Geopolitics

Feature One of BCA Research’s key geopolitical views since May 2019, outlined recently in our 2020 Outlook, is rapidly materializing: a dramatic escalation in the US-Iran conflict. On January 3 the United States successfully conducted a drone strike against a convoy carrying two high-level targets near the Baghdad International Airport. These were Iranian General Qassim Soleimani and his key Iraqi associate, Abu Mahdi al-Muhandes. The former, Soleimani, was Iran’s most influential military and intelligence leader, and one of its most powerful leaders overall. He was the head of the formidable Quds Force, the overseas arm of the Iranian Revolutionary Guard Corps (IRGC), the staunchest military wing of the regime at home and abroad. The latter target, al-Muhandes, was the head of Iraq’s Kataib Hezbollah militia and the broader coalition of pro-Iran Shiite militias in Iraq known as the Popular Mobilization Forces (PMF). This coalition was partly responsible for defeating the Islamic State in Iraq and Syria. Since then it has sought to consolidate Iranian influence in Iraq, pushing back against Iraqi Sunnis and Shia nationalists, and their allies in the US and Persian Gulf. Chart 1Bull Market In US-Iran Tensions Bull Market In US-Iran Tensions Bull Market In US-Iran Tensions The US assassinations follow a significant increase in Iranian and Iran-backed militant attacks against US allies in the Middle East this year. These stem from a breakdown in the US-Iran diplomatic detente that was enshrined in the 2015 nuclear agreement. President Donald Trump revoked this agreement in 2018 and in May 2019 imposed crippling sanctions on Iran’s oil exports and economy — initiating a “bull market” in US-Iran strategic tensions (Chart 1). Recent events show a clear path of strategic escalation — even in the wake of a summer of “fire and fury” and the extraordinary Iran-backed attack on Saudi Arabia’s Abqaiq oil refinery in September. Widespread popular unrest has dissolved the Iraqi government, creating intense competition between Iraqi nationalists, led by Moqtada al-Sadr, and Iran’s proxies, led by al-Muhandes and the PMF. This unrest marked a significant challenge to Iran’s sphere of influence and necessitated an Iranian backlash. For instance, al-Sadr’s enemies attacked his headquarters with a drone in early December. Meanwhile Kataib Hezbollah launched a spate of rocket strikes against US and Iraqi bases that culminated in the death of an American contractor near Kirkuk on December 28 — crossing an American red line. The US retaliated with damaging air strikes against Kataib Hezbollah in Iraq and Syria on December 29, prompting a PMF blockade of the US Embassy in Baghdad on December 31. While this was a limited blockade, the US has now retaliated by assassinating Soleimani and al-Muhandes, taking the conflict to a new level. There is every reason to expect tensions to escalate further in the new year. First, the Iranian regime is under severe economic stress due to the US sanctions and broader global slowdown (Charts 2A&B). Domestic protests have erupted in recent years, while the regime struggles with economic isolation, a restless youth population, and a looming succession when Supreme Leader Ali Khamenei eventually steps down. This is an existential struggle for the regime, while President Trump may only be in office for 12 months. Public opinion polls show that the Iranian populace blames the government for economic mismanagement, and yet that the renewed conflict with the US under the Trump administration is shifting the blame to US sanctions (Chart 3). Hence the regime will continue to distract the populace by resisting Trump’s pressure tactics. Chart 2ARegime Survival ... Regime Survival... Regime Survival... Chart 2B... An Existential Challenge ... An Existential Challenge ... An Existential Challenge     Chart 3US Conflict Distracts From Domestic Woes Trump And Iran: Will Maximum Pressure Work? Trump And Iran: Will Maximum Pressure Work? This tendency will be reinforced by the death of Soleimani, which heightens the regime’s vulnerability while rallying domestic support due to Soleimani’s popularity as a leader (Chart 4). The regime is looking to its survival over the long run. It would be a remarkable shift in policy for Tehran to enter negotiations with Trump, since it would then risk vindicating his “maximum pressure” doctrine, possibly helping him secure a second term in office. Chart 4Hard-Line Soleimani Was Popular (Reformist President Rouhani Is Not) Trump And Iran: Will Maximum Pressure Work? Trump And Iran: Will Maximum Pressure Work? Meanwhile President Trump’s circumstances are apparently urging him to double down on his aggressive foreign policy against Iran. First, while he will not be removed from office by a Republican Senate, his impeachment trial threatens to mar his re-election chances. This is a prime motivation to pursue foreign policy objectives to distract the public and seek policy wins. Chart 5Falling Oil Import Dependency Emboldens US Falling Oil Import Dependency Emboldens US Falling Oil Import Dependency Emboldens US Second, the Trump administration may feel emboldened by the rise of US shale oil production and decline in US oil import dependency (Chart 5). Simulations we published in our December 6 Strategic Outlook show that Iran would have to sustain an oil supply cutoff as large as the Abqaiq attack for four months in order to drive gasoline prices high enough to harm the US economy as a whole. This buffer may have convinced Trump he has plenty of room for maneuver in confronting Iran. Third, Trump undoubtedly feels the need to maintain the credibility of his threats against Iran, North Korea, and other nations given his impeachment, widely known electoral and economic vulnerability, and his recent capitulation to China in the trade war. The clear threat by Iran to create a humiliating US embassy crisis in Baghdad likely struck a nerve in the White House, reviving memories of Saigon under Gerald Ford, Tehran under Jimmy Carter, and Benghazi under Barack Obama. By taking the offensive, President Trump has reinforced the red line against the death of American citizens or attacks on US assets. Nevertheless he now runs the risk of driving Iran into further escalation rather than negotiation. Iran is not yet likely to court a full-scale American attack by shutting down the Strait of Hormuz. It is more likely to retaliate via regional proxy attacks, including cutting off oil production, pipelines, and shipping — at a time of its choosing. If Trump’s pressure tactics succeed, it will advance its nuclear program rather than staging large-scale attacks. Investment Conclusions Iraqi instability will worsen as a result of the past month’s events, bringing 3.5 million barrels of daily oil production under a higher probability of disruption than when we first flagged this risk. Supply disruptions there or elsewhere in the region would hasten the drawdown in global inventories and backwardation of prices occurring due to the revival in global demand on China stimulus and OPEC 2.0 production cuts. Continued oil volatility, as in 2018-19, should be expected, but the risk for now lies to the upside as Middle East tensions could cause an overshoot. We remain long Brent crude and overweight energy sector equities. Second, the US election — and hence US domestic and foreign policy over the next five years — could hang in the balance if the Iran conflict escalates to broader and more open hostilities as we expect. President Trump is favored for re-election. Yet we have contended since 2018 that the revocation of the Iran nuclear deal was a grave geopolitical decision that could jeopardize Trump’s economy and hence re-election — and that remains the case. Chart 6Trump 'Maximum Pressure' A Gamble In 2020 Trump 'Maximum Pressure' A Gamble In 2020 Trump 'Maximum Pressure' A Gamble In 2020 Trump was elected in part because he is viewed as strong on terrorism, and the confrontation with Iran and its proxies will reinforce that reputation in the short run. Iranian attacks will also boost Trump’s approval rating, other things being equal. However, much can change by November. Jimmy Carter’s election troubles with Iran point to a serious risk to Trump, as the initial surge in patriotic support could turn sour over time if unemployment rises as a result of any oil shocks (Chart 6). Even George Bush Jr saw a dramatic fall in approval, from a much higher base than Trump, despite foreign policy conditions that were more transparently favorable to him in 2004 than any conflict with Iran will be to Trump in 2020. Trump has campaigned against Middle Eastern wars to a war-weary public, so the rally around the flag effect will not necessarily play to his favor in the final count. It is too soon to speculate about these matters — our view remains unchanged — but the Iran conflict is now much more likely to be a major factor in the US election and Iran is certainly capable of frustrating US presidents. This reinforces our base case that Trump is only slightly favored to win. Moreover his foreign policy conflicts — in Asia as well as the Middle East — ensure that global policy uncertainty and geopolitical risk will remain elevated despite dropping off from the highs reached last year amid the trade war. We remain long pure play global defense stocks on a cyclical and secular basis. We see gold as the appropriate hedge given our expectation that the trade ceasefire and China stimulus will reinforce a global growth recovery despite Middle Eastern turmoil. Higher oil prices push up inflation expectations and limit any benefit to government bonds.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com

Feature One of BCA Research’s key geopolitical views since May 2019, outlined recently in our 2020 Outlook, is rapidly materializing: a dramatic escalation in the US-Iran conflict. On January 3 the United States successfully conducted a drone strike against a convoy carrying two high-level targets near the Baghdad International Airport. These were Iranian General Qassim Soleimani and his key Iraqi associate, Abu Mahdi al-Muhandes. The former, Soleimani, was Iran’s most influential military and intelligence leader, and one of its most powerful leaders overall. He was the head of the formidable Quds Force, the overseas arm of the Iranian Revolutionary Guard Corps (IRGC), the staunchest military wing of the regime at home and abroad. The latter target, al-Muhandes, was the head of Iraq’s Kataib Hezbollah militia and the broader coalition of pro-Iran Shiite militias in Iraq known as the Popular Mobilization Forces (PMF). This coalition was partly responsible for defeating the Islamic State in Iraq and Syria. Since then it has sought to consolidate Iranian influence in Iraq, pushing back against Iraqi Sunnis and Shia nationalists, and their allies in the US and Persian Gulf. Chart 1Bull Market In US-Iran Tensions Bull Market In US-Iran Tensions Bull Market In US-Iran Tensions The US assassinations follow a significant increase in Iranian and Iran-backed militant attacks against US allies in the Middle East this year. These stem from a breakdown in the US-Iran diplomatic detente that was enshrined in the 2015 nuclear agreement. President Donald Trump revoked this agreement in 2018 and in May 2019 imposed crippling sanctions on Iran’s oil exports and economy — initiating a “bull market” in US-Iran strategic tensions (Chart 1). Recent events show a clear path of strategic escalation — even in the wake of a summer of “fire and fury” and the extraordinary Iran-backed attack on Saudi Arabia’s Abqaiq oil refinery in September. Widespread popular unrest has dissolved the Iraqi government, creating intense competition between Iraqi nationalists, led by Moqtada al-Sadr, and Iran’s proxies, led by al-Muhandes and the PMF. This unrest marked a significant challenge to Iran’s sphere of influence and necessitated an Iranian backlash. For instance, al-Sadr’s enemies attacked his headquarters with a drone in early December. Meanwhile Kataib Hezbollah launched a spate of rocket strikes against US and Iraqi bases that culminated in the death of an American contractor near Kirkuk on December 28 — crossing an American red line. The US retaliated with damaging air strikes against Kataib Hezbollah in Iraq and Syria on December 29, prompting a PMF blockade of the US Embassy in Baghdad on December 31. While this was a limited blockade, the US has now retaliated by assassinating Soleimani and al-Muhandes, taking the conflict to a new level. There is every reason to expect tensions to escalate further in the new year. First, the Iranian regime is under severe economic stress due to the US sanctions and broader global slowdown (Charts 2A&B). Domestic protests have erupted in recent years, while the regime struggles with economic isolation, a restless youth population, and a looming succession when Supreme Leader Ali Khamenei eventually steps down. This is an existential struggle for the regime, while President Trump may only be in office for 12 months. Public opinion polls show that the Iranian populace blames the government for economic mismanagement, and yet that the renewed conflict with the US under the Trump administration is shifting the blame to US sanctions (Chart 3). Hence the regime will continue to distract the populace by resisting Trump’s pressure tactics. Chart 2ARegime Survival ... Regime Survival... Regime Survival... Chart 2B... An Existential Challenge ... An Existential Challenge ... An Existential Challenge     Chart 3US Conflict Distracts From Domestic Woes Trump And Iran: Will Maximum Pressure Work? Trump And Iran: Will Maximum Pressure Work? This tendency will be reinforced by the death of Soleimani, which heightens the regime’s vulnerability while rallying domestic support due to Soleimani’s popularity as a leader (Chart 4). The regime is looking to its survival over the long run. It would be a remarkable shift in policy for Tehran to enter negotiations with Trump, since it would then risk vindicating his “maximum pressure” doctrine, possibly helping him secure a second term in office. Chart 4Hard-Line Soleimani Was Popular (Reformist President Rouhani Is Not) Trump And Iran: Will Maximum Pressure Work? Trump And Iran: Will Maximum Pressure Work? Meanwhile President Trump’s circumstances are apparently urging him to double down on his aggressive foreign policy against Iran. First, while he will not be removed from office by a Republican Senate, his impeachment trial threatens to mar his re-election chances. This is a prime motivation to pursue foreign policy objectives to distract the public and seek policy wins. Chart 5Falling Oil Import Dependency Emboldens US Falling Oil Import Dependency Emboldens US Falling Oil Import Dependency Emboldens US Second, the Trump administration may feel emboldened by the rise of US shale oil production and decline in US oil import dependency (Chart 5). Simulations we published in our December 6 Strategic Outlook show that Iran would have to sustain an oil supply cutoff as large as the Abqaiq attack for four months in order to drive gasoline prices high enough to harm the US economy as a whole. This buffer may have convinced Trump he has plenty of room for maneuver in confronting Iran. Third, Trump undoubtedly feels the need to maintain the credibility of his threats against Iran, North Korea, and other nations given his impeachment, widely known electoral and economic vulnerability, and his recent capitulation to China in the trade war. The clear threat by Iran to create a humiliating US embassy crisis in Baghdad likely struck a nerve in the White House, reviving memories of Saigon under Gerald Ford, Tehran under Jimmy Carter, and Benghazi under Barack Obama. By taking the offensive, President Trump has reinforced the red line against the death of American citizens or attacks on US assets. Nevertheless he now runs the risk of driving Iran into further escalation rather than negotiation. Iran is not yet likely to court a full-scale American attack by shutting down the Strait of Hormuz. It is more likely to retaliate via regional proxy attacks, including cutting off oil production, pipelines, and shipping — at a time of its choosing. If Trump’s pressure tactics succeed, it will advance its nuclear program rather than staging large-scale attacks. Investment Conclusions Iraqi instability will worsen as a result of the past month’s events, bringing 3.5 million barrels of daily oil production under a higher probability of disruption than when we first flagged this risk. Supply disruptions there or elsewhere in the region would hasten the drawdown in global inventories and backwardation of prices occurring due to the revival in global demand on China stimulus and OPEC 2.0 production cuts. Continued oil volatility, as in 2018-19, should be expected, but the risk for now lies to the upside as Middle East tensions could cause an overshoot. We remain long Brent crude and overweight energy sector equities. Second, the US election — and hence US domestic and foreign policy over the next five years — could hang in the balance if the Iran conflict escalates to broader and more open hostilities as we expect. President Trump is favored for re-election. Yet we have contended since 2018 that the revocation of the Iran nuclear deal was a grave geopolitical decision that could jeopardize Trump’s economy and hence re-election — and that remains the case. Chart 6Trump 'Maximum Pressure' A Gamble In 2020 Trump 'Maximum Pressure' A Gamble In 2020 Trump 'Maximum Pressure' A Gamble In 2020 Trump was elected in part because he is viewed as strong on terrorism, and the confrontation with Iran and its proxies will reinforce that reputation in the short run. Iranian attacks will also boost Trump’s approval rating, other things being equal. However, much can change by November. Jimmy Carter’s election troubles with Iran point to a serious risk to Trump, as the initial surge in patriotic support could turn sour over time if unemployment rises as a result of any oil shocks (Chart 6). Even George Bush Jr saw a dramatic fall in approval, from a much higher base than Trump, despite foreign policy conditions that were more transparently favorable to him in 2004 than any conflict with Iran will be to Trump in 2020. Trump has campaigned against Middle Eastern wars to a war-weary public, so the rally around the flag effect will not necessarily play to his favor in the final count. It is too soon to speculate about these matters — our view remains unchanged — but the Iran conflict is now much more likely to be a major factor in the US election and Iran is certainly capable of frustrating US presidents. This reinforces our base case that Trump is only slightly favored to win. Moreover his foreign policy conflicts — in Asia as well as the Middle East — ensure that global policy uncertainty and geopolitical risk will remain elevated despite dropping off from the highs reached last year amid the trade war. We remain long pure play global defense stocks on a cyclical and secular basis. We see gold as the appropriate hedge given our expectation that the trade ceasefire and China stimulus will reinforce a global growth recovery despite Middle Eastern turmoil. Higher oil prices push up inflation expectations and limit any benefit to government bonds.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com

As 2019 draws to a close, we thank you for your ongoing readership and support. We wish you and your loved ones a happy holiday season and all the best for a healthy and prosperous 2020. Highlights We explore the principal risks to our optimistic 2020 outlook. Trade and the 2020 US Presidential election remain potential landmines. A stronger dollar would tighten global financial conditions and be deflationary. Credit market tremors would end buybacks. Stronger-than-expected inflation would force a cycle-ending Federal Reserve tightening. Weaker-than-expected inflation would first allow for larger bubbles to form at the expense of a more painful recession and deeper a bear market down the road. Hedging against those risks warrants overweighting cash, TIPs and gold. Feature Chart I-1Timing is Ripe For A Recovery Timing is Ripe For A Recovery Timing is Ripe For A Recovery As always, this year’s visit from Ms. and Mr. X was thought-provoking and generated diverse investment ideas.1 While we did not share Mr. X’s fears, his caution may be justified because an aging business cycle, elevated equity multiples and extremely expensive government bonds do not mesh with pro-risk portfolio positioning. With this in mind, we will explore the greatest risks to our positive market outlook, which include politics, the US dollar, problems in the credit market, a quicker resumption of inflation and lower inflation. The Central Scenario To understand how these five risks affect our central thesis, let’s review the key views and themes that underpin our bullish outlook. BCA expects global economic activity to recover in 2020. First, the global inventory contraction is advanced, which increases the chance that the manufacturing cycle will track its usual pattern of an 18-month decline followed by an 18-month acceleration (Chart I-1). Secondly, Chinese policymakers are putting a floor under domestic economic activity and the stabilization in credit growth and the climbing fiscal impulse already augur well for global growth (Chart I-2). Thirdly, global liquidity is in a major upswing, thanks to easing by central banks around the world (Chart I-3). Finally, the trade détente between the US and China agreed last week reduces the odds of a destructive trade war. Chart I-2China's Policy Turnaround China's Policy Turnaround China's Policy Turnaround Chart I-3Easing Abound! Easing Abound! Easing Abound!   US monetary policy will remain accommodative next year. US inflation will remain subdued in the first half of 2020 in response to both the global growth slowdown underway since mid-2018 and the lagged effect of a stronger dollar. Moreover, Fed policy will remain sensitive to inflation expectations. According to BCA’s US Bond Strategy’s model, it could take an extended overshoot in realized inflation before inflation expectations move back to the 2.3% to 2.5% range consistent with achieving a 2% inflation target (Chart I-4). Thus, the Fed will remain on pause for all of 2020. BCA’s positive outlook depends on both China and the US respecting their trade truce. In this context, the dollar will depreciate. The USD is a countercyclical currency and typically suffers when global economic activity rebounds, especially if inflation remains tame (Chart I-5). This behavior is due to the low share of the US economy dedicated to manufacturing and exports, which makes the US less sensitive to global trade and industrial activity. Moreover, when the world economy strengthens, safe-haven flows that boost the dollar in times of duress reverse, which accentuates the selling pressure on the USD. Chart I-4Realized Inflation Will Guide Expectations Realized Inflation Will Guide Expectations Realized Inflation Will Guide Expectations Chart I-5The Dollar Won't Respond Well To Stronger Global Growth The Dollar Won't Respond Well To Stronger Global Growth The Dollar Won't Respond Well To Stronger Global Growth   Global bond prices will be another victim of an improving economic outlook. Global safe-haven securities are extremely expensive and investors are too bullish toward this asset class (Chart I-6). This puts government bonds at risk in the face of positive economic surprises. However, the upside in Treasury yields will be capped between 2.25 and 2.5% because the Fed will be cautious about lifting rates. This move will likely be led by inflation expectations. As a result, we favor TIPs over nominal Treasurys. Chart I-6Safe-Haven Yields Have Upside Safe-Haven Yields Have Upside Safe-Haven Yields Have Upside Chart I-7Investors Aren't Feeling Exuberant About Earnings Growth Investors Aren't Feeling Exuberant About Earnings Growth Investors Aren't Feeling Exuberant About Earnings Growth   Equities will outperform bonds. The S&P 500 is trading at 18-times forward earnings and 2.3-times sales. However, those elevated multiples are due to depressed risk-free rates. Long-term growth expectations embedded in stock prices are only 1%, toward the bottom of this series’ historical distribution (Chart I-7). Therefore, investors are not particularly optimistic on the long-term prospects of per-share earnings. This lack of euphoria implies that stocks are not as expensive as bonds, and that if yields climb because of improving global economic activity, then equities will outperform bonds. Moreover, with a backdrop of easy money and no recession forecast until 2022, the timing still favors positive returns for equities in the coming 12 to 18 months (Table I-1).   Table I-1The End Game Can Be Rewarding January 2020 January 2020 Finally, we favor European equities over US stocks. This regional slant is as much a reflection of the better value offered by European stocks as it is of their sector composition. European stocks are trading at a forward PE of 14, implying an equity risk premium of 846 basis points versus 546 basis points in the US. Moreover, our preference for industrials, energy and financials favors European equities (Table I-2). Additionally, European banks are our favorite equity bet worldwide because they trade at a price-to-book ratio of only 0.6 and the drivers of their return on tangible equity are perking up (Chart I-8). Table I-2Europe: Overweight In The Right Sectors January 2020 January 2020 Chart I-8Brightening Prospects For Euro Area Banks Brightening Prospects For Euro Area Banks Brightening Prospects For Euro Area Banks     Risk 1: Politics BCA’s positive outlook depends on both China and the US respecting their trade truce. However, the two countries are long-term rivals and the rising geopolitical power of China relative to the US will cause tensions to escalate in the coming decades (Chart I-9). This also suggests that China and the US are highly unlikely to ever have an agreement that fully covers intellectual property transfers. Chart I-9China/US Tensions Are Structural China/US Tensions Are Structural China/US Tensions Are Structural The US could still renege on the “Phase One” deal. President Trump faces an election in 2020 and the majority of Democratic hopefuls are also hawkish on China. If Trump’s low approval rating does not improve soon (Chart I-10), he could become a more war-like president, in the hope that electors will rally around the flag. A renewed trade war would hurt business sentiment and undermine consumer spending (Chart I-11). A bellicose approach to international relations, especially on trade, would spark another spike in global policy uncertainty that will hurt global capex intentions. Meanwhile, companies could cut employment, which would weigh on household incomes. A rising unemployment rate could also hurt household confidence, reinforcing the slowdown in consumer spending. This would guarantee an earlier recession. Stocks would decline along with global government bond yields. Chart I-10President Trump Can Still Make It January 2020 January 2020 Chart I-11Households On The Edge Households On The Edge Households On The Edge   The US election creates an additional political risk. Democratic candidates are touting higher corporate taxes, a wealth tax, a greater regulatory burden, antitrust actions, and so on. These policies are worrisome to corporate leaders and business owners. For the time being, our Geopolitical Strategy team favors a Trump victory in 2020 (Chart I-12).2 However, if his odds deteriorate significantly, then business executives would likely curtail capex and hiring. This could also result in a US recession that would invalidate our central scenario for 2020. Chart I-12Our Model Still Favors President Trump January 2020 January 2020 Risk 2: A Strong Dollar A strong US dollar would hurt growth. A continued dollar rally would counteract a large proportion of the easing in liquidity conditions created by accommodative central banks around the world. The dollar affects the global cost of capital. Both advanced economies and emerging markets have USD-denominated foreign currency debt totaling around $6 trillion each. A strong USD raises the cost of servicing this large debt load, which could force borrowers to curtail their spending. A continued dollar rally would counteract a large proportion of the easing in liquidity conditions created by accommodative central banks around the world. Despite our conviction that the US dollar will depreciate in 2020, the following factors may invalidate our thesis: The USD still possesses the highest carry in the G10. When the dollar is supported by some of the highest interest rates in the G10, it often continues to rally (Chart I-13). Chart I-13The Dollar Offers An Elevated Carry The Dollar Offers An Elevated Carry The Dollar Offers An Elevated Carry The global growth rebound may be led by the US. If the US leads the rest of the world higher, then rates of return in the US would climb quicker than in the rest of the world. The resulting capital inflows would bid up the dollar. The shortage of USDs in offshore markets may flare up again. The September seize-up in the repo market was a reminder that because of the Basel III rules, global banks have a strong appetite for high-quality collateral and reserves. This generates substantial demand for the USD, which could put upward pressure on its exchange rate. The US dollar is a momentum currency. Among the G10 currencies, the USD responds most strongly to the momentum factor (Chart I-14).3 The dollar’s strength in the past 18 months could initiate another wave of appreciation. The dollar may not be as expensive as suggested by purchasing power parity (PPP) models. According to PPP estimates, the trade-weighted dollar is 24.2% overvalued. However, according to behavioral effective exchange rate models (BEER), the dollar may be trading closer to its fair value (Chart I-15). Chart I-14The Dollar Is A Momentum Currency January 2020 January 2020 Chart I-15Is The Dollar Expensive? Is The Dollar Expensive? Is The Dollar Expensive?   Why are the five items listed above risks for the dollar, but not our central scenario? Regarding the dollar’s carry, in 1985, 1999, and 2006, the US still offered some of the highest short-term interest rates among advanced economies, nevertheless the dollar began to depreciate. In those three instances, an acceleration in foreign economic activity relative to the US was the key culprit behind the USD’s weakness. In 2020, we expect foreign economies to lead the US higher. Since mid-2018, the manufacturing sector has been at the center of the global slowdown. But now, inventory and monetary dynamics point towards a re-acceleration in manufacturing activity. The US was the last nation to be hit by the growth slowdown; it will also be the last to reap a dividend from the recovery. The marginal buyers of US equities have been US firms. On the danger created by the dollar and the collateral shortage, the Fed is tackling the lack of excess reserves head-on by injecting $60 billion per month of reserves via its asset purchases. Moreover, the US fiscal deficit, which is tabulated to reach $1.1 trillion in 2020, will add a similar amount of dollars to the pool of high-quality collateral around the world, especially as the US current account deficit is widening anew. On the momentum tendency of the USD, the dollar’s momentum seems to be petering off. A move in the Dollar Index below 96 would indicate a major change in the trend for the DXY. Finally, estimates of a currency’s fair value based on BEER fluctuate much more than those based on PPP. If the global growth pick-up allows foreign neutral rates to increase relative to the US over the coming 12 to 24 months, then the dollar’s BEER equilibrium will likely converge toward PPP, putting downward pressure on the USD. Risk 3: Credit Market Tremors A credit market selloff is not our base case, but it would be damaging to risk assets. A deterioration in credit quality would be the main culprit behind a widening in credit spreads. Our Corporate Health Monitor already shows that the credit quality of US firms is worsening (Chart I-16). Moreover, the return on capital of the US corporate sector is rapidly deteriorating. Accentuating these risks, US profit margins have begun to decline because a tight labor market is exerting an upward pull on real unit labor costs (Chart I-17). Furthermore, the near-total disappearance of covenants in new corporate bond issuance increases the risks to lenders and will likely depress recovery rates when a default wave emerges. Chart I-16Deteriorating Fundamentals For US Corporates Deteriorating Fundamentals For US Corporates Deteriorating Fundamentals For US Corporates Chart I-17A Tight Labor Market Is Biting Into Margins A Tight Labor Market Is Biting Into Margins A Tight Labor Market Is Biting Into Margins     Widening credit spreads would signal a darkening economic outlook. Historically, wider spreads have been an excellent leading indicator of recessions (Chart I-18). Wider spreads have a reflexive relationship with the economy: they reflect anticipation of rising defaults by investors, but they also represent a price-based measure of lenders’ willingness to extend credit. Therefore, wider spreads force open the underlying cracks in the economy by depriving funds to weak borrowers. The resulting deterioration in capex and hiring would prompt a decline in consumer confidence and spending, ultimately leading to a recession. Chart I-18Widening Spreads Foreshadow Recessions Widening Spreads Foreshadow Recessions Widening Spreads Foreshadow Recessions Chart I-19Who Is Buying Stocks? Businesses! Who Is Buying Stocks? Businesses! Who Is Buying Stocks? Businesses! US equities may prove to be even more sensitive to the health of the credit market than in previous cycles. The marginal buyers of US equities have been US firms, which have engaged in equity retirements totaling $16.5 trillion since 2010. Since that date, pension plans, foreigners and households have sold a total of $7.7 trillion in US equities (Chart I-19). Both internally generated cash flows and borrowings have allowed for a decline in the equity portion of funding among US firms. Therefore, a weak credit market would hurt equities because a recession would depress firms’ free cash flows and hamper the capacity of firms to buy back their shares. Finally, the tendency of US firms to borrow to buy back their shares means that newly issued debt has not been matched by as much asset growth as in previous cycles. Therefore, borrowing is not backed by the same degree of collateral as in past cycles. If the credit market seizes up, then default and recovery rates will suffer even more than suggested by our corporate health monitor. The VIX will blow up and equities could suffer. Higher US inflation is potentially the most important downside risk for next year. While a widening in credit spreads would have a profound impact on stocks, it is unlikely to materialize when the Fed conducts a very accommodative monetary policy and global growth recovers. Risk 4: Higher Inflation Chart I-20The US Labor Market Is Tight The US Labor Market Is Tight The US Labor Market Is Tight Higher US inflation is potentially the most important downside risk for next year as it would catalyze the aforementioned dangers. Inflation could surprise to the upside because the labor market is tight. At 3.5%, the unemployment rate is well below equilibrium estimates that range between 4.1% and 4.6%. Small firms are increasingly citing their inability to find qualified labor as the biggest constraint to expand production. In the Conference Board Consumer Confidence survey, the number of households reporting that jobs are easily procured is near a record high relative to those preoccupied by poor job prospects. Finally, the voluntary quit rate is at 2.3%, a near record high (Chart I-20). Core PCE remains at only 1.6% year-on-year, but investors should recall the experience of the late 1960s. Through the 1960s, the labor market was tight, yet core inflation remained between 1% and 2%. However, in 1966, inflation suddenly accelerated to 4% before peaking near 7% in 1970. Some inflation dynamics warrant close monitoring. The three-month annualized rate of service inflation excluding rent of shelter has already surged to 4.5% and the same metric for medical care inflation stands at 5.9%. A continued tightening in the labor market could solidify a broadening of these trends because a rising employment-to-population ratio for prime-age workers points toward stronger salaries and ultimately higher domestic demand (Chart I-21). A very weak dollar would also allow this scenario to develop. Chart I-21Household Income Growth Will Accelerate January 2020 January 2020 A sudden flare in inflation would prompt an abrupt tightening in liquidity conditions that would be lethal for the economy. An out of the blue surge in CPI would likely cause a swift reassessment of inflation expectations by households and investors. Under these circumstances, the Fed could tighten monetary policy much faster than we currently envision. If interest rate markets are forced to price in a prompt removal of monetary accommodation, Treasury yields could easily spike above 3.5% by year end, which would hurt both the economy and the expensive equity market. If realized inflation turns out weaker than we expect in 2020, then central banks will maintain accommodative policies beyond next year. For now, this scenario remains a tail risk because the recent economic slowdown will probably continue to act as a dampener on US inflation in the first half of the year. Additionally, we do not expect the USD to collapse by 40% and fan inflation and inflation expectations, as occurred from 1985 to 1987. Instead, inflation expectations are much better anchored than they were in either the 1960s or 1980s, decreasing the risk that the Fed will suddenly have to tighten policy. Risk 5: Weaker-Than-Expected Inflation Chart I-22An Aggressive BoJ Did Not Achieve Inflation An Aggressive BoJ Did Not Achieve Inflation An Aggressive BoJ Did Not Achieve Inflation The last risk is paradoxical, but it is the one with the highest probability. It is paradoxical because it involves greater upside for stocks next year than we currently anticipate, but at the expense of a much deeper bear market in the future. The labor market may be tight, but Japan’s experience cautions us against extrapolating that inflation is necessarily around the corner. In Japan, the unemployment rate has been below 3.5% since 2014 and minimal domestically generated inflation has emerged. Inflation excluding food and energy remains at a paltry 0.7% year-on-year, even as the Bank of Japan has kept the policy rate at -0.1% and expanded its balance sheet from 20% of GDP in 2008 to 102% today (Chart I-22). If realized inflation turns out weaker than we expect in 2020, then central banks will maintain accommodative policies beyond next year. Central banks are currently toying with their inflation targets, discussing allowing inflation overshoots and displaying deep paranoia in the face of deflation. By weighing on inflation expectations, low realized inflation would nail policy rates around the world at currently depressed levels or even lower. Chart I-23Bubbles Destroy Long-Term Return On Capital Bubbles Destroy Long-Term Return On Capital Bubbles Destroy Long-Term Return On Capital In this context, bond yields would have even more limited upside than we envision and risk assets could experience higher multiples than today. In other words, we would have a perfect scenario for another stock market bubble. Vulnerability would escalate as valuations balloon and the perceived risk of monetary tightening dissipates from both investors’ and economic agents’ minds. Elevated asset valuations portend lower long-term expected returns (Chart I-23) and a larger share of the capital stock would become misallocated. Ultimately, the stimulative impact of such a bubble would create its own inflationary pressures. Consumers and companies would accumulate more debt and cyclical spending would rise (Chart I-24). In the end, the Fed would raise rates more aggressively, but the economy would be more vulnerable to those higher rates. Chart I-24Higher Cyclical Spending Creates Vulnerabilities Higher Cyclical Spending Creates Vulnerabilities Higher Cyclical Spending Creates Vulnerabilities Therefore, we would see a larger recession and, because assets are more expensive, a greater decline in prices. This would be extremely destabilizing for the global economy, potentially much more so than if a recession were to emerge today. Moreover, since the resulting slump would be yet another balance-sheet recession, it would likely entail a lack of capacity by central banks to reflate their economies. Conclusion The scenarios above are all risks to our benign view for 2020. The first four represent downside threats for assets next year, but the last one (weaker-than-expected inflation) entails upside potential to our forecast next year with significantly more painful results down the line. These risks are important to consider when protecting our portfolio, which has a pro-cyclical bias. It is overweight stocks, underweight bonds, and favors cyclical equities as well as foreign bourses at the expense of the US. BCA’s Global Asset Allocation service recently published an article on safe havens, which studied the profile of risk assets under various circumstances.4 Treasurys normally are the best safe haven, however, at current levels of yields, this benefit will be small compared with previous cycles. Instead, we favor an overweight position in cash, TIPs and gold. The best defense against short-term gyrations is to think about long-term strategic asset allocation. In this regard, this month’s Special Report – co-authored with BCA’s Equity, Geopolitical and Foreign Exchange Strategists, and Marko Papic, Chief Strategist at Clocktower Group – discusses our top sector calls for the upcoming decade. Mathieu Savary Vice President The Bank Credit Analyst December 20, 2019 Next Report: January 30, 2020   II. Top US Sector Investment Ideas For The Next Decade Every decade a dominant theme captures investors’ imaginations and morphs into a bubble. Massive speculation typically propels the relevant asset class into the stratosphere as investors extrapolate the good times far into the future and go on a buying frenzy. Chart II-1 shows previous manic markets starting with the Nifty Fifty, gold bullion, the Nikkei 225, the NASDAQ 100, crude oil and most recently the FAANGs. Chart II-1Manias: An Historical Roadmap Manias: An Historical Roadmap Manias: An Historical Roadmap What will be the dominant themes of the next decade? How should investors capitalize on some of these big trends? The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Theme #1: De-Globalization Picks Up Steam The first investment theme for the upcoming decade is the “apex of globalization” or “de-globalization”. We have written about this theme extensively at BCA Research and it is the mega-theme of our sister Geopolitical Strategy (GPS) service. Odds are high that countries will continue looking inward as the US adopts a more aggressive trade policy, China’s trend growth slows, and US-China strategic tensions intensify. The small cap preference is a secular view with a time horizon that spans the next decade. Chart II-2 shows that we are at the conclusion of a period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. The US is in a relative decline after decades of geopolitical stability allowed countries like China to rise to “great power” status and rivals like Russia to recover from the chaos of the 1990s. Chart II-2De-globalization Has Commenced De-globalization Has Commenced De-globalization Has Commenced De-globalization has become the consensus since the election of Donald Trump. But Trump is not the prophet of de-globalization; he is its acolyte. Globalization is ending because of structural factors, not cyclical ones. Three factors stand at the center of this assessment, outlined in our 2014 Special Report, “The Apex Of Globalization – All Downhill From Here”: multipolarity, populism and protectionism. Events have since confirmed this view. One final long-term playable investment idea from the apex of globalization is a structural bull market in defense stocks. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Investment Implication #1: Profit Margin Peak The most profound and provocative investment implication from de-globalization is that SPX profit margins have peaked and will likely come under intense pressure, especially for US conglomerates that – on a relative basis to international peers – most enthusiastically embraced globalization. Chart II-3 shows reconstructed S&P 500 profits and sales data back to the late-1920s. Historically, corporate profit margins and globalization (depicted as global trade as a percentage of GDP) have been positively correlated. Chart II-3Profit Margin Trouble Profit Margin Trouble Profit Margin Trouble As countries are more outward looking, trade flourishes and openness to trade allows the free flow of capital to take advantage of profit-maximizing projects. Following the Great Recession and similar to the Great Depression, trade has suffered and trade barriers have risen. The Sino-American trade war has accelerated the inward movement of countries, including Korea and Japan, and has had negative knock-on effects on trade as evidenced by the now two-year old global growth deceleration. China’s response to President Trump’s election was to redouble its pursuit of economic self-sufficiency, which meant a crackdown on corporate debt and a fiscal boost to household consumption. Trump’s tariffs then damaged sentiment and trade between the two countries. Any deal reached prior to the 2020 US election will remain in doubt among global investors. The longer the trade war remains unresolved, the deeper the cracks will be in the foundations of the global trading system. We are especially worried for the S&P interactive media & services index that includes GOOGL and FB. Such a backdrop is negative for profit margins, as inward looking countries prevent capital from being allocated most efficiently. Moreover, the uprooting of supply chains due to the trade war hurts margins and the redeployment of equipment in different jurisdictions will do the same at a time when final demand is suffering a setback. In addition, rising profit margins are synonymous with wealth accruing to the top 1% of US families and vice versa. This relationship dates back to the late-1920s, as far back as our dataset goes. Using Piketty and Saez data, which exclude capital gains, it is clear that profit margin expansion exacerbates income inequality (top panel, Chart II-4). Chart II-4Heightened Risk Of Wealth Re-distribution Heightened Risk Of Wealth Re-distribution Heightened Risk Of Wealth Re-distribution Expanding margins lead to higher profits. Because families at the top of the income distribution are often business owners, income disparities are the widest when margins are in overshoot territory. Eventually this income chasm comes to a head and generates political discontent. Populism has emerged on both the right and left wings of the US political spectrum – and since the rise of Trump, even Republicans complain about inequality and the excesses of “corporate welfare” and laissez-faire capitalism. Because inequality is extreme – relative to America’s developed peers – and political forces are mobilizing against it, the probability of wealth re-distribution is rising in the coming decades (middle panel, Chart II-4). Labor’s share of national income has nowhere to go but higher in coming years and that is negative for profit margins, ceteris paribus (bottom panel, Chart II-4). Buy or add software stock exposure on any weakness with a 10-year investment time horizon. Drilling beneath the surface, the three secular US equity sector/factor implications of the apex of globalization paradigm shift are: prefer small caps over large caps prefer value over growth overweight the pure-play BCA Defense Index Investment Implication #2: Small Is Beautiful Chart II-5It's A Small World After All It's A Small World After All It's A Small World After All While a small cap bias is contrary to the cyclical US Equity Strategy view of preferring large caps to small caps, the issue is timing: the small cap preference is a secular view with a time horizon that spans the next decade. The small versus large cap share price ratio’s ebbs and flows persist over long cycles. Small caps outshined large caps uninterruptedly from 1999 to 2010. Since then large caps have had the upper hand (Chart II-5). Were the apex of globalization theme to gain traction in the 2020s, small caps should reclaim the lead from large caps, especially in the wake of the next US recession. Similar to the death of the global banking model, companies with global footprints will suffer the most, especially compared with domestically focused outfits. One way to explore this theme is via domestic versus global sector preference. But a more investable way to position for this sea change, is to buy small caps (or microcaps) at the expense of large caps (or mega caps). Small caps are traditionally domestically geared compared with large caps that have significantly more foreign sales exposure. The closest ETF ticker symbols resembling this trade is long IWM:US/short SPY:US. Investment Implication #3: Buy Value At The Expense Of Growth Similar to the size bias, the style bias also moves in secular ways. Value outperformed growth from the dot com bust until the GFC. Since then growth has crushed value, even temporarily breaking below the year 2000 relative trough. This breakneck pace of appreciation for growth stocks is clearly unsustainable and offers long-term oriented investors a compelling entry point near two standard deviations below the historical mean (Chart II-6). Chart II-6Value Has The Upper Hand Versus Growth Value Has The Upper Hand Versus Growth Value Has The Upper Hand Versus Growth Financials populate value indexes, a similarity with small cap outfits. Traditionally, financials are a domestically focused sector with export exposure registering at half of the S&P’s average 40% level of internationally sourced revenues. On the flip side, tech stocks sit atop the growth table and they garner 60% of their revenue from abroad. This value over growth style preference will pay handsome dividends if the de-globalization theme becomes more mainstream as countries become more hawkish on trade and the Sino-American war continues to erect barriers to trade that took decades to lift. We have created a basket of ten stocks that we think will be driven over the long term by the demographic rise of the Millennial. The caveat? President Trump's recent short-term deal with China could set back the de-globalization theme. But our geopolitical strategists do not anticipate it to be a durable deal, and they also expect the trade war to resume in some way, shape or form in 2021-22, regardless of the outcome of the US election. The closest ETF ticker symbols resembling this trade is long IVE:US/short IVW:US. Investment Implication #4: Defense Fortress Chart II-7Stick With Pure-play Defense Stocks Stick With Pure-play Defense Stocks Stick With Pure-play Defense Stocks One final long-term playable investment idea from the apex of globalization is a structural bull market in defense stocks (Chart II-7). The US Equity Sector service's October 2016 “Brothers In Arms” Special Report drew parallels with the late nineteenth century period of European rearmament, and the American and Soviet arms race of the 1960s.5 These movements were greatly beneficial to the aerospace and defense industry. Currently, the move by several countries to adopt more independent foreign policies, i.e. to move away from collaboration and cooperation toward isolationism and self-sufficiency, entails an accompanying arms race. Table II-1 January 2020 January 2020 China’s challenge to the regional political status quo motivates a boost to defense spending globally. In fact, SIPRI data on global military spending by 2030 (Table II-1) increases our conviction that this trade will succeed on a five-to-ten year horizon. Beyond the global arms race, two additional forces are at work underpinning pure-play defense contractors. A global space race with China, India and the US wanting to have manned missions to the moon, and the rise of global cybersecurity breaches. Defense companies are levered to both of these secular forces and should be prime sales and profit beneficiaries of rising space budgets and increasing cybersecurity combat budgets. The ticker symbols for the stocks in the pure-play BCA defense index are: LMT, RTN, NOC, GD, HII, AJRD, BWXT, CW, MRCY. Theme #2: Tech Sector Regulation, US Enacts Privacy Laws The second long-term geopolitical theme that we are exploring is the regulatory or “stroke of pen” risk that is rising on FAANG stocks – Facebook, Apple, Amazon, Netflix, and Google. These companies were this decade’s undisputed stock market winners. The US anti-trust regulatory framework was designed to curb broad anti-competitive actions of trusts. As Lina Khan discusses in her seminal article, these actions “include not only cost but also product quality, variety, and innovation.” However, through subsequent regulatory evolution, the Chicago School has focused the US anti-trust process on consumer welfare and prices. If President Reagan and the courts could change how anti-trust laws were administered in the 1980s, so too can future administrations and courts. Today the US Congress, on both sides of the aisle, is looking into regulatory tightening, while the judicial system will take longer to change its approach. Moreover, the impetus for tougher anti-trust policy is here. It comes from a long period of slow growth, income inequality, and economic volatility – such as in the 1870s-80s. This was certainly the case for Standard Oil in 1911, which became a nation-wide boogeyman despite most of its transgressions occurring in the farm belt states. Today, income inequality is a prominent political theme and source of consumer discontent. A narrative is emerging – which will be super-charged during the next recession – that growth has been unequally distributed between the old economy and the twenty-first century technology leaders. While there are a few ESG related ETFs, we would rather explore this theme’s investment implications of sectors to avoid in the coming decade. With regard to privacy, the news is equally grim for large tech outfits. The EU General Data Protection Regulation (GDPR), which came into force on May 2018, imposes compliance burdens on any company handling user data. In the US, California has signed its own version of the law – the Consumer Privacy Act – which will go into effect in January 2020. These laws give consumers the right to know what information companies are collecting about them and who that data is shared with. They also allow consumers to ask technology companies to delete their data or not to sell it. While tech companies are likely to fight the new California law, and the US court system is a source of uncertainty, we believe the writing is on the wall. The EU is by some measures the largest consumer market on the planet. California is certainly the largest US market. It is unlikely that the momentum behind consumer protection will change, especially with the EU and California taking the lead. The odds of a federal privacy law, following in the footsteps of the Consumer Privacy Act, are also rising. Investment Implication #5: Shun Interactive Media & Services Stocks These risks introduce a severe overhang for FAANG stocks. We are especially worried for the S&P interactive media & services index that includes GOOGL and FB. Chart II-8Regulation Will Squeeze Tech Margins Regulation Will Squeeze Tech Margins Regulation Will Squeeze Tech Margins Tack on the threat of federal regulation and this represents another major headwind for profits and margins that are extremely elevated for these near monopolies. Given that advertising revenue is crucial to the business model of social media companies (GOOGL and FB included), a significant uptick in privacy regulation will likely hurt their bottom line. With regard to profit margins, tech stocks in general command a profit margin twice as high as the SPX. Specifically, FB and GOOGL enjoy margins that are 500 basis points higher than the broad tech sector (Chart II-8)! This is unsustainable and they will likely serve as easy prey for policymakers. Our view does not necessarily call for breaking up these monopolies. The US will have to weigh the economic consequences of anti-trust policy in a context of multipolarity in which China’s national tech champions are emerging to compete with American companies for global market share. Nevertheless, increased regulation is inevitable and some forced sales of crown jewel assets may take place. Moreover, the threat of a breakup will lurk in the background, creating uncertainty until key legislative and judicial battles have already been fought. That will take years. Finally, we doubt the tech sector will be left alone to “self-regulate” its incumbents and negotiate a price on consumers’ privacy. More likely, a new privacy law will loom, serving as a negative catalyst for profit growth. Uncertainty will weigh on the S&P interactive media & services relative performance. The ticker symbols to short/underweight the S&P interactive media & services index are an equally weighted basket of GOOGL and FB (they command a 98% market cap weight in the index). Theme #3: SaaS, Artificial Intelligence, Augmented Reality And Autonomous Driving Are Not Fads The third big theme that will even outlive the upcoming decade is the proliferation of software as a service (SaaS). The move to cloud computing and SaaS, the wider adoption of artificial intelligence, machine learning, autonomous driving and augmented reality are not fads, but enjoy a secular growth profile. In the grander scheme of things today’s world is surrounded by software. Millions of lines of code go even into gasoline powered automobiles, let alone electric vehicles. Autonomous driving is synonymous with software, the Internet of Things (IoT) needs software, the space race depends on software, modern manufacturing and software are closely intertwined, phone calls for quite some time have been a software solution, and the list goes on and on. This tidal effect is hard to reverse and is already embedded in workflows across industries. Opportunities to penetrate health care and financial services more deeply remain unexplored and it is difficult to envision another competing industry unseating “king software”. These secular trends are not only productivity enhancing, but will also most likely prove recession-proof. When growth is scarce investors flock to any source of growth they can come by and we are foreseeing that when the next recession arrives, investors will likely seek shelter in pure play SaaS firms. Investment Implication #6: Software Is Eating The World Chart II-9Software Is Eating The World Software Is Eating The World Software Is Eating The World Buying software stocks for the long haul seems like a bulletproof investment idea. But the recent stellar performance of software stocks has moved valuations to overshoot territory. Our recommended strategy is to buy or add software stock exposure on any weakness with a 10-year investment time horizon. All of these secular trends have pushed capital outlays on software into a structural uptrend. Software related capex is not only garnering a larger slice of the tech spending budgets but also of the overall capex pie. If it were not for software capex, the contraction in non-residential investment in recent quarters would have been more severe (Chart II-9). Private sector software capex is near all-time highs as a share of total outlays. Government investment in software is also reaccelerating at the fastest pace since the tech bubble. When productivity gains are anemic, both the business and government sectors resort to software upgrades in order to boost productivity. Cyber security is another more recent source of software related demand as governments around the globe are taking such risks extremely seriously (bottom panel, Chart II-9). Given this upbeat demand backdrop and ongoing equity retirement, software stocks are primed to grow into their pricey valuations. Finally, this long-term trade will also serve as a hedge to the short/underweight position we recommend in the S&P interactive media & services index. The closest ETF ticker symbol resembling the S&P software index is IGV:US. Theme #4: Millennials Already Are The Largest Cohort And Will Dominate Spending The fourth long-term theme we anticipate to gain traction in the 2020s is the demographic rise of the Millennial generation. Much has been made of preparing for the arrival of the Millennial generation, accompanied by well-worn stereotypes of general "failure to launch" as they reach adulthood. However, "arrival" is a misnomer as this age cohort is already the largest and "failure" is simply untrue. According to the US Census Bureau, Millennials are the US’s largest living generation. Millennials (or Echo Boomers) defined as people aged 18 to 37 (born 1982 to 2000), now number more than 80mn and represent more than one quarter of the US’s population. Baby Boomers (born 1946 to 1964) number about 75mn. Stealthily becoming the largest age group in the US over the last few years, Millennials per-year-birth-rate peaked at 4.3mn in 1990. Surprisingly, the pace matched that of the post-war Baby Boom peak-per-year-birth-rate in 1957 - the per-year average over the period was higher for the Baby Boomers (Chart II-10). Chart II-10Millennials Are The Largest Cohort Millennials Are The Largest Cohort Millennials Are The Largest Cohort This gap is now set to grow rapidly as the death rate of Baby Boomers accelerates. What is more, the largest one-year age cohort is only 25 years old, thus, Millennials will be the dominant generation for many years. It is unclear how these “kids” will impact the market as they become the most important consumers, borrowers and investors, but make no mistake: this is a seismic shift in economic power and it is here to stay. The Echo Boom is a big, generational demographic wave. A difficult and painful delay has not tempered its looming importance. Finally, this wave of echo-boomers is educated, relatively unburdened by debt (please see BOX in the June 11, 2018 Special Report on demystifying the student debt load as it pertains to Millennials), and as they inevitably “grow up”, form new households and have kids. They will borrow, spend, earn, but not necessarily save and invest to the same extent as the Boomers. And this will be an important long-term theme going forward. Near term, we might already be seeing signs of their arrival and firms have begun to pivot accordingly. Investment Implication #7: Buy The BCA Millennials Equity Basket Millennials will boost consumption spending in a number of different ways. The relatively unburdened Millennial cohort will be entering prime home acquisition age soon and this should underpin the long-term prospects of the US housing market and related industries. Furthermore, Millennials consume differently from their parents; social media, online shopping and smart phones are not the consumption categories of the Baby Boomers. With this in mind, we have created a basket of ten stocks that we think will be driven over the long term by the demographic rise of the Millennial. We note that these stocks are heavily weighted to the technology and consumer discretionary sectors, which is logical as Millennial consumption habits tend to be discretionary focused and technology-based. Beginning with consumer discretionary, we are highlighting AMZN, NFLX and SPOT as core holdings in our Millennials basket. AMZN’s heft dwarfs consumer discretionary indexes but it could fall in several categories; the acquisition of Whole Foods makes it a Millennials-focused consumer staples retailer and its cloud computing web services segment is a tech leader. NFLX and SPOT represent the means by which Millennials consume media, by streaming movies and music over the internet. The idea of owning physical media is rapidly becoming an anachronism. The home ownership theme noted in this report leads us to add HD and LEN to the basket. Millennials are “doers” and are set to be the dominant DIYers in the next few years, making HD a logical choice. LEN, as the nation’s largest home builder, should benefit from the Millennials coming of age into home buyers. We are also adding TSLA to our basket as a lone clean tech-oriented equity. TSLA capitalizes on the increasing shift to clean energy of Millennials (the key reason why no traditional energy companies have a spot in our basket). Chart II-11Buy BCA's Millennial Equity Basket Buy BCA's Millennial Equity Basket Buy BCA's Millennial Equity Basket The technology stocks in our Millennials basket are AAPL, UBER (which replaces FB as of today) and MSFT, together representing more than 9% of the total value of the S&P 500. AAPL’s inclusion in the list is predictable as the leading domestic purveyor of devices on which Millennials consume media content. FB is a predictable holding, with more than half of all Americans being monthly active users, dominated by the Millennial cohort. It has served our basket well since inception, but today we are compelled to remove it and replace it with UBER. UBER is a Millennial favorite and the epitome of the sharing economy. In reality UBER is a logistics company and while it is losing money, it is eerily reminiscent of AMZN in its early days. Maybe UBER will dominate all means of transportation and its ease of use will propel it to a mega cap in the coming decade. Our inclusion of MSFT is based on its leadership in cloud computing, a rapidly growing industry. We expect the connectivity and mobile computing demands of Millennials will accelerate. The last stock we are adding to our basket is also the only financial services equity. Though avid consumers, Millennials have shown an aversion to cash, preferring card payment systems, including both debit and credit-based. Accordingly, we are adding the leader in both of these, V, to our Millennials basket (Chart II-11). Investors seeking long-term exposure to stocks lifted by the supremacy of the Millennial generation should own our Millennial basket (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). We would not hesitate to add other sharing economy stocks, including Airbnb, to this basket should they become investable in the near future. Theme #5: ESG Becomes Mainstream Investors are increasingly looking at allocating assets based on environmental, social, and governance (ESG) considerations, and this mini-theme has the potential to become a big trend in the 2020s. There are a number of factors that underpin ESG investing. First, Millennials are climate conscious and given that they already are the largest cohort in the US they will not only dominate spending, but also influence election results. Moreover, via social media Millennials can sway public opinion and participate in the ESG conversation. Second, ECB President Christine Lagarde recent speech to the Economic and Monetary Affairs Committee of the European Parliament is a must read.6 If the ECB were to explicitly focus on climate change policy as part of its monetary policy operations then this is a game changer. Green investment financing including “green bonds” could become mainstream. Keep in mind that as reported in the FT, “the European Parliament has declared a climate emergency; the new European Commission (EC) has taken office on a promise of an imminent “green new deal”, and Commission president Ursula von der Leyen has vowed to accelerate emissions cuts.” Last week, the EC released “The European Green Deal” with a pretty aggressive time table. The EC president said “The green deal is Europe’s man on the moon moment” and presented 50 policies slated to get rolled by 2022 to meet revamped climate goals. The implication is that once ESG takes center stage at a number of these institutions, it will be easier to become mainstream and propagate the world over. Third, large institutional investors are starting to adopt an ESG mindset, especially pension plans. These investors with trillions of dollars at their disposal can not only disfavor fossil fuel investment, but also undertake investments in “green projects” via private and public equity markets. Banks are also moving in the “greening of finance” direction and given that they are the pipelines of the global plumbing system, swift adoption will go a long way in taking ESG mainstream. Finally, the electric vehicle (EV) proliferation is another key driver on how the ESG theme will play out in the 2020s. As a reminder, in the US 50% of all energy consumption is gasoline related linked to automobiles. While battery technology still has limitations, EV is no longer a fad as the German and Japanese automakers are starting to make inroads on TSLA. These car manufacturers do not want to be left out, especially if this shift toward EV becomes mainstream in the 2020s. The Chinese are not far behind on the EV manufacturing front, however government policy can really become a game changer. If a number of countries and/or California mandate a large share of all new vehicles sold be EV, then the investment implications will be massive. Investment Implication #8: Avoid Fossil Fuels, Gambling, Alcohol And Tobacco… While there are a few ESG related ETFs, we would rather explore this theme’s investment implications of sectors to avoid in the coming decade. We are believers that ESG criteria will continue to gain in importance in institutional investment management decisions. Accordingly, we would tend to avoid ‘sin stocks’, including gambling, tobacco and alcohol; demand for their services is unlikely to decline but investment weightings should mean that share prices will underperform. Further, we think a clean energy shift will mean energy stocks will likely continue to be long-term underperformers (Chart II-12). Final Thoughts On The US Dollar In this report, we tried to focus on the upcoming decade’s big themes that we expect to play out, and centered our recommendations on US equities/sectors. We do not want to neglect some macroeconomic variables that tend to mean revert over time. Specifically, the US dollar, interest rates and most importantly US indebtedness, will also be key drivers of investment theses in the 2020s. Currently, debt is rising faster than nominal GDP growth with the government and non-financial business debt-to-GDP profiles on an unsustainable path (second panel, Chart II-13). Chart II-12Areas To Avoid As ESG Becomes Mainstream Areas To Avoid As ESG Becomes Mainstream Areas To Avoid As ESG Becomes Mainstream Chart II-13Unsustainable Debt Profiles Unsustainable Debt Profiles Unsustainable Debt Profiles   Granted, the saving grace has been generationally low interest rates as the debt service ratios have fallen (top panel, Chart II-13). However, if the four decade bull market in Treasurys is over, or may end definitively with the next US recession sometime in the early 2020s, then rising interest rates are the only mechanism to concentrate CEOs’ and politicians’ minds. On the dollar front, Chart II-14 highlights the ebbs and flows of the trade-weighted US dollar since it floated in the early-1970s. The DXY index has moved in six-to-ten year bull and bear markets. The most recent trough was during the depths of the Great Recession, while the (tentative?) peak was in late-2016. If history repeats, eventually the dollar will mean revert lower in the 2020s, especially given the fiscal profligacy of the current administration that may continue into 2024, assuming President Trump gets re-elected next November. Chart II-14Greenback's Historical Ebbs And Flows Greenback's Historical Ebbs And Flows Greenback's Historical Ebbs And Flows The US dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges as the balance-of-payments dynamics are heading in the wrong direction. Over the next five years, the US Congressional Budget Office (CBO) estimates that the US budget deficit will swell to 4.8% of GDP. Assuming the current account deficit widens a bit then stabilizes (usually happens when global growth improves), this will pin the twin deficits at 8% of GDP. This assumes no recession, which would have the potential to swell the deficit even further. The US saw its twin deficits swell to almost 13% of GDP following the financial crisis, but the difference then was that in the wake of the commodity boom the dollar was cheap (and commodity currencies overvalued). The subsequent shale revolution also greatly cushioned the US trade deficit. Shale productivity remains robust and US output will continue to rise, but the low-hanging fruit has already been plucked. Chart II-15Twin Deficits Will Weigh On The US Dollar Twin Deficits Will Weigh On The US Dollar Twin Deficits Will Weigh On The US Dollar For one reason or another, foreign central banks are diversifying out of dollars. If due to the changing landscape in trade, this is set to continue. If it is an excuse to shy away from the rapidly rising US twin deficits, this will continue as well. In a nutshell, there has been hardly a time in recent history when the twin deficits in the US were rising and the dollar was in a secular uptrend (Chart II-15). Another dollar-negative force is its expensiveness. By rising 35% since its trough, the USD has sapped the competitiveness of the US manufacturing sector, which is accentuating the American trade deficit outside of the commodity sector. If the ESG trend ends up hurting oil prices, the US current account will follow the widening deficit in manufactured products. Moreover, the US is lagging Europe on the green revolution. Either the US will have to import green technologies, or the US government will have to provide more subsidies to the private sector. Either way, both of these dynamics will hurt the US current account deficit further. Historically, the currency market is the main vehicle to correct such imbalances. The apex of globalization will also hurt the greenback. In a world where all the markets are integrated, borrowers in EM nations often use the reserve currency to issue liabilities at a lower cost. This boosts the demand by EM central banks for US dollar reserves to protect domestic banking systems funded in USD. Moreover, some countries like China implement pegs (both official and unofficial) to the US dollar in order to maintain their competitiveness and export their production surpluses to the US. To do so they buy US assets. If the global economy becomes more fragmented and the Sino-US relationship continues to deteriorate structurally as we expect, then these sources of demand for the dollar will recede. Overlay the widening US current account deficit, and you have the perfect recipe for a depreciating trade-weighted US dollar. Finally, the US is likely to experience more inflation than the rest of the world following the next recession. The US economy has a smaller capital stock as a share of GDP than Europe or Japan, and American demographics are much more robust. This means that the neutral rate of interest is higher in the US than in other advanced economies. As a result, the Fed will have an easier time generating inflation by cutting real rates than both the ECB and the BoJ. Higher inflation will ultimately erode the purchasing power of the dollar and prove to be a structurally negative force for the USD.   Anastasios Avgeriou US Equity Strategist Matt Gertken Geopolitical Strategist Marko Papic Chief Strategist, Clocktower Group Chester Ntonifor Foreign Exchange Strategist Mathieu Savary Vice President The Bank Credit Analyst   III. Indicators And Reference Charts With a breakthrough in trade talks and Fed officials changing their language to suggest that policy will remain accommodative until inflation meaningfully overshoots 2%, the S&P 500 decisively broke out. Because it eases global financial conditions and boosts the profit outlook, the recent breakdown in the dollar should fuel the equity rally. Tactically, the S&P 500 may have overshot the mark, but on a cyclical basis, stronger growth and an easy Fed will propel US and global stocks higher. Our Revealed Preference Indicator (RPI) remains cautious towards equities. The RPI combines the idea of market momentum with valuation and policy measures. However, our Willingness-to-Pay (WTP) indicator for the US and Japan continues to improve. In Europe, this indicator has finally hooked up. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. This broad-based improvement therefore bodes well for equities. Moreover, the pickup in Europe suggests that European stocks are increasingly ripe to outperform their US counterparts. Global yields have turned higher but they remain at exceptionally stimulating levels. Moreover, money and liquidity growth remains very strong as global central banks have adopted strongly dovish slants. Additionally, a Fed that will allow inflation to overshoot before tightening policy is adding to this supportive monetary backdrop. As a result, our Monetary Indicator remains at extremely elevated levels. Furthermore, our Composite Technical Indicator is still flashing a buy signal. Finally, our BCA Composite Valuation index is suggesting that stocks are expensive, but not so much as to cancel out the supportive monetary and technical backdrop. As a result, our Speculation Indicator remains in the neutral zone. 10-year Treasurys yields are becoming slightly less expensive, however, they are no bargain. Moreover, our Composite Technical Indicator is quickly moving away from overbought territory but has yet to flash oversold conditions, indicating that yields are roughly half way through their move. The strengthening of the Commodity Index Advance/Decline line and higher natural resource prices further confirm the upside for yields. Therefore, the current setup argues for a below-benchmark duration in fixed-income portfolios. Small signs that global growth is bottoming, such as the stabilization in the global PMIs, the pick-up in the German ZEW and IFO surveys, or the acceleration in Singapore’s container throughput growth, point to a worsening outlook for the counter-cyclical US dollar. Moreover, the dollar trades at a large premium of 24% relative to its purchasing-power parity equilibrium. Additionally, our Composite Technical Indicator is quickly deteriorating after having formed a negative divergence with the Greenback’s level. Since the dollar is a momentum currency, this represents a dark omen for the USD. In fact, we continue to believe that a breakdown in the dollar will be the clearest signal that global growth is rebounding for good. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart II-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart II-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart II-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart II-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart II-20Euro Technicals Euro Technicals Euro Technicals Chart II-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart II-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart II-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart II-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see The Bank Credit Analyst "OUTLOOK 2020: Heading Into The End Game," dated November 22, 2019, available at bca.bcaresearch.com 2 Please see Geopolitical Strategy Special Report "US Election 2020: Civil War Lite," dated November 22, 2019, available at gps.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report "Riding The Wave: Momentum Strategies In Foreign Exchange Markets," dated December 8, 2017, available at fes.bcaresearch.com 4 Please see Global Asset Allocation Special Report "Safe Haven Review: A Guide To Portfolio Protection In The 2020s," dated October 29, 2019, available at gaa.bcaresearch.com. 5 Please see US Equity Strategy Special Report "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com 6 https://www.imf.org/en/News/Articles/2019/09/04/sp090419-Opening-Statement-by-Christine-Lagarde-to-ECON-Committee-of-European-Parliament

Highlights Mega-theme 1: A hypersensitivity to higher interest rates. Overweight equities versus bonds until 10-year bond yields rise 75 bps. At which point, switch into bonds. Mega-theme 2: Europe conquers its disintegration forces. Overweight European currencies, and underweight core European bonds within a fixed income portfolio. Mega-theme 3: Non-China exposed investments outperform structurally. Overweight non-China plays, underweight materials and resources, and underweight commodity currencies. Mega-theme 4: The rise of blockchain and alternative energy. Overweight alternative energy, underweight oil and gas, and underweight financials. Feature Feature ChartUnderweight Materials And Resources In The 2020s Underweight Materials And Resources In The 2020s Underweight Materials And Resources In The 2020s “Study the past if you would divine the future” – Confucius To paraphrase Confucius, we must study the mega-themes of the 2010s if we are to identify the mega-themes of the 2020s. From an economic, financial, and political perspective, the mega-themes of the past decade were: ‘universal QE’; Europe’s threatened disintegration; China becoming the world’s ‘stimulator of last resort’; and the decentralization of information, which threatened the established hierarchies in politics and society. These mega-themes of the 2010s point the way to four mega-themes for the 2020s: A hypersensitivity to higher interest rates. Europe conquers its disintegration forces. Non-China exposed investments outperform structurally. The rise of blockchain and alternative energy. Mega-Theme 1: A Hypersensitivity To Higher Interest Rates The 2010s was the decade of ‘universal QE’. One after another, the world’s major central banks bought trillions of dollars of government bonds (Chart I-2). Yet for all its apparent mystique, QE is nothing more than a signalling mechanism – signalling that central banks intend to keep policy interest rates depressed for a long time. Thereby, QE depresses long-term bond yields – which themselves are nothing more than the expected path of policy interest rates. Chart I-2The 2010s Was The Decade Of 'Universal QE' The 2010s Was The Decade Of 'Universal QE' The 2010s Was The Decade Of 'Universal QE' Something else happens. Close to the lower bound of interest rates, bonds become riskier investments. As holders of Swiss bonds discovered in 2019, low-yielding bonds become a ‘lose-lose’ proposition: prices can no longer rise much, but they can fall a lot. The upshot is that all long-duration assets become risky, and the much higher return required on formerly riskier assets – such as equities – collapses to the feeble return offered on equally-risky bonds. 'Universal QE' has boosted the valuation of all risky assets. Ten years ago, when the global 10-year bond yielded 3.5 percent, equities offered a prospective 10-year return of 9 percent (per annum). Today, when the bond is yielding around 1.5 percent, equities are offering a paltry 3 percent (Chart I-3 and Chart I-4). Meaning that while the present value of the 10-year bond is up around 20 percent, the present value of equities has surged by 60 percent.1 Chart I-3Equities Are Offering A Paltry 3 Percent Return Equities Are Offering A Paltry 3 Percent Return Equities Are Offering A Paltry 3 Percent Return Chart I-4The Return Offered By Equities Has Collapsed To The Feeble Return Offered By Bonds The Return Offered By Equities Has Collapsed To The Feeble Return Offered By Bonds The Return Offered By Equities Has Collapsed To The Feeble Return Offered By Bonds This exponential dynamic has applied to all risky assets in the 2010s. Most notably, real estate prices have sky-rocketed: Shenzhen 325 percent; Beijing 285 percent; Berlin 125 percent; Bangkok 120 percent; San Francisco 90 percent; Los Angeles 85 percent; Sydney 75 percent; and so on. From 2010 to 2020, the value of global real estate surged from an estimated $160 trillion to $300 trillion.2 The market value of equities also doubled from $35 trillion to $70 trillion.3 But global GDP grew by less than a third from $66 trillion to $85 trillion.3 The upshot is that in 2010 the value of real estate plus equities stood at 2.9 times GDP, whereas in 2020 it stands at 4.5 times GDP. Now add in the aforementioned exponentiality of risk-asset valuations at low bond yields. In 2010, a 1 percent rise in yields required a 10 percent decline in present values, whereas in 2020 it might require a 30 percent decline. In 2010, this meant a decline equivalent to 29 percent of global GDP, but in 2020 it means a decline equivalent to a staggering 135 percent of global GDP.4 So mega-theme 1 for the early 2020s is that any monetary policy tightening – in response to, say, wage inflation fears – will unleash a massive deflationary impulse into the economy from falling stock and real estate prices. This deflationary sledgehammer will annihilate the inflationary peanut, and almost certainly trigger the next major recession. But the good news is that it is unlikely to be a 2020 story, as all the major central banks are in ‘wait-and-see’ mode. Structural recommendation: Overweight equities versus bonds until 10-year bond yields rise 75 bps. At which point, switch into bonds. Mega-Theme 2: Europe Conquers Its Disintegration Forces In sub-atomic physics, a nucleus disintegrates when the electrostatic forces pulling it apart becomes stronger than the nuclear forces holding it together. Using the nucleus as a metaphor for Europe, two of the forces pulling it apart have weakened, while one of the forces holding it together has strengthened. We now know that Europe’s biggest rebel – the UK – is leaving the European Union in 2020. In the sub-atomic metaphor, the UK has become a free radical which will try and attach itself to the largest attractive body it can find. But in losing its most wayward member the European nucleus has, by definition, become more cohesive. A second destructive force has been the economic divergences between the ‘core’ and ‘periphery’ European member states. But over the past decade, these divergences have narrowed substantially. Relative to Germany, unit labour costs have declined by 25 percent in Spain, and 15 percent in Italy. More convergence is needed, but the economic forces pulling the European nucleus apart are much weaker in 2020 than they were in 2010 (Chart I-5). Chart I-5The Economic Divergence Between Europe's Core And Periphery Has Narrowed The Economic Divergence Between Europe's Core And Periphery Has Narrowed The Economic Divergence Between Europe's Core And Periphery Has Narrowed Meanwhile, a force holding the European nucleus together has strengthened. In 2010, the Target2 banking imbalance stood at €0.3 trillion; in 2020, it stands close to €1.5 trillion. In simple terms, this means Germany’s exposure to ‘Italian euro’ assets has surged via the ECB’s massive purchases of Italian BTPs. At the same time, Italian investors have parked their cash in German banks, meaning they are owed ‘German euros’ (Chart I-6). Chart I-6Europe’s Target2 Banking Imbalance Stands Close To €1.5 Trillion 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s With such a massive Target2 imbalance, the biggest casualty of the euro’s disintegration would be Germany, whose 2008 recession would look like a stroll in the park. Giving Germany a huge incentive to become more conciliatory to its partners, for example on the use of fiscal stimulus. The best way to play mega-theme 2 is through the currency and bond markets. European equity markets are plays on their dominant sectors, and as we are about to see, many of the sectors over-weighted in Europe face structural headwinds. Structural recommendation: Overweight European currencies, and underweight core European bonds within a fixed income portfolio. Mega-Theme 3: Non-China Exposed Investments Outperform Structurally The 2010s was the decade when China became the global ‘stimulator of last resort’. Prior to the 2010s, the credit impulse in China was inconsequential compared to the credit impulses in the US and Europe. But in the 2010s the tables turned. The credit impulses in the US and Europe became inconsequential, as the amplitude of China’s waves of stimulus swamped all others (Chart I-7). Chart I-7In The 2010s, China Became The Global 'Stimulator Of Last Resort' In The 2010s, China Became The Global 'Stimulator Of Last Resort' In The 2010s, China Became The Global 'Stimulator Of Last Resort' China became the global stimulator of last resort because in 2010 its indebtedness was significantly less than in other major economies. But today, China’s indebtedness has overtaken the others, and is levelling off at a point that has proved to be a reliable upper bound (Chart I-8). Chart I-8China's Indebtedness Is Reaching Its Upper Bound China's Indebtedness Is Reaching Its Upper Bound China's Indebtedness Is Reaching Its Upper Bound An upper bound to indebtedness exists because further debt creates mal-investments whose returns are lower than the cost of the debt. And as indebtedness approaches the upper bound, each wave of stimulus loses potency compared to the preceding wave. For example, in 2011 China’s nominal GDP growth accelerated to 20 percent, but in 2017 it accelerated to 10 percent. In the financial markets, China’s waves of stimulus enabled short bursts of countertrend outperformance within the structural bear market in materials and resources – sectors which feature large in European markets. However, as Chinese stimulus loses its potency in the 2020, the structural bear markets in China-exposed investments will re-establish (Chart I-1). Structural recommendation: Overweight non-China plays, underweight materials and resources, and underweight commodity currencies. Mega Theme 4: The Rise Of Blockchain And Alternative Energy Historian Niall Ferguson describes history as a perpetual oscillation between periods dominated by centralized hierarchies and periods dominated by decentralized networks. And quite often, he says, the switch is enabled by a revolutionary new technology. For example, the advent of the printing press in the mid-15th century catalysed the Protestant Reformation and turbocharged the Renaissance by unleashing a decentralization of knowledge, information, and news. Sound familiar? In the early-21st century the internet has similarly decentralized the production and consumption of knowledge, information, and news. And the new networked age has threatened the established hierarchies in politics and society, fuelled populism, and disrupted many sectors in the economy. Yet Ferguson points out that it is futile (as well as Luddite) to resist such shifts from hierarchical structures towards decentralized networks. In the 2020s the decentralization baton will pass from the internet to the blockchain. Just as the internet decentralizes information, the blockchain decentralizes intermediation and trust functions. Hence, the blockchain will be maximally disruptive to any economic sector whose raison d’être is intermediation and trust – most notably finance and law. The blockchain will be maximally disruptive to any economic sector whose raison d’être is intermediation and trust – most notably finance and law.  By the end of the decade, you will no longer need a bank to intermediate your excess savings to a borrower. And you will no longer need a lawyer to oversee a change of ownership. The blockchain will do these for you just as securely and much more cost effectively. One consequence is that the nature of the world’s energy requirements will change. The blockchain is very energy intensive, but unlike the internal combustion engine, the energy does not have to be portable. Hence, there will be a structural shift towards energy in the form of ‘moving electrons’ and away from energy in the form of the ‘chemical bonds’ in fossil fuels. This will be a boon for the alternative energy sector at the expense of oil and gas (Chart I-9). Chart I-9Underweight Oil And Gas In The 2020s Underweight Oil And Gas In The 2020s Underweight Oil And Gas In The 2020s We will cover this mega-theme in more detail in a Special Report next year. Structural recommendation: Overweight alternative energy, underweight oil and gas, underweight financials. And with that, it’s time to sign off for this year and for this decade. I do hope that you have found the past decade’s reports insightful, sometimes provocative, but always enjoyable. We promise to continue in the same vein in the 2020s. It just remains for me and the team to wish you a happy new year and a happy new decade! Fractal Trading System* The Conservatives won a surprise landslide victory in the UK election last week, but fractal structures suggest that some of the market euphoria is now overdone. Specifically, the 30 percent rally in UK homebuilders through the last 65 days is vulnerable to a short-term countertrend move. Accordingly, this week’s recommended trade is short UK homebuilders / long UK oil and gas. Set the profit target at 9 percent with a symmetrical stop-loss. Chart I-10UK: Homebuilders Vs. Oil and Gas UK: Homebuilders Vs. Oil and Gas UK: Homebuilders Vs. Oil and Gas In other trades, short MSCI AC World versus the global 10-year bond was closed at its 2.5 percent stop-loss, leaving three trades in comfortable profit, one neutral, and one in loss. 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.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 In simple terms, if the 10-year yield declines by 2 percent, a 2 percent a year lower return for 10 years requires the present value to rise by 2 percent times 10, which equals 20 percent. In the case of equities, the equivalent calculation is 6 percent times 10, which equals 60 percent. 2 Source: Savills 3 Source: Thomson Reuters 4 2.9 times 10 percent equals 29 percent, 4.5 times 30 percent equals 135 percent. Fractal Trading System 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s   Cyclical Recommendations Structural Recommendations 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s 2020s Key Views: Four Mega-Themes For The 2020s Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity

Highlights 2019 was a good year for our constraint-based method of political analysis. Trump was impeached, the trade war escalated, and China (modestly) stimulated – all as predicted. Nevertheless Trump caught us by surprise in Q2, with sanctions on Iran and tariffs on China. Our best trades were long defense stocks, gold, and Swiss bonds. Our worst trade was long rare earth miners. Feature Jean Buridan’s donkey starved to death because, faced with equal bundles of grain on both sides, it could not decide which to eat. So the legend goes. Investors face indecision all the time. This is especially the case when a geopolitical sea change is disrupting the global economy. Two or more political outcomes may seem equally plausible, heightening uncertainty. What is needed is a method for eliminating the options that require the farthest stretch. That’s what we offer in these pages, but we obviously make mistakes. The purpose of our annual report card is to identify our biggest hits and misses so we can hone our ability to combine fundamental macro and market analysis with the “art of the possible,” delivering better research and greater returns for clients. This is our last report for 2019. Next week we will publish a joint report with Anastasios Avgeriou of BCA Research’s US Equity Strategy. We will resume publication in early January. We wish all our clients a merry Christmas, happy holidays, and a happy new year! American Politics: Unsurprising Surprises Chart 1Our 2019 Forecast Held Up Our 2019 Forecast Held Up Our 2019 Forecast Held Up On the whole our 2019 forecast held up very well. We argued that the global growth divergence that began in 2018 would extend into 2019 with the Fed hiking rates, a lack of massive stimulus from China, and an escalation in the US-China trade war. The biggest miss was that the Fed actually cut rates three times – addressed at length in our BCA Research annual outlook. But the bulk of the geopolitical story panned out: the US dollar, US equities, and developed market equities all outperformed as we expected (Chart 1). Geopolitical risk in the Trump era is centered on Trump himself. Beginning in 2017, we argued that the Democrats would take the House of Representatives in the midterm elections and impeach the president. Congress would not be totally gridlocked: while we argued for a government shutdown in late 2018, we expected a large bipartisan budget agreement in late 2019 and always favored the passage of the USMCA trade deal. Still, Congress would encourage Trump to go abroad in pursuit of policy victories, increasing geopolitical risks. We also argued that, barring “smoking gun” evidence of high crimes, the Republican-held Senate would acquit Trump – assuming his popularity held up among Republican voters themselves (Chart 2). These views either transpired or remain on track. The implication is that Trump-related risk continues and yet that Trump’s policies are ultimately constrained by the guardrails of the election. The latter factor helped propel the equity rally in the second half of the year. We largely sat out that rally, however. We overestimated the chances that Senator Bernie Sanders would falter and Senator Elizabeth Warren would swallow his votes, challenging former Vice President Joe Biden for the leading position in the early Democratic Party primary. We expected a significant bout of equity volatility via fears of a sharp progressive-populist turn in US policy (Chart 3). Instead, Sanders staged a recovery, Warren fell back, Biden maintained his lead, and markets rallied on other news. Chart 2Trump Will Be Acquitted How Are We Doing? ... Geopolitical Strategy 2019 Report Card How Are We Doing? ... Geopolitical Strategy 2019 Report Card Chart 3Fears Of A Progressive Turn Did Not Derail The H2 Rally How Are We Doing? ... Geopolitical Strategy 2019 Report Card How Are We Doing? ... Geopolitical Strategy 2019 Report Card Warren could still recover and win the nomination next year. But the Democratic Primary was not a reason to remain neutral toward equities, as we did in September and October. China’s Tepid Stimulus In recent years China first over-tightened and then under-stimulated the economy – as we predicted. But we misread the credit surge in the first quarter as a sign that policymakers had given up on containing leverage. In total this year’s credit surge amounts to 3.4% of GDP, about 1.2% short of what we expected (based on half of the 9.2% surge in 2015-16) (Chart 4). China’s credit surge was about 1.2% short of what we expected, but the direction was correct. While the government maintained easy monetary policy as expected, its actions combined with negative sentiment to snuff out the resurgence in shadow banking by mid-year (Chart 5). Chart 4China's Credit Surge Was Underwhelming China's Credit Surge Was Underwhelming China's Credit Surge Was Underwhelming Still, China’s policy direction is clear – and fiscal policy is indeed carrying a greater load. The authorities are extremely unlikely to reverse course next year, so global activity should turn upward (Chart 6). Our “China Play Index” – iron ore prices, Swedish industrials, Brazilian stocks, and EM junk bonds, all in USD terms – has appreciated steadily (Chart 7). Chart 5China's Shadow Banking Remained Under Pressure China's Shadow Banking Remained Under Pressure China's Shadow Banking Remained Under Pressure   Chart 6Global Activity Should Turn Upward In 2020 Global Activity Should Turn Upward In 2020 Global Activity Should Turn Upward In 2020 Chart 7Our 'China Play Index' Performed Well Our 'China Play Index' Performed Well Our 'China Play Index' Performed Well US-China: Underestimating Trump’s Risk Appetite We have held a pessimistic assessment of US-China relations since 2012. We rejected the trade truces agreed at the G20 summits in December 2018 and June 2019 as unsustainable. Our subjective probabilities of Trump achieving a bilateral trade agreement with China have never risen above 50%. Since September we have expected a ceasefire but not a full-fledged deal. Nevertheless we struggled with the timing of the trade war ups and downs (Chart 8). In particular we accepted China's new investment law as a sufficient concession and were surprised on May 5 when talks collapsed and Trump increased the tariffs. The lack of constraints on tariffs prevailed in 2019 but in 2020 the electoral constraint will prevail as long as Trump still has a chance of winning. Our worst trade recommendation of the year emerged from our correct view that the June G20 summit would lead to trade war escalation. We went long rare earth miners based outside of China. We expected China to follow through on threats to impose a rare earth embargo on the US in retaliation for sanctions against Chinese telecom giant Huawei. Not only did the US grant Huawei a reprieve, but China’s rare earth companies outperformed their overseas rivals. The trade went deeply into the red as global sentiment and growth fell (Chart 9). Only with global growth turning a corner have these high-beta stocks begun to turn around. Chart 8Expect A Ceasefire, Not A Full-Fledged Trade Agreement Expect A Ceasefire, Not A Full-Fledged Trade Agreement Expect A Ceasefire, Not A Full-Fledged Trade Agreement Chart 9Our Worst Call: Long Rare Earth Miners Our Worst Call: Long Rare Earth Miners Our Worst Call: Long Rare Earth Miners Chart 10North Korean Diplomacy Has Not Collapsed (Yet) North Korean Diplomacy Has Not Collapsed (Yet) North Korean Diplomacy Has Not Collapsed (Yet) Our sanguine view on North Korea was largely offside this year. Setbacks in US negotiations with North Korea have often preceded setbacks in US-China talks. This was the case with the failed Hanoi summit in February and the inconsequential summit at the demilitarized zone in June. This could also be the case in 2020, as Washington and Pyongyang are now on the verge of breaking off talks with the latter threatening a “Christmas surprise” such as a nuclear or missile test. It is not too late to return to talks. Beijing is the critical player and is still enforcing crippling sanctions on North Korea (Chart 10). Beijing would benefit if North Korea submitted to nuclear and missile controls while the US reduced its military presence on the peninsula. We view this year as a hiccup in North Korean diplomacy but if talks utterly collapse and military tensions break out then it would undermine our view on US-China talks, Trump’s reelection odds, and US Treasuries in 2020. Hong Kong, rather than Taiwan, became the site of the geopolitical “Black Swan” that we expected surrounding Xi Jinping’s aggressive approach to domestic dissent. We have never downplayed Hong Kong. The loss of faith in the governing arrangement with the mainland began with the Great Recession and shows no sign of abating (Chart 11). We shorted the Hang Seng after the protests began, but closed at the appropriate time (Chart 12). The problem is not resolved. Also, Taiwan can test its autonomy much farther than Hong Kong and we still expect Taiwan to become ground zero of Greater China political risk and the US-China conflict. Chart 11Hong Kong Discontent Is Structural How Are We Doing? ... Geopolitical Strategy 2019 Report Card How Are We Doing? ... Geopolitical Strategy 2019 Report Card Chart 12Our Hang Seng Short Is Done Our Hang Seng Short Is Done Our Hang Seng Short Is Done Chart 13Trump Needs A Trade Ceasefire Trump Needs A Trade Ceasefire Trump Needs A Trade Ceasefire Trump is unlikely to seek another trade war escalation given the negative impact it would have on sentiment and the economy (Chart 13). He could engage in another round of “fire and fury” saber-rattling against North Korea, as the economic impact is small, but he will prefer a diplomatic track. Taiwan, however, cannot be contained so easily if tempers flare. As we go to press it is not clear if Trump will hike the tariff on China on December 15. Some investors would point to his tendency to take aggressive action when the market gives him ammunition (Chart 14). We doubt he will, as this would be a policy mistake – possibly quickly reversed or possibly fatal for Trump. Trump’s electoral constraint is more powerful in 2020 than it was in 2019. Chart 14Trump Ceasefire Will Last As Long As Economy Is At Risk Trump Ceasefire Will Last As Long As Economy Is At Risk Trump Ceasefire Will Last As Long As Economy Is At Risk Chart 15Our 'Doomsday Basket' Captured Trump's First Three Years Our 'Doomsday Basket' Captured Trump's First Three Years Our 'Doomsday Basket' Captured Trump's First Three Years Our best tactical trade of the year stemmed from the geopolitical risk in Asia (and the Fed’s pause): we recommended a long gold position this summer that gained 16%. We also closed out our “Doomsday Basket” of gold and Swiss bonds, initiated in Trump’s first year, for a gain of 14% (Chart 15). Now that the market has digested Trump’s tactical retreat, we have reinitiated the gold trade as a long-term strategic hedge against both short-term geopolitical crises and the long-term theme of populism. Iran: Fool Me Once, Shame On You … This is the second year in a row that we are forced to explain our analysis of Iran – we were only half-right. Our long-held view is that grand strategy will push the US to pivot to Asia to counter China while scaling back its military activity in the Middle East. Two American administrations have confirmed this trend. That said, there is still a risk that President Trump will get entangled in Iran and that risk is growing. Global oil volatility – which spiked during the market share wars of 2014 – declined through the beginning of 2018, until the Trump administration took clearer steps toward a policy of “maximum pressure” on Iran. The constraints on Trump are obvious: the US economy is still affected by oil prices, which are set globally, and Iran can damage supply and push up prices. Therefore Trump should back down prior to the 2020 election. Yet Trump imposed sanctions, waivered on them, and then re-imposed them in May 2019 – catching us by surprise each time (Chart 16). Chart 16Trump Flip-Flopped On Iran Policy Trump Flip-Flopped On Iran Policy Trump Flip-Flopped On Iran Policy Chart 17Iran Tensions Backwardated Oil Markets Iran Tensions Backwardated Oil Markets Iran Tensions Backwardated Oil Markets This saga is not resolved – we are witnessing what could become a secular bull market in Iran tensions. True, a Democratic victory in 2020 could lead to an eventual restoration of the 2015 nuclear deal. True, the Trump administration could strike a deal with the Iranians (especially after reelection). But no, it cannot be assumed that the US will restore the historic 2015 détente with Iran. Within Iran the regime hardliners are likely to regain control in advance of the extremely uncertain succession from Supreme Leader Ali Khamenei and this will militate against reform and opening up. We went long Brent crude Q1 2020 futures relative to Q1 2021 to show that tensions were not resolved (Chart 17) – the attack on Saudi Arabia in September confirmed this view. And yet the oil price shock was fleeting as global supply was adequate and demand was weak. Our current long Brent spot trade is not only about Iran. Global growth is holding up and likely to rebound thanks to monetary stimulus and trade ceasefire, OPEC 2.0 has strong incentives to maintain production discipline (driven by both Saudi Arabian and Russian interests), and the Iranian conflict has led to instability in Iraq, as we expected. The UK: Not Dead In A Ditch British Prime Minister Boris Johnson proclaimed this year that he would "rather be dead in a ditch” than extend the deadline for the UK to leave the EU. The relevant constraint was that a disorderly “no deal” exit would have meant a recession, which we used as our visual illustration of why Johnson would not actually die in a ditch (Chart 18). The test was whether parliament could overcome its coordination problems when it reconvened in September, which it immediately did, prompting us to go long GBP-USD on September 6 (Chart 19). This trade was successful and we remain long GBP-JPY. Chart 18The Reason We Rejected How Are We Doing? ... Geopolitical Strategy 2019 Report Card How Are We Doing? ... Geopolitical Strategy 2019 Report Card Chart 19UK Parliament Voted Down No-Deal Brexit UK Parliament Voted Down No-Deal Brexit UK Parliament Voted Down No-Deal Brexit Populism faltered in Europe, as expected. As we go to press, the UK Christmas election is reported to have produced a whopping Conservative majority. This year Johnson mounted the most credible threat of a no-deal Brexit that we are ever likely to see and yet ultimately delayed Brexit. The Conservative victory will produce an orderly Brexit. The trade deal that needs to be negotiated next year will bring volatility but it does not have a firm deadline and is not harder to negotiate than Brexit itself. The UK has passed through the murkiest parts of Brexit uncertainty. Moreover, our high-conviction view that more dovish fiscal policy would be the end-result of the Brexit saga is now becoming consensus. Europe: Not The Crisis You Were Looking For The European Union was a geopolitical “red herring” in 2019 as we expected. Anti-establishment feeling remained contained. Italy remains the weakest link in the Euro Area, but the political “turmoil” of 2018-19 is the populist exception that mostly proves the rule: Europeans are not as a whole rebelling against the EU or the euro. On France, Italy, and Spain our views were fundamentally correct. Even in the European parliament, where anti-establishment players have a better chance of taking seats than in their home governments, the true Euroskeptics who want to exit the union only make up about 16% of the seats (Chart 20). This is up from 11% prior to the elections in May this year. Chart 20Euroskepticism Was Overstated How Are We Doing? ... Geopolitical Strategy 2019 Report Card How Are We Doing? ... Geopolitical Strategy 2019 Report Card Yet the European political establishment is losing precious time to prepare for the next wave of serious agitation, likely when a full-fledged recession comes. Chart 21Trump Did Not Pile Tariffs Onto Auto Sector Trump Did Not Pile Tariffs Onto Auto Sector Trump Did Not Pile Tariffs Onto Auto Sector Germany is experiencing a slow transition from the long reign of Angela Merkel, whose successor has plummeted in opinion polls. The shock of the global slowdown – particularly heavy in the auto sector (Chart 21) – hastened Germany’s succession crisis. Chart 22Overstated EU Political Risk, Understated Chinese Risk Overstated EU Political Risk, Understated Chinese Risk Overstated EU Political Risk, Understated Chinese Risk There is a silver lining: this shock is forcing the Germans to reckon with de-globalization. Attitudes across the country are shifting on the critical question of fiscal policy. Even the conservative Christian Democrats are loosening their belts in the face of the success of the Green Party and a simultaneous change in leadership among the Social Democrats to embrace bigger spending. The Trump administration refrained from piling car tariffs onto Europe amidst this slowdown in the automobile sector and overall economy. We expected this delay, as there is little support in the US for a trade war with Europe, contra China, and it is bad strategy to fight a two-front war. But if the US economy recovers robustly and Trump is emboldened by a China deal then this risk could reignite in future. With European political risk overstated, and Chinese mainland risk understated, we initiated a long European equities relative to Chinese equities trade (Chart 22), as recommended by our colleagues at BCA Research European Investment Strategy. And now we are initiating the strategic long EUR/USD recommendation that we flagged in September with a stop at 1.18. Japan: Shinzo Abe Has Peaked Japanese Prime Minister Shinzo Abe is still in power and still very popular, whether judged by the average prime minister in modern memory or his popular predecessor Junichiro Koizumi. But he is at his peak and 2019 did indeed mark the turning point – it is all downhill from here. First, he lost his historic double super-majority in the Diet by falling to a mere majority in the upper house (Chart 23). He is still capable of revising the constitution, but now it is now harder – and the high water mark of his legislative power has been registered. Chart 23Abe Lost His Double Super Majority How Are We Doing? ... Geopolitical Strategy 2019 Report Card How Are We Doing? ... Geopolitical Strategy 2019 Report Card Chart 24Consumption Tax Hike Shows Limits Of Abenomics Consumption Tax Hike Shows Limits Of Abenomics Consumption Tax Hike Shows Limits Of Abenomics Second, he proceeded with a consumption tax from 8% to 10% that predictably sent the economy into a tailspin given the global slowdown (Chart 24). We thought the tax hike would be delayed, but Abe opted to hike the tax and then pass a stimulus package to compensate. This decision further supports the view that Abe’s power will decline going forward. It is now incontrovertible that the Liberal Democrats are eschewing a radical plan of debt monetization in which they coordinate ultra-dovish fiscal policy with ultra-dovish monetary policy. “Abenomics” has not necessarily failed but it is a fully known quantity. Abe will next preside over the 2020 summer Olympics and prepare to step down as Liberal Democratic party leader in September 2021. It is conceivable he will stay longer, but the likeliest successors have been put into cabinet positions, including Shinjiro Koizumi, son of the aforementioned, whom we would not rule out as a future prime minister. Constitutional revision or a Russian peace deal could mark the high point of his premiership, but the peak macro consequences have been felt. Japan suffered a literal and figurative earthquake in 2011. Over the long run Tokyo will resort to more unorthodox economic policies and redouble its efforts at reflation. But not until the external environment demands it. This suggests that the JPY-USD is a good hedge against risks to the cyclically bullish House View in 2020 and supports an overweight stance on Japanese government bonds. Emerging Markets: Notable Mentions India: We were correct that Narendra Modi would be reelected as prime minister, but we did not expect that he would win a single-party majority for a second time (Chart 25). The risk is that this result leads to hubris – particularly in foreign policy and domestic social policy – rather than accelerating structural reform. But for now we remain optimistic about reform. Chart 25 How Are We Doing? ... Geopolitical Strategy 2019 Report Card How Are We Doing? ... Geopolitical Strategy 2019 Report Card East Asia: We are optimistic on Southeast Asia in the context of US-China competition. But we proved overly optimistic on Malaysia and Indonesia this year, while we missed a chance to close our long Thai equity trade when it would have been very profitable to do so. Turkey: Domestic political challenges to President Recep Tayyip Erdoğan have led to a doubling down on unorthodox monetary policy and profligate fiscal policy, as expected. Early in the year we advised clients that Erdoğan would delay deployment of the Russian S-400 air defense system in deference to the US but it quickly became clear that this was not the case. Thus we correctly anticipated the sharp drop in the lira over the autumn (Chart 26). The US-Turkey relationship continues to fray and additional American sanctions are likely. Russia: President Vladimir Putin focused on maintaining domestic stability amid tight fiscal and monetary policy in 2019. This solidified our positive relative view of Russian currency and equities (Chart 27). But it also highlighted longer-term political risks. We expect this trend to continue, but by the same token Russia is a potential “Black Swan” risk in 2020. Chart 26The Lira's Autumn Relapse The Lira's Autumn Relapse The Lira's Autumn Relapse Chart 27Russia's Eerie Quiet In 2019 Russia's Eerie Quiet In 2019 Russia's Eerie Quiet In 2019 Venezuela: Venezuela’s President Nicolas Maduro eked out another year of regime survival in 2019 despite our high-conviction view since 2017 that he would be finished. However, the economy is still collapsing and Russian and Chinese assistance is still limited (Chart 28). Before long the military will need to renovate the regime, even if our global growth and oil outlook for next year is positive for the regime on the margin. Chart 28Maduro Clung To Power Maduro Clung To Power Maduro Clung To Power Chart 29Our 2019 Winner: Global Defense Stocks Our 2019 Winner: Global Defense Stocks Our 2019 Winner: Global Defense Stocks Brazil: We were late to the Brazilian equity rally. While we have given the Jair Bolsonaro administration the benefit of the doubt, a halt to structural reforms in 2020 would prove us wrong. Our worst trade of the year was long rare earth miners, mentioned above. Our best trade was long global defense stocks (Chart 29), a structural theme stemming from the struggle of multiple powerful nations in the twenty-first century. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Ekaterina Shtrevensky Research Analyst ekaterinas@bcaresearch.com Jingnan Liu Research Associate jingnan@bcaresearch.com Marko Papic Consulting Editor marko@bcaresearch.com

Highlights OPEC 2.0 agreed to cut output by another 500k b/d at its Vienna meeting last week, bringing the total official cuts by the producer coalition to 1.7mm b/d. Saudi Arabia added 400k b/d of additional voluntary cuts, bringing its total cuts to almost 900k b/d vs. its October 2018 production level. We think the market will tighten, as a result, and are getting long 2H20 Brent vs. short 2H21 Brent; this is the backwardation trade that worked well this year, producing an average return of 180%. There was no extension of OPEC 2.0 output cuts beyond end-March, although an extraordinary meeting of the coalition was scheduled for March 5, 2020. Anti-government civil unrest in Iraq and Iran has resulted in the killing of hundreds of protesters in both countries by state security forces. The unrest raises the threat of disruptions to oil supplies from Iraq and to ships transiting the Strait of Hormuz. Clashes between pro-Iranian protesters and Iraqi nationalists in Baghdad prompted a visit to the city by Iran’s top military commander, Qassem Soleimani, over the weekend. Soleimani reportedly is participating in talks to find a new prime minister for Iraq. Soleimani’s visit drew criticism from Grand Ayatollah Ali al-Sistani, the most prominent Shia religious leader in Iraq. Feature OPEC 2.0’s deepening of production cuts to 1.7mm b/d will be largely ceremonial, unless free riders in the producer coalition – led by the Kingdom of Saudi Arabia (KSA) and Russia – fully comply with the new levels agreed last week in Vienna (Chart of the Week).1 Contrary to our expectation, the production cuts were not extended beyond end-March, although an extraordinary meeting of the coalition was scheduled for March 5, 2020, in Vienna to review market conditions prior to the deal’s expiry.2 The market was not expecting anything other than symbolism in the just-concluded discussions among OPEC 2.0 members regarding production cuts. The bulk of the cuts in the coalition’s production are the result of US sanctions against Venezuela and Iran, which have removed ~ 1.8mm b/d from the market and KSA's cuts, which will total ~ 900k b/d following OPEC 2.0's Vienna meeting.  We believe this will lead to a tighter market, and will steepen the backwardation in the Brent forward curve.  We are, therefore, recommending a longer 2H20 Brent position vs. a short 2H21 Brent position. The sanctions-induced cuts are squeezing the economies of both Venezuela and Iran, which, in the case of the latter, is producing a blowback on Iraq. Chart of the WeekOPEC 2.0 Raises Output Cuts To 1.7mm b/d In Vienna Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Iran Fights To Maintain Influence In Iraq Following an unexpected increase in gasoline prices last month, violent anti-government protests erupted around Iran, which provoked a deadly crackdown by the state. The ongoing unrest has resulted in the death of hundreds of protesters, which, by the US’s estimate, stand at more than 1,000. This claim was refuted by Iranian officials.3 It is impossible to overstate the importance of maintaining freedom of navigation through the Strait of Hormuz. The unrest that followed the gasoline price hike was the deadliest since that country’s Islamic Revolution in 1979, according to the New York Times. The Times reported that the Islamic Revolutionary Guards Corps opened fire on protestors calling for the removal of leadership, killing scores.4 Protests also erupted in states closely aligned with Iran in the past couple of months – i.e., Lebanon, Iraq.5 For the oil market, Iraq matters most: It is difficult to overstate the importance of keeping Iraq’s 4.7mm b/d of crude oil production flowing to global markets. Likewise, it is impossible to overstate the importance of maintaining freedom of navigation through the Strait of Hormuz, which connects the Persian Gulf with the Arabian Sea and the rest of the world’s oil-consuming markets (Map 1). Map 1The Persian Gulf And Strait of Hormuz Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Iraq, Iran Violence Raises Gulf Oil Supply Threat Level More than 20% of the world’s crude oil and condensates supplies transit the Strait on any given day (Chart 2). The anti-government protests in Iraq and Iran raise the threat level to production in Iraq, and attacks on shipping transiting the Strait of Hormuz by the latter, or a direct confrontation with the US and its Gulf allies. Our colleagues in BCA Research’s Geopolitical Strategy (GPS) are following the evolution of events in Iran and Iraq closely. Following is their assessment of what led to the most recent unrest in Iraq.6 Chart 2Violence Again Threatens Gulf Oil Supply Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Chart 3AFertile Ground For Unrest In Iraq Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Deadlock In Iraq While both the grievances and demands of the protesters in Lebanon and Iraq are similar, the unrest in Iraq is of much greater consequence from a global investor’s perspective. The trigger was the removal of the highly revered Lieutenant General Abdul-Wahab al-Saadi from his position in the Iraqi army by Prime Minister Adel Abdul-Mahdi.7 The popular general was unceremoniously transferred to an administrative role in the Ministry of Defense. Iraqi protesters are united in their economic grievances, frustrated at a political and economic system that is unwilling to translate economic gains to improved livelihoods for its people. The sacking of al-Saadi – considered a neutral figure – was interpreted as evidence of Iranian influence and the greater sway of the Iran-backed Popular Mobilization Forces (PMF), an umbrella organization of various paramilitary groups. Iraqis all over the country responded by attacking the Iranian consulate in Karbala and offices linked to Iranian-backed militias. Iraqi protesters are united in their economic grievances, frustrated at a political and economic system that is unwilling to translate economic gains to improved livelihoods for its people. The May 2018 parliamentary elections, which ushered in Prime Minster Abdul-Mahdi, failed to generate much improvement. The country continues to be plagued by high unemployment, corruption, and an utter lack of basic services (Charts 3A & 3B). This has ultimately resulted in a lack of confidence in Iraqi leadership who are being increasingly perceived as benefiting from the status quo at the expense of the populace. Chart 3BFertile Ground For Unrest In Iraq Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Most importantly, the ruling elite has failed to respond to key trends that emerged in last year’s parliamentary elections. The extremely low voter turnout reveals that Iraqis are disenchanted with the government's ability to meet their needs. Meanwhile the success of Shia cleric Moqtada al-Sadr’s Sairoon coalition – running on a platform stressing non-sectarianism and national unity – in securing the largest number of seats highlights the desire for a reduction of foreign interference (both Iranian as well as US/Saudi) in domestic politics. Neither the US nor Saudi Arabia have an appetite to step in and provide the support necessary to counteract Iran. Moreover, Iran and its proxies in Iraq will not back down easily. Thus, the ongoing protests are to a great extent the result of the new government’s failure to heed the warnings brought about by the 2018 election and protests. They have served to deepen the rift between the rival Shia blocs, particularly those Iraqi nationalists who deeply resent the intrusion of Iran into its political structures. Iraq is in a state of deadlock. That said, Iran is unlikely to stand by idly as its influence wanes. As a result, we are likely to witness greater unrest as the rift between the two Shia blocs intensifies. Neither the US nor Saudi Arabia have an appetite to step in and provide the support necessary to counteract Iran. Moreover, Iran and its proxies in Iraq will not back down easily. At the same time, the geographical spread of the protest movement demonstrates that Iraqis are fed up with the current system.8 This points to greater instability in Iraq as no side is backing down and the only foreign power willing and able to interfere is Iran. US Sanctions Continue To Pressure Iran The Trump administration’s crippling “maximum pressure” sanctions have sent Iran’s Economy reeling. The Trump administration continues to enforce its “maximum pressure” sanctions, which have reduced Iranian oil exports from 1.8 million barrels per day at their recent peak to 100,000 barrels per day in November (Chart 4). These are crippling sanctions that have sent Iran’s economy reeling. Chart 4Iran Remains Under “Maximum Pressure” Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Iran’s Supreme Leader Ayatollah Ali Khamenei has ruled out negotiations with Trump. They would be unpopular at home without a major reversal on sanctions from Trump (Chart 5). Chart 5 Major US Reversal Prerequisite For Iran Talks Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Trump presumably aims to avoid an oil shock ahead of the election. The US and its allies have visibly shied away from conflict in the wake of Iran’s provocations, including the spectacular attack on eastern Saudi Arabia's oil infrastructure that knocked 5.7 million barrels of oil per day offline in September. However, this does not mean the odds of war are zero. Opinion polls show that the Iranian public primarily blames the government for the collapsing economy. The Americans or the Iranians could miscalculate. Both sides might think they can improve their standing at home by flexing military muscle abroad. Iran is a rational actor and would not normally court American airstrikes or antagonize a potentially lame duck president. Yet it is under extreme pressure due to the sanctions, as the riots and protests following the gasoline price hikes indicate. Iran also faces significant unrest in its sphere of influence, as discussed above. Opinion polls show that the Iranian public primarily blames the government for the collapsing economy, and yet that American sanctions are siphoning off some of this anger (Chart 6). This could tempt Iran’s leaders to continue staging provocations in the Strait of Hormuz or elsewhere in the region, perhaps with attacks on US assets or those of its GCC allies. Chart 6Iranians Blame Tehran, Tehran Blames America Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Hardline Iranian military leaders and politicians currently receive the most favor in polling, while the reformist President Rouhani – undercut by the American withdrawal from the 2015 deal – is among the least popular. Elections for the Majlis, or Parliament, in February will likely reverse the reformist turn in Iranian politics that began in 2012. The regime stalwarts are gearing up for the supreme leader’s succession in the coming years. While a