Middle East

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

Highlights Investors are underestimating the risks of U.S.-Iran tensions; The Obama administration's 2015 deal resulted in Iran curbing aggressive regional behavior that threatened global oil supply; The U.S. negotiating position vis-à-vis Iran has not improved; Unlike North Korea, Iran can retaliate against the Trump administration's "Maximum Pressure" doctrine - particularly in Iraq; U.S.-Iran conflicts will negatively affect global oil supply, critical geographies, and sectarian tensions - hence a geopolitical risk premium is warranted. Average Brent and WTI oil prices should rise to $80/bbl and $72/bbl in 2019 even without adding the full range of events that will drive up the geopolitical risk premium. Risks lie to the upside. Feature Tensions between the U.S. and Iran snuck up on the markets (Chart 1), even though President Trump's policy agenda was well telegraphed via rhetoric, action, and White House personnel moves.1 Still, investors doubt the market relevance of the U.S. withdrawal from the Joint Comprehensive Plan of Action (JCPOA), the international agreement between Iran and the P5+1.2 Chart 1Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Several reasons to fade the risks - and hence to fade any implications for global oil supply - have become conventional wisdom. These include the alleged ability of OPEC and Russia to boost production and Washington's supposed ineffectiveness without an internationally binding sanction regime. Our view is that investors and markets are underestimating the geopolitical, economic, and financial relevance of the U.S.-Iran tensions. First, the ideological rhetoric surrounding the original U.S.-Iran détente tends to be devoid of strategic analysis. Second, Iran's hard power capabilities are underestimated. Third, OPEC 2.0's ability to tap into its spare capacity is overestimated.3 To put some numbers on the difference between our view and the market's view, we rely on the implied option volatilities for crude oil futures.4 As Chart 2 illustrates, the oil markets are currently pricing in just under 30% probability that oil prices will exceed $80/bbl by year-end, and merely 14% that they will touch $90/bbl in the same timeframe. We believe these odds are too low and will take the other side of that bet. Chart 2The Market Continues To Underestimate High Oil Prices Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Did The U.S.-Iran Détente Emerge In 2015? Both detractors and defenders of the 2015 nuclear deal often misunderstand the logic of the deal. First, the defenders are wrong when they claim that the deal creates a robust mechanism that ensures that Iran will never produce a nuclear device. Given that the most critical components of the deal expire in 10 or 15 years, it is simply false to assert that the deal is a permanent solution. More importantly, Iran already reached "breakout capacity" in mid-2013, which means that it had already achieved the necessary know-how to become a nuclear power.5 We know because we wrote about it at the time, using the data of Iran's cumulative production of enriched uranium provided to the International Atomic Energy Agency (IAEA).6 In August 2013, Iran's stockpile of 20% enriched uranium, produced at the impregnable Fordow facility, reached 200kg (Chart 3). Chart 3Iran's Negotiating Leverage Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize At that point, Israeli threats of attacking Iran became vacuous, as the Israeli air force lacked the necessary bunker-busting technology to penetrate Fordow.7 As we wrote in 2013, this critical moment gave Tehran the confidence to give up "some material/physical components of its nuclear program as it has developed the human capital necessary to achieve nuclear status."8 The JCPOA forced Iran to stop enriching uranium at the Fordow facility altogether and to give up its stockpile of uranium enriched at 20%. However, Iran only agreed to the deal because it had reached a level of technological know-how that has not been eliminated by mothballing centrifuges and "converting" facilities to civilian nuclear research. Iran is a nuclear power in all but name. Second, the detractors of the JCPOA are incorrect when they claim that Iran did not give up any regional hegemony when it signed the deal. This criticism focuses on Iran's expanded role in the Syrian Civil War since 2011, as well as its traditional patronage networks with the Lebanese Shia militants Hezbollah and with Yemen's Houthis. However, critics ignore several other, far more critical, fronts of Iranian influence: Strait of Hormuz: In 2012, Iran's nearly daily threats to close the Strait of Hormuz were very much a clear and present danger for global investors (Map 1). Although we argued in 2012 that Iran's capability was limited to a 10-day closure, followed by another month during which they could threaten the safe passage of vessels through the Strait, even such a short crisis would add a considerable risk premium to oil markets given that it would remove about 17-18 million bbl/day from global oil supply (Chart 4).9 Since 2012, Iran's capabilities to threaten the Strait have grown, while the West's anti-mine capabilities have largely stayed the same.10 Map 1Saudi Arabia's Eastern Province Is A Crucial Piece Of Real Estate Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Chart 4Geopolitical Crises And Global Peak Supply Losses Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Iraq: The key geographic buffer between Saudi Arabia and Iran is Iraq (Map 2). Iran filled the power vacuum created by the U.S. invasion almost immediately after Saddam Hussein's overthrow. It deployed members of the infamous Quds Force of the Iranian Revolutionary Guard Corps (IRGC) into Iraq to support the initial anti-American insurgency. Iran's support for Prime Minister Nouri al-Maliki was critical following the American withdrawal in 2011, particularly as his government became increasingly focused on anti-Sunni insurgency. Map 2Iraq: A Buffer Between Saudi Arabia And Iran Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Bahrain: Home of the U.S. Fifth Fleet, Bahrain experienced social unrest in 2011. The majority of Bahrain's population are Shia, while the country is ruled by the Saudi-aligned, Sunni, Al Khalifa monarchy. The majority of Shia protests were at least rhetorically, and some reports suggest materially, supported by Iran. To quell the protests, and preempt any potential Iranian interference, Saudi Arabia intervened militarily with a Gulf Cooperation Council (GCC) Peninsula Shield Force. Eastern Province: Similar to the unrest in Bahrain, Shia protests engulfed Saudi Arabia's Eastern Province in 2011. The province is highly strategic, as it is where nearly all of Saudi oil production, processing, and transportation facilities are located (Map 1). Like Bahrain, it has a large Shia population. Saudi security forces cracked down on the uprising and have continued to do so, with paramilitary operations lasting into 2017. While Iranian involvement in the protests is unproven, it has been suspected. Anti-Israel Rhetoric: Under President Mahmoud Ahmadinejad, Iran threatened Israel with destruction on a regular basis. While these were mostly rhetorical attacks, the implication of the threat was that any attack against Iran and its nuclear facilities would result in retaliation against U.S. interests in the Persian Gulf and Iraq and direct military action against Israel. Both defenders and detractors of the JCPOA are therefore mistaken. The JCPOA does not impact Iran's ability to achieve "breakout capacity" given that it already reached it in mid-2013. And Iran's regional influence has not expanded since the deal was signed in 2015. In fact, since the détente in 2015, and in some cases since negotiations between the Obama administration and Tehran began in 2013, Iran has been a factor of stability in the Middle East. Specifically, Iran has willingly: Stopped threatening the Strait of Hormuz (the last overt threats to close the Strait of Hormuz were made in 2012); Acquiesced to Nouri al-Maliki's ousting as Prime Minister of Iraq in 2014 and his replacement by the far more moderate and less sectarian Haider al-Abadi; Stopped meddling in Bahraini and Saudi internal affairs; Stopped threatening Israel's existence (although its material support for Hezbollah clearly continues and presents a threat to Israel's security); Participated in joint military operations with the U.S. military against the Islamic State, cooperation without which Baghdad would have most likely fallen to the Sunni radicals in late 2014. The final point is worth expanding on. After the fall of Mosul - Iraq's second largest city - to the Islamic State in May 2014, Iranian troops and military advisors on the ground in Iraq cooperated with the U.S. air force to arrest and ultimately reverse the gains by the radical Sunni terrorist group. Without direct Iranian military cooperation - and without Tehran's material and logistical support for the Iraqi Shia militias - the Islamic State could not have been eradicated from Iraq (Map 3). How did such a dramatic change in Tehran's foreign policy emerge between 2012 and 2015? Iranian leadership realized in 2012 that the U.S. military and economic threats against it were real. Internationally coordinated sanctions had a damaging effect on the economy, threatening to destabilize a regime that had experienced social upheaval in the 2009 Green Revolution (Chart 5). It therefore began negotiations almost immediately after the imposition of stringent economic sanctions in early and mid-2012.11 Map 3The Collapse Of A Would-Be Caliphate Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Chart 5Iran's Sanctions Had A Hard Bite Iran's Sanctions Had A Hard Bite Iran's Sanctions Had A Hard Bite To facilitate the negotiations, the Guardian Council of Iran disqualified President Ahmadinejad's preferred candidate for the 2013 Iranian presidential elections, while allowing Hassan Rouhani's candidacy.12 Rouhani, a moderate, won the June 2013 election in a landslide win, giving him a strong political mandate to continue the negotiations and, relatedly, to pursue economic development. Many commentators forget, however, that Supreme Leader Ayatollah Sayyid Ali Hosseini Khamenei allowed Rouhani to run in the first place, knowing full well that he would likely win. In other words, Rouhani's victory revealed the preferences of the Iranian regime to negotiate and adjust its foreign policy. Bottom Line: The 2015 U.S.-Iran détente traded American acquiescence in Iranian nuclear development - frozen at the point of "breakout capacity" - in exchange for Iran's cooperation on a number of strategically vital regional issues. As such, focusing on just the JCPOA, without considering the totality of Iranian behavior before and since the deal, is a mistake. Iran curbed its influence in several regional hot spots - almost all of which are critical to global oil supply. The Obama administration essentially agreed to Iran becoming a de facto nuclear power in exchange for Iran backing away from aggressive regional behavior. This included Iran's jeopardizing the safe passage of oil through the Strait of Hormuz either by directly threatening to close the channel or through covert actions in Bahrain and the Eastern Province. The U.S. also drove Iran to accept a far less sectarian Iraq, by forcing out the ardently pro-Tehran al-Maliki and replacing him with a prime minister far more acceptable to Saudi Arabia and Iraqi Sunnis. Why Did The U.S. Chose Diplomacy In 2011? The alternative to the above deal was some sort of military action against Iranian nuclear facilities. The U.S. contemplated such action in late 2011. Two options existed, either striking Iran's facilities with its own military or allowing Israel to do it themselves. One reason to choose diplomacy and economic sanctions over war was the limited capability of Israel to attack Iran alone.13 Israel does not possess strategic bombing capability. As such, it would have required a massive air flotilla of bomber-fighters to get to the Iranian nuclear facilities. While the Israeli air force has the capability to reach Iranian facilities and bomb them, their effectiveness is dubious and the ability to counter Iranian retaliatory capacity with follow-up strikes is non-existent. The second was the fact that a U.S. strike against Iran would be exceedingly complex. Compared to previous Israeli strikes against nuclear facilities in Iraq (Operation Opera 1981) and Syria (Operation Outside The Box 2007), Iran presented a much more challenging target. Its superior surface-to-air missile capability would necessitate a prolonged, and dangerous, suppression of enemy air defense (SEAD) mission.14 In parallel, the U.S. would have to preemptively strike Iran's ballistic missile launching pads as well as its entire navy, so as to obviate Iran's ability to retaliate against international shipping or the U.S. and its allies in the region. The U.S. also had a strategic reason to avoid entangling itself in yet another military campaign in the Middle East. The public was war-weary and the Obama administration gauged that in a world where global adversaries like China and Russia were growing in geopolitical power, avoiding another major military confrontation in a region of decreasing value to U.S. interests (thanks partly to growing U.S. shale oil production) was of paramount importance (Chart 6). Notable in 2011 was growing Chinese assertiveness throughout East Asia (please see the Appendix). Particularly alarming was the willingness of Beijing to assert dubious claims to atolls and isles in the South China Sea, a globally vital piece of real estate (Diagram 1). There was a belief - which has at best only partially materialized - that if the United States divested itself of the Middle East, then it could focus more intently on countering China's challenge to traditional U.S. dominance in East Asia and the Pacific. Chart 6Great Power Competition Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Diagram 1South China Sea As Traffic Roundabout Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Bottom Line: The Obama administration therefore chose a policy of military posturing toward Iran to establish a credible threat. The military option was signaled in order to get the international community - both allies and adversaries - on board with tough economic sanctions. The ultimate deal, the JCPOA, did not give the U.S. and its allies everything they wanted precisely because they did not enter the negotiations from a position of preponderance of power. Critics of the JCPOA ignore this reality and assume that going back to the status quo ante bellum will somehow improve the U.S. negotiating position. It won't. What Happens If The U.S.-Iran Détente Ends? The Trump administration is serious about applying its Maximum Pressure tactics on Iran. Buoyed by the successful application of this strategy in North Korea, the White House believes that it can get a better deal with Tehran. We do not necessarily disagree. It is indeed true that the U.S. is a far more powerful country than Iran, with a far more powerful military. On a long enough timeline, with enough pressure, it ought to be able to force Tehran to concede, assuming that credible threats are used.15 Unlike the Obama administration, the Trump administration will presumably rely on Israel far less, and on its own military capability a lot more, to deliver those threats, which should be more effective. The problem is that the timeline on which such a strategy would work is likely to be a lot longer with Iran than with North Korea. This is because Iran's retaliatory capabilities are far greater than the one-trick-pony Pyongyang, which could effectively only launch ballistic missiles and threaten all-out war with U.S. and its regional allies.16 While those threats are indeed worrisome, they are also vacuous as they would lead to a total war in which the North Korean regime would meet its demise. Iran has a far more effective array of potential retaliation that can serve a strategic purpose without leading to total war. As we listed above, it could rhetorically threaten the Strait of Hormuz or attempt to incite further unrest in Bahrain and Saudi Arabia's Eastern Province. The key retaliation could be to take the war to Iraq. The just-concluded election in Iraq appears to have favored Shia political forces not allied to Iran, including the Alliance Towards Reform (Saairun) led by the infamous cleric, Muqtada al-Sadr (Chart 7). Surrounding this election, various Iranian policymakers and military leaders have said that they would not allow Iraq to drift outside of Iran's sphere of influence, a warning to the nationalist Sadr who has fought against both the American and Iranian military presence in his country. Iraq is not only a strategic buffer between Saudi Arabia and Iran, the two regional rivals, but also a critical source of global oil supply, having brought online about half as much new supply as U.S. shale since 2011 (Chart 8). If Iranian-allied Shia factions engage in an armed confrontation with nationalist Shias allied with Muqtada al-Sadr, such a conflict will not play out in irrelevant desert governorates, as the fight against the Islamic State did. Chart 7Iraqi Elections Favored Shiites But Not Iran Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Chart 8Iraq Critical To Global Oil Supply Iraq Critical To Global Oil Supply Iraq Critical To Global Oil Supply Instead, a Shia-on-Shia conflict would play out precisely in regions with oil production and transportation facilities. In 2008, for example, Iranian-allied Prime Minister Nouri al-Maliki fought a brief civil war against Sadr's Mahdi Army in what came to be known as the "Battle of Basra." While Iran had originally supported Sadr in his insurgency against the U.S., it came to Maliki's support in that brief but deadly six-day conflict. Basra is Iraq's chief port through which much of the country's oil exports flow. Iraq may therefore become a critical battleground as Iran retaliates against U.S. Maximum Pressure. From Iran's perspective, holding onto influence in Iraq is critical. It is the transit route through which Iran has established an over-land connection with its allies in Syria and Lebanon (Map 4). Threatening Iraqi oil exports, or even causing some of the supply to come off-line, would also be a convenient way to reduce the financial costs of the sanctions. A 500,000 b/d loss of exports - at an average price of $70 per barrel (as Brent has averaged in 2018) - could roughly be compensated by an increase in oil prices by $10 per barrel, given Iran's total exports. As such, Iran, faced with lost supply due to sanctions, will have an incentive to make sure that prices go up (i.e., that rivals do not simply replace Iranian supply, keeping prices more or less level). The easiest way to accomplish this, to add a geopolitical risk premium to oil prices, is through the meddling in Iraqi affairs. Map 4Iran Needs Iraq To Project Power Through The Levant Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize It is too early to forecast with a high degree of confidence precisely how the U.S.-Iran confrontation will develop. However, Diagram 2 offers our take on the path towards retaliation. Diagram 2Iran-U.S. Tensions Decision Tree Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize The critical U.S. sanctions against Iran will become effective on November 4 (Box 1). We believe that the Trump administration is serious and that it will force European allies, as well as South Korea and Japan, to cease imports of oil from Iran. China will be much harder to cajole. BOX 1 Iranian Sanction Timeline President Trump issued a National Security Presidential Memorandum to re-impose all U.S. sanctions lifted or waived in connection with the JCPOA. The Office of Foreign Assets Control expects all sanctions lifted under the JCPOA to be re-imposed and in full effect after November 4, 2018. However, there are two schedules by which sanctions will be re-imposed, a 90-day and 180-day wind-down periods.1 Sanctions Re-Imposed After August 6, 2018 The first batch of sanctions that will be re-imposed will come into effect 90 days after the announced withdrawal from the JCPOA. These include: Sanctions on direct or indirect sale, supply, or transfer to or from Iran of several commodities (including gold), semi-finished metals, and industrial process software; Sanctions on the purchase or acquisition of U.S. dollar banknotes by the government of Iran; Sanctions on trade in Iranian currency and facilitation of the issuance of Iranian sovereign debt; Sanctions on Iran's automotive sector; Sanctions on export or re-export to Iran of commercial passenger aircraft and related parts. Sanctions Re-Imposed After November 4, 2018 The second batch of sanctions will come into effect 180 days after the announced Trump administration JCPOA withdrawal decision. These include: Sanctions on Iranian port operators, shipping, and shipbuilding activities; Sanctions against petroleum-related transactions with the National Iranian Oil Company (NIOC), Naftiran Intertrade Company (NICO), and National Iranian Tanker Company (NITC); Sanctions against the purchase of petroleum, petroleum products, or petrochemical products from Iran; Sanctions on transactions and provision of financial messaging services by foreign financial institutions with the Central Bank of Iran; Sanctions on Iran's energy sector; Sanctions on the provision of insurance, reinsurance, and underwriting services. 1 Please see the U.S. Treasury Department, "Frequently Asked Questions Regarding the Re-Imposition of Sanctions Pursuant to the May 8, 2018, National Security Presidential Memorandum Relating to the Joint Comprehensive Plan of Action (JCPOA)," dated May 8, 2018, available at www.treasury.gov. By Q1 2019, the impact on Iranian oil exports will be clear. We suspect that Iran will, at that point, have the choice of either relenting to Trump's Maximum Pressure, or escalating tensions through retaliation. We give the latter a much higher degree of confidence and suspect that a cycle of retaliation and Maximum Pressure would lead to a conditional probability of war between Iran and the U.S. of around 20%. This is a significant number, and it is critical if President Trump wants to apply credible threats of war to Iran. Bottom Line: Unlike North Korea, Iran has several levers it can use to retaliate against U.S. Maximum Pressure. Iran agreed to set these levers aside as negotiations with the Obama administration progressed, and it has kept them aside since the conclusion of the JCPOA. It is therefore easy for Tehran to resurrect them against the Trump administration. Critical among these levers is meddling in Iraq's internal affairs. Not only is Iraq critical to Iran's regional influence; it is also key to global oil supply. We suspect that a cycle of Iranian retaliation and American Maximum Pressure raises the probability of U.S.-Iran military confrontation to 20%. We will be looking at several key factors in assessing whether the U.S. and Iran are heading towards a confrontation. To that end, we have compiled a U.S.-Iran confrontation checklist (Table 1). Table 1Will The U.S. Attack Iran? Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Investment Implications Over the past several years, there have been many geopolitical crises in the Middle East. We have tended to fade most of them, from a perspective of a geopolitical risk premium applied to oil prices. This is because we always seek the second derivative of any geopolitical event. In the context of the Middle East, by "second derivative" we mean that we are interested in whether the market impact of a new piece of information - of a new geopolitical event - will amount to more than just a random perturbation with ephemeral, decaying, market implications. To determine the potential of new information to catalyze a persistent market risk premium or discount, we investigate whether it changes the way things change in a given region or context. In 2015, we identified three factors that we believe are critical for a geopolitical event in the Middle East to have such second derivative implications, and thus global market implications.17 These are: Oil supply: The event should impact current global oil supply either directly or through a clear channel of contagion. Renewed sanctions against Iran do so directly. So would Iranian retaliation in Iraq or the Persian Gulf. Geography: The event should occur in a geography that is of existential significance to one of the regional or global players. Re-imposed sanctions obviously directly impact Iran as they could increase domestic political crisis. A potential Iranian proxy-war in Iraq would be highly relevant to Saudi Arabia, which considers Iraq as a vital buffer with Iran. Sectarian contagion: The event should exacerbate sectarian conflict - Sunni vs. Shia - which is more likely to lead contagion than tribal conflict such as the Libyan Civil War. A renewed U.S.-Iran tensions check all of our factors. The risk is therefore real and should be priced by the market through a geopolitical risk premium. In addition, Iranian sanctions could tighten up the outlook for oil markets in 2019 by 400,000-600,000 b/d, reversing most of the production gains that Iran has made since 2016 (Chart 9). This is a problem given that the enormous oversupply of crude oil and oil products held in inventories has already been significantly cut. BCA's Commodity & Energy Strategy and Energy Sector Strategy teams believe that global petroleum inventories will be further reduced in 2019 (Chart 10). Chart 9Current And Future Iran##br## Production Is At Risk Current And Future Iran Production Is At Risk Current And Future Iran Production Is At Risk Chart 10Tighter Markets And Lower Inventories,##br## Keep Forward Curves Backwardated Tighter Markets And Lower Inventories, Keep Forward Curves Backwardated Tighter Markets And Lower Inventories, Keep Forward Curves Backwardated What about the hints from the OPEC 2.0 alliance that they would surge production in light of supply loss from Iran? Oil prices fell on the belief OPEC 2.0 could easily restore 1.8 MMb/d of production that they agreed to hold off the market since early 2017. Our commodity strategists have 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 achieved (Chart 11). 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 12). Chart 11Primary OPEC 2.0 Members Are Producing##br## 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 12Secondary 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 Furthermore, 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 1.2 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 13). BCA's Commodity & Energy Strategy therefore projects that the combination of stable global demand, steady declines in Venezuela's crude oil output, and the loss of Iranian exports to U.S. sanctions in 2019 will lift the average Brent and WTI prices to $80 and $72/bbl respectively (Chart 14).18 This forecast, however, represents our baseline based on fundamentals of global oil supply and demand (Chart 15) and does not include our potential scenarios outlined in Diagram 2, which would obviously add additional geopolitical risk premium. Chart 13Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk Chart 14Brent Will Average $80/bbl In 2019 Brent Will Average $80/bbl In 2019 Brent Will Average $80/bbl In 2019 Chart 15Balances Tighter As Supply Falls Balances Tighter As Supply Falls Balances Tighter As Supply Falls For investors looking for equity-market exposure in this scenario, BCA's Energy Sector Strategy recommends overweighing U.S. shale producers and shale-focused service companies for investors looking for equity-market exposure to oil prices. Our colleague Matt Conlan, of the BCA Energy Sector Strategy, has broken down this recommendation into specific equity calls, which we encourage our clients to peruse.19 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 2 The JCPOA was concluded in Vienna on July 14, 2015 between Iran and the five permanent members of the United Nations Security Council (China, France, Russia, the United Kingdom, and the United States), plus Germany (the "+1" of the P5+1). 3 BCA's Senior Commodity & Energy Strategist Robert P. Ryan has given the name "OPEC 2.0" to the Saudi-Russian alliance that is focused on regaining a modicum of control over the rate at which U.S. shale-oil resources are developed. Please see BCA Commodity & Energy Strategy Weekly Report, "KSA's, Russia's End Game: Contain U.S. Shale Oil," dated March 30, 2017; and "The Game's Afoot In Oil, But Which One?" dated April 6, 2017, available at ces.bcaresearch.com. 4 We use Brent implied volatility - of at-the-money options of the selected futures contract - as an input to construct the cumulative normal density of future prices. Thus, the probability obtained is one where the terminal futures price, at the selected months, exceeds the strike price quoted. In order to derive this probability, we need the current market price of the selected future contract, the number of days to expiration, the strike price, and a measure of the volatility of this contract. 5 "Breakout" nuclear capacity is defined here as having enough uranium enriched at lower levels, such as at 20%, to produce sufficient quantities of highly-enriched uranium (HEU) required for a nuclear device. The often-reported amount of 20% enriched uranium required for breakout capacity is 200kg. However, the actual amount of uranium required depends on the number of centrifuges being employed and their efficiency. In our 2013 report, we gauged that Iran could produce enough HEU within 4-5 weeks at the Fordow facility to develop a weapon, which means that it had effectively reached "breakout capacity." 6 Please see International Atomic Energy Agency, "Implementation Of The NPT Safeguards Agreement And Relevant Provisions Of Security Council Resolutions In The Islamic Republic Of Iran," IAEA Board Report, dated August 28, 2013, available at www.iaea.org. 7 Although, in a move designed to increase pressure on Iran and its main trade partners, the Obama administration sold Israel the GBU-28 bunker-busting ordinance. That specific ordinance is very powerful, but still not capable enough to penetrate Fordow. 8 Please see BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift," dated November 13, 2013, available at gps.bcaresearch.com. 9 Please see BCA Special Report, "Crisis In The Persian Gulf: Investment Implications," dated March 1, 2012, available at gps.bcaresearch.com. 10 There are four U.S. Navy Avenger-class minesweepers based in Bahrain as part of the joint U.S.-U.K. TF-52. This number has been the same since 2012, when they were deployed to the region. 11 Particularly crippling for Iran's economy was the EU oil embargo imposed in January 2012, effective from July of that year, and the banning of Iranian financial institutions from participating in the SWIFT system in March 2012. 12 The Guardian Council of the Constitution is a 12-member, unelected body wielding considerable power in Iran. It has consistently disqualified reformist candidates from running in elections, which makes its approval of Rouhani's candidacy all the more significant. 13 Please see BCA Geopolitical Strategy Special Report, "Reality Check: Israel Will Not Bomb Iran (Ever)," dated August 14, 2013, available at gps.bcaresearch.com. 14 The NATO war with Yugoslavia in 1999 reveals how challenging SEAD missions can be if the adversary refuses to engage its air defense systems. The U.S. and its NATO allies bombed Serbia and its forces for nearly three months with limited effectiveness against the country's surface-to-air capabilities. The Serbian military simply refused to turn on its radar installations, making U.S. AGM-88 HARM air-to-surface anti-radiation missiles, designed to home in on electronic transmissions coming from radar systems, ineffective. 15 Please see BCA Geopolitical Strategy Special Report, "Trump Re-Establishes America's 'Credible Threats,'" dated April 7, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Middle East: A Tale Of Red Herrings And Black Swans," dated October 14, 2015, available at gps.bcaresearch.com. 18 Please see BCA Commodity & Energy Strategy Weekly Report, "Brent, WTI Average $80, $72 Next Year; Upside Risk Dominates, $100/bbl Possible In 2019," dated May 24, 2018, available at ces.bcaresearch.com. 19 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. Appendix Notable Clashes In The South China Sea (2010-18) Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Notable Clashes In The South China Sea (2010-18) (Continued) Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Notable Clashes In The South China Sea (2010-18) (Continued) Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize

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 Our constraints-based methodology does not rely on human intelligence or the "rumor mill" to analyze political risks; Yet insights from our travels across the U.S., including inside the Beltway, offer interesting background information and a sense of the general pulse; Anecdotal information suggests that Trump is not "normalizing" in office; that U.S.-China relations will get worse before they get better; and that Trump will walk away from the 2015 Iranian nuclear deal. Stick to our current trades: energy over industrial metals; South Korean bull steepener; long DXY; long DM equities versus EM; long JPY/EUR; short Chinese tech stocks and U.S. S&P500 China-exposed stocks. Feature With the third inter-Korean summit demonstrating our view that "diplomacy is on track,"1 we remind investors of the key geopolitical risks we have been emphasizing - souring U.S.-China relations and rising geopolitical risks over Iran's role in the Middle East.2 We at BCA's Geopolitical Strategy do not base our analysis on information from human "intelligence" sources. No private enterprise can obtain the volume of intelligence that would make the sample statistically significant. Private political analysts relying on such intelligence are at best using flawed reasoning devoid of an analytical framework, and at worst are hucksters. Government intelligence agencies obviously collect a wide swath of not only human but also electronic and signals intelligence. Their sample can be statistically significant. However, the cost of such an effort is prohibitive to the private sector. Nonetheless, we may use human intelligence for background information, insight into how to improve our framework, and to take the subjective pulse of any particular situation. The latter is sometimes the most useful. It is not what a policymaker says that matters so much as how they say it, or the fact that they mention the subject at all. Given that we live in an era of political paradigm shifts, and that "charismatic leadership" is rising in influence relative to more predictable, established institutions and systems,3 we have decided to do something we have not done in the past: share some insights from our recent trips to Washington, DC and elsewhere in the U.S. Caveat emptor: the rumor mill is often wildly misleading, which is why we do not base our research on it. Exhibit A: Donald Trump's tax cuts, which our constraints-based methodology enabled us to predict in spite of the prognostications of in-the-know people throughout the year.4 Trump Is Not Normalizing U.S. domestic politics is the top concern of investors, policymakers, and policy wonks almost everywhere we go. It routinely ranks above concerns about Russia, China, the Middle East, or emerging markets (EM). We frequently heard that the U.S. is entering a period of political turmoil worse than anything since President Richard Nixon and the Watergate scandal. Some old Washington hands even claim that the Trump era will cause even greater uncertainty than the Nixon era did because Congress is allegedly less willing to keep the president in check. Economic policy uncertainty, based on newspaper word count, is at least comparable today to the tumultuous 1973-74 period, which culminated with Nixon's resignation in August 1974, and is trending upward (Chart 1). Chart 1Trump Uncertainty Approaching Nixon Levels? Inside The Beltway Inside The Beltway Of course, there is a big difference between Trump's and Nixon's context: today the economy is not going through a recession but rip-roaring ahead, charged with Trump's tax cuts and a bipartisan spending splurge. And the nation is not in the midst of a large-scale and deeply divisive war (not yet, anyway). There is little chance of major new legislation this year, yet deregulation, particularly financial deregulation, will continue to pad corporate earnings and grease the wheels of the economy. The booming economy is lifting Trump's approval ratings, which are trying to converge to the average of previous presidents at this stage in their terms (Chart 2). This development poses the single biggest risk to the unanimous opinion in DC that Republicans face a "Blue Wave" (Democratic Party sweep) in the midterm elections on November 6. However, a key support of the "Blue Wave" theory is that Republicans are split among themselves - and no one in the Washington swamp will deny it. Pro-business, establishment Republicans have never trusted Trump. They are retiring in droves rather than face up to either populist challengers in the Republican primary elections this summer or enthusiastic "anti-Trump" Democrats and independents in the general election (Chart 3).5 Chart 2Is Trump's Stimulus Bump Over? Inside The Beltway Inside The Beltway Chart 3GOP Retirements Are Unprecedented Inside The Beltway Inside The Beltway Trump is expected to ignite a constitutional crisis by firing Special Counsel Robert Mueller, the man leading the investigation into the Trump campaign's alleged collusion with Russia. Republicans are widely against firing Mueller, but they are not united in legislating against it, leaving Trump unconstrained. Senate Majority Leader Mitch McConnell (R, KY) says he will not allow consideration on the Senate floor of a bill approved by the Senate Judiciary Committee that would protect Mueller from firing.6 If Trump fires Mueller, Democrats expect a political earthquake. Some think that mass protests, and mass counter-protests encouraged by Trump himself, will culminate in violence. (We would expect protests to be mostly limited to activists, but obviously violent incidents are probable at mass rallies with opposing sides.) The Democrats are widely expected to take the House of Representatives; most observers are on the fence about the Senate. The House is enough to impeach Trump, which is widely expected to occur, by hook or by crook. But the impact on the country's political polarization will be much worse if there is impeachment without "smoking gun" evidence against Trump's person. Nixon, recall, refused to hand over evidence (the Watergate tapes) under a court order. When he handed some tapes over, they emitted a suspicious buzzing sound at critical points in the recording. Public opinion turned against him, prompting his party to abandon ship. He resigned because the loss of party support made him unlikely to survive impeachment. By contrast, there is not yet any comparable missing or doctored evidence in Trump's case, nor any sinkhole in Republican opinion that would presage a 67-vote conviction in the Senate (Chart 4). Chart 4Trump Not Yet In Nixon's Shoes Inside The Beltway Inside The Beltway Still, clouds are on the horizon. When people raise concerns about geopolitical issues - the U.S.-Russia confrontation, or the potential for a trade war with China - their starting point is uncertainty about President Donald Trump and his administration's policies. The United States is seen as the chief source of political risk in the world. Bottom Line: People in the Beltway who were once willing to believe that Trump would learn on the job and become "normalized" in office now seem to be shifting to the view that he is truly an unorthodox, and potentially reckless, president. The New (Aggressive) Consensus On China China is in the air like never before in D.C. In policy circles, the striking thing is the near unanimity of the disenchantment with China. Republicans are angry with China over trade and national security. Democrats are not to be outdone, having long been angry with China over trade, and also labor issues and human rights violations. It seems that everyone in the government and bureaucracy, liberal or conservative, is either demanding a tougher policy on China or resigned to its inevitability. American officials flatly reject the view that the Trump administration is instigating a conflict with China that destabilizes the world economy. Rather they insist that China has already instigated the conflict and caused destabilizing global imbalances through its mercantilist policies. They firmly believe that the U.S. can and should disrupt the status quo in order to change China's behavior, but that no one wants a trade war. They believe that the U.S. can be aggressive without causing things to spiral out of control. This could be a problem, as we detect a similar hardening of sentiment in China. On our travels there, the attitude was one of defiance toward Trump and Washington. We have received assurances that Beijing will not simply fold, no matter how much pain is incurred from trade measures. Of course, it is in China's interest to bluster in order to deter the U.S. from tariffs. But Chinese policymakers may be ready to sustain greater damage than Washington or the investment community expects. Tech companies are particularly out of the loop with Washington. They are said to have been unprepared for the president's actions upon receiving the Section 301 investigation results. They may also be underestimating the product list that the U.S. Trade Representative has drawn up pursuant to Section 301.7 Even products on that list that are not imported directly from China could have their trade disrupted. While China is demanding that the U.S. ease restrictions on high-tech exports, to reduce the trade imbalance (Chart 5), the U.S. believes that export controls allow for plenty of waivers and exceptions. They do not see export controls as a major risk. Chart 5U.S. Deficit Due To Security Concerns Inside The Beltway Inside The Beltway Rather, they see rising U.S. restrictions on Chinese investment in the U.S. as the real risk. The U.S. wants reciprocity in investment as well as trade. The emphasis lies on fair and equal access, which will require massive compromises from China, given its practice of walling off "strategic" sectors (including aviation, energy, electricity, shipping, and communications) from foreign interests. China's recent pledges to allow foreigners majority stakes in financial companies may not be enough to pacify the U.S. negotiators, especially if the promises hinge on long-term implementation. Treasury Secretary Steve Mnuchin will cause a stir when he releases his guidelines for investment restrictions, as expected by May 21 under the president's declaration on the Section 301 probe (Table 1).8 Both the House of Representatives and Senate are expected, within a couple of months, to pass the Foreign Investment Risk Review Modernization Act, proposed by Senator John Cornyn (R, TX) and Representative Robert Pittenger (R, NC). This bill would grant greater powers to the secretive Committee on Foreign Investment in the United States (CFIUS) in conducting investigations into foreign investment deals with national security ramifications. Under the new law CFIUS will be able to review proposed investment deals on grounds that go beyond a strict reading of national security. They will now include economic security, and potential sectoral impacts as well as individual corporate impacts, and previously neglected issues like intellectual property.9 Trump is unlikely to veto the bill, as previous presidents have done when laws cracking down on China have passed Congress, given his desire to shake up the China relationship. Table 1Protectionism: Upcoming Dates To Watch Inside The Beltway Inside The Beltway Will CFIUS enforcement truly intensify? Treasury's actions may preempt the bill, and CFIUS has already been subjecting China to greater scrutiny for years (Chart 6). Moreover, American presidents have always canceled investment deals if CFIUS advised against them.10 Presumably broadening CFIUS's powers will result in a wider range of deals struck down. The government already stopped Broadcom, a Singaporean company, from taking over the U.S. firm Qualcomm, in March, for reasons that have more to do with R&D and competitiveness (economic security) than with any military applications of its technologies (national security). Separately, U.S. policy elites are starting to turn their sights toward China's global propaganda and psychological operations. The scandal over the Communist Party's subversive institutional and political influence in Australia has heightened concerns in other Western, especially Anglo-Saxon, countries.11 This is a new trend that will have bigger implications going forward in Western civil society and the business community, with state efforts to create firewalls against Chinese state intrusion exacerbating political and trade tensions. Australians have the most favorable view of China in the West, and on the whole they continue to see China in a positive light. However, this view will likely sour this year. The recent attempt by Prime Minister Malcolm Turnbull to pass legislation guarding against Communist Party interference in Australian politics has already led to a series of diplomatic incidents, including tensions over the South China Sea and Pacific Islands. These can get worse in the near future. Consistently, over 40% of Australians view China as "likely" to become a military threat over the next 20 years (Chart 7), and this number will worsen if attempts to safeguard democratic institutions from state-backed influence operations cause China to retaliate with punitive measures toward Australia. China is offering some concessions to counteract the new, aggressive consensus in Washington. Enforcing UN sanctions against North Korea was the big turn. But it is also allowing the RMB to appreciate against the USD (Chart 8), which is an issue close to Trump's heart. The change in temperature in Washington can be measured by the fact that these concessions seem to be taken for granted while the discussion moves onto other demands like trade and investment reciprocity. Chart 6U.S. To Restrict Chinese Investment U.S. To Restrict Chinese Investment U.S. To Restrict Chinese Investment Chart 7Australian Fears About China To Rise Inside The Beltway Inside The Beltway Chart 8Is This Enough To Stay Trump's Hand On Tariffs? Is This Enough To Stay Trump's Hand On Tariffs? Is This Enough To Stay Trump's Hand On Tariffs? Simultaneously, China is courting Europe. European policymakers say that they share U.S. concerns about China's trade practices but wish to resolve disputes through the World Trade Organization and reject unilateral American actions or aggressive punitive measures that could harm global stability. Meanwhile China hopes that American policy toward Iran and the Middle East will alienate the Europeans while distracting Washington from formulating a coherent pivot to Asia. Bottom Line: Investors are underestimating the potential for a full-blown trade war. Policymakers - in China as well as the U.S. - have greater appetite for confrontation. Iran: Reversing Obama's Legacy The financial news media continue to underrate the importance of geopolitical risk tied to Iran this year (Chart 9). Our sense is that the Trump administration, when in doubt, is still biased towards reversing Obama-era policy on any given issue. Iranian nuclear deal of 2015 appears to be no exception. Chart 9Iranian Geopolitical Risk About to Shoot Up Iranian Geopolitical Risk About to Shoot Up Iranian Geopolitical Risk About to Shoot Up Signs have emerged for months that Trump is likely to refuse to waive Iranian sanctions (Table 2) when the renewal comes due on May 12. He has fired his national security adviser and secretary of state, as well as lesser officials, in preference for Iran hawks.12 French President Emmanuel Macron, having tried to convince Trump to retain the deal on his recent state visit to Washington, is apparently convinced Trump will scrap it.13 Table 2U.S. Sanctions Have Global Reach Inside The Beltway Inside The Beltway Moreover, discussions of Iran mark the one exception to the hardening consensus on China. A number of people we spoke with were not convinced that the Trump administration will truly devote the main thrust of its foreign policy to countering China. Some believed U.S. voters did not have the stomach for a trade fight that would affect their pocketbooks. Others believed that the Trump administration would simply revert to a more traditional Republican foreign policy, accepting a "quick win" on China trade while pursuing a confrontational military posture in the Persian Gulf. Still others believed that Trump has unique reasons, such as political weakness at home and the desire to be respected abroad, for wanting to be in lock-step with Israeli Prime Minister Benjamin Netanyahu and Crown Prince Mohammad bin Salman against Iran. All agreed that while a shift to China makes strategic sense, it may not overrule Republican policy preferences or inertia. The stakes are high. Allowing sanctions to snap back into place would affect a substantial portion of the one million barrels per day of oil that Iran has brought onto global markets since sanctions were eased in January 2016 (Chart 10). Chart 10Re-Imposing Iranian Sanctions Threatens Oil Supply And Middle East Stability Re-Imposing Iranian Sanctions Threatens Oil Supply And Middle East Stability Re-Imposing Iranian Sanctions Threatens Oil Supply And Middle East Stability As BCA's Commodity & Energy Strategy notes, global oil supply is tight and the critical driver - emerging market demand - remains strong. Meanwhile the "OPEC 2.0" cartel plans to extend production cuts throughout 2018 and likely into 2019, further draining global inventories. Inventories are now on track to fall beneath their 2010-14 average level by next year. In this context, the geopolitical risk premium will add to upside oil price risks this year. Our commodity strategists still expect oil prices to average $70-$74 per barrel this year (WTI and Brent respectively), but they can see it shooting above $80 per barrel on occasion, and warn that even small supply disruptions (whether from Iran, Venezuela, Libya, or elsewhere) could send prices even higher (Chart 11).14 Chart 11Oil Prices Can Make Runs Into /Barrel Range Oil Prices Can Make Runs Into $80/Barrel Range Oil Prices Can Make Runs Into $80/Barrel Range If the U.S. re-imposes sanctions on Iran, we doubt that the full one million barrels per day of post-sanctions Iranian production will be taken offline. Global compliance with sanctions will be ineffective this time around. The Trump administration's sanctions will not have the legitimacy or buy-in that the Obama administration's sanctions did. Trump may even intend to impose the sanctions for domestic political consumption while giving Europe, Japan, and others a free pass. Still, the geopolitical and production impact will be significant. As for oil, price overshoots are even more likely when one considers Venezuela, where our oil analysts estimate that state collapse will remove around 500,000 barrel per day from last year's average by the end of this year.15 Bottom Line: We continue to expect energy commodities to outperform metals in an environment where energy prices benefit from a rising geopolitical risk premium, while metals could suffer from ongoing risks to Chinese growth. Investment Conclusions Independently of the above anecdotes, Geopolitical Strategy has laid out a case urging clients to sell in May and go away.16 Last year we were confident recommending that clients forget this old adage because we had clarity on the geopolitical risks and their constraints. This year, with both China and Iran, we lack that clarity. The U.S.'s European allies could perhaps convince Trump to maintain the 2015 Iranian nuclear agreement, and Trump could perhaps accept China's concessions (such as they are) to get a "quick win" on the trade front before the midterm elections. But we have no basis for assessing that he will do either with any degree of conviction. How long will it take to resolve the raft of outstanding U.S.-Iran and U.S.-China tensions? Our uncertainty here gives us a high conviction view that this summer will be turbulent. Geopolitical tensions will likely get worse before they get better. We would reiterate our recommendation that clients be long DXY and hold a "geopolitical protector portfolio" of Swiss bonds and gold. We remain long developed market equities relative to emerging markets and long JPY/EUR. We are also maintaining our shorts on Chinese tech stocks and U.S. stocks exposed to China. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 6 Please see Jordain Carney, "McConnell: Senate won't take up Mueller protection bill," April 17, 2018, available at thehill.com. 7 Please see U.S. Trade Representative, "Under Section 301 Action, USTR Releases Proposed Tariff List on Chinese Products," and "USTR Robert Lighthizer Statement on the President's Additional Section 301 Action," dated April 3 and April 5, 2018, available at ustr.gov. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 9 Please see Senator Jon Cornyn, "S.2098 - Foreign Investment Risk Review Modernization Act of 2017," dated Nov. 8, 2017, available at www.congress.gov. For the argument behind the bill, see Cornyn and Dianne Feinstein, "FIRRMA Act will give Committee on Foreign Investment a needed update," The Hill, dated March 21, 2018, available at thehill.com. 10 Please see Wilson Sonsini Goodrich & Rosati, "CFIUS In 2017: A Momentous Year," 2018, available at www.wsgr.com. 11 Australian Senator Sam Dastyari (Labor Party) resigned on December 11, 2017 after it was exposed that he accepted cash donations from a Chinese property developer that he used to repay his own debts. He had also supported China's position in the South China Sea. The scandal prompted revelations of a range of Chinese state-linked political donations. Prime Minister Malcolm Turnbull has introduced legislation banning foreign political donations and forcing lobbyists for foreign countries to register. 12 Mike Pompeo replaced Rex Tillerson as Secretary of State, John Bolton replaced H.R. McMaster as National Security Adviser, and Chief of Staff John Kelly has been sidelined; Bolton has appointed Mira Ricardel as his deputy, who has been said to clash with Secretary of Defense James Mattis in trying to staff the Pentagon with Trump loyalists. Please see Niall Stanage, "The Memo: Nationalists gain upper hand in Trump's White House," The Hill, April 25, 2018, available at thehill.com. 13 Macron has presented a framework that German Chancellor Angela Merkel and U.K. Prime Minister Theresa May have accepted that would call for improvements to outstanding issues with Iran while keeping the 2015 deal intact. Macron has also spoken with Iranian President Hassan Rouhani about retaining the deal while addressing the Trump administration's grievances. 14 Please see BCA Commodity & Energy Strategy Weekly Report, "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," dated April 19, 2018, available at ces.bcaresearch.com. 15 Please see footnote 14, and BCA Geopolitical Strategy and Energy Sector Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights The current U.S.-China trade skirmish is essentially the beginning of a new cold war. The U.S. and China are engaged in a struggle for supremacy, so trade conflicts will persist. The conflict could evolve into a "game of chicken" - the most dangerous type of game. The U.S. needs Europe's help against China - but an adventure in Iran could cost it that help. Geopolitical risks will cap the rise in bond yields over the next six months, push up oil, and give a tailwind to global defense stocks. Feature The opening salvo of the U.S.-China trade war has caught the investment community by surprise as the market is quickly repricing the odds of a global trade war.1 Nervousness over the breakdown of globalization comes at the same time as our key China view - that Beijing's structural reforms will constrain growth - are beginning to have an impact on global growth (Chart 1).2 Chart 1China Reforms Dragging On Global Growth China Reforms Dragging On Global Growth China Reforms Dragging On Global Growth Fortuitously, we found ourselves in Asia at the onset of "hostilities" and were thus able to see regional investors' reactions in real time. Our clients focused their questions on the economic impact of the announced tariffs (yet to be determined, in our view), constraints facing President Trump (minimal as well), and potential Chinese retaliation (understated). The focus, however, should be on the big picture. The March 23 U.S. announcement of tariffs on around $50 billion worth of Chinese imports is not just the opening salvo of a trade war. Rather the emerging trade war is the opening salvo of a new cold war, a global superpower competition between the U.S. and China that will define the twenty-first century. Put simply, the U.S. and China are now enemies. Not rivals, competitors, or sparing partners. Enemies. It will take the market some time for investors to internalize this idea and price it properly. Meanwhile, in the short term, fears of a full-born global trade war are overblown. The trade tensions are really only about two countries, with uncertain global implications. Investors are right to be cautious, but risks to global earnings are overstated at this time. How Did We Get Here? The ongoing trade tensions are not merely a product of a nationalist Trump administration that decided to call out China for decades of unfair trade practices. They are also the product of the geopolitical context, which we have defined through three "big picture" themes. These three themes allowed us to correctly forecast that the defining feature of the twenty-first century would be a Sino-American conflict. We would be thrilled to see this culminate merely in a trade war. The themes are: Multipolarity (Chart 2)3 Apex of globalization (Chart 3)4 The breakdown of laissez-faire economics (Chart 4)5 Chart 2Multipolarity Is Messy And Volatile Multipolarity Is Messy And Volatile Multipolarity Is Messy And Volatile Chart 3When Hegemony Declines, Globalization Declines When Hegemony Declines, Globalization Declines When Hegemony Declines, Globalization Declines Chart 2 elucidates a key lesson of history: the collapse of British hegemony at the end of the nineteenth century ushered in two world wars. Political science, game theory, and history teach us that periods of multipolarity are rarely peaceful.6 Today's world is not exactly multipolar, as the U.S. remains the preeminent global power. However, regional powers - such as China, the EU, Russia, India, Japan, Iran, and perhaps Turkey and Brazil - have a lot more room to maneuver within their spheres of influence. This means that global rules written by the U.S. at the conclusion of the Second World War are being rewritten for regional contexts. Normatively there is nothing wrong with this process. But practically, multipolarity means that "challenger powers" - such as China today or the German empire in the late nineteenth century - seek to undermine rules and norms of behavior that they had little or no say in setting up. And such rules are necessary to underpin geopolitical stability and grease the wheels of globalization. As Chart 3 shows, trade globalization peaked in the past when the hegemon could no longer enforce global rules. We have therefore emphasized to clients since 2014 that, if we are right that the world is multipolar, then we are essentially at the apex of globalization. A parallel process has seen the breakdown of the laissez-faire consensus, which underpinned the expansion of trade in goods, labor, and capital across sovereign borders. Economic globalization has lifted many boats around the world, but outsourcing - combined with technological innovation - has seen the lower middle class in developed nations face diminishing returns (Chart 4). Chart 4Globalization: No Friend To Developed-Market Middle Class We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now That said, a revolt against globalization and "globalists" is thus far mainly an Anglo-Saxon phenomenon, and particularly an American one. Why? Because the particularities of the U.S. laissez-faire economic model, with its scant social protections, laid its middle class bare to the vagaries of globalization and technological change (Chart 5). However, there is no guarantee that other DM countries will not succumb to the same pressures down the line. Chart 5The 'Great Gatsby' Curve: Or, How Anglo-Saxons Turned Against Laissez Faire We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now This background is important for investors because merely blaming a nationalist Trump administration or a mercantilist Beijing for today's tensions ignores the underlying context. President Trump can change his mind on a dime, but the geopolitical context can only evolve slowly.7 Mercantilism is here to stay; it is a feature, not a bug, of a multipolar world. Contrast today's tensions with those of the 1970s and 1980s between the U.S. and its major trade partners. The 1971 Smithsonian Agreement and the 1985 Plaza Accord ended overt trade protectionism by the U.S. (in 1971), and threats thereof (in 1985), by securing the compliance of these trade partners with Washington's currency and trade demands. Japan further conceded to U.S. demands in 1989 after a two-year trade war. Today, the U.S. and China are not geopolitical allies huddled under the same nuclear umbrella for protection against an ideologically fueled rival. They are ideological rivals. The reason it took a decade for the conflict to erupt is two-fold. First, the U.S. became entangled in the global war on terror after 9/11, which took its focus off of its emerging competitor in Asia. Second, the consensus view - that China would asymptotically approach a Western democracy as it embraced capitalism - has proven to be folly.8 Bottom Line: The China-U.S. trade conflict is a product of today's particular geopolitical context. At heart, it is a conflict for geopolitical primacy in the twenty-first century and thus unlikely to end quickly. Sino-American Conflict Is Intractable The current U.S.-China trade tensions are more of a skirmish than a war. We think that there is considerable room for a step-down in tensions over the next 12 months. First, the Trump administration has not launched an economic war against China. Not only has the U.S. restricted its list of Chinese goods under tariff consideration to just $50 billion of imports - roughly 12% of total Chinese exports to the U.S. - but it has decided to bring a case against China to the World Trade Organization (WTO). The latter is hardly a move by a mercantilist administration dead-set on across-the-board economic nationalism. Second, China has responded almost immediately by offering several concessions, including renewing pledges to open its economy to inward investment and to protect intellectual property (IP) rights. While these may seem like boilerplate concessions that Beijing has floated before, the current context of trade tensions and domestic structural reforms makes it more likely that Chinese policymakers will follow through on their promises. As such, we can see the current round of tensions tapering off, especially after the U.S. midterm elections. However, we doubt that the structural trajectory of Sino-American relations will be significantly altered even if current tensions subside. First, from China's perspective, its extraordinary economic ascent (Chart 6) is merely the return of the millennium's status quo (Chart 7). The last 180 years - roughly from the beginning of the First Opium War in 1839 to today - were the aberration. During this short period of Chinese weakness, the West - with Britain and then the U.S. at the helm - conspired to restructure global rules and norms of geopolitical and economic behavior without input from the Middle Kingdom. Chart 6China's Economic Rise Has Been Extraordinarily Fast... We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Chart 7China Sees Its Success As A Return To The Status Quo We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now As such, China's influence in key post-WWII economic institutions like the WTO and the IMF is limited while its military has second-class status even in its own "Caribbean Sea," the South China and East China Seas. From the U.S. perspective, China's growth over the past two decades was made possible by U.S. hegemony. The U.S. secured the global rules and norms that enabled China to integrate seamlessly into the global marketplace and then compete its way to the top. Not only did the U.S. allow China to access its credit-fueled markets, but the U.S. Navy protected China's maritime trade, including vital energy supplies transiting from the Middle East. As a thank you for these efforts, China reneged on its WTO commitments, periodically suppressed its currency, stole American intellectual property, and withheld market access from U.S. corporations via tariff and non-tariff barriers to trade. Washington policymakers, and not only Trump's hawkish advisors, are turning against China. There is an emerging consensus among the U.S. foreign policy, defense, intelligence, and economic policy elites that: Sino-American economic symbiosis is over (Chart 8); Chart 8U.S.-China ##br##Symbiosis Is Dead U.S.-China Symbiosis Is Dead U.S.-China Symbiosis Is Dead Chart 9The U.S. Is Least##br## Exposed To Trade The U.S. Is Least Exposed To Trade The U.S. Is Least Exposed To Trade Chart 10China's Share Of Global##br## Exports Has Skyrocketed China's Share Of Global Exports Has Skyrocketed China's Share Of Global Exports Has Skyrocketed The U.S. can afford to confront China over trade because it is the least exposed major economy to global trade (Chart 9); The Chinese have acquired a massive share of global exports without a commensurate opening of their domestic market (Chart 10); Arresting Chinese technology transfer and intellectual property theft is a national security issue (Chart 11); The U.S. can confront China because it has emerged victorious from every global conflagration in the past (Chart 12). Chart 11China Imports Conspicuously Little U.S. IP We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Chart 12America Is Chaos-Proof America Is Chaos-Proof America Is Chaos-Proof Fundamentally, American policymakers want to see China's rapid economic growth slow, they want to see China's capital markets and companies constrained by openness to global competition, and they want to put a leash on China's catch-up in the technological and manufacturing value chain (Chart 13). This is not their stated objective as it would imply that the U.S. wants to see China weakened, and the Chinese leadership miss its decade and century economic development goals. But this is precisely what the U.S. establishment wants. As such, the political and economic visions of American and Chinese policymakers are directly at odds with one another. What does this mean for investors? Over the past several years we have developed a reputation of being sanguine about geopolitics. While many of our peers in the political analysis industry overstate the probability of geopolitical risk, we have (successfully) bet against the worst-case scenario in several prominent crises.9 We like to think that this is because we combine game theory with an understanding of the underlying power dynamics. By emphasizing constraints, we have successfully identified how power dynamics constrain the worst-case outcome.10 When it comes to Sino-American tensions, however, we have always been alarmists. This is because we believe the constraints to conflict are overstated, not understated. Furthermore, the potential market impact of a new cold war is unclear and potentially very large. Both the U.S. and China fundamentally think they can win a trade war. This means that they are engaged in a "regular game of chicken," named after the 1950s practice of racing hot rods head-on in order to prove one's manhood.11 Game theory teaches us that a game of chicken is the most unpredictable game because it can create an equilibrium in which all rational actors have an incentive to keep driving head on - to stick to their guns - despite the risks. In Diagram 1, we can see that continuing to drive carries the greatest risk, but also the greatest reward, provided that your opponent swerves. Chart 13China's Steady Climb Up##br## The Value Ladder Continues We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Diagram 1A Regular ##br##Game Of Chicken We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Since all actors in a game of chicken assume the rationality of their opponents, they also expect them to eventually swerve. In the current context, this means that the U.S. assumes that China is driven by economic rationality and will not dare face off against the U.S., which has far less to lose given its modest exposure to global trade. Chinese policymakers, however, also think they can win. They look over the Pacific and see a country riven by political polarization (Chart 14) where half of the country thinks the other is "a threat to the nation's well-being" (Chart 15).12 China, meanwhile, has just consolidated its political leadership and feels confident enough in its domestic stability to dabble with growth-constraining economic reforms. Beijing can use any trade tensions with the U.S. to further justify painful reforms. Chart 14Inequality Fuels Political Polarization Inequality Fuels Political Polarization Inequality Fuels Political Polarization Chart 15Live And Let Die We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Who is right? We do not know. And that scares us as it means that the most sub-optimal equilibrium - the bottom-right quadrant of Diagram 1 - is more probable than people think. An important difference maker, one that would alter Beijing's risk calculus considerably, is Europe. Despite being highly leveraged to China's growth, the EU still exports nearly double the value of goods to the U.S. than China (Chart 16). In addition, Europe's trade surplus with the U.S. mostly pays for its deficit with China (Chart 17). Chart 16The EU Exports More To U.S. Than China The EU Exports More To U.S. Than China The EU Exports More To U.S. Than China Chart 17EU Surplus With U.S. Pays For Deficit With China EU Surplus With U.S. Pays For Deficit With China EU Surplus With U.S. Pays For Deficit With China Over the next several months, investors will be able to gauge whether the Trump administration is filled with ideological nationalists who believe in Fortress America or wily realists who know how to get things done. The key question is whether Trump will embrace America's traditional transatlantic alliance with Europe and harness it for the trade war with China. If he embraces it, we will predict that the combined forces of U.S. and Europe will successfully force China to concede to the pressure. If Trump fails, however, we could have a prolonged U.S.-China trade war. Early indications are optimistic. The U.S. gave the EU an exemption from tariffs on steel and aluminum imports on March 22, a delay that will end on May 1. This followed a March 21 meeting between EU Commissioner for Trade Cecilia Malmström and U.S. Secretary of Commerce Wilbur Ross. We suspect, but have no evidence, that the U.S. asked the EU to join in its effort to force China to change its trade practices at the WTO. As an exporting bloc, the EU has a lot more to lose from attacking China than the U.S. But it also has much to lose from unabated Chinese mercantilism and technological theft, and much to gain if China opens its doors wider. As such, we posit that Europe will, in the end, join the U.S. and Japan in a concerted effort to pressure China. This will increase the probability that Beijing ultimately gives in to trade pressure. In the long term, it will also ensure that President Trump does not break the critical transatlantic alliance with Europe, which would be paradigm shifting. But, on the other hand, it will set China and the West on a collision course. China's and the West's suspicions of each other will ossify. Bottom Line: In the short term, trade tensions are likely overstated as U.S. actions against China are largely muted and restrained. In the long term, the U.S.-China trade war could potentially devolve into a "game of chicken," the most dangerous type of conflict. The key variable will be whether the U.S. administration is savvy enough to arrange European collaboration against China. If the U.S. treats the EU harshly and ignores its transatlantic ally on other issues - such as conflict with Iran, discussed below - we could be in for a wild ride in the coming months and years. Either way, Europe stands to gain from a conflict between China and the U.S. Both sides are likely going to try to enlist the EU on their side. As such, we are opening a long Europe industrials / short U.S. industrials trade. Meanwhile, growing trade tensions, policy-induced slowdown in China, and repricing of geopolitical risks in East Asia and the Middle East should cap global bond yields over the next six months. We take 50.4bps and 54.4bps profits on our short U.S. 10-year government bond vs. German bund and short Fed Funds December 2018 futures trades. Iran: The Next Target Of Trump's "Maximum Pressure" Policy President Trump's North Korea policy worked brilliantly in 2017. The policy of "maximum pressure" combined military maneuvers, economic sanctions, and extremely bellicose rhetoric to convince Pyongyang and regional powers that the U.S. has lowered its threshold for full-scale war on the Korean peninsula. China reacted swiftly, starving North Korea of hard currency through economic sanctions (Chart 18). The result was a declaration by Pyongyang in late November that it had finally completed its quest to obtain a nuclear deterrent (an exaggeration at best), an olive branch for the Olympics, and an offer by Supreme Leader Kim Jong Un to meet with President Trump. Chart 18China Gives Kim To Trump China Gives Kim To Trump China Gives Kim To Trump The policy of "maximum pressure" yielded such extraordinary results with North Korea that President Trump is now eager to trademark the process and apply it to Iran and potentially other global issues. Ahead of the all-important May 12 deadline - when the White House will decide whether to end the current waiver of economic sanctions against Iran - President Trump has replaced two establishment advisors with hawks. Secretary of State Rex Tillerson has been replaced with CIA Director and noted Iran-hawk Mike Pompeo. Meanwhile, National Security Advisor H.R. McMaster has been replaced by conservative pundit (and former U.S. Ambassador to the UN) John Bolton. Bolton is on record arguing that the U.S. should bomb Iran. The role of the national security advisor varies with the president. Some presidents rely on the position more than others. However, given this administration's inexperience with foreign policy, the role is critical in shaping the White House worldview. The national security advisor manages the staff of the National Security Council (NSC), whose role is to coordinate with the vast network of U.S. intelligence agencies and filter information to the president. Given how large America's foreign, defense, and intelligence establishment is, and given the nature of human and signals intelligence, U.S. presidents often have to act upon diametrically opposing pieces of intelligence. As such, the national security advisor and the NSC can play a critical role in deciding what intelligence makes it to the president's desk and in what context. Staffers in the National Security Council (NSC) are often apolitical. We have been told that several current experts are leftovers from the Obama administration. It is likely that an ideological pundit like John Bolton, who served briefly in the George W. Bush administration, will set out to quickly eliminate non-partisan staffers on the NSC and tilt the information flow away from the empirical to the conspiratorial. With Bolton and Pompeo effectively in charge of U.S. foreign policy it is possible that the U.S. will misapply "maximum pressure" policy to Iran and bungle the complicated coordination with geopolitical allies on China. In particular, the U.S. has to endear itself to the EU if it wants a global economic alliance against China. But the EU also does not want to renegotiate Iran sanctions. Abrogating the 2015 nuclear deal - the Joint Comprehensive Plan of Action (JCPA) - would throw the tentative Middle East equilibrium into chaos. While Iran has played a role in preserving the regime of Bashar al-Assad in Syria, it has largely kept its vast network of Shia militias and allies in check, particularly in Lebanon and Iraq. Ironically, it was the Obama administration's "flawed" JCPA that has allowed Trump to focus on China in the first place. As we argued when the deal was signed, the conservative critics of the deal itself were correct. The JCPA did not degrade Iran's nuclear capability but merely arrested it.13 The point of the deal was implicitly to give Iran a sphere of influence in the Middle East so that the U.S. could extricate itself and focus on China. The Obama administration assessed, in our view non-ideologically, that the U.S. cannot fight two wars at the same time. If the Trump administration decides not to waive sanctions on May 12, it will be in abrogation of the deal. Unlike North Korea, however, Iran has multiple levers it can deploy against the U.S. and its allies' interests in the region. As such, the policy of "maximum pressure" will create much greater risks when applied to Iran. At the very end, it could be as successful as when applied to North Korea, but our conviction view is much lower (and to remind clients, we were optimists about the strategy when applied to North Korea!).14 Furthermore, and again unlike North Korea, Iran is beset with domestic risks. This actually makes it less likely that Tehran will cooperate with the U.S. North Korea is a simple domestic political system where Kim Jong Un can alter policy on a whim without much domestic pushback. In Iran, the dovish and moderate President Hassan Rouhani has to contend for power with hawks who have been critical of the JCPA. Meanwhile, the restive youth population could rise up at the first sign of elite division or weakness. This complicated domestic dynamic is why we cautioned clients back in January that Iran would likely add geopolitical risk premium to the oil markets.15 Bottom Line: It appears that President Trump, motivated by the success of his "maximum pressure" strategy against North Korea, now thinks he can apply it as successfully to Iran. This raises the prospect that Trump will discontinue the waiver of economic sanctions on May 12, effectively re-imposing a slew of economic sanctions against Iran and foreign companies looking to conduct business with it. Geopolitical risks are likely to rise in the Middle East as a result of U.S.-Iran tensions. As we go to publication, Saudi authorities have intercepted another Houthi missile heading towards Riyadh just days after Saudi Crown Prince Mohammad Bin Salman visited Washington, D.C. The White House appears to relish the opportunity to fight a war on two fronts, a trade war with China and a geopolitical war with Iran. Expect volatility and an elevated geopolitical risk premium in oil markets. Stay overweight global defense companies across markets. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2013," dated January 16, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, and "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 6 Please see John Mearsheimer, The Tragedy Of Great Power Politics (New York: Norton, 2001). 7 Would President Hillary Clinton have avoided a trade war with China? We do not think so. Secretary Clinton was considered a "China Hawk" while at the State Department and pushed for the "Pivot to Asia." Jennifer Harris, the lead architect of Clinton's economic statecraft agenda in the U.S. State Department, recently penned a book that called for greater use of economic tools for geopolitical ends. The book, War By Other Means, introduces the term geoeconomics and calls for the U.S. to use economic instruments to promote and defend national interests. Please see BCA Geopolitical Strategy Blog, "We Read (And Liked)... War By Other Means," dated July 13, 2016, available at gps.bcaresearch.com. 8 In 2000, while campaigning on behalf of China's WTO entry, President Bill Clinton remarked, "economically, this agreement (China's WTO entry) is the equivalent of a one-way street. It requires China to open its markets ... to both our products and services in unprecedented new ways. All we do is to agree to maintain the present access which China enjoys ..." Please see "Full Text of Clinton's Speech On China Trade Bill," dated March 9, 2009, available at nytimes.com. 9 To name just a few: the risk of an Israeli attack against Iran, the risk of a full-scale Russian invasion of Ukraine, the risk of Euro Area collapse, the risk of Saudi-Iranian war, the risk of Russian-Turkish war, etc. 10 For the best example of how game theory is combined with our constraint-based paradigm, please see BCA Geopolitical Strategy Special Report, "After Greece," dated July 8, 2015, available at gps.bcaresearch.com. 11 See James Dean in Rebel Without A Cause. 12 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 13 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. 14 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat,'" dated April 7, 2017, "North Korea: Beyond Satire," dated April 19, 2017, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, and "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com.

Highlights The U.S. government shutdown showed that the path of least resistance is for more fiscal spending; President Trump is turning to trade and foreign policy amid a lack of popularity at home; North Korean diplomacy is on track, but U.S.-China relations and Taiwan are potential black swans; Iran and the U.S. are playing a risky double game that will add geopolitical risk premium to oil; NAFTA will be a bellwether for Trump's future actions on issues that carry greater constraints, like Iran and China; Book profits on French vs German industrials and China volatility; close U.S. curve steepener and long PHP/TWD. Feature This weekend, investors woke up to the nineteenth government shutdown since 1976, a product of "grand standing" on both sides of the aisle. Our low-conviction view, which we elucidated last week, is that President Donald Trump will be forced to migrate to the middle on policy as the midterm election approaches.1 Chart 1Trump Hitting (And Building!) A Wall Watching Five Risks Watching Five Risks Despite a roaring stock market, strong economic fundamentals, and decade-low unemployment, President Trump's popularity continues to flounder. There is now even a perceptible decline in his support among GOP voters. Key problems for Trump have been the failure to repeal the Affordable Care Act and the intensification of the Mueller investigation (Chart 1). We suspect that he will try to preempt an electoral disaster in November by means of bipartisan deal-making and more orthodox policies. The government shutdown, although not entirely unexpected, undermined the view that President Trump is thinking about moderating his stance. That said, the Democrats are as much, if not more, to blame. With the Republicans in charge of Congress and the White House, it is clear that the Democrats thought that voters would ultimately see the shutdown as the GOP's fault. This was a dangerous assumption given that current polling suggests the Democrats have more to lose. One positive about the short-lived imbroglio is that it was the first government shutdown in twenty years that had little to do with government spending, whether the appropriations bill explicitly or entitlements. While immigration is an intractable issue, the disagreement between Republicans and Democrats is not about dollars. This is good news for the markets as it means that more spending will likely be necessary to grease the wheels of compromise. Our mantra continues to be that the political path of least resistance will lead towards profligacy. While the media's focus is on domestic politics, the real risks remain in the international arena. The two are connected. As political science theory teaches us, policymakers often play "two-level games," with the domestic arena influencing what is possible in the international one. As Donald Trump loses political capital on the domestic front, his options for affecting policy will become constrained. However, the U.S. constitution places almost no constraints on the president when it comes to foreign policy. To this arena we turn, starting with China-U.S. relations and the other potential risks in Asia (the Korean Peninsula and Taiwan). We also briefly turn to Iran and NAFTA. What binds all these risks is that it is essentially up to President Trump whether they become market-relevant or not. Korean Diplomacy Is On Track In mid-September North Korean tensions peaked (Chart 2).2 Leader Kim Jong Un chose to demonstrate known missile capabilities rather than escalate the crisis. Chart 2Markets Have Called Kim's Bluff Markets Have Called Kim's Bluff Markets Have Called Kim's Bluff Chart 3North Korea Is Running Out Of Cash North Korea Is Running Out Of Cash North Korea Is Running Out Of Cash We expected this choice given Pyongyang's considerable military constraints. Kim is a rational actor following his father Kim Jong Il's nuclear negotiations playbook.3 Just as brinkmanship reached new highs, Kim Jong Un declared victory and offered to play nice. Specifically, he launched his most advanced missile yet on November 28 (the Hwasong-15) and immediately thereafter North Korean state media declared that North Korea has "finally realized the great historic cause of completing the state nuclear force," complete with a fireworks celebration in Pyongyang.4 Kim confirmed this message personally on January 1 while offering an olive branch to South Korea for the New Year. Apparently, then, Kim is responsive to the United States' threats of devastating military retaliation against any attack. Kim is also responsive to the fact that China's President Xi Jinping has joined the U.S. coalition imposing sanctions on the North (Chart 3), squeezing North Korea's economy. The deep drop in exports to China suggests that the North will run into foreign-exchange problems if it does not adjust its posture - not to mention shortages of goods like fuel that China is gradually cutting off (Chart 4). In short, the U.S. established a credible military threat in 2017, just as it did with Iran in 2012 (Chart 5). China responded to the U.S. and established a credible economic threat of its own. Kim has de-escalated. Kim said in his New Year declaration that he would only use his nuclear deterrent if the U.S. committed an act of aggression. Rhetoric about destroying American cities is gone. Meanwhile Kim has engaged South Korea in direct negotiations, with military-to-military talks possibly to follow, and both sides will make a display of friendship at the Olympic Games in South Korea in February. Chart 4China Is Enforcing Sanctions China Is Enforcing Sanctions China Is Enforcing Sanctions Chart 5Credible Threat Cycle: North Korea Mirrors Iran Watching Five Risks Watching Five Risks While our view that diplomacy will reduce tensions is on track, we caution that the underlying disagreement is driven by North Korea's weapon capabilities and remains unresolved. The North Korean issue is not a red herring and the diplomatic route may continue to be bumpy from time to time.5 Markets could still be rattled by surprise North Korean provocations. Nevertheless, we do not expect a replay of the 2017 level of "fire and fury" that caused the U.S. 10-year treasury yield to drop from 2.31% to 2.05% between June and September 2017. If the North should jerk back toward a belligerent posture and decisively throw away this opportunity for diplomacy, then we will watch closely to determine whether its provocations truly alter the status quo and whether the U.S. shows any sign of greater willingness to respond with force. Otherwise we will simply monitor the diplomatic talks and watch for any signs of internal stress in North Korea as global sanctions tighten.6 Bottom Line: Korean risks remain market-relevant as the crisis is not resolved and talks are just beginning. Nevertheless, diplomacy is taking shape. We remain long the Korean two-year government bond versus the ten-year on the back of global trends and continued de-escalation. China-U.S. Relations May Sour Anyway Over the past year we have warned clients that U.S.-China tensions are the fundamental source of geopolitical risk globally and in Asia Pacific; that North Korea is a derivative of this fact; and that China's cooperation in policing North Korea would only temporarily dissuade the Trump administration from imposing punitive measures on China over trade. Despite China's assistance with North Korea, Trump will be driven by domestic American politics to slap tariffs on China in addition to those levied on January 22.7 First, Trump is committed to an "America First" trade policy and to economic nationalist voters. Thus he may need to show more muscle against China ahead of the midterm elections. This is particularly true for the key rust-belt states that handed him the election in 2016, where four Democratic senators' seats are in competition in November (not to mention nine other senate seats that could be swayed for similar reasons) (Chart 6). It is politically embarrassing to Trump that China racked up its largest trade surplus ever with the U.S. in his first year in office and is on track to continue racking up surpluses (Chart 7). While Beijing has vowed to open up market access and import more goods and services, these promises have yet to impress (Chart 8). Chart 6Trump's Base Expects Protectionism Trump's Base Expects Protectionism Trump's Base Expects Protectionism Chart 7China's Exports To U.S. Are Growing... China's Exports To U.S. Are Growing... China's Exports To U.S. Are Growing... Administrative rulings on several trade disputes early this year will give Trump ample opportunity to take additional trade action against China. The critical question, however, is whether Trump will continue to focus on item-by-item trade remedies (perhaps at an accelerated pace), or whether he goes beyond previous administrations and demands that China make progress on structural and systemic issues. The latter is more politically difficult and would have greater macro consequences. The U.S. has recently suggested that it made a mistake by bringing China into the WTO. This comes after the December WTO meeting in which the administration was able to secure a joint statement with Japan and Europe that increased the pressure on China.8 At the same time, Trump is weighing a significant decision (due by August, but possible any day now) on China's alleged systemic intellectual property theft, which Trump says is likely to require a "fine" (penalty). And comments by White House officials suggest that the administration may be going after China's promotion of state-owned enterprises (SOEs) as well as forced technology transfers (Chart 9).9 These are structural demands on China that will create much bigger frictions than tariffs on a few sub-sectors. Chart 8...While Imports Remain Tepid ...While Imports Remain Tepid ...While Imports Remain Tepid Chart 9Foreign Firms Forced To Transfer Tech Foreign Firms Forced To Transfer Tech Foreign Firms Forced To Transfer Tech Second, assuming that the U.S. and international community reach some kind of deal to reduce Korean tensions over the next six-to-eighteen months - for instance, a missile-test moratorium and corresponding easing of sanctions. It is likely still to be a complicated and ugly deal, as Pyongyang has no intention of giving up its nuclear and missile capabilities. The U.S. will have to make unpopular compromises with a rogue regime, comparable to the Iranian nuclear deal of 2015. The deal will leave a bitter taste in Trump's mouth and the administration will likely blame China for failing to prevent the North from achieving its nuclear status. It will rotate to address other long-standing disagreements with China, and may well look for compensation for Korea by taking a harder line on trade. Bottom Line: Korean diplomacy may delay or soften Trump's trade policies but cannot change his domestic political calculus. The Trump administration is more, not less, likely to impose further punitive trade measures on China as the midterm election draws near. We expect Chinese equity volatility to remain high. We are closing our recommendation to go long the CBOE China ETF Volatility Index, which has appreciated by 26.5%. This is not an investable index but an indicator of volatility in ETFs. A Fourth Taiwan Strait Crisis? The rumor is going around that China and Taiwan are on the verge of a "Fourth Taiwan Strait Crisis." Clients all over the world - from Hong Kong to San Francisco to Toronto - are asking us about cross-strait tensions and the risk of war. As we go to press, Taiwanese President Tsai Ing-wen has just publicly acknowledged that war is possible. Taiwan could indeed be a geopolitical "black swan." It was one of our top five black swans for 2016,10 and several extraordinary events that year suggested that our concerns are warranted: China cut off all communication with the island; the Taiwanese navy accidentally fired a missile towards the mainland on the Communist Party's birthday; and a U.S. president-elect spoke directly with a Taiwanese president for the first time since 1979, creating an uproar in Beijing.11 Today, in the wake of Xi Jinping's concentration of power at the nineteenth National Party Congress,12 and Beijing's heavy-handed crackdown on Hong Kong throughout 2017,13 there is renewed concern that China is about to stage a major intervention to rein in Taiwan. There is even talk that China could be preparing to mount a surprise attack.14 The rumors are arising from a confluence of events. On the mainland side, Xi is personally powerful and has made it a priority to lead China into a "New Era" of greater Chinese influence globally. This means that a decision to take bolder action on Taiwan could come from individual whim rather than a collective decision within the party (which would tend to maintain the status quo). Xi has also taken personal control of the military through promotions, and reasserted that the "party controls the gun," making it less likely that he would meet institutional resistance in any major foreign policy initiative. Finally, Xi has hardened Communist Party policies toward Taiwan, reflected in increased military drills, controversial new air traffic routes, and tougher language in the five-year policy blueprint that he presented to the party congress. On the Taiwanese side, the Democratic Progressive Party (DPP), which is the party that leans toward independence from the mainland, dominates the country's politics. The DPP not only won the presidency but also won legislative control for the first time in the January 2016 election.15 The DPP is also the leading party on lower levels of government. And young Taiwanese people increasingly identify as exclusively Taiwanese.16 While President Tsai has been relatively pragmatic so far, her party has fewer domestic political constraints than in the past - leaving room for the party's more radical side to have more influence or for Tsai to overreach. Internationally, Tsai has allies in Trump and Prime Minister Shinzo Abe of Japan - both nationalists who favor Taiwan and harbor deep suspicions about the reviving communism emanating from Beijing. Hence we still see Taiwan as a potential black swan event in the coming years. However, we would put a near 0% subjective probability on the likelihood that China will spring a massive surprise attack in the near future. Why? Xi is not yet breaking the status quo: Xi has not yet shown himself to be a reckless revisionist. China's foreign policy assertiveness is a gradual process that began in the mid-2000s - it traces the country's growing economic importance and need for supply-line security (Chart 10). Xi has trod carefully in both the East and South China Seas, and both of these strategic thrusts are connected with China's security vis-à-vis Taiwan, as well as vis-à-vis the U.S. and Japan. There is no reason to think that China is ready to launch a multi-front attack against the combined forces of the U.S., Taiwan, Japan, and the rest of the American alliance system. North Korea's new missile capabilities do not tip the scales in China's favor either. Incidentally, even Xi's tougher rhetoric at the party congress echoed the 2005 "Anti-Secession" law, so that more evidence would be needed to conclude that a drastic policy shift is under way.17 China may even want to avoid antagonizing the Taiwanese ahead of local elections later this year. Trump is not yet breaking the status quo: Trump's Asia policy has been consistent with that of previous administrations.18 And Trump's moves to assure Taiwan of U.S. commitment to its defense are status quo. After all, the Democratic Party is historically more enthusiastic about supplying Taiwan with arms (Chart 11). Trump has assured Xi Jinping he will adhere to the "One China" policy; and it is rarely observed that Trump's controversial phone call with Taiwanese President Tsai followed the first-ever tête-à-tête between a Chinese president and his Taiwanese counterpart.19 As long as Trump upholds the norm, the U.S. remains committed to Taiwan's defense yet will refuse to let Taiwan lock it into excessive tensions with China. This policy actually reduces the probability of a miscalculation by Beijing or Taipei. By contrast, the probability would rise if China and Taiwan perceived that the U.S. was withdrawing from its commitments, as Taiwan might want to suck the U.S. back in, or China might see Taiwan as vulnerable. Incidentally, if the Trump administration is not rushing into conflict over Taiwan, then Japan's Abe administration certainly is not. Tsai is not yet breaking the status quo: President Tsai has so far played a pragmatic role. While she is dissatisfied with the "1992 Consensus," which holds that there is only "One China" but two different interpretations of it, she has not rejected the status quo, and she has not implied that Taiwan should be its own state (either of which would cause a huge reaction from the mainland). And there is no serious prospect of a popular independence referendum ("Twexit"?) on the horizon, which would assuredly prompt Beijing to aggressive measures. Chart 10China's Assertiveness Grows With Trade China's Assertiveness Grows With Trade China's Assertiveness Grows With Trade Chart 11Trump Has Not Changed Status Quo Trump Has Not Changed Status Quo Trump Has Not Changed Status Quo In order for us to increase the probability of a Taiwanese war, we would have to see one of these three players start behaving in a way that truly violates the status quo that has prevailed since the U.S. and China normalized relations in 1979. The real risk for Taiwan comes if the U.S. and China fail to arrest the secular decline in relations that began in the mid-2000s. A serious misunderstanding between these two would have a range of global repercussions, and could lead to miscalculation over Taiwan. Unfortunately, a miscalculation is conceivable within Trump's and Tsai's terms, which last until 2020. Consider the following scenario as an example. The U.S. is currently demanding that China assist with the North Korean problem, and may believe that it can compensate China by delaying any punitive trade measures. However, China may be expecting something else - it may be expecting the U.S. to downgrade relations with Taiwan. (In other words, China says, we diminish the North Korean threat to the U.S. mainland, you diminish the Taiwanese threat to the Chinese mainland.) Instead of giving China what it wants, the U.S. may provide Taiwan with new weapon capabilities in response to China's militarization of the South China Sea. In this way, U.S.-China competition could shift to the Taiwan Strait in the aftermath of any Korean settlement. In the meantime, we see Taiwan as vulnerable to China's discrete economic sanctions, which China has not hesitated to use in this or other diplomatic spats (Chart 12).20 Chart 12Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Bottom Line: What is clear to us is that U.S.-China tensions continue to grow and Taiwan could become more frightened, or more emboldened, in the "security dilemma" between them. But until we see signs that any of the relevant powers are actively attempting to break the status quo, we see war as a distant prospect. More likely, today's robust trade between China and Taiwan could suffer a hit due to politics, and tit-for-tat cross-strait sanctions could be imposed. We are closing our tactical trade of long Philippine peso / short Taiwanese dollar for a loss of 5%. This was a speculative play on the divergence in diplomatic relations with China. Taiwan has allowed its currency to rise to avoid antagonizing President Trump, while China and Taiwan have so far avoided the diplomatic crisis that we expect eventually to occur, as outlined above. Iran: Could America Pivot Back To The Middle East? BCA's Geopolitical Strategy correctly forecast the U.S.-Iran détente two years before the nuclear deal was agreed in the summer of 2015.21 At the heart of this call was our read of global forces, namely the paradigm shift in the global distribution of power away from American hegemony towards multipolarity (Chart 13). As the U.S. pivoted its geopolitical focus towards China, Iran became a thorn in its side, forcing it to maintain considerable presence in the Middle East. Without a formal détente with Iran - of which the Joint Comprehensive Plan of Action (JCPOA) is the fulcrum - such a pivot to Asia would be extremely difficult. On January 12, President Trump imperiled our forecast by threatening not to waive sanctions against Iran the next time they come due (May 12).22 To avoid that fate, President Trump wants to see three major changes to the JCPOA: An indefinite extension of limits on Iran's uranium enrichment; Immediate access for inspectors to all nuclear sites; Adding new provisions to limit development of ballistic missiles. These additions are likely to kill the deal, although Trump appears to have directed his comments to the European signatories only. This could potentially create a loophole in the crisis, by allowing Europe to agree to new thresholds for re-imposing sanctions outside of the deal's framework. Pressure from the U.S. president comes at a delicate time for Iran. Domestic unrest has been ongoing since December 28. Although protests have largely fizzled out, they have reopened the rift between the clerical regime, led by Supreme Leader Ayatollah Ali Khamenei, and moderate President Hassan Rouhani. In a surprising statement, President Rouhani said, "it would be a misrepresentation and also an insult to Iranian people to say they only had economic demands ... people had economic, political, and social demands." He went on to say that "We cannot pick a lifestyle and tell two generations after us to live like that ... The views of the young generation about life and the world is different than ours." We agree with President Rouhani. First, 49% of Iran's population is under the age of 30 (Chart 14). Meanwhile, the Supreme Leader and the twelve members of the "Guardian Council" - which has the power to veto parliamentary legislation and to vet presidential candidates - have an average age of 73.23 As with the 2009 Green Revolution, which was brutally repressed, Iran's demographics provide the kindling for a potential regime change. Chart 13American Hegemony Ended,##br## Global Multipolarity Ascending American Hegemony Ended, Global Multipolarity Ascending American Hegemony Ended, Global Multipolarity Ascending Chart 14Iran's Youth:##br## A National Security Risk Iran's Youth: A National Security Risk Iran's Youth: A National Security Risk Second, Iran's economy is clearly not the main reason for the angst. While unemployment is elevated at 12%, it is only slightly above its two-decade average. Meanwhile, inflation is well below its average, with real GDP growth at 5.8% by the end of 2016 (Chart 15). Considering that inflation peaked at 44%, and real GDP growth bottomed at -16% during the most severe sanctions, the current situation is not dire. What has irked the population is that while the private sector suffered throughout the sanctions ordeal, government spending remained elevated (Chart 16). This is not merely because of automatic stabilizers amidst a deep recession. Instead, Iran has elevated its military spending as new geopolitical opportunities presented themselves in the region (Chart 17). It currently spends more on its military as a percent of GDP than any peer in the region (save for Saudi Arabia, its chief rival). It is openly engaged in military conflict in both Syria, Iraq, and Yemen, while it continues to support allies militarily, economically, and diplomatically across the region, particularly Hezbollah in Lebanon. Chart 15Economic Situation Poor But Not Dire Economic Situation Poor But Not Dire Economic Situation Poor But Not Dire Chart 16Government Felt No Pain During Sanctions Government Felt No Pain During Sanctions Government Felt No Pain During Sanctions Chart 17Iran Overspends On Military Iran Overspends On Military Iran Overspends On Military Third, Chart 18 shows that Iran is becoming "dangerously wealthy." Both the 1979 Islamic Revolution and the 2009 Green Revolution occurred at, or near, the peak of Iran's wealth. The 25 years preceding each event saw the country's GDP per capita triple and double, respectively. Chart 18Wealth Is Also A National Security Risk Wealth Is Also A National Security Risk Wealth Is Also A National Security Risk Political scientists Ronald Inglehart and Christian Welzel have empirically shown that wealth changes people's basic values and beliefs, from political and economic beliefs to religion and sexual mores.24 This is the process of modernization. Economic development gives rise to cultural changes that make individual autonomy, gender equality, and even democracy likely. Iran has essentially come full circle since 1979. We suspect that the conservative hardliners in the regime understand the revolutionary context well. After all, they were themselves in their 30s when they rebelled against the old corrupt regime. As such, they will welcome President Trump's pressure as it gives them a raison d'être and an opportunity to undermine the moderate President Rouhani who staked his presidency on the success of the nuclear deal. The risk in this scenario is that the domestic arena of the ongoing "two-level game" will prevent both the U.S. and Iran from backing away from a confrontation. Iranian hardliners, who control part of the armed forces, could lash out in the Persian Gulf, either by rhetorically threatening to close the Straits of Hormuz - as they did repeatedly in 2011 - or by boarding foreign vessels in international waters.25 Geopolitical tensions would therefore serve to undermine President Rouhani's embrace of diplomacy and to de-legitimize any further protests, which would be deemed treasonous. For Trump, a belligerent Iranian response to his pressure would in turn legitimize his suspicion of the nuclear deal. What about the global constraints of multipolarity that compelled the U.S. to seek a détente with Iran in order to pivot to Asia? They remain in place. As such, President Trump's simultaneous pressure on Iran and China runs counter to U.S. strategy, given its limited material resources and diplomatic bandwidth. It is therefore unsustainable. What we cannot forecast, however, is whether the White House will realize this before or after it commits the U.S. to a serious confrontation. Bottom Line: Domestic political calculus in both Iran and the U.S. make further Tehran-Washington tensions likely. The two countries are playing a dangerous two-level game that could spiral out of control in the Middle East. For the time being, however, we expect merely a minor geopolitical risk premium to seep into the energy markets, supporting our bullish BCA House View on oil prices. NAFTA: Of Global Relevance On a recent client trip through Toronto and Ottawa we were unsurprisingly asked a lot of questions regarding the fate of NAFTA. The deal is not just of importance to Canada but to the world. It is a bellwether for our low-conviction view that President Trump is going to moderate to the middle on policy issues ahead of the midterm elections. We encourage clients to read our November Special Report titled "NAFTA - Populism Vs. Pluto-Populism."26 In it, we cautioned clients that the probability of NAFTA being abrogated by Trump is around 50%. Why so high? Because there are few constraints: Economic: The U.S. economy has been largely unaffected by NAFTA (Chart 19) and would likely experience no disruption if Trump abrogated the deal and began negotiations on bilateral trade agreements with Canada and Mexico. Political: Investors and the media are overstating the importance of the Midwest automotive and agricultural sectors to Trump's base. Trump's Midwest voters knew well his view on NAFTA when they voted for him. In fact, they voted for him because of his NAFTA view. Investors have to realize that Americans do not support unbridled free trade (Chart 20). Constitutional/Legal: There is an argument that Congress could stop President Trump from withdrawing from NAFTA, but the only way to do so would be to nullify his executive orders or legislate a law that prevents the president from withdrawing. However, given the point from above, Congress is afraid to go against the median voter. The immediate implications for investors are that both the CAD and MXN could face downside pressure following the Montreal round of negotiations ending January 29. Both fell by 1.2% and 1.9% respectively in the week of trading following the third round of negotiations in September (Chart 21). Chart 19U.S. Economy:##br## Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA Chart 20America Belongs To##br## The Anti-Globalization Bloc Watching Five Risks Watching Five Risks Chart 21NAFTA Negotiations##br## Are FX-Relevant NAFTA Negotiations Are FX-Relevant NAFTA Negotiations Are FX-Relevant More broadly, NAFTA is an important bellwether for the direction of Trump's policy. He has practically no constraints to abrogating the deal. If his intention is to renegotiate two separate deals - or simply reactivate the 1988 Canada-U.S. Free Trade Agreement - then it makes sense for him to end NAFTA and score political points at home. As such, if he does not, it will indicate that the White House is not truly populist but has been captured by the Republican establishment. Bottom Line: If President Trump does not abrogate NAFTA, which comes with few constraints, then he has clearly decided to throw his lot in with the U.S. establishment, which has consistently been more pro-trade than the American voter. This would be highly bullish for investors as it would suggest that the (geo)political risk premium would dissipate going forward. In fact, the decision on NAFTA could be a broad indicator for future decisions on trade relations with China, Iranian sanctions, and policy writ large. For if Trump sides with the establishment on an issue with minimal constraints, then he is more likely to do so on issues with greater constraints. This month, we are closing our 2/30 curve steepener recommendation, which is down 90bps since inception. The two alternative ways we have played rising U.S. growth and inflation prospects - shorting the 10-year Treasury vs. the Bunds and shorting the Fed Funds December 2018 futures - are in the money, 27bps and 46bs respectively. We are keeping both open for now. In addition, we are closing our long French industrial equities relative to German industrials for a gain of 10.26%. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 3 The playbook is really Nikita Khruschev's. 4 Please see "NK celebrates completion of nuke arsenal with fireworks," The Korea Herald, December 2, 2017, available at www.koreaherald.com. 5 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 7 Trump decided to impose tariffs on solar panels and washing machine, mostly affecting China and South Korea, on January 22. On steel and aluminum, Trump has until late April to decide, i.e. 90 days after reports from the Commerce Department due Jan. 15 and Jan. 22. Please see Andrew Restuccia and Doug Palmer, "White House preparing for trade crackdown," Politico, dated January 7, 2018, available at www.politico.com. 8 The U.S. Trade Representative's latest edition of an annual report to Congress over China's compliance with World Trade Organization (WTO) commitments declares that the U.S. "erred in supporting China's entry into the WTO on terms that have proven to be ineffective in securing China's embrace of an open, market-oriented trade regime." Please see "Joint Statement by the United States, European Union and Japan at MC11," December 2017, and "USTR Releases Annual Reports on China's and Russia's WTO Compliance," dated January 2018, available at ustr.gov. 9 Please see Lesley Wroughton, "Trump administration says U.S. mistakenly backed China WTO accession in 2001," Reuters, January 19, 2018, available at www.reuters.com. 10 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 11 Please see "China cuts communication with Taiwan," Al Jazeera, June 25, 2016, available at www.aljazeera.com; "Taiwan mistakenly fires supersonic missile killing one," BBC, July 1, 2016, available at www.bbc.com; Mark Landler and David E. Sanger, "Trump Speaks With Taiwan's Leader, An Affront To China," New York Times, December 2, 2016, available at www.nytimes.com. 12 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 13 Please see "U.S.-China: From Rivalry To Proxy Wars" in BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 14 Xi Jinping is rumored to have told Communist Party leaders in 2012 that the country would invade Taiwan by 2020. Please see Ian Easton, The Chinese Invasion Threat: Taiwan's Defense and American Strategy in Asia (Project 2049 Institute, 2017). 15 Please see BCA Geopolitical Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 16 National Chengchi University's long-running data series on Taiwanese identity shows that 58% of Taiwanese people identify as Taiwanese, and 70% under the age of 40. However, 77.5% of twenty-year olds also support the political status quo, i.e. do not seek political independence. Please see Marie-Alice McLean-Dreyfus, "Taiwan: Is there a political generation gap?" dated June 9, 2017, available at lowyinstitute.org. 17 Please see Richard C. Bush, "What Xi Jinping Said About Taiwan At The 19th Party Congress," Brookings Institution, October 19, 2017, available at www.brookings.edu. 18 Even the North Korea threat portfolio was bequeathed to him from former President Barack Obama, and it is being managed largely by the Pentagon and navy. 19 In other words, the incoming Trump administration implied that if China's leader Xi Jinping can speak directly to Taiwan's leader Ma Ying-jeou, then U.S. President Donald Trump can speak to Taiwanese President Tsai Ing-wen. This is a sign that alliances are alive and well, and that there are tensions, but it is not a harbinger of war. 20 Please see BCA Geopolitical Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 21 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. 22 The JCPOA did not actually legislate the removal of sanctions against Iran as the Obama administration was unable to get the Republican-controlled Senate to agree. Instead, the president has to use his executive authority to continue waiving sanctions against Iran. 23 That is only two years away from the average life expectancy in Iran. 24 Please see Ronald Inglehart and Christian Welzel, Modernization, Cultural Change, and Democracy, Cambridge: Cambridge University Press, 2005. 25 Iranian military personnel - almost always the Navy of the Iranian Revolutionary Guards - seized British Royal Navy personnel in 2007 and U.S. Navy personnel in 2016. 26 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com.

Highlights Multipolarity will peak in 2017 - geopolitical risks are spiking; Globalization is giving way to zero-sum mercantilism; U.S.-China relations are the chief risk to global stability; Turkey is the most likely state to get in a shooting war; Position for an inflation comeback; Go long defense, USD/EUR, and U.S. small caps vs. large caps. Feature Before the world grew mad, the Somme was a placid stream of Picardy, flowing gently through a broad and winding valley northwards to the English Channel. It watered a country of simple beauty. A. D. Gristwood, British soldier, later novelist. The twentieth century did not begin on January 1, 1900. Not as far as geopolitics is concerned. It began 100 years ago, on July 1, 1916. That day, 35,000 soldiers of the British Empire, Germany, and France died fighting over a couple of miles of territory in a single day. The 1916 Anglo-French offensive, also known as the Battle of the Somme, ultimately cost the three great European powers over a million and a half men in total casualties, of which 310,862 were killed in action over the four months of fighting. British historian A. J. P. Taylor put it aptly: idealism perished on the Somme. How did that happen? Nineteenth-century geopolitical, economic, and social institutions - carefully nurtured by a century of British hegemony - broke on the banks of the Somme in waves of human slaughter. What does this have to do with asset allocation? Calendars are human constructs devised to keep track of time. But an epoch is a period with a distinctive set of norms, institutions, and rules that order human activity. This "order of things" matters to investors because we take it for granted. It is a set of "Newtonian Laws" we assume will not change, allowing us to extrapolate the historical record into future returns.1 Since inception, BCA's Geopolitical Strategy has argued that the standard assumptions about our epoch no longer apply.2 Social orders are not linear, they are complex systems. And we are at the end of an epoch, one that defined the twentieth century by globalization, the spread of democracy, and American hegemony. Because the system is not linear, its break will cause non-linear outcomes. Since joining BCA's Editorial Team in 2011, we have argued that twentieth-century institutions are undergoing regime shifts. Our most critical themes have been: The rise of global multipolarity;3 The end of Sino-American symbiosis;4 The apex of globalization;5 The breakdown of laissez-faire economics;6 The passing of the emerging markets' "Goldilocks" era.7 Our view is that the world now stands at the dawn of the twenty-first century. The transition is not going to be pretty. Investors must stop talking themselves out of left-tail events by referring to twentieth-century institutions. Yes, the U.S. and China really could go to war in the next five years. No, their trade relationship will not prevent it. Was the slaughter at the Somme prevented by the U.K.-German economic relationship? In fact, our own strategy service may no longer make sense in the new epoch. "Geopolitics" is not some add-on to investor's asset-allocation process. It is as much a part of that process as are valuations, momentum, bottom-up analysis, and macroeconomics. To modify the infamous Milton Friedman quip, "We are all geopolitical strategists now." Five Decade Themes: We begin this Strategic Outlook by updating our old decade themes and introducing a few new ones. These will inform our strategic views over the next half-decade. Below, we also explain how they will impact investors in 2017. From Multipolarity To ... Making America Great Again Our central theme of global multipolarity will reach its dangerous apex in 2017. Multipolarity is the idea that the world has two or more "poles" of power - great nations - that pursue their interests independently. It heightens the risk of conflict. Since we identified this trend in 2012, the number of global conflicts has risen from 10 to 21, confirming our expectations (Chart 1). Political science theory is clear: a world without geopolitical leadership produces hegemonic instability. America's "hard power," declining in relative terms, created a vacuum that was filled by regional powers looking to pursue their own spheres of influence. Chart 1Frequency Of Geopolitical Conflicts Increases Under Multipolarity Frequency Of Geopolitical Conflicts Increases Under Multipolarity Frequency Of Geopolitical Conflicts Increases Under Multipolarity The investment implications of a multipolar world? The higher frequency of geopolitical crises has provided a tailwind to safe-haven assets such as U.S. Treasurys.8 Ironically, the relative decline of U.S. power is positive for U.S. assets.9 Although its geopolitical power has been in relative decline since 1990, the U.S. bond market has become more, not less, appealing over the same timeframe (Chart 2) Counterintuitively, it was American hegemony - i.e. global unipolarity after the Soviet collapse - that made the rise of China and other emerging markets possible. This created the conditions for globalization to flourish and for investors to leave the shores of developed markets in search of yield. It is the stated objective of President-elect Donald Trump, and a trend initiated under President Barack Obama, to reduce the United States' hegemonic responsibilities. As the U.S. withdraws, it leaves regional instability and geopolitical disequilibria in its wake, enhancing the value-proposition of holding on to low-beta American assets. We are now coming to the critical moment in this process, with neo-isolationist Trump doubling down on President Obama's aloof foreign policy. In 2017, therefore, multipolarity will reach its apex, leading several regional powers - from China to Turkey - to overextend themselves as they challenge the status quo. Chaos will ensue. (See below for more!) The inward shift in American policy will sow the seeds for the eventual reversal of multipolarity. America has always profited from geopolitical chaos. It benefits from being surrounded by two massive oceans, Canada, and the Sonora-Chihuahuan deserts. Following both the First and Second World Wars, the U.S.'s relative geopolitical power skyrocketed (Chart 3). Chart 2America Is A Safe-Haven,##br## Despite (Because Of?) Relative Decline America Is A Safe-Haven, Despite (Because Of?) Relative Decline America Is A Safe-Haven, Despite (Because Of?) Relative Decline Chart 3America Is Chaos-Proof bca.gps_so_2016_12_14_c3 bca.gps_so_2016_12_14_c3 Over the next 12-24 months, we expect the chief investment implications of multipolarity - volatility, tailwind to safe-haven assets, emerging-market underperformance, and de-globalization - to continue to bear fruit. However, as the U.S. comes to terms with multipolarity and withdraws support for critical twentieth-century institutions, it will create conditions that will ultimately reverse its relative decline and lead to a more unipolar tendency (or possibly bipolar, with China). Therefore, Donald Trump's curious mix of isolationism, anti-trade rhetoric, and domestic populism may, in the end, Make America Great Again. But not for the reasons he has promised-- not because the U.S. will outperform the rest of the world in an absolute sense. Rather, America will become great again in a relative sense, as the rest of the world drifts towards a much scarier, darker place without American hegemony. Bottom Line: For long-term investors, the apex of multipolarity means that investing in China and broader EM is generally a mistake. Europe and Japan make sense in the interim due to overstated political risks, relatively easy monetary policy, and valuations, but even there risks will mount due to their high-beta qualities. The U.S. will own the twenty-first century. From Globalization To ... Mercantilism "The industrial glory of England is departing, and England does not know it. There are spasmodic outcries against foreign competition, but the impression they leave is fleeting and vague ... German manufacturers ... are undeniably superiour to those produced by British houses. It is very dangerous for men to ignore facts that they may the better vaunt their theories ... This is poor patriotism." Ernest Edwin Williams, Made in Germany (1896) The seventy years of British hegemony that followed the 1815 Treaty of Paris ending the Napoleonic Wars were marked by an unprecedented level of global stability. Britain's cajoled enemies and budding rivals swallowed their wounded pride and geopolitical appetites and took advantage of the peace to focus inwards, industrialize, and eventually catch up to the U.K.'s economy. Britain, by providing expensive global public goods - security of sea lanes, off-shore balancing,10 a reserve currency, and financial capital - resolved the global collective-action dilemma and ushered in an era of dramatic economic globalization. Sound familiar? It should. As Chart 4 shows, we are at the conclusion of a similar period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. There are other forces at work, such as pernicious wage deflation that has soured the West's middle class on free trade and immigration. But the main threat to globalization is at heart geopolitical. The breakdown of twentieth-century institutions, norms, and rules will encourage regional powers to set up their own spheres of influence and to see the global economy as a zero-sum game instead of a cooperative one.11 Chart 4Multipolarity And De-Globalization Go Hand-In-Hand bca.gps_so_2016_12_14_c4 bca.gps_so_2016_12_14_c4 At the heart of this geopolitical process is the end of Sino-American symbiosis. We posited in February that Charts 5 and 6 are geopolitically unsustainable.12 China cannot keep capturing an ever-increasing global market share for exports while exporting deflation; particularly now that its exports are rising in complexity and encroaching on the markets of developed economies (Chart 7). China's economic policy might have been acceptable in an era of robust global growth and American geopolitical confidence, but we live in a world that is, for the time being, devoid of both. Chart 5China's Share Of Global##br## Exports Has Skyrocketed... bca.gps_so_2016_12_14_c5 bca.gps_so_2016_12_14_c5 Chart 6And Now China ##br##Is Exporting Deflation bca.gps_so_2016_12_14_c6 bca.gps_so_2016_12_14_c6 China and the U.S. are no longer in a symbiotic relationship. The close embrace between U.S. household leverage and Chinese export-led growth is over (Chart 8). Today the Chinese economy is domestically driven, with government stimulus and skyrocketing leverage playing a much more important role than external demand. Exports make up only 19% of China's GDP and 12% of U.S. GDP. The two leading economies are far less leveraged to globalization than the conventional wisdom would have it. Chart 7China's Steady Climb Up ##br##The Value Ladder Continues Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 8Sino-American ##br##Symbiosis Is Over bca.gps_so_2016_12_14_c8 bca.gps_so_2016_12_14_c8 Chinese policymakers have a choice. They can double down on globalization and use competition and creative destruction to drive up productivity growth, moving the economy up the value chain. Or they can use protectionism - particularly non-tariff barriers, as they have been doing - to defend their domestic market from competition.13 We expect that they will do the latter, especially in an environment where anti-globalization rhetoric is rising in the West and protectionism is already on the march (Chart 9). Chart 9Protectionism On The March Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The problem with this likely choice, however, is that it breaks up the post-1979 quid-pro-quo between Washington and Beijing. The "quid" was the Chinese entry into the international economic order (including the WTO in 2001), which the U.S. supported; the "quo" was that Beijing would open its economy as it became wealthy. Today, 45% of China's population is middle-class, which makes China potentially the world's second-largest market after the EU. If China decides not to share its middle class with the rest of the world, then the world will quickly move towards mercantilism - particularly with regard to Chinese imports. Mercantilism was a long-dominant economic theory, in Europe and elsewhere, that perceived global trade to be a zero-sum game and economic policy to be an extension of the geopolitical "Great Game" between major powers. As such, net export growth was the only way to prosperity and spheres of influence were jealously guarded via trade barriers and gunboat diplomacy. What should investors do if mercantilism is back? In a recent joint report with the BCA's Global Alpha Sector Strategy, we argued that investors should pursue three broad strategies: Buy small caps (or microcaps) at the expense of large caps (or mega caps) across equity markets as the former are almost universally domestically focused; Favor closed economies levered on domestic consumption, both within DM and EM universes; Stay long global defense stocks; mercantilism will lead to more geopolitical risk (Chart 10). Chart 10Defense Stocks Are A No-Brainer Defense Stocks Are A No-Brainer Defense Stocks Are A No-Brainer Investors should also expect a more inflationary environment over the next decade. De-globalization will mean marginally less trade, less migration, and less free movement of capital across borders. These are all inflationary. Bottom Line: Mercantilism is back. Sino-American tensions and peak multipolarity will impair coordination. It will harden the zero-sum game that erodes globalization and deepens geopolitical tensions between the world's two largest economies.14 One way to play this theme is to go long domestic sectors and domestically-oriented economies relative to export sectors and globally-exposed economies. The real risk of mercantilism is that it is bedfellows with nationalism and jingoism. We began this section with a quote from an 1896 pamphlet titled "Made in Germany." In it, British writer E.E. Williams argued that the U.K. should abandon free trade policies due to industrial competition from Germany. Twenty years later, 350,000 men died in the inferno of the Somme. From Legal To ... Charismatic Authority Legal authority, the bedrock of modern democracy, is a critical pillar of civilization that investors take for granted. The concept was defined in 1922 by German sociologist Max Weber. Weber's seminal essay, "The Three Types of Legitimate Rule," argues that legal-rational authority flows from the institutions and laws that define it, not the individuals holding the office.15 This form of authority is investor-friendly because it reduces uncertainty. Investors can predict the behavior of policymakers and business leaders by learning the laws that govern their behavior. Developed markets are almost universally made up of countries with such norms of "good governance." Investors can largely ignore day-to-day politics in these systems, other than the occasional policy shift or regulatory push that affects sector performance. Weber's original essay outlined three forms of authority, however. The other two were "traditional" and "charismatic."16 Today we are witnessing the revival of charismatic authority, which is derived from the extraordinary characteristics of an individual. From Russia and the U.S. to Turkey, Hungary, the Philippines, and soon perhaps Italy, politicians are winning elections on the back of their messianic qualities. The reason for the decline of legal-rational authority is threefold: Elites that manage governing institutions have been discredited by the 2008 Great Recession and subsequent low-growth recovery. Discontent with governing institutions is widespread in the developed world (Chart 11). Elite corruption is on the rise. Francis Fukuyama, perhaps America's greatest political theorist, argues that American political institutions have devolved into a "system of legalized gift exchange, in which politicians respond to organized interest groups that are collectively unrepresentative of the public as a whole."17 Political gridlock across developed and emerging markets has forced legal-rational policymakers to perform like charismatic ones. European policymakers have broken laws throughout the euro-area crisis, with the intention of keeping the currency union alive. President Obama has issued numerous executive orders due to congressional gridlock. While the numbers of executive orders have declined under Obama, their economic significance has increased (Chart 12). Each time these policymakers reached around established rules and institutions in the name of contingencies and crises, they opened the door wider for future charismatic leaders to eschew the institutions entirely. Chart 11As Institutional Trust Declines, ##br##Voters Turn To Charismatic Leaders As Institutional Trust Declines, Voters Turn To Charismatic Leaders As Institutional Trust Declines, Voters Turn To Charismatic Leaders Chart 12Obama ##br##The Regulator Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Furthermore, a generational shift is underway. Millennials do not understand the value of legal-rational institutions and are beginning to doubt the benefits of democracy itself (Chart 13). The trend appears to be the most pronounced in the U.S. and U.K., perhaps because neither experienced the disastrous effects of populism and extremism of the 1930s. In fact, millennials in China appear to view democracy as more essential to the "good life" than their Anglo-Saxon peers. Chart 13Who Needs Democracy When You Have Tinder? Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Charismatic leaders can certainly outperform expectations. Donald Trump may end up being FDR. The problem for investors is that it is much more difficult to predict the behavior of a charismatic authority than a legal-rational one.18 For example, President-elect Trump has said that he will intervene in the U.S. economy throughout his four-year term, as he did with Carrier in Indiana. Whether these deals are good or bad, in a normative sense, is irrelevant. The point is that bottom-up investment analysis becomes useless when analysts must consider Trump's tweets, as well as company fundamentals, in their earnings projections! We suspect that the revival of charismatic leadership - and the danger that it might succeed in upcoming European elections - at least partly explains the record high levels of global policy uncertainty (Chart 14). Markets do not seem to have priced in the danger fully yet. Global bond spreads are particularely muted despite the high levels of uncertainty. This is unsustainable. Chart 14Are Assets Fully Pricing In Global Uncertainty? Are Assets Fully Pricing In Global Uncertainty? Are Assets Fully Pricing In Global Uncertainty? Bottom Line: The twenty-first century is witnessing the return of charismatic authority and erosion of legal-rational authority. This should be synonymous with uncertainty and market volatility over the next decade. In 2017, expect a rise in EuroStoxx volatility. From Laissez-Faire To ... Dirigisme The two economic pillars of the late twentieth century have been globalization and laissez-faire capitalism, or neo-liberalism. The collapse of the Soviet Union ended the communist challenge, anointing the U.S.-led "Washington Consensus" as the global "law of the land." The tenets of this epoch are free trade, fiscal discipline, low tax burden, and withdrawal of the state from the free market. Not all countries approached the new "order of things" with equal zeal, but most of them at least rhetorically committed themselves to asymptotically approaching the American ideal. Chart 15Debt Replaced Wages##br## In Laissez-Faire Economies Debt Replaced Wages In Laissez-Faire Economies Debt Replaced Wages In Laissez-Faire Economies The 2008 Great Recession put an end to the bull market in neo-liberal ideology. The main culprit has been the low-growth recovery, but that is not the full story. Tepid growth would have been digested without a political crisis had it not followed decades of stagnating wages. With no wage growth, households in the most laissez-faire economies of the West gorged themselves on debt (Chart 15) to keep up with rising cost of housing, education, healthcare, and childcare -- all staples of a middle-class lifestyle. As such, the low-growth context after 2008 has combined with a deflationary environment to produce the most pernicious of economic conditions: debt-deflation, which Irving Fisher warned of in 1933.19 It is unsurprising that globalization became the target of middle-class angst in this context. Globalization was one of the greatest supply-side shocks in recent history: it exerted a strong deflationary force on wages (Chart 16). While it certainly lifted hundreds of millions of people out of poverty in developing nations, globalization undermined those low-income and middle-class workers in the developed world whose jobs were most easily exported. World Bank economist Branko Milanovic's infamous "elephant trunk" shows the stagnation of real incomes since 1988 for the 75-95 percentile of the global income distribution - essentially the West's middle class (Chart 17).20 It is this section of the elephant trunk that increasingly supports populism and anti-globalization policies, while eschewing laissez faire liberalism. In our April report, "The End Of The Anglo-Saxon Economy," we posited that the pivot away from laissez-faire capitalism would be most pronounced in the economies of its greatest adherents, the U.S. and U.K. We warned that Brexit and the candidacy of Donald Trump should be taken seriously, while the populist movements in Europe would surprise to the downside. Why the gap between Europe and the U.S. and U.K.? Because Europe's cumbersome, expensive, inefficient, and onerous social-welfare state finally came through when it mattered: it mitigated the pernicious effects of globalization and redistributed enough of the gains to temper populist angst. Chart 16Globalization: A Deflationary Shock Globalization: A Deflationary Shock Globalization: A Deflationary Shock Chart 17Globalization: No Friend To DM Middle Class Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now This view was prescient in 2016. The U.K. voted to leave the EU, Trump triumphed, while European populists stumbled in both the Spanish and Austrian elections. The Anglo-Saxon median voter has essentially moved to the left of the economic spectrum (Diagram 1).21 The Median Voter Theorem holds that policymakers will follow the shift to the left in order to capture as many voters as possible under the proverbial curve. In other words, Donald Trump and Bernie Sanders are not political price-makers but price-takers. Diagram 1The Median Voter Is Moving To The Left In The U.S. And U.K. Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now How does laissez-faire capitalism end? In socialism or communism? No, the institutions that underpin capitalism in the West - private property, rule of law, representative government, and enforcement of contracts - remain strong. Instead, we expect to see more dirigisme, a form of capitalism where the state adopts a "directing" rather than merely regulatory role. In the U.S., Donald Trump unabashedly campaigned on dirigisme. We do not expand on the investment implications of American dirigisme in this report (we encourage clients to read our post-election treatment of Trump's domestic politics).22 But investors can clearly see the writing on the wall: a late-cycle fiscal stimulus will be positive for economic growth in the short term, but most likely more positive for inflation in the long term. Donald Trump's policies therefore are a risk to bonds, positive for equities (in the near term), and potentially negative for both in the long term if stagflation results from late-cycle stimulus. What about Europe? Is it not already quite dirigiste? It is! But in Europe, we see a marginal change towards the right, not the left. In Spain, the supply-side reforms of Prime Minister Mariano Rajoy will remain in place, as he won a second term this year. In France, right-wing reformer - and self-professed "Thatcherite" - François Fillon is likely to emerge victorious in the April-May presidential election. And in Germany, the status-quo Grand Coalition will likely prevail. Only in Italy are there risks, but even there we expect financial markets to force the country - kicking and screaming - down the path of reforms. Bottom Line: In 2017, the market will be shocked to find itself face-to-face with a marginally more laissez-faire Europe and a marginally more dirigiste America and Britain. Investors should overweight European assets in a global portfolio given valuations, relative monetary policy (which will remain accommodative in Europe), a weak euro, and economic fundamentals (Chart 18), and upcoming political surprises. For clients with low tolerance of risk and volatility, a better entry point may exist following the French presidential elections in the spring. From Bias To ... Conspiracies As with the printing press, the radio, film, and television before it, the Internet has created a super-cyclical boom in the supply and dissemination of information. The result of the sudden surge is that quality and accountability are declining. The mainstream media has dubbed this the "fake news" phenomenon, no doubt to differentiate the conspiracy theories coursing through Facebook and Twitter from the "real news" of CNN and MSNBC. The reality is that mainstream media has fallen far short of its own vaunted journalistic standards (Chart 19). Chart 18Europe's Economy Is Holding Up Europe's Economy Is Holding Up Europe's Economy Is Holding Up Chart 19 "Mainstream Media" Is A Dirty Word For Many "Mainstream Media" Is A Dirty Word For Many We are not interested in this debate, nor are we buying the media narrative that "fake news" delivered Trump the presidency. Instead, we are focused on how geopolitical and political information is disseminated to voters, investors, and ultimately priced by the market. We fear that markets will struggle to price information correctly due to three factors: Low barriers to entry: The Internet makes publishing easy. Information entrepreneurs - i.e. hack writers - and non-traditional publications ("rags") are proliferating. The result is greater output but a decrease in quality control. For example, Facebook is now the second most trusted source of news for Americans (Chart 20). Cost-cutting: The boom in supply has squeezed the media industry's finances. Newspapers have died in droves; news websites and social-media giants have mushroomed (Chart 21). News companies are pulling back on things like investigative reporting, editorial oversight, and foreign correspondent desks. Foreign meddling: In this context, governments have gained a new advantage because they can bring superior financial resources and command-and-control to an industry that is chaotic and cash-strapped. Russian news outlets like RT and Sputnik have mastered this game - attracting "clicks" around the world from users who are not aware they are reading Russian propaganda. China has also raised its media profile through Western-accessible propaganda like the Global Times, but more importantly it has grown more aggressive at monitoring, censoring, and manipulating foreign and domestic media. Chart 20Facebook Is The New Cronkite? Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 21The Internet Has Killed Journalism Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The above points would be disruptive enough alone. But we know that technology is not the root cause of today's disruptions. Income inequality, the plight of the middle class, elite corruption, unchecked migration, and misguided foreign policy have combined to create a toxic mix of distrust and angst. In the West, the decline of the middle class has produced a lack of socio-political consensus that is fueling demand for media of a kind that traditional outlets can no longer satisfy. Media producers are scrambling to meet this demand while struggling with intense competition from all the new entrants and new platforms. What is missing is investment in downstream refining and processing to convert the oversupply of crude information into valuable product for voters and investors.23 Otherwise, the public loses access to "transparent" or baseline information. Obviously the baseline was never perfect. Both the Vietnam and Iraq wars began as gross impositions on the public's credulity: the Gulf of Tonkin Incident and Saddam Hussein's weapons of mass destruction. But there was a shared reference point across society. The difference today, as we see it, is that mass opinion will swing even more wildly during a crisis as a result of the poor quality of information that spreads online and mobilizes social networks more rapidly than ever before. We could have "flash mobs" in the voting booth - or on the steps of the Supreme Court - just like "flash crashes" in financial markets, i.e. mass movements borne of passing misconceptions rather than persistent misrule. Election results are more likely to strain the limits of the margin of error, while anti-establishment candidates are more likely to remain viable despite dubious platforms. What does this mean for investors? Fundamental analysis of a country's political and geopolitical risk is now an essential tool in the investor toolkit. If investors rely on the media, and the market prices what the media reports, then the same investors will continue to get blindsided by misleading probabilities, as with Brexit and Trump (Chart 22). While we did not predict these final outcomes, we consistently advised clients, for months in advance, that the market probabilities were too low and serious hedging was necessary. Those who heeded our advice cheered their returns, even as some lamented the electoral returns. Chart 22Get Used To Tail-Risk Events Get Used To Tail-Risk Events Get Used To Tail-Risk Events Bottom Line: Keep reading BCA's Geopolitical Strategy! Final Thoughts On The Next Decade The nineteenth century ended in the human carnage that was the Battle of the Somme. The First World War ushered in social, economic, political, geopolitical, demographic, and technological changes that drove the evolution of twentieth-century institutions, rules, and norms. It created the "order of things" that we all take for granted today. The coming decade will be the dawn of the new geopolitical century. We can begin to discern the ordering of this new epoch. It will see peak multipolarity lead to global conflict and disequilibrium, with globalization and laissez-faire economic consensus giving way to mercantilism and dirigisme. Investors will see the benevolent deflationary impulse of globalization evolve into state intervention in the domestic economy and the return of inflation. Globally oriented economies and sectors will underperform domestic ones. Developed markets will continue to outperform emerging markets, particularly as populism spreads to developing economies that fail to meet expectations of their rising middle classes. Over the next ten years, these changes will leave the U.S. as the most powerful country in the world. China and wider EM will struggle to adapt to a less globalized world, while Europe and Japan will focus inward. The U.S. is essentially a low-beta Great Power: its economy, markets, demographics, natural resources, and security are the least exposed to the vagaries of the rest of the world. As such, when the rest of the world descends into chaos, the U.S. will hide behind its Oceans, and Canada, and the deserts of Mexico, and flourish. Five Themes For 2017: Our decade themes inform our view of cyclical geopolitical events and crises, such as elections and geopolitical tensions. As such, they form our "net assessment" of the world and provide a prism through which we refract geopolitical events. Below we address five geopolitical themes that we expect to drive the news flow, and thus the markets, in 2017. Some themes are Red Herrings (overstated risks) and thus present investment opportunities, others are Black Swans (understated risks) and are therefore genuine risks. Europe In 2017: A Trophy Red Herring? Europe's electoral calendar is ominously packed (Table 1). Four of the euro area's five largest economies are likely to have elections in 2017. Another election could occur if Spain's shaky minority government collapses. Table 1 Europe In 2017 Will Be A Headline Risk Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now We expect market volatility to be elevated throughout the year due to the busy calendar. In this context, we advise readers to follow our colleague Dhaval Joshi at BCA's European Investment Strategy. Dhaval recommends that BCA clients combine every €1 of equity exposure with 40 cents of exposure to VIX term-structure, which means going long the nearest-month VIX futures and equally short the subsequent month's contract. The logic is that the term structure will invert sharply if risks spike.24 While we expect elevated uncertainty and lots of headline risk, we do not believe the elections in 2017 will transform Europe's future. As we have posited since 2011, global multipolarity increases the logic for European integration.25 Crises driven by Russian assertiveness, Islamic terrorism, and the migration wave are not dealt with more effectively or easily by nation states acting on their own. Thus far, it appears that Europeans agree with this assessment: polling suggests that few are genuinely antagonistic towards the euro (Chart 23) or the EU (Chart 24). In our July report called "After BREXIT, N-EXIT?" we posited that the euro area will likely persevere over at least the next five years.26 Chart 23Support For The Euro Remains Stable Support For The Euro Remains Stable Support For The Euro Remains Stable Chart 24Few Europeans Want Out Of The EU Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Take the Spanish and Austrian elections in 2016. In Spain, Mariano Rajoy's right-wing People's Party managed to hold onto power despite four years of painful internal devaluations and supply-side reforms. In Austria, the establishment candidate for president, Alexander Van der Bellen, won the election despite Austria's elevated level of Euroskepticism (Chart 24), its central role in the migration crisis, and the almost comically unenthusiastic campaign of the out-of-touch Van der Bellen. In both cases, the centrist candidates survived because voters hesitated when confronted with an anti-establishment choice. Next year, we expect more of the same in three crucial elections: The Netherlands: The anti-establishment and Euroskeptic Party for Freedom (PVV) will likely perform better than it did in the last election, perhaps even doubling its 15% result in 2012. However, it has no chance of forming a government, given that all the other parties contesting the election are centrist and opposed to its Euroskeptic agenda (Chart 25). Furthermore, support for the euro remains at a very high level in the country (Chart 26). This is a reality that the PVV will have to confront if it wants to rule the Netherlands. Chart 25No Government For Dutch Euroskeptics Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 26The Netherlands & Euro: Love Affair The Netherlands & Euro: Love Affair The Netherlands & Euro: Love Affair France: Our high conviction view is that Marine Le Pen, leader of the Euroskeptic National Front (FN), will be defeated in the second round of the presidential election.27 Despite three major terrorist attacks in the country, unchecked migration crisis, and tepid economic growth, Le Pen's popularity peaked in 2013 (Chart 27). She continues to poll poorly against her most likely opponents in the second round, François Fillon and Emmanuel Macron (Chart 28). Investors who doubt the polls should consider the FN's poor performance in the December 2015 regional elections, a critical case study for Le Pen's viability in 2017.28 Chart 27Le Pen's Polling: ##br##Head And Shoulder Formation? Le Pen's Polling: Head And Shoulder Formation? Le Pen's Polling: Head And Shoulder Formation? Chart 28Le Pen Will Not Be##br## Next French President Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Germany: Chancellor Angela Merkel's popularity is holding up (Chart 29), the migration crisis has abated (Chart 30), and there remains a lot of daylight between the German establishment and populist parties (Chart 31). The anti-establishment Alternative für Deutschland will enter parliament, but remain isolated. Chart 29Merkel's Approval Rating Has Stabilized Merkel's Approval Rating Has Stabilized Merkel's Approval Rating Has Stabilized Chart 30Migration Crisis Is Abating bca.gps_so_2016_12_14_c30 bca.gps_so_2016_12_14_c30 Chart 31There Is A Lot Of Daylight... bca.gps_so_2016_12_14_c31 bca.gps_so_2016_12_14_c31 The real risk in 2017 remains Italy. The country has failed to enact any structural reforms, being a laggard behind the reform poster-child Spain (Chart 32). Meanwhile, support for the euro remains in the high 50s, which is low compared to the euro-area average (Chart 33). Polls show that if elections were held today, the ruling Democratic Party would gain a narrow victory (Chart 34). However, it is not clear what electoral laws would apply to the contest. The reformed electoral system for the Chamber of Deputies remains under review by the Constitutional Court until at least February. This will make all the difference between further gridlock and a viable government. Chart 32Italy Is Europe's bca.gps_so_2016_12_14_c32 bca.gps_so_2016_12_14_c32 Chart 33Italy Lags Peers On Euro Support bca.gps_so_2016_12_14_c33 bca.gps_so_2016_12_14_c33 Chart 34Italy's Next Election Is Too Close To Call bca.gps_so_2016_12_14_c34 bca.gps_so_2016_12_14_c34 Investors should consider three factors when thinking about Italy in 2017: The December constitutional referendum was not a vote on the euro and thus cannot serve as a proxy for a future referendum.29 The market will punish Italy the moment it sniffs out even a whiff of a potential Itexit referendum. This will bring forward the future pain of redenomination, influencing voter choices. Benefits of the EU membership for Italy are considerable, especially as they allow the country to integrate its unproductive, poor, and expensive southern regions.30 Sans Europe, the Mezzogiorno (Southern Italy) is Rome's problem, and it is a big one. The larger question is whether the rest of Italy's euro-area peers will allow the country to remain mired in its unsustainable status quo. We think the answer is yes. First, Italy is too big to fail given the size of its economy and sovereign debt market. Second, how unsustainable is the Italian status quo? OECD projections for Italy's debt-to-GDP ratio are not ominous. Chart 35 shows four scenarios, the most likely one charting Italy's debt-to-GDP rise from 133% today to about 150% by 2060. Italy's GDP growth would essentially approximate 0%, but its impressive budget discipline would ensure that its debt load would only rise marginally (Chart 36). Chart 35So What If Italy's Debt-To-GDP Ends Up At 170%? bca.gps_so_2016_12_14_c35 bca.gps_so_2016_12_14_c35 Chart 36Italy Has Learned To Live With Its Debt Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now This may seem like a dire prospect for Italy, but it ensures that the ECB has to maintain its accommodative stance in Europe even as the Fed continues its tightening cycle, a boon for euro-area equities as a whole. In other words, Italy's predicament would be unsustainable if the country were on its own. Its "sick man" status would be terminal if left to its own devices. But as a patient in the euro-area hospital, it can survive. And what happens to the euro area beyond our five-year forecasting horizon? We are not sure. Defeat of anti-establishment forces in 2017 will give centrist policymakers another electoral cycle to resolve the currency union's built-in flaws. If the Germans do not budge on greater fiscal integration over the next half-decade, then the future of the currency union will become murkier. Bottom Line: Remain long the nearest-month VIX futures and equally short the subsequent month's contract. We have held this position since September 14 and it has returned -0.84%. The advantage of this strategy is that it is a near-perfect hedge when risk assets sell off, but pays a low price for insurance. Investors with high risk tolerance who can stomach some volatility should take the plunge and overweight euro-area equities in a global equity portfolio. Solid global growth prospects, accommodative monetary policy, euro weakness, and valuations augur a solid year for euro-area equities. Politics will be a red herring as euro-area stocks climb the proverbial wall of worry in 2017. U.S.-Russia Détente: A Genuine Investment Opportunity Trump's election is good news for Russia. Over the past 16 years, Russia has methodically attempted to collect the pieces from the Soviet collapse. Putin sought to defend the Russian sphere of influence from outside powers (Ukraine and Belarus, the Caucasus, Central Asia). Putin also needed to rally popular support at various times by distracting the public. We view Ukraine and Syria through this prism. Lastly, Russia acted aggressively because it needed to reassure its allies that it would stand up for them.31 And yet the U.S. can live with a "strong" Russia. It can make a deal if the Trump administration recognizes some core interests (e.g. Crimea) and calls off the promotion of democracy in Russia's sphere, which Putin considers an attempt to undermine his rule. As we argued during the Ukraine invasion, it is the U.S., not Russia, which poses the greatest risk of destabilization.32 The U.S. lacks constraints in this theater. It can be aggressive towards Russia and face zero consequences: it has no economic relationship with Russia and does not stand directly in the way of any Russian reprisals, unlike Europe. That is why we think Trump and Putin will reset relations. Trump's team may be comfortable with Russia having a sphere of influence, unlike the Obama administration, which explicitly rejected this idea. The U.S. could even pledge not to expand NATO further, given that it has already expanded as far as it can feasibly and credibly go. Note, however, that a Russo-American truce may not last long. George W. Bush famously "looked into Putin's eyes and ... saw his soul," but relations soured nonetheless. Obama went further with his "Russian reset," removing European missile defense plans from Poland and the Czech Republic. These are avowed NATO allies, and this occurred merely one year after Russian troops marched on Georgia. And yet Moscow and Washington ended up rattling sabers and meddling in each other's internal affairs anyway. Chart 37Thaw In Russian-West##br## Cold War Is Bullish Europe bca.gps_so_2016_12_14_c37 bca.gps_so_2016_12_14_c37 Ultimately, U.S. resets fail because Russia is in structural decline and attempting to hold onto a very large sphere of influence whose citizens are not entirely willing participants.33 Because Moscow must often use blunt force to prevent the revolt of its vassal states (e.g. Georgia in 2008, Ukraine in 2014), it periodically revives tensions with the West. Unless Russia strengthens significantly in the next few years, which we do not expect, then the cycle of tensions will continue. On the horizon may be Ukraine-like incidents in neighboring Belarus and Kazakhstan, both key components of the Russian sphere of influence. Bottom Line: Russia will get a reprieve from U.S. pressure. While we expect Europe to extend sanctions through 2017, a rapprochement with Washington will ultimately thaw relations between Europe and Russia by the end of that year. Europe will benefit from resuming business as usual. It will face less of a risk of Russian provocations via the Middle East and cybersecurity. The ebbing of the Russian geopolitical risk premium will have a positive effect on Europe, given its close correlation with European risk assets since the crisis in Ukraine (Chart 37). Investors who want exposure to Russia may consider overweighing Russian equities to Malaysian. BCA's Emerging Market Strategy has initiated this position for a 55.6% gain since March 2016 and our EM strategists believe there is more room to run for this trade. We recommend that investors simply go long Russia relative to the broad basket of EM equities. The rally in oil prices, easing of the geopolitical risk premium, and hints of pro-market reforms from the Kremlin will buoy Russian equities further in 2017. Middle East: ISIS Defeat Is A Black Swan In February 2016, we made two bold predictions about the Middle East: Iran-Saudi tensions had peaked;34 The defeat of ISIS would entice Turkey to intervene militarily in both Iraq and Syria.35 The first prediction was based on a simple maxim: sustained geopolitical conflict requires resources and thus Saudi military expenditures are unsustainable when a barrel of oil costs less than $100. Saudi Arabia overtook Russia in 2015 as the globe's third-largest defense spender (Chart 38)! Chart 38Saudi Arabia: Lock And Load Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The mini-détente between Iran and Saudi Arabia concluded in 2016 with the announced OPEC production cut and freeze. While we continue to see the OPEC deal as more of a recognition of the status quo than an actual cut (because OPEC production has most likely reached its limits), nevertheless it is significant as it will slightly hasten the pace of oil-market rebalancing. On the margin, the OPEC deal is therefore bullish for oil prices. Our second prediction, that ISIS is more of a risk to the region in defeat than in glory, was highly controversial. However, it has since become consensus, with several Western intelligence agencies essentially making the same claim. But while our peers in the intelligence community have focused on the risk posed by returning militants to Europe and elsewhere, our focus remains on the Middle East. In particular, we fear that Turkey will become embroiled in conflicts in Syria and Iraq, potentially in a proxy war with Iran and Russia. The reason for this concern is that the defeat of the Islamic State will create a vacuum in the Middle East that the Syrian and Iraqi Kurds are most likely to fill. This is unacceptable to Turkey, which has intervened militarily to counter Kurdish gains and may do so in the future. We are particularly concerned about three potential dynamics: Direct intervention in Syria and Iraq: The Turkish military entered Syria in August, launching operation "Euphrates Shield." Turkey also reinforced a small military base in Bashiqa, Iraq, only 15 kilometers north of Mosul. Both operations were ostensibly undertaken against the Islamic State, but the real intention is to limit the Syrian and Iraqi Kurds. As Map 1 illustrates, Kurds have expanded their territorial control in both countries. Map 1Kurdish Gains In Syria & Iraq Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Conflict with Russia and Iran: President Recep Erdogan has stated that Turkey's objective in Syria is to remove President Bashar al-Assad from power.36 Yet Russia and Iran are both involved militarily in the country - the latter with regular ground troops - to keep Assad in power. Russia and Turkey did manage to cool tensions recently. Yet the Turkish ground incursion into Syria increases the probability that tensions will re-emerge. Meanwhile, in Iraq, Erdogan has cast himself as a defender of Sunni Arabs and has suggested that Turkey still has a territorial claim to northern Iraq. This stance would put Ankara in direct confrontation with the Shia-dominated Iraqi government, allied with Iran. Turkey-NATO/EU tensions: Tensions have increased between Turkey and the EU over the migration deal they signed in March 2016. Turkey claims that the deal has stemmed the flow of migrants to Europe, which is dubious given that the flow abated well before the deal was struck. Since then, Turkey has threatened to open the spigot and let millions of Syrian refugees into Europe. This is likely a bluff as Turkey depends on European tourists, import demand, and FDI for hard currency (Chart 39). If Erdogan acted on his threat and unleashed Syrian refugees into Europe, the EU could abrogate the 1995 EU-Turkey customs union agreement and impose economic sanctions. The Turkish foray into the Middle East poses the chief risk of a "shooting war" that could impact global investors in 2017. While there are much greater geopolitical games afoot - such as increasing Sino-American tensions - this one is the most likely to produce military conflict between serious powers. It would be disastrous for Turkey. The broader point is that the redrawing of the Middle East map is not yet complete. As the Islamic State is defeated, the Sunni population of Iraq and Syria will remain at risk of Shia domination. As such, countries like Turkey and Saudi Arabia could be drawn into renewed proxy conflicts to prevent complete marginalization of the Sunni population. While tensions between Turkey, Russia, and Iran will not spill over into oil-producing regions of the Middle East, they may cloud Iraq's future. Since 2010, Iraq has increased oil production by 1.6 million barrels per day. This is about half of the U.S. shale production increase over the same time frame. As such, Iraq's production "surprise" has been a major contributor to the 2014-2015 oil-supply glut. However, Iraq needs a steady inflow of FDI in order to boost production further (Chart 40). Proxy warfare between Turkey, Russia, and Iran - all major conventional military powers - on its territory will go a long way to sour potential investors interested in Iraqi production. Chart 39Turkey Is Heavily Dependent On The EU Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 40Iraq Is The Big, And Cheap, Hope bca.gps_so_2016_12_14_c40 bca.gps_so_2016_12_14_c40 This is a real problem for global oil supply. The International Energy Agency sees Iraq as a critical source of future global oil production. Chart 41 shows that Iraq is expected to contribute the second-largest increase in oil production by 2020. And given Iraq's low breakeven production cost, it may be the last piece of real estate - along with Iran - where the world can get a brand-new barrel of oil for under $13. In addition to the risk of expanding Turkish involvement in the region, investors will also have to deal with the headline risk of a hawkish U.S. administration pursuing diplomatic brinkmanship against Iran. We do not expect the Trump administration to abrogate the Iran nuclear deal due to several constraints. First, American allies will not go along with new sanctions. Second, Trump's focus is squarely on China. Third, the U.S. does not have alternatives to diplomacy, since bombing Iran would be an exceedingly complex operation that would bog down American forces in the Middle East. When we put all the risks together, a geopolitical risk premium will likely seep into oil markets in 2017. BCA's Commodity & Energy Strategy argues that the physical oil market is already balanced (Chart 42) and that the OPEC deal will help draw down bloated inventories in 2017. This means that global oil spare capacity will be very low next year, with essentially no margin of safety in case of a major supply loss. Given the political risks of major oil producers like Nigeria and Venezuela, this is a precarious situation for the oil markets. Chart 41Iraq Really Matters For Global Oil Production Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 42Oil Supply Glut Is Gone In 2017 bca.gps_so_2016_12_14_c42 bca.gps_so_2016_12_14_c42 Bottom Line: Given our geopolitical view of risks in the Middle East, balanced oil markets, lack of global spare capacity, the OPEC production cut, and ongoing capex reductions, we recommend clients to follow BCA's Commodity & Energy Strategy view of expecting widening backwardation in the new year.37 U.S.-China: From Rivalry To Proxy Wars President-elect Trump has called into question the U.S.'s adherence to the "One China policy," which holds that "there is but one China and Taiwan is part of China" and that the U.S. recognizes only the People's Republic of China as the legitimate Chinese government. There is widespread alarm about Trump's willingness to use this policy, the very premise of U.S.-China relations since 1978, as a negotiating tool. And indeed, Sino-U.S. relations are very alarming, as we have warned our readers since 2012.38 Trump is a dramatic new agent reinforcing this trend. Trump's suggestion that the policy could be discarded - and his break with convention in speaking to the Taiwanese president - are very deliberate. Observe that in the same diplomatic document that establishes the One China policy, the United States and China also agreed that "neither should seek hegemony in the Asia-Pacific region or in any other region." Trump is initiating a change in U.S. policy by which the U.S. accuses China of seeking hegemony in Asia, a violation of the foundation of their relationship. The U.S. is not seeking unilaterally to cancel the One China policy, but asking China to give new and durable assurances that it does not seek hegemony and will play by international rules. Otherwise, the U.S. is saying, the entire relationship will have to be revisited and nothing (not even Taiwan) will be off limits. The assurances that China is expected to give relate not only to trade, but also, as Trump signaled, to the South China Sea and North Korea. Therefore we are entering a new era in U.S-China relations. China Is Toast Asia Pacific is a region of frozen conflicts. Russia and Japan never signed a peace treaty. Nor did China and Taiwan. Nor did the Koreas. Why have these conflicts lain dormant over the past seventy years? Need we ask? Japan, South Korea, Taiwan, and Hong Kong have seen their GDP per capita rise 14 times since 1950. China has seen its own rise 21 times (Chart 43). Since the wars in Vietnam over forty years ago, no manner of conflict, terrorism, or geopolitical crisis has fundamentally disrupted this manifestly beneficial status quo. As a result, Asia has been a region synonymous with economics - not geopolitics. It developed this reputation because its various large economies all followed Japan's path of dirigisme: export-oriented, state-backed, investment-led capitalism. This era of stability is over. The region has become the chief source of geopolitical risk and potential "Black Swan" events.39 The reason is deteriorating U.S.-China relations and the decline in China's integration with other economies. The Asian state-led economic model was underpinned by the Pax Americana. Two factors were foundational: America's commitment to free trade and its military supremacy. China was not technically an ally, like Japan and Korea, but after 1979 it sure looked like one in terms of trade surpluses and military spending (Chart 44).40 For the sake of containing the Soviet Union, the U.S. wrapped East Asia under its aegis. Chart 43The Twentieth Century Was Kind To East Asia Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 44Asia Sells, America Rules bca.gps_so_2016_12_14_c44 bca.gps_so_2016_12_14_c44 It is well known, however, that Japan's economic model led it smack into a confrontation with the U.S. in the 1980s over its suppressed currency and giant trade surpluses. President Ronald Reagan's economic team forced Japan to reform, but the result was ultimately financial crisis as the artificial supports of its economic model fell away (Chart 45). Astute investors have always suspected that a similar fate awaited China. It is unsustainable for China to seize ever greater market share and drive down manufacturing prices without reforming its economy to match G7 standards, especially if it denies the U.S. access to its vast consumer market. Today there are signs that the time for confrontation is upon us: Since the Great Recession, U.S. household debt and Chinese exports have declined as a share of GDP, falling harder in the latter than the former, in a sign of shattered symbiosis (see Chart 8 above). Chinese holdings of U.S. Treasurys have begun to decline (Chart 46). China's exports to the U.S., both as a share of total exports and of GDP, have rolled over, and are at levels comparable to Japan's 1980s peaks (Chart 47). China is wading into high-tech and advanced industries, threatening the core advantages of the developed markets. The U.S. just elected a populist president whose platform included aggressive trade protectionism against China. Protectionist "Rust Belt" voters were pivotal to Trump's win and will remain so in future elections. China is apparently reneging on every major economic promise it has made in recent years: the RMB is depreciating, not appreciating, whatever the reason; China is closing, not opening, its capital account; it is reinforcing, not reforming, its state-owned companies; and it is shutting, not widening, access to its domestic market (Chart 48). Chart 45Japan's Crisis Followed Currency Spike bca.gps_so_2016_12_14_c45 bca.gps_so_2016_12_14_c45 Chart 46China Backing Away From U.S. Treasuries bca.gps_so_2016_12_14_c46 bca.gps_so_2016_12_14_c46 There is a critical difference between the "Japan bashing" of the 1980s-90s and the increasingly potent "China bashing" of today. Japan and the U.S. had established a strategic hierarchy in World War II. That is not the case for the U.S. and China in 2017. Unlike Japan, Korea, or any of the other Asian tigers, China cannot trust the United States to preserve its security. Far from it - China has no greater security threat than the United States. The American navy threatens Chinese access to critical commodities and export markets via the South China Sea. In a world that is evolving into a zero-sum game, these things suddenly matter. Chart 47The U.S. Will Get Tougher On China Trade bca.gps_so_2016_12_14_c47 bca.gps_so_2016_12_14_c47 Chart 48China Is De-Globalizing bca.gps_so_2016_12_14_c48 bca.gps_so_2016_12_14_c48 That means that when the Trump administration tries to "get tough" on longstanding American demands, these demands will not be taken as well-intentioned or trustworthy. We see Sino-American rivalry as the chief geopolitical risk to investors in 2017: Trump will initiate a more assertive U.S. policy toward China;41 It will begin with symbolic or minor punitive actions - a "shot across the bow" like charging China with currency manipulation or imposing duties on specific goods.42 It will be critical to see whether Trump acts arbitrarily through executive power, or systematically through procedures laid out by Congress. The two countries will proceed to a series of high-level, bilateral negotiations through which the Trump administration will aim to get a "better deal" from the Xi administration on trade, investment, and other issues. The key to the negotiations will be whether the Trump team settles for technical concessions or instead demands progress on long-delayed structural issues that are more difficult and risky for China to undertake. Too much pressure on the latter could trigger a confrontation and broader economic instability. Chart 49China's Demographic Dividend Is Gone bca.gps_so_2016_12_14_c49 bca.gps_so_2016_12_14_c49 The coming year may see U.S.-China relations start with a bang and end with a whimper, as Trump's initial combativeness gives way to talks. But make no mistake: Sino-U.S. rivalry and distrust will worsen over the long run. That is because China faces a confluence of negative trends: The U.S. is turning against it. Geopolitical problems with its periphery are worsening. It is at high risk of a financial crisis due to excessive leverage. The middle class is a growing political constraint on the regime. Demographics are now a long-term headwind (Chart 49). The Chinese regime will be especially sensitive to these trends because the Xi administration will want stability in the lead up to the CCP's National Party Congress in the fall, which promises to see at least some factional trouble.43 It no longer appears as if the rotation of party leaders will leave Xi in the minority on the Politburo Standing Committee for 2017-22, as it did in 2012.44 More likely, he will solidify power within the highest decision-making body. This removes an impediment to his policy agenda in 2017-22, though any reforms will still take a back seat to stability, since leadership changes and policy debates will absorb a great deal of policymakers' attention at all levels for most of the year.45 Xi will also put in place his successors for 2022, putting a cap on rumors that he intends to eschew informal term limits. Failing this, market uncertainty over China's future will explode upward. The midterm party congress will thus reaffirm the fact that China's ruling party and regime are relatively unified and centralized, and hence that China has relatively strong political capabilities for dealing with crises. Evidence does not support the popular belief that China massively stimulates the economy prior to five-year party congresses (Chart 50), but we would expect all means to be employed to prevent a major downturn. Chart 50Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses bca.gps_so_2016_12_14_c50 bca.gps_so_2016_12_14_c50 What this means is that the real risks of the U.S.-China relationship in 2017 will emanate from China's periphery. Asia's Frozen Conflicts Are Thawing Today the Trump administration seems willing to allow China to carve a sphere of influence - but it is entirely unclear whether and where existing boundaries would be redrawn. Here are the key regional dynamics:46 The Koreas: The U.S. and Japan are increasingly concerned about North Korea's missile advances but will find their attempts to deal with the problem blocked by China and likely by the new government in South Korea.47 U.S. threats of sanctioning China over North Korea will increase market uncertainty, as will South Korea's political turmoil and (likely) souring relations with the U.S. Taiwan: Taiwan's ruling party has very few domestic political constraints and therefore could make a mistake, especially when emboldened by an audacious U.S. leadership.48 The same combination could convince China that it has to abandon the post-2000 policy of playing "nice" with Taiwan.49 China will employ discrete sanctions against Taiwan. Hong Kong: Mainland forces will bring down the hammer on the pro-independence movement. The election of a new chief executive will appear to reinforce the status quo but in reality Beijing will tighten its legal, political, and security grip. Large protests are likely; political uncertainty will remain high.50 Japan: Japan will effectively receive a waiver from Trump's protectionism and will benefit from U.S. stimulus efforts; it will continue reflating at home in order to generate enough popular support to pass constitutional revisions in 2018; and it will not shy away from regional confrontations, since these will enhance the need for the hawkish defense component of the same revisions. Vietnam: The above issues may provide Vietnam with a chance to improve its strategic position at China's expense, whether by courting U.S. market access or improving its position in the South China Sea. But the absence of an alliance with the U.S. leaves it highly exposed to Chinese reprisals if it pushes too far. Russia: Russia will become more important to the region because its relations with the U.S. are improving and it may forge a peace deal with Japan, giving it more leverage in energy negotiations with China.51 This may also reinforce the view in Beijing that the U.S. is circling the wagons around China. What these dynamics have in common is the emergence of U.S.-China proxy conflicts. China has long suspected that the Obama administration's "Pivot to Asia" was a Cold War "containment" strategy. The fear is well-grounded but the reality takes time to materialize, which is what we will see playing out in the coming years. The reason we say "proxy wars" is because several American allies are conspicuously warming up to China: Thailand, the Philippines, and soon South Korea. They are not abandoning the U.S. but keeping their options open. The other ASEAN states also stand to benefit as the U.S. seeks economic substitutes for China while the latter courts their allegiance.52 The problem is that as U.S.-China tensions rise, these small states run greater risks in playing both sides. Bottom Line: The overarching investment implications of U.S.-China proxy wars all derive from de-globalization. China was by far the biggest winner of globalization and will suffer accordingly (Chart 51). But it will not be the biggest loser, since it is politically unified, its economy is domestically driven, and it has room to maneuver on policy. Hong Kong, Taiwan, South Korea, and Singapore are all chiefly at risk from de-globalization over the long run. Chart 51Globalization's Winners Will Be De-Globalization's Losers Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Japan is best situated to prosper in 2017. We have argued since well before the Bank of Japan's September monetary policy shift that unconventional reflation will continue, with geopolitics as the primary motivation for the country's "pedal to the metal" strategy.53 We will look to re-initiate our long Japanese equities position in early 2017. ASEAN countries offer an opportunity, though country-by-country fundamentals are essential. Brexit: The Three Kingdoms The striking thing about the Brexit vote's aftermath is that no recession followed the spike in uncertainty, no infighting debilitated the Tory party, and no reversal occurred in popular opinion. The authorities stimulated the economy, the people rallied around the flag (and ruling party), and the media's "Bregret" narrative flopped. That said, Brexit also hasn't happened yet.54 Formal negotiations with Europe begin in March, which means uncertainty will persist for much of the year as the U.K. and EU posture around their demands for a post-exit deal. However, improving growth prospects for Britain, Europe, and the U.S. all suggest that the negotiations are less likely to take place in an atmosphere of crisis. That does not mean that EU negotiators will be soft. With each successive electoral victory for the political establishment in 2017, the European negotiating position will harden. This will create a collision of Triumphant Tories and Triumphant Brussels. Still, the tide is not turning much further against the U.K. than was already the case, given how badly the U.K. needs a decent deal. Tightercontrol over the movement of people will be the core demand of Westminster, but it is not necessarily mutually exclusive with access to the common market. The major EU states have an incentive to compromise on immigration with the U.K. because they would benefit from tighter immigration controls that send highly qualified EU nationals away from the U.K. labor market and into their own. But the EU will exact a steep price for granting the U.K. the gist of what it wants on immigration and market access. This could be a hefty fee or - more troublingly for Britain - curbs on British financial-service access to euro markets. Though other EU states are not likely to exit, the European Council will not want to leave any doubt about the pain of doing so. The Tories may have to accept this outcome. Tory strength is now the Brexit voter base. That base is uncompromising on cutting immigration, and it is indifferent, or even hostile, to the City. So it stands to reason that Prime Minister Theresa May will sacrifice the U.K.'s financial sector in the coming negotiations. The bigger question is what happens to the U.K. economy in the medium and long term. First, it is unclear how the U.K. will revive productivity as lower labor-force growth and FDI, and higher inflation, take shape. Government "guidance" of the economy - dirigisme again - is clearly the Tory answer. But it remains to be seen how effectively it will be done. Second, what happens to the United Kingdom as a nation? Another Scottish independence referendum is likely after the contours of the exit deal take shape, especially as oil prices gin up Scottish courage to revisit the issue. The entire question of Scotland and Northern Ireland (both of which voted to stay in the EU) puts deeper constitutional and governmental restructuring on the horizon. Westminster is facing a situation where it drastically loses influence on the global stage as it not only exits the European "superstate" but also struggles to maintain a semblance of order among the "three kingdoms." Bottom Line: The two-year timeframe for exit negotiations ensures that posturing will ratchet up tensions and uncertainty throughout the year - invoking the abyss of a no-deal exit - but our optimistic outlook on the end-game (eventual "soft Brexit") suggests that investors should fade the various crisis points. That said, the pound is no longer a buy as it rises to around 1.30. Investment Views De-globalization, dirigisme, and the ascendancy of charismatic authority will all prove to be inflationary. On the margin, we expect less trade, less free movement of people, and more direct intervention in the economy. Given that these are all marginally more inflationary, it makes sense to expect the "End Of The 35-Year Bond Bull Market," as our colleague Peter Berezin argued in July.55 That said, Peter does not expect the bond bull market to end in a crash - and neither do we. There are many macroeconomic factors that will continue to suppress global yields: the savings glut, search for yield, and economic secular stagnation. In addition, we expect peak multipolarity in 2017 and thus a rise in geopolitical conflict. This geopolitical context will keep the U.S. Treasury market well bid. However, clients may want to begin switching their safe-haven exposure to gold. In a recent research report on safe havens, we showed that gold and Treasurys have changed places as safe havens in the past.56 Only after 2000 did Treasurys start providing a good hedge to equity corrections due to geopolitical and financial risks. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but has since become correlated with S&P 500 total returns. As deflationary risks abate in the future, we suspect that gold will return to its safe-haven status. In addition to safe havens, U.S. and global defense stocks will be well bid due to global multipolarity. We recommend that clients go long S&P 500 aerospace and defense relative to global equities on a strategic basis. We are also sticking with our tactical trade of long U.S. defense / short U.S. aerospace. On the equity front, we have closed our post-election bullish trade of long S&P 500 / short gold position for an 11.53% gain in just 22 days of trading. We are also closing our long S&P 600 / short S&P 100 position - a play on de-globalization - for an 8.4% gain. Instead, we are initiating a strategic long U.S. small caps / short U.S. large caps, recommended jointly with our colleague Anastasios Avgeriou of the BCA Global Alpha Sector Strategy. We are keeping our EuroStoxx VIX term-structure hedge due to mounting political risk in Europe. However, we are looking for an opening into European stocks in early 2017. For now, we are maintaining our long USD/EUR - return 4.2% since July - and long USD/SEK - return 2.25% since November. The first is a strategic play on our view that the ECB has to remain accommodative due to political risks in the European periphery. The latter is a way to articulate de-globalization via currencies, given that Sweden is one of the most open economies in the world. We are converting it from a tactical to a strategic recommendation. Finally, we are keeping our RMB short in place - via 12-month NDF. We do not think that Beijing will "blink" and defend its currency more aggressively just because Donald Trump is in charge of America. China is a much more powerful country than in the past, and cannot allow RMB appreciation at America's bidding. Our trade has returned 7.14% since December 2015. With the dollar bull market expected to continue and RMB depreciating, the biggest loser will be emerging markets. We are therefore keeping our strategic long DM / short EM recommendation, which has returned 56.5% since November 2012. We are particularly fond of shorting Brazilian and Turkish equities and are keeping both trades in place. However, we are initiating a long Russian equities / short EM equities. As an oil producer, Russia will benefit from the OPEC deal and the ongoing risks to Iraqi stability. In addition, we expect that removing sanctions against Russia will be on table for 2017. Europe will likely extend the sanctions for another six months, but beyond that the unity of the European position will be in question. And the United States is looking at a different approach. We wish our clients all the best in health, family, and investing in 2017. Thank you for your confidence in BCA's Geopolitical Strategy. Marko Papic Senior Vice President Matt Gertken Associate Editor Jesse Anak Kurri Research Analyst 1 In Michel Foucault's famous The Order of Things (1966), he argues that each period of human history has its own "episteme," or set of ordering conditions that define that epoch's "truth" and discourse. The premise is comparable to Thomas Kuhn's notion of "paradigms," which we have referenced in previous Strategic Outlooks. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2012," dated January 27, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2013," dated January 16, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com and Global Investment Strategy Special Report, "Underestimating Sino-American Tensions," dated November 6, 2015, available at gis.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, and "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2014 - Stay The Course: EM Risk - DM Reward," dated January 23, 2014, and Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 8 Please see BCA The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 10 A military-security strategy necessary for British self-defense that also preserved peace on the European continent by undermining potential aggressors. 11 Please see BCA Global Investment Strategy Special Report, "Trump And Trade," dated December 8, 2016, available at gis.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see Max Weber, "The Three Types Of Legitimate Rule," Berkeley Publications in Society and Institutions 4 (1): 1-11 (1958). Translated by Hans Gerth. Originally published in German in the journal Preussische Jahrbücher 182, 1-2 (1922). 16 We do not concern ourselves with traditional authority here, but the obvious examples are Persian Gulf monarchies. 17 Please see Francis Fukuyama, Political Order And Political Decay (New York: Farrar, Straus and Giroux, 2014). See also our review of this book, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 19 Please see Irving Fisher, "The Debt-deflation Theory of Great Depressions," Econometrica 1(4) (1933): 337-357, available at fraser.stlouisfed.org. 20 Please see Milanovic, Branko, "Global Income Inequality by the Numbers: in History and Now," dated November 2012, Policy Research Working Paper 6250, World Bank, available at worldbank.org. 21 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," June 8, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 23 In some way, BCA's Geopolitical Strategy was designed precisely to fill this role. It is difficult to see what would be the point of this service if our clients could get unbiased, investment-relevant, prescient, high-quality geopolitical news and analysis from the press. 24 Please see BCA European Investment Strategy Weekly Report, "Roller Coaster," dated March 31, 2016, available at eis.bcaresearch.com. 25 Please see The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at bca.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Client Note, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 28 Despite winning an extraordinary six of the 13 continental regions in France in the first round, FN ended up winning zero in the second round. This even though the election occurred after the November 13 terrorist attack that ought to have buoyed the anti-migration, law and order, anti-establishment FN. The regional election is an instructive case of how the French two-round electoral system enables the establishment to remain in power. 29 Please see BCA European Investment Strategy Weekly Report, "Italy: Asking The Wrong Question," dated December 1, 2016, available at eis.bcaresearch.com. 30 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 31 Please see BCA Geopolitical Strategy Special Report, "Cold War Redux?" dated March 12, 2014, and Geopolitical Strategy Special Report, "Russia: To Buy Or Not To Buy?" dated March 20, 2015, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Russia-West Showdown: The West, Not Putin, Is The 'Wild Card,'" dated July 31, 2014, available at gps.bcaresearch.com. 33 Please see BCA's Emerging Markets Strategy Special Report, "Russia's Trilemma And The Coming Power Paralysis," dated February 21, 2012, available at ems.bcaresearch.com. 34 Please see BCA Geopolitical Strategy, "Middle East: Saudi-Iranian Tensions Have Peaked," in Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 35 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 36 President Erdogan, speaking at the first Inter-Parliamentary Jerusalem Platform Symposium in Istanbul in November 2016, said that Turkey "entered [Syria] to end the rule of the tyrant al-Assad who terrorizes with state terror... We do not have an eye on Syrian soil. The issue is to provide lands to their real owners. That is to say we are there for the establishment of justice." 37 Please see BCA Commodity & Energy Strategy Weekly Report, "2017 Commodity Outlook: Energy," dated December 8, 2016, available at ces.bcaresearch.com. 38 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 39 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 40 In recent years, however, China's "official" defense budget statistics have understated its real spending, possibly by as much as half. 41 Please see "U.S. Election Update: Trump, Presidential Powers, And Investment Implications" in BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 42 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 43 Please see BCA Geopolitical Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 44 Please see BCA Geopolitical Strategy Monthly Report, "China: Two Factions, One Party - Part II," dated September 2012, available at gps.bcaresearch.com. 45 The National Financial Work Conference will be one key event to watch for an updated reform agenda. 46 Please see "East Asia: Tensions Simmer ... Will They Boil?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 47 Please see "North Korea: A Red Herring No More?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 48 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, and "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 49 The Trump administration has signaled a policy shift through Trump's phone conversation with Taiwanese President Tsai Ing-wen. The "One China policy" is the foundation of China-Taiwan relations, and U.S.-China relations depend on Washington's acceptance of it. The risk, then, is not so much an overt change to One China, a sure path to conflict, but the dynamic described above. 50 Please see BCA China Investment Strategy Weekly Report, "Hong Kong: From Politics To Political Economy," dated September 8, 2016, available at cis.bcaresearch.com. 51 Please see BCA Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 52 Please see "Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW" in BCA Emerging Markets Strategy Weekly Report, "The EM Rally: Running Out Of Steam?" dated October 19, 2016, and Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 53 Please see BCA Geopolitical Strategy Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, and "Unleash The Kraken: Debt Monetization And Politics," dated September 26, 2016, available at gps.bcaresearch.com. 54 Please see BCA Geopolitical Strategy Special Report, "BREXIT Update: Brexit Means Brexit, Until Brexit," dated September 16, 2016, available at gps.bcaresearch.com. 55 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 56 Please see Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 15, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights Trump's foreign policy proposals will exacerbate geopolitical risks. Sino-American relations are the chief risk - they will determine global stability. A Russian reset will benefit Europe, especially outside the Russian periphery. Trump will retain the gist of the Iran nuclear deal. Turkey and North Korea are wildcards. Feature Chart 1Market Rally Redoubled After Trump's Win Market Rally Redoubled After Trump's Win Market Rally Redoubled After Trump's Win Financial markets rallied sharply after the election of Donald Trump and the resulting prospect of lower taxes, fewer regulations, and greater fiscal thrust (Chart 1). But is the euphoria justified in light of Trump's unorthodox views on U.S. foreign policy and trade? Is Trump's "normalization" amid the transition to the White House a reliable indicator that the geopolitical status quo will largely be preserved? We believe Trump's election marks a substantial increase in geopolitical risk that is being understated by markets.1 This is not because of his personality, though that is not particularly reassuring, but rather because of his policy proposals. If acted on, Trump's geopolitical agenda would exacerbate global trends that are already underway: Waning U.S. Dominance: American power, relative to other nations, has been declining in recent years as a result of the emergence of new economic and military powers like China and India (Chart 2). If Trump allows himself to be sucked into another conflict despite his campaign promises - say, by overturning the nuclear deal with Iran - he could embroil the U.S. at a time when it is relatively weak. Multipolarity: America's relative decline has emboldened various other nations to pursue their interests independently, increasing global friction and creating a world with multiple "poles" of influence.2 If Trump keeps his word on reducing foreign commitments he will speed along this historically dangerous process. Lesser powers like Russia and Turkey will try to fill vacuums created by the U.S. with their own ambitions, with competition for spheres of influence potentially sparking conflict. Multipolarity has already increased the incidence of global conflicts (Chart 3). De-Globalization: The greatest risk of the incoming administration is protectionism. Trump ran on an overtly protectionist platform. Democratic-leaning economic patriots in the American "Rust Belt" handed him the victory (Chart 4), and he will enact policies to maintain these pivotal supporters in 2018 and 2020 elections. This will hasten the decline of trade globalization, which we signaled was peaking back in 2014.3 It does not help that multipolarity and collapse of globalization have tended to go hand in hand in the past. And historically speaking, big reversals in global trade do not end well (Chart 5). Chart 2U.S. Power Eroding In A Relative Sense U.S. Power Eroding In A Relative Sense U.S. Power Eroding In A Relative Sense Chart 3Multipolarity Increases Conflict Frequency bca.gis_sr_2016_12_02_c3 bca.gis_sr_2016_12_02_c3 Chart 4 Chart 5Declines In Global Trade Preceded World Wars Declines In Global Trade Preceded World Wars Declines In Global Trade Preceded World Wars In what follows we assess what we think are likely to be the most important geopolitical effects of Trump's "America First" policies. We see Russia and Europe as the chief beneficiaries, and China and Iran as the chief risks. A tougher stance on China, in particular, will feed broader strategic distrust; the combination of internal and external pressures on China will ensure that the latter will not be as flexible as in the past. For the past five years, BCA's Geopolitical Strategy has stressed that the deterioration in Sino-American cooperation is the greatest geopolitical risk for investors - and the world. Trump's election will accelerate this process. Trump And Eurasia Chart 6 Trump's election is clearly a boon for Russia. Over the past 16 years, Russia has methodically attempted to collect the pieces from the Soviet collapse. The purpose of Putin's assertiveness has been to defend the Russian sphere of influence (namely Ukraine and Belarus in Europe, the Caucasus, and Central Asia) from outside powers: the U.S. and NATO seemed eager to "move in for the kill" after Russia emerged from the ashes. Putin also needed to rally popular support at various times by distracting the public with "rally around the flag" operations. We view Ukraine and Syria through this analytical prism. Lastly, Russia acted aggressively because it needed to reassure its allies that it would stand up for them.4 And yet the U.S. can live with a "strong" Russia. It can make a deal with Russia if the Trump administration recognizes some core interests (e.g. Crimea) and calls off the "democracy promotion" activities that Putin considers to be directly aimed at the Kremlin. As we argued during the Ukraine invasion, it is the U.S., not Russia, which poses the greatest risk of destabilization.5 That is because the U.S. lacks constraints. It can be aggressive towards Russia and face zero consequences: it has no economic relationship with Russia (Chart 6) and does not stand directly in the way of any retaliation, as Europe does. That is why we think Trump and Putin will manage to reset relations. The U.S. can step back and allow Russia to control its sphere of influence. Trump's team may be comfortable with the concept, unlike the Obama administration, whose Vice-President Joe Biden famously pronounced that America "will not recognize any nation having a sphere of influence." We could even see the U.S. pledging not to expand NATO from this point onwards, given that it has already expanded as far as it can feasibly and credibly go. Note, however, that a Russo-American truce may not last long. George W. Bush famously "looked into Putin's eyes and ... saw his soul," but relations soured nonetheless. Obama went further with his "Russian reset," removing European missile defense plans from avowed NATO allies Poland and Czech Republic merely one year after Russian troops invaded Georgia. And yet Moscow and Washington ended up rattling sabers and meddling in each other's internal affairs. Ultimately, U.S. resets fail because Russia is in a structural decline as a great power and is attempting to hold on to a very large sphere of influence whose denizens are not entirely willing participants.6 Because Moscow often must use blunt force to prevent the revolt of its vassal states (e.g. Georgia in 2008, Ukraine in 2014), it renews tensions with the West. Unless Russia strengthens significantly in the next few years, we would expect the cycle to continue. On the horizon may be Ukraine-like incidents in neighboring Belarus and Kazakhstan, both key components of the Russian sphere of influence. Bottom Line: Russia will get a reprieve from U.S. pressure under Trump. While we expect Europe to extend sanctions through the end of 2017, a rapprochement with Washington could ultimately thaw relations by the end of next year. Europe stands to benefit, being able to resume business as usual with Russia and face less of a risk of Russian provocations via the Middle East, like in Syria. The recent decline in refugee flows will be made permanent with Russia's cooperation. The losers will be states in the Russian periphery that will feel less secure about American, EU and NATO backing, particularly Ukraine, but also Turkey. Countries like Belarus, which enjoyed playing Moscow against the West in the past, will lose the ability to do so. Once the U.S. abandons plans to prop up pro-West regimes in the Russian sphere of influence, Europeans will drop their designs to do the same as well. Trump And The Middle East Trump's "America First" foreign policy promises to be Obama's "geopolitical deleveraging" on steroids. He is opposed to American adventurism and laser-focused on counter-terrorism and U.S. domestic security. He also wants to deregulate the U.S. energy sector aggressively to encourage even greater energy independence (Chart 7). The chief difference from Obama - and a major risk to global stability - is Iran, where Trump could overturn the Obama administration's 2015 nuclear deal, potentially setting the two countries back onto the path of confrontation. Nevertheless, this deal never depended on Obama's preferences but was rooted in a strategic logic that still holds:7 Iraqi stability: The U.S. needed to withdraw troops from Iraq without creating a power vacuum that would open up a regional war or vast terrorist safe haven. With the advent of the Islamic State, this plan clearly failed. However, Iran did provide a Shia-led central government that has maintained security for investments and oil outflows (Chart 8). Iranian defenses: Bombing Iran is extremely difficult logistically, and the U.S. did not want to force the country into a corner where asymmetric warfare, like cutting off shipping in the Straits of Hormuz, seemed necessary. Despite growing American oil production, the U.S. will always care about the transit of oil through the Straits of Hormuz, as this impacts global oil prices.8 China's emergence: Strategic threats grew rapidly in Asia while the U.S. was preoccupied in Iraq and Afghanistan. China has emerged as a more technologically advanced and assertive global power that threatens to establish hegemony in the region. The deal with Iran was therefore a crucial piece of President Obama's "Pivot to Asia" strategy. Chart 7U.S. Becoming More Energy Independent U.S. Becoming More Energy Independent U.S. Becoming More Energy Independent Chart 8U.S. Policy Boosts Iraqi And Iranian Oil bca.gis_sr_2016_12_02_c8 bca.gis_sr_2016_12_02_c8 None of the above will change with Obama's moving on. Nor will the other powers that participated in sanctioning Iran (Germany, France, the U.K., Russia, and China) be convinced to re-impose sanctions now, just as they gain access to Iranian resources and markets. It is also not clear why Trump would seek confrontation with Iran in light of his desire to improve relations with Russia and concentrate U.S. firepower on ISIS - both objectives make Iran the ideal and obvious partner. Trump will therefore begrudgingly agree to the détente with Iran, perhaps after tweaking some aspects of the deal to save face. Meanwhile, it will serve the hawks in both countries if they can go back to calling each other "Satan." Iran itself is comfortable with the current situation, so it does not have an incentive to reverse the deal. It controls almost half of Iraq (and specifically the portion of Iraq that produces oil), its ally Hezbollah is safe in Lebanon, its ally Bashar Assad will win in Syria (more so with Trump in charge!), and its allies in Yemen (Houthi rebels) are a status quo power secure in a mountain fortress in the north of the country. It is hard to see where Trump would dislodge Iranian influence if he sought to do so. The U.S. is a powerful country that could put a lot of resources into rolling back Iranian influence, but the logic for such a move simply does not exist. Trump will also maintain Obama's aloof policy toward Saudi Arabia, which keeps it constrained (Chart 9).9 The country is in some ways the stereotype of the "ungrateful ally" that Trump wants to downgrade. For instance, Trump supported the law allowing victims of the September 11 attacks to sue the kingdom (a law that Obama tried unsuccessfully to veto). He has blamed the Saudis for the rise of ISIS and the failure to take care of Syrian refugees. His primary focus is on preventing terrorists from striking the U.S., and to that end he wants to cooperate with Russia and stabilize the region's regimes. This entails the relative neglect of Sunni groups under Shia rule in Syria and Iraq. Indeed, the few issues where the Saudis will welcome Trump - opposition to the Iran nuclear deal, support for Egypt's military ruler Abdel Fattah el-Sisi, and opposition to aggressive democracy promotion - are so far rhetorical, not concrete, commitments. Chart 9Saudi Arabia Sees The U.S. Stepping Back Saudi Arabia Sees The U.S. Stepping Back Saudi Arabia Sees The U.S. Stepping Back Will Trump get sucked into the region to intervene against ISIS? We do not think so. A bigger risk is Turkey.10 President Recep Erdogan may think that Trump will either be too complacent about Turkish interests in Syria, or that Trump is in fact a "kindred nationalist spirit" who will not prevent Turkey from pursuing its own sphere of influence in Syria and northern Iraq. Trump's foreign policy of "offshore balancing" would call for the U.S. to prevent Turkey from resurrecting any kind of regional empire, especially if it risks a war with Russia and Iran or comes at the cost of regional influence for American allies like the Kurds.11 Turkey will also be starkly at odds on Syria and ISIS. This means Turkey and the U.S. could see already tense relations get substantially worse in 2017. We would not be surprised to see President Trump threaten Erdogan with expulsion from NATO within his first term. Bottom Line: The biggest risk to our view is that Trump rejects the consensus of the intelligence and defense establishment and pushes Iran too far, leading to conflict. We do not think this will happen, but his rhetoric on the nuclear deal has been consistently negative and he seems likely to favor "Middle East hands" for top cabinet positions. He could involve the country in new Middle East entanglements if he does not show discipline in adhering to his non-interventionist preferences - particularly if he overreacts to an attack. Nonetheless, we believe that America's policy of geopolitical deleveraging from the Middle East will continue. Trump may have a mandate to be tough on terrorism from his voters, but he definitely does not have a free hand to commit military resources to the region. Trump And Asia Trump criticized China furiously during the campaign, declaring that he would name China a currency manipulator on his first day in office and threatening to impose a 45% tariff on Chinese imports. However, there is a familiar pattern of China bashing in U.S. presidential elections that leads to no sharp changes in policy.12 Will Trump be different? Some would argue that relations may actually improve, given how bad they already are. First, Trump's chief concern is to fire up the U.S. economy's animal spirits, and that would support China's ailing economy as long as he does not couple his tax cuts and fiscal stimulus with aggressive protectionist measures (Chart 10). Proponents of this view would point out that Trump's tougher measures may be called off when he realizes that the Chinese current account surplus has fallen sharply in recent years (Chart 11), and that the PBoC is propping up the RMB, not suppressing it. Similarly, Trump's China-bashing trade advisor, the former steel executive Dan DiMicco, may not get much traction given that the U.S. has largely shifted to Brazilian steel imports (Chart 12). In short, the U.S. could take a somewhat tougher stance on specific trade spats without provoking a vicious spiral of discriminatory actions. The fact that the U.S. is more exposed than ever to trade with emerging markets only reinforces the idea that it does not want to spark a real trade war (Chart 13). Chart 10A Trump Boom, Sans Protectionism, Would Lift Chinese Growth A Trump Boom, Sans Protectionism, Would Lift Chinese Growth A Trump Boom, Sans Protectionism, Would Lift Chinese Growth Chart 11China's Economy Rebalancing China's Economy Rebalancing China's Economy Rebalancing Chart 12China Already Lost The China Already Lost The "Steel Wars" China Already Lost The "Steel Wars" Chart 13A Reason To Eschew Protectionism A Reason To Eschew Protectionism A Reason To Eschew Protectionism Second, the Obama administration's "Pivot to Asia" and attempts to undermine China's economic influence in the region through the Trans-Pacific Partnership (TPP) have aggravated China with little substantive gain. By contrast, Trump may emphasize American business access to China over Chinese citizens' freedoms - which could reduce the risk of conflict. He may not go beyond symbolic protectionist moves, like the currency manipulation charge, and meanwhile canceling the never-ratified TPP would be a net gain for China.13 In essence, Trump, despite his populist rhetoric, could prove both pragmatic and willing to inherit the traditional Republican stance of business-oriented positive engagement with China. Chart 14 This is a compelling argument and we take it seriously. But it is not our baseline case. Rather, we think Trump will eventually take concrete populist steps that will mark a departure from U.S. policy in recent memory. As mentioned, it was protectionist blue-collar voters in the Midwest who gave Trump the White House, and he will need to retain their loyalty in coming elections. Moreover, the secular flatlining of American wages and the growth of income inequality have moved the median U.S. voter to the left of the economic spectrum, as we have argued.14 Neo-liberal economic policy has fewer powerful proponents than in the recent past. Thus, in the long run, we expect the grand renegotiation with China to fall short of market hopes, and Sino-American tensions to resume their upward trajectory.15 Why are we so pessimistic? Three main reasons: The "Thucydides Trap": Sino-U.S. tensions are fundamentally driven not by trade disputes but by the U.S.'s fear of China's growing capability and ambition.16 Great conflicts in history have often occurred when a new economic and military power emerged and tried to alter the regional political arrangements set up by the dominant power. This was as true in late nineteenth-century Europe, with the rise of Germany vis-à-vis the U.K. and France (Chart 14), as it was in ancient Greece. The rise of Japan in the first half of the twentieth century had a similar effect in Asia (Chart 15). Trump could, of course, endorse Xi's idea of a "new type of great power relations," which is supposed to avoid this problem. But nobody knows what that would look like, and greater trade openness is the only conceivable foundation for it. Chart 15AThe Disruptive Rise Of Germany The Disruptive Rise Of Germany The Disruptive Rise Of Germany Chart 15BThe Disruptive Rise Of Japan The Disruptive Rise Of Japan The Disruptive Rise Of Japan China's economic imbalances: A caustic dose of trade remedies from the Trump administration will compound internal economic pressures in China resulting from rampant credit expansion, misallocation of capital, excessive money printing, and capital outflows (Chart 16).17 The combination of internal and external pressures is potentially fatal and China's leaders will fight it. Otherwise, they risk either the fate of the Soviets or of the Asian strongman regimes that succumbed to democracy after embracing capitalism fully. Instead, China will avoid rushing its structural reforms (it is, after all, currently closing its capital account), and protect its consumer market, which it hopes to be the growth engine going forward. This is not a strong basis for the "better deal" that Trump will demand. President Trump will want China to open up further to U.S. manufacturing, tech, and service exports. Economics and the security dilemma: China and the U.S. will not be able to prevent economic tensions from spilling over into broader strategic tensions. Compare the spike in trade tensions with Japan in the 1980s, when Japanese exports to the U.S. peaked and the U.S. strong-armed Japan into appreciating its currency (Chart 17). The U.S. had nurtured Japan and South Korea out of their post-war devastation by running large trade deficits and enabling them to focus on manufacturing exports while minimizing spending on defense. China joined this system in the 1980s and has largely resembled the formal U.S. allies (Chart 18). Given that China has largely followed Japan's path, it was inevitable that the U.S. would eventually lose patience and become more competitive with China. China has seized a greater share of the U.S. market than Japan had done at that time, and its exports are even more important to the U.S. as a share of GDP (Chart 19). Comparing the exchange rates then and now, the Trump administration will be able to argue that China's currency is overdue for appreciation (Chart 20). However, in the 1980s, the U.S. and Japan faced no risk of military conflict - their strategic hierarchy was entirely settled in 1945. The U.S. and China have no such understanding. There is no way of assuring China that U.S. economic pressure is not about strategic dominance. In fact, it is about that. So while China may be cajoled into promising faster reforms - given that its trade surplus with the U.S. is the only thing that stands between it and current account deficits (Chart 21) - nevertheless it will tend to dilute and postpone these reforms for the sake of its own security, putting Trump's resolve to the test. Chart 16Flashing Red Light On China's Economy Flashing Red Light On China's Economy Flashing Red Light On China's Economy Chart 17The U.S. Forced Structural Changes On Japan The U.S. Forced Structural Changes On Japan The U.S. Forced Structural Changes On Japan Chart 18Asia Sells, America Rules Asia Sells, America Rules Asia Sells, America Rules Chart 19The U.S. Will Get Tougher On China Trade The U.S. Will Get Tougher On China Trade The U.S. Will Get Tougher On China Trade Chart 20China Drags Its Feet On RMB Appreciation China Drags Its Feet On RMB Appreciation China Drags Its Feet On RMB Appreciation Chart 21A Reason For China To Kowtow A Reason For China To Kowtow A Reason For China To Kowtow Trump's victory may also heighten Beijing's fears that it is being surrounded by the U.S. and its partners. That is because Trump will make the following developments more likely: Better Russian relations: From a bird's eye view, Trump's thaw with Putin could mark an inversion of Nixon's thaw with Mao. China is the only power today that can stand a comparison with the Soviet Union during the Cold War. The U.S. at least needs to make sure the Sino-Russian relationship does not become too warm (Chart 22).18 Russo-Japanese peace treaty: The two sides are already working on a treaty, never signed after World War II. Aside from their historic territorial dispute, the U.S. has been the main impediment by demanding Japan help penalize Russia after the invasion of Ukraine. Yet negotiations have advanced regardless, and Japanese air force scrambles against Russia have fallen while those against China have continued to spike (Chart 23). The best chance for a deal since the 1950s is now, with Abe and Putin both solidly in power until 2018. This would reduce Russian dependency on China for energy markets and capital investment, and free up Japan's security establishment to focus on China and North Korea. American allies are not defecting: The United States armed forces are deeply embedded in the Asia Pacific region and setbacks to the "pivot" policy should not be mistaken for setbacks to U.S. power in the absolute.19 U.S. allies like Thailand, the Philippines, and (soon) South Korea are in the headlines for seeking to warm up ties with China, but there is no hard evidence that they will turn away from the U.S. security umbrella. Rather, the pivot reassured them of U.S. commitment, giving them the flexibility to focus on boosting their economies, which means sending emissaries to Beijing. The problem is that Beijing knows this and will therefore still suspect that a "containment" strategy is underfoot over time. Better Indian relations: The Bush administration made considerable progress in improving ties with India. Trump also seems India-friendly, which would be supported by better ties with Russia and Iran. India could therefore become a greater obstacle to China's influence in South and Southeast Asia. Chart 22Energy A Solid Foundation For Sino-Russian Ties Energy A Solid Foundation For Sino-Russian Ties Energy A Solid Foundation For Sino-Russian Ties Chart 23Japan's Strategic Predicament Japan's Strategic Predicament Japan's Strategic Predicament From the above, we can draw three main conclusions: The U.S. role in the Pacific will determine global geopolitical stability under the Trump administration. The primary question is whether China is willing and able to accede to enough of Trump's demands to ensure that the U.S. and China have at least "one more fling," a further extension to the post-1979 trade relationship. It is possible that China is simply unable to do so and in the face of any concrete sanctions by Trump, will batten down the hatches, rally people around the flag, and shore up the state-led economy. There may be a tactical U.S.-China "improvement" over the next year - relative to the worst fears of trade war under Trump - but it will not be durable. The year 2017 will be the year of Trump's "honeymoon," while Xi Jinping will be focused on internal politics ahead of the Communist Party's crucial National Party Congress in the fall.20 Thus, after Trump gives China a "shot across the bow," like charging it with currency manipulation, the two sides will likely settle down at the negotiating table and send positive signals to the world about their time-tried ability to manage tensions. Financial markets will see through Trump's initially symbolic actions and begin to behave as if nothing has changed in U.S.-China relations. However, this calm will be deceiving, since economic and security tensions will eventually rise to the surface again, likely in a more disruptive way than ever before. China's periphery will be decisive, especially the Korean peninsula. The Koreas could become the locus of East Asia tensions for two reasons. First, North Korea's nuclear weaponization has reached a level that is truly alarming to the U.S. and Japan.21 New sanctions, if enforced, have real teeth because they target commodity exports (Chart 24). The problem is that China is unlikely to enforce them and South Korean politics are likely to turn more China-friendly and more pacific toward the North with the impending change of ruling parties. This will leave the U.S. and Japan with legitimate security grievances but less of an ability to change the outcome through non-military means. That is an arrangement ripe for confrontation. Separately, China's worsening relations with Taiwan, Vietnam's resistance to China's power-grab in the South China Sea, and conflicts between India and Pakistan will be key barometers of regional stability vis-à-vis China. Chart 24Will China Cut Imports From Here? Will China Cut Imports From Here? Will China Cut Imports From Here? The risk to this view, again, is that a Middle East crisis could distract the Trump administration. This would mark an excellent opportunity for China to build on its growing regional sway, and it would delay our baseline view that the Asia Pacific is now the chief source of geopolitical risk in the world. Investment Conclusions There is no geopolitical risk premium associated with Sino-American tensions. Our clients, colleagues, and friends in the industry are at a loss when we ask how one should hedge tensions in the region. This is a major risk for investors as the market will have to price emerging tensions quickly. Broadly speaking, Sino-American tensions will reinforce the ongoing de-globalization. If the top two global economies are at geopolitical loggerheads, they are more likely to see their geopolitical tensions spill over to the economic sphere. Unwinding globalization implies that inflation will make a comeback, as the reduction in flows of goods, services, capital, and people gradually increases supply constraints. This is primarily bad for bonds, which have enjoyed a bull market for the past three decades that we see reversing.22 At the same time, these trends suggest that investors should favor consumer-oriented sectors and countries relative to their export-reliant counterparts, and small-to-medium sized businesses over externally-exposed multinationals. BCA Geopolitical Strategy's long S&P 600 / short S&P 100 trade is up 7.4% since inceptionon November 9. Finally, these trends, combined with the associated geopolitical risks of various powers struggling for elbow room, warrant a continuation of the Geopolitical Strategy theme of favoring Developed Markets over Emerging Markets, which has made a 45.5% return since inception in November 2012. The centrality of China risk only reinforces this view. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 Please see our initial discussion of Trump's foreign policy, "U.S. Election Update: Trump, Presidential Powers, And Investment Implications," in BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization: All Downhill From Here," dated November 12, 2014, and, more recently, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 4 Please see "In Focus - Cold War Redux?" in BCA Geopolitical Strategy Monthly Report, "It's A Long Way Down From The 'Wall Of Worry,'" dated March 2014, and Geopolitical Strategy Special Report, "Russia: To Buy Or Not To Buy?" dated March 20, 2015, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Russia-West Showdown: The West, Not Putin, Is The 'Wild Card,'" dated July 31, 2014, available at gps.bcaresearch.com. 6 Please see BCA's Emerging Markets Strategy Special Report, "Russia's Trilemma And The Coming Power Paralysis," dated February 21, 2012, available at ems.bcaresearch.com. 7 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. 8 Please see BCA Geopolitical Strategy Special Report, "End Of An Era For Oil And The Middle East," dated April 8, 2015, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "Saudi Arabia's Choice: Modernity Or Bust," dated May 11, 2016, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "Turkey: Strategy After The Attempted Coup," dated July 18, 2016, available at gps.bcaresearch.com. 11 Please see John J. Meirsheimer and Stephen M. Walt, "The Case For Offshore Balancing: A Superior U.S. Grand Strategy," Foreign Affairs, July/August 2016, available at www.foreignaffairs.com. 12 Please see BCA China Investment Strategy, "China As A Currency Manipulator?" dated November 24, 2016, available at cis.bcaresearch.com. 13 One of his foreign policy advisors, former CIA head James Woolsey, has floated the idea that the U.S. could turn positive about Chinese initiatives like the Asian Infrastructure Investment Bank and the One Belt One Road program to link Eurasian economies. Please see Woolsey, "Under Donald Trump, the US will accept China's rise - as long as it doesn't challenge the status quo," South China Morning Post, dated November 10, 2016, available at www.scmp.com. 14 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy and Global Investment Strategy Joint Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 16 Please see Graham Allison, "The Thucydides Trap: Are The U.S. And China Headed For War?" The Atlantic, September 24, 2015, available at www.theatlantic.com. 17 Please see BCA Emerging Markets Strategy Special Report, "China's Money Creation Redux And The RMB," dated November 23, 2016, available at ems.bcaresearch.com. 18 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 21 Please see "North Korea: A Red Herring No More?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 22 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com.

The median voter moving to the left has spurred paradigm shifts. These new regimes are giving way to transformational leaders who seek change by breaking convention. As they test their constraints and pursue their preferences, a cautious stance towards risk assets is warranted. In this Monthly Report, BCA's Geopolitical Strategy discusses Trump's recent comeback, rising EM political risk, and Italy's upcoming constitutional referendum.

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