Geopolitics

Special Report

Highlights The United States has produced too many elites, while popular well-being has fallen; Elite-controlled institutions have failed to protect households from the negatives of globalization and technological change; Tribalism, polarization, and money politics are preventing political compromise; Trump won by assaulting the "elites" but neither his policies, Congress, nor the economy look to improve well-being; With recession likely by 2019, the U.S. will see a revolt of some kind by the 2020 election. Feature Crime is increasing Trigger happy policing Panic is spreading God knows where We're heading Oh, make me wanna holler They don't understand Make me wanna holler They don't understand - Marvin Gaye, "Inner City Blues," 1971 If we had to explain the election of Donald Trump and the decision by U.K. voters to exit the EU with one chart it would be Chart 1. It depicts the relationship between high income inequality and low generational mobility and suggests that highly unequal societies develop structures that perpetuate unequal income through generations.1 The U.S. and the U.K. stand at the extreme of the relationship, with Italy close behind. Not surprisingly, the common people, "the plebs," in all three countries are dissatisfied with the arrangement. Low social mobility perpetuates unequal economic outcomes, throwing middle- and low-income voters into a sense of desperation. They fear that both their children's lot in life and their own is already decided, i.e. cannot and will not improve. A pre-election Gallup study of 125,000 American adults confirms that President Trump's support was strongest among voters in communities with poor health and low generational mobility.2 Of no relevance was whether respondents came from areas supposed to suffer most heavily from the ills that Trump opposed, i.e. communities exposed to global competition via trade, or those with high levels of immigration, or areas with relatively high unemployment and low incomes. America is supposed to be immune to income inequality because of social mobility. Equality of opportunity matters more than equality of outcome. This is the trade-off that has existed at the heart of America since its founding. For decades this trade-off has atrophied. Donald Trump was then elected to bring the U.S. back to its default setting. In this report, we explain why it may be too late and what will happen if he fails. If BCA's House View is correct, that a recession will occur by the end of 2019 (if not earlier), then the economic and political conditions are ripe for serious socio-political instability by the 2020 election.3 The Dynamic Of Elite Overproduction In Why Nations Fail, economist Daron Acemoglu and political scientist James Robinson tell a story of "How Venice Became A Museum."4 From the eleventh to fourteenth century, Venice was one of the richest places in the world. Behind its rapid economic expansion was the commenda, an early form of a joint-stock company formed for the duration of a single trading mission. It spurred Venice's ambitious entrepreneurs to find new trading routes by allowing them to share in the profits with the owners of capital who funded the risky journeys. As new families enriched themselves, political institutions grew more inclusive to accommodate them: in 1032, for instance, Venice held elections for its doge, or leader. An independent judiciary, private contracts, and bankruptcy laws followed. By 1330, Venice was a wealthy and strikingly modern republic with a population as large as that of Paris. The commenda system, however, had a dark side: creative destruction. Each new wave of young, enterprising explorers reduced the political privileges and profits of the established elites. In the late thirteenth century, these elites began to restrict membership in the Great Council, or legislature. Such efforts culminated in La Serrata ("The Closure") in 1297, which severely restricted access to the Great Council for new members but expanded it for families of established elites. An economic serrata quickly followed the political one, and the commenda system that underpinned Venice's wealth was replaced by a state monopoly on trade in 1314. The rest is, as they say, history. Venice rapidly declined as the newly closed economic and political institutions failed to deal with the rise of Portugal and Spain, the revolution in navigation and discovery of new trade routes to the East, and various regional attempts to encroach on its wealth and power. After the seventeenth century this decline accelerated. Today, its only source of income is tourism, which parlays the pre-Serrata wonders - such as the Doge's Palace and St. Mark's Cathedral - for cash that the city desperately needs to keep itself afloat.5 Acemoglu and Robinson make the case in their research that societies with both politically and economically inclusive institutions are rare. They cite a number of reasons for this, but the one that is most relevant to this report is "elite overproduction." Elites have a perfectly human and rational desire to perpetuate their political and economic privileges and pass them on to their children. A society that truly promotes equality of opportunity is one that leaves its elites to the fates. The elite desire to pass on privileges to future generations is a constant, but human conflict and state collapse are cyclical. Peter Turchin, a biologist who studies human conflict, has noted that periods of intense conflict in societies tend to recur within 40-to-60-year cycles. He posits that elite overproduction - and its counterpart, low societal well-being - is to blame.6 In post-industrial societies, low and falling labor costs are one of the principal conditions for elite multiplication. International trade, immigration, technological advancements, and investment in human and physical capital all suppress labor costs, benefiting the consumers of labor, i.e. the elites. Globalization has played a particularly important role in suppressing wages in the modern developed world. It expanded the global supply of labor by opening up new populations to capitalism (Chart 2), leading to suppressed wage growth for the middle classes in advanced economies (Chart 3). This process has been reinforced by technological change, particularly innovation that is biased in favor of capital (i.e. saving on labor costs) (Chart 4). Chart 2Globalization Expanded ##br##The Global Supply Of Labor... As elites capture an ever-greater share of the economic pie (even a growing economic pie), they become accustomed to ever greater levels of consumption, which drives inter-elite competition for social status. Everyone tries to "keep up with the Joneses," which for many is only achievable by supplementing wages with debt (Chart 5).7 The demand for elite goods - say homes in the "right" zip codes - exhibits runaway growth as the cost of elite membership rises and as sub-elites with rising income levels compete for access (Chart 6). Chart 5Credit Supplanted Income Chart 6Middle Class Incomes Don't ##br##Buy Middle Class Goods Focusing on the U.S., Turchin shows that Americans are today living in the second "Gilded Age." His research shows that "elite overproduction" has not been this high, and "population well-being" this low, since the early twentieth century (Chart 7). He calculates population well-being as a combination of general health, family formation, and wage and employment prospects. All indicators are currently in decline relative to history, save for health. But even life expectancy is taking a hit, albeit for select demographic groups most negatively impacted by poor job and wage prospects (Chart 8). For elite overproduction, Turchin relies on standard measures: wealth inequality, university education cost, and political polarization. This makes intuitive sense, since major policies aimed at reversing entrenched inequality can only be enacted after polarization has fallen due to events that subdued elites, such as major economic calamities or geopolitical challenges - e.g. the New Deal following the Great Depression, or the Great Society following World War II and amidst the Cold War. The danger of extreme polarization between elite prosperity and general well-being is that it is theoretically and empirically associated with political polarization, social unrest, and war. Acemoglu and Robinson detail case after case - from ancient Mayans and Romans to modern French and Japanese - in which the competition for resources between elites and the general population led to civil strife or all-out warfare. Meanwhile Turchin's research shows that politically motivated violence in the U.S. (Chart 9), which last peaked 50 years ago in the late 1960s, is associated with large gaps in well-being between elites and the masses (Chart 10).8 Bottom Line: Elite overproduction has been identified by academic research as a constant source of social instability throughout human history. Elites subvert inclusive political and economic institutions in order to stifle creative destruction, which would enrich new entrepreneurs but dilute elite privileges. As such, societies that prevent elite overproduction and promote equality of opportunity (and creative destruction) are successful in perpetuating themselves over the long term. Repatrimonialization In The U.S. Chart 11Tax Rates Were High In The Roaring '50s A sure sign that a society is in decline? When elites strive to hold onto their status and create barriers to entry for others. In the case of Venice, these barriers were overtly political. Le Serrata was followed by the introduction of Libro d'Oro (the "Golden Book"), which created an official registry of Venetian families that would be allowed to share in the deliberations of the Great Council. As the population revolted against such measures, Venice introduced a police force in 1310, with other coercive methods to follow. Today, the U.S. exhibits similar signs of institutional capture by the elites, albeit updated for the twenty-first century. Political theorist Francis Fukuyama calls this process "repatrimonialization." It occurs amidst long periods of economic prosperity and peace, as elites lose sight of their symbiotic relationship with fellow citizens and begin to serve their own "tribal" interests.9 Note in the above Chart 7 that elite overproduction, as defined by Turchin, reaches its peak after long periods of peace: the first high point came in 1902, 37 years after the Civil War, and the second came in 2007, 62 years after World War II. The latter case in particular suggests that as threats dissipate, elites lose sight of personal sacrifices - military service, income redistribution, public service, public works - that are required for geopolitical competition with peer challengers. At the height of the Cold War (1949 to 1962), for example, the top marginal tax rate in the U.S. was 92% (Chart 11).10 The point is not the tax rate, but that elites were far more acquiescent to fiscal sacrifices on behalf of the public. Fukuyama points to the U.K. and the U.S. as the two countries that have been the least politically responsive to the challenges of globalization and technological change in the developed world. In the case of the U.S., this is because interest groups are capable of steering policy towards further globalization and technological change. Both processes have also empowered elites, which have steered policy towards less redistribution and more austerity for the middle classes. The data is clear on this point. Despite Europe's being as exposed to globalization and technological advances as the U.S., European median wage growth has kept pace with GDP growth since 2000, whereas in the U.S. it not only failed to keep up but declined over the same time period (Chart 12). Chart 12Europe Shielded ##br##Households From Global Winds What are some of the mechanisms of repatrimonialization in the U.S. and can they be reversed? The good news is that elite capture of state institutions is now out in the open and easy to identify. Both Donald Trump and Democratic candidate Senator Bernie Sanders campaigned explicitly against it. The bad news is that it is unlikely to be reversed endogenously, at least not without a catalyst. What follows is a short description of the most salient problems facing the country as a result of elite entrenchment. Campaign Financing The 2010 Supreme Court decision Citizens United v. Federal Election Commission gave rise to political action committees, also known as Super PACs. These groups are allowed to receive unlimited contributions from individuals and corporations as long as they do not cooperate, coordinate, or directly contribute funding to actual candidates. This supposed firewall, however, is a fig leaf. The elimination of caps on this type of campaign financing allows single-issue groups and even single individuals with deep pockets to fund fringe candidates or support single-issue ballot measures that would otherwise lack sources of funding. This is especially important in primary elections where turnout is very low. In response, incumbent legislators have to tread carefully and avoid angering individual donors or Super PACs that could single-handedly fund a campaign against them in the primary elections, especially since the average cost of a congressional election campaign is relatively low at $1.4 million (a small amount compared to the funds that can be brought to bear by activist donors). In 2012, more than 40% of the campaign donations used in all federal elections was contributed by 0.01% of the voting-age population. That means that about 24,000 people were responsible for a near-majority of all contributions.11 Two other findings reported in the academic literature provide insight on how (and if) that money might steer policy. First, a study confirmed the general belief that the wealthiest Americans are much more conservative than the general public when it comes to tax policy and economic regulation.12 Second, another study found that when the policy preferences of the top 10% of income earners diverge from the preferences of the bottom 50%, the policy outcome is more likely to reflect the intentions of the former group.13 Polarization Political polarization benefits elites by impeding the democratic process and locking in rules that are beneficial to the status quo. Chart 13 shows that income inequality and political polarization in the sphere of economic policy are correlated.14 The simple reason the two are so highly correlated is because the right-of-center Republican Party increasingly opposes redistribution, while the left-of-center Democratic Party favors it. As the two parties diverge on matters of economic principle, compromises become virtually impossible, locking redistributive efforts at the current levels favored by the elites. Polarization is subsequently reinforced by electoral-district "gerrymandering" and an extremely bifurcated and increasingly distrusted news media. Over the last two decades, both the Democrats and Republicans (but mainly the latter due to their superior position at the state level) have redrawn administrative boundaries to create "ideologically pure" electoral districts. Of the 435 seats in the House of Representatives, only about 56 are truly competitive (Chart 14). Chart 13Inequality Fuels Political Polarization Chart 14Few Congressional Seats Truly Competitive Tribalization Elite overproduction often leads to the tribalization of society. Elites, to ensure that they are not torn asunder by the plebs, mobilize the population behind various causes that divert attention away from themselves, i.e. away from the real cause of social malaise. These causes are "wedge issues," in today's parlance. They can include identity politics, religious issues, as well as foreign policy. The Democratic Party has often relied on identity issues to mobilize support, but the effort kicked into high gear as it evolved from a redistributive "Old Left" party to the more centrist, "Third Way," neo-liberal orientation of Bill Clinton's presidency. Senator Bernie Sanders attempted to reverse this trend and overtly downplayed identity politics during his presidential campaign. He saw his party's neo-liberal turn as an elite-driven effort to distract from the real problems affecting low-income households. Hillary Clinton, the neo-liberal Democrat, by contrast, suffered as a result of the perception that she was an elite. The problem is that these wedge issues have begun to ossify into actual identities. For example, Pew Research showed in 2012 that the difference between Americans on a list of 48 values is the greatest between Republicans and Democrats, as opposed to other elements of identity. This has not always been the case, as Chart 15 shows. We suspect that this data will grow even starker after the divisive, borderline hysterical 2016 campaign. This means that "Republican" and "Democrat" labels have become almost tribal in nature. In fact, one's values are now determined more by one's party identification than race, education, income, religiosity, or gender! This is incredible, given America's history of racial and religious divisions. Bottom Line: America's repatrimonialization is advanced. The democratic process, which is supposed to adjudicate between interest groups and regulate elite economic and political privileges, has been drawn to a halt by polarization, the political influence of big money, and emerging tribalism between non-elites. It is extremely difficult to see how these hurdles can be overcome via America's regular political process. As such, they will be resolved only after some kind of crisis, whether endogenous or exogenous. Will Trump Fix It? President Donald Trump famously said in his nomination speech at the Republican Convention, "I alone can fix it." In a way, he may be correct. Although he is very much part of the American economic elite, he has no links to the D.C. establishment and owes no favors to special interest groups.15 His entire campaign personified the conclusions of this report: that the U.S. economy has been captured by economic and political elites and that the well-being of regular citizens is in the doldrums. It is unfair to judge President Trump's record and legacy based on a little over four months in office. However, we lean heavily towards the conclusion that his efforts to undermine American patricians will ultimately fail. Here is why: Policy President Trump does not have much of a legislative record. Nonetheless, his first major piece of legislation - the Obamacare repeal and replace bill - would, in its current form, leave 14 million people without health care - and an estimated 24 million by 2026. If not substantially revised, the bill is likely to impose a roughly $445 billion burden on U.S. households in order to pay for the "hyuge" tax cuts that Trump has promised (Chart 16). Further throwing Trump's plebeian credentials into doubt is his second signature legislative act: tax reform. His campaign proposal fell largely in line with previous Republican efforts, which, it should be noted, have contributed greatly to elite overproduction in the U.S. (Chart 17). Trump's original proposal would cut the top marginal rate from 39.6% to 33%, but would also leave a significant number of middle-class Americans with an increase, or no change, to their marginal tax rate.16 We expect that his White House team will adjust this original plan to offer middle-class tax cuts, but the main thrust of the effort is still to eliminate estate taxes and lower the top marginal rates significantly. Chart 17Tax Reform Always Benefits Elites On trade and immigration, Trump has little record to show. His meeting with President Xi Jinping of China revealed that he is like previous presidents in talking tough about Chinese trade on the campaign trail yet lacking the desire to take aggressive action once in office. We expect that Trump will eventually pivot towards greater protectionism, but it is not clear that it will be executed in a way that actually improves household well-being.17 Congress So far Trump has shown that he is more interested in getting legislation passed than shaping it in a populist way. For example, he has urged Congress to pass the Obamacare replacement even though many conservative Senators are wary of its negative impact on households. If he adopts the same strategy with tax reform, we would suspect that he will err on the side of "getting things done," rather than fulfilling his campaign pledges to blue-collar workers. The problem for Trump is the same problem President Obama had: polarization. Trump would be far more successful in passing populist legislation if he developed a working relationship with Democrats, who ostensibly have discarded the elitism of the Clinton years. Yet to do so he would have to "betray" his only friends, leaving himself vulnerable should the Democrats refuse to play ball. He is thus stuck with partisan Republican policies, which means voters are stuck with a lack of compromise. Macroeconomics Populists everywhere have one overarching goal when they come to power: boosting nominal GDP growth (Chart 18). We suspect that Trump will ultimately get tax reform through Congress and that it will be moderately stimulative.18 The problem is that the U.S. economic recovery is already far advanced. As such, even moderate stimulus could hasten the timing of an economic recession. Given the lack of major economic imbalances, it is unlikely that such a recession would freeze the financial system and be as painful as that of 2008-9. Nonetheless, the trade-off between moderate stimulus and a quicker recession is unlikely to benefit Trump's voters. Bottom Line: Donald Trump has tapped into the deep social malaise in the U.S. and responded to the populace's demands that elite overproduction be curbed. Unfortunately, his track record during the campaign and as president gives little evidence that he will be successful in restraining America's elites. Especially because he is forced to cooperate with them through Congress, and in a way that does not encourage broad compromise. Investment Implications We suspect that polarization will grow throughout Trump's term and that he will largely be unsuccessful in pursuing an agenda that genuinely increases opportunity or well-being. In fact, we would bet that most of his policies will contribute to, not reduce, elite overproduction in the U.S. What happens when Donald Trump fails to reform America and resolve its elite overproduction problem? If a recession occurs by 2019 - our House View at BCA - then the economic and political conditions suggest that a serious revolt is in the cards by the time of the 2020 election. By this we mean not just an electoral revolt, like Trump's election, but also a concrete increase in social tension and unrest. A repeat of the 2011 Occupy Wall Street protests, yet more violent, could be in cards. By the 2020 election, we would also suspect that our clients may look back fondly, with nostalgia, for Senator Bernie Sander's campaign platform, which by that point may look downright centrist. Investors should prepare for an increase in economic populist policy proposals, from both the left and the right. If economic policy begins to steer towards populism, investors should bet on higher inflation and thus higher nominal - but potentially lower real - Treasury yields. The independence of the Fed could also suffer, putting considerable downward pressure on the USD. In this environment, equities will outperform bonds, but global assets should outperform those of the U.S. Gold, which has failed as a safe-haven asset in the contemporary deflationary era, should become attractive once again.19 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see Miles Corak, "Income Inequality, Equality of Opportunity, and Intergenerational Mobility," Forschungsinstitut zur Zukunft der Arbeit, Discussion paper no. 7520, July 2013, available at iza.org. 2 Please see Jonathan Rothwell and Pablo Diego-Rosell, "Explaining Nationalist Political Views: The Case Of Donald Trump," Gallup, dated November 2, 2016, available at papers.ssrn.com. 3 Please see BCA's The Bank Credit Analyst Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, available at bca.bcaresearch.com, and Global Investment Strategy Outlook, "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. 4 Please see Daren Acemoglu and James A. Robinson, Why Nations Fail (New York: Crown Publishers, 2012). 5 Literally. 6 Please see Peter Turchin and Sergey Nefedov, Secular Cycles (Princeton, NJ: Princeton University Press, 2009). 7 Please see Neal Fligstein et al, "Keeping up with the Joneses: Inequality and Indebtedness, in the Era of the Housing Price Bubble, 1999-2007," presented at the Annual Meetings of the American Sociological Association, August 2015. 8 Please see Peter Turchin, "Dynamics of political instability in the United States, 1780-2010," Journal of Peace Research 49:4 (2012), pp. 577-91. 9 Please see Francis Fukuyama, Political Order And Political Decay (New York: Farrar, Straus, and Giroux, 2014). 10 Today's dispersed terrorist threat does not even come close to approximating the threat that the Soviet Union during the Cold War presented to the U.S., and as such we do not consider it seriously as an existential threat to either the U.S. or the West. Please see BCA Global Investment Strategy and Geopolitical Strategy, "A Bull Market For Terror," dated August 5, 2016, available at gis.bcaresearch.com. 11 Please see Adam Bonica et al., "Why Hasn't Democracy Slowed Rising Inequality?" Journal of Economic Perspectives 27:3 (Summer 2013), pp. 103-24. 12 Please see Benjamin Page et al., "Democracy And The Policy Preferences Of Wealthy Americans," Perspectives On Politics 11:1 (March 2013), pp. 51-73. 13 Please see Martin Gilens, "Inequality And Democratic Responsiveness," Public Opinion Quarterly 69:5 (2005), pp. 778-796. 14 The latter measure of polarization is one of Turchin's factors in elite overproduction. 15 Save for the Kremlin! We jest, we jest. At least, we think we jest ... 16 Several groups would have seen no substantial tax cuts under his original campaign plan. Those making $15,000-$19,000 would have seen their tax rate increase from 10% to 12%. Those making $52,500-101,500 would have seen their rate stay the same at 25%, while those making $127,500-$200,500 would have seen their rate rise from 28% to 33%. Please see Jim Nunns et al, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016, available at www.taxpolicycenter.org. For our original discussion, see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day," dated April 26, 2017, available at gps.bcaresearch.com. 19 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com.