Democratic White House could restore the 2015 deal Trump unilaterally abrogated, that ship may have sailed. Trump, under impeachment, could seek to distract the public. This was Bill Clinton’s tactic with Operations Infinite Reach, Desert Fox, and Allied Force in 1998-99. These operations were minor and not comparable to a conflict with Iran. However, Trump may be emboldened. On paper the US Strategic Petroleum Reserve – along with OPEC and other petroleum reserves and spare capacity – could cover most major oil-shock scenarios. A supply outage the size of the Abqaiq attack in September would have to persist for four months to cause enough price pressure to harm the US economy and decrease Trump’s chances of winning re-election. The simulations in Chart 7 overstate the gasoline price impact by assuming that global strategic oil reserves remain untapped, along with spare capacity. Chart 7Desperation Could Force Iran To Take Excessive Risks Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Thus while the Iranians may take excessive risks, the Trump administration may not refrain this time from airstrikes. Bottom Line: While the Middle East is always full of risks to oil supply, Iran’s vulnerability and Trump’s status at home make the situation unusually precarious. We continue to believe an historic oil-supply disruption is a fatter tail risk than investors realize, or are pricing in currently. Market Round-Up Energy: Overweight Following the long-awaited OPEC 2.0 meeting held last week, the group “surprised” the market by announcing it will deepen its production cut by ~ 500k b/d, pushing the total cut to 1.7mm b/d. The bulk of the additional adjustments comes from Saudi Arabia (Chart of the Week). Importantly, the group emphasizes the importance of full compliance by every member – this would imply a ~225k b/d reduction from Iraq alone. We remain overweight oil in 2020. Base Metals: Neutral Copper prices rose sharply over the past week, reaching $2.71/lb at Tuesday's close, a level last seen in July 2019. US-China trade optimism last Friday sparked the rally. Copper’s physical market remains tight, inventories are low globally, and demand is set to rebound on the back of major central banks’ accommodative monetary policy. Even so, sentiment and positioning remain weak (Chart 8). We expect this to reverse, further supporting prices over the short term. Precious Metals: Neutral Risk-on sentiment following President Trump’s upbeat comments on US-China trade negotiations pushed gold prices down by $18/oz last Friday – one of the largest single-day declines YTD. Precious metals markets continue to follow the ups and downs of trade-war headlines and global growth-related news. Nonetheless, our fair-value model suggests gold is fairly priced at ~ $1,465/oz (Chart 9). Any significant drop below that level would provide an entry opportunity for investors to add gold as a portfolio hedge in 2020. Ags/Softs: Underweight The USDA released its final crop progress update on Monday. Corn was 8% behind full harvest, with North Dakota remaining the laggard with only 43% of the corn picked. Markets ignored this as March Corn futures slid close to 1.5% on a weekly basis. Chinese purchases of at least five bulk cargo shipments of U.S. soybeans lifted prices above $9/bu on Tuesday in anticipation of the USDA monthly crop production report. Wheat prices were flat on a weekly basis, as traders awaited results of an Egyptian purchase tender on Tuesday. Chart 8Copper Sentiment And Positioning Remain Weak Copper Sentiment And Positioning Remain Weak Copper Sentiment And Positioning Remain Weak Chart 9Gold Fair Value Is ~ 5/oz Gold Fair Value Is ~ $465/oz Gold Fair Value Is ~ $465/oz   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Footnotes 1     Please see On OPEC 2.0’s Agenda In Vienna: More Production Cuts, Longer Deal, published December 5, 2019.  We noted  most of the production cuts that matter to the market already are in place – i.e., Saudi Arabia’s over-compliance of ~ 400k b/d, along with Venezuela’s and Iran’s involuntary production cuts of ~ 1.8mm b/d resulting from US sanctions, as of October 2019.  Under the amended production cuts, KSA agreed to remove close to 170k b/d more, lifting its total official voluntary quota and over-compliance, which brings its total cuts to close to 900k b/d.  The total OPEC 2.0 additional cuts come to just over 500k b/d.  Based on media reports going into the Vienna meeting last week, it would appear Russia prevailed on the producer coalition in its effort to keep the expiry of the production deal at end-March.  However, the March 5 extraordinary meeting of the coalition states indicates KSA was successful in keeping the discussion re extending the deal alive. 2     In our current modeling, we assume the original 1.2mm b/d of cuts will remain in place to year-end 2020.  We will be updating our balances and price forecasts in next week’s Commodity & Energy Strategy. 3    Please see U.S. says Iran may have killed more than 1,000 in recent protests, published by uk.reuters.com December 5, 2019.   Iranian leaders blamed “thugs” aligned with the US and rebels for the violence, and, in a separate report citing an Amnesty International claim that 143 protesters were killed, said “several people, including members of the security forces, were killed and more than 1,000 people arrested.”  Please see Iran says hundreds of banks were torched in 'vast' unrest plot published November 27, 2019, by uk.reuters.com.  The size of the price increase is difficult to ascertain: The government says gasoline costs were increased by 50% with a goal of raising $2.55 billion/year, while other reports claim the hike amounted to as much as 300% in different parts of the country last month. 4    Please see With Brutal Crackdown, Iran Is Convulsed by Worst Unrest in 40 Years, published by the New York Times December 1, 2019. 5    The extent to which these states are entwined with Iran recently came to light via a cache of leaked Iranian diplomatic cables obtained by The Intercept, a not-for-profit news organization established by Pierre Omidyar, a founder of eBay.  The cables were published jointly by The Intercept and the New York Times November 19, 2019.  Please see The Iran Cables: Secret Documents Show How Tehran Wields Power in Iraq, published by the Times.  The article claims “The unprecedented leak exposes Tehran’s vast influence in Iraq, detailing years of painstaking work by Iranian spies to co-opt the country’s leaders, pay Iraqi agents working for the Americans to switch sides and infiltrate every aspect of Iraq’s political, economic and religious life.” 6    This analysis in the remainder of this report is an abridged version of original work published by BCA Research’s GPS service in reports entitled Iraq's Challenge To Iran Is Underrated and 2020 Key Views: The Anarchic Society published November 8 and December 6, 2019.  We believe events over the past week and weekend warrant this in-depth examination of the ongoing unrest and instability in Iraq and Iran.  Both reports are available at gps.bcaresearch.com. 7     Lt. Gen. Abdul-Wahab al-Saadi was recognized and respected among Iraqis for fighting terrorism and his role in ridding the country of the Islamic State. The Iran-backed Popular Mobilization Forces were uneasy with Saadi’s close relationship with the US military. His abrupt removal was likely a result of the Iraqi government’s growing concern over al-Saadi’s popularity and rumors of a potential military coup. 8    Protests are occurring in all regions in Iraq. They are supported by Grand Ayatollah Ali al-Sistani. This is a significant development from the 2018 protests which were mainly concentrated in Iraq’s southern region.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Iraq, Iran Violence Raises Gulf Oil Supply Threat Level Iraq, Iran Violence Raises Gulf Oil Supply Threat Level

The 2019 UK General Election result offers four possible medium-term outcomes for UK exposed investments: Conservatives win 340 seats or more: This comfortable majority for the Conservatives is medium-term positive for UK exposed investments, as prime minister Johnson would not be dependent on the 20 or so hard Brexit extremists to pass any free trade deal (FTA) through parliament. Albeit the markets are already pricing the Conservatives to win 337-343 seats. Conservatives win 320-340 seats: This marginal majority for the Conservatives is medium-term risky for UK exposed investments, because the hard Brexit extremists would have disproportionate influence and leverage, keeping open the possibility of a hard Brexit on WTO terms after the standstill transition period ends on December 31 2020.         Conservatives win 310-320 seats: This ‘marginally hung’ parliament is medium-term risky for UK exposed investments, as it is essentially no change from the current gridlocked parliament. Conservatives win less than 310 seats: This ‘comfortably hung’ parliament is medium-term positive for UK exposed investments, as it creates the possibility of the softest (or no) Brexit under a Labour-led minority government. At the same time, a minority government would be unable to pass its most contentious and supposedly ‘market unfriendly’ policies. If the result is 2. the marginal majority, and the market does not appreciate the risk, then it presents a sell opportunity. Conversely, if the result is 4. the comfortably hung parliament, and the market does not appreciate the upside, then it presents a buy opportunity. Fourth Time Lucky For The UK Pollsters? The 2019 UK General Election is the fourth major UK vote since 2015 in which the UK/EU relationship has featured front and centre. The first was the 2015 General Election, in which then prime minister David Cameron promised a referendum on EU membership, subject to the Conservative party winning an outright parliamentary majority, which it duly did. The second was the subsequent 2016 in/out EU referendum in which the UK voted to leave the EU. The third was the 2017 General Election called by prime minister May to bolster her Brexit negotiating position. But May’s plan backfired. She managed to lose the Conservative majority, her party’s Brexit negotiating position, and ultimately her job. So here we are at the fourth major UK vote in little over four years. Significantly, the pollsters got the 2015, 2016, and 2017 UK votes very wrong. In 2015, they predicted a hung parliament; but the actual outcome was a comfortable majority for the Conservatives, forcing Cameron to deliver his promise of an EU referendum. In the ensuing 2016 referendum, the pollsters predicted a narrow win for remain; the actual outcome was a narrow win for leave. Then in 2017, the pollsters predicted a very healthy vote share win for the Conservatives – and the spread betting markets priced the party to win 364-370 seats in the 650 seat UK parliament; but the actual outcome was 317 seats and a hung parliament – because the pollsters had underestimated the Labour vote by five percentage points. Today, just as in 2017, the pollsters are predicting a healthy vote share win and comfortable parliamentary majority for the Conservatives. At the time of writing (election eve) the spread betting markets are pricing the Conservative party to win 337-343 seats. When the election day exit poll comes out at 10pm UK time, we will get a good idea whether it is fourth time lucky for the pollsters. But irrespective of whether they are right or wrong, the immediate market reaction might still offer some medium-term investment opportunities. The Key Numbers… And Where The Immediate Market Reaction Could Be Wrong The Conservatives need a working majority – because having burnt their bridges with the DUP (Northern Ireland unionists), no other party is likely to support prime minister Johnson’s EU withdrawal agreement. Given that the speaker, deputy speakers, and Sinn Fein (Northern Ireland republicans) do not vote in the UK parliament, and depending on the number of seats that Sinn Fein win, the threshold for a working majority will be around 320 seats. This creates four potential outcomes for the markets: Conservatives win 340 seats or more: This comfortable majority for the Conservatives is medium-term positive for UK exposed investments, as Johnson would not be dependent on the 20 or so hard Brexit extremists to pass any free trade deal (FTA) through parliament. But as noted above, the markets are already pricing the Conservatives to win 337-343 seats. Conservatives win 320-340 seats: This marginal majority for the Conservatives is medium-term risky for UK exposed investments, because the hard Brexit extremists would have disproportionate influence and leverage, keeping open the possibility of a hard Brexit on WTO terms after the standstill transition period ends on December 31 2020. Conservatives win 310-320 seats: This ‘marginally hung’ parliament is medium-term risky for UK exposed investments, as it is essentially no change from the current gridlocked parliament. Conservatives win less than 310 seats: This ‘comfortably hung’ parliament is medium-term benign for UK exposed investments, as it creates the possibility of the softest (or no) Brexit under a Labour-led minority government. At the same time, a minority government would be unable to pass its most contentious and supposedly ‘market unfriendly’ policies. Of these four possibilities, if the immediate market reactions to 2. the marginal majority, or 4. the comfortably hung parliament do not appreciate the risk and upside respectively, then they will create sell and buy opportunities for UK exposed investments. What Are The UK Exposed Investments? The most obvious UK exposed investment is the pound, which is still trading at a near 10 percent discount versus the euro and the dollar, based on the pre-referendum relationship with real interest rate differentials (Chart I-1 and Chart I-2). However, the extent to which that discount can narrow depends on how much worse off (if at all) the UK economy finds itself in its new trading relationships with the EU and the rest of the world compared with full membership of the EU. Chart I-1The Pound Is Cheap Versus The Euro The Pound Is Cheap Versus The Euro The Pound Is Cheap Versus The Euro Chart I-2The Pound Is Cheap Versus The Dollar The Pound Is Cheap Versus The Dollar The Pound Is Cheap Versus The Dollar In this regard, the best outcomes are a rapidly negotiated and maximally-aligned FTA with the EU, or the softest (or no) Brexit. Meaning that the aforementioned possibilities 1. or 4. – a comfortable Conservative win or a comfortably hung parliament – are the best outcomes for the UK economy, and therefore for the pound. To the extent that the Bank of England policymakers recognise this, the same conclusion applies to the direction of UK gilt yields, and therefore inversely to UK gilt prices. Turning to the stock market, the FTSE100 is categorically not a UK exposed investment – because it comprises multinationals with minimal exposure to the UK economy. If anything, the FTSE100 is an anti-UK exposed investment. This is because sales and profits are denominated in international currencies, and if these non-pound currencies weaken versus the pound (meaning the pound strengthens) it weighs down the pound-denominated FTSE100 versus other markets (Chart I-3). In fact, the ‘real’ UK stock market is the more UK focussed FTSE250 (Chart I-4), or the FTSE Small Cap index (Chart I-5). Chart I-3When The Pound Strengthens, The FTSE 100 Underperforms When The Pound Strengthens, The FTSE 100 Underperforms When The Pound Strengthens, The FTSE 100 Underperforms Chart I-4The 'Real' UK Stock Market Is The FTSE 250, Not The FTSE 100 The 'Real' UK Stock Market Is The FTSE 250, Not The FTSE 100 The 'Real' UK Stock Market Is The FTSE 250, Not The FTSE 100 Chart I-5Small Caps Are Exposed To The UK Economy Small Caps Are Exposed To The UK Economy Small Caps Are Exposed To The UK Economy In terms of equity sectors, the least exposed to the UK economy are the multinationals with international currency earnings. As well as the obvious oil and gas, resources, and healthcare sectors, it includes the global banks and clothing and apparel (Chart I-6). Chart I-6Clothing Is Not Exposed To The UK Economy Clothing Is Not Exposed To The UK Economy Clothing Is Not Exposed To The UK Economy The sectors most exposed to the UK economy are the homebuilders (Chart 7), real estate (Chart 8), and general retailers (Chart 9). All of these, plus the FTSE250 and FTSE Small Cap, and of course the pound, can outperform in the medium term in the aforementioned possibilities 1. and 4. – a comfortable win for the Conservatives or a comfortably hung parliament. But they will face pressure in possibilities 2. and 3. – a marginal win for the Conservatives or a marginally hung parliament. Chart I-7Homebuilders Are Exposed To The UK Economy Homebuilders Are Exposed To The UK Economy Homebuilders Are Exposed To The UK Economy Chart I-8Real Estate Is Exposed To The UK Economy Real Estate Is Exposed To The UK Economy Real Estate Is Exposed To The UK Economy Chart I-9General Retailers Are Exposed To The UK Economy General Retailers Are Exposed To The UK Economy General Retailers Are Exposed To The UK Economy Fractal Trading System* This week's recommended trade is long nickel / short gold, the reverse of the successful trade we recommended on October 3. Back then the nickel price had become technically extended due to scares about an Indonesian export ban. And as predicted, the price subsequently collapsed (by 30 percent) to the point where the price has now become technically depressed. Accordingly, this week's recommendation is long nickel / short gold setting a profit target of 10 percent with a symmetrical stop-loss. The rolling 1-year win ratio stands at 64 percent. A UK Election Special (Again) A UK Election Special (Again) 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.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model A UK Election Special (Again) A UK Election Special (Again) A UK Election Special (Again) A UK Election Special (Again)   Cyclical Recommendations Structural Recommendations A UK Election Special (Again) A UK Election Special (Again) A UK Election Special (Again) A UK Election Special (Again) A UK Election Special (Again) A UK Election Special (Again) A UK Election Special (Again) A UK Election Special (Again) Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations