Italy

Highlights China-U.S. trade détente goes against our alarmist forecast, prompting us to reassess the view; We do not expect the truce to last long, as China has not given the U.S. what we believe the Trump administration wants; Instead, we see the truce lasting until at least the completion of the North Korea - U.S. summit, at most early 2019; Market is correct to fret about Italy, as the populist agenda will be constrained by the bond market in due course; Stay long DXY, but close our recommendations to short China-exposed S&P 500 companies. Feature Our alarmist view on trade wars appears to be in retreat, or at least "on hold," following the conclusion of the latest trade talks between U.S. and Chinese officials. Global markets breathed a sigh of relief on Monday, after a weekend of extremely positive comments from President Trump's advisers and cabinet members. Particularly bullish were the comments from Trump's top economic adviser, Larry Kudlow, who claimed that China had agreed to reduce its massive trade surplus with the U.S. by $200 billion (Chart 1). Chart 1China, Not NAFTA, Is The Problem China, Not NAFTA, Is The Problem China, Not NAFTA, Is The Problem The official bilateral statement, subsequently published by the White House, was vague. It claimed that "there was a consensus" regarding a substantive - but unquantifiable - reduction in the U.S. trade deficit.1 The only sectors that were mentioned specifically were "United States agriculture and energy exports." China agreed to "meaningfully" increase the imports of those products, which are low value- added commodity goods. With regard to value-added exports, China merely agreed that it would encourage "expanding trade in manufactured goods and services." The two sides also agreed to "attach paramount importance to intellectual property protections," with China specifically agreeing to "advance relevant amendments to its laws and regulations in this area." Subsequent to the declaratory statement, China lowered tariffs on auto imports from 25% to 15%. It will also cut tariffs on imported car parts, to around 6%, from the current average of about 10%. Is that it? Was the consensus view - that China would merely write a check for some Boeings, beef, and crude oil - essentially right? The key bellwether for trade tensions has been the proposed tariffs on $50-$150 billion worth of goods, set to come in effect as early as May 21. According to Treasury Secretary Steven Mnuchin, this tariff action is now "on hold." Mnuchin was also supposed to announce investment restrictions by this date, another bellwether that is apparently on hold. This is objective evidence that trade tensions have probably peaked for this year.2 On the other hand, there are several reasons to remain cautious: Section 301 Investigation: Robert Lighthizer, the cantankerous U.S. Trade Representative who spearheaded the Section 301 investigation into China's trade practices that justified the abovementioned tariffs and investment restrictions, immediately issued a statement on Sunday dampening enthusiasm: "Real work still needs to be done to achieve changes in a Chinese system that facilitates forced technology transfers in order to do business in China." In the same statement, Lighthizer added that China facilitates "the theft of our companies' intellectual property and business know-how." In other words, Lighthizer does not appear to be excited by the prospect of trading IP and tech protection for additional exports of beef and crude oil. Political Reaction: The reaction from conservative circles was less than enthusiastic, with both congressional officials and various Trump supporters announcing their exasperation with the supposed deal over the weekend.3 The Wall Street Journal claimed that China refused to put a number - such as the aforementioned $200 billion - in the final statement.4 The implication is that Beijing won this round of negotiations. But President Trump will not want to appear weak. If a narrative emerges that he "lost," we would expect President Trump to pivot back to tariffs and confrontation. Support for free trade has recently rebounded among Republican voters but remains dramatically lower among them than among Democrats (Chart 2). As such, it is a salient issue for the president politically. Chart 2Support For Free Trade Recovering, ##br##But Republicans Still Trail Democrats Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 3China Already ##br##Imports U.S. Commodities... Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Investment Restrictions: Senator Cornyn's (Texas, Republican) bill to strengthen the Committee on Foreign Investment in the United States (CFIUS) process continues to move through the Senate.5 The Foreign Investment Risk Review Modernization Act Of 2017 (FIRRMA) is currently being considered by the Senate Committee on Banking, Housing, and Urban Affairs and should be submitted to a vote ahead of the November election. Congress is also looking to pass a bipartisan bill that would prevent President Trump from taking it easy on Chinese telecommunication manufacturer ZTE. Chart 4U.S. Commodity Export Growth Is Solid Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 5... But Impedes Market Access For Higher Value-Added Goods Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Beef And Oil Is Not Enough: The U.S. already has a growing market share in China's imports of commodities and crude materials, although it could significantly increase its exports in several categories (Chart 3). As the Chinese people develop middle-class consumption habits, the country was always going to import more agricultural products. And as their tastes matured, the U.S. was always going to benefit, given the higher quality and price point of its agricultural exports. In fact, China's imports of U.S. primary commodity exports have been increasing faster than imports of U.S. manufacturing goods (Chart 4). As such, the statement suggests that the U.S. and China have opted for the easiest compromises (commodities) to grant U.S. greater market access; the U.S. may have fallen short on market access for value-added manufacturing (Chart 5). In addition, there was little acknowledgment of the American demands that China cease forced tech transfers, cut subsidies for SOEs, reduce domestic content requirements under the "Made in China 2025" plan, and liberalize trade for U.S. software and high-tech exporters (Chart 6). Given these outstanding and unresolved issues, there are three ways to interpret the about-face in U.S. trade demands: Geopolitical Strategy is wrong: One scenario is that we are wrong, that the Trump administration is not focused on forced tech transfers and IP theft in any serious way.6 On the other hand, if that is true, the U.S. is also not serious about significantly reducing its trade deficit with China, since structurally, IP theft and non-tariff barriers to trade of high-value exports are a major reason why China has a massive surplus. Instead, the U.S. may only be focused on reducing the trade deficit through assurances of greater market access - a key demand as well, but one that could prove temporary or un-strategic, especially if access is only granted for commodities.7 If this is true, it suggests that President Trump's demands on China are transactional, not geopolitical, as we asserted in March.8 Midterms matter: Another scenario is that President Trump does not want to do anything that would hurt the momentum behind the GOP's polling ahead of the November midterms (Chart 7). The administration can always pick up the pressure on China following the election, given that 2019 is not an election year. Trump's political team may believe that Beijing concessions on agriculture, autos, and energy will be sufficient to satisfy the base until then. By mid-2019, the White House can also use twelve months of trade data to assess whether Beijing has actually made any attempt to deliver on its promises of increased imports from the U.S. Chart 6China's High-Tech Protectionism Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 7Republicans Are Gaining... Republicans Are Gaining... Republicans Are Gaining... North Korea matters: Along the same vein as the midterms, there is wisdom in delaying trade action against China given the upcoming June 12 summit between President Trump and North Korean Supreme Leader Kim Jong-un in Singapore. President Trump's approval ratings began their second surge this year following the announced talks (Chart 8), and it is clear that the administration has a lot of political capital invested in the summit's success. Recent North Korean statements, suggesting that they are willing to break off dialogue, may have been the result of the surprise May 8 meeting between Chinese President Xi Jinping and Kim, the second in two months. As such, President Trump may have had to back off on the imposition of tariffs against China in order to ensure that his summit with Kim goes smoothly. At this point, it is difficult to gauge whether the decision to ease the pressure against China was due to strategic or tactical reasons. We expect that the market will price in both, easing geopolitical risk on equity markets. However, if the delay is tactical - and therefore temporary - then the risk premium would remain appropriate. We do not think that we are wrong when it comes to U.S. demands on China. These include greater market access for U.S. value-added exports and services (not just commodities), as well as a radical change in how China awards such access (i.e., ending the demand that technology transfers accompany FDI and market access). In addition, China still massively underpays for U.S. intellectual property (IP) rights and has been promising to do more on that front for decades (Chart 9). Given that China has launched some anti-piracy campaigns, and given its recent success in other top-down campaigns like shuttering excess industrial capacity, it is hard to believe that Beijing could not crack down on IP theft even more significantly. Chart 8...Thanks To Tax Cuts And Kim Jong-un ...Thanks To Tax Cuts And Kim Jong-un ...Thanks To Tax Cuts And Kim Jong-un Chart 9What Happened To ~$100 Billion IP Theft? Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Furthermore, U.S. demands on China are not merely about market access and IP. There is also the issue of aggressive geopolitical footprint in East Asia, particularly the South China Sea. The U.S. defense and intelligence establishment is growing uneasy over China's pace of economic and technological development, given its growing military aggressiveness. In fact, over the past two weeks, China has: Landed the Xian H-6K strategic bombers capable of carrying nuclear weapons on disputed "islands" in the South China Sea; Installed anti-ship cruise missiles, as well as surface-to-air missiles, on three of its outposts in disputed areas. Of course, if we are off the mark on our view of Sino-American tensions, it would mean that the Trump administration is willing to make transactional economic concessions for geopolitical maneuvering room. In other words, more crude oil and LNG exports in exchange for better Chinese positioning in vital sea and air routes in East Asia. We highly doubt that the Trump administration is making such a grand bargain, even if the rhetoric from the White House often suggests that the "America First" agenda would allow for such a strategic shift. Rather, we think the Trump administration, like the Obama administration, put the South China Sea low on the priority list, but will focus greater attention on it when is deemed necessary at some future date. Bottom Line: Trade tensions between China and the U.S. have almost assuredly peaked in a tactical, three-to-six month timeframe. While still not official, it appears that the implementation of tariffs on $50-$150 billion worth of imports from China, set for any time after May 21, is now on hold. As such, a trade war is on hold. We are closing our short China-exposed S&P 500 companies versus U.S. financials and telecoms, a trade that has returned 3.94% and long European / short U.S. industrials, which is down 2% since inception. This greatly reduces investment-relevant geopolitical risk this summer and makes us far less confident that investors should "sell in May and go away." Our tactical bearishness is therefore reduced, although several other geopolitical risks - such as Iran-U.S. tensions, Italian politics, and the U.S. midterm election- remain relevant.9 We do not think that Sino-American tensions have peaked cyclically or structurally (six months and beyond). The Trump Administration continues to lack constraints when it comes to acting tough on China. As such, investors should expect tensions to renew either right after the summit between Trump and Kim in early June or, more likely, following the November midterm elections. Italy: The Divine Comedy Continues Since 2016, we have noted that Italy remains the premier risk to European markets and politics.10 There are two reasons for the view. First, Italy has retained a higher baseline level of Euroskepticism relative to the rest of Europe (Chart 10). While support for the common currency has risen in other member states since 2013, it has remained between 55%-60% in Italy. This is unsurprising given the clearly disappointing economic performance in Italy relative to that of its Mediterranean peers (Chart 11). Chart 10Italy Remains A Relative Euroskeptic Italy Remains A Relative Euroskeptic Italy Remains A Relative Euroskeptic Chart 11Lagging Economy Explains Cyclical Euroskepticism Lagging Economy Explains Cyclical Euroskepticism Lagging Economy Explains Cyclical Euroskepticism Italy's Euroskepticism, however, is not merely a product of economic malaise. Chart 12 shows that a strong majority of Europeans are outright pessimistic about the future of their country outside of the EU. But when Italians are polled in that same survey, the population is increasingly growing optimistic about the option of exit (Chart 13). The only other EU member state whose citizens are as optimistic about a life outside the bloc is the U.K., where population obviously voted for Brexit. Chart 12Europeans Are Pessimists About EU Exit... Europeans Are Pessimists About EU Exit... Europeans Are Pessimists About EU Exit... Chart 13...But Italians Are More Like Brits ...But Italians Are More Like Brits ...But Italians Are More Like Brits Furthermore, Italian respondents have begun to self-identify as Italian only, not as "European" also, which breaks with another long-term trend in the rest of the continent (Chart 14) and is also reminiscent of the U.K. The second reason to worry about Italy is its economic performance. Real GDP is still 5.6% below its 2008 peak, while domestic demand continues to linger at 7.9% below its pre-GFC levels (Chart 15). As we posited at the end of 2017, the siren song of FX devaluation would become a powerful political elixir in the 2018 election, as populist policymakers blame Italy's Euro Area membership for the economic performance from Chart 15.11 Chart 14Italians Feel More Italian Italians Feel More Italian Italians Feel More Italian Chart 15Italian Demand Never Fully Recovered Italian Demand Never Fully Recovered Italian Demand Never Fully Recovered Is the Euro Area to blame for Italy's ills? No. The blame lies squarely at the feet of Italian policymakers, who flubbed efforts to boost collapsing productivity throughout the 1990s and 2000s (Chart 16). There was simply no pressure on politicians to enact reforms amidst the post-Maastricht Treaty convergence in borrowing costs. Italy punted reforms to its educational system, tax collection, and corporate governance. Twenty years of complacency have led to a massive loss in global market share (Chart 17). Chart 16Italy Has A Productivity Problem Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 17Export Performance Is A Disaster Export Performance Is A Disaster Export Performance Is A Disaster While it is difficult to prove a counterfactual, we are not sure that even outright currency devaluation would have saved Italy from the onslaught of Asian manufacturing in the late 1990s. Euro Area imports from EM Asia have surged from less than 2% of total imports to nearly 10% in the last twenty years. Italy began losing market share to Asia well before the euro was introduced on January 1, 1999, as Chart 18 illustrates. The incoming populist government is unfortunately coming to power with growing global growth headwinds (Chart 19), with negative implications for Italy (Chart 20). These are likely to act as a constraint on plans by the Five Star Movement (M5S) and Lega coalition to blow out the budget deficit in pursuit of massive tax cuts, reversals of pension reforms, minimum wage hikes, and a proposal to increase spending on welfare. Our back-of-the-envelope calculation sees Italy's budget deficit growing to over 7% in 2019 if all the proposed reforms were enacted, well above the 3% limit imposed by the EU on its member states. Chart 18Italy Lost Market Share Amid Globalization Italy Lost Market Share Amid Globalization Italy Lost Market Share Amid Globalization Chart 19Tepid Global Growth... Tepid Global Growth... Tepid Global Growth... Chart 20...Is Bad News For Italy ...Is Bad News For Italy ...Is Bad News For Italy How would the EU Commission react to these proposals, given that Italy would break the rules of the EU Stability and Growth Pact (SGP)? We think the question is irrelevant. The process by which the EU Commission enforces the rules of the SGP is the Excessive Deficit Procedure (EDP), which would take over a year to put into place.12 First, the Commission would have to review the 2019 budget proposed by the new Italian government in September 2018. It would likely tell Rome that its plans would throw it into non-compliance with SGP rules, at which point the EU Commission would recommend the opening of a Significant Deviation Procedure (SDP). If Italy failed to follow the recommendations of the SDP, the Commission would then likely throw Italy into EDP at some point in the first quarter of 2019, or later that year.13 And what happens if Italy does not conform to the rules of the EDP? Italy would be sanctioned by the EU Commission by forcing Rome to make a non-interest-bearing deposit of 0.2% GDP.14 (Because it makes perfect sense to force a country with a large budget deficit to go into an even greater budget deficit.) Even if Rome complied with the sanctions, the punishment would only be feasible at the end of 2019, most likely at the end of Q1 2020. The point is that the above two paragraphs are academic. The Italian bond market would likely react much faster to Rome's budget proposals. The EU Commission operates on an annual and bi-annual timeline, whereas the bond market is on a minute-by-minute timeline. Given the bond market reaction thus far, it is difficult to see how Rome could be given the benefit of the doubt from investors (Chart 21). Investors have been demanding an ever-greater premium on Italian bonds, relative to their credit rating, ever since the election (Chart 22). Chart 21Uh Oh Spaghettio! Uh Oh Spaghettio! Uh Oh Spaghettio! Chart 22Bond Vigilantes Are Coming Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) As such, the real question for investors is not whether the EU Commission can constrain Rome. It cannot. Rather, it is whether the bond market will. Rising borrowing costs would obviously impact the economy via several transmission channels, including overall business sentiment. But the real risk is Italy's banking sector. Domestic financial institutions hold 45% of Italian treasury bonds (BTPs) (Chart 23), which makes up 9.3% of all their assets, an amount equivalent to 77.8% of their capital and reserves (Chart 24). Foreign investors own 32%, less than they did before the Euro Area crisis, but still a significant amount. Chart 23Foreign Investors Still Hold A Third Of All Italian Debt Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 24Italian Banks Also Hold Too Many BTPs Italian Banks Also Hold Too Many BTPs Italian Banks Also Hold Too Many BTPs In 2011, when the Euro Area crisis was raging, Italian 10-year yields hit 7%, or a spread of more than 500 basis points over German bunds. This was equivalent to an implied probability of a euro area breakup of 20% over the subsequent five years (Chart 25).15 What would happen if the populists in Rome followed through with their fiscal plans by September 2018 by including them in the 2019 budget? The bond market would likely begin re-pricing a similar probability of a Euro Area breakup, if not higher. In the process, Italian bonds could lose 20%-to-30% of their value - assuming that German bunds would rally on risk-aversion flows - which would result in a potential 15%-to-25% hit to Italian banks' capital and reserves. With the still large overhang of NPLs, Italian banks would be, for all intents and purposes, insolvent (Chart 26). Chart 25In 2011, Italian Spreads Signal Euro Break-Up In 2011, Italian Spreads Signal Euro Break-Up In 2011, Italian Spreads Signal Euro Break-Up Chart 26Italian Banks Still Carry Loads Of Bad Loans Italian Banks Still Carry Loads Of Bad Loans Italian Banks Still Carry Loads Of Bad Loans The populist government in Rome may not understand this dynamic today, but they will soon enough. This is perhaps why the leadership of both parties has decided to appoint a relatively unknown law professor, Guiseppe Conte, as prime minister. Conte is, according to the Italian press, a moderate and is not a Euroskeptic. It will fall to Conte to try to sell Europe first on as much of the M5S-Lega fiscal stimulus as he can, followed by the Italian public on why the coalition fell far short of its official promises. If the coalition pushes ahead with its promises, and ignores warnings from the bond market, we can see a re-run of the 2015 Greek crisis playing out in Italy. In that unlikely scenario, the ECB would announce publicly that it would no longer support Italian assets if Rome were determined to egregiously depart from the SGP. The populist government in Rome would try to play chicken with the ECB and its Euro Area peers, but the ATM's in the country would stop working, destroying its credibility with voters. In the end, the crisis will cause the populists to mutate into fiscally responsible Europhiles, just as the Euro Area crisis did to Greece's SYRIZA. For investors, this narrative is not a reassuring one. While our conviction level that Italy stays in the Euro Area is high, the scenario we are describing here would still lead to a significant financial crisis centered on the world's seventh-largest bond market. Bottom Line: Over the next several months, we would expect bond market jitters concerning Italy to continue, supporting our bearish view on EUR/USD, which we are currently articulating by being long the DXY (the EUR/USD cross makes up 57.6% of the DXY index). Given global growth headwinds, which are already apparent in the European economic data, and growing Italian risks, the ECB may also turn marginally more dovish for the rest of the year, which would be negative for the euro. Our baseline expectation calls for the new coalition government in Rome to back off from its most populist proposals. We expect that Italy will eventually flirt with overt Euroskepticism, but this would happen after the next recession and quite possibly only after the next election. If we are wrong, and the current populist government does not back off, then we could see a global risk-off due to Italy either later this summer, or in 2019. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see "Joint Statement of the United States and China Regarding Trade Consultations," dated May 19, 2018, available at whitehouse.gov. 2 President Trump later tweeted that the announced deal was substantive and "one of the best things to happen to our farmers in many years!" 3 The most illustrative comment may have come from Dan DiMicco, former steel industry CEO and staunch supporter of President Trump on tariffs, who tweeted "Did president just blink? China and friends appear to be carrying the day." 4 Please see Bob Davis and Lingling Wei, "China Rejects U.S. Target For Narrowing Trade Gap," The Wall Street Journal, dated May 19, 2018, available at wsj.com. 5 Please see "S. 2098 - 115th Congress: Foreign Investment Risk Review Modernization Act Of 2017," dated May 21, 2018, available at www.govtrack.us. 6 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "Are You Ready For 'Maximum Pressure?'" dated May 16, 2018; and "Expect Volatility... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 12 Please see, The Treaty on the Functioning of the European Union, "Excessive deficit procedure (EDP)," available at eur-lex.europa.eu. 13 Have you been missing the European alphabet soup over the past three years? 14 The EU Commission can also suspend financing from the European Structural and Investment Funds (ESIF), but Italy has never participated in a bailout and thus could not be sanctioned that way. 15 Please see BCA European Investment Strategy Weekly Report, "Threats And Opportunities In The Bond Market," dated April 7, 2016, available at eis.bcaresearch.com.

Highlights Global Yields: Relative growth and inflation trends continue to favor the U.S., with divergences widening as non-U.S. is downshifting. This means that the cyclical peak in spreads between U.S. Treasuries and other developed market government bonds has not been reached yet, and the latest bout of U.S. dollar strength can continue. Stay underweight U.S. Treasuries in global government bond portfolios. Italy: Concerns over the future policies of the new Five-Star/League populist coalition government in Italy have triggered a selloff in Italian financial markets. While investors are right to be worried about the potential for greater fiscal stimulus and move vocal euroskepticism from those in charge in Italy, slowing economic growth is an even bigger immediate problem for debt sustainability concerns. Downgrade Italy to underweight (2 of 5) in global government bond portfolios. Feature After knocking on the door of the 3% threshold several times this year, the 10-year U.S. Treasury yield finally blew through that level last week. The ease with which this move occurred was a bit surprising, given that bond investor sentiment has stayed consistently bearish and Treasury market positioning remains extremely short. This raises the odds of a potential pullback in yields if the U.S. economy or inflation were to lose upside momentum. The only problem for the Treasury market is that neither of those trends is occurring at the moment. Chart of the WeekTreasuries Are Losing##BR##For The Right Reasons Treasuries Are Losing For The Right Reasons Treasuries Are Losing For The Right Reasons U.S. real GDP expanded at a 2.3% annualized rate in the first quarter of 2018, and the latest real-time GDP estimates for the second quarter from the Atlanta Fed (+4.1%) and New York Fed (+3.0%) are calling for an acceleration. The leading economic indicators produced by both the OECD and the Conference Board continue to climb higher, in stark contrast to the lost momentum in hard data and lead indicators in other major regions like Europe and Japan (Chart of the Week). Similar divergences are occurring in the inflation data, where core CPI inflation is accelerating in the U.S. and languishing elsewhere. The ability of U.S. Treasury yields to ignore the negative international headlines coming from typical trouble spots like Turkey, Argentina, Italy, Iran and North Korea is impressive. Clearly, none of these developments are big enough (yet!) to have any negative impact on U.S. growth expectations and, in turn, Fed rate hike expectations. At the same time, Fed officials continue to signal that another two or three rate increases are still likely over the remainder of the year. Add in the steady climb in inflation expectations, supported by oil prices reaching multi-year highs, and it is no surprise that those aggressive Treasury short positions have been on the right side of the market. If we were to apply a weather analogy to the global economy, conditions appear "partly sunny" if looking at the U.S, but "mostly cloudy" when looking elsewhere. This has major implications for the future path of U.S. Treasury yields versus other government bond markets, and for the U.S. dollar as well. Expect U.S. Bond Relative Underperformance To Continue From a more global perspective, the ability of non-U.S. bond yields to rise has become more limited. The overall OECD leading economic indicator - which is correlated to real global bond yields - looks to be rolling over, and our diffusion index of individual country indicators shows that this trend is broad-based (Chart 2). Within the major developed economies, only the U.S. stands out as having a rising leading economic indicator (although the Canadian index is holding up at a high level). The most depressed readings come from the three markets we are overweight in our model bond portfolio - the U.K., Japan and Australia (Chart 3). These growth divergences are not only visible in "soft" economic data like leading indicators and purchasing manager indices. U.S. retail sales showed a surprising burst of strength in April, and the release of that data last week was the trigger for pushing the 10-year Treasury yield above 3%. Meanwhile, readings on real GDP growth in the first quarter for the euro area and Japan were quite weak compared to the acceleration seen throughout 2017. In the case of Japan, GDP actually contracted at a 0.6% annualized rate in Q1, ending a run of eight consecutive quarters of positive growth which was the longest such streak in 28 years (Chart 4). Chart 2A Stagflationary Tug-Of-War##BR##On Global Yields A Stagflationary Tug-Of-War On Global Yields A Stagflationary Tug-Of-War On Global Yields Chart 3U.S. Growth##BR##Stands Out U.S. Growth Stands Out U.S. Growth Stands Out Chart 4Is China To Blame For##BR##Slowing Non-U.S. Growth? Is China To Blame For Slowing Non-U.S. Growth? Is China To Blame For Slowing Non-U.S. Growth? At the same time, China's domestic economy has seen some slowing of growth, as well, as evidenced by the rapid deceleration of import growth (bottom panel). For the economies in Europe and Japan where growth is still heavily geared towards exports, and where domestic demand still struggles to gain sustainable upward momentum in the absence of an export/production cycle, a slowing China poses a big problem - one that is less of an issue for the more domestically-focused U.S. economy. The divergence of growth and inflation accelerating in the U.S. but potentially peaking out elsewhere, can be seen in the widening of government bond yield spreads between the U.S. and its developed market peers. In Table 1, we show the change in the bond yield spread between 10-year U.S. Treasuries and similar maturity government debt from the U.K., Germany, Japan, Canada and Australia since the last major trough in global yields in September 2017. The spread changes are broken down into movements in inflation expectations and real yields to see which was more influential. For example, of the 75bps widening in the 10-year U.S. Treasury-German Bund spread, 55bps has been due to widening real yield differentials and only 20bps has come from higher inflation expectations in the U.S. Table 1Cross-Country Yield Spread Changes (in bps) Since The September 2017 Low In U.S. Treasury Yields Is It Partly Sunny Or Mostly Cloudy? Is It Partly Sunny Or Mostly Cloudy? These changes show that the underperformance of U.S. Treasuries (i.e. spread widening) has come mostly though higher real yields in the U.S. Inflation expectations are widening in the U.S., but are also moving higher in all other countries except the U.K. So the relative change in inflation expectations between the U.S. and the other countries has been more modest than the absolute change in U.S. TIPS breakevens (Chart 5). The fact that the real yield differentials are moving increasingly in favor of the U.S. has implications for the U.S. dollar. The greenback has finally begun to appreciate after the weakness seen in 2017, with potentially a lot more room to run judging by the levels implied by those wide real yield gaps. This is most evident for the euro, yen and British pound (Chart 6). Chart 5Higher Inflation Expectations##BR##& Yields In The U.S. Higher Inflation Expectations & Yields In The U.S. Higher Inflation Expectations & Yields In The U.S. Chart 6USD Finally Responding To Wide##BR##Real Yield Differentials USD Finally Responding To Wide Real Yield Differentials USD Finally Responding To Wide Real Yield Differentials The path of the U.S. dollar is the key to how this U.S./non-U.S. growth divergence story will end. If the dollar continues to strengthen as the Fed lifts rates in the coming months, then monetary conditions in the U.S. run the risk of moving into restrictive territory. This could spur a bout of renewed U.S. market turbulence not unlike that seen in 2015 and 2016 when the Fed was trapped in what we described at the time as a "policy loop", where a higher dollar and rising market volatility (especially in the emerging markets) prompted the Fed to delay planned rate hikes. The circumstances are different now compared to three years ago. The dollar is only mildly appreciating from the depressed levels of 2017, U.S. core inflation is approaching the Fed's 2% target, and the U.S. economy is at full employment with fiscal stimulus on the way. In other words, the hurdle for the Fed to alter its current rate hike plans is much higher than it was in 2015/16 when the U.S. economy and inflation were in more fragile states. For now, we continue to see relative growth and inflation trends pushing in a direction for continued U.S. government bond underperformance over the balance of 2018. One-sided bearish positioning may create a backdrop where Treasury yields could fall for a brief period, but the true cyclical peak in yields - somewhere in the 3.25-3.5% range - and in U.S./non-U.S. yield spreads has not been reached yet. Bottom Line: Relative growth and inflation trends continue to favor the U.S., with divergences widening as non-U.S. is downshifting. This means that the cyclical peak in spreads between U.S. Treasuries and other developed market government bonds has not been reached yet, and the latest bout of U.S. dollar strength can continue. Stay underweight U.S. Treasuries in global government bond portfolios. Italy: Worry More About Slowing Growth Than Politics Italian political risk returned to European financial markets last week after details of the policy program for the new Five-Star Movement/League coalition government were leaked to the press. Some of the more alarming proposals included: Having the European Central Bank (ECB) "freeze" or "cancel" the €250bn in Italian government debt it holds via its asset purchase program. Revising the rules of the European Union (EU) Growth and Stability Pact, specifically its fiscal rules on debt and deficits, while also asking for Europe to, more generally, return to a "pre-Maastricht" (pre-euro?) position. These headlines were interpreted as a sign that the populists taking over Italy were looking for a way to loosen fiscal policy in excess of EU rules, if not abandon the euro currency entirely. This would be a realization of the outcome from the March election that investors feared the most. Markets responded as expected, with Italian government bond yields soaring across the entire yield curve and Italian equities and the euro selling off (Chart 7). We last discussed Italy back in February in a Special Report co-written with our colleagues at BCA Geopolitical Strategy.1 We concluded that, even though euroskepticism would continue to have appeal in Italy because support for the common currency is much weaker than in the rest of the euro area (Chart 8), none of the likely coalition partners in a new government would make noise about potentially bringing back the lira with the economy in a cyclical expansion. All of the likely winning coalitions would seek to ease Italian fiscal policy, however, which would bring back investor worries about Italian debt sustainability. Chart 7The Return Of##BR##The Italy Risk Premium The Return Of The Italy Risk Premium The Return Of The Italy Risk Premium Chart 8The Euro Is Still Less Popular##BR##In Italy Than Elsewhere The Euro Is Still Less Popular In Italy Than Elsewhere The Euro Is Still Less Popular In Italy Than Elsewhere The first part of our conclusion went in a fashion that we did not expect, with the anti-establishment Five-Star party joining forces with the far-right League in a populist coalition that could embrace euroskepticism more emphatically. The second part of that conclusion does appear to be panning out, with the new government already looking to cut taxes and ramp up fiscal spending. These outcomes would be enough for investors to begin pricing in a higher fiscal risk premium in Italian assets, thus justifying the market moves seen last week. Yet there was one other conclusion from our report that is more relevant now for fixed income investors. Italian government bonds would not begin to underperform until there were signs that Italy's economy was slowing - which is what appears to be happening now. Like the rest of the euro area, Italy saw a deceleration of economic growth in the first quarter of the year. The most cyclical components of the Italian economy, manufacturing and exports, have both shown a considerable deceleration. Exports to non-EU countries, in particular, have noticeably slowed (Chart 9), which is likely yet another sign of how slowing Chinese growth is spilling over into much of the global economy through trade channels. Domestic demand has seen some cyclical strength on the back of the surge in exports, production and employment seen in 2016/17. However, the risk now is that slowing exports feed back into slowing production and weaker hiring activity. Any sign of a slowdown would only embolden the new coalition government to aim for easier fiscal policy. That would be a logical response by any government, particularly with current budget forecasts calling for tightening fiscal policy over the next few years. The latest set of debt and deficit projections from the IMF show that Italy is expected to have a balanced budget by 2021 (Chart 10). This would imply that the primary budget balance (i.e. net of interest payments) would rise to as high as 3.6% of GDP - an enormously restrictive policy stance that no advanced economy currently runs. Chart 9Italian Cyclical Momentum##BR##Has Peaked Italian Cyclical Momentum Has Peaked Italian Cyclical Momentum Has Peaked Chart 10This Rosy Trajectory For##BR##Italian Debt Will Not Happen This Rosy Trajectory For Italian Debt Will Not Happen This Rosy Trajectory For Italian Debt Will Not Happen That degree of fiscal tightening also makes the debt dynamics of Italy look much more sustainable, with debt/GDP projected to fall by ten percentage points by 2021 according to the IMF (bottom panel). Given the leanings of the new government, and with the economy starting to lose some momentum, there is zero chance that the IMF deficit and debt projections will come to fruition. In fact, the opposite is likely to happen under the new government, with the fiscal deficit likely to widen and debt/GDP likely to increase. While a return to the "bad old" economic policies of Italy might harken back to the days of the 2011 European debt crisis, there are two major differences between then and now: Italy's borrowing costs are far lower, thanks to the hyper-easy monetary policies of the ECB (both zero/negative interest rates and outright bond purchases). The average debt on newly-issued Italian government debt has plunged from the 6-7% levels around the time of the debt crisis to less than 1% over the past three years, according to the Bank of Italy (Chart 11). This has helped substantially reduce the amount of net interest payments made by the Italian government - by one full percentage point of GDP, according to the IMF. Less Italian debt is owned by non-Italian residents than during the crisis. According to data from the Bruegel think tank in Brussels, the percentage of Italian sovereign debt held by non-Italian residents is now 36%, compared to 50% during the years before the crisis (Chart 12). As that crisis unfolded, those investors rapidly dumped their Italian bonds, cutting their ownership share by ten percentage points in less than one year. Domestic Italian banks were forced to pick up the slack, which increased the already significant fiscal exposure of the Italian banking system. Now, the ownership mix is much more balanced, including the 20% of Italian bonds owned by the ECB. This means that, today, 64% of Italy's debt is owned by those with a vested interest in Italian stability, rather than fickle foreign investors who would be much more willing to dump their bonds when the Italian news turns less favorable. Chart 11The Big Difference Between 2011 & Today The Big Difference Between 2011 & Today The Big Difference Between 2011 & Today Chart 12A Smaller Share Of Italy's Debt Is Held By Fickly Foreigners Now Vs 2011 A Smaller Share Of Italy's Debt Is Held By Fickly Foreigners Now Vs 2011 A Smaller Share Of Italy's Debt Is Held By Fickly Foreigners Now Vs 2011 This is not to say that another Italian debt crisis could not happen, especially if the Five-Star/League coalition were to more seriously discuss a potential exit from the euro. The only difference now is that Italy's debt sustainability issues are not as acute as in 2011 because of the low borrowing costs and more diverse ownership of Italian debt. Chart 13Downgrade Italian Debt To Underweight Downgrade Italian Debt To Underweight Downgrade Italian Debt To Underweight From a bond strategy perspective, however, we are more focused on the growth dynamics in Italy than the current political noise. As we also concluded in our February Special Report, the time to downgrade Italian debt was when the economy was clearly about to slow, as heralded by a decline in the OECD's leading economic indicator for Italy. That series has been highly correlated to the relative performance of Italian government debt (Chart 13) and, therefore, is a useful indicator to follow to determine Italian bond strategy. With the leading indicator now falling for four consecutive months, and with hard Italian data also starting to slow, a period of Italian bond underperformance has likely just begun - an outcome that can only be made worse by the new euroskeptic and free spending Italian government. Thus, we are downgrading Italy in our country rankings this week to underweight (2 out of 5), and cutting our recommended allocations to Italian debt in our model bond portfolio to ½ index weight. We place the proceeds of that reduction into German bonds across the yield curve. Bottom Line: Concerns over the future policies of the new Five-Star/League populist coalition government in Italy have triggered a selloff in Italian financial markets. While investors are right to be worried about the potential for greater fiscal stimulus and move vocal euroskepticism from those in charge in Italy, slowing economic growth is an even bigger immediate problem for debt sustainability concerns. Downgrade Italy to underweight (2 of 5) in global government bond portfolios. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy/Geopolitical Strategy Special Report, "Italy: Growth Cures All Ills ... For Now", dated February 21st 2018, available at gfis.bcaresearch.com and gps.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Is It Partly Sunny Or Mostly Cloudy? Is It Partly Sunny Or Mostly Cloudy? Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Stay tactically long the SEK. Our preferred expression is long SEK/GBP. Stay tactically short the NOK. Our preferred expression is long AUD/NOK. Take profits in the underweight to Poland... ...and open a tactical countertrend position: long Poland's Warsaw General Index, short Italy's MIB. A coalition of populists governing Italy might ruffle some feathers in Brussels, but the main risk appears to be contained. Both The League and 5 Star Movement have dropped calls for a referendum on Italy's membership of the monetary union. Feature Italy And The U.K. Compete For Political Risk The European political lens is once again focussed on Italy as the two anti-establishment parties - The League and 5 Star Movement - negotiate to form a government. A coalition of populists governing Italy might ruffle some feathers in Brussels, but the main risk appears to be contained. Both parties have dropped calls for a referendum on Italy's membership of the monetary union, and have instead turned their fire on the EU's fiscal rules, specifically the 3 per cent limit on budget deficits. Chart of the WeekThe SEK Is Due A Tactical Rebound The SEK Is Due A Tactical Rebound The SEK Is Due A Tactical Rebound The populist demand for some fiscal relaxation is actually smart economics. When the private sector is paying down debt - as it is in Italy - private sector demand shrinks. To prevent a recession, the government must step in to borrow and spend the paid-down debt. And what seems to be fiscal largesse does not lead to crowding out, inflation, or surging interest rates. This means that as long as Italian populists correctly push back on the EU's draconian fiscal rules rather than the monetary union per se, the market is right to regard Italian politics as a drama, rather than an existential risk to the euro (Chart I-2). Chart I-2The Market Remains Unconcerned ##br##About Euro Break-Up Risk The Market Remains Unconcerned About Euro Break-Up Risk The Market Remains Unconcerned About Euro Break-Up Risk Maybe the European political lens should be focussed instead on Britain. The Conservative party remains as bitterly divided as ever on its vision for the U.K.'s future trading and customs relationships with the EU and the rest of the world. Paralysed and frightened by this division, Theresa May is delaying the legislative passage of three crucial bills - the EU Withdrawal Bill, the Trade Bill, and the Customs Bill. When these bills eventually reach a vote in the House of Commons later this year, any one of them could result in a humiliating defeat for May - and, quite likely, resignations from the government. Meanwhile, as the government kicks the issue into the long grass, firms are holding fire on long-term spending commitments in the U.K. and rechannelling the investment to elsewhere in Europe. Buy SEKs, Avoid NOKs For all the recent swings in the euro versus the dollar and pound, the trade-weighted euro has remained a paragon of relative stability (Chart I-3). This is because the moves versus the dollar and pound have largely cancelled out (Chart I-4). Earlier this year, euro weakness versus the pound coincided with strength versus the dollar; more recently, euro weakness versus the dollar has coincided with strength versus the pound. Chart I-3The Trade-Weighted Euro Has ##br##Remained Relatively Stable... The Trade-Weighted Euro Has Remained Relatively Stable... The Trade-Weighted Euro Has Remained Relatively Stable... Chart I-4...Because Moves Versus The Dollar And The ##br##Pound Have Largely Cancelled Out ...Because Moves Versus The Dollar And The Pound Have Largely Cancelled Out ...Because Moves Versus The Dollar And The Pound Have Largely Cancelled Out Interestingly, the driver of the trade-weighted euro remains the same as it has been for the past fifteen years - it is simply the euro area's long bond yield shortfall versus the U.K. and U.S. (Chart I-5). With the ECB already at the realistic limit of ultra-loose policy, the path for policy rate expectations cannot go meaningfully lower. This means that the trade-weighted euro has some long-term support given that the BoE and/or the Fed have tightening expectations that could be priced out, while the ECB effectively doesn't. Chart I-5The Trade Weighted Euro Is A Function Of The Euro Area's ##br##Long Bond Yield Shortfall Versus The U.K. And U.S. The Trade Weighted Euro Is A Function Of The Euro Area's Long Bond Yield Shortfall Versus The U.K. And U.S. The Trade Weighted Euro Is A Function Of The Euro Area's Long Bond Yield Shortfall Versus The U.K. And U.S. Put another way, for the trade-weighted euro to drift significantly lower, relative surprises in the economic, financial and political news have to be significantly worse in the euro area than in both the U.K. and the U.S. We think this configuration is unlikely. Nevertheless, the more interesting tactical opportunities lie elsewhere: the Swedish krona and the Norwegian krone. Recent tweaks to monetary policy frameworks in Sweden and Norway are responsible, at least partly, for technically exaggerated moves in their currencies which are likely to reverse. In the case of Sweden, the inflation target is unchanged at 2 per cent but the Riksbank introduced a variation band of 1-3 per cent, because "monetary policy is not able to steer inflation in detail." Given that Sweden's inflation rate is now close to 2 per cent, the market interpreted this tweak as very dovish - because it permits the continuation of ultra-accommodative policy. The upshot was that the SEK sold off. But our tried and tested indicator of excessive groupthink suggests that the currency may have overreacted (Chart of the Week). Hence, the tactical opportunity is to stay long the SEK, and our preferred expression is long SEK/GBP. In the case of Norway, a Royal Decree on Monetary Policy lowered the Norges Bank inflation target from 2.5 to 2.0 per cent. This followed years of failure to achieve the higher target. The market interpreted this change as hawkish, as it created the scope for tighter - or at least, less loose - policy than was previously expected. The upshot was that the NOK rallied. But again, the market reaction shows evidence of a technical overreaction (Chart I-6). Hence, the tactical opportunity is to stay short the NOK, and our preferred expression is long AUD/NOK. Chart I-6Our Preferred Expression Of Short NOK Is Versus The AUD Our Preferred Expression Of Short NOK Is Versus The AUD Our Preferred Expression Of Short NOK Is Versus The AUD Financial Markets Are Not Complicated, But They Are Complex The words 'complicated' and 'complex' appear to be interchangeable, but their meanings are quite distinct. The distinction is important because financial markets are not complicated, but they are complex. Something that is complicated is the sum of a large number of separate parts or processes. For example, making a car is complicated. But predicting the performance of financial markets over the medium term - say, a year or longer - is uncomplicated. The philosophy of Investment Reductionism teaches us that investment strategy is not made up of many separate parts or processes. It reduces to just three things: Predicting the evolution of the global economy. Predicting central bank reaction functions. Predicting tail-events: political, economic and financial. For example, this week's lesson in Investment Reductionism is to illustrate that the medium term decision to allocate between emerging market equities and the Eurostoxx600 largely reduces to the prospects for global metal prices (Chart I-7). Chart I-7EM Versus Eurostoxx600 = Metal Prices EM Versus Eurostoxx600 = Metal Prices EM Versus Eurostoxx600 = Metal Prices By contrast, something that is complex is not the sum of its parts, because the parts interact in unpredictable ways. Complexity characterizes the behaviour of financial markets over the short term - say, up to around six months. Therefore, the best way to model the behaviour of any investment over the very short term is to think of it as a complex adaptive system. A complex adaptive system is a system with a large number of mutually interacting agents, which can learn from their interactions and thereby adapt their subsequent behaviour. Examples include traffic flows, crowds in stadiums, and of course financial markets. A crucial property of all such systems is they possess an endogenous tipping point of instability, at which the behaviour undergoes a 'phase-shift'. This is the essence of how we identify likely short-term trend reversals in any investment such as the SEK and the NOK. This week's final trade recommendation uses this idea once again. Poland's equity market has underperformed recently in line with the general underperformance of the emerging market basket - and our underweight in the Warsaw General Index versus the Eurostoxx600 is handsomely in profit. However, looking at the market as a complex adaptive system, the extent of Poland's underperformance is overdone (Chart I-8). Chart I-8The Extent Of Poland's Underperformance Is Overdone The Extent Of Poland's Underperformance Is Overdone The Extent Of Poland's Underperformance Is Overdone Hence we are taking profit on our underweight in Poland and putting on a short-term countertrend position: long Poland's Warsaw General Index, short Italy's MIB. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* As discussed in the main body of the report, this week's new trade recommendation is a pair-trade: long Poland's Warsaw General Index, short Italy's MIB. The profit target is 5% with a symmetrical stop loss. Our preferred expression of long SEK is versus the GBP which is already in profit since initiation. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 Long SEK Long SEK The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields 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 ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Divergence between U.S. and global economic outcomes is bullish for the U.S. dollar and bad for EM assets; Maximum Pressure worked with North Korea, but it may not with Iran, putting upside pressure on oil; An election is the only way to resolve split over Brexit and the new anti-establishment coalition in Italy is not market positive; Historic election outcome in Malaysia and the prospect of a weakened Erdogan favors Malaysian over Turkish assets; Reinitiate long Russian vs EM equities in light of higher oil price and reopen French versus German industrials as reforms continue unimpeded in France. Feature "Speak softly and carry a big stick; you will go far." - Theodore Roosevelt, in a letter to Henry L. Sprague, January 26, 1900. May started with a geopolitical bang. On May 4, a high-profile U.S. trade delegation to Beijing returned home after two days of failed negotiations. Instead of bridging the gap between the two superpowers, the delegation doubled it.1 On May 8, President Trump put his Maximum Pressure doctrine - honed against Pyongyang - into action against Iran, announcing that the U.S. would withdraw from the Obama administration's Iran nuclear deal - also referred to as the Joint Comprehensive Plan of Action (JCPOA). These geopolitical headlines were good for the U.S. dollar, bad for Treasuries, and generally miserable for emerging market (EM) assets (Chart 1).2 We have expected these very market moves since the beginning of the year, recommending that clients go long the DXY on January 31 and go short EM equities vs. DM on March 6.3 Chart 1EM Breakdown? EM Breakdown? EM Breakdown? Chart 2U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows Geopolitical risks, however, are merely the accelerant of an ongoing process of global growth redistribution. A key theme for BCA's Geopolitical Strategy this year has been the divergent ramifications of populist stimulus in the U.S. and structural reforms in China. This political divergence in economic outcomes has reduced growth in the latter and accelerated it in the former, a bullish environment for the U.S. dollar (Chart 2).4 Data is starting to support this narrative: Chart 3Global Growth On A Knife Edge Global Growth On A Knife Edge Global Growth On A Knife Edge Chart 4German Data... German Data... German Data... The BCA OECD LEI has stalled, but the diffusion index shows a clear deterioration (Chart 3); German trade is showing signs of weakness, as is industrial production and IFO business confidence (Chart 4); Another bellwether of global trade, South Korea, is showing a rapid deterioration in exports (Chart 5); Global economic surprise index is now in negative territory (Chart 6). Chart 5...And South Korean, Foreshadows Risks ...And South Korean, Foreshadows Risks ...And South Korean, Foreshadows Risks Chart 6Unexpected Slowdown In Global Growth Unexpected Slowdown In Global Growth Unexpected Slowdown In Global Growth Meanwhile, on the U.S. side of the ledger, wage pressures are rising as the number of unemployed workers and job openings converge (Chart 7). Given the additional tailwinds of fiscal stimulus, which we see no real chance of being reversed either before or after the midterm election, the U.S. economy is likely to continue to surprise to the upside relative to the rest of the world, a bullish outcome for the U.S. dollar (Chart 8). In this environment of U.S. outperformance and global growth underperformance, EM assets are likely to suffer. Chart 7U.S. Labor Market Is Tightening U.S. Labor Market Is Tightening U.S. Labor Market Is Tightening Chart 8U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD Additionally, it does not help that geopolitical risks will weigh on confidence and will buoy demand for safe haven assets, such as the U.S. dollar. First, U.S.-China trade relations will continue to dominate the news flow this summer. President Trump's positive tweets on the smartphone giant ZTE aside, the U.S. and China have not reached a substantive agreement and upcoming deadlines on trade-related matters remain a risk (Table 1). Table 1Protectionism: Upcoming Dates To Watch Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" Second, President Trump's application of Maximum Pressure on Iran will cause further volatility and upside pressure on the oil markets. The media was caught by surprise by the president's announcement that he is withdrawing the U.S. from the JCPOA, which is puzzling given that the May 12 expiration of the sanctions waiver was well-telegraphed (Chart 9). It is also surprising given that President Trump signaled his pivot towards an aggressive foreign policy by appointing John Bolton and Mike Pompeo - two adherents of a hawkish foreign policy - to replace more middle-of-the-road policymakers. It was these personnel changes, combined with the U.S. president's lack of constraints on foreign policy, that inspired us to include Iran as the premier geopolitical risk for 2018.5 Chart 9Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Iran-U.S. Tensions: Maximum Pressure Is Real Last year, BCA's Geopolitical Strategy correctly forecast that President Trump's Maximum Pressure doctrine would work against North Korea. First, we noted that President Trump reestablished America's "credible threat," a crucial factor in any negotiation.6 Without credible threats, it is impossible to cajole one's rival into shifting away from the status quo. The trick with North Korea, for each administration that preceded President Trump, was that it was difficult to establish such a credible threat given Pyongyang's ability to retaliate through conventional artillery against South Korean population centers. President Trump swept this concern aside by appearing unconcerned with what were to befall South Korean civilians or the Korean-U.S. alliance. Second, we noted in a detailed military analysis that North Korean retaliation - apart from the aforementioned conventional capacity - was paltry.7 President Trump called Kim Jong-un's bluff about targeting Guam with ballistic missiles and kept up Maximum Pressure throughout a summer full of rhetorical bluster. As tensions rose, China blinked first, enforcing President Trump's demand for tighter sanctions. China did not want the U.S. to attack North Korea or to use the North Korean threat as a reason to build up its military assets in the region. The collapse of North Korean exports to China ultimately starved the regime of hard cash and, in conjunction with U.S. military and rhetorical pressure, forced Kim Jong-un to back off (Chart 10). In essence, President Trump's doctrine is a modification of President Theodore Roosevelt's maxim. Instead of "talking softly," President Trump recommends "tweeting aggressively".8 It is important to recount the North Korean experience for several reasons: Maximum Pressure worked with North Korea: It is an objective fact that President Trump was correct in using Maximum Pressure on North Korea. Our analysis last year carefully detailed why it would be a success. However, we also specifically outlined why it would work with North Korea. Particularly relevant was Pyongyang's inability to counter American economic pressure and rhetoric with material leverage. Kim Jong-un's only objective capability is to launch a massive artillery attack against civilians in Seoul. Given his preference not to engage in a full-out war against South Korea and the U.S., he balked and folded. Trump is tripling-down on what works: President Trump, as all presidents before him, is learning on the job. The North Korean experience has convinced him that his Maximum Pressure tactic works. In particular, it works because it forces third parties to enforce economic sanctions on the target nation. If China were to abandon its traditional ally North Korea and enforced painful sanctions, the logic goes, then Europeans would ditch Iran much faster. Iran is not North Korea: The danger with applying a Maximum Pressure tactic against Iran is that Tehran has multiple levers around the Middle East that it could deploy to counter U.S. pressure. President Obama did not sign the JCPOA merely because he was a dove.9 He did so because the deal resolved several regional security challenges and allowed the U.S. to pivot to Asia (Chart 11). Chart 10Maximum Pressure Worked On Pyongyang Maximum Pressure Worked On Pyongyang Maximum Pressure Worked On Pyongyang Chart 11Iran Nuclear Deal Had A Strategic Imperative Iran Nuclear Deal Had A Strategic Imperative Iran Nuclear Deal Had A Strategic Imperative To understand why Iran is not North Korea, and how the application of Maximum Pressure could induce greater uncertainty in this case, investors first have to comprehend why the U.S.-Iran nuclear deal was concluded in the first place. Maximum Pressure Applied To Iran The 2015 U.S.-Iran deal resolved a crucial security dilemma in the Middle East: what to do about Iran's growing power in the region. Ever since the U.S. toppling of Saddam Hussein's regime in 2003, the fulcrum of the region's disequilibrium has been the status of Iraq. Iraq is a natural geographic buffer between Iran and Saudi Arabia, the two regional rivals. Hussein, a Sunni, ruled Iraq - 65% of which is Shia - either as an overt client of the U.S. and Saudi Arabia (1980-1988), or as a free agent largely opposed to everyone in the region (from 1990s onwards). Both options were largely acceptable to Saudi Arabia, although the former was preferable. Iran quickly seized the initiative in Iraq following the U.S. overthrow of Hussein, which created a vast vacuum of power in the country. Elite members of the country's Revolutionary Guards (IRGC), the so-called Quds Force, infiltrated Iraq and supplied various Shia militias with weapons and training that fueled the anti-U.S. insurgency. An overt Iranian ally, Nouri al-Maliki, assumed power in 2006. Soon the anti-U.S. insurgency evolved into sectarian violence as the Sunni population revolted and various Sunni militias, supported by Saudi Arabia, rose up against Shia-dominated Baghdad. The U.S. troops stationed in Iraq quickly became either incapable of controlling the sectarian violence or direct targets of the violence themselves. This rebellion eventually mutated into the Islamic State, which spread from Iraq to Syria in 2012 and then back to Iraq two years later. The Obama administration quickly realized that a U.S. military presence in Iraq would have to be permanent if Iranian influence in the country was to be curbed in the long term. This position was untenable, however, given U.S. military casualties in Iraq, American public opinion about the war, and lack of clarity on U.S. long-term interests in Iraq in the first place. President Obama therefore simultaneously withdrew American troops from Iraq in 2011 and began pressuring Iran on its nuclear program between 2011 and 2015.10 In addition, the U.S. demanded that Iran curb its influence in Iraq, that its anti-American/Israel rhetoric cease, and that it help defend Iraq against the attacks by the Islamic State in 2014. Tehran obliged on all three fronts, joining forces with the U.S. Air Force and Special Forces in the defense of Baghdad in the fall 2014.11 In 2014, Iran acquiesced in seeing its ally al-Maliki replaced by the far less sectarian Haider al-Abadi. These moves helped ease tensions between the U.S. and Iran and led to the signing of the JCPOA in 2015. From Tehran's perspective, it has abided by all the demands made by Washington during the 2012-2015 negotiations, both those covered by the JCPOA overtly and those never explicitly put down on paper. Yes, Iran's influence in the Middle East has expanded well beyond Iraq and into Syria, where Iranian troops are overtly supporting President Bashar al-Assad. But from Iran's perspective, the U.S. abandoned Syria in 2012 - when President Obama failed to enforce his "red line" on chemical weapons use. In fact, without Iranian and Russian intervention, it is likely that the Islamic State would have gained a greater foothold in Syria. The point that its critics miss is that the 2015 nuclear deal always envisioned giving Iran a sphere of influence in the Middle East. Otherwise, Tehran would not have agreed to curb its nuclear program! To force Iran to negotiate, President Obama did threaten Tehran with military force. As we have detailed in the past, President Obama established a credible threat by outsourcing it to Israel in 2011. It was this threat of a unilateral Israeli attack, which Obama did little to limit or prevent, that ultimately forced Europeans to accept the hawkish American position and impose crippling economic sanctions against Iran in early 2012. As such, it is highly unlikely that a rerun of the same strategy by the U.S., this time with Trump in charge and with potentially less global cooperation on sanctions, will produce a different, or better, deal. The recent history is important to recount because the Trump administration is convinced that it can get a better deal from Iran than the Obama administration did. This may be true, but it will require considerable amounts of pressure on Iran to achieve it. At some point, we expect that this pressure will look very much like a preparation for war against Iran, either by U.S. allies Israel and Saudi Arabia, or by the U.S. itself. First, President Trump will have to create a credible threat of force, as President Obama and Israeli Prime Minister Benjamin Netanyahu did in 2011-2012. Second, President Trump will have to be willing to sanction companies in Europe and Asia for doing business with Iran in order to curb Iran's oil exports. According to National Security Advisor John Bolton, European companies will have by the end of 2018 to curb their activities with Iran or face sanctions. The one difference this time around is Iraqi politics. Elections held on May 13 appear to have resulted in a surge of support for anti-Iranian Shia candidates, starting with the ardently anti-American and anti-Iranian Shia Ayatollah Muqtada al-Sadr. Sadr is a Shia, but also an Iraqi nationalist who campaigned on an anti-Tehran, anti-poverty, anti-corruption line. If the election signals a clear shift in Baghdad against Iran, then Iran may have one less important lever to play against the U.S. and its allies. However, we are only cautiously optimistic about Iraq. Pro-Iranian Shia forces, while in a clear minority, still maintain the support of roughly half of Iraqi Shias. And al-Sadr may not be able to govern effectively, given that his track record thus far mainly consists of waging insurgent warfare (against Americans) and whipping up populist fervor (against Iran). Any move in Baghdad, with U.S. and Saudi backing, to limit Iranian-allied Shia groups from government could lead to renewed sectarian conflict. Therein lies the key difference between North Korea and Iran. Iran has military, intelligence, and operational capabilities that North Korea does not. This is precisely why the U.S. concluded the 2015 deal in the first place, so that Iran would curb those capabilities regionally and limit its operations to the Iranian "sphere of influence." In addition, Iran is constrained against reopening negotiations with the U.S. domestically by the ongoing political contest between the moderates - such as President Hassan Rouhani - and the hawks - represented by the military and intelligence nexus. Supreme Leader Khamenei sits somewhere in the middle, but will side with the hawks if it looks like Rouhani's promise of economic benefits from the détente with the West will fall short of reality. The combination of domestic pressure and capabilities therefore makes it likely that Iran retaliates against American pressure at some point. While such retaliation could be largely investment-irrelevant - say by supporting Hezbollah rocket attacks into Israel or ramping up military operations in Syria - it could also affect oil prices if it includes activities in and around the Persian Gulf. Bottom Line: We caution clients not to believe the narrative that "Trump is all talk." As the example in North Korea suggests, Trump's rhetoric drove China to enforce sanctions in order to avert war on the Korean Peninsula. We therefore expect the U.S. administration to continue to threaten European and Asian partners and allies with sanctions, causing an eventual drop in Iranian oil exports. In addition, we expect Iran to play hardball, using its various proxies in the region to remind the Trump administration why Obama signed the 2015 deal in the first place. Could Trump ultimately be right on Iran as he was on North Korea? Absolutely. It is simply naïve to assume that Iran will negotiate without Maximum Pressure, which by definition will be market-relevant. Impact On Energy Markets BCA Energy Sector Strategy believes that the re-imposition of sanctions could result in a loss of 300,000-500,000 b/d of production by early 2019.12 This would take 2019 production back down to 3.3-3.5 MMB/d instead of growing to nearly 4.0 MMb/d as our commodity strategists have modeled in their supply-demand forecasts. In total, Iranian sanctions could tighten up the outlook for 2019 oil markets by 400,000-600,000 b/d, reversing the production that Iran has brought online since 2016 (Chart 12). Is the global energy market able to withstand this type of loss of production? First, Chart 13 shows that the enormous oversupply of crude oil and oil products held in inventories has already been cut from 450 million barrels at its peak to less than 100 million barrels today. Surplus inventories are destined to shrink to nothing by the end of the year even without geopolitical risks. In short, there is no excess inventory cushion. Chart 12Current And Future Iran Production Is At Risk Current And Future Iran Production Is At Risk Current And Future Iran Production Is At Risk Chart 13Excess Petroleum Inventories Are All But Gone Excess Petroleum Inventories Are All But Gone Excess Petroleum Inventories Are All But Gone Second, spare capacity within the OPEC 2.0 alliance - Saudi Arabia and Russia - is controversial. Many clients believe that OPEC 2.0 could easily restore the 1.8 MMb/d of production that they agreed to hold off the market since early 2017. However, our commodity team has always considered the full number to be an illusion that consists of 1.2 MMb/d of voluntary cuts and around 500,000 b/d of natural production declines that were counted as "cuts" so that the cartel could project an image of greater collaboration than it actually has achieved (Chart 14). In fact, some of the lesser "contributors" to the OPEC cut pledged to lower 2017 production by ~400,000 b/d, but are facing 2018 production levels that are projected to be ~700,000 b/d below their 2016 reference levels, and 2019 production levels are estimated to decline by another 200,000 b/d (Chart 15). Chart 14Primary OPEC 2.0 Members Are ##br##Producing 1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Chart 15Secondary OPEC 2.0 "Contributors"##br## Can't Even Reach Their Quotas Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Third, renewed Iran-U.S. tensions may only be the second-most investment-relevant geopolitical risk for oil markets. Our commodity team expects Venezuelan production to fall to 1.23 MMb/d by the end of 2018 and to 1 MMb/d by the end of 2019, but these production levels could turn out to be optimistic (Chart 16). Venezuelan production declined by 450,000 b/d over the course of 21 months (December 2015 to September 2017), followed by another 450,000 b/d plunge over the past six months (September 2017 to March 2018), as the country's failing economy goes through the death spiral of its 20-year socialist experiment. The oil production supply chain is now suffering from shortages of everything, including capital. It is difficult to predict what broken link in the supply chain is most likely to impact production next, when it will happen, and what the size of the production impact will be. The combination of President Trump's Maximum Pressure doctrine applied to Iran, continued deterioration in Venezuelan production, and the inability of OPEC 2.0 to surge production as fast as the market thinks is unambiguously bullish for oil prices. Oil markets are currently pricing in a just under 35% probability that oil prices will exceed $80/bbl by year-end (Chart 17).13 We believe these odds are too low and will take the other side of that bet. Indeed, we think that the odds of Brent prices ending above $90/bbl this year are much higher than the 16% chance being priced in the markets presently, even though this is up from just under 4% at the beginning of the year. Chart 16Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk Chart 17Market Continues To Underestimate High Oil Prices Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" Bottom Line: Our colleague Bob Ryan, Chief Commodity & Energy Strategist, also expects higher volatility, as news flows become noisier. The recommendation by BCA's Commodity & Energy Strategy is to go long Feb/19 $80/bbl Brent calls expiring in Dec/18 vs. short Feb/19 $85/bbl calls, given our assessment that the odds of ending the year above $90/bbl are higher than the market's expectations. A key variable to watch in the ongoing saga will be President Trump's willingness to impose secondary sanctions against European and Asian companies doing business with Iran. We do not think that the White House is bluffing. The mounting probability of sanctions will create "stroke of pen" risk and raise compliance costs to doing business with Iran, leading to lower Iranian exports by the end of the year. Europe Update: Political Risks Returning Risks in Europe are rising on multiple fronts. First, we continue to believe that the domestic political situation in the U.K. regarding Brexit is untenable. Second, the coalition of populists in Italy - combining the anti-establishment Five Star Movement (M5S) and the Euroskeptic Lega - appears poised to become a reality. Brexit: Start Pricing In Prime Minister Corbyn Since our Brexit update in February, the pound has taken a wild ride, but our view has remained the same.14 PM May has an untenable negotiating position. The soft-Brexit majority in Westminster is growing confident while the hard-Brexit majority in her own Tory party is growing louder. We do not know who will win, but odds of an unclear outcome are growing. The first problem is the status of Northern Ireland. The 1998 Good Friday agreement, which ended decades of paramilitary conflict on the island, established an invisible border between the Republic of Ireland and Northern Ireland. Membership in the EU by both made the removal of a physical border a simple affair. But if the U.K. exits the bloc, and takes Northern Ireland with it, presumably a physical barrier would have to be reestablished, either in Ireland or between Northern Ireland and the rest of the U.K. The former would jeopardize the Good Friday agreement, the latter would jeopardize the U.K.'s integrity as a state. The EU, led on by Dublin's interests, has proposed that Northern Ireland maintain some elements of the EU acquis communautaire - the accumulated body of EU's laws and obligations - in order to facilitate the effectiveness of the 1998 Good Friday agreement. For many Tories in the U.K., particularly those who consider themselves "Unionists," the arrangement smacks of a Trojan Horse by the EU to slowly but surely untie the strings that bind the U.K. together. If Northern Ireland gets an exception, then pro-EU Scotland is sure to ask for one too. The second problem is that the Tories are divided on whether to remain part of the EU customs union. PM May is in favor of a "customs partnership" with the EU, which would see unified tariffs and duties on goods and services across the EU bloc and the U.K. However, her own cabinet voted against her on the issue, mainly because a customs union with the EU would eliminate the main supposed benefit of Brexit: negotiating free trade deals independent of the EU. It is unclear how PM May intends to resolve the multiple disagreements on these issues within her party. Thus far, her strategy was to simply put the eventual deal with the EU up for a vote in Westminster. She agreed to hold such a vote, but with the caveat that a vote against the deal would break off negotiations with the EU and lead to a total Brexit. The threat of such a hard Brexit would force soft Brexiters among the Tories to accept whatever compromise she got from Brussels. Unfortunately for May's tactic, the House of Lords voted on April 30 to amend the flagship EU Withdrawal Bill to empower Westminster to send the government back to the negotiating table in case of a rejection of the final deal with the EU. The amendment will be accepted if the House of Commons agrees to it, which it may, given that a number of soft Brexit Tories are receptive. A defeat of the final negotiated settlement could prolong negotiations with the EU. Brussels is on record stating that it would prolong the transition period and give the U.K. a different Brexit date, moving the current date of March 2019. However, it is unclear why May would continue negotiating at that point, given that her own parliament would send her back to Brussels, hat in hand. The fundamental problem for May is the same that has plagued the last three Tory Prime Ministers: the U.K. Conservative Party is intractably split with itself on Brexit. The only way to resolve the split may be for PM May to call an election and give herself a mandate to negotiate with the EU once she is politically recapitalized. This realization, that the probability of a new election is non-negligible, will likely weigh on the pound going forward. Investors would likely balk at the possibility that Jeremy Corbyn will become the prime minister, although polling data suggests that his surge in popularity is over (Chart 18). Local elections in early May also ended inconclusively for Labour's chances, with no big outpouring for left-leaning candidates. Even if Labour is forced to form a coalition with the Scottish National Party (SNP), it is unlikely that the left-leaning SNP would be much of a check on Corbyn's Labour. Chart 18Corbyn's Popularity Is In Decline Corbyn's Popularity Is In Decline Corbyn's Popularity Is In Decline Bottom Line: Theresa May will either have to call a new election between now and March of next year or she will use the threat of a new election to get hard-Brexit Tories in line. Either way, markets will have to reprice the probability of a Labour-led government between now and a resolution to the Brexit crisis. Italy: Start Pricing In A Populist Government Leaders of Italy's populist parties - M5S and Lega - have come to an agreement on a coalition that will put the two anti-establishment parties in charge of the EU's third-largest economy. Markets are taking the news in stride because M5S has taken a 180-degree turn on Euroskepticism. Although Lega remains overtly Euroskeptic, its leader Matteo Salvini has said that he does not want a chaotic exit from the currency bloc. Is the market right to ignore the risks? On one hand, it is a positive development that the anti-establishment forces take over the reins in Italy. Establishment parties have failed to reform the country, while time spent in government will de-radicalize both anti-establishment parties. Furthermore, the one item on the political agenda that both parties agree on is to radically curb illegal migration into Italy, a process that is already underway (Chart 19). On the other hand, the economic pact signed by both parties is completely and utterly incompatible with reality. It combines a flat tax and a guaranteed basic income with a lowering of the retirement age. This would blow a hole in Italy's budget, barring a miraculous positive impact on GDP growth. The market is likely ignoring the coalition's economic policies as it assumes they cannot be put into action. This is not because Rome is afraid to flout Brussels' rules, but because the bond market is not going to finance Italian expenditures. Long-dated Italian bonds are already cheap relative to the country's credit rating (Chart 20), evidence that the market is asking for a premium to finance Italian expenditures. This is despite the ongoing ECB bond buying efforts. Once the ECB ends the program later this year, or in early 2019, the pressure on Rome from the bond market will grow. Chart 19European Migration Crisis Is Over European Migration Crisis Is Over European Migration Crisis Is Over Chart 20Italian Bonds Still Require A Risk Premium Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" We suspect that both M5S and Lega are aware of their constraints. After all, neither M5S leader Luigi Di Maio nor Lega's Salvini are going to take the prime minister spot. This is extraordinary! We cannot remember the last time a leader of the winning party refused to take the top political spot following an election. Both Di Maio and Salvini are trying to pass the buck for the failure of the coalition. In one way, this is market-positive, as it suggests that the anti-establishment coalition will do nothing of note during its mandate. But it also suggests that markets will have to deal with a new Italian election relatively quickly. As such, we would warn investors to steer clear of Italian assets. Their performance in 2017, and early 2018, suggests that the market has already priced in the most market-positive outcome. Yes, Italy will not leave the Euro Area. But no, there is no "Macron of Italy" to resolve its long-term growth problems. Bottom Line: The Italian government formation is not market-positive. Italian bonds are cheap for a reason. While it is unlikely that the populist coalition will have the room to maneuver its profligate coalition deal into action, the bond market may have to discipline Italian policymakers from time to time. In the long term, none of the structural problems that Italy faces - many of which we have identified in a number of reports - will be tackled by the incoming coalition.15 This will expose Italy to an eventual resurgence in Euroskepticism at the first sight of the next recession. Emerging Markets: Elections In Malaysia And Turkey Offer Divergent Outcomes As we pointed out at the beginning of this report, an environment of rising U.S. yields, a surging dollar, and moderating global growth is negative for emerging markets. In this context, politics is unlikely to make much of a difference. The recently announced early election in Turkey is a case in point. Markets briefly cheered the announced election (Chart 21), before investors realized that there is unlikely to be a consolidation of power behind President Erdogan (Chart 22). Even if Erdogan were to somehow massively outperform expectations and consolidate political capital, it is not clear why investors would cheer such an outcome given his track record, particularly on the economy, over the past decade. Chart 21Investors Briefly Cheered Ankara's Snap Election Investors Briefly Cheered Ankara's Snap Election Investors Briefly Cheered Ankara's Snap Election Chart 22Is Erdogan In Trouble? Is Erdogan In Trouble? Is Erdogan In Trouble? Malaysia, on the other hand, could be the one EM economy that defies the negative macro context due to political events. Our most bullish long-term scenario for Malaysia - a historic victory for the opposition Pakatan Harapan coalition - came to pass with the election on May 9 (Chart 23).16 Significantly, outgoing Prime Minister Najib Razak accepted the election results as the will of the people. He did not incite violence or refuse to cede power. Rather, he congratulated incoming Prime Minister Mahathir Mohamad and promised to help ensure a smooth transition. This marks the first transfer of power since Malaysian independence in 1957. It was democratic and peaceful, which establishes a hugely consequential and market-friendly precedent. How did the opposition pull off this historic upset? Ethnic-majority Malays swung to the opposition; Mahathir's "charismatic authority" had an outsized effect; Barisan Nasional "safety deposits" in Sabah and Sarawak failed; Voters rejected fundamentalist Islamism. What are the implications? Better Governance - Governance has been deteriorating, especially under Najib's rule, but now voters have demanded improvements that could include term-limits for prime ministers and legislative protections for officials investigating wrongdoing by top leaders (Chart 24). Economic Stimulus - Pakatan Harapan campaigned against some of the painful pro-market structural reforms that Najib put in place. They have promised to repeal the new Goods and Services Tax (GST) and reinstate fuel subsidies. They have also proposed raising the minimum wage and harmonizing it across the country. While these pledges will be watered down,17 they are positive for nominal growth in the short term but negative for fiscal sustainability in the long term. Chart 23Comfortable Majority For Pakatan Harapan Coalition Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" Chart 24Voters Want Governance Improvements Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" The one understated risk comes from China. Najib's weakness had led him to court China and rely increasingly on Chinese investment as an economic strategy. Mahathir and Pakatan Harapan will seek to revise all Chinese investment (including under the Belt and Road Initiative). This review is not necessarily to cancel projects but to haggle about prices and ensure that domestic labor is employed. Mahathir will also try to assert Malaysian rights in the South China Sea. None of this means that a crisis is impending, but China has increasingly used economic sanctions to punish and reward its neighbors according to whether their electoral outcomes are favorable to China,18 and we expect tensions to increase. Investment Conclusion On the one hand, in the short run, the picture for Malaysia is mixed. Pakatan Harapan will likely pursue some stimulative economic policies, but these come amidst fundamental macro weaknesses that we have highlighted in the past - and may even exacerbate them. On the other hand, a key external factor is working in the new government's favor: oil. With oil prices likely to move higher, the Malaysian ringgit is likely to benefit (Chart 25), helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power, a key election grievance. Higher oil prices are also correlated with higher equity prices. Over the long run, we have a high-conviction view that this election is bullish for Malaysia. It sends a historic signal that the populace wants better governance. BCA's Emerging Markets Strategy has found that improvements in governance are crucial for long-term productivity, growth, and asset performance.19 Hence, BCA's Geopolitical Strategy recommends clients go long Malaysian equities relative to EM. Now is a good entry point despite short-term volatility (Chart 26). We also think that going long MYR/TRY will articulate both our bullish oil story as well as our divergent views on political risks in Malaysia and Turkey (Chart 27). Chart 25Oil Outlook Favors Malaysian Assets Oil Outlook Favors Malaysian Assets Oil Outlook Favors Malaysian Assets Chart 26Long Malaysian Equities Versus EM Long Malaysian Equities Versus EM Long Malaysian Equities Versus EM Chart 27Higher Oil Prices Favor MYR Than TRY Higher Oil Prices Favor MYR Than TRY Higher Oil Prices Favor MYR Than TRY We are re-initiating two trades this week. First, the recently stopped out long Russian / short EM equities recommendation. We still believe that the view is on strong fundamentals, at least in the tactical and cyclical sense.20 Russian President Vladimir Putin has won another mandate and appears to be focusing on domestic economy and the constraints to Russian geopolitical adventurism have grown. The Trump administration has apparently also grown wary of further sanctions against Russia. However, our initial timing was massively off, as tensions between Russia and West did not peak in early March as we thought. We are giving this high-risk, high-reward trade another go, particularly in light of our oil price outlook. Second, we booked 10.26% gains on our recommendation to go long French industrials versus their German counterparts. We are reopening this view again as structural reforms continue in France unimpeded. Meanwhile, risk of global trade wars and a global growth slowdown should impact the high-beta German industrials more than the French. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Senior Analyst jesse.kuri@bcaresearch.com 1 Washington's demand that China cut its annual trade surplus has grown from $100 billion, announced previously by President Trump, to at least $200 billion. 2 Please see BCA Emerging Markets Strategy Weekly Report, "EM: A Correction Or Bear Market?" dated May 10, 2018, available at ems.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "'America Is Roaring Back!' (But Why Is King Dollar Whispering?),"dated January 31, 2018, and Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat,'" dated April 7, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, and "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 8 Instead of a "big stick," President Trump would likely also recommend a "big nuclear button." 9 This is an important though obvious point. We find that many liberally-oriented clients are unwilling to give President Trump credit for correctly handling the North Korean negotiations. Similarly, conservative-oriented clients refuse to accept that President Obama's dealings with Iran had a strategic logic, even though they clearly did. President Obama would not have been able to conclude the JCPOA without the full support of U.S. intelligence and military establishment. 10 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 11 While there was no confirmed collaboration between Iranian ground forces in Iraq and the U.S. Air Force, we assume that it happened in 2014 in the defense of Baghdad. The U.S. A-10 Warthog was extensively used against Islamic State ground forces in that battle. The plane is most effective when it has communication from ground forces engaging enemy units. Given that Iranian troops and Iranian backed Shia militias did the majority of the fighting in the defense of Baghdad, we assume that there was tactical communication between U.S. and the Iranian military in 2014, a whole year before the U.S.-Iran nuclear détente was concluded. 12 Please see BCA Energy Sector Strategy Weekly Report, "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," dated May 9, 2018, available at nrg.bcaresearch.com. 13 Please see BCA Commodity & Energy Strategy Weekly Report, "Feedback Loop: Spec Positioning & Oil Price Volatility," dated May 10, 2018, available at ces.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "Bear Hunting And A Brexit Update," dated February 14, 2018, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, and "Europe's Divine Comedy Party II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "How To Play Malaysia's Elections (And Thailand's Lack Thereof)," dated March 21, 2018, available at gps.bcaresearch.com. 17 For instance, the proposed Sales and Services Tax (SST) is more like a rebranding of the GST than a true abolition. And while fuel subsidies will be reinstated - weighing on the fiscal deficit - they will have a quota and only certain vehicles will be eligible. It will not be a return to the old pricing regime where subsidies were unlimited and were for everyone. 18 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Special Report, "Ranking EM Countries Based on Structural Variables," dated August 2, 2017, available at ems.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Special Report, "Vladimir Putin, Act IV," dated March 7, 2018, available at gps.bcaresearch.com.

Highlights The big danger of higher bond yields is to the $380 trillion edifice of global risk-assets, rather than to the global economy per se. Buy a small portfolio of 30-year government bonds, given that higher bond yields are now hurting equities and 30-year yields are close to resistance levels. The ongoing drama of Italian politics is an irritation, rather than an existential risk to the euro area, as long as Italian populists correctly focus their fire on EU fiscal rules rather than the single currency. Nevertheless, we prefer France's CAC over Italy's MIB and Spain's IBEX, given the latter markets' outsize exposure to banks, a sector in which we remain underweight. Feature When travellers from the U.K. find themselves in Continental Europe or the U.S. they frequently make a potentially fatal error. Trying to cross a busy street, they look right instead of left... Your author has made this error several times and lived to tell the tale, but there is an important moral to the story. However carefully you look, you won't spot the oncoming truck if you are looking in the wrong direction! Chart of the WeekEquities And Bonds Are Both Offering A Paltry 2% Equities And Bonds Are Both Offering A Paltry 2% Equities And Bonds Are Both Offering A Paltry 2% Look At the Markets, Not The Economy The global long bond yield is up around 60bps from the lows of last September, and it would be natural to ask if this poses a danger to the economy. Credit sensitive economic sectors are understandably feeling a headwind, and global growth has indisputably decelerated (Chart I-2). Yet there is no sense of an oncoming truck. Chart I-2Credit Sensitive Sectors Are Feeling A Headwind Credit Sensitive Sectors Are Feeling A Headwind Credit Sensitive Sectors Are Feeling A Headwind But are we looking in the wrong direction? While higher bond yields do not yet threaten the global economy, the big danger is to the $380 trillion edifice of global risk-assets.1 In the space of a few weeks, the correlation between bond yields and equities has suddenly and viciously reversed. When the 10-year T-bond yield was below 2.65%, the correlation was a near perfect positive, r = +0.9 (Chart I-3) but above 2.85%, it has flipped to a near perfect negative, r = -0.8 (Chart I-4). Chart I-3Below A 2.65% T-Bond Yield, Equities And##br## Bond Yields Were Positively Correlated The Danger Of Looking The Wrong Way The Danger Of Looking The Wrong Way Chart I-4Above A 2.85% T-Bond Yield, Equities And ##br##Bond Yields Have Been Negatively Correlated The Danger Of Looking The Wrong Way The Danger Of Looking The Wrong Way In 2000, 2008 and 2011, the right direction to look was at the financial markets. Recall that it was instabilities in the financial markets - the bursting of the dot com bubble, the mispricing of U.S. subprime mortgages, and the widening of euro area sovereign credit spreads - that spilled over into economic downturns. In any case, for investment strategy, whether such financial instabilities do or do not spill over into the real economy is a secondary concern. The primary concern must always be to identify financial market vulnerabilities - and opportunities. Rich Valuations Are In A Precarious Equilibrium The single most important determinant of an investment's long term return is not the investment's cash flows per se, it is the price that you pay for the cash flows. This is the fundamental lesson of investment. An investment's cash flows might be growing strongly, but if you overpay for the cash flows - for example, in a bubble - you will end up with a negative return. Conversely, cash flows might be collapsing, but if you buy them at an overly depressed price, you will end up with a positive return. It turns out that the long term prospective return from most investments is well-defined. For government bonds, it is the yield to maturity;2 for equities and other risk-assets it is empirically well-defined by the starting valuation, which tends to be an excellent predictor of the prospective long term return (Chart I-5). Chart I-5World Equities Are Priced To Generate 2% A Year World Equities Are Priced To Generate 2% A Year World Equities Are Priced To Generate 2% A Year For the long term prospective return from bonds, the main determinant is central bank policy, and specifically the expected path for interest rates. For the long term prospective return from equities, the main determinant is the return that the market demands relative to that on offer from bonds. What establishes this relative return? The answer is relative riskiness, specifically the potential for short term losses versus short term gains, technically known as negative skew. Investors hate negative skew - the potential to experience larger short term losses than gains. Hence, investors demand relative returns that are commensurate with the investments' relative negative skews. This brings us to the crux of the matter. At low bond yields, bonds become much more risky: their returns take on negative skew. Intuitively, this is because the lower bound to interest rates forces a very unattractive asymmetry on bond returns: prices can fall a lot, but they can no longer rise a lot. At a bond yield of 2%, theoretical and empirical evidence shows that bonds and equities possess the same negative skew (Chart I-6 and Chart I-7). Chart I-6At A 2% Bond Yield, 10-Year Bonds Have##br## The Same Negative Skew As Equities... The Danger Of Looking The Wrong Way The Danger Of Looking The Wrong Way Chart I-7...So At A 2% Bond Yield, Equities ##br##Must Also Offer A 2% Return The Danger Of Looking The Wrong Way The Danger Of Looking The Wrong Way Right now, the negative skews on bonds and equities are roughly the same, so investors are accepting roughly the same long term return from global equities as they can get from global bonds - a paltry 2% (Chart of the Week). This justifies an equity valuation as rich as at the peak of the dot com bubble. The trouble is that the valuation justification for $380 trillion of global risk-assets would crumble if the bond yield were to rise meaningfully. But which bond yield? As asset-classes tend to move as global rather than regional assets, the yield that matters is the global long bond yield. Given the large spread in yields across major bonds, a global yield of 2% equates to around 3% in the U.S. and 1% in Europe. This may explain why these are the yield levels at which the correlation between bond yields and equities has suddenly and viciously reversed. This brings us to the investment opportunity: 30-year government bonds. In recent years, 30-year yields have failed to sustain breaks through upper bounds: 3.2% for T-bonds; 2.0% for U.K. gilts; 1.4% for German bunds; and 0.9% for JGBs. Indeed, looking at these yields since 2015 it is hard to discern a bear market in 30-year government bonds (Charts I-8- I-11). Chart I-8Resistance At 3.2% Resistance At 3.2% Resistance At 3.2% Chart I-9Resistance At 2.0% Resistance At 2.0% Resistance At 2.0% Chart I-10Resistance At 1.4% Resistance At 1.4% Resistance At 1.4% Chart I-11Resistance At 0.9% Resistance At 0.9% Resistance At 0.9% With higher bond yields now hurting equities, and 30-year yields close to resistance levels, it is a good time to buy a small portfolio of 30-year government bonds. What Unites Italy With Japan? Italy and Japan are the only two major economies in which private indebtedness is considerably less than public indebtedness (Chart I-12 and Chart I-13). In the case of Italy, the very low private indebtedness means that its total indebtedness - as a share of GDP - is actually less than that in the U.K., France, Spain and Sweden. Chart I-12Private Indebtedness Is Less Than ##br##Public Indebtedness In Italy... Private Indebtedness Is Less Than Public Indebtedness In Italy... Private Indebtedness Is Less Than Public Indebtedness In Italy... Chart I-13...And In ##br##Japan ...And In Japan ...And In Japan The other thing that unites Italy with Japan is that their banking systems were left undercapitalised and in a 'zombie' state for years. Which, to a large extent, explains why private indebtedness has been declining in both economies. When somebody in the private sector pays down debt, say €100, and the banking system does not reallocate that €100 to a new private sector borrower, aggregate demand will contract by €100. To prevent this demand recession, the government must step in to borrow and spend the €100. Moreover, because the private sector is deleveraging, what seems to be fiscal largesse does not lead to crowding out, inflation, or surging interest rates. Instead, government borrowing and spending turns out to be a very sensible economic policy. On this basis, Japan countered its aggressive private sector deleveraging with equally aggressive public sector leveraging and thereby kept its economy motoring along. By contrast, Italy had its hands tied by the EU fiscal compact - which mistakenly looks at public indebtedness in isolation rather than in combination with private indebtedness. Hence, the Italian government was prevented from recapitalizing its banking system, and the Italian economy stagnated for a decade (Chart I-14 and Chart I-15). Chart I-14The Italian Government Was Prevented ##br##From Recapitalising The Banks... The Italian Government Was Prevented From Recapitalising The Banks... The Italian Government Was Prevented From Recapitalising The Banks... Chart I-15...And The Italian Economy ##br##Stagnated For A Decade ...And The Italian Economy Stagnated For A Decade ...And The Italian Economy Stagnated For A Decade In this sense, the populist parties in Italy - The League and 5 Star Movement - have correctly identified that Italy's problem is not the euro per se, but the EU's fiscal dogma. Both parties have dropped calls for a referendum on Italy's membership of the euro area, but have doubled down on their intentions to ignore the EU's misguided fiscal rules, such as the 3 per cent limit on budget deficits. As long as Italian populists correctly focus their fire on EU rules rather than the single currency, investors should view the ongoing drama of Italian politics as an irritation, rather than an existential risk to the euro area. Nevertheless, for the time being, we prefer France's CAC over Italy's MIB and Spain's IBEX. This is less a function of politics, and more a function of the latter markets' outsize exposure to banks, a sector in which we remain underweight. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Global equities and high yield and EM debt is worth around $160 trillion and global real estate is worth $220 trillion. 2 Assuming no default risk and no reinvestment risk. Fractal Trading Model* This week, we note that SEK/EUR is at a key technical turning point, and due a countertrend rally. As we already have a long SEK/GBP position open, we are not doubling up with SEK/EUR. In other trades, we are pleased to report that long USD/Chilean peso hit its 2.7% profit target, and is now closed. This leaves us with four open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-16 SEK/EUR SEK/EUR The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields 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##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Two big distortions in the euro area economy arose because Germany depressed its wages for a decade, and then Italy failed to fix its broken banks for a decade... ...but both distortions are now correcting. Long-term property investors in Europe should seek out undervalued gems on the Greek islands, Portuguese Atlantic coast, Italy and German second-tier cities. Steer clear of Scandinavia, France and central London. Stay overweight a basket of German real estate stocks. Maintain a long basket of German consumer services versus a short basket of exporters comprising autos, chemicals and industrials. Feature In Germany and Italy, real house prices are at the same level today as they were in 1995 (Chart of the Week). Germany and Italy share another similarity. Through the past two decades, they have delivered their workers the same subpar real wage growth (Chart I-2). Chart of the WeekThe Mirror Image Journeys Of German ##br##And Italian House Prices The Mirror Image Journeys Of German And Italian House Prices The Mirror Image Journeys Of German And Italian House Prices Chart I-2The Mirror Image Journeys Of ##br##German And Italian Wages The Mirror Image Journeys Of German And Italian Wages The Mirror Image Journeys Of German And Italian Wages However, while the point-to-point growth rates for both house prices and wages look identical, the journeys that Germany and Italy have travelled have been mirror images of one another. Germany's journey has been a decline followed by rapid ascent; Italy's journey has been a rapid ascent followed by decline. These mirror image journeys encapsulate the two big distortions within the euro area economy. The Euro Area's Two Big Distortions The euro area's first distortion arose from Germany's labour market reforms at the start of the millennium. Germany's labour reforms were putatively to boost productivity. In fact, the reforms' main impact was to depress German wages for a decade. The consequent boost in competitiveness caused symmetrical distortions: a bubble in German exports, and an anti-bubble in German household incomes. Before Germany joined the euro, such a distortion would have been impossible. An appreciating deutschemark would have arbitraged away any rise in export competitiveness. But an exchange rate appreciation could no longer happen once Germany was sharing its currency with other economies that were not replicating Germany's wage depression strategy. Hence, German household incomes - and house prices - have been one of Europe's biggest losers in the single currency era. Conversely, Germany's export-oriented companies - and their shareholders - have been amongst the biggest winners (Chart I-3). Just consider, the Siemens dividend is up almost one thousand percent! The euro area's second distortion arose because Italy failed to fix its broken banks for a decade. After a financial crisis such as in 2008, the golden rule is to nurse the financial system back to health as quickly as possible. Which is precisely what all the major economies did. All the major economies, that is, apart from Italy (Chart I-4). Chart I-3Distortion 1: Germany Depressed##br## Its Wages For A Decade Distortion 1: Germany Depressed Its Wages For A Decade Distortion 1: Germany Depressed Its Wages For A Decade Chart I-4Distortion 2: Italy Failed To Fix Its ##br##Broken Banks For A Decade Distortion 2: Italy Failed To Fix Its Broken Banks For A Decade Distortion 2: Italy Failed To Fix Its Broken Banks For A Decade Italy procrastinated because its government is more indebted than other sovereigns and because its dysfunctional banks did not cause an acute domestic crisis. Nevertheless, Italy's reluctance to fix its banks is the central reason for its decade-long economic stagnation, and declining real house prices. The good news is that the euro area's two big distortions are now correcting. Germany is allowing its wages to adjust rapidly upwards. Meanwhile, in the space of just a year, Italy has raised almost €50 billion in equity capital for its banks. Italian bank solvency and loan quality have improved sharply. This raises an interesting question: do the German and Italian housing markets now offer compelling long-term investment opportunities? European Housing Markets: The Good, The Bad, And The Ugly Property investments offer income via rents. Over time, these rents should increase in real terms. Items such as a litre of milk or a London commuter train journey do not increase in quality. If anything, the London commuter train journey has decreased in quality! By contrast, accommodation does increase in quality. For example, kitchens and bathrooms, home security, and heating and cooling systems should all get better over time. In essence, the quality of accommodation benefits from productivity improvements, so real rents rise. Of course, such improvements require investment expenditure. But a property investor requires a return on this investment. Therefore, property income - even after expenses - should and does increase in real terms. What about capital values? In the long term, we would expect capital values to have some connection to rising real rents. So if real house prices have not increased over several decades, then it signals a very likely undervaluation. Conversely, if real house prices have increased an implausibly large amount over several decades, then it raises a red flag for a likely overvaluation (Chart I-5, Chart I-6, and Chart I-7). Chart I-5German Real House Prices Are No Higher Than In 1995 German Real House Prices Are No Higher Than In 1995 German Real House Prices Are No Higher Than In 1995 Chart I-6Scandinavian Real House Prices Have Trebled Since 1995 Scandinavian Real House Prices Have Trebled Since 1995 Scandinavian Real House Prices Have Trebled Since 1995 Chart I-7Italy, Portugal And Greece Offer Good Opportunities For Property Investors Italy, Portugal And Greece Offer Good Opportunities For Property Investors Italy, Portugal And Greece Offer Good Opportunities For Property Investors On this evidence, we expect the long-term returns from the housing markets in France, Netherlands, Belgium and Finland to be bad. More worrying, we expect the long-term returns from the housing markets in Sweden and Norway to be ugly. Real house prices have more than trebled since 1995. For this, blame the central banks. In recent years, Sweden's Riksbank and the Norges Bank have had to shadow the ECB's ultra-loose policy to prevent a sharp appreciation of their currencies. The trouble is that ultra-low and negative interest rates have been absurdly inappropriate for the booming Scandinavian economies. So the ECB's policy may indeed have generated credit-fuelled bubbles... albeit in Sweden and Norway. Chart I-8London House Prices Have Rolled Over London House Prices Have Rolled Over London House Prices Have Rolled Over We are also reluctant to own London property. London house prices have rolled over, and headwinds persist (Chart I-8). Theresa May wants to drag the U.K. out of the EU single market and customs union, which cannot be a good thing for London. On the other hand, if parliament forces May to soften her Brexit stance, it could fracture a precarious truce between hard and soft Brexiters in her cabinet and topple the government. Thereby, it could pave the way for a Jeremy Corbyn led Labour government and the spectre of a high-end 'land value' tax. So where are long-term returns likely to be good? We repeat that where house prices have shown no real increase from 25 years ago, it bodes very well for the long-term investment opportunity. This describes the situation for the housing markets in Germany, Italy, Portugal and Greece. To summarise, if you are looking for a long-term investment property in Europe, steer clear of Scandinavia, France and central London. And seek out undervalued gems on the Greek islands, Portuguese Atlantic coast, Italy and German second-tier cities. What Is The Related Opportunity In Equity Markets? Real estate holding and development companies and REITS are the equity market plays on real estate. The trouble is that the stocks are too few and too small for a meaningful investment in Greece, Italy and Portugal. However, in Germany, stay overweight the basket of real estate stocks which we first introduced a few years ago. The basket has outperformed by 50%, but the outperformance isn't over. In Germany, the catch-up of house prices is closely connected to the catch-up of household incomes. As Germany continues to reduce its export-dependence and rebalance its economy towards domestic demand, the catch-up has further to run. Chart I-9German Consumer Services Will ##br##Outperform Consumer Goods German Consumer Services Will Outperform Consumer Goods German Consumer Services Will Outperform Consumer Goods It is possible to play this structural theme in the equity market via an overweight in consumer services versus consumer goods. Consumer services tend to have more domestic exposure compared to the consumer goods sector which is dominated by autos. Understandably, during the era of German export-dominance, the German consumer services sector strongly underperformed consumer goods. But in recent years, as the German economy has rebalanced, the tables have turned. German consumer services have been outperforming German consumer goods (Chart I-9). We expect this trend to persist. Our preferred expression is to maintain a long basket of German consumer services versus a short basket of exporters comprising autos, chemicals and industrials. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* This week's recommendation is a commodity pair-trade: short nickel / long lead. The pair trade's 65-day fractal dimension is at the lower bound which has signalled several reversals in recent years. Set a profit target of 8% with a symmetrical stop-loss. We are also pleased to report that all of the four other open trades are comfortably in profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Nickel vs. Lead Nickel vs. Lead * 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 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##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights The global economic mini-cycle is set to weaken while the euro is set to grind higher. Upgrade Telecoms to overweight. Also overweight Healthcare and Airlines. Underweight Banks, Basic Materials and Energy. Overweight France, Ireland, U.K., Switzerland and Denmark. Underweight Italy, Spain, Sweden and Norway. The Eurostoxx50 will struggle to outperform the S&P500. Feature We are strong believers in Investment Reductionism, a philosophy synthesized from the Pareto Principle and Occam's Razor.1 Investment reductionism offers a liberating thesis - the incessant barrage of investment research, newsfeeds and ten thousand word commentaries is largely superfluous to the investment process. What seems like a complexity of investment choice usually reduces to getting a few over-arching decisions right. Chart of the WeekIn Quadrant 4, Overweight Domestic Defensives And Underweight International Cyclicals The Four Quadrants Of Cyclical Investing The Four Quadrants Of Cyclical Investing For equity sector and country allocation, two over-arching decisions dominate: Whether the global economic mini-cycle is set to strengthen or weaken (Chart I-2). Whether the domestic currency is set to strengthen or weaken. Chart I-2The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The four permutations of these two decisions create the four quadrants of cyclical investing (Chart of the Week). Right now, European investors find themselves in quadrant four: the global economic mini-cycle is set to weaken while the euro is set to grind higher. This favours an overweight stance to defensives, especially domestic-focused defensives. Therefore today, we are upgrading Telecoms to overweight. We also recommend an underweight stance to the most cyclical sectors, especially international-focused cyclicals such as Basic Materials and Energy. Country allocation then just drops out of this sector allocation. The Global Economic Mini-Cycle Is Set To Weaken We can predict the changes of the seasons and the tides of the sea with utmost precision. How? Not because we have an ingenious leading indicator for the seasons and tides, but because we recognise that these phenomena follow perfectly regular cycles. Regular cycles create predictability. Significantly, global bank credit flows also exhibit remarkably regular cycles with half-cycle lengths averaging around eight months. Recognizing these mini-cycles is immensely powerful because, just as for the seasons and the tides, it creates predictability. Furthermore, if most investors are unaware of these cycles, the next turn will not be discounted in today's price - providing a compelling investment opportunity for those who do recognise the predictability. The empirical evidence for credit mini-cycles is irrefutable. The theoretical foundation is also rock solid, based on an economic model called the Cobweb Theory.2 This states that in any market where supply lags demand, both the quantity supplied and the price must oscillate. Given that credit supply clearly lags credit demand, the quantity of credit supplied and its price (the bond yield) must experience mini-cycles (Chart I-3). And as the quantity of credit supplied is a marginal driver of economic activity, economic activity will also experience the same regular oscillations. Today, the global 6-month credit impulse is turning from mini-upswing to mini-downswing, with all three subcomponents - the euro area, the U.S. and China - now in decline (Chart I-4). This is exactly in line with prediction. Mini half-cycles average eight months, and the latest mini-upswing started eight months ago. Chart I-3The Global Economic Mini-Cycle##br## Is Set To Weaken The Global Economic Mini-Cycle Is Set To Weaken The Global Economic Mini-Cycle Is Set To Weaken Chart I-4All Three Subcomponents Of The Global 6-Month ##br##Credit Impulse Are Now Declining All Three Subcomponents Of The Global 6-Month Credit Impulse Are Now Declining All Three Subcomponents Of The Global 6-Month Credit Impulse Are Now Declining More importantly, as we enter a mini-downswing, we can also predict that global growth is likely to experience at least a modest deceleration through the coming two to three quarters. The Euro Is Set To Grind Higher, Except Versus The Yen Chart I-5Lost In Translation Lost In Translation Lost In Translation Nowadays, mainstream stock markets tend to be eclectic collections of multinational companies which happen to be quoted on bourses in Frankfurt, Paris, New York, and so on. For example, BASF is not really a German chemical company, it is a global chemical company headquartered in Germany. For operational hedging, multinational companies like BASF will intentionally diversify their sales and profits across multiple major currencies, say euros and dollars. But of course, the primary stock market quotation will be in the currency of its home bourse, euros. Therefore, when the euro strengthens, the company's multi-currency profits, translated back into a stronger euro, will necessarily weaken (Chart I-5). Clearly, more domestic-focused companies like telecoms will not experience such a strong currency-translation headwind. We expect the main euro crosses to continue strengthening over the next 8 months, with the exception being the cross versus the Japanese yen. Our central thesis is that the payoff profile for a foreign exchange rate just tracks the bond yield spread. This means that when a central bank has already taken bond yields close to their lower bound, its currency possesses a highly attractive asymmetry called positive skew. In essence, as the ECB is at the realistic limit of ultra-loose policy, long-term expectations for the ECB policy rate possess an asymmetry: they cannot go significantly lower, but they could go significantly higher. Exactly the same applies to long-term expectations for the BoJ policy rate. In contrast, long-term expectations for the Fed policy rate possess full symmetry: they could go either way, lower or higher. This stark asymmetry of central bank 'degrees of freedom' favours the euro and the yen over the dollar. Which Sectors And Countries To Own And Which To Avoid? Pulling together the preceding two sections, the global economic mini-cycle is set to weaken while the euro is set to grind higher. This puts Europe in quadrant four of our four quadrant framework for cyclical investing. Unsurprisingly, the relative performance of the most cyclical sectors - Banks, Basic Materials and Energy - very closely tracks the regular mini-cycles in the global 6-month credit impulse. In a mini-downswing these cyclical sectors always underperform (Chart I-6, Chart I-7 and Chart I-8). Accordingly, underweight these three sectors on a two to three quarter horizon. Chart I-6In A Mini-Downswing, ##br##Banks Always Underperform In A Mini-Downswing, Banks Always Underperform In A Mini-Downswing, Banks Always Underperform Chart I-7In A Mini-Downswing,##br## Basic Materials Always Underperform In A Mini-Downswing, Basic Materials Always Underperform In A Mini-Downswing, Basic Materials Always Underperform Chart I-8In A Mini-Downswing,##br## Energy Always Underperforms In A Mini-Downswing, Energy Always Underperform In A Mini-Downswing, Energy Always Underperform Conversely, overweight the relatively defensive Healthcare sector. Also overweight the Airlines sector. Airlines' performance is a mirror-image of the oil price cycle, given that aviation fuel comprises the sector's main variable cost. Furthermore, as aviation fuel is priced in dollars, it also insulates European Airlines against a strengthening euro. Today, we are also upgrading the Telecoms sector to overweight given its relative non-cyclicality (Chart I-9), its domestic-focus, and the excessively negative groupthink towards it (Chart I-10). Chart I-9In A Mini-Downswing, ##br##Telecoms Always Outperform In A Mini-Downswing, Telecoms Always Outperform In A Mini-Downswing, Telecoms Always Outperform Chart I-10Telecoms Are Due ##br##A Trend Reversal Telecoms Are Due A Trend Reversal Telecoms Are Due A Trend Reversal In summary: Overweight: Healthcare, Telecoms, and Airlines Underweight: Banks, Basic Materials and Energy Then to arrive at a country allocation, just combine the cyclical view on the major sectors with the country sector skews in Box 1. The result is the following unchanged European equity market allocation. Overweight: France, Ireland, U.K., Switzerland and Denmark Neutral: Germany and Netherlands Underweight: Italy, Spain, Sweden and Norway Lastly, what is the prognosis for the Eurostoxx50 relative to the S&P500? Essentially, this reduces to a battle between the multinational cyclicals - especially banks - that dominate euro area bourses and the multinational technology giants that dominate the U.S. stock market. With the global economic mini-cycle set to weaken and the euro set to grind higher, the Eurostoxx50 will struggle to outperform the S&P500. Box 1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The Pareto Principle, often known as the 80-20 rule, says that 80% of effects come from just 20% of causes. Occam's Razor says that when there are many competing explanations for the same effect, the simplest explanation is usually the best. 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11, 2018 and available at eis.bcaresearch.com. Fractal Trading Model* This week's recommended trade is to short the Helsinki OMX versus the Eurostoxx600. Apply a profit target of 3% with a symmetrical stop-loss. In other trades, we are pleased to report that short Japanese Energy versus the market achieved its 8% profit target at which it was closed. This leaves four open positions. 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 11 Helsinki OMX Vs. Eurostoxx 600 Helsinki OMX Vs. Eurostoxx 600 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields 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##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Risk assets find themselves in a precarious equilibrium. Record high valuations are fully justified if bond yields remain at current levels or fall, but valuations become increasingly hard to justify if bond yields march much higher. If the average of the German 10-year bund yield and U.S. 10-year T-bond yield breaks through 2%, we would downgrade equities and upgrade bonds. Stay long Italian BTPs versus French OATs. The Italian election result is not an investment game changer... ...but stay underweight the Italian equity market (MIB) on a 6-9 month horizon. Our sector stance to underweight banks necessarily implies underweighting the bank-heavy MIB. Feature "Even yet we may draw back, but once cross yon little bridge, and the whole issue is with the sword." - Julius Caesar, contemplating whether to cross the Rubicon River in 49 BC World GDP amounts to $80 trillion. But the combined value of equities and correlated risk assets such as high yield and EM debt is worth double that, around $160 trillion. Real estate is worth $220 trillion. Hence, global risk assets are worth around five times world GDP. With the value of risk assets dwarfing the world economy by a factor of five, it perplexes us that many commentators insist that causality must always run from the economy to financial markets. In fact, in major downturns, the causality usually runs the other way. Rather than economic downturns causing financial instabilities, it is more common for financial instabilities to cause economic downturns. Specifically, the last three economic downturns had their geneses in the financial markets. The bursting of the dot com bubble triggered the downturn of 2001; the large-scale mispricing of U.S. mortgages caused the Great Recession of 2008; and the explosive widening of euro area sovereign credit spreads resulted in the euro area recession of 2011. This raises a crucial question: is there a major vulnerability in financial markets right now? Risk Assets Are As Expensive As In 2000... For at least five decades, the ratio of global equity market capitalization to world GDP (effectively, the price to sales ratio) has proved to be an excellent predictor of subsequent 10-year global equity returns (Chart I-2). Chart of the WeekWorld Equities As Highly-Valued As In 2000 On Price To Sales World Equities As Highly-Valued As In 2000 On Price To Sales World Equities As Highly-Valued As In 2000 On Price To Sales Chart I-2Price To Sales Has Been An Excellent Predictor Of World Equity Returns Price To Sales Has Been An Excellent Predictor Of World Equity Returns Price To Sales Has Been An Excellent Predictor Of World Equity Returns Today's extreme ratio of global equity market capitalization to world GDP has been seen only once before in modern history - at the peak of the dot com boom in 2000. In the subsequent decade global equities went on to return a paltry 2% a year. Using the particularly tight predictive relationship in recent decades, we can infer that global equities are now priced to generate 2% a year in the coming decade too (Chart of the Week). Still, equities are not as extremely valued relative to government bonds as they were in 2000. Today, the global 10-year bond yield stands near 2%, implying a broadly equal prospective 10-year return from equities and bonds. In 2000, the global 10-year bond yield stood at 5%, implying that equities would return 3% less than bonds, which they duly did (Chart I-3). Chart I-3Relative To Government Bonds, Equities Were More Expensive In 2000 Relative To Government Bonds, Equities Were More Expensive In 2000 Relative To Government Bonds, Equities Were More Expensive In 2000 On the other hand, high yield credit is more extremely valued relative to government bonds than it was in 2000. Today, the global high yield credit spread stands at a very tight 4%: in 2000, it stood at 8% (Chart I-4). So taking the combination of equities and high yield credit, we can say that risk assets are as highly valued today as they were in 2000. Chart I-4Relative To Government Bonds, High Yield Credit Was Less Expensive In 2000 Relative To Government Bonds, High Yield Credit Was Less Expensive In 2000 Relative To Government Bonds, High Yield Credit Was Less Expensive In 2000 ...But Risk Assets Should Be Very Expensive When Bond Yields Are Ultra-Low The record high valuation of risk assets is fully justified when government bond yields are ultra-low. This is because bond returns take on the same unattractive asymmetry - known as 'negative skew' - that equity and high yield credit returns possess. For a detailed explanation, please revisit our report Are Bonds A Greater Risk Than Equities? 1 But in a nutshell, as bond risk becomes 'equity-like' it diminishes the requirement for a superior return on equities and other risk-assets, lifting their valuations exponentially. Consider what happens to valuations when bond yields decline from 4% to 2%. At a 4% bond yield, equities possess significantly more negative skew than 10-year bonds. So investors will demand a comparatively higher return from equities, let's say 8% a year. Whereas, at a 2% bond yield, equities and 10-year bonds possess the same negative skew. So investors will demand the same return from equities as they can get from bonds, 2% a year (Chart I-5). Chart I-5Below A 2% Yield, 10-Year Bonds Are Riskier Than Equities Markets Approach The Rubicon Markets Approach The Rubicon At the lower bond yield, the bond must deliver 2% a year less for ten years, meaning its price must rise by 22%.2 But equities must deliver 6% a year less for ten years, so the equity market must surge by 80%.3 All well and good, except if bond yields go back up to 4%. In which case, bond and equity prices must fall again - in proportion to their preceding rise. Hence, risk assets find themselves in a precarious equilibrium. Record high valuations are fully justified if bond yields remain at current levels or fall, but valuations become increasingly hard to justify if bond yields march much higher. However, a setback to $380 trillion of global risk assets means that yields can't march much higher without at least a temporary reversal. Unfortunately, the exact point at which the precarious equilibrium becomes threatened is hard to define. Still, we might define crossing the Rubicon as follows. If the average of the German 10-year bund yield and U.S. 10-year T-bond yield - now standing at 1.8% - breaks through 2%, we would downgrade equities and upgrade bonds. Italy: Banks More Important Than Politics On Sunday, Italy's electorate punished the establishment centre-left and centre-right parties - the Democratic Party and Forza Italia - whose combined vote share collapsed to just 33%. Italians gravitated to parties offering populist, anti-establishment and anti-migration bromides. Sound familiar? This is just a continuation of the pattern seen in recent elections in France, Germany and Austria - as well as the victories for Brexit and President Trump. Begging the question, does the Italian election result change anything for investors? Political change disrupts markets if it dislocates the long-term expectations embedded in economic agents and financial prices. The vote for Brexit changed expectations about the U.K.'s long-term trading relationships; the election of Trump changed expectations about fiscal stimulus, the tax structure, and protectionism; and the election of Macron exorcised the potential chaos of a Le Pen presidency. On this basis, the Italian election result is not an investment game changer. The one exception would be if M5S and Lega joined forces to govern, as it could throw EU integration into reverse. But the likelihood of this unholy alliance seems very low. Many people - including some of the more populist Italian politicians - claim that Italy's long-standing economic underperformance is because it is shackled to the euro. But membership of the single currency cannot be the main cause of Italy's underperformance. After all, through 1999-2007, Italian real GDP per head performed more or less in line with the U.S., Canada and France, even without a private sector credit boom. Italy's underperformance really started after the 2008 financial crisis (Chart I-6). And the most plausible explanation is that its dysfunctional banking system has been left broken for close to a decade (Chart I-7). Italy procrastinated because its government is more indebted than other sovereigns and its banking problems did not cause an outright crisis. Chart I-6Italy Has Underperformed##br## Since The Great Recession... Italy Has Underperformed Since The Great Recession... Italy Has Underperformed Since The Great Recession... Chart I-7...Because The Banks ##br##Were Left Unfixed ...Because The Banks Were Left Unfixed ...Because The Banks Were Left Unfixed But now the banking system is finally recuperating. In the past year, banks have raised almost €50 billion in much needed equity capital, the share of non-performing loans (NPLs) is down sharply having peaked at the same level as in Spain in 2013 (Chart I-8), and bank solvency is much healthier (Chart I-9). Chart I-8Italy's NPLs Are Finally Declining... Italy"s NPLs Are Finally Declining... Italy"s NPLs Are Finally Declining... Chart I-9...And Bank Solvency Is Getting Better ...And Bank Solvency Is Getting Better ...And Bank Solvency Is Getting Better In effect, Italy is where Spain was in 2014. So could Italy in 2018-21 repeat Spain's turnaround in 2014-17? Italy has more work to do, but on balance we remain cautiously optimistic, and express this optimism through a relative trade in bonds: long Italian BTPs versus French OATs. The connection with the Italian equity market (MIB) is more tenuous. The market's outsize exposure to banks means that sustained outperformance of the MIB requires sustained outperformance of banks. On a 6-9 month horizon, our sector stance is to underweight banks. Necessarily, this means our country stance must be to underweight Italy. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report "Are Bonds A Greater Risk Than Equities?" published on January 25, 2018 and available at eis.bcaresearch.com 2 1.02^10 3 1.06^10 Fractal Trading Model* The rally in the Chilean peso appears technically extended. Hence, this week's trade recommendation is to short the Chilean peso versus the U.S. dollar setting a profit target of 2.7% with a symmetrical stop-loss. 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 USD/CLP LONG USD/CLP The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields 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 ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Economy: The Italian economy is enjoying a solid, if unspectacular, cyclical upturn led by exports, but inflation pressures remain subdued. Banks: The health of Italian banks has improved drastically over the last year, with liquidity, solvency, and systemic risks fading for the time being. Politics: Euroskepticism will not be the major issue in the election given an expanding economy, but none of the likely outcomes will lead to a prudent fiscal policy. ECB: The inevitable tapering of ECB asset purchases later in 2018 will not have a meaningful impact on Italian government bond valuations - as long as the ECB does not begin to raise rates soon after. Upgrade Italian government bonds to neutral until signs of an economic slowdown in Italy emerge. Feature Italy's financial markets have been on quite a roll over the past year. Italian equities are up 13% since the beginning of 2017 in local currency terms, well above the 8% increase in overall Euro Area stocks (Chart 1). Italian government bonds returned 1.8% over that same period (also in local currency terms), massively outperforming core European equivalents that have suffered significant losses as global bond yields have risen substantially. Investors have been focusing on the upbeat news of a cyclical economic expansion and the improving health of Italian banks, which has helped reduce the risk premia on Italian financial assets (Chart 2). At the same time, markets are not pricing in any political risk in the run-up to next month's Italian parliamentary elections that could end up with, at best, yet another unstable coalition government. Chart 1Italy Has Been##BR##A Star Performer Italy: Growth Cures All Ills ... For Now Italy: Growth Cures All Ills ... For Now Chart 2Investors Are Focusing On Italian Growth,##BR##Not Politics Investors Are Focusing On Italian Growth, Not Politics Investors Are Focusing On Italian Growth, Not Politics Most importantly, the growing pressure on the European Central Bank (ECB) to begin shifting away from the era of extreme monetary policy accommodation threatens to remove a major buyer of Italian debt. This is a large problem down the road, as the easy money policies of the ECB have helped paper over a lot of structural cracks that still exist in Italy. In this Special Report, jointly prepared by BCA's Global Fixed Income Strategy and Geopolitical Strategy teams, we examine the outlook for Italian financial assets, both in the short run heading into the March 4th election and also over a medium-term perspective. Specifically, we look at the ultimate measure of Italian risk - the Italy-Germany government bond yield spread. Our conclusion is that Italy's economy and financial markets may be better placed to survive the more volatile global investment backdrop in 2018 than is commonly believed. Beyond this time horizon, however, Italian politics remains a risk. The Economy: Looking Better, But Highly Levered To Global Growth Italy's economy is enjoying a relatively strong economic expansion, judged by its own modest standards. Real GDP grew 1.5% last year, delivering the fourth consecutive year of growth following the recession in 2012-13. That was slower than the 2.5% pace witnessed across the entire Euro Area. The cyclical trend in Italy, however, remains highly correlated to that of its common currency neighbors, as all have benefitted from the easy financial conditions created by ECB policy (Chart 3). Consumer spending has been a modest contributor to the current economic upturn. Consumer confidence is steadily climbing and approaching its 2015 highs, yet retail sales volumes are only growing at a 1% pace. Sluggish incomes are the reason. Real wage growth has struggled to stay positive in the years since the last recession and now sits at a mere 0.25% (Chart 4). Against this backdrop, Italian consumers have been reluctant to significantly run down savings or ramp up debt to support a faster pace of consumption. The household debt/GDP ratio is only 42%, well below the Euro Area median. The decline in Italian interest rates, however, has helped free up income available for spending; the household debt service ratio is now sitting at 4.5%, one full percentage point below the 2012 peak (bottom panel). Chart 3Italian Growth Is Out Of The Doldrums Italian Growth Is Out Of The Doldrums Italian Growth Is Out Of The Doldrums Chart 4A Modest Pick-Up In Consumer Spending A Modest Pick-Up In Consumer Spending A Modest Pick-Up In Consumer Spending A bigger boost to Italian growth has come from the corporate sector. Business confidence has been steadily improving in response to the cyclical upturn in global economic growth. Exports, which now represent about one-third of Italian GDP, are growing just over 5% in real terms. This has helped boost industrial production and capacity utilization, with the latter reaching the highest level since 2007 (Chart 5). Companies have responded by ramping up capital spending, which grew 4.6% (year-over-year) in Q3 2017. Structurally, problems of poor labor productivity continues to plague Italian companies, however, and it remains to be seen if the rise in the euro over the past year will begin to have an impact on sales and profits. For now, the cyclical industrial upturn will likely continue as long as global growth, and specifically export demand, remain buoyant. Another underappreciated driver of the current Italian expansion has been mildly stimulative fiscal policy. Italy benefited from four consecutive years of positive "fiscal thrust", i.e., the change in the cyclically-adjusted primary budget balance (Chart 6). This was a welcome relief given the austerity that was imposed on Italy after the European Debt Crisis, which drained 3% from the Italian economy from 2011 to 2013. The IMF is projecting that Italian fiscal policy will turn restrictive this year and in 2019 but, as we discuss later in this report, the upcoming Italian election is likely to deliver a government that will go for more fiscal stimulus, not less. Chart 5An Expansion##BR##Fueled By Exports An Expansion Fueled By Exports An Expansion Fueled By Exports Chart 6Fiscal Tightening Will Not Happen,##BR##Post-Election Fiscal Tightening Will Not Happen, Post-Election Fiscal Tightening Will Not Happen, Post-Election The labor market recovery from the 2012 recession has been slow. Italy's unemployment rate is 10.8%, down from a peak level of 13% in 2014 but still well above the OECD's estimate of full employment (NAIRU). For Italy, the youth unemployment rate remains a major problem - at 33%, it is easily the highest among European countries and continues to fuel support for the anti-establishment Five Star Movement. More generally, Italy's relatively high unemployment rate is not necessarily a sign of underlying economic malaise. Italy's labor force participation rate has risen from a low of 60.4% in August 2010 to 64.5% at the end of 2017 (Chart 7). The steadily improving economy is drawing discouraged workers back into the labor force, as we predicted it would in 2012,1 with the extra labor supply ensuring that Italian wage growth will stay sluggish for some time. On a related note, Italy's inflation remains well below the ECB's 2% target rate. Headline HICP and core HICP inflation are 1% and 0.6%, respectively. These levels are also well below the Euro Area aggregate levels, which are 1.35% and 1.2% for headline and core HICP, respectively. Although consumer spending has improved in Italy, it has not been strong enough to put upward pressure on consumer prices, and weaker wage growth will not force businesses to raise prices to protect profitability. In addition, the IMF projects that Italy's output gap will not close until 2022, or three years after the overall Euro Area gap will be eliminated (Chart 8). Chart 7Plenty Of Labor Market Slack In Italy Plenty Of Labor Market Slack In Italy Plenty Of Labor Market Slack In Italy Chart 8No Sign Of Inflation Pressures No Sign Of Inflation Pressures No Sign Of Inflation Pressures Bottom Line: The Italian economy is enjoying a solid, if unspectacular, cyclical upturn. This is being led by exports and flowing through into domestic production and investment. Inflation pressures remain subdued, however, given ample slack in labor markets. The Banks: Drastic Improvement, But Risks Remain The Italian banking system has a well-earned reputation of being dysfunctional, undercapitalized and plagued by non-performing loans (NPLs). However, last summer, the ECB declared that two Italian banks were "failing or likely to fail," prompting state intervention. The Italian government followed that with a E5.4 billion bailout for Monte dei Paschi di Siena, Italy's fourth largest bank. Given the tight correlation between Italy's relative financial asset performance and its banking sector, these actions were met with loud cheers from investors as both Italian equities and bonds rallied. Standard & Poor's credit rating agency then raised Italy's sovereign debt rating to BBB, citing "subsiding risks" in the banking sector. As a result, investors' fears have eased, as evidenced by recent successful capital raisings and the collapse in bank credit default spreads (CDS) for the major banks, which have now fallen to nearly the same levels as their European counterparts (Chart 9). The health of the Italian banking system has improved drastically over the past year given the improving economy. Italy still sits on a large absolute amount of non-performing loans at E274 billion, but this is a risk has receded quickly from its peak of E328 billion in Q1 2017. The continued economic recovery and sales of bad loans have pushed the NPL ratio down to approximately 15%, well below its peak of over 19% (Chart 10). The Bank of Italy's recent Financial Stability Review projects that the one-year forward default probability from a sample of nearly 300,000 indebted companies has fallen to 1% in mid-2017 from 2.5% in 2013. Fewer new loans are becoming impaired, which is encouraging given the ongoing pressures on the banks from the ECB and the Italian government to improve asset quality. Chart 9Italian Bank Risk##BR##Has Declined Italian Bank Risk Has Declined Italian Bank Risk Has Declined Chart 10Banks Better Capitalized,##BR##But NPLs Remain A Problem Banks Better Capitalized, But NPLs Remain A Problem Banks Better Capitalized, But NPLs Remain A Problem The rise in capital ratios over the last year is also a very positive development. For the major banks, liquidity coverage ratios are nearly 200%, the ratio of tangible equity to tangible assets has skyrocketed to nearly 7%, and the Tier 1 capital ratio has increased to 14.8%. Even with the introduction of the IFRS 9 accounting rules in January, which is estimated to reduce the Tier 1 ratio by 38bps, capital levels are high and will allow for banks to operate more normally. Bank earnings rebounded in Q4 2017 on the back of aggressive cost cutting, falling loan impairments and solid net interest income. Margins remain stubbornly weak, even though the yield curve has been steepening since early 2015. Going forward, earnings expectations do not seem overly optimistic, particularly in relation to long-term averages. The continued acceleration in economic growth will provide a considerable tailwind. Lending volumes should rise, albeit at a relatively slow pace, due to improving business confidence. Asset quality is set to strengthen as NPLs decline further, reducing the cost of capital and loss provisions. Bank expenses will also decline due to additional layoffs and a reduction in branch locations. However, despite the substantial improvement in their balance sheets, the Italian banking system is far from invulnerable. Apart from the obvious downturn in economic growth, banks are heavily exposed to Italian government bonds. Holdings of government debt securities as a percentage of total assets have declined considerably to 9% from nearly 11% a year ago, but still remain much higher than levels seen during the euro debt crisis (Chart 11). This suggests that fears of the so-called "doom loop" - where the credit quality of the government and the banks are intertwined through bond holdings – may arise once again in the future if Italy suffers another sovereign debt crisis. Another potential source of risk to the banking sector is the housing market. Unlike its EU counterparts, where house prices have been in an uptrend since 2013, house prices in Italy have been collapsing in both nominal and real terms since 2008, falling -20% and -28% respectively (Chart 12). The Italian real estate market is facing multiple headwinds: poor demographics, a lack of property investors dampening transaction volumes, banks aggressively selling repossessed homes at large discounts, and a large stock of unsold properties. Further declines could damage asset quality and impair bank balance sheets. Nevertheless, prices in nominal terms appear to be stabilizing. As real GDP growth continues to recover, the real estate market should eventually start to catch up. Chart 11Can The 'Doom Loop' Be Broken? Can The 'Doom Loop' Be Broken? Can The 'Doom Loop' Be Broken? Chart 12No Recovery In Italian House Prices No Recovery In Italian House Prices No Recovery In Italian House Prices Bottom Line: The health of Italian banks has improved drastically over the last year. Cost cutting has been aggressive, capital levels have risen, and non-performing loans are slowly declining in a growing economy. Recently added macro-prudential measures will provide additional buffers. As such, liquidity, solvency and systemic risks have faded for the time being. The Political Outlook: Acute Pain Is Gone, But Chronic Risks Linger Italian equity and bond markets have priced out political risk in the country's asset markets over the past 12 months, and for good reasons: New election rules: The October 2017 electoral rule changes have made it highly likely that the next government in Italy will be a coalition government, reducing the probability of a runaway electoral performance by an anti-establishment party.2 Anti-establishment becomes the establishment: Italy's populists have dulled their edge by moving to the middle on the key question of Euro Area membership. The anti-establishment Five Star Movement (M5S) announced in early January that "it is no longer the right moment for Italy to leave the euro." The party's leader, Luigi Di Maio, pledged to remain "comfortably below the antiquated and stupid three percent level" EU deficit limit. The party followed this announcement by slaughtering its final sacred cow and renouncing its promise never to form a coalition with traditional, centrist parties. Migration crisis has ended: While continental Europe has gotten relief from the migration wave since early 2016, Italy continued to be impacted throughout 2017. Nonetheless, the EU's intervention in Libyan security and politics has successfully, and dramatically, altered the trajectory of migrants arriving in Italy and Europe as a whole (Chart 13). Current polls show that no single party is close to the 40% threshold needed to win the election outright, although the ostensibly center-right coalition of Forza Italia, Lega Nord, and Fratelli d'Italia is the closest (Chart 14). Predicting the outcome of the election is therefore impossible, other than to guarantee that the next Italian government will be a coalition. Chart 13Italians (And Europeans) Reject Immigration Italians (And Europeans) Reject Immigration Italians (And Europeans) Reject Immigration Chart 14Italy: No Party Will Rule Alone Italy: No Party Will Rule Alone Italy: No Party Will Rule Alone New electoral rules - which favor coalition building - and poor turnout in a recent regional election will encourage parties to make extravagant promises, particularly on the spending side of the ledger. Italian politicians understand that, in a coalition government, the partner can always be blamed for why election promises fell by the wayside. This has produced a deluge of unrealistic promises.3 What should investors know about the upcoming election? First, the center-right is not the center-right. When investors hear that the "center right is likely to win," they are likely to bid up assets in expectation of structural reforms and prudent fiscal policy. If the recent polling performance of Forza Italia and Lega Nord has in any way contributed to the appreciation of Italian assets, we would caution investors to fade the rally. Former PM Silvio Berlusconi, leader of Forza Italia, has promised to reverse crucial (and bitterly fought) employment law reforms. Meanwhile, his coalition partner Matteo Salvini, leader of Lega Nord, has promised to scrap pension cuts altogether. The proper characterization for the Forza-Lega alliance is therefore "conservative populism," not pro-market center-right. In fact, the two parties are the most vociferously anti-EU and anti-euro of the four major parties, with Lega still pushing for the abolishment of the euro and even for an EU exit. For a summary of the most market-relevant electoral promises, please refer to Box 1. Box 1: Italian Electoral Promises Of Major Parties Presented in the order of current polling Five Star Movement (M5S) Italy's anti-establishment party wants to abolish 400 laws, including a web of regulation that makes it difficult for businesses to invest. The promise is unusually "supply-side" oriented for an anti-establishment party, but Italy's establishment has made the business environment difficult. In addition, the party wants to invest in technology and clean energy. What is truly anti-establishment is that M5S has promised to provide a monthly universal income of E780, but also to introduce means-testing for public services so that the well-off pensioners do not receive them. It also seeks broad justice system reforms, including a crackdown on corruption and the mafia, building new prisons, and hiring more police. Its immigration plans are centrist, if not right-leaning, with plans to repatriate migrants back to their original countries. Democratic Party (PD) Led by former PM Matteo Renzi, the Democratic Party (PD) is contesting elections on the basis of its past achievements, which includes passing the 2015 "Jobs Act," mitigating the country's banking crisis, and keeping up the pulse of the otherwise sclerotic economy. Current caretaker PM Paolo Gentiloni remains popular, in part because of his no-nonsense, humble approach to governance. Other than minor proposals - scrapping the TV license fee that finances the national Rai network and raising the minimum wage - the party is largely standing pat in terms of promises. The PD-led government has clashed with the EU, including over its 2018 budget proposal, which the Commission criticized as a "significant deviation" from the bloc's fiscal target. However, aside from its disagreements with the Commission over fiscal policy, PD is broadly pro-Europe and pro-euro. Forza Italia Populist Forza is proposing a flat tax of 23%, which would abolish the current staggered income tax rate. It would also abolish taxes on real estate, inheritance, and transportation, and expand reprieves to tax payers with financial problems. The party would double minimum pension payments and scrap the 2015 "Jobs Act." That said, leader Silvio Berlusconi has said that his proposals would respect the EU's 3% of GDP budget deficit target - in fact that his government would eliminate the deficit completely by 2023 - and that it would rein in the debt-to-GDP ratio to 100%. However, it is unclear how the math would actually work. At the same time, a collision course with the EU is likely as the party wants not only to end budget austerity but also to revise EU treaties, including the fiscal compact, and to pay less into the EU's annual budget. Lega Nord The other populist party looks to out-do the more establishment Forza by proposing an even lower flat tax rate of 15%. The revenue shortfall would be made up by aggressive enforcement against tax cheats. The party is the most Euroskeptic of the major Italian parties, arguing that a Euro-exit is in the country's national interest and should be contemplated unless fiscal rules set out by the Maastricht Treaty are scrapped. Leader Matteo Salvini recently suggested that he had changed his position on the euro, but the chief economist of the party - Claudio Borghi - has since reversed that position, stating that "one second after the League is in government it will begin all possible preparations to arrive at our monetary sovereignty." This last statement is more in keeping with the Lega's recent history of euroskepticism. Second, the electoral platforms of all four major parties are profligate. The flat tax proposal by Forza and Lega is likely the most egregious. Generally speaking, Berlusconi's previous governments can be associated with a rise in expenditure, deficits, and debt levels, with no real track record of fiscal prudence. Even during the boom years (2001-2006), Berlusconi failed to reduce the budget deficit. By contrast, the center-left has been marginally more fiscally prudent (Chart 15), with a considerable improvement in the country's budget balance under each Democratic Party-led government (Chart 16). Chart 15Italy's Debt Dynamics Are Contained Italy's Debt Dynamics Are Contained Italy's Debt Dynamics Are Contained Chart 16Democratic Party Is Relatively Prudent Italy: Growth Cures All Ills ... For Now Italy: Growth Cures All Ills ... For Now Given the mildly Euroskeptic positioning of the conservative populist coalition and their likely bias toward profligacy, we would rank the currently most likely electoral coalition as the least pro-market. Below are the three potential outcomes and their likely impact on the markets: Scenario 1 - Populist Coalition Probability of winning: 35% - Polls currently put the Forza-Lega coalition in a clear lead and only several percentage points away from the likely 40% threshold needed to secure a majority. Fiscal impact: We would assign a 100% probability that the Forza-Lega coalition would negatively impact the country's budget balance, with debt levels most likely rising. Reform impact: There is a 0% probability of pro-growth, structural reforms being passed by the conservative populist coalition. As such, investors should stop referring to the Forza-Lega alliance as a center-right alliance. European integration: We would assign a high probability, around 50%, that a Forza-Lega government would threaten to exit the Euro Area at some point during its mandate. This is based on a two-fold assumption that there will be a recession at some point during its reign and that its electoral platform reveals the potential for a serious Euroskeptic turn not only by Lega Nord but also by the formerly staunchly pro-EU Forza Italia. Scenario 2 - Grand Coalition Probability of winning: 35% - If the Forza-Lega coalition fails to win enough votes, the second-most likely outcome would be a grand coalition between Forza Italia and the center-right Democratic Party (PD), perhaps with both M5S and Lega joining in. Fiscal impact: Given that all four major parties are essentially looking to spend more money and collect less revenue, we would expect that the country's budget balance would be negatively impacted in this scenario. However, both PD and M5S have less profligate electoral platforms. As such, the impact would likely be a lot less dramatic than if Forza-Lega coalition won. Reform impact: With Forza-Lega potentially in a grand coalition, we would expect the probability of pro-growth reforms to be just 25%. European integration: We would assign a very low probability, essentially 0%, that a grand coalition contemplates Euro-exit during its mandate. However, a global recession that impacts Italy would almost certainly force such a government to fall as Euroskeptic parties withdrew their support, thus shortening the electoral mandate. This means that a grand coalition is the least viable and least stable outcome. It would allow the Euroskeptic Forza-Lega to campaign from a populist, Euroskeptic, position. Scenario 3 - Center-Left Coalition Probability of winning: 30% - A PD-M5S coalition is less likely despite being mathematically the most likely. This is because M5S has not said that it would ever join a coalition with the PD; only that it would join a grand coalition with all parties. Nonetheless, such a coalition makes the most sense ideologically now that M5S has abandoned its Euroskepticism. Fiscal impact: Both parties are looking to expand the minimum wage, with M5S arguing for a universal basic income. It is very likely that the impact on the budget balance would be negative, although we would not expect extreme profligacy. Reform impact: Given the electoral platform of M5S and the reform record of PD, we assign a healthy 75% probability for pro-growth structural reforms. Despite the view that M5S is an anti-establishment party, it is actually quite pro-reform, with several of its proposals in the past being characterized as impacting the supply-side. Investors should remember that being anti-establishment does not mean being anti-reform, especially in Italy where the establishment has an atrocious record of being pro-reform! European integration: We do not think that the M5S move to the middle on European integration is false. Forcing it to be in government, particularly once a recession hits over the course of its mandate, will only lock in its establishment position on European integration. As we have expected for some time, the M5S has followed the path of other Mediterranean, left-leaning, anti-establishment parties on the euro, with both Podemos (Spain) and SYRIZA (Greece) now being fully pro-Europe. As such, the probability that a PD-M5S government considers Euro-exit during its mandate is 0%. Counterintuitively, a PD-M5S coalition is therefore the most pro-market option for Italy. It would be relatively fiscally prudent and would surprise to the upside on structural reforms. In addition, it would give Italy a five-year window during which no challenge to its membership in European institutions is possible (provided that the coalition does not rely on small parties whose exit threatens the stability of government). This outcome could extend the current rally in Italian assets, although that rally is already long-in-the-tooth. On the other hand, a Forza-Lega coalition is the least stable. First, we believe that such a coalition has a 50% probability of challenging Italy's membership in European institutions at the first sign of a domestic recession. Lega is outwardly Euroskeptic, even at the top of the global economic cycle and with a healthy Italian recovery underway. Meanwhile, Silvio Berlusconi has consciously evolved his Forza Italia towards a more Euroskeptic position. In addition, we believe that this populist alliance would be fiscally profligate and would not attempt any structural reforms. This political outcome is therefore an occasion to underweight Italian sovereign bonds. Finally, a grand coalition would have a neutral market impact. However, due to structural political risks, we would expect such a government to collapse at the first sign of economic hardship.4 This would open up the risk of a Euroskeptic electoral challenge and a potential market riot as the likelihood of brinkmanship with Brussels and Berlin rises.5 We encourage our clients to revisit our "Divine Comedy" series on Italy, where we have set out the argument for why Euroskepticism continues to have appeal in Italy. We would briefly remind our readers that: Italians remain Euroskeptic despite a European-wide recovery in support for the common currency (Chart 17); Italians are increasingly confident in a future outside of Europe (Chart 18), whereas such a trend is not identifiable in wider Europe (Chart 19); Chart 17Italy Lags In Support For Euro Italy Lags In Support For Euro Italy Lags In Support For Euro Chart 18Italians Optimists About Future Outside EU Italians Optimists About Future Outside EU Italians Optimists About Future Outside EU While Europeans are increasingly comfortable with dual-identities (national and continental), Italians are increasingly identifying as strictly Italian (Chart 20); Chart 19Europeans Pessimists About Future Outside EU Europeans Pessimists About Future Outside EU Europeans Pessimists About Future Outside EU Chart 20We Are Italian (Not European)! We Are Italian (Not European)! We Are Italian (Not European)! Italians do not see the EU as a geopolitical project, leaving them more likely to focus on the transactional and economic nature of their relationship with Europe (Chart 21); Chart 21Italians View The EU In Transactional Terms Italy: Growth Cures All Ills ... For Now Italy: Growth Cures All Ills ... For Now On net, Italians are the most anti-immigrant people in core Europe (Chart 22), which suggests that the migration crisis hit them quite hard. Any restart of that crisis could push the country towards anti-EU politicians; Chart 22Italians Are Staunchly Anti-Immigration Italy: Growth Cures All Ills ... For Now Italy: Growth Cures All Ills ... For Now Finally, we would remind investors that many Italians continue to see FX devaluation as a panacea that can save the economy. Our view is that Italy has, by far, the highest baseline level of Euroskepticism among Euro Area members. The March 4 election is important because the next government will likely have to face a recession and a global downturn during its mandate. A grand coalition or a populist coalition would both leave Italy more vulnerable to Euroskeptic alternatives. This is because a grand coalition would most likely collapse at the first sign of a recession whereas a populist government would itself turn to Euroskepticism. If the election produces either of these outcomes, we would assign a very high probability - near 50% - that Italy produces a global risk off event sometime within the next five years. Bottom Line: The upcoming Italian parliamentary election is difficult to call, but one thing seems certain - the winning coalition will seek to ease fiscal policy. Euroskepticism will not be the major issue in the election given the expanding economy; yet, in two of the scenarios discussed above, it will come back with a vengeance after the next Italian recession. The ECB: Don't Fear The QE Unwind If there is one consensus view on Italy among investors (at least among the BCA clients that ask questions on Italy!), it is that Italian government bonds will suffer significant losses when the ECB begins to unwind its easy money policies. For many people, 10-year bonds trading with less than a 2% yield, with a government debt/GDP ratio near 130%, in a country with a structural low growth problem and perpetually unstable politics, just screams "bubble" - one that will end badly when the ECB is eventually forced to stop buying government bonds. With the broader Euro Area economy now operating at full employment, an announcement of a tapering of asset purchases by the ECB is inevitable. Our base case remains that the ECB will announce during the summer that the bond buying program will be wound down by year-end. After that, maturing bonds will be reinvested, with the first interest rate hike not taking place until the latter half of 2019. How the ECB communicates that message to the markets will be critical in avoiding a "Taper Tantrum 2.0." Already, the ECB is sending a bit of a mixed message with its current asset purchases. Officially, the central bank has been aiming to distribute its monthly pace of asset purchases along the lines of the ECB's Capital Key, which is roughly correlated to the size of each Euro Area country. This rule was put in place by the ECB to avoid any accusations that the central bank would politically favor the more indebted countries when executing its bond buying. Yet a look at the ECB's actual data on its monthly purchases shows that the Capital Key limits have often been breached, and for what appears to be reasons rooted in politics (Chart 23). The ECB exceeded the Capital Key limit on French bonds in the run-up to last year's French presidential election. The limit on Italian bonds was also consistently breached for much of last year, as investors were beginning to grow more concerned about potential ECB tapering and anti-euro factions winning the next election in Italy. We shared those concerns, which led us to downgrade Italian government bonds to underweight in Global Fixed Income Strategy in late 2016, both in absolute terms and versus Spanish debt. That call has obviously not worked out as we hoped. In fact, a counterintuitive result occurred where Italian bonds outperformed German debt in 2017, even as the ECB was already beginning to slow the pace of its bond buying. That can be seen in Chart 24, which shows the annual growth rate of the ECB's monetary base (which proxies the flow of bonds purchased by the ECB) versus both the Italy-Germany 10-year government bond spread (top panel) and the annual excess return of Italian government bonds relative to German debt (bottom panel).6 There has been no reliable correlation between the pace of ECB buying and the Italy-Germany spread, but there has been a very strong correlation with relative returns. When the ECB was buying more bonds in 2015 and 2016, Germany was outperforming Italy. The opposite occurred last year when the ECB started to dial back the pace of its purchases. Why? Most likely, it was because the Italian economy was starting to gain momentum, which helps alleviate (but not eliminate) the debt sustainability fears about Italy's massive debt stock. The ECB's other extraordinary policy tool, low interest rates, has been an even bigger support for Italian debt sustainability. The government of Italy has been able to consistently issue bonds with coupons below 1% in the years after the ECB went to its zero interest rate policy (ZIRP) in 2014, according to the Bank of Italy (Chart 25). This has lowered the average interest rate on all outstanding Italian government bonds from 4% to 3% over that same period. This also reduced the ratio of Italian government interest payments to GDP by nearly one full percentage point over the past three years (bottom panel). Chart 23The Capital Key Is Only##BR##A 'Guideline' For ECB QE The Capital Key Is Only A 'Guideline' For ECB QE The Capital Key Is Only A 'Guideline' For ECB QE Chart 24Less ECB Bond Buying =##BR##Italian Bond Outperformance! Less ECB Bond Buying = Italian Bond Outperformance! Less ECB Bond Buying = Italian Bond Outperformance! Chart 25ZIRP/NIRP More Helpful##BR##For Italy Than QE ZIRP/NIRP More Helpful For Italy Than QE ZIRP/NIRP More Helpful For Italy Than QE Italy still has a significant long-run fiscal problem, however. The gross government debt/GDP ratio of 126% is only dwarfed by Japan and Greece within the developed markets (Chart 26). Even when looked at on a net basis (i.e. excluding the debt owned by Italian government entities like state pension funds) and, more importantly, after removing the bonds owned by the ECB, Italy still has a stock of debt equal to 100% of GDP (Chart 27). This is the highest in the Euro Area for countries eligible for the ECB's asset purchase program. Chart 26Italy's Debt Problems Have Not Gone Away Italy: Growth Cures All Ills ... For Now Italy: Growth Cures All Ills ... For Now Chart 27Still A Big Stock Of Italian Debt, Net Of ECB Purchases Italy: Growth Cures All Ills ... For Now Italy: Growth Cures All Ills ... For Now Importantly for market perceptions of Italy's debt sustainability, the ECB absorbing 15% of the stock of Italian government bonds has provided some wiggle room for an expansion of fiscal deficits without materially affecting long-term interest rates. That is no small matter, given how it is highly likely that the winner of the March 4th Italian election will step on the fiscal accelerator. Bottom Line: The inevitable tapering of ECB asset purchases later in 2018 will not have a meaningful impact on Italian government bond valuations - as long as the ECB is not planning on quickly raising interest rates soon after tapering. Upgrade Italian government bonds to neutral until signs of an economic slowdown in Italy emerge. Investment Conclusions After assessing the four main drivers of Italian bond risk premia - economic growth, the health of the banks, domestic politics and ECB monetary policy - it is clear that the state of the economy is the most important factor. If Italian growth is strong enough, investors will feel more comfortable about chasing the higher yields on Italy's government bonds and be a lot more relaxed about its Euroskeptic leanings. Given Italy's heavy reliance on exports as the driver of the current cyclical upturn, this means Italian financial assets are a levered play on global growth. The next most important factor is the ECB's monetary policy, but specifically, its interest rate policy and not its asset purchase program. Chart 28Upgrade Italian Debt To##BR##Neutral Until Growth Rolls Over Upgrade Italian Debt To Neutral Until Growth Rolls Over Upgrade Italian Debt To Neutral Until Growth Rolls Over This week, we are upgrading our recommended allocation to Italian government bonds to neutral from underweight in Global Fixed Income Strategy. At current yield levels and spreads to core European debt, a move all the way to an overweight recommendation is not ideal. Yet the case for Italian bond underperformance on the back of political uncertainty and eventual ECB tapering is even less ideal. Moving to neutral is a sensible compromise between a positive cyclical backdrop with poor valuation. Going forward through 2018, we will monitor the Italy Leading Economic Indicator (LEI) as a signal for when to consider downgrading Italian debt. If the LEI begins to hook down, that would be a bearish sign for the relative performance of both Italian government bonds and Italian equities (Chart 28). In addition, any indication that the ECB is considering not only tapering its bond buying, but also raising interest rates, could pose a problem for Italian assets. Although given the low starting point for any shift higher in policy rates, it would likely take several interest rate increases before Italian economic growth would start to be negatively impacted. Over a longer-term time horizon, investment implications are difficult to gauge. Structurally, both from an economic and political perspective, Italy is the least stable pillar of European economy. As such, it still has a potential to be a source of global risk-off if an economic downturn negatively impacts the current political stability. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst Ray@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Demographics And Geopolitics, Part I: A Silver Lining?", dated October 10, 2012, available at gps.bcaresearch.com. 2 The new Italian Electoral law - also known as Rosatellum - is particularly negative for Five Start Movement (M5S). First, it assigns over a third (37%) of the seats using a first-past-the-post system. This will hurt M5S, which lacks a geographical base where it can guarantee easy electoral district wins. Second, the vote eliminates a seat bonus for the party that wins a plurality of votes, forcing the winning coalition to gain at least around 40% of the vote to govern. Eliminating the bonus hurts M5S as it has led other parties in the polls. That said, a coalition government almost guarantees that fiscal spending will increase over the course of the next administration, given that budget outlays will be used to grease-the-wheels of any coalition deal. 3 The Italian public, known for its knack for satire, has parodied the electoral platforms with a Twitter hashtag #AboliamoQualcosa ("let's abolish something"). Twitter and Facebook have suggested that everything from French carbonara to vegan Bolognese should be abolished (BCA's Geopolitical Strategy heartily agrees with both suggestions!). 4 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 6 It is important to note that the relative returns shown in the bottom panel Chart 24 are calculated using the Bloomberg Barclays benchmark Treasury indices for Italy and Germany. These indices include debt across all maturities for both countries, not just the benchmark 10-year Italy-Germany spread shown in the top panel.

Highlights The German 10-year bund yield rising to 1%, or the U.S. 10-year T-bond yield rising to 3% would be a trigger to downgrade equities and upgrade bonds... ...especially as the blue sky expectations for global growth in H1 2018 will turn out to be overly-optimistic. On a 6-9 month horizon, upgrade Airlines to overweight. Downgrade Banks to underweight. Upgrade Germany (DAX) to neutral. Downgrade Italy (MIB) and Spain (IBEX) to underweight. Feature Where has the equity market cycle gone? Since 2012, the stock market's 6-month returns have generated an unprecedented consistency, with only a brief breakdown - at the end of 2015 - into negative territory (Chart of the Wesk and Chart I-2). Chart of the WeekSince 2012, The Equity Market ##br##Cycle Has Disappeared Since 2012, The Equity Market Cycle Has Disappeared Since 2012, The Equity Market Cycle Has Disappeared Chart I-2Much Less Cyclicality In Equities ##br##Than In Commodities Much Less Cyclicality In Equities Than In Commodities Much Less Cyclicality In Equities Than In Commodities The disappearance of the equity market cycle brings to mind the concept of the "Great Moderation", a term coined in 2002 to describe the big drop in business cycle volatility during the 1990s. In 2004, Ben Bernanke suggested that "improvements in monetary policy, though certainly not the only factor, probably were an important source of the Great Moderation." Today's Great Moderation 2.0 refers to the equity market cycle - or rather, its disappearance. And in finding a reason for the Great Moderation 2.0, Bernanke's attribution to monetary policy might be right on the money. Stick With TINA, Or Flirt With TIA? For many years, ultra-accommodative monetary policy has provided a consistent and substantial uplift to world stock market valuations. Since 2012, our preferred measure of equity market valuation - world stock market capitalisation to GDP - has almost doubled. This inexorable and relatively trouble-free rise has even spawned its own acronym: TINA - There Is No Alternative (to owning equities.) However, the uplift to stock market valuations has happened in a less obvious way than you might realise. Based on the excellent predictive power of stock market capitalisation to GDP, the prospective 10-year annualised return from world equities has collapsed from 9% in 2012 to 1.5% now (Chart I-3). Over the same period, the global 10-year bond yield has compressed from 3% to 1.5%. Hence, the collapse in prospective equity returns is not due to the decline in bond yields per se. It has happened mostly because the excess return offered by equities over bonds - the so-called 'equity risk premium' has compressed from 6% to zero (Chart I-4). Chart I-3World Equity Market Cap To GDP Implies##br## A Feeble Prospective 10-Year Return World Equity Market Cap To GDP Implies A Feeble Prospective 10-Year Return World Equity Market Cap To GDP Implies A Feeble Prospective 10-Year Return Chart I-4Prospective Equity Returns ##br##Have Become 'Bond Like' Prospective Equity Returns, Have Become "Bond Like" Prospective Equity Returns, Have Become "Bond Like" Ultra-accommodative monetary policy has caused the disappearance of the equity risk premium. The simple reason is that at low bond yields, the risk of owning bonds becomes similar to the risk of owning equities. Chart I-5Below A 2% Yield, 10-Year Bonds Have ##br##More Negative Skew Than Equities Beware The Great Moderation 2.0 Beware The Great Moderation 2.0 When bond yields approach their lower bound, bond prices have little upside but they have a lot of downside. This ratio of an investment's potential losses relative to its potential gains is the risk that most frightens investors,1 and is known as negative skew. At yields below 2%, bond returns become as negatively skewed as equity returns, or even more negatively skewed than equities (Chart I-5). As the risk of bonds increases to become 'equity-like', the prospective return from equities must compress to become 'bond-like'. Which is to say, equity valuations become substantially richer. All well and good - so long as the global 10-year bond yield stays low. Above a 2% yield, the negative skew on bond returns disappears, and equities once again require an excess prospective return over bonds. More colloquially, investors would dump TINA and start flirting with TIA (There Is an Alternative). In essence, a big threat to the Great Moderation 2.0 comes the global 10-year bond yield rising to 2% - broadly equivalent to the German 10-year bund yield rising to 1%, or the U.S. 10-year T-bond yield rising to 3%. Any moves towards these thresholds would be a trigger to downgrade equities and upgrade bonds - especially as we now explain why the blue sky expectations for global growth in H1 2018 will turn out to be overly-optimistic. The Equity Sector Cycle Is Alive And Well For the stock market in aggregate, the cycle has been moribund. But for equity sector relative performance, the cycle is very much alive and well. In The Cobweb Theory And Market Cycles 2 we showed and explained the existence of mini-cycles in economic and financial variables. To summarise, a lag between the demand for credit and its supply necessarily creates mini-cycles in both the price of credit (the bond yield) and the quantity of credit (the global credit impulse). Thereby it also creates mini-cycles in GDP growth. The useful point is that these cycles are very regular with half-cycles averaging 6-8 months. Which makes their turning points and phases predictable. Given that the global credit impulse cycle has been in a mini-upswing phase since last May, it is highly likely to turn into a mini-downswing phase through the first half of 2018. The latest data point, showing a tick down, seems to corroborate such a turning point. From an equity sector perspective, Banks versus Healthcare has closely tracked the phases of the credit impulse mini-cycle (Chart I-6). In all five of the last five mini-downswings, Banks have underperformed Healthcare, and we would expect no difference in the next mini-downswing. Hence, on a 6-9 month horizon, downgrade Banks to underweight. Unsurprisingly, exactly the same pattern applies to Basic Materials (and Energy) versus Healthcare (Chart I-7). Hence, on a 6-9 month horizon, stay underweight Basic Materials and Energy versus Healthcare. Also unsurprisingly, the performance of European Airlines is a mirror-image of the oil price cycle, given that aviation fuel comprises the sector's main variable cost (Chart I-8). As an aside, this also somewhat insulates the European Airlines against a strengthening euro, given that this variable cost is priced in dollars. Hence, on a 6-9 month horizon, upgrade European Airlines to overweight. Chart I-6Banks Vs. Healthcare Tracks The ##br##Credit Impulse Mini-Cycle Banks Vs. Healthcare Tracks The Credit Impulse Mini-Cycle Banks Vs. Healthcare Tracks The Credit Impulse Mini-Cycle Chart I-7Materials Vs. Healthcare Tracks The##br## Credit Impulse Mini-Cycle Materials Vs. Healthcare Tracks The Credit Impulse Mini-Cycle Materials Vs. Healthcare Tracks The Credit Impulse Mini-Cycle Chart I-8European Airlines Relative Performance Is A##br## Mirror-Image of The Oil Price Cycle European Airlines Relative Performance Is A Mirror-Image of The Oil Price Cycle European Airlines Relative Performance Is A Mirror-Image of The Oil Price Cycle Country Allocation Just Drops Out Of Sector Allocation Our core philosophy of investment reductionism teaches us that for most stock markets, the sector (and dominant company) skews swamp any effect that comes from the domestic economy. For example, the defining skew for Italy's MIB and Spain's IBEX is their large overweighting to banks. So unsurprisingly, MIB and IBEX relative performance reduces to: will banks outperform the market? (Chart I-9 and Chart I-10). Chart I-9Italy = Long Banks Italy = Long Banks Italy = Long Banks Chart I-10Spain = Long Banks Spain = Long Banks Spain = Long Banks Therefore, the key consideration for European equity country allocation is always: how to allocate to the vital few equity sectors that feature most often in the skews: Banks, Healthcare, Energy and Materials. To reiterate, our 6-9 month recommendation is to underweight Banks, Materials And Energy versus Healthcare, and to overweight Airlines versus the market. Then to arrive at a country allocation, combine the cyclical view on the vital few sectors with the country sector skews shown in Box I-1. Even if you disagree with our sector views, the sector-based approach is the right way to pick European equity markets. If you agree with our sector views, the result is the following updated European equity market allocation: Box I-1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands. Underweight: Italy, Spain, Sweden and Norway. In terms of change, it means upgrading Germany (DAX) to neutral and downgrading Italy (MIB) and Spain (IBEX) to underweight. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report "Are Bonds A Greater Risk Than Equities", January 28, 2018 available at eis.bcaresearch.com. 2 Please see the European Investment Strategy Weekly Report "The Cobweb Theory And Market Cycles", January 11, 2018 available at eis.bcaresearch.com. Fractal Trading Model* There is a lot of optimism already priced into the South African rand, making it vulnerable to a countertrend reversal. Therefore, this week's recommended trade is to go long USD/ZAR with a profit-target of 6% and a symmetrical stop-loss. In other trades, short S&P500/long Eurostoxx50 hit its stop-loss, while short Japanese energy and short palladium moved comfortably into profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 USD/ZAR USD/ZAR The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields 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 ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations