grindr, to pose an excessive national security risk.3 This is not a high bar for intervention and it suggests that any trade deal will fail to improve China’s investment options in the U.S. tech sector. Diagram 1South China Sea As Traffic Roundabout U.S.-China Conflict: The End Of The Beginning U.S.-China Conflict: The End Of The Beginning Table 3CFIUS Is Mostly About China U.S.-China Conflict: The End Of The Beginning U.S.-China Conflict: The End Of The Beginning The takeaway is that while both sides want a deal over the short term, it will not mark the end of the trade war. It is more likely the end of the beginning of a cold war. As long as China’s economy and industrial capabilities continue to grow relative to the United States, its geographic periphery remains a cauldron of geopolitical risks, and its technological advancement remains rapid, the competition will continue. Bottom Line: There is no substantial evidence from the current trade talks that underlying strategic conflicts will be resolved. This implies that the U.S. and China will shift their focus to these conflicts in the weeks and months after any trade deal. That process will be a nuisance to global equity markets expecting a clean deal; Chinese and American tech stocks in particular will remain exposed to tail risks. The status of Chinese tech companies is a critical risk, as a deal for the U.S. to admit Huawei would be a game-changer. Investment Conclusions Ironically, an early resolution of the trade war – in April or May – offers less of a benefit for Chinese equities and other risk assets than a later resolution in June or thereafter. While we expect to have greater clarity on China’s stimulus magnitude from the March data, it is still possible that stimulus will remain mixed or disappointing. Stimulus measures may also be toned down after a deal is approved, which means that an earlier deal would reduce the total stimulus by the end of 2019. The Trump administration will use the new flexibility gained from a China deal to toughen its policies in other areas, potentially with negative market consequences. The decision to designate the Iranian Revolutionary Guard Corps (IRGC) as a foreign terrorist organization is an important example. This decision is squarely within the Trump administration’s policy of pressuring Iran, which is a high-risk policy with substantial market-relevance. Trump may have made the decision in order to save face while planning to renew waivers on Iranian oil sanctions on May 4 – we would be extremely surprised if he did not renew. Sanctioning the IRGC involves a string of consequences but it is not a direct attack on oil supply that could produce an oil shock dangerous to Trump’s re-election prospects in 2020 (Chart 13). Of course, Iran will retaliate to the IRGC blacklisting – and one way it could do so would be through oil production in various places, including Iraq. The result would be oil volatility and higher prices. Chart 13 Further, an early deal could encourage Trump to instigate a trade war with Europe. Trump’s four-to-six week time frame for the conclusion of talks with China is conspicuously close to the tentative May 18 deadline by which he is required to determine whether to impose tariffs on foreign auto and auto part imports (Chart 14). Such tariffs would be pursuant to the Section 232 investigation that likely found such imports a threat to national security. We have argued that a U.S.-China deal raises the risk of tariffs on European cars to 35%, with Japanese and Korean cars less at risk, progressively. The EU is ready to retaliate so this would be a drawn-out trade conflict. Chart 14 Chart 15   By contrast, we are less concerned about the market impact of Trump’s recent threats to close the border with Mexico or include Mexico in car tariffs (Chart 15). True, Trump could close the border and generate a temporary drag on trade and the border economy. However, the Republicans have limited patience for the economic blowback of an extended border closure, and Trump cannot afford to jeopardize passage of his USMCA trade deal as long as he has alternative ways of looking tough on the border. Geopolitical Strategy would view the U.S. and China as good overweights relative to global equities and within their respective developed and emerging market contexts. What about a later resolution of the trade deal, in June or later in the summer? This would remove some risks. By that time, the Iran decision and possibly the car tariff decision will be past and there will be greater clarity on the magnitude of China’s stimulus. More extensive negotiations could also suggest that the ensuing trade deal will resolve deeper disagreements – unless the talks drag on without consequence amid signs of declining trust. Given the risk of trade war with Europe, oil volatility, and uncertainties about China’s stimulus, Geopolitical Strategy would view the U.S. and China as good overweights relative to global equities and within their respective developed and emerging market contexts. When and if the above political hurdles are cleared, the emphasis can shift to other bourses. Geopolitical Strategy’s preferred emerging market plays are EM energy producers and EM Asian states like Thailand and Indonesia.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 See Ailsa Chang, “U.S. Trade Representative Robert Lighthizer Discusses Ongoing Trade Talks With China,” National Public Radio, March 25, 2019, www.npr.org. 2 For the above quotations see Andrew Mayeda, Xiaoqing Pi, and Margaret Talev, “Kudlow Sees No Letup in China Talks as Both Sides Cite Progress,” Bloomberg, April 4, 2019, www.bloomberg.com. 3 See David E. Sanger, “Grindr Is Owned by a Chinese Firm, and the U.S. Is Trying to Force It to Sell,” March 28, 2019, www.nytimes.com.

Highlights So what? EM elections bring opportunities as well as risks. Why?   Emerging market equities will benefit as long as China’s stimulus does not fizzle. Modi is on track to win India’s election – which is a positive – though risks lie to the downside. Thailand’s next cycle of political instability is beginning, but we are still cyclically overweight. Indonesia will defy the global “strongman” narrative – go overweight tactically. Populism remains a headwind to Philippine and Turkish assets. Wait for Europe to stabilize before pursuing Turkish plays. Feature Chart 1Risks of China's Stimulus Have Shifted To The Upside Risks of China's Stimulus Have Shifted To The Upside Risks of China's Stimulus Have Shifted To The Upside China’s official PMIs in March came at just the right time for jittery emerging market investors awaiting the all-important March credit data. EM equities, unlike the most China-sensitive plays, have fallen back since late January, after outperforming their DM peers since October (Chart 1). This occurred amid a stream of negative economic data and policy uncertainties: China’s mixed signals, prolonged U.S.-China trade negotiations, the Fed’s extended “pause” in rate hikes, the inversion of the yield curve, Brexit, and general European gloom. We have been constructive on EM plays since February 20, when we determined that the risks of China’s stimulus had shifted to the upside. However, several of the EM bourses that are best correlated with Chinese stimulus are already richly valued (the Philippines, Indonesia, Malaysia, etc). The good news is that a series of elections this spring provide a glimpse into the internal politics of several of these countries, which will help determine which ones will outperform if we are correct that global growth will find its footing by Q3.  First, A Word On Turkey … More Monetary Expansion On The Way Local elections in Turkey on March 31 have dealt a black eye to President Recep Tayyip Erdogan. His ruling Justice and Development Party (AKP) has lost control of the capital Ankara for the first time since 2004. Erdogan has also (arguably) conceded the mayoralty of Istanbul, the economic center of the country, where he first rose to power in 1994. Other cities also fell to the opposition. Vote-counting is over and the aftermath will involve a flurry of accusations, investigations, and possibly unrest. Erdogan’s inability to win elections with more than a slim majority is a continual source of insecurity for him and his administration. This weekend’s local elections reinforce the point. The AKP alone failed to cross 45% in terms of popular votes. Combined with its traditional ally – the Nationalist Movement Party (MHP) – it received 51.6% of the total vote (in the 2015 elections, the two parties combined for over 60% of the vote). While losing the local elections will not upset the balance in parliament, it is a rebuke to Erdogan over his economic policy and a warning to the AKP for the future. Erdogan does not face general elections until 2023. But judging by his response to the first serious challenge to his rule – the Gezi Park protests of May 2013 – his reaction will be to double down on unorthodox, populist economic policy. Chart 2Erdogan Will Respond With Populist Politics Erdogan Will Respond With Populist Politics Erdogan Will Respond With Populist Politics Back in 2013, the government responded to the domestic challenge through expansive monetary policy. The central bank gave extraordinary liquidity provisions to the banking system. Chart 2 clearly shows that the liquidity injections began with the Gezi protests. These provisions only paused in 2016-17, when global growth rebounded on the back of Chinese stimulus and EM asset prices rose, supporting Turkey’s currency and enabling the central bank to hold off. Today, the severe contraction in GDP (by 3% in Q4 2018), with a negative global backdrop, will likely end Erdogan’s patience with tight monetary policy.1 To illustrate how tight policy has been, note that bank loan growth denominated in lira is contracting at a rate of 17% in real terms. Given the authorities’ populist track record, rising unemployment will likely lead to further “backdoor” liquidity easing. A new bout of unorthodox monetary policy will be negative for domestic bank equities, local-currency bonds, and the lira. As one of the first EM currencies and bourses to begin outperforming in September 2018, Turkey has been at the forefront of the EM mini-rally over the past six months. But with global growth still tepid, this mini-cycle is likely to come to an end for the time being. Watch for the bottoming in Chinese followed by European growth before seeking new opportunities in Turkish assets. Erdogan’s domestic troubles could also prompt him to renew his foreign combativeness, which raises tail risks to Turkish risk assets, such as through U.S. punitive measures. Last year, Erdogan responded to the economic downswing by toning down his belligerent rhetoric and mending fences with Europe and the U.S. However, a reversion to populism may require him to seek a convenient distraction. The U.S. is withdrawing from Syria and the Middle East, leaving Turkey in a position where it needs other relationships to pursue its interests. Russia is a key example. Currently Erdogan is bickering with the U.S. over the planned purchase of a missile defense system from Russia. But the consequence is that relations with the U.S. could deteriorate further, potentially leading to new sanctions. Bottom Line: Turkey is still in the grip of populist politics and will respond to the recession and domestic discontent with easier monetary policy which would bode ill for the lira and lira-denominated assets. The stabilization of the European economy is necessary before investors attempt to take advantage of the de-rating of Turkish assets. India: Focus On Modi’s Political Capital We have long maintained that Modi is likely to stay in power after India’s general election on April 11-May 19. His coalition has recovered in public opinion polling since the Valentine’s Day attack on Indian security forces in Indian Kashmir (Chart 3). The government responded to the attacks by ordering airstrikes on February 26 against Pakistani targets in Pakistani territory for the first time since 1974. The attack was theatrical but the subsequent rally-around-the-flag effect gave Modi and his Bharatiya Janata Party (BJP) a badly needed popular boost. The market rallied on the back of Modi’s higher chances of reelection. Modi is the more business-friendly candidate, as opposed to his chief rival, Rahul Gandhi of the Indian Congress Party. Nevertheless, election risks still lie to the downside: Modi and his party are hardly likely to outperform their current 58% share of seats in the lower house of parliament, since the conditions for a wave election – similar to the one that delivered the BJP a single-party majority in 2014 – do not exist today. While the range of outcomes is extremely broad (Chart 4), the current seat projections shown in Chart 3 put Modi’s coalition right on the majority line. Meanwhile his power is already waning in the state legislatures. Chart 3 Chart 4 Thus Modi’s reform agenda has lost momentum, at least until he can form a new coalition. This will take time and markets may ultimately be disappointed by the insufficiency of the tools at his disposal in his second term. Indian equities are the most expensive in the EM space, and only more so after the sharp rally in March on the back of the Kashmir clash and Modi’s recovering reelection chances (Chart 5). Additional clashes with Pakistan are not unlikely during the election season, despite the current appearance of calm. This is because Modi’s patriotic dividend in the polls could fade. Since even voters who lack confidence in Modi as a leader believe that Pakistan is a serious threat (Chart 6), he could be encouraged to stir up tensions yet again. This would be playing with fire but he may be tempted to do it if his polling relapses or if Pakistan takes additional actions. Chart 5...And Lofty Valuations ...And Lofty Valuations ...And Lofty Valuations Chart 6 Further escalation would be positive for markets only so long as it boosts Modi’s chances of reelection without triggering a wider conflict. Yet the standoff revealed that these two powers continue to run high risks of miscalculation: their signaling is not crystal clear; deterrence could fail. Thus, further escalation could become harder to control and could spook the financial markets.2 Even if Modi eschews any further jingoism, his lead is tenuous. First, the economic slowdown is taking a toll – even the official unemployment rate is rising (Chart 7) and the government has been caught manipulating statistics. There is no time for the economy to recover enough to change voters’ minds. Opinion polls show that even BJP voters are not very happy about the past five years. They care more about jobs and inflation than they do about terrorism, and a majority thinks these factors have deteriorated over Modi’s five-year term (Chart 8). Chart 7Manipulated Stats Can't Hide Deteriorating Economy Manipulated Stats Can't Hide Deteriorating Economy Manipulated Stats Can't Hide Deteriorating Economy   Chart 8 If the polling does not change, Modi will win with a weak mandate at best. A minority government or a hung parliament is possible. A Congress Party-led coalition, which would be a market-negative event, cannot be ruled out. The latter especially would prompt a big selloff, but anything short of a single-party majority for Modi will register as a disappointment. Bottom Line: There may be a relief rally after Modi is seen to survive as prime minister, but his likely weak political capital in parliament will be disappointing for markets. The market will want additional, ambitious structural reforms on top of what Modi has already done, but he will struggle to deliver in the near term. While we are structurally bullish, in the context of this election cycle –  which includes rising oil prices that hinder Indian equity outperformance – we urge readers to remain underweight Indian equities within emerging markets. Thailand: An Outperformer Despite Quasi-Military Rule Chart A new cycle of political instability is beginning in Thailand as the country transitions back into civilian rule after five years under a military junta. However, this is not an immediate problem for investors, who should remain overweight Thai equities relative to other EMs on a cyclical time horizon. The source of Thai instability is inequality – both regional and economic. Regionally, 49% of the population resides in the north, northeast, and center, deprived of full representation by the royalist political and military establishment seated in Bangkok (Map 1). Economically, household wealth is extremely unevenly distributed. Thailand’s mean-to-median wealth ratio is among the highest in the world (Chart 9). Eventually these factors will drive the regional populist movement – embodied by exiled Prime Minister Thaksin Shinawatra and his family and allies – to reassert itself against the elites (the military, the palace, and the civil bureaucracy). New demands will be made for greater representation and a fairer distribution of wealth. The result will be mass street protests and disruptions of business sentiment and activity that will grab headlines sometime in the coming years, as occurred most recently in 2008-10 and 2013-14.   Chart 9 Chart 10Social Spending Did Not Hinder Populism Social Spending Did Not Hinder Populism Social Spending Did Not Hinder Populism The seeds of the next rebellion are apparent in the results of the election on March 24. The junta has sought to undercut the populists by increasing infrastructure spending and social welfare (Chart 10), and controlling rice prices for farmers. Yet the populists have still managed to garner enough seats in the lower house to frustrate the junta’s plans for a seamless transition to “guided” civilian rule. The final vote count is not due until May 9 but unofficial estimates suggest that the opposition parties have won a majority or very nearly a majority in the lower house. This is despite the fact that the junta rewrote the constitution, redesigned the electoral system to be proportional (thus watering down the biggest opposition parties), and hand-picked the 250-seat senate. Such results point to the irrepressible population dynamics of the “Red Shirt” opposition in Thailand, which has won every free election since 2001. Nevertheless, the military and its allies (the “Yellow Shirt” political establishment) are too powerful at present for the opposition to challenge them directly. The junta has several tools to shape the election results to its liking in the short run.3 It would not have gone ahead with the election were this not the case. As a result, the cycle of instability is only likely to pick up over time. Investors should note the silver lining to the period of military rule: it put a halt to the spiral of polarization at a critical time for the country. The unspoken origin of the political crisis was the royal succession. The traditional elites could not tolerate the rise of a populist movement that flirted with revolutionary ideas at the same time that the revered King Bhumibol Adulyadej drew near to passing away. This combination threatened both a succession crisis and possibly the survival of the traditional political system, a constitutional monarchy backed by a powerful army. With the 2014 coup and five-year period of military rule (lengthy even by Thai standards), the military drew a stark red line: there is no alternative to the constitutional monarchy. The royalist faction had its bottom line preserved, at the cost of an erosion of governance and democracy. The result is that going forward, there is a degree of policy certainty. Chart 11Thai Confidence Has Bottomed Thai Confidence Has Bottomed Thai Confidence Has Bottomed Chart 12Strong Demand Sans Risk Of Being Overleveraged Strong Demand Sans Risk Of Being Overleveraged Strong Demand Sans Risk Of Being Overleveraged The long-term trend of Thai consumer confidence tells the story (Chart 11). Optimism surged with the election of populist Thaksin in the wake of the Asian Financial Crisis in 2001. The long national conflict that ensued – in which the elites and generals exiled Thaksin and ousted his successors, and the country dealt with a global financial crisis and natural disasters – saw consumer confidence decline. However, the coup of 2014 and the royal succession (to be completed May 4-6 with the new king’s coronation) has reversed this trend, with confidence trending upward since then. Revolution is foreclosed yet the population is looking up. Military rule is generally disinflationary in Thailand and this time around it initiated a phase of private sector deleveraging. Yet the economy has held up reasonably well. Private consumption has improved along with confidence and investment has followed, albeit sluggishly (Chart 12). The advantage is that Thailand has had slow-burn growth and has avoided becoming overleveraged again, like many EM peers. Chart 13Thailand Outperformed EM Despite Military Interference Thailand Outperformed EM Despite Military Interference Thailand Outperformed EM Despite Military Interference Furthermore, Thailand is not vulnerable to external shocks. It has a 7% current account surplus and ample foreign exchange reserves. It is not too exposed to China, either economically or geopolitically: China makes up only 12% of exports, while Bangkok has no maritime-territorial disputes with Beijing in the South China Sea. In fact, Thailand maintains good diplomatic relations with China and yet has a mutual defense treaty with the United States (the oldest such treaty in Asia). It is perhaps the most secure of any of the Southeast Asian states from the point of view of the secular U.S.-China conflict. Finally, if our forecast proves wrong and political instability returns sooner than we expect, it is important to remember that Thailand’s domestic political conflicts rarely affect equity prices in a lasting way. Global financial crises and natural disasters have had a greater impact on Thai assets over the past two decades than the long succession crisis. Thailand has outperformed both EM and EM Asia during the period of military interference, though democratic Indonesia has done better (Chart 13). Bottom Line: Thailand’s political risks are domestic and stem from regional and economic inequality, which will result in a revived opposition movement that will clash with the traditional military and political elite. This clash will eventually create policy uncertainty and political risk. But it will need to build up over time, since the military junta has strict control over the current environment. Meanwhile macro fundamentals are positive. Indonesia: Rejecting Strongman Populism We do not expect any major surprises from the Indonesian election. Instead, we expect policy continuity, a marginal positive for the country’s equities. However, stocks are overvalued, overexposed to the financial sector,4 and vulnerable if global growth does not stabilize. Chart 14 The most important trend since the near collapse of Indonesia in the late 1990s has been the stabilization of the secular democratic political system and peaceful transition of power. That trend looks to continue with President Joko Widodo’s likely victory in the election on April 17. President Jokowi defeated former general Prabowo Subianto in the 2014 election and has maintained a double-digit lead over his rival in the intervening years (Chart 14). Prabowo is a nationalist and would-be strongman leader who was accused of human rights violations during the fall of his father-in-law Suharto’s dictatorship in 1998. Emerging market polls are not always reliable but a lead of this size for this long suggests that the public knows Prabowo and does not prefer him to Jokowi. In fact he never polled above 35% support while Jokowi has generally polled above 45%. The incumbent advantage favors Jokowi. Household consumption is perking up slightly and consumer confidence is high (see Chart 11 above). Wages have received a big boost during Jokowi’s term and are now picking up again, in real as well as nominal terms and for rural as well as urban workers. Jokowi’s minimum wage law has not resulted in extravagant windfalls to labor, as was feared, and inflation remains under control (Chart 15). Government spending has been ramped up ahead of the vote (and yet Jokowi is not profligate). All of these factors support the incumbent. Real GDP growth is sluggish but has trended slightly upward for most of Jokowi’s term. Chart 15Favorable Economic Conditions Support Incumbent Jokowi Favorable Economic Conditions Support Incumbent Jokowi Favorable Economic Conditions Support Incumbent Jokowi Chart 16 Jokowi has been building badly needed infrastructure with success and has been attracting FDI to try to improve productivity (Chart 16). This is the most positive feature of his government and is set to continue if he wins. A coalition in parliament has largely supported him after an initial period of drift. The biggest challenge for Jokowi and Indonesia are lackluster macro fundamentals. For instance, twin deficits, which show a lack of savings and invite pressure on the currency, which has been very weak. The twin deficits have worsened since 2012 because China’s economic maturation has forced a painful transition on Indonesia, which it has not yet recovered from. Chart 17 There is some risk to governance as Jokowi has chosen Ma’ruf Amin, the top cleric of the world’s largest Muslim organization, as his running mate. Jokowi wants to counteract criticisms that he is not Islamic enough (or is a hidden Christian), which cost his ally the governorship of Jakarta in 2017. However, Jokowi is not a strongman leader like Erdogan in Turkey, whose combination of Islamism and populism has been disastrous for the country’s economy. As mentioned, Jokowi will be defeating the would-be strongman Prabowo, who has also allied with Islamism. In fact, Indonesia is a relatively secular and modern Muslim-majority country and Amin is the definition of an establishment religious leader. The security forces have succeeded in cracking down on militancy in the past decade, greatly improving Indonesia’s stability and security as a whole (Chart 17). Governance is weak on some measures in Indonesia, but Jokowi is better than the opposition on this front and neither his own policies nor his vice presidential pick signals a shift in a Turkey-like, Islamist, populist direction. Bottom Line: We should see Indonesian equities continue to outperform EM and EM Asia as long as China’s stimulus efforts do not collapse and global growth picks up as expected in the second half of the year. Peaceful democratic transitions and economic policy continuity have been repeatedly demonstrated in Indonesia despite the inherent difficulties of developing a populous, multi-ethnic archipelago. Nationalism is a constant risk but it would be more virulent under Jokowi’s opponent. The Philippines: Embracing Strongman Populism Chart 18 The May 13 midterm elections mark the three-year halfway point in President Rodrigo Duterte’s presidential term. Duterte is still popular, with approval ratings in the 75%-85% range. These numbers likely overstate his support, but it is clearly above 50% and superior to that of his immediate predecessors (Chart 18). Further, his daughter’s party, Faction for Change, has gained national popularity, reinforcing the signal that he can expand his power base in the vote. The senate is the root of opposition to Duterte. His supporters control nine out of 24 seats. But of the twelve senators up for election, only three are Duterte’s supporters. So he could make gains in the senate which would increase his ability to push through controversial constitutional reforms. (He needs 75% of both houses of parliament plus a majority in a national referendum to make constitutional changes.) In terms of the economy, we maintain the view that Duterte is a true “populist” – pursuing nominal GDP growth to the neglect of everything else. His fiscal policy of tax cuts and big spending have supercharged the economy but macro fundamentals have deteriorated (Chart 19). He has broken the budget deficit ceiling of 3%, up from 2.2% in 2017. His reflationary policies have turned the current account surplus into a deficit, weighing heavily on the peso, which peaked against other EM currencies when he came to power in 2016 (Chart 20). Inflation peaked last year but we expect it to remain elevated over the course of Duterte’s leadership. He has appointed a reputed dove, Benjamin Diokno, as his new central banker. Chart 19Reflationary Policies Created Twin Deficits... Reflationary Policies Created Twin Deficits... Reflationary Policies Created Twin Deficits...   Chart 20...And Twin Deficits Weigh On The Peso ...And Twin Deficits Weigh On The Peso ...And Twin Deficits Weigh On The Peso Rule of law has deteriorated, as symbolized by the removal of the chief justice of the Supreme Court for questioning Duterte’s extension of martial law in Mindanao. Duterte also imprisoned his top critic in the senate, Leila de Lima, on trumped-up drug charges. He tried but failed to do so with Senator Antonio Trillanes, a former army officer and quondam coup ring-leader who has substantial support in the military. The army is pushing back against any prosecution of Trillanes, and against Duterte’s ongoing détente with China, prompting Duterte to warn of the risk of a coup.   Duterte’s China policy is to attract Chinese investment while avoiding a conflict in the South China Sea. His administration has failed to downgrade relations with the U.S. thus far, but further attempts could be made. This strategy could make the Philippines a beneficiary of Chinese investment if it succeeds. However, China knows that the Philippine public is very pro-American (more so than most countries) and that Duterte could be replaced by a pro-U.S. president in as little as three years, so it is not blindly pouring money into the country. Pressure to finance the current account deficit will persist. If pro-Duterte parties gain seats in the senate the question will be whether he comes within reach of the 75% threshold required for constitutional changes. His desire to change the country into a federal system has not gained momentum so far. He claims he will stand down at the end of his single six-year term but he could conceivably attempt to use any constitutional change to stay in power longer. If the revision goes forward, it will be a hugely divisive and unproductive use of political capital. Bottom Line: The Philippine equity market is highly coordinated with China’s credit cycle and so should benefit from China’s stimulus measures this year (as well as the Fed’s backing off). Nevertheless, Philippine equities are overvalued and macro fundamentals and quality of governance have all deteriorated. Duterte’s emphasis on building infrastructure and human capital is positive, but the means are ill-matched to the ends: savings are insufficient and inflation will be a persistent problem. We would favor South Korea, Thailand, Indonesia, and Malaysia over the Philippines in the EM space. Investment Implications We expect China’s stimulus to be significant and to generate increasingly positive economic data over the course of the year. China is a key factor in the bottoming of global growth, which in turn will catalyze the conditions for a weaker dollar and outperformance of international equities relative to U.S. equities. Caveat: In the very near term, it is possible that China plays could relapse and EM stocks could fall further due to the fact that Chinese and global growth have not yet clearly bottomed. We are structurally bullish India, but recommend sitting on the sidelines until financial markets discount the disappointment of a Modi government with insufficient political capital to pursue structural reforms as ambitious as the ones undertaken in 2014-19. Go long Thai equities relative to EM on a cyclical basis. Stay long Thai local-currency government bonds relative to their Malaysian counterparts. Go long Indonesian equities relative to EM on a tactical basis. Maintain vigilance regarding Russian and Taiwanese equities: the Ukrainian election, Russia’s involvement in Venezuela, and the unprecedented Taiwanese presidential primary election reinforce our view that Russia and Taiwan are potential geopolitical “black swans” this year.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      See BCA Emerging Markets Strategy, “Turkey: Brewing Policy Reversal?” March 21, 2019, available at www.bcaresearch.com. 2      See Sanjeev Miglani and Drazen Jorgic, “India, Pakistan threatened to unleash missiles at each other: sources,” Reuters, March 16, 2019, available at uk.reuters.com.  3      The junta can disqualify candidates and rerun elections in the same district without that candidate if the candidate is found to have violated a range of very particular laws on campaigning and use of social media. Also, the Election Commission is largely an instrument of the Bangkok establishment and can allocate seats according to the junta’s interests. 4      See BCA Emerging Markets Strategy, “Indonesia: It Is Not All About The Fed,” March 7, 2019, available at www.bcaresearch.com.   Geopolitical Calendar

Highlights So What? It makes sense for long-term investors to buy the GBP. However, short-term investors should instead buy the 2-year call while selling 3-month ones. Why? The U.K. electorate is not staunchly Euroskeptic. In fact, Bregret has already set in. Volatility is the only sure bet over the tactical and strategic time horizons. The most likely scenario is that Theresa May either resigns and is replaced by a soft-Brexit Tory, or that she agrees to a long-term extension to give the U.K. time to call a new election. Brexit is unsustainable over the secular time horizon. Our low-conviction view is that in the long term, the U.K. will remain inside the European Union. Feature The hour is late in the ongoing Brexit saga. The original deadline, once spoken of with religious reverence, will be tossed aside for one, potentially two, extensions. In this analysis, we attempt to consider the state of Brexit from multiple time horizons. First, we offer our tactical view, what will happen in the next several weeks and months. Second, we offer our strategic view, surveying the Brexit process to the end of the year. Third, we consider the secular view and attempt to answer the question of whether the U.K. will ever fully exit the EU. We then assign investment recommendations across the three time horizons. The Conservative Party has wrapped itself into an intellectual pretzel trying to deliver on a referendum that the pro-Brexit Tories promised would not mean losing access to the Common Market. How Did We Get Here? In March 2016, three months ahead of the fateful June referendum, BCA’s Geopolitical Strategy and European Investment Strategy published a joint report on the topic that drew three conclusions: The probability of Brexit was understated by the market. “According to our modeling results, roughly 64% of Tory undecided voters would have to swing to the “Stay” camp in order to ensure that the vote crosses the 50% threshold in favour of continued EU membership … Conventional wisdom suggests that the probability of Brexit is around 30%, anchoring to the 1975 referendum results. Our own analysis of current polling data suggests that it is much closer to 50%, as in too close to call.” The biggest loser of Brexit, domestically, would be the Conservative Party. “The risk is that the British populace realizes that leaving the EU was a sub-optimal result and that little sovereignty was recovered. As such, there could be a backlash against the Tories in the next general election. In this scenario, the winner would not necessarily be UKIP, but rather the Jeremy Corbyn-led Labour Party – as close to the Michael Foot-led opposition in the early 1980s as any Labour Leadership.” The EU would survive, intact, with no further “exits.” “European integration is therefore a gambit for relevance by Europe’s declining powers. Brexit will not create centrifugal forces that tear the EU apart, and could in fact enhance the sinews that bind EU member states in a bid for 21st century geopolitical relevance.” Thus far, all three predictions have proven prescient. Not only was the probability of Brexit understated, but the electorate actually voted to exit the EU.1 The Conservative Party has wrapped itself into an intellectual pretzel trying to deliver on a referendum that the pro-Brexit Tories – a minority in the party – promised would not mean losing access to the Common Market. And the EU has not only seen no other “exits,” but has held firm and united in the negotiations with the U.K. while witnessing an increase in the support for its troubled currency union, both in the Euro Area in aggregate as well as in crisis-ridden Italy (Chart 1). Chart 1The Euro Area Stands Unified The Euro Area Stands Unified The Euro Area Stands Unified The net assessment we conducted in 2016 correctly gauged what the Brexit referendum was about and what it was not about. Our view was that behind the angst lay factors too general to be laid at the feet of European integration. Decades of supply-side reforms combined with competition from emerging economies led to a sharp rise in U.K. income inequality (Chart 2), the erosion of its manufacturing economy (Chart 3), and the ballooning of the country’s financial sector (Chart 4). As a result, the U.K.’s income inequality and social mobility were, in 2016 as today, much closer to those of its Anglo-Saxon peer America than to those of its continental European neighbors (Chart 5). Chart 2Brits Saw Inequality Surge Brits Saw Inequality Surge Brits Saw Inequality Surge Chart 3Manufacturing Jobs Collapsed Manufacturing Jobs Collapsed Manufacturing Jobs Collapsed Chart 4The Financial Bubble Burst The Financial Bubble Burst The Financial Bubble Burst Chart 5 The underlying economic angst has continued to influence British politics since Brexit. Campaigning on an anti-austerity platform in the summer of 2017, the Labour Party leader Jeremy Corbyn nearly won the general election, only underperforming the Conservative vote by 2% (Chart 6). The election was supposed to politically recapitalize Theresa May and allow her to lead the U.K. out of the EU. But the failure to secure a single-party majority created the political math in the House of Commons that is today preventing the prime minister from executing on Brexit. There are simply not enough committed Brexiters in Westminster to deliver on the relatively hard Brexit – no access to the EU Common Market or customs union – that Prime Minister May has put on offer (Chart 7). Chart 6 Chart 7 The decision not to pursue a customs union arrangement with the EU is particularly disastrous. As our colleague Dhaval Joshi – Chief Strategist of BCA’s European Investment Strategy – has pointed out, remaining in the customs union would have protected the cross-border supply chains that are vital to many U.K. businesses and would have avoided a hard customs border on the island of Ireland.2 However, the slim margin of the Tory victory in 2017 has boosted the influence of the 20-to-40 hard-Brexiters in the party. They pushed Theresa May to the extreme, where a customs union arrangement – let alone access to the Common Market – became politically unpalatable. The underlying economic angst has continued to influence British politics since Brexit. Had the British electorate genuinely wanted “Brexit über alles,” or the relatively hard Brexit on offer today, the margin of victory for Leave would have been greater. Furthermore, the electorate would not have come so close to giving the far-left Corbyn – who nonetheless supports the softest-of-soft Brexits – a majority in mid-2017. The slim margin of victory effectively tied May’s hands in her subsequent negotiations with both the EU and her own party. But there was more to the 2016 referendum than just general malaise centered on the economy and inequality. There were idiosyncratic events that provided tailwinds for the Leave campaign. Or, as we put it in 2016: Certainly, a number of ills have befallen the continent in quick succession: the euro area sovereign debt crisis, Russian military intervention in Ukraine, rampant migrant inflows from Africa and the Middle East, and terrorist attacks in France. It is no surprise that the U.K. populace wants to think twice about tying itself even more closely to a Europe apparently on the run from the Four Horsemen of the Apocalypse. The two issues we would particularly focus on were the migrant crisis and terrorist attacks in Europe. Data ahead of the referendum clearly gave credence to the view that the influx of migrants was raising “concerns about immigration and race.” This angst was primarily focused on EU migrants who came to the U.K. legally (Chart 8), but the influx of millions of migrants into the EU in 2015 – peaking at 172,000 in the month of October – certainly bolstered the anxiety in the U.K. (Chart 9).3 Chart 8EU Migrants A Source Of Anxiety In 2016 EU Migrants A Source Of Anxiety In 2016 EU Migrants A Source Of Anxiety In 2016 Chart 9The Refugee Crisis Boosted Brexit Vote The Refugee Crisis Boosted Brexit Vote The Refugee Crisis Boosted Brexit Vote Terrorism was another concern. In the 18 months preceding the referendum, continental Europe experienced 13 deadly terror attacks. Two were particularly egregious: the November 2015 Paris terror attack that led to 130 deaths, and the March 2016 Brussels terror attack that led to 32 deaths. The idiosyncratic events that provided tailwinds behind Brexit … were the migrant crisis and terrorist attacks in Europe. Both the migration and terror crises, however, were temporary and caused by idiosyncratic variables with short half-lives. BCA’s Geopolitical Strategy argued that both would eventually abate. The migration crisis would subside due to firming European attitudes towards asylum seekers and the exhaustion of the supply of migrants as the Syrian Civil War drew to its tragic close. The extremist Islamic terror attacks would dwindle due to the decrease in the marginal utility of terror that has been observed in previous waves of terrorism (Chart 10). Neither forecast was popular with our client base, but both have been spot on. Chart 10Fewer Attacks Due To Declining Marginal Utility Of Terror Fewer Attacks Due To Declining Marginal Utility Of Terror Fewer Attacks Due To Declining Marginal Utility Of Terror The point is that the British electorate was never as Euroskeptic as the Euroskeptics cheering on Brexit thought. Support for EU integration has waxed and waned for decades (Chart 11). Instead, a combination of macro-malaise caused by the general plight of the middle class – the same factors that have given tailwinds to populist policymakers across developed markets – and idiosyncratic crises in the middle of this decade created the context in which the public voted to leave the EU. Whatever the vote was for, we can say with a high degree of certainty that it was not in favor of the current deal on offer, a relatively hard Brexit. After all, the pro-Leave Tories almost universally campaigned in favor of remaining in the Common Market post-Brexit.4 Chart 11Data Does Not Support Euroskeptic U.K. Data Does Not Support Euroskeptic U.K. Data Does Not Support Euroskeptic U.K. Today, Bregret has clearly set in. Not only on the specific issue of whether the U.K. should leave the EU – where the gap between Bremorseful voters and committed Brexiters is now 8% (Chart 12), a 12% swing since just after the referendum – but also on the more existential question of whether U.K. citizens feel European (Chart 13). Chart 12Bregret Has Set In... Bregret Has Set In... Bregret Has Set In... Chart 13...And Brits Feel More European ...And Brits Feel More European ...And Brits Feel More European The political reality of Bregret is the most important variable in predicting Brexit. Not only is it difficult for Prime Minister May to deliver her relatively hard Brexit in Westminster due to the mid-2017 electoral math, but it is especially the case when the electorate does not want it. Yes, the mid-2016 referendum is an expression of a democratic will that must be respected. But no policymaker wants to respect the referendum at the cost of disrespecting the current disposition of the median voter, which is revealed through polls. Doing so will cost them in the next election. The British electorate was never as Euroskeptic as the Euroskeptics cheering on Brexit thought. Reviewing “how we got here” is essential in forecasting the tactical, strategic, and secular time horizons in the ongoing Brexit imbroglio. To this task we now turn. Bottom Line: The U.K. electorate is not staunchly Euroskeptic: data clearly support this fact. The Brexit referendum simply came at the right time for the Leave vote, as the secular forces of middle-class discontent combined with idiosyncratic crises of migration and terror. Three years following the referendum, the discontent remains unaddressed by British policymakers while the idiosyncratic crises have abated. As such, Bregret has set in, creating a new reality that U.K. policymakers must respond to if they want to retain political capital. Where Are We Going? The Tactical And Strategic Time Horizons The EU has offered a two-step delay to the Article 50 deadline of March 29. The first option is a delay until May 22, but only if Theresa May successfully passes her Brexit plan through Westminster. The second option is a delay until April 12. This would come in effect if the House of Commons rejects the deal on offer. The short time frame is supposed to pressure London to come up with the next steps, which the EU has inferred would either be to get out of the bloc without a deal or to plan for a long-term extension. Although there are no official conditions to awarding a long-term extension, it is clear that the EU only envisages three options: Renegotiate the terms of Brexit, to include either a customs union or full Common Market membership (a softer Brexit); Hold a general election to break the impasse; Hold another referendum. The EU is suggesting that it could deny the U.K. an extension if London does not come back with a plan. There are two reasons why we would call the EU’s bluff. First, it is likely an attempt to help May get the deal through the House of Commons by creating a sense of urgency. Second, the European Court of Justice (ECJ) ruled in December 2018 that the U.K. could “revoke that notification unilaterally, in an unequivocal and unconditional manner, by a notice addressed to the European Council in writing.”5 The only requirement is that the notification be sent to Brussels prior to March 29 (or, in the case of a mutually agreed upon extension, prior to April 12). It is increasingly likely that, after the deal on offer fails, Theresa May will have to go “hat-in-hand” to the EU to ask for a much longer extension. She will have until April 12 to ask for that extension, but it would require participation in the European Parliamentary (EP) elections on May 23. Prime Minister May has said that the U.K. will not hold those elections. We beg to differ. Not holding the election would allow the EU to end the U.K.’s membership in the bloc, which would by default mean contravening the Parliament’s will to reject a no-deal Brexit (which it did in a rebuke to the government in March). As such, the U.K. will absolutely hold an EP election in May. Yes, it will be a huge embarrassment to the Conservative government. And we would venture that the election would turn out a huge pro-EU majority from the U.K., given that it is the Europhile side of the aisle that is now excited and activated, further embarrassing the ruling government. The most likely scenario is that Theresa May either resigns and is replaced by a soft-Brexit Tory, or that she agrees to a long-term extension to give the U.K. time to call a new election. The most likely scenario, therefore, is that Theresa May either resigns and is replaced by a soft-Brexit Tory, or that she agrees to a long-term extension to give the U.K. time to call a new election. As we have been arguing throughout the year, the only way to break the impasse without calling a referendum – is to call a new election. A new election would be contested almost exclusively on the issue of Brexit – unlike the 2017 election, which Jeremy Corbyn managed to be almost exclusively contested on the issue of austerity. As such, the winner would have a clear political mandate to pursue the Brexit of their choice. If it is Jeremy Corbyn, this would mean a second referendum, given his recent conversion to supporting one. If Theresa May remains prime minister, it would be her relatively hard Brexit option; if another Tory replaces her, it would potentially be a softer Brexit. Intriguingly, Theresa May is coming up to the average “expiry date” of a “takeover” prime minister, which is 3.3 years (Chart 14). Chart 14 Why do we think that Theresa May would be replaced with a soft Brexit Tory? Because there are simply not enough members of parliament in the Conservative Party caucus to elect a hard Brexiteer. Furthermore, the current deal on offer, which is a form of hard Brexit, clearly has no chance of passing in the House of Commons. Theresa May herself did not support the Leave campaign, but she converted into a hard Brexiteer due to the pressures in the Conservative Party caucus. If, on the other hand, we are wrong and the Conservative Party elects a hard Brexit Tory as leader, the odds of losing the election to the Labour Party would increase. Furthermore, the impasse in the House of Commons would not be resolved as Theresa May would be replaced by a prime minister with essentially the same approach to Brexit. Confused? You are not alone. Diagram 1 illustrates the complexity of the tactical (0-3 months) and strategic (3-12 months) time horizons. There are so many options over the next six months alone that we ran out of space in our diagram to consider the consequences of the general election. Diagram 1Confused? You Are Not Alone The State Of Brexit The State Of Brexit Needless to say, an election would induce volatility in the market as it would put Jeremy Corbyn close to the premiership. While he has now promised a second referendum, his government would also implement policies that could, especially in the short term, agitate the markets. Our forecasts of the currency moves alone suggest that volatility is the only sure bet over tactical and strategic time horizons. We do not have a high-conviction view on a directional call on the pound or U.K. equities. However, global growth concerns, combined with political uncertainty, should create a bond-bullish environment. Bottom Line: Over the course of the year, political uncertainty will remain high in the United Kingdom. A general election is the clearest path to breaking the current deadlock. However, it is not guaranteed, as Labour’s recent decline in the polls appears to be reversing since Jeremy Corbyn finally succumbed to the demands that he support a new referendum (Chart 15). Chart 15Labour Party Revives On Referendum Support Labour Party Revives On Referendum Support Labour Party Revives On Referendum Support The Secular Horizon BCA Geopolitical Strategy believes that the median voter is the price maker in the political market place. Politicians are merely price takers. This is why Theresa May’s notion that the sanctity of the 2016 referendum cannot be abrogated is doubly false. First, she cannot truly claim from the slim 52%-48% result that U.K. voters want her form of Brexit. The referendum therefore may be a sacred expression of the democratic will, but her “no customs union” Brexit option is not holy water: It is an educated guess at best, pandering to hard Brexit Tories (a minority of the electorate) at worst. Given that 48% of the electorate wanted to remain in the EU and that a large portion of Brexit voters wanted a Common Market membership as part of Brexit, it is mathematically obvious that the