Special Report

Highlights The U.K. election was about austerity, not Brexit; The median voter in the U.K. and the U.S. has moved to the left; Nationalism will not satisfy the popular revolt in these countries; The pound is not likely to fall much below GBP/USD 1.2. Feature The political consequences of the extraordinary U.K. general election are still not clear. The coalition-building process will take time as the horse-trading between parties proceeds over the weekend. Our high-conviction view, however, is that the investment implications were in fact already self-evident and do not require foresight into the eventual make-up of the U.K. government. How can that be? Last year, in anticipation of unorthodox electoral results, we introduced the "Median Voter Theory."1 This theory in political science posits that policymakers are not price-makers but price takers in the political marketplace. The price maker is the median voter. Policymakers, of all stripes and colors, will attempt to approximate the policy demands of the median voter in order to win over as many voters as they can in the marketplace. Further, we argued that the median voter in the two most laissez-faire economies, the U.S. and the U.K., had moved to the left of the economic spectrum.2 The U.K. election confirms this argument. It also confirms our suspicion that the plebian revolts in these two bastions of free-market capitalism will not be extinguished merely by rallying the public around the flag and promoting nationalist themes of de-globalization.3 As such, the two trends we believe will emerge from this election, regardless of the ultimate political outcome, are: The Brexit process will continue, albeit toward a "softer" variety and with a somewhat higher probability of eventual reversal; Fiscal austerity is dead in Britain and investors should expect its economic policy - under whatever leadership ultimately gains power - to swing firmly to the left on fiscal, trade, and regulatory policy. Because of this mix of policy outcomes, we expect the GBP to suffer little in the post-election environment, though heading back towards its January lows versus the USD later this year. The market will have to price in much looser fiscal policy out of the U.K. over the course of the next government, with expectations that the BoE will continue to stand pat. This Election Was About Austerity And Globalization, Not Brexit It is absolutely crucial for investors to understand that the Labour Party did not, in any way whatsoever, focus its campaign on the results of the Brexit referendum. Labour leader Jeremy Corbyn's strategy was not only to accept Brexit as a done deal, but ostensibly even to accept the "hard Brexit" of keeping the U.K. out of the Common Market, which PM Theresa May announced in a major policy speech on January 17. The three policy positions of the Labour Party on Brexit during the campaign were: Gain "tariff-free access" to the EU single market, while accepting that Common Market membership was off the table; Keep the option of negotiating a customs union - which would prohibit the U.K. from negotiating its own trade deals - on the table; Refuse the mantra that "no deal" is better than a "bad deal." Overall, these points are not too far from Tory strategy, although they are devoid of nationalist rhetoric. More importantly, the key difference between the Labour and Tory approach to Brexit was that Labour was not trying to entice blue-collar voters, battered by the winds of globalization, with promises of free-trade agreements with India and China. If last year's Brexit voters did not want a free-trade tie-up with Europe, why on earth would they support a Tory vision of free trade deals with China and India?! Jeremy Corbyn's Labour has, in other words, a much better handle on what the Brexit referendum was all about. As we concluded in our net assessment ahead of the referendum in March of last year, the vote would ultimately be about globalization and its impact on the economic wellbeing of the median voter in the U.K. (Chart 1), not the angst over the EU's technocratic elites and bureaucratic overreach.4 Yes, the latter also mattered, but not to the blue-collar voters who crossed the aisle to support the Tory/UKIP vision on Brexit. For them, Brexit was a vote against elites that have profited from globalization. Election polls gave investors a hint that blue-collar Brexit voters would shift back to Labour. Tories began to see a drop in support almost immediately after they called the election on April 18 - i.e. before May's various mistakes (Chart 2). All the subsequent gaffes by May reinforced the trend, but the trend started on the first day of campaigning. This suggested that traditional Labour voters were turning back to their bread-and-butter economic demands immediately as the campaign began. Chart 1Brits Exposed To Harsher Change Chart 2Labour Rally Began When Election Called Corbyn, who has been underestimated by the media for over a year, was quick to press the gas pedal on left-wing economic issues, steering clear of Brexit. In fact, if one was unfamiliar with British politics, and only focused on the Labour campaign rhetoric, one would hardly know that a referendum on EU membership had even taken place. Corbyn's campaign was straight out of the Labour playbook of the 1980s. He gambled that the median voter had swung to the left. In particular, the Labour campaign pounced on three policy issues that isolated Tory tone-deafness on the unpopularity of austerity: "Dementia tax" - May's quip that the elderly would be means-tested by including the value of their homes in assessing government support for social care ultimately proved to be profoundly self-harming. At the moment when she made the gaffe, Tories were up 11% on Labour in the polls. "Triple Lock" - May hesitated and waffled over the triple lock pension system - which was introduced by the Conservative and Liberal Democratic coalition from 2010-15. It guaranteed that government pension payouts would rise annually at the highest rate of inflation, 2.5% per year, or wage growth. She did so even as inflationary pressures built up as a result of Brexit, which similarly fell flat with voters. This is unsurprising, given that it was the Euroskeptic Tories and UKIP plan to exit the EU that caused inflationary pressures in the economy in the first place. That they then asked low-income elderly to shoulder the costs of Brexit also illustrates a profound misunderstanding of what the Brexit referendum was about. Police funding - May thought that the Manchester and London Bridge terrorist attacks would swing the vote towards the center-right, security-conscious party. She went so far as to announce that human rights concerns would not stand in the way of Britain's fight against terrorism, doubling down on nationalist rhetoric.5 Corbyn stuck to the strategy of tying everything to austerity: he condemned the attacks but criticized the Tories for significant cuts to police forces under May's watch as Home Secretary, claiming that these imperiled law enforcement's ability to keep U.K. citizens safe. Following Brexit, May did try to shift policy to the left. For example, her October 2016 speech - her first major address as the U.K. Prime Minister - blamed "globalized elites" for the pain incurred by Britain's low and medium income households. However, Tories could not help to subsequently promise corporate tax cuts and budget-saving measures. And her gaffes during the election convinced voters - many of whom may have voted for Brexit - that Tories were stereotypical Tories; i.e., not concerned for the plight of the common man. All that said, the Conservative Party will still win around 57 seats more than the Labour Party. In any previous election, that would be considered a decent, if not commanding, result. What we want to stress to clients is that the Conservative Party in fact only won 22 more seats than the combined result of the most left-wing Labour Party in half a century and an extremely left-leaning Scottish National Party. When seen from that perspective, and when we consider the Tories' 22% lead in polls at the onset of the electoral campaign, the result on June 8 is an unmitigated disaster for the party and a wake-up call: the economic preferences of the U.K.'s median voter are as left wing as they have been since the mid-1920s. Bottom Line: The U.K. election was not contested solely on Brexit. As such, investors should not overthink the implications of the election on the Brexit process and hence the implications for the pound and U.K. assets. Labour gained around 29 more seats despite firmly accepting the Brexit referendum. This is not to say that the Labour Party, were it to cobble together a governing coalition with the SNP and others, would not be quick to reverse the Brexit process and call a second referendum if the economic costs of Brexit were to rise over the course of its mandate. That is a possible scenario. But the bigger picture is that Labour's opposition to austerity politics is what made all the difference in this election. Likely Government Formation Scenarios At the time of publication of this Client Note, May's comments and the distribution of seats favor a Tory minority government (or perhaps a formal coalition) supported by the Democratic Unionist Party (DUP) of Northern Ireland. As we discussed in our just-published Weekly Report, the Northern Irish have not exercised real power in Westminster in a century, literally.6 The party won ten seats, which makes for a majority with the Tories, and thus could provide just enough support to accomplish the single goal of a Tory-led Brexit. Tories and the DUP have already been in an informal coalition due to the Tories' attempts to increase their earlier majority of only 17 seats. Nonetheless, such a coalition will be controversial and will lead to uncertainties about parliament's ability to pass a final Brexit deal in 2019. Currently, such an arrangement would see a Tory government depend on the slimmest of majorities, around two seats over the 326 needed for a nominal majority. However, because the Irish nationalist Sinn Fein MPs (who gained seven seats this time around) normally do not sit in the parliament, and because the speaker and deputy speakers do not vote, Tory's would have some buffer. (And yet the extraordinary circumstances suggest that one should not rule out Sinn Fein taking up their seats!) How much political capital would a May-led government have? Extremely little. First of all, not only did the Tories squander an extraordinary lead in the polls, but their ultimate share of the total population's vote is merely 2.4% above Labour's haul (Chart 3). In fact, the only thing that saved the Tories from opposition is the U.K.'s first-past-the-post electoral system, which allowed them to win more seats merely by being the only right-of-center option for British voters. In addition, it is now clear that May failed to get all of the UKIP voters to swing to the center-right, establishment party. The UKIP vote declined by over 11% in the election, but the Tory net gain in percentage terms from the last election is only half that figure. This supports our view from above that many blue-collar voters, who voted for Brexit, swung back to the Labour party the minute the election was announced, reflecting deep distrust of the Tory Party on bread-and-butter, non-Brexit issues. A slim government majority made possible by a Euroskeptic Northern Irish Party will ensure that the Brexit process continues. Would Euroskeptic Tories have a bigger say in such a government, forcing May to swing further to the nationalist right and leading to acrimony with Europe? Normally we would say "yes." However, it was May's turn to the nationalist right at the expense of nurturing left-leaning economic policies that cost her a majority. As such, we doubt that she, or her potential replacement in the wake of the disastrous result, would double-down on more Euroskepticism. That would be a profound error following a clear signal from the electorate that nationalist rhetoric and Brexit chest-beating is insufficient to bolster the Conservative Party in the post-Brexit environment. As May herself said, Brexit means Brexit. The median voter appears to agree and now wants the government to move on by turning the U.K. away from austere economic policies. We suspect the Tories understand this now. As for a potential Labour coalition with the SNP and Liberal Democratic Party, the numbers do not add up at the moment. Nonetheless, if we combine all the left-of-center parties in the U.K., their share of total vote is 52%. As such, we expect the Tories, assuming they govern, to tilt to the left on the economic front. Bottom Line: Tories are likely to produce a government in some kind of coalition with Northern Irish DUP. We highly doubt that they will double down on Euroskepticism after that strategy proved so disastrous in the election. The U.K. voters have moved on from Brexit and are not interested in re-litigating the reasons for it. They are, however, interested in seeing a definitive end to austerity. Investment Implications Another reason this election is not a game changer on anything other than domestic economic policy is that the Scottish National Party sustained serious losses of 21 seats. Former banner-bearing member Alex Salmond even lost his seat. Voters are simply not interested in the constitutional struggles within the U.K. or the EU at this point. The key takeaway for investors is that fiscal policy is the driving issue in British politics. Brexit was not only a vote about sovereignty and immigration, it was also a demand from the lower and middle classes for an end to second-class status. That is why May highlighted the need for government to moderate the forces of globalization and capitalism and make the economy "work for everyone" in her October 2016 speech at the Conservative Party conference and in her rhetoric since then. She lost sight of her own message and squandered her massive lead. The Tories had started to ease fiscal policy ahead of the election. In his first Autumn Statement, Chancellor Philip Hammond abandoned his predecessor George Osborne's promise to eliminate the budget deficit by 2019, pushing the timeline beyond 2022 (Chart 4). The latest budget projections by the Office for Budget Responsibility show that the current government is projecting more spending than its predecessor (Chart 5). Thus monetary and fiscal conditions are both accommodative in the short and medium term. Given that we do not expect the European Union to exact crippling measures on the Brits for leaving, as we have outlined in previous reports, the result is a relatively benign environment for the U.K., at least until the business cycle turns, the effects of Brexit begin to bite, and/or global growth slows down. The combination of fiscal stimulus and easy monetary policy, however, should weigh on the pound regardless of the election outcome. We do not expect the GBP to retest its January 16, 2016 lows against the USD in the near term, but the large amount of uncertainty injected into the British political sphere will nonetheless result in a few more days of cable weakness that can be exploited by short-term traders. The competing crosswinds confusing investors in the immediacy of the election are as follow: Jeremy Corbyn's Labour is as left-wing as any major center-left party has become in the West. Yet it just won over 40% of the vote in the U.K.; Brexit remains the likely outcome of U.K.-EU negotiations, but the chances of a "super hard Brexit" or some sort of a "Brexit cliff" have been reduced as voters have repudiated May's hard right turn; The pound has already fallen on every gaffe and misstep by the Tories, suggesting that the current disappointing result, although not fully priced, was partly anticipated by the FX markets. In the long term, however, a reversal of austerity and a relatively dovish monetary policy from the BoE should be negative for the pound. While less austerity is a big plus for the economy, the inflationary momentum experienced in recent months should increase further and dampen the fiscal dividend as higher prices hurt real spending (Chart 6). This puts the BoE in a bind, in which it will be hard to move away from its super-accommodative stance even if inflation is becoming dangerous. Thanks to these dynamics, the leftward tilt for one of the previously most laissez-faire economies in the world could see the GBP ultimately retest its January 16 lows over the medium term as the recent surge in FDI could peter off, increasing the cost of financing the U.K.'s large current-account deficit. Moreover, BCA's House View calls for a higher dollar by year's end, another negative for cable. Yet a fall much below GBP/USD 1.2 is unlikely, given that uncertainty over Brexit negotiations with the EU were overstated to begin with and likely to be resolved towards a "softer Brexit" outcome over the life of the next government. Additionally, the pound is now cheap, and another pullback would result in a more than 1-sigma undervaluation relative to long-term fundamentals (Chart 7). Chart 6The BOE's Dilemma Chart 7The Pound Enjoys A Valuation Cushion Is there a message for the rest of the world from the U.K. election? Absolutely. It signals that the voters who did not benefit from globalization are singularly focused on economic issues and that distracting them with nationalism will only go so far. This is a message that the Trump administration in the U.S. will either heed over the next three years or ignore and suffer a left-wing backlash in the 2020 election that will unsettle the markets in a fundamental way.7 The bastions of laissez-faire economics - the U.K. and the U.S. - are swinging to the left. We continue to believe that investors are unprepared for the consequences of this reality. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy," dated April 13, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 4 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. 5 The failure of May's tough rhetoric on terrorism to help her in the polls suggests, along with other evidence, that Europeans are becoming desensitized to terror attacks. Please see BCA Geopolitical Strategy Special Report, "A Bull Market For Terror," dated August 5, 2016, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Has Europe Switched From Reward To Risk?" dated June 7, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com.

Highlights 'Super Thursday' June 8 brings three potentially high-impact events for financial markets: a U.K. General Election; a ECB monetary policy meeting; and former FBI Director James Comey's testimony to the U.S. Senate intelligence committee. Each of these events has the potential to move markets - especially currencies - abruptly in either direction. Medium-term investors should use Super Thursday and its aftermath as follows: If the pound sells off, use it to buy pound/dollar. If the euro sells off, use it to buy both euro/pound and euro/dollar. Use any associated underperformance of FTSE100/Eurostoxx50 to buy this relative equity position. Feature Traders will be salivating at the prospect of three potentially high-impact events for financial markets in the space of a day: a U.K. General Election; a ECB monetary policy meeting; and former FBI Director James Comey's testimony to the U.S. Senate intelligence committee about possible collusion between the campaign of President Donald Trump and Russian officials. This report will focus on the first two of these 'Super Thursday' events. Chart of the WeekRelative Interest Expectations Must Follow Relative Economic Performance 300-340 Conservative Seats = Short-Term Pain For The Pound Chart I-2The Pound Is Where It Was When##br## The Election Was Called The U.K. General Election result has the potential to move the pound abruptly in either direction. Therefore, it also has the potential to drive FTSE100/Eurostoxx50 relative performance which is just an inverse currency play. But treat the U.K. election result as a trading opportunity rather than as a game changer for any investment position. Theresa May admits that she called the snap election to strengthen her narrow parliamentary majority ahead of Brexit negotiations. When she called the election, the Conservatives were riding high in the polls, and markets expected May easily to achieve her aim. Reasoning that a much strengthened majority would reduce the influence of the hard Brexiters in her party, the pound rallied (Chart I-2). But as the polls have tightened, it has given back this gain. If the number of Conservative seats does not meaningfully move up from the current 330, or worse, if the result increases uncertainty, the pound is vulnerable to a further snap sell-off. A parliamentary majority requires 326 MPs, but around 320 is enough for an effective majority because Sinn Fein MPs,1 the speaker and deputy speakers do not vote. 315 might just scrape a Conservative minority government supported by its Northern Ireland Unionist allies. Hence, if the Conservatives win 300-340 seats, a knee-jerk sell-off in the pound is likely. Chart I-3The Brexit Vote Depressed The Pound Because##br## It Depressed U.K. Interest Rate Expectations If the Conservatives win well above 340 seats, the pound should knee-jerk rally - as May's effective majority would strengthen enough to marginalize the hard Brexiters. If the Conservatives win well below 300 seats, the pound might also settle higher - as this is the territory of a Labour minority government supported by the Scottish National Party and Liberal Democrats, and thereby a softer Brexit. But any major moves in the pound after the election will prove to be transient, because the over-arching driver of currencies is the interplay of interest rate expectations. Chart I-3 illustrates that last year's Brexit vote depressed the pound because the shock outcome precipitated a base rate cut and depressed expectations for Bank of England interest rate policy. In contrast to the Brexit vote, the General Election result per se will not have a lasting impact on the pound because it is unlikely to change the interest rate setting calculus for the BoE relative to other central banks. The BoE has been one of the most inert central banks when it comes to changing interest rates in either direction. Last year's emergency rate cut, forced by the shock vote for Brexit, has been the BoE's only policy rate move in 8 years! We expect the BoE to continue with its policy rate inertia because U.K. real consumption is highly correlated (inversely) to inflation. When inflation is too high, real consumption is undermined, making it difficult to hike rates; when inflation is too low, real consumption tends to grow strongly, making it difficult to cut rates (Chart I-4). This mirror image performance of inflation and real consumption has tied the hands of the BoE for 8 years, and will continue to do so. Chart I-4Why The Bank Of England's Hands Are Tied With the BoE's hands tied, relative interest rate expectations - and therefore the medium-term direction of the pound - will depend on the other central bank in the respective cross rate. Which brings us neatly to the ECB. The ECB Must Follow The Hard Data Years of extreme and experimental central bank intervention have left markets hyper-sensitive to the slightest change of nuance in central bank communication. We have now come to a ridiculous state of affairs where reducing two instances of the sentence "the balance of risks remain tilted to the downside" in the March 9 ECB press conference introductory statement to just one instance in the April 27 statement is regarded as de facto monetary tightening! The slightest change of nuance in central bank communication can powerfully drive markets over a timeframe of a few weeks or months. As Peter Praet, the ECB Chief Economist, warns: "After a prolonged period of exceptional monetary policy accommodation, financial markets are particularly sensitive to any perceived change in the future course of monetary policy. (Therefore) any substantial change in communication needs to be motivated by some more evidence in the hard data." On this basis, we expect the ECB to acknowledge the hard data showing euro area growth is solid and broad, and downside risks are diminishing; but that the required upward adjustment in inflation remains sluggish. For euro/dollar, a mixed message such as this might create a near-term setback of around 2%, given that it has rallied strongly in the past 65 days and is now technically overbought (see page 8). We would regard a 2% setback for the euro as a medium-term buying opportunity. As Peter Praet points out, central banks' data-dependency means that policy must follow the hard data over a timeframe of six months or longer. The Chart of the Week, Chart I-5 and Chart I-6 should make this crystal clear. Relative interest rate expectations and bond yield spreads ultimately follow relative economic performance. Chart I-5Bond Yield Spreads Must Follow The Hard Data On Economic Growth Differentials... Chart I-6...And Inflation Differentials If, as we expect, euro area growth2 continues to perform in line with or better than the U.S. and U.K. - and inflation differentials continue to narrow - then relative interest rate expectations will also continue to converge. Even the ECB admits that its main growth worry comes not from the euro area economy itself but rather from "the considerable uncertainty surrounding the new U.S. Administration's policies." In this regard, observe that the post-Trump spike in U.S. interest rate expectations has barely unwound (Chart I-7). We think it should unwind more. And who knows, perhaps James Comey will be the immediate catalyst. Chart I-7The Trump Spike In U.S. Interest Rate Expectations Hasn't Unwound What To Do After Super Thursday Chart I-8Pound/Euro (Inversely) Drives ##br##FTSE100/Eurostoxx50 In summary, policy rate expectations - in relative terms - will structurally continue to: Get less dovish in the euro area. Remain broadly unchanged in the U.K. Get more dovish in the U.S. Hence, our structural preference for currencies is euro first, pound second, dollar third. Which brings us finally to what medium-term investors should do after Super Thursday. If the pound sells off, use it to buy pound/dollar. If the euro sells off, use it to buy both euro/pound and euro/dollar. And use any associated underperformance of FTSE100/Eurostoxx50 to buy this relative equity position (Chart I-8). Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Sinn Fein MPs are not eligible to vote because they refuse to pledge allegiance to the Queen. 2 Growth must be adjusted for different demographics. Our preference is to use real GDP per head based on working age (15-64) population. Fractal Trading Model* Euro/dollar is technically overbought, so traders can play a countertrend move. Target a 2% retracement. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Merkel is not revolutionizing but reaffirming Germany's Europhile policy; An earlier date for the Italian election would bring market jitters forward from Q1 2018; Yet a new German-style electoral law would decrease the risks of a populist win; The Tories will retain their majority in U.K. elections. Fiscal policy will ease regardless of the outcome; Close long Chinese equities versus Hong Kong/Taiwan; remain overweight Euro Area equities. Feature Possible early elections in Italy and a narrowing lead for Theresa May in the June 8 U.K. election has unsettled investors over the past week. The former threatens to rekindle the flames of the Euro Area conflagration and has weighed on Euro Area equities (Chart 1). The latter threatens Prime Minister May's mandate and political capital, suggesting that the U.K.-EU Brexit negotiations could be acrimonious later this year. This report deals with both issues. Yes, Italy is a major risk to the Euro Area, and despite general awareness of the election, it is not clear to us that investors realize the depth of the risk. As such, Euro Area equities may outperform developed market peers right until the election. As for the U.K. election, we think its impact on global risk assets is non-existent and its impact on U.K. assets is likely to be fleeting. The bigger threat to global markets remains China. In a March report, we suggested that Chinese policymakers may be testing the waters for broad-based financial and industrial sector reform akin to their late 1990s efforts.1 These reforms could be deflationary in cyclical terms and thus a risk for global growth. We argued that the timeline for these efforts would have to wait for the conclusion of the nineteenth National Party Congress this fall and thus Beijing's policy represented a potential problem for 2018.2 Chart 1Italy Weighs On European Risk Assets Chart 2China: Monetary Tightening Takes A Toll Then again, President Xi Jinping may flout the rule of thumb in Chinese politics that aggressive policy actions should wait until after the five-year party congresses. Monetary tightening - which could be the first salvo of broader financial-sector reform - has already had negative effects on the real economy (Chart 2). The economic surprise index has corrected, as have China's PMI and LEI. Further Chinese tightening would invariably hurt Chinese demand for imports (Chart 3), which would have negative knock-on effects for EM economies, whose growth momentum appears to have already rolled over (Chart 4). Investors should carefully monitor China over the summer. Any signaling from policymakers that they are willing to move away from the "Socialist Put" and towards genuine deleveraging (not to mention their promised free-market reforms) would have negative global implications. Our colleague Mathieu Savary, of BCA's Foreign Exchange Strategy, has pointed out that Europe's economic outperformance relative to the U.S. is highly leveraged to Chinese liquidity (Chart 5).3 As such, decisions made by policymakers in Beijing will likely be more important for European asset performance than who sits in Rome's Palazzo Chigi. Chart 3Tighter Credit Impulse##br## Will Drag Down Imports Chart 4A Chinese Import ##br##Drag Will Hurt EM Chart 5Euro/U.S. Growth Differentials ##br##And Chinese Liquidity We are closing our long Chinese equities / short Taiwanese and Hong Kong equities trade for a gain of 3.45%. While policymakers are already backpedaling a bit, financial tightening inherently raises risks in an excessively leveraged economy. Europe Über Alles? Many clients are asking about German Chancellor Angela Merkel's recent comments on European unity. On the heels of the G7 summit, during which Merkel locked horns with U.S. President Donald Trump, Merkel delivered the most Europhile speech of her career: The era in which we could fully rely on others is over ... That's what I experienced over the past several days ... We Europeans truly have to take our fate into our own hands ... But we have to know that we Europeans must fight for our own future and destiny. To many in the media and financial industry the speech seemed like a massive departure from Merkel's cautious and reticent approach to European policymaking. We could not disagree more. European integration imperatives are intrinsically geopolitical, as we have argued since 2011.4 Members of the Euro Area are integrating not because of liberal idealism or misguided dogmatism on monetary union. Rather, they are engaged in a cold, calculated, and deeply realist political project to remain relevant in the twenty-first century. This net assessment has guided our analysis of various Euro Area crises. We supported our top-down theoretical view with bottom-up data showing that European voters were not revolting against integration. Integration may be elite-driven, but it has broad popular support. Support for the common currency has never dipped below 50% (Chart 6), despite a once-in-a-generation economic crisis, and most European states are pessimistic about their separate futures outside the EU (Chart 7). Chart 6Voters Approve Of The Euro Chart 7EU Exits: Not On Horizon German policymakers have operated within these geopolitical confines since the Euro Area sovereign debt crisis began in the waning days of 2009. At every turn of the crisis, whenever one or another German policymaker issued a "red line" regarding what "Berlin cannot accept," the correct view was to bet against that policymaker, i.e. against any Euroskeptic outcome. Since 2010, we have seen: Numerous direct bailouts of member states; A dove appointed to lead the ECB, with Berlin's blessing; Direct ECB purchases of government bonds; Deeper fiscal and banking integration of the Euro Area, albeit at a slow pace; Expansion - not contraction - of Euro Area membership; The reversal of fiscal austerity. We were able to forecast these turns because our constraint-based methodology gave us a high-conviction view that German policymakers would ultimately be forced down the integrationist, Europhile road. The German population did not revolt against these constraints. Germans are not Euroskeptic. We have no idea why many investors think they are: there is no evidence of it in data or history. German history is replete with failed efforts to unify (and lead) the European continent by hook or by crook. The country is cursed with just enough economic prowess to be threatening to its peers and yet not enough to dominate them by force. As such, it is a German national security imperative to ensure that it does not see the rest of Europe coalesce into an economic or military alliance against it. The EU and its institutions, which allow Germany to be prosperous without the threat of an enemy coalition, are therefore worth preserving, even at a steep cost. True, the costs of bailing out Greece, Ireland, Portugal, and Spain tested German enthusiasm for European integration. However, German support for the common currency never dipped below 60% amidst the sovereign debt crisis and has since rebounded to a record high of 81% (Chart 8). Only 20% of Germans are confident of a future outside the EU (Chart 9). Chart 8Rise Of The Europhile Germany Chart 9Germany: No Life After EU Death As such, Merkel's statement following the G7 summit is only surprising because it is explicit. Indeed, the reason Merkel made this statement now is not because she suddenly had a grand geopolitical realization, nor because Trump suddenly disabused her of a naïve belief in the benevolence of the United States. Merkel has understood Europe's imperatives for at least a decade. The real reason for her statement is domestic politics. Martin Schulz, Merkel's opponent in general elections to be held on September 24, has tapped into the rising Europhile sentiment among Germans. The Social Democratic Party (SPD) sprang back to life this year following Schulz's appointment as SPD chancellor-candidate. Despite a recent relapse for the SPD in the polls, Merkel wants to ensure that she is not vulnerable on her left flank to the more Europhile Social Democrats. In the face of this renewed threat from the SPD, the venue of Merkel's speech was highly symbolic: a summit of the Christian Social Union (CSU), the Bavarian sister party to Merkel's Christian Democratic Union (CDU), held in a beer hall no less! Bavaria is the most conservative and Euroskeptic part of Germany. Over the past two years, the CSU has flirted with abandoning its post-war electoral alliance with the CDU due to Berlin's various Europhile turns. This development threatened to undermine Merkel and her base of power from within. Merkel's speech, to the most Euroskeptic part of Germany, was designed to prepare her conservative base for a further deepening of European integration. It was not a policy shift but rather a statement that brought her rhetoric more in line with her policy actions. It was also a reminder to her core allies that they must continue on the current policy path unless they would rather have Schulz's SPD force them into even deeper European integration, and faster. What does this mean going forward? We think that the dirty word of European politics - "Eurobonds" - will come into play again. As if on cue, the European Commission has published a report that proposes bundling the debt of Euro Area sovereigns.5 The proposal is not exactly calling for Eurobonds, but rather for securitizing existing bonds into new instruments. As usual, a German finance ministry spokesperson opposed the plan. However, the path of least resistance will be towards more integration that may include such securitization. In fact, Eurobonds already exist. Europe's fiscal backstop mechanisms - formerly the European Financial Stability Facility (EFSF) and now the European Stability Mechanism (ESM) - have both issued bonds to finance sovereign bailout efforts. So has the European Investment Bank (EIB). Their bonds trade largely in line with French sovereign debt, with a 37 basis point premium over German 10-year Bunds (Chart 10). Most importantly, the European Commission - the executive arm of the EU - already has authority to issue bonds and even tap member states for funds in case it needs to fill a gap. As the European Commission cites in its pitch-book to bond investors (yes, you read that correctly), "should the funds available from the EU budget be insufficient, the Commission may directly draw on the Member States, without any extra decision making being required."6 Currently, EU treaties forbid bond issuance that would directly finance the budget of a member state. However, Article 143 lays down the possibility of granting mutual assistance to an EU country facing a balance-of-payments crisis, which the EU Commission handles via its €50 billion balance-of-payments assistance program. In the future, the Commission could issue bonds to finance joint, EU-wide projects for areas like defense or infrastructure. It does not appear that such a decision would require a change to EU treaties. Over the long term, the integration imperative will remain strong in Europe. Ironically, Donald Trump is probably the best thing that has happened to European unity, at least since President Vladimir Putin. However, we think media commentators may be overstating President Trump's impact. The U.S. was already growing aloof toward Europe under President Obama, who overtly tilted his foreign policy towards Asia, and President Bush, whose administration clashed with "old Europe" and merely flirted with "new Europe." With the prospect of the U.S. withdrawing its security blanket, Europeans are being forced to integrate. Otherwise they would have to deal with the full range of global crises - from debt to terrorism to migration to war - as separate, and weak, individual states. And the U.S. is unlikely to return to its post-World War II level of concern regarding European affairs anytime soon. We doubt that even a recession would greatly impede the integrationist impulse on the continent. The Great Financial Crisis was a once-in-a-generation economic crisis and yet it has deepened, not decreased, support for integration. That said, risks remain. While the median voter in Europe appears to support the elite-driven integrationist effort, the median voter in Italy is on the fence. Bottom Line: Merkel's Europhile speech in Bavaria was meant to reinforce the ongoing integrationist path to her domestic audience in an election year. We suspect that Germany under Merkel, along with France under recently elected President Emmanuel Macron, will continue down the same path. At some point in the not-so-distant future, this may include the issuance of Eurobonds for specific projects. Our long-held geopolitical view supports overweighting Euro Area risk assets, given economic momentum and valuations. However, near-term political risks in Italy are substantial and pose the main risk to our strategic view. Italy's Divine Comedy - Coming Soon To A Theater Near You? Early Italian elections - in September 2017, instead of February-May 2018 - have become a real possibility. Matteo Renzi, leader of the ruling Democratic Party (PD) and former prime minister, recently signaled that he would be willing to compromise on a new electoral law, and that it could pass as early as July, given a tentative agreement with the Forza Italia party of former prime minister Silvio Berlusconi. This would satisfy the condition of President Sergio Mattarella that a new electoral law be passed before elections can proceed. What does this development mean for markets? Italian political elites share the same integrationist goals of their European peers. There is no logic in Italian independence from the EU. Rome's ability to patrol its coastline for smugglers bringing in migrants would not improve with independence, nor would its ability to negotiate a low price for Russian natural gas. Italy is, as much as any European country, in terminal decline as a geopolitical power. Membership in the EU is therefore a natural, and realist, response to its weakness. In addition, exiting the monetary union would be fraught with risks that would overwhelm any benefits that Italian exports may gain from devaluation. It is highly unlikely that Germany, France, Spain, and the Netherlands would allow Italy - the Euro Area's third largest economy - to set a precedent of using massive currency devaluation while maintaining access to the Common Market. Rome would in fact break its Maastricht Treaty obligations. These stipulate that every member state, save for Denmark and the U.K., must become a member of the EMU. It would likely be evicted from both the EU and the Common Market. Furthermore, as we discussed in our September net assessment of Italy, the country's 19th nineteenth century unification has never made much sense.7 We would go so far as to argue that Euro Area amalgamation makes more sense than the unification of Italy. Northern Italy remains as much part of "core Europe" as London, the Rhineland, or the Netherlands, whereas the south - the Mezzogiorno - might as well be in the Balkans. We do not see how Rome would afford the Mezzogiorno on its own without access to both the EU's markets and ECB-induced low financing costs. All that said, the median Italian voter is not buying the Euro Area at the moment. Unlike their European peers, Italians seem to be flirting with overt Euroskepticism. When it comes to support for the common currency, Italians are clear outliers, with support levels around 50% (Chart 11). Similarly, a plurality of Italians appears to be confident in the country's future outside the EU (Chart 12). Chart 11Italy A Clear Outlier On The Euro Chart 12Italians Willing To Go Solo? Of course, only about a third of Italians identify themselves as only "Italians," largely in line with the Euro Area average and nowhere near the trend in Britain, where the share of the public that feels exclusively British has generally ranged from half to two-thirds (Chart 13). Nevertheless, the Euroskeptic trend in Italy is real and jeopardizes European integration. Our high-conviction view that European politics would be a "red herring" in 2017 was originally based on data that showed that voters in the Netherlands, France, and Germany increasingly supported European integration. This allowed us to dismiss polls that suggested that Euroskeptic politicians - such as Geert Wilders or Marine Le Pen - would do well in this year's elections. Even if they did perform well, the median voter's stance on European integration would force such policymakers to modify their Euroskepticism. This process has already happened in Spain (Podemos), Finland (The Finns, formerly known as the True Finns), and Greece (SYRIZA). In Italy, however, the median voter's Euroskepticism has not abated. As such, parties such as the Five Star Movement (M5S) and Lega Norde (LN) have no political incentive to modify their Euroskepticism. In fact, LN has done the opposite, evolving from a liberal and pro-EU regional sovereignty movement into a far-right, anti-immigrant, Euroskeptic, and nationalist Italian party -- a full brand overhaul. The timing of the upcoming election is difficult to forecast. Nonetheless, Renzi's compromise on changing electoral rules has now increased the probability that the election be held in Q4 2017, instead of Q1 2018. Renzi reportedly favors the same date as the German election, September 24. To accomplish this timetable, the new electoral law would have to be rushed through Italy's bicameral Parliament. The Chamber of Deputies - the lower house - is expected to vote on the compromise law in the first week of June, with the Senate passing the law by July 7. Given that the top four parties all seem to agree with adopting a German-style electoral system - proportional representation, with parties required to gain at least 5% of the vote to gain any seats - this ambitious timeline is possible. However, there are still some minor outstanding issues, which could drag out the process until the fall. In addition, local elections scheduled for June 11 (with a second-round run-off on June 25) could change the calculus of the ruling PD. If Renzi's party underperforms, he may back away from early elections, although the message would be that a strong populist performance in early 2018 is more likely. Polls have not budged much for the past 18 months, although Renzi's PD lost support around the time of its failed December 2016 constitutional referendum (Chart 14). The market may find solace in the fact that the revised electoral law would grant no "majority-bonus" to the winner, virtually ensuring that the Euroskeptic M5S cannot govern on its own. Chart 13Majority Of Italians Are Also Europeans Chart 14Ruling Party And Populist M5S Neck-In-Neck The risk to the market, however, is that M5S outperforms and then creates a limited coalition with right-wing Euroskeptics. Such a coalition could have the singular goal of calling a "non-binding, consultative" referendum on Italy's Euro Area membership. The official M5S line is that it would call such a referendum "if fiscal policies of the Euro Area did not change." Either way, the Italian constitution forbids referendums on international treaties, but a consultative referendum would give impetus to Euroskeptic parties to start negotiating a Euro Area exit for the country. There are two reasons why such an outcome is possible, if not our base scenario. First, a German-style 5% threshold will eliminate the votes cast for a number of minor parties from the overall calculation. These currently combine to make up about 18% of the total vote. This means that the parties that meet the 5% minimum will gain a larger share of seats in the parliament than they gained of the overall popular vote (82% of the vote will hold 100% of the seats), as is the case in Germany. There is a chance that both the PD and M5S get a considerable seat boost in the final tally that puts them close an overall majority. Second, much will hinge on whether the right wing - and Euroskeptic - Fratelli d'Italia (FdI) enter parliament. They are currently polling at about 5% of the vote. If they gain seats, it would significantly increase the percentage of total seats held by Euroskeptic parties. There is no evidence at the moment that M5S, which is on the left of the policy spectrum, would contemplate such an electoral alliance with LN and FdI. The party remains opposed to any coalitions and we suspect that it would not break its pledge to pursue the highly risky strategy of calling a referendum on the Euro Area. The M5S stands for a lot of different things: anti-corruption, anti-establishment, youth empowerment, etc. Euroskepticism is one of its pillars, not a singular objective. In fact, party leader Beppe Grillo recently attempted to abandon the Euroskeptic alliance with UKIP at the European Parliament to join the ultra-liberal, and Europhile, Alliance of Liberals and Democrats for Europe. Various factions vying for control of the movement oscillate between overt Euroskepticism, aloofness toward Europe, and open support for European integration. In addition, Italian voters may adjust ahead of the election by switching their support away from the various minor parties currently polling below 5% and toward the four major parties. This will likely benefit the ruling PD more than any other party. Out of the four parties highly unlikely to cross the 5% threshold - Campo Progressista (CP), Movimento Democratica e Progressista (MDP), Alternativa Popolare (MP), and Sinistra Italiana (SI) - three are centrist or aligned with the PD. One (Sinistra Italiana) would likely see its voters split between the PD and M5S (Chart 15). Such vote migration would clearly benefit the center-left PD, which Renzi is likely counting on in accepting the German-style proportional electoral system.8 Chart 15Most Minor Party Votes ##br##Would Help Ruling Democrats Bottom Line: Investors trying to make sense of the Italian election will find relief in the new electoral law. A purely German-style system - given the current level of factionalism in Italian politics - is unlikely to produce a populist government in Italy. In fact, the center-left PD could see a boost in support as voters switch away from minor parties. The tentative compromise on the electoral law has both increased risks by making an earlier election more likely and decreased risks by reducing the probability of an anti-market result. That said, there is still a possibility that M5S crosses the ideological aisle to form an alliance with right-wing Euroskeptics to try to take Italy out of the Euro Area. We doubt that they will do so. Nonetheless, it will be appropriate to hedge such a risk in currency markets closer to the date of the election, once the date is known. We therefore closed our long EUR/USD recommendation last week for a gain of 3.48%. Whatever the outcome of the election, Italian political risks will remain the main threat to European integration (and assets) going forward. We therefore expect the ECB to keep one eye on Italy, forcing it to be less hawkish than it otherwise would be. We will explore Italian politics and economy further in an upcoming report with our colleagues at BCA's Foreign Exchange Strategy. U.K.: The Election Is About G The latest polling averages show that Prime Minister Theresa May's Conservative Party maintains a 5% lead over Jeremy Corbyn's Labour Party, despite Labour's remarkable rally since early elections were called on April 18 (Chart 16). One projection of actual parliamentary seats that takes into account the crucial factor of voter turnout suggest that the Tories could add from 15 to 34 seats to their 2015 take of 330 seats - and this roughly matches our back-of-the-envelope calculation that the Tories could pick up 11 seats on account of the Brexit referendum (Table 1).9 Chart 16Labour Revives On Snap Election Table 1Referendum Results Offer Some Simple Gains For Tories There have been only two other cases in recent memory in which Britain's incumbent party led by double digits two months ahead of an election: 1983 and 2001. In the first case, Margaret Thatcher followed up the hugely successful Falklands campaign by expanding her popular support in the final two weeks to win a huge 144-seat majority. In the second case, Tony Blair lost some of his lead but still won the election handily.10 There has not been a case in recent memory where a double-digit lead dropped into single digits as quickly as it did this past month. Moreover, looking at the latest individual polls, it is too soon to say that Labour's rally has ended. Indeed, YouGov's model even shows the Conservatives losing their majority.11 Snap elections are always a gamble, as we have stressed throughout this campaign.12 There is no question that Labour has the momentum and May is feeling the heat. Yet the Tories have a fairly solid foundation of support at the moment. First, they are still polling above 40% support, almost 10% higher than before the referendum, reflecting the rally-around-the-flag effect after voters' surprising decision to leave the EU. They even poll above 40% among working-class voters, the original base of Labour, and the country's aging demographic profile also heavily favors them. (Youth turnout would have to surprise upward to upset the Tories.) Second, the Tory strategy of gobbling up supporters of the U.K. Independence Party (UKIP) has succeeded (Chart 17). UKIP has no raison d'être after achieving its foundational goal of Brexit. The Conservative Party's decision to hold a referendum on the EU was, in fact, driven by this rivalry from the right flank. UKIP posed the chief threat to the Tories through its ability to dilute their vote share in Britain's first-past-the-post electoral system. Now, almost all conservative voters will vote for the Conservative Party, while Labour must still compete with the Liberal Democrats, Greens, Scottish National Party, and Welsh Plaid Cymru in various constituencies (Chart 18). Chart 17Tories Keep Devouring UKIP Chart 18Labour Has Rivals, Tories Do Not Third, while May's popularity is merely converging with her party's still-buoyant level, Corbyn is less popular than both May and his own party (Chart 19). Corbyn still has a net negative favorability and is seen as less "decisive" and less "in touch" with voters than May. Fourth, voters still see Brexit as the most important issue of the election (Chart 20) and May as the best candidate to manage the tricky exit negotiations ahead. Because Brexit is the driver, the benefit of the doubt goes to the Tories. The 2015 elections, the EU referendum, the polls since the referendum, and the parliamentary votes (driven by popular pressure) enshrining the referendum result all suggest a great deal of public momentum on this key issue. The only truly historic development that could have broken this momentum, given that the economy is holding up, is the Tory decision to seek a "hard Brexit," i.e. exit from the EU's Common Market. Yet opinion polls show that Brexit still has the support of a majority of likely voters; moreover, 55% of voters would rather have "no exit deal" than "a bad exit deal."13 If voters still see this as the defining issue, then the Tories still have a key advantage. On the other hand, perceptions of Jeremy Corbyn and Labour have improved rapidly and May's simultaneous popularity slump is especially important in this election. She is a "takeover prime minister" (having initially gained the office when Cameron resigned rather than leading her party into an election as the presumed prime minister) and thus highly vulnerable. This election is largely about her need for a "personal mandate."14 Her political missteps (both real and perceived) are very much at issue in this particular election. Chart 19May Lifts Tories, Corbyn Drags Labour If polls continue to narrow, the election could produce a "hung parliament," in which no single party holds the 326 seats necessary for a majority in the House of Commons. What should investors expect in that scenario? First, May would have the chance to rule a minority government or form a coalition. A minority government would be weak, vulnerable to collapse under pressure, and would have a harder time controlling the Brexit negotiations. As for a coalition, there is very little chance that the other major parties would cooperate with her - the Liberal Democrats would not reprise their role as coalition partner from 2010-15. But there is a slim chance that the Democratic Unionist Party (DUP) of Northern Ireland could unite with the Tories to obtain a majority. The DUP has not exercised real power in a century, literally, and several of its members do not normally even take their seats in Westminster. However, the party is Euroskeptic and could provide just enough support to accomplish the single goal of a Tory-led Brexit. Suffice it to say that this outcome is not impossible - the Tories have been courting the DUP for months and the existence of a historic "common cause" changes the usual parliamentary dynamic. Still, this arrangement would be highly unusual, causing a massive uproar, and would lead to all kinds of uncertainties about parliament's ability to pass a final Brexit deal in 2019. Second, assuming May fails, the Labour Party would have to rule in the minority or form a coalition (if informal) with the Scottish National Party, LibDems, Plaid Cymru, Greens, and others. Here are the most likely outcomes of such an arrangement, in broad brush strokes: Brexit will in all likelihood proceed, given that all parties have professed respect for the referendum outcome. Since the new government would likely not seek to curtail immigration as strictly, it could seek to retain membership in the Common Market. However, a la carte membership in the Common Market remains the greatest difficulty with the EU member states, and therefore it is possible that even Labour would have to accept the logic of exiting the Common Market. In fact, we could see Labour's insistence on access to the Common Market producing more acrimony with the EU than the Tory clean-break strategy. Nevertheless, the odds of a "Brexit cliff" in which the U.K. exits without a trade deal would fall from their already low level, given Labour's unwillingness to let that happen. Despite moving ahead with Brexit, a Labour-led government would increase the relatively low probability of an eventual reversal of the decision, given that it would be more inclined to accept or encourage such an outcome in the face of a bad exit deal, a recession, or other challenges that cause public opinion to shift. The Scottish National Party would probably sideline its demands for a second Scottish independence referendum - especially given that polls supporting a second referendum have floundered for the time being - though not permanently.15 Fiscal spending would increase as a result of Labour's and the SNP's campaign promises and greater focus on domestic social issues. Even if May avoids squandering her party's majority (our baseline case), there are several important takeaways from her drop in the polls: Chart 21Dementia Tax' Gaffe Added To Tory Woes The median voter wants government support: The Labour Party's rally began as soon as elections were called, with left-leaning voters switching away from the LibDems once they saw a chance to challenge the ruling party. But the Tories took a hit from May's unprecedented (and publicly awkward) reversal on a party manifesto pledge only days after publishing it (Chart 21). The pledge, now infamous as the "dementia tax," was an attempt at fiscal tightening by which the government would include the value of an elderly person's home in the assessment of their financial means when it came to government support for social care. By contrast, Labour has rallied on the back of a party manifesto that promises fiscal expansion in various categories, including £7.7 billion additional funds for health care, social care, and nursing. More broadly, National Health Service funding, rent caps, and a higher "living wage" are the top four campaign pledges that gain above 60% popular support. As we elucidated last year, the two economies that most enthusiastically embraced a laissez-faire model - the U.S. and the U.K. - are now experiencing the most effective swing to the left.16 The U.K. campaign confirms that, with the Tories minimizing cuts and Labour offering greater spending. Brexit means Brexit: 69% of the public claims that government should follow the referendum outcome, and 52% favor Theresa May's proposed Brexit strategy. The opposition parties are not openly opposing the referendum outcome, as mentioned. Moreover, Labour's pledge to prevent the U.K. leaving the bloc without a trade deal is one of the least popular campaign pledges (only 31% approve), while the Liberal Democrats' pledge to hold a second nationwide referendum on the outcome of the exit talks is also unpopular (34% approve) (Chart 22). Labour is recovering support by focusing on its bread-and-butter, left-wing, social platform. Terrorism is not driving voters: The tragic terrorist attacks at parliament, Manchester, and London Bridge have hardly given May and the Tories any additional support despite being the party viewed as stronger on security. Amid a bull market in terrorism, British voters, like European peers, are becoming somewhat inured to periodic attacks against "soft" targets.17 Health is a bigger concern than immigration: A large majority of Britons think immigration has been too high in recent years, but only about 25% think it is a major issue facing the country, compared with 43% who cite health care as a major issue (see Chart 20 above). These are not completely independent issues because many people believe that immigrants are putting pressure on scarce health care resources. Immigration is closely tied to Brexit and will remain a burning issue if the government does not convince voters that it is more vigilant. But the Labour Party's greater support on health care (as well as education and other social issues) is a growing liability to the Tories as Brexit becomes more settled. If Brexit was a revolt against the elites, it is not necessarily the only manifestation of that revolt. The elitist Tories should be careful that they do not rest on their laurels having been on the right side of that particular issue. The key takeaway is that, aside from Brexit, fiscal policy is the driving issue in British politics. Brexit was not only a vote about sovereignty and immigration, it was also a demand from the lower and middle classes for an end to second-class status. That is why May highlighted the need for government to moderate the forces of globalization and capitalism and make the economy "work for everyone" in her October 2016 speech at the Conservative Party conference and in her rhetoric since then.18 That is also why the ruling party has already eased fiscal policy. In his first Autumn Statement, Chancellor Philip Hammond abandoned his predecessor George Osborne's promise to eliminate the budget deficit by 2019, pushing the timeline to beyond 2022 (Chart 23). The latest budget projections by the Office for Budget Responsibility show that the current government is projecting more spending than its predecessor (Chart 24). The Tories are also claiming that they will reboot the country's industrial strategy to improve productivity, which will become all the more imperative if they even partially follow through on their pledge to cut immigration numbers from the current annual ~250,000 to under 100,000, which will necessarily reduce labor force growth and thus also potential GDP growth.19 The National Productivity Investment Fund will need a projected £23 billion just to get on its feet. Given that Labour is proposing even more ambitious spending increases (£49 billion additional spending through 2022), the direction of U.K. politics - away from austerity - is clear regardless of the election outcome. Finally, our colleagues at BCA's Global Fixed Income Strategy expect the Bank of England to maintain loose monetary policy for the foreseeable future, being unable to turn more hawkish against inflation in the context of continued risks and uncertainties related to Brexit.20 Thus monetary and fiscal conditions are both accommodative for the short and medium term. Given that we do not expect the European Union to exact crippling measures on the Brits for leaving, as we have outlined in previous reports,21 the result is a relatively benign environment for the U.K., at least until the business cycle turns, the effects of Brexit begin to bite, and/or global growth slows down. The combination of fiscal stimulus and easy monetary policy, however, could weigh on the pound regardless of the election outcome. As such, we closed our short USD/GBP last week for a gain of 3.34%. Bottom Line: We do not expect a hung parliament; most signs suggest that the Tories will retain at least a weak majority. However, a hung parliament that produces a Labour-SNP alliance would not likely reverse Brexit (though it would make a reversal more conceivable). Such an alliance could eventually result in an exit deal that is both less politically logical than the Tory deal (because London would pay to stay in the Common Market yet have less say in how it is managed) and more favorable to the British economy in the long run (because retaining the benefits of Common Market access). But this is not a foregone conclusion. We maintain our view that Brexit itself has largely ceased to have concrete market-relevant impacts other than a decline in Britain's long-term potential GDP growth. There are two reasons for this. First, May has ruled out membership in the Common Market and thus has removed a potential source of acrimony with Brussels over any "special treatment." Second, the EU does not want to precipitate a crisis in the U.K. that could reverberate back onto the continental economy. Investment Implications We remain strategically overweight European equities relative to their U.S. peers, a trade that has returned 7.39% thus far. We would remind clients that we closed our long GBP/USD and long EUR/USD tactical trades last week for 3.34% and 3.48% gains, respectively. We are also booking a 3.45% profit on our "One China Policy" strategic trade (long Chinese equities as against their Taiwanese and Hong Kong peers). We still think policymakers will do everything they can to keep China's economic growth stable ahead of the party congress this fall, but, as we discussed in our May 24 missive,22 the decision to tighten financial regulation is risky and threatens to cause unintended consequences. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, “China Down, India Up?” dated March 15, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, “Political Risks Are Understated In 2018,” dated April 12, 2017, available at gps.bcaresearch.com. 3 Please see BCA Foreign Exchange Strategy Weekly Report, “ECB: All About China?” dated April 7, 2017, available at fes.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, “Europe’s Geopolitical Gambit: Relevance Through Integration,” dated November 3, 2011; and “Europe: The Euro And (Geo)politics,” dated February 11, 2015, available at gps.bcaresearch.com. 5 Please see European Commission, “Reflection paper on the deepening of the economic and monetary union,” May 31, 2017, available at ec.europa.eu. 6 Please see European Commission, “EU Investor Presentation,” April 7, 2017, available at ec.europa.eu. 7 Please see BCA Geopolitical Strategy Special Report, “Europe’s Divine Comedy: Italian Inferno,” dated September 14, 2016, available at gps.bcaresearch.com. 8 The only minor party that is Euroskeptic, FdI, is just close enough to the 5% threshold that its voters are unlikely to abandon it. They will not likely give the Euroskeptic Lega Norde and M5S much of a boost. 9 Please see Lord Ashcroft Polls, “2017 Seat Estimates: Overall,” May 2017, available at lordashcroftpolls.com. 10 In the 1997 election, Tony Blair and Labour led by double digits, but they were in the opposition. Their lead in the polls shrank slightly before Blair won a 178-seat majority, even larger than Thatcher’s 144 seats in 1983 and Clement Attlee’s 147 seats in 1945. 11 Please see YouGov, “2017 UK General Election Model,” accessed June 6, 2017, available at yougov.co.uk. 12 Please see BCA Geopolitical Strategy Weekly Report, “Buy In May And Enjoy Your Day!” dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see Anthony Wells, “Attitudes to Brexit: Everything We Know So Far,” March 29, 2017, available at yougov.co.uk. 14 Please see footnote 12 above. 15 Please see The Bank Credit Analyst and Geopolitical Strategy Special Report, “Will Scotland Scotch Brexit?” dated March 30, 2017, available at bca.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, “The End Of The Anglo-Saxon Economy?” dated April 13, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, “A Bull Market For Terror,” dated August 5, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, “Brexit Update: Does Brexit Really Mean Brexit?” dated July 15, 2016, and “Brexit Update: Red Dawn Over Britain” in Geopolitical Strategy Monthly Report, “King Dollar: The Agent Of Righteous Redistribution,” dated October 12, 2016, available at gps.bcaresearch.com. 19 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. 20 Please see BCA Global Fixed Income Strategy Weekly Report, “Adventures In Fence-Sitting,” dated May 16, 2017, available at gfis.bcaresearch.com. 21 Please see “Brexit: A Brave New World” in BCA Geopolitical Strategy Weekly Report, “The ‘What Can You Do For Me’ World?” dated January 25, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Weekly Report, “Northeast Asia: Moonshine, Militarism, And Markets,” dated May 24, 2017, available at gps.bcaresearch.com.

Special Report

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

Highlights Markets have gone too far in pricing out the Republican's market-friendly policy agenda. The President desperately needs a win ahead of mid-term elections. A bill that at least cuts taxes should be forming by year end. The risk is that continued political turbulence, now including the possibility of impeachment, distracts Congress and delays or completely derails tax reform plans. Fortunately for the major global equity markets, corporate profits are providing solid support. We expect U.S. EPS growth to accelerate further into year end, peaking at just under 20%. The projected profit acceleration is even more impressive in the Eurozone and Japan. Corporations are still in a sweet spot in which the top line is growing but there is no major wage cost pressure evident yet. U.S. EPS growth is well ahead of both Japan and the Eurozone at the moment, but we expect some "catch up" by year end that will favor the latter two bourses in local currency terms. EPS growth will fall short of bottom-up estimates for 2017, but what is more important for equity indexes is the direction of 12-month forward EPS expectations, which remain in an uptrend. The positive earnings backdrop means that stocks will outperform bonds for the remainder of the year even if Congress fails to pass any market-friendly legislation. The FOMC is "looking through" the recent soft economic data and slower inflation, and remains on track to deliver two more rate hikes this year. The impact of the Fed's balance sheet runoff on the Treasury market will be limited by several factors, but a shrinking balance sheet and Fed rate hikes will force bond yields to rise faster than is currently discounted. Policy divergence will push the dollar higher. The traditional relationship between the euro/USD and short-term yield differentials should re-establish following the French election. The euro could reach parity before the next move is done. "Dr. Copper" is not signaling that global growth will soften significantly this year. Chinese growth has slowed but the authorities are easing policy, which will stabilize growth and support base metals. That said, we remain more upbeat on oil prices than base metals. Feature Investors have soured on the prospects for U.S. tax reform in recent weeks, but the latest travails in Washington inflicted only fleeting damage on U.S. and global bourses. The S&P 500 appears to have broken above the 2400 technical barrier as we go to press. Market expectations for a more tepid Fed rate hike cycle, lower Treasury yields and related dollar softness undoubtedly provided some support. But, more importantly, corporate profits are positively surprising in the major economies and this is not just an energy story. The good news on company earnings should continue to drive stock prices higher this year in absolute terms and relative to bond prices. It is a tougher call on the dollar and the direction of bond yields. We remain short duration and long the dollar, but much depends on the evolution of U.S. core inflation and fiscal policy. A Death Knell For U.S. Tax Reform? Chart I-1 highlights that the market now sees almost a zero chance that the Republicans will ever be able to deliver any meaningful tax cuts or infrastructure spending. Many believe that mushrooming political scandals encumbering President Trump will distract the GOP and delay or derail tax reform. Indeed, impeachment proceedings would be a major distraction, although this outcome would not necessarily lead to an equity bear market. The historical record shows that the economy is much more important than politics for financial markets. BCA's geopolitical strategists looked at three presidential impeachments, covering the Teapot Dome Scandal (April 1922 to October 1927), Watergate (February 1973 to August 1974) and the President Clinton's Lewinsky Affair (January 1998 to February 1999).1 Watergate was the only episode that coincided with a bear market, but it is difficult to pin the market downturn on Nixon's impeachment since the U.S. economy entered one of the worst post-war recessions in 1973 that was driven by tight Fed policy and an oil shock. Impeachment would require that Trump loses support among the Republican base, which so far has not happened. The President still commands the support of 84% of Republican voters (Chart I-2). Investors should monitor this support level as an indicator of the President's political capital and the risk of impeachment. Chart I-1Fading Hopes For Tax Reform We believe that markets have gone too far in pricing out Trump's market-friendly policy agenda. The President desperately needs a win ahead of mid-term elections, and tax reform and deregulation are two key areas where the President and congressional Republicans see eye to eye. The odds are good that an agreement to cut taxes will be formed by year end. Congressional leaders want tax reform to be revenue neutral, but finding sufficient areas to cut spending will be extremely difficult. They may simply require that tax cuts are paid for in a 10-year window. This makes it possible to lower taxes upfront and promise non-specific spending cuts and revenue raising measures down the road. Or, Congress may pass tax reform that is not revenue neutral through the reconciliation process, which would require that tax cuts sunset at some point in the future. Tax cuts would give stocks a temporary boost either way but, as we discuss below, it may be better for corporate profits in the medium term if Congress fails to deliver any fiscal stimulus. Profits, Beats And Misses While economists fret over the soft U.S. economic data so far this year, profit growth is quietly accelerating in the background (Chart I-3). On a 4-quarter moving total basis, S&P 500 earnings-per-share were up by more than 13% in the first quarter (84% reporting). We expect growth to accelerate further into year end, peaking at about 18%, before moderating in 2018. Profit growth is accelerating outside of the energy sector. The projected acceleration in EPS growth is equally impressive in the Eurozone and Japan. The favorable profit picture in the major economies reflects two key factors. First, profits are rebounding from a poor showing in 2015/16, when EPS was dragged down by the collapse in oil prices and a global manufacturing recession. Oil prices have since rebounded and global industrial production is recovering as expected (Chart I-4). Our short-term forecasting models for real GDP, based on a mixture of hard data and surveys, continue to flag a pickup in economic growth in the major economies (Chart I-5). Chart I-3Top-Down Profit Projection Chart I-4EPS Highly Correlated With Industrial Production Chart I-5GDP Growth Poised To Accelerate The U.S. model's forecast paints an overly rosy picture, but it does support our view that Q1 softness in the hard data reflected temporary factors that will give way to a robust rebound in the second and third quarters. The Eurozone economy is really humming at the moment, as highlighted by our model and recent readings from the IFO and purchasing managers' surveys. Indeed, these indicators are consistent with real GDP growth of nearly 3%! Our GDP models are also constructive for Japan and the U.K., although not nearly as robust as in the U.S. and Eurozone. Chart I-6Profit Margins On The Rise Second, the corporate sectors in the major economies are still in a sweet spot in which the top line is growing but there is no major wage cost pressure evident yet. This is the case even in the U.S., where labor market slack has largely been absorbed. Indeed, margins rose in Q1 2017 for the third quarter in a row (Chart I-6). Our indicators suggest that the corporate sector has gained some pricing power at a time when wage gains are taking a breather.2 The hiatus of wage pressure may not last long, and we expect the "mean reversion" in profit margins to resume next year. But for now, our short-term EPS growth model remains upbeat for the next 3-6 months (not shown). Profit margins are also on the rise in Japan and the Eurozone. Margins in the latter appear to have the most upside potential of the three major markets, given the fact that current levels are still depressed by historical standards, and that there remains plenty of slack in the European labor market. We are not incorporating any margin expansion in Japan because they are already very high. Nonetheless, we do not expect any "mean reversion" in margins over the next year either, because the business sector is going to great lengths to avoid any increase in the wage bill despite an extremely tight labor market. U.S. EPS growth is well ahead of both Japan and the Eurozone at the moment, but we expect some "catch up" by year end: The U.S. is further ahead in the global profit mini recovery and year-ago EPS comparisons will become more difficult by the end of the year. The drag on corporate profits in 2017 from previous dollar strength will be larger than the currency drag in the Eurozone according to our models, assuming no change in trade-weighted exchange rates in the forecast period (Chart I-7). The pass-through of past yen movements will be a net boost to EPS growth for Japanese companies this year.3 Currency shifts would favor the Japanese and the Eurozone markets versus the U.S. even more if the dollar experiences another upleg. We expect the dollar to appreciate by 10% in trade-weighted terms. A 10% broad-based dollar appreciation would trim EPS growth by 2½ percentage points, although most of this would occur in 2018 due to lags (Chart I-8). Eurozone and Japanese EPS growth would receive a lift of 2 and ½ percentage points, respectively, as their currencies depreciate versus the dollar. Chart I-7Currency Impact On EPS Growth Chart I-8A 10% Dollar Rise Would Trim Profits Finally, the fact that profits in Japan and the Eurozone are more leveraged to overall economic growth than in the U.S. gives the former two markets the edge as global industrial production continues to recover this year and into 2018. Japanese and Eurozone equity market indexes also have a higher beta with respect to the global equity index. The implication is that we remain overweight these two markets relative to the U.S. on a currency hedged basis. Lofty Expectations Even though the message from our EPS models is upbeat, our forecasts still fall short of bottom-up estimates for 2017. Is this a risk for the equity market, especially in the U.S. where valuations are stretched? Investors are well aware that bottom-up estimates are perennially optimistic. Table I-1 compares the beginning-of-year EPS growth estimate with the actual end-of-year outcome for 2007-2016. Not surprisingly, bottom-up analysts massively missed the mark in the recession. But even outside of 2008, analysts significantly over-estimated earnings in seven out of nine years. Despite this, the S&P 500 rose sharply in most cases. One exception was 2015, when the S&P 500 fell by 0.7%. Plunging oil and material prices contributed to an EPS growth "miss" of seven percentage points. Chart I-9 highlights that the level of the 12-month forward EPS estimate fell that year, unlike in the other years since the Great Recession. Valuations are more demanding today than in the past, but the message is that attaining bottom-up EPS year-end estimates is less important for the broad market than the trend in 12-month forward estimates (which remains up at the moment). Chart I-9S&P 500 Follows ##br##12-month Forward EPS The bottom line is that the backdrop is constructive for equities even if the Republicans are unable to push through any fiscal stimulus. In fact, it may be better for the stock market in the medium term if the GOP fails to pass any meaningful legislation. The U.S. economy does not need any demand stimulus at the moment (although measures to boost the supply side of the economy would help lift profits over the long term). The current long-in-the-tooth U.S. expansion is likely to stretch further in the absence of stimulus, extending the moderate growth/low inflation/low interest rate backdrop that has been positive for risk assets in recent years. The Fed's Balance Sheet: It's Diet Time The minutes from the May FOMC meeting reiterated that policymakers plan to begin scaling back on reinvesting the proceeds of its maturing securities of Treasurys and MBS by the end of the year. The Fed is leaning toward a gradual tapering of reinvestment in order to avoid shocking the bond market. Still, investors are rightly concerned about the potential impact of the balance sheet runoff, especially given that memories of the 2013 "taper tantrum" are still fresh. Chart I-10 presents a forecast for the flow of Treasurys available to the private sector, taking into consideration the supply that is absorbed by foreign official institutions and by the Fed. The bottom panel shows a similar calculation for the aggregate supply of government bonds from the U.S., Japan, the Eurozone and the U.K. While the supply of Treasurys has been positive since 2012, the net flow has been negative for these four economies as a whole because of aggressive quantitative easing programs. This year will see the largest contraction in the supply of government bonds available to the private sector, at US$800 billion. The flow will become less negative in 2018 even if the Fed were to keep its balance sheet unchanged (mostly due to assumed ECB tapering). If the Fed goes ahead with its balance sheet reduction plan, the net supply of government bonds from the major economies will move slightly into positive territory for the first time since 2014. There is disagreement among academics about whether quantitative easing (QE) directly depressed bond yields by restricting the supply of high-quality fixed income assets, or whether the impact on yields was solely via the "signaling effect" for the path of future short rates. Either way, balance sheet runoff will likely have some impact on bond yields. A good starting point is to employ an empirical estimate of the impact of QE. The IMF has modeled long-term Treasury yields based on a number of economic and financial variables and the stock of assets held by the Fed as a share of GDP. Just for exposition purposes, let us take an extreme example and assume that the Fed simply terminates all re-investment as of January 2018 (i.e. the runoff is not tapered). In this case, the amount of bank reserves held at the Fed would likely evaporate by 2021. This represents a contraction of roughly 10 percentage points of GDP (Chart I-11). Applying the IMF interest rate model's coefficient of -0.09, it implies that long-term Treasury yields and mortgage rates would rise by 90 basis points from the "portfolio balance" effect alone. Chart I-11Fed Balance Sheet Runoff Scenario However, it is more complicated than that. The impact on yields is likely to be tempered by two factors: The balance sheet may never fully revert to historic norms relative to GDP. Some academic experts are recommending that the Fed maintain a fairly large balance sheet by historical standards because of the need in financial markets for short-term, risk-free assets that would diminish if there are fewer excess bank reserves available. Banks, for example, are required by regulators to hold more high-quality assets than they did in the pre-Lehman years. As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions to tighten too quickly. Thus, the path of short-term rates is dependent on the dollar and the reaction of the long end of the curve. It is difficult to estimate how it will shake out, but a recent report from the Federal Reserve Bank of Kansas City estimated that a $675 billion reduction in the size of the Fed's balance sheet is equivalent to a 25 basis point increase in the fed funds rate (although the authors admit that the confidence band around this estimate is extremely wide).4 We expect that the impact of runoff alone will be much less than the 90 basis point estimate discussed above. Still, the combination of balance sheet shrinkage and Fed rate hikes will lead to higher bond yields than are currently discounted in the market. Fed Outlook: Mostly About Inflation The May FOMC minutes confirmed that the FOMC is "looking through" the soft economic data in the first quarter, chalking it up to temporary factors such as shifts in inventories. They are also inclined to believe that the moderation in core CPI inflation in recent months is temporary. The message is that policymakers remain on track to deliver two more rate hikes this year, in line with the 'dot plot' forecast. The market is pricing almost a 100% chance of a June rate hike. However, less than two full rate hikes are expected over the next year, which is far too benign in our view. Investors have been quick to conclude that recent economic data have convinced Fed officials to shift from a "gradual" pace of rate hikes to a "glacial" pace. Treasurys rallied on this shift in Fed expectations and a decline in long-term inflation expectations. The 10-year TIPS breakeven inflation rate has dropped to about 1.8%, the lowest level since before the U.S. election. This appears to us that the bond market over-reacted to the drop in core CPI inflation from 2.2% in February to 1.9% in April. The evolution of actual inflation will be critical to the outlook for the Fed and Treasury yields in the coming months. Our U.S. fixed-income strategists have simulated a traditional Phillips Curve model of inflation (Chart I-12).5 The model projects that core PCE inflation will reach 2.1% by December, even assuming no change in the unemployment rate or the trade-weighted dollar. Inflation ends the year not far below the 2% target even in an alternative scenario in which we assume that the dollar appreciates and that the full-employment level of unemployment is lower than the Fed currently assumes. Chart I-12U.S. Inflation Should End Year At 2% Thus, the trend in inflation should reinforce the FOMC's bias to keep tightening policy, forcing the bond market to reassess the pace of rate hikes discounted in the curve. That said, if we are wrong and inflation does not trend higher in the next 3-4 months, then it is the FOMC that will be forced to reassess and our short duration recommendation will probably not pan out on a six month horizon. Longer-term, last month's Special Report highlighted that we have reached an inflection point in some of the structural forces that have depressed bond yields. This month's Special Report, beginning on page 20, builds on that theme with a look at the impact of technological progress on equilibrium bond yields. With respect to credit spreads, the state of nonfinancial corporate sector balance sheets and the overall stance of monetary policy will continue to be the main drivers of the credit cycle. If unwinding the balance sheet leads to a premature tightening of financial conditions, then the Fed will proceed more slowly on rate hikes. The crucial indicator to watch is core PCE inflation. Credit spreads will remain fairly well contained until core PCE inflation reaches the Fed's 2% target. At that point, the pace of monetary normalization will ramp up, putting spreads at risk of widening. Stay overweight corporate bonds within fixed income portfolios for now. While the Fed's balance sheet reduction by itself may not have a big impact on the dollar, we still believe the currency has more upside because of the divergence in the overall monetary policy stance between the U.S. on one side and the ECB and Bank of Japan (BoJ) on the other. The BoJ will hold the 10-year JGB near to zero for quite some time. The ECB will also not be in a position to tighten policy for an extended period, outside of removing negative short rates and tapering QE purchases a bit further in 2018. The euro has appreciated versus the dollar even as two-year real interest rate differentials have moved in favor of the dollar since the end of March. This divergence probably reflects euro short-covering following the market-friendly French election outcome. Next up are the two rounds of French legislative elections in June. Polls support the view that Macron's En Marche and the center-right Les Republicains will capture the vast majority of seats in the legislature. Such an election outcome would make possible the passage of genuine structural reforms that would suppress wage growth and make French exports more competitive. Investors may be shocked into pricing greater odds of Euro Area dissolution when Italy comes back into focus. In the meantime, we do not see any risk factors emanating from the Eurozone that could upset the global equity applecart in the near term. Moreover, the traditional relationship between the euro/USD exchange rate and 2-year real yield differentials should now re-establish. The implication is that the euro could reach parity before the next move is done. Dr. Copper? The recent setback in the commodity pits has added to investor angst regarding global growth momentum. The LMEX base metals index is up almost 25% on a year-ago basis, but has fallen by 5% since February (Chart I-13). From their respective peaks earlier this year, zinc and copper are down about 7-10%, nickel has dropped by 18% and iron ore has lost almost half of its value. Is the venerable "Dr. Copper" sending an important warning about world growth? Chart I-13What Are Commodities Telling Us? Some of our global leading economic indicators have edged lower this year, as we have discussed in previous reports. Nonetheless, the decline in base metals prices likely has more to do with other factors, such as an unwinding of the surge in speculative demand that immediately followed the U.S. election last autumn. Speculators may be disappointed by the lack of progress on Republican promises to cut taxes and boost infrastructure spending. The main story for base metals demand and prices, however, is the Chinese real estate sector. China accounts for roughly 50% of world consumption for each of the major metals. The Chinese authorities are trying to cool the property market and transition to a more consumer spending-oriented economy, thereby reducing the dependence on exports, capital spending and real estate as growth drivers. Fiscal policy tightened last year and new regulations were introduced to limit housing speculation. The effect of policy tightening can be seen in our Credit and Fiscal Spending Impulse indicator, which has been softening since mid-2016 (Chart I-14). The economy held up well last year, but the policy adjustment resulted in a peaking of the PMI at year-end. Growth in housing starts also appears to be rolling over. Both the PMI and housing starts are correlated with commodity prices. The good news is that BCA's China Investment Strategy service does not expect a major downshift in Chinese real GDP growth this year, which means that commodity import demand should rebound: The authorities wish to slow credit growth, but there is no incentive for the authorities to crunch the economy given that consumer price inflation is still low and the surge in producer price inflation appears to have peaked. Monetary conditions have tightened a little in recent months, but overall conditions are not restrictive. Both direct fiscal spending and infrastructure investment have picked up noticeably this year (Chart I-15). Finally, the PBoC re-started its Medium-Term Lending Facility and recently made the largest one-day cash injection into the financial system in nearly four months. Chart I-14China Is The Main Story ##br##For Base Metals Demand Chart I-15Direct Fiscal Spending And ##br##Infrastructure Have Picked Up Recently Export growth will continue to accelerate based on our model (not shown). The upturn in the profit cycle and firming output prices should boost capital spending. Robust demand will ensure that housing construction will continue to grow at a healthy pace. Households' home-buying intentions jumped to an all-time high last quarter. Tighter housing policies in major cities will prevent a massive boom, but this will not short-circuit the recovery in housing construction. Fading fears about a China meltdown may give commodities a lift later this year. Our commodity strategists are particularly positive on crude oil, as extended production cuts from OPEC and Russia outweigh the impact of surging shale production, allowing bloated inventories to moderate. In contrast, the backdrop is fairly benign for base metals. Our commodity strategists do not see the conditions for a major bull or bear phase on a 6-12 month horizon. Within commodity portfolios, they recommend a benchmark allocation to base metals, an underweight in agricultural products and an overweight in oil. From a broader perspective, our key message is that "Dr. Copper" is not signaling that global growth will soften significantly this year. Investment Conclusions: Accelerating corporate profit growth in the major advanced economies provides a healthy tailwind and suggests that stocks could perform well under a couple of different scenarios in the second half of 2017. If the rebound in U.S. economic growth from the poor first quarter is unimpressive and it appears that Congress will be sidetracked by political turmoil in the White House, then the S&P 500 should benefit from the 'goldilocks' combination of healthy profit growth, low bond yields, an accommodative Fed and a soft dollar. If, instead, U.S. growth rebounds strongly and Congress makes progress on the broad outline of a tax reform bill over the summer months, then stocks should benefit from the prospect of stronger growth in 2018. Rising bond yields and a firmer dollar would provide some offset for stocks, but would not derail the equity bull market as long as inflation remains below the Fed's target. Our model suggests that U.S. inflation will remain below-target for the next several months, but could be near 2% by year end. This scenario would set the stage for a more aggressive Fed in 2018, a surge in the dollar and possibly a bear market in risk assets next year. We are therefore comfortable in predicting that the stock-to-bond total return ratio will continue to rise for at least the remainder of this year. The tough part relates to bond yields and the dollar, since the above two scenarios have very different implications for these two asset classes. Our base case is closer to the second scenario, such that we remain below benchmark in duration and long the dollar. That said, much depends on the evolution of U.S. core inflation and U.S. politics. Both are particularly difficult to forecast. A failure for core PCE inflation to pick up in the next 3-4 months and/or continuing political scandals in Washington would force us to reconsider our asset allocation. Of course, there are other risks to consider, including growing mercantilism in the U.S., Sino-American tensions and North Korea. At the top of the list are China and Italy. (1) China China remains our geopolitical strategists' top pick as the catalyst most likely to scuttle our upbeat view on global risk assets in 2017.6 Our base case assumption is that policymakers will not enact wide-scale financial sector reform, which would entail a surge in realized non-performing loans and bankruptcies and defaults, ahead of the Fall Party Congress. The regulatory crackdown so far seems merely to keep the financial sector in check for a while. The government has already stepped back somewhat in the face of the liquidity squeeze, and fiscal policy has been loosened (as mentioned above). All of the key Communist Party statements have emphasized that stability remains a priority. Nonetheless, it may be difficult for the authorities to manage the deleveraging process given nose-bleed levels of private-sector leverage. Politicians could misjudge the fragility of the financial system and investors might front-run the reform process, sending asset prices down well in advance of policy implementation. (2) Italy We have flagged the next Italian election as a key risk for markets because of polls showing that voters have become disillusioned with the euro. It appeared that an election would not take place until 2018, and we have downplayed European elections as a risk factor for 2017. However, the 5-Star Movement has now backed a proportional electoral system, which raises the chances of an autumn election in Italy. This would obviously spark turbulence in financial markets in the months leading up to the event. Turning to emerging markets, the pickup in global growth and a modest bounce in commodity prices would support this asset class. However, our view that the dollar is headed higher on the back of Fed rate hikes keeps us from getting too excited about EM stocks, bonds or currencies. Our other recommendations include the following: Within global government bond portfolios, overweight JGBs and underweight Treasurys. Gilts and core Eurozone bonds are at benchmark. Underweight the periphery of Europe. Overweight European and Japanese equities versus the U.S. on a currency-hedged basis. Overweight the dollar versus the other major currencies. Overweight small caps stocks versus large in the U.S. market. Stay exposed to oil-related assets, and favor oil to base metals within commodity portfolios. Mark McClellan Senior Vice President The Bank Credit Analyst May 31, 2017 Next Report: June 29, 2017 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 7, 2017, available at gps.bcaresearch.com 2 Please see The Bank Credit Analyst, "Overview," April 017, available at bca.bcaresearch.com 3 Currency shifts affect earnings with a lag, which in captured by our models. 4 Forecasting the Stance of Monetary Policy Under Balance Sheet Adjustments. The Macro Bulletin, Federal Reserve Bank of Kansas City. Troy Davig and A. Lee Smith. May 10, 2017. 5 Please see BCA U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers," dated May 23, 2017, available at usbs.bcaresearch.com 6 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets ," dated May 24, 2017, available at gps.bcaresearch.com II. Is Slow Productivity Growth Good Or Bad For Bonds? This month's Special Report was written by Peter Berezin, Chief Global Strategist for BCA's Global Investment Strategy Service. The report is a companion piece to last month's Special Report, which argued that some of the structural factors that have depressed global interest rates are at an inflection point. These factors include demographic trends and the integration of China's massive labor supply into the global economy. Peter's report focuses on technology's impact on bond yields. He presents the non-consensus view that slow productivity growth likely depresses interest rates at the outset, but will lead to higher rates later on. Not only could sluggish productivity growth lead to higher inflation, it could also deplete national savings. Both factors would be bond bearish, reinforcing the other factors discussed in last month's Special Report. I trust that you will find the report as insightful and educational as I did. Mark McClellan Productivity growth has declined in most countries. This appears to be a structural problem that will remain with us for years to come. In theory, slower productivity growth should reduce the neutral rate of interest, benefiting bonds in the process. In reality, countries with chronically low productivity growth typically have higher interest rates than faster growing economies. The passage of time helps account for this seeming paradox: Slower productivity growth tends to depress interest rates at the outset, but leads to higher rates later on. The U.S. has reached an inflection point where weak productivity growth is starting to push up both the neutral real rate and inflation. Other countries will follow. The implication for investors is that government bond yields have begun a long-term secular uptrend. The market is not at all prepared for this. Slow Productivity Growth: A Structural Problem Productivity growth has fallen sharply in most developed and emerging economies (Chart II-1). As we argued in "Weak Productivity Growth: Don't Blame The Statisticians," there is little compelling evidence that measurement error explains the productivity slowdown.1 Yes, the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, indoor plumbing, and air conditioning. No one has offered a convincing explanation for why the well-known problems with productivity calculations suddenly worsened about 12 years ago. If mismeasurement is not responsible for the productivity slowdown, what is? Cyclical factors have undoubtedly played a role. In particular, lackluster investment spending has curtailed the growth in the capital stock (Chart II-2). This means that today's workers have not benefited from the improvement in the quality and quantity of capital to the same extent as previous generations. Chart II-2The Great Recession Hit ##br##Capital Stock Accumulation However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. These include: Waning gains from the IT revolution. Recent innovations have focused more on consumers than businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. The rising share of value added coming from software relative to hardware has also contributed to the decline in productivity growth. Chart II-3 shows that productivity gains in the latter category have been much smaller than in the former. Slower human capital accumulation. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart II-4). Educational achievement, as measured by standardized test scores in mathematics and science, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart II-5). Test scores tend to be much lower in countries with rapidly growing populations (Chart II-6). Consequently, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart II-3The Shift Towards Software ##br##Has Dampened IT Productivity Gains Decreased creative destruction. The birth rate of new firms in the U.S. has fallen by half since the late 1970s and is now barely above the death rate (Chart II-7). In addition, many firms in advanced economies are failing to replicate the best practices of industry leaders. The OECD reckons that this has been a key reason for the productivity slowdown.2 Chart II-7Secular Decline In U.S. Firm Births Productivity Growth And Interest Rates Investors typically assume that long-term interest rates will converge to nominal GDP growth. All things equal, this implies that faster productivity growth should lead to higher interest rates. Most economic models share this assumption - they predict that an acceleration in productivity growth will raise the rate of return on capital and incentivize households to save less in anticipation of faster income gains.3 Both factors should cause interest rates to rise. The problem is that these theories do not accord with the data. Chart II-8 shows that interest rates are far higher in regions such as Africa and Latin America, which have historically suffered from chronically weak productivity growth. In contrast, rates are lower in regions such as East Asia, which have experienced rapid productivity growth. One sees the same negative correlation between interest rates and productivity growth over time in developed economies. In the U.S., for example, interest rates rose rapidly during the 1970s, a decade when productivity growth fell sharply (Chart II-9). Chart II-9U.S. Interest Rates Soared In The ##br##1970s While Productivity Swooned Two Reasons Why Slower Productivity Growth May Lead To Higher Interest Rates There are two main reasons why slower productivity growth may lead to higher nominal interest rates over time: Slower productivity growth may eventually lead to higher inflation; Slower productivity growth may deplete national savings, thereby raising the neutral real rate of interest. We discuss each reason in turn. Reason #1: Slower Productivity Growth May Fuel Inflation Most economists agree that chronically weak productivity growth tends to be associated with higher inflation. Even Janet Yellen acknowledged as much, noting in a 2005 speech that "the evidence suggests that the predominant medium-term effect of a slowdown in trend productivity growth would likely be higher inflation."4 In theory, the causation between productivity and inflation can run in either direction: Weak productivity gains can fuel inflation while high inflation can, in turn, undermine growth. With respect to the latter, economists have focused on three channels: First, higher inflation may make it difficult for firms to distinguish between relative and absolute price shocks, leading to suboptimal resource allocation. Second, higher inflation may stymie capital accumulation because investors typically pay capital gains taxes even when the increase in asset values is entirely due to inflation. Third, high inflation may cause households and firms to waste time and effort on economizing their cash holdings. There are also several ways in which slower productivity growth can lead to higher inflation. For example, sluggish productivity growth may increase the likelihood that a country will be forced to inflate its way out of any debt problems. In addition, central banks may fail to recognize structural declines in productivity growth in real time, leading them to keep interest rates too low in the errant belief that weak GDP growth is due to inadequate demand when, in fact, it is due to insufficient supply. There is strong evidence that this happened in the U.S. in the 1970s. Chart II-10 shows that the Fed consistently overestimated the size of the output gap during that period. Chart II-10The Fed Continuously Overstated The ##br##Magnitude Of Economic Slack In The 1970s Reason #2: Slower Productivity Growth May Deplete National Savings, Leading To A Higher Neutral Real Rate Imagine that you have a career where your real income is projected to grow by 2% per year, but then something auspicious happens that leads you to revise your expected annual income growth to 20%. How do you react? If you are like most people, your initial inclination might be to celebrate by purchasing a new car or treating yourself to a lavish vacation. As such, your saving rate is likely to fall at the outset. However, as the income gains pile up, you might find yourself running out of stuff to buy, resulting in a higher saving rate. This is particularly likely to be true if you grew up poor and have not yet acquired a taste for conspicuous consumption. Now consider the opposite case: One where you realize that your income will slowly contract over time as your skills become increasingly obsolete. The logic above suggests that your immediate reaction will be to hunker down and spend less - in other words, your saving rate will rise. However, as time goes by and the roof needs to be changed and the kids sent off to college, you may find it hard to pay the bills - your saving rate will then fall. The same reasoning applies to economy-wide productivity growth. When productivity growth increases, household savings are likely to decline as consumers spend more in anticipation of higher incomes. Meanwhile, investment is likely to rise as firms move swiftly to expand capacity to meet rising demand for their products. The combination of falling savings and rising investment will cause real rates to increase. As time goes by, however, it may become increasingly difficult for the economy to generate enough incremental demand to keep up with rising productive capacity. At that point, real rates will begin falling. The historic evidence is consistent with the notion that higher productivity growth causes savings to fall at the outset, but rise later on. Chart II-11 shows that East Asian economies all had rapid growth rates before they had high saving rates. China is a particularly telling example. Chinese productivity growth took off in the early 1990s. Inflation accelerated over the subsequent years, while the country flirted with current account deficits - both telltale signs of excess demand. It was not until a decade later that the saving rate took off, pushing the current account into a large surplus, even though investment was also rising at the time (Chart II-12). Chart II-11Asian Tigers: Growth Took Off First, ##br##Followed By Higher Savings Chart II-12China: Productivity Growth Accelerated, ##br##Then Savings Rate Took Off Today, Chinese deposit rates are near rock-bottom levels, and yet the household sector continues to save like crazy. This will change over time. The working-age population has peaked (Chart II-13). As millions of Chinese workers retire and begin to dissave, aggregate household savings will fall. Meanwhile, Chinese youth today have no direct memory of the hardships that their parents endured. As happened in Korea and Japan, the flowering of a consumer culture will help bring down the saving rate. Meanwhile, sluggish income growth in the developed world will make it difficult for households to save much. Population aging will only exacerbate this effect. As my colleague Mark McClellan pointed out in last month's edition of the Bank Credit Analyst, elderly people in advanced economies consume more than any other age cohort once government spending for medical care on their behalf is taken into account (Chart II-14).5 Our estimates suggest that population aging will reduce the household saving rate by five percentage points in the U.S. over the next 15 years (Chart II-15). The saving rate could fall as much as ten points in Germany, leading to the evaporation of the country's mighty current account surplus. As saving rates around the world begin to fall, real interest rates will rise. Chart II-13China's Very High Rate Of National Savings ##br##Will Face Pressure From Demographics Chart II-15Aging Will Reduce ##br##Aggregate Savings The Two Reasons Reinforce Each Other The discussion above has focused on two reasons why chronically low productivity growth could lead to higher interest rates: 1) weak productivity growth could fuel inflation; and 2) weak productivity growth could deplete national savings, leading to higher real rates. There is an important synergy between these two reasons. Suppose, for example, that weak productivity growth does eventually raise the neutral real rate. Since central banks cannot measure the neutral rate directly and monetary policy affects the economy with a lag, it is possible that actual rates will end up below the neutral rate. This would cause the economy to overheat, resulting in higher inflation. Thus, if the first reason proves to be true, it is more likely that the second reason will prove to be true as well. The Technological Wildcard So far, we have discussed productivity growth in very generic terms - as basically anything that raises output-per-hour. In reality, the source of productivity gains can have a strong bearing on interest rates. Economists describe innovations that raise the demand for labor relative to capital goods as being "capital saving." Paul David and Gavin Wright have argued that the widespread adoption of electrically-powered processes in the early 20th century serves as "a textbook illustration of capital-saving technological growth."6 They note that "Electrification saved fixed capital by eliminating heavy shafts and belting, a change that also allowed factory buildings themselves to be more lightly constructed." In contrast, recent technological innovations have tended to be more of the "labor saving" than "capital saving" variety. Robotics and AI come to mind, but so do more mundane advances such as containerization. Marc Levinson has contended that the widespread adoption of "The Box" in the 1970s completely revolutionized international trade. Nowadays, huge cranes move containers off ships and place them onto waiting trucks or trains. Thus, the days when thousands of longshoremen toiled in the great ports of Baltimore and Long Beach are gone.7 If technological progress is driven by labor-saving innovations, real wages will tend to grow more slowly than overall productivity (Chart II-16). In fact, if technological change is sufficiently biased in favour of capital (i.e., if it is extremely "labor saving"), real wages may actually decline in absolute terms (Chart II-17). Owners of capital tend to be wealthier than workers. Since richer people save more of their income than poorer people, the shift in income towards the former will depress aggregate demand (Chart II-18). This will result in a lower neutral rate. Chart II-16U.S.: Real Wages Have Been ##br##Lagging Productivity Gains Chart II-18Savings Heavily Skewed ##br##Towards Top Earners It is difficult to know if the forces described above will dissipate over time. Productivity growth is largely a function of technological change. We like to think that we are living in an era of unprecedented technological upheavals, but if productivity growth has slowed, it is likely that the pace of technological innovation has also diminished. If so, the impact that technological change is having on such things as the distribution of income and global savings - and by extension on interest rates - could become more muted. To use an analogy, the music might remain the same, but the volume from the speakers could still drop. Capital In A Knowledge-Based Economy Chart II-19Falling Capital Goods Prices Have Allowed ##br##Companies To Slash Capex Budgets Labor-saving technological change has not been the only force pushing down interest rates. Modern economies are transitioning away from producing goods towards producing knowledge. Companies such as Google, Apple, and Amazon have thrived without having to undertake massive amounts of capital spending. This has left them with billions of dollars in cash on their balance sheets. The price of capital goods has also tumbled over the past three decades, allowing companies to cut their capex budgets (Chart II-19). In addition, technological advances have facilitated the emergence of "winner-take-all" industries where scale and network effects allow just a few companies to rule the roost (Chart II-20). Such market structures exacerbate inequality by shifting income into the hands of a few successful entrepreneurs and business executives. As noted above, this leads to higher aggregate savings. Market structures of this sort could also lead to less aggregate investment because low profitability tends to constrain capital spending by second- or third-tier firms, while the worry that expanding capacity will erode profit margins tends to constrain spending by winning companies. The combination of higher savings and decreased investment results in a lower neutral rate. As with labor-saving technological change, it is difficult to know how these forces will evolve over time. The growth of winner-take-all industries has benefited greatly from globalization. Globalization, however, may be running out of steam. Tariffs are already extremely low in most countries, while the gains from further breaking down the global supply chain are reaching diminishing returns (Chart II-21). Perhaps more importantly, political pressures for greater income distribution, trade protectionism, and stronger anti-trust measures are likely to intensify. If that happens, it may be enough to reverse some of the downward pressure on the neutral rate. Chart II-21The Low-Hanging Fruits Of ##br##Globalization Have Been Picked Investment Conclusions Is slow productivity growth good or bad for bonds? The answer is both: Slow productivity growth is likely to depress interest rates at the outset, but is liable to lead to higher rates later on. The U.S. has likely reached the inflection point where slow productivity is going from being a boon to a bane for bonds. Chart II-22 shows that the U.S. output gap would be over 8% of GDP had potential GDP grown at the pace the IMF projected back in 2008. Instead, it is close to zero and will likely turn negative if growth remains over 2% over the next few quarters. Other countries are likely to follow in the footsteps of the U.S. Chart II-22Output Gap Has Narrowed ##br##Thanks To Lower Potential Growth To be clear, productivity is just one of several factors affecting interest rates - demographics, globalization, and political decisions being others. However, as we argued in our latest Strategy Outlook, these forces are also shifting in a more inflationary direction.8 As such, fixed-income investors with long-term horizons should pare back duration risk and increase allocations to inflation-linked securities. Peter Berezin, Chief Global Strategist Global Investment Strategy 1 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 2 Dan Andrews, Chiara Criscuolo, and Peter N. Gal,"The Best versus the Rest: The Global Productivity Slowdown, Divergence across Firms and the Role of Public Policy," OECD Productivity Working Papers, No. 5 (November 2016). 3 Consider the widely-used Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. All things equal, an increase in g will result in a higher equilibrium real interest rate. The same is true in the Ramsey model, which goes a step further and endogenizes the saving rate within a fully specified utility-maximization framework. In this model, consumption growth is pinned down by the so-called Euler equation. Assuming that utility can be described by a constant relative risk aversion utility function, the Euler equation states that consumption will grow at (r-d)/h where d is the rate at which households discount future consumption and h is a measure of the degree to which households want to smooth consumption over time. In a steady state, consumption increases at the same rate as GDP, n+g. Rearranging the terms yields: r=(n+g)h+d. Notice that both models provide a mechanism by which a higher g can decrease r. In the Solow model, this comes from thinking about the saving rate not as an exogenous variable, but as something that can be influenced by the growth rate of the economy. In particular, if s rises in response to a higher g, r could fall. Likewise, in the Ramsey model, a higher g could make households more willing to forgo consumption today in return for higher consumption tomorrow (equivalent to a decrease in the rate of time preference, d). This, too, would translate into a lower neutral rate. 4 Janet L. Yellen, "The U.S. Economic Outlook," Presentation to the Stanford Institute of Economic Policy Research, February 11, 2005. 5 Please see The Bank Credit Analyst, "Beware Inflection Points In The Secular Drivers Of Global Bonds," April 28, 2017, available at bca.bcaresearch.com. 6 Paul A. David, and Gavin Wright,"General Purpose Technologies And Surges In Productivity: Historical Reflections On the Future Of The ICT Revolution," January 2012. 7 Marc Levinson, "The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger," Princeton University Press, 2006. 8 Please see Global Investment Strategy, "Strategy Outlook Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. III. Indicators And Reference Charts The breakout in the S&P 500 above 2400 in May has further stretched valuation metrics. Measures such as the Shiller P/E and price/book are elevated relative to past equity cycles. The price/sales ratio is in a steep rise too. However, our U.S. Composite valuation metric, which takes into consideration 11 different measures of value, is still a little below the one sigma level that marks significant overvaluation. This is because our composite indicator includes valuation measures that take into account the low level of interest rates. Of course, these measures will not look as favorable when rates finally rise. Technically, the U.S. equity market has upward momentum. Our Equity Monetary Indicator has remained around the zero line, meaning that it is not particularly bullish or bearish at the moment. Our Speculation Index is high, pointing to froth in the market. The high level of our Composite Sentiment Index and low level of the VIX speaks to the level of investor complacency. The U.S. net revisions ratio jumped higher this month, and it is bullish that the earnings surprise index advanced again. Our U.S. Willingness-to-Pay (WTP) indicator continues to send a positive message for the S&P 500, although it is now so elevated that it suggests that there could be little "dry powder" left to buy the market. This indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The widening gap between the U.S. WTP and that of Japan and Europe highlights that recent flows have favored the U.S. market relative to the other two. Looking forward, this means that there is more "dry powder" available to buy the Japanese and European markets. A rise in the WTPs for these two markets in the coming months would signal that a rotation into Europe and Japan is taking place. It is disconcerting that our Europe WTP suffered a pull-back over the past month. Nonetheless, we believe that accelerating corporate profit growth in the major advanced economies provides a strong tailwind and suggests that stocks remain in a window in which they will outperform bonds. U.S. bond valuation is hovering close to fair value. However, we believe that fair value itself is moving higher as we have reached an inflection point in some of the structural forces that have depressed bond yields. We also believe that the combination of Fed balance sheet shrinkage and rate hikes will lead to higher bond yields than are currently discounted in the market. Technically, our composite indicator has touched the zero line, clearing the way for the next leg of the bond bear market. The dollar is very expensive on a PPP basis, although it is less so by other measures. Technically, the dollar has shifted down this year, crossing the 200-day moving average. That said, according to our dollar technical indicator, overbought conditions have been totally worked off, suggesting that the currency is clear to move higher if Fed rate expectations shift up as we expect. Moreover, we believe that policy divergence in the overall monetary policy stance between the U.S. on one side and the ECB and BoJ on the other will push the dollar higher. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation Chart III-5U.S. Earnings Chart III-6Global Stock Market And ##br##Earnings: Relative Performance Chart III-7Global Stock Market And ##br##Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations Chart III-9U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield ComponentsChart III-12U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Chart III-19Euro Technicals Chart III-20Euro/Yen Technicals Chart III-21Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Chart III-23Commodity Prices Chart III-24Commodity Prices Chart III-25Commodity Sentiment Chart III-26Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot Chart III-29U.S. Growth Outlook Chart III-30U.S. Cyclical Spending Chart III-31U.S. Labor Market Chart III-32U.S. Consumption Chart III-33U.S. Housing Chart III-34U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Highlights Geopolitical risks remain overstated in 2017, but China and Italy could scuttle the party; June elections in France and the U.K. are not market-movers; But early Italian election is a risk that could prompt the ECB to stay easy, close long EUR/USD for a gain; U.S. budget reconciliation process may be arcane, but is vital to understand upcoming tax reform process; Investors should expect details of tax reform by Q4 2017, but legislation may only pass in Q1 2018. Feature We turned the traditional adage of "sell in May and go away" on its head last month in a report titled "Buy In May And Enjoy Your Day!"1 So far so good (Chart 1). The fundamental reasons behind the breakout is the narrowing of the global equity risk premium on the back of easy monetary policy and a recovering global economy (Chart 2) two trends that our colleagues at the Global Alpha Sector Strategy highlighted last September.2 Since then, geopolitical risks cited as likely to end the party have been largely overstated.3 We continue to worry about Chinese financial sector reforms, U.S. politics, Sino-American tensions, signs of growing U.S. mercantilism, prospects of early Italian elections, and especially the developments in North Korea. But these remain risks for 2018, rather than 2017.4 Chart 1Blow-Off Phase Has Resumed Chart 2Global ERP Has Room To Fall There are still some "loose ends" to tie up from the first quarter, including the upcoming French legislative and U.K. general elections. On the former, there is nothing to say other than that investors should indeed prepare for a "French Revolution," by which we mean a supply-side revolution.5 Current seat projections based on the latest polling have pro-market, centrist, Europhile parties controlling between 85-92% of the National Assembly following the two-round elections in mid-June (Diagram 1).6 Diagram 1French National Assembly Seat Projection Yes. In France. Skeptical commentary will surely rain on the centrist parade by pointing out that anti-establishment presidential candidates won nearly 50% of the vote in the first round of the presidential election (true), that Marine Le Pen will be back even stronger in 2020 (false), or that the electoral system is designed to suppress the populist vote (yes, so what?). We are not as perceptive nor profound as the witty op-ed writers. Our far simpler conclusion is that the French National Assembly will elucidate the revealed preference of the French electorate, given the electoral rules that are quite familiar to all French voters. And that preference appears to be for pro-market, and quite possibly painful, structural reforms. We remain long French industrials relative to German ones, but our clients may find alternative ways to play the upcoming free-market revolution in France. On the British front, Tory PM Theresa May is facing her first genuine crisis. The impact of the Manchester terrorist attack on the election is difficult to forecast. However, May's "dementia tax" gaffe has clearly given Labour new life in the polls (Chart 3). What most commentators saw as a clear shoo-in for the Conservative Party has now become a competitive, if not exactly tight, race. Chart 3Labour Gains... Chart 4...But Tories Keep Devouring UKIP We would note that despite Labour's rise in the polls, May's strategy of suppressing the UKIP vote by campaigning from the nationalist right is paying off. As Chart 4 illustrates, UKIP voters appear to be switching to the Tories en masse: UKIP has gone from support of 20% in April 2016 to under 5% today. Given Britain's first-past-the-post electoral system, May's strategy of swallowing the UKIP whole is a savvy move. It will eliminate the probability that UKIP siphons votes away from the Tories in competitive constituencies. Our own, highly conservative, estimate gives the Tories a minimum of 11 gained seats (Table 1). This is based on constituencies that voted for Brexit but where Labour and the Liberal Democrats won by less than 5% in the last election. Table 1Minimal Scenario Gives Tories 11 New Seats For Their Majority We do not think that the election will have much impact on the Brexit process. Political risks peaked in January when May announced that she planned to take the U.K. out of the EU Common Market. We pointed out at the time that this decision made it highly unlikely that the U.K. and EU negotiations would take an acrimonious turn.7 The market agreed with us, with the pound bottoming in mid-January. We continue to believe that the Brexit process will have no investment relevance for global assets. As for U.K. equities and the pound, a larger-than-expected seat grab by the Tories (375+) at the upcoming election would likely strengthen the pound further, which in turn could weigh on the FTSE 100 (with the FTSE 250 being less affected). A disappointing result, one where the Conservative Party fails to reach 350 seats, could create temporary headwinds for the pound. The one risk that remains on our horizon is faster-than-expected deleveraging in China. As we mentioned in our report last week, China's financial crackdown raises near-term risks (Chart 5).8 We do not think that policymakers are looking to enact wide scale financial sector reform, which would entail a surge in realized non-performing loans, bankruptcies, and defaults ahead of the Fall Party Congress. However, Chinese investors and businesses may already be looking ahead to 2018. Chart 5Policymakers Are Inducing Financial Risk... Chart 6...At A Time When Vulnerability Is Growing China's reserves-to-M2 ratio - an IMF-proposed measure that captures Chinese reserves of liquid assets against those that its residents could potentially liquefy as part of wide scale capital flight - has continued to decline (Chart 6). Measures of quarterly net portfolio flows and capital flight show that the Q4 2016 outflows accelerated sharply after a slowdown in outflows in the previous two quarters (Chart 7), although we have no information for Q1 2017. More recently, there has been a stunning surge in Bitcoin prices. The crypto-currency is up 65% since the start of May, which cannot be attributed to Euro Area fears given the victory of Europhile Emmanuel Macron in the French election. Could it be related to policy uncertainty in China? We think yes (Chart 8). China remains our pick for the risk that is most likely to scuttle our sanguine view on global risk assets in 2017. Chart 7Chinese Outflows Restarted In Q4 2016 Chart 8Chinese Uncertainty Is Bitcoin's Gain The final risk to investors that we have been tracking this year is inaction by U.S. Congress on the tax reform front. We have received many client questions regarding when investors should expect to see tax reform legislation and when (and how) it is expected to pass. We turn to this question in the rest of this report. Market Relevance Of The Budget Reconciliation Process The U.S. legislative process is complicated, arcane, and highly mutable. We have tried to spare our clients as much of the headache of U.S. congressional procedure as possible.9 However, the budget reconciliation process underpins current efforts to reform both the 2010 Affordable Care Act (Obamacare) and enact tax reform. To understand how, when, and whether the GOP-controlled Congress will pass these pieces of legislation, it is necessary for investors to learn the basics of the reconciliation process in particular, and the budget process more broadly. Budget reconciliation - or simply, reconciliation - simplifies the process of passing a budget and was introduced by the Congressional Budget Act of 1974.10 To understand why reconciliation matters, we first have to explain how the U.S. Congress sets the budget. The U.S. Budget Process The U.S. budget process (Diagram 2) begins with the U.S. president submitting the White House budget request to Congress. This is a largely ceremonial act as Congress has the power over the appropriations process. Diagram 2U.S. Budget Process: A Tentative Timeline Congress takes into account the president's request as it formulates a budget resolution, which both houses of Congress pass but which is not presented to the president and does not actually constitute law. The resolution sets out the guidelines for the budget process, which is supposed to ultimately produce an appropriations bill. It is this bill, also referred to as a budget bill, which appropriates funding for the various federal government departments, agencies, and programs. Under a revised timetable in effect since 1987, the annual budget resolution is supposed to be adopted by both chambers of Congress by April 15, giving legislators sufficient time to then pass a budget bill by the start of the fiscal year on October 1. However, there is no obligation to do so. In fact, Congress failed to pass a budget resolution for most of President Obama's two terms in office due to a high degree of polarization between the Democrats and Republicans. As such, the government was funded via "continuing resolutions," which merely extended pre-existing appropriations at the same levels as the previous fiscal year. Reconciliation Process Where does the reconciliation process fit? It was originally introduced to simplify the process of changing the law on the books in order to bring revenue and spending levels into line with the budget resolution. The crucial feature of the process, and the reason we are focusing so much on it, is that it limits the debate in the Senate to 20 hours, thus automatically preventing any Senator from filibustering the ultimate legislation that emerges from the reconciliation process. No filibuster, no need to reach 60 Senate votes to invoke cloture, an act that ends the debate in the chamber. In the current context, where the Republican Party controls 52 seats, this means that the Republicans can use the reconciliation process to pass legislation that would otherwise be "filibustered" in the Senate. The reconciliation procedure is a very powerful legislative tool by which Congress can pass controversial legislation, as long as such legislation has an impact on government revenues or spending levels. Tax legislation, obviously, would impact government revenues. George W. Bush used the reconciliation procedure to lower taxes in 2001 and 2003. His father, George H. W. Bush used reconciliation to raise taxes in 1990 (and thus roll back some of the Ronald Reagan 1986 tax reform). The 1996 welfare reform - the Personal Responsibility and Work Opportunity Reconciliation Act of 1996 - was also passed via the reconciliation process. Obamacare was not passed via the reconciliation procedure. The main portion of the bill - including almost all of its key provisions - was passed at the beginning of the 111th Congress in 2009 when the Democrats held 58 seats in the Senate following the momentous 2008 election.11 It was the subsequent amendments to the original bill that required the reconciliation process due to the death of Massachusetts Senator Ted Kennedy, particularly several crucial funding provisions. The one unifying feature of all reconciliation bills is that they must have an impact on the budget, essentially by changing the revenue or spending levels of the federal government. If the bill introduces extraneous provisions that deviate from the budgetary requirement, then these can be struck out by invoking the so-called "Byrd rule." Waiving the Byrd rule requires an affirmative vote of three-fifths of the Senate, which is 60 votes. As such, it essentially requires the 60-seat majority needed to also invoke cloture, making the entire reconciliation process redundant. Bottom Line: The budget reconciliation process allows U.S. Congress to pass legislation without the a 60-seat Senate majority. However, procedural rules require the provisions of a reconciliation bill to deal exclusively with legislation that impact government revenue or spending levels. Timing Since the introduction of the procedure in 1974, there have been 24 reconciliation bills, three of which were vetoed by the president. The reconciliation process begins with the passing of the budget resolution, which sets out the "reconciliation instructions." However, since the procedure was introduced, it has rarely progressed along the intended timeline. The very first reconciliation act in 1980 was introduced in a budget resolution that passed well after the April 15 deadline, in mid-June. And the ultimate appropriations bill, the Omnibus Reconciliation Act of 1980, was only signed into law in early December 1980, so essentially two months after the start of FY1981 on October 1. Investors should therefore understand that the U.S. budget process has no real firm deadlines. The schedule is highly malleable. A reconciliation bill also does not have to be passed with the actual budget. Despite being initiated by the budget resolution, reconciliation runs parallel to the budget process. For example, Congress has already set appropriations for FY2017, but the reconciliation bill on Obamacare - set by the FY2017 budget resolution - is still in negotiations. Diagram 3 illustrates that half of all reconciliation bills were passed after the start of the fiscal year for which they were introduced in a budget resolution. And five reconciliation bills were passed in the calendar year of the fiscal year for which they were supposed to reconcile the budget, basically mid way through the fiscal year. Diagram 3Timing Of Reconciliation Procedures This is important in the current context because investors are waiting for tax reform legislation which is supposed to be passed via the budget reconciliation process for FY2018. However, the GOP-controlled Congress has not even finished the budget process for FY2017. In fact, the budget resolution for FY2017 only passed the House on January 13, 2017. As we learned above, U.S. budget process guidelines call for the budget resolution to have been passed by April 15, 2016. As such, the Obamacare repeal and replace bill, if it were to ultimately pass the Senate, would certainly be the most delayed reconciliation bill ever. In fact, we could see the current Congress passing the FY2017 reconciliation bill in the waning days of FY2017! Congressional rules only allow one budget resolution to be active at any one time. In fact, as soon as a new budget resolution is passed, the old reconciliation instructions are made void. As such, investors have to wait for the Republicans to decide what they plan to do with the Obamacare reconciliation bill before they begin contemplating tax reform. Bottom Line: Republicans in Congress decided to issue reconciliation instructions as part of the FY2017 budget resolution, which passed in January. As such, investors have to wait until that process ends - with either Obamacare repeal or failure of the bill - before Congress can produce a FY2018 budget resolution with reconciliation instructions for tax reform. We suspect that the FY2018 budget resolution will be passed sometime between the end of the August Congressional recess, on September 5, and December. But that is just a guess (Diagram 4). It could happen earlier, in July, if Obamacare is dealt with over the next month. Diagram 4Tentative U.S. Political Timeline Reconciliation Rules And Tax Reform Changing America's complex tax laws is precisely the sort of legislative action that reconciliation was designed to facilitate. That said, investors are still not sure whether the Trump administration and Congress will be able to agree on comprehensive tax reform that includes lowering top rates for corporations, or whether they will merely agree to cut household taxes on households. Some clarity will emerge once the Republican-controlled Congress passes the FY2018 budget resolution, which will contain reconciliation instructions for either comprehensive tax reform (most likely) or merely household tax reform (unlikely). At that point, the length of the reconciliation process will depend on how much agreement there is surrounding tax reform. Diagram 3 shows that tax cuts - such as those in 2001 and 2003 - take relatively little time to pass. Tax reform, on the other hand, could take a while longer given multiple competing interests. If comprehensive, we would expect tax reform to be passed by the end of Q1 2018. Would that mean that tax cuts would only be effective from January 1, 2018? Or, even less bullish, from the start of FY2019? No. The GOP would have the option of making tax cuts retroactive and thus can avoid a huge market disappointment if tax cuts come later in the next year. It is even legally possible for tax laws passed in 2018 to take effect on January 1, 2017 - though it is admittedly more of a stretch than doing it this year.12 Can reconciliation be used to pass budget-busting tax reform, as we have argued investors should expect? You bet! From 1980 to the 1990s the reconciliation procedure was primarily used - and in fact designed - to reduce the deficit through reductions in mandatory spending, revenue increases, or both. It has since become a tool to expand deficits. This was most famously done by the Bush era reconciliation bills in 2001 and 2003, which introduced large tax cuts. The aforementioned Byrd rule forces any provision of a bill that increases the deficit beyond the years covered by the reconciliation bill to "sunset." In the case of the 2001 and 2003 bills, this meant that Bush-era tax cuts expired in 2011 (estate tax) and 2013 (which investors will remember as the "fiscal cliff"). The sunset period does not have to be ten years, it could conceivably be a lot longer, in effect making tax reform permanent, as far as most investors' time horizons are concerned. Following the Democratic Party sweep in the 2006 midterm elections, the Democrat-controlled Senate changed reconciliation rules to prohibit any deficit-increasing measures, regardless of the sunset clause loophole. However, the Republicans changed the rules back in 2015, after they re-took the Senate in the 2014 midterm election. This is crucial for two reasons: first, it means that the current procedural rules on the books allow deficits to be blown out via the reconciliation procedure and second, it establishes that the current cohort of Republicans in Congress is fiscally profligate, despite media punditry to the contrary. Bottom Line: The reconciliation process was designed to facilitate precisely the type of legislation that Republicans will try to pass via tax reform. According to the current procedural rules, such legislation can increase the budget deficit, as long as it sunsets at the conclusion of the budgetary period set out by the legislation (normally 10-years, but it could be longer). We suspect that tax reform will take until Q1 2018 to pass, but Republicans will be able to make its effects retroactive to January 1, 2017. The Big Picture - What Does It All Mean For Fiscal Policy? We expect the Republican-held Congress to attempt to pass comprehensive tax reform over the next four quarters. If the GOP fail to agree on "revenue offsets" for corporate tax cuts, we could see the Republican Congress electing to pass simple tax cuts for households, as the Bush-era tax cuts of 2001 and 2003 did. To facilitate such legislation politically, the Republicans will rely on "dynamic scoring," the macroeconomic modeling tool based on the work of economist Arthur Laffer (of the "Laffer curve" fame). The idea is that the headline government revenue lost through tax cuts fails to take into account the growth-generating consequences ("macroeconomic feedback") of the cuts, factors that actually add to revenues. In other words, "tax cuts pay for themselves." It is true that the Congressional Budget Office (CBO) will balk at dynamic scoring. But we doubt that "egghead, socialist economists" will stand in the way of tax reforms. As we discussed above, the CBO's score will ultimately only force the Republicans to "sunset" tax reform legislation, not scuttle it. The market disagrees with us. After a wave of euphoria following the presidential election, the market has largely priced out meaningful fiscal stimulus. This can be seen in the flagging relative performance of infrastructure stocks and highly-taxed companies, as well as in the sharp decline in inflation expectations (Chart 9). Chart 9Market Has Voted: No Fiscal Stimulus We think the market is making a serious mistake by taking the Republican mantra of "revenue neutral" - meaning that any tax cuts would need to be offset by other revenue-raising measures - tax reform seriously. This is easier said than done. The three main ways that House Republicans have offered to pay for corporate and personal tax cuts - introducing a border adjustment tax, eliminating the deductibility of business interest payments, and jettisoning the deduction for state and local income taxes for individuals - will all face resistance from vested interests. We suspect that the GOP will produce some revenue offsets, but not enough to have a revenue-neutral tax reform. The path of least resistance, therefore, will be to bust the budget and then force the measures to expire over the life of the budget-setting window. White House budget director Mick Mulvaney has already floated the idea of extending the 10-year budget scoring window to 20 years. This would allow tax reform measures, even if they are characterized by the CBO as profligate, to expire in two decades. That's practically a lifetime away, as far as any investor is concerned. What is the investment significance of a stimulative tax reform package? Our colleague Peter Berezin has recently pointed out that it is ironic that fiscal stimulus is coming to America only when the economy has reached full employment. This means that much of the increase in aggregate demand arising from a more expansionary fiscal stance will be reflected in higher inflation rather than faster growth. This does not represent a major threat to risk assets now, but could later next year, as the Fed responds to greater fiscal thrust with tighter monetary policy.13 We encourage our clients to read BCA Special Report "Beware The 2019 Trump Recession," penned by Martin Barnes in March, which details the likely path that assets and the economy will take over the next two years.14 In the short term, the market will continue to fret that tax reform is doomed and that Republicans are committed to austerity. However, budget-busting tax reform could begin to be priced in by the market well before the reconciliation bill is ultimately passed. We suspect that the outlines of tax reform will emerge this summer. The market may realize that stimulus is coming as soon as the FY2018 budget resolution, containing tax reform instructions, is passed in Q3 or Q4 2017. Such a realization later this year could augur a violent snap-back in the USD. Currently, the two-year real interest rate differentials between the euro area and the U.S. have widened by 58 basis points in favor of the latter since the end of March, even though EUR/USD has actually rallied over this period (Chart 10). We have been long EUR/USD since March 22,15 in expectations that investors would be busy covering their euro hedges that they put on in the lead up to the French elections, the outcome of which we have had a high conviction on since November.16 However, now that net long speculative positions in the euro have risen to a three-year high - having been deeply short just a few weeks ago - the speculative demand for euros will ultimately subside (Chart 11). Chart 10Widening Real Rate ##br##Differentials Support The Dollar Chart 11Speculators Are Long The Euro##br## For The First Time In Three Years We are therefore closing our USD short versus both the euro and the pound, for gains of 3.48% and 3.34% respectively. As we expected, the ECB is going to look to guide investors towards a "dovish" tapering of its QE program. Speaking before the European Parliament's committee on economic affairs, ECB President Mario Draghi confirmed that "very accommodative financing conditions" reliant on "a fairly substantial amount of monetary accommodation" would continue. The ECB will have to make a decision whether to extend its sovereign bond purchase program into the next year or start winding it down as planned. Given news flow out of Italy that an election may be planned as early as September, the ECB may be forced to stand pat until after the end of the year. Given our view that tax reform in the U.S. would ultimately happen, and that it would eventually be marginally stimulative, any resurfacing of political risks in Europe - which we are expecting - should be negative for the EUR/USD. What should investors do about European equities? We are cautious. As we have been pointing out to our clients since September of last year, Italy is the political risk in Europe.17 However, we think that most investors are willing to bet that European equities can survive Italian political turbulence. This could be a mistake in the short term, as we think that Euroskeptic (albeit evolving) Five Star Movement could win a plurality in the next election. In the long term, Italy will become ECB's proverbial boulder, that Draghi must push up a hill like Sisyphus, only to see it roll down to the bottom with each bout of Italian political instability. As such, Italy's instability will force ECB to set its monetary policy for the weakest link in the Euro Area (Italy), rather than the aggregate. This should be positive for Euro Area risk assets, but negative for the euro, all other things being equal. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Global Alpha Sector Strategy Weekly Report, "Strike While The Iron Is Hot," dated September 2, 2016, available at gss.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at fes.bcaresearch.com. 6 The dates for the two rounds of the legislative elections are June 11 and 18. 7 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 10 We draw on several overviews of the budget reconciliation process in this report. Please see David Reich and Richard Kogan, Center on Budget and Policy Priorities, "Introduction To Budget 'Reconciliation'," dated November 9, 2016, available at cbpp.org; Megan S. Lynch, Congressional Research Service, "The Budget Reconciliation Process: Timing Of Legislative Action," dated February 23, 2016, available at fas.org; and Megan S. Lynch, Congressional Research Service, "Budget Reconciliation Measures Enacted Into Law: 1980-2010," dated January 4, 2017, available at fas.org. 11 To reach the required 60 seat filibuster-proof majority the Democrats relied on some luck and cunning. Democrat Al Franken unseated Republican Incumbent Norm Coleman in a recount in Minnesota and Arlen Specter, a Republican from Pennsylvania, switched his party affiliation to Democrat. 12 Congress, after the sweeping 1986 tax reforms, corrected certain oversights in that law by passing subsequent measures in 1987. These were made to be retroactive back to the previous calendar year, i.e. January 1, 1986, and the courts upheld the legislation. Hence, there is precedent for Republicans to pass tax reform in 2018 that takes effect January 1, 2017, though admittedly the circumstances would matter. Courts have even upheld retroactive tax legislation back to two calendar tax years. Please see Erika K. Lunder, Robert Meltz, and Kenneth R. Thomas, "Constitutionality of Retroactive Tax Legislation," Congressional Research Service, October 25, 2012, available at fas.org. 13 Please see BCA Global Investment Strategy Weekly Report, "Fiscal Policy In The Spotlight," dated May 26, 2017, available at gis.bcaresearch.com. 14 Please see BCA Research Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, available at bca.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights Fiscal policy is likely to be eased modestly in most advanced economies over the next two years. The U.S. Congress will ultimately cut taxes, although the size of the cuts will be far smaller than what President Trump has proposed. Ironically, fiscal stimulus is coming to America just when the economy has reached full employment. The market is pricing in too little Fed tightening over the remainder of the year. The dollar's swoon is ending. Go short EUR/USD with a target of parity by the end of the year. Feature Fiscal Thrust Around The World In its latest Fiscal Monitor, the IMF estimated that advanced economies eased fiscal policy by 0.2% of GDP in 2016, reversing a five-year streak of fiscal tightening (Chart 1). The Fund expects a further 0.1% of GDP of easing in 2017, followed by a neutral stance in 2018. In the EM universe, the IMF foresees a fiscal thrust1 of -0.2% of GDP in 2017 and -0.4% of GDP in 2018. Chart 1IMF Expects Modest Fiscal Easing In Advanced Economies, Further Tightening In EM Averages can disguise a lot of variation across countries (Charts 2). Comparing 2018 with 2016, the IMF expects Canada and the U.S. to experience a positive fiscal thrust of 0.7% of GDP and 0.4% of GDP, respectively. The fiscal thrust is projected to be -0.2% of GDP in the euro area, -1% of GDP in the U.K., and -0.5% of GDP in Japan. Among the larger advanced economies, Australia is expected to experience the largest degree of fiscal tightening, with a fiscal thrust of -1.2% of GDP. Across the EM universe, most of the fiscal tightening is projected to occur among oil producers. The IMF expects oil-exporting economies to collectively reduce their fiscal deficits by US$150 billion between 2016 and 2018. Political considerations require that the IMF give considerable weight to the stated objectives of governments when formulating fiscal projections. In reality, governments often struggle to meet their budget targets. Consequently, the Fund has typically overestimated the degree of fiscal consolidation that ends up happening (Chart 3). As such, our own projections foresee somewhat less fiscal tightening - and in some countries, a fair bit of fiscal easing - than the IMF projects. In particular: Chart 2Countries Will Follow Different Fiscal Paths Chart 3IMF Forecasts Tend To Overestimate Extent Of Fiscal Consolidation We do not expect much more incremental fiscal tightening out of the euro area. Thanks to a slew of austerity measures, the euro area's structural primary budget balance went from a deficit of 2.6% of GDP in 2010 to a surplus of 1.0% of GDP in 2014. It has remained close to those levels ever since. Now that a primary surplus has already been achieved and interest rates and bond spreads have fallen to exceptionally low levels, the need for further belt tightening has abated. That's the good news. The bad news is that high government debt levels in many European economies rule out any major new stimulus programs (Chart 4). The U.K. will slow the pace of fiscal consolidation. The U.K.'s structural primary budget deficit fell from a peak of 7.1% of GDP in 2009 to 1.3% of GDP in 2016. The IMF expects the primary balance to move into a surplus of 0.6% of GDP in 2019. We think that's unlikely. The Conservatives are under intense pressure to keep the economy afloat during Brexit negotiations. Prime Minister Theresa May has indicated she will delay eradicating the budget deficit until the middle of the next decade, having previously promised a 2020 target date. Japan has limited scope to further tighten fiscal policy. Japan's structural primary budget deficit reached 6.9% of GDP in 2010. The IMF expects it to reach 3.7% this year and fall further to 2% in 2020, provided the government goes forward with raising the VAT from 8% to 10%. We are skeptical that Japan's economy will be strong enough to allow the government to raise taxes. However, even if it is, this will only be because the Bank of Japan gooses growth by keeping long-term yields pinned to zero, thereby allowing the yen to depreciate further. China is making a structural transition to large budget deficits. The IMF estimates that China's structural primary budget balance deteriorated from a surplus of 0.1% of GDP in 2014 to a deficit of 2.8% of GDP in 2016. The increase in the fiscal deficit cannot be explained by the reclassification of off-budget spending as on-budget, since the IMF's "augmented" fiscal balance - which attempts to control for such statistical issues - deteriorated by roughly the same amount (Chart 5). Part of the erosion in China's fiscal balance stemmed from the global manufacturing slowdown in 2015-2016, which hit tax receipts and necessitated a healthy dose of fiscal stimulus. However, there is more to the story than that. As we controversially argued in "China Needs More Debt," now that China is no longer in a position to run gargantuan current account surpluses, large fiscal deficits will be necessary to absorb excess private-sector savings.2 The government's desire to rein in credit growth will only add to the impetus to find new sources of aggregate demand. The era of red ink has begun. Chart 4Government Debt Levels Outside Of Germany Are Still High Chart 5China's Fiscal Deficit Has Been Increasing The U.S. Congress will ultimately cut taxes, although the size of the cuts will be far smaller than what President Trump has ambitiously proposed. After a wave of euphoria following the presidential election, the market has largely priced out meaningful fiscal stimulus. This can be seen in the flagging relative performance of infrastructure stocks and highly-taxed companies, as well as in the sharp decline in inflation expectations (Chart 6). We think this pessimism is overdone. Donald Trump desperately needs a "win," and cutting taxes is one key area where the President and Congress both see eye to eye. Trump's falling poll numbers have heightened the risk that the Republicans will lose control of the House of Representatives next November (Chart 7). This makes passing a tax bill before the midterm elections all the more urgent. The main questions surround the scale and scope of any tax cuts, and just as critically, how they are paid for. We discuss these issues next. Chart 6Markets Have Priced Out Meaningful Fiscal Stimulus Chart 7Challenging Outlook For Republicans In 2018 Trump's Budget Proposal: Fake Math Chart 8Trump In Wonderland? If the definition of a good leader is one who underpromises and overdelivers, then President Trump's budget proposal left much to be desired. Trump's plan assumes that U.S. growth will reach 3% over the next ten years. Even in the unlikely event that the economy manages to avert a recession over this period, such a growth rate would be a remarkable feat. After all, growth has averaged only 2.1% since 2009. And keep in mind that the unemployment rate has fallen from 10% to 4.4% over this interval, consistent with potential GDP growth of only 1.4%. The slow pace of capital accumulation following the Great Recession undoubtedly hurt the supply side of the economy, but it would take a phenomenal - and rather implausible - acceleration in potential GDP growth to justify Trump's 3% target. Many of the other assumptions in Trump's blueprint are no less dubious (Chart 8). Despite projecting much slower growth, the Federal Reserve expects short-term rates to rise to 3% in 2019. In contrast, the Trump administration sees rates increasing to only 2.4%, an assumption that perhaps not coincidentally helps reduce projected debt-servicing costs. Most flagrantly, the plan assumes no decline in the revenue-to-GDP ratio, even though the basis for faster growth largely rests on the assumption of steep tax cuts. When pressed on the issue, officials from the Office of Management and Budget sheepishly noted that there would be offsetting limits on tax deductions, which would have the effect of broadening the tax base. However, no specific information was given on what these would entail. Many theories have been offered as to why Trump offered such an outlandish budget plan. Was he trying to appease conservatives in Congress? Perhaps this was just a sly attempt to gain leverage in future budget negotiations? Our theory is simpler: Trump promised an economic boom during the election campaign, while assuring voters that his tax cuts would more than pay for themselves. Hell would need to freeze over before he released a plan that did not share these assumptions. Congress Will Decide So where do we go from here? The specifics of Trump's plan are irrelevant. Congress will rewrite the budget from scratch. Major spending cuts will be scrapped. So will the onerous cuts to insurance subsidies and Medicaid in the House version of the health care bill. The Senate will ditch those. In contrast, Trump's tax cuts will be preserved, albeit on a smaller scale than envisioned in his budget proposal. Granted, congressional leaders have said they want tax reform to be revenue neutral, meaning that any tax cuts would need to be offset by other revenue-raising measures. That is easier said than done, however. The three main ways that House Republicans have offered to pay for corporate and personal tax cuts - introducing a border adjustment tax, eliminating the deductibility of business interest payments, and jettisoning the deduction for state and local income taxes for individuals - all face severe resistance from vested interests. In Washington, where there is a will there is usually a dishonest way. Budget forecasts are typically made over a 10-year window. Thus, it is possible to lower taxes upfront and promise spending cuts and ill-defined revenue raising measures in the tail end of the budget window. Such a strategy would generate a positive fiscal thrust early on, while leaving the door open for Congress to dump any future spending reduction or revenue measures before they are actually implemented. Add to that the tax revenue that is projected to pour in from supply-side reforms, and the stage is set for a dollop of fiscal easing starting in early 2018. How likely is it that Republicans will pursue such a strategy? Very likely. As evidence, look no further than the fact that White House budget director Mick Mulvaney floated the idea on Wednesday of extending the 10-year budget scoring window to 20 years. Investment Conclusions Chart 9Phillips Curve Is Alive And Well An obsessive focus on fiscal austerity hamstrung the recovery in many countries following the Great Recession. The irony is that fiscal stimulus is coming to America just when the economy has reached full employment. This means that much of the increase in aggregate demand arising from a more expansionary fiscal stance will be reflected in higher inflation rather than faster growth. This does not represent a major threat to risk assets now, but could later next year. Despite all the obituaries that have been written for the death of the Phillips curve, the data show that it is alive and well (Chart 9). Higher inflation will allow the Fed to raise rates once per quarter. The market is not prepared for this. Investors currently expect only 45 basis points in rate hikes over the coming 12 months. That is far too low. On the other side of the Atlantic, the ECB's months-to-hike measure has plummeted from 65 months in July 2016 to only 24 months today (Chart 10). Real rates are projected to be a mere 14 basis points higher in the U.S. than in the euro area in five years' time (Chart 11). Chart 10The Big Shift In Market Sentiment Towards ECB Policy Chart 11The Vanishing Transatlantic Bond Spread Poor demographics and high private-sector debt levels imply that the neutral rate of interest is lower in the euro area than in the U.S. And while the euro area may not be tightening fiscal policy any longer, the fact that its structural primary budget balance is 2.6% of GDP larger than America's means that the euro area's overall fiscal stance will contribute less to aggregate demand than in the U.S. This will force the ECB to keep rates lower for longer, causing the euro to weaken. Chart 12Widening Real Rate Differentials ##br##Support The Dollar Chart 13Speculators Are Long The Euro For ##br##The First Time In Three Years Incredibly, two-year real interest rate differentials between the euro area and the U.S. have widened by 41 basis points in favor of the latter since the end of March, even though EUR/USD has actually rallied over this period (Chart 12). We think this divergence has occurred because investors have been busy covering the euro hedges that they put on in the lead up to the French elections. However, now that net long speculative positions in the euro have risen to a three-year high - having been deeply short just a few weeks ago - the speculative demand for euros will subside (Chart 13). With all this in mind, we are going short EUR/USD today with a year-end target of parity and a stop-loss of 1.14. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 The fiscal thrust is defined as the change in the structural primary budget balance from one year to the next. As a convention, we define a positive thrust as loosening in fiscal policy (i.e., a lower fiscal balance). 2 Please see Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, and "China Needs More Debt," dated May 20, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Highlights Brazilian President Michel Temer has been accused of crimes much worse than what got his predecessor impeached; Further instability is likely, with low probability that Temer's impeachment would restart reforms; Only a technocratic government, or brand new election, could produce a market-friendly outcome. Odds are that Brazil's public debt load will continue to escalate, and that in two years or so the debt-to-GDP ratio will spiral out of control. Without structural reforms and higher commodities prices, Brazilian financial markets are looking into the abyss. Stay put on Brazilian financial markets. Feature Investors cheered the impeachment of Brazil's President Dilma Rousseff, bidding up Brazilian assets for over a year despite the challenging macroeconomic context. BCA's Emerging Markets Strategy and Geopolitical Strategy services have repeatedly cautioned investors not to buy the hype. Brazil was already "priced for political perfection" on May 12, 2016 when Rousseff was removed from office to face trial by the senate over fiscal accounting irregularities.1 And yet, the political context has been far from perfect. As we wrote last May: "It is highly unlikely that the political dysfunction within Brazil's political class will end with a Temer administration, at least not anytime soon." The latest corruption revelations have directly implicated acting president Michel Temer of the Brazilian Democratic Movement Party (PMDB) as well as Senator Aecio Neves, the leader of centrist and investor-friendly Brazilian Social Democratic Party (PSDB) and a key Temer ally in Congress. The market has placed a massive bullish bet in the abilities of the tentative Temer-Neves (PMDB-PSDB) entente cordiale to push through largely unpopular fiscal reforms through Congress. These reforms, none of which have passed yet (!), are now likely to stall until either an early election is called (best case scenario) or until the current government's mandate expires in October 2018. We have expected Brazil's political rally to dissipate. As we argued in 2016, without a new election, the interim government has no mandate for painful structural reforms. We are sticking to this view today. What Is Going On In Brazil? According to revelations in the Brazilian press, President Temer was caught in an audio recording asking the chairman of JBS Group - the world's largest meatpacker - to continue making payments to the former President of the Chamber of Deputies Eduardo Cunha, who was jailed for corruption in 2016. Cunha, a former Temer ally and member of PMDB, was indicted in the large scale "Operation Car Wash" corruption scandal involving the state-owned oil company Petrobras. The payments by JBS were allegedly meant to ensure that Cunha did not spill the beans on his co-conspirators. Cunha had previously disclosed that he possessed compromising information about several senior politicians linked to the Petrobras scandal. JBS Chairman Joesley Batista, himself under investigation, recorded a conversation with Temer on March 7 as part of his plea bargain negotiations with law enforcement officials. According to press reports, Temer asked Batista to continue payments to ensure Cunha's silence. As part of the same investigation, Senator Aecio Neves - the darling of the Brazilian investment community who narrowly lost the presidential election to Rousseff in 2014 - was filmed soliciting two million reals ($638,000) from Batista. This is not his first brush with the law, Neves was also under corruption investigation when he was the governor of the state of Minas Gerais. Neves's apartment has since been raided by the police as the corruption probe against Brazilian politicians reaches a fever pitch. How serious are the charges against the Temer and his ruling coalition? They are deadly serious. As an aside, we have been puzzled that investors have never posed the following question: how was it possible that the entire political and especially congressional system is so corrupt but Temer - the long-serving head of the largest party in the congress and one of the most shrewd politicians in Brazil - has not been involved in this corruption scheme. President Dilma Rousseff, former leader of the left-wing Workers Party (PT) and successor to President Inácio "Lula" da Silva, was impeached and removed from power for a lot less. There was never any actual evidence that Rousseff was personally involved in Operation Car Wash, at least at the time of her impeachment. In fact, the strongest legal case against Rousseff was that she failed to uphold the so-called Fiscal Responsibility Law. Essentially, Rousseff was impeached and removed from power because she stimulated the economy for political gain. A charge that practically every president in Brazil's history has been guilty of (if not every leader in the world!). Temer and Neves are accused of much greater crimes. If the reporting of the Brazilian press is accurate, Neves personally profited and continues to profit from Operation Car Wash. And Temer is then directly involved, to this day, in obstruction of justice and witness intimidation. These are not crimes by association or mere technicalities resulting from politically charged fiscal profligacy. Rather, they are serious crimes that could end with lengthy jail terms, let alone removal from power. Rousseff claimed that her removal from power was a coup d'état. She was correct to characterize it as such. Unlike in the U.S., where a president removed from power is replaced with the vice president from the same party, in Brazil vice presidents are often appointed from a coalition partner. As such, Vice President Temer replaced Rousseff and proceeded to alter Brazilian policy in a dramatic fashion. He abandoned the PMDB legislative alliance with left-wing PT, turned to the centrist PSDB for votes in Congress and proceeded to enact orthodox, conservative, supply-side reforms. While these are absolutely the reforms that Brazil needs, we never accepted the view that they are reforms that Brazilians want. In fact, Rousseff won the 2014 election against Neves, with Temer as her running mate, by campaigning on a populist platform against precisely these types of supply-side reforms. Bottom Line: We hate to tell our clients "we told you so," but Temer's 180-degree turn in policy was never going to work. Not without an election that bolsters his political mandate to enact painful structural reforms. We also cautioned our clients that corruption in Brazilian Congress was endemic and severe and would therefore not magically disappear with Rousseff's removal from power. As such, "impeachment was no panacea,"2 especially not when many members of Congress voting against Dilma were under investigation for corruption themselves! The high level of corruption is not because of a moral failing particular to Brazilian mentality. Rather, corruption is a feature of Brazil's fractured and regionalized politics that depend on side-payments and pork barreling to grease the wheels of legislative process. Rousseff's crimes appear paltry when compared to the (yet unproven) allegations against Temer and Neves. J-Curve Of Structural Reforms Amidst the 2016 political crisis, we argued that the only positive outcome for Brazilian politics and markets in the long-term would be a new election (Figure I-1).3 Why? Because we understood how painful fiscal reforms would have to be to deal with Brazil's disastrous fiscal position (Chart I-1). Without a new election, the interim Temer administration would not have the political capital to enact painful reforms. Figure I-1Brazil: Our Take On Possible Political Scenarios ##br##Before Former President Rousseff Was Impeached Chart I-1Brazil's Fiscal Position The market has disagreed with us for a full year now. However, the rally based on political hopes was always unsustainable. First, investors have misunderstood the nature of political corruption in Brazilian politics and just how intrinsic the problem has been. In retrospect, Rousseff may have been the least corrupt major politician in Brazil! Second, investors have ignored the message of our J-Curve of structural reforms (Diagram I-1). Diagram I-1Structural Reforms Are Painful: ##br##Stylized Representation Reform is always and everywhere painful, otherwise it would be the form. Every government pursuing reforms has to get through the "danger zone" on our J-curve of structural reform. As reforms are passed and enacted, they begin to "bite." This is when the protests against reforms mount and the government loses its political capital. If the policymakers in charge of the reform effort are already starting with low political capital - as the Temer and his congressional coalition most certainly did in August 2016 - than the "danger zone" is essentially insurmountable. We have disagreed with the market as it has confused Rousseff's removal from power with widespread support for reforms that amount to economic austerity. As we often repeated in client meetings, "a vote for impeachment is not a vote for austerity." With general election only roughly one year away in October 2018, we doubted that the Temer administration would have the political capital to push through such reforms. After all, every government wants to be reelected and pursuing painful reforms ahead of the elections is not feasible election winning strategy. What has the Temer coalition managed to do thus far? It must have done a lot, given the positive market performance over the past 12 months? False. The market has rallied despite remarkably shoddy evidence of actual reforms. As we predicted in our analyses throughout 2016, the post-Rousseff Brazilian policymakers have been dogged by lack of political capital. Out of five major reform efforts, only two have passed - oil-auction legislation (Production Sharing Agreement Bill) and a fiscal-spending cap. We do not wish to claim that the latter is insignificant but as we discuss below they are insufficient to stabilize Brazil's public debt load. The main three reform efforts that would have significant long-term effect on Brazil's fiscal sustainability - social security reform, labor reform, and tax reform - have stalled and are now likely to fail (Table I-1). Table I-1President Temer's Proposed Structural Reforms & Their Status Brazilian Senator Ricardo Ferraço, of the centrist PSDB, in charge of drafting the labor reform report for the Senate, has already canceled the work on the proposal. Ferraço issued a statement that said, "the institutional crisis we are facing is devastating and we need to prioritize finding a solution. Everything else is secondary now." This is a major blow against labor reforms, which already passed the lower house in April. We suspect that it will largely be impossible to restart and, more importantly, pass the reforms without an election that gives a new government a political mandate. Alternatively, a technocratic government led by technocrats without political ambitions, could try to enact reforms until the next election. Without a new election or a technocratic government, members of centrist PSDB and center-left PMDB will start to distance themselves from the allegedly corrupt Temer administration. It makes no political sense for Congressmen like Ferraço to sacrifice their own political capital on the cross of austerity just a year from the start of the electoral campaign in the summer of 2018. Bottom Line: The results made clear by Figure I-1 are not surprising and were eminently forecastable. However, the market ignored the structural realities of Brazilian politics, as well as the theoretical foundation of successful structural reforms, and charged ahead regardless. Without fiscal reforms outlined in Table I-1, however, Brazil will likely end up in a debt trap very soon. A Perilous Fiscal Situation Brazil's fiscal position and public debt remain on an unsustainable trajectory. In fact, there has been limited fiscal improvement compared to what financial markets have priced in. In particular: The constitutional amendment by Brazilian President Michel Temer's government that introduced a cap on government spending was a dilution of the Fiscal Responsibility Law adopted in 2000 which stipulated that the government had to run primary fiscal surpluses. Capping government expenditure growth to the inflation rate de facto represents a relaxation of structural fiscal policy. Under the new fiscal rules, the government is targeting not the primary fiscal deficit (and, by extension, public debt), but only government expenditures. This implies that in a case where government revenues fall short of projections, the government is not obliged to rein in spending. On the whole, Temer's government has relaxed rather than tightened structural fiscal rules. While this makes sense because the economy is in a depression and needs fiscal relief, it has been bad news for government creditors. As a final point, the former President Dilma Rousseff was impeached for violating this exact same law that the current government has now relaxed. The fiscal balance has stabilized around 9% of GDP in the past year, but this has been due to one-off temporary measures. With nominal GDP growth at around 5%, the bulk of the 16% rise in collected income taxes from a year ago came from one-off measures such as the repayment of funds by the Brazilian Development Bank (BNDES) to the government, taxes on foreign asset repatriation and other temporary actions (Chart I-2). In short, Temer's government has resorted to one-off measures to improve the country's fiscal position. Unless the economy and tax collection recover strongly in the next 12 months, Brazil's fiscal position will worsen substantially, and public debt servicing will become unsustainable. Furthermore, the federal government's transfers to states have surged as the latter are facing their own fiscal crises due to revenue shortfalls. Local governments are reluctant to curb spending amid the ongoing depression, and will continue to pressure the federal government for more transfers. This will worsen public debt dynamics. Importantly, the social security deficit, presently at 2.4% of GDP, will continue to escalate without meaningful reforms (Chart I-3). According to IMF estimates,4 the social security deficit will reach 14% of GDP by 2021 if no reforms are implemented. This is assuming robust economic recovery this year and solid growth in the years ahead. Given social security reforms are unlikely to occur and economic growth will continue to underwhelm amid heightened political uncertainty, odds are that the impact of the social security deficit on the public debt dynamics will be worse than the IMF projections suggest. Moreover, the gap between local currency interest rates and nominal GDP growth remains extremely wide (Chart I-4). To offset this, the government has to run primary surpluses. The primary deficit is currently 2.3% of GDP. Chart I-2Income Tax Collection Has Been ##br##Boosted By One-Off Measures Chart I-3Brazil's Social Security System ##br##Is On Unsustainable Track Chart I-4An Untenable Gap That said, tightening fiscal policy amid the ongoing economic depression is politically suicidal. Finally, our public debt simulation suggests that unless economic growth recovers strongly, Brazil's public debt-to-GDP ratio will rise above 90% of GDP by the end of 2019 - in both our baseline and most pessimistic scenarios. Notably, our baseline scenario assumes nominal GDP growth of 5.5% in 2017, and 7% in both 2018 and 2019 (Table I-2). These are not bearish assumptions, but and could prove optimistic given the escalating political crisis. This debt simulation assumes that interest rates will stay above 10%, but it also assumes no bailout for public banks and state-owned companies, or a rise in transfers to state governments. Table I-2Brazil: Public Debt Sustainability Scenarios 2017-2019 Bottom Line: Odds are that Brazil's public debt load will continue to escalate, and that in two years or so the debt-to-GDP ratio will spiral out of control. The Economy, Corporate Profits And Markets There has been no recovery in either the economy or corporate profits (excluding commodities companies). Brazilian share prices have rallied massively in the past 17 months, yet profits in companies leveraged to the domestic business cycle have continued to shrink. Specifically, EPS for consumer staples companies and banks have dropped a lot in local currency terms, despite the equity market rally (Chart I-5). It is normal that share prices lead profits by six to 12 months, but the current rally in Brazil is already 16 months old. In short, the discrepancy between share prices and EPS is unprecedented and unsustainable. Ongoing profit weakness is consistent with a lack of recovery in domestic demand, which is corroborated by the macro data: retail sales volumes, manufacturing production and capital goods imports have not grown at all; their pace of contraction has simply moderated (Chart I-6). Chart I-5No Recovery In Corporate Profits ##br##In Non-Commodities Sectors Chart I-6No Recovery In Economy In Brazil, key to its financial markets is the exchange rate. If and when the currency appreciates, interest rates will decline and share prices will rally and the economy will eventually revive - and vice versa. In turn, the exchange rate is driven not by the interest rate differential versus the U.S., as shown in Chart I-7, but by commodities prices, with which it strongly correlates (Chart I-8). Chart I-7Interest Rate Differential And ##br##Exchange Rate: No Correlation Chart I-8BRL Is Sensitive To Commodities Prices BCA's Emerging Markets Strategy team believes commodities prices have peaked and will decline in the months ahead. This, along with renewed political turmoil, warrants a bearish stance on the Brazilian currency. While the central bank has large foreign currency reserves and could sell U.S. dollars to support the real, this cannot preclude a selloff in the nation's financial markets. Selling foreign currency by a central bank entails withdrawing local currency from the banking system, tighter local liquidity and higher interest rates. Hence, a central bank can defend the exchange rate from depreciation if it tolerates higher interbank rates. Higher interest rates will, however, be devastating for Brazil. If the central bank of Brazil, having used its international reserves to defend the currency, decides to inject local currency liquidity into the system to bring down local rates, the outcome will be currency depreciation. In a nutshell, a central bank cannot control both the exchange rate and local interest rates if the nation has an open capital account structure. Remarkably, Chart I-9 contends that in Brazil, the exchange rate correlates with central bank lending to commercial banks. If the central bank lends to commercial banks, the currency depreciates, and vice versa. Facing the choice between currency depreciation and higher local rates, the Brazilian central bank will choose the former because of its perilous public debt situation as well as the imperative of a revival in credit growth. Hence, the Brazilian central bank is unlikely to defend the currency on a sustainable basis. If the currency depreciates, local bonds, sovereign and corporate U.S. dollar credit and share prices will sell off too. Bottom Line: Without structural reforms and higher commodities prices, Brazilian financial markets are looking into the abyss. Investment Recommendations Politics has fueled the rally in Brazilian assets since early 2016, and now politics taketh away. With the political tailwinds reversing, investors will have nothing left to base their decisions on but the terrible macroeconomic picture. We maintain our bearish stance on Brazilian financial markets: We continue to short the BRL versus both the U.S. dollar and the Mexican peso. The real is not cheap at all while the peso offers good value (Chart I-10). Chart I-9Central Bank's Liquidity Provision ##br##To Banks Vs. Exchange Rate Chart I-10BRL Is Not Cheap, MXN Is Dedicated EM equity and credit investors should continue underweighting Brazil in their respective portfolios. Finally, local rates will be under upward pressure as the currency depreciates. We remain offside this market. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Santiago E. Gomez, Consulting Editor santiago@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Brazil: Priced For Political Perfection," dated May 12, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Client Note, "Brazil: Impeachment Is No Panacea," dated April 26, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Brazil's Political Honeymoon Is Over," dated August 18, 2016, available at gps.bcaresearch.com. 4 Cuevas et al., IMF Working Paper: Fiscal Challenges of Population Aging in Brazil, March 2017

