Secession/Breakup

This month's Special Report, on Scotland's role in Brexit negotiations, was penned by our colleagues Matt Gertken, Marko Papic, and Jesse Kurri of BCA's Geopolitical Strategy service. Scottish secessionist sentiment has increased in response to First Minister Nicola Sturgeon's decision to push for a second popular referendum on Scottish independence, tentatively set for late 2018 or early 2019, though likely to be denied for some time by Westminster. The outcome of a referendum on leaving the U.K., which eventually will occur, is too close to call at this point. The possibility will influence the U.K.'s negotiations with the EU, and vice versa. The risk of a U.K. break-up adds an important constraint to Prime Minister Theresa May's government in the Brexit talks. Since the EU also has an interest in avoiding a devastating outcome for the U.K., our geopolitical team believes that the worst version of a "hard Brexit" will be avoided. That said, independence for Scotland cannot be ruled out, particularly in the context of any adverse economic shock stemming from the U.K.'s divorce proceedings. I trust that you will find the report as insightful as I did. Mark McClellan Senior Vice President A second Scottish referendum will be "too close to call"; There is upside potential to the 45% independence vote of 2014; Scots may vote with their hearts instead of their heads; But the EU will not seek to dismember the U.K. ... ...And that may keep the kingdom united. "No sooner did Scots Men appear inclined to set Matters upon a better footing, than the Union of the two Kingdoms was projected, as an effectual measure to perpetuate their Chains and Misery." - George Lockhart, Memoirs Concerning The Affairs Of Scotland, 1714. British Prime Minister Theresa May has had a busy week. On Monday she met with Scotland's First Minister Nicola Sturgeon as part of a tour of the United Kingdom to drum up national unity. On Wednesday she communicated with European Council President Donald Tusk and formally invoked Article 50 of the Lisbon Treaty, initiating the process of the U.K.'s withdrawal from the European Union. And on that day and Thursday, she turns to the parliamentary battle over the "Great Repeal Bill" that will replace the 1972 European Communities Act, which until now translated European law into British law. Brexit is finally getting under way. As our colleague Dhaval Joshi puts it, the "Phoney War" has ended, and now the real battle begins.1 Indeed, the dynamic has truly shifted in recent weeks. Not because PM May invoked Article 50, which was expected, but rather because Scottish secessionist sentiment has ticked up in reaction to Sturgeon's decision to hold a second popular referendum on Scottish independence (Chart II-1), tentatively set for late 2018 or early 2019. Scottish voters are still generally opposed to holding a second referendum, but the gap is narrowing (Chart II-2). A sequel to the September 2014 referendum was always in the cards in the event of a Brexit vote. Financial markets called it, by punishing equities domiciled in Scotland following the U.K.'s EU referendum (Chart II-3). The timing of the move toward a second referendum is significant for two reasons. First, the odds of Scotland actually voting to leave have increased relative to 2014, even as the economic case for secession has worsened. Second, Scotland's threat of leaving will impact the U.K.'s negotiations with the EU, slated to end in March 2019.2 Chart II-1A Second Independence Referendum... A Second Independence Referendum ... A Second Independence Referendum ... Chart II-2...Is Looking More Likely ... Is Looking More Likely ... Is Looking More Likely Chart II-3Scottish Stocks Have Underperformed Scottish Stocks Have Underperformed Scottish Stocks Have Underperformed BCA's Geopolitical Strategy service believes that a second Scottish referendum will eventually take place. And as with the Brexit referendum, the outcome will be "too close to call," at least judging by the data available at present. In what follows we discuss why, and how Scotland could influence the Brexit negotiations, and vice versa. While the U.K. can avoid the worst version of a "hard Brexit," the high risk of a break-up of the U.K. will add urgency to negotiations with the EU. Why Scotland Rejected "Freedom" In 2014 In a Special Report on "Secession In Europe," in May 14, 2014, we argued that the incentives for separatism in Europe had weakened and that this trend specifically applied to Scotland:3 The world is a scary place: Whereas the market-friendly 1990s fueled regional aspirations to independence by suggesting that the world was fundamentally secure and that "the End of History" was nigh, the multipolar twenty-first century discourages those aspirations, with nation-states fighting to maintain their integrity. For Scotland, the Great Recession drove home the dangers of socio-economic instability. EU and NATO membership is difficult to obtain: Scotland could not be assured to find easy accession to the EU as it faced opposition from states like Spain, which wanted to discourage Catalan independence. Enlargement of the EU and NATO have both become increasingly difficult and Scotland would need a special dispensation. The United States and the European Union vociferously discouraged Scotland from striking out on its own ahead of the 2014 referendum. Domestic politics: The Great Recession revived old fissures in every country, including the old Anglo-Scots divide. The U.K. imposed budgetary austerity while Scotland opposed it. Left-leaning Scotland resented the rightward shift in the U.K., ruled by the Conservative Party after 2010. We also highlighted some of Scotland's particular impediments to independence: Energy: Scotland's domestic sources of energy are in structural decline. This would weigh on the fiscal balance and domestic private demand. The referendum actually signaled a top in the oil market, with oil prices collapsing by 58% in 2014. Deficits and debt: Scotland's public finances would get worse if it left the U.K. If that had happened in 2014, it was estimated that the country's fiscal deficit would have been 5.9% of GDP and that its national debt would have been 109% of GDP. (Today those numbers are 8% and 84% of GDP respectively) (Table II-1). A newborn Scotland would have to adopt austerity quickly. Table II-1Scotland Would Be A High-Debt Economy April 2017 April 2017 Central banking: If Scotland walked away from its share of the U.K.'s national debt, yet retained the pound unilaterally and without the blessing of the BoE, it would lose access to the English central bank as lender of last resort. And if it walked away from its U.K. debt obligation and the pound, then it would also lose its financial sector and much of its wealth, which would be newly redenominated into a Scots national currency. Scotland is every bit as reliant on the financial sector as the U.K. as a whole (Chart II-4), making for a major constraint on any political rupture that threatens to force it to change currencies or lose control of monetary policy. Chart II-4Highly Financialized Societies April 2017 April 2017 Politics: We also posited that domestic political changes in the U.K. could provide inducements to keep Scotland in the union, particularly if the Conservatives suffered in the 2015 elections. The opposite, in fact, occurred, sowing the seeds for today's confrontation. For all these reasons, we argued that the risks of Scottish secession were overstated. The September 2014 referendum confirmed our forecast. The economic prospects were simply too daunting outside the U.K. But the 45% pro-independence tally also left open the possibility for another referendum down the line. Bottom Line: Scottish independence did not make sense in 2014 for a range of geopolitical, political, and economic reasons. But note that while independence still does not make economic sense, the political winds have shifted. Scottish antagonism toward the Conservative leadership in England has only intensified, while it remains to be seen how the European Union will respond to Scotland in a post-Brexit world. The Three Kingdoms Chart II-5Three Cheers For Brexit And The Tories Three Cheers For Brexit & The Tories Three Cheers For Brexit & The Tories In our Strategic Outlook for 2017, we argued that the British public not only did not regret the Brexit referendum outcome, but positively rallied around the flag because of it. This helped set up an environment in which the ruling party could charge forward aggressively and pursue the outcome confirmed by the vote (Chart II-5). Brexit does indeed mean Brexit. We have since seen that the Tories have forced parliament's hand in approving the bill authorizing the government to initiate exit proceedings. It stood to reason that the crux of tensions would shift to the domestic sphere, i.e. to the troubling constitutional problems that Brexit would provoke between what were once called "the Three Kingdoms," England (and Wales), Scotland, and Northern Ireland.4 While 52% of the U.K. public voted to leave the EU, the subdivision reveals the stark regional differences: England and Wales voted to leave (53.4% and 52.5% respectively), while Scotland and Northern Ireland voted to stay (62% and 55.8% respectively). Scotland and the London metropolitan area were the clear outliers. The Scottish parliament is a devolved parliament subordinate to the U.K. parliament in Westminster, and it cannot hold a legally binding referendum on independence without the latter's permission.5 The May government is insisting that it will not allow a referendum to go forward until the Brexit negotiations are completed. This is an obvious strategic need. Although the Scottish National Party (SNP), the dominant party in Edinburgh, could hold a non-binding referendum at any time to apply pressure on London (reminder: the Brexit vote was also non-binding), it has an interest in waiting to see whether public opinion of Brexit will shift in England and what kind of deal the U.K. might get from the EU in the exit negotiations. Eventually, however, Scotland is likely to push for a new vote. The SNP is a party whose raison d'être is independence sooner or later. It faces a once-in-a-generation opportunity, with the 2014 referendum producing an encouraging result and Brexit adding new impetus. The party manifesto made clear in 2016 that a new independence vote would be justified in case of "a significant and material change in the circumstances that prevailed in 2014, such as Scotland being taken out of the EU against our will." Why have the odds of Scottish independence increased? First, Brexit removes a domestic political constraint on independence. After the Brexit vote, the SNP and other pro-independence groups can say that England changed the status quo, not Scotland. It is worth remembering that the Anglo-Scots union was forged in 1707 at a time of severe Scottish economic hardship, in which a common market was the primary motivation to merge governments. Today, Scotland's comparable interest lies in maintaining access to the European single market, which is now under threat from Westminster. In particular, as with the U.K. as a whole, Scotland stands to suffer from a decline in immigration and hence workforce growth (Chart II-6). Second, Brexit removes an external constraint. The EU's official opposition to Scottish independence, particularly European Commission President Jose Manuel Barroso's threat that Scottish accession would be "extremely difficult, if not impossible," likely affected the outcome of the 2014 referendum. Of course, many Scots rejected all such warnings as the vote approached, with polls showing a rally just before the referendum date toward the 45% outcome (Chart II-7). But if the EU's warnings even had a temporary effect, what happens if the EU gives a nod and wink this time around? While EU officials have recently reiterated the so-called "Barroso doctrine," we suspect that they are less likely to play an interventionist role under the new circumstances. Spain - which is still concerned about Scotland fanning Catalan ambitions - might be less vocal this time, since Madrid could plausibly argue that Brexit makes a material difference from its own case. Catalonians could not argue, like the Scots, that their parent country attempted to deprive them of access to the European Single Market. Chart II-6Immigration Curbs Threaten Scots Growth April 2017 April 2017 Chart II-7Scottish Patriots Only Temporarily Deterred Scottish Patriots Only Temporarily Deterred Scottish Patriots Only Temporarily Deterred To put this into context, remember that it is not historically unusual for continental Europe to act as a patron to Scotland to keep England in check. There is ample record of this behavior, namely French and Spanish patronage of the exiled Stuart kings after 1688. The situation is very different today, but the analogy is not absurd: insofar as Brexit undermines the integrity of the EU, the EU can be expected to reciprocate by not doing everything in its power to defend the integrity of the U.K. All is fair in love and war. Nevertheless, the economic constraints to Scottish secession are even clearer than they were in 2014: The North Sea is drying up: Scotland's North Sea energy revenues have essentially collapsed to zero (Chart II-8). Meanwhile the long-term prospects for the North Sea oil production remain as bleak as they were in 2014, especially since oil prices halved. Reserves of oil and gas are limited, hovering at around five to eight years' worth of supply - i.e. not a good basis for long-term independence (Chart II-9). Decommissioning costs are also expected to be high as the sector is wound down. Chart II-8No Golden Goose In The North Sea April 2017 April 2017 Chart II-9Limited Domestic Energy Supplies April 2017 April 2017 England still foots many bills: Total government expenditures in Scotland exceed the total revenue raised in Scotland by about £15 billion or 28% of Scotland's government revenue (Chart II-10). Scottish finances stand at risk: Scotland's fiscal, foreign exchange, and monetary policy dilemmas are as discouraging as they were in 2014 (Chart II-11). Judging by the value of financial assets (which come under risk if Scotland loses the BoE's support or changes currencies), Scotland is incredibly exposed to financial risk (Chart II-12). Chart II-10The U.K. Pays For Scotland's Allegiance April 2017 April 2017 Chart II-11Scotland's Deficits Getting Worse Scotland's Deficits Getting Worse Scotland's Deficits Getting Worse Thus, while key domestic political and foreign policy impediments may be removed, the country's internal economic impediments remain gigantic. Moreover, Scotland already has most of the characteristics of a nation state. It has its own legal and education system, prints its own banknotes, and has some powers of taxation (about 40% of revenue). It lacks a standing army and full fiscal control, but in these cases it clearly benefits from partnering with England. It also has a strong sense of national identity, regardless of whether it is technically independent. Chart II-12Scottish Financial Assets Need Currency Stability April 2017 April 2017 Why, then, do we believe Scottish independence is too close to call? Because Brexit has shown that "math" is insufficient! The Scots may go with their hearts against their heads, just as many English voters did in favor of Brexit. Nationalism and political polarization are a two-way street. History also shows that strictly materialist or quantitative assessments cannot anticipate paradigm shifts or national leaps into the unknown. Compare Ireland in 1922, the year of its independence from the U.K. Ireland was far less prepared to strike out on its own than Scotland is today. It comprised a smaller share of the U.K.'s population, workforce, and GDP than Scotland today (Charts II-13 and II-14). It was less educated and less developed relative to its neighbors, and it faced unemployment rates above 30%. Yet it chose independence anyway - out of political will and sheer Celtic grit. Ireland's case was very different than Scotland's today, but there is an interesting parallel. The U.K. was absorbed with continental affairs, the Americans played the role of external economic patron, and the Irish were ready to seize their once-in-a-lifetime opportunity. Today the U.K. is similarly distracted with Europe, and the SNP leadership is ready to seize the moment, having revealed its preference in 2014. But foreign support (in this case the EU's) will be a critical factor, even though the EU's common market is much less valuable to Scotland than the U.K.'s (Chart II-15). Chart II-13Irish Independence: Poverty Not An Obstacle April 2017 April 2017 Chart II-14Scotland: If The Irish Can Do It So Can We April 2017 April 2017 Chart II-15EU Market No Substitute For British Market April 2017 April 2017 Will the SNP be able to get enough votes? We know that more Scots voted to stay in the EU (62%) than voted to stay in the U.K. (55%), which in a crude sense implies that there is upside potential to the first referendum outcome. However, looking at the referendum results on the local level, it becomes clear that there is no correlation between Scottish secessionists and Europhiles, or unionists and Euroskeptics (Chart II-16). Nor is there any marked correlation between level of education and the desire for independence, as was the case in Brexit. Yet there is evidence that love of the Union Jack is correlated with age (Chart II-17). Youngsters are willing to take risks for the thrill of freedom, while their elders better understand the benefits from economic links and transfer payments. In the short and medium run, this suggests that demographics will continue to work against independence - reinforcing the fact that the SNP can wait to see what kind of deal the U.K. gets first.6 Chart II-16No Relationship Between IndyRef And Brexit April 2017 April 2017 Chart II-17Old Folks Loyal To The Union Jack April 2017 April 2017 The most striking indicator of Scottish secessionism is unemployment (Chart II-18). Thus an economic downturn that impacts Scotland, for example as result of uncertainty over Brexit, poses a critical risk to the union. The SNP will be quick to blame even a shred of economic pain on Tory-dominated Westminster. The British government and BoE have shown a commitment to use accommodative monetary and fiscal policy to smooth over the transition period, and they have fiscal room for maneuver (Chart II-19), but much will depend on what kind of a deal London gets from the EU and whether the markets remain calm. Chart II-18Joblessness Boosts Independence Vote April 2017 April 2017 Chart II-19The U.K. Has Room To Maneuver The U.K. Has Room To Maneuver The U.K. Has Room To Maneuver Bottom Line: Economics is an argument against Scottish independence, but history and politics are unclear. We simply note that independence cannot be ruled out, particularly in the context of any adverse economic shock stemming from the U.K.'s actual divorce proceedings. Will Scotland Scotch Brexit? From the beginning of the Brexit saga, BCA's Geopolitical Strategy service has argued that Britain, of all EU members, was uniquely predisposed and positioned to leave the union. Hence the referendum was "too close to call."7 This did not mean that the U.K. could do so without consequences. Leaving would be detrimental (albeit not apocalyptic) to the U.K.'s economy, particularly by harming service exports to the EU and reducing labor force growth via stricter immigration controls. In the event, upside economic surprises have occurred, though of course Brexit has not happened yet.8 How does the Scottish referendum threat affect the Brexit negotiations? This is much less clear and will require constant monitoring over the coming two years, and perhaps longer if the European Council agrees to extend the negotiating period (which would require a unanimous vote). Still, we can draw a few conclusions from the above. First, London is a price taker not a price maker. It cannot afford not to agree to a trade deal or transition deal of some sort upon leaving in 2019. Even if England were willing to walk away from the EU's offers, a total rupture (reversion to minimal WTO trade rules) would be unacceptable to Scotland after being denied a say in the negotiation process. Therefore Scotland is now a moderating force on the Tory leadership that is otherwise unconstrained by domestic politics due to the high level of support for May's government (see Chart II-5, page 24). To save the United Kingdom, the Tories may simply have to accept what Europe is willing to give. This supports our view that the risk of a total diplomatic war between Europe and the U.K. is unlikely and that expectations of cross-channel fireworks may be overdone. Second, Scotland is twice the price taker, because it can only afford independence from the U.K. if the EU is willing to grant it a special arrangement. This is possible, but difficult to see happen early in the negotiations process. It will be important to monitor Brussels' statements on Scottish independence carefully for signs that the EU is taking a tough stance on Brexit negotiations. Sturgeon has to play it safe and see what kind of a deal May brings back from Brussels. By waiting, she can profit from Scottish indignation over both May's use of prerogative to block the referendum in the first place and then over the Brexit deal itself, when it takes place. Third, the saving grace for both countries is that it is not in Europe's interest to dismantle the U.K., or to force it into a debilitating economic crisis. We have long differed from the view that the EU will be remorseless in its negotiations over Brexit. The EU seeks extensive trade engagements with every European country, from Norway and Switzerland to Iceland and Turkey, because its interest lies in expanding markets and forging alliances. Europe is not Russia, seeking to impose punitive economic embargoes on Ukraine and Belarus for failure to conform to its market standards. While free trade agreements usually take longer than two years to negotiate, and while the CETA agreement between the EU and Canada is a recent and relevant example of the risks for the U.K., the U.K. and EU are already highly integrated, unlike the two parties in most other bilateral trade negotiations. In addition, the U.K. is a military and geopolitical ally of key European states. The U.K.-EU negotiations are not being conducted in a ceteris paribus economic laboratory, but are occurring in 2017, a year in which Russian assertiveness, transnational terrorism and migration, and global multipolarity are all shared risks to both the U.K. and EU. Investment Implications Since January 17 - the date of Theresa May's speech calling for the exit from the common market - we have argued that the worst is probably over for the U.K.9 Yes, the EU negotiations will be tough and the British press - surprisingly lacking the stiff upper lip of its readers - will make mountains out of molehills. However, by saying no to the common market, Theresa May plays the role of a spouse who does not want to fight over the custody of the children, thus defusing the divorce proceedings. Our Geopolitical Strategy service has been short EUR/GBP since mid-January and the trade is down 2%. This suggests that the market has been in "wait and see mode" since the speech. We are comfortable with this trade regardless of our analysis on the rising probability of the Scottish referendum for two reasons: Hard Brexit is less likely: Many Tory MPs have had a tough time getting behind the "hard Brexit" policy, but until now they have had a tough time expressing their displeasure. However, the threat of Scottish independence and the dissolution of the U.K. will give the members of the Conservative and Unionist Party (as it is officially known) plenty of ammunition to push May towards a softer Brexit outcome. This should be bullish GBP in ceteris paribus terms. It's not the seventeenth century: We do not expect the EU to act like seventeenth-century France and subvert U.K. unity, at least not this early in the negotiations. For clients who expect the "knives to come out," we offer Scottish independence as a critical test of the thesis. Let's see if the EU is ready to play dirty and if it decides to alter the "Barroso doctrine" for Scotland. If they do, then our sanguine thesis is truly wrong. To be clear, we do not have high conviction that the pound will outperform either the euro or the U.S. dollar. Instead, we offer this currency trade as a way to gauge our political thesis that the U.K.-EU negotiations will likely go more smoothly than the market expects. Matt Gertken Associate Editor Geopolitical Strategy Marko Papic Senior Vice President Geopolitical Strategy Jesse Anak Kuri Research Analyst Geopolitical Strategy 1 Please see BCA European Investment Strategy Weekly Report, "Phoney War Ends. Battle Begins," dated March 16, 2017, available at eis.bcaresearch.com. 2 Article 50 allows for a two-year negotiation period, after which the departing party may have an exit deal but is not guaranteed a trade deal for the future. The negotiation period can be extended with a unanimous vote in the European Council. 3 Please see BCA Geopolitical Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy, "Brexit: The Three Kingdoms," in Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 5 The union of the kingdoms of Scotland and England is a power "reserved" to parliament and the crown in Schedule 5 of the Scotland Act of 1998. Altering the union would therefore require the U.K. and Scottish parliaments to agree to devolve the power to Scotland using Section 30(2) of the same act, which the monarch would then endorse. This was the case in 2012 when the 2014 referendum was initiated. 6 On the other hand, demographics also may work against Brexit in the long run, given that - as our colleague Peter Berezin has said in the past - many who voted to leave the EU will eventually pass away. 7 Please see BCA Geopolitical Strategy Strategic Outlook, "Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. 8 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, and "BREXIT Update: Brexit Means Brexit, Until Brexit," dated September 16, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com.

Highlights The financial market landscape has shifted over the past month with asset correlations changing and the so-called 'Trump trades' going into reverse. Equity valuation is stretched and plenty of risks remain. Nonetheless, we do not believe it is time to become defensive, scale back on risk assets, upgrade bonds and short the dollar. The economic data remain constructive for profits in the major countries. The risks posed by upcoming European elections have eased for 2017, now that the Italian election appears unlikely until 2018. The failure to replace Obamacare does not mean that tax reform is necessarily going to be delayed. If a tax reform package proves too difficult to pass, then the GOP will settle for straight tax cuts and a modest amount of infrastructure spending. Market reaction to the FOMC's 'dovish hike' was overdone. If the U.S. economy performs as we expect, the Fed will have to take a more hawkish tone later this year. Not before September will the ECB be in a position to announce a further tapering of its asset purchases beginning in 2018. A "Bund Tantrum" could thus be the big story for the global bond market later this year. In Japan, the 0% yield cap on the 10-year JGB to remain in place at least for the remainder of this year. Our views on U.S. fiscal policy and the major central banks paint a bullish picture for the dollar, and suggest that the other 'Trump trades' still have legs. The dollar has another 10% upside in trade-weighted terms and the global bond bear phase is not yet over. Another key market development has been the continuing drop in risk asset correlations. This reflects falling perceptions of downside "tail risk", which is reflected in a declining equity risk premium (ERP). Absent further negative shocks, perceptions of downside risk should continue to wane, allowing risk premia and asset correlations to ease further. And, if business leaders come to believe that deflation risk has finally been vanquished, they can focus more on long-term revenue generation rather than on guaranteeing their existence. Much of the normalization of the ERP since 2012 has been due to multiple expansion. Going forward, the lion's share of the remaining adjustment is likely to be in the bond market, with equity multiples trending sideways. This means that equity total returns will be roughly in line with dividends and earnings growth over the next couple of years. The only adjustment to asset allocation we are making this month is an upgrade for U.S. high-yield based on improved valuation. Feature The financial market landscape has shifted over the past month with asset correlations changing and a number of popular trades going into reverse. First, the failure to replace Obamacare triggered a pull-back of the so-called 'Trump trades.' Stock indexes are holding up well, but the U.S. dollar has given back most of the gains made in March and the 10-year Treasury yield has dropped back to the bottom of the post-U.S. election trading range. Moreover, the negative correlation between the U.S. dollar and risk assets has flipped (Chart I-1). Even oil prices have diverged from their usual negative trading relationship with the dollar. Second, investors are questioning the FOMC's appetite for rate hikes in the coming months. They are also wondering how much longer the European Central Bank (ECB) and the Bank of Japan (BoJ) can maintain current hyper-stimulative policy settings. The whole narrative regarding equity strength, a dollar overshoot and bond price weakness may be over if there is not going to be any fiscal stimulus in the U.S., the Fed is not going to hike more aggressively than the market currently expects, and monetary policy is near a turning point in Japan and the Eurozone. Is it time for investors to become defensive, scale back on risk assets, upgrade bonds and short the dollar? We believe the answer is 'not yet', although 2017 was always destined to be a rough ride given the ups-and-downs in the U.S. legislative process and the lineup of European elections. President Trump's first 100 days are turning out to be even more tumultuous than many expected. Allegations of wiretaps and the FBI investigation into the alleged interference of Russia in the U.S. election are costing the President political capital, as well as raising question marks over the Republican Party's wish list. Simply removing the possibility of corporate tax cuts would justify a healthy haircut on the S&P 500. The political situation has admittedly become more complicated, but our geopolitical team makes the following observations: The GOP base supports Trump: Until the mid-term elections, Trump's popularity with Republican voters remains strong, which means that the President still has political capital (Chart I-2). Chart I-1Changing Correlations Changing Correlations Changing Correlations Chart I-2Trump Not Dead To Republicans Yet April 2017 April 2017 Republicans want tax reform: Even if reform gets bogged down, there is broad support for cutting taxes at a minimum. Many deficit hawks appear willing to use the magic of "dynamic scoring" to justify tax cuts as revenue-neutral. Even the chairman of the Freedom Caucus has signaled that he is open to tax reform that is not revenue neutral. Tax reform not conditional on Obamacare: The failure to replace Obamacare does not mean that tax reform is necessarily going to be delayed. The Republicans will need to show success on at least one of their signature platforms before heading into the mid-term elections. The prospective savings from Obamacare's repeal are not needed to "fund" tax cuts. Infrastructure: We still expect that President Trump will get his way on additional spending on defense, veterans, infrastructure and the wall. The tax reform process will undoubtedly be full of drama and may be stretched out, adding volatility to the equity market. Our base case is that some sort of tax reform and infrastructure package will be passed by year end. However, if a reform package proves too difficult to pass, then we believe that the GOP will settle for straight-forward tax cuts and a modest amount of infrastructure spending (please see Table I-1 in the March 2017 monthly Bank Credit Analyst for the probabilities we have attached to the various GOP proposals). Tax cuts and increased spending will be positive for risk assets. The caveat is that we see little change in Trump's commitment to mercantilism. This means he will lean toward backing the border tax or tariff increases, which will offset some of the benefits for risk assets from reduced tax rates. Excess Reaction To FOMC Chart I-3FOMC & Market Disagree Beyond This Year FOMC & Market Disagree Beyond This Year FOMC & Market Disagree Beyond This Year Given the uncertainty on the fiscal side, one can't blame the FOMC for taking a "wait and see" approach. The range for the funds rate was raised to 0.75-1.00% at the March meeting, as expected, but there was virtually no change to any of the median FOMC member projections for GDP growth, inflation or interest rates out to 2019. Another 50 bps of tightening is expected by the Committee this year, with 75 bps expected in both 2018 and 2019 (Chart I-3). The FOMC signaled in March that it was not yet prepared to adjust the 'dot plot,' sparking a rally in bond prices and a pullback in the dollar. This market reaction seemed excessive in our view. The key message from the March meeting was that the Fed now sees inflation as having finally reached its 2% target, as highlighted by the decision to strip the reference to the "current shortfall of inflation" from the statement. If the U.S. economy performs as we expect, the Fed will have to take a more hawkish tone later this year. Is The Dollar Bull Over? Still, recent market action suggests that the dollar may not get a lift from future Fed rate hikes because the outlook for global growth outside of the U.S. is brightening. Moreover, it could be that monetary policy in the Eurozone and Japan is at a turning point. There is increasing speculation that the ECB will have to taper the quantitative easing program sooner than planned. Some are even speculating the ECB will lift rates this year. The recent economic data for the euro area have indeed been stellar. The composite PMI surged to 56.7 in March, with the forward-looking new orders components hitting new cyclical highs. Capital goods orders continue to trend higher, which bodes well for investment spending over the coming months (Chart I-4). In addition, private-sector credit growth has accelerated to the fastest pace since the 2008-09 financial crisis. Our real GDP model for the Eurozone, based on our consumer and business spending indicators, remains quite upbeat for the first half of the year. With unemployment rapidly falling in many parts of the Euro Area, it is becoming increasingly difficult to establish a consensus view on the ECB policy committee. The Bundesbank has been quite vocal on this issue, especially given that Eurozone headline HICP inflation reached 2% in February. The core rate of inflation remains close to 1%, but the rising diffusion index suggests that budding inflation pressure is becoming more broadly based (Chart I-5). Chart I-4Solid Eurozone Economic Data Solid Eurozone Economic Data Solid Eurozone Economic Data Chart I-5Eurozone Inflation Broadening Out Eurozone Inflation Broadening Out Eurozone Inflation Broadening Out BCA's Global Fixed Income Strategy service recently compared the current economic situation to that of the U.S. around the time of the Fed's 2013 "Taper Tantrum."1 In Chart I-6, we show "cycle-on-cycle" comparisons for the Euro Area and U.S. In the Euro Area, the number of months to the first rate hike discounted in money markets peaked in July of last year right around the time of the U.K. Brexit vote. Interestingly, this indicator has converged with the U.S. path. There is less spare capacity in European labor markets today than was the case in the U.S. when the Fed first hinted at tapering its asset purchases. Nonetheless, the relatively calmer readings on Euro Area core inflation suggest that the ECB does not have to rush to judgment on asset purchases, especially given upcoming elections. Not before September will the ECB be in a position to announce another tapering of its asset purchases beginning in 2018. A "Bund Tantrum" could thus be the big story for the global bond market later this year. We do not believe that the ECB will raise short-term interest rates before it starts the tapering process. A rate hike would result in a stronger euro, downward pressure on inflation, and an unwanted tightening in financial conditions that would threaten the current economic impulse. This means that, between now and September, the window is still open for U.S./Eurozone interest rate spreads to move further in favor of the dollar. The European election calendar remains a risk to our view on currencies and risk assets. Widening OAT/Bund yield spreads highlight that investors remain concerned that the French election will follow last year's populist script in the U.K. and the U.S. However, our geopolitical team believes that Le Pen is unlikely to win since she trails in the polls by a 25-30% margin relative to Macron, her most likely opponent. Even if she were to pull off a win, she will not hold the balance of power in the National Assembly. Over in Germany, where the election is heating up, the fact that the Europhile SPD party is gaining in the polls means that the September vote is unlikely to be a speed bump for financial markets. The real political risk lies in Italy. While the election has been pushed off to February 2018, it appears that there will be genuine fireworks at that time because Euroskeptic parties have seized the lead in the polls (Chart I-7). In the meantime, European elections will be a source of volatility, but investors should ride it out until we get closer to the Italian election. Chart I-6Less Spare Capacity In Europe ##br##Now Vs. Pre-Taper Tantrum U.S. Less Spare Capacity in Europe Now vs Pre-Taper Tantrum U.S. Less Spare Capacity in Europe Now vs Pre-Taper Tantrum U.S. Chart I-7Italian Elections: The Big Risk Italian Elections: The Big Risk Italian Elections: The Big Risk Japanese Yield Cap To Hold Chart I-8Japanese Wages Still Disappointing Japanese Wages Still Disappointing Japanese Wages Still Disappointing Similar to our view on the ECB, we do not believe that the Bank of Japan (BoJ) will be in a position to begin removing monetary accommodation anytime soon. We expect that the 0% yield cap on the 10-year JGB to remain in place at least for the remainder of this year. True, deflationary forces appear to have eased somewhat. Japan is also benefiting from the faster global growth on the industrial side. Nonetheless, the domestic demand story is less positive, with consumer confidence and real retail sales growth languishing. Wages continue to struggle as well (Chart I-8). This year's round of Japanese wage negotiations was particularly disappointing, with many manufacturing companies offering pay raises only half as large as those of last year. We continue to see this as the only way out of the low-inflation trap for Japan - keeping Japanese interest rates depressed versus the rest of the world, thus making the yen weaken alongside increasingly unattractive interest rate differentials. Our views on U.S. fiscal policy and the outlook for the major central banks paint a bullish picture for the dollar and suggest that the other 'Trump trades' still have legs. The dollar has another 10% upside in trade-weighted terms and the global bond bear phase is not yet over. Admittedly, however, the next major move in global yields may not occur until the autumn when the ECB takes a less dovish tone. In the meantime, our fixed-income strategists remain underweight Treasurys within global currency-hedged portfolios. The team recently upgraded (low beta) JGBs to overweight at the expense of core European government bonds, which move to benchmark. Correlation, ERP And Hurdle Rates Chart I-9Market Correlations Are Shifting Market Correlations Are Shifting Market Correlations Are Shifting Another key market development has been the continuing drop in risk asset correlations, a trend that began before the U.S. election (Chart I-9). Elevated financial market correlations have been a hallmark of this expansion, making life difficult for traders and for investors searching for diversification. Correlations have been higher than normal across assets, across regions and within asset classes. However, the situation has changed dramatically over the past 6 months. A drop in asset correlations is important for diversification reasons and because it provides a better backdrop for those seeking alpha. But the reasons behind the decline in correlations may have broader financial and economic implications. One can only speculate on the underlying cause of the surge in asset correlations in the first place. Our theory has been that the large global output gap lingered because of the sub-par recovery that followed the most damaging macroeconomic shock since the Great Depression. The growth headwinds were formidable and many felt that the sustainability of the recovery hinged solely on the success or failure of radical monetary policy. Either policy would "work", the output gap will gradually close, the deflation threat would be extinguished and risk assets would perform well, or it would fail, and risk assets would be dragged down as the economy fell back into recession. Thus, risk assets fluctuated along with violent swings in investor sentiment in what appeared to be a binary economic environment. In the March 2017 Quarterly Review, the Bank for International Settlements described it this way: "In a global environment devoid of growth but plentiful in liquidity, central bank decisions appear to draw investors into common, successive phases of buying or selling risk." In previous research, we developed a model that helps to explain the historical movements in correlations. We chose to focus on the correlation of individual stocks within the S&P 500 (Chart I-10). The two explanatory variables are: (1) the equity risk premium (ERP; the difference between the S&P 500 forward earnings yield and the 10-year Treasury yield); and (2) rolling 1-year realized downside volatility.2 The logic behind the model is that a higher ERP causes investors to revalue cash flows from all firms, which in turn, causes structural shifts in the correlation among stocks. Conversely, a lower ERP results in less homogenization of the present value of future cash flows, and raises the effect of differentiation among business models. A rise in the ERP could occur for different reasons, but the most obvious include an increase in the perceived riskiness of firms, a shift in investor risk aversion, or both. Volatility is included to explain the cyclical variation of correlations, but we use only below-average returns in the calculation because we are more concerned about the risk of equity market declines. It makes sense that perceptions of downside "tail risk" should affect investors' appetite for risk. The model almost completely explains the trend in stock price correlations over the past decade, highlighting the importance of the ERP in driving the structural change in correlations (Chart I-11). But why was the ERP so elevated after 2007? Chart I-10Market Correlation And The ERP bca.bca_mp_2017_04_01_s1_c10 bca.bca_mp_2017_04_01_s1_c10 Chart I-11Modeling The Stock ##br##Correlation Within The S&P 500 Modeling The Stock Correlation Within The S&P 500 Modeling The Stock Correlation Within The S&P 500 The preceding moderation in risk premia in the 1990s was likely due to a decline in macroeconomic volatility, a phenomenon that began in the early 1980s and has since been dubbed "The Great Moderation". A waning in the volatility of global inflation and growth contributed to a decline in the volatility of interest rates, which are used to discount future cash flows. This also reduced the perceived riskiness of investing in securities that are leveraged to economic growth, thus causing investors to trim their required excess returns to equities. Unfortunately, the Great Moderation contributed to complacency and bubbles in tech stocks and, later, housing.3 The bursting of the U.S. housing bubble brought the Great Moderation to a crushing end, ushering in an era of rolling financial crises and monetary extremism. Our measure of downside volatility soon returned to normal levels after the recession-driven spike. However, the ERP continued to fluctuate at a higher average level, which helps to explain the strong correlation among risk asset prices in the years since the recession. The ERP And Capital Spending Chart I-12Capex Hurdle Rates Never Came Down Capex Hurdle Rates Never Came Down Capex Hurdle Rates Never Came Down An elevated equity risk premium is consistent with the view that investors demanded a more generous premium to take risk in a post-Lehman world. This may also help to explain the disappointing rate of capital spending growth in the major countries in recent years. Firms demanded a fat "hurdle rate" when evaluating new investment projects. Sir John Cunliffe, a member of the Bank of England Monetary Policy Committee, recently cited survey evidence related to the dismal U.K. capital spending record since the recession.4 The main culprits were bank lending issues, the high cost of