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Highlights Today, we are sending out a previously scheduled Special Report, highlighting our thoughts on the how to assess the impact of China on global bond markets. This is an important topic that we hope you will find of great interest. We will not be offended, however, if that report sits in your inboxes for a day or two while the world awaits the results of today's U.S. Presidential election. Feature Global financial markets have been subject to extraordinary volatility over the past couple of weeks as the election campaign has drawn to a close. Investors have had to deal with the steady inflow of shifting poll results, overbearing media punditry, surprising FBI letters and wild conspiracy theories, all while trying to price the risks associated with two of the most polarizing presidential candidates in U.S. history. The recent narrowing of Hillary Clinton's lead in the polls has forced investors to seriously consider the possibility of a President Donald J. Trump, with all the change from the status quo that he represents. Given how markets have reacted to Trump closing the gap with Clinton - falling equity prices, higher volatility, lower bond yields and a weaker U.S. dollar - a Trump win could trigger a true risk-off market rout, with global investors wanting to avoid been burned by another political surprise after Brexit. Our colleagues at BCA Geopolitical Strategy still view a narrow Clinton victory as the most likely outcome, with admittedly lower conviction levels than usual for such an important election. Such is the problem of making predictions when polls are within margins of error. However, given the well-understood realities of the U.S. Electoral College map and the still-uphill climb needed for Trump to win, the result that would catch investors most off-guard would be The Donald pulling off the upset. From our perspective at BCA Global Fixed Income Strategy, a Clinton victory would keep the global economy on its current positive growth track in the near-term. This would shift bond investors' focus back over to the Fed and a likely December rate hike. However, a risk-off market move after a Trump win would represent the biggest risk to our current portfolio recommendations: We are positioned for rising global bond yields via an overall below-benchmark duration stance, given our view that we are in a cyclical growth upturn that is also pushing global inflation higher (more details on China's contribution to that can be found in the Special Report sent out today). In terms of regional bond allocation, we are favoring the areas with the lowest inflation rates and most credible dovish central banks, via an above-benchmark tilt in core Europe and a neutral stance on Japan and Canada. We are underweight the countries where central bankers are either in the process of raising rates (the U.S.) or will soon face a decision to tighten policy in the face of strong growth and rising inflation pressures (the U.K., Australia). We are also underweight Peripheral European debt (Italy, Spain, Portugal) versus Germany due to our concerns over decelerating growth in the Periphery combined with the ongoing stresses on Euro Area banks. We are overweight inflation protection (via linkers and CPI swaps) in the U.S. and U.K. where we see the greatest potential for rising inflation expectations. Within global credit markets, we are maintaining a defensive stance via underweights in U.S., Euro Area and Emerging Markets High-Yield (which are all overvalued and overlevered). Within Investment Grade corporates, we are only maintaining a neutral stance in the U.S. and above-benchmark tilts in the Euro Area and U.K. We are also neutral on Emerging Market hard currency debt, both sovereigns and corporates. In the event that Trump pulls out the win tonight, we would expect our overall below-benchmark duration call to suffer if bond yields declines in a risk-off move. However, our "break-even" level on that call allows some cushion to stick with the underweight, as we initiated the recommendation back in July when the 10-year U.S. Treasury yield was just below 1.60%. A return to those levels would be a 25bp decline from yesterday's closing level of 1.83%, which would be a massive move if it happened in a short period of time immediately after Trump was declared the winner. Yet if such large move in yields were to occur, it would almost certainly be in the context of a rout in global equity markets. Our underweight stance on high-yield corporates and Peripheral Europe would perform very well there. Our generally cautious stance on higher-quality corporates and Emerging Markets would likely cause minor hits only via our overweights in Europe, but with those markets supported by the ongoing central bank buying by the ECB and Bank of England, the losses should be relatively well-contained. There is also a risk that our overweights in inflation protection in the U.S. and U.K. would underperform, especially if the market rout turns into a lasting shock to global growth and inflation expectations. That will be difficult to determine in the immediate aftermath of a Trump win. Summing it all up, there are enough offsetting positions within our recommended portfolio to not suggest any changes into tonight's election. Let us hope that the election result is decisive enough that a winner can be declared tonight and this period of U.S. political uncertainty can end, whoever wins. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Recommendations Duration Regional Allocation Spread Product

Highlights The perceived shape of Brexit is the single most important driver of the pound and most U.K. assets. The U.K. Courts are due to deliver landmark legal rulings, which have huge implications for the perceived shape of Brexit. Expect an eventual soft Brexit if the Courts decide against the U.K. government and deem that triggering Article 50 requires parliamentary approval. Expect a much harder Brexit if the Courts decide in favour of the U.K. government. Tactical investors should consider owning some very short-term call options on pound/dollar or a combination of call and put options. Feature Within the next two weeks, the U.K. High Court will deliver a landmark legal ruling which will have huge implications for the future of the U.K. and Europe. Chart of the WeekDifferent Levels Of Brexit Mean Different Levels Of The Pound bca.eis_wr_2016_10_27_s1_c1 bca.eis_wr_2016_10_27_s1_c1 The U.K. High Court will rule whether Prime Minister Theresa May can start the legal process to exit the EU using the so-called 'royal prerogative' - the power granted to governments to make decisions without a vote from parliament. If May cannot use the royal prerogative, she will require an Act of Parliament to trigger Article 50 of the Lisbon Treaty. The High Court judgement hinges on a fundamental issue. Triggering Article 50 necessarily means that the current government will overturn previous parliamentary decisions - the European Communities Act (1972) and European Union Act (2011). Does the constitution permit a government to overturn parliamentary decisions, take away treaties, and remove the population's legal rights without obtaining parliamentary approval? Although we are not legal experts, the court could regard that as overstretching government authority. If the High Court's judgement does go against the U.K. government, expect pound/dollar to rally immediately by about 4-5 cents. Conversely, a judgement in favour of the government could see the pound sell off by about 1-2 cents. Given the possibility of this gapping, tactical investors should consider owning some very short-term call options on pound/dollar, or a combination of call and put options. Nevertheless, the story will not end with the High Court. Whichever side loses will appeal the decision and take the case to the Supreme Court, which is expected to respond by the end of the year. This ultimate pronouncement of law will have a landmark bearing on the shape of Brexit and, thereby, the future of the U.K. and the other EU 27. Where Is The Pound Headed Longer-Term? For investors, the spectrum of Brexit possibilities - no Brexit, 'soft' Brexit, 'hard' Brexit, or 'very hard' Brexit - will be the single-most important driver of the pound, and by extension, other U.K. assets. Of course, U.K. asset prices ultimately depend on economic and financial fundamentals. But Chart I-2, Chart I-3, Chart I-4, Chart I-5, Chart I-6, Chart I-7 illustrate that by far the most important fundamental for all U.K. assets right now is the perceived hardness of Brexit, as captured in the pound's value. Chart I-2Harder Brexit Means The Eurostoxx600 ##br##Underperforms The FTSE100... bca.eis_wr_2016_10_27_s1_c2 bca.eis_wr_2016_10_27_s1_c2 Chart I-3...And The FTSE250 ##br##Underperforms The FTSE100 ...And The FTSE250 Underperforms The FTSE100 ...And The FTSE250 Underperforms The FTSE100 Chart I-4Harder Brexit Means U.K. ##br##Goods Exporters Outperform... bca.eis_wr_2016_10_27_s1_c4 bca.eis_wr_2016_10_27_s1_c4 Chart I-5Harder Brexit Means ##br##Retailers Underperform... bca.eis_wr_2016_10_27_s1_c5 bca.eis_wr_2016_10_27_s1_c5 Chart I-6...Travel And Leisure Underperforms... bca.eis_wr_2016_10_27_s1_c6 bca.eis_wr_2016_10_27_s1_c6 Chart I-7...And Real Estate Underperforms bca.eis_wr_2016_10_27_s1_c7 bca.eis_wr_2016_10_27_s1_c7 Pound/dollar has (so far) traded at three distinct levels, based on three distinct levels of perceived Brexit severity: near 1.50 before the Brexit vote; near 1.30 after the Brexit vote but perceiving a soft Brexit; and near 1.20 after Theresa May announced that she would trigger Article 50 by next March and was contemplating a hard Brexit (Chart of the Week). Hence the (post-appeal) outcome of the legal case against the government carries great significance. If the government loses, and requires a parliamentary vote to trigger Article 50, several consequences follow. Theresa May's end-March deadline for firing the Brexit starting gun would become very difficult to meet, severely delaying the whole process. Would the government even win a parliamentary majority? If in doubt, would the government call a snap General Election to try and beef up its majority? The current batch of parliamentarians has a strong bias for staying in the EU, but it would be difficult to fly in the face of the referendum result. On the other hand, the checks and balances of parliament are there precisely to stop the country walking over the cliff-edge that a very hard Brexit would be. All the while, with investment slowing and higher inflation from the weaker pound squeezing household real incomes, the economic headwinds from the U.K.s limbo status would be becoming more apparent. Given the high stakes and likely irreversibility of the formal legal process, parliamentarians would rightfully want to examine and approve the U.K.'s negotiating hand. It seems that Parliament would almost certainly water down or delay Brexit before voting it through. Hence, if the government loses its legal case after appeal, Brexit will likely end up in a soft form. And pound/dollar will ultimately elevate to 1.35. Conversely, if the government wins its legal case after appeal, Theresa May will be on course to trigger Article 50 early next year, as promised. At which point, the EU 27's optimal game-theoretical first play is to be very aggressive - effectively opening with a very hard Brexit offer as described in the next section. Whereupon, pound/dollar would find its fourth, even lower, new level: near 1.10. Two Myths About Brexit It is important to debunk a couple of common myths about Brexit. First, that the U.K.'s current position as the EU 28's second largest economy will force the remaining EU 27 to give the U.K. a special status - allowing access to the three freedoms of goods, services, and capital but with controls on the fourth freedom of movement: people. This belief is misplaced. The biggest worry for the EU 27 is that a special status for Britain could catalyse other countries, under populist pressure, to ask for equivalent deals. The EU 27 does not want to give Marine Le Pen the opportunity to say "let's follow the Brits, they've negotiated a great deal." Hence, the U.K. will not get special treatment. Quite the contrary, it must be seen to be paying a substantial price for Brexit. Even for Anglophile Angela Merkel, protecting the indivisibility of the four freedoms and the integrity of the EU is the overriding priority. If the U.K. restricts free movement of people, it almost certainly means a hard Brexit: substantially restricted access to the single market. The U.K. would then have to negotiate a free trade agreement (FTA) with the EU. Given the current difficulty that Canada is experiencing in negotiating a FTA, this might not be a straightforward process for the U.K either. Furthermore, as a FTA does not usually cover services, it would handicap the services-heavy U.K. economy, while perfectly suiting the goods-heavy German economy. A second common belief is that the pound will act as an automatic economic stabilizer. That irrespective of a very tough deal from the EU 27, a weaker sterling will soothe the pain of a very hard Brexit by making British exports more competitive. Granted, the weaker pound will boost the demand for the U.K.'s goods exports. But total U.K exports are much less sensitive to devaluations compared to when the pound tumbled out of the Exchange Rate Mechanism in 1992. Then, just a quarter of the U.K's exports were services; today that proportion is approaching a half (Chart I-8) With the exception of tourism, these services tend to be high value-added financial and business services. Cutting their price will not significantly boost the demand for them. Chart I-8Almost Half Of U.K. Exports Are Services Almost Half Of U.K. Exports Are Services Almost Half Of U.K. Exports Are Services Meanwhile, U.K. consumers will feel distinctly poorer as the sterling prices of food and energy rise (Chart I-9), squeezing real household incomes and spending. In turn, this will leave the Bank of England with a major headache. How best to support real spending: defend the plunging pound to keep a lid on food and energy prices, or cut interest rates? Chart I-9Higher Sterling Prices For Food And Energy Will Squeeze Real Incomes Higher Sterling Prices For Food And Energy Will Squeeze Real Incomes Higher Sterling Prices For Food And Energy Will Squeeze Real Incomes Investment Reductionism For U.K. Assets The charts throughout this report show that the strategy for many U.K. investments reduces to an overriding question. Will the U.K largely retain access to the single market, defining a soft Brexit? Or will the U.K. largely lose access to the single market, defining a hard Brexit? In a soft Brexit: Sterling would rally 10%, taking pound/dollar to 1.35. The Eurostoxx600 and S&P500 would outperform the FTSE100. Within U.K. equities, sterling earners would outperform dollar earners, favouring small and mid-cap over large cap. The FTSE250 would outperform the FTSE100. The heavily domestic-focused retailers, travel and leisure, and real estate sectors would outperform the market. Goods exporters, such as the apparel sector would become less competitive and underperform the market. In a hard Brexit, expect the exact opposite of the above. Pound/dollar would slump 10% to 1.10, and so on. To determine which strategy to follow, await the post-appeal Supreme Court judgement on how Article 50 must be triggered, due at the end of the year. If Article 50 requires parliamentary approval, expect a soft Brexit. If it doesn't require parliamentary approval, expect the Brexit game theory to become hard and aggressive. Right now this is a coin toss, but forced to choose, we expect events may eventually prevent a damaging hard Brexit. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* This week's trade is another commodity pair trade: long copper / short tin. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart 10 Long Copper / Short Tin Long Copper / Short Tin * 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 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields bca.eis_wr_2016_10_27_s2_c1 bca.eis_wr_2016_10_27_s2_c1 Chart II-2Indicators To Watch - Bond Yields bca.eis_wr_2016_10_27_s2_c2 bca.eis_wr_2016_10_27_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_wr_2016_10_27_s2_c3 bca.eis_wr_2016_10_27_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_wr_2016_10_27_s2_c4 bca.eis_wr_2016_10_27_s2_c4 Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_27_s2_c5 bca.eis_wr_2016_10_27_s2_c5 Chart II-6Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_27_s2_c6 bca.eis_wr_2016_10_27_s2_c6 Chart II-7Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_27_s2_c7 bca.eis_wr_2016_10_27_s2_c7 Chart II-8Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_27_s2_c8 bca.eis_wr_2016_10_27_s2_c8

Highlights Just ahead of the attempted coup d'état in Turkey, the international press was largely complementary of the political situation in the country. For example, a Bloomberg headline read "Once Spurned, Turkey Stocks Find Love As Political Risk Ebbs" mere hours before the coup!1 Feature Politics Stay The Same: Not Good BCA's Geopolitical Strategy has challenged the sanguine narrative on Turkey since 2013.2 The ruling Justice and Development Party (AKP) - once a reformist beacon in emerging markets - has become a political vehicle for President Recep Erdogan's political power grab - Erdogan has been planning to turn Turkey into a presidential republic, giving himself more powers - since 2013. Protests erupted that year against the government, in large part due to growing suspicion among secular, and mainly urban, middle classes that Erdogan and his Islamist AKP were evolving the country towards soft authoritarianism. Since the protests in 2013, the country's politics have been off track: A vast corruption scandal ensnaring the ruling AKP, including Erdogan's family, erupted in late 2013, prompting then-Prime Minister Erdogan to blame the moderate Islamist Gülen movement and its allies in the judiciary; Erdogan won a closer-than-expected presidential election in 2014, becoming the first democratically-elected president in modern Turkish history, and immediately set out to award himself greater powers through constitutional reform; AKP then failed to win a majority in the June 2015 general election; The election was immediately followed by a manufactured anti-insurgency campaign against ethnic Kurds designed to reduce support for moderate pro-Kurdish parties and allow the AKP to win a majority in the next election; In November 2015, the AKP finally won a majority; Many reformist members of the AKP have since been sidelined, including Erdogan's predecessor as President Abdullah Gül, and his successor as Prime Minister Ahmet Davutoglu. Despite the political turbulence, markets have largely looked through the risks (Chart 1). And, this is not even including the geopolitical risks engulfing Turkey's neighbors, including the souring relations with Russia, Israel, and the EU, due to Ankara's role in the migration crisis. Investors have largely given Turkey the benefit of the doubt, despite Erdogan's penchant for heterodox monetary policy and lack of focus on structural reforms. The AKP - which swept into power in the early 2000s on an agenda of promoting democracy, moderate Islamist cultural values, and economic reforms - has essentially become completely focused on the single goal of enhancing Erdogan's power. The failed coup is a silver lining for Erdogan as it will allow him to accomplish what electoral politics could not (he has in fact referred to the coup as a "gift of God"). Thousands of military, law enforcement, and judicial professionals have been arrested since the uprising. It is very likely that Erdogan will use the event as a pretext to undermine whatever checks and balances still exist in the country. In addition, it would appear that relations between Turkey and the West are also set to sour. First, Erdogan has demanded that the U.S. extradite moderate cleric Fethullah Gülen, who Erdogan sees as a chief rival, despite the fact that Gülen has not lived in Turkey since 1999. Second, the government has arrested the Turkish commander in charge of the Incirlik Air Base, which hosts U.S. forces, grounding U.S. air operations against the Islamic State. Third, the EU could pull the plug on its deal with Turkey which would see Ankara limit the migrant flows into the bloc, which Turkey had agreed to in exchange for visa-free travel, progress in negotiations for EU membership, and EUR 3 billion. The deal was signed in March, well past the point at which the migrant flows to Europe peaked (Chart 2), which suggests that the deal may not be as relevant to stopping the flow of migrants as most pundits claim. The EU's post-coup statement emphasized support for democracy in Turkey, but also stopped short of backing Erdogan personally. Chart 1Investors Should Stay##br##Underweight Turkish Assets Investors Should Stay Underweight Turkish Assets Investors Should Stay Underweight Turkish Assets Chart 2Migrant Flows: No Longer##br##A Bargaining Chip For Turkey bca.ems_sr_2016_07_18_s1_c2 bca.ems_sr_2016_07_18_s1_c2 Bottom Line: Investors who hoped that the November election would resolve political intrigue in Turkey and focus Ankara on structural reforms will be disappointed. The coup gives Erdogan the excuse to use extra-judicial methods to grab as much power as he can and to concentrate on rooting out enemies in the judiciary and the armed forces. Economic And Financial Headwinds While President Erdogan will consolidate power and finalize the formation of an authoritarian regime, the economic and financial challenges facing the government will intensify. A negative confidence shock is the last thing Turkey needs: The country runs a current account deficit of US$ 27 billion, or 4% of GDP (Chart 3). Any country running a current account deficit relies on foreign funding in order to grow. If foreign funding diminishes, the country will have to reduce domestic demand. This will be achieved via a weaker currency, higher interest rates, or a combination of the two. A weaker currency will depress imports by making them more expensive for residents, while higher interest rates will curtail domestic demand. Given recent political developments, it is reasonable to assume that foreign investors will reduce their appetite for Turkish assets. This will weigh on the currency and potentially force interest rates higher. Furthermore, tourism makes up 22% of total exports and 4% of GDP. Tourism revenues will be hit more in the following months (Chart 4), aggravating their current nose-dive. Chart 3Turkey Is Heavily Reliant##br##On Foreign Funding Turkey Is Heavily Reliant On Foreign Funding Turkey Is Heavily Reliant On Foreign Funding Chart 4Plunging Tourist Arrivals Will##br##Weigh On The Currency's Value bca.ems_sr_2016_07_18_s1_c4 bca.ems_sr_2016_07_18_s1_c4 The central bank only has US$12 billion of net foreign exchange reserves - equivalent to 0.6 months of imports - to defend the exchange rate. The gross value of foreign exchange reserves (US$ 103 billion) published by the central bank includes commercial banks foreign currency deposits at the central bank (Chart 5). These foreign currency resources do not belong to the central bank. The authorities might use them to defend the lira, but that could undermine investor confidence and reduce their willingness to hold Turkish assets. Finally, the funding of Turkey's current account deficit is not of high quality. Net FDI has amounted to US$ 9 billion over the past 12 months, with net portfolio investment at US$ -5 billion, and net errors and omission at US$ 2 billion. Overall, odds are that the foreign flows will diminish in the wake of political uncertainty and the lira will depreciate. As this occurs, local market-driven interest rates - bond yields and money-market rates - will rise. This will force banks to hike their lending rates and credit growth, which has been running at an annual pace of 10%, will decelerate further (Chart 6). This will weigh on the economy and thus odds of recession are not trivial. Chart 5Turkey Is Low On Hard Currency Reserves Turkey Is Low On Hard Currency Reserves Turkey Is Low On Hard Currency Reserves Chart 6Credit Growth To Slow Further bca.ems_sr_2016_07_18_s1_c6 bca.ems_sr_2016_07_18_s1_c6 Chart 7The Credit-Led Growth Boom Is Over The Credit-Led Growth Boom Is Over The Credit-Led Growth Boom Is Over As growth deteriorates following a 10-year credit boom (Chart 7), bank non-performing loans (NPL) and provisions will have to rise, and bank balance sheets will weaken noticeably. With bank stocks accounting for 38% of the MSCI Turkey equity index, poor banking health will weigh on the stock market. Bottom Line: Asset allocators should stay underweight Turkish stocks and sovereign credit within their respective EM benchmarks. We also recommend maintaining short positions in both the Turkish lira versus the U.S. dollar and Turkish bank stocks. Marko Papic, Managing Editor marko@bcaresearch.com Arthur Budaghyan, Managing Editor arthurb@bcaresearch.com 1 Please see Bloomberg, "Once Spurned Turkey Stocks Find Love As Political Risk Ebbs," dated July 13, 2016, available at bloomberg.com. 2 Please see BCA Geopolitical Strategy Monthly Report, "The Coming Political Recapitalization Rally - Turkey: Canary In The EM Coal Mine?," dated June 13, 2013, and BCA Geopolitical Strategy Special Report, "Emerging Markets: No Curtain To Hide Behind," dated September 11, 2013, available at gps.bcaresearch.com.

Highlights The U.K. has a new Prime Minister - former Home Secretary Theresa May - who has committed her cabinet to pursue a divorce from the EU. With the government in London now falling inline with the mantra that "Brexit means Brexit," is there no hope for a reversal of the June 23 referendum results? Feature In this Brexit Update, we tackle three questions: What is the big picture relevance of Brexit? Have the "next steps" of the Brexit saga become any clearer? What does the U.K. want and can it get it from the EU? The global relevance of Brexit is that it will signal to the markets that stimulative fiscal policy is around the corner. To be clear, Brexit will not cause fiscal stimulus (at least not outside the U.K.). Rather both Brexit and government spending are symptoms of the same disease: low growth, deflationary, environment in the context of two decades of stagnating wages and high household debt levels. This dynamic is politically pernicious and thus unsustainable, inevitably leading policymakers to reach for the fiscal lever, as BCA's Geopolitical Strategy has argued for some time.1 Here Comes G Voters in the U.K. rejected EU membership for a number of reasons. However, data shows that the best predictor for Brexit support was a level of education (Chart 1), suggesting that voters ultimately decided based on their own personal level of competitiveness in a globalized economy. Theresa May is a shrewd politician who understands that the Brexit referendum was about more than just the EU, British sovereignty, and overbearing Brussels' bureaucrats. Only London, as far as England is concerned, voted to remain in the union. London's denizens are neither threatened by changes to the British economy wrought by globalization, nor bothered by Eastern European immigrants working primarily in the service industry. For the U.K. Conservative Party, which draws its support almost exclusively from England, the referendum is a massive wake up call. The Tories who do not heed the alarm-bells, will be left without a job. For investors trying to make sense of this post-Brexit Britain, May's first speech may serve as a useful guide. The Prime Minister promised to fight "against the burning injustice that if you're born poor you will die on average nine years earlier than others." She added that for an "ordinary working class family, life is much harder than many people in Westminster realize. When it comes to opportunity, we won't entrench the advantages of the fortunate few, we will do everything we can to help anybody, whatever your background, to go as far as your talents will take you."2 There were no promises of corporate tax cuts, business-friendly policies, or free-trade deals with India and China.3 And we suspect that May's government, with new Chancellor of the Exchequer Philip Hammond at the head, will do away with austerity and look to counter any Brexit-induced recession with fiscal stimulus in the fall. Chart 1Brexit: A Protest Vote##br##By Those Left Behind Brexit Update: Does Brexit Really Mean Brexit? Brexit Update: Does Brexit Really Mean Brexit? Chart 2Here Comes G bca.gps_sr_2016_07_15_c2 bca.gps_sr_2016_07_15_c2 If Britain's Tories can move towards the left-of-spectrum on economic policy, then almost any center-right party can. A low-growth environment is politically pernicious in a context where median wages have stagnated for decades and households are laden with debt. The median voter in developed economies is moving to the left, which means that political parties will either follow or become uncompetitive.4 As such, investors should not think of Brexit as the cause for inflationary fiscal policies. Rather, both Brexit and government spending are the symptoms of the same disease. Bottom Line: When the political and geopolitical intrigue of Brexit is removed, investors are left with one key takeaway: popular anger in developed economies will end austerity. We expect to see a positive fiscal thrust from most major economies by the end of 2017 (Chart 2). In the long term, however, investors will lament the erosion of political support for laissez-faire economics. With demand-side policies coming back into vogue, investors should prepare for inflation to make a comeback. The Next Steps Our rule of thumb with flow-charts and decision-trees is simple: If they become unintelligible when one squints at them, then they are a sign that the author does not really know what is going on (Diagram 1). Diagram 1Next Steps: It's Complicated Brexit Update: Does Brexit Really Mean Brexit? Brexit Update: Does Brexit Really Mean Brexit? We admit that we have little conviction with the next steps laid out in our decision-tree diagram. But we know one thing with a high degree of certainty: nobody else does either. There are three questions that our decision-tree diagram immediately brings to mind: Is a new election necessary? Not at all. There is no constitutional reason why May would call a new election. She was a key member of David Cameron's cabinet, heading a high-profile ministry. As such, she can rightly say that she represents a continuation of the Conservative Party democratic mandate, received with the last election. We do not expect May to call an election. Does invoking Article 50 require parliamentary approval? The governments says no, many constitutional law experts in Britain say yes.5 We suspect that May will not seek parliamentary approval, given that she has already empowered Brexit-advocate David Davis to pursue negotiations with the EU via a new ministry solely dedicated to exiting the EU. Will exiting the EU require parliamentary approval? We have a high conviction view that Westminster will ultimately have to decide whether the U.K. leaves the EU.6 This is because the act of leaving the EU is not just related to invoking Article 50, which handles London's relationship with the EU. In order to formally abrogate the supremacy of Brussels-made laws, the U.K. will have to repeal the European Communities Act (1972). What do our answers mean for investors? First, May and her "Brexit Minister" Davis have hinted that Article 50 would only be invoked by January. This suggests that May still wants to have a "cooling off" period ahead of negotiations with the EU despite her surprising early victory (in addition, it further suggests that Brexit proponents truly have no plan as to how to pursue exit). While May continues to repeat her election pledge that "Brexit means Brexit," she did support the "Stay" side and may be trying to allow economic and political consequences of Brexit to hit home with voters. Second, we do not see Article 50 as a doomsday clock that begins ticking once negotiations for exit with the EU begin. Given that May would likely ask Westminster to formalize EU exit in parliament, say some time in 6-18 months, political realities of that moment would decide the vote. As such, investors should carefully watch opinion polls, particularly party performance (Chart 3) for any sign of "Bremorse." Chart 3Watch The Opinion Polls##br##For Signs Of Bremorse bca.gps_sr_2016_07_15_c3 bca.gps_sr_2016_07_15_c3 Third, May has appointed a number of prominent Brexit supporters in her cabinet, with Davis heading the new "Brexit Ministry" and Boris Johnson installed as the Foreign Secretary. What message should investors take from this move? On one hand, it could mean that May has come to terms with the referendum and is committed to Brexit. On the other, she may be setting up her potential rivals for failure when the public turns on Brexit and its proponents. Either way, she remains above the fray and able to manoeuvre out of Brexit if needed. Fourth, we believe that a second referendum is possible, despite May's firm statement that there would be no second referendum on "EU membership." That may be true, but there could be a referendum on whatever kind of a deal - or more precisely, outlines of a deal - the U.K. negotiators produce with Brussels. Bottom Line: May has undoubtedly started her premiership with a commitment to executing an exit from the EU. However, the probability of Brexit is still a coin-toss. It will depend on how the U.K. economy and politics evolve over the course of its negotiations with the EU. By putting Eurosceptics in charge of the negotiations with the EU, May is absolving herself of any poorly negotiated Brexit terms, a cunning political move if there ever was one. Introducing The Brexit Trilemma The U.K. is caught in a Brexit Trilemma. London wants to retain access to the common market and maintain "passporting" rights for its services industry (particularly the City's financial firms), while preventing EU citizens from accessing its labor market. According to Brussels and Berlin, the U.K. cannot get all three. London believes that it can ultimately threaten market access for German car manufacturers and use it to get all that it wants in negotiations. At least, that is what Davis, the "Brexit Minister" has publicly stated on a number of occasions. In our view, this is a poor negotiating strategy. First, German car exports are highly competitive globally, regardless of trade arrangements. If BMW and Mercedes-Benz can sell cars in China, we're pretty sure a post-EU U.K. will not be a challenge. Second, the U.K. is a significant market for German exports, at 7% of all exports destined for Britain. However, the EU is a far greater destination for British exports, with 55% of all exports going to the bloc.7 Third, the U.K. may have a deficit with the EU in goods and thus wouldn't mind if severing of links with the bloc improved its trade balance, but it has a surplus in services (Chart 4). In a post-WTO environment, it is difficult to be protectionist with trade in manufactured goods, but it is relatively easy to protect one's domestic services market via non-tariff barriers to trade. In fact, one of the biggest complaints out of London in relation to its EU membership has been the slow implementation of the 2006 EU's Services Directive, which would have enhanced cross-EU trade in services. The directive was transposed by all member states, but has only been implemented half-heartedly, and at times not at all, since coming into force in 2009.8 Now that the U.K. is preparing to exit the bloc, it is likely that it would see a reversal in whatever small steps the EU had made towards a "services union." Taking these constraints into consideration, the U.K. has a decision to make on its future relationship with the EU. There are three options: WTO option: no trade deal, U.K.-EU relationship falls to the level of two WTO-signatories. Bespoke option: A "bespoke" trade deal is one akin to the Swiss-EU relationship - which is in fact a large number of smaller bilateral deals - or one that the EU negotiated with Canada, and that took seven years to conclude. This is essentially as unappetizing as the WTO option as it would leave the U.K. in limbo for years. EEA: Members of the European Economic Area (EEA) retain full access to the Single Market. This also includes "passporting" for various services industries. It is therefore the optimal option for the U.K. from a trade perspective. However, the U.K. would have to continue paying a somewhat reduced membership fee and give EU citizens access to its labor market. The EEA option does provide for "safeguard measures" to be enacted on any part of the agreement, including on migration, in cases of "serious economic, societal or environmental difficulties of a sectoral or regional nature."9 These measures can be retaliated against by other EEA members, but only "in kind." This would mean that U.K. citizens would be barred access to the EU labor market, which would be an acceptable cost for U.K. policymakers. As such, the EEA option may be acceptable to all sides. Ultimately, the main question is whether Brussels and Berlin will allow the U.K. to limit EU migration. From a perspective of national interest, we do not see why EU member states would insist on forcing the U.K. to take on EU immigrants. After all, does it not serve Germany's interests that Eastern European EU nationals lose the option of migrating to the U.K. and instead have to choose Germany as their destination? However, from the perspective of EU-wide interests, it does make sense that the U.K. is made to jump through hoops so as to discourage other member states from seeking their own à la carte deals. Bottom Line: Brexit vote was very clearly motivated by the influx of migrants from "EU accession countries. (Chart 5)"10 There is no flexibility on this issue for U.K. politicians, unless Bremorse sets in and the British public changes its mind. We suspect that various EU member states are more flexible on the issue of migration, but may want to make the U.K. suffer nonetheless, in order to prevent further exits down the line. Chart 4Brexit: Bad For The U.K.##br##Services-Dominated Economy bca.gps_sr_2016_07_15_c4 bca.gps_sr_2016_07_15_c4 Chart 5Brexit Sends A Clear##br##Signal On Immigrants bca.gps_sr_2016_07_15_c5 bca.gps_sr_2016_07_15_c5 A happy medium may ultimately be possible. One where the U.K. gets limits to free movement of people, but pays for the privilege to "shoot its economy in the foot" through a trade-deal that favors the EU. Why do we put it that way? Because immigrants from EU accession countries account for a quarter of the U.K. potential GDP growth rate. As such, the U.K. will be made to pay for the right to limit its own potential GDP growth rate. Marko Papic, Managing Editor marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation), dated July 13, 2016, "Introducing: The Median Voter Theory," dated June 8, 2016, "Nuthin' But A G Thang," dated August 12, 2015, "Is Abenomics The Future?," dated February 11 2015, "The Apex Of Globalization - All Downhill From Here," November 12, 2014, "The Return Of 'G?'" dated November 13, 2013, "Austerity Is Kaputt," dated May 8, 2013, all available at gps.bcaresearch.com. 2 Please see BBC, "Boris Johnson made foreign secretary by Theresa May," dated July 13, 2016, available at BBC.com. 3 One of the main arguments in favor of Brexit was that it would allow the U.K. to negotiate free trade deals with the entire world once it became unencumbered by protectionist EU member states such as France and Italy. The problem with this idea is that it assumes that the voters who rejected EU membership will then support a doubling-down on free trade, with countries such as India and China no less! Our view? Not a chance. 4 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 5 Please see Nick Barber et al, "Pulling the Article 50 'Trigger:' Parliament's Indispensable Role," dated June 27, 2016, available at ukconstitutionallaw.org. 6 Please see BCA Geopolitical Strategy Special Report, "The Coming EXITentialist Crisis," dated June 24, 2016, available at gps.bcaresearch.com. 7 This is not a coincidence. The whole point of the EU is that it is the world's richest consumer market. As such, it has a massive negotiating leverage with all trade partners. As a side note, this throws into doubt the logic that the U.K. can get better trade deals by leaving the bloc. First test of that premise will be its negotiations with the EU itself. 8 Please see EU Commission, "Implementation of the Services Directive," available at ec.europa.eu. 9 Please see EEA Treaty Articles 112-114. 10 Countries which were admitted to the EU in the 1990s and are mostly located in Eastern Europe. This includes Bulgaria, Croatia, Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Romania, Slovakia, and Slovenia.

Yield and Protector Portfolios should continue to benefit in current environment. Equities face seasonal headwinds.

A benchmark overall duration stance is still warranted, as central banks will maintain exceptionally accommodative monetary policies to offset potential Brexit-related shocks to confidence.

The Brexit vote will either usher in the complete dissolution of the euro area, or it will prove to be a blessing in disguise. Our bet is the latter, but the next few months are still likely to see heightened political uncertainty and elevated financial volatility, warranting a cautious stance towards risk assets. Investors have become too complacent about the prospect of Fed hikes over the coming years. Even a slight upward move in rate expectations could cause the dollar to surge. Underweight U.S. stocks in currency-hedged terms.

Global uncertainty is elevated, but markets know this. Brexit could prove extremely negative for the global economy if it prompts a questioning of the EU's integrity. The cyclical outlook for the pound remains poor, but a short-term opportunity to buy GBP/JPY has emerged. We still like the SEK and commodity currencies. The SNB will continue to intervene, but the peg is increasingly dangerous.

Even if commodity markets are not yet pricing a higher probability of fiscal stimulus following the U.K.'s Brexit vote, we believe they will begin doing so in very short order.

The Brexit drama has moved from the realms of psephology into the realms of game theory. How will the game play out? And how will the economy and financial markets react?