Geopolitics

Highlights President Trump has little to do with the ongoing EM selloff; The macro backdrop is the real culprit behind Turkey's woes, particularly the strong dollar... ... Which is a product of global policy divergence, with the U.S. stimulating while China pursues growth-constraining reforms; Chinese stimulus is important to watch, as it could change the game, but we do not expect China to save EM as it did in 2015; Turkey's troubles are a product of its late-stage populist cycle and will not end with Trump's magnanimity; The positive spin on the EM bloodbath is that it may force the Fed to slow its rate hikes, prolonging the business cycle. Feature Chart 1EM: Bloodbath EM: Bloodbath EM: Bloodbath Markets are selling off in Turkey and the wider EM economies (Chart 1), with the financial media focusing on the actions taken by the U.S. President Donald Trump in the escalating diplomatic spat between the two countries. Investors should be very clear what it means to ascribe the ongoing selloff to President Trump's aggressive posture with Ankara in particular and trade in general. If President Trump started EM's troubles with his tweets, he can then end them with another late-night missive. This is not our view. Turkey is enveloped in a deep morass of populism and weak fundamentals since at least 2013. What is worse, the ongoing selloff is likely going to ensnare at least the other fragile EM economies and potentially take down EM as an asset class. In this Report, we recount the pernicious macro backdrop - both geopolitical and economic - that EM economies face today. We then focus on Turkey itself and show that President Trump has little to do with the current selloff. The Bloodbath Is Afoot, Again Every financial bubble, and every financial bust, begins with a compelling story grounded in solid fundamentals. The now by-gone EM "Goldilocks Era" (2001-2011) was primarily driven by exogenous factors: a generational debt-fueled consumption binge in DM; an investment-fueled double-digit growth rate in China that kicked off a structural commodity bull market; and the unleashing of pent-up EM consumption/credit demand (Chart 2).1 These EM tailwinds petered out by 2011. Subsequently, China and EM economies entered a major downtrend that culminated in a massive commodity rout that began in 2014. But before the bloodbath could motivate policymakers to initiate painful structural reforms, Chinese policymakers stimulated in earnest. In the second half of 2015, Beijing became unnerved and injected enormous amount of credit and fiscal stimulus into the mainland economy (Chart 3). The intervention, however, did not change the pernicious fundamentals driving EM economies but merely caused "a mid-cycle recovery, or hiatus, in an unfinished downtrend," as our EM strategists have recently pointed out (Chart 4).2 Chart 2Goldilocks Era##BR##Is Over For EM Goldilocks Era Is Over For EM Goldilocks Era Is Over For EM Chart 3Is China About To Cause Another##BR##EM Mid-Cycle Recovery? Is China About To Cause Another EM Mid-Cycle Recovery? Is China About To Cause Another EM Mid-Cycle Recovery? Take Brazil, for example. Instead of using the 2014-2015 generational downturn to double-down on painful fiscal and pension reforms, the country's politicians declared President Dilma Rousseff to be the root-cause of all evil that befell the nation, impeached her in April 2016, and then proceeded to unceremoniously punt all painful reforms until after this year's election (if ever). They were enabled to do so by the "mid-cycle recovery" spurred by Chinese stimulus. In other words, Brazil's policymakers did nothing to actually deserve the recovery in asset prices but got one anyway. The country now will experience "faceoff time" with the markets, with no public support for painful reforms (Chart 5) and hardly an orthodox candidate in sight ahead of the October general election.3 Chart 4Where Are China/EM In The Cycle? Where Are China/EM In The Cycle? Where Are China/EM In The Cycle? Chart 5Brazil's Population Is Not Open To Fiscal Austerity The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Could Brazilian and Turkish policymakers be in luck, as Chinese policymakers have blinked again?4 Our assessment is that the coming stimulus will not be as stimulative as in 2015. First, President Xi's monetary and fiscal policy, since coming into office in 2012, has been biased towards tightening (Chart 6). Second, Chinese leverage has plateaued (Chart 7). In fact, "debt servicing" is now the third-fastest category of fiscal spending growth since Xi came to power (Table 1). Third, the July 31 Politburo statement pledged to make fiscal policy "more proactive" and "supportive," but also reaffirmed the commitment to continue the campaign against systemic risk. Chart 6Xi Jinping Caps##BR##Government Spending And Credit Xi Jinping Caps Government Spending And Credit Xi Jinping Caps Government Spending And Credit Chart 7The Rise And Plateau##BR##Of Macro Leverage The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Whether China's mid-year stimulus will be globally stimulative is now the question for global investors. The key data to watch out of China will be August credit numbers, to be released September 9th through 15th. Is President Trump not to be blamed at all for the EM selloff? What about the trade war against China? If anything, tariffs against China have caused Beijing to "blink" and implement some stimulative measures this summer. If one must find fault in U.S. policy, it is the double dose of fiscal stimulus that has endangered EM economies. A key theme for BCA's Geopolitical Strategy this year has been the idea that global policy divergence would replace the global growth convergence.5 Populist economic stimulus in the U.S. and structural reforms in China would imperil growth in the latter and accelerate it in the former, forming a bullish environment for the U.S. dollar (Chart 8). Table 1Total Government Spending Preferences (Under Leader's General Control) The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Chart 8U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD As such, the White House is partly responsible for the EM selloff, but not in any way that can be changed with a tweet or a handshake. Furthermore, we do not see the upcoming U.S. midterm election as somehow capable of altering the global growth dynamics.6 It is highly unlikely that Democrats will seek to spend less, and they cannot raise taxes under Trump. Bottom Line: EM economies have never adjusted to the end of their Goldilocks era. A surge in global liquidity pushed investors further down the risk-curve, propping up EM assets despite poor macro fundamentals. China's massive 2015-2016 stimulus arrested the bear market, giving investors a perception that EM economies had recovered. This mid-cycle hiatus, however, has now been overtaken by the global policy divergence between Washington and Beijing, which is bullish USD. President Trump's trade tariffs and aggressive pressure on Turkey do not help. However, they are merely the catalyst, not the cause, of the selloff. As such, investors should not "buy" EM on a resolution of China-U.S. trade tensions or of the Washington-Ankara diplomatic dispute. Contagion Risk BCA's Emerging Market Strategy is clear: in all episodes of a major EM selloff, the de-coupling between different regions proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside (Chart 9).7 One reason to expect contagion risk among all EM markets is that the primary export market for China and other East Asian exporters are other EM economies, particularly the commodity producers (Chart 10). As such, it is highly unlikely that East Asian EM economies will be able to avoid a downturn. In fact, leading indicators of exports and manufacturing, such as Korea's manufacturing shipments-to-inventory ratio and Taiwan's semiconductor shipments-to-inventory ratio herald further deceleration in their respective export sectors (Chart 11). Chart 9Asian And Latin American Equities:##BR##Unsustainable Divergences Asian And Latin American Equities: Unsustainable Divergences Asian And Latin American Equities: Unsustainable Divergences Chart 10EM Trades##BR##With EM EM Trades With EM EM Trades With EM Chart 11Asia Export##BR##Slowdown Is Afoot Asia Export Slowdown Is Afoot Asia Export Slowdown Is Afoot In respect of foreign funding requirements of EM economies, our EM strategists have pointed out that there is a substantive amount of foreign currency debt coming due in 2018 (Table 2), with majority EM economies facing much higher foreign debt burdens than in 1996 (Table 3).8 Investors should not, however, rely merely on debt as percent of GDP ratios for their vulnerability assessment. For example, Malaysia's private sector FX debt load stands at 63.7% of GDP, the second highest level after Turkey. But relative to total exports (a source of revenue for its indebted corporates) and FX reserves (which the central bank can use to plug the gap in the balance of payments), Malaysia actually scores fairly well. Table 2EM: Short-Term (Due In 2018) FX Debt The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Table 3EM Private Sector FX Debt: 1996 Versus Today The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Chart 12 shows the most vulnerable EM economies in terms of foreign currency private sector debt exposure relative to FX reserves and total exports. Unsurprisingly, Turkey stands as the most vulnerable economy, along with Argentina, Brazil, Indonesia, Chile, and Colombia. Chart 12BCA's Emerging Markets Strategy Has Already Pinned Turkey As The Most Vulnerable EM Economy The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Will the EM selloff eventually ensnare DM economies as well, particularly the U.S.? We think yes. The drawdown in EM will bid up safe-haven assets like the U.S. dollar. The dollar can be thought of as America's second central bank, along with the Fed. If both the greenback and the Fed are tightening monetary conditions, eventually the U.S. economy will feel the burn. As such, it is dangerous to dismiss the ongoing crisis in Turkey as a merely localized problem that could, at its worst, spread to other EM economies. In 1997, Thailand played a similar role to that of Turkey. The Fed tightened rates in early 1997 and largely remained aloof of the developing East Asia crisis that eventually spread to Brazil and Russia, ignoring the tumult abroad until September 1998 when it finally cut rates three times. Fed policy easing at the end of 1998 ushered in the stock market overshoot and dot-com bubble, whose burst caused the end of the economic cycle. The same playbook may be occurring today. The Fed, motivated by the strong U.S. economy and fears of being too close to the zero-bound ahead of the next recession, is proceeding apace with its tightening cycle. It is likely to ignore troubles in the rest of the world until the USD overshoots or U.S. equities are impacted directly. At that point, perhaps later this year or early next year, the Fed will back off from tightening, ushering the one last overshoot phase ahead of the recession in 2020 - or beyond. Bottom Line: Research by BCA's EM strategists shows that EM contagion is almost never contained in just a few vulnerable economies. For investors who have to remain invested in EM economies, we would recommend that they go long Chinese equities relative to EM, given that Beijing policymakers are stimulating the economy to ensure that Chinese growth is stabilized. While this will be positive for China, it is likely to fall short of the 2015 stimulus that also stimulated non-China EM. An alternative play is to go long energy producers vs. the rest of EM - given our fundamentally bullish oil view combined with rising geopolitical risks regarding sanctions against Iran.9 We eventually expect EM risks to spur an appreciation in the USD that the Fed has to lean against by either pausing its tightening cycle, or eventually reversing it as it did in the 1997-1998 scenario. This decision will usher in the final blow-off stage in U.S. equities that investors will not want to miss. What About Turkey? Chart 13Turkey: Volatile Politics, Volatile Stocks Turkey: Volatile Politics, Volatile Stocks Turkey: Volatile Politics, Volatile Stocks In 2013, we called Turkey a "canary in the EM coal mine" arguing that its historically volatile financial markets would mean-revert as domestic politics became turbulent (Chart 13).10 Turkey is a deeply divided society equally split between the secularist cities, which are primarily located on the Mediterranean (Istanbul, Izmir, Bursa, Adana, etc.), and the religiously conservative Anatolian interior. This split dates back to the founding of the modern Turkish Republic in the post-World War I era (and in truth, even before that). The ruling Justice and Development Party (AKP), a religiously conservative but initially pro-free-market party, managed to appeal to the conservative Anatolia while neutering the most powerful secularist institution in Turkey, its military. Investors hailed AKP's dominance because it reduced political volatility and initially promised both pro-market policies and even accession to the EU. However, the AKP has struggled to win more than 50% of the popular vote in a slew of elections and referendums since coming to power (Chart 14), a fact that belies its supposed iron-grip hold on Turkish politics since it came to power in 2002. The vulnerability behind AKP's hold on office has largely motivated President Recep Tayyip Erdogan's attempt to consolidate political power. While we disagree with the consensus view that Erdogan's constitutional changes have turned Turkey into a dictatorship, some of his actions do suggest a deep fear of losing power.11 Populist leadership is characterized by a strategy of "giving people what they want" so that the policymakers in charge remain in office. Erdogan's perpetually slim hold on power has motivated several populist policy decisions that have stretched Turkey's macro fundamentals. First, Turkey's central bank has essentially been conducting quantitative easing since 2013 via net liquidity injections into the banking system (Chart 15). Notably, these injections began at the same time as the May 2013 Gezi Park protests, which saw a huge outpouring of anti-government sentiment across Turkey's large cities. Essentially, politics has been motivating Ankara's monetary policy over the past five years. Chart 14AKP's Stranglehold On Power Is Overstated The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Chart 15Turkey's Populist Policies Began##BR##With Gezi Park Protests Turkey's Populist Policies Began With Gezi Park Protests Turkey's Populist Policies Began With Gezi Park Protests Second, Turkey's current account balance has suffered under the weight of rising energy costs, with no attempt to improve the fiscal balance (Chart 16). The government has done little in terms of structural reforms or fiscal austerity, instead President Erdogan has continued to challenge central bank independence on interest rates, despite a clear sign that the country is experiencing a genuine inflationary breakout (Chart 17). Chart 16Populism Means No Austerity Is In Sight Populism Means No Austerity Is In Sight Populism Means No Austerity Is In Sight Chart 17Genuine Inflation Breakout Genuine Inflation Breakout Genuine Inflation Breakout Overall, Turkey is a classic example of how populism in a highly divided and polarized country can get out of control. Foreign investors have long assumed that Erdogan's populism was benign, if not even positive, given the presumably ample political capital at the president's disposal. However, with every election or referendum, the government did not double-down on pro-market structural reforms. Instead, the pressure on the central bank only increased while Turkey's expensive and extravagant geopolitical adventures in neighboring Syria accelerated. In this pernicious macro context, it has not taken much to knock Turkey's assets off balance. President Trump's threats to expand sanctions to Turkish trade are largely irrelevant, given that the vast majority of Turkey's exports and FDI sources are non-American (Chart 18). However, given past behavior - such as after the shadowy Gülen "plot" to take over power or the 2016 coup d'état - markets are by now conditioned to expect that Turkish policymakers will double-down on populist policies in the face of renewed pressure. Chart 18Turkey-U.S. Relationship Is Not Economic Turkey-U.S. Relationship Is Not Economic Turkey-U.S. Relationship Is Not Economic What of Turkey's membership in NATO? Should investors fear broader geopolitical instability due to the domestic crisis? No. Ankara has used its membership in NATO, and particularly the U.S. reliance on its Incirlik air base in southern Turkey, as levers in previous negotiations and diplomatic spats with Europe and the U.S. If Ankara were to renege on its commitments to the Western military alliance, it would likely face a united front from Europe and the U.S. As such, we would expect Turkey neither to threaten exit from NATO, which it has not done in the past, nor even to threaten U.S. operations in Incirlik, which Erdogan's government has threatened before. The most likely outcome of the ongoing diplomatic spat, in fact, would be to see Ankara give in to U.S. demands, given the accelerating financial and economic crisis. Such an outcome, however, will not arrest the downturn. Turkey's economy and assets are fundamentally under pressure due to the realization by investors that this year's main macro theme is not the resynchronized global growth recovery, but rather the global policy divergence between the U.S. and China, which has appreciated the U.S. dollar. No amount of kowtowing by Ankara will change this macro trend. Bottom Line: The list of Turkish policy sins is long. Erdogan's reign has been characterized by deep polarization and populism, leading to suboptimal policy choices since at least 2013. The latest U.S.-Turkey spat is therefore merely one of many problems plaguing the country. As such, its resolution will not be a buying opportunity for investors. Investment Implications Our main investment theme in 2018 was that the global policy divergence between the U.S. and China - emblematized by fiscal stimulus in the U.S. and structural reforms in China - would end the global growth resynchronization. As the U.S. economy outperformed the rest of the world, the U.S. greenback would appreciate, imperiling EM economies. The best cognitive roadmap for today is the late 1990s, when the U.S. economy continued to grow apace as the rest of the world suffered from an EM crisis. The problems eventually washed onto American shores in the form of a stronger dollar, forcing the Fed to back off from tightening in mid-1998. Policy easing then led to the overshoot phase in U.S. equities in 1999. Investors should prepare for a similar roadmap by being long DXY relative to EM currencies, long DM equities (particularly U.S.) relative to EM equities, and tactically cautious on all global risk assets. Strategically, however, it makes sense to remain overweight equities as a Fed capitulation would be a boon for risk assets. If the current selloff in EM gets worse, we would expect that the Fed would again back off from tightening as it did in 1998, ushering in a blow-off stage in equities ahead of the next recession. Once the dollar peaks and EM assets bottom, U.S. equities will become the laggard, with global cyclicals outperforming. A secondary conclusion is that President Trump's trade rhetoric in general, and aggressive policies towards Turkey in particular, are merely a catalyst for the selloff. As such, if President Trump changes his mind, we would fade any rally in EM assets. The fundamental policy decisions that have led to the greenback rally have already been taken in 2017 and early 2018. The profligate tax cuts and the two-year stimulative appropriations bill, combined with Chinese policymakers' focus on controlling financial leverage, are the seeds of the current EM imbroglio. Finally, a small bit of housekeeping. We are booking gains on our long Malaysian ringgit / short Turkish lira trade for a gain of 51.2% since May. We are also closing our speculative long Russian equities relative to EM trade for a loss of -0.9% as a result of the persistent headwind from U.S. sanctions. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," dated July 19, 2018, available at ems.bcaresearch.com. 3 Please see BCA Emerging Markets Special Report, "Brazil: Faceoff Time," dated July 27, 2018, available at ems.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "China: How Stimulating Is The Stimulus?" dated August 8, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, and Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018, available at ems.bcaresearch.com. 8 Please see BCA Emerging Markets Strategy Special Report, "A Primer On EM External Debt," dated June 7, 2018, available at ems.bcaresearch.com. 9 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," dated July 19, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Monthly Report, "Turkey: Canary In The EM Coal Mine?" in "The Coming Political Recapitalization Rally," dated June 13, 2013, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Weekly Report, "Turkey: Deceitful Stability," in "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com.