capital and elevated hurdle rates. Eighty percent of publically-owned firms in the survey agreed that financial market pressure for short-term returns to shareholders had been an obstacle to investment. This short-termism makes sense if investors feared that the recovery could turn to bust at any moment. The survey highlighted that market pressure, together with macro uncertainty among CEOs, kept the hurdle rate applied to new investment projects at close to 12%, despite the major drop in market interest rates. In other words, the gap between the required rate-of-return on new projects and the risk-free rate or corporate borrowing rates surged (Chart I-12). J.P. Morgan concluded that hurdle rates have also been sticky at around 12% in the U.S.5 This study blamed uncertainty over the cash-flow outlook (macro risk) and the fact that CEOs believed that low borrowing rates are temporary. It is rational for a firm to hold cash and buy back stock if perceptions of downside tail risk remain lofty. The bottom line is that uncertainty and higher risk aversion related to macro volatility kept the ERP elevated, curtailing animal spirits and lifting correlation among risk asset prices. The good news is that the situation appears to have changed since the U.S. election. Measures of market correlation have dropped sharply across asset classes, within asset classes and across regions. Animal spirits also appear to be reviving given the jump in consumer and business confidence in the major countries. We are not making the case that all risks have dissipated. The military situation in North Korea and upcoming European elections are just two on a long list, as highlighted in this month's Special Report on Brexit's implication for Scotland independence, beginning on page 19. Our point is that, absent further negative shocks, perceptions of downside tail risk and a binary economic future should wane further. And, if business leaders come to believe that deflation risk has finally been vanquished, they can now focus more on long-term revenue generation rather than on guaranteeing their existence. Does The ERP Have More Downside? It is difficult to determine the equilibrium equity risk premium, but back-of-the-envelope estimates can provide a ballpark figure. Let us assume that the ERP is not going back into negative territory, as was the case from 1980-2000. A more reasonable assumption is that the ERP instead converges with the level that prevailed during the last equity bull market, from 2003 to 2007 (about +200 basis points). The ERP is currently 3.2, which is equal to the forward earnings yield of 5.6 minus the 10-year yield of 2.4% (Chart I-13). The ERP would need to fall by 120 basis points to get back to the 2% average yield of 2003-2007. This convergence can occur through some combination of a lower earnings yield or a higher bond yield. If the 10-year Treasury yield is assumed to peak in this cycle at about 3%, then this leaves room for the earnings yield to fall by 60 basis points. This would boost the earnings multiple from 17.8 to 20. However, a rise in the 10-year yield to 3½% would leave no room for multiple expansion. We lean to the latter scenario for bonds, although it will take some time for the bond bear phase to play out. In the meantime, an equity overshoot is possible. The bottom line is that much of the normalization of the ERP since 2012 has been due to multiple expansion. Going forward, the lion's share of the remaining adjustment is likely to be in the bond market, with equity multiples trending sideways. This means that equity total returns will be roughly in line with dividends and earnings growth over the next couple of years, although that will be much better than the (likely negative) returns in the bond market. We continue to favor higher beta developed markets where value is less stretched, such as the euro area and Japan, over the U.S. on a currency-hedged basis. Europe is about one standard deviation cheap relative to the U.S. index, although the extra value in the Japanese market has dissipated recently (Chart I-14). Moreover, both Eurozone and Japanese stocks in local currency terms will benefit from weaker currencies in the coming months, as rising inflation expectations and stable nominal interest rates result in declining in real rates, at least relative to the U.S. Chart I-13Forward Multiple Scenarios bca.bca_mp_2017_04_01_s1_c13 bca.bca_mp_2017_04_01_s1_c13 Chart I-14Eurozone Stocks Are Cheap Eurozone Stocks Are Cheap Eurozone Stocks Are Cheap Conclusion We have reassessed our asset allocation given that several market calls have gone against us over the past month. However, three key views argue to stay the course for now: Recent economic data support our view that a synchronized global acceleration is underway. This is highlighted by an update of the real GDP growth models we introduced last month (Chart I-15). The implication is that earnings growth will be constructive for stocks; Tax reform is still likely to be passed this year in the U.S. Moreover, were a broad tax reform package to elude the Administration, the fallback position will involve (stimulative) tax cuts, some infrastructure spending and de-regulation; and The FOMC will shift to a more hawkish tone in the coming months, while the ECB, Bank of England and Bank of Japan will maintain extremely accommodative monetary policy at least into the fall. The result is that stocks will outperform cash and bonds, while the dollar still has another 10% upside potential. The only adjustment we are making this month is in the U.S. high-yield corporate bond allocation. According to our fixed-income strategists, value has improved enough that it is worth upgrading the sector to overweight at the expense of Treasurys. Some of the indicators that comprise our default rate model have become more constructive for credit risk, including lending standards, the PMIs and profits. The combination of wider junk spreads and an improving default rate outlook have resulted in a widening in our estimate of the default-adjusted high-yield spread to 219 basis points (Chart I-16). Historically, high-yield earns a positive 12-month excess return 81% of the time when the default-adjusted spread is between 200 and 250 basis points. Chart I-15GDP Models Are Bullish GDP Models Are Bullish GDP Models Are Bullish Chart I-16Upgrade U.S. High Yield Upgrade U.S. High Yield Upgrade U.S. High Yield Turning to oil markets, we expect recent price weakness to reverse despite dollar strength. Building inventories have weighed on crude, but this is a head fake according to our commodity experts. We expect to see a sustained draw in OECD storage volumes this year, now that the year-end surge on crude product from OPEC's Gulf producers has been fully absorbed. With global supply/demand fundamentals now dominating price movements, the recent breakdown in the inverse correlation between oil prices and the dollar should persist. Oil prices will rise back toward the US$55 range that we believe will be the central tendency over 2016 and 2017. Risks are to the upside. Our other recommendations include: Maintain below-benchmark duration within bond portfolios. Shift to benchmark in Eurozone government bonds and upgrade JGBs to overweight within currency-hedged portfolios. The U.S. remains at underweight. Overweight European and Japanese equities versus the U.S. in currency-hedged portfolios. Be defensively positioned within equity sectors to temper the risk associated with overweighting stocks over bonds. In U.S. equities, maintain a preference for exporting companies over those that rely heavily on imports. Overweight investment-grade corporate bonds relative to government issues in the U.S.; upgrade U.S. high-yield to overweight, but downgrade European investment-grade to underweight due to fading support from the ECB. Within European government bond portfolios, continue to avoid the Periphery in favor of the core markets. Fade the widening in French/German spreads. Overweight the dollar relative to the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market, on expected policy changes that will disproportionately favor small companies. Favor oil to base metals. Mark McClellan Senior Vice President The Bank Credit Analyst March 30, 2017 Next Report: April 27, 2017 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Will The Hawks Walk The Talk?" dated March 7, 2017, available at gfis.bcaresearch.com. 2 Downside volatility is calculated in a fashion similar to standard deviation, except only using below-average returns. 3 Of course, the Great Moderation was not the only factor that contributed to the financial market bubbles. 4 Are Firms Underinvesting - and if so why? Speech by Sir Jon Cunliffe, Deputy Governor Financial Stability and Member of the Monetary Policy Committee. Greater Birmingham Chamber of Commerce. February 8, 2017. 5 It's Time to Reassess Your Hurdle Rates. J.P. Morgan, November 2016. II. Will Scotland Scotch Brexit? This month's Special Report, on Scotland's role in Brexit negotiations, was penned by our colleagues Matt Gertken, Marko Papic, and Jesse Kurri of BCA's Geopolitical Strategy service. Scottish secessionist sentiment has increased in response to First Minister Nicola Sturgeon's decision to push for a second popular referendum on Scottish independence, tentatively set for late 2018 or early 2019, though likely to be denied for some time by Westminster. The outcome of a referendum on leaving the U.K., which eventually will occur, is too close to call at this point. The possibility will influence the U.K.'s negotiations with the EU, and vice versa. The risk of a U.K. break-up adds an important constraint to Prime Minister Theresa May's government in the Brexit talks. Since the EU also has an interest in avoiding a devastating outcome for the U.K., our geopolitical team believes that the worst version of a "hard Brexit" will be avoided. That said, independence for Scotland cannot be ruled out, particularly in the context of any adverse economic shock stemming from the U.K.'s divorce proceedings. I trust that you will find the report as insightful as I did. Mark McClellan Senior Vice President A second Scottish referendum will be "too close to call"; There is upside potential to the 45% independence vote of 2014; Scots may vote with their hearts instead of their heads; But the EU will not seek to dismember the U.K. ... ...And that may keep the kingdom united. "No sooner did Scots Men appear inclined to set Matters upon a better footing, than the Union of the two Kingdoms was projected, as an effectual measure to perpetuate their Chains and Misery." - George Lockhart, Memoirs Concerning The Affairs Of Scotland, 1714. British Prime Minister Theresa May has had a busy week. On Monday she met with Scotland's First Minister Nicola Sturgeon as part of a tour of the United Kingdom to drum up national unity. On Wednesday she communicated with European Council President Donald Tusk and formally invoked Article 50 of the Lisbon Treaty, initiating the process of the U.K.'s withdrawal from the European Union. And on that day and Thursday, she turns to the parliamentary battle over the "Great Repeal Bill" that will replace the 1972 European Communities Act, which until now translated European law into British law. Brexit is finally getting under way. As our colleague Dhaval Joshi puts it, the "Phoney War" has ended, and now the real battle begins.1 Indeed, the dynamic has truly shifted in recent weeks. Not because PM May invoked Article 50, which was expected, but rather because Scottish secessionist sentiment has ticked up in reaction to Sturgeon's decision to hold a second popular referendum on Scottish independence (Chart II-1), tentatively set for late 2018 or early 2019. Scottish voters are still generally opposed to holding a second referendum, but the gap is narrowing (Chart II-2). A sequel to the September 2014 referendum was always in the cards in the event of a Brexit vote. Financial markets called it, by punishing equities domiciled in Scotland following the U.K.'s EU referendum (Chart II-3). The timing of the move toward a second referendum is significant for two reasons. First, the odds of Scotland actually voting to leave have increased relative to 2014, even as the economic case for secession has worsened. Second, Scotland's threat of leaving will impact the U.K.'s negotiations with the EU, slated to end in March 2019.2 Chart II-1A Second Independence Referendum... A Second Independence Referendum ... A Second Independence Referendum ... Chart II-2...Is Looking More Likely ... Is Looking More Likely ... Is Looking More Likely Chart II-3Scottish Stocks Have Underperformed Scottish Stocks Have Underperformed Scottish Stocks Have Underperformed BCA's Geopolitical Strategy service believes that a second Scottish referendum will eventually take place. And as with the Brexit referendum, the outcome will be "too close to call," at least judging by the data available at present. In what follows we discuss why, and how Scotland could influence the Brexit negotiations, and vice versa. While the U.K. can avoid the worst version of a "hard Brexit," the high risk of a break-up of the U.K. will add urgency to negotiations with the EU. Why Scotland Rejected "Freedom" In 2014 In a Special Report on "Secession In Europe," in May 14, 2014, we argued that the incentives for separatism in Europe had weakened and that this trend specifically applied to Scotland:3 The world is a scary place: Whereas the market-friendly 1990s fueled regional aspirations to independence by suggesting that the world was fundamentally secure and that "the End of History" was nigh, the multipolar twenty-first century discourages those aspirations, with nation-states fighting to maintain their integrity. For Scotland, the Great Recession drove home the dangers of socio-economic instability. EU and NATO membership is difficult to obtain: Scotland could not be assured to find easy accession to the EU as it faced opposition from states like Spain, which wanted to discourage Catalan independence. Enlargement of the EU and NATO have both become increasingly difficult and Scotland would need a special dispensation. The United States and the European Union vociferously discouraged Scotland from striking out on its own ahead of the 2014 referendum. Domestic politics: The Great Recession revived old fissures in every country, including the old Anglo-Scots divide. The U.K. imposed budgetary austerity while Scotland opposed it. Left-leaning Scotland resented the rightward shift in the U.K., ruled by the Conservative Party after 2010. We also highlighted some of Scotland's particular impediments to independence: Energy: Scotland's domestic sources of energy are in structural decline. This would weigh on the fiscal balance and domestic private demand. The referendum actually signaled a top in the oil market, with oil prices collapsing by 58% in 2014. Deficits and debt: Scotland's public finances would get worse if it left the U.K. If that had happened in 2014, it was estimated that the country's fiscal deficit would have been 5.9% of GDP and that its national debt would have been 109% of GDP. (Today those numbers are 8% and 84% of GDP respectively) (Table II-1). A newborn Scotland would have to adopt austerity quickly. Table II-1Scotland Would Be A High-Debt Economy April 2017 April 2017 Central banking: If Scotland walked away from its share of the U.K.'s national debt, yet retained the pound unilaterally and without the blessing of the BoE, it would lose access to the English central bank as lender of last resort. And if it walked away from its U.K. debt obligation and the pound, then it would also lose its financial sector and much of its wealth, which would be newly redenominated into a Scots national currency. Scotland is every bit as reliant on the financial sector as the U.K. as a whole (Chart II-4), making for a major constraint on any political rupture that threatens to force it to change currencies or lose control of monetary policy. Chart II-4Highly Financialized Societies April 2017 April 2017 Politics: We also posited that domestic political changes in the U.K. could provide inducements to keep Scotland in the union, particularly if the Conservatives suffered in the 2015 elections. The opposite, in fact, occurred, sowing the seeds for today's confrontation. For all these reasons, we argued that the risks of Scottish secession were overstated. The September 2014 referendum confirmed our forecast. The economic prospects were simply too daunting outside the U.K. But the 45% pro-independence tally also left open the possibility for another referendum down the line. Bottom Line: Scottish independence did not make sense in 2014 for a range of geopolitical, political, and economic reasons. But note that while independence still does not make economic sense, the political winds have shifted. Scottish antagonism toward the Conservative leadership in England has only intensified, while it remains to be seen how the European Union will respond to Scotland in a post-Brexit world. The Three Kingdoms In our Strategic Outlook for 2017, we argued that the British public not only did not regret the Brexit referendum outcome, but positively rallied around the flag because of it. This helped set up an environment in which the ruling party could charge forward aggressively and pursue the outcome confirmed by the vote (Chart II-5). Brexit does indeed mean Brexit. We have since seen that the Tories have forced parliament's hand in approving the bill authorizing the government to initiate exit proceedings. Chart II-5Three Cheers For Brexit And The Tories Three Cheers For Brexit & The Tories Three Cheers For Brexit & The Tories It stood to reason that the crux of tensions would shift to the domestic sphere, i.e. to the troubling constitutional problems that Brexit would provoke between what were once called "the Three Kingdoms," England (and Wales), Scotland, and Northern Ireland.4 While 52% of the U.K. public voted to leave the EU, the subdivision reveals the stark regional differences: England and Wales voted to leave (53.4% and 52.5% respectively), while Scotland and Northern Ireland voted to stay (62% and 55.8% respectively). Scotland and the London metropolitan area were the clear outliers. The Scottish parliament is a devolved parliament subordinate to the U.K. parliament in Westminster, and it cannot hold a legally binding referendum on independence without the latter's permission.5 The May government is insisting that it will not allow a referendum to go forward until the Brexit negotiations are completed. This is an obvious strategic need. Although the Scottish National Party (SNP), the dominant party in Edinburgh, could hold a non-binding referendum at any time to apply pressure on London (reminder: the Brexit vote was also non-binding), it has an interest in waiting to see whether public opinion of Brexit will shift in England and what kind of deal the U.K. might get from the EU in the exit negotiations. Eventually, however, Scotland is likely to push for a new vote. The SNP is a party whose raison d'être is independence sooner or later. It faces a once-in-a-generation opportunity, with the 2014 referendum producing an encouraging result and Brexit adding new impetus. The party manifesto made clear in 2016 that a new independence vote would be justified in case of "a significant and material change in the circumstances that prevailed in 2014, such as Scotland being taken out of the EU against our will." Why have the odds of Scottish independence increased? First, Brexit removes a domestic political constraint on independence. After the Brexit vote, the SNP and other pro-independence groups can say that England changed the status quo, not Scotland. It is worth remembering that the Anglo-Scots union was forged in 1707 at a time of severe Scottish economic hardship, in which a common market was the primary motivation to merge governments. Today, Scotland's comparable interest lies in maintaining access to the European single market, which is now under threat from Westminster. In particular, as with the U.K. as a whole, Scotland stands to suffer from a decline in immigration and hence workforce growth (Chart II-6). Second, Brexit removes an external constraint. The EU's official opposition to Scottish independence, particularly European Commission President Jose Manuel Barroso's threat that Scottish accession would be "extremely difficult, if not impossible," likely affected the outcome of the 2014 referendum. Of course, many Scots rejected all such warnings as the vote approached, with polls showing a rally just before the referendum date toward the 45% outcome (Chart II-7). But if the EU's warnings even had a temporary effect, what happens if the EU gives a nod and wink this time around? While EU officials have recently reiterated the so-called "Barroso doctrine," we suspect that they are less likely to play an interventionist role under the new circumstances. Spain - which is still concerned about Scotland fanning Catalan ambitions - might be less vocal this time, since Madrid could plausibly argue that Brexit makes a material difference from its own case. Catalonians could not argue, like the Scots, that their parent country attempted to deprive them of access to the European Single Market. Chart II-6Immigration Curbs ##br##Threaten Scots Growth April 2017 April 2017 Chart II-7Scottish Patriots ##br##Only Temporarily Deterred Scottish Patriots Only Temporarily Deterred Scottish Patriots Only Temporarily Deterred To put this into context, remember that it is not historically unusual for continental Europe to act as a patron to Scotland to keep England in check. There is ample record of this behavior, namely French and Spanish patronage of the exiled Stuart kings after 1688. The situation is very different today, but the analogy is not absurd: insofar as Brexit undermines the integrity of the EU, the EU can be expected to reciprocate by not doing everything in its power to defend the integrity of the U.K. All is fair in love and war. Nevertheless, the economic constraints to Scottish secession are even clearer than they were in 2014: The North Sea is drying up: Scotland's North Sea energy revenues have essentially collapsed to zero (Chart II-8). Meanwhile the long-term prospects for the North Sea oil production remain as bleak as they were in 2014, especially since oil prices halved. Reserves of oil and gas are limited, hovering at around five to eight years' worth of supply - i.e. not a good basis for long-term independence (Chart II-9). Decommissioning costs are also expected to be high as the sector is wound down. England still foots many bills: Total government expenditures in Scotland exceed the total revenue raised in Scotland by about £15 billion or 28% of Scotland's government revenue (Chart II-10). Chart II-8No Golden Goose In The North Sea April 2017 April 2017 Chart II-9Limited Domestic Energy Supplies April 2017 April 2017 Chart II-10The U.K. Pays For Scotland's Allegiance April 2017 April 2017 Scottish finances stand at risk: Scotland's fiscal, foreign exchange, and monetary policy dilemmas are as discouraging as they were in 2014 (Chart II-11). Judging by the value of financial assets (which come under risk if Scotland loses the BoE's support or changes currencies), Scotland is incredibly exposed to financial risk (Chart II-12). Chart II-11Scotland's Deficits Getting Worse Scotland's Deficits Getting Worse Scotland's Deficits Getting Worse Chart II-12Scottish Financial Assets Need Currency Stability April 2017 April 2017 Thus, while key domestic political and foreign policy impediments may be removed, the country's internal economic impediments remain gigantic. Moreover, Scotland already has most of the characteristics of a nation state. It has its own legal and education system, prints its own banknotes, and has some powers of taxation (about 40% of revenue). It lacks a standing army and full fiscal control, but in these cases it clearly benefits from partnering with England. It also has a strong sense of national identity, regardless of whether it is technically independent. Why, then, do we believe Scottish independence is too close to call? Because Brexit has shown that "math" is insufficient! The Scots may go with their hearts against their heads, just as many English voters did in favor of Brexit. Nationalism and political polarization are a two-way street. History also shows that strictly materialist or quantitative assessments cannot anticipate paradigm shifts or national leaps into the unknown. Compare Ireland in 1922, the year of its independence from the U.K. Ireland was far less prepared to strike out on its own than Scotland is today. It comprised a smaller share of the U.K.'s population, workforce, and GDP than Scotland today (Charts II-13 and II-14). It was less educated and less developed relative to its neighbors, and it faced unemployment rates above 30%. Yet it chose independence anyway - out of political will and sheer Celtic grit. Ireland's case was very different than Scotland's today, but there is an interesting parallel. The U.K. was absorbed with continental affairs, the Americans played the role of external economic patron, and the Irish were ready to seize their once-in-a-lifetime opportunity. Today the U.K. is similarly distracted with Europe, and the SNP leadership is ready to seize the moment, having revealed its preference in 2014. But foreign support (in this case the EU's) will be a critical factor, even though the EU's common market is much less valuable to Scotland than the U.K.'s (Chart II-15). Chart II-13Irish Independence: ##br##Poverty Not An Obstacle April 2017 April 2017 Chart II-14Scotland: If The Irish ##br##Can Do It So Can We April 2017 April 2017 Chart II-15EU Market No ##br##Substitute For British Market April 2017 April 2017 Will the SNP be able to get enough votes? We know that more Scots voted to stay in the EU (62%) than voted to stay in the U.K. (55%), which in a crude sense implies that there is upside potential to the first referendum outcome. However, looking at the referendum results on the local level, it becomes clear that there is no correlation between Scottish secessionists and Europhiles, or unionists and Euroskeptics (Chart II-16). Nor is there any marked correlation between level of education and the desire for independence, as was the case in Brexit. Yet there is evidence that love of the Union Jack is correlated with age (Chart II-17). Youngsters are willing to take risks for the thrill of freedom, while their elders better understand the benefits from economic links and transfer payments. In the short and medium run, this suggests that demographics will continue to work against independence - reinforcing the fact that the SNP can wait to see what kind of deal the U.K. gets first.6 Chart II-16No Relationship Between IndyRef And Brexit April 2017 April 2017 Chart II-17Old Folks Loyal To The Union Jack April 2017 April 2017 The most striking indicator of Scottish secessionism is unemployment (Chart II-18). Thus an economic downturn that impacts Scotland, for example as result of uncertainty over Brexit, poses a critical risk to the union. The SNP will be quick to blame even a shred of economic pain on Tory-dominated Westminster. The British government and BoE have shown a commitment to use accommodative monetary and fiscal policy to smooth over the transition period, and they have fiscal room for maneuver (Chart II-19), but much will depend on what kind of a deal London gets from the EU and whether the markets remain calm. Chart II-18Joblessness Boosts Independence Vote April 2017 April 2017 Chart II-19The U.K. Has Room To Maneuver The U.K. Has Room To Maneuver The U.K. Has Room To Maneuver Bottom Line: Economics is an argument against Scottish independence, but history and politics are unclear. We simply note that independence cannot be ruled out, particularly in the context of any adverse economic shock stemming from the U.K.'s actual divorce proceedings. Will Scotland Scotch Brexit? From the beginning of the Brexit saga, BCA's Geopolitical Strategy service has argued that Britain, of all EU members, was uniquely predisposed and positioned to leave the union. Hence the referendum was "too close to call."7 This did not mean that the U.K. could do so without consequences. Leaving would be detrimental (albeit not apocalyptic) to the U.K.'s economy, particularly by harming service exports to the EU and reducing labor force growth via stricter immigration controls. In the event, upside economic surprises have occurred, though of course Brexit has not happened yet.8 How does the Scottish referendum threat affect the Brexit negotiations? This is much less clear and will require constant monitoring over the coming two years, and perhaps longer if the European Council agrees to extend the negotiating period (which would require a unanimous vote). Still, we can draw a few conclusions from the above. First, London is a price taker not a price maker. It cannot afford not to agree to a trade deal or transition deal of some sort upon leaving in 2019. Even if England were willing to walk away from the EU's offers, a total rupture (reversion to minimal WTO trade rules) would be unacceptable to Scotland after being denied a say in the negotiation process. Therefore Scotland is now a moderating force on the Tory leadership that is otherwise unconstrained by domestic politics due to the high level of support for May's government (see Chart II-5, page 24). To save the United Kingdom, the Tories may simply have to accept what Europe is willing to give. This supports our view that the risk of a total diplomatic war between Europe and the U.K. is unlikely and that expectations of cross-channel fireworks may be overdone. Second, Scotland is twice the price taker, because it can only afford independence from the U.K. if the EU is willing to grant it a special arrangement. This is possible, but difficult to see happen early in the negotiations process. It will be important to monitor Brussels' statements on Scottish independence carefully for signs that the EU is taking a tough stance on Brexit negotiations. Sturgeon has to play it safe and see what kind of a deal May brings back from Brussels. By waiting, she can profit from Scottish indignation over both May's use of prerogative to block the referendum in the first place and then over the Brexit deal itself, when it takes place. Third, the saving grace for both countries is that it is not in Europe's interest to dismantle the U.K., or to force it into a debilitating economic crisis. We have long differed from the view that the EU will be remorseless in its negotiations over Brexit. The EU seeks extensive trade engagements with every European country, from Norway and Switzerland to Iceland and Turkey, because its interest lies in expanding markets and forging alliances. Europe is not Russia, seeking to impose punitive economic embargoes on Ukraine and Belarus for failure to conform to its market standards. While free trade agreements usually take longer than two years to negotiate, and while the CETA agreement between the EU and Canada is a recent and relevant example of the risks for the U.K., the U.K. and EU are already highly integrated, unlike the two parties in most other bilateral trade negotiations. In addition, the U.K. is a military and geopolitical ally of key European states. The U.K.-EU negotiations are not being conducted in a ceteris paribus economic laboratory, but are occurring in 2017, a year in which Russian assertiveness, transnational terrorism and migration, and global multipolarity are all shared risks to both the U.K. and EU. Investment Implications Since January 17 - the date of Theresa May's speech calling for the exit from the common market - we have argued that the worst is probably over for the U.K.9 Yes, the EU negotiations will be tough and the British press - surprisingly lacking the stiff upper lip of its readers - will make mountains out of molehills. However, by saying no to the common market, Theresa May plays the role of a spouse who does not want to fight over the custody of the children, thus defusing the divorce proceedings. Our Geopolitical Strategy service has been short EUR/GBP since mid-January and the trade is down 2%. This suggests that the market has been in "wait and see mode" since the speech. We are comfortable with this trade regardless of our analysis on the rising probability of the Scottish referendum for two reasons: Hard Brexit is less likely: Many Tory MPs have had a tough time getting behind the "hard Brexit" policy, but until now they have had a tough time expressing their displeasure. However, the threat of Scottish independence and the dissolution of the U.K. will give the members of the Conservative and Unionist Party (as it is officially known) plenty of ammunition to push May towards a softer Brexit outcome. This should be bullish GBP in ceteris paribus terms. It's not the seventeenth century: We do not expect the EU to act like seventeenth-century France and subvert U.K. unity, at least not this early in the negotiations. For clients who expect the "knives to come out," we offer Scottish independence as a critical test of the thesis. Let's see if the EU is ready to play dirty and if it decides to alter the "Barroso doctrine" for Scotland. If they do, then our sanguine thesis is truly wrong. To be clear, we do not have high conviction that the pound will outperform either the euro or the U.S. dollar. Instead, we offer this currency trade as a way to gauge our political thesis that the U.K.-EU negotiations will likely go more smoothly than the market expects. Matt Gertken Associate Editor Geopolitical Strategy Marko Papic Senior Vice President Geopolitical Strategy Jesse Anak Kuri Research Analyst Geopolitical Strategy 1 Please see BCA European Investment Strategy Weekly Report, "Phoney War Ends. Battle Begins," dated March 16, 2017, available at eis.bcaresearch.com. 2 Article 50 allows for a two-year negotiation period, after which the departing party may have an exit deal but is not guaranteed a trade deal for the future. The negotiation period can be extended with a unanimous vote in the European Council. 3 Please see BCA Geopolitical Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy, "Brexit: The Three Kingdoms," in Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 5 The union of the kingdoms of Scotland and England is a power "reserved" to parliament and the crown in Schedule 5 of the Scotland Act of 1998. Altering the union would therefore require the U.K. and Scottish parliaments to agree to devolve the power to Scotland using Section 30(2) of the same act, which the monarch would then endorse. This was the case in 2012 when the 2014 referendum was initiated. 6 On the other hand, demographics also may work against Brexit in the long run, given that - as our colleague Peter Berezin has said in the past - many who voted to leave the EU will eventually pass away. 7 Please see BCA Geopolitical Strategy Strategic Outlook, "Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. 8 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, and "BREXIT Update: Brexit Means Brexit, Until Brexit," dated September 16, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. III. Indicators And Reference Charts The S&P 500 index has pulled back from its recent highs, but it has not corrected enough to 'move the dial' in terms of the valuation or technical indicators. Stocks remain expensive based on our valuation index made up of 11 different measures. The technical indicator is still bullish. Our equity monetary indicator has dropped back to the zero line, meaning that it is not particularly bullish or bearish at the moment. The speculation index is elevated, however, pointing to froth in the market. The high level of our composite sentiment index and the low level of the VIX speaks to the level of investor complacency. Net earnings revisions remain close to the zero mark, although it is somewhat worrying that the earnings surprises index is slowly deteriorating. Our U.S. Willingness-to-Pay (WTP) indicator continues to send a positive message for the S&P 500. This indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. However, the widening gap between the U.S. WTP and that of Japan and Europe highlights that recent flows have favored the U.S. market relative to the other two. Looking ahead, this means that there is more "dry powder" available to buy the Japanese and European markets. A rise in the WTPs for these two markets in the coming months would signal that a rotation into Europe and Japan is taking place. U.S. bond valuation is hovering close to fair value. However, we believe that fair value itself is moving higher as some of the economic headwinds fade. The composite technical indicator for the 10-year Treasury shows that oversold conditions are unwinding, although the indicator is not yet back to zero. This suggests that the consolidation period for bonds is not yet complete. Oversold conditions are almost completely gone in terms of the U.S. dollar. The dollar is very expensive on a PPP basis, although it is less so by other measures. We believe the dollar has more upside. Technical conditions are also benign in the commodity complex. However, we are only bullish on oil at the moment. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market ##br##And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market ##br##And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop ECONOMY: Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Highlights A second Scottish referendum will be "too close to call"; There is upside potential to the 45% independence vote of 2014; Scots may vote with their hearts instead of their heads; But the EU will not seek to dismember the U.K. ... ...And that may keep the kingdom united. We are tactically short EUR/GBP and USD/GBP. Feature "For who is it that would not prefer the greatest Hardships attended with Liberty, to a State that deprived him of all means to defend himself against the Oppressions that must inevitably follow [the Union of the two Crowns]." "No sooner did Scots Men appear inclined to set Matters upon a better footing, than the Union of the two Kingdoms was projected, as an effectual measure to perpetuate their Chains and Misery." - George Lockhart, Memoirs Concerning The Affairs Of Scotland, 1714. British Prime Minister Theresa May has had a busy week. On Monday she met with Scotland’s First Minister Nicola Sturgeon as part of a tour of the United Kingdom to drum up national unity. On Wednesday she communicated with European Council President Donald Tusk and formally invoked Article 50 of the Lisbon Treaty, initiating the process of the U.K.’s withdrawal from the European Union. And on that day and Thursday, she turns to the parliamentary battle over the “Great Repeal Bill” that will replace the 1972 European Communities Act, which until now translated European law into British law. Brexit is finally getting under way. As our colleague Dhaval Joshi puts it, the “Phoney War” has ended, and now the real battle begins.1 Indeed, the dynamic has truly shifted in recent weeks. Not because PM May invoked Article 50, which was expected, but rather because Scottish secessionist sentiment has ticked up in reaction to Sturgeon's decision to hold a second popular referendum on Scottish independence (Chart 1), tentatively set for late 2018 or early 2019. Scottish voters are still generally opposed to holding a second referendum, but the gap is narrowing (Chart 2). A sequel to the September 2014 referendum was always in the cards in the event of a Brexit vote. Financial markets pretty much called it, by punishing equities domiciled in Scotland following the U.K.'s EU referendum (Chart 3). The timing of the move toward a second referendum is significant for two reasons. First, the odds of Scotland actually voting to leave have increased relative to 2014, even as the economic case for secession has worsened. Second, Scotland's threat of leaving will impact the U.K.'s negotiations with the EU, slated to end in March 2019.2 Chart 1A Second Independence Referendum... A Second Independence Referendum... A Second Independence Referendum... Chart 2...Is Looking More Likely ...Is Looking More Likely ...Is Looking More Likely Chart 3Scottish Stocks Have Underperformed Scottish Stocks Have Underperformed Scottish Stocks Have Underperformed BCA's Geopolitical Strategy service believes that a second Scottish referendum will eventually take place. And as with the Brexit referendum, it is "too close to call," at least judging by the data available at present. In what follows we discuss the ways in which Scotland could influence the Brexit negotiations, and vice versa. While the U.K. can avoid the worst version of a "hard Brexit," the high risk of a break-up of the U.K. will add urgency to negotiations with the EU. Why Scotland Rejected "Freedom" In 2014 In a Special Report on "Secession In Europe," in May 14, 2014, we argued that the incentives for separatism in Europe had weakened and that this trend specifically applied to Scotland:3 The world is a scary place: Whereas the market-friendly 1990s fueled regional aspirations to independence by suggesting that the world was fundamentally secure and that "The End of History" was nigh, the multipolar twenty-first century discourages those aspirations, with nation-states fighting to maintain their integrity. For Scotland, the Great Recession especially drove home the dangers of socio-economic instability. EU and NATO membership is difficult to obtain: Scotland could not be assured to find easy accession to the EU as it faced opposition from states like Spain, which wanted to discourage Catalan independence. Enlargement of the EU and NATO have both become increasingly difficult and Scotland would need a special dispensation. The United States and the European Union vociferously discouraged Scotland from striking out on its own ahead of the 2014 referendum. Domestic politics: The Great Recession revived old fissures in every country, including the old Anglo-Scots divide. The U.K. imposed budgetary austerity while Scotland opposed it. Left-leaning Scotland opposed the rightward shift in the U.K., ruled by the Conservative Party after 2010. We also highlighted some of Scotland's particular impediments to independence: Energy: Scotland's domestic sources of energy are in structural decline. This would weigh on the fiscal balance and domestic private demand. The referendum actually signaled a top in the oil market, with oil prices collapsing by 58% in 2014. Deficits and debt: Scotland's public finances would get worse if it left the U.K. The fiscal deficit, in 2014, would have been 5.9% of GDP and the national debt would have been 109% of GDP - now those numbers are 8% and 84% of GDP respectively (Table 1). A newborn Scotland would have to adopt austerity quickly. Central banking: If Scotland walked away from its share of the U.K.'s national debt, yet retained the pound unilaterally and without the blessing of the BoE, it would lose access to the English central bank as lender of last resort. And if it walked away from its U.K. debt obligation and the pound, then it would also lose its financial sector and much of its wealth, which would be newly redenominated into a Scots national currency. Scotland is every bit as reliant on the financial sector as the U.K. as a whole (Chart 4), making for a major constraint on any political rupture that threatens to force it to change currencies or lose control of monetary policy. Politics: We also posited that domestic political changes in the U.K. could provide inducements to keep Scotland in the union, particularly if the Conservatives suffered in the 2015 elections. The opposite, in fact, occurred, sowing the seeds for today's confrontation. Table 1Scotland Would Be A High-Debt Economy Will Scotland Scotch Brexit? Will Scotland Scotch Brexit? Chart 4Highly Financialized Societies Will Scotland Scotch Brexit? Will Scotland Scotch Brexit? For all these reasons, we argued that the risks of Scottish secession were overstated. The September 2014 referendum confirmed our forecast. The economic prospects were simply too daunting outside the U.K. But the 45% pro-independence tally also left open the possibility for another referendum down the line. Bottom Line: Scottish independence did not make sense in 2014 for a range of geopolitical, political, and economic reasons. But note that while independence still does not make economic sense, the political winds have shifted. Scottish antagonism toward the Conservative leadership in England has only intensified, while it remains to be seen how the European Union will respond to Scotland in a post-Brexit world. The Three Kingdoms In our Strategic Outlook for 2017, we argued that the British public not only did not regret the Brexit referendum outcome, but positively rallied around the flag because of it. This helped set up an environment in which the ruling party could charge forward aggressively and pursue the outcome confirmed by the vote (Chart 5). Brexit indeed does mean Brexit. We have since seen that the Tories have forced parliament's hand in approving the bill authorizing the government to initiate exit proceedings. Chart 5Three Cheers For Brexit & The Tories Three Cheers For Brexit & The Tories Three Cheers For Brexit & The Tories It stood to reason that the crux of tensions would shift to the domestic sphere, i.e. to the troubling constitutional problems that Brexit would provoke between what were once called "the Three Kingdoms," England (and Wales), Scotland, and Northern Ireland.4 While 52% of the U.K. public voted to leave the EU, the subdivision reveals the stark regional