softest of soft Brexit options was the desire of the median voter in June 2016. An election would induce volatility to the market as it would put Jeremy Corbyn close to the premiership. Furthermore, polling data (presented in Chart 12 and Chart 13) now clearly show that the median voter is migrating away from even the softest of soft Brexit options to the “Stay” camp. Bregret has set in and a strong plurality of voters no longer supports Brexit. The question behind Chart 12 is unambiguous. It clearly asks, “In hindsight, do you think Britain was right or wrong to vote to leave the EU?” What does all of this infer for the long term, or secular, horizon? First, an election this year could usher in a Labour government that delivers a new referendum. At this time, given the polling data and the geopolitical context, sans terror and migration crises, we would expect such a referendum to lead to a win for the Stay camp. Second, an election that produces a soft Brexit prime minister or negotiated outcome would allow the U.K. to leave the EU in an orderly fashion. A new Tory prime minister, pursuing a soft Brexit outcome, could even entice some Labour MPs to cross the aisle and support such an exit from the bloc. However, over a secular time horizon of the next two-to-three years, we doubt that a soft Brexit outcome would be viable. Investors have to realize that the vote on leaving the EU does not conclude the U.K. long-term deal with the bloc. That negotiating phase will last during the transition phase, over the next two-to-three years, and would conclude in yet another Westminster vote – and likely crisis – at the end of the period. If this deal entails membership in the Common Market, our low- conviction view over the long term is that it will ultimately fail. Take the financial community’s preferred soft Brexit option, the so-called super soft “Norway Plus” option. A Norway Plus option would entail the highest loss of sovereignty imaginable, given that the U.K. would essentially pay full EU membership fees with no ability to influence the regulatory policies that London would have to abide by. There is also a debate as to whether London would be able to constrict immigration from the EU under that option over the long term, a key demand of Brexiters.6 As such, the only viable option would be to switch to a customs union relationship. However, we fear that even this option may no longer be available to U.K. policymakers. Conservative Party leaders have wasted too much time and lost too much of the public’s good will. With only 40% of the electorate now considering Brexit the correct decision, it is possible that even a customs union arrangement will be unacceptable by the end of the transition period. Aside from the electorate’s growing Bregret, there is also the economic logic – or lack thereof – behind a customs union. A customs union would ensure the unfettered transit of goods between the U.K. and the continent, but not of services. This arrangement greatly favors the EU, not the U.K., as the latter has a wide (and growing) deficit in goods and an expanding surplus in services with the bloc (Chart 16). Chart 16Services Are Key For The U.K. Services Are Key For The U.K. Services Are Key For The U.K. The only logic behind selecting a customs union over the Common Market is that a customs union would allow the U.K. to conclude separate trade deals with the rest of the world. While that may be a fantasy of the few remaining laissez-faire free traders in the U.K. Conservative Party, the view hardly represents the desire of the median voter. Other than a potential trade deal with the U.S., it is practically inconceivable to expect the U.K. electorate to support a free trade agreement with China or India, both of which would likely entail an even greater loss of blue-collar jobs. Even a trade deal with the U.S. would likely face political opposition, given that the U.K. is highly unlikely to be given preferential treatment by an economy seven times its size.7 The Conservative Party has wasted its window of opportunity to push a hard, or moderately hard, Brexit through Parliament. The fact of the matter is that the Conservative Party has wasted its window of opportunity to push a hard, or moderately hard (customs union), Brexit through Parliament. Bregret has set in, as the doyens of Brexit increasingly pursued an unpopular strategy. On the other hand, a Brexit that retains the U.K. membership in the Common Market has never had much logic to begin with. Where does this leave the U.K. in the long term? Given the time horizon and the uncertainty on multiple fronts, our low-conviction view is that it leaves the U.K. inside the European Union. Bottom Line: The combination of increasing Bregret, lack of economic logic behind a customs union membership alone, and the lack of a political logic behind a Common Market membership, suggests that Brexit is unsustainable over the secular time horizon. This imperils the ultimate deal between the U.K. and the EU, which we think will not be able to pass the House of Commons in two-to-three years when it comes up for approval. This is a low-conviction view, however, as political realities can change. Support for Brexit could turn due to exogenous factors, such as a global recession that renews the Euro Area economic imbroglio or a major geopolitical crisis. Both are quite likely over the secular time horizon. Investment Implications Today, cable is cheap, trading at an 18% discount to its long-term fair value as implied by purchasing-power parity models (Chart 17). The growing probability that the U.K. may, down the road, remain in the European Union means that, at current levels the pound is indeed attractive, especially against the U.S. dollar. Chart 17Cable Attractive On Higher Odds Of Bremain Cable Attractive On Higher Odds Of Bremain Cable Attractive On Higher Odds Of Bremain However, when it comes to short-term dynamics, the picture is much murkier. The low probability of a no-deal Brexit implies limited downside. However, the path to get the U.K. to abandon the current relatively hard Brexit is also one that involves a new election. This implies that before a resolution is reached, multiple scenarios are possible, including one where Corbyn becomes the next prime minister. Jeremy Corbyn could be the most left-of center leader of any G-10 nation since Francois Mitterrand in France in the early 1980s. Mitterrand’s audacious nationalization and left-leaning policies were met with a collapse in the French franc (Chart 18). Chart 18A Left-Wing Leader Bodes Ill For The Currency A Left-Wing Leader Bodes Ill For The Currency A Left-Wing Leader Bodes Ill For The Currency Global growth also has an impact on cable. Despite all the noise around Brexit, the reality remains that exports constitute 30% of U.K. GDP, a larger contribution to output than in the euro area. This means that if global growth deteriorates, GBP/USD will face another headwind. If, however, global growth improves, then cable would face a new tailwind. Since BCA is of the view that global growth will likely trough by the summer, we are inclined to be positive on the pound. It makes sense for long-term investors to buy the GBP … short-term investors should buy the 2-year call while selling 3-month ones. Netting out all those factors, it makes sense for long-term investors to buy the GBP, using the dips along the way to build a larger position in this currency. Even on a six-to-twelve-month basis, the path of least resistance for cable is likely upward. The problem is that risk-adjusted returns are likely to be poor as volatility will remain very elevated. We therefore recommend that short-term investors instead buy the 2-year call while selling 3-month ones (Chart 19). Chart 19Volatility Will Be A Challenge For Short Term Investors Volatility Will Be A Challenge For Short Term Investors Volatility Will Be A Challenge For Short Term Investors Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President The Bank Credit Analyst mathieu@bcaresearch.com Footnotes 1 At the time of publication of our March report, we still had a low-conviction view that the vote would swing towards Stay at the last moment. 2 Please see BCA Research European Investment Strategy Weekly Report, “Important Message From The Currency Markets,” dated March 14, 2019, available at eis.bcaresearch.com. 3 Trying to play up the threat of unchecked migration, the U.K. Independence Party ran a famous campaign poster showing hundreds of refugees on a road under the title of “Breaking Point – The EU has failed us all.” Despite the fact that the U.K. accepted only around 10,000 Syrian refugees since the 2015 crisis. Germany has accepted over 700,000 while Canada – which is located across the Atlantic Ocean on a different continent – accepted over 40,000. Even the impoverished Serbia has accepted more Syrian refugees than the U.K. ­4 One of the most prominent Leave supporters, Boris Johnson, famously quipped after the referendum result that “There will continue to be free trade and access to the single market.” 5 Please see The European Court of Justice, “Judgement Of The Court,” In Case C-621/18, dated December 10, 2018, available at curia.europa.eu. 6 Proponents of the Norway Plus option point out that Article 112(1) of the European Economic Area (EEA) Agreement allows for restriction of movement of people within the area. However, these restrictions are intended to be used in times of “serious economic, societal or environmental difficulties.” It certainly appears to be an option for London to restrict EU migration, but it is not clear whether Europe would agree for this to be a permanent solution. Liechtenstein has been using Article 112 to impose quantitative limitations on immigration for decades, but that is because its tiny geographical area is recognized as a “specific situation” that justifies such restrictions. 7 President Donald Trump may want to give the U.K. preferential trade terms on the basis of the filial Anglo-Saxon relationship alone, but it is highly unlikely that the increasingly protectionist Congress would do the same. There is also no guarantee that President Trump will be around to bring such trade negotiations across the finish line.

Clearly the president will benefit from being vindicated in such an authoritative way. He will not only avoid any mushrooming scandal, which can hurt a president seeking reelection, but will also gain sympathy from at least some voters for having been falsely accused. While Mueller technically did not exonerate Trump from charges of obstruction of justice, he also did not make any such charges. This means that House Democrats could conceivably still use the Mueller report’s evidence of potential obstruction to impeach Trump. But if they do they will fail. Attorney General Anthony Barr and his deputy, Rod Rosenstein, have both determined that there was no obstruction. With the special counsel having ruled out any collusion or even coordination with Russia, Trump will remain secure among grassroots Republicans. Hence the senators in his party will not convict him and any impeachment trial will be a charade. Thus to some extent Trump’s odds of reelection must be going up. Right? Wrong. The problem is that any positive impact on Trump’s reelection odds from the Mueller report ultimately matters much less than the inversion of the yield curve on March 22. This curve is the most reliable indicator of forthcoming economic recession. If the inversion is deep and persistent then it makes an election year recession probable. Presidents can survive a grand scandal, but they live or die by recessions. There have only been two presidents in the post-Civil War era who won reelection despite a recession in the calendar year of the election. These were William McKinley in 1900 and Theodore Roosevelt in 1904. Yet in 1900, the recession was drawing to a close and economic conditions were better than when McKinley first took office in 1896. And in 1904, the recession technically ended in August, before the fall campaign began. In ten other cases the ruling party has lost the White House amid a recessionary environment. In recent decades yield curve inversion precedes recessions by anywhere from five to sixteen months. The average is eleven months. This means that if the 10yr/3mo signal proves accurate once again, Trump would get extremely lucky to see the economy rebounding by the fall campaign. Granted, the yield curve could send a false signal. For instance, some take the view that the term premium is historically low for structural reasons and that this makes inversion easier and less indicative than in the past. However, when it comes to politics, President Trump cannot afford to assume that this time is different. It is already clear from his waivers on Iranian oil sanctions and trade negotiations with China that he lives in great fear of the business cycle expiring before November 3 next year, when it will be very long-in-the-tooth. Trump is also more vulnerable to recession than the usual president. He is a self-styled commercial leader – a CEO president and Washington outsider who staked his credibility on the claim that he will create jobs and grow the economy. Trump can possibly survive an election with a large trade deficit or a surge in immigrants on the southern border because these developments would highlight the very policy concerns that he did so much to emphasize: they would not necessarily invalidate his approach. But if unemployment is rising, it is hard to see how this president, let alone any other, could wriggle out of it. If he tries to shift the blame to the Federal Reserve or China in any concrete way, the equity market will riot and exacerbate the downturn. The takeaway is, first, that we should continue to see President Trump show relative risk aversion on market-relevant matters like Iran, China, and the “stimulus cliff” affecting the U.S. budget next fiscal year. Second, that if the current economic wobbles pass and the economic expansion gets a new breath of life, then Trump’s chances of retaining the White House will soar. Trump’s reelection odds have important investment consequences. His reelection will entail policy continuity and the maintenance of a low-tax, deregulatory environment that encourages animal spirits and pads corporate earnings. The more likely it appears that Trump will lose the White House, the more animal spirits will sag. A Democratic win will mean yet another violent vacillation in U.S. policy, like 2016, which will cause a spike in policy uncertainty. It will also bring a probable increase in taxes (including possibly the corporate rate) and regulations across a range of sectors. If a Democrat wins in 2020, he or she will most likely have a fairly left-wing agenda, due to trends in the party, and whoever takes the White House will likely also take the Senate. Since the same goes for the House, a presidential win will deliver full Democratic control of the executive and legislative branches: a window of minimal political constraints in which a sweeping piece of legislation can be enacted, like in 2009 or 2017. Image In short, a Trump loss would not only mean the end of the status quo but likely a united government in favor of a rather left-leaning Democratic agenda. If the market has reason to believe a recession is looming, and that a recession will occasion a lurch to the “anti-business” side of the Left, then the impact on investment decisions and capex intentions will be negative and immediate. Economic policy uncertainty has nowhere to go but up. Matt Gertken,  Geopolitical Strategist mattg@bcaresearch.com

Highlights So What? The late-cycle rally still faces non-trivial political hurdles. Why? U.S.-China trade talks, the U.S. threat of tariffs on auto imports, and Brexit continue to pose risks. A shocking revelation from the Mueller report could have a temporary negative impact on equity markets. A bombshell would increase Trump’s chances of removal from office. We give 35% odds to tarrifs on autos and auto parts, and 10% odds to a hard Brexit. Feature In our February 6 report we outlined how a “Witches’ Brew” of geopolitical risks had the potential to short-circuit the late-cycle equity rally. A month later, that brew is still bubbling. President Donald Trump’s approval rating has rebounded but going forward it faces challenges from negative headlines (Chart 1). These include a soaring trade deficit, a large influx of illegal immigrants on the southern border, a weak jobs report for February, a setback in North Korean diplomacy, and an intensification of the scandals plaguing Trump’s inner circle. Chart 1Don't Get Comfortable Just Yet, Mr. President Don't Get Comfortable Just Yet, Mr. President Don't Get Comfortable Just Yet, Mr. President Each of these issues calls into question the effectiveness of Trump’s core policies and the stability of his administration, though in reality they are only potentially problematic. While Special Counsel Robert Mueller’s forthcoming report poses a tail risk, the substantial threat remains Trump’s trade policy.  Indeed, investors face “the persistence of uncertainties related to geopolitical factors” and the “threat of protectionism,” according to European Central Bank President Mario Draghi, who spoke as he rolled out a new round of monetary stimulus for Europe and its ailing banks. What did Draghi have in mind? The obvious culprits are the U.S.-China trade talks, the U.S. threat of tariffs on auto imports, and Brexit. There were other issues – such as “vulnerabilities in emerging markets” – but the first three are the most likely to have turned Draghi’s head. The global economic outlook is likely to improve on the back of Chinese stimulus and policy adjustments by the ECB and Federal Reserve. But growth has not yet stabilized and financial markets face additional volatility due to the fact that none of these “geopolitical factors” is going to be resolved easily. The good news is that Trump, overseeing a precarious economy ahead of an election, has an incentive to play softball rather than hardball.  Mueller’s Smoking Gun? News reports suggest that Mueller will soon issue the final report of his investigation into President Trump’s election campaign links with Russia. There is really only one way in which the Mueller report could be market relevant: it could produce smoking-gun evidence that results in non-trivial impeachment proceedings. Any scandal big enough to remove Trump from office or clearly damage his reelection chances is significant because financial markets would dislike the extreme policy discontinuity (Chart 2). Anything short of this will be a red herring for markets, though admittedly many of our clients disagree. Chart 2 Very little is known about what Mueller will report and how he will interpret his mandate. Mueller’s investigation may or may not make it to the public in full form, at least initially, and he may or may not make any major additional indictments. Congress will strive to get access to the report, which is internal to the Justice Department, while spin-off investigations will proliferate among lower-level federal district attorneys and congressional committees. The legal battle, writ large, will run into the 2020 election and beyond. House Democrats alone can decide whether to bring articles of impeachment against Trump, but the case would be struck down in the Senate if it did not rest on ironclad evidence of wrongdoing that implicated Trump personally. Republican Senators will not jump ship easily – especially not 18 of them. That would require a sea change in grassroots support for Trump. Trump’s approval among Republicans remains the indicator to watch, and it is still strong (Chart 3). If this number crashes in the aftermath of the Mueller report, then Trump could find himself on a Nixonian trajectory, implying higher odds of a Senate conviction (Chart 4). At that point, markets would begin discounting a Democratic sweep in 2020, with business sentiment and risk assets likely to drop at the prospect of higher taxes and increased regulation (Chart 5). Chart 3 Chart 4 Chart 5A 2020 Democratic Sweep Would Dent Business Sentiment A 2020 Democratic Sweep Would Dent Business Sentiment A 2020 Democratic Sweep Would Dent Business Sentiment After all, if scandals remove Trump from office, then not only is a Democrat likely to win the White House, but any Democrat is likely to win – even a non-centrist like Bernie Sanders or other Democratic candidates like Kamala Harris who have swung hard to the left. Meanwhile, the odds of Democrats taking control of the Senate (while keeping the House) will rise. With Democratic candidates flirting with democratic socialism and proposing a range of left-wing policies, the prospect of full Democratic control of the legislative and executive branches would weigh on financial markets. We doubt that the Mueller report can fall short of a smoking gun while still dealing a fatal blow to Trump. The Democrats control the House, so if the scandal grows to gigantic proportions, they will impeach. Yet if they impeach without an ironclad case, Trump will be acquitted. And if Trump is acquitted, it is hard to see how his chances of reelection would fall. The impeachment of former President Bill Clinton looms large over Democrats, since it ended up boosting his popularity. If Democrats are overzealous to no end, it will help Trump’s campaign. If Trump should then win re-election, he will have veto power and likely a GOP Senate, so his policies will remain in place. The outcome for markets would be policy continuity, though the market-positive aspects of Trump’s first term may not be improved while the market-negative aspects, such as his trade policy and foreign policy, may reboot. Mueller is an all-or-nothing prospect: he either leads us to the equivalent of the Watergate Tapes or not. Lesser crimes are unlikely to have a decisive impact on the election. But volatility is likely to go up as the report comes due, just as it did during the Lewinsky scandal (Chart 6), at least until the dust settles and there is clarity on impeachment. And an equity sell-off at dramatic points in the saga cannot be ruled out, especially if global factors combine with actual impeachment (Chart 7). Chart 6Impeachment Proceedings Likely To Raise Vol... Impeachment Proceedings Likely To Raise Vol... Impeachment Proceedings Likely To Raise Vol... Chart 7… And Potentially Dampen Returns ...And Potentially Dampen Returns ...And Potentially Dampen Returns Bottom Line: A specific, shocking revelation from the Mueller report could have a negative impact on equity markets and risk assets, but any such moves would be temporary as long as the growth and earnings backdrop remain positive and Mueller does not drop a bombshell that increases Trump’s chances of removal from office. Separating The Budget From The Border The president faces adverse developments on the southern border after having initiated a controversial national emergency in order to transfer military funds to construct new barriers. The U.S. has seen an abnormally large increase in apprehensions and attempted entries this year (Charts 8A & 8B). Ultimately the influx calls attention to the porous southern border and as such may help to justify Trump’s policy focus. For now it raises the question of why the administration’s tough tactics are failing to deter immigrants. Meanwhile his emergency declaration has divided the Republican Party, with several members likely to join with Democrats in a resolution of disapproval that Trump will veto. Chart 8 Chart 8 Congress will not be able to override the veto, but Trump’s decree also faces challenges in the judicial system. We doubt that the Supreme Court will rule against him but it certainly is possible. The ruling is highly likely to come before the election. Meanwhile Trump is kicking off the FY2020 budget battle with his newest request of $8.6 billion for the border wall and cuts to a range of discretionary non-defense spending. The presidential budget is a fiction – it is based on unrealistic cuts to a range of government programs. Any budget that is passed will bear no relation to the administration’s proposals. Opinion polls referenced above clearly demonstrate that Trump’s approval rating suffered from the recent government shutdown. This does not mean that he will conclude the next budget battle by the initial deadline of October 1 or that a late-2019 shutdown is impossible. He might accept a short shutdown to try to secure defense spending that would arguably legitimize his repurposing of military funds for border construction. But his experience early this year means that the odds of another long-running, bruising shutdown are low. Might Trump refuse to raise the debt ceiling later this year to get his way on the wall? This is even less likely than a shutdown due to the negative impact that a debt ceiling constraint would have on social security recipients and bond markets. Trump also has the most to lose if the 2011 budget caps snap back into place in 2020 due to any failure of the FY2020 negotiations (Chart 9). As such, the debt ceiling – which the Treasury Department can keep at bay until the end of the fiscal year in October – and the 2020 budget may be resolved together this time around. Chart 9 In short, Trump will be forced to punt on congressional funding for the wall later this year and will have to campaign on it again in November 2020, with the slogan “Finish the Wall.” This is a market-positive outcome, as the hurdles to fiscal spending in 2020 are likely to be reduced: Trump will have to concede to some Democratic priorities and abandon his proposed cuts. The Democrats, for their part, are likely to have enough moderates to get the next budget over the line with Republican support. To illustrate, Republicans only need 21 votes for a majority, while no fewer than 26 Democrats were recently chastised by House Speaker Nancy Pelosi for cooperating with Republicans. The implication is that a bipartisan majority can be found. Since Trump cannot get his budget cuts, and does not really even want them, the projected contraction of the budget deficit in 2020 will be reduced or erased (Chart 10). On the margin, this would support higher inflation and bond yields.  Chart 10 The biggest threat to Trump’s reelection is still the risk that the long business cycle will expire by November next year. However, the exceedingly low February payrolls print was misleading – the unemployment rate fell and wage growth was firm (Chart 11). American households are in relatively good shape and that bodes well for Trump, for the time being. Chart 11American Households Are In Good Shape American Households Are In Good Shape American Households Are In Good Shape Bottom Line: The economy is relatively well supported and Trump and the Democrats are ultimately likely to cooperate on the budget under the table, reducing the risks of a debt ceiling breach, or an extended government shutdown later this year, or a fall off the 2020 stimulus cliff. The Trade Deficit: Trump’s Pivot To Europe Trade policy is where Trump’s challenges merge with Draghi’s woes. The U.S. trade deficit lurched upwards to a ten-year high of $621 billion in 2018 (Chart 12). The trade deficit is uniquely important to Trump because he campaigned on an unorthodox protectionist agenda in order to reduce it. It will be very difficult for him to evade the consequences if the deficit is higher, as a share of GDP, in November 2020 than it was in January 2017. Chart 12Trade Deficit Jump Is A Blow To Trump Trade Deficit Jump Is A Blow To Trump Trade Deficit Jump Is A Blow To Trump The underlying cause of the rising deficit is that a growing American economy at full employment with a relatively strong dollar will suck in larger quantities of imports. This effect is overriding any that Trump’s tariffs have had in discouraging imports. Meanwhile the global slowdown, reinforced by trade retaliation and negative sentiment, are harming U.S. exports (Chart 13). The administration’s policies of fiscal stimulus combined with encouraging private investment are guaranteed to lead to a higher current account deficit, barring an offsetting (and highly unlikely) rise in private saving. The current account deficit must equal the gap between domestic saving and investment and a rising fiscal deficit represents a drop in saving. Chart 13Trade War Hurting U.S. Exports Trade War Hurting U.S. Exports Trade War Hurting U.S. Exports What does the trade deficit imply for the U.S.-China talks? On one hand, the U.S. could put more pressure on China after feeling political heat from the large deficit. On the other hand, China has always offered to reduce the bilateral trade deficit directly through bulk purchases of goods, particularly commodities. It is Trump’s top negotiator, Robert Lighthizer, who has insisted that China make structural changes to reduce trade imbalances on a long-term and sustainable basis.1  In a sign of progress, the U.S. and China have reportedly arrived at a currency agreement. No details are known and therefore it is impossible to say if it would mean a more “market-oriented” renminbi, which could fluctuate and have a variable impact on the trade deficit, or a renminbi that is managed to be stronger against the dollar, which would tend to weigh on the deficit, as Trump might wish. The two negotiating teams are working on the text of five other structural issues that should also mitigate the deficit. Moreover, China’s new foreign investment law, if enforced, could increase American market access by leveling the playing field for foreign firms. However, there is still no monitoring mechanism, the two presidents have not scheduled a final signing summit, and the deterioration in North Korean peace talks also works against any quick conclusion. If Trump concludes a deal, the next question for investors is whether he will impose Section 232 tariffs on auto and auto imports on the EU and other partners (Chart 14). Chart 14 The European Commission’s top trade negotiator, Cecilia Malmstrom, recently met with Lighthizer in Washington to discourage tariffs. She refused to admit agriculture into the negotiations, as per a U.S.-EU joint statement in July 2018, but proposed equalizing tariffs on industrial goods as a way for both sides to make a positive start (Chart 15). She said that the U.S. repealing the Section 232 steel and aluminum tariffs are necessary for any final deal. And she reiterated that any new tariffs (e.g., the proposed Section 232 tariffs on autos and auto parts) would prevent a deal and provoke immediate retaliation on $23 billion worth of American exports. Chart 15 Malmstrom also said that the EU would prefer to work with the U.S. on reforming the World Trade Organization and addressing China’s trade violations. This approach fits with that of Japan, which has joined the U.S. and EU in trilateral discussions toward reforming the global trade architecture in a bid to mitigate U.S. protectionism and constrain China. The problem with the EU’s position is that once the U.S. and China make a trade deal, the U.S. will not have as immediate of a need to form a trade coalition against China (other than in dealing with WTO issues). Moreover, Japan will be forced to accept a deal with the U.S. in short order. A rotation of Trump trade policy to focus on Europe is likely. We give 35% odds to tariffs on autos and auto parts. The USMCA will increase the cost of production in North America while Europe is so far excluding cars from negotiations with the U.S., so there is room for a clash. But any tariffs on autos will be less sweeping than those against China. Trump will play softball rather than hardball for the following reasons: The public is less skeptical of trade with Europe and Japan than with China. The auto sector is heavily concentrated in the Red States and many states that are heavily exposed to trade with the EU are also critical to Trump’s reelection (Map 1). Chart Section 232 tariffs that are required to be enacted by May 18 would have plenty of time to impact the U.S. economy negatively by November 2020. Congress and the defense establishment are against a trade war with U.S. allies, while bipartisanship reigns when it comes to tougher actions toward China. The bilateral trade deficit is less excessive with Europe than with China (see Chart 12 above). The U.S. carmaker and auto parts lobby are unanimously against the tariffs – and in fact has called for the removal of the steel and aluminum tariffs in a stance that echoes that of the EU. The existing steel and aluminum tariffs provide Trump with leverage in the negotiations with the EU and Japan, whereas the U.S. has agreed not to impose new tariffs on these partners while trade negotiations are underway. New tariffs would nix negotiations and ensure that the ensuing quarrels are long and drawn out, with a necessarily worse economic impact. To initiate a new trade war in the wake of the U.S.-China war would be to undercut the positive impact on trade, financial conditions, and sentiment that is supposedly driving Trump’s desire for a China deal in the first place. The U.S. eventually will need to build a trilateral coalition to hold China to account and ensure that it does not slide back into its past mercantilist practices. Even limited or pinprick tariffs will have an adverse impact on equity markets, given that they will hit Europe at a time when its economy is decelerating dangerously and when Brexit uncertainty is already weighing on European assets and sentiment (see next section).  This may be why both the U.K. and Germany have recently softened their positions on Chinese telecom company Huawei, which they have been investigating for national security concerns related to the rollout of 5G networks. They are signaling that they are not going to sacrifice their relationship with China if the U.S. is dealing with China bilaterally while threatening to turn around and slap tariffs on their auto exports. If the U.S. goes ahead with tariffs – on the basis that its China agreement allows it to isolate Europe – the EU will not be a pushover, as exports to the U.S. only amount to 2.6% of GDP (Chart 16). The result of the U.S.-China quarrel has been a deepening EU-China trade relationship and that trend is set to continue (Chart 17), especially if the U.S. continues to use punitive measures that increase the substitution effect and the strategic value of the Chinese and European markets to each other. Chart 16The EU Will Not Be A Pushover In Face Of U.S. Tariffs The EU Will Not Be a Pushover In Face Of U.S. Tariffs The EU Will Not Be a Pushover In Face Of U.S. Tariffs Chart 17EU-China Trade Relationship Deepening EU-China Trade Relationship Deepening EU-China Trade Relationship Deepening Bottom Line: In the wake of any U.S.-China agreement, we give a 35% chance that Trump will impose tariffs on European cars and car parts. Such tariffs are not our base case because they are unlikely to shrink the U.S. trade deficit and would have a negative impact on the Red State economy. But lower magnitude tariffs cannot be ruled out – and the impact on the euro and European industrial sector would clearly be detrimental in the short run. Assuming that global and European growth is recovering, a tariff shock to Europe’s carmakers could present a good opportunity to buy on the dip. Any U.S.-EU trade war will ultimately be shorter-lived and less disruptive than the U.S.-China trade war, which is likely to resume at some point even if Presidents Trump and Xi get a deal this year. The United Kingdom: Snap Election More Likely A series of important votes is taking place in Westminster this week, with the end result likely to be an extension to negotiations over a withdrawal deal at the EU Council summit on March 21. Conditional on that extension, the odds of a new election are sharply rising. The first vote, as we go to press on Tuesday, has resulted in a rejection of Prime Minister Theresa May’s exit plan by 149 votes – the second rejection after her colossal defeat in January by 230 votes. The loss was expected because the EU has not offered a substantial compromise on the contentious Irish “backstop” arrangement, which would keep Northern Ireland and/or the U.K. in the European Customs Union beyond the transition date of December 31, 2020. All that was offered was an exit clause for the U.K. sans Northern Ireland. But Northern Ireland is part of the U.K. and the introduction of additional border checks on the Irish Sea would mark a new division within the constitutional fabric. This is unacceptable to the Conservative Party and especially to the Democratic Union Party of Northern Ireland, which gives May her majority in parliament. On Wednesday, we expect the vote for a “no deal” exit, in which the U.K. simply leaves the EU without any arrangements as to the withdrawal (or future relationship), to fail by an even larger margin than May’s plan. Leaving without a deal would cause a negative economic shock due to the automatic reversion to relatively high WTO tariff levels with the EU, which receives 46% of the U.K.’s exports and is thus vital in the maintenance of its trade balance and terms of trade (Chart 18). It is impossible to see parliament voting in favor of such an outcome – parliament was never the driving force behind Brexit, with most MPs preferring to remain in the EU.     Chart 18No Deal Brexit A Huge Blow To U.K. No Deal Brexit Huge Blow To U.K. No Deal Brexit Huge Blow To U.K. The risk is that parliament should fail repeatedly to pass the third vote this week, a motion asking the EU for an extension period to the March 29 “exit day.” This is unlikely but possible. In this case, the supreme decision-making body of the U.K. will be paralyzed. A bloodbath will ensue in which the country will either see Prime Minister May ousted, a snap election called, or both. If the extension passes, the EU Council is likely to go along with the decision. It is in the EU’s near-term economic interest not to trigger a crash Brexit and in its long-term interest to delay Brexit until the U.K. public decides they would rather stay after all. The problem is that it will not want to grant an extension for longer than July, when new Members of the European Parliament take their seats after the May 23-26 EU elections. The U.K. may be forced to put up candidates for the election. What good would an extension do anyway? The likeliest possibility is, yet again, a new election. The conditions are not yet ripe for a second referendum, though the odds are rising that one will eventually occur. The Labour Party has fallen in the opinion polls amidst Jeremy Corbyn’s indecisive leadership and a divisive platform change within the party to push for a second Brexit referendum (Chart 19). An election now gives May’s Conservatives an opportunity to build a larger and stronger majority – after all, in the U.K. electoral system, the winner takes all in each constituency, so the Tories would pick up most of the seats that Labour loses. May’s faction might be able to strengthen its hand vis-à-vis hard Brexiters who have less popular support yet currently have the numbers to block May’s withdrawal plan. Chart 19A New Election Would Be Opportunistic A New Election Would Be Opportunistic A New Election Would Be Opportunistic Theresa May might be unwilling to call an election given her fateful mistake of calling the snap election of 2017. If she demurs, she could face an internal party coup. There is a slim chance that a hard Brexiter could take the helm, bent on steering the U.K. out of the EU without a deal. Parliament, however, would rebel against such a leader. Ultimately, the economic and financial constraints of a crash Brexit are too hard and we expect that the votes will reflect this fact, whether in an adjusted exit deal or a new election. But both outcomes require an extension.  However, we must point out that the constitutional and geopolitical constraints alone are not sufficient to prevent a crash out: parliament is the supreme lawmaking authority and there is no other basis for the U.K. to leave in an orderly fashion. The United Kingdom has survived worse, as many hard Brexiters will emphasize. A crash is a mistake that can happen. But the odds are not higher than 10%-20% given the stakes (Diagram 1). Diagram 1The Path To Salvation Remains Fraught With Dangers The Witches’ Brew Keeps Bubbling… The Witches’ Brew Keeps Bubbling… With the EU economy not having stabilized and the U.S. contemplating Section 232 trade tariffs, Brexit is all the more reason to be wary of sterling, the euro, and European equities in the near term, especially relative to the U.S. dollar and U.S. equities. Gilts can rally even in the event of an extension given the uncertainty that this would entail, though the BCA House View is neutral. Bottom Line: Expect parliament to ask for an extension. At the same time, the odds of a new election have risen sharply. The absence of a new election could lead to a power struggle within the Tory party that could escalate the risk of a hard Brexit, though we still place the odds at 10%. A second referendum is rising in probability but will only become possible after the dust settles from the current crisis. Investment Conclusions The ECB’s stimulus measures are positive for European and global growth over a 6-to-12-month time frame. They suggest that financial assets could be supported later in the year, depending in great part on what happens in China. China’s combined January and February total social financing growth reinforces our Feb 20 report arguing that the risk of stimulus is now to the upside. As People’s Bank Governor Yi Gang put it, the slowdown in total social financing last year has stopped. The annual meeting of the National People’s Congress also resulted in largely accommodative measures on top of this credit increase. Nevertheless, stimulus operates with a lag, and for the reasons outlined above we are not yet willing to favor EUR/USD or European equities within developed markets. A 35% chance of tariffs is non-negligible. We expect U.S. equities to outperform within the developed world and Chinese equities to outperform within the emerging world on a 6-to-12 month basis.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Footnotes 1      Lighthizer now has bipartisan support in Congress, whose members will lambast Trump if he squanders the historic leverage he has built up in exchange for a shallow deal that only temporarily weighs on the trade deficit. 

Highlights So What? Optimism over a U.S.-China trade deal is becoming excessive. Why? Presidents Trump and Xi appear to want a deal but their late March summit is not yet finalized. Several news reports supporting the bullish consensus are overrated. The odds of a “grand compromise” that entails China implementing U.S. structural demands are 10%. The odds of trade war escalation are 30%. China’s policy stimulus is a better reason than trade talks to become more constructive on Chinese and China-sensitive risk assets. Feature The Chinese equity market is rallying enthusiastically as the annual “Two Sessions” legislative meeting convenes (Chart 1). The basis for the rally is evidence of greater policy support for the economy along with a general belief that the U.S. and China are close to concluding a trade deal, possibly at a fourth summit between President Donald Trump and Xi Jinping that may be held in late March. The NPC session will build on the optimism with Premier Li Keqiang’s promise of more “forceful” policy support and the passage of a new foreign investment law that promises fair treatment to foreign companies. Chart 1Positive Trade Signals, But Market Getting Ahead Of Itself Positive Trade Signals, But Market Getting Ahead Of Itself Positive Trade Signals, But Market Getting Ahead Of Itself Our view is that the trade signals are broadly positive – implying a 70% chance that tariffs will either remain frozen or decrease in the scenario analysis below – but that the market is getting ahead of itself both in terms of the likelihood of a “structural deal” and in terms of the positive market impact from any deal. The market impact will depend on the depth of the concessions that China offers the United States. If the concessions are significant, President Donald Trump will be able to roll back tariffs to a considerable extent – trade policy uncertainty will fall, China’s economic outlook will improve, and Trump’s reelection odds (and hence U.S. economic policy continuity) could increase marginally. If China’s concessions are slight, tariff rollbacks will be limited or non-existent and the deal will stand on shaky ground, ensuring elevated policy uncertainty in the aftermath of the agreement and raising the probability of a relapse into trade war ahead of the 2020 election. Trump may feel he has to prove his protectionist credentials anew against a trade critic in the general election. Will the outcome be positive enough to surprise Chinese and global markets that have already discounted a lot of positive news? From where we sit, this is unlikely. More likely, investors will be underwhelmed by a lack of resolution or the shallowness of a deal. The risk to this view is the aforementioned structural deal that involves substantial Chinese concessions combined with a major reduction in U.S. tariffs and sanctions. But even in this case investors will face additional trade uncertainty relating to the U.S. Section 232 investigation into auto imports, on which Trump must decide by May 18, underscoring the point that trade alone is not a firm basis for bullish investment recommendations over the course of H1 2019. The continued strength of the U.S. economy and China’s policy stimulus provide a more realistic basis for global risk assets to rally over the 6-12 month horizon. Presidential Momentum For A Trade Deal We remain pessimistic about U.S.-China relations in general and the prospects for a structural trade deal in particular. This is reflected in our subjective trade-deal probabilities, which hold that an additional extension is as likely as a final deal this month and that the risk of a relapse into trade war remains elevated at 30% (Table 1). Table 1Updated Trade War Probabilities China-U.S. Trade: A Structural Deal? China-U.S. Trade: A Structural Deal? Fundamentally, our pessimism stems from our view that the U.S. and China are locked in the early chapters of an epic struggle for supremacy in Asia Pacific that will reduce their ability to engage cooperatively (Chart 2). Chart 2China, U.S. In Geopolitical Power Struggle China, U.S. In Geopolitical Power Struggle China, U.S. In Geopolitical Power Struggle Critically, the economic impact of a trade war is not prohibitive for either country. China is not as reliant on exports as it once was. In addition, neither the U.S. nor China is too reliant on trade with the other to make a trade war unthinkable, as was the case with Canada and Mexico (Chart 3). Chart 3Economic Impact Of A Trade War Is Not Prohibitive Economic Impact Of A Trade War Is Not Prohibitive Economic Impact Of A Trade War Is Not Prohibitive China is economically vulnerable but is politically centralized, as symbolized by Xi Jinping’s aggressive purge of the Communist Party on the basis of corruption (Chart 4). The ruling party can and will accept the worst international economic outcomes since 1989-91, if it believes this is necessary for regime survival. Chart 4Regime Survival is Paramount Regime Survival is Paramount Regime Survival is Paramount Meanwhile the U.S. is economically insulated and performing relatively well (Chart 5), and is not politically divided on the question of China. A bipartisan, hawkish consensus has developed that will be discussed below. Just as we argued correctly that this trade war would occur, so too we believe it has a fair chance of reigniting. This could be due to policy miscalculation, unforeseen events, or the likelihood that Trump will face heat from the left-wing ahead of the election if he gives China as easy of a deal as he gave to Canada. Chart 5The U.S. Economy Is Strong But Softening... The U.S. Economy Is Strong But Softening... The U.S. Economy Is Strong But Softening... Nevertheless we accept that there is top-level momentum in favor of a deal for the time being, and this comes from both Presidents Trump and Xi. In China, delaying tactics are the standard way of coping with an angry Washington, as the perception in Beijing is that economic and technological advancement give it greater leverage over time. Moreover, the economy is weakening on several fronts, private sector sentiment is bearish, and the easing of fiscal and monetary policy is of unclear effectiveness (Chart 6). These are all reasons for Xi to seek at least a temporary reprieve. Chart 6...While the Chinese Economy Is Weak But Stimulating ...While the Chinese Economy Is Weak But Stimulating ...While the Chinese Economy Is Weak But Stimulating In the United States, Trump faces a difficult election campaign due to his relatively low job approval with voters (Chart 7). His polling has recently improved with the settlement of the FY2019 budget and avoidance of a second government shutdown, and this is despite his controversial decision to press forward unilaterally on southern border security. But he will be running for office late in the business cycle and is vulnerable to an equity bear market and recession. This explains why he has shown risk aversion since October on market-relevant issues ranging from NAFTA, Iran, and China. A trade deal with China offers the possibility not only of satisfying a campaign promise (renegotiating the terrible trade deals of the past) but also of a substantial boost to investor sentiment and key parts of the U.S. economy via Chinese cash. Chart 7 Thus it is reasonable to assess that Trump and Xi can satisfy their political preference for a deal in the short run. If Xi does not gratify Trump’s campaign platform as a great deal-maker, he will give impetus to Trump to form a grand protectionist coalition. Such a coalition could eventually succeed in constricting China’s technological development, as exemplified by the U.S.’s campaign against Chinese telecoms equipment maker Huawei. Fundamentally, China still depends on the West for the computer chips that are essential building blocks for its manufacturing sector (Chart 8). Chart 8 However, while this is a reason for Xi to play ball, it is far from clear that Xi will rapidly implement deep structural changes demanded by the United States. Xi has good reason to fear that Trump will continue the tech war on national security grounds despite any trade deal. Plus, either Trump or a Democratic president could take new punitive trade measures after 2020, given the underlying strategic struggle. For these reasons China is likely to slow-walk any structural concessions. We recognize that our 35% probability that trade talks will be extended cannot last forever. Assuming that Trump and Xi confirm the time and place of a fourth summit, the probability of some kind of deal will rise toward 70%. We doubt very much that Trump and Xi will attend such a summit without a high degree of confidence in the outcome, unlike the Trump-Kim summit in Hanoi, which suffered from inadequate preparation. Yet even if the probability of a deal rises to 70%, we still think there would remain a 30% chance of either an unexpected extension or a disastrous breakdown in negotiations – and we are not yet at that 70% mark. Bottom Line: Until a Trump-Xi summit is finalized in the context of continued progress in trade negotiations, we maintain our pessimistic probabilities for the trade negotiations, with a 30% chance of total collapse and a 35% chance of a further extension of talks beyond March. Remain Vigilant On The Trade Talks It is debatable whether momentum in favor of a U.S.-China trade deal has increased over the past two weeks as much as the news flow suggests. First, Trump’s extension of the tariff deadline – which he originally envisioned as a pause for a month “or less” – could just as easily lead to additional extensions rather than a quick resolution. This will be clear if a Trump-Xi summit does not materialize in late March. A logical time for the two to meet would be at the G20 summit in Osaka, Japan on June 28-29, which would prolong the trade policy uncertainty for nearly four months from today. Second, reports suggest that China, like the EU, is demanding that all Trump’s tariffs be removed as part of any trade deal. If true, this demand is more likely to result in a failure to make a deal than a total tariff rollback. The reason is that the U.S. needs to retain the ability to adjust Section 301 tariffs based on China’s actual degree of implementation of any commitments it makes to reduce forced technology transfers, economic espionage, and intellectual property theft. Several of these commitments are enshrined in the new foreign investment law that would pass through China’s legislature over the next two weeks (Table 2), but the U.S. will want to ensure that the law is actually implemented. Table 2New Foreign Investment Law Would Be A Positive For U.S.-China Negotiations China-U.S. Trade: A Structural Deal? China-U.S. Trade: A Structural Deal? If the U.S. rolls back all Section 301 tariffs it will lose a convenient legal standing from which to dial the tariffs back up if necessary. It is more likely that part or all of the 10% tariff on $200 billion worth of goods will be rolled back (our short-term trade deal scenario with 25% odds) than that the entire Section 301 tariffs will be rolled back (our best-case trade deal scenario with a 10% probability). The degree of rollback will be a critical indicator of the durability of any deal, as it will make a material difference for China’s export-manufacturing outlook (Chart 9). Thus far, China’s economy has counterintuitively benefited from the trade war due to tariff front-running. Chart 9The Degree Of Tariff Rollback Matters The Degree Of Tariff Rollback Matters The Degree Of Tariff Rollback Matters Third, the disagreements between President Trump and his hawkish lead negotiator, U.S. Trade Representative Robert Lighthizer, are likely overstated in their ability to increase the odds of finalizing a deal. There are two arguments for the view that Trump is losing faith in Lighthizer. The first is that he blames Lighthizer’s tough tactics for the equity market selloff. This may not be valid given that stocks continued to sell off after Trump sided with the trade doves and agreed to a trade truce with Xi Jinping. In December the S&P 500 suffered the worst monthly performance since February 2009 and the worst December performance since 1931. The second argument is more substantial and comes from Trump’s public interchange with Lighthizer over the use and value of memorandums of understanding (MOUs). The interchange was awkward and suggests that tensions exist between Trump and his top negotiator.1 However, the episode may have an important implication. Whatever the reason for the disagreement, Lighthizer gained the assent of two Chinese negotiators – Vice Premier Liu He and U.S. ambassador Cui Tiankai – in his declaration, on camera, that the term MOU would be dropped in preference for the term “trade agreement.” The result is that while the deal is still not going to be a “Free Trade Agreement” that requires legislative ratification, the language of the final document will be if anything more, not less, binding. This episode cannot possibly accelerate a final deal. It is hard to believe that Lighthizer is not secretly happy with the result of his dust-up with the president. It is well known – and frequently complained about by Lighthizer and other Trump administration officials – that China has very active diplomacy and makes many international agreements that are more nominal than real in their results. As a simple example, China typically agrees to a larger value of outbound investment than is ultimately realized (Chart 10). In fact, Lighthizer is at the forefront of the administration’s repeated and explicit aim to pin China down to better implementation and enforcement of any agreement. Indeed, in both of Lighthizer’s reports on the Section 301 investigation that motivate the tariffs, he refers to a well-known September 2015 commitment, between President Xi and former U.S. President Barack Obama, not to conduct cyber-espionage against each other’s countries. Lighthizer shares the view of the broader U.S. political establishment that China only temporarily enforced this commitment and later ramped up its hacking to steal trade secrets.2 Chart 10China Known For Overpromising China Known For Overpromising China Known For Overpromising Fourth, Trump’s failure to conclude a peace and denuclearization deal with North Korean leader Kim Jong Un in Hanoi, Vietnam does not increase the odds of a U.S.-China deal – it is either neutral or negative for U.S.-China talks. Whether intentional or not, the summit reminded the Chinese that Trump’s “art of the deal” requires the willingness to walk away from a bad deal. As mentioned, we view the odds of Trump walking away from a China deal at 30%. But the deeper problem is that Trump expects China’s assistance with North Korea as a condition of the trade deal. Whenever Trump thinks that China is not providing enough assistance, he threatens to walk away from talks with Kim. This occurred in May 2018 and has apparently occurred again. The failure of the summit is a failure of U.S.-China diplomacy in the sense that China could not or would not convince Kim Jong Un to offer more concrete steps toward denuclearization. This reflects negatively on the trade talks if it reflects anything at all. Bottom Line: Aside from the presidential momentum behind a trade deal, none of the recent news reports or leaks form a basis for upgrading the probability of a final agreement in late March. Will It Be A “Structural Deal”? Lighthizer is not isolated in driving a hard bargain with China: he enjoys the support of both parties in the U.S. Congress. At his recent testimony on U.S.-China trade to the House Ways and Means Committee, bipartisanship was a key theme. Democrats as well as Republicans voiced support for Lighthizer as the top negotiator due to his strict stance on China’s trade practices, while Lighthizer himself praised both Trump and Democrats such as House Speaker Nancy Pelosi for being skeptical about China’s trade practices as far back as 2001. The takeaway is that Trump needs deep concessions from China – what the top Democrat on the committee called “a structural deal” – in order to defend any trade deal against domestic critics and skeptical voters on the campaign trail in 2020. In other words, there is unanimity in Congress, as there was in May 2018, that Trump should not sacrifice his leverage for a deal limited to Boeings and soybeans but should instead obtain victories on core disagreements: national security, foreign exchange rates, market access, and intellectual property. The MOUs – now “agreements” – that are reportedly being drafted address these core disagreements. Therefore signs of progress in producing final drafts should be seen as evidence that the odds of a final deal are improving: Forced tech transfers: Raising equity caps for foreign investment in key sectors is a headline way to reduce the leverage that Chinese companies have used to extract technology (Table 3). There are other arbitrary licensing and permitting practices that could also be curtailed. Table 3Foreign Investment Equity Caps China-U.S. Trade: A Structural Deal? China-U.S. Trade: A Structural Deal? Intellectual property: China’s purchases of U.S. intellectual property are conspicuously small, especially when considering that China is not yet an innovation giant in terms of international IP licensing receipts relative to the amount that it pays out.3 If the U.S.’s IP trade balance with China were equivalent to its balance with South Korea, it would result in a $36.7 billion improvement in the U.S. balance (Chart 11). Chart 11 Services: China is a major growing market for U.S. service exports but Washington frequently complains about denial of market access, for instance in financial and legal services. Services exports also underscore the above point about intellectual property (Chart 12). Chart 12 Foreign exchange: The U.S. is asking China not to maintain a more market-oriented currency but rather to promote a stronger currency relative to the dollar, perhaps referring to the yuan’s undervaluation according to purchasing power parity (Chart 13). It is impossible for Trump to accept a deal that does not include some text on the currency since he has hammered the issue of Chinese currency manipulation on the campaign trail and is trying to talk down the greenback. South Korea agreed to a currency annex and Japan is likely to do the same, and that makes it even less feasible for China to get off the hook. Non-tariff barriers: The U.S. has a long roster of complaints about China’s trade practices, including subsidies to state-owned companies, dumping, and inadequate health, environmental, and labor standards. Changing these practices will raise the costs of production in China. Changes to non-tariff barriers can also increase American market access in a way that goes beyond the simultaneous demands for lower tariffs on U.S. imports (Chart 14). Chart 13China Not Off The Hook On Currency Manipulation China Not Off The Hook On Currency Manipulation China Not Off The Hook On Currency Manipulation Chart 14 If China pledges improvements on these issues then it could justify substantial tariff rollback, perhaps the entire 10% tariff on $200 billion. This scenario, the best version of our 25% trade deal scenario, would comprise a positive surprise for markets in the current environment. It still could fall short of a grand bargain justifying a total tariff rollback, unless implementation is swift and decisive, which is highly improbable. A lesser but still market-positive surprise would be an American agreement to reduce pressure on Huawei (comparable to the deal reached in May 2018 on that other besieged Chinese tech company, ZTE). Still less positive outcomes would be a partial reduction in the tariff rate or an American agreement to expand or expedite exemptions to existing tariffs. The last would indicate relatively low expectations about the depth of China’s concessions. Bottom Line: Until the actual details of any Chinese structural concessions and American tariff relief are known, the durability of any U.S.-China trade deal cannot be assessed. This warrants at best cautious optimism regarding the trade talks: the two sides are working on draft texts about the right things. Investors will not be positively surprised by an agreement that does not include structural concessions of the nature above as well as substantial American tariff rollback, which is needed to verify American confidence in China’s commitments. Investment Implications The outcomes that are currently available to investors leave substantial room for prolonged trade policy uncertainty (Chart 15). Any further extension of trade talks means that uncertainty will persist at current levels. A deal that includes limited structural concessions means that uncertainty will ease but remain elevated relative to pre-2018 levels, due to the persistent threat of Section 301 tariffs that the U.S. will wield in order to secure Chinese concessions. A failure of negotiations means a dramatic escalation in uncertainty; this is our 30% risk due to the geopolitical and technological struggle underway. We allot only a 10% chance to a grand bargain that includes deep structural reforms and full tariff rollback. Chart 15Trade Uncertainty Will Persist Trade Uncertainty Will Persist Trade Uncertainty Will Persist As a final consideration, investors should be aware that the better the U.S.-China trade deal, the higher the probability that Trump imposes tariffs on auto and auto part imports pursuant to the Section 232 investigation into the impact of these imports on national security, which concluded February 17. The Commerce Department’s recommendations are still unknown but it is not a stretch to imagine that the administration has discovered a national security threat. However, this determination alone does not require Trump to impose tariffs. If he is to impose, he has until May 18 to do so. The full value of U.S. auto and auto parts imports is larger than the value of Chinese imports that currently fall under Trump’s tariffs. It is very unlikely that the U.S. will match this size of tariffs against the EU (Chart 16). Certainly it will not do so if the U.S.-China conflict remains unresolved, since it seems a stretch to believe the equity market can sustain both trade wars at the same time. The Trump administration has already found that the China tariffs without negotiations were disruptive to the U.S. equity market and economy, and the U.S. has told the European Union and Japan that it will not impose tariffs as long as negotiations are underway. To do so would be practically to foreclose the possibility of a trade agreement prior to the 2020 election, at least in the case of the EU. Chart 16 Thus it is only after any U.S.-China deal that the risk of EU impositions rises. We take the view that Japan is likely to conclude an agreement with the Trump administration quickly, possibly even before the China deal but almost certainly shortly afterwards. Trump administration officials will also likely intervene on behalf of South Korea due to the strategic need to stay on the same page regarding North Korea, which itself led to the successful renegotiation of the two countries’ existing trade agreement last year (which included autos but did not explicitly exempt Korea from Section 232 auto tariffs). This leaves the EU, which is quarreling with the U.S. over a range of issues: trade, Iran, Russia, China, Brexit, Syria, etc. Our base case is that the U.S. will not impose sweeping Section 232 tariffs on the EU due to the negative impact this would have on the U.S. auto industry, which is rooted in the electorally critical Midwest; the aforementioned risk to the equity market and economy; and the fact that neither the U.S. public, nor Congress, nor the corporate lobby are supportive of a trade war with Europe. Tariffs would also harm the Trump administration’s broader attempt to galvanize Western countries against the strategic challenge of China, Russia, and Iran. Nevertheless, the risk of such sweeping tariffs is non-trivial because Trump does not face legal constraints in imposing them – he can act unilaterally, just as he did with the early Section 232 tariffs on steel and aluminum, which broadly remain in force. A negative trade shock to the EU at a time of economic weakness may not overwhelm the positive trade impact of a U.S.-China deal in the context of China’s policy stimulus, but it would take the shine off of any risk-on exuberance following a China deal. In the end, China’s risk assets are likely to continue benefiting from domestic policy stimulus plus the 70% likelihood that tariffs will not go up. BCA’s Geopolitical Strategy remains cyclically positive Chinese stocks relative to emerging market stocks over a 12-month horizon given China’s more robust stimulus measures and the above trade view. We are shifting our long China Play Index to a trade as opposed to a portfolio hedge. We are also long copper. We would anticipate that the trend for CNY-USD will be flat to up as long as negotiations proceed in a positive manner. BCA’s China Investment Strategy is tactically positive Chinese stocks relative to the global MSCI benchmark on the same basis, but is awaiting more evidence of a stabilization in the earnings outlook before recommending that investors shift to an outright overweight over the cyclical horizon. Still, our China team placed Chinese stocks on upgrade watch in their February 27 Weekly Report, signaling that the next change in recommended allocation is likely to be higher rather than lower.4   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com     Footnote 1 News reports had indicated that Lighthizer and his Chinese counterparts were negotiating six MOUs – on forced tech transfer and cyber theft, intellectual property rights, services, currency, agriculture, and non-tariff barriers to trade – in pursuit of the March 1 deadline. When asked about the time horizon of the MOUs at a public press conference with the Chinese trade delegation in the White House, President Trump said that MOUs were not the same as a “final, binding contract” that he wanted as an outcome of the talks. Lighthizer spoke up in defense of MOUs, leading the president to publicly disagree with him. Lighthizer then declared that the term “MOU” would no longer be used and instead the two sides would use the term “trade agreement.” 2 This was the same summit at which Xi Jinping declared in the Rose Garden that China had no intention to militarize the South China Sea – an even more frequently cited example of divergence between China’s official rhetoric and policy actions on matters of strategic consequence. 3 Please see Scott Kennedy, “The Fat Tech Dragon: Benchmarking China’s Innovation Drive,” CSIS, August 2017, available at www.csis.org. 4 Please see China Investment Strategy Weekly Report “Dealing With A (Largely) False Narrative,” dated February 27, 2019, available at cis.bcaresearch.com.

Highlights So What? The yellow vest movement has not soured our optimistic view on France – if anything, it tells us it is time to turn more bullish. Why? The constraints on Macron pursuing reforms are overstated; he has no choice but to double-down.  France has multiple tailwinds: strong demographic trends, comparative advantages in exports, and an increasingly pro-business market environment.  Also … The roadmap for the European Union to change structurally is set, though it will need political will to materialize. Feature “La réforme oui, la chienlit non!” Charles De Gaulle, May 1968 “France is only herself when she leads fights that are bigger than herself.” Emmanuel Macron, August 2018 “When France sneezes the rest of Europe catches cold.” Prince Clemens von Metternich, 1848   In May 2017, the election of 39-year-old Emmanuel Macron brought an end to the seemingly unstoppable tide of populist nationalism in the developed world. As it turned out, the median voter in France was not as angry as the median voter in the U.K. and the U.S.  The reforms implemented since the French election have hardly made headlines outside of domestic media. The struggles of Italy, akin to la commedia dell’arte, and the jousting between London and Brussels, have drawn more attention. More recently, the yellow vest protests have reaffirmed the usual stereotypes about France. Behind the headlines, however, one cannot ignore the market relevance of what is happening in France. Thought to be condemned to stagnation by the rigidity of its labor market and the size of its state, the country is now looking to undo the malaise of the past two decades. The only surprise about the protests is that they did not occur sooner in Macron’s term. In this Special Report, we assess the ongoing yellow vest protests, review the reforms conducted since 2017, and give Macron favorable chances of reforming France further. We also highlight structural tailwinds that will support the French economy in the long run. Finally, we briefly go over the European Union’s roadmap for reforms. How Relevant Are The Yellow Vest Protests? Where there are reforms, there are protests. Or, as an astute client once told us: Buy when blood is in the streets. Had there been no protest against President Macron’s reforms, it would have signaled they lacked teeth. Protests were inevitable as soon as Macron set in motion his ambitious pro-growth and pro-business reform agenda. The yellow vest movement is not a coherent force led by a clear leadership. The demands of the group are many: lower taxes, better services, less of the current reforms (specifically in education), and more of other reforms. But despite this lack of clarity, the protesters have convinced most of the public that the reform agenda should pause, or at least slow down (Chart 1). Chart 1 What started on 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. In fact, 77% 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 favoring the wealthiest households. It resonated strongly with the perception that past governments helped the wealthiest households to accumulate more wealth at the expense 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 2). Chart 2What Income Inequality? What Income Inequality? What Income Inequality? Public support for the protests has hovered around 70% for several weeks since they started in November 2018, but is now coming down (Chart 3). There are now more respondents who think that the protests should stop than those who believe they should continue (Chart 4). 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.1 Chart 3 Chart 4 Who are the yellow vests? The profile is shown in Diagram 1. 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 center. Diagram 1The Profile Of A 'Yellow Vest' Protester France: La Marche A Suivre? France: La Marche A Suivre? How many French people are actually protesting? Although there was a slight pickup in protests at the beginning of January, nationwide numbers 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 5). If we are to compare these protests to those in 1995 or 2010, the numbers pale in comparison (Table 1). 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 6). Chart 5   Table 1In A Glorious History Of Protests, 'Yellow Vests' Are A Footnote France: La Marche A Suivre? France: La Marche A Suivre? Chart 6   Instead 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. In the Spanish case, the right-of-center government of Mariano Rajoy plowed ahead with painful, pro-market reforms that have significantly improved Spain’s competitiveness. Thus the yellow vests should not have a major impact on Macron’s reform agenda. Although they have dragged his approval rating to historic lows (Chart 7), there is no constitutional procedure for the French president to lose power. The president’s mandate runs until 2022 and he has a solid 53% of the seats in the Assemblée Nationale. In other words, despite the consensus view – including among voters (Chart 8) – that he will not be able to implement the reforms he had planned, he still has the political power to push forward new initiatives. Chart 7...Although Macron Wishes He Was Sarkozy! ...Although Macron Wishes He Was Sarkozy! ...Although Macron Wishes He Was Sarkozy! Chart 8 Nevertheless, Macron will certainly have to 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. The reforms brought forward in response to the protest are highlighted in Table 2. This should help reduce the movement’s fervor or otherwise its support. Table 2Macron’s Reforms: The Scorecard France: La Marche A Suivre? France: La Marche A Suivre? More importantly, Table 2 provides a list of the main reforms that have been implemented, proposed, or are yet to be completed since the election. The pace and breadth of these reforms come close to a revolution by the standards of the past forty years.2 What really matters is how these reforms tackle the following three key issues: the size of the state, the cost of financing such a large state, and the inflexible labor market. Macron is making progress on the latter two.  Labor reforms, effective since the beginning of 2018, simplify a complex labor code to allow for more negotiations at the company level, leaving unions outside the process. They also establish ceilings on damages awarded by labor courts, which represent a real burden on small and medium-sized French companies. The objective is to better align firm-level wage and productivity developments and encourage hiring on open-ended contracts. Education and vocational reforms aim at reducing the slack in the economy by reallocating skills. The youth unemployment rate, and the percentage of the youth population not in education, employment, or training, are both high (Chart 9). This is very relevant for the labor market given that the lack of skilled labor is the most important barrier to hiring (Chart 10), more so than regulation or employment costs. Chart 9Stagnant Youth Employment Figures... Stagnant Youth Employment Figures... Stagnant Youth Employment Figures... Chart 10...Are A Product Of Skill Deficiencies And Economic Uncertainty ...Are A Product Of Skill Deficiencies And Economic Uncertainty ...Are A Product Of Skill Deficiencies And Economic Uncertainty The administration’s weak spot is the large size of the state, which is undeniably at the root of the French malaise. At 55% of GDP, total government spending makes the French state the largest amongst developed economies (Chart 11). Although cutbacks have been announced, they have not materialized yet. These would include bringing the defense budget back to 2% of GDP, decreasing the number of deputies in the National Assembly by 30%, and cutting 120,000 jobs in the public sector. Chart 11 On the bright side, polls show that the French people understand the need to pare back the state. Indeed, 71% are in favor of the announced 100 billion euro cuts in government spending by 2022. Even Marine Le Pen campaigned on the promise of cutting the size of the public sector. Despite having a relatively good opinion of government employees, the majority of respondents approve of increasing work hours and job cuts for redundant government employees (Chart 12). Chart 12 The fundamental problem of a large public sector is that it has to be financed by taxing the private sector. This has fallen on the shoulders of businesses. However, under Macron, the corporate tax rate is set to decline progressively from 33.33% to 25% by 2022 – a cut of 8.3% in the corporate tax rate over four years (Chart 13). Chart 13Respite Coming For The Private Sector Respite Coming For The Private Sector Respite Coming For The Private Sector Bottom Line: 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. The global media’s focus on the protests ignores the structural reforms that Paris has already passed. This is a mistake as the reforms have been significant thus far, though much remains to be done. What To Expect Going Forward? Macron stands in what we call the “danger zone” of the J-Curve of structural reform (Diagram 2). Cutting the size of the state might be what he needs to get out of that zone over the course of his term. Diagram 2In The Danger Zone Of The J-Curve France: La Marche A Suivre? France: La Marche A Suivre? Unlike the last two presidents, Macron’s term has begun with a whirlwind. If he stops now, it is highly unlikely that he will recover his support levels. As such, there is no strategic reason why he would reverse course. His popularity is already in the doldrums. His only chance at another term is to plow ahead and campaign in 2022 on his accomplishments. He just needs to ensure that he will not plow into a rock. As expected, Macron has not made any mention of 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. Pension reforms, however, 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 with its own calculation rules. Though protests (both yellow vest and otherwise) have been unimpressive by historical standards (Table 1), it might be too risky for the government to push the pension reform so close to these events. Bottom Line: Macron has turned France into one of the fastest-reforming countries in Europe. Do not read too much into the lows in approval rating and the protests. Macron has no choice but to own the reform agenda and try to campaign on it in 2022. France Is Not Hopelessly Condemned To Stagnation No country elicits investor doom and gloom like France. It is like the adage that Brazil has been turned on its head: France is the country of the past and always will be. However, we think that such pessimism ignores three important structural tailwinds.  Demographics From 2015 to 2050, the age distribution will remain broadly unchanged (Chart 14). The same cannot be said of Italy or Germany, where low fertility rates and ageing populations will permanently shift the demographic picture. Indeed, France has the highest fertility rate amongst advanced economies and less than 20% of the population is older than 65 (Chart 15). And France is far from relying on net migration to keep its population growing; migration represented only 27% of total population growth between 2013 and 2017, lower than in the U.S., the U.K. and Germany even if we were to exclude the migration crisis (Chart 16). Chart 14   Chart 15France Has Healthy Demographics… Positive Demographic Trends Positive Demographic Trends Chart 16 Whenever one mentions France’s positive demographics, criticism emerges that the high fertility rate is merely the result of migrants having lots of kids. This is not entirely correct. While data is scarce due to nineteenth century laws prohibiting censuses based on race or religious belief, data from neighboring European states shows that the birth rate among migrants and citizens of migrant descent essentially declines to that of the native population by the second generation, which in France remains at the replacement level.3 Solid population growth will be a boon to the French economy. A stable dependency ratio – the ratio of working-age to very old or very young people – should limit the burden on government budgets. Further, France will avoid the downward pressure on aggregate household savings associated with an ageing population, the negative implications of a smaller pool of funds available to the private sector, and the resulting inflationary pressures. We also expect the structural rise in European elderly labor force participation to finally take effect in France. The aftermath of the Great Recession and the burden of having to provide for unemployed youth should spur French retirees to work longer. At 3.1%, France is still some way behind Germany at 7% and the average of 6% for European countries (Chart 17). Chart 17Time For Pépère To Get Back To Work Time For Pépère To Get Back To Work Time For Pépère To Get Back To Work Together, these forces imply a higher long-term French potential growth. Based on demographic divergence alone, the European Commission expects French nominal GDP to overtake German nominal GDP by 2040. The French Savoir-Faire France has lost competitiveness in the global marketplace. French export performance has suffered from decades of rigidities and high unit-labor costs while some of France’s peers, such as Germany, benefited greatly from an early implementation of labor reforms (Chart 18). While pro-growth and pro-market reforms ought to reverse some of these trends, France can still rely on a manufacturing savoir-faire that gives it a strong foothold in high value-added sectors of manufacturing, such as in transportation, defense, and aeronautics. Chart 18The Hartz Reforms Gap The Hartz Reforms Gap The Hartz Reforms Gap Table 3 lists the 10 largest export sectors as a share of total exports for France and Germany. These two economies share five similar categories of exports amongst their largest exports, representing respectively 23.8% and 24.3% of their total exports. However, France displays a substantially higher revealed comparative advantage (RCA) in its flagship sectors.4 In other words, the level of specialization of these sectors relative to the world average is higher in France than in Germany. Going forward, it is precisely this level of specialization in the high value-added sectors that will support the French manufacturing industry. Table 3France Vs. Germany: Closer Than You Think France: La Marche A Suivre? France: La Marche A Suivre? We also view the bullish trends for defense spending and arms trade, and the burgeoning EM demand for transportation goods, as important tailwinds for French manufacturing. France is the world’s fourth-largest global defense exporter and will benefit from shifting geopolitical equilibriums caused by multipolarity. France is also well positioned in the transportation sector where its exports to EM countries represent 20% of its overall transportation exports – a share that more than doubled in the past 15 years (Chart 19). While this trend is currently declining with the end of Chinese industrialization, we expect that it will resume over the next several decades as more EM and FM economies grow. Chart 19EM: A Growth Market For France EM: A Growth Market For France EM: A Growth Market For France France Is Much More Business-Friendly Than You Think A surge in the number of businesses created followed the election of the French president. Last year, more than 520,000 new businesses were created (Chart 20). Chart 20The New 'Start-Up Nation' The New "Start-Up Nation" The New "Start-Up Nation" The ease of doing business has improved on various metrics and the economy-wide regulatory and market environment should continue on this trend, as measured by the OECD product market regulation indicator (Chart 21). For instance, it takes only three and a half days to set up a business in France and no more than five steps, which is much easier than in most European countries. Chart 21 France also ranks 10th on the Global Entrepreneurship Index – a measure of the health of entrepreneurship ecosystems in 137 countries. It appears prepared for more tech start-ups as it ranks amongst the top countries on the Technological Readiness Index. Overall, France is now a much more attractive destination for investments (Chart 22). It appears that Brexit uncertainty is also driving some long-term capital investments. Between 2016 and 2017, the number of FDI projects in France jumped by 31% and Paris has become the most attractive European city for foreign direct investments (Chart 23). Chart 22 Chart 23Paris: The City Of (Love) FDI Paris: The City Of (Love) FDI Paris: The City Of (Love) FDI Cyclical View Despite the end of QE, markets do not expect the ECB to start hiking rates in the next 12 months – the expected change in ECB policy rate as discounted by the Overnight Index Swap curve is only 7 bps. This means the private sector will keep benefiting from extremely low lending rates, nearing 2%. Bank loans to the private sector will continue growing at a solid pace (Chart 24). Chart 24Banks Are Itching To Lend Banks Are Itching To Lend Banks Are Itching To Lend A lower unemployment rate and accelerating wage growth are positive for both consumer spending and residential investment. Average monthly earnings have strongly rebounded in the past five quarters (Chart 25). These two trends could put a floor under deteriorating household confidence and support consumer spending (Chart 26). Should household confidence rebound, consumers might spend more and stimulate the economy given their high savings rate. Chart 25Consumers Are Primed To Consume Consumers Are Primed To Consume Consumers Are Primed To Consume Chart 26But Protests Have Dented Confidence But Protests Have Dented Confidence But Protests Have Dented Confidence How does this dynamic translate in economic growth? Despite the setback experienced by the euro area – due to weaker external demand, or “vulnerabilities in emerging markets” to use the European Central Bank’s (ECB) own words – and the negative economic impact of the yellow vests, French real GDP grew by 1% (annualized) in the fourth quarter. The concessions made by Macron to answer the protests will bring the budget deficit close to 3.2% of GDP – from an earlier projection of 2.8%. The fiscal thrust will contribute positively to GDP growth (Chart 27), though 2020 may witness a larger fiscal drag.  Chart 27Macron Has Given Up On Austerity Macron Has Given Up On Austerity Macron Has Given Up On Austerity Bottom Line: The overall fundamentals of the economy are not as bad as the pessimists say. Cyclical and structural tailwinds will support the French economy going forward and should be reinforced by reforms. Can Europe Be Set En Marche Too? Macron’s presidency offers the European Union a window of opportunity to change structurally. He is already perceived as the “default leader” of Europe and might be the answer to the EU’s desperate need for strong leadership. What we have so far looks like a roadmap for a roadmap, but some progress could materialize this year. The European Stability Mechanism (ESM) – the European instrument for economic crisis prevention – is supposed to be granted new powers. At the Euro Summit in December, the ministers agreed on the terms of reference of the common backstop to the euro zone bank resolution fund (SRF), which would allow the ESM to lend to the SRF should a crisis or number of crises suck away all its funds. It would be ready from 2024 to come up with loans for bank resolution. While this may appear to be too late to make a difference in the next recession, we would remind clients that all dates are malleable in the European context. The possibility of the ESM playing a role in a potential sovereign debt restructuring in the future, like a sort of “European IMF,” was also discussed. However, some – including the ESM’s leadership – argue that such an expanded role will necessitate a greater injection of capital, which obviously Berlin must accept. Second, the stalled Banking Union project requires Berlin’s intimate involvement. In fact, Germany remains practically the only member state against the European Deposit Insurance Scheme (EDIS). This deposit insurance union would go a long way toward stabilizing the Euro Area amid future financial crises. However, a high-level working group should report by June 2019. As such, with Merkel sidelined and Macron taking leadership of the reform process, there could be movement on the EDIS by mid-year. Bottom Line: As Merkel exits the stage, France is likely to seize the opportunity to take the leading role from the Germans. By delivering the reforms he promised during his campaign and thus performing effectively at home, Macron hopes to obtain the legitimacy to set the EU en marche as well. Some material progress could be achieved as early as June this year. Stay tuned.   Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1      According to the government, 10,500 “red scarves” marched in Paris on January 27, 2018. 2      Sans the guillotine! 3      Rojas, Bernardi, and Schmid, “First and second births among immigrants and their descendants in Switzerland,” Demographic Research 38:11 (2018), pp. 247-286, available at https://www.demographic-research.org/Volumes/Vol38/11/Ariane Pailhé, “The convergence of second-generation immigrants’ fertility patterns in France: The role of sociocultural distance between parents’ and host country,” Demographic Research 36:45 (2017), pp. 1361-1398, available at https://www.demographic-research.org/Volumes/Vol36/45/Kulu et al., “Fertility by Birth Order among the Descendants of Immigrants in Selected European Countries,” Population And Development Review 43:1 (2017), pp. 31-60, available at https://doi.org/10.1111/padr.12037  4      A country displays a revealed comparative advantage in a given product if it exports more than its “fair” share, that is, a share that is equal to the share of total world trade that the product represents.