According to market lore, one should never say, "It's Different This Time". But every time is always different: there is a never a previous period that perfectly matches the current environment. That is why forecasting is so difficult and why all model-based predictions should be treated with caution. Yet, some basic common sense can go a long way in helping to assess investment risks and potential rewards. As I look at the world, it looks troubled enough to warrant a very conservative investment stance, but that clearly puts me at odds with the majority of investors. In aggregate, investors and market analysts are upbeat. Major equity indexes are close to all-time highs, earnings expectations are ebullient and surveys of investor sentiment do not imply much concern about the outlook. There is a strong consensus that a U.S. recession will not occur before 2020, meaning that risk assets still have decent upside. That may indeed turn out to be true, but I can't shake off my concerns about a number of issues: The consensus may be too complacent about the timing of the next U.S. recession. The dark side of current strong growth is growing capacity pressures that warn of upside surprises for inflation and thus interest rates. Uncertainty about trade wars represents a risk to the global economic outlook beyond the direct impact of tariffs because it also gives companies a good reason to hold back on investment spending. Profit growth in the U.S. has remained much stronger than I expected, but the forces driving this performance are temporary. Rising pressures on wages suggest that labor's share of income will rise, leading to lower margins. The geopolitical environment is ugly, ranging from a shambolic Brexit process to rising populist pressures in Europe, a flaring in U.S./Iran tensions and possible disappointment with North Korea negotiations. The Debt Supercycle may be over, but global debt levels remain worryingly high in several major economies. This could become a problem in the next economic downturn. It would be easier to live with the above concerns if markets were cheap, but that is far from the case - especially in the U.S. Credit spreads in the corporate bond market are below historical averages while equities continue to trade at historically high multiples to earnings. Even if equity prices do move higher, the upside from current levels is likely to be limited. Yes, there could be a final, dramatic blow-off phase similar to that of the late 1990s, but that would be an incredibly risky period and not one that I would want to participate in. Timing The Next Recession Sad to say, economists do a very poor job of forecasting recessions. As I showed in a report published last year, the Fed has missed every recession in the past 60 years (Table 1).1 One could argue that the Fed could never publish a forecast of recession because it would be an admission of policy failure: they generally have to be seen aiming for soft landings. But private forecasters have not done any better. For example, the consensus of almost 50 private forecasters published in mid-November 2007 was that the U.S. economy would grow by 2.5% in the year to 2008 Q4.2 The reality was that the economy was then at the precipice of its worst downturn since the 1930s. Table 1Fed Economic Forecasts Versus Outcome Personal Observations On The Current Environment Personal Observations On The Current Environment The U.S. economy currently is very strong, but that often is the case just a few quarters before a recession starts. Strong growth today is not a predictor of future strong growth. As has been widely acknowledged, the yield curve has been one of the few indicators to give advance warning of economic trouble ahead. Yet, in the past, its message typically was ignored or downplayed, with the result that most forecasters stayed too bullish on the economy for too long. History is repeating itself with a flurry of reports explaining why the recent flattening of the yield curve is giving a misleading signal. The principal argument is that term premiums have been artificially depressed by the Fed's bond purchases. However, the curve has flattened even as the Fed has pulled back from quantitative easing. As usual, the flattening reflects the tightening in monetary policy and, therefore, should not be discounted. To be fair, there is still a positive slope across the curve, so this indicator is not yet flashing red. But it is headed in that direction (Chart 1). Chart 1Recession Indicators: Not Flashing Red...Yet Recession Indicators: Not Flashing Red...Yet Recession Indicators: Not Flashing Red...Yet The other series to watch closely is the Conference Board's Leading Economic Index. Typically, the annual rate of change in this index turns negative ahead of recessions, although once again, there is a history of forecasters ignoring or downplaying the message of this signal. Currently, the growth in the index is firmly in positive territory, so no alarm bells are ringing. Overall, there are no indications that a U.S. recession is imminent. At the same time, late cycle pressures and thus risks are building. Anecdotal evidence abounds of labor shortages and supply bottlenecks in a number of industries. Wage growth has stayed relatively muted given the low unemployment rate, but that is starting to change. My colleague Peter Berezin has shown compelling evidence of a "kinked" relationship between wage growth and unemployment whereby the former accelerates noticeably after the latter drops below its full employment level (Chart 2). We are at the point where wage growth should accelerate and it is significant that the 2.8% rise in the employment cost index in the year to the second quarter was the largest rise in a decade. It also should be noted that the Fed's preferred inflation measure (the core personal consumption deflator) has been running at around a 2% pace in the past three quarters, in line with its target (Chart 3). As capacity pressures build, an overshoot of 2% seems inevitable, forcing the Fed to react. Current market expectations that the funds rate will rise by only 25 basis points over the remainder of this year and by 100 basis points in 2019 are likely to prove too optimistic. Chart 2Faster Wage Growth Ahead Personal Observations On The Current Environment Personal Observations On The Current Environment Chart 3Core Inflation At The Fed's Target Core Inflation At The Fed's Target Core Inflation At The Fed's Target Admittedly, there is huge uncertainty about what interest rate level will be restrictive enough to damage growth. Historically, recessions did not occur until the fed funds rate reached at least the level of potential GDP growth. The Congressional Budget Office estimates that potential GDP growth will average around 4% over the coming year, and the funds rate probably will not reach that level in 2019. However, additional restraint is coming from the strong dollar, and lingering high debt burdens mean that rates are likely to bite at lower levels than past relationships would suggest. Chart 4U.S. Trade Performance: No Major Surprises U.S. Trade Performance: No Major Surprises U.S. Trade Performance: No Major Surprises Trade Wars Etc. President Trump appears to believe that the large U.S. trade deficit is largely a reflection of unfair trade practices. The reality is obviously more complicated, even if there is truth to the claim that the playing field with China is far from level. The key drivers of trade imbalances are relative economic growth rates and relative real exchange rates. The trend in the volume of U.S. non-oil merchandise imports has been exactly in line with that of domestic demand for goods (Chart 4). In other words, there is no indication that the U.S. is being "taken advantage of". The growth in U.S. non-oil exports has been a little on the soft side relative to overseas growth in recent years, but that occurred against the background of a rising real dollar exchange rate. Overall, the trend in the ratio of U.S. real non-oil imports to exports has broadly followed the ratio of U.S. real GDP to that of other OECD economies. The periods where the trade ratio deteriorated somewhat faster than the GDP ratio were times when the real trade-weighted dollar was strong, such as in the past few years. The irony, which seems to escape the administration, is that recent policy actions - tax cuts and efforts to boost private investment spending - are bound to further boost the trade deficit. This may partly explain the clumsy attempt to encourage the Fed to slow down its rate hikes in order to dampen the dollar's ascent. Of course, that will not work - the Fed will not be deflected from its policy course by political interference. Meanwhile, the administration's imposition of tariffs will not change the underlying drivers of the U.S. trade deficit. I have no way of knowing whether current trade skirmishes will degenerate into an all-out war. There are some glimmers of hope with the EU and U.S. promising to engage in talks about reducing trade barriers. But the more important issue is what happens with China. While China has an economic incentive to make concessions, I cannot imagine that President Xi wants to be seen as giving ground in the face of U.S. bullying. My rather unhelpful conclusion is that trade wars are a serious risk that need watching but are unforecastable at this stage. Earnings Galore, But... It's confession time. The performance of U.S. corporate earnings has been far better than I have been predicting during the past few years. In several previous reports, I argued that earnings growth was bound to slow sharply as labor's share of income eventually climbed from its historically low level. I certainly had not expected that the annual growth in S&P 500 operating earnings would average 20% in the two years to 2018 Q2 (Chart 5). In defense, my original argument was not completely wrong. Labor's share of corporate income bottomed in the third quarter of 2014 and that marked the peak in margins, based on national income data of pre-tax profits (Chart 6). Margins have fallen particularly sharply for the national income measure of non-financial profits before interest, taxes and depreciation (EBITD). I believe this is a good measure of the underlying performance of the corporate sector as it is unaffected by policy changes to taxes, depreciation rates and monetary policy. This measure of margins used to be very mean reverting but currently is still far above its historical average. Given the tightness in the labor market, there is still considerable downside in margins as wage costs edge higher. Chart 5Spectacular U.S. Earnings Growth Spectacular U.S. Earnings Growth Spectacular U.S. Earnings Growth Chart 6Profit Margins Have Peaked Profit Margins Have Peaked Profit Margins Have Peaked An unusually large gap has opened up in recent years between S&P earnings data and the national accounts numbers. While there are several definitional differences between the two datasets, this cannot explain the large divergence shown in Chart 7. The national income data are generally believed to be less susceptible to accounting gimmicks and are thus a better reflection of underlying trends. Analysts remain extraordinarily bullish on future earnings prospects. Not only are S&P 500 earnings forecast to rise a further 14% over the next 12 months, but the current expectation of 16% per annum long-run earnings growth was only exceeded at the peak of the tech bubble (Chart 8). And we know how that episode ended! Chart 7A Strange Divergence in Profit Data A Strange Divergence in Profit Data A Strange Divergence in Profit Data Chart 8Insanely Bullish Long-Term Earnings Expectations Insanely Bullish Long-Term Earnings Expectations Insanely Bullish Long-Term Earnings Expectations I am inclined to stick to my view that earnings surprises will disappoint over the next year. The impact of corporate tax cuts will disappear, and both borrowing costs and wage growth are headed higher. A marked slowdown in earnings growth will remove a major prop under the bull market. Brexit As a Brit, I am totally appalled with the Brexit fiasco. It was all so unnecessary. Yes, the EU has an intrusive bureaucracy that imposes some annoying rules and regulations on member countries. However, OECD data show that the U.K. is one of the world's least regulated economies and it scores high in the World Bank's Ease of Doing Business rankings. In other words, there is no compelling evidence that EU bureaucratic meddling has undermined business activity in the U.K. The vote for Brexit probably had more to do with immigration than anything else, and that also makes little sense given that the U.K. has a tight labor market and needs a plentiful supply of immigrant workers. History likely will dictate that former Prime Minister David Cameron's decision to call for the Brexit referendum was the U.K.'s greatest political miscalculation of the post-WWII period. Not only was the decision to hold the referendum a mistake, but it also was foolhardy to base such a momentous vote on a simple majority rather than a super-majority of at least 60%. Adjusting the referendum result by voter turnout, those backing Brexit represented only around 37% of the eligible voting public.3 Clearly, the government was unprepared for the vote result and divorce proceedings have moved ahead with no viable plan to achieve an acceptable separation. Meanwhile, the inevitable confusion has created huge uncertainty for businesses and is doing significant damage to the economy. This is not the place to get into the minutiae of the Brexit morass such as the Northern Ireland border issue and the difficulty of agreeing new trade relationships. Those have been well aired in the press and by many other commentators. My lingering hope is that the enormous challenges of coming up with a mutually acceptable deal with the EU will prove intractable, resulting in a new referendum or election that will consign the whole idea to its grave. We should not have to wait too long to discover whether that is a futile wish. Investment Strategy Chart 9The U.S. Equity Market Is Expensive The U.S. Equity Market Is Expensive The U.S. Equity Market Is Expensive Equities are still in a bull market and we are thus in a period where investors are biased to be optimistic. Bears have been discredited and the current strength of the economy gives greater credence to the market's cheerleaders. I have been in the forecasting business for long enough (45+ years) to be suitably humble about my ability to forecast where markets are headed. I am very sympathetic to the famous Keynes quote that "the market can stay irrational longer than you can stay solvent". Investors will have their own set of preferences and constraints about whether it makes sense to stay heavily invested during times when markets appear to have diverged from fundamentals. The U.S. equity market's price-earnings ratio (PER) currently is about 20% above historical averages, based on both trailing and 12-month forward earnings and more than 30% above based on cyclically-adjusted earnings (Chart 9). Yes, interest rates are low by historical standards, giving scope for higher PERs, but rates are going up and profit margins are at historically elevated levels with lots of downside potential. I fully accept that equity markets can continue to rise over the next year, beating the meagre returns available from cash and bonds. For those investors being measured by quarterly performance, it is difficult to stay on the sidelines while prices march higher. Nevertheless, I believe this is a time for caution. The perfect time for equity investing is when markets are cheap, earnings expectations are overly pessimistic and the monetary environment is highly accommodative. Currently, the opposite conditions exist: valuations are stretched, earnings expectations are euphoric and the Fed is in tightening mode. It does not seem a propitious time to be aggressive. The future is always shrouded in mist, but there currently is an unusually large number of important economic and political questions hanging over the market. These include the timing of the next recession, the related path of monetary policy, the outcome of the U.S. midterm elections, trade wars, U.S.-Sino relations and Brexit, just to name a few. The good news is that our Annual Investment Conference on September 24/25 will be tackling these issues head on with an incredible group of experts. I am looking forward to hearing, among others, from Janet Yellen on monetary policy, Leland Miller and Elizabeth Economy on China, Greg Valliere on U.S. politics, and Stephen King and Stephen Harper on global trade. It promises to be an exceptional event and I hope to see you there. Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com 1 BCA Special Report "Beware The 2019 Trump Recession," March 7, 2017. Available at bca.bcaresearch.com. 2 Source: Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters (www.philadelphiafed.org). 3 The referendum result was 51.9% in favor of Brexit, with a voter turnout of close to 72%.

Highlights Editor's Note: I am pleased to return to U.S. Investment Strategy (USIS). I worked with the service when I joined BCA in 2010, and previously led it from August 2013 through September 2014. Sara Porrello, who has been with the team for over 20 years, and I look forward to re-aligning USIS with its original mandate. We hope you will find it consistently insightful. Best regards, Doug Peta U.S. Investment Strategy is getting back to basics: Today's report, plainly stating our position on the near-term direction of interest rates, is the first in an ongoing series meant to stake out our views on the macro issues that are most important to investors. Rates are headed higher, consistent with a booming economy that may well overheat, ... : Assuming trade tensions don't short-circuit the expansion, the U.S. economy is poised to grow above trend well into 2019. ...thanks to a tightening labor market and dubious fiscal spending, ... : Employers will be forced to bid up wages as the pool of idled and under-utilized workers dries up, and the fiscal stimulus package is all but certain to goose inflation pressures. ... and neither tweets nor testy interviews nor other expressions of presidential pique are likely to stay the Fed from its appointed rounds: The Federal Reserve cherishes its independence, and it is extremely unlikely to bow to presidential pressure. Feature U.S. Investment Strategy is meant to provide analyses of the U.S. economy and its future direction for the purpose of helping our clients make asset-allocation decisions. Starting with this report, we are going back to the basics of meeting that mandate. Over the rest of the summer, we intend to outline our positions on the key macro drivers of financial markets: rates, credit, the business cycle, and the state of monetary policy. Laying out our big-picture views, and the rationale underpinning them, will establish a framework for evaluating incoming data. The goal is to allow our clients to think along with us as new information is disseminated, and to distinguish signals from noise. We also want to make it easier for clients to anticipate the evolution of our views. To that end, will make frequent use of checklists highlighting the specific elements that might lead us to change our take on the evolution of the key cycles. The ultimate goal is to stay on top of cyclical inflection points, and to use them to inform asset-allocation decisions. The Fed Gets Its Way On Rates Monetary policy is a blunt instrument that works with indeterminate lags, and its effect has been roundly questioned. At the ends of the armchair-quarterback continuum, the Fed is mocked as a clueless bumbler, turning dials at random like a fumbling Mr. Magoo, or bemoaned as an omnipotent manipulator of financial markets and real-world activity. Strictly speaking, it controls nothing more than short rates. As its post-crisis communications strategy has shown, however, its reach extends well beyond its official policy-rate dominion. Talk of last decade's "conundrum" aside, changes in the fed funds rate reverberate along the entire yield curve. As the Chart Of The Week demonstrates, the aggregate yield on all outstanding Treasury issues is joined at the hip, directionally, with the fed funds rate. Aggregate weighted-average Treasury duration sits squarely in the belly of the curve, and it is a not-quite-perfect proxy for the long end, where the Fed's gravitational pull wanes (Table 1). Its pull is still powerful, though; the 90% correlation between the fed funds rate and the 30-year bond testifies eloquently to the Fed's significant influence at all points of the curve (Chart 2). Chart of the WeekThe Fed Gets Its Way The Fed Gets Its Way The Fed Gets Its Way The investment takeaway is that the Fed gets what it wants across the full spectrum of rates the vast majority of the time. Given the FOMC's repeatedly expressed intention to continue on its normalization course, the path of least resistance for rates at all maturities is higher. Despite the money markets' resistance to extrapolate the 25-bps-a-quarter "gradual pace" across the rest of this year and next (Chart 3), six more quarters of that pace is our baseline expectation provided an economic shock does not occur. Investors should be prepared for a higher peak in the fed funds rate than the consensus expects. Table 1Correlation With The Fed Funds##BR##Rate By Bond Maturity The Rates Outlook The Rates Outlook Chart 2The Long Arm##BR##Of The Fed The Rates Outlook The Rates Outlook Chart 3Rates Have Room To##BR##Surprise To The Upside Rates Have Room To Surprise To The Upside Rates Have Room To Surprise To The Upside Bottom Line: The Treasury curve faithfully reflects changes in the fed funds rate. In the absence of a shock that would cause the FOMC's repeatedly expressed plans to change, monetary policy is a catalyst for higher rates. But What About An Inverted Yield Curve? The yield curve typically inverts in the latter stages of a rate-hiking campaign, so it is more correct to say a higher fed funds rate implies higher Treasury yields until the yield curve inverts. An inverted yield curve is a classic recession indicator, albeit often a very early one (Table 2), and it should not be taken as a signal to immediately de-risk portfolios. The yield curve may be prone to invert even earlier than it otherwise would this time around, given that QE1, QE2, and QE3 may well have depressed the term premium on long-term bonds,1 as The Bank Credit Analyst noted in its August edition. The question of how much the Fed's asset purchases have affected the term premium, if at all, is far from settled within either the Fed or BCA, but its potential to impact the signal from the yield curve reinforces our conviction to look to other indicators to confirm its recession message before declaring the end of the bull markets in equities and spread product. Table 2The Yield Curve Is Early The Rates Outlook The Rates Outlook The Inflation Outlook As the tepid post-crisis expansion has stretched on and on, investors have grown accustomed to sleepy inflation readings and begun to regard the prospects for a pickup in inflation with skepticism, if not outright disdain. Even within BCA, there has been spirited debate about the relevance of the Phillips Curve - the formalization of the idea that there is an inverse relationship between wage growth and the unemployment rate. Despite the stagflation of the 1970s and the lengthy post-crisis dry spell that have undermined the Phillips Curve's credibility with the rigorously empirically-minded, we do not find it controversial. The relationship between unemployment and compensation may not be perfectly linear, but the Phillips Curve is nothing more than an extension of the laws of supply and demand to wage negotiations. We can accept that the Phillips Curve is kinked - that compensation growth is utterly indifferent to changes in the unemployment rate when labor supply is glutted (as can be seen in Chart 4 when covering all of the observations below 7%), but rather sensitive to its moves when it is in the neighborhood of full employment (as can be seen when covering all of the observations above 5%). We believe the U.S. labor market has reached the point at which employers will have to compete fiercely to attract new talent. After nine years, the economy has finally worked down nearly all of the hidden slack that had padded the broader U-6 unemployment rate.2 The pool of discouraged workers - those who are not counted as officially unemployed because they're not actively looking for a job, but would start tomorrow if offered one - has shrunk below its 2000 and 2007 levels (Chart 5, top panel). Similarly, the share of the labor force that is working part time but would prefer to be working full time is approaching its pre-crisis bottom (Chart 5, bottom panel). The prospects for inflation gained another boost last December upon the passage of the spending package on the coattails of the tax-cut bill. The U.S. economy is poised to receive a substantial dose of fiscal stimulus this year and next (Chart 6). Mainstream macroeconomic thought holds that stimulus injected into an economy that is already operating at full capacity is prone to kindle inflation.3 Chart 4The Phillips Curve Can't Handle Copious Slack ... The Rates Outlook The Rates Outlook Chart 5... But Almost All Of It Has Been Worked Off ... But Almost All Of It Has Been Worked Off ... But Almost All Of It Has Been Worked Off Chart 6Goosing Inflation Along With Output Goosing Inflation Along With Output Goosing Inflation Along With Output Bottom Line: The U.S. labor market has tightened considerably and competition between employers to attract scarce talent should soon translate to a pickup in wage growth. Unneeded fiscal stimulus is also likely to push prices higher. There are plenty more inflation green shoots behind the ones that have already begun to emerge. White House-Fed Tension Is Nothing New It is not beyond the realm of possibility that presidential pressure could deter the Fed from following through on its intentions and present a risk to our above-consensus terminal rate estimate. The bond market immediately discounted the potential of a less independent Fed by selling off at the long end after the president stated he was "not thrilled" with ongoing rate hikes in an interview with CNBC. There would seem to be little doubt that a captive Fed would be more reluctant to remove the punch bowl than a Fed which was free to pursue its inflation mandate without outside interference. After all, elected officials would be happy to trade long-term pain for near-term gain (at least through the next campaign). The president may have upended convention by publicly airing his displeasure, but there is a natural tension between the White House and the Fed. There have been dust-ups in the past, and there will be dust-ups in the future for as long as elected officials shudder at the thought of an economic downturn. Alan Greenspan wrote frankly in his memoir about friction with the first Bush administration, which included public criticism from the sitting president. "I do not want to see us move so strongly against inflation that we impede growth," President Bush told the press at the beginning of his term, in response to hawkish congressional testimony from Greenspan.4 By all accounts, however, the conflict between Bush père and Greenspan was of a lower-pressure variety than the conflicts between LBJ and William McChesney Martin, and Nixon and Arthur Burns. The legendarily intimidating LBJ summoned Martin to his ranch following an unwelcome rate hike. According to several accounts (and consistent with his longstanding negotiating practices in the Senate), LBJ backed the smaller Martin up against a wall before giving full voice to his complaints. Martin did not budge, pointing out that the Fed had acted in accordance with the legislation governing its actions.5 If Martin represents the heroic Fed chief, standing his ground in the face of heavy pressure from a larger-than-life figure, Arthur Burns is the poster child for folding like a cheap lawn chair. The Nixon tapes capture Nixon and his proxies repeatedly pressuring Burns to prime the pump ahead of the 1972 election, which Burns ultimately did.6 Our view is that Fed Chair Powell is more likely to follow Martin than Burns. The Fed is more transparent today, and its independence is more firmly established than it was in the 1970s. Even if Powell were amenable to doing the president's bidding, he would be held back by the realization that it would ultimately be self-defeating: any hint of political manipulation in the rate-setting process would risk a bond market riot that would blast rates far beyond the levels where a 3.5% fed funds rate would take them. Bottom Line: We are not concerned that the FOMC will yield to pressure from the White House to back away from their rate hike plans. Attempted influence of the Fed is nothing new, and investors need not worry about it now. Investment Implications If we are correct in our view that rates have not yet peaked, the bond market is likely to face continued headwinds. Long-dated Treasuries will come under more pressure than shorter-maturity issues. Thanks to positive carry, spread product will be less vulnerable to higher rates, but our bond strategists are lukewarm on the risk-reward offered by investment-grade and high-yield bonds given the late stage of the cycle and historically tight spreads. We acknowledge the potential seriousness of the current spate of geopolitical risks, headlined by trade tensions, and advocate temporarily de-risking portfolios in line with the BCA house view (equal weight equities, underweight bonds, overweight cash). We are more constructive than the BCA consensus, however, because we remain constructive on the business cycle, the monetary policy cycle, and the credit cycle. If the key cycles aren't over, the equity bull market probably isn't over, and neither spread widening nor a pickup in defaults is likely to wipe out spread product's excess returns. We will express all of our calls in a basket of ETF recommendations once we have completed our review of the most impactful macro questions, but for now we recommend maintaining below-benchmark positioning in Treasury portfolios while overweighting TIPS at the expense of nominal Treasuries. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Long-term bond yields can be decomposed into the expected path of short-term rates and a term premium, which compensates an investor for the uncertainties that can arise over the extended time period that s/he is locking up his/her money by buying a longer-maturity instrument. 2 In the monthly employment report, the headline unemployment rate, which includes only jobless workers who are actively seeking work, is labeled U-3 unemployment. The U-6 series broadens the definition of unemployment to include the jobless who aren't actively searching and those who are working part time only because they cannot find a full-time position. 3 Please see the November 7, 2016 U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability," available at usis.bcaresearch.com, for a discussion of fiscal multipliers under a range of scenarios. 4 Greenspan, Alan. The Age of Turbulence: Adventures in a New World, Penguin (New York): 2007, p.113. To this day, several members of the G.H.W. Bush administration continue to pin a large measure of blame for its 1992 electoral loss on overly conservative monetary policy. The ex-president himself, in a 1998 television interview, said, "I reappointed him [Greenspan], and he disappointed me." 5 Granville, Kevin. "A President at War With His Fed Chief, 5 Decades Before Trump," New York Times, June 15, 2017, page B3 (updated July 19, 2018). https://www.nytimes.com/2017/06/13/business/economy/a-president-at-war-with-his-fed-chief-5-decades-before-trump.html 6 "How Richard Nixon Pressured Arthur Burns: Evidence from the Nixon Tapes, Vol. 20, No. 4," Journal of Economic Perspectives (Fall 2006). https://fraser.stlouisfed.org/title/1167/item/2388, accessed on July 24, 2018.

Highlights Without swift and considerable fiscal austerity or aggressive privatization, Brazil's public debt situation will become uncontrollable. Brazilian voters' priorities and preferences are for more public spending, not fiscal austerity. Hence, the upcoming president will not have a mandate to pursue fiscal austerity. The sole politically viable solution to stabilize Brazil's public debt situation is to boost nominal GDP growth - something that can only be achieved by sacrificing the exchange rate. The real is set to depreciate considerably. Provided the currency is key to the performance of Brazilian asset prices, the latter will remain in a bear market. Stay put/underweight on Brazilian risk assets. Feature Brazil is approaching a major showdown between creditors and the government. The country's public debt burden is out of control and unsustainable, unless immediate and drastic actions on the fiscal front are undertaken. At the same time, the economy has barely recovered after an extended period of depression, and the general population does not have the appetite for fiscal austerity. Crucially, the nation is heading into presidential and general elections in October. Whoever is elected, the new president will struggle to stabilize public debt dynamics amid a weak economy and the public's intolerance for fiscal tightening. On the surface, the plunge in Brazilian financial markets in recent months could well be attributed to the truckers' strike following the liberalization of fuel prices. The authorities hiked fuel prices because the deteriorating budget situation forced them to discontinue subsiding it. However, the strike was a symptom of a much deeper problem: the government's debt dynamics are degenerating, while the population and businesses have grown tired of the prolonged depression - and are deeply opposed to any kind of fiscal austerity. The sole macro solution to this debt problem is to boost nominal growth. This can be achieved via much lower real interest rates and/or a major currency devaluation. The latter will be detrimental to foreign investors holding Brazilian assets. Fiscal Austerity Is Required... Chart I-1Nominal Growth (A Proxy For Revenue) Is Lower Than Borrowing Costs Nominal Growth (A Proxy For Revenue) Is Lower Than Borrowing Costs Nominal Growth (A Proxy For Revenue) Is Lower Than Borrowing Costs Brazil continues to head towards a fiscal debacle. Not only does the government's fiscal position remain untenable, but nominal GDP growth has also relapsed to its 2015 lows (Chart I-1). The lack of nominal growth is depressing government revenues. Importantly, the widened gap between nominal GDP growth that currently stands at 4% and local currency borrowing rates of 10% is not sustainable (Chart I-1). Barring swift and substantial fiscal tightening, weak economic growth and high borrowing costs will ensure that the public debt-to-GDP ratio continues to rise into the foreseeable future. A rising debt-to-GDP ratio without clear government policies and actions to tackle indebtedness will feed into a higher risk premium in the exchange rate as well as government borrowing costs. Hence, a vicious cycle will likely unravel: escalating public debt will exert upward pressure on the government's borrowing costs, rising interest rate payments on public debt will keep the fiscal deficit wide and, consequently, the debt-to-GDP ratio will continue to escalate. Table 1 presents three scenarios for Brazil's public debt trajectory. In our base case scenario, the gross debt-to-GDP ratio1 reaches 82% by the end of 2019. In fact, even under the optimistic scenario, the gross public debt-to-to GDP ratio will continue to rise and end up at 80%. Table 1Brazil: Public Debt Sustainability Test Brazil: Faceoff Time Brazil: Faceoff Time Chart I-2High Debt Is Not A Problem In The U.S. High Debt Is Not A Problem In The U.S. High Debt Is Not A Problem In The U.S. A public debt burden above 80% of GDP would not be alarming if interest rates on that debt were not in the double digits. For example, the U.S.'s public debt burden of 100% of GDP is not a problem because interest rates are low, in fact well below nominal GDP growth (Chart I-2). To stabilize the public debt dynamics, the Brazilian government must run primary fiscal surpluses. In the late 1990s and early 2000s, Brazil escaped a public debt trap because the government tightened fiscal policy considerably. They adopted Fiscal Responsibility Law in 2000, whereby the authorities were required by law to keep government expenditures limited to 50% of net revenues for that year. In turn, this allowed governments to run comfortable primary fiscal surpluses of 3% and above (Chart I-3). As shown on this chart, Brazil ran primary surpluses of 3-4% from 2001 through to 2012. Presently, the primary fiscal balance stands at -1.5% of GDP (Chart I-3, bottom panel). To stabilize the public debt dynamics, the government must undertake fiscal tightening of about 3% of GDP within the next 12-24 months to bring the primary surplus to around 1.5% of GDP. However, such fiscal tightening at a time when the economy is still very weak will push it back into recession. More importantly such fiscal tightening is politically unfeasible, as discussed below. Brazil's Achilles heel has been and remains social security finances. The social security deficit at the moment amounts to 3% of GDP (Chart I-4). According to IMF projections,2 social security expenditures will rise to 15% of GDP by 2021, bringing the total social security deficit to 12% of GDP under the current system. Chart I-3Brazilian Public Debt Dynamics Are Unsustainable Brazilian Public Debt Dynamics Are Unsustainable Brazilian Public Debt Dynamics Are Unsustainable Chart I-4Brazil's Social Security Deficit Brazil's Social Security Deficit Brazil's Social Security Deficit Crucially, Brazil is facing demographic headwinds that are contributing to the ballooning social security deficit. In particular, a rapidly aging population and rising life expectancy are all expected to drag government finances lower in the coming decades (Chart I-5). The social security deficit has increased in recent years to 40% of the overall deficit. Chart I-5Deteriorating Demographics Deteriorating Demographics Deteriorating Demographics Major and front-loaded cuts in social security expenditures are vital to stabilize government finances and debt dynamics. However, there is little support among the population and Congress for such austerity measures (we discuss this in more detail in the next section). Aggressive privatization could be a one-off short-term solution if the proceeds are used to reduce public debt. This could avert a vicious cycle of rising risk premiums, higher interest rates and larger debt burdens, at least for a while. However, the recent case of the privatization of Eletrobras shows that the process has been much slower than expected. Moreover, the total estimated sale price of Eletrobras will only produce BRL 12 billion. This compares with a BRL 104 billion annual primary deficit. Further, a sale of the Brazilian government's ownership of oil giant Petrobras would bring in an estimated BRL 90-95 billion, or 1.6% of GDP (this assumes a sale of a 64% stake in common shares, including government, BDNES and Caixa shares). This is still less than the annual primary deficit of BRL 104 billion (1.5% of GDP). Consequently, even aggressive privatization will not be sufficient to reduce debt or improve the nation's fiscal position on a sustainable basis. Further, aggressive privatization is not politically feasible as it lacks public support, and Congressional approvals on this matter will be a challenge. Bottom Line: The public debt burden is surging and fiscal dynamics remain unsustainable. Without swift and considerable fiscal austerity or aggressive privatization, Brazil's public debt situation will become uncontrollable. ...But Is Politically Unfeasible The prospects for fiscal reforms and improved public debt sustainability are dependent on the upcoming presidential elections. As October's vote approaches, social security and privatization reforms will be key determinants of the path of Brazil's risk premium for the foreseeable future. The presidential elections are scheduled for October 7 and 28 (a second round will be held if no candidate achieves an absolute majority of the vote). Uncertainty is unusually high. Yet investors need to understand the constraints that underpin the current presidential race. First, Brazilian voters' priorities and preferences are for more public spending, not fiscal austerity. According to polls conducted by Confederacao Nacional da Industria (CNI), the top five priorities of respondents are to improve health and education, and raise wages (Chart I-6). By contrast, only 3% of respondents believe that pension reform (cutting spending) should be a top government priority. Chart 6Brazil's Population Is Not Open To Fiscal Austerity Brazil: Faceoff Time Brazil: Faceoff Time This polling confirms our thesis that the median voter in Brazil remains firmly on the left of the economic policy spectrum.3 The combined support for left-leaning candidates Lula, Marina Silva and Ciro Gomes remains close to 50% (Table 2). Table 2The Left Is Ahead Brazil: Faceoff Time Brazil: Faceoff Time On the whole, fiscal austerity and privatization, as proposed by centrist and right-leaning candidates, will garner little support from the electorate. Second, Brazil's Congress is one the most fractious in the world. With over 20 political parties in Congress, the key to passing critical reforms is contingent on the ability of the president to form, maintain and reward a coalition that can muster majority votes in Congress. Crucially, reforms requiring constitutional amendments, such as the pension system, would need a supermajority of 308 out of 513 seats in the Chamber of Deputies, or 60% of congressmen. As the recent experience of acting president Temer shows, this will be difficult. Temer was an experienced political operator and the head of the largest party in Congress, yet even he failed to gain sufficient support to pass social security reforms, even when they were watered down and their costs back-loaded. There are low odds that any of the existing presidential candidates - all of whom have single-digit or low double-digit support rates - will be able to get enough votes to adopt meaningful social security reforms. True, the right-wing candidate, Jair Bolsonaro, has proposed aggressive privatization and spending cuts to rein in the public debt. Ultimately, only policies of this kind can reduce spending, correct the debt trajectory, stabilize the foreign exchange rate, and enable the country to avoid a vicious cycle of escalating risk premiums in financial markets. That, in turn, would give the economy some breathing room -- a buying opportunity in financial markets might emerge. However, Jair Bolsonaro faces an uphill battle in the presidential election given that the median voter is on the left. Even if elected, he is unlikely to garner support for privatization and austerity in a fractionalised Congress. Bottom Line: Brazilian voters' priorities and preferences are for more public spending, not fiscal austerity. Hence, the upcoming president will not have a mandate to pursue fiscal austerity. Monetary Policy And The Exchange Rate Given fiscal austerity is politically unviable, the other option to stabilize the debt-to-GDP ratio is to boost nominal GDP. Yet the nominal GDP growth rate has relapsed to 2015 lows (refer to Chart I-1 above). Even though real GDP is slowly recovering, inflation has plunged, depressing nominal growth (Chart I-7). As a result, real rates in Brazil remain very high (Chart I-7, bottom panel). This in turn has curbed the economic recovery. Low income growth and high real rates are not only impairing public sector creditworthiness, but they are also hurting the private sector's ability to service its debt. Consistently, weaker nominal GDP growth points to a renewed rise in NPLs and NPL provisions at banks (shown inverted in the chart) (Chart I-8). Chart I-7Real Rates Are Still Punishingly High In Brazil Real Rates Are Still Punishingly High In Brazil Real Rates Are Still Punishingly High In Brazil Chart I-8Banks' Bad Loans And Provisions Are Set To Rise Banks' Bad Loans And Provisions Are Set To Rise Banks' Bad Loans And Provisions Are Set To Rise Monetary policy in Brazil is constrained by exchange rate movements. With the exchange rate currently under selling pressure, the central bank is unlikely to reduce interest rates for now. The next government will have no option but to force the central bank to reduce nominal and real interest rates in an attempt to both boost nominal growth and decrease public debt servicing costs. The victim of this policy will be the currency: the Brazilian real will plunge. The good news for the government is that 96% of its debt is in local currency. Hence, sizable currency depreciation will not have much of an effect on the public debt burden. Table 3External Debt As Of Q4 2017 Brazil: Faceoff Time Brazil: Faceoff Time That said, companies and banks have high levels of external debt (Table 3), and they will suffer at the hands of significant currency depreciation. However, this is the most politically viable and economically feasible way to avoid a public debt fiasco. If the government's pressure on the central bank to reduce interest rates leads to a riot in financial markets and borrowing costs on government debt rise, the government may put pressure on the central bank and state-owned commercial banks to monetize public debt - i.e., purchase government bonds to bring bond yields down. In short, Brazil could institute quantitative easing to reduce and cap government bond yields. The U.S., the UK, Japan, the euro area and Sweden have all done this, and the new government in Brazil may also opt for such a solution. It might either be done in a transparent way, as central banks in the developed economies did, or it might be done in a disguised manner. Chart I-9Divergence Between Central Bank Reserves & The Real Divergence Between Central Bank Reserves & The Real Divergence Between Central Bank Reserves & The Real Interestingly, there are some indications the central bank is trying to err on the side of easier money, despite the latest currency depreciation. Specifically, it has in recent months been injecting more liquidity into the banking system, despite the sharp selloff in the real, as illustrated in Chart I-9. This constitutes a departure from past policy reactions to selloffs in the real, and in a way is a form of disguised easing. The central bank's recent liquidity additions have prevented interbank rates - and hence the entire structure of interest rates - from increasing more than they otherwise would have. In short, the upcoming government might resort to open or disguised public debt monetization to prevent a fiscal debacle. Needless to say, the Brazilian real will plummet in such a scenario. Bottom Line: The sole politically viable solution to stabilize Brazil's public debt situation is to boost nominal GDP growth - something that can only be achieved by sacrificing the exchange rate. Financial Markets The currency is the key to the performance of Brazilian asset prices. The real will depreciate much further. In addition to the above factors, the following will continue to weigh on the currency: Export growth is decelerating (Chart I-10), and this trend is likely to persist as China's growth slows further and commodities prices drop. The currency is not yet very cheap, according to the real effective exchange rate based on consumer and producer prices (Chart I-11). Chart I-10Brazilian Export Growth Is Decelerating Brazilian Export Growth Is Decelerating Brazilian Export Growth Is Decelerating Chart I-11The Real Is Not Cheap The Real Is Not Cheap The Real Is Not Cheap Foreign debt obligations - external debt servicing over the next 12 months - are elevated both in dollars and from a historical perspective relative to exports (Chart I-12). Not surprisingly, demand for dollars is very strong, as evidenced by rising U.S. dollar funding rates (Chart I-13 ). Finally, even though interest rate differentials over the U.S. have never been a key driving force behind the real, they are currently at a record low (Chart I-14). Chart I-12Foreign Private Sector Debt Is High Foreign Private Sector Debt Is High Foreign Private Sector Debt Is High Chart I-13Demand For U.S. Dollars Is Strong Demand For U.S. Dollars Is Strong Demand For U.S. Dollars Is Strong Chart I-14Brazilian Interest Rate Differentials: At A Historical Low Brazilian Interest Rate Differentials: At A Historical Low Brazilian Interest Rate Differentials: At A Historical Low Chart I-15Brazil: Weak Trade Balance Is Negative For Equities Brazil: Weak Trade Balance Is Negative For Equities Brazil: Weak Trade Balance Is Negative For Equities With respect to equities, Brazilian share prices perform poorly when the current account and trade balances are deteriorating (Chart I-15). Falling commodities prices are negative for resource companies. Finally, the stock market's long-term technical profile seems to suggest that a major top has been reached in share prices in U.S. dollar terms and the path of least resistance is down (Chart I-16). Chart I-16Brazilian Stocks In U.S. Dollars Brazilian Stocks In U.S. Dollars Brazilian Stocks In U.S. Dollars Investment Conclusions We remain negative on Brazil's financial markets. Further depreciation in the currency will continue, and will cause a selloff in equities, local bonds and sovereign and corporate credit markets. Dedicated EM portfolios should continue to underweight Brazil in equity and fixed-income portfolios. We continue recommending a long position in the nation's sovereign CDSs. The BRL is among our favoured currency shorts - we are maintaining both our short BRL/long USD and our short BRL/long MXN positions. Among equity sectors, we are reiterating our short position in bank stocks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthur@bcaresearch.com Andrija Vesic, Research Analyst AndrijaV@bcaresearch.com 1 In our simulations, we used gross government debt, which is calculated as total government public debt excluding central bank holdings of government securities. Gross public debt-to-GDP ratio is now at 74%. Under the older methodology, which included accounting for government debt held by the central bank, the public debt-to-GDP ratio would have been 85%. 2 Cuevas et al. IMF Working Paper; Fiscal Challenges of Population Aging in Brazil, March 2017 3 Pease see Emerging Markets Strategy Special Report "Brazil's Election: Separating Signal From The Noise", dated September 10, 2014, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Our forecast of higher geopolitical risk in 2018 is coming to fruition; President Trump's two key policies, economic populism (fiscal stimulus) and mercantilism (trade tariffs), will counteract each other; Stimulus is leading to trade deficits and a stronger dollar, while a stronger dollar encourages trade deficits. This is a problem for Trump in 2020; The administration will seek coordinated international currency moves, but the U.S. has less influence today than it did at the time of key 1971 and 1985 precedents; Favor DM over EM assets; favor U.S. over DM stocks; and expect Trump to threaten tariffs against currency manipulation. Feature "China, the European Union and others have been manipulating their currencies and interest rates lower, while the U.S. is raising rates while the dollars [sic] gets stronger and stronger with each passing day - taking away our big competitive edge. As usual, not a level playing field... The United States should not be penalized because we are doing so well. Tightening now hurts all that we have done. The U.S. should be allowed to recapture what was lost due to illegal currency manipulation and BAD Trade Deals. Debt coming due & we are raising rates - Really?" - President Donald Trump, tweet, July 20, 2018 "The dollar may be our currency, but it is your problem." - Treasury Secretary John Connally, 1971, speaking to a group of European officials Chart 1A Fiscal Boost Will Accelerate Inflation A Fiscal Boost Will Accelerate Inflation A Fiscal Boost Will Accelerate Inflation In April 2017, BCA's Geopolitical Strategy concluded that "Political Risks Are Overstated In 2017," but also "Understated In 2018."1 At the heart of our forecast was the interplay between three factors: "Domestic Policy Is Bullish USD:" We argued in early 2017 that the political "path of least resistance" would lead to "tax cuts in 2017" and that President Trump's economic policies "will involve greater budget deficits than the current budget law augurs." The conclusion was that "even a modest boost to government spending will motivate the Fed to accelerate its tightening cycle at a time when the output gap is nearly closed and unemployment is plumbing decade lows" (Chart 1). "Chinese Growth Scare Is Bullish USD:" We also correctly predicted that "Chinese data is likely to decelerate and induce a growth scare." Even though Chinese data was peachy in early 2017, we pointed out that "Chinese policymakers have gone forward with property market curbs and begun to tighten liquidity marginally in the interbank system." We would go on to produce several in-depth research reports throughout the year that outlined these reform efforts and linked them to President Xi Jinping's reduced political constraints following the nineteenth National Party Congress in October.2 "European Political Risks Are Bullish USD:" Finally, we argued that a combination of political risks - e.g., the 2018 Italian election - and the slowdown in China would reverberate in Europe, forcing "the ECB to be a lot more dovish than the market expects." Our conclusion in April 2017 - quoted verbatim below - was that these three factors would combine to force President Trump to try to talk down the greenback: The combination of Trump's domestic policy agenda and these global macro-economic factors will drive the dollar up. At some point in 2018, we assume that USD strength will begin to irk Donald Trump and his cabinet, particularly as it prevents them from delivering on their promise of shrinking trade deficits. We suspect that President Trump will eventually reach for the "currency manipulation" playbook of the 1970s-80s. On July 20, President Trump put a big red bow on our forecast by doing precisely what we expected: talking down the USD by charging the rest of the world with currency manipulation. Speaking with CNBC, Trump pointed out that "in China, their currency is dropping like a rock and our currency is going up, and I have to tell you it puts us at a disadvantage." President Trump is correct: Beijing is definitely manipulating the currency, as we pointed out last week (Chart 2).3 Chart 2The CNY Is Much Weaker Than The DXY Implies The CNY Is Much Weaker Than The DXY Implies The CNY Is Much Weaker Than The DXY Implies Chart 3U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD But President Trump wants to have his cake and eat it too. His economic stimulus is inevitably leading to a widening trade deficit. With tax cuts and increased capital spending, U.S. demand is growing faster than demand in the rest of the world. This economic outperformance in the context of stalling global growth is leading to the greenback rally that we forecast (Chart 3). When the U.S. economy outperforms the rest of the world, the Fed tends to be in the lead of tightening policy among G10 economies, spurring a rally in the trade-weighted dollar index (Chart 4).4 A rising currency then reinforces the trade deficit. Chart 42018 Rally Is Not Over 2018 Rally Is Not Over 2018 Rally Is Not Over There is much uncertainty regarding President Trump's true preferences, but we know two things: he is an economic populist and a mercantilist. He has been clear on both fronts throughout his campaign. The problem for President Trump is that the two policies are working against one another. His stimulus has spurred a USD rally that will likely offset the impact of his tariffs, particularly the more modest 10% variety he has said he will impose on all Chinese imports (Chart 5). Chart 5Trump Threatens Tariffs On All ##br##Chinese Imports (And Then Some) The Dollar May Be Our Currency, But It Is Your Problem The Dollar May Be Our Currency, But It Is Your Problem The Trump administration is therefore facing a choice: triple-down on tariffs, potentially causing a market and economic calamity in the process; or, use protectionism as a bargaining chip in a bout of orchestrated and negotiated, global, currency manipulation. As we pointed out last April, President Trump would not be the first to face this choice: 1971 Smithsonian Agreement President Richard Nixon famously closed the gold window on August 15, 1971 in what came to be known as the "Nixon shock."5 Less understood, but also part of the "shock," was a 10% surcharge on all imported goods, the purpose of which was to force U.S. trade partners to appreciate their currencies against the USD. Much like Trump, Nixon had campaigned on a mercantilist platform in 1968, promising southern voters that he would limit imports of Japanese textiles. As president, he staffed his cabinet with trade hawks, including Treasury Secretary John Connally who was in favor of threatening reduced U.S. military presence in Europe and Japan to force Berlin and Tokyo to the negotiating table. Connally also gave us the colorful quote for the title of this report and also famously quipped that "foreigners are out to screw us, our job is to screw them first." The economists in the Nixon cabinet - including Paul Volcker, then the Undersecretary of the Treasury under Connally - opposed the surcharge, fearing retaliation from trade partners, but policymakers like Connally favored brinkmanship. The U.S. ultimately got other currencies to appreciate, mostly the deutschmark and yen, but not by as much as it wanted. Critics in the administration - particularly the powerful National Security Advisor Henry Kissinger - feared that brinkmanship would hurt Trans-Atlantic relations and thus impede Cold War coordination. As such, the U.S. removed the surcharge merely four months later without meeting most of its objectives, including increasing allied defense-spending and reducing trade barriers to U.S. exports. Even the currency effects dissipated within two years. 1985 Plaza Accord The U.S. reached for the mercantilist playbook once again in the early 1980s as the USD rallied on the back of Volcker's dramatic interest rate hikes. The subsequent dollar bull market hurt U.S. exports and widened the current account deficit (Chart 6). U.S. negotiators benefited from the 1971 Nixon surcharge because European and Japanese policymakers knew that the U.S. was serious about tariffs and had no problem with protectionism. The result was coordinated currency manipulation to drive down the dollar and self-imposed export limits by Japan, both of which had an almost instantaneous effect on the Japanese share of American imports (Chart 7). Chart 6Dollar Bull Market And Current Account Balance In 1980s-90s Dollar Bull Market And Current Account Balance In 1980s-90s Dollar Bull Market And Current Account Balance In 1980s-90s Chart 7The U.S. Got What It Wanted From Plaza Accord The U.S. Got What It Wanted From Plaza Accord The U.S. Got What It Wanted From Plaza Accord The Smithsonian and Plaza examples are important for two reasons. First, they show that Trump's mercantilism is neither novel nor somehow "un-American." It especially is not anti-Republican, with both Nixon and Reagan having used overt protectionism and currency manipulation in recent history. Second, the experience of both negotiations in bringing about a shift in the U.S. trade imbalance will motivate the Trump administration to reach for the same "coordinated currency manipulation" playbook. In fact, Trump's Trade Representative, Robert Lighthizer, is a veteran of the 1985 agreement, having negotiated it for President Ronald Reagan. Should investors get ahead of the Plaza Accord 2.0 by shorting the greenback? The knee-jerk reactions of the market suggest that this is the thinking of the median investor. For instance, the DXY fell by 0.7% on the day of Trump's tweet. We disagree, however, and are sticking with our long DXY position, initiated on January 31, 2018, and up 6.17% since then.6 Why? Because 2018 is neither 1985 nor 1971. President Trump, and America more broadly, is facing several constraints today. As such, we do not expect that he will find eager partners in negotiating a coordinated currency manipulation. Chart 8Globalization Has Reached Its Apex Globalization Has Reached Its Apex Globalization Has Reached Its Apex Chart 9Global Protectionism Has Bottomed Global Protectionism Has Bottomed Global Protectionism Has Bottomed Economy: Europe and Japan were booming economies in the early 1970s and mid-1980s, and had the luxury of appreciating their currencies at the U.S.'s behest. Today, it is difficult to see how either Europe or China (now in Japan's place) can afford significant monetary policy tightening that would engineer structural bull markets in their currencies. For Europe, the risk is that the peripheral economies may not survive a back-up in yields. For China, if the PBOC engineered a persistently strong CNY/USD, it would tighten financial conditions and hurt the export sector. Apex of Globalization: U.S. policymakers were able to negotiate the 1971 and 1985 currency agreements in part because of the underlying promise of growing trade. Europe and Japan agreed to a tactical retreat to get a strategic victory: ongoing trade liberalization. In 2017-18, however, this promise has been muted. Global trade has peaked as a percent of GDP (Chart 8), average tariffs have bottomed (Chart 9), and the number of preferential trade agreements signed each year has collapsed (Chart 10). Temporary trade barriers have ticked up since 2008 (Chart 11). To be clear, these signs are not necessarily proof that globalization is reversing, but merely that it has reached its apex. Nonetheless, America's trade partners will be far less willing to agree to coordinated currency manipulation in an era where the global trade pie is no longer growing. Chart 10Low-Hanging Fruit Of Globalization Already Picked The Dollar May Be Our Currency, But It Is Your Problem The Dollar May Be Our Currency, But It Is Your Problem Chart 11Temporary Trade Barriers Ticking Up The Dollar May Be Our Currency, But It Is Your Problem The Dollar May Be Our Currency, But It Is Your Problem Multipolarity: The U.S. is simply not as powerful - relatively speaking - as it was at the height of the Cold War (Chart 12). As such, it is difficult to see how President Trump can successfully bully major economies into self-defeating currency manipulation. The Cold War gave the U.S. far greater leverage, particularly vis-à-vis Europe and Japan. Today, Trump's threats of pulling out of NATO are merely spurring Europeans to integrate further as Russia is no longer the threat it once was. There are no Soviet tank divisions arrayed across the Fulda Gap in Eastern Germany. In fact, Russia is cutting defense spending and further integrating into the European economy with new pipeline infrastructure (which Trump has pointedly criticized). And China is overtly hostile to the U.S. and thus completely unlike Japan, which huddled under the American nuclear umbrella during the U.S.-Japan trade war. Chart 12The U.S. Has Less Weight To Throw Around The U.S. Has Less Weight To Throw Around The U.S. Has Less Weight To Throw Around Is the Trump administration ignoring these major differences? No. There may be a much simpler explanation for President Trump's dollar bearishness: domestic politics. We only see a probability of around 20% that the U.S. trade deficit will shrink during the course of Trump's first term in office. Most likely, the trade deficit will widen as domestic stimulus supercharges the U.S. economy relative to the rest of the world and the greenback rallies. Economic slowdown in China and EM will likely further expand the U.S. trade deficit as these economies cut interest rates and allow their exchange rates to drop. President Trump therefore has a problem. The only way the trade deficit will shrink by 2020 is if the U.S. enters a recession and domestic demand shrinks - but presidents do not survive re-election during recessions. If a recession does not develop, he will have to explain to voters in early 2020 why the trade deficit actually surged, despite all his tough rhetoric, tariffs, and trade negotiations. The charge of currency manipulation could therefore do the trick, blaming the rest of the world for the USD rally that was largely caused by U.S. stimulus. Bottom Line: We do not expect the Fed to respond to President Trump's rhetoric. The current Powell Fed is not the 1970s Burns Fed. As such, we would fade any upcoming weakness in the USD. We expect the dollar bull market to carry on in 2018 and to continue weighing on global risk assets, namely EM equities and currencies. Investors should remain overweight DM assets relative to EM in terms of broad global asset allocation, and overweight U.S. equities in particular relative to other DM equities. The major risk to our bullish USD view is not a compliant Fed but rather a China that "blinks." Beijing has begun some modest stimulus in the face of the economic slowdown produced by the Xi administration's aforementioned efforts to contain systemic financial risk. Over the next month, we will dive deep into Chinese politics to see if the trade conflict will prompt Xi to reverse his attempt to tighten policy and once again embrace a resurgence in credit growth. In the long term, however, we expect that the Trump administration will grow frustrated with the fact that its two main policies - economic populism at home and mercantilism abroad - will offset each other and that the U.S. trade imbalance will continue to grow apace. At that point, President Trump may decide to reach for two levers: staffing the Fed with über doves and/or ratcheting up tariffs to much higher levels. We expect the latter to be the more likely outcome than the former, and either would result in a serious blowback from the rest of the world that would unsettle markets. More importantly, it would be the death knell of globalization, stranding trillions of dollars of capex behind suddenly very relevant national borders. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, and "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "China Down, India Up," dated March 15, 2017, "China: Looking Beyond The Party Congress," dated July 19, 2017, "China's Nineteenth Party Congress: A Primer," dated September 13, 2017, "China: Party Congress Ends... So What?" dated November 1, 2017, "A Long View Of China," dated December 28, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Whoever Said Anything About Bluffing?" dated July 18, 2018, available at gps.bcaresearch.com. 4 Please see BCA Foreign Exchange Strategy Weekly Report, "The S&P Doesn't Abhor A Strong Dollar," dated July 20, 2018, available at fes.bcaresearch.com. 5 Please see Douglas A. Irwin, "The Nixon shock after forty years: the import surcharge revisited," World Trade Review 12:01 (January 2013), pp. 29-56, available at www.nber.org; and Barry Eichengreen, "Before the Plaza: The Exchange Rate Stabilization Attempts of 1925, 1933, 1936, and 1971," Behl Working Paper Series 11 (2015). 6 Please see BCA Geopolitical Strategy Weekly Report, "America Is Roaring Back! (But Why Is King Dollar Whispering?)," dated January 31, 2018, available at gps.bcaresearch.com.

Highlights Rising non-OPEC production and the Trump administration's successful efforts at jawboning OPEC into increasing oil production - including a not-so-subtle threat that American protection of the Cartel's Gulf Arab producers would be withheld if production weren't ramped - will keep oil prices under pressure in 2H18. Markets could become chaotic in 2019: Iran's capacity to close the Strait of Hormuz - discussed below in this Special Report written jointly by BCA's Commodity & Energy Strategy and Geopolitical Strategy - cannot be dismissed. An extended closure of the Strait - our most dire scenario - could send prices on exponential trajectories: In one simulation, above $1,000/bbl. We are keeping our forecast for 2H18 Brent at $70/bbl, unchanged from June, and lowering our 2019 expectation by $2 to $75/bbl. We expect WTI to trade $6/bbl below Brent. Rising geopolitical uncertainty will widen the range in which oil prices trade - i.e., it will lift volatility. Energy: Overweight. We are moving to a tactically neutral weighting, while maintaining our strategic overweight recommendation. We are closing our Dec18 Brent $65 vs. $70/bbl call spread but are retaining long call-spread exposures in 2019 along the Brent forward curve. Base Metals: Neutral. Contract renegotiations at Chile's Escondida copper mine are yet to be resolved. The union rejected BHP's proposal late last week, and threatened to vote for a strike unless substantial changes were made. Failure to reach a labor deal at the Escondida mine led to a 44-day strike last year, and an extension of the contract. This agreement expires at the end of this month. Precious Metals: Neutral. Increasing real rates in the U.S. and a stronger USD are offsetting safe-haven demand for gold, which is down 10% from its 2018 highs of $1360/oz. Ags/Softs: Underweight. The Chinese agriculture ministry lowered its forecast for 2018/19 soybean imports late last week to 93.85 mm MT from 95.65 mm MT. This is in line with its adjustment to consumption this year, now forecast at 109.23 from 111.19 mm MT. Tariffs are expected to incentivize Chinese consumers to prefer alternative proteins - e.g., rapeseed - and to replace U.S. soybean imports with those from South America. Feature U.S. President Donald Trump jawboned OPEC Cartel members - particularly its Gulf Arab members - into raising production. This was accompanied with a none-too-subtle threat implying continued U.S. protection of the Gulf Arab states was at risk if oil production were not lifted.1 OPEC, particularly KSA, responded by lifting production and pledging to keep it at an elevated level. In addition, non-OPEC production growth has been particularly strong this year, and will remain so. These combined production increases will contribute to a modest rebuilding of inventories in 2H18, as markets prepare for the loss of as much as 1 MMb/d of Iranian oil exports beginning in November (Chart of the Week). Chart of the WeekOECD Inventory##BR##Depletion Will Slow OECD Inventory Depletion Will Slow OECD Inventory Depletion Will Slow Chart 2Global Balances Will Loosen,##BR##As Higher Supply Meets Steady Demand Global Balances Will Loosen, As Higher Supply Meets Steady Demand Global Balances Will Loosen, As Higher Supply Meets Steady Demand Estimated 2H18 total OPEC production rose a net 130k b/d, led by a 180k b/d increase on the part of KSA, which will average just under 10.6 MMb/d in the second half of the year. Non-OPEC production for 2H18 was revised upward by 180k b/d in our balances models - based on historical data from the U.S. EIA and OPEC - led by the U.S. shales, which were up close to 700k b/d over 1Q18 levels. This led to a combined increase in global production of 310k b/d in 2H18. With demand growth remaining at 1.7 MMb/d y/y for 2018 and 2019, we expect the higher output from OPEC and non-OPEC sources to loosen physical balances in 2H18 (Chart 2 and Table 1).2 Table 1BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic In and of itself, increased production will reverse some of the depletion of OECD inventories targeted by OPEC 2.0 in its effort to rebalance the market. All else equal, this would be bearish for prices. However, we are keeping our price forecast for 2H18 unchanged from last month - $70/bbl for Brent in 2H18 - and lowering our expectation for Brent to $75/bbl in 2019. This adjustment in next year's expectation reflects our belief that this round of increased production by OPEC 2.0 arguably is being undertaken specifically to rebuild storage ahead of the re-imposition of export sanctions by the U.S. against Iran. Re-imposing sanctions unwinds a deal negotiated by the U.S. and its allies in 2015, which relaxed nuclear-related sanctions against Iran in exchange for commitments to scale back its involvement across the Middle East in the affairs of Arab states with restive Shia populations.3 The re-imposition of sanctions by the U.S. against Iran has set off a round of diplomatic barbs and thrusts on both sides. President Trump declared he wanted Iran's oil exports to go to zero, which was followed by Iran's threat to close the Strait of Hormuz. This set oil markets on edge, given that close to 20% of the world's oil flows through the Strait on any given day.4 Geopolitics Reasserts Itself In The Gulf Oil prices will become increasingly sensitive to geopolitical developments, particularly in the Gulf, now that the U.S. and its allies - chiefly KSA - and Iran and its allies are preparing to square off diplomatically, and possibly militarily. This will lead to a wider range in which oil will trade - i.e., we expect more significant deviations from fundamentally implied values, as markets attempt to price in highly uncertain outcomes to political events.5 Tensions around the Strait of Hormuz - discussed below - will remain elevated post-sanctions being re-imposed, even if we only see threats to traffic through this most-important oil transit. Chart 3 shows that in periods when the error term of our fundamental econometric model increases, it typically coincides with higher implied volatilities. Specifically, the confidence interval around our fundamental-based price forecast widens in times of heightened uncertainty and volatility. The larger the volatility, the larger the squared deviation between our fitted Brent prices against actual prices.6 This indicates the probability of ending 2H18 exactly at our $70/bbl target is reduced as mounting upside - e.g. faster-than-expected collapse in Venezuelan crude exports, rising tensions around the Strait of Hormuz or larger-than-expected Permian pipeline/production bottlenecks - and downside - e.g. escalating U.S.-Sino trade war tensions, increasing Libyan and Nigerian production - risks push the upper and lower bounds around our forecast further apart. Chart 3Increasing Sensitivity To Geopolitics Will Widen Crude's Price Range Increasing Sensitivity To Geopolitics Will Widen Crude's Price Range Increasing Sensitivity To Geopolitics Will Widen Crude's Price Range This directly translates into a wider range in which prices will trade - uncertainty is high, and, while it is being resolved, markets will remain extremely sensitive to any information that could send prices on an alternative path (Chart 4). Chart 4Greater Geopolitical Uncertainty Widens Oil Price Trading Range Greater Geopolitical Uncertainty Widens Oil Price Trading Range Greater Geopolitical Uncertainty Widens Oil Price Trading Range Risks related to a closure of the Strait are not accounted for in our forecasts. However, given the magnitude of the risks implied by even the remote possibility of a closure, we expect markets will put a risk premium into prices. In an attempt to frame out price estimates from a short (10-day) and long (100-day) closure, we provide some cursory simulation results below.7 Can Iran Close The Strait Of Hormuz? The Strait of Hormuz, through which some 20% of global oil supply transits daily, is the principal risk that will keep markets hyper-vigilant going forward.8 A complete closure of the Strait of Hormuz (Map 1) would be the greatest disruption of oil production in history, three times more significant than the supply loss following the Islamic Revolution in 1979 (Chart 5). By our estimate, a 10-day closure at the beginning of 2H19 could pop prices by ~ $25/bbl. A 100-day closure could send prices above $1,000/bbl in our estimates. Map 1Iran Threatens Gulf Shipments Again U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic Chart 5Geopolitical Crises And Global Peak Supply Losses U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic So, the question naturally arises, can Iran's forces close the Strait? Iran's ability is limited by structural and military factors, but it could definitely impede traffic through the globe's most crucial energy chokepoint. There are two scenarios for the closure of the Strait: (i) Iran does so preemptively in retaliation to crippling economic sanctions; or (ii) Iran does so in retaliation to an attack against its nuclear facilities. Either scenario is possible in 2019, as the U.S. intends to re-impose sanctions against Iranian oil exports on November 9, a move that could lead to armed conflict if Iran were to retaliate (Diagram 1).9 Diagram 1Iran-U.S. Tensions Decision Tree U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic SCENARIO I - Preemptive Closure In the past, Tehran has threatened to preemptively close the Strait of Hormuz whenever tensions regarding its nuclear program arose. The threats stopped in mid-2012, as U.S. and Iranian officials engaged in negotiations over the country's nuclear program. However, on July 4 of this year, Iran's nominally moderate President Hassan Rouhani pledged that Tehran would retaliate to an oil export embargo by closing the Strait. Rouhani's comments were reinforced on July 5 by the commander of Iran's elite Revolutionary Guards, whose forces patrol the Strait, Mohammad Ali Jafari. Could Iran actually impede traffic through the Strait of Hormuz?10 Yes. Our most pessimistic scenario posits that Iran could close the waterway for about three or four months. This is based on three military capabilities: mines, land-based anti-ship cruise missiles (ASCM), and a large number of small boats for suicide-like attack waves. In our pessimistic scenario, we assume that Iran would be able to deploy about 700 mines and threaten the Strait by firing only one anti-ship cruise missiles (ASCM) operated via land-based batteries or ship per day, in order to prolong the threat.11 In that way, Iran could draw out the threat indefinitely. The length of closure is based on how long it would take the U.S. naval assets in the region to clear the mines, establish a Q-route - corridor within which the probability of hitting a mine is below 10% - and locate ASCM radars and batteries. The pessimistic scenario is unlikely to occur because of several countermeasures that the U.S. and its regional allies could employ - anti-mine operations, meant to clear a so-called Q route allowing safe passage of oil tankers under U.S. naval escort; punitive retaliation, which would inflict punitive damage on Iran's economy and infrastructure; and, lastly, Iran would not want to risk exposing its radar-guided anti-ship missiles to U.S. suppression of enemy air-defense (SEAD) operations that seek and destroy radars. Despite Iran's growing capability, we still posit that its forces would only be able to close the Strait of Hormuz for between three-to-four months. However, the more likely, "optimistic," scenario is that the closure itself lasts 7-10 days, while Iran then continues to threaten, but not actually close, the Strait for up to four months. It would be worth remembering that the U.S. has already retaliated against a potential closure, precisely 30 years ago. Midway through the Iran-Iraq war, both belligerents began attacking each other's tankers in the Gulf. Iran also began to attack Kuwaiti tankers after it concluded that the country was assisting with Iraq's war efforts. In response, Kuwait requested U.S. assistance and President Ronald Reagan declared in January 1987 that tankers from Kuwait would be flagged as American ships. After several small skirmishes over the following year, the USS Samuel B Roberts hit a mine north of Qatar. The mine recovered was linked to documents found by the U.S. during an attack on a small Iranian vessel laying mines earlier in 1987. The U.S. responded by launching Operation Praying Mantis on April 18, 1988. During the operation, which only lasted a day, the U.S. navy seriously damaged Iran's naval capabilities before it was ordered to disengage as the Iranians quickly retreated. Specifically, two Iranian oil platforms, two Iranian ships, and six gunboats were destroyed. The USS Wainwright also engaged two Iranian F-4s, forcing both to retreat after one was damaged. From this embarrassing destruction of Iran's naval assets, the country realized that conventional capabilities stood little chance against a far superior U.S. navy. As a result, Iran has strengthened its asymmetrical sea capabilities, such as the use of small vessels, and has made evident that the use of mines would be integral to its engagements with foreign navies in the Gulf. However, the switch to asymmetrical warfare means that Iran would likely threaten, rather than directly close, the Strait. From an investment perspective, the threat to shipping would have to be priced-in via higher insurance rates. According to research by the University of Texas Robert S. Strauss Center, the insurance premiums never rose above 7.5% of the price of vessel during the 1980s Iran-Iraq war and actually hovered around 2% throughout the conflict. Rates for tankers docking in Somali ports, presumably as dangerous of a shipping mission as it gets, are set at 10% of the value of the vessel. A typical very large crude carrier (VLCC) is worth approximately $120 million. Adding the market value of two million barrels of crude would bring its value up to around $270 million at current prices. If insurance rates were to double to 20%, the insurance costs alone would add around $30 per barrel, $15 per barrel if rates stayed at the more reasonable 10%. This is without factoring in any geopolitical risk premium or direct loss of supply of Iran's output due to war. Bottom Line: Iran's military capabilities have increased significantly since the 1980s when it last threatened the shipping in the Strait. Iran has also bolstered its asymmetric capabilities since 2012, while the U.S. has largely remained the same in terms of anti-mine capabilities. If Iran had the first-mover advantage in our preemptive closure scenario, the most likely outcome would be that it could close the Strait for up to 10 days and then threaten to close it for up to four months in total. SCENARIO II - Retaliatory Closure A retaliatory closure is possible in the case of a U.S. (or Israeli) attack against Iran's nuclear facilities. Following from the military analysis of a preemptive closure, we can ascertain that a retaliatory closure would be far less effective. The U.S. would deploy all of its countermeasures to Iranian closure tactics as part of its initial attack. If Iran loses its first-mover advantage, it is not clear how it would lay the mines that are critical to closing the Strait. Iran's Kilo class submarines, the main component of a covert mine-laying operation, would be destroyed in port or hunted down in a large search-and-destroy mission that would "light up" the Strait of Hormuz with active sonar pings. The duration of the closure could therefore be insignificant, even non-existent. The only potential threat is that of Iran's ASCM capability. Iran would be able to use its ASCMs in much the same way as in the preemptive scenario, depending on the rate of fire and rate of discovery by U.S. assets. Bottom Line: It makes a big difference whether Iran closes the Strait of Hormuz preemptively or as part of a retaliation to an attack. The U.S. would, in any attack, likely target Iran's ability to retaliate against global shipping in the Persian Gulf. As such, Tehran's asymmetric advantages would be lost. Putting It All Together - Can Iran Close The Strait? Our three scenarios are presented in Table 2. Iran has the ability to close the Strait of Hormuz for up to three-to-four months. That "pessimistic" scenario, however, is highly unlikely. The more likely scenarios are the "preemptive optimistic" and retaliatory scenarios. Table 2Closing The Strait Of Hormuz: Scenarios U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic Assessing the price implications of these scenarios is extremely difficult. Even though the "preemptive optimistic" and the "retaliatory" scenarios are short-lived, up to 20% of the world's daily demand would be removed from the market in the event the Strait of Hormuz was closed. Of course, the U.S. would release barrels from its 660mm-barrel Strategic Petroleum Reserve (SPR) - likely the full maximum of 30 million barrels authorized under law, released over 30 days for a 1 MMb/d release - and Europe would also release ~ 1 MMb/d or so from its crude and product stocks. China likely would tap its SPR as well for 500k b/d. In addition, there is ~ 2 MMb/d of spare capacity in OPEC, which could be brought on line in 30 days (once the Strait is re-opened), and delivered for at least 90 days. How and when a closure of the Strait of Hormuz occurs cannot be modeled, since, as far as prices are concerned, so much depends on when it occurs, and its duration. For this reason, and the extremely low probability we attach to any closure of the Strait, we do not include these types of simulations in our analysis of the various scenarios we include in our ensemble. That said, it is useful to frame the range implied by the scenarios above. We did a cursory check of the impact of scenarios 1 and 2 above, in which we assume 19 MMb/d flow through the Strait is lost for 10 days and 100 days due to closure by Iran in July 2019. We assume this will be accompanied by a 2 MMb/d release from various SPRs globally. In scenario 1, the 10-day closure of the Strait lifts price by $25/bbl, and is resolved in ~ 2 months, with prices returning to ~ $75/bbl for the remainder of the year. In scenario 2, the Strait is closed for 100 days, and this sends prices to $1,500/bbl in our simulation. This obviously would not stand and we would expect the U.S. and its allies - supported by the entire industrialized world - would launch a powerful offensive to reopen the Strait. This would be extremely destructive to Iran, which is why we give it such a low probability. Bottom Line: While the odds of a closure of the Strait of Hormuz are extremely low - to the point of not being explicitly modeled in our balances and forecasts - framing the possible outcomes from the scenarios considered in this report reveals the huge stakes involved. A short closure of 10 days could pop prices by $25/bbl before flows are restored to normal and inventory rebuilt, while an extended 100-day closure could send prices to $1,500/bbl or more. Because the latter outcome would result in a massive offensive against Iran - supported by oil-consuming states globally - we view this as a low-probability event. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 President Trump's tweets calling for higher oil production have consistently been directed at the original OPEC Cartel, as seen July 4: "The OPEC monopoly must remember that gas prices are up & they are doing little to help. If anything, they are driving prices higher as the United States defends many of their members for very little $'s. This must be a two way street. REDUCE PRICING NOW!" Since the end of 2016, we have been following the production and policy statements of OPEC 2.0, the name we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. 2 We will be exploring the rising risks to our demand projections in future research. Still, we are in broad agreement with the IMF's most recent assessment of global economic growth, which remains at 3.9% p.a. Please see "The Global Expansion: Still Strong but Less Even, More Fragile, Under Threat," published July 16, 2018, on the IMF's blog. 3 We discuss this at length in the Special Report we published with BCA's Geopolitical Strategy on June 7, 2018, entitled "Iraq Is The Prize In U.S. - Iran Sanctions Conflict." It is available at ces.bcaresearch.com. 4 In an apparent recognition of what it would mean for world oil markets if Iran's exports did go to zero - particularly with Venezuela so close to collapse, which could take another 800k b/d off the market - U.S. Secretary of State Mike Pompeo announced waivers to the sanctions would be granted, following Trump's remarks at the beginning of July. See "Pompeo says US could issue Iran oil sanctions waivers" in the July 10, 2018, Financial Times. The Trump administration, however, is keeping markets on their toes, with Treasury Secretary Steven Mnuchin telling the U.S. Congress, "We want people to reduce oil purchases to zero, but in certain cases, if people can't do that overnight, we'll consider exceptions." See "Iran sues US for compensation ahead of re-imposition of oil sanctions," published by S&P Global Platts on July 17, 2018, on its spglobal.com/platts website. 5 Technically, this means the confidence interval around the target is now wider, which implies high probability of going above $80/bbl as well as the probability of going under $70/bbl. Still, the 2019 risks are skewed to the upside, in our view. 6 Given that our model is based solely on a variety of fundamental variables - i.e. supply-demand-inventory - the deviations can be interpreted as movements in the risks premium/discount. 7 This exercise does not include any estimate of oil flows through KSA's East-West pipeline, and possible exports therefrom. The rated capacity of the 745-mile line is 5 MMb/d, possibly 7 MMb/d. KSA's Red Sea loading capacity and the capacity of the Suez Canal and Bab el Mandeb under stress - i.e., the volumes either can handle with a surge of oil-tanker traffic - is not considered either. 8 This is the U.S. EIA's estimate. The EIA notes that in 2015 the daily flow of oil through the Strait accounted for 30% of all seaborne-traded crude oil and other liquids. Natural gas markets also could be affected by a closure: In 2016, more than 30% of global liquefied natural gas trade transited the Strait. Please see "Three important oil trade chokepoints are located around the Arabian Peninsula," published August 4, 2017, at eia.gov. 9 We encourage our clients to read our analysis of potential Iranian retaliatory strategies, penned by BCA's Geopolitical Strategy team. Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 10 Analysis of Iran's military strategy and U.S. counterstrategy used in this paper relies on research from three heavily cited papers. Eugene Gholz and Daryl Press are skeptical of Iran's ability to close the Strait in their paper titled "Protecting 'The Prize': Oil and the National Interest," published in Security Studies Vol. 19, No. 3, 2010. Caitlin Talmadge gives Iran's capabilities far more credit in a paper titled "Closing Time: Assessing the Iranian Threat to the Strait of Hormuz," published in International Security Vol. 33, No. 1, Summer 2008. Eugene Gholz also led a project at the University of Texas Robert S. Strauss Center for International Security and Law that published an extensive report titled "The Strait of Hormuz: Political-Military Analysis of Threats to Oil Flows." 11 In the Strauss Center study, the most likely number is 814 mines, if Iran had a two-week period to do so covertly. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic Trades Closed in 2018 Summary of Trades Closed in 2018 U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic

Highlights President Trump is a prisoner of his own mercantilist rhetoric - there is more trade tension and volatility to come; China's depreciation of the RMB can go further - and will elicit more punitive measures from Trump; Gasoline prices are a constraint on Trump's Maximum Pressure campaign against Iran, but only until midterm elections are done; Brexit woes are keeping us short GBP/USD, but Theresa May has discovered the credible threat of new elections - we are putting a trailing stop on this trade at 2%; The EU migration "crisis" is neither a real crisis nor investment relevant. Feature General Hummel: I'm not about to kill 80,000 innocent people! We bluffed, they called it. The mission is over. Captain Frye: Whoever said anything about bluffing, General? The Rock, 1996 As BCA's Geopolitical Strategy has expected since November 2016, the risk of trade war poses a clear and present danger for investors.1 The U.S. imposed tariffs of 25% on $34 billion of Chinese goods on July 6, with tariffs on another $16 billion going into effect on July 20. President Trump announced on July 10 that he would levy a 10% tariff on an additional $200 billion of Chinese imports by August 31 and then on another $300 billion if China still refused to back down. That would add up to $550 billion in Chinese goods and services that could be subject to tariffs, more than China exported to the U.S. last year (Chart 1)! Chart 1President Trump Magically Threatens ##br##Even Non-Existent China Imports Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Table 1Market's Couldn't Care##br## Less About Tariffs Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? The S&P 500 couldn't care less. Trade-related events - and other geopolitical crises - have thus far had a negligible impact on U.S. equities (Table 1). If anything, stocks appear to be slowly climbing the geopolitical wall of worry since plunging to a low of 2,581 on February 8, which was before any trade tensions emerged in full focus (Chart 2A and Chart 2B).2 Chart 2AStocks Climbing The 'Wall Of Worry' On Trade Tensions... Stocks Climbing The 'Wall Of Worry' On Trade Tensions... Stocks Climbing The 'Wall Of Worry' On Trade Tensions... Chart 2B...And On Military Tensions ...And On Military Tensions ...And On Military Tensions Speaking with clients, the consensus appears to be that President Trump is "bluffing." After all, did he not successfully create a "credible threat" amidst the tensions with North Korea, thus forcing Pyongyang to stand down, change its bellicose rhetoric, free U.S. prisoners, and freeze its nuclear device and ballistic tests? This was a genuinely successful application of his "Maximum Pressure" tactic and he did not have to fire a shot!3 Yes, but the Washington-Pyongyang 2017 brinkmanship caused 10-year Treasuries to plunge 35bps from their July 7 peak to their September 7 low.4 Our colleague Rob Robis - BCA's Chief Fixed Income Strategist - assures us that this move in Treasuries last summer was purely North Korea-related, which suggests that not all investors were relaxed and expecting tensions to resolve themselves.5 President Trump may be bluffing on protectionism, on Iran, and on the U.S.'s trade and geopolitical relationship with its G7 allies. However, we should consider two risks. The first is that his opponents might not back down. Yes, we agree with the consensus that China will ultimately lose a trade war with the U.S. It is a trade surplus country fighting a trade war with its chief source of final export demand (Chart 3). Chart 3China Has More To Lose Than The U.S. China Has More To Lose Than The U.S. China Has More To Lose Than The U.S. Forecasting when China backs down, however, is difficult. If Beijing backs down in 2018, investors betting on stocks ignoring trade risks will be proven correct. We do not see this happening. Instead, we expect Beijing to continue using CNY depreciation to offset the impact of tariffs, likely exacerbating the ongoing USD rally in the process, and eventually putting pressure on U.S. corporate earnings in Q3 and Q4. China does not appear to be panicking about the threat of a 10% tariff. In fact, Beijing may decide to double-down on its structural reform efforts, which have negatively impacted growth in the country thus far, blaming President Trump's protectionist policies for the pain. The other question is whether the U.S. political context will allow President Trump to end the trade war. Our clients, colleagues, and friends in the financial industry seem to have collective amnesia about the "trade truce" orchestrated by Treasury Secretary Steven Mnuchin on May 20. The truce lasted merely a couple of days, with the U.S. ultimately announcing on May 29 that the tariffs on $50 billion of Chinese imports would go forward. President Trump may have wanted to present the Mnuchin truce as a big victory ahead of the midterm elections. His tweets the next day were triumphant.6 However, once the collective American establishment (Congress, pundits, and even Trump's ardent supporters in the conservative media) got hold of the details of the deal, they were shocked and disappointed.7 Why? The American "median voter" is far more protectionist than the political establishment has wanted to admit. Now that this public preference has been elucidated, President Trump himself cannot move against it. He is a prisoner of his own mercantilist rhetoric. President Trump may be dealing with a situation similar to the one General Hummel faced in the iconic mid-1990s action thriller The Rock. Hummel, played by the steely Ed Harris, holed up in Alcatraz with VX gas-armed M55 rockets, threatening to take out tens of thousands in San Francisco unless a ransom was paid by the Washington establishment. Unfortunately for Hummel, the psychotic marines he brought to "The Rock" turned against him when he suggested that the entire operation was in fact a bluff. As such, we reiterate: Whoever said anything about bluffing? China: Beware Beijing's Retaliation Since 2017, we have cautioned investors that Beijing was likely to retaliate to the imposition of tariffs by weakening the CNY/USD.8 June was the largest one-month decline in CNY/USD since the massive devaluation in 1994 (Chart 4). BCA's China Investment Strategy has shown that the PBOC is indeed allowing China's currency to depreciate against the U.S. dollar.9 Chart 5 shows the actual CNY/USD exchange rate alongside the value that would be predicted based on its relationship with the dollar over the year prior to its early-April peak. The chart suggests that the decline in CNY/USD appears to have reflected the strength in the U.S. dollar until very recently. However, CNY/USD has fallen over the past few days by a magnitude in excess of what would be expected given movements in the greenback, implying that the very recent weakness is likely policy-driven. Chart 4The Biggest One-Month Yuan Drop Since 1994 The Biggest One-Month Yuan Drop Since 1994 The Biggest One-Month Yuan Drop Since 1994 Chart 5The CNY Is Much Weaker Than The DXY Implies The CNY Is Much Weaker Than The DXY Implies The CNY Is Much Weaker Than The DXY Implies BCA's Foreign Exchange Strategy has pointed out that currency depreciation is also a way to stimulate the economy in the face of the central government's ongoing deleveraging policy.10 Not only does a weaker CNY dull the impact of Trump's tariffs, it also insulates China against a slowdown in global trade volumes (Chart 6). Moreover, China's current account fell into deficit last quarter (Chart 7). A weaker RMB helps deal with this issue, but the PBoC may be forced to cut Reserve Requirement Ratios (RRRs) further if the deficit remains in place, forcing the currency even lower. Chart 6China Needs A Buffer Against Slowing Trade China Needs A Buffer Against Slowing Trade China Needs A Buffer Against Slowing Trade Chart 7Supportive Conditions For A Lower CNY Supportive Conditions For A Lower CNY Supportive Conditions For A Lower CNY There is no silver lining in this move by Beijing. Evidence that China is manipulating its currency would be a clear sign of an outright, full-scale trade war between the U.S. and China. On one hand, a falling RMB will improve the financial position of China's exporters. On the other hand, it may invite further protectionist action from the U.S., including a threat by the White House to increase the tariff levels on the additional $500 billion of imports from the current 10% rate, or to enhance export restrictions on critical technologies, or to add new investment restrictions. Several of our clients have pointed out that China does not want a trade war, that it cannot win a trade war, and that it is therefore likely to offer concessions ahead of the U.S. midterm election. We agree that China is at a disadvantage.11 But we also reiterate that the concessions have already been offered, in mid-May following the Mnuchin negotiations with Chinese Vice Premier Liu He. China and the U.S. may of course resume negotiations at any time, but it will likely take months, at best, to arrange a deal that reverses this month's actual implementation of tariffs. We think that the obsession with "who will win the trade war" is misplaced. Of course, the U.S. will "win." The problem is that what the Trump administration and what investors consider a "victory" may be starkly different: victory may not include a rip-roaring stock market. In fact, President Trump may require a stock market correction precisely to convince his audience, including those in Beijing, that his threats are indeed credible. Bottom Line: President Trump's promise of a 10% tariff on $500 billion of Chinese imports can easily be assuaged by a CNY/USD depreciation. If we know that Beijing is depreciating its currency, so does the White House. The charge against Beijing for currency manipulation could occur as late as the Treasury Department's semiannual Report to Congress in October, or informally via a presidential tweet at any time before then. While the formal remedies against a country deemed to be officially engaged in currency manipulation are relatively benign in the context of the ongoing trade war, we would expect President Trump to up the pressure on China regardless. Iran: Can Midterm Election Stay President Trump's Hand? We identified U.S.-Iran tensions in our annual Strategic Outlook as the premier geopolitical risk in 2018 aside from trade concerns.12 We subsequently argued that President Trump's application of "Maximum Pressure" against Iran would likely exacerbate tensions in the Middle East, add a geopolitical risk premium to oil prices, and potentially lead to a military conflict in 2019 (Diagram 1).13 Diagram 1Iran-U.S. Tension Decision Tree Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? The Brent crude oil price has come off its highs just below $80/bbl in late May and appears to be holding at $75/bbl. Is the market once again ignoring bubbling U.S.-Iran tensions or is there another factor at play? We suspect that investors are placing their hopes on White House pressure on producers to bring massive amounts of crude online to offset the impact of "Maximum Pressure" on Iran. First, Trump tweeted in April that "OPEC is at it again," keeping oil prices artificially high. He followed this with another tweet at the end of June, directly requesting that Saudi Arabia increase oil production by up to 2 million b/d so that he may continue to play brinkmanship with Tehran. Second, the Libyan media leaked that President Trump sent letters to the representatives of Libya's warring factions, imploring them to restart oil exports or face international prosecution and potential U.S. military intervention.14 The pressure on the Libyan authorities appears to have worked, with the Tripoli-based National Oil Corporation (NOC) ending its force majeure, a legal waiver on contractual obligations, on the ports of Ras Lanuf, Es Sider, Zueitina, and Hariga. Third, Secretary of State Mike Pompeo signaled on July 10 that the U.S. would consider granting waivers to countries seeking to avoid being sanctioned for buying oil from Iran. On July 15, however, the administration clarified the comment by stating that it would only grant limited exceptions based on national security or humanitarian efforts. The White House is realizing that, unlike its brinkmanship with North Korea, "Maximum Pressure" on Iran comes with immediate domestic costs: higher gasoline prices (Chart 8). The last thing President Trump wants to see is his household tax cut trumped by the higher cost of gasoline. Chart 8How Badly Do Americans Want A New Iran Deal? How Badly Do Americans Want A New Iran Deal? How Badly Do Americans Want A New Iran Deal? Chart 9Iran Is Not Yet At Peak North Korean Levels Of Threat Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Applying Maximum Pressure on Iran is tricky. Politically, the upside is limited for President Trump. First, a majority of Americans (62%) do not want to see the U.S. withdraw from the deal, and do not consider Iran to be as critical of a threat as North Korea (Chart 9). That said, 40% believe that Iran is a "very serious" threat - up from just 30% in October, 2017 - and 62% of Americans believe that "Iran has violated the terms" of the nuclear agreement. These are numbers that President Trump can "work with," but not if gasoline prices rise to consumer-pinching levels. As such, the question is whether we should stand down from our bullish oil outlook given President Trump's active role in eking out new supply. We should, if there were supply to be eked out. BCA's Commodity & Energy Strategy believes that global supply capacity will not be sufficient to keep prices below $80/bbl in the event that Venezuela collapses in 2019 or that Iranian export losses are greater than the 500,000 b/d we are currently projecting.15 The U.S. EIA estimates there is only 1.8mm b/d of spare capacity available worldwide this year, to fall to just over 1 mm b/d next year (Chart 10). Our commodity strategists believe that the idle and spare capacity of KSA, Russia, and other core OPEC 2.0 states that can actually increase production would be taxed to the extreme to cover losses of Iranian exports, especially if the losses reached 1 mm b/d. In fact, many secondary OPEC 2.0 producers are struggling to produce at their 2017-2018 production quota, suggesting that lack of investment and natural depletion have already taken their toll (Chart 11). Chart 10Global Spare Capacity##br## Stretched Thin Global Spare Capacity Stretched Thin Global Spare Capacity Stretched Thin Chart 11OPEC 2.0's Core Producers Would##br## Struggle To Replace Lost Exports OPEC 2.0's Core Producers Would Struggle To Replace Lost Exports OPEC 2.0's Core Producers Would Struggle To Replace Lost Exports Could President Trump back off from the threat of brinkmanship with Iran due to the risk of rising oil prices? Yes, absolutely. We have argued in the past that President Trump appears to be an intensely domestically-focused president. We also see little logic, from the perspective of U.S. interests broadly defined or President Trump's "America First" strategy specifically, in undermining the Obama-era nuclear agreement. As such, domestic constraints could stay President Trump's hand. On the other hand, these constraints would have the greatest force ahead of the November 2018 midterm and the 2020 general elections. This gives President Trump a window between November 2018 and at least the early summer of 2020 to put Maximum Pressure on Iran. As such, we think that investors should fade White House attempts to shore up global supply. Once the midterm election is over, the pressure will fall back on Iran. What about Iran's calculus? Tehran has an interest in dampening tensions ahead of the midterms as well. However, if the U.S. actually enforces sanctions, as we expect it will, we are certain that Iran will begin to ponder the retaliatory action we describe in Diagram 1. In fact, Iran's population appears to be itching for a confrontation, with an ever-increasing majority supporting the restart of Iranian nuclear facilities in response to U.S. withdrawal from the JCPOA nuclear agreement (Chart 12). Iranian officials have also already threatened to close the Straits of Hormuz as we expected they would. Chart 12Iranians Supported Ending Nuclear Deal If The U.S. Did (And It Did!) Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Bottom Line: Between now and November, U.S. policy towards Iran may be much ado about nothing. However, we expect the pressure to rise by the end of the year and especially in 2019. Our subjective probability of armed conflict remains at an elevated 20%, by the end of 2019. This is four times greater than our probability of kinetic action amidst the tensions between the U.S. and North Korea. Brexit: Has Theresa May Figured Out How Credible Threats Work? We have long argued that a soft Brexit is incompatible with Euroskeptic demands for increased sovereignty (Diagram 2). And, indeed, sovereignty was one of the main demands - if not the main demand - of Brexit voters ahead of the referendum. A large percent, 32% of "leave" voters, said they would be willing to vote "stay" if a deal with the EU gave "more power to the U.K. parliament," an even greater share than those focused on migration (Chart 13). As such, since March 2016, we have expected the U.K. Conservative Party to split into factions regardless of the outcome of the vote on EU membership.16 Diagram 2The Illogic Of ##br##Soft Brexit Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Chart 13Sovereignty Topped The##br## List Of Brexit Voter Concerns Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? U.K. Prime Minister Theresa May has fought against the inevitable by inviting notable Euroskeptics into her cabinet and by trying to pursue a hard Brexit in practice. The problem with this strategy is that it won't work in Westminster, where a whopping 74% of all members of parliament, and 55% of all Tory MPs, declared themselves as "remain" supporters ahead of the 2016 referendum (Chart 14). Given that the House of Commons has to approve the ultimate U.K.-EU deal, a hard-Brexit deal is likely to fail in Parliament. While such a defeat would not automatically bring up an election, May would be essentially left without any political capital with which to continue EU negotiations and would either have to resign or call a new election. Chart 14Westminster MPs Support Bremain! Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Theresa May therefore has two options. The first is to trust the political instincts of David Davis and Boris Johnson and try to push a hard Brexit through the House of Commons. But with a slim majority of just one MP, how would she accomplish such a feat? Nobody knows, ourselves included, which is why we shorted the GBP as long as May stubbornly listened to the Euroskeptics in her cabinet. However, it appears that May has finally decided to ditch her Euroskeptic cabinet members and establish the "credible threat" of a new election. While May has not uttered the phrase directly, she hinted at a new election when she suggested that "there may be no Brexit at all." The message to hard-Brexit Tory rebels is clear: back my version of Brexit or risk new elections. From an economic perspective, retaining some semblance of Common Market membership is obviously superior to the hard-Brexit alternative. It is so superior, in fact, that Boris Johnson himself called for it immediately following the referendum!17 From a political perspective, it is also much easier to persuade less than two-dozen committed Tory Euroskeptics that a new election would be folly than it is to convince half of the party that the economic risks of a hard-Brexit are inconsequential. The switch in May's tactic therefore warrants a cautionary approach to our current GBP/USD short. The recommendation is up 5.55% since February 14. However, the GBP could be given a tailwind if investors sniff out fear amongst hard Brexit Tories. We still believe that downside risks exist in the short term. First, there is no telling if the EU will accept the particularities of May's Brexit strategy. In fact, the EU may want to make May's life even more difficult by asking for more concessions. Second, Euroskeptic Tories in the House of Commons may be willing martyrs, rebelling against May regardless of the economic and political consequences. Bottom Line: We are keeping our short GBP/USD on for now, which has returned 5.55% since February 14, but we will tighten the stop to just 2%. We think that Theresa May has finally figured out how to use "credible threats" to cajole her party into a soft Brexit. The problem, however, is that she still needs Brussels to play ball and her Euroskeptic MPs to act against their ideology. Europe: Will The Immigration Crisis End The EU? Chart 15European Migration Crisis Is Over European Migration Crisis Is Over European Migration Crisis Is Over No. There is no migration crisis in the EU (Chart 15). Despite the posturing in Europe over the past several months, the migration crisis ended in October 2015. As we forecast at the time, Europe has since taken several steps ovet the succeeding years to increase the enforcement of its external borders, including illiberal methods that many investors thought beyond European sensibilities.18 Today, EU member states are openly interdicting ships carrying asylum seekers and turning them away in international waters. Chancellor Angela Merkel has become just the latest in a long line of policymakers to succumb to her political constraints - and abandon her preferences - by agreeing to end the standoff with her conservative Bavarian allies. Merkel has agreed to set up transit centers on the border of Austria from where migrants will be returned to the EU country where they were originally registered, or simply sent across the border to Austria. The idea behind the move is to end the "pull" that Merkel inadvertently created by openly declaring that Germany was open to migrants regardless of where they came from. Why wouldn't migrants keep coming to Europe regardless? Because if the promise of a job and a legal status in Germany or other EU member states is no longer available, the cost - in treasure, limb, and life - of the journey through the Sahara and unstable states like Libya, and the Mediterranean Sea will no longer make sense. As Chart 15 shows, potential migrants are capable of making the cost-benefit calculation and are electing to stay put. Bottom Line: The EU migration crisis is not investment-relevant. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see the Appendices for the detailed description of events. 3 Please see BCA Geopolitical Strategy Special Report, "Pyongyang's Pivot To America," June 8, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 5 BCA Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," dated September 12, 2017, available at gfis.bcaresearch.com. 6 His tweets in the immediacy of the deal suggest that this was the case. He tweeted, immediately following Mnuchin's Fox News appearance, "China has agreed to buy massive amounts of ADDITIONAL Farm/Agricultural Products - would be one of the best things to happen to our farmers in many years!" He then tweeted again, suggesting that his deal was superior to anything President Obama got, "I ask Senator Chuck Schumer, why didn't President Obama & the Democrats do something about Trade with China, including Theft of Intellectual Property etc.? They did NOTHING! With that being said, Chuck & I have long agreed on this issue! Trade, plus, with China will happen!" His third tweet suggested that the deal being negotiated was indeed a big compromise, "On China, Barriers and Tariffs to come down for first time." All random capitalizations are President Trump's originals. 7 We reacted to the truce by arguing that it would not "last long." It lasted merely three days! Please see BCA Geopolitical Strategy Weekly Report, "Some Good News (Trade), Some Bad News (Italy)," dated May 23, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, and "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com. 9 Please see BCA China Investment Strategy Weekly Report, "Now What?" dated June 27, 2018, available at cis.bcaresearch.com. 10 Please see BCA Foreign Exchange Strategy Weekly Report, "What Is Good For China Doesn't Always Help The World," dated June 29, 2018, available at fes.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 14 Please see "Trump's letter to rivals allegedly results in resumption of oil exports in Libya," Libyan Express, dated July 11, 2018, available at libyanexpress.com. 15 Please see BCA Commodity & Energy Strategy Weekly Report, "Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf," dated July 5, 2018, available at ces.bcaresearch.com. 16 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 17 Johnson stated right after the referendum that "there will continue to be free trade and access to the single market." Please see "U.K. will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. 18 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. Appendix Appendix 2A Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Appendix 2B Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Appendix 2B (Cont.) Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Geopolitical Calendar

Dear Client, Geopolitical analysis is a fundamental part of the investment process. BCA’s Chief Geopolitical Strategist, Marko Papic, will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Highlights The U.S. and China have now acted on their threats and imposed tariffs; A full-blown trade war is expected, as President Trump retaliates to China's retaliation; The Tiananmen Square incident, the third Taiwan Strait Crisis, and the Hainan Island incident are previous U.S.-China clashes worth comparing to today's conflict - they point to more trouble ahead; Trade tensions are already spilling out into strategic tensions in China's near seas. It is too soon to buy Chinese or China-exposed equities. Feature On July 6, President Donald Trump imposed a 25% tariff on $34 billion worth of Chinese imports, to expand to $50 billion on July 20. China responded with tariffs of its own on the same amount (Chart 1). Trump has since threatened to slap a 10% tariff on $200 billion worth of goods, and potentially additional tariffs on another $300 billion. Beijing is refusing to negotiate under duress. Trade tensions have already spilled into the military realm, with scuffles occurring from the coast of Africa to the Taiwan Strait.1 BCA's Geopolitical Strategy has long maintained that U.S.-China relations are in a structural, not merely cyclical, decline.2 One of the most striking illustrations of this thesis has been the divergence of the two economies since the global financial crisis. The Chinese exporter has fallen in importance to China's economy while the U.S. consumer has been taking on less debt (Chart 2). Previously, a close economic dependency - dubbed "Chimerica" by prominent commentators - limited the two countries' underlying strategic distrust. Today, strategic distrust is aggravating economic divisions. Chart 1U.S.-China Trade Hit By Tariffs The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis Chart 2Sino-American Symbiosis Is Over Sino-American Symbiosis Is Over Sino-American Symbiosis Is Over How significant is the current rupture in U.S.-China relations? A brief look at the three major crisis points of the 1980s-2000s reinforces our structural assessment: the current conflict has the potential to become the biggest conflict in U.S.-China relations since the early Cold War. Judging by previous crises, it could last two years or more and involve extensive economic sanctions and military saber-rattling. The disruption to global markets could be much greater than in the past due to China's greater heft on the world stage. Crisis #1: Tiananmen Square, 1989-91 The first major crisis in modern U.S.-China relations was also the worst to date. It is therefore the model against which to compare today's fraying relationship. It centered on the suppression of the Tiananmen Square protests in 1989 by the Communist Party and People's Liberation Army (PLA). Throughout the 1980s, China struggled to manage the rapid economic and social consequences of opening up to the outside world. The release of pent-up demand in an inefficient, command-style supply system resulted in rising bouts of inflation that spurred popular unrest (Chart 3). Meanwhile, student activism and democratic sentiment emerged in the political climate of glasnost across communist regimes. These forces coalesced into the large-scale demonstrations at Tiananmen Square, Beijing, and other cities, in the spring of 1989. In response, the ruling party declared martial law and ordered the PLA to break up the demonstrations on June 3-4. The United States responded with a series of sanctions intended to punish and isolate China's leaders. President George H. W. Bush halted arms exports, other sensitive exports, most civilian and military dialogue, development aid, and support for multilateral bank lending to China.3 The other G7 countries joined with their own restrictions on exports, aid, and loans. China's economy slowed sharply to a 4% growth rate from above 10% for most of the decade. Meanwhile the government expanded the crackdown on domestic dissent. Exports to China clearly suffered from the crisis (Chart 4). Chart 3China's Reform Era Sparked Inflation China's Reform Era Sparked Inflation China's Reform Era Sparked Inflation Chart 4Trade Suffered From Tiananmen Incident Trade Suffered From Tiananmen Incident Trade Suffered From Tiananmen Incident Ultimately, however, the U.S. and its allies proved unwilling to sustain the pressure. While multilateral lending dropped off, direct lending continued (Chart 5). China was also allowed to retain its Most Favored Nation (MFN) trading status. The G7 began removing some of the sanctions as early as the following year. The inflow of FDI recovered sharply (Chart 6). Only a few of the sanctions had a lasting effect.4 Chart 5Multilateral Lending Cut Off After Tiananmen The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis Chart 6FDI Recovered From Tiananmen Quickly The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis The relevance of Tiananmen today is that when faced with domestic instability, China's ruling party took drastic measures to ensure its supremacy. This included weathering the pain of the combined G7 trade sanctions at a time when China's economy was small, weak, and slowing. By comparison, today's trade war also threatens domestic stability - through unemployed manufacturing workers rather than pro-democracy students. Yet it does not involve a united front against China from the West (the Trump administration is simultaneously slapping tariffs on the G7!). Moreover, China's economy is far larger and more influential than in 1989. This gives it a greater ability to retaliate and to deter a conflict that is all the more consequential for global economies and markets (Table 1). As for the market impact, mainland China did not have functional stock markets until 1990-91, but Hong Kong-listed stocks collapsed during the Tiananmen protests and did not fully recover for a year (Chart 7). Today, tariffs are a more direct and lasting threat to corporate earnings than the Tiananmen fallout and it is not clear how far the cycle of retaliation will go. The implication for investors is that Chinese and China-exposed equities are not yet a buy, despite the 10% and 13% selloff in A-shares and H-shares in recent weeks. Table 1China Much Bigger Today Than In Previous U.S.-China Clashes The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis Chart 7Tiananmen Hit Hong Kong Stocks Tiananmen Hit Hong Kong Stocks Tiananmen Hit Hong Kong Stocks Finally, the 1980s-90s marked the heyday of U.S.-China economic engagement and the Bush White House was eager to get on with business (even the Bill Clinton White House proved to be the same). By contrast, the Washington establishment today is united in demanding a tougher stance on China. The two countries are now "peers" locked in a struggle that goes beyond trade to affect long-term national security.5 Rebuilding trust will require painstaking negotiations that may take months; more economic and financial pain may be necessary to force cooperation. Bottom Line: The Tiananmen incident has long provided the basic framework for a rupture in U.S.-China relations, as it involved an official diplomatic cutoff along with a serious blow to Chinese growth rates and foreign trade and investment. Circumstances are even more dangerous today, as China is in a better position to stare down U.S. pressure and the U.S. is more desirous of a drawn-out confrontation. This is a bad combination for risk assets. It is too early to buy into the selloff in Chinese and China-related equities. Crisis #2: The Taiwan Strait, 1995-96 From the end of the Chinese Civil War in 1949 and beginning of the Korean War in 1950, the United States undertook to defend the routed Chinese nationalists on their island refuge of Taiwan. Fighting occasionally broke out over control of the small coastal islands across the strait from Taiwan, most notably in the two "Taiwan Strait Crises" of 1954-55 and 1958. An uneasy equilibrium then developed that lasted until the third Taiwan Strait Crisis in 1995-96. The third crisis arose in the aftermath of Taiwan's democratization. China's economy was booming, it was seeking to modernize its military, and the U.S. was increasing arms sales to Taiwan (Chart 8). In July 1995, Beijing launched a series of missile tests and military exercises, hoping to discourage pro-independence sentiment and dissuade the Taiwanese people from voting for President Lee Teng-hui - who was rightly suspected of favoring independence - ahead of the 1996 elections. The United States responded with a show of force on behalf of its informal ally, eventually deploying two aircraft carriers, USS Nimitz and USS Independence, and various warships to the area. The Nimitz sailed through the strait. Tensions peaked ahead of the Taiwanese election on March 23, 1996 - in which voters went against China's wishes - and simmered for years afterwards. Chart 8Arms Sales Could Reemerge As An Irritant Arms Sales Could Reemerge As An Irritant Arms Sales Could Reemerge As An Irritant Chart 9Taiwan Crisis Hit Mainland And Taiwan, Not U.S. Stocks Taiwan Crisis Hit Mainland And Taiwan, Not U.S. Stocks Taiwan Crisis Hit Mainland And Taiwan, Not U.S. Stocks The military and diplomatic standoff had a pronounced negative impact on financial markets. Both mainland and Taiwanese stock markets sold off and were suppressed for months afterwards (Chart 9). Our measure of the Taiwanese geopolitical risk premium - which utilizes the JPY/USD and USD/KRW exchange rates as proxies - shows that risks reached a peak during this period (Chart 10). As with Tiananmen, however, U.S. stocks were insulated from the crisis. Chart 10Taiwanese Geopolitical Risk Likely To Rise From Here Taiwanese Geopolitical Risk Likely To Rise From Here Taiwanese Geopolitical Risk Likely To Rise From Here Over the long run, China's saber-rattling promoted pro-independence sentiment and Taiwanese identity, factors that are proving to be political risks once again in 2018 (Chart 11). China has held provocative military drills and imposed discrete sanctions as a result of pro-independence election outcomes in 2014-16 (Chart 12). Local elections on November 24 this year could serve as a lightning rod for provocations, especially if pro-independence politicians, which currently hold all branches of government, continue to win.6 Chart 11Beijing's Saber-Rattling Was Counter-Productive The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis Chart 12Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Further, the Trump administration has upgraded Taiwan relations and its trade war with China is already spilling over into Taiwan affairs. The decision to send the destroyers USS Mustin and Benfold through the Taiwan Strait on July 7-8 should be seen in the context of trade tensions. A new aircraft carrier transit is being openly discussed. These are negative signs that warrant caution toward both mainland and Taiwanese equities. Bottom Line: The Third Taiwan Strait Crisis marked the biggest spike in military tensions between the U.S. and China in recent memory and had a markedly negative impact on regional risk assets. It is a worrying sign that the U.S.-China trade war is becoming intermeshed with cross-strait political tensions. We continue to view Taiwan as the potential site of a "Black Swan" event, especially if this November's local election goes against Beijing's wishes.7 Crisis #3: Hainan Island, 2001 Lastly, the "Hainan Island Incident" marks another point of tension in U.S.-China relations. On April 1, 2001 a Chinese jet struck a U.S. EP-3 ARIES II signals reconnaissance plane in the skies over the South China Sea, between Hainan and the contested Paracel Islands. The U.S. plane landed on the southern island, where its crew was detained and interrogated for 10 days while their aircraft was meticulously disassembled. The U.S. issued a half-hearted apology and the crew was released. The Chinese pilot went missing in the crash and was later declared killed in action. The incident fed into already sour feelings between Washington and Beijing. Just two years earlier, the U.S. government had "botched" an attack on a federal Yugoslav target in Belgrade, striking the Chinese embassy and killing three Chinese civilians.8 Thus, at the turn of the century, China was angry about U.S. military interventionism, while the U.S. was wary of China's military modernization. But this period of tensions was ultimately overshadowed by the September 11 terrorist attacks later that year, which prompted the U.S. to turn its attention to the Middle East and the war on terrorism. We highlight the Hainan incident for a simple reason: the South China Sea is a much more fiercely contested space today than it was in 2001. This is not only because global trade traffic has multiplied to around $4.14 trillion in the sea (Diagram 1). It is also because China has attempted to enforce its sovereignty claims over most of the sea by building up military assets there over the past several years.9 The U.S. has begun to push back by conducting "freedom of navigation" exercises that directly challenge China's maritime-territorial claims. Diagram 1South China Sea As Traffic Roundabout The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis In fact, China's entire maritime periphery - from the South China Sea to the Taiwan Strait to the East China Sea - has become a zone of geopolitical risk. The risk stems from China's attempts to establish a sphere of influence - and the American, Japanese, and other Asian nations' attempts to contain China's rise. A Hainan incident today would have a much bigger impact on the market than in 2001, when China's share of global GDP, imports, and military spending was roughly one-third of what it is today (see Table 1 above). And while a diplomatic crisis of this nature could easily cause global stocks to fall, the greater danger to the marketplace is that a military incident occurs. That would jeopardize global trade and growth, and the geopolitical fallout would be more difficult to contain. Bottom Line: U.S.-China strategic tensions came to a head in the South China Sea in 2001, but quickly subsided.. Today both the risk of a miscalculation and the economic stakes are greater than in the past. China's maritime periphery is thus an additional source of geopolitical risk at a time of U.S.