Highlights U.S. fiscal stimulus will be priced back into markets; Northeast Asia is consumed with domestic politics for now; China's financial crackdown raises risks, but so far looks contained; South Korea's relief rally will lead to buyer's remorse; Japan's constitutional reforms portend more reflation. Feature The market has lost faith in U.S. fiscal stimulus. The bond market has given back all of the expectations of faster growth and higher inflation (Chart 1). Hopes of populist, budget-busting tax cuts appear to have been dashed by the Putin-gate scandal and alleged White House obstruction of justice. As a result, the DXY has fallen to pre-election levels, while the Goldman Sachs high tax-rate basket of equities has fallen to its lowest level relative to the S&P 500 since February 2016 (Chart 2). We continue to believe that tax reform, or just tax cuts, will happen this year or early next year and that the market will have to re-price fiscal stimulus and budget profligacy at some point this year.1 As such, we are not ready to close our tactical recommendations of going long the high-tax rate basket relative to S&P 500 (down 1.62% since April 5) or playing the 2-year / 30-year Treasury curve steepener (down 11.4 bps since November 1). Republicans in Congress will push through tax reforms or cuts for the sake of remaining competitive in the upcoming midterm elections. And we doubt their commitment to budget discipline. That said, it is not clear that the equity market needs tax reforms to continue its upward trajectory. The Atlanta Fed's GDPNow model is predicting growth of 4.1% in the second quarter while the NY Fed's Nowcast is forecasting 2.3%. BCA U.S. Equity Strategy's earnings model continues to predict continued healthy profit growth for the remainder of the year both in the U.S. and abroad (Chart 3).2 In fact, if expectations of stimulus in the U.S. fully dissipate, the USD will take a breather - giving global stocks a boost - and the Fed will be able to take it easy on tightening U.S. rates, easing global monetary conditions. Chart 1Market No Longer##br## Believes In Trump Stimulus... Chart 2...Or Trump ##br##Tax Cuts Chart 3Corporate Profit ##br##Outlook Still Strong Perhaps far more important for global and U.S. risk assets is global growth. And the fulcrum of global growth has been China's economic performance. As the only country willing to run pro-cyclical monetary and fiscal policy, China has had a disproportionate impact on global growth since 2008. As such, we turn this week to the geopolitics and politics of Northeast Asia. China: How Far Will Deleveraging Go? Chinese financial policy tightening caught the market by surprise this year. The running assumption was that policy would be fully accommodative in order to ensure stability ahead of the all-important nineteenth National Party Congress in October or November.3 However, it is possible that the assumption is flawed. First, as we have pointed out in the past, China does not have a record of proactive economic stimulus ahead of party congresses (Chart 4). Second, President Xi Jinping may be far more secure in his position than is understood. Chart 4Not Much Evidence Of Aggressive Stimulus Ahead Of Mid-Term Party Congresses In China The crackdown on the financial sector in recent months suggests that Xi's administration has a greater appetite for risk ahead of the party congress than is generally believed: The administration is continuing to tamp down on the property sector. The PBoC has drained liquidity and allowed interbank rates to rise (Chart 5). The China Banking Regulatory Commission (CBRC) has launched inspections and new regulations on wealth management products and the shadow lending sector. The China Insurance Regulatory Commission (CIRC) has imposed new restrictions, including preventing insurers from selling new policies. One can make a good case that these measures will be limited so as not to cause excessive disruption in the financial system. All of the key Communist Party statements, from Premier Li Keqiang's recent comments to those made by the economic leadership in December, at the beginning of this tightening cycle, have emphasized that stability remains the priority.4 The PBoC's measures have been marginal; other measures have mostly to do with supervision. Notable personnel changes affecting the top economic and financial government positions fall under preparations for the party congress and do not necessarily suggest a new ambitious policy initiative is under way.5 Moreover, the government has already stepped back a bit in the face of the liquidity squeeze. One of the signs of the PBoC's tighter stance was its discontinuation of its Medium-Term Lending Facility in January, but this has since been reinstated.6 And throughout May the PBoC has injected increasing amounts of liquidity into the interbank system, marking an apparent tactical shift (Chart 6). Furthermore, government spending is already growing again after a brief contraction. Chart 5People's Bank Tightens Marginally... Chart 6...But Keeps Interbank Rates On A Leash In light of these decisions, it seems policy tightening is intended not to be stringent but merely to keep the financial sector - especially the shadow banking sector - in check during a year in which the assumption is that regulators' hands are tied. After all, an unchecked expansion of leverage throughout the year could interfere with the stability imperative. There are two major risks to this view. First, there is the danger of unintended consequences: China is overleveraged: The fundamental problem for China is that there is too much leverage in the system and there has not been a bout of deleveraging for several years (Chart 7). Much of the leverage is off-balance sheet as a result of the rapid growth in shadow lending. There are complex and opaque webs of counterparty risk. When authorities crack down, they cannot be certain that their actions will not spiral out of control. Recently, heightened scrutiny of "mutual guarantees," a type of shadow lending between corporations, led to the default of a company in Shandong that prompted a local government bailout, and more such credit events have occured.7 Policymakers are human: It is a fallacy to assume that Chinese policymakers are omnipotent. The mishaps of 2015-16 put a point on this. A state-backed newspaper has recently reiterated that its "deleveraging" campaign is not finished - the government could accidentally push too far.8 The rise in bond yields has already inverted the yield curve, causing the five-year bond yield to rise higher than the ten-year (Chart 8). This is a red flag and warrants caution.9 Quick fixes have negative side-effects: China escaped the last round of financial jitters, in 2015-16, by using its time-tried technique of credit and fiscal spending to boost the property market and build infrastructure, while imposing draconian capital controls. The growth rebound came at the expense of more debt, less economic rebalancing, and less financial openness. Chart 7China Is Massively Overleveraged Chart 8China's Yield Curve Has Inverted Second, there is the risk that Xi Jinping's calculus ahead of the party congress is not knowable. It may well be the case that Xi's position in the party is strengthened by a disruptive financial crackdown. The party congress is already under way: The party congress runs all year; it is not merely a one-off event this fall. Senior party officials will come up with a list of candidates for promotion in June or July. Then the PSC and former PSC members will likely meet behind the scenes to hash out their final list, which the Central Committee will ratify in the fall. If financial jitters were supposed to be strictly avoided for the party congress, then the current crackdown would never have begun. The outcomes are uncertain: The negotiations for the Politburo and PSC are not a foregone conclusion no matter how well positioned Xi appears to be as the "core" of the Communist Party. A simple assessment of the current Politburo suggests that the factions are evenly balanced when it comes to the current Politburo members capable of filling the five positions on the new PSC. Two of these positions should go to President Xi's and Premier Li Keqiang's successors, likely to be of opposing factions, while there will probably be three remaining slots that will have to be divvied up among an equal number of candidates from the two main factions (Table 1). Xi may still need to win some battles for influence behind the scenes in order to stack the Central Committee, Politburo, and PSC with his people for 2017 and beyond.10 His anti-corruption campaign has slowed down but is not over (Chart 9). This is all the more imperative for him since his retirement could be rattled by future enemies, given that he has removed the longstanding impunity of former PSC members. Table 1Lineup Of New Politburo Standing Committee Yet To Take Shape - Factions Evenly Balanced Despite these risks, we still tend to think that for China, as for the world, political risks are overstated in 2017 and understated in 2018.11 If Xi deliberately courts instability this year, as opposed to merely staying vigilant over the financial sector, then it will mark a major break from the norms of Chinese politics. The true risk to China's stability - aside from the unintended consequences discussed above - arises after the party congress, when Xi's political capital is replenished and he can attempt to reboot his policy agenda. Previous presidents Hu Jintao and Jiang Zemin both launched reform pushes after their midterm congresses in 2007 and 1997, respectively. Hu's reform drive was cut short by the global financial crisis, while Jiang's was large-scale and disruptive and paved the way for a decade of higher potential GDP. Having consolidated power in the party, bureaucracy, and military, and tightened controls over the media, Xi Jinping will be in a position in 2018 to launch sweeping reforms should he choose to do so. Presumably these reforms would follow along the lines of those he outlined in the Third Plenum of the Eighteenth Central Committee back in 2013 - they would be pro-market reforms focused on raising productivity by transferring more wealth to households and SMEs at the expense of state-owned enterprises and local governments.12 To illustrate the process of structural reform, we have often used the notion of the "J-Curve" in Diagram 1. This shows that painful reforms deplete political capital, creating a "danger zone" for political leaders in which they lose popularity as economic pain hurts the public. Xi's work over the past five years to fight corruption and rebuild the party's public image have given him the ability to start the J-Curve process from a higher point than otherwise would have been the case. He will start at point D in the diagram, instead of point A, which means that the low point E may not embroil him as deeply in the danger zone of serious political instability as point B. Chart 9Embers Still Burning In ##br##Anti-Corruption Campaign Diagram 1The J-curve Of##br## Structural Reform But there is still no guarantee that he intends to expend his political capital in this way. The current round of financial tightening could be preliminaries for bigger moves next year - or it could be just another mini-cycle in the ongoing process of "managing" China's massive leverage. If China decides to execute a major deleveraging campaign, either now or next year, it will have a negative effect on global commodity demand (particularly base metals), on commodity exporters, on emerging markets in general, and ultimately on global growth. It would be beneficial for Chinese growth in the long run but negative in the short run, and in terms of Chinese domestic risk assets would open up opportunities for investors to favor "new (innovative) China" versus "old (industrial) China." Bottom Line: We remain long Chinese equities versus Taiwanese and Hong Kong equities for now, but are wary of any sign of doubling down on policy tightening in the face of more frequent and intense credit events. That would indicate that the Chinese leadership has a higher risk appetite than anyone expects and may be willing to induce serious financial disruption before the party congress. Korea: Drunk On Moonshine The Korean election is over and with it much of the heightened uncertainty that accompanied the impeachment and removal from office of President Park Geun-hye over the past year. The new president, Moon Jae-in of the Democratic Party, performed right around the polled expectations at 41% of the vote (Table 2). His competitor on the right wing, Hong Jun-pyo, outperformed expectations, though he still trailed well behind at 24%, giving Moon a large margin of victory by Korean standards that will help provide him with political capital (Chart 10). Table 2South Korean Presidential Election Results Chart 10Moon Will Have A Honeymoon Moon's election will bring relief to markets on both the domestic and geopolitical front. On the domestic front, he is proposing a series of policies that will cumulatively boost fiscal thrust and growth. On the geopolitical front, he will revive the "Sunshine Policy" (now "Moonshine Policy") of engagement with North Korea, reducing the appearance that the peninsula is slipping into war.13 The power vacuum in South Korea was a key driver of North Korea's belligerence in 2016, as the lead-up to South Korean elections has been in the past (Chart 11). South Korean presidents typically enjoy a substantial honeymoon period in which they are able to drive policy. The fact that the election occurred seven months early, as a result of the impeachment, gives Moon a notable boost to this period - he has seven months longer than he would have had before he faces any potential check from voters in the 2020 legislative elections. That is not to say that Moon has free rein. Ahn Cheol-soo's People's Party holds 40 seats in the National Assembly and is therefore in a "kingmaker" position - able to provide either the ruling Democratic Party or the fractured right-wing opposition with a majority of seats (Diagram 2). The People's Party is already criticizing Moon's call for increasing government spending by around 0.7% of GDP to fulfill his campaign pledges. True, the People's Party leans to the left and rose to power as a result of the median voter's shift to the left in the 2016's legislative elections. This may limit its ability to obstruct Moon's agenda at first. Nevertheless, it poses a substantial constraint on Moon's agenda through 2020. Chart 11Bull Market For##br## North Korean Threats Diagram 2Center-Left People's Party##br## Is The Korean Kingmaker Markets are relieved but not ebullient. The impeachment rally is over and eventually markets will realize that while Moon's agenda is pro-growth, it is not necessarily pro-corporate profits (Chart 12). He is promising to introduce a higher minimum wage, to convert temporary labor contracts into permanent ones, to increase social spending, and to toughen up labor and environmental regulation (Table 3). He has also appointed the so-called "chaebol sniper" as his point man in leading the reform of the country's chaebol industrial giants. On one hand, South Korea definitely needs corporate governance reform; on the other, the process will add uncertainty and Moon's approach may not be market-positive.14 Chart 12Relief Rally Likely To Disappoint Table 3South Korean President's Campaign Proposals To get an indication of what kind of impact Moon's economic agenda may have, it is helpful to compare that of his mentor, Roh Moo-hyun, president from 2002-7. Roh gave a boost to consumption, both government and private, and saw a relative drop off in fixed capital accumulation, which fits with the broad agenda of supporting workers and households and removing privileges for Korea's traditional export-oriented industrial complex (Chart 13). Roh proved very beneficial for the financial sector, wholesale and retail trade, and health and social work. Education and public administration received some support but were flat overall (Chart 14 A & B). If Moon follows in Roh's footsteps, he will be beneficial for the domestic-oriented economy. Chart 13South Korea's Left Wing##br## Boosts Domestic Consumption Chart 14ASouth Korea's Left Wing Boosts Finance,##br## Domestic Trade, And Health Care (I) Chart 14BSouth Korea's Left Wing Boosts Finance,##br## Domestic Trade, And Health Care (II) Abroad, the Moonshine Policy is likely to have some success, at least in the medium term. The Trump administration is pursuing a strategy comparable to the U.S.'s nuclear negotiations with Iran from 2011-15, in which it tries to rally a coalition to impose tougher sanctions on the rogue state with the purpose of entering into a new round of negotiations that will actually generate concrete results. The "arc of diplomacy" will take time to get going and could last several years - it is essentially a last-ditch effort to convince North Korea to pause its nuclear and missile advances. The tail risk of conflict on the Korean peninsula will be moved out to the end of this effort, perhaps around the end of Trump's term.15 Meanwhile, Moon is already patching up trade relations with China, according to reports, after the latter imposed sanctions on Korea for deploying the U.S. THAAD missile defense system (Chart 15). He will also seek joint infrastructure projects with China and Russia to connect the peninsula. China has a vested interest in Moon's success because it is attempting to demonstrate to the Trump administration that it is cooperating on North Korean security. Chart 15China Likely To Ease##br## Sanctions On South Korea Chart 16South Korean Inflation##br## And Credit Impulse Weak The geopolitical risk to markets is, first, that North Korea miscalculates the threshold of other nations' patience, continues with provocations, and eventually causes an incident that derails the new negotiations. This is possible given the North's record of belligerent acts and the fact that both the Trump administration and the Abe administration could cut diplomacy short in the face of a truly disruptive provocation for domestic political reasons. Second, there is a risk that Trump decides to escalate North Korean tensions again, whether to distract from domestic scandals or to reinforce the military deterrent in the event that China and South Korea appear to be giving North Korea a free pass in another round of useless talks. If Moon pursues a unilateral détente with North Korea, without adequate coordination with the U.S., and pushes for the removal of THAAD missiles, then the U.S. and South Korea are headed for a period of higher-than-normal alliance tensions that could become market-relevant.16 Bottom Line: We remain short KRW/THB. Core inflation and domestic demand remain weak in Korea, which reinforces the central bank's recent decision to stick to an accommodative monetary policy. Credit growth is cyclically weak, which reinforces the fact that rate cuts are still on the table (including the possibility of a surprise rate cut like in mid-2016) (Chart 16). Finally, the KRW has been relatively strong compared to the currencies of Korea's competitors (Chart 17). Chart 17South Korean Won Has Outpaced The Yuan And Yen In terms of equities, the top six chaebol have come under scrutiny, but Samsung has rallied despite lying at the center of the corruption scandal. The others have not performed well amid the economic slowdown. We see no opportunity at present to short the chaebol in relation to the broader market. Broadly, however, Moon's policies will add burdens to large internationally competitive industrials while boosting small and medium-sized enterprises. We also remain short the Korean ten-year government bond versus the two-year (see Chart 12, panel three, above). Moon's policy bent will subtract from a 1% budget surplus (2016) and worsen the long-term trajectory of the country's relatively low public debt (39% of GDP). Insofar as his foreign policy succeeds, it entails a larger future debt burden as a result of efforts to integrate with North Korea, which is relevant to long-term bonds well before reunification appears anywhere on the horizon. At bottom, we are structurally bearish South Korea because of rising headwinds both to U.S.-China relations and to the broader globalization process that has benefited South Korea so much in the recent past. Japan: Is Militarism The Final Act Of Abenomics? Japan has reached peak political capital under Shinzo Abe. The ruling Liberal Democratic Party, with its New Komeito coalition partner, continues to play in a totally different league from its competitors - there is no political alternative at the moment (Chart 18). The ruling party has a de facto two-thirds supermajority in both houses of the Diet. Abe himself is more popular than any recent prime minister, and has retained that popularity over a longer period of time (Chart 19). He has secured permission from his party to stay on as its president until 2021, though he faces general elections in December 2018 to stay on as prime minister. Chart 18Japan: Liberal Democrats Still Supreme Chart 19Shinzo Abe Remains The Man Of The Hour Political capital is a fleeting thing, so Abe must use it or lose it. This is why we have insisted that he would press forward rapidly with attempts to revise Japan's constitution, his ultimate policy goal, which he has now confirmed he will do. His proposed deadline is July 2020 for the new provisions coming into force.17 Constitutional revision is not only about enshrining the Japanese Self-Defense Forces (JSDF) so as to normalize the country's defense policy. It is also about Japan becoming an independent nation again, capable of forging its own destiny outside of the one foreseen by the American framers of the post-WWII constitution. Though Abe has specific constitutional aims, any change to the constitution will demonstrate that change is possible and break a taboo, advancing Abe's broader goal of nudging the Japanese public toward active rather than passive policies.18 Hence Japanese politics are about to heat up in a big way. Abe has already done a trial run in his passage of a new national security law in September 2015. This law allowed the government to reinterpret the constitution so as to achieve many of his chief military-strategic aims (e.g. allowing the JSDF to come to the aid of allies in "collective self-defense"). Over the course of that year, Abe's popularity flagged, as public opinion punished him for shifting attention away from the economic reflation agenda that got him elected so as to focus on his more controversial, hawkish security agenda (Chart 20). Nevertheless, Abe stuck to the security agenda, in the face of some of the largest protests in Japan's post-Occupation history, and managed to shift back to the economy in time to notch another big victory in the upper house elections of 2016. We expect a similar process to unfold this time, though with bigger stakes and far less of a chance that Abe can "pivot" again. Under no circumstances do we see him reversing the constitutional drive now that he has the rare gift of supermajorities in the Diet; rather, he is going to spend his political capital. After all, there is no telling what could happen in the 2018 election. What are the market implications of this agenda? There may be some hiccups in consumer and business sentiment as a result of the rise in activism, political opposition, and controversy that is already beginning and will intensify as the process gets under way. Abe will be accused of putting the economy on the backburner. Abenomics is already of questionable success (Chart 21) and it will come under greater criticism as Abe shifts attention elsewhere, especially if global headwinds gain strength. Chart 20Abe Loses Support When He Talks##br## Security Instead Of Economy Chart 21Abenomics: ##br##Progress Is Gradual However, we recommend investors fade this narrative and buy Japan. Abe's constitutional changes must receive a simple majority in a nationwide popular referendum in order to pass - and Abe does not clearly have what he needs at the moment (Chart 22). This means that he cannot, in reality, afford to put Abenomics on the back burner, but instead must err on the side of monetary dovishness, fiscal stimulus, and reflation in order to win support for the non-economic agenda. There has been virtually no talk of fiscal stimulus this year, yet the policy setting is conducive to increasing spending as necessary. The Bank of Japan has explicitly embraced a monetary regime designed to allow for greater "coordination" with fiscal policy (Chart 23).19 There is no reason whatsoever to believe Abe is backing away from this stance. (Incidentally, the next consumption tax hike is not slated until October 2019, and could be delayed again.) Geopolitics are also fairly supportive of the Abe administration. First, the Korean situation is currently alarming enough to help justify the constitutional changes yet not alarming enough to provoke outright conflict. Abe is also making headway toward a historic improvement of relations with Russia, allowing Japan's military to pivot from the north to the south and west (i.e. China and North Korea). The chief risk for Abe is if North Korea surprises on the dovish side and new international diplomatic efforts appear so fruitful as to reduce domestic support for remilitarization. China, South Korea, and possibly North Korea will encourage the latter dynamic, while drumming up global criticism of Japan for warmongering. Meanwhile Japan will try to remind the domestic public and the U.S. that North Korea remains a clear and present danger and tends to take advantage of negotiations. Given the relatively positive geopolitical backdrop for Abe, the biggest risk to his agenda is an exogenous economic shock. Even then, if that shock stems from China and causes Beijing to rattle-sabers as a domestic distraction, then it will benefit Abe's remilitarization agenda. What would hurt Abe is if global growth sags but China and North Korea lay low. It is too soon to say that they will do this, but it is unlikely. Trump is also a wild card whose threats of "tough" policy toward China and North Korea may reemerge in 2018, in time to help Japan make constitutional changes that the U.S. generally supports. Bottom Line: Go long Japan. While there is no correlation between Japan's defense-exposed equity sector performance and the current government's remilitarization efforts, there is a clear case to be made that nominal GDP and defense spending will both be going up as a result of constitutional and economic policies (Chart 24). Abe will double down on reflation for at least as long as is necessary to maintain popular approval of his government ahead of a historic constitutional referendum. Chart 22Revise The Constitution? Yes.##br## End Pacifism? Maybe. Chart 23Japanese Reflation ##br##Will Continue Chart 24Expect Higher Nominal##br## Growth And Defense Spending Housekeeping: Play Pound Strength Through USD, Not EUR We are closing our short EUR/GBP position, open since January 25, for a loss of 1.77%. This trade has largely been flat. We put it on as a way to articulate our view that Brexit political risks are overstated and that the pound bottomed on January 16. The political call was right, but the pound has largely moved sideways versus the euro since then. We maintain our short USD/GBP, which is up 4.63% since March 29, as a way to articulate the same view that Brexit (and the upcoming U.K. elections) are not a risk. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Global Investment Strategy Weekly Report, "Trump Thumps The Markets," dated May 19, 2017, available at gis.bcaresearch.com. 3 The party congress, which occurs every five years and marks the "midterm" of President Xi Jinping's administration, will see a sweeping rotation of Communist Party officials, including on the Central Committee, the Politburo, and the Politburo Standing Committee (PSC). 4 Please see "China able to keep its financial markets stable, Premier Li says," Reuters, May 14, 2017, available at www.reuters.com. For the December meeting, see "China's monetary policy to be prudent, neutral in 2017," Xinhua, December 16, 2016, available at www.chinadaily.com. 5 Finance Minister Xiao Jie, Commerce Minister Zhong Shan, NDRC Chairman He Lifeng, and China Banking Regulatory Commission Chairman Guo Shuqing have all recently been appointed, but they replaced leaders due to retire as part of the party congress reshuffle. Only the new China Insurance Regulatory Commission Chairman Xiang Junbo and the new Director o f the National Bureau of Statistics Wang Baoan were replaced for reasons other than retirement, having been stung by the anti-corruption campaign. By March 2018 the world should have a better sense of Xi's economic and financial "team" for 2018-22. 6 Please see BCA China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 7 Zouping government, in Shandong, intervened into the case of Qixing aluminum company's insolvency in order to transfer control to Xiwang, a corn oil and steel producer that had given a mutual guarantee to Qixing. The Zouping authorities arrested the son of Qixing's chairman to force the transfer. Please see "Bond Buyers Blacklist Some Chinese Provinces After Run Of Defaults," Bloomberg, April 26, 2017, available at www.bloomberg.com. 8 Please see "China Deleveraging To Continue As Goals Not Yet Achieved: State Paper," Reuters, May 17, 2017, available at www.reuters.com. 9 Please see BCA Emerging Markets Strategy Weekly Report, "Signs Of An EM/China Growth Reversal," dated April 12, 2017, available at ems.bcaresearch.com, and Global Investment Strategy Special Report, "The Signal From Commodities," dated May 19, 2017, available at gis.bcaresearch.com. 10 Xi may yet go after another big "tiger," Zeng Qinghong, the right-hand man of former President Jiang Zemin. 11 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated in 2018," dated April 12, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Special Report, "Reflections On China's Reforms," dated December 11, 2013, and "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com, and China Investment Strategy Special Report, "Tracking The Reform Progress," dated October 22, 2014, available at cis.bcaresearch.com. 13 "Moonshine Policy" is a phrase we regrettably did not coin, but we discussed its coming in BCA Geopolitical Strategy Weekly Report, "What About Emerging Markets?" dated May 3, 2017, and "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 14 Moon has nominated Kim Sang-jo, a professor of economics at Hansung University in Seoul, to head his Fair Trade Commission. Kim is a long-time advocate for shareholders against the family-controlled chaebol and led a prominent law suit against Samsung. Past efforts at reforming the chaebol led by Presidents Kim Dae-jung and Roh Moo-hyun focused on improving balance sheets, protecting minority shareholders' rights, limiting the total amount of investment, and improving corporate management and accountability. It remains to be seen how Moon (and Kim Sang-jo, assuming his nomination is confirmed) will proceed, but the effort will bring domestic challenges to the top industrial conglomerates' operating environment at least initially. 15 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 16 South Korea's special envoy Hong Seok-hyun claims that Trump told him at the White House that he will work closely with Moon and is willing to try engagement with Pyongyang, conditions permitting, though he is not interested in talks for the sake of talks. This fits with our view that the U.S. saber-rattling this year was designed to make the military option more credible before pursuing a new round of diplomacy. 17 Please see BCA Geopolitical Strategy "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, and Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, available at gps.bcaresearch.com. 18 So, for instance, if it should happen that, over the course of the coming debates, Abe is forced to drop his proposed revisions to the pacifist Article 9, he may still achieve changes to the amendment-making procedure in Article 96. The latter would be even more important for Japan's future, since it would make it easier for Japan to change the constitution for whatever reason in the coming decades. 19 Please see BCA Geopolitical Strategy Monthly Report, "King Dollar: The Agent Of Righteous Retribution," dated October 12, 2016, available at gps.bcaresearch.com.