Secession/Breakup

Dear Client, Yesterday, my colleagues Marko Papic, Matt Gertken, and I had a webcast to discuss the rising threats of trade wars between the U.S. and China. If you have not listened to it yet, I encourage you to listen to it here. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights A trade war between China and the U.S. is an increasing source of long-term risk for the global economy. While the tensions between China and the U.S. are likely to decline in the short run, their materialization as the global economy is set to hit a soft patch and as the Federal Reserve's policy is becoming tight further validates our view that financial market volatility is rising cyclically. The dollar and the yen should prove to be the main beneficiaries of this phenomenon. The U.K. economy remains soft and investors should not become complacent about British political risk. Moreover, British inflation is set to slow in response to tighter monetary conditions. Sell GBP/USD on a tactical basis. Feature Two weeks ago, we argued that volatility was making a comeback in global financial markets.1 The interim events have only confirmed this thesis. Geopolitical risk is rearing its unwanted head as macroeconomic vulnerabilities are already rising because U.S. policy will soon exit accommodative territory and global growth is experiencing a speed bump. The dollar and the yen should benefit from these circumstances. Trade Wars Are Back Trade wars are once again on the radar screen of investors. The U.S. is the bellicose country, but as we argued three weeks ago, this acrimony is not really generalized to the entire world: it is first and foremost pointed at China.2 The events of the past weeks are confirming this thesis, with U.S. President Donald Trump having announced the levy of a potential 25% tariff on US$60 billion of Chinese shipments to the U.S. Beijing also announced its own tariffs - a retaliation to the U.S.'s steel and aluminum tariffs - of at least 15% on US$3 billion U.S. exports to China. The response from China is a measured one, and BCA's Geopolitical Strategy service argues that President Xi Jinping will likely push Beijing to offer small concessions to the U.S., especially as President Trump is currently trying to rally the EU to his cause.3 However, while China is willing to pacify Trump for now, this recent episode highlights that the relationship between the two global superpowers is becoming increasingly fraught with tensions - a consequence of China's ascent and the U.S.'s relative decline (Chart I-1). Chart I-1The Incumbent Versus The Upstart Do Not Get Flat-Footed By Politics Do Not Get Flat-Footed By Politics While fears of a trade war are likely to recede in the short term, the longer-term outlook remains worrisome. China is likely to become more confrontational toward the U.S. as time passes, and vice-versa. This supports one of BCA's important theses: The apex of globalization is behind us. As a result, global trade is unlikely to expand anymore on a secular basis. China and the U.S. are also likely to become increasingly insular, which could hurt their future growth. Table I-1 highlights the G-10 economies most at risk from this phenomenon, at least measured by their combined exports to the two superpowers. Canada and Switzerland stand out as the two countries most exposed to a rise in future trade conflicts, with exports to China and the U.S. representing 20.6% and 9.6% of their respective GDP. Australia, Germany and New Zealand stand as the second group most at risk, with around 6% of their GDP dependent on these economies. Interestingly, Sweden, an economy that has historically fluctuated with EM growth indicators, seems modestly impacted by China and the U.S., with exports to those countries only representing 3.2% of GDP. However, this picture is misleading. While Swedish exports to the euro area represent 12% of GDP, 60% of Swedish overall exports are intermediate and capital goods. As a result, euro area demand for Swedish goods is deeply affected by fluctuations in Chinese and EM final demand. This means that Sweden is in fact on par with Australia regarding its exposure to a trade war between the U.S. and China. Ranked Exposure To The Warring Kingdoms Do Not Get Flat-Footed By Politics Do Not Get Flat-Footed By Politics The rising risks of a trade conflict between the U.S. and China has been very impactful on financial market volatility. This is because the world economy is being affected by two other negatives right now: global growth is set to decelerate and the Fed's real fed funds rate is moving close to equilibrium, which normally supports financial market volatility. Regarding the outlook for a growth slowdown this year, we have already highlighted that EM carry trades funded in yen have rolled over, which has historically led to a weakening in global industrial activity (Chart I-2). Not only are EM carry trades very sensitive to the outlook for global growth, they are also a key component of EM liquidity conditions: when carry trades are increasingly profitable, they attract capital which generate funds inflow in EM economies; when they become less profitable, the capital abandons these strategies, generating fund outflows out of the EM space. These dynamics end up affecting global economic conditions. The OECD's global leading economic indicator has also begun corroborating this message. Its diffusion index has collapsed below the 50% line, which normally leads to a deceleration in the LEI itself (Chart I-3, top panel). Meanwhile, Korean exports have clearly rolled over, providing another negative signal for global growth (Chart I-3, bottom panel). None of these charts suggest that growth will fall below trend anytime soon, but they clearly highlight that the sunniest days for global growth are behind us. Chart I-2Global Growth Is Slowing Global Growth Is Slowing Global Growth Is Slowing Chart I-3More Indicators Of A Slowdown More Indicators Of A Slowdown More Indicators Of A Slowdown Despite this backdrop, the U.S. Fed is being forced to tighten policy as the U.S. economy is at full employment and the federal government is expanding stimulus. Interestingly, the next two hikes or so are likely to bring the real fed funds rate above the neutral rate, or R-star. As Chart I-4 highlights, when this happens, volatility increases. The upside to volatility is only made more salient by the current upgrade to long-term geopolitical risks and the imminent soft patch in global growth. In this environment, the clearest winner could remain the yen. The yen enjoys rising volatility. This is first and foremost because when volatility picks up, carry trades are reversed, prompting investors to buy back funding currencies like the yen. AUD/JPY seems especially vulnerable in this context. Not only is this cross directly hurt by rising volatility (Chart I-5), but Australia also stands to lose from tensions between the U.S. and China. The U.S. dollar could also benefit for now if the current environment does lead to higher financial market volatility. Historically, the USD has benefited from periods of rising risk aversion,4 but the recent widening in the LIBOR-OIS spread could also exacerbate these pressures (Chart I-6). The widening in this spread may have been aggravated by technical considerations: as financial intermediaries begin to move away from LIBOR as the key interest rate benchmark for USD loans, liquidity in this market may decline. This in of itself would not represent a systematic decline in USD-liquidity. However, this year's U.S. corporate tax cuts are prompting important repatriations of profits held abroad, to the tune of US$300-400 billion. Because U.S. firms keep their earnings abroad in the form of high-quality U.S. securities, this repatriation is likely to mean there will be less collateral available to secure transactions in the offshore USD market. This increases the cost of dollar funding. Thus, some of the rise in the LIBOR-OIS spread does in fact reflect a real tightening in global liquidity conditions. This is why the widening in this spread could help the USD, albeit temporarily. Chart I-4Policy Is Getting Tighter, ##br##Higher Vol Will Ensue Policy Is Getting Tighter, Higher Vol Will Ensue Policy Is Getting Tighter, Higher Vol Will Ensue Chart I-5Short AUD/JPY As##br## A Volatility Hedge Short AUD/JPY As A Volatility Hedge Short AUD/JPY As A Volatility Hedge Chart I-6Money Market Tensions Will Help ##br##The Dollar In Coming Months Money Market Tensions Will Help The Dollar In Coming Months Money Market Tensions Will Help The Dollar In Coming Months Bottom Line: Even if the recent spike peters off in the short term, geopolitical tensions between China and the U.S. are on a structural uptrend, reflecting growing competition between the incumbent power and the rising upstart. Trade conflicts between these two nations will only grow as time passes, hurting global trade and global growth in the process. Small open economies like Canada, Australia and Sweden could be the main collateral damage of this process. Today, the pricing of this risk is likely to exacerbate pressure on financial volatility created by a soft patch in growth and a tightening Fed. The yen and the USD should benefit from these dynamics over the coming months. Sterling: Risks Brewing Ahead Early last year, in a report titled "GBP: Dismal Expectations,"5 we argued that investors were too pessimistic on the British economic outlook, and that the cheap pound could surprise to the upside. Since then, GBP/USD has rallied by nearly 20%, back to pre-Brexit levels. Apart from generalized dollar weakness, three main factors have been behind the surge in cable: Fears of a hard Brexit have dissipated. Brexit did not plunge the U.K. economy into immediate recession. The Bank of England and market participants were surprised by higher-than-expected inflation, prompting a rethink of policy. Hard Brexit Chart I-7Monetary Conditions Are No ##br##Longer Accommodative Monetary Conditions Are No Longer Accommodative Monetary Conditions Are No Longer Accommodative BCA's Geopolitical Strategy team has written extensively against underestimating the probability of a hard Brexit, given that polls have not turned definitively to bremorse.6 Thus, if Labour becomes the ruling party, U.K. politicians will continue to pursue Brexit so long as the polls show support for it. Thus, investors should be careful in quickly removing the Brexit risk premium from the pound, especially as EU-U.K. negotiations remain fraught with risks. The Economy The dire economic forecasts made in the direct wake of the 2016 referendum did not come to fruition because the collapse in the pound and the fall in Gilts yields massively eased British financial conditions (Chart I-7), providing an unexpected boon to the economy. This is no longer the case: both the pound and U.K. yields have come back to pre-Brexit levels. The impact of this tightening in monetary conditions is now being felt. Household real consumption growth has fallen to seven-year lows, creating a drag for businesses, as consumer spending represents 66% of the British economy (Chart I-8). Moreover, various measures of the British credit impulse have collapsed, pointing to a continued slowdown in economic activity (Chart I-9). Chart I-8Weak Demand Is Hurting Businesses Weak Demand Is Hurting Businesses Weak Demand Is Hurting Businesses Chart I-9Credit Impulse Points To Downside Credit Impulse Points To Downside Credit Impulse Points To Downside How exactly is Brexit affecting the economy today? Simply put, money is leaving the U.K. Before the referendum, both the basic balance and net FDI stood at 2% of GDP. Today these measures stand at -4% and -3%, respectively. Uncertainty about the exact terms of the Brexit deal and the loss of passporting rights for financial institutions have scared away international capital. The housing market has been especially hit, experiencing its slowest growth rate since 2013, in spite of extremely low mortgage rates (Chart I-10). Foreign capital is a major driver of the U.K.'s real estate market, with academic research suggesting that a 1% increase in foreign residential transactions translates to a 2.1% increase in house prices.7 Hence, as foreign capital continues to flee, the housing market will suffer further. Moreover, the housing market has historically been a key leading indicator of U.K. growth, suggesting that British domestic demand will remain weak (Chart I-11). Chart I-10Low Mortgage Rates Are##br## Not Helping Real Estate Low Mortgage Rates Are Not Helping Real Estate Low Mortgage Rates Are Not Helping Real Estate Chart I-11The Housing Market Points##br## To A Contraction In Demand The Housing Market Points To A Contraction In Demand The Housing Market Points To A Contraction In Demand Inflation Can inflation dynamics trump the lack of growth and force the BoE to tighten policy anyway, supporting the pound in the process? Two opposing forces could determine the path of inflation: the tight labor market and the appreciating pound. A hot labor market like the U.K.'s (Chart I-12) should put upward pressure on wages, pushing up inflation and consequently, rate expectations. However, this ignores the behavior of British inflation over the past 25 years. U.K. core inflation has mostly been driven by previous movements in the currency (Chart I-13). Meanwhile, the labor market has had very little impact on prices, with core inflation staying below 2% from 1996 to 2008, despite an unemployment rate consistently below NAIRU and a global economy firing on all cylinders. Chart I-12U.K. Has A Tight Labor Market... U.K. Has A Tight Labor Market... U.K. Has A Tight Labor Market... Chart I-13...But Inflation Is Determined By The Currency ...But Inflation Is Determined By The Currency ...But Inflation Is Determined By The Currency This kind of tight relationship between inflation and exchange rate fluctuations tends to be associated with EM countries and small open economies, not large service-based economies like the U.K. In fact, the U.K. has to import a larger percentage of its goods and services than other developed countries. Therefore, despite its large service-oriented economy, British import penetration is much more similar to New Zealand and Norway than to the U.S. or Japan (Chart I-14).8 Consequently, core inflation is relatively insensitive to labor market dynamics. Instead, prices of import-sensitive goods and services are the main contributors to variations in core inflation (Chart I-15). Chart I-14Imports Are A Big Share Of U.K. Demand Imports Are A Big Share Of U.K. Demand Imports Are A Big Share Of U.K. Demand Chart I-15Import Prices Determine U.K. Core Inflation Import Prices Determine U.K. Core Inflation Import Prices Determine U.K. Core Inflation Because of this interplay, we do not expect that the labor market tightness will be enough to compensate the depressing impact on inflation from the pound's recent large appreciation. The above dynamics will likely limit how high the BoE will be able to lift interest rates. As a result, we do not expect the pound to buck any rally in the USD this year. Moreover, rising volatility will likely increase the cost of financing the already large current account deficit, which further argues for a weaker pound. We are therefore selling GBP/USD this week. Bottom Line: The combined impact of a likely rollover in inflation, continued soft growth and still-elevated political uncertainty will limit the capacity of the BoE to hike rates. Since the pound's discount to fair value has now melted, the outlook for GBP/USD is now more bearish, particularly as U.S. inflation is set to outperform expectations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Analyst juanc@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "The Return Of Macro Volatility", dated March 16, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "Are Tariffs Good Or Bad For The Dollar?", dated March 9, 2018, available at fes.bcaresearch.com 3 Please see Geopolitical Strategy Weekly Report, titled "We Are All Geopolitical Strategists Now", dated March 28, 2018, available at gps.bcaresearch.com 4 Please see Foreign Exchange Strategy Special Report, titled "In Search Of A Timing Model", dated July 22, 2016, available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Special Report, "GBP: Dismal Expectations", dated January 13, 2017, available at fes.bcaresearch.com 6 Please see Geopolitical Strategy Weekly Report, "Bear Hunting And A Brexit Update", dated February 14, 2018, available at gps.bcaresearch.com 7 Sa, Filipa. "The Effect of Foreign Investors on Local Housing Markets: Evidence from the UK". King's College London, 2016. 8 It is worth noting that although imports constitute an even higher share of consumption in euro area economies, a lot of this imports are from other EMU countries, therefore the impact of currency fluctuations on prices is more muted on the continent. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was mixed: Q4 GDP growth was revised up to 2.9%, more than the expectations of 2.7%; Headline PCE came out higher than expected at 1.8%; Core PCE improved to 1.6% from 1.5% but was in line with expectations; Initial jobless claims came in at 215,000, lower than the expected 230,000; The DXY's downward momentum has subsided, and trading has been constrained to a range of around 88.5 to 90.5 for the past two months. Importantly, the DXY is approaching a key downward-sloping trendline which the greenback has not been able to punch above since Q1 2017. As signs are accumulating that global growth may experience a soft patch, the USD may finally be able to punch above this powerful resistance over the coming months. Report Links: Are Tariffs Good Or Bad For The Dollar? - March 9, 2018 The Dollar Deserves Some Real Appreciation - March 2, 2018 Who Hikes Again? - February 9, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data has generally been weak: German import prices contracted by 0.6%; Euro area private loans grew by 2.9%, less than the expected 3%; Euro area M3 money supply increased by 4.2%, underperforming expectations of 4.6%; Euro area Business Climate survey fell to 1.34 from 1.48, below the anticipated 1.39; German headline consumer prices came in below expectations of 1.6% annually; German harmonized consumer prices also failed to meet expectations, coming in at 1.5%. Mirroring the DXY, EUR/USD is has lost some of its powerful upward momentum. Net speculative positions are still at all-time highs, but long positions seem to be rolling over. Markets may begin to be concerned about the implications for euro area growth and inflation of a global growth prospects. Investors should be positioned for a short-term correction. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been negative: Both import and export yearly growth underperformed expectations, coming in at 16.5% and 1.8% respectively. Moreover, both the coincident and the leading economic indicators surprised negatively, coming in at 114.9 and 105.6. The Nikkei manufacturing PMI also underperformed expectations, coming in at 53.2 Finally, the National consumer price index also surprised to the downside, coming in at 1.5% Economic data in Japan show that the strength in the currency has started to bite into the Japanese economic outlook. Overall we continue to be bullish on the yen, as this currency doesn't need a strong Japanese economy to rise, instead, it tends to benefit from rising financial market volatility, a rising risk in the current environment. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Both core and headline inflation underperformed expectations, coming in at 2.4% and 2.7% respectively. Moreover, mortgage approvals also underperformed expectations, coming in at 64 thousand. However, average hourly earnings yearly growth surprised to the upside, coming in at 2.8%. GBP/USD has fallen by roughly 2.3% this week. Right now there are two opposing forces that could affect inflation. The first is a very tight labor market, which right is pushing up wages. The second is the pass through from an appreciating pound, which is lowering import prices. Out of these two, the effect of the pound will likely win out, given that imports satisfy a large percentage of demand in the U.K., making inflation less sensitive to labor market dynamics. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Last week's lackluster employment report for Australia continues to weigh down on the Aussie as investors are rightfully reticent to bet on any policy tightening by the RBA. Further hampering the prospects of hikes are the recent developments in the Australian interbank market: Funding costs for Australian banks have increased substantially since the end of last year, with the 3-month Australian bank bill rates gaining 26 bps, and the yield on AUD 3-month implied yield gaining about 50 bps. This is consistent with the increase in the LIBOR-OIS spread. Additionally, this has occurred alongside a flat AUD Swap OIS curve, meaning that no additional rate hikes are being priced in by the market. It will be extremely difficult for the RBA to hike rates alongside these widening spreads, especially when equipped with a slacking economy. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Last Thursday the RBNZ kept its policy rate unchanged at 1.75%. The statement was rather dovish, as governor Graham Spencer stated that "monetary policy will remain accommodative for a considerable period". Moreover Governor Spencer also highlighted that the RBNZ expected CPI to weaken further in the near term due to soft tradable inflation. Overall, we expect that the NZD will outperform the AUD, given that the kiwi economy is less sensitive to a global growth slowdown than the Australian economy. However the kiwi will suffer against the USD or the JPY, given that its positive link with commodity prices and inverse relationship with volatility. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canadian data was disappointing: Raw material prices contracted by 0.3% in February; Industrial product prices grew by less than expected, at 0.1% in monthly terms; Monthly GDP was also lackluster, contracting by 0.1%. However, inflation in February was at 2.2%, which is in line with the Bank's target. The fiscal impulse flow-through from the U.S. to Canada is likely to at the very least uphold this inflation figure. This will allow the BoC to stay in line with hike expectations. However, risks such as low wage growth, high debt levels, and NAFTA negotiations were mentioned in the Bank's 2017 Annual Report and need to be monitored carefully when proceeding with hikes. But on the bright side, recent reports that the U.S. is willing to drop its auto-content proposal from NAFTA talks point toward a positive outcome for NAFTA negotiations. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: The trade balance for February outperform expectations, coming in at 3.138 billion. However, the KOF leading indicator underperformed expectations. EUR/CHF has rallied by roughly 1% this past week. Overall, we expect that this cross will continue to appreciate given that inflation in Switzerland is still very weak. Therefore the SNB will intervene in the currency markets to keep the franc from appreciating. Report Links: The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been mixed: The credit indicator underperformed expectations, coming in at 6.1%. Moreover, registered unemployment also surprised negatively, coming in at 2.5%. However it stay flat from last month's reading. USD/NOK has rallied by nearly 2.5% in the past couple days, as the dollar has regained vigor and oil prices have been toppy. Overall, we expect that the Norwegian krone will be one of the best performing commodity currency, as OPEC cuts will help oil outperform other commodities. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Lackluster data continued to come out of Sweden: Consumer confidence dropped to 101.5, underperforming the expected 105; Producer prices contracted 0.5% on a monthly basis, but grew 2.8% on an annual basis; The monthly trade deficit contracted by SEK 3.4 bn; Retail sales disappointed, coming in at 1.5%, less than the expected 1.7%. EUR/SEK has continued to climb on this news flow. It is likely that the SEK received a hit due to Riksbank Deputy Governor Cecilia Skingsley's comments that if the krona appreciates too much, it would jeopardize their inflation outlook. However, she also brought up Sweden's higher inflation relative to the euro area, which means it is "natural" that the Riksbank eventually can start raising rates "a little bit before" the ECB. This will prove to be bullish for the krona this year. Another factor weighing on the SEK today is the rising acrimony in global trade, a risk to which Sweden is very exposed. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

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

Highlights The best recession indicators are not flashing red, but volatility is rising as the end of the cycle approaches; U.S. fiscal policy is surprising to the upside, as we expected; The next recession will usher in an inflationary political paradigm shift, with wealth transferred from Baby Boomers to Millennials; Expect a new U.K. election ahead of March 2019, but do not expect a second referendum unless popular opinion swings decisively against Brexit; Stay short U.S. 10-year Treasuries versus German bunds; short Fed Funds Dec 2018 futures; and initiate a short GBP/USD trade. Feature February has been tough for global markets, with the S&P 500 falling by 5.9% since the beginning of the month. Several clients have pointed out that the market may be sniffing out a recession and that the "buy the dip" strategy is therefore no longer applicable. It is true that markets and recessions go together (Chart 1), but it is not clear from the data that the equity market alone predicts recessions correctly. Chart 1Bear Markets & Recessions: Unclear Which One Leads The Other Bear Markets & Recessions: Unclear Which One Leads The Other Bear Markets & Recessions: Unclear Which One Leads The Other BCA's House View is that a recession is likely at the end of 2019.1 This view is in no small part based on our political analysis.2 President Trump ran on a populist electoral platform and populist policymakers globally have a successful track record of delivering higher nominal GDP growth than their non-populist counterparts (Chart 2). We assume that the Powell Fed will respond to such higher growth and inflation prospects no differently from the Yellen Fed and that it will restrict monetary policy to an extent that will usher in a mild recession by the end of next year. Chart 2Populists Deliver (Nominal) GDP Growth Bear Hunting And A Brexit Update Bear Hunting And A Brexit Update Of course, predicting recessions is extraordinarily difficult. Being six months early or late would still be an achievement, but the implications for the equity market would likely be considerably different. If our "late 2019" call is actually an "early 2019" recession, then equity markets may indeed be at or near their cyclical peaks. A "buy on dips" strategy may work for the next quarter or so, but superior returns over the course of the year may be achieved with a bearish strategy. To help guide clients through the uncertainty, our colleague Doug Peta, chief strategist of BCA's Global ETF Strategy, has recently updated BCA's methodology for identifying the inflection points that usher in a recession.3 In our 70-year history as an investment research house, we have picked up two definitive truths: valuation and technical indicators cannot call a recession. So what can? We encourage clients to pick up a copy of Doug's analysis.4 The report highlights the three BCA Research recession indicators: the orientation of the yield curve, the year-over-year change in the leading economic indicator (LEI),5 and the monetary policy backdrop. Charts 3, 4, and 5 show how successful the three indicators are in calling recessions. In our 50-year sample period, the yield curve has successfully called all seven recessions with just one false positive. However, it tends to be overly eager, preceding the onset of a recession by an average of nearly twelve months. When we combine the yield curve indicator with the LEI, the false positives go away. Chart 3The Yield Curve Has Called Seven Of The Last Eight Recessions... The Yield Curve Has Called Eight Of The Last Seven Recessions... The Yield Curve Has Called Eight Of The Last Seven Recessions... Chart 4... And So Has The Leading Economic Indicator ...And So Has The Leading Economic Indicator ...And So Has The Leading Economic Indicator To confirm the recession signal and make it more robust, we also consider the monetary policy backdrop. Over the nearly 60 years for which BCA's equilibrium fed funds rate model has calculated an estimate of the equilibrium policy rate, every recession has occurred when the fed funds rate exceeded our estimate of equilibrium. In other words, recessions only occur when monetary policy settings are restrictive. Today, none of the indicators are even close to pointing to a recession, with the LEI at a cyclical peak. However, the yield curve and monetary policy are directionally moving towards the end of the cycle. Taken together, they suggest that the only controversy about our late 2019 recession call is that it is so early. So why the market volatility? Because wage growth in the U.S. has begun to pick up in earnest (Chart 6), revealing that BCA's concerns about inflation may at last be coming true. Investors, after more than a year of rationalizing weak inflation by means of dubious concepts (Amazon, AI, robots, etc.), may be reassessing their forecasts in real time, causing market turbulence. Chart 5Tight Policy Is A Necessary,##br## If Not Sufficient, Recession Ingredient Tight Policy Is A Necessary, If Not Sufficient, Recession Ingredient Tight Policy Is A Necessary, If Not Sufficient, Recession Ingredient Chart 6Wages Picking##br## Up In Earnest Wages Picking Up In Earnest Wages Picking Up In Earnest There is of course a political explanation as well. Our colleague Peter Berezin correctly called the end of the 35-year bond bull market on July 5, 2016.6 The timing of the call - mere days after the U.K. EU membership referendum - was not a coincidence. As Peter mused at the time, "the post-Brexit shock running through policy circles leads to a further easing in fiscal and monetary policy." He was not speaking about the U.K. alone, but in global terms. Indeed, the populists have begun to deliver. Ever since President Trump's election, we have cautioned clients not to doubt the White House's populist credentials.7 After a surge in bond bearishness immediately following the election, investors lost faith in the populist narrative due to the failure of Congress to pass any significant legislation, as if Congress has ever been a nimble institution under previous presidents. But investors are beginning to realize that their collective political analysis was extremely wrong. Not only have profligate tax cuts been passed, as we controversially expected throughout 2017, but Congress is now on the brink of a monumental two-year appropriations bill that will add nearly 1% of GDP worth of fiscal thrust in 2018 higher than what the IMF expected for the U.S. (Chart 7). In addition, Congress has set in motion the process to re-authorize the use of "earmarks" - i.e. legislative tags that direct funding to special interests in representatives' home districts (Chart 8).8 Chart 72018 Fiscal Thrust Was Unexpected Bear Hunting And A Brexit Update Bear Hunting And A Brexit Update Chart 8Here Comes Pork! Bear Hunting And A Brexit Update Bear Hunting And A Brexit Update By our back-of-the-envelope accounting, Congress is about to authorize just shy of $400bn in extra spending over the next two years.9 If earmarks are allowed back into the legislative process, we could see up to another $50bn in spending. An infrastructure deal, which now also looks likely given that the Democrats have realized that their "resistance"/ "outrage" strategy does not work against the Trump White House, could add significantly to that total. We are already positioned for these political developments through two fixed-income recommendations. We are short U.S. 10-year Treasuries vs. German Bunds, a recommendation that has returned 27.7 bps since September 2017. In addition, we are short the Fed Funds December 2018 futures, a recommendation that has returned 43.17 bps since the same initiation date. In addition, we went long the U.S. dollar index (DXY) on January 31, right before the stock market correction and precisely when the greenback appeared to bottom. Should investors prepare for runaway inflation this cycle? Is it time to load up on gold? We do not think so. The fiscal impulse from the two-year budget deal will become negative in 2020. The capex incentives from the tax cut plan are also front-loaded. The paradigm-shifting impact on inflation will require a policy paradigm shift. And we expect such a shift only after the next recession. To put it bluntly, U.S. voters elected a TV game show host due to angst at a time when unemployment stood at 4.6% (the rate on November 2016). Who will they elect with unemployment rising to 6% in the aftermath of the next recession, or God forbid if that next recession is worse than we think it will be? Policymakers are unlikely to sit around and wait for an answer to that question. Extraordinary measures will be taken to prevent the median voter from lashing out against the system when the next recession hits. Inflation, which is a redistributive mechanism, will be employed to transfer wealth from savers (mainly well-to-do retirees) to consumers (their children). In large part, this will be a generational wealth transfer between Baby Boomers (or at least those with some savings) and their Millennial children. Given that Millennials have become the largest voting bloc in the U.S. as of the 2016 election, this will be a populist policy with firm backing in the electorate. The next recession will therefore usher in the inflationary era of the next decade, regardless of how painful the actual recession is. In the meantime, we recommend that clients with a 9-to-12 month horizon continue to "buy on dips," given that a recession is not on the horizon. However, with the U.S. 10-year yield approaching 3%, China moderately slowing down (with considerable risk to the downside), and the U.S. dollar slide arrested, we think that the outperformance of EM equities is over. Brexit: We Can't Work It Out10 The EU agreed on January 29 to its negotiation guidelines for the temporary transition period after the U.K. officially leaves the bloc in March 2019.11 The British press predictably balked at the conditions - the term "vassal state" has been liberally bandied about - which in our view included absolutely nothing out of the expected. The EU conditions for the transition period are not the fundamental problem. Rather, the problem is that the "Vote Leave" campaign was never honest with its promises. Boris Johnson, the most prominent supporter of Brexit ahead of the vote and now the foreign minister in Prime Minister Theresa May's cabinet, famously quipped after the referendum that "there will continue to be free trade and access to the single market."12 The problem with that promise, however, was that it was predicated on using London's "superior negotiating position" vis-à-vis the EU in order to force the Europeans to redefine what membership in the Common Market means. As we pointed out in our net assessment ahead of the Brexit referendum, the problem with exiting the EU but remaining in the Common Market is that the issue of sovereignty is not resolved (Diagram 1).13 As such, Johnson and other Brexit supporters argued that they could change the relationship by forcing the EU to change how the Common Market works. Diagram 1Common Market Membership Is Illogical Bear Hunting And A Brexit Update Bear Hunting And A Brexit Update Except for one problem: the U.K.'s negotiating position is not, never was, nor ever will be, superior. Anyone with a rudimentary understanding of how trade works can understand this. For example, the U.K. is a significant market for Germany, at 6% of German exports (right in line with the 6% of total EU exports that go to the U.K.). However, the EU is a far greater destination for British exports, with 47% of all exports going to the bloc.14 As we expected, the EU has surprised the conventional wisdom by remaining united in the face of negotiations. And as we also predicted, the Tories are now completely divided.15 PM May will attempt to hammer out an internal deal on how to approach the transition deal. But her political capital is so drained by the disastrous early election results that there is practically no way that she can produce a set of negotiating guidelines that will not be pilloried in the press. As such, we expect a new election to take place in the U.K. ahead of March 2019, perhaps sooner. We do not see how May's negotiating position will satisfy all wings of the Conservative Party. In addition, we see no scenario by which the ultimate exit deal with the EU gets enough votes in Westminster. Investors betting on that election replacing a second Brexit referendum would be wrong. A Jeremy Corbyn-led, Labour government will only turn against Brexit once the polls definitively turn against it. This has not yet happened, as the gap between supporters and opponents of Brexit in the polls, while widening in favor of opponents, remains within a margin of error (Chart 9). As such, Corbyn would scrap the Tory-led negotiations with the EU and ask Brussels for even more time - and thus more market uncertainty! - in order to produce a Labour-led Brexit deal.16 In order for the probability of Brexit to definitively decline, the polls have to show that "Bregret" or "Bremorse" is setting in. Without a move in the polls, U.K. politicians will continue to pursue Brexit, no matter how flawed their tactics may be. Policymakers are ultimately not the price makers but the price takers. On the issue of Brexit, the U.K. median voter is only slightly miffed regarding the outcome. Current polls suggest that Labour could win the next election, albeit needing to rule with a coalition (Chart 10). This would prolong the uncertainty facing the economy. Not only is Corbyn the most left-leaning politician in a major European economy since François Mitterand, but also his coalition would likely include the Scottish National Party and potentially the Liberal Democrats. Keeping all their priorities aligned could be even more difficult than the balancing act PM May is performing between soft-Brexiters, hard-Brexiters, and the Democratic Unionist Party. Chart 9Bremorse: Rising, But Not Definitive Bremorse: Rising, But Not Definitive Bremorse: Rising, But Not Definitive Chart 10Anti-Brexit Forces On The Rise Anti-Brexit Forces On The Rise Anti-Brexit Forces On The Rise Meanwhile, on the economic front, the situation is not much better. Our colleague Rob Robis, BCA's chief bond strategist, recently penned a critical assessment of the U.K. economy.17 As Rob pointed out, the OECD leading economic indicator is decelerating steadily and pointing to a real GDP growth rate below 2% in 2018 (Chart 11). The biggest factors that will weigh on growth will be a sluggish consumer and softer capex. Household consumer growth has been slowing since early 2017, driven by diminishing consumer confidence (Chart 12, top panel). High realized inflation, which has sapped the purchasing power of U.K. workers who have not seen matching increases in wages, is weighing on confidence (third panel). Consumers were able to maintain a decent pace of spending during a period of stagnant real income growth by drawing on savings, but that looks to be tapped out now with the saving rate down to a 19-year low of 5.5% (bottom panel). Chart 11U.K. Growth Set To Slow U.K. Growth Set To Slow U.K. Growth Set To Slow Chart 12The U.K. Consumer Looks Tapped Out The U.K. Consumer Looks Tapped Out The U.K. Consumer Looks Tapped Out Making matters worse, U.K. consumers are not seeing much of a wealth effect from the housing market. The January 2018 readings of the year-over-year growth rate of U.K. house prices from the Halifax and Nationwide indexes came in at 1.9% and 3.1% respectively (Chart 13). In addition, the net balance of national house price expectations from the Royal Institution of Chartered Surveyors (RICS) has steadily declined since mid-2016 and now sits just above zero (i.e. equal number of respondents expecting higher prices and falling prices). The same indicator for London was a staggering -47% in January 2018. Apparently, foreigners are no longer interested in a Brexit discount. Our global bond team goes on to point out that political uncertainty is also weighing on U.K. business investment spending. Capital expenditure growth slowed to 4.3% year-over-year in nominal terms in Q3 2017 and is even lower in real terms (Chart 14). Chart 13No Wealth Effect ##br## From Housing No Wealth Effect From Housing No Wealth Effect From Housing Chart 14Brexit Gloom Trumps ##br##Export Boom For U.K. Companies Brexit Gloom Trumps Export Boom For U.K. Companies Brexit Gloom Trumps Export Boom For U.K. Companies Putting all of this together, neither our global bond team nor our foreign exchange team expect the Bank of England to raise interest rates, despite the market pricing in 36 bps of rate hikes over the next twelve months. As Chart 15 illustrates, inflation across a broad swath of components is likely to slow sharply in the coming months as the trade-weighted pound has stopped depreciating. Thus, the pass-through from a lower exchange rate is beginning to dissipate.18 In the long-term, we understand why investors are itching to bet on Brexit never happening. But to get from here to there, the market will have to riot. And that means more downside to U.K. assets. Chart 15U.K. Inflation:##br## Less Pass-Through From The Pound U.K. Inflation: Less Pass-Through From The Pound U.K. Inflation: Less Pass-Through From The Pound Chart 16GBP:##br## Stuck In A Rut GBP: Stuck In A Rut GBP: Stuck In A Rut Bottom Line: BCA's FX strategist, Mathieu Savary, has pointed out that the trade-weighted pound is testing the upper bound of its post-Brexit trading range (Chart 16). As our FX and bond teams show in their respective research, the economics currently at play make it unlikely that the pound will be able to punch above the ceiling of this range. Our political assessment adds to this view. In fact, we expect that the coming political uncertainty, including an early election prior to March 2019, is likely to take the pound back to the floor of its trading range. As such, we are recommending that clients short cable, GBP/USD. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," June 16, 2017, available at gis.bcaresearch.com. 2 Please see BCA Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, and "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017, available at bcaresearch.com. 3 Please see BCA Special Report, "Timing The Next Equity Bear Market," dated January 24, 2014, and "Timing Equity Bear Markets," dated April 6, 2011, available at bcaresearch.com. 4 Please see BCA Global ETF Strategy Special Report, "A Guide To Spotting And Weathering Bear Markets," dated August 16, 2017, available at etf.bcaresearch.com. 5 The ten components of leading economic index for the U.S. include: 1. Average weekly hours, manufacturing; 2. Average weekly initial claims for unemployment insurance; 3. Manufacturers' new orders, consumer goods and materials; 4. ISM® Index of New Orders; 5. Manufacturers' new orders, nondefense capital goods excluding aircraft orders; 6. Building permits, new private housing units; 7. Stock prices, 500 common stocks; 8. Leading Credit Index TM; 9. Interest rate spread, 10-year Treasury bonds less federal funds; and 10. Index of consumer expectations. Source: The Conference Board. 6 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. 7 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, and "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 8 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. 9 We are referring to the Senate deal struck last week to authorize additional military spending ($80bn in FY2018 and $85bn in FY2019) and discretionary spending ($63bn in FY2018 and $68bn in FY2019), as well as to provide disaster relief in the amount of $45bn for both fiscal years. 10 Life is very short, and there's no time ... For fussing and fighting, my friend ... 11 Please see European Council, "Brexit: Council (Article 50) adopts negotiating directives on the transition period," dated January 29, 2018, available at consilium.europa.eu. 12 Please see "UK will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. 13 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. 14 This is not a coincidence. The whole point of the EU is that it is the world's richest consumer market. As such, it has massive negotiating leverage with all trade partners. As a side note, this throws into doubt the logic that the U.K. can get better trade deals by leaving the bloc. The first test of that premise will be its negotiations with the EU itself. 15 Please see BCA Special Report, "Break Glass To Brexit: A Fact Sheet," dated June 17, 2016, available at bca.bcaresearch.com. 16 Investors should remember that Westminster voted decisively 319 to 23 to reject the Liberal Democrats' amendment seeking a referendum on the final Brexit agreement. Only nine Labour MPs voted in favor of the amendment after Jeremy Corbyn instructed his party to abstain. 17 Please see BCA Global Fixed Income Strategy Weekly Report, "A Melt-Up In Equities AND Bond Yields?" dated January 23, 2018, available at gfis.bcaresearch.com. 18 Please see BCA Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com.

Highlights Should the U.S. 10-year T-bond yield approach 3% it would be a red flag, and a trigger to downgrade equities. Equity investors should stay overweight defensive-heavy Switzerland and Denmark. Contrary to what the consensus is expecting, global growth will lose steam in the first half of 2018. EUR/USD will continue to trend higher through 2018 as long-term interest rate differentials converge further. The multi-year prognosis for GBP/USD is higher. U.K. parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. Feature A happy and prosperous 2018 to you all! In this first report of the year, we describe some investment outcomes in 2017 that at first glance seemed odd or unexpected; but that on deeper reflection provide valuable insights for 2018. Some of these insights deviate substantially from the BCA house view. Bonds Became More Risky Than Equities The first oddity of 2017 concerns the 'drawdowns' suffered by bonds and equities. A drawdown is defined as an investment's peak to trough decline. In 2017, the odd thing was that the drawdowns suffered by government bonds - a supposedly safe asset-class - were equal to or worse than those suffered by equities - a supposedly risky asset-class (Chart of the Week, Chart I-2 and Chart I-3). Chart of the WeekBonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Chart I-2Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Chart I-3Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Contrary to classical theory, empirical evidence now proves that investors do not define an investment's risk in terms of its volatility, the fluctuations of its return around a mean. Instead, investors define risk as the ratio of large and sudden drawdowns versus potential gains. This unattractive asymmetry in an investment's return is technically known as negative skew. And it is as compensation for this negative skew that investors demand an excess return, the so-called 'risk premium'. Significantly, at low bond yields, the mathematics of bond returns necessarily means that their negative skew increases. The risk of large and sudden drawdowns rises while the prospect for price gains diminishes. But if bond risk becomes 'equity-like', it follows that equities' prospective long-term return should become 'bond-like'. Meaning, equities should no longer offer a meaningful risk premium over bonds. Is this the case? According to my colleague Martin Barnes, BCA Chief Economist, the answer appears to be yes - at least in certain major markets. In BCA's Outlook 2018, Martin projects that from current valuations U.S. equities are set to deliver a total nominal return of 2.6% a year to 2028 - almost indistinguishable from the 2.5% a year that a U.S. 10-year T-bond will deliver over the same period. But the mathematics of bond pricing tells us that the negative skew on bond returns fully disappears when a yield approaches 3%. At which point the risk of bonds once again declines to become 'bond-like', and the required return on equities should once again rise to become 'equity-like'. This higher required return would necessarily require today's equity prices to drop, perhaps substantially. Admittedly in Europe there is a bigger gap between the expected returns from equities and bonds than there is in the U.S. The trouble is that global capital markets move together and a chain is only as strong as its weakest link. Hence, one lesson for 2018 is that investors should downgrade equities to neutral should the U.S. 10-year T-bond yield approach 3%. In this event, investors should redeploy the funds into U.S. T-bonds, because any substantial adjustment in risk-asset prices would trigger supportive flows into haven bonds, reversing the spike in yields. Euro/Dollar Hit A 3-Year High EUR/USD ended 2017 touching 1.21, a 3-year high. At first glance, this might seem odd given that the ECB has committed to maintaining its zero and negative interest rate policy for at least another year while the Federal Reserve has already hiked interest rates five times. But EUR/USD is not tracking short-term rate differentials. It is tracking long-term rate differentials, and EUR/USD at a 3-year high is fully consistent with the 30-year T-bond/German bund yield spread converging to its narrowest for several years (Chart I-4). Chart I-4Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Where will this yield spread go from here? Let's consider both sides of the spread. On the ECB side, policy is at the realistic limit of ultra-looseness, so policy rate expectations cannot go significantly lower, but they can go higher. On the Federal Reserve side, long-term policy rate expectations are not far from our upper bound of the 'high 2s' at which risk-assets become vulnerable to a sell-off, perhaps substantial. So these interest rate expectations cannot go sustainably higher, but they can go lower. Considering this strong asymmetry, the most likely outcome is that the 30-year T-bond/German bund yield spread will continue to converge. The upshot is that EUR/USD will continue to trend higher through 2018. No Connection Between Economic Outperformance And Stock Market Outperformance Chart I-5The Eurostoxx50 Underperformed Even Though##br## The Euro Area Economy Outperformed The Eurostoxx50 Underperformed Even Though The Euro Area Economy Outperformed The Eurostoxx50 Underperformed Even Though The Euro Area Economy Outperformed 2017 proved that there is no positive correlation between relative economic performance and relative equity market performance. For example, the euro area was one of the best performing developed economies, yet the Eurostoxx50 was one of the worst performing stock market indexes (Chart I-5). This seems odd, until you realise that major stock market indexes are dominated by multinational rather than domestic stocks. And that when stock markets have vastly different sector weightings, the sector effect completely swamps the domestic economy effect. Therefore the first decision for international equity investors should never be which regions to own. The first decision should always be which sectors to own, and above all whether to tilt to cyclicals or defensives. The regional and country allocation then just drops out automatically. At the moment, our mini-cycle framework for global growth suggests tilting to defensives rather than to cyclicals. Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started last May we can infer that it is likely to end at some point in early 2018 (Chart I-6 and Chart I-7). So one surprise could be that global growth will lose steam in the first half of 2018 rather than in the second half - contrary to what the consensus is expecting. Chart I-6The Current Mini-Upswing##br## Is Long In The Tooth The Current Mini-Upswing Is Long In The Tooth The Current Mini-Upswing Is Long In The Tooth Chart I-7China Has Driven The Global 6-Month##br## Credit Impulse Higher China Has Driven The Global 6-Month Credit Impulse Higher China Has Driven The Global 6-Month Credit Impulse Higher We will provide further ammunition for our mini-cycle thesis in next week's report. In the meantime, we will leave you with one ramification of paring back equity exposure to cyclicals and redeploying to defensives. Stay overweight defensive-heavy Switzerland and Denmark. Realpolitik Will Prevent A Hard Brexit For the FTSE100, the paradox is that its relative performance is negatively correlated with relative economic performance. When the U.K. economy outperforms, the FTSE100 underperforms. And vice-versa (Chart I-8). Chart I-8FTSE 100 Relative Performance Is The Inverse ##br##Of U.K. Economic Relative Performance FTSE 100 Relative Performance Is The Inverse Of U.K. Economic Relative Performance FTSE 100 Relative Performance Is The Inverse Of U.K. Economic Relative Performance The simple explanation is that FTSE100 multinational sales and profits tend to be denominated in dollars and euros, whereas the FTSE100 index is denominated in pounds. The upshot is that an outperforming U.K. economy weighs on the U.K. stock market because a strengthening pound diminishes the FTSE100's multi-currency profits in pound terms. And vice-versa. Compared to a year ago, investors can be more optimistic about the long-term prospects for the U.K. economy and the pound (and therefore expect long-term underperformance from the FTSE100). This is because after the unexpectedly disastrous 2017 election for Theresa May, the parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. The constraints that come from this realpolitik means that Brexit's endpoint will retain much of the current trading relationship with the EU, albeit the journey to that eventual destination is likely to be a wild roller coaster ride. Therefore, the multi-year prognosis for GBP/USD is higher. But investors who want to optimize their timing into 'cable' can wait for one of the inevitable roller coaster dips in 2018. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* We are delighted to say that three of our recent trades quickly hit their profit targets: short bitcoin 29%, long silver 4.5% and long NZD/USD 3%. Against this, short Nikkei/long Eurostoxx50 hit its 3% stop-loss. This week's trade recommendation is to go short palladium. Set a profit target of 6% with a symmetrical stop-loss. This leaves us with three open trades. Chart I-9 Short Palladium Short Palladium For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Geopolitical risks were overstated in 2017, but have now become understated; If Donald Trump becomes an early "lame duck" president, he will seek relevance abroad; This could mean a protectionist White House, or increased geopolitical tensions with Iran and North Korea; North Korean internal stability could come into question as economic sanctions begin to bite; Political risks in the U.K. and Italy could rise with markets overly complacent on both; Emerging markets, particularly Brazil and Mexico, will see renewed political risk. Feature Buoyant global growth, political stability in Europe, and steady policymakers' hands in China have fueled risk assets in 2017. As the year draws to a close, investors also have tax cuts in the U.S. to celebrate. Our high conviction view that tax cuts would happen - and that they would be fiscally profligate - is near the finish line.1 In making this call, we ignored the failure to repeal Obamacare, the "wisdom" of old "D.C. hands," and direct intelligence from a source inside the White House circle who swore tax reform would be revenue neutral. Throughout the year, BCA's Geopolitical Strategy remained confident that the GOP would ignore its fiscal conservative credentials and focus on the midterm elections.2 That election is increasingly looking like a bloodbath-in-the-making for the Republican Party (Chart 1). What of the latest opinion polls showing that the tax cuts are unpopular with half of all Americans? The polls also show that a solid one-third of all Americans remain in support of the Republican plan (Chart 2). We suspect - as do Republican strategists - that those are the Republicans who vote in midterm elections. Given the atrociously low turnout in midterm elections - just 36.4% of Americans voted in 2014 - Republicans need their base to turn out in November. The tax cuts are not about the wider American public but the Republican base. Chart 1Midterm Election: A Bloodbath? Midterm Election: A Bloodbath? Midterm Election: A Bloodbath? Chart 2Republican Base Supports Tax Cuts Five Black Swans In 2018 Five Black Swans In 2018 As we close the book on 2017, we look with trepidation towards 2018. Our main theme for next year is that the combination of economic stimulus from the tax cuts in the U.S. and structural reforms in China will create a U.S.-dollar-bullish policy mix that will combine into a headwind for global risk assets, particularly emerging market equities.3 However, in this report, we focus on some of the more exotic risks that investors may have to deal with. In particular we focus on five potential "black swans" - low probability, high market-impact events - that are neither on the market's radar nor the media's. To qualify for our list, the events must be: Unlikely: There must be less than a 20% probability that the event will occur in the next 12 months. Out of sight: The scenario we present should not be receiving media coverage, at least not as a serious market risk. Geopolitical: We must be able to identify the risk scenario through the lens of our geopolitical methodology. Genuinely unpredictable events - such as meteor strikes, pandemics, crippling cyber-attacks, solar flares, alien invasions, and failures in the computer program running the simulation that we call the universe - do not make the cut. Black Swan 1: Lame Duck Trump "Lame duck" presidents - leaders whose popularity late in their term has sunk so low that they can no longer affect policy - are said to be particularly adventurous in the foreign arena. While this adage has a spotty empirical record, there are several notable examples in recent memory.4 American presidents have few constitutional constraints when it comes to foreign policy. Therefore, when domestic constraints rise, U.S. presidents seek relevance abroad. Chart 3The Day After The Midterms, Trump's Overall Popularity Will Matter More Than That Among Republicans Five Black Swans In 2018 Five Black Swans In 2018 President Trump may become the earliest, and lamest, lame duck president in recent U.S. history. While his Republican support remains healthy, his overall popularity is well below the average presidential approval rating at this point in the political cycle (Chart 3). Based on these poll numbers, his party is likely to underperform in the upcoming midterm election (Chart 4). A Democrat-led House of Representatives would have the votes to begin impeachment, which we would then consider likely in 2019. As we have argued in our "impeachment handbook," the market impact of such a crisis would ultimately depend on market fundamentals and the global context, not political intrigue.5 Chart 4Trump Is Becoming A Liability For The GOP Five Black Swans In 2018 Five Black Swans In 2018 President Trump's political capital ahead of the midterm elections is based on his ability to influence Republican legislators. Despite low overall poll numbers, President Trump can use the threat of endorsing primary challengers against conservative peers in Congress to move his agenda in the legislature. He has effectively done this with tax cuts. However, the day after the midterm elections, President Trump's own numbers will matter for the GOP. Given that President Trump will be on the ballot in the 2020 general election, his low approval numbers with non-Republican voters will hang like an albatross around the party's neck. This is a serious issue, particularly given that 22 of the 33 Senators up for reelection in 2020 will be Republican.6 Robust economic growth and a roaring stock market have not boosted Trump's popularity so far. At the same time, a strong economy ready to translate into higher wages is about to be "pump-primed" by stimulative tax cuts (Chart 5). We would expect the result to be a stronger dollar, which should keep the U.S. trade deficit widening well into Trump's second year in office. At some point, this will become a sore political point, given Trump's protectionist rhetoric and his administration's focus on the trade balance as a key measure of U.S. power. Chart 5Wage Pressures Are Building Wage Pressures Are Building Wage Pressures Are Building What kind of adventures would we expect to see President Trump embark on in 2018? There are three prime candidates: China-U.S. trade war: The Trump administration started off with threats against China and then proceeded to negotiations. However, neither the North Korean situation nor the trade deficit has seen substantial improvement, and a lame duck Trump administration would be more likely to resort to serious punitive actions. Even improvements on the Korean peninsula would not necessarily prevent Washington from getting tougher on Beijing over trade, as the Trump administration will be driven by domestic politics. Investors should carefully watch whether the World Trade Organization deems China a "market economy," which could trigger a U.S. backlash, and whether the various investigations by U.S. Trade Representative Robert Lighthizer and Commerce Secretary Wilbur Ross result in anti-dumping and countervailing duties being imposed more frequently on specific Chinese exports. Thus far, the empirical evidence suggests that the Trump administration has picked up the pace of protectionist rulings (Chart 6). Notably, the Trump administration claims that the Comprehensive Economic Dialogue has "stalled," and it is reviving deeper, structural demands on Chinese policymakers.7 Iran Jingoism: Rumors that Secretary of State Rex Tillerson may be replaced by CIA Director Mike Pompeo - who would be replaced at the CIA by Senator Tom Cotton - can only mean one thing: the White House has Iran in its sights. Both Pompeo and Cotton are hawks on Iran. The administration may be preparing to shift its focus from North Korea, where American allies in the region are urging caution, to the Middle East, where American allies in the region are urging aggression. Investors should watch whether Tillerson is removed and especially how Congress reacts to President Trump's decision on October 15 to decertify the Iran nuclear agreement (also called the Joint Comprehensive Plan of Action or JCPOA). The Republican-controlled Congress has until December 15 to reimpose sanctions on Iran that were suspended as part of the deal, with merely a simple majority needed in both chambers. However, President Trump will also have an opportunity, as early as January, to end waivers on a slew of sanctions that were not covered under the JCPOA. North Korea: It would be natural to slot North Korea as first on our list of potential foreign policy adventures for President Trump. However, it does not really fit our qualification of a black swan. North Korea is not "out of sight." Additionally, President Trump has already broken with the tradition of previous administrations by upping the pressure on Pyongyang. In fact, a North Korean black swan would be if President Trump succeeded in breaking the regime in Pyongyang. To that scenario we turn next. Chart 6Trump: Game Changer In U.S. Trade Policy? Five Black Swans In 2018 Five Black Swans In 2018 Bottom Line: Geopolitics has not affected the markets in 2017, with risk assets reaching record highs and the VIX reaching record lows (Chart 7). This was our view throughout the year and we called for investors to "buy in May and have a nice day" as a result of our analysis.8 We do not see this as likely in 2018. The Trump administration has no credible legislative agenda after tax cuts. We expect Congress to stall as we enter the summer primary season and for the GOP to lose the House to the Democrats. President Trump is an astute political analyst and will sense these developments before they happen. There is a good chance that he will attempt to sway the election and pre-empt his lame duck status with an aggressive foreign policy. Chart 72017 Goldilocks: S&P 500 Up, VIX Down 2017 Goldilocks: S&P 500 Up, VIX Down 2017 Goldilocks: S&P 500 Up, VIX Down Investment implications are twofold. First, we continue to recommend an equally weighted basket of Swiss 10-year bonds and gold as a portfolio hedge.9 Second, risk premium for oil prices should rise in 2018. Not only is the supply-demand balance favorable for oil prices, but geopolitical risks are likely to rise as well. Black Swan 2: A Coup In Pyongyang Our colleague Peter Berezin, BCA's Chief Global Strategist, has suggested that a coup d'état against Supreme Leader Kim Jong-un could be a black swan trigger that spooks the markets.10 While Peter used the scenario as a tongue-in-cheek way to weave Kim into a narrative that tells of a late 2019 recession, we have long raised North Korean domestic politics as the true Korean black swan.11 Here we entertain Peter's idea for three reasons.12 First, China has upped the economic pressure on Pyongyang. Under Kim Jong-un, the North Korean state has attempted some limited economic "opening up," namely to China. But the attempt to finalize the nuclear deterrent has delayed an already precarious process. There has now been a $617 million drop in Chinese imports from the country since the beginning of the year (Chart 8), with coal imports particularly affected (Chart 9). China has also pulled back on tourism. Meanwhile, North Korea's imports of Chinese goods have risen, which suggests that the country's current account balance may be widening. At some point, if these trends continue, Pyongyang will run out of foreign currency with which to purchase Chinese and Russian imports. Chart 8China Is Turning The Screws On Pyongyang... China Is Turning The Screws On Pyongyang... China Is Turning The Screws On Pyongyang... Chart 9...Particularly On Coal Imports ...Particularly On Coal Imports ...Particularly On Coal Imports Second, Pyongyang is well aware of pressures against the regime. The assassination of Kim Jong-nam - the older half-brother of Kim Jong-un - in February of this year sent a message to the world, but especially to China, which kept Kim Jong-nam around as an alternative to the current Kim. That Pyongyang went to the extreme lengths of poisoning Kim Jong-nam with VX nerve agent in a foreign airport suggests that Kim Jong-un is still worried about threats to his rule.13 If Beijing's economic sanctions continue to tighten in 2018, the military could conceivably see the Supreme Leader's aggressive foreign policy as a risk to regime survival. Third, Pyongyang could miscalculate and create a crisis from which it cannot deescalate. A provocation that disrupts international infrastructure and commerce or kills civilians from the U.S. or Japan could trigger a downward spiral. For instance, an attack against international shipping in the Yellow Sea or Sea of Japan by North Korean submarines would be an unprecedented act that the U.S. and Japan would likely retaliate against.14 We could see the U.S. following the script from Operation Praying Mantis in the Persian Gulf in 1988 - the largest surface engagement by the U.S. Navy since the Second World War. In that incident, the U.S. sunk half of Iran's navy in retaliation for the mining of the guided missile frigate USS Samuel B. Roberts. In the case of North Korea, this would primarily mean taking out its approximately 20 Romeo-class submarines and an unknown number of domestically-produced - Yugoslav-designed - newly built submarines. Such a conflict is not our baseline case, but we assign much higher probability to it than an all-out war on the Korean Peninsula. How would Pyongyang react to the sinking of its submarines? Our best case is that the regime would do nothing. The leadership in Pyongyang is massively constrained by its quantifiable military inferiority. True, North Korea has around 6 million military personnel - about 25% of the total population is under arms - but unfortunately for Pyongyang, this large army is arrayed against one of the most sophisticated defenses ever constructed by man: the Demilitarized Zone (DMZ). To support its ground forces, North Korea would have at its disposal only about 20-30 Mig-29s. Countering two dozen jets would be South Korea's combined 177 F-15s and F-16s, plus American forces that would vary in size depending on how many aircraft carriers were deployed in the vicinity. Given that a single American aircraft carrier holds up to 48 fighter jets, North Koreans would quickly find themselves fighting a losing battle. Which is why they may never initiate one. If Kim Jong-un insists on retaliation, the military could remove and replace him with, for instance, his 30-year old sister, who has recently risen in party ranks, or his 36-year old brother Kim Jong-chul, who is apparently not entirely uninvolved in the regime despite living an unassuming life in Pyongyang. What would a regime change mean for the markets? It depends on whether it is successful or not. An unsuccessful coup could lead to a massive purge and likely a total break in Pyongyang's relations with the outside world, including China. This would seriously destabilize North Korea's decision-making. The global community would have to begin contemplating a total war on the Korean peninsula. Alternatively, a successful coup could lead to temporary volatility, yet long-term stability. The military regime in the North may even be open to reunification over the long term, depending on how U.S.-China relations evolve. Bottom Line: China does not want to cripple North Korea or throw a coup. But it is cooperating with sanctions and could therefore trigger one by mistake. At least two regimes have collapsed in the past when facing the pincer movement of economic sanctions and American military pressure - South Africa's apartheid regime in 1991 and Slobodan Miloševic's Yugoslavia in 1999. Kim Jong-un could face a similar fate, particularly if China applies excessive economic pressure. Black Swan 3: Prime Minister Jeremy Corbyn There is no election scheduled in the U.K. for 2018, but if one were to be held the ruling Tories would be in trouble (Chart 10). In fact, the combined anti-Brexit forces are currently in a solid lead over the pro-Brexit parties, Conservatives and the U.K. Independence Party (UKIP) (Chart 11). Chart 10Labour Is In The Lead... Labour Is In The Lead... Labour Is In The Lead... Chart 11...As Are Anti-Brexit Forces Writ-Large ...As Are Anti-Brexit Forces Writ-Large ...As Are Anti-Brexit Forces Writ-Large What could trigger such an election? Ultimately, the final exit deal may prompt a new election. More immediately, the ongoing negotiations over the status of the Irish border would be a prime candidate. As our colleague Dhaval Joshi, head of BCA's European Investment Strategy noted recently, Prime Minister Theresa May's government is propped up by the Northern Irish Unionists to whom May has promised that there will be no hard border between Northern Ireland and the Republic of Ireland. This will likely create a crisis as the EU negotiations may inadvertently threaten the Good Friday peace agreement. The Northern Ireland Unionists will not tolerate the border moving to the Irish Sea. This would effectively take Northern Ireland into the EU customs union and single market, and out of the U.K.'s domestic trading zone. It would also embolden Scotland's push for single market access. In essence, the Tory government may collapse because of differences within the U.K.'s "three kingdoms" before it even has the chance to collapse over differences with the EU.15 The market may cheer a Labour-Scottish National Party (SNP) coalition government, a potential winner of an early election, as it would mean that a new referendum on the U.K. leaving the EU could be held. The latest polls suggest that "Bremorse" (remorse for Brexit) has set in, as a clear majority in the U.K. thinks that Brexit was a bad idea (Chart 12). However, we suspect that it would take Prime Minister Jeremy Corbyn several months, if not over a year, before he called such a referendum. First, Corbyn is on record supporting a soft Brexit, not a new referendum, and he has only just begun to adjust this position. Second, a soft Brexit is far more difficult to achieve than the hard Brexit of Prime Minister Theresa May since it requires the U.K. to subvert its sovereignty in significant ways (i.e., accepting EU regulation) in order to access the EU Common Market. Third, the most politically palatable way to re-do the referendum is to put a U.K.-EU deal up to the people to decide, which means that Corbyn first has to spend a long time negotiating that deal. Chart 12Bremorse Sets In Bremorse Sets In Bremorse Sets In The market may be disappointed to find out that PM Corbyn is not willing or able to put the question of the U.K.'s EU exit up to a vote right away. Instead, the market would have to deal with Corbyn's economic policies, which are markedly left-wing. Corbyn harkens back to the 110 Propositions pour la France of French President François Mitterrand, if not exactly to the ghastly 1970s of the U.K.'s own history. A brief sample platter of Labour's proposals under Corbyn includes: Increasing the U.K. corporate tax rate to 26% from 20%; Increasing the minimum wage; Forcing companies not to out-source operations; Nationalizing public infrastructure companies. How should investors play a Corbyn victory? We think that the U.K. pound would likely rally on a higher probability of reversing Brexit. However, this "no Brexit" rally would quickly dissipate as PM Corbyn reiterated his promise to fulfill the democratic desire of the population to exit the EU. While Corbyn's negotiating team set to work on getting a better Brexit deal out of Brussels, the market would quickly turn its attention to the reality that Corbyn is not kidding about socialism.16 The result would be a selloff in the pound. Bottom Line: BCA's Foreign Exchange Strategy has pointed out that the pound remains well below its fair value (Chart 13). However, as BCA's chief FX strategist Mathieu Savary points out, the valuation technicals may be misleading as the currency has entered a new economic, trade, and political paradigm. A Corbyn premiership is not clearly positive for Brexit, while opening up a completely different question: is the U.K. also exiting the free-market, laissez-faire paradigm that it has helped lead since May 1979? Black Swan 4: Italy Is A Black Swan Hiding In Plain Sight The spread between Italian and German 10-year government bonds has narrowed 72 basis points since April, suggesting that investors have grown comfortable with the risks associated with the Italian election due by May (Chart 14). There are three reasons why we agree with the market: Chart 13Pound Valuation Reflects Post-Brexit Paradigm Pound Valuation Reflects Post-Brexit Paradigm Pound Valuation Reflects Post-Brexit Paradigm Chart 14Investors Not Worried About Italy Investors Not Worried About Italy Investors Not Worried About Italy New electoral rules passed in October make it highly likely that a center-right alliance will take shape between the Forza Italia of former Prime Minister Silvio Berlusconi and the mildly Eurosketpic Lega Nord. These two could form a government alone, or in a grand coalition with the center-left Democratic Party (PD) (Chart 15). Both Lega Nord and the anti-establishment Five Star Movement (M5S) have moved to the center on the questions of European integration and membership in the currency union; The European migration crisis is over and its supposedly constant impact on Italy is waning (Chart 16). Meanwhile, Italy's economy is on the mend, with its banking sector finally following the Spanish trajectory with a drop in non-performing loans (Chart 17). Chart 15Italy Set For A Hung Parliament Italy Set For A Hung Parliament Italy Set For A Hung Parliament Chart 16Migration Crisis Is Over (Yes, Even In Italy) Migration Crisis Is Over (Yes, Even In Italy) Migration Crisis Is Over (Yes, Even In Italy) Chart 17Italian Recovery Is Just Starting Italian Recovery Is Just Starting Italian Recovery Is Just Starting That said, we continue to warn clients that the underlying support for the common currency is lagging in Italy. The support level is just above 55%, despite a strong rally in the rest of the Euro Area (Chart 18). Similarly, over 40% of Italians appear confident in the country's future outside of the EU (Chart 19). Chart 18Italians Stand Out For Distrust Of Euro Italians Stand Out For Distrust Of Euro Italians Stand Out For Distrust Of Euro Chart 19Italians Not Enthusiastic About EU Italians Not Enthusiastic About EU Italians Not Enthusiastic About EU Our baseline case is that Italian elections will produce a weak and ineffective government, though crucially not a Euroskeptic one. How could we be wrong? Easy: one of the three reasons why we agree with the market could shift. For example, M5S could alter its pledge to remain in the Euro Area and surprisingly win on a Euroskeptic platform. Why would the party do something like that? Because it makes sense! Polls are already showing that M5S's recent moderation on the euro is not paying political dividends, with its support sharply sliding since the summer. With power quickly slipping out of reach for the party, why wouldn't they put a down-payment on the next election by trusting the underlying trend in opinion polling and investing in a Euroskeptic platform that might pay political dividends in the future? If we think that this strategy makes sense based on the data, then the M5S leadership might as well. Chart 20Can MIB Keep Outperforming? Can MIB Keep Outperforming? Can MIB Keep Outperforming? Another scenario is a major terror attack perpetrated by recent migrants from North Africa. Italy has been spared from radical Islamic terror. As such, the country may not be as desensitized to it as other European nations. A strong showing by Lega Nord and the far-right Fratelli d'Italia could force Forza Italia to move to the right as well. On our travels, we have noticed that few investors want to talk about Italy. There is wide acknowledgement of the structural trends pointing to a rise of Euroskepticism in the country, but also an appearance of consensus that this is a problem for a later date. We agree with this consensus, but our conviction is low. Bottom Line: Italian election risk is completely unappreciated by the markets. The country's equity market is one of the best performing this year (Chart 20), while government bonds are pricing in no political risk as the election approaches. We believe that shorting both would present a good hedging opportunity. Black Swan 5: Bloodbath In Latin America Our last black swan risk is not really a black swan to us but a forecast we believe will happen. As we outlined last month, we fear that Chinese policy-induced credit contraction will be negative for emerging markets, as BCA's Emerging Markets Strategy data asserts (Chart 21). BCA's Foreign Exchange Strategy has pointed out in its latest missive that its "Carry Canary Indicator" - performance of EM/JPY crosses - is signaling that a sharp deceleration in global growth is coming in Q1 2018 (Chart 22).17 Latin America (especially Chile, Peru, and Brazil) is the region most exposed to the combination of a slowing China and a China-induced drop in commodity prices. Chart 21When China Sneezes, EM Gets The Flu When China Sneezes, EM Gets The Flu When China Sneezes, EM Gets The Flu Chart 22Ominous Signal From EM/JPY Ominous Signal From EM/JPY Ominous Signal From EM/JPY From a political perspective, this is most negative for Brazil and Mexico. Both countries hold elections in 2018, with the Mexican election further complicated by the ongoing NAFTA renegotiations. We believe that the future of NAFTA hangs in the balance, with a high probability that the Trump administration will decide to abrogate the deal.18 Currently, anti-market political forces are in the lead in both countries. In Brazil, no pro-market candidate is leading in the polls (Chart 23). In fact, anti-market options have a 48% lead on the centrists. Granted, there are ten months until the election, but we are skeptical that the Brazilian population will change its mind and support reformers. If the "median voter" in Brazil supported reforms, the current Temer administration would have passed them already. In Mexico, anti-establishment candidate Andrés Manuel López Obrador (also known as AMLO) is leading in the polls (Chart 24), as is his new party Morena (Chart 25). If Morena wins the most seats in the Mexican Congress, it will be more difficult for the opposition parties to combine to counter it.19 Chart 23There Is No Pro-Market Option In Brazil There Is No Pro-Market Option In Brazil There Is No Pro-Market Option In Brazil Chart 24AMLO Is In The Lead ... Five Black Swans In 2018 Five Black Swans In 2018 Chart 25...As Is Morena Five Black Swans In 2018 Five Black Swans In 2018 In 2017, we argued that politics were not a tailwind for EM asset performance. Instead, investors chased yield in the favorable economic context of Chinese economic stimulus, low developed market yields, and a weak U.S. dollar. In reality, politics was just as dire in much of EM as it was in prior years of asset underperformance, but the surge of global liquidity in 2018 masked the problems. We do not think the EM rally is sustainable in 2018. As the global economic and market context shifts, investors will start paying attention. Suddenly, political problems will enter into focus. Here we argue that Brazil and Mexico are likely to be the main targets of portfolio outflows, but a strong case could be made for South Africa and Turkey as well.20 Bottom Line: Political risk in Latin America will return. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy, "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, and "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, and "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 4 President Clinton launched the largest NATO military operation against Yugoslavia amidst impeachment proceedings against him while President George H. W. Bush ordered U.S. troops to Somalia a month after losing the 1992 election. Ironically, President George H. W. Bush intervened in Somalia in order to lock in the supposedly isolationist Bill Clinton, who had defeated him three weeks earlier, into an internationalist foreign policy. President George W. Bush ordered the "surge" of troops into Iraq in 2007 after losing both houses of Congress in 2006; President Obama arranged the Iranian nuclear deal after losing the Senate (and hence Congress) to the Republicans in 2014. 5 Please see BCA Geopolitical Strategy, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 6 Particularly vulnerable, in our view, will be Cory Gardner (R, Colorado), Joni Ernst (R, Iowa), Susan Collins (R, Maine), and Thom Tillis (R, North Carolina). 7 U.S. Treasury Under Secretary for International Affairs David Malpass recently claimed that high-level talks had "stalled" and re-emphasized the U.S.'s structural complaints: "We are concerned that China's economic liberalization seems to have slowed or reversed, with the role of the state increasing ... State-owned enterprises have not faced hard budget constraints and China's industrial policy has become more and more problematic for foreign firms. Huge export credits are flowing in non-economic ways that distort markets." The growing presence of Communist Party cells within corporations is another important structural concern that puts the administration at loggerheads with China's leaders. Please see Andrew Mayeda and Saleha Mohsin, "US Rebukes China For Backing Off Market Embrace," Bloomberg, November 30, 2017, available at www.bloomberg.com. 8 Please see BCA Geopolitical Strategy, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 10 Please see BCA Global Investment Strategy, "A Timeline For The Next Five Years: Part II," dated December 1, 2017, available at gis.bcaresearch.com. 11 Please see "North Korea: From Overstated To Understated" in BCA Geopolitical Strategy, "Strategic Outlook 2016: Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. A notable coup attempt occurred in 1995-96 in North Hamgyong; something like a coup attempt may have occurred in 2013; and defectors from North Korea have reported various stories of plots and conspiracies against the regime. 12 After all, Peter predicted that Donald Trump would be a serious candidate for the U.S. presidency back in September 2015! 13 Still worried, that is, even after Kim Jong-un's supposed "consolidation of power" in 2013-14 when he executed his influential and China-aligned uncle, Jang Song Thaek, and purged the latter's faction. There were reports of rogue military operations at that time. With low troop morale reported by North Korean defectors, the possibility of insubordination cannot be ruled out. 14 A North Korean submarine sank the South Korean corvette Cheonan in 2010, and North Korean artillery shelled two islands killing South Korean civilians later that year, but these attacks were still within the norm of North Korean provocations. The two countries are still technically at war and have contested maritime as well as land borders. 15 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 16 To help investors get ready for a Corbyn premiership, we thought his appearance on President Nicolás Maduro's weekly radio show would be a good place to start: https://www.youtube.com/watch?v=7eL8_wtS-0I 17 Please see BCA Foreign Exchange Strategy, "Canaries In The Coal Mine Alert: EM/JPY Carry Trades," dated December 1, 2017, available at fes.bcaresearch.com. 18 Please see BCA Geopolitical Strategy and Global Investment Strategy, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy and Emerging Markets Strategy "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy, "South Africa: Crisis Of Expectations," dated June 28, 2017, and "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights Geopolitical risks were overstated in 2017, but have now become understated; If Donald Trump becomes an early "lame duck" president, he will seek relevance abroad; This could mean a protectionist White House, or increased geopolitical tensions with Iran and North Korea; North Korean internal stability could come into question as economic sanctions begin to bite; Political risks in the U.K. and Italy could rise with markets overly complacent on both; Emerging markets, particularly Brazil and Mexico, will see renewed political risk. Feature Buoyant global growth, political stability in Europe, and steady policymakers' hands in China have fueled risk assets in 2017. As the year draws to a close, investors also have tax cuts in the U.S. to celebrate. Our high conviction view that tax cuts would happen - and that they would be fiscally profligate - is near the finish line.1 In making this call, we ignored the failure to repeal Obamacare, the "wisdom" of old "D.C. hands," and direct intelligence from a source inside the White House circle who swore tax reform would be revenue neutral. Throughout the year, BCA's Geopolitical Strategy remained confident that the GOP would ignore its fiscal conservative credentials and focus on the midterm elections.2 That election is increasingly looking like a bloodbath-in-the-making for the Republican Party (Chart 1). What of the latest opinion polls showing that the tax cuts are unpopular with half of all Americans? The polls also show that a solid one-third of all Americans remain in support of the Republican plan (Chart 2). We suspect - as do Republican strategists - that those are the Republicans who vote in midterm elections. Given the atrociously low turnout in midterm elections - just 36.4% of Americans voted in 2014 - Republicans need their base to turn out in November. The tax cuts are not about the wider American public but the Republican base. Chart 1Midterm Election: A Bloodbath? Midterm Election: A Bloodbath? Midterm Election: A Bloodbath? Chart 2Republican Base Supports Tax Cuts Five Black Swans In 2018 Five Black Swans In 2018 As we close the book on 2017, we look with trepidation towards 2018. Our main theme for next year is that the combination of economic stimulus from the tax cuts in the U.S. and structural reforms in China will create a U.S.-dollar-bullish policy mix that will combine into a headwind for global risk assets, particularly emerging market equities.3 However, in this report, we focus on some of the more exotic risks that investors may have to deal with. In particular we focus on five potential "black swans" - low probability, high market-impact events - that are neither on the market's radar nor the media's. To qualify for our list, the events must be: Unlikely: There must be less than a 20% probability that the event will occur in the next 12 months. Out of sight: The scenario we present should not be receiving media coverage, at least not as a serious market risk. Geopolitical: We must be able to identify the risk scenario through the lens of our geopolitical methodology. Genuinely unpredictable events - such as meteor strikes, pandemics, crippling cyber-attacks, solar flares, alien invasions, and failures in the computer program running the simulation that we call the universe - do not make the cut. Black Swan 1: Lame Duck Trump "Lame duck" presidents - leaders whose popularity late in their term has sunk so low that they can no longer affect policy - are said to be particularly adventurous in the foreign arena. While this adage has a spotty empirical record, there are several notable examples in recent memory.4 American presidents have few constitutional constraints when it comes to foreign policy. Therefore, when domestic constraints rise, U.S. presidents seek relevance abroad. Chart 3The Day After The Midterms, Trump's Overall Popularity Will Matter More Than That Among Republicans Five Black Swans In 2018 Five Black Swans In 2018 President Trump may become the earliest, and lamest, lame duck president in recent U.S. history. While his Republican support remains healthy, his overall popularity is well below the average presidential approval rating at this point in the political cycle (Chart 3). Based on these poll numbers, his party is likely to underperform in the upcoming midterm election (Chart 4). A Democrat-led House of Representatives would have the votes to begin impeachment, which we would then consider likely in 2019. As we have argued in our "impeachment handbook," the market impact of such a crisis would ultimately depend on market fundamentals and the global context, not political intrigue.5 Chart 4Trump Is Becoming A Liability For The GOP Five Black Swans In 2018 Five Black Swans In 2018 President Trump's political capital ahead of the midterm elections is based on his ability to influence Republican legislators. Despite low overall poll numbers, President Trump can use the threat of endorsing primary challengers against conservative peers in Congress to move his agenda in the legislature. He has effectively done this with tax cuts. However, the day after the midterm elections, President Trump's own numbers will matter for the GOP. Given that President Trump will be on the ballot in the 2020 general election, his low approval numbers with non-Republican voters will hang like an albatross around the party's neck. This is a serious issue, particularly given that 22 of the 33 Senators up for reelection in 2020 will be Republican.6 Robust economic growth and a roaring stock market have not boosted Trump's popularity so far. At the same time, a strong economy ready to translate into higher wages is about to be "pump-primed" by stimulative tax cuts (Chart 5). We would expect the result to be a stronger dollar, which should keep the U.S. trade deficit widening well into Trump's second year in office. At some point, this will become a sore political point, given Trump's protectionist rhetoric and his administration's focus on the trade balance as a key measure of U.S. power. Chart 5Wage Pressures Are Building Wage Pressures Are Building Wage Pressures Are Building What kind of adventures would we expect to see President Trump embark on in 2018? There are three prime candidates: China-U.S. trade war: The Trump administration started off with threats against China and then proceeded to negotiations. However, neither the North Korean situation nor the trade deficit has seen substantial improvement, and a lame duck Trump administration would be more likely to resort to serious punitive actions. Even improvements on the Korean peninsula would not necessarily prevent Washington from getting tougher on Beijing over trade, as the Trump administration will be driven by domestic politics. Investors should carefully watch whether the World Trade Organization deems China a "market economy," which could trigger a U.S. backlash, and whether the various investigations by U.S. Trade Representative Robert Lighthizer and Commerce Secretary Wilbur Ross result in anti-dumping and countervailing duties being imposed more frequently on specific Chinese exports. Thus far, the empirical evidence suggests that the Trump administration has picked up the pace of protectionist rulings (Chart 6). Notably, the Trump administration claims that the Comprehensive Economic Dialogue has "stalled," and it is reviving deeper, structural demands on Chinese policymakers.7 Iran Jingoism: Rumors that Secretary of State Rex Tillerson may be replaced by CIA Director Mike Pompeo - who would be replaced at the CIA by Senator Tom Cotton - can only mean one thing: the White House has Iran in its sights. Both Pompeo and Cotton are hawks on Iran. The administration may be preparing to shift its focus from North Korea, where American allies in the region are urging caution, to the Middle East, where American allies in the region are urging aggression. Investors should watch whether Tillerson is removed and especially how Congress reacts to President Trump's decision on October 15 to decertify the Iran nuclear agreement (also called the Joint Comprehensive Plan of Action or JCPOA). The Republican-controlled Congress has until December 15 to reimpose sanctions on Iran that were suspended as part of the deal, with merely a simple majority needed in both chambers. However, President Trump will also have an opportunity, as early as January, to end waivers on a slew of sanctions that were not covered under the JCPOA. North Korea: It would be natural to slot North Korea as first on our list of potential foreign policy adventures for President Trump. However, it does not really fit our qualification of a black swan. North Korea is not "out of sight." Additionally, President Trump has already broken with the tradition of previous administrations by upping the pressure on Pyongyang. In fact, a North Korean black swan would be if President Trump succeeded in breaking the regime in Pyongyang. To that scenario we turn next. Chart 6Trump: Game Changer In U.S. Trade Policy? Five Black Swans In 2018 Five Black Swans In 2018 Bottom Line: Geopolitics has not affected the markets in 2017, with risk assets reaching record highs and the VIX reaching record lows (Chart 7). This was our view throughout the year and we called for investors to "buy in May and have a nice day" as a result of our analysis.8 We do not see this as likely in 2018. The Trump administration has no credible legislative agenda after tax cuts. We expect Congress to stall as we enter the summer primary season and for the GOP to lose the House to the Democrats. President Trump is an astute political analyst and will sense these developments before they happen. There is a good chance that he will attempt to sway the election and pre-empt his lame duck status with an aggressive foreign policy. Chart 72017 Goldilocks: S&P 500 Up, VIX Down 2017 Goldilocks: S&P 500 Up, VIX Down 2017 Goldilocks: S&P 500 Up, VIX Down Investment implications are twofold. First, we continue to recommend an equally weighted basket of Swiss 10-year bonds and gold as a portfolio hedge.9 Second, risk premium for oil prices should rise in 2018. Not only is the supply-demand balance favorable for oil prices, but geopolitical risks are likely to rise as well. Black Swan 2: A Coup In Pyongyang Our colleague Peter Berezin, BCA's Chief Global Strategist, has suggested that a coup d'état against Supreme Leader Kim Jong-un could be a black swan trigger that spooks the markets.10 While Peter used the scenario as a tongue-in-cheek way to weave Kim into a narrative that tells of a late 2019 recession, we have long raised North Korean domestic politics as the true Korean black swan.11 Here we entertain Peter's idea for three reasons.12 First, China has upped the economic pressure on Pyongyang. Under Kim Jong-un, the North Korean state has attempted some limited economic "opening up," namely to China. But the attempt to finalize the nuclear deterrent has delayed an already precarious process. There has now been a $617 million drop in Chinese imports from the country since the beginning of the year (Chart 8), with coal imports particularly affected (Chart 9). China has also pulled back on tourism. Meanwhile, North Korea's imports of Chinese goods have risen, which suggests that the country's current account balance may be widening. At some point, if these trends continue, Pyongyang will run out of foreign currency with which to purchase Chinese and Russian imports. Chart 8China Is Turning The Screws On Pyongyang... China Is Turning The Screws On Pyongyang... China Is Turning The Screws On Pyongyang... Chart 9...Particularly On Coal Imports ...Particularly On Coal Imports ...Particularly On Coal Imports Second, Pyongyang is well aware of pressures against the regime. The assassination of Kim Jong-nam - the older half-brother of Kim Jong-un - in February of this year sent a message to the world, but especially to China, which kept Kim Jong-nam around as an alternative to the current Kim. That Pyongyang went to the extreme lengths of poisoning Kim Jong-nam with VX nerve agent in a foreign airport suggests that Kim Jong-un is still worried about threats to his rule.13 If Beijing's economic sanctions continue to tighten in 2018, the military could conceivably see the Supreme Leader's aggressive foreign policy as a risk to regime survival. Third, Pyongyang could miscalculate and create a crisis from which it cannot deescalate. A provocation that disrupts international infrastructure and commerce or kills civilians from the U.S. or Japan could trigger a downward spiral. For instance, an attack against international shipping in the Yellow Sea or Sea of Japan by North Korean submarines would be an unprecedented act that the U.S. and Japan would likely retaliate against.14 We could see the U.S. following the script from Operation Praying Mantis in the Persian Gulf in 1988 - the largest surface engagement by the U.S. Navy since the Second World War. In that incident, the U.S. sunk half of Iran's navy in retaliation for the mining of the guided missile frigate USS Samuel B. Roberts. In the case of North Korea, this would primarily mean taking out its approximately 20 Romeo-class submarines and an unknown number of domestically-produced - Yugoslav-designed - newly built submarines. Such a conflict is not our baseline case, but we assign much higher probability to it than an all-out war on the Korean Peninsula. How would Pyongyang react to the sinking of its submarines? Our best case is that the regime would do nothing. The leadership in Pyongyang is massively constrained by its quantifiable military inferiority. True, North Korea has around 6 million military personnel - about 25% of the total population is under arms - but unfortunately for Pyongyang, this large army is arrayed against one of the most sophisticated defenses ever constructed by man: the Demilitarized Zone (DMZ). To support its ground forces, North Korea would have at its disposal only about 20-30 Mig-29s. Countering two dozen jets would be South Korea's combined 177 F-15s and F-16s, plus American forces that would vary in size depending on how many aircraft carriers were deployed in the vicinity. Given that a single American aircraft carrier holds up to 48 fighter jets, North Koreans would quickly find themselves fighting a losing battle. Which is why they may never initiate one. If Kim Jong-un insists on retaliation, the military could remove and replace him with, for instance, his 30-year old sister, who has recently risen in party ranks, or his 36-year old brother Kim Jong-chul, who is apparently not entirely uninvolved in the regime despite living an unassuming life in Pyongyang. What would a regime change mean for the markets? It depends on whether it is successful or not. An unsuccessful coup could lead to a massive purge and likely a total break in Pyongyang's relations with the outside world, including China. This would seriously destabilize North Korea's decision-making. The global community would have to begin contemplating a total war on the Korean peninsula. Alternatively, a successful coup could lead to temporary volatility, yet long-term stability. The military regime in the North may even be open to reunification over the long term, depending on how U.S.-China relations evolve. Bottom Line: China does not want to cripple North Korea or throw a coup. But it is cooperating with sanctions and could therefore trigger one by mistake. At least two regimes have collapsed in the past when facing the pincer movement of economic sanctions and American military pressure - South Africa's apartheid regime in 1991 and Slobodan Miloševic's Yugoslavia in 1999. Kim Jong-un could face a similar fate, particularly if China applies excessive economic pressure. Black Swan 3: Prime Minister Jeremy Corbyn There is no election scheduled in the U.K. for 2018, but if one were to be held the ruling Tories would be in trouble (Chart 10). In fact, the combined anti-Brexit forces are currently in a solid lead over the pro-Brexit parties, Conservatives and the U.K. Independence Party (UKIP) (Chart 11). Chart 10Labour Is In The Lead... Labour Is In The Lead... Labour Is In The Lead... Chart 11...As Are Anti-Brexit Forces Writ-Large ...As Are Anti-Brexit Forces Writ-Large ...As Are Anti-Brexit Forces Writ-Large What could trigger such an election? Ultimately, the final exit deal may prompt a new election. More immediately, the ongoing negotiations over the status of the Irish border would be a prime candidate. As our colleague Dhaval Joshi, head of BCA's European Investment Strategy noted recently, Prime Minister Theresa May's government is propped up by the Northern Irish Unionists to whom May has promised that there will be no hard border between Northern Ireland and the Republic of Ireland. This will likely create a crisis as the EU negotiations may inadvertently threaten the Good Friday peace agreement. The Northern Ireland Unionists will not tolerate the border moving to the Irish Sea. This would effectively take Northern Ireland into the EU customs union and single market, and out of the U.K.'s domestic trading zone. It would also embolden Scotland's push for single market access. In essence, the Tory government may collapse because of differences within the U.K.'s "three kingdoms" before it even has the chance to collapse over differences with the EU.15 The market may cheer a Labour-Scottish National Party (SNP) coalition government, a potential winner of an early election, as it would mean that a new referendum on the U.K. leaving the EU could be held. The latest polls suggest that "Bremorse" (remorse for Brexit) has set in, as a clear majority in the U.K. thinks that Brexit was a bad idea (Chart 12). However, we suspect that it would take Prime Minister Jeremy Corbyn several months, if not over a year, before he called such a referendum. First, Corbyn is on record supporting a soft Brexit, not a new referendum, and he has only just begun to adjust this position. Second, a soft Brexit is far more difficult to achieve than the hard Brexit of Prime Minister Theresa May since it requires the U.K. to subvert its sovereignty in significant ways (i.e., accepting EU regulation) in order to access the EU Common Market. Third, the most politically palatable way to re-do the referendum is to put a U.K.-EU deal up to the people to decide, which means that Corbyn first has to spend a long time negotiating that deal. Chart 12Bremorse Sets In Bremorse Sets In Bremorse Sets In The market may be disappointed to find out that PM Corbyn is not willing or able to put the question of the U.K.'s EU exit up to a vote right away. Instead, the market would have to deal with Corbyn's economic policies, which are markedly left-wing. Corbyn harkens back to the 110 Propositions pour la France of French President François Mitterrand, if not exactly to the ghastly 1970s of the U.K.'s own history. A brief sample platter of Labour's proposals under Corbyn includes: Increasing the U.K. corporate tax rate to 26% from 20%; Increasing the minimum wage; Forcing companies not to out-source operations; Nationalizing public infrastructure companies. How should investors play a Corbyn victory? We think that the U.K. pound would likely rally on a higher probability of reversing Brexit. However, this "no Brexit" rally would quickly dissipate as PM Corbyn reiterated his promise to fulfill the democratic desire of the population to exit the EU. While Corbyn's negotiating team set to work on getting a better Brexit deal out of Brussels, the market would quickly turn its attention to the reality that Corbyn is not kidding about socialism.16 The result would be a selloff in the pound. Bottom Line: BCA's Foreign Exchange Strategy has pointed out that the pound remains well below its fair value (Chart 13). However, as BCA's chief FX strategist Mathieu Savary points out, the valuation technicals may be misleading as the currency has entered a new economic, trade, and political paradigm. A Corbyn premiership is not clearly positive for Brexit, while opening up a completely different question: is the U.K. also exiting the free-market, laissez-faire paradigm that it has helped lead since May 1979? Black Swan 4: Italy Is A Black Swan Hiding In Plain Sight The spread between Italian and German 10-year government bonds has narrowed 72 basis points since April, suggesting that investors have grown comfortable with the risks associated with the Italian election due by May (Chart 14). There are three reasons why we agree with the market: Chart 13Pound Valuation Reflects Post-Brexit Paradigm Pound Valuation Reflects Post-Brexit Paradigm Pound Valuation Reflects Post-Brexit Paradigm Chart 14Investors Not Worried About Italy Investors Not Worried About Italy Investors Not Worried About Italy New electoral rules passed in October make it highly likely that a center-right alliance will take shape between the Forza Italia of former Prime Minister Silvio Berlusconi and the mildly Eurosketpic Lega Nord. These two could form a government alone, or in a grand coalition with the center-left Democratic Party (PD) (Chart 15). Both Lega Nord and the anti-establishment Five Star Movement (M5S) have moved to the center on the questions of European integration and membership in the currency union; The European migration crisis is over and its supposedly constant impact on Italy is waning (Chart 16). Meanwhile, Italy's economy is on the mend, with its banking sector finally following the Spanish trajectory with a drop in non-performing loans (Chart 17). Chart 15Italy Set For A Hung Parliament Italy Set For A Hung Parliament Italy Set For A Hung Parliament Chart 16Migration Crisis Is Over (Yes, Even In Italy) Migration Crisis Is Over (Yes, Even In Italy) Migration Crisis Is Over (Yes, Even In Italy) Chart 17Italian Recovery Is Just Starting Italian Recovery Is Just Starting Italian Recovery Is Just Starting That said, we continue to warn clients that the underlying support for the common currency is lagging in Italy. The support level is just above 55%, despite a strong rally in the rest of the Euro Area (Chart 18). Similarly, over 40% of Italians appear confident in the country's future outside of the EU (Chart 19). Chart 18Italians Stand Out For Distrust Of Euro Italians Stand Out For Distrust Of Euro Italians Stand Out For Distrust Of Euro Chart 19Italians Not Enthusiastic About EU Italians Not Enthusiastic About EU Italians Not Enthusiastic About EU Our baseline case is that Italian elections will produce a weak and ineffective government, though crucially not a Euroskeptic one. How could we be wrong? Easy: one of the three reasons why we agree with the market could shift. For example, M5S could alter its pledge to remain in the Euro Area and surprisingly win on a Euroskeptic platform. Why would the party do something like that? Because it makes sense! Polls are already showing that M5S's recent moderation on the euro is not paying political dividends, with its support sharply sliding since the summer. With power quickly slipping out of reach for the party, why wouldn't they put a down-payment on the next election by trusting the underlying trend in opinion polling and investing in a Euroskeptic platform that might pay political dividends in the future? If we think that this strategy makes sense based on the data, then the M5S leadership might as well. Chart 20Can MIB Keep Outperforming? Can MIB Keep Outperforming? Can MIB Keep Outperforming? Another scenario is a major terror attack perpetrated by recent migrants from North Africa. Italy has been spared from radical Islamic terror. As such, the country may not be as desensitized to it as other European nations. A strong showing by Lega Nord and the far-right Fratelli d'Italia could force Forza Italia to move to the right as well. On our travels, we have noticed that few investors want to talk about Italy. There is wide acknowledgement of the structural trends pointing to a rise of Euroskepticism in the country, but also an appearance of consensus that this is a problem for a later date. We agree with this consensus, but our conviction is low. Bottom Line: Italian election risk is completely unappreciated by the markets. The country's equity market is one of the best performing this year (Chart 20), while government bonds are pricing in no political risk as the election approaches. We believe that shorting both would present a good hedging opportunity. Black Swan 5: Bloodbath In Latin America Our last black swan risk is not really a black swan to us but a forecast we believe will happen. As we outlined last month, we fear that Chinese policy-induced credit contraction will be negative for emerging markets, as BCA's Emerging Markets Strategy data asserts (Chart 21). BCA's Foreign Exchange Strategy has pointed out in its latest missive that its "Carry Canary Indicator" - performance of EM/JPY crosses - is signaling that a sharp deceleration in global growth is coming in Q1 2018 (Chart 22).17 Latin America (especially Chile, Peru, and Brazil) is the region most exposed to the combination of a slowing China and a China-induced drop in commodity prices. Chart 21When China Sneezes, EM Gets The Flu When China Sneezes, EM Gets The Flu When China Sneezes, EM Gets The Flu Chart 22Ominous Signal From EM/JPY Ominous Signal From EM/JPY Ominous Signal From EM/JPY From a political perspective, this is most negative for Brazil and Mexico. Both countries hold elections in 2018, with the Mexican election further complicated by the ongoing NAFTA renegotiations. We believe that the future of NAFTA hangs in the balance, with a high probability that the Trump administration will decide to abrogate the deal.18 Currently, anti-market political forces are in the lead in both countries. In Brazil, no pro-market candidate is leading in the polls (Chart 23). In fact, anti-market options have a 48% lead on the centrists. Granted, there are ten months until the election, but we are skeptical that the Brazilian population will change its mind and support reformers. If the "median voter" in Brazil supported reforms, the current Temer administration would have passed them already. In Mexico, anti-establishment candidate Andrés Manuel López Obrador (also known as AMLO) is leading in the polls (Chart 24), as is his new party Morena (Chart 25). If Morena wins the most seats in the Mexican Congress, it will be more difficult for the opposition parties to combine to counter it.19 Chart 23There Is No Pro-Market Option In Brazil There Is No Pro-Market Option In Brazil There Is No Pro-Market Option In Brazil Chart 24AMLO Is In The Lead ... Five Black Swans In 2018 Five Black Swans In 2018 Chart 25...As Is Morena Five Black Swans In 2018 Five Black Swans In 2018 In 2017, we argued that politics were not a tailwind for EM asset performance. Instead, investors chased yield in the favorable economic context of Chinese economic stimulus, low developed market yields, and a weak U.S. dollar. In reality, politics was just as dire in much of EM as it was in prior years of asset underperformance, but the surge of global liquidity in 2018 masked the problems. We do not think the EM rally is sustainable in 2018. As the global economic and market context shifts, investors will start paying attention. Suddenly, political problems will enter into focus. Here we argue that Brazil and Mexico are likely to be the main targets of portfolio outflows, but a strong case could be made for South Africa and Turkey as well.20 Bottom Line: Political risk in Latin America will return. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy, "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, and "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, and "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 4 President Clinton launched the largest NATO military operation against Yugoslavia amidst impeachment proceedings against him while President George H. W. Bush ordered U.S. troops to Somalia a month after losing the 1992 election. Ironically, President George H. W. Bush intervened in Somalia in order to lock in the supposedly isolationist Bill Clinton, who had defeated him three weeks earlier, into an internationalist foreign policy. President George W. Bush ordered the "surge" of troops into Iraq in 2007 after losing both houses of Congress in 2006; President Obama arranged the Iranian nuclear deal after losing the Senate (and hence Congress) to the Republicans in 2014. 5 Please see BCA Geopolitical Strategy, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 6 Particularly vulnerable, in our view, will be Cory Gardner (R, Colorado), Joni Ernst (R, Iowa), Susan Collins (R, Maine), and Thom Tillis (R, North Carolina). 7 U.S. Treasury Under Secretary for International Affairs David Malpass recently claimed that high-level talks had "stalled" and re-emphasized the U.S.'s structural complaints: "We are concerned that China's economic liberalization seems to have slowed or reversed, with the role of the state increasing ... State-owned enterprises have not faced hard budget constraints and China's industrial policy has become more and more problematic for foreign firms. Huge export credits are flowing in non-economic ways that distort markets." The growing presence of Communist Party cells within corporations is another important structural concern that puts the administration at loggerheads with China's leaders. Please see Andrew Mayeda and Saleha Mohsin, "US Rebukes China For Backing Off Market Embrace," Bloomberg, November 30, 2017, available at www.bloomberg.com. 8 Please see BCA Geopolitical Strategy, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 10 Please see BCA Global Investment Strategy, "A Timeline For The Next Five Years: Part II," dated December 1, 2017, available at gis.bcaresearch.com. 11 Please see "North Korea: From Overstated To Understated" in BCA Geopolitical Strategy, "Strategic Outlook 2016: Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. A notable coup attempt occurred in 1995-96 in North Hamgyong; something like a coup attempt may have occurred in 2013; and defectors from North Korea have reported various stories of plots and conspiracies against the regime. 12 After all, Peter predicted that Donald Trump would be a serious candidate for the U.S. presidency back in September 2015! 13 Still worried, that is, even after Kim Jong-un's supposed "consolidation of power" in 2013-14 when he executed his influential and China-aligned uncle, Jang Song Thaek, and purged the latter's faction. There were reports of rogue military operations at that time. With low troop morale reported by North Korean defectors, the possibility of insubordination cannot be ruled out. 14 A North Korean submarine sank the South Korean corvette Cheonan in 2010, and North Korean artillery shelled two islands killing South Korean civilians later that year, but these attacks were still within the norm of North Korean provocations. The two countries are still technically at war and have contested maritime as well as land borders. 15 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 16 To help investors get ready for a Corbyn premiership, we thought his appearance on President Nicolás Maduro's weekly radio show would be a good place to start: https://www.youtube.com/watch?v=7eL8_wtS-0I 17 Please see BCA Foreign Exchange Strategy, "Canaries In The Coal Mine Alert: EM/JPY Carry Trades," dated December 1, 2017, available at fes.bcaresearch.com. 18 Please see BCA Geopolitical Strategy and Global Investment Strategy, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy and Emerging Markets Strategy "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy, "South Africa: Crisis Of Expectations," dated June 28, 2017, and "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights Idea 1: Long Eurodollar, short Euribor - December 2022 interest rate futures contracts. Alternatively just go outright long the Eurodollar contract. Idea 2: Long EUR/USD Idea 3: Underweight Basic Materials equities versus market. Alternative expressions are to go short the LMEX index, or underweight Norway (OMX) versus Ireland (ISE). Idea 4: Long Norwegian 10-year bonds, short German 10-year bunds. Idea 5: Long U.K. 10-year gilts, short Irish 10-year bonds. Feature Question 1: Where Is The Worrying Imbalance? Last week, in the Quantum Theory Of Finance,1 we pointed out that when bond yields reach ultra-low levels, the payoff profile from bonds becomes highly asymmetric. When yields approach a lower bound, they cannot fall much further but they can rise a lot. Meaning that bond prices have very limited potential for gains, but have great potential for sudden and deep losses. Chart of the WeekThe Norway Versus Euro Area Bond Yield Spread Is Too Wide The Norway Versus Euro Area Bond Yield Spread Is Too Wide The Norway Versus Euro Area Bond Yield Spread Is Too Wide The unattractive asymmetric payoff profile - known as negative skew - applies to both nominal and real returns. This is because negative skew is concerned about deep nominal losses over a relatively short period. In which case, a deep nominal loss will be a deep real loss too.2 As equity returns always possess negative skew we can say that at ultra-low bond yields, bond risk becomes equity-like. Given this risk equalization, equities no longer justify a risk premium over bonds. And the lower prospective return required from equities means that today's equity valuations and prices become a lot richer. But the new delicate balance of valuations is conditional on bond yields remaining ultra-low. This is because the unattractive negative skew on a 10-year bond's returns disappears when its yield moves up into the 'high 2s' (Chart I-2). At this point, risk is no longer equalized and the equity risk premium must fully re-emerge - requiring today's equity market valuation and price to drop, perhaps substantially. However, the ensuing fight to havens would then once again pull bond yields back down from the 'high 2s'. It follows that the rise in expected interest rates is self-limiting. Any policy interest rate expectation already in the 'high 2s' - such as the Eurodollar December 2022 contract - cannot sustainably rise much further, whereas those that are still some way below - such as the Euribor December 2022 contract - can (Chart I-3). Which leads to our first investment idea. Chart I-2Bonds Become Much More ##br##Risky At Ultra-Low Yields Five Pressing Questions (And Investment Ideas) Five Pressing Questions (And Investment Ideas) Chart I-3The Euro Area/U.S. Interest Rate Expectation ##br##Spread Is Too Wide The Euro Area/U.S. Interest Rate Expectation Spread Is Too Wide The Euro Area/U.S. Interest Rate Expectation Spread Is Too Wide Investment idea 1: Long Eurodollar, short Euribor - December 2022 interest rate futures contracts. Alternatively just go outright long the Eurodollar contract. Question 2: Which Is The Safest Currency To Hold? Chart I-4Euro/Dollar Just Tracks ##br##The Bond Yield Spread Euro/Dollar Just Tracks The Bond Yield Spread Euro/Dollar Just Tracks The Bond Yield Spread To reiterate, at ultra-low bond yields, bond returns offer a highly unattractive payoff profile. Put simply, you can quickly lose a lot more money - in both nominal and real terms - than you can make! Now observe that the payoff profile for a foreign exchange rate just tracks the bond yield spread (Chart I-4). This means that when a central bank has already taken bond yields close to their lower bound, its currency possesses a highly attractive payoff profile called positive skew. In essence, as the ECB is at the realistic limit of ultra-loose policy, the direction of policy rate expectations cannot go significantly lower. Conversely, policy rate expectations for the Federal Reserve (for 2022) are not far from our upper bound of the 'high 2s'. So these expectations cannot go significantly higher without threatening a risk-asset selloff. On this basis, EUR/USD has more scope to gap up than to gap down. Investment idea 2: Long EUR/USD But be aware that investment ideas 1 and 2 are highly correlated with each other! Question 3: Where Are We In The Global Growth Mini-Cycle? Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started in May we can infer that it is likely to end in early 2018. So one surprise in 2018 could be that global growth slows in the first half rather than in the second half - contrary to what the consensus is expecting. That said, half-cycle lengths do have some degree of variation: the current upswing might be a few months longer or shorter than the average. So how can we avoid positioning too early or too late for the next turn? The answer is to focus on investments that have already fully priced the current upswing, so that timing becomes less of an issue. On this basis, we propose that the rally in industrial metals and Basic Materials equities is already extended. Our technical indicator which captures herding and groupthink correctly identified the trough at the end of 2015, the mini-peak at the end of 2016, and is now signalling that the latest rally is likely to fade (Chart I-5 and Chart I-6). Chart I-5Metals Have Fully Priced ##br##The Mini-Upswing... Metals Have Fully Priced The Mini-Upswing... Metals Have Fully Priced The Mini-Upswing... Chart I-6...And The Metal Rally Is Reaching##br## Its Technical Limit ...And The Metal Rally Is Reaching Its Technical Limit ...And The Metal Rally Is Reaching Its Technical Limit Investment idea 3: Underweight Basic Materials equities versus market. Alternative expressions are to go short the LMEX index, or underweight Norway (OMX) versus Ireland (ISE). Question 4: Will Inflation Lift Off? The ECB's continued indulgence with ultra-loose monetary policy would make you think that the euro area is on the edge of a deflationary abyss. In fact, inflation has been running comfortably within a 0-2% band for almost two years. Will inflation edge closer to the ECB's 2% point target? Given our view on the growth mini-cycle, not immediately. In the first half of 2018, inflation may even edge lower within the 0-2% band, but this global dynamic will affect inflation in all jurisdictions, not just in the euro area. There is nothing wrong with inflation running comfortably within a 0-2% band. Now that we know that nominal interest rates can go slightly negative, a 0-2% inflation band even permits negative real interest rates. The big mistake is to aim for an arbitrary point target, like 2%. This is because inflation is a non-linear phenomenon, and a defining characteristic of a non-linear phenomenon is that it cannot hit an arbitrary point target.3 It is our high conviction expectation that the major central banks will eventually change their point targets for inflation into target bands such as 0-2% or 1-3%. But afraid to lose credibility, they will not change tack abruptly. In the meantime, we notice that the Norges Bank is undershooting its 2.5% inflation target by considerably more than the ECB is undershooting its 2% target (Chart I-7). Yet the yield spread between Norwegian and euro area bonds has not caught up with this reality (Chart of the Week). Chart I-7The Norges Bank Is Undershooting Its Inflation Target By More Than The ECB The Norges Bank Is Undershooting Its Inflation Target By More Than The ECB The Norges Bank Is Undershooting Its Inflation Target By More Than The ECB Investment idea 4: Long Norwegian 10-year bonds, short German 10-year bunds. Question 5: Will Political Risk Re-emerge? Political events have had a hand in three of the sharpest recent moves in financial markets. The vote for Brexit catalysed a 15% decline in the pound; the vote for Trump triggered an 80 bps spike in the 10-year T-bond yield, and the vote for Macron unleashed a 10% rally in the euro. Political change disrupts markets if it dislocates the long-term expectations embedded in economic agents and financial prices. The vote for Brexit changed expectations about the U.K.'s long-term trading relationships; the election of Trump changed expectations about fiscal stimulus, the tax structure, and protectionism (perhaps unrealistically); and the election of Macron exorcised the potential chaos of a Le Pen presidency. Chart I-8The U.K. Versus Ireland Bond ##br##Yield Spread Is Too Wide The U.K. Versus Ireland Bond Yield Spread Is Too Wide The U.K. Versus Ireland Bond Yield Spread Is Too Wide In contrast, the recent (disputed) vote for independence in Catalonia, and the breakdown of coalition discussions in Germany barely moved the markets - because neither event changed expectations of long-term economic outcomes. As investors, this is the test we should apply to all political events. In 2018, the evolution of Brexit has the potential to move markets. This is because hard Brexiters and the EU27 are on a collision course. Specifically, the issue of the Irish border is insoluble. It is Brexit's Gordian knot. Theresa May has promised the hard Brexiters that the U.K. will leave the EU customs union and single market. She has also promised the Northern Ireland Unionists - who are propping up May's minority government - that there will be no hard border between Northern Ireland and the Republic of Ireland or the rest of the U.K. But these promises are irreconcilable. The Republic of Ireland will veto a border that threatens the Good Friday peace agreement; the Northern Ireland Unionists will not tolerate the border moving to the Irish Sea, which would effectively take Northern Ireland into the EU customs union and single market; and the EU27 will block a Hong Kong type 'free port' status for Northern Ireland - as this would remove the integrity of harmonized standards across the EU. Eventually, the impenetrable Irish border problem is likely to be the roadblock to a hard Brexit. But first there needs to be a collision. And the collision could move markets. With the yield spread between U.K. 10-year gilts and Irish 10-year bonds near a 2-year wide (Chart I-8), this leads us to our fifth investment idea. Investment idea 5: Long U.K. 10-year gilts, short Irish 10-year bonds. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report 'The Quantum Theory Of Finance' November 23 2017 available at eis.bcaresearch.com. 2 For example if the nominal return over 3 months was a very painful -10%, and inflation was running at -10% per annum, the real return over 3 months would be a still very painful -7.5%. 3 Please see the European Investment Strategy Weekly Report 'Three Mantras For Investors' August 17 2017 available at eis.bcaresearch.com. Fractal Trading Model* Ahead of the OPEC meeting on November 30, the WTI crude oil price is vulnerable to any disappointment - because its rally is technically very extended. This week's trade recommendation is to expect a retracement of 7.5% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Chart I-9 Short WTI Oil Short WTI Oil The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions.Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights London house prices have dropped 7% since the U.K. Government started the formal process of Brexit seven months ago. Stay underweight U.K. real estate and consumer services versus German real estate and consumer services. The global bond yield mini-cycle is driving asset allocation, sector allocation, value/growth allocation and country allocation. We are more than half way through the current mini-upswing in global bond yields. Look for opportunities to cut back overall portfolio cyclicality towards the end of the year. Feature London house prices have dropped 7% since the U.K. Government started the formal process of Brexit seven months ago (Chart of the Week). The average London home is now worth £584,000,1 down from £628,000. Moreover, our leading indicator for London house prices which compares the number of new viewings (demand) with the number of new listings (supply) suggests no imminent end to the sharpest price decline since the 2008 financial crisis (Chart I-2). Chart I-1Brexit Begins To Bite In London Brexit Begins To Bite In London Brexit Begins To Bite In London Chart I-2The Sharpest Decline In London House Prices Since 2008... The Sharpest Decline In London House Prices Since 2008... The Sharpest Decline In London House Prices Since 2008... Unsurprisingly, the many uncertainties surrounding the unfolding Brexit process are having a much greater impact on the London housing market than on the U.K. housing market as a whole. Outside London, the housing market is broadly flat-lining (Chart I-3). The average U.K. home outside London is now worth £256,500, modestly down from £260,000. Chart I-3 ...But Outside London, Prices Are Flat-Lining ...But Outside London, Prices Are Flat-Lining ...But Outside London, Prices Are Flat-Lining U.K. Households Squeezed We are writing ahead of the Bank of England monetary policy meeting, at which the BoE may deliver its first interest rate hike since July 2007. But hike or no hike, we can confidently say one thing: U.K. households will be squeezed. If the BoE does hike the base rate in an attempt to counter overshooting inflation, it could tip the precariously flat-lining housing market outside London into a downturn - as this market is much more exposed to mortgage affordability than it is to Brexit uncertainties. Alternatively, if the BoE does not hike the base rate, the boost to sterling from recent hawkish rhetoric will be priced out, and the pound will come under renewed downward pressure. This would keep U.K. inflation elevated, and further choke U.K. households' real incomes. Absent the post Brexit vote slump in the pound, U.K. inflation would be substantially lower than it is (Chart I-4 and Chart I-5). So the pound's weakness explains why the U.K. is one of the few major economies where inflation is running well north of 2%. Unfortunately for U.K. households, nominal wage inflation has not followed price inflation higher. And as we explained in Why Robots Will Kill Middle Incomes,2 nor is it likely to in the near future. Chart I-4The Weaker Pound Lifted U.K. Headline Inflation... The Weaker Pound Lifted U.K. Headline Inflation... The Weaker Pound Lifted U.K. Headline Inflation... Chart I-5...And U.K. Core Inflation ...And U.K. Core Inflation ...And U.K. Core Inflation But doesn't textbook economic theory say that the pound's weakness should make U.K. exports more competitive - thereby boosting the net export contribution to economic growth? Yes, the theory does say that a currency devaluation should allow firms to trade in markets that were previously unprofitable to them. However, to trade in these newly profitable markets, firms first need to invest - for example, in marketing and distribution. The trouble is that, post-Brexit, many of the newly profitable markets may be unavailable, or come with heavy tariffs. So firms will hold off making the necessary investments, unless the currency devaluation is massive. But in this case, the corresponding surge in inflation and choke on households' real incomes would also be massive. In summary, U.K. consumer spending faces a continued squeeze. If the BoE delivers a rate hike, household borrowing is likely to fade as a driver of spending. But if the BoE does not deliver the rate hike, the pound will once again weaken, keeping inflation elevated and weighing on real incomes. Stay underweight U.K. consumer services versus German consumer services (Chart I-6). And stay underweight U.K. real estate versus German real estate - expressed either through direct real estate exposure or through real estate equities (Chart I-7). Chart I-6U.K. Consumer Services Equities Are Underperforming U.K. Consumer Services Equities Are Underperforming U.K. Consumer Services Equities Are Underperforming Chart I-7U.K. Real Estate Equities Are Underperforming U.K. Real Estate Equities Are Underperforming U.K. Real Estate Equities Are Underperforming Investment Reductionism Illustrated Turning to markets more generally, it is crucial to understand that most of the moves in most financial markets reduce to a very small number of over-arching macro drivers. We call this very important principle Investment Reductionism. Investment Reductionism emerges from two guiding philosophies: Occam's Razor - which says that when there are competing explanations for the same effect, the simplest explanation is usually the best; and the Pareto Principle (the 80:20 rule) - which says that a small minority of causes usually explain a large majority of effects. The upshot of Investment Reductionism is that the seeming complexity of asset allocation, sector selection, the choice between value or growth, and country allocation usually reduces to something much simpler. Let's illustrate this. The global 6-month credit impulse leads the cyclical direction of the global bond yield, and thereby determines asset allocation (Chart I-8). The direction of the global bond yield drives sector selection: for example Banks versus Healthcare. This is because higher bond yields imply higher net interest margins for banks as well as an improving growth outlook, favouring cyclicals over defensives. And vice-versa (Chart I-9). Chart I-8Investment Reductionism Step 1: ##br##The Global Credit Impulse Leads The Bond Yield Cycle Investment Reductionism Step 1: The Global Credit Impulse Leads The Bond Yield Cycle Investment Reductionism Step 1: The Global Credit Impulse Leads The Bond Yield Cycle Chart I-9Step 2: The Bond Yield Drives ##br##Sector Performance Step 2: The Bond Yield Drives Sector Performance Step 2: The Bond Yield Drives Sector Performance Banks versus Healthcare determines the European Value versus Growth decision. This is because in Europe, Banks and Healthcare are the dominant value sector and growth sector respectively (Chart I-10). Banks versus Healthcare also determines the country allocation between, say, Italy's MIB - which is bank heavy - and Denmark's OMX - which is healthcare heavy (Chart I-11). Chart I-10Step 3: Sector Performance Drives Value ##br##Vs. Growth Step 3: Sector Performance Drives Value Vs. Growth Step 3: Sector Performance Drives Value Vs. Growth Chart I-11Step 4: Sector Performance Drives ##br##Country Performance Step 4: Sector Performance Drives Country Performance Step 4: Sector Performance Drives Country Performance Therefore, the important lesson from Investment Reductionism is to ignore the hundreds of things that matter little, and to focus on the very small number of things that matter a lot. And one of the things that matters a lot is the global bond yield mini-cycle. Where Are We In The Bond Yield Mini-Cycle? Empirically, the acceleration and deceleration of global bank credit flows - as measured in the global credit impulse - exhibits a remarkably regular wave like pattern, with each half-cycle lasting about 8 months (Chart I-12). The global bond yield shows a similarly regular wave like pattern with each half-cycle also averaging about 8 months (Chart I-13). Chart I-12The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern Chart I-13The Global Bond Yield Has Shown A Regular Wave Like Pattern The Global Bond Yield Has Shown A Regular Wave Like Pattern The Global Bond Yield Has Shown A Regular Wave Like Pattern It is not a coincidence that the bank credit impulse and bond yield exhibit near identical half-cycle lengths. The global credit impulse and global bond yield are inextricably embraced in a perpetual mini-cycle. A stronger credit impulse boosts economic growth. In response to the stronger economic data, the bond yield rises, which slows credit growth. A weaker credit impulse weighs down economic growth. In response to the weaker economic data, the bond yield declines, which re-accelerates credit growth. Go back to step 1 and repeat ad perpetuam. At this moment, from an investment perspective, there are three points worth making: first, bond yield mini-upswings tend to occur mostly within the credit impulse upswing; second, credit impulse mini-upswings have a consistent duration lasting about 8 months; and third, the current mini-upswing started in May. What does this mean for investment strategy? It means that we are more than half-way through the current mini-upswing which we would expect to end around January/February. And at some point early next year we are likely to enter a mini-downswing. So it is slightly premature to cut back cyclical exposure right now. But we would certainly consider opportunities as we move to the end of the year - especially if our now tried and tested fractal timing indicators signal that the price action in specific investments has reached a technical tipping point. Stay tuned. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Source: LSL Acadata 2 Please see the European Investment Strategy Special Report "Why Robots Will Kill Middle Incomes", dated August 10 2017 available at eis.bcaresearch.com. Fractal Trading Model* This week, our model suggests that the New Zealand dollar is oversold and ripe for a technical rebound. The recommended trade is long NZD/USD with a profit target/stop loss set at 3%. In other trades, long Canada 10-year bond/short German 10-year bund achieved its profit target while short Norway/long Switzerland hit its stop loss. This leaves five open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-14 Long NZD/USD Long NZD/USD * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com. Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Tipping points tend to occur when too many long-term value investors are uncharacteristically behaving like short-term momentum traders. Long IBEX35 versus Eurostoxx50 constitutes a good tactical trade. The underperformance of Spanish equities appears excessively pessimistic. Euro/dollar is technically extended by about 4 cents. The near term event risk is the ECB meeting on October 26, when a taper of asset purchases which extends well beyond 12 months might be regarded as dovish. But in the medium term, euro/dollar will head well north of 1.30. Underweight Basic Materials equities relative to the market as a tactical trade. Feature Spain: Red Herring Or Red Flag? Long Spanish equities is an excellent tactical trade provided that the imbroglio in Catalonia turns out to be a red herring. The IBEX35 index is at a classic tipping point of excessive short-term (negative) groupthink and herding (Chart of the Week). Chart Of The WeekThe Underperformance Of Spanish Equities Seems Excessive The Underperformance Of Spanish Equities Seems Excessive The Underperformance Of Spanish Equities Seems Excessive But is the imbroglio in Catalonia a red herring? Most likely, yes. As my colleague Marko Papic, BCA Chief Geopolitical Strategist points out, any unilateral declaration of independence from Catalonia would be vacuous if it lacked international legitimacy, or the ability to enforce it with arms. German sociologist Max Weber famously defined a nation's sovereignty as a "monopoly over the use of legitimate force." Unlike the Basque separatists, Catalan separatists have never resorted to force. A descent into violence remains unlikely because the Catalan independence movement is mainly a bourgeois, middle and upper class intellectual vision. The majority of Catalonia's working class are neither Catalan, nor support independence. Any unilateral declaration of independence would also lack political credibility because the opponents of independence largely boycotted the recent referendum to avoid giving it legitimacy. The vote for independence comprised only 37% of the electorate, meaning that popular support for independence remains questionable. The real (and unspoken) reason for the independence referendum was that it was the only glue holding together the Junts Pel Si (Together For Yes) four party coalition forming Catalonia's regional government. Without this glue, the two nationalist parties from opposite sides of the ideological spectrum would not be in bed with each other. And it is unclear whether this unholy alliance can stay entwined. To sum up, Catalan independence is an intellectual vision which at the moment lacks political and implementation credibility. For the imbroglio to become a full-blown crisis, the Catalan government, or militant groups, or the Spanish government would have to escalate tensions with the use of force. We do not expect this to happen. So the underperformance of Spanish equities appears excessively pessimistic, and long IBEX35 versus Eurostoxx50 constitutes a good 3-month trade (Chart I-2 and Chart I-3). Chart I-2The IBEX 35 And Euro Stoxx 50 Have Parted Company The IBEX35 And Euro Stoxx 50 Have Parted Company The IBEX35 And Euro Stoxx 50 Have Parted Company Chart I-3The IBEX 35 Has Catch-Up Potential The IBEX35 Has Catch-Up Potential The IBEX35 Has Catch-Up Potential Identifying Tipping Points Of Price Trends Let's take this opportunity to review how we identify such tipping points of excessive groupthink and herding. Tipping points tend to occur when too many long-term value investors are uncharacteristically behaving like short-term momentum traders. Instead of dispassionately investing on the basis of value, long-term investors get sucked into chasing a price trend, and thereby amplify it. These price trends reach exhaustion when there are no more value investors left to suck in, and at the margin, someone wants to get out. The following analysis describes the tipping point of a price uptrend, but exactly the same analysis applies in reverse to the tipping point of a price downtrend. When a financial asset price starts to rise, the momentum trader's natural inclination is to chase the price rise, and buy. Conversely, the long-term value investor's natural inclination, ordinarily, is to lean against the price rise, and sell. The two investors interpret the same information in polar opposite ways because they have very different time horizons. Importantly, their different interpretations of the same information - stemming from their different time horizons - allow the momentum trader and the value investor to trade with one another in very large volume at the current price. This is what creates a healthy market with plentiful liquidity. Now consider what happens when a long-term value investor flips out of character and acts like a momentum trader. With the numerical balance shifting to the momentum traders, the price has to move up to balance buy and sell orders. As more and more value investors defect to momentum trading, the price uptrend gathers steam. This uptrend is exhausted when the long-term value investors have all joined the trend. Regular readers know that we identify these tipping points by comparing the behaviour of investors with 'short-term' 1-day horizons and investors with 'long-term' 65-day horizons. For any financial asset, a near term price reversal is likely to occur when its 65-day fractal dimension hits a lower limit of 1.25 (Chart I-4), which we have found to be the 'universal constant of finance'.1 Chart I-4When The Valuation Framework Changes, It Is More Difficult To Assess Tipping Points When The Valuation Framework Changes, It Is More Difficult To Assess Tipping Points When The Valuation Framework Changes, It Is More Difficult To Assess Tipping Points At this remarkably consistent limit, the long-term investor reverts back to character, realises the stock is now overvalued and wants to sell. The trouble is that everybody has already joined the trend. To sell, there needs to be a buyer. But who will buy at the current price? Usually, the answer is nobody. The marginal buyer will be a new category of investor: an 'ultra-long term' value investor - let's say, with a 130-day horizon - who stayed true to character and refused to join the uptrend. As this investor knows that the stock is overvalued at the current price, he will only provide liquidity at the 'correct' lower price. So this is the tipping point at which the price trend reverses. Occasionally, there is another possibility. The ultra-long term value investor could also join the trend at the current price. This might happen when the valuation framework for an investment is especially uncertain, leaving long-term value investors extremely disoriented and unable to assess the 'correct' price. An important conclusion is that when the valuation framework for an investment is undergoing a major change, it is much more difficult to assess the tipping point of a price trend. Which brings us to the euro. Is The Euro Overbought? Through the second half of 2014 and early 2015, the euro was in a major downtrend as the ECB first signalled and then implemented its QE program. On several occasions, the 65-day downtrend seemed technically exhausted but after only minor reversals, the downtrend continued (see Chart I-4 again). Even after the 130-day downtrend seemed exhausted at the start of 2015, it persisted into the spring (Chart I-5). The reason was that as the ECB moved into the uncharted territory of QE, ZIRP and NIRP, the valuation framework for the euro also moved into uncharted territory. Without a reliable valuation anchor, longer and longer term investors jumped on the euro bear bandwagon. Chart I-5The Euro Is Overbought, But The Reversal Might Be Minor The Euro Is Overbought, But The Reversal Might Be Minor The Euro Is Overbought, But The Reversal Might Be Minor Today, we face the mirror-image situation. The euro has been in a major uptrend for most of 2017 as the ECB has signalled a recalibration of its extraordinary monetary easing. But though the 65-day uptrend seemed exhausted in the early summer, the uptrend continued as longer term investors joined the trend. Just as in 2014-15, the question today is: at a major turning point in ECB policy, what is the most reliable valuation anchor? For us, the best explanatory model for euro/dollar is the expected difference in ECB versus Fed policy rates 5 years ahead. As this differential compressed from -230 bps to -160 bps, euro/dollar rallied in perfect lockstep from 1.03 to 1.15. However, the subsequent rally has deviated from the expected policy rate differential, suggesting that the euro's uptrend is indeed overdone by about 4 cents. But in the medium term, the much bigger question is: what will happen to the expected policy rate differential? As we explained in Positioning For A Sea-Change2 the differential must eventually compress to around -40 bps, because this is the mid-point of a very well established multi-decade cycle (Chart I-6 and Chart I-7). In which case, euro/dollar must eventually head well north of 1.30 (Chart I-8). Chart I-6The Euro Area - U.S. Average ##br##Interest Rate Differntial = -40 bps... The Euro Area - U.S. Average Interest Rate Differntial = -40bps... The Euro Area - U.S. Average Interest Rate Differntial = -40bps... Chart I-7...Because The Euro Area-U.S. ##br##Inflation Differential = -40 bps ...Because The Euro Area-U.S. Inflation Differential = -40bps ...Because The Euro Area-U.S. Inflation Differential = -40bps Chart I-8An Expected Interest Differential ##br##Of -40 bps Means EUR/USD Goes North Of 1.30 An Expected Interest Differential Of -40 bps Means EUR/USD Goes North Of 1.30 An Expected Interest Differential Of -40 bps Means EUR/USD Goes North Of 1.30 To be clear, north of 1.30 is the medium term direction of travel, and the journey will not be a straight line. The near term event risk is the ECB meeting on October 26, when the central bank will very likely announce a recalibration of its monetary policy. A taper of asset purchases which extends well beyond 12 months might be regarded as dovish, as it would delay the timing of policy rate normalisation. In which case, euro/dollar could retest 1.15. Finally, and very briefly, Chart I-9 shows the major equity sector most at risk of a price trend reversal is Basic Materials. Although global growth seems healthy and synchronized, materials equities seem to have run much too far ahead, especially relative to other cyclical equity sectors. We recommend tactically underweighting Basic Materials relative to the market. Chart I-9Tactically Underweight Basic Materials Tactically Underweight Basic Materials Tactically Underweight Basic Materials Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report, "The Universal Constant Of Finance," September 25 2014, available at eis.bcaresearch.com. 2 Published on September 7 2017 and available at eis.bcaresearch.com. Fractal Trading Model* As decribed in the main body of this report, this week’s new trade recommendation is to go long Spain’s IBEX35 versus the Eurostoxx50 with a profit target/stop loss of 2.5%. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Long Canadian 10-Year Government Bond Long Canadian 10-Year Government Bond * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Dear Client, This week, in addition to this regular Geopolitical Strategy Weekly Report, we decided to send you a collaborative report we penned with BCA's Energy Sector Strategy. My colleague Matt Conlan runs the service, which blends BCA's macroeconomic framework with his bottom-up expertise in the energy sector. Matt's service is one of the few that our firm publishes with specific company recommendations. In the report titled "King Salman Goes To Moscow, Bolsters OPEC 2.0," Matt argues that the emerging détente between Russia and Saudi Arabia will strengthen OPEC 2.0 and provide a structural tailwind for BCA's bullish view on energy. I highly recommend that you check out the research Matt and his team produce at nrg.bcaresearch.com. All the very best, Marko Papic Senior Vice President, Geopolitical Strategy Highlights Easier fiscal policy and tighter monetary policy is bullish for U.S. equities; The Dec. 12 Alabama Senate race could be a game changer in U.S. politics; Trump's anti-immigration policies could boost inflation; Our Catalan view is bearing out. Go long Spain's IBEX 35 / short Eurostoxx 50. Separately, book profits on our China volatility trade and our long China big bank trade. Feature "Buy In May And Enjoy Your Day!" has been our mantra throughout the summer. Despite the doom and gloom in the media surrounding the Mueller investigation, North Korea, Trump's legislative agenda, the French elections, Brexit, and so on, the S&P 500 is up 16% and global equities are up 10.8%. Our April 23 Weekly Report bearing the same cheery title focused on three overstated risks:1 European politics - massively overstated; U.S. politics - all noise, no signal; Brexit - irrelevant for global investors. We have also cautioned investors throughout the year to worry, but not to obsess, about North Korea. Yes, it is a risk.2 Yes, it will continue to buoy safe haven assets on occasion.3 But it is extremely unlikely to produce total war and therefore has lost some market relevance as assets have adjusted to the higher geopolitical volatility on the Korean Peninsula under the Trump regime.4 We are not reiterating these calls just to pat ourselves on the back. Rather, our point is to emphasize that there is nothing supernatural about the ongoing bull market. It has not "ignored" geopolitical risks. Rather, geopolitical risks on hand have not developed in a market-relevant way. The bottom line here is that geopolitics is not voodoo. It is not an "error term," a disturbance in an elegant model that can go awry at any moment because "one cannot forecast politics." Investors can systematically analyze geopolitics just as they do the economy or the markets. When geopolitical risks are overstated, as they have been since the beginning of the year, recognizing the mispricing can generate significant alpha. Going forward, however, geopolitics will likely play a headwind for the market. We are particularly concerned with three dynamics: The upcoming party congress in China may signal a shift towards more growth-stalling reforms, as we have been writing all year. The Trump administration could make a hard turn towards a more populist agenda, particularly on trade, if it fails to enact any legislative successes this year. A plethora of political risks in emerging markets (EM) - with the usual suspects of Brazil, South Africa, and Turkey on top of our list - could re-surface in 2018 if China is not firing on all cylinders. We will be focusing on these three risks to markets until the end of 2017 and beyond. This week, however, we focus on upcoming tax legislation in the U.S. First, a reason to be optimistic ("easier fiscal policy, tighter monetary policy" is a winning policy combination). Then, a reason to be pessimistic (Alabama). Finally, a few words about inflation from a political perspective and a quick word on Catalonia. Easy Fiscal, Tighter Monetary Policy Mix - What Does It Mean? If our base case view on tax legislation is correct, U.S. equities should gain double-digit returns from current levels. Our colleague Anastasios Avgeriou, Chief Strategist of BCA's U.S. Equity Strategy, believes that the passage of stimulative tax legislation would serve as a catalyst to further fuel the blow-off phase in equities. In his latest Weekly Report, Anastasios presents empirical evidence suggesting that easy fiscal policy outweighs the drag from Fed interest rate tightening.5 Filtering the post-World War Two era for periods of easing fiscal and tightening monetary policies during economic expansions is revealing. Anastasios defines easy fiscal policy as periods with a positive fiscal thrust and tight monetary policy as a rising fed funds rate. Fiscal thrust is the year-over-year change in the cyclically-adjusted fiscal balance as a percentage of potential GDP (shown inverted on the bottom panel of Chart 1). While such a policy mix is a rare occurrence, it has happened seven times since the mid-1950s (shaded areas, Chart 1).6 All iterations resulted in positive returns, with the SPX rising on average by over 16%. Table 1 details all seven periods that have an average duration of 16 months. For sectoral implications of such an "easier fiscal, tighter monetary" policy mix, we encourage our clients to peruse the work of BCA's U.S. Equity Strategy. On the other hand, the demand for fiscal stimulus usually rises during times of high volatility, unlike today (Chart 2). Investors have become acutely aware of the political difficulties of stimulating the economy late in the economic cycle. We now turn to some emerging risks to our sanguine view on tax policy. Chart 1Easy Fiscal + Tight Money##br## = Buy SPX Easy Fiscal + Tight Money = Buy SPX Easy Fiscal + Tight Money = Buy SPX Table 1SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Why So Serious? Why So Serious? Chart 2Fiscal Stimulus Usually##br## Comes With High Volatility Fiscal Stimulus Usually Comes With High Volatility Fiscal Stimulus Usually Comes With High Volatility Bottom Line: If our base case view holds, and Republicans pass mildly stimulative tax legislation, the blow-off phase in equities should continue. "Alabama, You Got The Weight On Your Shoulders" The market continues to doubt that the Trump administration can pass significant tax legislation over the next six-to-nine months. The gap in the probabilities assigned to such an outcome by the market and ourselves has narrowed over the past two weeks, generating alpha on several of our "Trump Reflation" trades (Chart 3). But skepticism abounds. Chart 3Signs Of Life For 'Trump Reflation' Trades Signs Of Life For 'Trump Reflation' Trades Signs Of Life For 'Trump Reflation' Trades We have spent the entire year pushing against the skepticism, but there is now an actual reason to worry. The December 12 Alabama Senate special election - being held to elect a replacement for former Senator Jeff Sessions, now the U.S. Attorney General - has become a premier league event. Former Alabama Chief Justice Roy Moore won the Republican primary against a candidate backed by the Republican establishment and President Trump. The reason the Alabama special election is of global significance is because the Republicans are already down to essentially 50 votes in the Senate. The rhetorical war between President Donald Trump and Senator Bob Corker (R - Tennessee) has reached epic proportions, with the latter insinuating via twitter that the president was an adult baby. Corker has announced his retirement from the Senate, which increases the probability that he will go out by refusing to support the president's agenda across all fronts.7 This now makes two GOP senators that want nothing to do with President Trump's agenda. John McCain (R - Arizona) has harbored ill will since the presidential campaign and has twice played the spoiler in the effort to repeal Obamacare. Further complicating matters is the role of former White House Chief Strategist Steve Bannon, who strongly backed Moore when nobody in the Republican establishment would. If Moore should remain loyal to Bannon beyond the election, it would mean that Trump's former campaign strategist would become the kingmaker on tax legislation. Bannon's departure from the White House was cheered by the markets, as it signaled victory for the "Goldman Sachs clique" and the trio of generals managing President Trump's foreign policy over Bannon's populist "Breitbart clique." We do not think that Bannon is opposed to stimulative tax policy. Yes, he has branded his ideology "economic nationalism," but his media empire, Breitbart, has so far stayed away from attacking the Republican tax plan. Instead, Bannon and Moore could hold out on supporting tax policy until they see movement on other pillars of the populist agenda, namely on immigration policy. As such, Moore's Alabama victory would complicate the horse-trading surrounding tax legislation, and elevate Bannon's standing on Capitol Hill, but it would not be a death knell for stimulus. The actual death knell for tax reform would be if Moore actually lost the December 12 Alabama special election. Moore's views are generally considered to be staunchly conservative, even for Alabama, and therefore a shock defeat cannot be ignored.8 Polls are limited, but most show Moore leading the Democratic candidate Doug Jones by only 5%-8%. This in a state where Republican Senate candidates have defeated their Democrat counterparts by an astounding average of 36% in the last decade! If Jones were to win, Republicans would be down to 51 Senators. Given the staunch opposition to Trump by Corker and McCain, this would effectively end the tax legislation push. Not all is negative for the tax push in Washington. The U.S. House of Representatives has passed a budget resolution that includes steep spending cuts as well as reconciliation instructions for tax legislation. This now sets in motion the reconciliation process by which Republicans can pass tax legislation with merely 51 votes in the Senate. Of the 18 GOP representatives who voted against the budget resolution, only three were from the 31-member Freedom Caucus, which is rhetorically committed to fiscal conservativism. This is very bullish for tax cuts as it means that the Freedom Caucus is toeing the line of its Chair Mark Meadows (R - North Carolina) who has been hinting since the spring that he would have no problem with budget-busting tax cuts. The majority of Republicans who voted against the budget resolution were from highly-taxed "Blue States," suggesting that the real point of contention for Republicans in the House was the proposal to end the state and local tax deduction. Treasury Secretary Steven Mnuchin has already signaled that the White House is willing to compromise on this particular revenue offset. Bottom Line: The December 12 Alabama special election now has global market relevance. A defeat for GOP candidate Roy Moore would be a massive game changer. It would reduce the Republican majority in the Senate to 51 votes, putting in danger President Trump's tax agenda given the staunch opposition from Senators Corker and McCain. What Can Politics Do To Inflation? The greatest surprise to the markets this year has been lackluster inflation data in the U.S. Both headline and core data have been disappointing (Chart 4). This is particularly puzzling as the U.S. has closed its output gap and unemployment has fallen below the low reached in 2007 (Chart 5). Chart 4U.S. Inflation Has Disappointed... U.S. Inflation Has Disappointed... U.S. Inflation Has Disappointed... Chart 5...Which Is Puzzling At Full Employment ...Which Is Puzzling At Full Employment ...Which Is Puzzling At Full Employment One possible explanation is that the U.S. has been importing deflation from abroad. The U.S. imports around 12.5% of GDP worth of goods and 2.8% of GDP worth of services (Chart 6). However, the import price deflator has been growing at 2.7% so far this year and yet inflation has been nonexistent (Chart 6, bottom panel). Export prices have grown by 5% in 2017, from the lows of -15% amidst the commodity bust in 2015 (Chart 7). Chart 6The U.S. Is Not Importing Deflation The U.S. Is Not Importing Deflation The U.S. Is Not Importing Deflation Chart 7Global Export Prices Are Rising Global Export Prices Are Rising Global Export Prices Are Rising Another explanation is that structural changes in the labor market - globalization and the fall in the unionization rate - have eroded the bargaining power of workers (Chart 8). When combined with the shock of the 2008 Great Recession, workers may simply be happy to have a job and are therefore delaying asking of a raise or switching to a higher-paying, but higher-risk, job. As a result, the economy may have closed its output gap, but with no inflationary effects coming from the low unemployment figures. Chart 8Globalization Suppressed U.S. Wages Globalization Suppressed U.S. Wages Globalization Suppressed U.S. Wages Further restricting wage gains may be the high number of migrants - legal or illegal (Chart 9). The foreign born population in the U.S. is at an all-time high of 43.2 million, although unauthorized migration has come down from around 12 million prior to the GFC to 11.3 million in 2016. The conventional wisdom is that most immigrants are uneducated, competing with blue collar laborers and suppressing wages at the lower income levels. However, this is a stereotype stuck in the 1980s. Today's migrants are as educated as Americans: 29.7% have a Bachelor's degree or higher, compared with just over 30% Americans in general (Chart 10). Chart 9Immigration Helps Explain Weak Wage Growth Why So Serious? Why So Serious? Chart 10Immigrants Not Stealing Low-Skill Jobs Why So Serious? Why So Serious? The point is that immigration has evolved along with the U.S. economy. With 78% of the U.S. economy based in services, the modern migrant has had to keep up with the educational requirements of the American job market. The Trump administration could be a game-changer for the skilled, legal immigration into the U.S. First, President Trump ordered a full review of the high-skilled, H-1B immigration visa in April. Second, President Trump asked Congress in August to curb legal migration by sharply curtailing family reunification while keeping immigration based on job skills roughly the same. Third, anti-immigrant rhetoric - as well as restrictions to family reunification down the line - could influence highly-skilled migrants to choose job opportunities in countries like Australia, Canada, and New Zealand, instead of in the U.S. Bottom Line: Investors often think of fiscal policy as the main vehicle through which politicians can influence inflation. However, the U.S. economy has been enjoying, since the 1980s, the combined effect of rapidly expanding immigration and a parallel increase in the educational attainment of incoming migrants. In a way, the influx of skilled migrants has been an important supply side reform for the U.S. economy. The Trump administration could influence immigration either directly, through policies to curb it, or indirectly, through creating a general atmosphere that redirects some of the flows to other developed economies. Spain: Fade Catalan Risks As we have expected since 2014, the prospects for Catalan independence remain slim.9 As we go to press, Catalan President Carles Puigdemont has backed away from his earlier hints toward a unilateral declaration of independence. Instead, he has succumbed to domestic and international pressure and told the regional parliament that he has "suspended" any declaration in order to begin negotiations with Madrid. Puigdemont's decision to suspend something that has not happened is not only illogical but also ineffectual. The Catalan pro-independence government is trying to force Madrid to be the "bad guy" and refuse negotiations; Spain has refused any discussion of independence. But slight narrative shifts and "gotcha" politics will not work in this case. While Puigdemont is playing checkers with Spanish Prime Minister Mariano Rajoy, the rest of Europe is playing chess. International recognition of Catalan independence is not forthcoming. And without it, Catalonia will not become independent. As we have extensively written, we strongly believe that investors should fade secessionism risk in Spain. First, the independence process in Catalonia falls far short of the democratic ideals established in similar referendums in the developed world, particularly in Scotland (2014), Montenegro (2006), and Quebec (1980 and 1995) (Table 2). The pro-independence government has been unable to significantly boost turnout figures from 2014, no doubt due to interference by the federal authorities. However, even if the pro-independence Catalans were to receive mediation from the EU, the outcome would likely be to strengthen Madrid's hand. For example, when the EU negotiated the 2006 divorce between Serbia and Montenegro, it required a supermajority of 55% in order to recognize the result of the Montenegro independence referendum. As an integrationist project, the EU has an anti-secession bias. Table 2Catalan Independence Demand Exaggerated By Low Voter Turnout Why So Serious? Why So Serious? Second, the French government has come out forcefully against Catalan independence, as we suspected it would. This is particularly important for Catalonia as it is nestled between Spain and France.10 It is quite likely that, were Catalans somehow to enforce their independence, both European powers would close their borders to Catalan travel and trade. In addition, French European Affairs Minister Nathalie Louiseau has repeated Madrid's assertion that by choosing independence Catalonia would automatically be kicked out of the EU. Third, Madrid is unlikely to make another mistake as the disastrous attempt to disrupt the independence referendum. Images of civilians being dragged through the streets of an advanced European economy while attempting to vote - even if the referendum was constitutionally illegal - shocked the world. Spanish officials have already offered rather tepid apologies for the police action, suggesting that a re-run of the heavy-handed actions is not to be expected. For investors who disagree with us, we suggest an empirical way to test our thesis. Chart 11 shows that only 34.7% of Catalans support independence. These are not pro-Madrid polls. They are the product of the Centre d'Estudis d'Opinió, which is affiliated with the Catalan (currently staunchly pro-independence) government and has been conducting polls on the issue of independence since 2005. Even if the level of support for independence is off in this data, the direction gives us valuable insight into the support for secession. The data clearly suggests that (A) the majority of Catalans have never supported independence and that (B) support for independence peaked in 2013, at the height of Spain's economic crisis, and has been in steady decline since then. That said, Chart 11 also shows that the other 57.5% of Catalans are not necessarily "pro-Spain." In fact, 30.5% support Catalonia remaining in its current form of an autonomous region, with considerable sovereignty devolved to the province. Another 21.7% favor a federal state, which would be a step in the direction of even greater sovereignty. Investors should watch the polls to see whether voters who previously favored federal or autonomous status have begun to shift towards independence, especially in light of the crackdown against the referendum by Madrid. Centre d'Estudis d'Opinió normally releases its third series of polls in October, which would mean that investors will have an update from the official polling agency soon. That said, we are willing to put our geopolitical views on the line. An unwarranted selloff in Spanish equities on the back of increased Catalonia-related geopolitical risk has created an opportunity for a market neutral trade: long Spanish IBEX 35/short Eurostoxx 50. This is a market neutral way to express our view that Catalonia does not pose a grand geopolitical risk as it will remain an integral part of Spain and thus the EU. Importantly, adding a hedge to this pair trade would also make sense for certain investors. Chart 12 shows that EUR/USD and relative Spanish equity performance are joined at the hip. Currently an uncharacteristically wide gap has opened. Thus, putting on this equity pair trade and simultaneously going short EUR/USD on the expectation of a convergence, should generate alpha, as the geopolitical dust settles. Chart 11The Silent Majority Fears Independence The Silent Majority Fears Independence The Silent Majority Fears Independence Chart 12Expect A Convergence Expect A Convergence Expect A Convergence Bottom Line: Fade geopolitical risks in Spain. For those with risk appetite, buy Spanish equities at any sign of geopolitical risk premium. Housekeeping With the Communist Party convening for the nineteenth National Party Congress over the next week, we think the time is opportune to book profits on two trades: our long China ETF volatility index, for a gain of 17.72%, and our long Chinese Big Five state-owned banks versus small and medium-sized banks, for a gain of 11.63%. We will revisit these trades in an upcoming report. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day," dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 4 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. 5 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?" dated October 9, 2017, available at uses.bcaresearch.com. 6 Omitted from the sample are brief periods in the early-1960s, early-1970s, and twice in the early-1980s as they were very close to the end of recessions. 7 We suspect that Senator Corker is planning a centrist challenge to President Trump in the 2020 GOP presidential primaries. 8 "Staunchly conservative" does not do justice to Moore's ideological orientation. He was removed from his position as Chief Justice of the Alabama Supreme Court twice for failing to follow federal law. In both cases, Moore chose to inform his actions as the Chief Justice through Biblical scripture, rather than the U.S. Constitution. 9 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014, available at gps.bcaresearch.com. 10 Yes, we are aware that Catalonia also borders Andorra. However, given that French President Emmanuel Macro is the co-prince of Andorra, and that Andorra is a microstate, this fact is largely irrelevant and would in no way aid Catalan independence. However, you have now learned that the French President is automatically a co-prince of another country. And that there is such a thing as a "co-prince." Therefore, this footnote has not been a complete waste of your time.