-China trade war. Investment Conclusions: Then And Now What the three examples above have in common is that they occurred during the springtime of U.S.-China relations after the rise of Deng Xiaoping and China's "reform and opening up" policy. In each case, thriving trade and corporate profits provided an impetus for Washington and Beijing to move beyond their difficulties. The political elite across the West also believed that economic engagement would nudge China toward fuller liberalization and eventually even democracy. Today, however, the economic logic of a U.S.-China détente has been replaced by strategic rivalry, as the two economic systems are diverging. The U.S. is growing fearful of China's technological prowess, while China fears having its access to technology unplugged.10 As we have highlighted before, President Trump is virtually unconstrained on trade policy as well as on foreign policy and national security. And while he faces congressional resistance to his tariffs on G7 allies, Congress is actually egging him on in the fight against China - as seen with the Senate's vote to re-impose, against Trump's will, sanctions on Chinese telecommunications company ZTE.11 The kerfuffle over Trump's attempted trade deal with China in May was highly illuminating: Trump attempted to sign off on a deal with China to get a "quick win" ahead of the midterms. Secretary of Treasury Steve Mnuchin called it a "truce" and top economic adviser Larry Kudlow promoted it on talk shows. But the deal was rebuffed by Congress, which is demanding resolution to the thornier problems of forced tech transfer and intellectual property theft that Trump's own administration prioritized. Hence this trade war can go farther than even Trump intended. In other words, Trump's protectionist rhetoric on China has been so successful that it now constrains his actions. The U.S. engaged in a similar trade war with Japan in the 1980s and succeeded in reducing Japan's share of the American market and in forcing Japan to invest long-term capital in the U.S. The Trump administration presumably wants to repeat this process and achieve a similar outcome (Chart 13). The intention is not necessarily to destabilize China, but to change the composition of the U.S.'s Asia trade, and hence the distribution of Asian power, and to re-capture Chinese savings via American hard assets. Chart 13The U.S. Hopes To Replicate Japan Trade War The U.S. Hopes To Replicate Japan Trade War The U.S. Hopes To Replicate Japan Trade War Chart 14The U.S. Seeks To Redistribute Asian Trade The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis If China's exports to the U.S. are taxed, both it and other manufacturing nations will have to invest more in other developing Asian economies. The latter can gradually make their manufacturing sectors more efficient, but cannot pose a strategic threat to the United States (Chart 14). However, Japan ultimately capitulated to U.S. tariff pressure because the two countries were Cold War allies with a clear national security hierarchy. By contrast, China and the U.S. are antagonists without a clear hierarchy. Beijing perceives U.S. actions as part of its strategy to contain China's rise. The Southeast Asian countries that stand to benefit from the transformation of international supply chains are also the ones that will eventually become most exposed to U.S.-China conflicts.12 As highlighted above, China is not likely to shrink from the fight that the U.S. is bringing. Given that we expect diplomacy to remain on track in North Korea,13 the result is that Taiwan and the countries around the South China Sea are the likeliest candidates for geopolitical risk events in Asia that disrupt markets this year or next. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 For Taiwan, please see Section II below. For Africa, please see Ryan Browne, "Chinese lasers injure US military pilots in Africa, Pentagon says," CNN, May 4, 2018, available at www.cnn.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, and Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 3 The institutions affected included the multilateral development banks and other U.S. and international development agencies. Please see Dianne E. Rennack, "China: U.S. Economic Sanctions," Congressional Research Service, October 1, 1997, available at congressionalresearch.com 4 Arms and certain high-tech exports remained under restriction for years after the event, both from Europe and the U.S. China is still unable to receive funding from the U.S. Overseas Private Investment Corporation or exports of items on the U.S. Munitions List. 5 Please see BCA Geopolitical Strategy Special Report, "Italy, Spain, Trade Wars... Oh My!" dated May 30, 2018, available at gps.bcaresearch.com. 6 Or if the pro-independence third party or the anti-establishment candidates win. 7 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan," dated March 30, 2018, available at gps.bcaresearch.com. 8 There is an extensive debate over the Belgrade embassy bombing. It can be summarized by saying that although the U.S. apologized for the mistake, the U.S. suspected Chinese collaboration with the Yugoslav government, while China maintains its innocence. 9 We have tracked the South China Sea closely since 2012. Please see BCA Geopolitical Strategy Special Report, "The South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, and "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Pyongyang's Pivot To America," dated June 8, 2018, available at gps.bcaresearch.com. Appendix Returns Following Crises In U.S.-China Relations Returns Following Crises In U.S.-China Relations The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis Open Trades & Positions Open Tactical Recommendations* The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis Open Strategic Recommendations* The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis

Highlights Systemic, data-driven, political analysis is a "must-have" (and "nice to have" too!); Investment-relevant political analysis has to be data driven; Predicting political outcomes is difficult, but to generate geopolitical alpha investors should focus on "beating the spread," not predicting the match winner; Focus on policymaker constraints, not their preferences; The median voter is the price maker in the political marketplace. Feature Since the launch of our Geopolitical Strategy service in 2012, BCA Research has made a simple proposition to financial professionals: political analysis is a vital tool in the investor toolbox. It may not be the most important tool, or the one used most frequently. But a toolbox without it is incomplete. At this year's BCA Investment Conference - taking place in Toronto from September 23-25 - I will lead a seminar that will introduce the attendees to the method and philosophy the Geopolitical Strategy team employs to generate geopolitical alpha. As an introduction to the seminar, this note focuses on five frequent myths about geopolitical forecasting. Myth Number 1: Getting Geopolitics Right Is A "Nice To Have, Not A Must Have" Some investors remain skeptical about the value of geopolitical analysis. The holdouts most frequently respond with a variation of "this analysis is a nice to have, but it is not a must have." In other words, investment-focused political analysis is seen as ancillary to the investment decision-making process. A tool to be used when an exogenous event threatens one's strategic decisions. Another way to put it is to say "we will call you when something blows up." Table 1Geopolitical Crises And SPX Returns Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting Please don't. No need. If something does "blow up," just close your eyes and buy risk assets. Table 1 lists the major geopolitical crises since the Second World War. While the average peak-to-trough decline during a major crisis is 9%, equity returns also tend to rise 5% within six months and 8% within twelve months after the crisis.1 To illustrate this trend, we have grafted the average S&P 500 return following past geopolitical crises on to the current equity bull market (Chart 1). The picture is encouraging and shows the market often grinds higher even if something does "blow up." BCA's Geopolitical Strategy takes a different approach to political analysis. We seek to understand the market-relevant interplay between global policy decisions. Rather than reacting to things "blowing up," we look to proactively predict the path of fiscal, monetary, and government policy. Take our fundamental view in 2018 that the resynchronization in global growth - the dominant market narrative in 2017 - would be interrupted by de-synchronization between U.S. and Chinese policy. The U.S. economy often dictates global monetary conditions given the dollar's status as the global reserve currency. However, China often influences global fiscal policy given its oversized contribution to global growth (Chart 2). In 2017, we argued with high conviction that U.S. fiscal policy would turn stimulative, thus encouraging the Fed to hike rates at a faster pace than investors expected.2 We also argued that Chinese policymakers would continue to double-down on growth-constraining structural reforms.3 The interplay of these two views would weigh on global growth, supercharge the U.S. economy relative to the rest of the world, and pull the U.S. dollar higher (Chart 3). Chart 1Buy Risk If Something Blows Up Buy Risk If Something Blows Up Buy Risk If Something Blows Up Chart 2China Makes The World Go Round Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting Chart 3Political Analysis Predicted This Would Happen Political Analysis Predicted This Would Happen Political Analysis Predicted This Would Happen We relied minimally on economic data in making this strategic market call. In fact, for much of 2017, economic data was not supporting our out-of-consensus view. There were few indications of a slowdown in China and the U.S. dollar kept facing headwinds. Instead, we relied on a high conviction view that politics would be stimulative to growth in the U.S. and restrictive to Chinese growth.4 This allowed us to: Recommend a high-conviction "Long U.S. Dollar Index (DXY)" view on January 31, 2018 - up 5.90% since initiation; Recommend a "Long Developed Markets Equities / Short Emerging Markets Equities" view on March 6, 2018 - up 12.09% since initiation; Recommend a "Long Indian Equities / Short Brazilian Equities" view on March 6, 2018 - up 36.40% since initiation; Recommend that clients overweight U.S. equities relative to Europe and Japan in January 2018; Highlight in April that U.S. equities would face headwinds this summer and investors should be tactically cautious. These views have now become the House View of BCA Research as a whole.5 Prescient political analysis is indeed a "nice to have." Myth Number 2: Political Data Is Useless The second-most frequent claim by geopolitical Luddites is that political data is of poor quality and thus systematic research is impossible. Our favorite two examples of this shortcoming are the Brexit referendum and the 2016 U.S. election, which polls supposedly "got wrong." But the polls did not get Brexit and President Trump's election wrong, the pundits did. If anything, the polls were showing the Brexit camp comfortably ahead throughout June 2016. It was only once MP Jo Cox was tragically murdered on June 16, a week ahead of the vote, that the polls favored the "Stay" vote. But on the day of the vote, the "Stay" camp was ahead by only 4%, well within the statistical "margin of error."6 That should not have given investors the level of confidence they had in the pro-EU vote. The probability of Brexit occurring, in other words, should have been a lot higher than the 30% imbued by the betting markets (Chart 4). We made a case for alarm early in 2016 based on a fundamental analysis of the British electorate.7 Chart 4AOnline Betting Got Brexit Wrong... Online Betting Got Brexit Wrong... Online Betting Got Brexit Wrong... Chart 4B... Not The Polls ... Not The Polls ... Not The Polls Similarly, the national polls in the U.S. election were not wrong. Rather, the pundits and quantitative models overstated the probability of a Clinton victory despite her slim poll lead on the day of the election. What modelers missed is the unfavorable structural backdrop for Clinton: the challenges associated with one party holding the White House for three terms, lackluster economic growth, lukewarm approval ratings for President Obama, and the presence of third-party challengers. We addressed these, as well as Trump's successful "White Hype" strategy, early on in the electoral process.8 The truth is that there is an incredible wealth of political data, but investors are not familiar with it because we have become over-professionalized in our own discipline. Polling agencies, political science academics, non-governmental organizations, all provide investors with an incredible array of historical data. Some of it is of poor quality, some of it is solid. But dismissing it all outright in favor of punditry, op-eds, and the whispers of "wise old men," is folly. More recently we relied on a Pew Research survey that began in 1976 to correctly forecast that there are very few genuine fiscal conservatives in America (Chart 5). This was a critical part of our forecast, last year, that the members of the Freedom Caucus - ideologically allied with the precepts of the Tea Party revolution - would vote in favor of a massively profligate tax cut. In fact, it was Freedom Caucus members who first supported President Trump's plan to pass non-revenue neutral tax cut. Chart 5Data Told Us That America's Fiscal Conservatism Is Optional Data Told Us That America's Fiscal Conservatism Is Optional Data Told Us That America's Fiscal Conservatism Is Optional Another notable example is our long-held assertion that the world is multipolar and thus more likely to face paradigm shifts in terms of security and trade policy (Chart 6).9 To drive this point home, we have relied on our Geopolitical Power Index (GPI). To construct our GPI, we enhanced the classic National Capability Index (NCI), which was originally created by political scientists in 1963 for the Correlates of War project. Chart 6BCA's Geopolitical Power Index Illustrates A Multipolar World BCA's Geopolitical Power Index Illustrates A Multipolar World BCA's Geopolitical Power Index Illustrates A Multipolar World Political data is all around us. Just because it is not served on a platter - or accessible on a Bloomberg Terminal - does not make it useless. Myth Number 3: One Cannot Predict Politics In sports betting, gamblers are not trying to predict the outcome of a game. To be a successful gambler, one has to be agnostic to the ultimate winner. In other words, you cannot be a fan and a gambler at the same time. Instead, the goal is to "beat the spread" or choose an "over/under" on the "line" set by the casino. This is precisely what we do for a living. We do not forecast politics. We try to "beat the spread" on political outcomes set by the ultimate bookie, the market. Take our Brexit forecast. In March of 2016, we argued the probability of Brexit was closer to 50% than the 30% that was priced-in by the currency markets. Did we actually forecast that Brexit would happen? No. We argued a week ahead of the vote that Bremain would win a tight referendum. Swing and a miss, right? Wrong. Our clients do not pay us to make political forecasts. They expect us to make market forecasts. We correctly forecasted that the U.K. currency, gilts, and equity markets were not pricing in the higher-than-expected odds of a Brexit outcome. Occasionally both our political and market calls will be correct. For example, we had an extremely high conviction view that Marine Le Pen would not be able to win the French election in 2017.10 The combination of Brexit and the U.S. presidential election had bid up the probability of an anti-establishment outcome in France. Investors were imbuing an extremely erroneous conditional relationship between political outcomes in those two Anglo-Saxon countries and France. But our net assessment, made in early 2016, was that populist outcomes were far more likely in laissez-faire economies than in continental Europe, where expensive social welfare states acted as political social shock absorbers.11 Generating geopolitical alpha is the art of finding overstated and understated geopolitical risks in capital markets. Therefore, whether predicting politics is possible is an irrelevant question. The fact is capital markets are constantly pricing geopolitical risk. We believe it is our job to unearth when the market is mispricing these risks. Myth Number 4: ______ (INSERT POLITICIAN NAME) Is Unpredictable Several of our clients have pointed out that trying to forecast President Trump's policies is impossible. He is erratic, emotional, and bound to make gross errors in judgement. Another set of clients believes, with a high conviction, he is a deal-making businessman obsessed with the performance of the equity market. Yet a third group holds both views at the same time! What do we think? Nothing. We have no view on President Trump's preferences. We are indifferent and aloof of them. The fundamental precept of our method is that constraints are the superior predictor of human behavior, rather than preferences. Preferences are optional and subject to constraints. Constraints are neither optional nor subject to preferences. This is not just a neat mantra we repeat at the onset of every meeting with a prospective client. As Lee Ross and Richard Nisbett discuss in their classic of social psychology, The Person and the Situation, the context and the situation are often more important than the person themselves. In other words, what (if anything) you had for breakfast matters more for whether you were grumpy this morning than your personality traits, education, religion, and usual disposition.12 The policy path of least resistance will be bound by constraints. When faced with rigid and material constraints, predicting policymaker action is easy and our conviction is high. Take the behavior of the Greek leaders in 2015. We had a high conviction view that their political, economic, financial, and geopolitical constraints would force Athens to accept the EU's loan conditionality. In the "Game of Chicken" between Prime Minister Alexis Tsipras and Chancellor Angela Merkel, the former was riding a tricycle, while Frau Merkel was behind the wheel of a Mercedes Benz G-Wagen (Diagram 1). We therefore assigned an extremely low probability of "Grexit" even following the Greek electorate's rejection of bailout conditionality in the June 2015 referendum.13 Diagram 1ARegular Game Of Chicken Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting Diagram 1BGreece Versus Euro Area 2015 Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting On the other hand, policymaker optionality increases when constraints are low. Following President Trump's victory in November 2016, we penned a report that correctly forecast the next 18 months of his presidency by purely focusing on what aspects of executive power were poorly bound by constraints.14 We particularly pointed out the U.S. Congress has given up its constitutional power over tariffs through successive legislative acts (Table 2). Table 2Trump Lacks Legal Constraints On Trade Issues Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting When constraints on policymakers are low - as is the case with Trump and protectionism - investors are tempted to fall back on preference-based forecasting. This is folly. Nobody knows what Trump really wants. No private sector institution has the necessary human intelligence (HUMINT) that would produce a statistically significant forecast of President Trump's behavior. As such, when constraints are unclear or low, investors should prepare for volatility at best, downside risks at worst. Myth Number 5: Politicians Are Price Makers The most important constraint to policymakers is the public - particularly in a democracy, but not exclusively. The public can revolt through the ballot box, tweets, or with pitchforks. As such, policymakers drain their political capital by pursuing policies that are not aligned with the "median voter." The "Median Voter Theory" is one of the few genuine theories of political science.15 It argues that parties and politicians will approximate the policy choices of the median voter in order to win an election or stay in power. Empirical work since the 1950s has both confirmed and challenged the theory, but the fact that every U.S. presidential election concludes with a mad dash to the "center" proves it has merits. That said, the median voter is not always a centrist. First, there are multiple political issues on which there exists a median voter. The job of a successful politician is to identify the most salient issue of the day and then gauge where the median voter sits on that issue. President Trump successfully identified "the issue" of the 2016 election globalization and where the American median voter sits on the topic. The American median voter is far less supportive of globalization and free trade than was previously assumed (Chart 7). By focusing on trade, President Trump forced his opponent, Secretary Clinton, and subsequently members of his pro-business, pro-free trade, Republican Party, to swing against globalization. Chart 7America Belongs To The Anti-Globalization Bloc Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting To this day, investors continue to believe that the median voter will come to the rescue of globalization and free trade. The conventional view is that U.S. voters will revolt once the price of T-shirts, toaster ovens, and toys go up 10-15% at the local Walmart store. We vociferously disagree. The median voter is far less supportive of globalization. And ultimately, it is the median voter who sets the price in the political marketplace, policymakers are merely price takers. As such, investors should focus on the preferences of the median voter as they form the constraint matrix that policymakers have to navigate. Putting It All Together Investment-relevant political analysis is not a science. Data is of varying quality, theory is rarely foolproof, and confidence intervals are wide. However, investing is not a science either. If it were, finance and economics PhDs would be, on average, significantly wealthier than their less educated counterparts in the financial industry (they are not).16 Investors should not throw up their hands and ignore politics altogether just because of the disciplinary limitations of geopolitical analysis. By tweaking some key precepts of political science to fit the necessities of the financial industry, we have developed a set of "best practices" - if not exactly a scientific method - through which we have made geopolitical analysis investment-relevant. Ultimately, the key to sober and investment-relevant geopolitical analysis begins with the right state of mind. The job of an investor is not to predict what should happen or who will emerge victorious. Our job is much simpler: find inefficiencies in the market's pricing of geopolitical events and trends, and generate geopolitical alpha. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17 2018, available at gps.bcaresearch.com. 5 Please see BCA Global Investment Strategy Weekly Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018, available at gis.bcaresearch.com. 6 Given that the Brexit referendum was a "one off" and without precedent, the margin of error should have been wide to begin with. 7 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013; and "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 12 Please see our book review of this seminal work in our February 2014 Monthly Report. Lee Ross and Richard Nisbett, The Person and the Situation - Essential Contributions of Social Psychology, (London: Pinter & Martin, 2011). 13 Please see BCA Geopolitical Strategy Monthly Report, "After Greece," dated July 8, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 15 The Median Voter Theory was in fact first posited by economist Harold Hotelling in his 1929 article "Stability in Competition." His en passant comment in an article otherwise focused on business decision-making remains prescient today. Please see "Stability in Competition," Economic Journal 39 (1929), pp. 41-57. For subsequent treatments of the concept in political science, please see Duncan Black, "On The Rationale of Group Decision-Making," Journal of Political Economy 56 (1948), pp. 23-34; and Anthony Downs, An Economic Theory of Democracy (New York: Harper Collins, 1957). 16 Please see The Economist, "Why doing a PhD is often a waste of time," dated December 27, 2016, available at economist.com.

Highlights Systemic, data-driven, political analysis is a "must-have" (and "nice to have" too!); Investment-relevant political analysis has to be data driven; Predicting political outcomes is difficult, but to generate geopolitical alpha investors should focus on "beating the spread," not predicting the match winner; Focus on policymaker constraints, not their preferences; The median voter is the price maker in the political marketplace. Feature Since the launch of our Geopolitical Strategy service in 2012, BCA Research has made a simple proposition to financial professionals: political analysis is a vital tool in the investor toolbox. It may not be the most important tool, or the one used most frequently. But a toolbox without it is incomplete. At this year's BCA Investment Conference - taking place in Toronto from September 23-25 - I will lead a seminar that will introduce the attendees to the method and philosophy the Geopolitical Strategy team employs to generate geopolitical alpha. As an introduction to the seminar, this note focuses on five frequent myths about geopolitical forecasting. Myth Number 1: Getting Geopolitics Right Is A "Nice To Have, Not A Must Have" Some investors remain skeptical about the value of geopolitical analysis. The holdouts most frequently respond with a variation of "this analysis is a nice to have, but it is not a must have." In other words, investment-focused political analysis is seen as ancillary to the investment decision-making process. A tool to be used when an exogenous event threatens one's strategic decisions. Another way to put it is to say "we will call you when something blows up." Table 1Geopolitical Crises And SPX Returns Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting Please don't. No need. If something does "blow up," just close your eyes and buy risk assets. Table 1 lists the major geopolitical crises since the Second World War. While the average peak-to-trough decline during a major crisis is 9%, equity returns also tend to rise 5% within six months and 8% within twelve months after the crisis.1 To illustrate this trend, we have grafted the average S&P 500 return following past geopolitical crises on to the current equity bull market (Chart 1). The picture is encouraging and shows the market often grinds higher even if something does "blow up." BCA's Geopolitical Strategy takes a different approach to political analysis. We seek to understand the market-relevant interplay between global policy decisions. Rather than reacting to things "blowing up," we look to proactively predict the path of fiscal, monetary, and government policy. Take our fundamental view in 2018 that the resynchronization in global growth - the dominant market narrative in 2017 - would be interrupted by de-synchronization between U.S. and Chinese policy. The U.S. economy often dictates global monetary conditions given the dollar's status as the global reserve currency. However, China often influences global fiscal policy given its oversized contribution to global growth (Chart 2). In 2017, we argued with high conviction that U.S. fiscal policy would turn stimulative, thus encouraging the Fed to hike rates at a faster pace than investors expected.2 We also argued that Chinese policymakers would continue to double-down on growth-constraining structural reforms.3 The interplay of these two views would weigh on global growth, supercharge the U.S. economy relative to the rest of the world, and pull the U.S. dollar higher (Chart 3). Chart 1Buy Risk If Something Blows Up Buy Risk If Something Blows Up Buy Risk If Something Blows Up Chart 2China Makes The World Go Round Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting Chart 3Political Analysis Predicted This Would Happen Political Analysis Predicted This Would Happen Political Analysis Predicted This Would Happen We relied minimally on economic data in making this strategic market call. In fact, for much of 2017, economic data was not supporting our out-of-consensus view. There were few indications of a slowdown in China and the U.S. dollar kept facing headwinds. Instead, we relied on a high conviction view that politics would be stimulative to growth in the U.S. and restrictive to Chinese growth.4 This allowed us to: Recommend a high-conviction "Long U.S. Dollar Index (DXY)" view on January 31, 2018 - up 5.90% since initiation; Recommend a "Long Developed Markets Equities / Short Emerging Markets Equities" view on March 6, 2018 - up 12.09% since initiation; Recommend a "Long Indian Equities / Short Brazilian Equities" view on March 6, 2018 - up 36.40% since initiation; Recommend that clients overweight U.S. equities relative to Europe and Japan in January 2018; Highlight in April that U.S. equities would face headwinds this summer and investors should be tactically cautious. These views have now become the House View of BCA Research as a whole.5 Prescient political analysis is indeed a "nice to have." Myth Number 2: Political Data Is Useless The second-most frequent claim by geopolitical Luddites is that political data is of poor quality and thus systematic research is impossible. Our favorite two examples of this shortcoming are the Brexit referendum and the 2016 U.S. election, which polls supposedly "got wrong." But the polls did not get Brexit and President Trump's election wrong, the pundits did. If anything, the polls were showing the Brexit camp comfortably ahead throughout June 2016. It was only once MP Jo Cox was tragically murdered on June 16, a week ahead of the vote, that the polls favored the "Stay" vote. But on the day of the vote, the "Stay" camp was ahead by only 4%, well within the statistical "margin of error."6 That should not have given investors the level of confidence they had in the pro-EU vote. The probability of Brexit occurring, in other words, should have been a lot higher than the 30% imbued by the betting markets (Chart 4). We made a case for alarm early in 2016 based on a fundamental analysis of the British electorate.7 Chart 4AOnline Betting Got Brexit Wrong... Online Betting Got Brexit Wrong... Online Betting Got Brexit Wrong... Chart 4B... Not The Polls ... Not The Polls ... Not The Polls Similarly, the national polls in the U.S. election were not wrong. Rather, the pundits and quantitative models overstated the probability of a Clinton victory despite her slim poll lead on the day of the election. What modelers missed is the unfavorable structural backdrop for Clinton: the challenges associated with one party holding the White House for three terms, lackluster economic growth, lukewarm approval ratings for President Obama, and the presence of third-party challengers. We addressed these, as well as Trump's successful "White Hype" strategy, early on in the electoral process.8 The truth is that there is an incredible wealth of political data, but investors are not familiar with it because we have become over-professionalized in our own discipline. Polling agencies, political science academics, non-governmental organizations, all provide investors with an incredible array of historical data. Some of it is of poor quality, some of it is solid. But dismissing it all outright in favor of punditry, op-eds, and the whispers of "wise old men," is folly. More recently we relied on a Pew Research survey that began in 1976 to correctly forecast that there are very few genuine fiscal conservatives in America (Chart 5). This was a critical part of our forecast, last year, that the members of the Freedom Caucus - ideologically allied with the precepts of the Tea Party revolution - would vote in favor of a massively profligate tax cut. In fact, it was Freedom Caucus members who first supported President Trump's plan to pass non-revenue neutral tax cut. Chart 5Data Told Us That America's Fiscal Conservatism Is Optional Data Told Us That America's Fiscal Conservatism Is Optional Data Told Us That America's Fiscal Conservatism Is Optional Another notable example is our long-held assertion that the world is multipolar and thus more likely to face paradigm shifts in terms of security and trade policy (Chart 6).9 To drive this point home, we have relied on our Geopolitical Power Index (GPI). To construct our GPI, we enhanced the classic National Capability Index (NCI), which was originally created by political scientists in 1963 for the Correlates of War project. Chart 6BCA's Geopolitical Power Index Illustrates A Multipolar World BCA's Geopolitical Power Index Illustrates A Multipolar World BCA's Geopolitical Power Index Illustrates A Multipolar World Political data is all around us. Just because it is not served on a platter - or accessible on a Bloomberg Terminal - does not make it useless. Myth Number 3: One Cannot Predict Politics In sports betting, gamblers are not trying to predict the outcome of a game. To be a successful gambler, one has to be agnostic to the ultimate winner. In other words, you cannot be a fan and a gambler at the same time. Instead, the goal is to "beat the spread" or choose an "over/under" on the "line" set by the casino. This is precisely what we do for a living. We do not forecast politics. We try to "beat the spread" on political outcomes set by the ultimate bookie, the market. Take our Brexit forecast. In March of 2016, we argued the probability of Brexit was closer to 50% than the 30% that was priced-in by the currency markets. Did we actually forecast that Brexit would happen? No. We argued a week ahead of the vote that Bremain would win a tight referendum. Swing and a miss, right? Wrong. Our clients do not pay us to make political forecasts. They expect us to make market forecasts. We correctly forecasted that the U.K. currency, gilts, and equity markets were not pricing in the higher-than-expected odds of a Brexit outcome. Occasionally both our political and market calls will be correct. For example, we had an extremely high conviction view that Marine Le Pen would not be able to win the French election in 2017.10 The combination of Brexit and the U.S. presidential election had bid up the probability of an anti-establishment outcome in France. Investors were imbuing an extremely erroneous conditional relationship between political outcomes in those two Anglo-Saxon countries and France. But our net assessment, made in early 2016, was that populist outcomes were far more likely in laissez-faire economies than in continental Europe, where expensive social welfare states acted as political social shock absorbers.11 Generating geopolitical alpha is the art of finding overstated and understated geopolitical risks in capital markets. Therefore, whether predicting politics is possible is an irrelevant question. The fact is capital markets are constantly pricing geopolitical risk. We believe it is our job to unearth when the market is mispricing these risks. Myth Number 4: ______ (INSERT POLITICIAN NAME) Is Unpredictable Several of our clients have pointed out that trying to forecast President Trump's policies is impossible. He is erratic, emotional, and bound to make gross errors in judgement. Another set of clients believes, with a high conviction, he is a deal-making businessman obsessed with the performance of the equity market. Yet a third group holds both views at the same time! What do we think? Nothing. We have no view on President Trump's preferences. We are indifferent and aloof of them. The fundamental precept of our method is that constraints are the superior predictor of human behavior, rather than preferences. Preferences are optional and subject to constraints. Constraints are neither optional nor subject to preferences. This is not just a neat mantra we repeat at the onset of every meeting with a prospective client. As Lee Ross and Richard Nisbett discuss in their classic of social psychology, The Person and the Situation, the context and the situation are often more important than the person themselves. In other words, what (if anything) you had for breakfast matters more for whether you were grumpy this morning than your personality traits, education, religion, and usual disposition.12 The policy path of least resistance will be bound by constraints. When faced with rigid and material constraints, predicting policymaker action is easy and our conviction is high. Take the behavior of the Greek leaders in 2015. We had a high conviction view that their political, economic, financial, and geopolitical constraints would force Athens to accept the EU's loan conditionality. In the "Game of Chicken" between Prime Minister Alexis Tsipras and Chancellor Angela Merkel, the former was riding a tricycle, while Frau Merkel was behind the wheel of a Mercedes Benz G-Wagen (Diagram 1). We therefore assigned an extremely low probability of "Grexit" even following the Greek electorate's rejection of bailout conditionality in the June 2015 referendum.13 Diagram 1ARegular Game Of Chicken Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting Diagram 1BGreece Versus Euro Area 2015 Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting On the other hand, policymaker optionality increases when constraints are low. Following President Trump's victory in November 2016, we penned a report that correctly forecast the next 18 months of his presidency by purely focusing on what aspects of executive power were poorly bound by constraints.14 We particularly pointed out the U.S. Congress has given up its constitutional power over tariffs through successive legislative acts (Table 2). Table 2Trump Lacks Legal Constraints On Trade Issues Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting When constraints on policymakers are low - as is the case with Trump and protectionism - investors are tempted to fall back on preference-based forecasting. This is folly. Nobody knows what Trump really wants. No private sector institution has the necessary human intelligence (HUMINT) that would produce a statistically significant forecast of President Trump's behavior. As such, when constraints are unclear or low, investors should prepare for volatility at best, downside risks at worst. Myth Number 5: Politicians Are Price Makers The most important constraint to policymakers is the public - particularly in a democracy, but not exclusively. The public can revolt through the ballot box, tweets, or with pitchforks. As such, policymakers drain their political capital by pursuing policies that are not aligned with the "median voter." The "Median Voter Theory" is one of the few genuine theories of political science.15 It argues that parties and politicians will approximate the policy choices of the median voter in order to win an election or stay in power. Empirical work since the 1950s has both confirmed and challenged the theory, but the fact that every U.S. presidential election concludes with a mad dash to the "center" proves it has merits. That said, the median voter is not always a centrist. First, there are multiple political issues on which there exists a median voter. The job of a successful politician is to identify the most salient issue of the day and then gauge where the median voter sits on that issue. President Trump successfully identified "the issue" of the 2016 election globalization and where the American median voter sits on the topic. The American median voter is far less supportive of globalization and free trade than was previously assumed (Chart 7). By focusing on trade, President Trump forced his opponent, Secretary Clinton, and subsequently members of his pro-business, pro-free trade, Republican Party, to swing against globalization. Chart 7America Belongs To The Anti-Globalization Bloc Five Myths On Geopolitical Forecasting Five Myths On Geopolitical Forecasting To this day, investors continue to believe that the median voter will come to the rescue of globalization and free trade. The conventional view is that U.S. voters will revolt once the price of T-shirts, toaster ovens, and toys go up 10-15% at the local Walmart store. We vociferously disagree. The median voter is far less supportive of globalization. And ultimately, it is the median voter who sets the price in the political marketplace, policymakers are merely price takers. As such, investors should focus on the preferences of the median voter as they form the constraint matrix that policymakers have to navigate. Putting It All Together Investment-relevant political analysis is not a science. Data is of varying quality, theory is rarely foolproof, and confidence intervals are wide. However, investing is not a science either. If it were, finance and economics PhDs would be, on average, significantly wealthier than their less educated counterparts in the financial industry (they are not).16 Investors should not throw up their hands and ignore politics altogether just because of the disciplinary limitations of geopolitical analysis. By tweaking some key precepts of political science to fit the necessities of the financial industry, we have developed a set of "best practices" - if not exactly a scientific method - through which we have made geopolitical analysis investment-relevant. Ultimately, the key to sober and investment-relevant geopolitical analysis begins with the right state of mind. The job of an investor is not to predict what should happen or who will emerge victorious. Our job is much simpler: find inefficiencies in the market's pricing of geopolitical events and trends, and generate geopolitical alpha. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17 2018, available at gps.bcaresearch.com. 5 Please see BCA Global Investment Strategy Weekly Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018, available at gis.bcaresearch.com. 6 Given that the Brexit referendum was a "one off" and without precedent, the margin of error should have been wide to begin with. 7 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013; and "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 12 Please see our book review of this seminal work in our February 2014 Monthly Report. Lee Ross and Richard Nisbett, The Person and the Situation - Essential Contributions of Social Psychology, (London: Pinter & Martin, 2011). 13 Please see BCA Geopolitical Strategy Monthly Report, "After Greece," dated July 8, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 15 The Median Voter Theory was in fact first posited by economist Harold Hotelling in his 1929 article "Stability in Competition." His en passant comment in an article otherwise focused on business decision-making remains prescient today. Please see "Stability in Competition," Economic Journal 39 (1929), pp. 41-57. For subsequent treatments of the concept in political science, please see Duncan Black, "On The Rationale of Group Decision-Making," Journal of Political Economy 56 (1948), pp. 23-34; and Anthony Downs, An Economic Theory of Democracy (New York: Harper Collins, 1957). 16 Please see The Economist, "Why doing a PhD is often a waste of time," dated December 27, 2016, available at economist.com.