differences: England and Wales voted to leave (53.4% and 52.5% respectively), while Scotland and Northern Ireland voted to stay (62% and 55.8% respectively). Scotland and the London metropolitan area were the clear outliers. The Scottish parliament is a devolved parliament subordinate to the U.K. parliament in Westminster, and it cannot hold a legally binding referendum on independence without the latter's permission.5 The May government is insisting that it will not allow a referendum to go forward until the Brexit negotiations are completed. This is an obvious strategic need. Although the Scottish National Party (SNP), the dominant party in Edinburgh, could hold a non-binding referendum at any time to apply pressure on London (reminder: the Brexit vote was also non-binding), it has an interest in waiting to see whether public opinion of Brexit will shift in England and what kind of deal the U.K. might get from the EU in the exit negotiations. Eventually, however, Scotland is likely to push for a new vote. The SNP is a party whose raison d'être is independence sooner or later. It faces a once-in-a-generation opportunity, with the 2014 referendum producing an encouraging result and Brexit adding new impetus. The party manifesto made clear in 2016 that it would call for a new independence vote in case of "a significant or material change" in Scotland's constitutional circumstances - a clear hint at Brexit. Why have the odds of Scottish independence increased? First, Brexit removes a domestic political constraint on independence. After the Brexit vote, the SNP and other pro-independence groups can say that England changed the status quo, not Scotland. It is worth remembering that the Anglo-Scots union was forged in 1707 at a time of severe Scottish economic hardship, in which a common market was the primary motivation to merge governments. Today, Scotland's comparable interest lies in maintaining access to the European single market, which is now under threat from Westminster. In particular, as with the U.K. as a whole, Scotland stands to suffer from a decline in immigration and hence workforce growth (Chart 6). Second, Brexit removes an external constraint. The EU's official opposition to Scottish independence, particularly European Commission President Jose Manuel Barroso's threat that Scottish accession would be "extremely difficult, if not impossible," likely affected the outcome of the 2014 referendum. Of course, many Scots rejected all such warnings as the vote approached, with polls showing a rally just before the referendum date toward the 45% outcome (Chart 7). But if the EU's warnings even had a temporary effect, what happens if the EU gives a nod and wink this time around? While EU officials have recently reiterated the so-called "Barroso doctrine," we suspect that they are less likely to play an interventionist role under the new circumstances. Spain - which is still concerned about Scotland fanning Catalan ambitions - might be less vocal this time, since Madrid could plausibly argue that Brexit makes a material difference from its own case. Catalonians could not argue, like the Scots, that their parent country attempted to deprive them of access to the European Single Market. Chart 6Immigration Curbs Threaten Scots Growth Will Scotland Scotch Brexit? Will Scotland Scotch Brexit? Chart 7Scottish Patriots Only Temporarily Deterred Scottish Patriots Only Temporarily Deterred Scottish Patriots Only Temporarily Deterred To put this into context, remember that it is not historically unusual for continental Europe to act as a patron to Scotland to keep England in check. There is ample record of this behavior, namely French and Spanish patronage of the exiled Stuart kings after 1688. The situation is very different today, but the analogy is not absurd: insofar as Brexit undermines the integrity of the EU, the EU can be expected to reciprocate by not doing everything in its power to defend the integrity of the U.K. All is fair in love and war. Nevertheless, the economic constraints to Scottish secession are even clearer than they were in 2014: The North Sea is drying up: Scotland's North Sea energy revenues have essentially collapsed to zero (Chart 8). Meanwhile the long-term prospects for the North Sea oil production remain as bleak as they were in 2014, especially since oil prices halved. Reserves of oil and gas are limited, hovering at around five to eight years' worth of supply - i.e. not a good basis for long-term independence (Chart 9). Decommissioning costs are also expected to be high as the sector is wound down. Chart 8No Golden Goose In The North Sea Will Scotland Scotch Brexit? Will Scotland Scotch Brexit? Chart 9Limited Domestic Energy Supplies Will Scotland Scotch Brexit? Will Scotland Scotch Brexit? England still foots many bills: Total government expenditures in Scotland exceed the total revenue raised in Scotland by about £15 billion or 28% of Scotland's government revenue (Chart 10). Chart 10The U.K. Pays For Scotland's Allegiance Will Scotland Scotch Brexit? Will Scotland Scotch Brexit? Chart 11Scotland's Deficits Getting Worse Scotland's Deficits Getting Worse Scotland's Deficits Getting Worse Scottish finances stand at risk: Scotland's fiscal, foreign exchange, and monetary policy dilemmas are as discouraging as they were in 2014 (Chart 11). Judging by the value of financial assets (which come under risk if Scotland loses the BoE's support or changes currencies), Scotland is incredibly exposed to financial risk (Chart 12). Chart 12Scottish Financial Assets Need Currency Stability Will Scotland Scotch Brexit? Will Scotland Scotch Brexit? Thus, while key domestic political and foreign policy impediments may be removed, the country's internal economic impediments remain gigantic. Moreover, Scotland already has most of the characteristics of a nation state. It has its own legal and education system, prints its own banknotes, and has some powers of taxation (about 40% of revenue). It lacks a standing army and full fiscal control, but in these cases it clearly benefits from partnering with England. It also has a strong sense of national identity, regardless of whether it is technically independent. Why, then, do we believe Scottish independence is too close to call? Because Brexit has shown that "math" is insufficient! The Scots may go with their hearts against their heads, just as many English voters did in favor of Brexit. Nationalism and political polarization are a two-way street. History also shows that strictly materialist or quantitative assessments cannot anticipate paradigm shifts or national leaps into the unknown. Compare Ireland in 1922, the year of its independence from the U.K. Ireland was far less prepared to strike out on its own than Scotland is today. It comprised a smaller share of the U.K.'s population, workforce, and GDP than Scotland today (Charts 13 and 14). It was less educated and less developed relative to its neighbors, and it faced unemployment rates above 30%. Yet it chose independence anyway - out of political will and sheer Celtic grit. Chart 13Irish Independence: Poverty Not An Obstacle Will Scotland Scotch Brexit? Will Scotland Scotch Brexit? Chart 14Scotland: If The Irish Can Do It So Can We Will Scotland Scotch Brexit? Will Scotland Scotch Brexit? Ireland's case was very different than Scotland's today, but there is an interesting parallel. The U.K. was absorbed with continental affairs, the Americans played the role of external economic patron, and the Irish were ready to seize their once-in-a-lifetime opportunity. Today the U.K. is similarly distracted with Europe, and the SNP leadership is ready to seize the moment, having revealed its preference in 2014. But foreign support (in this case the EU's) will be a critical factor, even though the EU's common market is much less valuable to Scotland than the U.K.'s (Chart 15). Will the SNP be able to get enough votes? We know that more Scots voted to stay in the EU (62%) than voted to stay in the U.K. (55%), which in a crude sense implies that there is upside potential to the first referendum outcome. However, looking at the referendum results on the local level, it becomes clear that there is no correlation between Scottish secessionists and Europhiles, or unionists and Euroskeptics (Chart 16). Nor is there any marked correlation between level of education and the desire for independence, as was the case in Brexit. Yet there is evidence that love of the Union Jack is correlated with age (Chart 17). Youngsters are willing to take risks for the thrill of freedom, while the elders better understand the benefits from economic links and transfer payments. In the short and medium run, this suggests that demographics will continue to work against independence - reinforcing the fact that the SNP can wait to see what kind of deal the U.K. gets first.6 Chart 15EU Market No Substitute For British Market Will Scotland Scotch Brexit? Will Scotland Scotch Brexit? Chart 16No Relationship Between IndyRef And Brexit Will Scotland Scotch Brexit? Will Scotland Scotch Brexit? Chart 17Old Folks Loyal To The Union Jack Will Scotland Scotch Brexit? Will Scotland Scotch Brexit? The most striking indicator of Scottish secessionism is unemployment (Chart 18). Thus an economic downturn that impacts Scotland, for example as result of uncertainty over Brexit, poses a critical risk to the union. The SNP will be quick to blame even a shred of economic pain on Tory-dominated Westminster. The British government and BoE have shown a commitment to use accommodative monetary and fiscal policy to smooth over the transition period, and they have fiscal room for maneuver (Chart 19), but much will depend on what kind of a deal London gets from the EU and whether the markets remain calm. Chart 18Joblessness Boosts Independence Vote Will Scotland Scotch Brexit? Will Scotland Scotch Brexit? Chart 19The U.K. Has Room To Maneuver The U.K. Has Room To Maneuver The U.K. Has Room To Maneuver Bottom Line: Economics is an argument against Scottish independence, but history and politics are unclear. We simply note that independence cannot be ruled out, particularly in the context of any adverse economic shock stemming from the U.K.'s actual divorce proceedings. Will Scotland Scotch Brexit? From the beginning of the Brexit saga, BCA's Geopolitical Strategy service has argued that Britain, of all EU members, was uniquely predisposed and positioned to leave the union. Hence the referendum was "too close to call."7 This did not mean that the U.K. could do so without consequences. Leaving would be detrimental (albeit not apocalyptic) to the U.K.'s economy, particularly by harming service exports to the EU and reducing labor force growth via stricter immigration controls. In the event, upside economic surprises have occurred, but Brexit has not happened yet.8 How does the Scottish referendum threat affect the Brexit negotiations? This is much less clear and will require constant monitoring over the coming two years, and perhaps longer if the European Council agrees to extend the negotiating period (which would require a unanimous vote). Still, we can draw a few conclusions from the above. First, London is a price taker not a price maker. It cannot afford not to agree to a trade deal or transition deal of some sort upon leaving in 2019. Even if England were willing to walk away from the EU's offers, a total rupture (reversion to minimal WTO trade rules) would be unacceptable to Scotland after being denied a say in the negotiation process. Therefore Scotland is now a moderating force on the Tory leadership that is otherwise unconstrained by domestic politics due to the high level of support for May's government (see Chart 5, page 5). To save the United Kingdom, the Tories may simply have to accept what Europe is willing to give. This supports our view that the risk of a total diplomatic war between Europe and the U.K. is unlikely and that expectations of cross-channel fireworks may be overdone. Second, Scotland is twice the price taker, because it can only afford independence from the U.K. if the EU is willing to grant it a special arrangement. This is possible, but difficult to see happen early in the negotiations process. It will be important to monitor Brussels' statements on Scottish independence carefully for signs that the EU is taking a tough stance on Brexit negotiations. Sturgeon has to play it safe and see what kind of a deal May brings back from Brussels. By waiting, she can profit from Scottish indignation over both May's use of prerogative to block the referendum in the first place and then over the Brexit deal itself, when it takes place. Third, the saving grace for both countries is that it is not in Europe's interest to dismantle the U.K., or to force it into a debilitating economic crisis. We have long differed from the view that the EU will be remorseless in its negotiations over Brexit. The EU seeks extensive trade engagements with every European country, from Norway and Switzerland to Iceland and Turkey, because its interest lies in expanding markets and forging alliances. Europe is not Russia, seeking to impose punitive economic embargoes on Ukraine and Belarus for failure to conform to its market standards. While free trade agreements usually take longer than two years to negotiate, and while the CETA agreement between the EU and Canada is a recent and relevant example of the risks for the U.K., the U.K. and EU are already highly integrated, unlike the two parties in most other bilateral trade negotiations. In addition, the U.K. is a military and geopolitical ally of key European states. The U.K.-EU negotiations are not being conducted in a ceteris paribus economic laboratory, but are occurring in 2017, a year in which Russian assertiveness, transnational terrorism, and global multipolarity are all shared risks to both the U.K. and EU. Investment Implications Since January 17 - the date of Theresa May's speech calling for the exit from the Common Market - we have argued that the worst is probably over for the U.K.9 Yes, the EU negotiations will be tough and the British press - surprisingly lacking the stiff upper lip of its readers - will make mountains out of molehills. However, by saying no to the Common Market, Theresa May plays the role of a spouse who does not want to fight over the custody of the children, thus defusing the divorce proceedings. We have been short EUR/GBP since mid-January and the trade is down only 1.96%, suggesting that the market has been in "wait and see mode" since the speech. We are comfortable with this trade regardless of our analysis on the rising probability of the Scottish referendum for two reasons: Hard Brexit is less likely: Many Tory MPs have had a tough time getting behind the "hard Brexit" policy, but until now they have had a tough time expressing their displeasure. However, the threat of Scottish independence and the dissolution of the U.K. will give the members of the Conservative and Unionist Party (as it is officially known) plenty of ammunition to push May towards a softer Brexit outcome. This should be bullish GBP in ceteris paribus terms. It's not the seventeenth century: We do not expect the EU to act like seventeenth-century France and subvert U.K. unity, at least not this early in the negotiations. For clients who expect the "knives to come out," we offer Scottish independence as a critical test of the thesis. Let's see if the EU is ready to play dirty and if it decides to alter the "Barroso doctrine" for Scotland. If they do, then our sanguine thesis is truly wrong. On the other hand, our short EUR/GBP trade may be threatened by a potential surge in bullish euro sentiment as French election risks abate and the ECB threatens hawkish rhetoric. We have just gone long EUR/USD on a three-to-six month basis for these reasons. As such, we would suggest that clients go short USD/GBP instead. To be clear, we do not have high conviction that the pound will outperform either the euro or the U.S. dollar. Instead, we offer these currency trades as a way to gauge our political thesis that the U.K.-EU negotiations will likely go more smoothly than the market expects. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA European Investment Strategy Weekly Report, "Phoney War Ends. Battle Begins," dated March 16, 2017, available at eis.bcaresearch.com. 2 Article 50 allows for a two-year negotiation period, after which the departing party may have an exit deal but is not guaranteed a trade deal for the future. The negotiation period can be extended with a unanimous vote in the European Council. 3 Please see BCA Geopolitical Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy, "Brexit: The Three Kingdoms," in Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 5 The union of the kingdoms of Scotland and England is a power "reserved" to parliament and the crown in Schedule 5 of the Scotland Act of 1998. Altering the union would therefore require the U.K. and Scottish parliaments to agree to devolve the power to Scotland using Section 30(2) of the same act, which the monarch would then endorse. This was the case in 2012 when the 2014 referendum was initiated. 6 On the other hand, demographics also works against Brexit in the long run, given that - as our colleague Peter Berezin has said in the past - many who voted to leave the EU will eventually pass away. 7 Please see BCA Geopolitical Strategy Strategic Outlook, "Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. 8 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, and "BREXIT Update: Brexit Means Brexit, Until Brexit," dated September 16, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights Trump's agenda has not derailed ... at least not yet; Europe remains a red herring ... as the Dutch showed; Turkey cannot restart Europe's immigration crisis; Supply-side reforms are still likely in France; The ECB will remain dovish for longer than expected; EUR/USD may rise in the short term, but it will relapse. Feature In this Weekly Report, we focus on the key questions regarding continental European politics. To begin, however, we will briefly address the U.S., since investors are starting to worry about whether President Donald Trump can get his legislative agenda through, given the recent testimony of FBI Director James Comey on the alleged interference of Russia in the U.S. election. There are three points to focus on in the U.S.: Chart 1Trump Not Dead To Republicans Yet Five Questions On Europe Five Questions On Europe The GOP base supports Trump: President Trump was always going to be a controversial president. Anyone who is surprised by it today clearly was not paying attention last year. In the long term, Trump's extraordinarily low popularity will be an albatross around his neck, draining his political capital. However, until the mid-term elections, his popularity with Republican voters is all that matters, and it remains strong (Chart 1). House Republicans have to worry that they could face pro-Trump challengers in primary elections in the summer ahead of the 2018 midterms. As such, as long as the Republican voters support Trump, he still has political capital. Republicans in Congress want tax reform: Budget-busting tax reform is not only a Trump policy, it is a Republican policy. We have already received plenty of signals from fiscal hawks in Congress that they intend to use "dynamic scoring," macroeconomic modeling that takes into account revenue-positive effects of tax cuts when assessing the impact on the budget, in order to justify cuts as revenue-neutral. Republicans are also looking at the repatriation of corporate earnings and a border adjustment tax to raise revenue. Obamacare delay may not mean much: We already pointed out before that the GOP intention to focus on Obamacare first, tax reform second, would get them in trouble.1 This is now playing out. Opposing the Obamacare replacement may make sense to small-government Tea Party members. Repeal, alone, is why they are in Congress in the first place, given the 2010 wave election. But opposing tax cuts - once justified by dynamic scoring as revenue neutral - will be much more difficult. The Tea Party is "small government" first, fiscal restraint second. In other words, if tax reform cuts taxes and reduces revenue available to Washington D.C., "temporary" budget deficits will be easy to swallow. This is not to say that the recent events have not hurt the chances of whopping tax cuts and infrastructure spending. In particular, we think that Congressional GOP members may take over the agenda if Trump loses any more political capital. And this will mean less budget-busting than Trump would have done. Also, tax reform was always going to be difficult as special interests and lobbyists were bound to get involved. Chart 2French Spreads Are Overstated French Spreads Are Overstated French Spreads Are Overstated In addition, the probability of an eventual Trump impeachment - were Republicans to lose the House, or grassroots Republicans to abandon him in droves - has risen. Investors can no longer ignore this issue, even though it was initially a liberal fantasy. However, all of these risks to the Trump agenda will likely spur the GOP in the House to focus on passing tax reform while they still have a majority in Congress and control of the White House. We still expect tax reform to be done this year - within the fiscal year 2018 reconciliation bill - as time now may truly be running out for Republicans. Europe, meanwhile remains a focal point in client meetings. Our view that Europe will be a geopolitical red herring in 2017 - and thus an investment opportunity - remains controversial. We will address Brexit and the new Scottish independence referendum in our report next week, to coincide with London's formal invocation of Article 50 of the Lisbon Treaty to initiate the exit proceedings. Popular support for independence in Scotland has been one of our measures of "Bregret" since last summer and it has just sprung back to life, which adds a new source of risk for investors. On the continent, investors are particularly concerned that the upcoming French election will follow the populist script from the U.K. and the U.S. last year. This worry has pushed French bond yield spreads over German bonds to the highest level since 2011, bringing French bonds into the same trend as peripheral bonds (Chart 2). Since the outbreak of the euro area's sovereign debt crisis, a tight correlation between French and Italian/Spanish bonds has signified systemic political risk. We disagree that political events represent a systemic risk to the euro area in 2017. This week, we address five critical questions inspired by challenges to our view presented by our clients in meetings and conference calls. Question 1: Is The Dutch Election Result Important? Few clients have asked for a post-mortem on the March 15 Dutch election, but many asked about the vote beforehand. It has come and gone with little fanfare. Financial media have brushed it aside as it does not fit the neat script of rising Euroskepticism on the continent. To recap, the Euroskeptic and populist Party for Freedom (PVV), led by Geert Wilders, gained five seats in the election (13% of the votes cast), bringing its total support to 20 in the 150-seat parliament. Despite the gains, however, the election was an unmitigated disaster for Wilders, as the PVV was polling strong for most of the campaign and was expected to win between 30 and 35 seats (Chart 3). In terms of its share of total votes, the PVV's performance in 2017 trails its performance in the 2010 general election and the 2009 and 2014 European Parliament elections. Not only did the PVV underperform the past year's polls, but also they only managed to eke out their fourth-best performance ever. Chart 3Dutch Euroskeptics Were Always Overrated Five Questions On Europe Five Questions On Europe Chart 4Austria Leans Euroskeptic... Austria Leans Euroskeptic... Austria Leans Euroskeptic... Chart 5...Yet Chose A Europhile President ...Yet Chose A Europhile President ...Yet Chose A Europhile President It is a mistake to ignore these results. They teach us three valuable lessons: Trend reversal: In April of last year we warned clients that the upcoming Brexit referendum and U.S. elections had a much higher chance of populist outcomes than the European elections in 2017.2 The basis for our controversial claim was the notion that European social-welfare states dampened the pain of globalization for the middle class. We now have two elections that confirm our view that European voters are just not as angry as their Anglo-Saxon counterparts. Aside from the Dutch, there is also the lesson from the similarly ignored Austrian presidential election last December. Despite Austria's baseline as a relatively Euroskeptic country (Chart 4), the right wing, populist candidate lost his solid lead in the last few weeks ahead of the election (Chart 5). Clients should not ignore Austria and the Netherlands, since both countries have a long tradition of Euroskepticism and their populist, anti-immigration parties are well established and highly competitive. If Euroskeptics cannot win here, where can they win? It's immigration, stupid: Investors should make a distinction between anti-immigrant and anti-euro sentiment. In both the Netherlands and Austria, it was anti-immigrant sentiment that propelled populist parties in the polls. However, as the migration crisis abated, their polling collapsed. This was clearest in the Netherlands, where asylum applications to the EU - advanced by six months - tracked closely with PVV polling (Chart 6). The distinction is highly relevant as it means that even if the populists had taken power, they would not necessarily have had enough political support to take their country out of the euro area. This is particularly the case in the Netherlands, where support for the euro remains high (Chart 7). Brexit is not helping: Much ink has been spilt in the media suggesting that Brexit would encourage voters in Europe to hold similar popular referendums. We disagreed with this assertion and now the evidence from Austria and the Netherlands supports our view.3 Chart 3 shows that the decline in the PVV's support sped up around the time of the U.K. referendum, suggesting that Brexit may even have discouraged voters from voting for the populist option. Geert Wilders was temporarily buoyed by the kangaroo court accusing him of racial insensitivity. But the sympathy vote quickly dissipated and PVV polling reverted back to the post-Brexit trend.4 Chart 6Dutch Populists Linked To Immigration Dutch Populists Linked To Immigration Dutch Populists Linked To Immigration Chart 7The Dutch Approve Of The Euro The Dutch Approve Of The Euro The Dutch Approve Of The Euro Bottom Line: The election in the Netherlands provides an important data point that should not be ignored. The populist PVV not only failed to meet polling expectations, it failed to repeat its result from seven years ago. Investors are ignoring how important the abating of the migration crisis truly was for European politics. Question 2: Can Turkey Restart The Immigration Crisis? The end of the migration crisis in Europe clearly played a major role in dampening support for the Dutch and Austrian populists. We expected this in September 2015, when we argued with high conviction that the migration crisis would prove ephemeral (Chart 8).5 How did we make the right call at the height of the influx of asylum seekers into Europe? Three insights guided us: Civil wars end: No civil war can last forever. Eventually, battle lines ossify into de facto borders between warring factions and hostilities draw to a close. The Syrian Civil War is still going, but its most vicious phase has ended. Civilians have either moved into safer zones or, tragically, have perished. Enforcement increases: The influx of 220,000 asylum seekers per month - the height of the crisis in October 2015 - was unsustainable. Eventually, enforcement tightens. This happened to the "Balkan route" as countries reinforced their borders and Hungary built a fence. Liberal attitudes wane: European attitudes towards migrants soured quickly as the crisis escalated. After the highly publicized welcoming message from Chancellor Angela Merkel, the tone shifted to one of quiet hostility. This significantly changed the cost-benefit calculus of the economic migrants most likely to be deported. Given that roughly half of asylum seekers in 2015 were not fleeing war, but merely looking for a better life, the change in attitude in Europe was important. Many of our clients are today worried that Turkey might deliberately restart the migration crisis as a way to punish Europe amidst ongoing Euro-Turkish disputes. The rhetoric from Ankara supports this concern: Turkish officials have threatened economic sanctions against the Netherlands, and accused Germany of supporting the July 2016 coup and the U.S. of funding the Islamic State. We call Turkey's bluff on this threat. First, the number of migrants crossing the Mediterranean collapsed well before the EU-Turkey deal was negotiated in March 2016. This puts into doubt Turkey's role in dampening the flow in the first place. Second, unlike in 2015, Turkey is now officially involved in the Syrian conflict, having invaded the country last August. By participating directly, Turkey can no longer tolerate the unfettered flow of migrants through its territory to Europe, a luxury in 2015 when it was a "passive" bystander. Today, migrants flowing through its territory are even more likely to be parties active in the Syrian war looking to strike Turkish targets for strategic reasons. Third, the Turkish economy is reliant on Europe for both FDI and export demand (Chart 9). If Turkey were to lash out by encouraging migration into Europe, the subsequent economic sanctions would devastate the Turkish economy and collapse its currency. Investment and trade with Europe make up the vast majority of its current account deficit. Chart 8Migration Crisis Well Past Its Peak Migration Crisis Well Past Its Peak Migration Crisis Well Past Its Peak Chart 9Turkey Depends On Europe Turkey Depends On Europe Turkey Depends On Europe Bottom Line: Turkey can make Europe's life difficult. However, the migration crisis did not end because of Turkey and therefore will not restart because of Turkey. Furthermore, Ankara has its own security to consider and will continue to keep its border with Syria closed and closely monitored. Question 3: Is A Supply-Side Revolution Still Possible In France? In February, we posited that a supply-side revolution was afoot in France.6 Since then, the Thatcherite candidate for presidency - François Fillon - has suffered an ignominious fall in the polls due to ongoing corruption scandals. This somewhat dampens our enthusiasm, given that Fillon's program was by far the most aggressive in proposing cuts to the size of the French state. Still, the new leading candidate Emmanuel Macron (Chart 10) is quite possibly the most right-wing of left-wing candidates that France has ever fielded. He quit the Socialist Party and has received endorsements across the ideological spectrum. In addition, his governing program is largely pro-market: Public expenditure will go down to 50% of GDP (from 57%) by 2022; Corporate taxes will be reduced from 33.3% to 25%; Regulation will be simplified for small and medium-sized businesses; Productive investment will be exempt from the wealth tax, which will focus solely on real estate; Exceptions to the 35-hour work week will be allowed at the company level. More important than Macron's campaign promises is the evidence that the French "median voter" is shifting. Polls suggest that a "silent majority" in France favors structural reform (Chart 11). Chart 10Macron's Huge Lead Over Le Pen Macron's Huge Lead Over Le Pen Macron's Huge Lead Over Le Pen Chart 11France: 'Silent Majority' Wants Reform Five Questions On Europe Five Questions On Europe As such, France may be ready for reforms and Emmanuel Macron could be France's Gerhard Schröder, a centrist reformer capable of pulling the left-wing towards pro-market reforms. What about the fears that Macron will not be able to command a majority in France's National Assembly? Macron's party En Marche! was founded less than a year ago and is unlikely to be competitive in the upcoming June legislative elections (a two-round election to be held on June 10 and 17). This will force Macron, should he win, to "cohabitate" with a prime minister from another party. Most likely, this will mean a prime minister from the center-right Republicans. For investors, this could be very positive. The French constitution gives the National Assembly most power over domestic affairs when the president cannot command a majority. This means that a center-right prime minister who receives his mandate from Macron will be in charge of domestic reforms. We see no reason why Macron would not be able to work with such a prime minister. In fact, the worse En Marche! does in the parliamentary election, the more likely that Macron will be perceived as non-threatening to the center-right Republicans. What if no party wins a majority in parliament? We think that Macron would excel in this situation. He would be able to get support from the right-wing of the Socialist Party and the centrist elements of the Republicans. And if the National Assembly fails to support his program, he could always call for a new parliamentary election in a year's time, given his presidential powers. In other words, investors may be unduly pessimistic about the prospect of reforms under Macron. Several prominent center-right figures - including Alain Juppé and Manuel Valls - have already distanced themselves from Fillon, perhaps opening up the possibility of a premiership under Macron. In addition, Macron himself has refused to accuse Fillon of corruption, a smart strategy given that he will need his endorsement in the second round against Le Pen and that he will likely need to cohabitate with the Republicans to govern. What of Marine Le Pen's probability of winning? At this point, polling does not look good for her. Not only is she trailing Macron by 22% in the second round, but she is even trailing Fillon by 11%. Nonetheless, we suspect that she will close the gap over the next month. Election momentum works in cycles and she should be able to bounce back, giving investors another scare ahead of the election. Bottom Line: Concerns over Emmanuel Macron's ability to pursue structural reforms are overstated. Yes, he is less ideal of a candidate than Fillon from the market's perspective, but no, we do not doubt that he would be able to cohabitate with a center-right parliament. That said, we cannot pass definitive judgment until the parliamentary election takes place in June. Question 4: Will Germans Want A Hawk In 2019? An Austrian member of the ECB Governing Council, Ewald Nowotny, spooked the markets by suggesting that Bundesbank President Jens Weidmann would be one of the two most likely candidates to replace Mario Draghi in 2019. Weidmann is a noted hawk who has opposed the ECB's easy monetary policy and even testified against Angela Merkel's government during the court case assessing the constitutionality of the ECB's Outright Monetary Transactions (OMT). The prospect of a Weidmann ECB presidency fits the narrative that Germans will want a hawk to replace Mario Draghi in 2019. The idea is that by 2019, inflation will be close to the ECB's target of 2% and Germans would be itching to beat it down. We have heard this view from colleagues and clients for some time. And we have disagreed with it for quite some time as well! As we pointed out in 2012, it was a German political decision to shift the ECB towards a dovish outlook.7 This is not to say that the ECB takes its orders from Berlin. Rather, it is that Chancellor Merkel had plenty of opportunities via personnel decisions to ensure that the ECB followed a more monetarist and hawkish line. For example, she could have signed off on former Bundesbank President Axel Weber, who was the leading candidate for the job in 2011. She refused when Weber signaled his opposition to the ECB's initial bond-buying program (the Securities Market Program). Mario Draghi was quickly tapped as the alternative candidate suitable to Berlin. Later in 2011, ECB Executive Board member Jürgen Stark resigned over opposition to the same ECB bond-buying program. Since Stark was the German member of the Executive Board, convention held that Berlin would propose his replacement. In other words, while Merkel had her pick of Germany's foremost economists, she picked her finance minister's deputy, Jörg Asmussen. Neither Draghi nor Asmussen have a strand of monetarist or inflation-hawk DNA between the two of them. ECB policy has not been dovish by accident but by design. While it is true that the ECB will inhabit a different macro environment in 2017-19 from the crisis of 2011-12, nevertheless we suspect that dovishness will continue beyond 2019 for two key reasons: German domestic politics: Germans are not becoming Euroskeptic, they are turning rabidly Europhile! If the polls are to be believed, Germans are now the most pro-euro people in Europe (Chart 12). Martin Schulz, chancellor-candidate of the center-left Social Democratic Party (SPD), is campaigning on an aggressive anti-populist, pro-EU platform. He has accused Merkel of being too reticent and of providing Europe's Euroskeptics with a tailwind due to her policies. The SPD's recent climb in the polls is stunning (Chart 13). But even if Schulz fails to win, Merkel will have to take into account his brand of politics if she intends to reconstitute the Grand Coalition with the SPD. It is highly unlikely that Schulz will sign off on a hawkish ECB president (or on the return of Finance Minister Wolfgang Schäuble for that matter). Italian risks: While we have been sanguine about this year's political risks, the Italian election slated for February 2018 is set for genuine fireworks. Euroskeptic parties have now taken a lead in the polls (Chart 14). While the election is still too close to call, and a lot of things can happen between now and then, we expect it to be a risk catalyst in Europe. The problem with Italy is that the election is unlikely to provide any clarity. A hung parliament will likely produce a weak, potentially minority government. Given Italy's potential GDP growth rate of about 0%, this means that a weak government will at some point have to deal with a recession, heightening political risks beyond 2018. Chart 12Germans Love The Euro Germans Love The Euro Germans Love The Euro Chart 13Pro-Europe Sentiment Drives SPD Revival Pro-Europe Sentiment Drives SPD Revival Pro-Europe Sentiment Drives SPD Revival Chart 14Italian Elections: The Big Risk Italian Elections: The Big Risk Italian Elections: The Big Risk Bottom Line: Italy will hang over Europe like a Sword of Damocles for quite some time. The ECB will therefore be forced to remain dovish a lot longer than investors think. We see no evidence that Berlin will seek to reverse this policy. In fact, given the political paradigm shift in Germany itself, we suspect that Berlin will turn more Europhile over the next several years. Question 5: What Is The Big Picture For Europe? What explains the dogged persistence of support for European integration on the continent? Even in the case of Italy - where Euroskepticism is clearly on the rise - we would bet on voters supporting euro area and EU membership in a referendum (albeit with a low conviction). Why? In 2011, at the height of the euro area sovereign debt crisis, we elucidated our view on the long-term trajectory of European integration.8 We highly recommend that our clients re-read this analysis, as it continues to inform our net assessment of Europe. Our assertion in 2011 was that Europe is integrating out of weakness, not out of misplaced hope of strength. Much of the analysis in the financial community and media does not understand this point. It therefore rejects the wisdom of integration on the basis that Europhile policymakers are blinded by ambition. In our view, they are driven by necessity. As Chart 15 suggests, the average "hard power" of the five largest economies in the euro area (the EMU-5) is much lower than the average "hard power" of the BRIC states.9 European integration is therefore an attempt to asymptotically approach the aggregate, rather than the average, "hard power" of the EMU-5. Europe will never achieve the aggregate figure, as that will require a level of integration that is impossible. But the effort lies beneath European policymakers' goal of an "ever closer union." The truth of the matter is that European nation-states - as individual sovereign states - simply do not matter anymore. Their economic weight, demographics, and military strength relative to other nations are a far cry from when Europe dominated the world (Chart 16). Chart 15European Integration Is About Geopolitics... European Integration Is About Geopolitics... European Integration Is About Geopolitics... Chart 16...And Global Relevance ...And Global Relevance ...And Global Relevance If European countries seek to shape their geopolitical and macroeconomic environment, they have to act in unison. This is not a normative statement, it is an empirical fact. This means that everything from Russian assertiveness and immigration crises to energy policy and trade negotiations have to be handled as a bloc. But is this not an elitist view? To what extent do European voters think in such grand geopolitical terms? According to polling, they think this way more than most analysts are willing to admit! Chart 17 shows that most Europeans - other than the British and Italians - are "in it" for geopolitical relevance and security, and only secondarily for economic growth. Even in Italy, geopolitical concerns are more important than economic performance, although levels of both suggest that Italy is again the critical risk for Europe. We suspect that it is this commitment to the non-economic goals of European integration that sustains the political commitment of both elites and the general public to the European project. As Chart 18 suggests, European voters continue to doubt that their future will be brighter outside of the bloc. Chart 17Voters Grasp The EU's Purpose ... Five Questions On Europe Five Questions On Europe Chart 18...And Most Want To Stay In It ...And Most Want To Stay In It ...And Most Want To Stay In It Bottom Line: European integration is not just an economic project. Voters understand this - not in all countries, but in enough to sustain integration beyond the immediate risks. Given this assessment, it is not clear to us that the project would collapse even if Italy left. Investment Implications Given our political assessment, we continue to support the recommendation of our colleague Peter Berezin that investors overweight euro area equities in a global portfolio.10 As Peter recently elucidated, capital goods orders continue to trend higher, which is a positive for investment spending on a cyclical horizon - helping euro area assets (Chart 19). Furthermore, private-sector credit growth remains robust, despite political risks (Chart 20). Chart 19European Economy Looking Up European Economy Looking Up European Economy Looking Up Chart 20Credit Growing Well Despite Election Risk Credit Growing Well Despite Election Risk Credit Growing Well Despite Election Risk Over the next 6-12 months, we see EUR/USD rising, especially as the ECB contemplates tapering its bond purchases. We recommend a tactical long EUR/USD trade as a result. The euro could rise higher if the Trump administration disappoints the market on tax reform and infrastructure spending, policies that were supposed to supercharge the U.S. economy and prompt further Fed hawkishness. Over the long term, however, we doubt that the ECB will have the luxury of hawkishness. And we highly doubt that Berlin will rebel against dovish monetary policy. In fact, investors may be using the wrong mental map if they are equating Mario Draghi's taper with that of Ben Bernanke. While Bernanke intended to signal eventual tightening, Draghi will likely do everything in his power to dissuade the market from believing that interest rate hikes are inevitably coming soon. Therefore, we suspect that EUR/USD will eventually hit parity, after a potential rally in 2017. While this long-term depreciation may make sense from a political and macroeconomic perspective for Europe, it will likely set the stage for a geopolitical confrontation between the Trump Administration and Europe sometime next year. Marko Papic, Senior Vice President marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy," dated April 13, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 4 The media has suggested that the PVV merely suffered because of the Turkey-Netherlands spat over Turkish political campaigning in the Netherlands. We see no evidence of this. First, the PVV's collapse in the polls predates the crisis by several weeks. Second, the crisis had all the hallmarks of a trap for the establishment. It is not the fault of incumbent Prime Minister Mark Rutte for adeptly capitalizing on the situation. 5 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 7 Please see "Draghi And Asmussen, Not The OMT, Are A Game Changer," in BCA Geopolitical Strategy Monthly Report "Fortuna And Policymakers," dated October 10, 2012, available at gps.bcaresearch.com. 8 Please see BCA Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at bca.bcaresearch.com. 9 As measured by the BCA Geopolitical Power Index. 10 Please see BCA Global Investment Strategy Weekly Report, "Three Battles That Will Determine The Euro Area's Destiny," dated March 10, 2017, available at gis.bcaresearch.com.

Highlights Once the Brexit starting gun is fired, the EU27's high-level guidelines and red lines will create more vulnerabilities and uncertainties for the U.K. than for the euro area. The BoE will be more boxed in than the ECB. Brexit trades have more legs. We describe four structural disruptors to economies and financial markets (on page 6). Our favourite structural investment themes are Personal Product equities, euro/yuan, and real estate in Spain, Ireland and Germany. Feature "Many in Great Britain expected a major calamity... but what happened was near enough nothing ." The citation above perfectly describes the 9 months that have elapsed since the U.K.'s June 23 2016 vote to exit the EU. In fact, it refers to the 9 months that elapsed after Britain declared war on Germany on September 3 1939 - a period of calm, militarily speaking, which became known as the 'Phoney War'.1 But outside the military sphere a lot did happen in the Phoney War. Most notably, a propaganda war ensued. On the night of September 3 1939 alone, the Royal Air Force dropped 6 million leaflets over Germany titled 'Note to the German People'. Chart of the WeekOne Big Correlated Trade: Pound/Euro And Eurostoxx600 Vs. FTSE100 One Big Correlated Trade: Pound/Euro And Eurostoxx600 Vs. FTSE100 One Big Correlated Trade: Pound/Euro And Eurostoxx600 Vs. FTSE100 Brexit Phoney War And The Markets Fast forward 77 years. The 9 months since the Brexit vote has also been a period of calm, economically speaking. Indeed, the U.K. economy has sailed along remarkably smoothly. And this has fuelled a propaganda war for those who believe that Brexit's economic impact will be near enough nothing. But outside the economic sphere, a lot has happened in the Brexit Phoney War: The pound has slumped 12% versus the euro and 17% versus the dollar. The FTSE100 has surged 16%, substantially outperforming the 8% gain in the Eurostoxx600 The U.K. 10-year gilt yield is down 40 bps when the equivalent German bund yield is up 40 bps and the equivalent U.S. Treasury yield is up 90 bps. These relative moves appear to reflect different asset class stories, but it is crucial to realise that: All of these relative moves are just one big correlated trade. The relative moves in bond yields have just tracked the expected differences in central bank policy rates two years ahead (Chart I-2 and Chart I-3). This is exactly in line with the theory that a bond yield just equals the expected average interest rate over the bond's lifetime. Chart I-2Difficult Brexit = Gilt Yields Fall Vs. Bund Yields Difficult Brexit = Gilt Yields Fall Vs. Bund Yields Difficult Brexit = Gilt Yields Fall Vs. Bund Yields Chart I-3Difficult Brexit = Gilt Yields Fall Vs. T-Bond Yields Difficult Brexit = Gilt Yields Fall Vs. T-Bond Yields Difficult Brexit = Gilt Yields Fall Vs. T-Bond Yields Likewise, the moves in pound/dollar and pound/euro have also closely tracked the same expected differences in central bank policy rates (Chart I-4 and Chart I-5). Again, this is exactly in line with theory. Over short horizons, the biggest driver of exchange rates is fixed income cross-border portfolio flows - which always seek out the highest yield adjusted for hedging costs. Chart I-4Difficult Brexit = Pound/Euro Falls Difficult Brexit = Pound/Euro Falls Difficult Brexit = Pound/Euro Falls Chart I-5Difficult Brexit = Pound/Dollar Falls Difficult Brexit = Pound/Dollar Falls Difficult Brexit = Pound/Dollar Falls In turn, FTSE100 performance versus the Eurostoxx600 has near-perfectly tracked the inverse direction of pound/euro. Once more, this is exactly as theory would suggest. The FTSE100 and Eurostoxx600 are just a collection of multinational dollar-earning companies quoted in pounds and euros respectively. So when pound/euro weakens, the dollar earnings increase more in FTSE100 index terms than in Eurostoxx600 index terms, resulting in Eurostoxx600 underperformance (Chart of the Week). Now that the Brexit battle is about to begin in earnest, what will happen to these Brexit trades? Brexit Battle Begins It is not our intention here to forecast all the twists and turns of the Brexit battle. We will leave that to a later report. Instead, we just want to list the likely opening salvos. With Parliamentary approval now sealed, Theresa May is due to trigger Article 50 of the Lisbon Treaty in the week commencing March 27 and thereby formally begin the Brexit battle. Expect the first EU27 response within 48 hours, probably through the President of the European Council, Donald Tusk. In this response, Tusk may also give the date for the first European Council 'Brexit' summit. This EU27 Brexit summit will take place within 8 weeks of the Article 50 trigger, and likely after the two-round French Presidential Election in April/May. At the Brexit summit, the EU27 will establish its strategy, high-level guidelines and red lines for the Brexit negotiations. The European Council will present these negotiating guidelines to the European Commission. Drawing upon its own legal and policy expertise, the Commission will then draft a mandate which sets out more technical details of each area of negotiation. Next, the Council of the EU2 must approve this draft mandate by qualified majority vote (obviously excluding the U.K.) Once approved, the European Commission can begin the detailed negotiations with the U.K., keeping within the final mandate's guidelines. But what does all this mean for investors? The preceding analysis showed that the dominant driver for all Brexit trades is the expected difference in central bank policy interest rates two years ahead. Recall that not long ago the BoE was vying with the Fed to be the first to hike rates in this cycle, while the ECB was likely to ease further. But after the Brexit vote and the resulting uncertainty about the U.K.'s position in the world, the tables have turned. The EU27's high-level negotiating guidelines and red lines are likely to create more vulnerabilities and uncertainties for the U.K. than for the euro area. And now, these vulnerabilities and uncertainties are amplified by Scotland First Minister, Nicola Sturgeon, calling for a second referendum on Scottish Independence. For central bank policy, this means that the BoE will be hamstrung; whereas, absent any tail-events, the ECB can continue to back away from its extreme dovishness - a process that Draghi verbally started at the ECB Press Conference last week. Therefore, at least into the early summer, stay: Overweight U.K. gilts versus German bunds. Long euro/pound. Long FTSE100 versus Eurostoxx600 (or Eurostoxx50). Long U.K. Clothes and Apparel equities versus the market (Chart I-6). Short U.K. Real Estate equities versus the market (Chart I-7). But a word of warning for risk control. Remember that all five positions are in effect just one big correlated trade. So they will all work together, or they will all not work together! Chart I-6Difficult Brexit = U.K. Clothes And Apparel Outperforms Difficult Brexit = U.K. Clothes And Apparel Outperforms Difficult Brexit = U.K. Clothes And Apparel Outperforms Chart I-7Difficult Brexit = U.K. Real Estate Equities Underperform Difficult Brexit = U.K. Real Estate Equities Underperform Difficult Brexit = U.K. Real Estate Equities Underperform Four Disruptors The final section this week takes a wider-angle view of the world, and briefly highlights four structural disruptors to economies and financial markets in the coming years. Disruptor 1: Protectionism. Since the Great Recession, an extremely polarised distribution of economic growth has left most people's standard of living stagnant - despite seemingly decent headline economic growth and job creation (Chart I-8). Looking to find a scapegoat, economic nationalism and protectionism have resonated very strongly with voters in the U.K. and U.S. - resulting in Brexit and President Donald Trump. Other voters could follow in the same vein. But history teaches us that protectionism ends up hurting many more people than it helps. Disruptor 2: Technology. The bigger danger is that people are misdiagnosing the illness. The vast majority of middle-income job losses are not due to globalization, but due to technology. Specifically, Artificial Intelligence (AI) is replacing secure middle-income jobs and displacing workers into insecure low-income manual jobs - like bartending and waitressing - which AI cannot (yet) replace (Table I-1). And AI's impact on middle-income jobs is only in its infancy.3 The worry is that by misdiagnosing the illness as globalization and wrongly taking a protectionist medicine, the illness will intensify, rather than improve. Chart I-8Disruptor 1: Protectionism Disruptor 1: Protectionism Disruptor 1: Protectionism Table I-1Disruptor 2: Technology Phoney War Ends. Battle Begins. Phoney War Ends. Battle Begins. Disruptor 3: Debt super-cycles have reached exhaustion. The protectionist medicine carries a further danger. Major emerging market economies are coming to the end of structural credit booms and need to wean themselves off their credit addictions (Chart I-9). At this point of vulnerability, aggressive protectionism risks tipping these emerging economies into a sharp slowdown. Chart I-9Disruptor 3: Debt Super-Cycles Have Reached Exhaustion Disruptor 3: Debt Super-Cycles Have Reached Exhaustion Disruptor 3: Debt Super-Cycles Have Reached Exhaustion Disruptor 4: Equities are overvalued. Disruptors one, two and three come at a time when equities are valued to generate feeble total nominal returns over the next decade (Chart I-10). Risk premiums are extremely compressed. And if investors suddenly demand that risk premiums rise to average historical levels, it necessarily requires equity prices to adjust downwards. Chart I-10Disruptor 4: Equities Are Overvalued Disruptor 4: Equities Are Overvalued Disruptor 4: Equities Are Overvalued The long-term investment message is crystal clear. With the four disruptors in play, we strongly advise long-term investors not to follow passive (equity) index-tracking strategies. Instead, we advise long-term investors to stick to bespoke structural investment themes. Our favourite structural investment themes are Personal Product equities, euro/yuan, and real estate in Spain, Ireland and Germany. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 C N Trueman 'The Phoney War'. 2 The Council of the EU should not be confused with the European Council. 3 Please see the European Investment Strategy Special Report, "The Superstar Economy: Part 2," dated January 19, 2017, available at eis.bcaresearch.com Fractal Trading Model This week's trade is to short Netherlands equities, but wait until after the election result. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Short AEX Short AEX 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 Nothing in Trump's congressional address changes our outlook from November; Trump has reaffirmed his commitment to mercantilism; Investors should continue to favor small caps over large caps; We expect Trump to get his way on more spending, and a tax reform plan to pass by the end of the year; The Dutch election is a red herring, Le Pen's chances of winning are falling, but Italy remains a risk, especially in 2018; North Korea has evolved from a red herring into a black swan, stay short KRW/THB. Feature President Donald J. Trump delivered a reassuring speech last week. Sporting a magnanimous tone (and a new tie!) the president shocked the media by invoking a "new surge of optimism." Gone were the diatribes about "American carnage." Instead, President Trump implored Congress to work together to bring forth a major infrastructure program that would rival that of Eisenhower's interstate highway system, adopt a merit-based immigration system akin to Canada, and reform Obamacare in a way that would retain all its popular pillars. Trump concluded the speech by stating that "everything that is broken in our country can be fixed" and warning the polarized Congress that "true love for our people requires us to find common ground." After the speech, a narrative emerged in the media and financial press saying that Trump was a changed man. Should investors believe it? Not at all! There was simply nothing in the Trump speech that changes our outlook in November: that President Trump was elected on a populist platform and that he will be unconstrained on blowing out the U.S. budget and pursuing a mercantilist agenda.1 On everything else - from immigration reform to Obamacare - Trump may pursue a pragmatic set of policies. Or he may not. But what investors really care about is whether the Trump administration and Congress will: Get sweeping tax cut legislation done in 2017; Pass some infrastructure spending in 2017; Pursue protectionist policies. On all three counts, we believe that the answer is yes. Trump will get his way on both his pro-growth - anti-fiscal discipline - and mercantilist agendas. The timing is difficult to gauge, but we believe that we will see all three policy avenues aggressively pursued throughout the year and passed into law by the year's end. Trump's speech has only reinforced this view. Who Is Trump? Tax Cuts As we discussed in a recent report detailing the border adjustment tax (BAT) proposal, newly elected presidents rarely fumble on tax reform.2 Presidents Reagan, Clinton, and Bush all managed to pass major tax legislation in their first years, and Trump has stronger majorities than Bush did (Table 1). The GOP has been planning tax reform throughout the Obama administration, staffers and think tanks have "off the shelf" plans, and lawmakers know that time is short. In recent decades, the average length of time from the introduction of a major tax reform to the president's signature has been five months. Table 1Major Tax Legislation And The Congressional Balance Of Power Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was In addition, the GOP knows that it must move fast if it wants to pass any tax cuts in 2017. President Trump is now the most unpopular president since polling began tracking the question (Chart 1). Chart 1Does President Trump Lack Political Capital? Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was However, Republican voters continue to support him at 88%. This means that the House Republicans are vulnerable both to a Democrat/Independent backlash against Trump in the midterm elections and a Trump supporter backlash in the Republican primaries. They need to pass major legislation that satisfies middle class concerns and ensure that they do not incur the wrath of the Trump voters in primary races. While it is unlikely that the Democrats could significantly eat into Republican majorities in the House of Representatives and the Senate, stranger things have happened.3 Adding fire under the GOP are two special Congressional Elections, in Georgia's sixth district and for Montana's "at large" seat, to be held in April and May respectively.4 Both were easily won in November by Republicans. A slippage by the Republicans in either would send shockwaves through Congress. There is therefore little time to waste. The Republicans know that they must strike while the iron is hot. We suspect that most representatives will abandon their demand for revenue-neutral tax reform to get any tax reform. That may mean adjusting House Speaker Paul Ryan's favorite revenue-raising proposal - the border adjustment tax (BAT) - so that it brings less revenue by exempting whole categories of imports from punitive corporate taxes. "Dynamic scoring" - an accounting method that considers the holistic impact of budget measures on revenues and thus deficits - will be used to make the "math" work and satisfy the procedural demand for budget responsibility.5 What about Obamacare? A narrative has emerged in the media that Republicans cannot work on tax reform while the issue of "repealing and replacing" the Affordable Care Act looms over their heads. We disagree. There are plenty of examples of the White House and Congress cooperating on multiple policy agendas at the same time. For example, the Obama White House used its majorities in Congress to push through a major fiscal stimulus, financial reform, and the controversial health care plan. Ronald Reagan also managed to enact comprehensive immigration and tax reform in 1986. Trump's congressional address made only one mention of government debt. But he did emphasize that his tax plan would provide "massive tax relief for the middle class." This implies that the election campaign's individual income tax proposals may have to be altered. Trump's and the GOP's plans from last year agreed that the individual income tax should be reduced from seven to three brackets, with the marginal rates at 12%, 25%, and 33%. This would have cut the top marginal rate from 39.6% to 33%, but would also have left a significant number of Americans with an increase, or no change, to their marginal tax rate.6 It is likely that this will have to change, potentially creating an even greater impact on the deficit. Bottom Line: We expect both corporate and individual tax reform by the end of 2017. We do not have clarity on how legislators will go from here to there, but we suspect that to get both passed, Republicans in Congress will err on the side of greater deficits. As such, investors should expect exemptions on many imports under the final BAT (weakening any USD spike) and likely greater middle class tax cuts than are currently priced in the market. Infrastructure Spending Trump's congressional address ended several weeks of silence from the Trump administration on infrastructure spending. Not only did Trump reference the Eisenhower interstate highway system as a model to emulate, but he also promised a considerable increase in military spending and the completion of the wall on the border with Mexico ahead of schedule. Trump referred back to the original $1 trillion price tag that he announced in the heat of the electoral campaign. This figure was revised down by Trump's transition team to a modest $550 billion, though the difference may only be due to time frame. Whatever the case, Trump is using the bigger number now. We continue to believe that GOP representatives will not obstruct Trump's spending priorities. First, "dynamic scoring" can be applied to both tax cuts and infrastructure spending to make anything look close to revenue neutral. Second, voters want infrastructure spending (Chart 2). It is in fact the only issue other than combating drug addiction that Republicans and Democrats deeply agree on (Chart 3). Chart 2Everyone Loves Infrastructure Spending Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Chart 3Infrastructure Is Not A Partisan Issue Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Third, history is not on the side of deficit hawks. True, the national debt is higher today at $20 trillion than it has been for previous Republican administrations. However, it is not only an arithmetic fact that Republican administrations run large deficits (Chart 4), it is also a fact that they tend to get more than they ask from Congress. Chart 5 shows, with astonishing consistency, that Congress is only a check on Democratic presidents when it comes to the final size of appropriation bills, whereas Republican presidents always managed to get Congress to approve more funding than they asked for. Chart 4Fact: Republicans Run##br## Bigger Budget Deficits Fact: Republicans Run Bigger Budget Deficits Fact: Republicans Run Bigger Budget Deficits Chart 5Budgets: Republican Presidents ##br##Get What They Want Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Bottom Line: It remains difficult to gauge the actual size or economic impact of Trump's government spending proposals. However, we expect that President Trump will get his way on more spending not only for defense, veterans, and the wall, but also for infrastructure. While the impact will be minimal in 2017, investors should see greater fiscal thrust in 2018. Mercantilism While the media focused on the magnanimous tone of Trump's speech last week, we saw little change in his commitment to mercantilism. We continue to believe that Trump is a populist protectionist and that he is serious about enacting mercantilist policies.7 Recent government appointments (Table 2) and statements from the Trump administration (Table 3) suggest that we are correct. Table 2Government Appointments That Certify That Trump Is A Protectionist Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was In his speech, Trump invoked President Abraham Lincoln's words that "abandonment of the protective policy by the American Government [will] produce want and ruin among our people."8 He went on to call for "fair trade," contrasted explicitly with "free trade," and to suggest that he would support changing the U.S. corporate tax system to make U.S. exports more competitive. Trump also said on February 24, in a Reuters interview, that he thought that the border adjustment tax would boost exports and help keep jobs in the U.S.9 This should end the speculation - prompted by an early comment from Trump on the BAT - that the president and congressional GOP are irreconcilably at odds over the BAT. Table 3Protectionist Statements From The Trump Administration Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was While Trump has yet to endorse Ryan's BAT proposal officially, he does not oppose its protectionist aspects. As a reminder, the BAT is protectionist because of two key elements: The BAT would give a "rebate" on exports (implicitly or explicitly) that could be higher than the amount of tax due on foreign profits (Diagram 1). For all intents and purposes, this is a dirigiste government subsidy for export-oriented industries. Diagram 1Explaining The Border-Adjusted Destination-Based Cash-Flow Tax Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was The BAT would allow companies to write off wages and salaries as costs, just like under the current corporate income tax system. But under the value-added tax systems of the rest of the world wages are not deductible. In addition, Trump still retains a bevy of traditional tools like tariffs with which to go after potential trade rivals. As we have pointed out since November, there are few constraints on a U.S. president when imposing protectionist measures.10 Bottom Line: Donald Trump remains committed to a mercantilist agenda. Investors should expect him to live up to the hype at some point in 2017. Investment Implications If markets have been cheering Trump's pro-growth policies, in addition to improving global growth data, we suspect the stock-market party will continue. Investors can take from President Trump's March 1 speech a renewed commitment to a populist agenda that should cause government spending to increase, regulations to be cut, corporate and individual tax rates to fall, and the budget deficit to widen. Won't this pursuit of nominal GDP growth at any cost create conditions for inflation and eventually a recession? Yes, but the timing is difficult to gauge and much will depend on whether Donald Trump replaces the doves on the Fed governing board with hawks, as current conventional wisdom has it. We highly doubt that he would chose hawks, or policymakers committed to rules-based central banking, given his singular focus on reviving economic growth. But even a dovish Fed may move to raise interest rates aggressively given the slate of pro-growth policies being undertaken so late in the economic cycle. In the meantime, on a cyclical horizon, the party will continue and stocks will go higher. As we posited two weeks ago, many of our clients are cautious and tactically bearish, expecting a correction, but we cannot find a single structural bear. In this environment, where everyone expects to "buy on dips" following the correction that never seems to happen, it is hard for a correction to happen. But isn't protectionism and a trade war between the U.S. and China, or even the rest of the world, a risk to the rally? Not necessarily. First, the timing is uncertain. Second, the impact on economic growth is even more uncertain. Third, aside from any knee-jerk selloffs, protectionism will split sectors and stocks into winners and losers. Those with a greater share of revenues abroad will suffer due to potential retaliation from America's trade partners. Furthermore, much of Trump's policies will be dollar bullish - including tax cuts, greater government spending, and likely the BAT. As such, export-oriented sectors and companies will stand to suffer. We continue to believe that an overweight position in small caps will be a way to play the "Trump effect" on a strategic basis. Europe - Election Update Europe's election season is heating up, with the Dutch election just a week away and the first round of the French presidential election in just over a month. Here is a quick update on the key developments: The Netherlands According to the latest polls from the Netherlands, the Euroskeptic Party for Freedom (PVV) appears to be slipping (Chart 6). Just two months ago, the PVV was projected to capture around 35 seats, a number that has now fallen to around 25. Given that the Dutch parliament has 150 seats and that the PVV has no potential allies amongst the other 13 competitive parties, this election is largely a red herring. Should investors be worried about the Netherlands' role in European integration in the future? We don't think so. Support for the euro and the EU has not slipped in the Netherlands, at least not according to the data we have presented in these pages before.11 Instead, the PVV's support has risen due to the recent migration crisis. In fact, the number of asylum seekers has correlated almost perfectly with the PVV's support level since mid-2015 when the influx began (Chart 7). Given that the migration crisis is over (and we do not expect it to restart any time soon), we suspect that the PVV's support will moderate over the next electoral cycle. Chart 6Dutch Euroskeptics Are##br## An Overstated Threat Donald Trump Is Who We Thought He Was Donald Trump Is Who We Thought He Was Chart 7Dutch Populists Are A##br## Derivative Of The Immigration Crisis Dutch Populists Are A Derivative Of The Immigration Crisis Dutch Populists Are A Derivative Of The Immigration Crisis France The French election continues to grab headlines in Europe. However, almost all the news is bad news for Marine Le Pen. First, François Bayrou, a notable centrist who captured 9.3% of the vote in the first round of the 2012 election and 18.6% in 2007, has decided not to contest the election and instead support Emmanuel Macron. Non-French media have not picked up on the significance of the endorsement. It is more important than Bayrou's 3-5% level of support in the polls suggests. While Bayrou is a centrist, he once belonged to the center-right, conservative movement and was a cabinet minister during Jacques Chirac's reign. As such, his endorsement will give Macron, a former Socialist Party minister, even more "cross-over appeal" for center-right voters in the second round against Le Pen. Chart 8Le Pen Is Facing Resistance Le Pen Is Facing Resistance Le Pen Is Facing Resistance Second, the rumored alliance between the far-left Jean-Luc Mélenchon and the left-wing candidate of the ruling Socialist Party, Benoît Hamon, has failed to materialize. Their potential alliance was one of the main concerns that many of our clients brought to us in recent meetings. Given current polling, such a marriage could have produced a singular left-wing candidacy that would have propelled either Mélenchon or Hamon into the second round. However, the alliance was always a long shot, as anyone who has followed French politics knows, given Mélenchon's staunch commitment to running on his own platform. And furthermore, arithmetically combining the polling of the two candidates makes no sense given that a singular platform would have forced compromises that would have led to serious defections by voters to other candidates. As such, the combined ticket's support level was always just a theoretical exercise. Third, the latest polls suggest that Le Pen's mini-rally has been arrested (Chart 8). She has failed to consistently break through the 40% percentile mark for the second round. Against Macron, her most likely opponent, she continues to trail by a 25-30% margin. The second-round election is on May 7, just two months away. Two months from November 8, Donald Trump trailed Hillary Clinton by just 5%. Italy Our main political concern in Europe remains Italy. Polls continue to show that Euroskeptics are gaining on the centrist parties (Chart 9). Most worryingly, Italians continue to gain confidence in life outside the EU. According to a poll that asks respondents whether they think "their country could better face the future outside of the EU," Italians are the most optimistic, next to the Brits and the historically Euroskeptic Austrians, about life outside the bloc (Chart 10). Chart 9Italian Establishment##br## Is Collapsing Italian Establishment Is Collapsing Italian Establishment Is Collapsing Chart 10AItalians Are Now The Only People In ##br##The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits Chart 10BItalians Are Now The Only People In##br## The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits Italians Are Now The Only People In The EU Who Are Like The Brits We therefore find the market's sanguine view on Italy to be myopic. Yes, the probability of an election in 2017 is declining. The ruling Democratic Party (PD) has set its leadership race for April 30, which rules out an election this summer, and former Prime Minister Matteo Renzi appears to have agreed to an election in February 2018.12 On a cyclical time horizon of 12 months, Italy is therefore not a major risk. However, once the election does take place, it could be source of considerable market volatility. At that point, investors would have to ask whether the election would take place under a new electoral law. If not, then the probability of a hung parliament would be considerable. Unless, that is, the Euroskeptic parties could form a coalition based solely on holding a referendum to leave the euro area. We doubt that the left-wing Five Star Movement (M5S) would be able to cooperate with the more staunchly Euroskeptic and right-wing Northern League and Brothers of Italy on this matter. Particularly since M5S has already begun to moderate on the issue of Euroskepticism. There is no point in speculating on an outcome of an election a year from now given that we are not even certain what electoral rules the contest would use. However, we do not think that investors should be sanguine because the likeliest outcome is governmental dysfunction. Chart 11SPD Continues Its Incredible Ascent SPD Continues Its Incredible Ascent SPD Continues Its Incredible Ascent The one thing that may help Italy in 2018 is the outcome of the German election in September. The radically Europhile chancellor-candidate of the Social Democratic Party (SPD), Martin Schulz, has continued to do well in the polls against Angela Merkel (Chart 11). On a recent tour of highly sophisticated clients in New York we were surprised that only a handful were aware of Schulz's platform and background. Even if Schulz does not win, a renewed Grand Coalition between Merkel's Christian Democratic Union and the SPD would have to take into consideration his meteoric rise. The price for a renewed Grand Coalition could be the abandonment of Merkel's reticent leadership of the euro area. Investment Implications For now, our view that the markets will climb the wall of worry in Europe in 2017 is holding up. We suspect that investors will quickly refocus their attention on Italy once the French election is out of the way. One of the best gauges of euro area breakup risk has been the performance of French bonds versus German bonds relative to the performance of Spanish and Italian bonds versus German bonds. In our view, every time French spreads have correlated highly with Spanish and Italian spreads, the euro area faced existential threats. The shaded sections of Chart 12 largely conform to the political context in Europe over the past five years. In particular, it is interesting that French yields have decoupled from their Mediterranean peers ever since the ECB's "whatever it takes" announcement. Chart 12French Spreads Are Overstated French Spreads Are Overstated French Spreads Are Overstated Until right now, that is. We think the bond market is making a mistake. France is not a risk and euro area breakup risk over the next 12 months is essentially near zero. However, the probability of a major economy leaving the euro area over the next five years is going up. This is both because of the political situation in Italy and because Euroskeptics like Marine Le Pen could take over the mantle of the "official opposition" to the "centrist consensus" running Europe. If a country like Italy exits the euro area, would the currency union be doomed? It depends, largely on how that economy were to perform post-exit. In the ceteris paribus world of macroeconomics, a massive currency devaluation post-exit would be a clear and definitive positive. However, BCA's Geopolitical Strategy was created specifically to go beyond ceteris paribus analysis. And we doubt that the euro area exit would be undertaken by pragmatic policymakers capable of taking advantage of currency devaluation while reassuring both markets and EU member states that they would pursue orthodox economic policies. As a guide for what we think would happen to Italy, we would suggest our clients read our January 2016 report on the Greek future post euro area.13 In this think piece, we argue that Greece would not become a "land of milk and honey" after exiting, largely because the political context of exit would be turbulent and lead to populist policies that would devastate the economy. As such, we would stress that while the probability of an individual member state leaving the euro area is climbing - even one as important as Italy - it does not necessarily mean that the probability of euro area dissolution is climbing at the same rate. North Korea: No Longer A Red Herring A brief word about the Korean peninsula is in order after the four North Korean missile tests on March 6 and our report last week recommending that clients steer clear of South Korean assets.14 Simply put, the Korean peninsula is a source of real geopolitical risk right now, contrary to the status quo in which North Korea was largely a red herring. We have narrated this transition since last year,15 but it boils down to the following points: North Korea is finally "arriving" at the nuclear club: It is coming upon that horizon foreseen long ago in which it possesses the ability strike the United States with a nuclear missile, however crude. The American and Japanese defense establishments are becoming more concerned, and their public opinion can follow on command.16 Trump's policy looks to be more assertive, though that is not certain. U.S.-China relations have gone sour: The worsening of Sino-American tensions makes these two more suspicious of each other's motives and simultaneously increases economic and political pressure on both Koreas. Ironically, China is currently sanctioning both North and South Korea, the latter because it is hosting the U.S. THAAD missile defense system (Chart 13). The U.S., for its part, has been rushing THAAD, which it is just now rapidly deploying after the latest North Korean launches. North Korean internal stability is overrated: It is hard to argue that Kim Jong Un has not consolidated power impressively. But this consolidation has coincided with some loosening of internal economic control to help compensate for slower Chinese growth and worse Chinese relations. Gradual marketization threatens to undermine the regime from within, yet the standard playbook of belligerence threatens to provoke sanctions with real teeth from without, like China's proposed coal import ban for the rest of this year.17 Chart 13China Hits Seoul Over U.S. THAAD Missiles China Hits Seoul Over U.S. THAAD Missiles China Hits Seoul Over U.S. THAAD Missiles Adding to the volatile mix, South Korea's right-of-center ruling party is collapsing, which affects the behavior of all the interested parties. The Constitutional Court is set to decide whether to uphold the president's impeachment as early as this week. Where is it all going? In the short term, markets will respond to the court case and elections. A ruling is expected immediately, but could take until June. A ruling ejecting the president would be positive for South Korean risk assets, as it would reduce the current extreme uncertainty. As to the long-term outlook, if everything were to happen according to the region's familiar patterns of rising and falling tensions, China's sanctions would force North Korea to offer de-escalation, a new left-wing government in South Korea would launch a bold new "Sunshine Policy" of engagement with the North, and the alignment of these three in favor of new diplomatic negotiations would drive Japan and the United States to give peace another chance despite their skepticism about the outcome. By 2018, a revival of something like the Six Party Talks, discontinued in 2009, would be on the horizon or even underway. The problem is that the usual cycle is less assured because of the North's improving capabilities and other factors above. Thus, until we see China verifiably enforce sanctions, North Korea step back from its provocations, and the Trump administration take a non-aggressive posture (with Japan following suit), the Korean peninsula will be at a heightened risk of producing geopolitical "black swan" events. Bottom Line: North Korea is shifting from a red herring to a potential black swan, at least until U.S.-China relations improve and lend some stability to the situation. Stay short KRW/THB. Marko Papic, Senior Vice President marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?" dated February 8, 2017, available at gps.bcaresearch.com. 3 For example, the 2010 "Tea Party" revolution reversed the Democrat's majority in the House with one of the most sweeping victories merely 24 months following President Obama's 2008 victory, which itself was a lot more convincing than Trump's victory over Clinton. 4 Republican Ryan Zinke won the Montana seat but left it to become Trump's Secretary of Interior; Republican Tom Price won the Georgia seat but left it to become Secretary of Health and Human Services. 5 Dynamic-scoring, also known as macroeconomic modeling, is a favorite tool of Republican legislators when passing tax cut legislation. It allows policymakers to cut taxes and then score the impact on the budget deficit holistically, taking into consideration the supposed pro-growth impact of the legislation. The same method could be used to pass "revenue-neutral" infrastructure spending, given that it too would produce higher economic growth and thus presumably higher government revenues. 6 Several income brackets would see no substantial tax cuts under the original tax cut plan proposed by the Trump campaign. Those making $15,000-$19,000 would see their tax rate increase from 10% to 12%. Those making $52,500-101,500 would see their rate stay the same at 25%, while those making $127,500-$200,500 would see their rate rise substantively, from 28% to 33%. Please see Jim Nunns et al, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016, available at www.taxpolicycenter.org. 7 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, and "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 8 President Trump failed to mention that the U.S. was - when Lincoln made the statement in 1846 - a developing economy. Nor did he mention that Lincoln made the statements not as a president but a representative. 9 Please see Holland, Steve, Reuters, "Exclusive: Trump says Republican border tax could boost U.S. jobs," dated February 24, 2017, available at reuters.com. 10 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 12 Renzi said on February 26 that "The elections are envisaged in February 2018. Fullstop." Please see Reuters, "Decision on early Italian elections up to PM Gentiloni: Renzi," dated February 26, 2017, available at reuters.com. 13 Please see BCA Geopolitical Strategy Special Report, "Greece After The Euro: A Land Of Milk And Honey?," dated January 20, 2016, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy, "Strategic Outlook 2016: Multipolarity & Markets," dated December 9, 2015, and "North Korea: A Red Herring No More?" in Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 16 Please see Mark Landler, "North Korea Nuclear Threat Cited by James Clapper, Intelligence Chief," New York Times, February 9, 2016; Siegfried S. Hecker, "The U.S. Must Talk To North Korea," New York Times, January 12, 2017, available at www.nytimes.com. See also Jeff Seldin, "N. Korea Capable of Nuclear Strike at US, Military Leader Says," Voice of America, April 7, 2015, available at www.voanews.com. In 2013, Chairman of the Joint Chiefs of Staff General Martin Dempsey said that "in the absence of concrete evidence to the contrary, we have to assume the worst case, and that's ... why we're postured as we are today," quoted in "Hagel: North Korea Near 'Red Line,'" UPI, April 10, 2013, available at www.upi.com. 17 Enforcement is as yet unclear. Please see Leo Byrne, "North Korean cargo ship moves between Chinese, DPRK coal facilities," dated March 6, 2017, available at www.nknews.org.

Highlights Nervousness and uncertainty abound within the investment community, but greed is overwhelming fear as the U.S. equity market breaks out and other stock markets test the upside. Technical conditions are stretched and a correction is overdue, but investors can at least take some comfort that earnings are rebounding and that the economic data are surprising to the upside. Upbeat leading indicators and survey data are now being reflected in a synchronized upturn of the "hard" economic data across the major economies. History shows that the risk of recession increases when the U.S. unemployment rate falls below its full employment level. Nonetheless, for extended "slow burn" expansions like the current one, inflation pressure accumulates only slowly. These late cycle phases can last for years and can be rewarding for equity investors. Stock markets are also benefiting from an earnings recovery from last year's profit recession in some of the major economies. Importantly, it is not just an energy story and is occurring even in the U.S., where companies are dealing with a strong dollar. The U.S. Administration and Congressional Republicans are considering some radical changes to the tax code and not all of them are positive for risk assets. The probability of a watered-down border tax being passed as part of a broader tax reform package is higher than the market believes. Overall, tax reform should be positive for growth and profits in the medium term, but is likely to cause near-term turbulence in financial markets. Eurozone breakup risk has re-entered investors' radar screen. Most of the political events this year will end up being red herrings. However, we are quite concerned about Italy, where support for the euro is slipping. Our Duration Checklist supports our short-duration recommendation. The FOMC will hike three times this year, while the European Central Bank and the Bank of England will adopt a more hawkish tone later in 2017 (assuming no political hiccups). The policy divergence backdrop remains positive for the U.S. dollar. Technical and valuation concerns will be a headwind, but will not block another 5-10% appreciation. The Trump Administration is very limited in its ability to engineer a weaker dollar. The robust upturn in the economic and profit data keeps us positive on the stock-to-bond total return ratio for the near term. Investors should maintain an overweight allocation to stocks versus bonds within global portfolios. The backdrop could become rockier in the second half of the year. We will be watching political trends in Italy, our leading economic indicators, and U.S. core inflation for a signal to trim risk. Feature U.S. equity markets have broken out and stock indexes in the other major markets are flirting with the top end of their respective trading ranges. Nervousness and uncertainty abound within the investment community, but greed is overwhelming fear. The latter is highlighted by the fact that our Complacency-Anxiety Indictor hit a new high for the cycle (Chart I-1). Chart I-1Complacency Indicator Signals Equity Vulnerability Complacency Indicator Signals Equity Vulnerability Complacency Indicator Signals Equity Vulnerability It is disconcerting that there has been no 15-20% equity correction for six years and that technical conditions are stretched. Nonetheless, investors can at least take some comfort that earnings are rebounding and that the economic data are surprising to the upside. As we highlight in this month's Special Report, beginning on page 22, upbeat leading indicators and survey data are now being reflected in a synchronized upturn of the "hard" economic data across the major economies. The economic and profit data are thus providing stocks with a solid tailwind at the moment. Unfortunately, the noise surrounding the Trump/GOP fiscal policy agenda is no less than it was a month ago. Investors are also dealing with another bout of euro breakup jitters ahead of upcoming elections. While most of the European pressure points will turn out to be red herrings in our view, Italy is worrisome (see below). Investors are also concerned that, even if the geopolitical risks fade and Trump's protectionist proposals get watered down, the U.S. is nearing full employment. This means that any growth acceleration this year could show up in rising U.S. wages, a more aggressive Fed and a margin squeeze. In other words, the benefits of growth could go to Main Street rather than to Wall Street. This month we research past cycles to shed some light on this concern. We remain overweight stocks versus bonds, but are watching Italy's political situation, U.S. core inflation and our leading economic indicators for signs to take profits. On a positive note, we are not concerned that the U.S. is "due" for a recession just because it has reached full employment. Late Cycle Economic And Equity Dynamics Previous economic cycles are instructive regarding the recession and margin pressure concerns. In our December 2016 issue, we presented some research in which we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment, similar to what has occurred since the Great Recession. Chart I-2 and Chart I-3 compare the current cycle to the average of two of the long cycles (the 1980s and the 1990s). We excluded the long-running 1960s expansion because the Fed delayed far too long and fell well behind the inflation curve. Chart I-2Long Expansion Comparison (I) Long Expansion Comparison (I) Long Expansion Comparison (I) Chart I-3Long Expansion Comparison (II) Long Expansion Comparison (II) Long Expansion Comparison (II) We define the 'late cycle' phase to be the time period from when the economy first reached full employment to the subsequent recession (shaded portions in Chart I-2 and Chart I-3). The average late-cycle phase for these two expansions lasted almost four years, highlighting that reaching full employment does not necessarily mean that a recession is imminent. Some studies have demonstrated that the probability of recession rises once full employment is reached. We agree with this conclusion when looking across all the post-war cycles.1 However, recessions are almost always triggered by Fed tightening into rising inflationary pressures. Such pressures are slower to emerge in 'slow burn' recoveries, allowing the Fed to proceed gradually. The Fed waited an average of 25 months to tighten policy after reaching full employment in these two long expansions, in part because core CPI inflation was roughly flat (not shown). Wage growth accelerated in both cases, but healthy productivity growth kept unit labor costs in check. The result was an extended late-cycle phase that allowed profits to continue growing. Earnings-per-share for S&P 500 companies expanded by an average of 18% in inflation-adjusted terms during the two late-cycle phases, despite the twin headwinds of narrowing profit margins and a strengthening dollar (the dollar appreciated by an average of 23% in trade-weighted terms). The stock market provided an impressive average real return of 25%. Of course, no two cycles are the same. Both the 1980s and 1990s included a financial crisis in the second half that interrupted the Fed's tightening timetable, which likely extended the expansion phases (the 1987 crash and the 1998 LTCM financial crisis). Today, unit labor costs are under control, but wage and productivity growth rates are significantly lower. The implication is that nominal GDP is expanding at a significantly slower underlying pace in this cycle, limiting the upside for top line growth in the coming years. In terms of valuation, stocks are more expensive today than they were in the second half of the 1980s. Stocks were even more expensive in the late 1990s, but that provides little comfort because the market had entered the 'tech bubble' that did not end well. We are not making the case that the current late-cycle phase will be as long or rewarding for equity holders as it was for the two previous slow-burn expansions. Indeed, fiscal stimulus this year could lead to overheating and a possible recession in late 2018 or 2019. Our point is that reaching full employment does not condemn the equity market to flat or negative returns. Indeed, the previous cycles highlight that earnings growth can be decent even with the twin headwinds of narrowing margins and a strengthening dollar. The Earnings Mini-Cycle Another factor that distinguishes the current late-cycle phase from the previous two is that the main equity markets endured an earnings recession last year that did not coincide with an economic recession. Since the mid-1980s, there have been three similar episodes (shaded periods in Chart I-4). Bottom-up analysts failed to see the profit recession coming in each case, such that actual EPS fell well short of expectations set 12 months before (the 12-month forward EPS is shown with a 12-month lag to facilitate comparison). In each case, forward EPS estimates trended sideways while actual profits contracted. Chart I-4Market Dynamics During Previous Profit Recessions (But No Economic Recession) Market Dynamics During Previous Profit Recessions (But No Economic Recession) Market Dynamics During Previous Profit Recessions (But No Economic Recession) This was followed by a recovery in profit growth that eventually closed the gap again between actual and (lagged) 12-month forward EPS. This 'catch up' phase coincided with some multiple expansion and a total return to the S&P 500 of about 8% in the late 1990s and 20% in 2013/14.2 The starting point for the forward P/E is elevated today, which means that double-digit returns may be out of reach. Nonetheless, stocks are likely to outperform bonds on a 6-12 month view. A Bird's Eye View Of The Trump Agenda The U.S. Administration and Congressional Republicans are considering some radical changes to the tax code and not all of them are positive for risk assets. We have no doubt that some sort of tax bill will be passed in 2017. The GOP faces few constraints to cutting corporate taxes and there is every reason to believe it will occur quickly. The major question is whether a broader tax reform will be passed. Trying to understand all the moving parts to tax reform is a daunting task. In order to simplify things, Table I-1 lists the main policies that are being considered, along with the economic and financial consequences of each. Some policies on their own, such as ending interest deductibility, would be negative for the economy and risk assets. However, the top three items in the table will likely be combined if a broad tax reform package is passed. Together, these three items define a destination-based cash-flow tax, which some Republicans would like to replace the existing corporate income tax. The aim is to promote domestic over foreign production, stimulate capital spending and remove a bias in the tax system that favors imports over exports. Table I-1A Bird's Eye View Of The Implications Of The Trump/GOP Fiscal Policy Agenda March 2017 March 2017 Table I-1A Bird's Eye View Of The Implications Of The Trump/GOP Fiscal Policy Agenda March 2017 March 2017 Perhaps the most controversial aspect is the border-adjustment tax (BAT), which would tax the value added of imports and rebate the tax that exporters pay. We will not get into the details of the BAT here, but interested readers should see two recent BCA reports for more details.3 The implications of the BAT for the economy and financial markets depend importantly on the dollar's response. In theory, the dollar would appreciate by enough to offset the tax paid by importers and the tax advantage gained by exporters, leaving the trade balance and the distribution of after-tax corporate profits in the economy largely unchanged. This is because a full dollar adjustment would nullify the subsidy on exports, while reducing import costs by precisely the amount necessary to restore importers' after-tax profits. A 20% border tax, for example, would require an immediate 25% jump in the dollar to level the playing field. In reality, much depends on how the Fed and other countries respond to the BAT. We believe the dollar's rise would be less than fully offsetting, but would still appreciate by a non-trivial 10% in the event of a 20% border tax. If the dollar's adjustment is only partially offsetting, then it would have the effect of boosting exports and curtailing imports, thereby adding to GDP growth and overall corporate profits. It would make it more attractive for U.S. multinational firms to produce in the U.S., rather than produce elsewhere and export to the U.S. A partial dollar adjustment would also be inflationary because import prices would rise. The smaller the dollar appreciation, the more inflationary the impact. The result would be dollar strength coinciding with higher Treasury yields, breaking the typical pattern in recent years. The impact on the U.S. equity market is trickier. To the extent that dollar strength is not fully offsetting, then the resulting economic boost will lift corporate earnings indirectly. However, the BAT will reduce after-tax profits directly. One risk is that the FOMC slams the brakes on the economy in the face of rising inflation. Another is that, with the economy already operating close to full employment, faster growth might be reflected in accelerating wage inflation that eats into profit margins. However, our sense is that the labor market is not tight enough to immediately spark cost-push inflation. As noted above, it usually takes some time for wage inflation to get a head of steam once the labor market gap is closed in a slow-burn expansion. Full employment is not a hard threshold beyond which the economy suddenly changes. Moreover, the Phillips curve has been quite flat in this recovery, suggesting that it will require significant levels of excess demand to move the dial on inflation. More likely, a slow upward creep in core PCE inflation will allow the Fed to err on the side of caution. Unintended Consequences There are a number of risks and unintended consequences associated with the border tax. One major drawback of the BAT is that, to the extent that the dollar appreciates, it reduces the dollar value of the assets that Americans hold abroad. We estimate that a 25% appreciation, for example, would impose a whopping paper loss of about 13% of GDP. Moreover, a partial dollar adjustment could devastate the profits of importers, while generating a substantial negative tax rate for exporters. It would also be disruptive to multinational supply chains and to the structure of corporate balance sheets (debt becomes more expensive relative to equity finance). Partial dollar adjustment would also be bad news for countries that rely heavily on exports to the U.S. to drive growth, especially emerging economies that have piled up a lot of dollar-denominated debt. An EM crisis cannot be ruled out. Finally, it is unclear whether or not a border tax is consistent with World Trade Organization Rules. At a minimum, it will be seen as a protectionist act by America's trading partners and could trigger a trade war. President Trump has sent conflicting views on the BAT and there has been a wave of criticism from sectors that will lose from such legislation. However, the House GOP leaders signaled a greater flexibility in drafting the law so as to win over various stakeholders. Our Geopolitical Strategy team believes that Trump will ultimately hew to the Republican Party leadership on tax reform, largely because his protectionist and mercantilist vision is fundamentally aligned with the chief aims of the BAT. Critics will be won over by the use of carve-outs and/or phased implementation for key imports like food, fuel and clothing. Interestingly, the sectors that suffer the most from the import tax also tend to pay higher effective tax rates and thus stand to benefit from the rate cuts (Chart I-5). Finally, the BAT would raise revenue that can be used to offset the corporate tax cuts, helping to sell the package to Republican deficit hawks. Chart I-5Cuts In Tax Rates Mitigate A New Import Tax Somewhat March 2017 March 2017 But even if the border adjustment never sees the light of day, there will certainly be tax cuts for both corporations and households, along with specific add-ons to deal with concerns like corporate inversions and un-repatriated corporate cash held overseas. An infrastructure plan and cuts to other discretionary non-defense government spending also have a high probability, although the amounts involved may be small. An outsourcing tax has a significant, though less than 50%, chance of occurring in the absence of a border tax. On its own, an outsourcing tax would be negative for growth, profits and equity returns. We place a 50/50 chance on a broad tax reform package that includes the border adjustment. We believe that a broad tax reform package will ultimately be positive for the bottom line for the corporate sector as a whole, although unintended consequences will complicate the path to higher stock prices. Eurozone: Breakup Risk Resurfaces Investors have lots to consider on the other side of the Atlantic as well. The European election timetable is packed and plenty is at stake. Could we see a wave of populism generate game-changing political turmoil in the E.U., as occurred in the U.S. and U.K.? Our geopolitical strategists believe that European risks are largely red-herrings for 2017. Investors are overestimating most of the inherent risks:4 In the Netherlands, the Euroskeptic Party for Freedom is set to capture about 30 out of 150 seats in the March election. However, that is not enough to win a majority. Dutch support for the euro is at a very high level, while voters lack confidence in the country's future outside of the EU. Support for the euro is also elevated in France, limiting the chance that Le Pen will win the upcoming presidential election. Even if she is somehow elected, it is unlikely that she would command a majority of the National Assembly. Exiting the Eurozone and EU would necessitate changing the constitution, possibly requiring a referendum that Le Pen would likely lose. That said, these constraints may not be clear to investors, sparking a market panic if Le Pen wins the election. The German public is not very Euroskeptic either and anti-euro parties are nowhere close to governing. Markets may take a Merkel loss at the hands of the SPD negatively at first. However, the new SPD Chancellor candidate, Martin Schulz, is even more supportive of the euro than Merkel and he would be less insistent on fiscal austerity in the Eurozone. A handover of power to Schulz would ultimately be positive for European stocks. The Catlan independence referendum in September could cause knee-jerk ripples as well. Nonetheless, without recognition from Spain, and no support from EU and NATO member states, Catlonia cannot win independence with a referendum alone. Greece faces a €7 billion payment in July, by which time the funding must be released or the government will run out of cash. The IMF refuses to be involved in any deal that condones Greece's unsustainable debt path. If a crisis emerges, the likely outcome would be early elections. While markets may not like the prospect of an election, the pro-euro and pro-EU New Democratic Party (NDP) is polling well above SYRIZA. The NDP would produce a stable, pro-reform government that would be positive for growth and financial markets. It is a different story in Italy, where an election will occur either in the autumn or early in 2018. Support for the common currency continues to plumb multi-decade lows, while Italian confidence in life outside the EU is perhaps the greatest on the continent (Chart I-6 and Chart I-7). Euroskeptic parties are gaining in popularity as well. The possibility of a referendum on the euro, were a Euroskeptic coalition to win, would obviously be very negative for risk assets in Europe and around the world. Chart I-6Italians Turning Against The Euro Italians Turning Against The Euro Italians Turning Against The Euro Chart I-7Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU The implication is that most of the risks posed by European politics should cause no more than temporary volatility. The main exception is Italy. We will be watching the Italian polls carefully in the coming months, but we believe that the widening in French/German bond spreads presents investors with a short-term opportunity to bet on narrowing.5 Bond Bear Market Is Intact These geopolitical concerns and uncertainty over President Trump's policy priorities put the cyclical bond bear market on hold early in the New Year, despite continued positive economic surprises. Even Fed Chair Yellen's hawkish tone in her recent Congressional testimony failed to move long-term Treasury yields sustainably higher, after warning that "waiting too long to remove accommodation would be unwise." In the money markets, expectations priced into the overnight index swap curve have returned to levels last seen on the day of the December 2016 FOMC meeting (Chart I-8). The market is priced for 53 basis points of rate increases between now and the end of the year, with a 26% chance that the next rate hike occurs in March. March is too early to expect the next FOMC rate hike. One reason is that core PCE inflation has been stuck near 1.7% and we believe it will rise only slowly in the coming months. Even though the strong January core CPI print seemed to strengthen the case for a March hike, the details of the report show that only a few components accounted for most of the gains. In fact, our CPI diffusion index fell even further below the zero line. With both our CPI and PCE diffusion indexes in negative territory, inflation may even soften temporarily in the coming months. This would take some heat off of the FOMC (Chart I-9). Chart I-8Fed Rate Expectations Shift Toward Dots Fed Rate Expectations Shift Toward Dots Fed Rate Expectations Shift Toward Dots Chart I-9U.S. Inflation May Soften Temporarily U.S. Inflation May Soften Temporarily U.S. Inflation May Soften Temporarily Second, Fed policymakers will want to see how the Trump policy agenda shakes out in the next few months before moving. We still expect three rate hikes this year, beginning in June. The stance of central bank policy is on our Duration Checklist, as set out by BCA's Global Fixed Income Strategy service (Table I-2). We will not go through all the items on the checklist, but interested readers are encouraged to see our Special Report.6 Table I-2Stay Bearish On Bonds March 2017 March 2017 Naturally, leading and coincident indicators for global growth feature prominently in the Checklist. And, as we highlight in this month's Special Report, a synchronized global growth acceleration is underway that is broadly based across economies, consumer and business sectors, and manufacturing and services industries. Our indicators for private spending suggest that real GDP growth in the major countries accelerated sharply between 2016Q3 and the first quarter of 2017, to well above a trend pace. In the Euro Area, jobless rate has been declining quickly and reached 9.6% in January, the lowest level in nearly eight years. Even if economic growth is only 1½% in 2017 (i.e. below our base case), the unemployment rate could reach 9% by year-end, which would be close to full employment. Core inflation already appears to be bottoming and broad disinflationary pressures are abating. When the ECB re-evaluates its asset purchase program around the middle of this year, policymakers could be faced with rising inflation and an economy that has exhausted most of its excess slack. At that point, possibly around September, ECB members will begin to hint that the asset purchases will be tapered at the beginning of 2018. Moreover, the annual growth rate of the ECB's balance sheet will peak by around mid-year and then trend lower (Chart I-10). This inflection point, along with expectations that the ECB will taper further in 2018, will place upward pressure on both European and global bond yields. The Bank of England (BoE) may become more hawkish as well. At the February BoE meeting, policymakers re-iterated that they are willing to look through a temporary overshoot of the inflation target that is related to pass-through from the weak pound and higher oil prices. However, the BoE has its limits. The Statement warned that tighter policy may be necessary if wage growth accelerates and/or consumer spending growth does not moderate in line with the BoE's projection. In the absence of Brexit-related shocks, the BoE is unlikely to see the growth slowdown it is expecting, given healthy Eurozone economic activity and the stimulus provided by the weak pound. Investors should remain positioned for Gilt underperformance of global currency-hedged benchmarks (Chart I-11). Chart I-10Bond Strategy And ##br## The ECB Balance Sheet Bond Strategy And The ECB Balance Sheet Bond Strategy And The ECB Balance Sheet Chart I-11Gilts To Underperform Gilts To Underperform Gilts To Underperform Outside of central bank policy, a majority of items on the Duration Checklist are checked at the moment, indicating that investors with a 3-12 month view should maintain below-benchmark duration within bond portfolios. That said, technical conditions are a headwind to higher yields in the very near term. Oversold conditions and heavy short positioning suggest that yields will have a tough time rising quickly as the market continues to consolidate last year's sharp selloff. Can Trump Force Dollar Weakness? Chart I-12Trump Can't Weaken ##br## Dollar With Tweets For Long Trump Can't Weaken Dollar With Tweets For Long Trump Can't Weaken Dollar With Tweets For Long The U.S. dollar appears to have recently decoupled from shifts in both nominal and real interest rate differentials this year (Chart I-12). The dollar is expensive, but we do not believe that valuation is a barrier to an extended overshoot given the backdrop of diverging monetary policies between the U.S. and the other major central banks. The dollar's recent stickiness appears to be driven by recent comments from the new Administration that the previous 'strong dollar' policy is a relic of the past. Let us put aside for the moment the fact that expansionary fiscal policy, higher import tariffs and/or a border tax would likely push the dollar even higher. "Tweeting" that the U.S. now has a 'weak dollar' policy will have little effect beyond the near term. A lasting dollar depreciation would require changes in the underlying macro fundamentals and policies. President Trump would have to do one of the following: Force the Fed to ease policy rather than tighten. However, the impact may be short-lived because accelerating inflation would soon force the Fed to tighten aggressively. Convince the other major central banks to tighten their monetary policies at a faster pace than the Fed (principally, the People's Bank of China, the BoJ, the ECB, Banco de Mexico, and the Bank of Canada). Again, the impact on the dollar would be fleeting because premature tightening in any of these economies would undermine growth and investors would conclude that policy tightening is unsustainable. Convince these same countries to implement very expansionary fiscal policies. This has a better chance of sustainably suppressing the dollar, but foreign policy would have to be significantly more stimulative than U.S. fiscal policy. The U.S. Administration will not be able to force the Fed's hand or convince other countries to change tack. President Trump has an opportunity to stack the FOMC with doves if he wishes next year, given so many vacant positions. Nonetheless, Trump's public pronouncements on monetary policy have generally been hawkish. It will be difficult for him to make a complete U-turn on the subject, especially since Congressional Republicans would likely resist. This means that the path of least resistance for the dollar remains up. Dollar valuation is stretched and market technicals are a headwind to the rally. However, valuation signals in the currency market have a poor track record at making money on a less than 2-year horizon. The dollar is currently about 8% overvalued by our measure, which is far from the 20-25% overvaluation level that would justify short positions on valuation grounds alone (Chart I-13). What is more concerning for dollar bulls is that there is near universal unanimity on the trade. Nonetheless, both sentiment and net speculative positions are not nearly as stretched as they were at the top of the Clinton USD bull market (Chart I-14). Moreover, it took six years of elevated bullishness and long positioning to prompt the end of the bull market in 2002. We believe that the dollar will appreciate by another 5-to-10% in real trade-weighted terms by the end of the year, despite lopsided market positioning. The appreciation will be even greater if a border tax is implemented. Chart I-13Dollar is Overvalued, But Far From an Extreme Dollar is Overvalued, But Far From an Extreme Dollar is Overvalued, But Far From an Extreme Chart I-14In The 1990s, The Concensus Was Right In The 1990s, The Concensus Was Right In The 1990s, The Concensus Was Right Conclusions Many investors, including us, have been expecting an equity market correction for some time. But the longer that the market goes without a correction, the "fear of missing out" forces more investors to throw in the towel and buy. This market backdrop means that now is not the best time to commit fresh money to stocks, but we would not recommend taking profits either. On a positive note, the U.S. economy is not poised on the edge of recession just because it has reached full employment. Indeed, a synchronized growth acceleration is underway across the major countries that is broadly based across industries. Inflationary pressure is building only slowly in the U.S., which gives the Fed room to maneuver. Moreover, the Trump Administration has not labelled China a currency manipulator, and has sounded more conciliatory toward NATO and the European Union in recent days. This is all good news, but the direction of U.S. fiscal policy remains highly uncertain. Moreover, investors must navigate a host of geopolitical landmines in Europe this year, most important of which is an Italian election that may occur in the autumn. The ECB and the BoE will likely become more hawkish in tone later this year. The impressive upturn in the economic and profit data keeps us positive on the stock-to-bond total return ratio for the near term. Investors should maintain an overweight allocation to stocks versus bonds within global portfolios. The backdrop could become rockier for risk assets in the second half of the year. We will be watching political trends in Italy, our leading economic indicators, and U.S. core inflation among other factors for a signal to trim risk. Our other recommendations include: Maintain below-benchmark duration within bond portfolios. Overweight Eurozone government bonds relative to the U.S. and U.K. in currency-hedged portfolios. Overweight European and Japanese equities versus the U.S. in currency-hedged portfolios. Be defensively positioned within equity sectors to temper the risk associated with overweighting stocks versus bonds. In U.S. equities, maintain a preference for exporting companies over those that rely heavily on imports. Overweight investment-grade corporate bonds relative to government issues, but stay underweight high-yield where value is very stretched. Within European government bond portfolios, continue to avoid the Periphery in favor of the core markets. Fade the widening in French/German spreads. Overweight the dollar relative to the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market, on expected policy changes that will disproportionately favor small companies. We are bullish on oil prices in absolute terms on a 12-month horizon, and recommend favoring this commodity relative to base metals. Mark McClellan Senior Vice President The Bank Credit Analyst February 23, 2017 Next Report: March 30, 2017 1 Indeed, this must be true by definition. 2 The S&P 500 contracted during 1987 because of the market crash. 3 Please see BCA Global Investment Strategy "U.S. Border Adjustment Tax: A Potential Monster Issue for 2017," dated January 20, 2017. Also see: BCA Geopolitical Strategy "Will Congress Pass The Border Adjustment Tax?", dated February 8, 2017. 4 Please see Global Political Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017. 5 Please see Global Political Strategy Special Report, "Our Views On French Government Bonds," dated February 7, 2017. 6 Please see Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasurys And German Bunds," dated February 15, 2017. II. Global Growth Pickup: Fact Or Fiction? Risk assets have discounted a lot of good economic news. There is concern that the growth impulse evident in surveys of business activity and confidence has been slow to show up clearly in the "hard" economic data related to final demand. If the optimism displayed in the survey data is simply reflecting "hope" for less government red tape, tax cuts and infrastructure spending in the U.S., then risk assets are highly vulnerable to policy disappointment. After a deep dive into the economic data for the major countries, we have little doubt that a tangible growth acceleration is underway. Momentum in job creation has ebbed, but retail sales, industrial production and capital spending are all showing more dynamism in the advanced economies. Evidence of improving activity is broadly-based across countries and industrial sectors (including services). Orders and production are gaining strength for goods related to both business and household final demand. Inventory rebuilding will add to growth this year, but this is not the main story. The energy revival is not the main driver either. Indeed, energy production has lagged the overall pick-up in industrial production growth. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our models, based largely on survey data, point to a significant acceleration in G7 real GDP growth in early 2017. Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. A return of animal spirits could prolong a period of robust growth, even if President Trump's growth-boosting policies are delayed or largely offset by spending cuts. This economic backdrop is positive for risk assets and bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this current cyclical upturn will be any more resilient and enduring than previous mini-cycles in this lackluster expansion. Much depends on U.S. policy and European politics in 2017. The so-called Trump reflation trades lost momentum in January, but the dollar and equity indexes are on the rise again as we go to press. A lot of recent volatility is related to the news flow out of Washington, as investors gauge whether President Trump will prioritize the growth-enhancing aspects of his policy agenda over the ones that will hinder economic activity. Much is at stake because it appears that risk assets have discounted a lot of good economic news. Investors have taken some comfort from the fact that leading indicators are trending up across most of the Developed Markets (DM) and Emerging Markets (EM) economies. In the major advanced economies, only the Australian leading indicator is not above the boom/bust mark and rising. Our Global Leading Economic Indicator is trending higher and it will climb further in the coming months given that its diffusion index is well above 50 (Chart II-1). The Global ZEW indicator and the BCA Boom/Bust growth indicator are also constructive on the growth outlook (although the former ticked down in February). Consumers and business leaders are feeling more upbeat as well, both inside and outside of the U.S. (Chart II-2). The improvement in sentiment began before the U.S. election. Surveys of business activity, such as the Purchasing Managers Surveys (PMI), are painting a uniformly positive picture for near-term global output in both the manufacturing and service industries. Chart II-1A Consistent, Positive ##br## Message On Growth A Consistent, Positive Message On Growth A Consistent, Positive Message On Growth Chart II-2Surging Confidence, ##br## Production Following Suit Surging Confidence, Production Following Suit Surging Confidence, Production Following Suit While this is all good news for risk assets, there is concern that a growth impulse has been slow to show up clearly in the "hard" economic data related to final demand. Could it be that the bounce in confidence is simply based on faith that U.S. fiscal policy will be the catalyst for a global growth acceleration? Could it be that, beyond this hope, there is really nothing else to support a brighter economic outlook? Is it the case that the improved tone in the survey data only reflects the end of an inventory correction and a rebound in energy production? If the answer is 'yes' to any of these questions, then equity and corporate bond markets are highly vulnerable to U.S. policy disappointment. This month we take deep dive into the economic data for the major economies. The good news is that there is more to the cyclical upturn than hope, inventories or energy production. The improved tone in the forward-looking data is now clearly showing up in measures of final demand. The caveat is that there is no evidence yet that the cyclical mini up-cycle in 2017 is any less vulnerable to negative shocks than was the case in previous upturns since the Great Recession. The Hard Data First, the bad news. There has been a worrying loss of momentum in job creation, although the data releases lag by several months in the U.K. and the Eurozone, making it difficult to get an overall read on payrolls into year-end (Charts II-3 and II-4).1 Job gains have accelerated in recent months in Japan, Canada and Australia. The payroll slowdown is mainly evident in the U.S. and U.K. This may reflect supply constraints as both economies are near full employment, but it is difficult to determine whether it is supply or demand-related. The good news is that the employment component of the global PMI has rebounded sharply following last year's dip, suggesting that the pace of job creation will soon turn up. Chart II-3Global Employment Growth Cooling Off (I) Global Employment Growth Cooling Off (I) Global Employment Growth Cooling Off (I) Chart II-4Global Employment Growth Cooling Off (II) Global Employment Growth Cooling Off (II) Global Employment Growth Cooling Off (II) On the positive side, households are opening their wallets a little wider according to the retail sales data (Chart II-5 and Chart II-6). Year-over-year growth of a weighted average of nominal retail sales for the major advanced economies (AE) has accelerated to about 3%, and the 3-month rate of change has surged to 8%. Sales growth has accelerated sharply in all the major economies except Australia. The retail picture is less impressive in volume terms given the recent pickup in headline inflation, but the consumer spending backdrop is nonetheless improving. The major exception is the U.K., where inflation-adjusted retail sales have lost momentum in recent months. Chart II-5On Your Mark, Get Set, Shop!! (I) On Your Mark, Get Set, Shop!! (I) On Your Mark, Get Set, Shop!! (I) Chart II-6On Your Mark, Get Set, Shop!! (II) On Your Mark, Get Set, Shop!! (II) On Your Mark, Get Set, Shop!! (II) Similarly, business capital spending is finally showing some signs of life following a rocky 2015 and early 2016. An aggregate of Japanese, German and U.S. capital goods orders2 is a good leading indicator for G7 real business investment (Chart II-7). Order books began to fill up in the second half of 2016 and the year-over-year growth rate appears headed for double digits in the coming months. The pickup is fairly widespread across industries in Germany and the U.S., although less so in Japan. The acceleration of imported capital goods for our 20 country aggregate corroborates the stronger new orders reports (Chart II-7, bottom panel). Recent data on industrial production show that the global manufacturing sector is clearly emerging from last year's recession. Short-term momentum in production growth has accelerated over the past 3-4 months across most of the major advanced economies (Chart II-8 and Chart II-9). Chart II-7Global Capex Cycle Turning Positive... Global Capex Cycle Turning Positive... Global Capex Cycle Turning Positive... Chart II-8...Driving A Global Manufacturing Upturn ... Driving A Global Manufacturing Upturn ... Driving A Global Manufacturing Upturn Chart II-9Global Manufacturing Upturn Global Manufacturing Upturn Global Manufacturing Upturn The fading of the negative impacts of the oil shock and last year's inventory correction are playing some role in the manufacturing rebound, but there is more to it than that. The production upturn is broadly-based across sectors in Japan and the U.K., although less so in the Eurozone and the U.S. Industrial output related to both household and capital goods is showing increasing signs of vigor in recent months (Chart II-10). Interestingly, energy-related production is not a driving force. Indeed, energy production is lagging the overall improvement in industrial output growth, even in the U.S. where the shale oil & gas sector is tooling up again (Chart II-11). Chart II-10A Broad-Based Acceleration A Broad-Based Acceleration A Broad-Based Acceleration Chart II-11Energy Is Not The Main Driver Energy Is Not The Main Driver Energy Is Not The Main Driver The Boost From Inventories And Energy Some inventory rebuilding will undoubtedly contribute to the rebound in industrial production and real GDP growth in 2017. The inventory contribution has been negative for 6 quarters in a row for the major advanced economies, which is long for a non-recessionary period (Chart II-12). We estimate that U.S. industrial production growth will easily grow in the 4-5% range this year given a conservative estimate of manufacturing shipments and a flattening off in the inventory/shipments ratio (which will require some inventory restocking; Chart II-13). Chart II-12Global Inventory Correction Is Over Global Inventory Correction Is Over Global Inventory Correction Is Over Chart II-13U.S. Manufacturing Outlook Is Bullish U.S. Manufacturing Outlook Is Bullish U.S. Manufacturing Outlook Is Bullish Nonetheless, the inventory cycle is not the main story for 2017. The swing in inventories seldom contributes to annual real GDP growth by more than a tenth of a percentage point for the major countries as a whole outside of recessions. Moreover, inventory swings generally do not lead the cycle; they only reinforce cyclical upturns and downturns in final demand. U.S. industrial production growth this year will undoubtedly exceed the 4-5% rate discussed above because that estimate does not include a resurgence of capital spending in the energy patch. BCA's Energy Sector Strategy service predicts that energy-related capex will surge by 40% in 2017, largely in the shale sector (Chart II-13, bottom panel). Even if energy capital spending outside the U.S. is roughly flat, as we expect, this would be a major improvement relative to the 15-20% contraction last year. According to Stern/NYU data, energy-related investment spending currently represents about a quarter of total U.S. capital spending.3 Thus, a 40% jump in energy capex would boost overall U.S. business investment in the national accounts by an impressive 10 percentage points. This is a significant contribution, but at the moment the upturn in manufacturing production is being driven by a broader pickup in business spending. The acceleration in production and orders related to consumer goods in the major countries suggests that household final demand is also showing increased vitality, consistent with the retail sales data. Soft Survey Data Notwithstanding the nascent upturn in the hard data, some believe that the soft data are sending an overly constructive signal in terms of near-term growth. The soft data generally comprise measures of confidence and surveys of business activity. One could discount the pop in U.S. sentiment as simply reflecting hope that election promises to cut taxes, remove red tape and boost infrastructure spending will come to fruition. Nonetheless, improved sentiment readings are widespread across the major countries, which means that it is probably not just a "Trump" effect. Moreover, there is no reason to doubt the surveys of actual business activity. Surveys such as the PMIs, the U.K. CBI Business Survey, the German IFO current conditions index and the Japanese Tankan survey all include measures of activity occurring today or in the immediate future (i.e. 3 months). There is no reason to believe that these surveys have been contaminated by "hope" and are sending a false signal on actual spending. We analyzed a wide variety of survey data and combined the ones that best lead (if only slightly) consumer and capital spending into indicators of private final demand (Chart II-14 and Chart II-15). A wide swath of confidence and survey data are rising at the moment, with few exceptions. Moreover, the improvement is observed in both the manufacturing and services sectors, and for both households and businesses. We employed these indicators in regression models for real GDP in the four major advanced economies and for the G7 as a group (Chart II-16). The models predict that G7 real GDP growth will accelerate to 2½% on a year-over-year basis in the first quarter, from 1½% in 2016 Q3. We expect growth of close to 3% in the U.S. and about 2½% in the Eurozone, although the model for the latter has been over-predicting somewhat over the past year. Japanese growth should accelerate to about 1.7% in the first quarter based on these indicators. Chart II-14Our Consumer Indicators Have Turned Up... Our Consumer Indicators Have Turned Up... Our Consumer Indicators Have Turned Up... Chart II-15...Our Capex Indicators Too ...Our Capex Indicators Too ...Our Capex Indicators Too Chart II-16Real Growth To Accelerate Real Growth To Accelerate Real Growth To Accelerate The outlook is less impressive for the U.K. While the survey data have revealed the biggest jump of the major countries in recent months, this represents a rebound from last years' Brexit-driven plunge. Nonetheless, current survey levels are consistent with continued solid growth. The implication is that the survey data are not sending a distorted message; underlying growth is accelerating even though it is only now showing up in the hard economic data. Turning for a moment to the emerging world, output is picking up on the back of an upturn in exports. However, we do not see much evidence of a domestic demand dynamic that will help to drive global growth this year. The main exception is China, where private sector capital spending growth has clearly bottomed. Infrastructure spending in the state-owned sector is slowing, but overall industrial capital spending growth has turned up because of private sector activity. An easing in monetary conditions last year is lifting growth and profitability which, in turn, is generating an incentive for the business sector to invest. There are also budding signs of recovery in housing-related investment. Stronger Chinese capital spending in 2017 will encourage imports and thereby support activity in China's trading partners, particularly in Asia. Will The Growth Impulse Have Legs? The cyclical dynamics so far appear a lot like the rebound in global growth following the 2011/12 economic soft patch and inventory correction (Chart II-17). That mini cycle was caused by a second installment of the Eurozone financial crisis. The damage to confidence and the tightening in financial conditions sparked a recession on the European continent and a loss of economic momentum globally. The financial situation in Europe began to improve in 2013. Consumer spending growth in the major advanced economies was the first to turn up, followed by capital spending, industrial production and, finally, hiring. Then, as now, the upturn in the surveys led the hard data. Unfortunately, the growth surge was short-lived because the 2014/15 collapse in oil prices undermined confidence and tightened financial conditions once again. The result was a manufacturing recession and inventory correction in 2016. There are reasons to believe that the cyclical upturn will have legs this time. It is good news that the growth impetus is observed in both the manufacturing and service sectors, and that it is widespread across the major advanced economies. Fiscal policy will likely be less restrictive this year than in 2014/15, and our sense is that some of the lingering scar tissue from the Great Recession is beginning to fade. The latter is probably most evident in the case of the U.S.; a Special Report from BCA's U.S. Investment Strategy service highlighted that the U.S. expansion has become more self-reinforcing.4 In the U.S. business sector, it appears that "animal spirits" have been stirred by the promise of less government red tape, lower taxes and protection from external competitive pressures. Regional Fed surveys herald a surge in capital spending plans in the next six months (Chart II-18). The rebound in corporate profitability also bodes well for capital spending. Chart II-17Consumers Usually Lead At Turning Points... Consumers Usually Lead At Turning Points... Consumers Usually Lead At Turning Points... Chart II-18...But Capex Appears To Be Leading Now ...But Capex Appears To Be Leading Now ...But Capex Appears To Be Leading Now Conclusions: We have little doubt that a meaningful global growth acceleration is underway. It is possible that consumer and business confidence measures are contaminated by hopes of policy stimulus in the U.S., but there is widespread verification from survey data of current spending that real final demand growth accelerated in 2016Q4 and 2017Q1. In terms of the hard data, evidence of improving manufacturing output and capital spending is broadly-based across industrial sectors and countries, suggesting that there is more going on than the end of an inventory correction and energy rebound. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. CEOs appear to have more swagger these days. Since the start of the year there have been a slew of high-profile announcements of fresh capital spending and hiring plans from companies such as Amazon, Toyota, Walmart, GM, Lockheed Martin and Kroger. A return of animal spirits could prolong a period of stronger growth, which would be positive for risk assets and the dollar, but bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this cyclical upturn will be any more enduring than previous mini-cycles in this lackluster expansion. The economy may be just as vulnerable to shocks as was the case in 2014. As discussed in the Overview, there are numerous risks that could truncate the economic and profit upswing. On the U.S. policy front, tax cuts and some more infrastructure spending would be positive for risk assets on their own. However, the addition of the border tax or the implementation of other trade restrictions would disrupt international supply chains, abruptly shift relative prices and possibly generate a host of unintended consequences. And in Europe, markets have to navigate a minefield of potentially disruptive elections this year. Any resulting damage to household and business confidence could short-circuit the upturn in growth. For now, we remain overweight equities and corporate bonds relative to government bonds in the major countries, but political dynamics may force a shift in asset allocation as we move through the year. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Note that where only non-seasonally adjusted data is available, we have seasonally-adjusted the data so that we can get a sense of short-term momentum via the annualized 3-month rate of change. 2 Machinery orders used for Japan. 3 Please see http://www.stern.nyu.edu/ 4 Please see U.S. Investment Strategy Special Report "The State Of The Economy In Pictures," dated January 30, 2017. III. Indicators And Reference Charts The breakout in the S&P 500 over the past month has further stretched valuation metrics. The Shiller P/E is very elevated, and the price/sales ratio is almost back to the tech bubble peak. However, our composite valuation indicator is still slightly below the one sigma level that marks significant overvaluation. This composite indicator comprises 11 different measures of value. The monetary indicator is slightly negative, but not dangerously so for stocks. Technical momentum is positive, although several indicators suggest that the equity rally is stretched and long overdue for a correction. These include our speculation indicator, composite sentiment and the VIX. Forward earnings estimates are still rising, although it may be a warning sign that the net earnings revisions ratio has rolled over. Our Willingness-to-Pay (WTP) indicators continue to send a positive message for stock markets. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The WTP indicators have turned up for the Japanese, Eurozone and U.S. markets, although only the latter is sending a particularly bullish message at the moment. The U.S. WTP has risen above the 0.95 level that historically provides the strongest bullish signal for the stock-to-bond total return ratio. The WTP indicator suggests that, after loading up on bonds last year, investors still have "dry powder" available to buy stocks as risk tolerance improves. Bond valuation is roughly unchanged from last month at close to fair value, as long-term yields have been stuck in a trading range. The Treasury technical indicator suggests that oversold conditions have not yet been fully unwound, suggesting that the next leg of the bear market may take some time to develop. The dollar is extremely expensive based on the PPP measure shown in this section. However, other measures suggest that valuation is not yet at an extreme (see the Overview). Technically overbought conditions are still being unwound according to our dollar technical indictor. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market ##br## And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market ##br## And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Highlights European populism is a red herring in 2017; France is a buy, Le Pen is overrated; Merkel's demise would be an opportunity, not a risk; Yet Italy poses a real risk - elections will be crucial; Moreover, Euro breakup risk is rising over the long run. Feature Clients are nervous. Nationalist and Euroskeptic French presidential candidate Marine Le Pen continues to lead first-round polling in the elections. Meanwhile, one of her establishment opponents - François Fillon - is facing corruption charges while anti-police riots have flared up in the banlieue of Aulnay-sous-Bois, northeast of Paris. Everything seems to be falling in place for another "black swan" political outcome (Chart 1). With Brexit and President Trump's victory fresh in everyone's consciousness, it is unsurprising that Le Pen's election probability is more than double our own assessment of 15% (Chart 2). Chart 1Another Black Swan In The Making? Climbing The Wall Of Worry In Europe Climbing The Wall Of Worry In Europe Chart 2Brexit/Trump Drive Up Bets On Le Pen Brexit/Trump Drive Up Bets On Le Pen Brexit/Trump Drive Up Bets On Le Pen In this analysis, we take our clients around Europe in under 3,000 words. There is a lot happening on the continent this year. Yet, as we argued in our Strategic Outlook, Europe is setting up to be a massive red herring for investors.1 For example, France is more likely to have a free-market revolution than a populist one! It could be the chief investment opportunity in developed markets over the next several years.2 We are also optimistic about the Netherlands and Germany, despite alarms about populism. As such, we are going to play devil's advocate in this analysis and push our sanguine view to its limit. Where does our bullish logic break down? The Netherlands We begin with the Netherlands, which is the first to hit a busy electoral calendar in 2017. General elections are set for March 15 and the Euroskeptic Party for Freedom (PVV) of Geert Wilders will win a plurality of seats in the House of Representatives. According to the latest polls, Wilders' PVV will capture about 30 out of the 150 seats in the Tweede Kamer, the largest of any party. However, it is not enough to form a majority (Chart 3). Chart 3Dutch Populists A Minority In Parliament Climbing The Wall Of Worry In Europe Climbing The Wall Of Worry In Europe The problem for the centrist parties in the Netherlands is that there are too many of them. In Chart 3, we combine the center-left and center-right, pro-EU integration parties together. There are approximately ten such parties fighting over the pro-EU middle ground. None is expected to get to the 30-seat projected average of PVV. Given that the center-right and center-left parties split the establishment vote roughly in half (~60 seats each), it is likely that the Dutch pro-EU parties will need a cross-aisle "Grand Coalition" to produce a government. Coalitions take a long time to form in the Netherlands. In 2012, the process took 54 days, whereas in 2010 it took four months. The 2010 election is a good guide to this year's event, as it also produced a relatively complicated seat breakdown that ultimately forced the center-right to depend on PVV votes to govern. We suspect that the Netherlands will be deep into the coalition talks in the summer months, well after the French election is over. Investors take comfort in the fact that PVV cannot form an anti-EU/euro government on their own. This is true. We would also point out that the Dutch support the euro at a very high level (Chart 4) and that they surprisingly lack confidence in the country's future outside the EU (Chart 5). However, a "Grand Coalition" whose only purpose is to keep PVV out of government would cede the "opposition" ground to Wilders and his Euroskeptic government. And while this seems like a good idea today, while Europe's economic growth is rebounding and the migration crisis has abated (Chart 6), it could be a very bad idea once the next recession hits or the next geopolitical crisis reveals flaws in EU governance. Chart 4The Dutch Highly Approve Of The Euro... The Dutch Highly Approve Of The Euro... The Dutch Highly Approve Of The Euro... Chart 5...And See Little Future Outside The EU ...And See Little Future Outside The EU ...And See Little Future Outside The EU Chart 6Waning Migrant Crisis Undermines Populist Waning Migrant Crisis Undermines Populist Waning Migrant Crisis Undermines Populist France Constraints to a Le Pen victory in the upcoming presidential election - April 23 and May 7 - are considerable, and we expanded on them in our February 3rd Special Report "The French Revolution."3 Briefly, they are: Strong French support for the euro: Support appears to be inversely correlated with Le Pen's overall popularity, suggesting that her stance on the euro and EU creates a ceiling to her support level (Chart 7). Le Pen is weak in the polls: Le Pen continues to trail both centrist Emmanuel Macron and center-right François Fillon in the second-round polling, both by around 20% (Chart 8)! Comparing Le Pen's chances to those of Trump is a massive insult to the latter, given that Trump never trailed Clinton by more than 8% with three months to go. Bad omens for Le Pen's party: The December 2015 regional elections pose a troubling precedent for Le Pen and her National Front (FN). Her party was decimated in the two-round format, despite a slew of tailwinds at the time, including the largest terrorist attack in recent French history. Chart 7Le Pen Hobbled By Her Anti-Euro Stance Le Pen Hobbled By Her Anti-Euro Stance Le Pen Hobbled By Her Anti-Euro Stance Chart 8Le Pen Lags By ~20% In Key Second-Round Polls Climbing The Wall Of Worry In Europe Climbing The Wall Of Worry In Europe So, how does Le Pen win? We can imagine a scenario where a combination of another terrorist attack, banlieue rioting, and perhaps a restart of the migration crisis inspires enough voters to vote for Le Pen. Further, given that relatively liberal Macron is likely to make it to the second round, center-right voters may stay home or even shift to Le Pen in case of such a toxic brew. One problem with recent French electoral history is that it is replete with examples of center-left and left-wing voters strategically voting against Le Pen, yet little evidence exists that French conservative voters are willing to do the same and cast their vote for a left-leaning candidate. As such, despite better polling than Fillon in the second-round head-to-head against Le Pen, Macron remains vulnerable. What happens if Le Pen wins the election? This depends on whether FN wins the legislative elections set for June 11 and 18 - also a two-round election. Polls for the legislative election are sparse and unreliable, but it would be a shock if FN won a majority, especially given its performance in the December 2015 regional elections. As such, President Le Pen would have to co-habitate with an opposition-led parliament. The president of France has a lot of power, but it is checked by the National Assembly, the lower house of the parliament. For example, Le Pen's choice for prime minister would have to command a majority in the National Assembly in order to govern. And a number of constitutional powers - appointing members of the government, calling a referendum, dissolving the National Assembly, or ruling by decree - require the consent of the prime minister and cabinet. She would not even have a veto power over laws passed by parliament, as the French president can only delay legislation. Le Pen would only be unconstrained in matters of defense and foreign policy, where she could pursue several unorthodox policies. However, France's EU membership is written into the constitution (Article 88-1). Modifying the constitution would require an act of parliament (and potentially also a referendum, depending on a majority in parliament). In addition, France's membership in the euro is a legal obligation of its membership in the EU - given that France did not opt-out of the monetary union as Denmark and the U.K. did during the negotiations of the Maastricht Treaty. As such, it is unclear how Le Pen would be able to get the country out of the euro without pursuing the same procedure as the U.K. under Article 50 of the Lisbon Treaty, for which she would need to change the French constitution. All that said, these constraints may not be clear to the market if she is elected. We suspect that global markets would panic. A market riot, in fact, would be necessary to force Le Pen into orthodox policy, as it did with the surprise 1981 victory by socialist-leaning François Mitterrand. However, Mitterrand did not reverse policy until after two currency devaluations in the first year of his presidency, with the possibility of an IMF program openly discussed in Paris. The volte-face came after two years of sustained market pressure. It is not clear that France, or Europe for that matter, has that much time to dither today. Spain A referendum on the independence of Catalonia is expected by September. A referendum has been the main goal of the pro-independence government since Catalan elections in September 2015. The government combines far-left and center-right nationalists in an ungovernable coalition whose only common goal is independence. Chart 9Catalans Want Autonomy, Not Independence Catalans Want Autonomy, Not Independence Catalans Want Autonomy, Not Independence News flash to the markets: Catalans do not want independence, but rather a renegotiation of the region's relationship with Spain (Chart 9). And as we argued in our net assessment of the issue in 2014, a surge in internal migration since the Second World War has diluted the Catalan share of the total population.4 In fact, only 31% of the population identifies Catalan as their "first language," compared with 55% who identify with Spanish.5 Another 10% identify non-Iberian languages as their first language, suggesting that migrants will further dilute support for sovereignty, as they have done in other places (most recently: Quebec). According to the Spanish constitution, Catalonia does not have the legal right to call for an independence referendum. We suspect that the center-right government in Madrid will continue to deny the legitimacy of any referendum. Ironically, this will suppress the anti-independence turnout and hand the nationalists a victory in September. What then? A low-turnout vote, combined with no recognition from Madrid, means that the only way for the Catalan referendum to be relevant is if the nationalist government is willing to enforce sovereignty. The globally recognized definition of sovereignty is the "monopoly of the legitimate use of physical force within a defined territory." To put it bluntly: the Catalan government has to take up arms in order for its referendum to be relevant to markets (beyond the inevitable knee-jerk reactions surrounding the vote). Without recognition from Spain, and with no support from EU and NATO member states, Catalonia cannot win independence with a referendum alone. Germany General elections are set for September 24, with investors concerned that Chancellor Angela Merkel may face a tougher-than-expected challenge from the center-left Social Democratic Party (SPD). The new SPD Chancellor candidate, Martin Schulz, is polling very well and has even overtaken Merkel in the head-to-head polls (Chart 10). Schulz's overtly Europhile position - he has been the European Parliament Speaker since 2012 - appears to be winning over voters. The CDU held on to a double-digit lead over the SPD right up until Schulz took over as the primary challenger to Merkel (Chart 11). Chart 10Schulz Now Leads Merkel For Chancellor Climbing The Wall Of Worry In Europe Climbing The Wall Of Worry In Europe Chart 11Pro-Europe Sentiment Drives SPD Revival Pro-Europe Sentiment Drives SPD Revival Pro-Europe Sentiment Drives SPD Revival To some extent, CDU's drop in the polls was inevitable. It is correlated with a decline in Merkel's popularity (Chart 12). But we suspect there is more to it. Schulz's confidently pro-European attitude is a breath of fresh air for voters in Germany who have perhaps lost faith in Merkel's cautious approach to the euro crisis. Record-high support for the common currency in Germany suggests that we may be on to something (Chart 13). The German public is simply nowhere close to being as Euroskeptic as the financial media would have investors believe. And that is for good reason: euro area membership has clearly worked for Germany. Can Schulz and the Europhile SPD keep up the pressure on Merkel? Time will tell. But we take two messages from the polls. First, Euroskeptic parties are nowhere close to governing in Germany (Chart 14). Second, Merkel is a shrewd politician who has shamelessly pivoted on policy issues in the past. If Merkel senses that her lukewarm embrace of European integration can cost her the election, and that voters are buying Schulz's claim that she is to blame for the rise of populists in Europe, then she will pivot on Europe. This would be very bullish for markets as it would suggest that Berlin is ready and willing to apply fewer sticks and more carrots to its euro area peers. Chart 12Merkel's Popularity##br## In Decline Merkel's Popularity In Decline Merkel's Popularity In Decline Chart 13Germans See The Euro##br## As A Great Deal Germans See The Euro As A Great Deal Germans See The Euro As A Great Deal Chart 14There Is A Lot Of Daylight... ##br##Euroskeptic Parties Weak In Germany There Is A Lot Of Daylight... Euroskeptic Parties Weak In Germany There Is A Lot Of Daylight... Euroskeptic Parties Weak In Germany What if Schulz defeats Merkel and the SPD takes over the leadership of the grand coalition, or perhaps forms a coalition with left-leaning Greens and Die Linke? Is Merkel's demise not a risk to the markets? Most of our clients would see Merkel's retirement as a risk. We disagree. Investors are overstating Merkel's role as the "anchor" of euro area stability. She has, in fact, dithered multiple times throughout the crisis. In 2011, for example, Merkel delayed the decision on whether to set up a permanent euro area fiscal backstop mechanism due to upcoming Lander elections in Rhineland-Palatinate and Baden Württemberg. Her handling of the migration crisis also left much to be desired, to put it kindly. The SPD has picked up on this line of criticism and Schulz has begun to blame Merkel's cautious approach and insistence on austerity for the populism sweeping Europe. Given that polls suggest that Germans are not really in favor of austerity, this is potentially a winning strategy (Chart 15). Chart 15Germans Are Not Obsessed With Austerity Climbing The Wall Of Worry In Europe Climbing The Wall Of Worry In Europe We therefore believe that Merkel's demise is not being correctly priced by the markets. First, investors seem to believe that she will easily win another term. Second, those that fret about her future incorrectly price the downside risk. We actually see Merkel's retirement as an opportunity, not a risk. Whether the SPD takes over, or a more Europhile member of the CDU replaces an embarrassed Merkel as the leader of a grand coalition (Box 1), investors should contemplate what the continent will look like with a new Europhile chancellor. BOX 1 Likely Successors To German Chancellor Angela Merkel If Merkel decides to retire, who are her potential successors? Wolfgang Schäuble, Finance Minister (CDU): The bane of the financial community, Schäuble is seen as the least market-friendly option due to his hardline position on bailouts and the euro area. In our view, this is an incorrect interpretation of Schäuble's heavy-handedness. He is by all accounts a genuine Europhile who believes in the integrationist project. At 74 years old, he comes from a generation of policymakers who consider European integration a national security issue for Germany. He has pursued a tough negotiating position in order to ensure that the German population does not sour on European integration. Nonetheless, we doubt that he will choose to take on the chancellorship if Merkel retires. He suffered an assassination attempt in 1990 that left him paralyzed and he has occasionally had to be hospitalized due to health complications from this injury. As such, it is unlikely that he would replace Merkel, but he may stay on as Finance Minister and thus be as close to a "Vice President" role as possible in Germany. Ursula von der Leyen, Defense Minister (CDU): Most often cited as the likely replacement for Merkel, Leyen nonetheless is not seen favorably by most of the population. She is a strong advocate of further European integration and has supported the creation of a "United States of Europe." Leyen has gone so far as to say that the refugee crisis and the debt crisis are similar in that they will ultimately force Europe to integrate further. As a defense minister, she has promoted the creation of a robust EU army. She has also been a hardliner on Brexit, saying that the U.K. will not re-enter the EU in her lifetime. The markets and pro-EU elites in Europe would love Leyen, who has handled U.S. President Trump's statements on Germany, Europe, Russia and NATO with notable tact. Thomas De Maizière, Interior Minister (CDU): Maizière is a former Defense Minister and a close confidant of Chancellor Merkel. He was her chief of staff from 2005 to 2009. Like Schäuble, he is somewhat of a hawk on euro area issues (he drove a hard bargain during negotiations to set up a fiscal backstop, the European Financial Stability Fund, in 2010) and as such could be a compromise candidate between the Europhiles and Eurohawks within the CDU ranks. Though he has been implicated in scandals as defense minister, his popularity as interior minister is surging at the moment as a result of his declared intention to overhaul immigration policy and internal security. Julia Klöckner, Executive Committee Member, Deputy Chair (CDU): A CDU politician from Rhineland-Palatinate, Klöckner is a socially conservative protégé of Merkel. While she has taken a more right-wing stance on the immigration crisis, she has remained loyal to Merkel otherwise. She is a staunch Europhile who has portrayed the Euroskeptic AfD as "dangerous, sometimes racist." We think that she would be a very pro-market choice as she combines a popular, market-irrelevant wariness about immigration with a market-relevant centrism that favors further European integration. Hermann Gröhe, Minister of Health (CDU): Gröhe is a former CDU secretary general and very close to Merkel. He is a staunch supporter of the euro and European integration. Markets would have no problem with Gröhe, although they may take some time to get to know who he is! Volker Bouffier, Minister President of Hesse (CDU): As Minister President of Hesse, home of Germany's financial center Frankfurt, Bouffier's handling of Brexit will attract much scrutiny. He is a heavyweight within the CDU's leadership and a staunch Europhile. Fritz Von Zusammenbruch, Hardline Euroskeptic (CDU): Significantly, no such candidate exists! Greece The financial media have begun to fret about the ongoing negotiations between Greece and its euro area creditors over further aid to the country. Greece faces a €7bn euro repayment in July, by which time the funding must be released or the government will run out of cash. The problem is that the IMF refuses to be involved in any deal that condones Greece's unsustainable debt path. Europeans are willing to turn a blind eye to the reality in Greece and project high growth and primary surpluses. The IMF is not. And yet both Germany and Finland have made their participation in the Greek rescue conditional on the IMF's involvement. Even if a crisis emerges, the likely outcome would be early elections in Greece. Prime Minister Alexis Tsipras is holding on to a three-seat majority in the parliament. This majority is at risk, especially in a repeat of the 2015 crisis. Investors should cheer new elections in Greece, not fret about them. Polling shows that the pro-euro and pro-EU New Democracy Party is polling well above SYRIZA, and would produce a stable, pro-reform government (Chart 16). And there is no longer any Euroskeptic alternative in Greece. Chart 16No More Euroskeptic Option In Greece No More Euroskeptic Option In Greece No More Euroskeptic Option In Greece Given Tsipras's limited choices and the upcoming German elections, we suspect that investors will not see a return of the Greek saga this year, at least not at the same level of intensity as two years ago. And is Greek debt sustainable? Yes, it is sustainable as long as the Europeans decide to pretend that it is sustainable. Italy Last but not least is Italy. Investors have recently received some clarity on the timing of the next election as former Prime Minister Matteo Renzi has called a new leadership race in the ruling Democratic Party (PD). Given that the party must hold an internal election sometime in the spring, it is unlikely that elections will occur by mid-June, as Renzi had hoped. The most likely date is therefore in autumn 2017, given that Italy shuts down in the summer. However, interim Prime Minister Paolo Gentiloni, along with a large minority of MPs, opposes Renzi's leadership and could see him defeated in the leadership race. If that happens, investors may be spared an election until closer to the formal due date of May 23, 2018. The election, whenever held, will be the main political risk for European markets in 2017. First, support for the common currency continues to plumb multi-decade lows in Italy (Chart 17), while Italian confidence in life outside the EU is perhaps the greatest on the continent (Chart 18). Second, rising negative sentiment towards the euro and the EU are reflected in very strong polling for Euroskeptic parties. Chart 19 shows that establishment parties are barely fending off the Euroskeptic challenge - and that is only because we include the Forza Italia of former Prime Minister Silvio Berlusconi in the pro-Europe camp. Meanwhile, the ruling PD and Euroskeptic Five Star Movement (M5S) are neck-and-neck in the disaggregated polls (Chart 20). Chart 17Italians Turning Against The Euro Italians Turning Against The Euro Italians Turning Against The Euro Chart 18Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU Chart 19Euroskeptic Parties##br## Strong In Italy Euroskeptic Parties Strong In Italy Euroskeptic Parties Strong In Italy Chart 20Five Star Movement Rivals##br## Ruling Democratic Party Five Star Movement Rivals Ruling Democratic Party Five Star Movement Rivals Ruling Democratic Party What happens if M5S wins the election? Given the recent Supreme Court ruling on the electoral law, it is essentially impossible for any party to win the majority in the next election, at least with the current polling numbers. As such, M5S would have to break its electoral pledge not to form coalition governments and either form one or rule with an unstable minority. It is highly possible that M5S would use support from other Euroskeptic parties - such as the nationalist Lega Nord - to pass a law on a non-binding referendum on the euro. While the Italian constitution prohibits referenda on international treaties - and membership in the monetary union is such a treaty - a vote against the euro in a non-binding referendum would give M5S legitimacy in pursuing an Italian exit from the euro area. At such a point, we would expect that a severe market riot would be needed to push Italy away from the brink. Our assessment is that M5S would ultimately back off, as Greece did in 2015. However, Italians in 2017 are more Euroskeptic than Greeks were in 2015. Whereas Greeks saw euro membership as a key link to their membership in the Western club, Italians appear to be a lot more confident in their ability to survive euro exit. That said, M5S is not a single-issue party. Rather, it is a protest movement against government corruption and incompetence that is also moderately Euroskeptic. As such, it is not clear that it would risk an economic crisis and a potential popular revolt over an issue that has split the Italian electorate. Rather, we suspect that M5S would use the threat of euro exit to win concessions on fiscal spending from the rest of Europe. As we explained in our September 2016 net assessment of Italian politics, European integration is vital for Rome both politically and economically.6 While Italy would theoretically benefit from currency devaluation by exiting the euro, it would in practice lose access to the common market as its euro membership is legally tied to its EU membership. Politically, it would also be highly unlikely that the other euro member states would allow such a large economy to devalue against them. Investment Implications European markets remain in a sweet spot in 2017. Global growth is showing signs of improvement, the ECB will remain dovish relative to the Fed, the EU Commission is calling for more expansionary fiscal policy, and valuations continue to favor European plays over other developed market plays. Will politics spoil the party? Of the six risks we reviewed in this report, Italy is the one where the devil's advocate argument is most convincing. Polls in the country have shown no improvement in support for the euro despite the continent-wide resurgence in support (Chart 21). The other five risks will likely remain limited to fodder for the news media, allowing markets to climb the proverbial wall of worry in 2017, especially if Italian elections are pushed off into 2018. But even if the slew of elections returns pro-euro governments, long-term political risks are mounting in Europe. As we pointed out in 2013, there is a danger in relying on "Grand Coalitions" between the center-right and center-left to sustain European integration.7 Such a centrist consensus cedes the opposition ground to the Euroskeptics. If - or rather, when - a major recession or geopolitical crisis occurs, voters will no longer have a pro-establishment political alternative to turn to. As such, we agree with our market gauge of euro area breakup probability - which measures the probability of a common currency breakup over the next five years. It currently stands at 30.2% (Chart 22). Chart 21Italy Poses Chief Risk ##br##To European Integration Italy Poses Chief Risk To European Integration Italy Poses Chief Risk To European Integration Chart 22Euro Breakup##br## Risk Is Rising Euro Breakup Risk Is Rising Euro Breakup Risk Is Rising Thankfully for investors, neither a recession nor a geopolitical crisis is on the horizon in 2017. The migration crisis has ended, as we expected (Chart 23).8 Given the geographical proximity of the Middle East and North Africa to Europe, another refugee deluge is possible. We suspect it would require the collapse of new states, such as Algeria or Egypt, not merely the ongoing crises in Libya and Syria. However, with the Middle East still in flux, a recession on the five-year horizon, and the first anti-EU president in the White House, risks are beginning to stack up against European integration. Chart 23Migrant Crisis Waning Migrant Crisis Waning Migrant Crisis Waning The key question for 2017 is the same as it has been since 2010: what will Germany do? If the Europhile turn in German politics is real, then the assumptions that investors have taken for granted may be shifting. A Germany more willing to shoulder the cost of economic rebalancing via higher inflation and debt relief would be a game changer for markets. Pessimists will say that Germans would never accept such costs. But with a 3.9% unemployment rate, an 8.5% of GDP current account surplus, and a budget surplus, Germany is firing at all cylinders. Ultimately, the question for German voters is whether they are willing to bear the costs of regional hegemony. If they are, then Europe's economy and markets are about to enter a multi-year bull market. If they are not, then the centrist victories in 2017 may be the calm before the storm. As BCA's Geopolitical Strategy argued in our aforementioned Special Report on the French election, we recommend going long French industrials versus German industrials, to capitalize on reforms we think are likely after the election (whereas Germany has already reformed). We are also sticking with our long German consumers versus exporters trade, reflecting the robust German economy and persistently dovish ECB. Finally, by contrast with these bullish trades, we maintain our more bearish tactical trade of matching every €1 of euro area equity exposure with 40 cents of VIX term structure, since the latter will spike if and when the various headline political risks cause market flutters. BCA is cyclically overweight euro-area equities relative to the U.S. in currency-hedged terms. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 Please see Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 2 Please see Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 3 See footnote 2 above. 4 Please see Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 2014, available at gps.bcaresearch.com. 5 Please see "Language Use of the Population of Catalonia," Generalitat de Catalunya Institut d'Estadustuca de Catalunya, dated 2013, available at web.gencat.cat. 6 Please see Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 7 Please see Geopolitical Strategy Monthly Report, "Austerity Is Kaputt," dated May 8, 2013, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com.

Highlights France is on the verge of pro-market structural reforms; Marine Le Pen will not win the presidency. Her odds are 15%; The French economic upswing will continue to surprise; Overweight French stocks relative to German; Buy the euro on any election-related dip. Feature Le courage consiste à savoir choisir le moindre mal, si affreux soit-il encore. - Stendhal La France ne peut être la France sans la grandeur. - Charles de Gaulle Every decade, a country defies stereotypes and surprises investors with ambitious, pro-market and pro-business, structural reforms (Chart 1). Margaret Thatcher's laissez-faire reforms pulled Britain out of the ghastly 1970s and into the wild 1980s. Sweden surprised the world in the 1990s when voters turned against the generous social welfare system under the stewardship of the center-right Moderate Party. At the turn of the century, Germany's Social Democratic Party (SPD) defied its own label and moved the country to the right of the economic spectrum. Finally, this decade's reform surprise is Spain, which undertook painful labor and pension reforms that have underpinned its impressive recovery. What do all of these episodes have in common? Investors - and the public at large - didn't see them coming. Our favorite example is the Hartz IV labor reforms in Germany. The SPD government of Gerhardt Schröder completely re-wired Germany's labor market, leading to the export boom that has lasted to this day (Chart 2). And yet The Economist welcomed the Schroeder government with a scathing critique that is a textbook example of how the media often confuses stereotyping for data-driven analysis.1 Chart 1Each Decade Has A Reform Surprise Each Decade Has A Reform Surprise Each Decade Has A Reform Surprise Chart 2The German Miracle The German Miracle The German Miracle We think that this decade will belong to France. Yes, France. While the dominant narrative today is whether Marine Le Pen will win the presidential elections on April 23 (with a possible runoff on May 7), we think the real story is that the two other serious candidates are pro-growth, pro-reform, pro-market candidates. François Fillon and Emmanuel Macron are both running platforms of structural reforms. They are not hiding the fact that the reforms would be painful. On the contrary, their campaigns revel in the self-flagellation narrative. Most of our clients either politely roll their eyes when we present this view or counter that the French are ______ (insert favorite stereotype). We welcome the pessimism! It shows that the market is not yet pricing in a pro-market revolution that guillotines a long list of French inefficiencies. In this analysis, we present what is wrong with France, whether the presidential candidates running in the election plan to fix the problems, and our view of who is likely to win. Forecasting elections is a Bayesian process, which means that the probabilities must be constantly updated with new information. As such, we intend to keep a very close eye on the developments in the country over the next four months. What Is Wrong With France? France has a growth problem. While this is partly a cyclical issue, the reality is that its real per-capita GDP growth has been closer to Greek levels than German over the last two decades (Chart 3). In addition, France has lost competitiveness in the global marketplace, judging by its falling share of global exports relative to peers (Chart 4). Chart 3France's Lost Millennium The French Revolution The French Revolution Chart 4Export Performance Is A Disaster Export Performance Is A Disaster Export Performance Is A Disaster Three issues underpin the French malaise of the past two decades: The state is too large; The cost of financing the large state falls on the corporate sector; The labor market is inflexible. First, the French state relative to GDP is the largest in the developed world. In 2016, public spending was estimated to be 56% of GDP, compared with 44% of GDP in Germany and just 36% in the U.S. (Chart 5)! What is most concerning is that the state has actually grown in the past two decades from already unsustainable levels (Chart 6). Government employment as share of total employment is naturally very high (Chart 7). Chart 5The French State Is Large... The French Revolution The French Revolution Chart 6... And Continues To Be In Charge The French Revolution The French Revolution Chart 7French Talent Is Wasted In The Public Sector The French Revolution The French Revolution Such a large public sector requires very high levels of taxation. Government tax revenues are also second-largest in the developed world at 45% of GDP (Chart 8) and, like the size of the overall public sector, continue to grow (Chart 9). Chart 8French Tax Burden Is Large... The French Revolution The French Revolution Chart 9...And Growing The French Revolution The French Revolution Part of the problem is the labyrinth of administrative layers beneath the central government. France has 13 regional governments, 96 departments, 343 arrondissements, 4,058 cantons, and 35,699 municipalities.2 What do they all do? We have no idea. Reforms in 2015 have sought to reduce the number of sub-federal layers, but the process ought to go much further and faster. The French social welfare state is also inefficient. To be fair, it has kept income inequality in check, which has not been the case in more laissez-faire countries (Chart 10). This is an important part of our political analysis. French "socialism" is what keeps populism at bay, which was the intention of the expensive welfare state in the first place.3 However, there is a lot of room to trim the fat. The French welfare state is essentially an "insurance program" for the middle class, with more transfers going to the households in the top 30% income bracket than in the bottom 30% (Chart 11)! France could cut its massive social spending by means-testing the benefits that accrue to the upper middle class.4 Somebody ultimately must pay for the enormous public sector. In France, a large burden falls on employers. The French "tax wedge" - the difference between the cost of labor for the employer and the take-home pay of the employee as a percent of total remuneration - is one of the largest in the OECD (Chart 12). The heavy tax burden on employers, combined with a relatively high minimum wage, means that business owners are wary of hiring new workers. The tax wedge is ultimately passed on to the consumer by businesses, which hurts competitiveness and contributes to the poor performance of French exports.5 Chart 10A Positive: ##br##No Income Inequality A Positive: No Income Inequality A Positive: No Income Inequality Chart 11French Welfare State##br## Protects...The Rich! The French Revolution The French Revolution Chart 12Employees Are Too Expensive ##br##For Employers The French Revolution The French Revolution The French labor market remains inflexible and overprotected (Chart 13), which not only hurts competitiveness but also discourages youth employment (Chart 14). According to the OECD Employment Protection Index, both regular and temporary contracts have some of the highest levels of protection in the developed world. Germany actually has a higher level of protection in regular contracts, but not in temporary employment, thanks to ambitious reforms. Chart 13French Labor Market##br## Is Too Rigid The French Revolution The French Revolution Chart 14French Youth Underperforms ##br##OECD Peers The French Revolution The French Revolution Chart 15Starting A Business In France? ##br##Bonne Chance! The French Revolution The French Revolution Finally, France suffers from too much red-tape (Chart 15), too much regulation (Chart 16), high wealth taxes that force capital out of the country, and too many barriers to entry for medium-sized enterprises, the lifeblood of innovation and productivity gains (Chart 17). Part of the reason that France suffers from a lack of German-styled Mittelstand (small and medium-sized enterprises) is that the effective tax rate of the medium-sized businesses is greater than that of large enterprises (Chart 18). This is a problem given the already high levels of corporate tax rates in the country (Chart 19).6 Chart 16Too Much Regulation The French Revolution The French Revolution Chart 17France Needs A Mittelstand The French Revolution The French Revolution François Hollande's government tried to address many problems facing France. However, Hollande largely spent his term treating the symptoms and not trying to cure the disease. France can reduce regulatory barriers and tinker with labor flexibility. It can even shift the tax burden from employers to consumers. But the fundamental problem is the large state, which forces the government to raise lots of taxes one way or another. Chart 18French SMEs Are Punished ##br##With High Taxes The French Revolution The French Revolution Chart 19French Corporate Taxes ##br## Are High By European Standards The French Revolution The French Revolution Bottom Line: The French state is too big. Up to this point, reforms have largely focused on tinkering with how the government raises funds for the welfare state. But what France needs is to alleviate the tax burden in the first place. The state, therefore, must be cut. Why Will France Reform? Our clients and colleagues challenge our view on France by rightly pointing out that painful structural reforms are easiest following a "market riot" or deep recession. Neither has befallen France. It actually did remarkably well in weathering the 2008 Great Recession, compared to OECD peers, and it has not faced the extraordinary housing or unemployment busts of neighboring Spain. Yet crises are not necessarily a must for successful reforms. Australia, starting in the mid-1980s and throughout the 1990s, pursued broad-based reforms due to a prolonged period of mediocre growth.7 So did Germany in the 2000s. We think that it is precisely this underperformance that is today motivating France. In particular we see three broad motivations: Competition with Germany: France did not lead the creation of European institutions in the twentieth century in order to cede leadership to Germany. As Charles de Gaulle said, "France is not France without greatness." The economic underperformance versus Germany is not geopolitically sustainable (Chart 20). If France continues to lose economic ground to Germany, it will continue to play second-fiddle to Berlin in the governing of the EU. At some point, but not likely in 2017, this will reinforce the populist logic that France should go it alone, sans the European institutions. Change impetus: It is difficult to imagine how François Fillon and Emmanuel Macron can run on an anti-establishment, "change" platform. Fillon proudly calls himself a Thatcherite (in 2017!) and Macron is a former Rothschild investment banker. And yet they are doing so. This is especially astonishing after the successes of Donald Trump and the Brexit campaign, which specifically targeted elitist policymakers like Fillon and Macron. But in France, the status quo is a large state, dirigiste economy, and a generous welfare system. In other words, the French are turning against their status quo. Laissez-faire is change in France. Social welfare fatigue: Our colleague Peter Berezin argued in a recent Special Report that Europeans will turn against the welfare state due to the breakdown in social cohesion. Significant populations of immigrant descent - as well as recent arrivals - fail to properly integrate in countries where the welfare state is large.8 Resentment against immigrants, and citizens of immigrant descent, could therefore be fueling resentment against the expensive welfare state. Chart 20France Is Not France Without Greatness France Is Not France Without Greatness France Is Not France Without Greatness Chart 21"Silent Majority" Wants Reform The French Revolution The French Revolution Polls suggest that we are on to something. Chart 21 illustrates that there may be a Nixonian "silent majority" in France favoring supply side reforms. Per January 2017 polling, "blue collar" and "left leaning" employees oppose reforms. But surprisingly by extremely narrow margins (Chart 21, bottom panel)! Thus, there is demand for structural reforms, but is there supply? According to a review of the platforms of Macron and Fillon, we think the answer is a resounding yes (Table 1). Generally speaking, François Fillon's proposed reforms are the deepest, but Macron would also pursue reforms aimed at reducing the size of the state. Marine Le Pen, too, promises to reduce the size of the public sector, suggesting that the narrative of reform is now universal. However, it is not clear how she would do so. Her views on the EU and the euro are also not positive for growth or the markets, as they would precipitate a recession and an immediate redenomination crisis. As we discuss below, it is likely that her opposition to European integration is precisely what is preventing her from being a much more competitive opponent against Fillon and Macron in the second round. Table 1French Presidential Election: Policy Positions Of Chief Contenders The French Revolution The French Revolution What of implementation? In France, several reform efforts - the 1995 Juppé Plan, 2006 labor reforms and 2010 Sarkozy pension reforms in particular - prompted significant social unrest. However, unrest is having diminishing returns for unions and left-wing activists. While unrest forced the government to fully reverse both the 1995 Juppé Plan and the 2006 labor reforms, it did not manage to hold back retirement reforms in 2010. The Sarkozy government made some concessions, but the core of the reforms remained in place despite severe unrest that brought the country to a standstill. Most recently, in spring 2016, the El Khomri law - proposing modest changes to the French labor code - was rammed through by Prime Minister Manuel Valls using Article 49.3 of the French constitution. Despite significant unrest, the law passed and became law in August. Protests remained peaceful - unlike the 2010 unrest - and eventually fizzled out. Investors should not be afraid of unrest. Unrest is a sign that reforms are being enacted. We would be far more concerned if the election of Fillon or Macron did not lead to strikes and protests! That would be a sign that their reform efforts are not ambitious. But our review of the unrest and strikes in France since 1995 suggests that the last two events - in 2010 and 2016 - ultimately did lead to reforms. In addition, most significant international reform efforts lead to protests. The U.K. miners' strike (1984-85) led to over 10,000 arrests and significant violence. German labor reforms in the 2000s led to a spike in strikes. And the 2011 Spanish reforms under PM Rajoy led to the rise of Indignados, student protesters occupying public spaces, who ultimately gave the world Occupy Wall Street. When it comes to reforms, the adage "no pain, no gain" rings true. Most effective reforms, however, will come right after the election. The incoming president will have about 12 months to convince investors that he is serious about reforms, as this is when the new government has the most political capital and legitimacy for reforms. In addition, much will depend on whether Fillon and Macron have parliamentary majorities with which to work to enact reforms. France's parliamentary election will follow the presidential (two rounds, June 10 and 17). Every president has managed to gain the majority in parliament since the two elections were brought to the same year (2002). Macron's new third party - En Marche! - will likely struggle to gain a foothold in the parliament, even if he wins. However, we suspect that both Les Républicains and centrist members of the Socialist Party will support his reforms. Macron's reforms are more modest than Fillon, at least according to Table 1 and his rhetoric, but they would still be a net positive. Ultimately, investors will have plenty of opportunity to reassess the reform efforts as the new government proposes them. In this analysis, we have sought to simplify what we think is wrong with France. If the government does not address our three core issues - how big is the state, how the state is funded, and the flexibility of the labor market - then we will know that our optimism was misplaced. Bottom Line: We believe that the support for reform exists. A review of electoral platforms reveals that all three major candidates are promising reforms that reduce the size of the French state. This can only mean that French politicians recognize that the "median voter" wants it to be reduced.9 Can Le Pen Win? Although Marine Le Pen, leader of National Front (FN), wants to reduce the size of the state as much as her counterparts, her broader approach poses an obvious risk to the stability of France, Europe, and potentially the world. Her position on the EU and the euro is extreme. She seeks to replace the EU with a strategic alliance with Russia, that she thinks would then include Germany. In the process, the euro would be abandoned. The extreme nature of Le Pen's proposals may ironically increase the likelihood of pro-market reforms in France. François Fillon's problem - aside from the ongoing corruption scandal involving his wife - is that 62% of the French public believes that "his program is worrisome."10 He may therefore win purely because Le Pen's proposal of dissolving the EU and the euro is even more worrisome. What are Le Pen's chances of overcoming the population's fear of abandoning the euro and EU institutions? We think they are very slim. Fillon's corruption scandal could grow, but we think that it is too little too early. With three months ahead of the first round, the spotlight on Fillon may have come too soon. Meanwhile, Le Pen's FN is not without skeletons in her closet. The party's main financial backer has been a Russian bank whose license was revoked by Russia's central bank in June. Le Pen refuses to disclose the details of her campaign funding, unlike Fillon and Macron.11 So what are the chances of a Le Pen presidency? Following the U.S. election, many of our clients wonder where populism will triumph next. In meetings and at conference panels, clients ask whether Marine Le Pen can replicate the success of Donald Trump and the anti-establishment Brexit campaign. Our view has not changed since our Client Note on the topic last November: Le Pen has a very low probability of winning.12 Our subjective figure is 15%. This view is not necessarily based on the strength of her opponents. In other words, if François Fillon stumbles in the first round, we believe that Emmanuel Macron will win in the second round. Our view is focused more on the structural constraints that Le Pen faces. There are three reasons for this view: The Euro The French support the euro at a high level. Marine Le Pen wants to take France out of the euro. Thus, her popularity is inversely correlated with the support for the euro (Chart 22). Euro support bottomed in France in 2013 at 62%, the same year when Le Pen's popularity peaked at 36%. The populist and nationalist Le Pen has not regained her 2013 levels of support despite a massive immigration crisis in Europe and numerous terrorist attacks against French citizens. This is surprising and important. Chart 22The Euro Is Le Pen's Foil The Euro Is Le Pen's Foil The Euro Is Le Pen's Foil The only way we can explain her lackluster performance in the face of crises that should have helped her popularity is her ideological and rhetorical consistency on the euro. For several different reasons,13 the French public supports the common currency as well as the EU - like most Europeans. Le Pen's insistence on "Frexit" is a major hurdle to her chances of winning. The Polls Before we dive into the French presidential polls we should remind our readers of our view that polls did not get Brexit and Trump wrong. Pundits, the media, and data-journalists did. Polls were actually showing the Brexit camp ahead throughout the first two weeks of June. It was only once MP Jo Cox was tragically murdered on June 16 that polls favored the "Stay" vote for the final days of the campaign. Yet on the day of the vote, the "Stay" camp was ahead by only 4%. That should not have given investors the level of confidence they had in the pro-EU vote. The probability of Brexit, in other words, should have been a lot higher than the 30% estimated by the markets (Chart 23). Chart 23ASmart Money Got Brexit Wrong... Smart Money Got Brexit Wrong... Smart Money Got Brexit Wrong... Chart 23B...Despite Close Polling ...Despite Close Polling ...Despite Close Polling Similarly, the national polls in the U.S. election were not wrong. Rather, the pundits and quantitative models overstated the probability of a Clinton victory. What the modelers missed was the unfavorable structural backdrop for Clinton: the challenges associated with one party holding the White House for three terms, lackluster economic growth, lukewarm approval ratings for Barack Obama and his policies, and general discontent, partly signaled by the non-negligible polling of third-party challengers. In addition, the modelers ignored that American polls have a track record of underestimating, or overestimating, performance by about 2-3% (Chart 24). And crucially, the 2016 election was different in that the number of undecided voters at the cusp of the vote was nearly triple the average of the previous three elections (Chart 25). Chart 24Election Polls Usually Miss By A Few Points The French Revolution The French Revolution Chart 25Undecided Voters Decided The Election Undecided Voters Decided The Election Undecided Voters Decided The Election The polls were much closer, in other words, than the dominant media narrative revealed. With four months until the election, Donald Trump actually took a slight lead against Hillary Clinton, following the July GOP convention. In aggregate polling, he never trailed Clinton by more than 7% from that point onwards (Chart 26). With four months until the second round of the French election in May, Marine Le Pen is trailing her two centrist opponents by 20-30% (Chart 27)! In other words, Trump at this point in the campaign was roughly three times more competitive than Le Pen! Chart 26Le Pen Is No Trump Le Pen Is No Trump Le Pen Is No Trump Chart 27Second Round Polls Are All That Matters The French Revolution The French Revolution We will therefore agree with the narrative that Le Pen could be the next Trump or Brexit when she starts performing in the polls as well as Trump and Brexit! Right now, she is nowhere close to that. Could Marine Le Pen close the gap in the next four months? It is unlikely. Le Pen is not a political "unknown" like Trump. She is not going to "surprise" voters into voting for her in 2017. She was her party's presidential candidate in the 2012 election. Her father, Jean-Marie Le Pen, contested elections in 1988, 1995, 2002, and 2007. The National Front has contested elections in France since the 1970s. Voters know what they are getting with Le Pen. The best-case scenario for Le Pen is that Fillon gets into the second round, and then during the two-week interval between the first and second rounds (April 23, May 7) more corruption is revealed by Fillon and his popularity tanks. This is the "Clinton model" and it is certainly plausible. But it would have to be egregious corruption given that Le Pen's popularity ceiling appears to be the same percentage of French population not in favor of the euro. We suspect that this ceiling is hard. Which is why we have Le Pen's probability of winning the election at only 15%. In addition, there is no vast pool of the undecided in France. French turnouts for the presidential election are consistently 80%. Therefore, translating polling data to actual turnout data will be relatively straightforward. The polls are real. Le Pen may be able to outperform her polls by several points. But not by the 20-30% by which she trails Fillon and Macron in polling for the crucial second round. In fact, Le Pen could even struggle to get into the second round given that the winner of the Socialist Party primary - Benoit Hamon - could bleed left-wing voters away from Le Pen, leaving Fillon and Macron to enter the second round instead. At that point, the election becomes a coin toss between two reformers, but we would give the less "worrisome" Macron a slight edge. Precedent History is important because there is a precedent for solid Euroskpetic performances in France. In fact, Euroskeptic candidates - broadly defined - have won around 32% of the vote in the first round of the presidential election since 1995 (Chart 28). As such, Le Pen's current polling in the first round - 26% level of support - and second round - 37% of support - is within the historical average. It is on the high end, but still within the norm. Her father, for example, got 17% in the first round of the 2002 election and 18% in the second. Chart 28French Euroskepticism ##br##Is Not A Novel Concept The French Revolution The French Revolution We also have a very good recent case study - a natural experiment if you will - of the anti-establishment's electoral performance: the December 2015 regional elections. The two-round regional elections occurred only 23 days following the November 2015 terrorist attack in Paris and at the height of that year's migration crisis. They should have favored the Front National (FN). They also should have favored the FN for these technical and political reasons: Rules: The second round in the regional elections has a participation threshold of 10%, unlike the presidential and parliamentary elections which eliminate all but the top two candidates. This means that FN faced off against multiple candidates, reducing the probability that "strategic voting" drove centrist voters to choose the one remaining establishment candidate over the anti-establishment candidate, as will be the case in the upcoming presidential election. Protest vote: The regions of France have no authority to negotiate international treaties. As such, voters could freely vote for the anti-establishment FN as a sign of protest, without fear that the FN councilors would then take the country out of the euro and the EU. Voters faced no clear downside risk of sending a harsh message to the establishment. Context: Both the ruling Socialists and the opposition Union for a Popular Movement (now renamed Les Républicains) were in disarray ahead of the regional elections for a number of reasons, including the aforementioned terrorist attacks, unpopularity of President Hollande, leadership struggle within UMP, and EU mismanagement of the migration crisis. The National Front ended the first round with a slight lead in total votes, but captured the lead in six out of the 13 regions. The financial press went wild, calling it an extraordinary win for the anti-establishment in France. Yet despite the near optimal circumstances and a strong showing in the first round, FN was obliterated in the second round, a mere one week later. The populists won none of the regions that they captured in the first round! Why? Participation increased in the second round from 49% to 59%, signaling that many French voters were motivated to vote in less-relevant regional elections purely to keep FN out of power. The National Front share of the total vote remained stable at 27%, despite the increase in the turnout. This means that almost none of the "new" voters cast their support for FN, an incredible development. Socialist Party candidates withdrew from the contest in several regions where FN candidates were high profile politicians (Nord Pas de Calais led by Marine Le Pen herself and Province Alpes Cote d'Azur led by Le Pen's niece Marion Marechal Le Pen). Most importantly, Socialist voters did not swing to the economically left-leaning FN in these contest, but rather either stayed home or swung to the center-right rival, the UMP. If French voters decided to cast a strategic vote against FN in an election where the downside risk to a protest vote was non-existent, why would they do any different in a vote that clearly and presently matters? Furthermore, the fact that the higher turnout hurt FN should concern Le Pen. As we mentioned above, presidential election turnouts in France are around 80%. The 2015 election also should teach us an important lesson about France: polls work. Based on IFOP polling conducted two weeks before the election, the average polling error in the December 2015 regional election was 2.5%. Bottom Line: Marine Le Pen's support is precisely the inverse of the French support for the euro. Her anti-European stance is apparently a "deal breaker" for many voters who would otherwise support her candidacy. If she asked us for advice, we would say to flip-flop on the euro. It would make her far more competitive in 2017. Le Pen is trailing her centrist opponents by a massive margin in the second round. Polls can be wrong when they suggest that the contest is within the margin of error. But that is definitely not the case in the upcoming French election. Finally, the 2015 election teaches us that strategic voting continues in France, even when the establishment parties are in disarray and the geopolitical and political context favors populists. Cyclical View The French economy is currently experiencing an economic upswing. This upswing is not much of a mystery. It is explained by three factors: Easing monetary conditions in Europe, pent-up demand, and reflationary policies in China. Let's start with monetary conditions. The easing began in July 2012, with ECB president Mario Draghi's now famous pronouncement that he would do "Whatever it takes" to ensure the survival of the euro. Thanks to these soothing words, risk premia in the region collapsed, with a massive narrowing of government bond spreads between the periphery and Germany. France too benefited from that phenomenon, with its own spreads moving from a max of 190 basis points in late 2011, to 21 basis points seven months ago. Thanks to this normalization, lending rates to the private sector collapsed from 4.6% to 2% (Chart 29) This meant that the fall in the repo rate engineered by the ECB was finally passed on to the private sector. Additionally, the ECB stress tests of 2014 played a major role. In anticipation of that exercise, euro area banks curtailed credit in order to clean up their balance sheets. This resulted in a large contraction of the European credit impulse. However, once the tests were passed, euro area banks, with somewhat healthier balance sheets, normalized credit conditions, letting credit growth move closer in line with trend GDP growth. The result was a surge in the credit impulse that lifted growth in Europe (Chart 30). Chart 29Whatever It Takes Equals##br## Lower Private Sector Rates Whatever It Takes Equals Lower Private Sector Rates Whatever It Takes Equals Lower Private Sector Rates Chart 30Credit Impulse Dynamics##br## And Growth Credit Impulse Dynamics And Growth Credit Impulse Dynamics And Growth The euro also was an important factor. In mid-2014, investors started to speculate on a major easing by the ECB, maybe even QE. Through this discounting process, the euro collapsed from a high of 1.39 in May 2014 to a low of 1.05 in March 2015, when the ECB indeed began implementing asset purchases. This incredible 25% collapse in the currency boosted net exports, and helped GDP, while limiting existing deflationary pressures in Europe. The final reflationary impulse came from fiscal policy. In the wake of 2008, French fiscal deficits ballooned. As a result, from 2011 to 2013, the French fiscal thrust was negative and subtracted an average 1% from GDP growth. However, starting 2014, this drag vanished, arithmetically lifting growth in the country (Chart 31). Ultimately, with the accumulated pent-up demand resulting from the double-dip recession, France was able to capitalize on these developments. First, after having contracted by 14% between 2008 and 2009, and then by another 3% between 2011 and 2013, capex growth was able to resume in earnest in 2015 . This was necessary because, due to the subpar growth in capital stock, even the current tepid economic improvement was able to push capacity utilization above its 5-year moving average. When this happens, the economy ends up displaying the clearest sign of capacity constraint, i.e. higher prices, which we are seeing today. It also results in growing orders (Chart 32). Chart 31The Vanishing Of ##br##French Fiscal Drag The Vanishing Of French Fiscal Drag The Vanishing Of French Fiscal Drag Chart 32French Capacity Utilization Has Tightened ##br##And Orders Are Improving French Capacity Utilization Has Tightened And Orders Are Improving French Capacity Utilization Has Tightened And Orders Are Improving Second, we have witnessed a stabilization in employment and wages. The unemployment rate has fallen by 1% from 10.5% in 2015 to 9.5% today. Most importantly, our wage and employment models are pointing toward higher salaries and job growth in the coming quarters (Chart 33). This is crucial. The French economy remains fundamentally driven by domestic demand and household consumption in particular. In fact, these signs of coming higher household income suggest that the consumer can once again begin to support economic activity in France. First, we expect real retail sales to improve in the coming quarter. Second, because of the combined effect of rising labor income, consumer confidence, and housing prices, the recent upswing in housing activity should gather momentum (Chart 34), creating a further floor under economic activity. Chart 33Improving French Labor Market Conditions Improving French Labor Market Conditions Improving French Labor Market Conditions Chart 34Housing Will Contribute More To Growth Housing Will Contribute More To Growth Housing Will Contribute More To Growth Third, the improvement in credit growth corroborates these developments. In fact, being supported by easing credit standards, it even suggests that broad economic activity in France could accelerate further in the coming months. The key question mark at this point in time is China. France exports to China are only 3.7% of total exports, or 0.7% of GDP, below Belgium. However, the largest single export market for France is Germany, at 16.2% of total exports or 3.3% of GDP (Chart 35). Most interestingly, combined French exports to Germany and China are an important source of economic volatility for France. However, because French exports to Germany are a function of broader German income shocks and demand for German exports, the result is that French exports to Germany and China are a direct function of Chinese industrial activity, as illustrated with their tight correlation with the Keqiang index (Chart 36). As a result, French manufacturing conditions have displayed co-relationship with Chinese LEIs since 2002. Chart 35French Export ##br## Distribution The French Revolution The French Revolution Chart 36French Business Cycle And China: ##br##Germany Is The Key Link French Business Cycle And China: Germany Is The Key Link French Business Cycle And China: Germany Is The Key Link So going forward, what to expect? The recent surge in the ZEW expectation index is likely to be validated and French GDP growth is likely to improve from 1% today to nearly 2% in mid-2017, well above the current expectation of 1.3%. We are more confident about the robustness of domestic demand than international demand. The support created by higher wages and rising credit will have a lagged effect for a few more quarters. In fact, the up-tick to 0.5% from -0.2% in underlying inflation suggests that French real borrowing costs for the private sector should remain well contained despite the recent improvement in capacity utilization. This means the support to housing activity remains solid, especially as France has some of the strongest demographics of the whole euro zone, and thus demand for housing is solid. Chart 37France Too Would Be Affected##br## By A Chinese Deceleration France Too Would Be Affected By A Chinese Deceleration France Too Would Be Affected By A Chinese Deceleration Fillon's threat to cut public sector employment by 500,000 thousand could at face value derail the improvement in the labor market - if such measures were implemented today and in one shot, the unemployment rate would spike from 9.5% to 11.2%. However, Fillon's victory is not yet baked in the cake, and even if he wins, this risk is unlikely to materialize in 2017 as it will take time to get the required laws passed. Moreover, the progressive nature of the cut, along with the tax cuts and regulatory easing for the private sector, suggest that firms would likely create many jobs during the same time frame, mitigating the pain created by such drastic job cutting. Nonetheless, some downside to growth should be expected from Fillon's policies. China and EM represent a more palpable risk. The Chinese uptake of machinery has recently spiked and real estate activity and prices have surged (Chart 37). Beijing is currently uneasy with this development and the PBoC has already increased medium-term lending-facility rates in recent weeks despite low loan demand and disappointing fixed-asset investment numbers. Moreover, China has also massively curtailed the fiscal stimulus that has been a key component of its recent powerful rebound in industrial activity. Finally, the strength in the dollar along with rising real rates globally could put a lid on commodity price appreciation, which means that the rise in Chinese producer prices that has greatly contributed to lower Chinese real rates and thus easier Chinese monetary conditions could be waning. French exports to Germany and China might be seeing their heyday as we write. Bottom Line: The French economy is enjoying a healthy upswing powered by easier monetary conditions in Europe, slight fiscal thrust, pent-up demand and improving credit conditions. While these domestic factors will prove durable, the improvement in external demand faced by France in 2016 raises a slight question mark. Nonetheless, we expect French economic growth to move toward 2% in 2017, a sharp beat of currently depressed expectations. On the political front, robust growth should help centrist candidates and hurt the anti-establishment Le Pen. Investment Implications While reforms, tax cuts, strong domestic demand, and potentially falling political risk premia point to an outperformance of French small cap equities, the story is more complex. Indeed, French small caps are heavily weighted toward IT and biotech firms, and have been mimicking the performance of the Nasdaq, corrected for currency developments (Chart 38). Thus, they do not represent a play on the story above. Instead, we favor buying French industrial equities relative to Germany's. Both sectors are exposed to similar global risk factors as their sales are a function of commodity prices and EM developments. However, French unit labor costs should be contained relative to German ones going forward. French competitiveness has been hampered by decades of rigidities while German competitiveness benefited greatly following the implementation of the Hartz IV labor reforms. Not only should the potential for reform help France over Germany, but the fact that the French unemployment rate remains elevated while that of Germany is at generational lows points also toward rising German labor costs vis-à-vis France (Chart 39). Additionally, our secular theme of overweighting defense stocks plays in France's favor, given that France is the world's fourth largest global defense exporter.14 Finally, adding to the attractiveness of the trade, French industrial equities are trading near the low of their 12-year trading range against German ones (Chart 40). Chart 38French Small Cap Equals Nasdaq##br## (And The Euro, Of Course) French Small Cap Equals Nasdaq (And The Euro, Of Course) French Small Cap Equals Nasdaq (And The Euro, Of Course) Chart 39Reforms Could ##br##Close This Gap Reforms Could Close This Gap Reforms Could Close This Gap Chart 40Industrials: Buy France / ##br##Short Germany Industrials: Buy France / Short Germany Industrials: Buy France / Short Germany In a broader sense, the implementation of the Hartz IV reforms in Germany resulted in a general outperformance of German stocks over French stocks. Now that reforms have been fully implemented and priced in Germany, while investors remain highly skeptical of the outlook for French reforms (and indeed, fear an anti-establishment revolution), today may be the time to begin overweighting French equities at the expense of German ones in European portfolios on a structural basis. Finally, the spike in French yield differentials against German suggest that investors are imbedding a risk premium for the probability of a Le Pen win in the May election. A Le Pen victory would represent a death knell for the euro. As such, the euro countertrend bounce could find further support from a falling risk premium. Any selloff in the euro if Le Pen wins the first round of the election would represent a tactical buying opportunity in EUR/USD. Bottom Line: French industrials should be the key outperformers vis-a-vis Germany in the event of a Fillon or Macron electoral victory. However, French stocks in general should be able to outperform. Buy the euro on any election-related dip, particularly following the first round of the election on April 23. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see The Economist, "The sick man of the euro," dated June 3, 1999, available at economist.com. 2 The figures presented here are actually the reduced numbers from the 2013 Acte III de la decentralization. 3 Please see BCA Research Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 4 A generous pension system is part of the problem. The effective retirement age is around 61 years, well below the legal age of 65. According to the OECD, the French spend 25 years in retirement, the longest in the developed world. 5 To address this problem, President François Hollande's Responsibility and Solidarity Pact has begun to shift the burden of financing the public purse away from payroll taxes and onto consumption (via higher VAT taxes). But a greater effort is needed. 6 Oddly, France does not do that badly in the World Bank Ease of Doing Business ranking - it is 29th out of 190, ahead of Switzerland and Japan and only one place behind the Netherlands. 7 Please see Gary Banks, OECD, "Structural reform Australian-style: lessons for others?" presentations to the IMF and World Bank, May 26-27, 2005, and OECD, May 31, 2005, available at oecd.org. 8 Please see BCA Research Global Investment Strategy, "Après Paris," dated November 20, 2015, available at gis.bcaresearch.com. 9 Please see Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 10 IFOP poll from December 2016. 11 To be fair, French law does not require parties to publish their donations and spending. Please see Bloomberg, "Le Pen Struggling to Fund French Race as Russian Bank Fails," dated December 22, 2016, available at Bloomberg.com. 12 Please see Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 13 Please see BCA Research Geopolitical Strategy Special Report, "After BREXIT, N-Exit?" dated July 13, 2016, and The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at gps.bcaresearch.com. 14 Please see Global Alpha Sector Strategy and Geopolitical Strategy Special Report, "Brothers In Arms," dated January 11, 2017, available at gps.bcaresearch.com.

Highlights President Trump is as protectionist as Candidate Trump; USD shortage to tighten global financial conditions; Go Long MXN/RMB as a tactical play on U.S.-China trade war; Brexit risks are now overstated; EU will not twist the knife. EUR/GBP is overbought; go short. Feature "We assembled here today are issuing a new decree to be heard in every city, in every foreign capital, and in every hall of power. From this day forward, a new vision will govern our land. From this moment on, it's going to be America First." U.S. President Donald Trump, January 20, 2017, Inaugural Address What are the investment implications of an "America First" world? First, it may be useful to visualize the "America Second" world that President Trump is looking to leave in the rear-view mirror. Chart 1 shows the cost of hegemony. Since the Nixon shock in 1971, the U.S. has seen its trade balance deepen and its military commitments soar, in absolute terms. For President Donald Trump, the return on American investment has been low. Wasteful wars, crumbling infrastructure, decaying factories, stagnant wages, this is what the U.S. has to show for two decades of hegemony. Chart 1United States: The Cost Of Hegemony The "What Can You Do For Me" World? The "What Can You Do For Me" World? On the other hand, the U.S. has enjoyed the exorbitant privilege of its hegemonic position. In at least one major sense, America's allies (and China) are already paying for American hegemony: through their investments in U.S. dollar assets. Chart 2 illustrates this so-called "exorbitant privilege." Despite a deeply negative net international investment position, the U.S. has a positive net investment income.1 Chart 2The "Exorbitant Privilege" The "What Can You Do For Me" World? The "What Can You Do For Me" World? Being the global hegemon effectively lowers U.S. borrowing costs and domestic interest rates, giving U.S. policymakers and consumers an "interest rate they do not deserve." That successive administrations decided to waste this privilege on redrawing the map of the Middle East and giving the wealthiest Americans massive tax cuts, instead of rebuilding Middle America, is hardly the fault of the rest of the world! Foreigners hold U.S. assets because of the size of the economy, the sustainability and deep liquidity of the market, and the perceived stability of its political system. More importantly, they hold U.S. assets because the U.S. acts as both a global defender and a consumer of last resort. If Washington were to raise barriers to its markets and become a doubtful provider of security, states may gradually see less of a payoff in holding U.S. assets and decide to diversify more rapidly. Investors can interpret Trump's "America First" agenda broadly as an effort to dramatically reduce the U.S. current account deficit. Certainly we see his statements on renegotiating NAFTA, facing off against China on trade, and encouraging U.S. exports with tax legislation as parts of a broad effort aimed at improving the U.S. trade balance. If the U.S. were to pursue these protectionist policies aggressively, the end result would be a massive shortage of U.S. dollars globally, a form of global financial tightening. The rest of the world is not blind to the dangers of an America focused on reducing its current account deficit. According to the reporting of Der Spiegel magazine, Chancellor Angela Merkel sent several delegations to meet with the Trump team starting in 2015! No doubt Berlin was nervous hearing candidate Trump's protectionist talk, given that Germany runs one of the largest trade surpluses with the U.S. (Chart 3). In the last such meeting, taking place after the election was decided, Trump's son-in-law and White House advisor, Jared Kushner, asked the Germans a point-blank question, "What can you do for us?"2 In the 1980s, the U.S. asked West Germany and Japan the same question. The result was the 1985 Plaza Accord that engineered the greenback's depreciation versus the deutschmark and the yen (Chart 4). Recent comments from Donald Trump suggest that he would like to follow a similar script, where dollar depreciation does the heavy lifting in adjusting the country's current account deficit.3 Chart 3Trump's Black List Trump's Black List Trump's Black List Chart 4The Impact Of The Plaza Accord The Impact Of The Plaza Accord The Impact Of The Plaza Accord The Trump administration may have dusted off the Reagan playbook from the 1980s, but the world is playing a different game in 2017. First, the Soviet Union no longer exists and certainly no longer has more than 70,000 tanks ready to burst through the "Fulda Gap" towards Frankfurt. President Trump will find China, Germany, and Japan less willing to help the U.S. close its current account deficit, particularly if Trump continues his rhetorical assault on everything from European unity to Japanese security to the One China policy. Second, China, not U.S. allies Germany and Japan, has the largest trade surplus with the U.S. It is very difficult to see Beijing agreeing to a coordinated currency appreciation of the RMB, particularly when it is being threatened with a showdown over Taiwan and the South China Sea. Third, even if China wanted to kowtow to the Trump administration, it is not clear that RMB appreciation can be engineered. The country's capital outflows have swelled to a record level of $205 billion (Chart 5) and the PBoC has continued to inject RMB into the banking system via outright lending to banks and open-market operations (Chart 6). Unlike Japan in 1985, China is at the peak of its leveraging cycle and thus unwilling to see its currency - and domestic interest rates - appreciate. At best, Beijing can continue to fight capital outflows and close its capital account. But even this creates a paradox, since the U.S. administration can accuse it of currency manipulation even if such manipulation is preventing, not enabling, currency depreciation!4 Chart 5China: Unrecorded Capital Outflows China: Unrecorded Capital Outflows China: Unrecorded Capital Outflows Chart 6PBoC Injects Massive Liquidity PBoC Injects Massive Liquidity PBoC Injects Massive Liquidity To conclude, the world is (re)entering a mercantilist era and sits at the Apex of Globalization.5 The new White House is almost singularly focused on bringing the U.S. current account deficit down. It intends to do this by means of three primary tools: Protectionism: The Republicans in the House of Representatives have proposed a "destination-based border adjustment tax," which would effectively subsidize exports and tax imports. (It would levy the corporate tax on the difference between domestic revenues and domestic costs, thus giving a rebate to exporters who make revenues abroad while incurring costs domestically.)6 While the proponents of the new tax system argue it is equivalent to the VAT systems in G7 economies, the change would nonetheless undermine America's role as "the global consumer of last resort." In our view, it would be the opening salvo of a global trade war. Dirigisme: President Trump has not shied away from directly intervening to keep corporate production inside the U.S. He has also insisted on a vague proposal to impose a 35% "border tax" on U.S. corporates that manufacture abroad for domestic consumption. (Details are scant: His Treasury Secretary Steven Mnuchin has denied an across-the-board tax of this nature, but has confirmed that one would apply to specific companies.) Structural Demands: Trump's approach suggests that he wishes to force structural changes on trade surplus economies in order to correct structural imbalances in the American economy - and in this process he is not adverse to lobbing strategic threats. While he holds out the possibility of charging China with currency manipulation, in fact he can draw from a whole sheet of American trade grievances not limited to the currency to demand major changes to their trade relationship. The fundamental problem for the global economy is that in order to reduce the U.S. current account deficit, the world must experience severe global tightening. Dollars held by U.S. multinationals abroad, which finance global credit markets, will come back to the U.S. and tighten liquidity abroad. And emerging market corporate borrowers who have overextended themselves borrowing in U.S. dollars will struggle to repay debts in appreciating dollars. These structural trends are set to exacerbate an already ongoing cyclical process. As BCA's Emerging Markets Strategy has recently pointed out, global demand for U.S. dollars is rising faster than the supply of U.S. dollars.7 Our EM team's first measure of U.S. dollar liquidity is "the sum of the U.S. monetary base and U.S. Treasury securities held in custody for official and international accounts." The second measure "is the sum of the U.S. monetary base and U.S. Treasury securities held by all foreign residents." As Chart 7 and Chart 8 illustrate, both calculations indicate that dollar liquidity is in a precipitous decline already. Meanwhile, foreign official holdings of U.S. Treasury securities is contracting, while the amount of U.S. Treasury securities held by all foreigners has stalled (Chart 9). Chart 7Dollar Liquidity Declining... Dollar Liquidity Declining... Dollar Liquidity Declining... Chart 8... Any Way You Look At It ... Any Way You Look At It ... Any Way You Look At It Chart 9Components Of U.S. Dollar Liquidity Components Of U.S. Dollar Liquidity Components Of U.S. Dollar Liquidity Chart 10It Hurts To Borrow In USD It Hurts To Borrow In USD It Hurts To Borrow In USD Concurrently, U.S. dollar borrowing costs continue to rise (Chart 10). Our EM team expects EM debtors with U.S. dollar liabilities to either repay U.S. dollar debt or hedge it. This will ultimately increase the demand for U.S. dollars in the months ahead. Near-term U.S. dollar appreciation will only reinforce and accelerate the mercantilist push in the White House and Congress. President Trump and the GOP in the House will find common ground on the border-adjustment tax, which Trump recently admitted he did not understand or look favorably upon. The passage of the law, or some such equivalent, has a much greater chance than investors expect. So does a U.S.-China trade war, as we argued last week.8 How should investors position themselves for the confluence of geopolitical, political, and financial factors we have described above? The world is facing both the cyclical liquidity crunch that BCA's Emerging Markets Team has elucidated and the potential for a secular tightening as the Trump administration focuses its efforts on closing the U.S. current account deficit. Five investment implications are top of our mind: Chart 11Market Response To Trump Win On High End Market Response To Trump Win On High End Market Response To Trump Win On High End Chart 12Market Is Priced For 'Magnificent' Events Market Is Priced For 'Magnificent' Events Market Is Priced For 'Magnificent' Events Buy VIX. The S&P 500 has continued to power on since the election, buoyed by positive economic surprises, strong global earnings, and the hope of a pro-business shift in the White House. The equity market performance puts the Trump presidency in the upper range of post-election market outcomes (Chart 11). However, with 10-year Treasuries back above fair value, the VIX near 12, and EM equities near their pre-November high, the market is pricing none of the political and geopolitical risks of an impending trade war between the U.S. and China, nor is it pricing the general mercantilist shift in Washington D.C. (Chart 12). As a result, we recommend that clients put on a "mercantilist hedge," like deep out-of-the-money S&P 500 puts, or VIX calls. For instance, a long VIX 20/25 call spread for March expiry. Long DM / Short EM. Mercantilism and the U.S. dollar bull market are the worst combination possible for EM risk assets. We therefore reiterate our long-held strategic recommendation of being long developed markets / short emerging markets. Overweight Euro Area Equities. Investors should overweight euro area equities relative to the U.S. As we have discussed in the 2017 Strategic Outlook, political risks in Europe this year are a red herring.9 We will expand on the upcoming French elections in next week's report. Meanwhile, investors appear complacent about protectionism and what it may mean for the S&P 500, which sources 44% of its earnings abroad. European companies, on the other hand, could stand to profit from a China-U.S. trade war. Chart 13Peso Is A Buy Versus Trump's Enemy #1 Peso Is A Buy Versus Trump's Enemy #1 Peso Is A Buy Versus Trump's Enemy #1 Chart 14Peso As Cheap As During Tequila Crisis Peso As Cheap As During Tequila Crisis Peso As Cheap As During Tequila Crisis Long MXN/RMB. As a tactical play on the U.S.-China trade war, we recommend clients go long MXN/RMB (Chart 13). The peso is now as cheap as it was in early 1995, at the heights of the Tequila Crisis, as per the BCA's Foreign Exchange Strategy model (Chart 14). While Mexico remains squarely in Trump's crosshairs on immigration and security, the damage to the currency appears to be done and has ironically made the country's exports more competitive. In addition, Trump's pick for Commerce Secretary, Wilbur Ross, has informed his NAFTA counterparts that "rules of origin" will be central to NAFTA re-negotiation. This can be interpreted as the U.S. using every tool at its disposal to impose punitive measures on China, including forcing NAFTA partners to close off the "rules of origin" loophole.10 But the reality is that the U.S. trade deficit with its NAFTA partners is far less daunting than that with China (Chart 15). Meanwhile, we remain negative on the RMB for fundamental reasons that we have stressed in our research. Small Is Beautiful. We continue to recommend that clients find protection from rising protectionism in small caps. Small caps are traditionally domestically geared irrespective of their domicile. Anastasios Avgeriou, Chief Strategist of BCA's Global Alpha Sector Strategy, also points out that small caps in the U.S. will benefit as the new administration follows through with promised corporate tax cuts, which will benefit small caps disproportionally to large caps given that the effective tax rate of multinationals is already low. Moreover, small companies will benefit most from any cuts in regulations, most of which have been written by multinationals in order to create barriers to entry (Chart 16). Of course, we could just be paranoid! After all, much of Trump's proposed policies - massive tax cuts, infrastructure spending, major rearmament, the border wall - would increase domestic spending and thus widen the current account deficit, not shrink it. And all the protectionism and de-globalization could just be posturing by the Trump administration, both to get a better deal from China and Europe and to give voters in the Midwest some political red meat. Chart 15China, Not NAFTA, In Trump's Crosshairs China, Not NAFTA, In Trump's Crosshairs China, Not NAFTA, In Trump's Crosshairs Chart 16Small Is Beautiful Small Is Beautiful Small Is Beautiful But Geopolitical Strategy analysts get paid to be paranoid! And we worry that much of Trump's promises that would widen U.S. deficits are being watered down or pushed to the background. Yes, we have held a high conviction view that infrastructure spending would come through, but now it appears that it will be complemented with significant spending cuts. The next 100 days will tell us which prerogatives the Trump Administration favors: rebuilding America directly, or doing so indirectly via protectionism. If the former, then the current market rally is justified. If the intention is to reduce the current account deficit, look out. Marko Papic, Senior Vice President marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Brexit: A Brave New World Miranda: O brave new world! Prospero: 'Tis new to thee. — Shakespeare, The Tempest The U.K. Supreme Court ruled on January 24 that parliament must have a say in triggering Article 50 of the Lisbon Treaty, which enables the U.K. to "exit" the European Union. This decision, as well as Theresa May's January 17 "Brexit means exit" speech, caught us in London while visiting clients. Reactions were mixed. The pound continues to rally. January 16 remains the low point in the GBP/USD cross since the vote to leave on June 23 last year (Chart 17). Chart 17Has Brexit Uncertainty Bottomed? Has Brexit Uncertainty Bottomed? Has Brexit Uncertainty Bottomed? Should investors expect more downside to the pound or do the recent events mark a bottom in political uncertainty? The market consensus suggests that further volatility in the pound is warranted for three reasons: Europeans will seek to punish the U.K. for Brexit, to set an example to their own Euroskeptics; Prime Minister May's assertion that the U.K. would seek to exit the common market is negative for the country's economy; Legal uncertainties about Brexit remain. We disagree with this assessment, at least in the short and medium term. Therefore, the pound rally on the day of May's speech was warranted, although we agree that exiting the EU Common Market will ultimately be suboptimal for the country's economy. First, by setting out a clean break from the EU, including the common market, Prime Minister May has removed a considerable amount of political uncertainty. As we pointed out in our original net assessment of Brexit, leaving the EU while remaining in its common market is illogical.11 Paradoxically, the U.K. stood to lose rather than regain sovereignty if it left the EU yet remained in the common market (Diagram 1). Diagram 1The Quite Un-British Lack Of Common Sense Behind Soft Brexit The "What Can You Do For Me" World? The "What Can You Do For Me" World? Why? Because membership in the common market entails a financial burden, full adoption of the acquis communautaire (the EU body of law), and acceptance of the "Four Freedoms," including the freedom of movement of workers. Given that the Brexit vote was largely motivated by concerns of sovereignty and immigration (Chart 18), it did not make sense to vote to leave the EU and then seek to retain membership in the common market. Apparently May and her cabinet agree. Chart 18It's Sovereignty, Stupid! The "What Can You Do For Me" World? The "What Can You Do For Me" World? Second, now that the U.K. has chosen to depart from the common market, the EU no longer needs to take as hostile of a negotiating position as before. The EU member states were not going to let the U.K. dictate its own terms of membership. That would have set a precedent for future Euroskeptic governments looking for an alternative relationship with the bloc, i.e. the so-called "Europe, à la carte" that European policymakers dread. But now that the U.K. is asking for a clean exit, with a free trade agreement to be negotiated in lieu of common market membership, the EU has less reason to punish London. An FTA arrangement will be beneficial to EU exporters, who want access to the U.K. market, and it will send a message to Euroskeptics on the continent that there is no alternative to full membership. Leaving the EU means leaving the market and falling back - at best - to an FTA-level relationship that the EU shares with Mexico and (most recently) Canada. Third, leaving the EU and the common market are political, not legal, decisions, and the lingering legal battles are neither avoidable nor likely to be substantive. Theresa May had already stolen thunder when she said that the final deal with the EU would be put to a vote in parliament. The Supreme Court ruling - as well as other legal hangups - could conceivably give rise to complications that bind the government's hands, but most likely parliament will pass a simple bill or motion granting permission for the government to invoke Article 50. That is because the referendum, and public opinion since then, speak loud and clear (Chart 19). The Conservative Party remains in a comfortable lead over the Labour Party (Chart 20), which itself is not opposing the referendum outcome. In addition, the House of Commons has already approved the government's Brexit timetable by a margin of 372 seats in a 650-seat body - with 461 ayes. That is a stark contrast with a few months ago when around 494 MPs were said to be against Brexit. Chart 19No 'Bremorse' Or 'Bregret' The "What Can You Do For Me" World? The "What Can You Do For Me" World? Chart 20Tories Still Triumphant Tories Still Triumphant Tories Still Triumphant The bigger question comes down to the parliamentary vote on the deal that is to be negotiated over the next two years. Could the Parliament vote down the final agreement with the EU? Absolutely. However, it is unlikely. The economic calamity predicted by many commentators has not happened, as we discuss below. Bottom Line: The combination of the Supreme Court decision and Prime Minister May's speech has reduced political uncertainty regarding Brexit. The EU will negotiate hard with the U.K., but the main cause of consternation - the U.K. asking for special treatment with respect to the common market - is now off the table. Yes, the EU does hold all the cards when it comes to negotiating an FTA agreement, and the process could entail some alarming twists and turns (given the last-minute crisis in the EU-Canada FTA). But we do not expect EU-U.K. negotiations to imperil the pound dramatically beyond what we've already seen. Will Leaving The Common Market Hurt Britain? Does this mean that Brexit is "much ado about nothing?" In the short and medium term, we think the answer is yes. In the long-term, leaving the EU Common Market is a suboptimal outcome for three reasons: Trade - Net exports rarely contribute positively to U.K. growth (Chart 21) and the trade deficit with the EU is particularly deep. As such, proponents of Brexit claim that putting up modest trade barriers against the EU could be beneficial. However, the U.K. has a services trade surplus with the EU (Chart 22). While it is not as large as the trade deficit, there was hope that the eventual implementation of the 2006 EU's Services Directive would have opened up new markets for U.K.'s highly competitive services industry and thus reduced the trade deficit over time. As the bottom panel of Chart 22 shows, the U.K.'s service exports to the rest of the world have outpaced those to the EU, suggesting that there is much room for improvement. This hope is now dashed and the EU may go back to putting up non-tariff barriers to services that reverse Britain's modest surplus with the bloc. Free Trade Agreements rarely adequately cover services, which means that the U.K.'s hope of expanding service exports to a new high is probably gone. Chart 21U.K. Is Consumer-Driven U.K. Is Consumer-Driven U.K. Is Consumer-Driven Chart 22Service Exports At Risk After Brexit Service Exports At Risk After Brexit Service Exports At Risk After Brexit Foreign Investment - FDI is declining, whether for cyclical reasons or because foreign companies fear losing access to Europe via the U.K. It remains to be seen how FDI will respond to the U.K.'s renunciation of the common market, but it is unlikely to be positive (Chart 23). The U.K.'s financial sector will also be negatively impacted since leaving the common market will mean that London will no longer have recourse to the EU judiciary in order to stymie European protectionism.12 This is unlikely to destroy London's status as the global financial center, but it will impact FDI on the margin. Labor Growth - The loss of labor inflow will be the biggest cost of Brexit. A decrease of immigration from the EU could reduce the U.K.'s labor force growth by a maximum of two-thirds, translating to a 25% loss in the potential GDP growth rate (Chart 24). While the U.K. is not, in fact, closing off all immigration, labor-force growth will decline, and potential GDP with it. Chart 23FDI To Suffer From Brexit? FDI To Suffer From Brexit? FDI To Suffer From Brexit? Chart 24Labor Growth Suffers Most From Brexit The "What Can You Do For Me" World? The "What Can You Do For Me" World? In addition, the EU Common Market forces companies to compete for market share in the developed world's largest consumer market. This competition is supposed to accelerate creative destruction and thus productivity, while giving the winners of the competition the spoils, i.e. a better ability to establish "economies of scale." In a 2011 report, the Bank of International Settlements (BIS) published an econometric study that compared four scenarios: the U.K. remains in the common market as the EU fully liberalizes trade; the U.K. remains in the EU's single market, but does not fully liberalize trade with the rest of the EU; the U.K. leaves the common market; the U.K. enters NAFTA.13 Of the four scenarios, only the first leads to an increase in wealth for the U.K., with 7.1% additional GDP over ten years. U.K. exports would increase by 47%, against 38.1% for its imports. Wages of both skilled and unskilled workers would increase as well. Meanwhile, the report finds that closer integration with NAFTA would not compensate for looser U.K. ties with the EU. In fact, the U.K. national income would be 7.4% smaller if the U.K. tied up with NAFTA instead of taking part in further trade liberalization on the continent. Why rely on a 2011 report for the assessment of benefits of the common market? Because it was written by a competent, relatively unbiased international body and predates the highly politicized environment surrounding Brexit that has since infected almost all think-tank research. And yet the more recent research echoes the 2011 report in terms of the negative consequences of leaving the common market.14 In addition, the BIS study actually attempts to forecast the benefit of further removing trade barriers in the single market, which is at least the intention of the EU Commission. That said, our concerns regarding the U.K. economy are long-term. It may take years before the full economic impact of leaving the common market can be assessed. In addition, much of our analysis hinges on the Europeans fully liberalizing the common market and removing the last remaining non-tariff barriers to trade, particularly of services. At the present-day level of liberalization, the U.K. may benefit by leaving. In addition, we do not expect a balance-of-payments crisis in the U.K. any time soon. The U.K. current account is deeply negative, unsurprisingly so given the deep trade imbalance with the EU and world. However, our colleague Mathieu Savary, Vice-President of BCA's Foreign Exchange Strategy, has pointed out that the elasticity of imports to the pound is in fact negative, a very surprising result. This reflects an extremely elevated import content of British exports. A lower pound is therefore unlikely to be the most crucial means of improving the current-account position. Certainly leaving the common market will not improve the competitiveness of British exports in the EU. Chart 25The U.K.'s Basic Balance Is Healthy The U.K.'s Basic Balance Is Healthy The U.K.'s Basic Balance Is Healthy But this raises a bigger question: why does the U.K. have to improve its current account deficit? As our FX team points out in Chart 25, despite having a current-account deficit of nearly 6% of GDP, the U.K. runs a basic balance-of-payments surplus of 12%, even after the recent fall in FDI inflows. The reason for the massive balance-of-payments surplus is the financial account surplus of 6.17% of GDP, a feature of the U.K. being a destination for foreign capital, which flows from its status as a global financial center and prime real estate destination. In other words, leaving the common market will not change the fundamentals of the U.K. balance of payments much. The country will remain a global financial center and will still run a capital account surplus, which will suppress the country's interest rates, buoy the GBP, and give tailwinds to imports of foreign goods. Meanwhile, exports will not benefit as they will face marginally higher tariffs as the country exits the EU Common Market. At best, new tariffs will be offset by a cheaper GBP. As such, leaving the common market is not going to be a disaster for the U.K. Nor will it be a panacea for the country's deep current account deficit. And that is okay. The U.K. will not face a crisis in funding its current account deficit. What is clear is that for the time being, the U.K. economy is holding up. Our forex strategists recently argued that U.K.'s growth has surprised to the upside and that the improvement is sustainable: Monetary and fiscal policy are both accommodative (Chart 26); Inflation is limited; Tight labor market drives up wages and puts cash in consumers' pockets (Chart 27); Credit growth remains robust (Chart 28). Chart 26Easy Money Smooths The Way To Brexit Easy Money Smooths The Way To Brexit Easy Money Smooths The Way To Brexit Chart 27British Labor Market Tightening British Labor Market Tightening British Labor Market Tightening Chart 28U.K. Credit Growth Looking Good U.K. Credit Growth Looking Good U.K. Credit Growth Looking Good This means that the political trajectory is set for the time being. "Bremorse" and "Bregret" will remain phantoms for the time being. Bottom Line: Leaving the common market is a suboptimal but not apocalyptic outcome for the U.K. The combination of decent economic performance and lowered political uncertainty in the near term will support the pound. Given the pound's 20% correction since the June referendum, we believe that the market has already priced in the new, marginally negative, post-Brexit paradigm. The Big Picture It is impossible to say whether the long-term negative economic effects of Brexit will affect voters drastically enough and quickly enough for Scotland, or parliament, to act in 2018 or 2019 and modify the government's decision to pursue a "Hard Brexit." It seems conceivable if something changes in the fundamental dynamics outlined above, but we wouldn't bet on it. At the moment even a new Scottish referendum appears unlikely (Chart 29). Scottish voters have soured on independence, perhaps due to a combination of continued political uncertainty in the EU (Scotland's political alternative to the U.K.) and a collapse in oil prices (arguably Scotland's economic alternative to the U.K.). The issue is not resolved but on ice for the time being. Chart 29Brexit Not Driving Scots To Independence (Yet) Brexit Not Driving Scots To Independence (Yet) Brexit Not Driving Scots To Independence (Yet) More likely, the government will get its way on Brexit and the 2020 elections will mark a significant popular test of the Conservative leadership and the final deal with the EU. Then the aftermath will be an entirely new ballgame for the U.K. and all four of its constituent nations. If Britain's new beginning is founded on protectionism and dirigisme - as the government suggests - then the public is likely to be disappointed. The "brave new world" of Brexit may prove to be rather mundane, disappointing, and eerily reminiscent of the ghastly 1970s.15 Hence the Shakespeare quote at the top of this report. The political circumstances of Brexit resemble the U.K. landscape before it joined the European Economic Community in 1973: greater government role in the economy, trade protectionism, tight labor market, higher wages, and inflation. Yet this was a period when the U.K. economy underperformed Europe's. The U.K.'s eventual era of outperformance was contingent on the structural reforms of the Thatcher era and expanded access to the European market (Chart 30). It remains to be seen what happens when the U.K. leaves the market and rolls back Thatcherite reforms. The weak pound and proactive fiscal policy will fail to create a manufacturing revolution. That is because most manufacturing has hollowed out because of automation, not foreign workers stealing Britons' jobs. Moreover, as for the pound, it is important to remember that currency effects are temporary and any boost to exports that the weak pound is generating will be short-lived, as with the case of China in the 1990s and the EU in the past two years (Chart 31). Chart 30U.K. Growth To Lag Europe's Once Again? U.K. Growth To Lag Europe's Once Again? U.K. Growth To Lag Europe's Once Again? Chart 31Export Boost From Devaluation Is Fleeting Export Boost From Devaluation Is Fleeting Export Boost From Devaluation Is Fleeting In addition, we would argue that, in an environment of de-globalization - in which tariffs are rising, albeit slowly for the time being (Chart 32) - the EU Common Market provides Europe with a mechanism by which to protect its vast consumer market. The U.K. may have chosen the precisely wrong time in which to abandon the protection of continental European protectionism. It could suffer by finding itself on the outside of the common market as global tariffs begin to rise significantly. Chart 32Protectionism On The March The "What Can You Do For Me" World? The "What Can You Do For Me" World? What about the restoration of the "Special Relationship" between the U.K. and the U.S.? Could moving to the "front of the queue" on negotiating an FTA with the world's largest economy make a difference for the U.K.? Perhaps, but as the BIS study above indicates, an FTA with North America or the U.S. alone is unlikely to replace the benefits of the common market. In addition, it is difficult to imagine how a protectionist U.S. administration that is looking to massively decrease its current account deficit will help the U.K. expand trade with the U.S. By contrast, Trump's election in the United States poses massive risks to globalization, both through his protectionism and the strong USD implications of his core policies. This will reverberate negatively across the commodities and EM space. In such an environment, the U.K. may not be able to make much headway in its "Global Britain" initiatives to conclude fast trade deals with EM economies that stand to lose the most in the de-globalization era. Bottom Line: As a trading nation, the U.K. is likely to lose out in a prolonged period of de-globalization. Membership in the EU could have served as a bulwark against this global trend. Investment Implications We diverge from our colleagues in the Foreign Exchange Strategy and European Investment Strategy when it comes to the assessment of political risk looming over Brexit.16 The decision to leave the common market will alleviate the pressure on Europeans to seek vindictive punishment. Earlier, the U.K. was forcing them to choose between making an exception to the rules and demonstrating the negative consequences of leaving the bloc. Now the U.K. is self-evidently taking on its own punishment - the economic burden of leaving the common market - and the EU will probably deem that sufficient. Will the EU play tough? Yes, especially since the EU retains considerable economic leverage over Britain (Chart 33). But the stakes are far smaller now. Furthermore, investors should remember that core European states - especially France and Germany - remain major military allies of the U.K. and will continue to be deeply intertwined economically. As such, we believe that the pound has already priced in the new economic paradigm and that the expectations of political uncertainty ahead of the U.K.-EU negotiations may be overdone. We therefore recommend that investors short EUR/GBP outright. Our aforementioned forex strategist Mathieu Savary argues that, on an intermediate-term basis, the outlook for this cross is driven by interest rate differentials and policy considerations. Due to the balance-sheet operations conducted by the BoE and ECB, interest rates in the U.K. and the euro area do not fully reflect domestic policy stances. Instead, Mathieu uses the shadow rates. Currently, shadow rates unequivocally point toward a lower EUR/GBP (Chart 34). In fact, balance-sheet dynamics point toward shorting EUR/GBP. Chart 33EU Holds The Cards In FTA Negotiation EU Holds The Cards In FTA Negotiation EU Holds The Cards In FTA Negotiation Chart 34Shadow Rates Point To Stronger GBP Shadow Rates Point To Stronger GBP Shadow Rates Point To Stronger GBP For full disclosure, Mathieu cautions clients to wait on executing a short EUR/GBP until after Article 50 is enacted. By contrast, we think that political uncertainty regarding Brexit likely peaked on January 16. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President marko@bcaresearch.com 1 While the U.S. runs a massively negative net international investment position, its net international income remains positive. In other words, foreigners receive a much lower return on U.S. assets while the U.S. benefits from risk premia in foreign markets. 2 Please see Spiegel Online, "Donald Trump and the New World Order," dated January 20, 2017, available at Spiegel.de. 3 In a widely-quoted interview with The Wall Street Journal, Donald Trump said that the U.S. dollar is "too strong." He continued that, "Our companies can't compete with [China] now because our currency is too strong. And it's killing us." Please see The Wall Street Journal, "Donald Trump Warns on House Republican Tax Plan," dated January 16, 2017, available at wsj.com. 4 We would note that the Trump administration and its Treasury Department have considerable leeway over how they choose to interpret China's foreign exchange practices. In 1992, when the U.S. government last accused China of currency manipulation, it issued a warning in its spring report before leveling the accusation in the winter report. The RMB did not depreciate in the meantime but remained stable, and Treasury noted this approvingly; however, Treasury chose 1989 as the base level for its assessment, and found manipulation. The Trump administration could use much more aggressive interpretive methods than this to achieve its ends. 5 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, and Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 14, 2014, available at gps.bcaresearch.com. 6 Please see BCA Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Weekly Report, "The U.S. Dollar's Uptrend And China's Options," dated January 11, 2017, available at ems.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 10 Critics, including Trump supporters, claim that NAFTA sets too low of a threshold for the domestic content of a good deemed to have originated within the NAFTA countries. Goods that are nearly 40% foreign-made can thus be treated as NAFTA-made. This is one of many contentious points in the trade deal. 11 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. 12 In 2015, the U.K. took the ECB to court over its decision to require financial transactions denominated in euros to be conducted in the euro area, i.e. out of the City, and won. This avenue of legal redress will no longer be available for the U.K., allowing EU member states to slowly introduce rules and regulations that corral the financial industry - or at least to the parts focused on transactions in euros - out of London. 13 Please see Bank of International Settlements, "The economic consequences for the U.K. and the EU of completing the Single Market," BIS Economics Paper No. 11, dated February 2011, available at www.gov.uk. 14 Please see Her Majesty's Government, "H.M. Treasury Analysis: The Long-Term Economic Impact Of EU Membership And The Alternatives," Cmnd. 9250, April 2016, available at www.gov.uk. and Jagjit S. Chadha, "The Referendum Blues: Shocking The System," National Institute Economic Review 237 (August 2016), available at www.niesr.ac.uk. 15 We were going to use "grey" to describe Britain in the 1970s. However, our colleague Martin Barnes, BCA's Chief Economist, insisted that "grey" did not do the "ghastly" 1970s justice. When it comes to the U.K. in the 1970s, we are going to defer to Martin. 16 Please see BCA Research European Investment Strategy Weekly Report, “May’s Brexit Speech: No Substance,” dated January 19, 2017, available at eis.bcaresearch.com. Geopolitical Calendar