Secession/Breakup

Highlights The U.S. midterm elections are far less investment-relevant than consensus holds; Trump will increase the pressure on China and Iran regardless of the likely negative election results for the GOP; The Iranian sanctions, civil conflict in Iraq, and other oil supply issues are the real geopolitical risk; Despite the tentative good news on Brexit, political uncertainty in the U.K. makes now a bad time to buy the pound; Go long Brent crude / short S&P 500; long U.S. energy / tech equities; long JPY / short GBP. Feature The U.S. political cycle begins in earnest after Labor Day. Understandably, we have noticed an uptick in client interest, with a steady stream of questions and conference call requests about U.S. politics. Generally, our forecast remains unchanged since our April net assessment of the upcoming midterm election.1 Democrats have a slightly better than 60% probability of winning the House of Representatives, with a solid 45% probability of taking the Senate, and rising. The latter is astounding, given that the "math" of the Senate rotation is against the Democrats. Our bias toward a Democratic victory is based on current polling (Chart 1) and President Trump's woeful approval rating (Chart 2). There are a lot of other moving parts, however, and we will update them next week in detail. Chart 1GOP Trails In Polls, But It Is Still Close GOP Trails In Polls, But It Is Still Close GOP Trails In Polls, But It Is Still Close Chart 2Trump's Approval Rating Lines The GOP Up For Steep Losses Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit But why, dear client, should you care? Do the midterms really matter for investors? History suggests that they tend to be a bullish catalyst for the stock market (Chart 3). Will this time be any different? The two bearish narratives hanging over markets have to do with the Democrats foiling President Trump's pro-business policy and impeaching him. The former would purportedly have a direct impact on earnings by stymieing Trump's pluto-populist agenda, while the latter would presumably force Trump to seek relevance abroad - through an aggressive foreign policy or trade policy. We think both concerns are without merit. First, by taking over the House of Representatives, the Democrats will not be able to stop or reverse the president's economic agenda. Trump's deregulation will continue, given that regulatory affairs are the sole prerogative of the executive branch of government. Tax cuts will not be reversed, given that Democrats have no chance of gaining a 60-seat, filibuster-proof, majority in the Senate, and would not have a two-thirds majority in each chamber to override Trump's veto. As for fiscal stimulus, it is highly unlikely that the party of the $15 minimum wage and "Medicare for all" would seek to impose fiscal discipline on the nation. As far as the market is concerned, President Trump has accomplished all he needed to accomplish. Gridlock is perfectly fine, which is why a divided Congress has not stopped bull markets in the past (Chart 4). And should the Republicans somehow retain Congress, the result would be a "more of the same" rally. Chart 3Midterm U.S. Elections Tend To Be Bullish... Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit Chart 4... Even Those That Produce Gridlock Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit What about impeachment? Well, what about it? As we have illustrated in our net assessment of the impeachment risk, the Senate is not likely to convict Trump, so markets can look through it, albeit with bouts of volatility (Chart 5A & 5B).2 Chart 5AMarkets Can Rally Through Impeachment... Markets Can Rally Through Impeachment... Markets Can Rally Through Impeachment... Chart 5B...Despite Volatility ...Despite Volatility ...Despite Volatility To this our clients counter: "But Trump is different!" According to this theory, President Trump would respond to the threat of impeachment by becoming unhinged and seeking relevance abroad through an aggressive foreign and trade policy. But can he be more aggressive than ... Threatening nuclear war with North Korea; Re-imposing an oil embargo against Iran - and thus unraveling the already shaky equilibrium in the Middle East; Imposing tariffs on half, possibly all, U.S. imports from China; Threatening additional tariffs on U.S. allies like Canada, the EU, and Japan? More aggressive than that? We are agnostic towards the upcoming midterm elections. We already have a deeply alarmist view towards U.S. foreign policy posture vis-à-vis Iran3 and U.S. trade policy vis-à-vis China,4 both of which we have articulated at length. The midterm elections factor very little in our analysis of either. As such, they are a non-diagnostic variable. The outcome of the vote is a red herring. President Trump will seek relevance abroad whether or not his Republican Party holds the House and Senate. In fact, we believe that the midterms are a distraction. Investors have already forgotten about Iran (Chart 6), at a time when global oil spare capacity is falling (Chart 7). BCA's Commodity & Energy Strategy is forecasting Brent to average $80/bbl in 2019, but prices would easily reach $120/bbl in a case where all three pernicious scenarios occur (shale production bottlenecks, Venezuela export collapse, and Iran sanctions).5 Chart 6Nobody Is Paying Attention To Iranian Supply Risk! Nobody Is Paying Attention To Iranian Supply Risk! Nobody Is Paying Attention To Iranian Supply Risk! Chart 7Global Spare Capacity Stretched Thin Global Spare Capacity Stretched Thin Global Spare Capacity Stretched Thin These figures are alarming. But they could become even worse if our Q4 Black Swan - a Shia-on-Shia civil war in Iraq - manifests. The end of the U.S.-Iran détente has put the tenuous geopolitical equilibrium in Iraq on thin ice.6 Since our missive on this topic last week, the violence in Basra has intensified, with rioters setting the Iranian consulate alight. Investors were largely able to ignore the Islamic State insurgency in Iraq because it occurred in areas of the country that do not produce oil. A Shia-on-Shia conflict, however, would take place in Basra. This vital port exports 3.5 bpd. Any damage to its facilities, which is highly likely if Iran gets involved in the conflict, would instantly become the world's largest supply loss since the first Gulf War (Chart 8). Bottom Line: Our message to clients is that midterm elections are far less investment-relevant than is assumed. President Trump has already initiated aggressive foreign and trade policy. We expect the White House to intensify the pressure on Iran and China regardless of the outcome of the midterm election. And we also expect the Democratic Party to be unable to stop President Trump on either front, should it gain a majority in the House of Representatives. The truly underappreciated risk for investors is a massive oil supply shock in 2019 that comes from a combination of instability in Venezuela, aggressive U.S. enforcement of the oil embargo against Iran, and Iran's retaliation against such sanctions via chaos in Iraq. We are initializing a long Brent / short S&P 500 trade, as well as a long energy stocks / short tech trade, as hedges against this risk (Chart 9). Chart 8Civil Unrest In Basra Would Be Big Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit Chart 9Two Hedges We Recommend Two Hedges We Recommend Two Hedges We Recommend Government Shutdown Is The One True Midterm-Related Risk There is a declining possibility of a government shutdown before the midterm - and a much larger possibility afterwards. It is well known that the election odds favor the Democrats, but if there were ever a president who would do something drastic to try to turn the tables, it would be Trump. A majority in the House gives Democrats the ability to impeach. While we think the Senate would acquit Trump of any impeachment articles, this view is based on stout Republican support. A "smoking gun" from Special Counsel Robert Mueller - comparable to Nixon's Watergate tapes - could still change things. Trump would rather avoid impeachment altogether. Trump could still conceivably try to upset the election by insisting on funding his promised "Wall" on the border. The Republicans want to delay the appropriations bill for the Department of Homeland Security, which would include any border security funding increases, until after the election (but before the new House sits in January). Trump has repeatedly threatened to reject his own party's plan, though he has recently backed off these threats. A shutdown ahead of an election would conventionally be political suicide - especially given the likely need for a federal response to Hurricane Florence. Moreover Trump's border wall is opposed by over half the populace. But Trump could reason that the greatest game changer would be a spike in turnout when his supporters hear that he is willing to stake the entire election on this key issue. Turnout is everything. The success of such a kamikaze run would hinge on the Senate. Assuming that Trump retained full Republican support to push through wall funding, as GOP incumbents frantically sought to end the shutdown, there would be 12 Democratic senators, in the broadest measure, who could conceivably be intimidated into voting with them (Table 1). These senators would have to decide on the spot whether they are safer running for office during a government shutdown or after having given Trump his wall. They may decide on the latter. Table 1A Government Shutdown Could Conceivably Intimidate Trump-State Democrats Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit This would total 63 votes in the Senate, enough to invoke "cloture," ending debate, and hence break any Democratic filibuster against proposed wall funding. But this calculation is also extremely generous to Trump. More likely, at least four of the twelve senators would refuse to break rank: Debbie Stabenow of Michigan, Robert Menéndez of New Jersey, Sherrod Brown of Ohio, and Bob Casey of Pennsylvania. They would be averse to defecting from their party on such a consequential vote, even if eight of their colleagues were willing to do so.7 This is presumably why Mick Mulvaney, Trump's budget director, has already gone to Capitol Hill and "personally assured" the leading Republicans that Trump is not going to pursue a government shutdown.8 The legislative math doesn't really work. Nevertheless, there is still some chance that Trump - as opposed to any other president - will try this gambit. Especially as the loss of the House and potentially the Senate begins to appear "inevitable." After the midterm, of course, all bets are off. A lame duck Congress, or worse a Democratic Congress, will give President Trump all the reason he needs to grind things to a halt over his wall, with a view to 2020. The odds of a shutdown will shoot up. Do shutdowns matter for investors? Not really. S&P 500 returns tend to be flat for the first two weeks after a shutdown. Looking at eight past shutdowns, the average return was 1% fifteen days later, and 4.5% two months later. Bottom Line: We give a pre-election shutdown 10% odds due to Trump's unorthodoxy and desperate need to boost turnout among his voter base. Post-midterm election, a government shutdown is inevitable, unless congressional Republicans manage to convince President Trump to sign long-term appropriation bills before the election. Brexit: Is The Pound Pricing In Uncertainty? The U.K.-EU negotiations are entering their final, and thus most uncertain, phase. Our Brexit decision-tree looks messy and complicated (Diagram 1). While we believe that Prime Minister Theresa May has increased the probability of the sanguine "soft Brexit" outcome, there are plenty of pathways that lead to risk-off events. Diagram 1Brexit: Decision Tree And Conditional Probabilities Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit Is the pound sufficiently pricing in this uncertainty? According to BCA's Foreign Exchange Strategy, which recently penned a special report on the subject, the answer is no.9 According to their long-term fair value model, the trade-weighted pound exhibits only a 3% discount - well within its historical norm (Chart 10). Chart 10Pound: A Much Smaller Discount On A Trade-Weighted Basis Pound: A Much Smaller Discount On A Trade-Weighted Basis Pound: A Much Smaller Discount On A Trade-Weighted Basis In order to assess the degree of political risk priced into the pound, one needs to isolate the risk of the U.K. leaving the EU. This is because all fair value models - including that of our FX team - are based on a potentially unrepresentative sample, one where the U.K. is part of the EU! The problem is that the traditional variables used to explain exchange rate movements were also greatly affected by the shock following the Brexit vote in June 2016. For example, looking at the behavior of British gilts, the FTSE, consumer confidence, and business confidence, one can see very abnormal moves occurring in conjunction with large fluctuations in the pound during the summer of 2016 (Chart 11A & 11B). Thus, if one were to regress the pound on these variables, one would not have observed a risk premium, even though the market was clearly very concerned with the geopolitical outlook for the U.K. Chart 11AAbnormal Moves Around The Brexit Vote... Abnormal Moves Around The Brexit Vote... Abnormal Moves Around The Brexit Vote... Chart 11B...Make It Hard To Spot Geopolitical Risk ...Make It Hard To Spot Geopolitical Risk ...Make It Hard To Spot Geopolitical Risk Our FX team therefore decided to try to explain the pound's normal behavior using variables that did not experience large abnormal moves in the direct aftermath of the British referendum. For GBP/USD (cable), the currency pair was regressed versus the dollar index and the British leading economic indicator (LEI). For EUR/USD, the currency pair was regressed against the trade-weighted euro and U.K. LEI. The reason for using the trade-weighted dollar and euro as explanatory variables is simple: it helps isolate the pound's movements from the impact of fluctuations in the other leg of the pair. Using the U.K. LEI helps incorporate the immediate outlook for U.K. growth and U.K. monetary policy into the pound's movement. The remaining error term was mostly a reflection of geopolitical risk.10 The results of the models are shown in Chart 12A & 12B. While the pound did show a geopolitical discount in the second half of 2016 (as evidenced by the abnormally large discount from the fundamental-based model), today the pound's pricing shows no geopolitical risk premium, whether against the dollar or the euro. This corroborates the message from the economic policy uncertainty index computed by Baker, Bloom, and Davis, which shows a very low level of economic policy uncertainty based on news articles (Chart 13). Chart 12ANo Geopolitical Risk Embedded... No Geopolitical Risk Embedded... No Geopolitical Risk Embedded... Chart 12B...In Today's Pound Sterling ...In Today's Pound Sterling ...In Today's Pound Sterling Chart 13Policy Uncertainty Index Muted Policy Uncertainty Index Muted Policy Uncertainty Index Muted Considering the thin risk premium embedded in the pound against both the dollar and the euro, GBP does not have much maneuvering room through the upcoming busy calendar. The problem for the pound is that the 5% net disapproval of Brexit among the British public remains smaller than the cohort of British voters who remain undecided (Chart 14). This means that domestic politics in the U.K. could remain a source of surprise, especially as Prime Minister Theresa May's polling remains tenuous (Chart 15). This raises the risk that Hard Brexiters end up controlling 10 Downing Street - despite their status as a minority within the ranks of Conservative MPs (Chart 16). Chart 14A Liability For Sterling A Liability For Sterling A Liability For Sterling Chart 15Theresa May's Tenuous Grip Theresa May's Tenuous Grip Theresa May's Tenuous Grip Chart 16Hard Brexiters Are A Minority Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit With the global economic outlook already justifying a lower pound, especially versus the dollar, the pound seems to be too risky of an investment at this moment. It is true that positioning and sentiment towards cable are currently very depressed, raising the risk of a short-term rebound (Chart 17). This could particularly occur if the EU meeting in Salzburg in two weeks results in some breakthrough. Such an event would still not resolve May's domestic conundrum, which is why we would be inclined to fade any such rebound. Bottom Line: On a six-to-nine-month basis, it makes sense to short the pound against the dollar and the yen. Slowing global growth hurts the pound but also hurts the euro while benefiting the greenback and the yen. The political environment in Japan, in particular, supports this reasoning. As we have maintained, Shinzo Abe is not going to lose the September 20 leadership election for the ruling party (Chart 18).11 And the Trump administration is not going to wage a full-scale trade war against Japan. However, after the leadership poll, Abe will press ahead with his agenda to revise the constitution, which will initiate a controversial process and stake his fate on a popular referendum that is likely to be held next year. Chart 17Fade Any Short-Term Rebound Fade Any Short-Term Rebound Fade Any Short-Term Rebound Chart 18Abe Lives, But Yen Will Rise Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit At the same time, Trump might try throwing some threats or jabs against Japan before his defense secretary and admirals are able to convince him that such actions subvert U.S. strategy against China. Therefore Japan-specific political risks are on the horizon, in addition to the ongoing trade war with China, which is already a boon for the yen. We are therefore initiating a long yen / short pound tactical trade. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Juan Manuel Correa, Senior Analyst juanc@bcaresearch.com Ekaterina Shtrevensky, Research Associate ekaterinas@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "The U.S. And China: Sizing Up The Crisis," dated July 11, 2018, available at gps.bcaresearch.com. 5 Please see BCA Commodity & Energy Strategy Weekly Report, "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," dated August 23, 2018, available at ces.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply," dated September 5, 2018, available at gps.bcaresearch.com. 7 Please see Burgess Everett, "Key red-state Democrat sides with Trump on wall funding," Politico, August 8, 2018, available at www.politico.com, and Ali Vitali, "Vulnerable Senate Democrats embrace Trump's wall," NBC News, August 13, 2018, available at www.nbcnews.com. 8 Please see Niv Elis and Scott Wong, "Trump again threatens shutdown," The Hill, September 5, 2018, available at thehill.com. 9 Please see BCA Foreign Exchange Strategy Special Report, "Assessing The Geopolitical Risk Premium In The Pound," dated September 7, 2018, available at fes.bcaresearch.com. 10 To make sure the exercise was robust, Foreign Exchange Strategy tested the out-of-sample performance of the model. Reassuringly, the GBP/USD and EUR/GBP models showed great predictive power out-of-sample (see Appendix), while remaining significant and explaining 80% and 65% of the pairs' variations respectively. 11 Please see BCA Geopolitical Strategy Special Report, "Japan: Kuroda Or No Kuroda, Reflation Ahead," dated February 7, 2018, available at gps.bcaresearch.com. Appendix: Traditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium Chart 19 Out-Of-Sample Testing Of Model (I) Out-Of-Sample Testing Of Model (I) Chart 20 Out-Of-Sample Testing Of Model (II) Out-Of-Sample Testing Of Model (II) Geopolitical Calendar

Highlights Cable is cheap on a PPP basis. However, the discount does not reflect a geopolitical risk premium; it reflects the dollar's general expensiveness. In fact, when the British productivity picture is taken into account, the trade-weighted pound's discount appears rather modest. Our model specifically designed to capture the geopolitical risk premia in GBP/USD and EUR/GBP shows that investors are currently pricing in a very rosy political outlook in the U.K., and near certainty that a soft Brexit will materialize. We are not willing to bet that the path toward a soft Brexit will be easy. As a result, we would expect that if the GBP experiences any rebounds, they will prove short-lived, especially as the outlook for global growth outside the U.S. remains murky. Feature This fall will be a tumultuous time for the pound, as the Brexit process goes into full swing ahead of March 2019. While there remain many possible paths that the U.K.'s relationship with the rest of the EU could ultimately take, ranging from a complete reset of the relationship (i.e. a hard Brexit) to no Brexit at all, another unknown needs to be tackled: Is the GBP priced to adequately compensate investors for such heightened uncertainty? In this week's piece, we develop a simple model to try to ascertain whether geopolitical risk premium is currently present in the pound. We conclude that even though the pound seems cheap enough to compensate investors for the high degree of uncertainty surrounding the U.K.'s long-term economic outlook, this picture is deceiving. As a result, BCA remains concerned about the pound's cyclical outlook, especially against the euro. Is The Pound That Cheap? At first glance, it seems obvious that the pound is very cheap. Cable currently trades at a prodigious 20% discount to it purchasing power parity (PPP) estimate (Chart I-1). Such bargain-basement levels must be a reflection of the economic risks surrounding Brexit. Well, perhaps not. First, the pound may be trading at a large discount against the dollar, but the euro also trades well below its PPP fair value. In fact, when using PPP models, it is hard to dissociate the cheapness of the pound from the expensiveness of the U.S. dollar against its trading partners (Chart I-2). Thus, PPP models are not enough to gauge whether or not the pound is adequately compensating investors for inherent geopolitical risk. Chart I-1Is The Pound Cheap... Is The Pound Cheap... Is The Pound Cheap... Chart I-2U.S. Dollar And PPP ...Or Is The Dollar Expensive? U.S. Dollar And PPP ...Or Is The Dollar Expensive? U.S. Dollar And PPP ...Or Is The Dollar Expensive? Second, when one uses a slightly more sophisticated valuation approach, the discount of the pound seems much more muted than when one looks at PPP alone. Based on our proprietary long-term fair value model, the trade-weighted pound exhibits a much more muted discount of only 3% - well within the historical norm (Chart I-3). Chart I-3Pound: A Much Smaller Discount On A Trade-Weighted Basis Pound: A Much Smaller Discount On A Trade-Weighted Basis Pound: A Much Smaller Discount On A Trade-Weighted Basis What explains this disconnect is the U.K.'s poor productivity performance. In the world of exchange rate determination, there is a phenomenon called the Penn effect. It is an empirical observation - one not fully understood under a theoretical lens1 - which shows that countries with higher levels of productivity growth than their trading partners tend to experience an appreciation in their real exchange rates. As Chart I-4 illustrates, the U.K. is on the wrong side of this phenomenon, as its relative productivity has been falling in comparison to its trading partners. This factor has played an important role in dragging down the pound's fair value. This poor productivity performance has also had another pernicious effect: unit labor costs in the U.K. have risen much more sharply than in the majority of its important trading partners (Chart I-5). This hurts the pound's competitiveness and suggests that a simple PPP model based purely on producer prices might be missing the mark for the true fair value of the British currency - further supporting the message of our proprietary long-term valuation model. Chart I-4Negative Penn Effect For The Pound Negative Penn Effect For The Pound Negative Penn Effect For The Pound Chart I-5The U.K. Is Uncompetitive The U.K. Is Uncompetitive The U.K. Is Uncompetitive Even when these adjustments are taken into account, our model might still be missing the mark due to a very significant problem: All fair value models for the pound are now based on a potentially unrepresentative sample, one where the U.K. was part of the EU. Thus, another exercise is needed to evaluate the pound's geopolitical risk premium. Bottom Line: Based on simple PPP models, cable looks cheap and therefore may already embed a large geopolitical risk premium. However, this conclusion is misleading. A large share of the pound's undervaluation is not GBP-specific and instead simply mirrors the USD's premium to its fair value. Additionally, the U.K.'s poor productivity performance relative to its trading partners already provides an economic justification for a cheap pound. Thus, we need a different exercise to zero in on the degree of geopolitical discount present in the pound. Zeroing In On The Geopolitical Risk In order to assess the degree of political risk priced into the pound, one needs to isolate this risk. The problem is that the traditional variables used to explain exchange rate movements were also greatly affected by the shock following the Brexit vote in June 2016. For example, looking at the behavior of British gilts, the Footsie, consumer confidence or business confidence, one can see very abnormal moves occurring in conjunction with large fluctuations in the pound during the summer of 2016 (Chart I-6). Thus, if one were to regress the pound on these variables, one would not have observed a risk premium, even though the market was clearly very concerned with the geopolitical outlook for the U.K. Chart I-6ATraditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium (I) Traditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium (I) Traditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium (I) Chart I-6BTraditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium (II) Traditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium (II) Traditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium (II) We therefore decided to try to explain the pound's normal behavior using variables that did not experience large abnormal moves in the direct aftermath of the British referendum. Moreover, we wanted to keep the model simple, as simplicity permits us to better understand the pound's deviation from its predicted value. Practically, we settled on the following specification: for GBP/USD, we regressed the pair versus the dollar index and the British leading economic indicator. For EUR/GBP, we regressed the cross against the trade-weighted euro and the U.K. LEI. The reason for using the trade-weighted dollar and euro as explanatory variables is simple: it helps us isolate the pound's movements from the impact of fluctuations in the other leg of the pair. Using the U.K. LEI helps incorporate the immediate outlooks for U.K. growth and U.K. monetary policy into the pound's movement. The remaining error term was mostly a reflection of geopolitical risks. To make sure the exercise was robust, we then tested the out-of-sample performance of the model. Reassuringly, the GBP/USD and EUR/GBP models showed great predictive power out-of-sample (see Appendix), while remaining significant and explaining 80% and 65% of the pairs' variations, respectively. The results of the models are shown in Chart I-7, and they are startling. While the pound did show a geopolitical discount in the second half of 2016 (as evidenced by the abnormally large discount from our fundamental-based model), today the pound's pricing shows an absence of geopolitical risk premium, both against the dollar and against the euro. This corroborates the message from the uncertainty index computed by Baker Bloom and Davis, which shows a very low level of economic policy uncertainty based on language in the press (Chart I-8). Chart I-7ALittle Risk Premium In The Pound (I) Little Risk Premium In The Pound (I) Little Risk Premium In The Pound (I) Chart I-7BLittle Risk Premium In The Pound (II) Little Risk Premium In The Pound (II) Little Risk Premium In The Pound (II) This is particularly salient when compared to the euro, where the geopolitical risk premium is currently exaggerated. As Chart I-9 illustrates, the probability of a euro area breakup in the next five years priced into the bond market is at its highest level since the heyday of the euro area crisis in 2011 and 2012. However, this risk is currently overstated as investors have been frightened by the recent Italian elections. Yet, after a tumultuous beginning, the populist Five Star Movement / Lega Nord coalition is backing away from a budget confrontation with Brussels. Giovanni Tria, Italy's minister of finance, wants a 2% budget deficit while Deputy Prime Minister Matteo Salvini is arguing for a 2.9% budget hole - well south of the 6% levels touted during the campaign. Italians realize that life outside the euro area will not be a land of milk and honey. Chart I-8British Political Uncertainty Has Collapsed British Political Uncertainty Has Collapsed British Political Uncertainty Has Collapsed Chart I-9Investors Are Worries About The Euro Area Investors Are Worries About The Euro Area Investors Are Worries About The Euro Area Instead, the pound's cheapness reflects the weakness in the British LEI. This is a consequence of the deterioration in global economic activity. As Chart I-10 shows, the trade-weighted pound has been more sensitive to EM gyrations than the euro or the dollar. This is because total trade represents a stunning 40% of U.K. GDP, versus 37% for the euro area or 28% for the U.S. The U.K. is therefore highly sensitive to global economic conditions. Moreover, the tightening in global liquidity conditions that has contributed to the deterioration of the global growth outlook is itself particularly negative for the pound. The U.K. runs a current account deficit of 4% of GDP, and as FDI inflows into Great Britain have collapsed, the U.K. now runs a basic balance-of-payments deficit (Chart I-11). As such, it is highly dependent on global liquidity flows to finance its current account deficit. As a result, the recent weakness in the pound is more a function of global economic conditions than Brexit itself. Chart I-10The Pound Has Fallen Because of EM Risks... The Pound Has Fallen Because of EM Risks... The Pound Has Fallen Because of EM Risks... Chart I-11...And As Global Liquidity Has Tightened ...And As Global Liquidity Has Tightened ...And As Global Liquidity Has Tightened Bottom Line: After developing a more precise method for evaluating the size of the geopolitical risk premium embedded in the pound, we arrived at an interesting conclusion: There is currently no evidence of a risk premium at all. Instead, the pound's weakness reflects the expensiveness of the dollar, weakening global growth and deteriorating global liquidity conditions. In fact, it is the euro that currently suffers from an exaggerated geopolitical risk premium, as euro area bonds currently incorporate too-large of a break-up risk premium. Investment Implications Taking into account the thin risk premium embedded in the pound against both the dollar and the euro, the GBP does not have much maneuvering room through the fall season. The problem for the pound is that the 5% net disapproval of Brexit among the British public remains smaller than the cohort of British voters who remain undecided (Chart I-12). This means that domestic politics in the U.K. could remain a source of surprise, especially as Prime Minister Theresa May's polling remains tenuous (Chart I-13). This raises the risk that Hard Brexiters end up controlling 10 Downing Street - despite their status as a minority within Conservative MPs. This also raises the risk that Jeremy Corbyn, whose popularity is rising, could end up as British Prime Minister (Chart I-14). Both of these outcomes are worrisome. The pound is currently pricing in neither the risk of a hard Brexit, nor the risk of the U.K. being controlled by the most leftist government of any G10 nation since the election of Francois Mitterrand in France in 1981. Chart I-12More Undecided Voters Than ##br##Net Brexit Detractors More Undecided Voters Than Net Brexit Detractors More Undecided Voters Than Net Brexit Detractors Chart I-13A Risk To ##br##U.K. Stability... A Risk To U.K. Stabiity... A Risk To U.K. Stabiity... Chart I-14...Especially With Mitterand 2.0 ##br##Lurking In The Shadows ...Especially With Mitterand 2.0 Lurking In The Shadows ...Especially With Mitterand 2.0 Lurking In The Shadows Moreover, while Germany and EU chief negotiator Michel Barnier seem amenable to keeping the window of negotiations open for the ultimate form of Brexit during the transition period, it remains to be seen what kind of concessions London is willing to make on the free movement of people required to be granted access to the common market in goods. Additionally, the Northern Ireland border remains an unresolved issue. These factors increase the chances that negotiations with the EU will remain difficult. Hence, the implementation of the Chequers White Paper is far from certain, yet the pound currently seems to be priced for an absolute soft Brexit. With the global economic outlook already justifying a lower pound, especially versus the dollar, it therefore seems that the pound today is too risky an investment. It is true that positioning and sentiment in cable are currently very depressed, raising the risk of a short-term rebound (Chart I-15), especially if the EU meeting in Salzburg in two weeks shows an acquiescent EU. However, this will not remove Britain's domestic political problems. Hence, we would be inclined to fade any such rebound. Finally, it is unlikely that the Bank of England will be of much help to the pound either. The British LEI continues to slow, which not only drags the fair value of the pound lower, but also limits how fast the BoE can raise interest rates. Moreover, while British inflation surged as imported goods prices skyrocketed after the GBP plummeted in 2016, domestic prices have remained well behaved (Chart I-16). Thus, as the pass-through to inflation of the previous pound weakness dissipates, British inflation will decelerate further, limiting the upside for interest rates in the process. This combination is only made more binding for the BoE as the government is expected to exert some drag on growth as the British fiscal thrust will subtract 0.4%, 0.2%, and 0.2% to growth in 2018, 2019, and 2020, respectively (Chart I-17). Chart I-15There Is Room For A ##br##Countertrend GBP Rally U.K. XR There Is Room For The A Countertred GBP Rally U.K. XR There Is Room For The A Countertred GBP Rally Chart I-16Little Domestic ##br##Price Pressures Little Domestic Price Pressures Little Domestic Price Pressures Chart I-17Fiscal Drag ##br##Not Over Fiscal Drag Not Over Fiscal Drag Not Over On a six- to nine-month basis, it makes most sense to short the pound against the dollar and the yen, as slowing global growth hurts the pound but also hurts the euro while benefiting the greenback and the yen. However, on a longer-term basis, we would expect the break-up risk premium in the euro area to dissipate, which will boost the cheap euro in the process. This means that on investment horizons beyond one year, being long EUR/GBP still makes sense. Bottom Line: Since this year's pound weakness did not represent a swelling of the GBP's geopolitical risk premium but instead has been a reflection of poor global growth and liquidity, any hiccups in British politics could inflict considerable pain on cable. While the EU negotiations may progress positively, domestic British politics remain a big source of risk that investors are not being compensated to take on. As such, we are inclined to fade any rally in the pound. While the pound could weaken most against the dollar and the yen through the fall months, the longer-term outlook looks riskier against the euro. To be clear, the confidence interval around these views remains wide, as the British political situation remains very fluid. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Senior Analyst juanc@bcaresearch.com Ekaterina Shtrevensky, Research Associate ekaterinas@bcaresearch.com 1 The Balassa-Samuelson effect has been cited as a potential explanation for this observation, but it still does not fully satisfy many theorists. Appendix Chart II-1Out-Of-Sample Testing Of Model (I) Assessing The Geopolitical Risk Premium In The Pound Assessing The Geopolitical Risk Premium In The Pound Chart II-2Out-Of-Sample Testing Of Model (II) Out-Of-Sample Testing Of Model (II) Out-Of-Sample Testing Of Model (II) Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

According to market lore, one should never say, "It's Different This Time". But every time is always different: there is a never a previous period that perfectly matches the current environment. That is why forecasting is so difficult and why all model-based predictions should be treated with caution. Yet, some basic common sense can go a long way in helping to assess investment risks and potential rewards. As I look at the world, it looks troubled enough to warrant a very conservative investment stance, but that clearly puts me at odds with the majority of investors. In aggregate, investors and market analysts are upbeat. Major equity indexes are close to all-time highs, earnings expectations are ebullient and surveys of investor sentiment do not imply much concern about the outlook. There is a strong consensus that a U.S. recession will not occur before 2020, meaning that risk assets still have decent upside. That may indeed turn out to be true, but I can't shake off my concerns about a number of issues: The consensus may be too complacent about the timing of the next U.S. recession. The dark side of current strong growth is growing capacity pressures that warn of upside surprises for inflation and thus interest rates. Uncertainty about trade wars represents a risk to the global economic outlook beyond the direct impact of tariffs because it also gives companies a good reason to hold back on investment spending. Profit growth in the U.S. has remained much stronger than I expected, but the forces driving this performance are temporary. Rising pressures on wages suggest that labor's share of income will rise, leading to lower margins. The geopolitical environment is ugly, ranging from a shambolic Brexit process to rising populist pressures in Europe, a flaring in U.S./Iran tensions and possible disappointment with North Korea negotiations. The Debt Supercycle may be over, but global debt levels remain worryingly high in several major economies. This could become a problem in the next economic downturn. It would be easier to live with the above concerns if markets were cheap, but that is far from the case - especially in the U.S. Credit spreads in the corporate bond market are below historical averages while equities continue to trade at historically high multiples to earnings. Even if equity prices do move higher, the upside from current levels is likely to be limited. Yes, there could be a final, dramatic blow-off phase similar to that of the late 1990s, but that would be an incredibly risky period and not one that I would want to participate in. Timing The Next Recession Sad to say, economists do a very poor job of forecasting recessions. As I showed in a report published last year, the Fed has missed every recession in the past 60 years (Table 1).1 One could argue that the Fed could never publish a forecast of recession because it would be an admission of policy failure: they generally have to be seen aiming for soft landings. But private forecasters have not done any better. For example, the consensus of almost 50 private forecasters published in mid-November 2007 was that the U.S. economy would grow by 2.5% in the year to 2008 Q4.2 The reality was that the economy was then at the precipice of its worst downturn since the 1930s. Table 1Fed Economic Forecasts Versus Outcome Personal Observations On The Current Environment Personal Observations On The Current Environment The U.S. economy currently is very strong, but that often is the case just a few quarters before a recession starts. Strong growth today is not a predictor of future strong growth. As has been widely acknowledged, the yield curve has been one of the few indicators to give advance warning of economic trouble ahead. Yet, in the past, its message typically was ignored or downplayed, with the result that most forecasters stayed too bullish on the economy for too long. History is repeating itself with a flurry of reports explaining why the recent flattening of the yield curve is giving a misleading signal. The principal argument is that term premiums have been artificially depressed by the Fed's bond purchases. However, the curve has flattened even as the Fed has pulled back from quantitative easing. As usual, the flattening reflects the tightening in monetary policy and, therefore, should not be discounted. To be fair, there is still a positive slope across the curve, so this indicator is not yet flashing red. But it is headed in that direction (Chart 1). Chart 1Recession Indicators: Not Flashing Red...Yet Recession Indicators: Not Flashing Red...Yet Recession Indicators: Not Flashing Red...Yet The other series to watch closely is the Conference Board's Leading Economic Index. Typically, the annual rate of change in this index turns negative ahead of recessions, although once again, there is a history of forecasters ignoring or downplaying the message of this signal. Currently, the growth in the index is firmly in positive territory, so no alarm bells are ringing. Overall, there are no indications that a U.S. recession is imminent. At the same time, late cycle pressures and thus risks are building. Anecdotal evidence abounds of labor shortages and supply bottlenecks in a number of industries. Wage growth has stayed relatively muted given the low unemployment rate, but that is starting to change. My colleague Peter Berezin has shown compelling evidence of a "kinked" relationship between wage growth and unemployment whereby the former accelerates noticeably after the latter drops below its full employment level (Chart 2). We are at the point where wage growth should accelerate and it is significant that the 2.8% rise in the employment cost index in the year to the second quarter was the largest rise in a decade. It also should be noted that the Fed's preferred inflation measure (the core personal consumption deflator) has been running at around a 2% pace in the past three quarters, in line with its target (Chart 3). As capacity pressures build, an overshoot of 2% seems inevitable, forcing the Fed to react. Current market expectations that the funds rate will rise by only 25 basis points over the remainder of this year and by 100 basis points in 2019 are likely to prove too optimistic. Chart 2Faster Wage Growth Ahead Personal Observations On The Current Environment Personal Observations On The Current Environment Chart 3Core Inflation At The Fed's Target Core Inflation At The Fed's Target Core Inflation At The Fed's Target Admittedly, there is huge uncertainty about what interest rate level will be restrictive enough to damage growth. Historically, recessions did not occur until the fed funds rate reached at least the level of potential GDP growth. The Congressional Budget Office estimates that potential GDP growth will average around 4% over the coming year, and the funds rate probably will not reach that level in 2019. However, additional restraint is coming from the strong dollar, and lingering high debt burdens mean that rates are likely to bite at lower levels than past relationships would suggest. Chart 4U.S. Trade Performance: No Major Surprises U.S. Trade Performance: No Major Surprises U.S. Trade Performance: No Major Surprises Trade Wars Etc. President Trump appears to believe that the large U.S. trade deficit is largely a reflection of unfair trade practices. The reality is obviously more complicated, even if there is truth to the claim that the playing field with China is far from level. The key drivers of trade imbalances are relative economic growth rates and relative real exchange rates. The trend in the volume of U.S. non-oil merchandise imports has been exactly in line with that of domestic demand for goods (Chart 4). In other words, there is no indication that the U.S. is being "taken advantage of". The growth in U.S. non-oil exports has been a little on the soft side relative to overseas growth in recent years, but that occurred against the background of a rising real dollar exchange rate. Overall, the trend in the ratio of U.S. real non-oil imports to exports has broadly followed the ratio of U.S. real GDP to that of other OECD economies. The periods where the trade ratio deteriorated somewhat faster than the GDP ratio were times when the real trade-weighted dollar was strong, such as in the past few years. The irony, which seems to escape the administration, is that recent policy actions - tax cuts and efforts to boost private investment spending - are bound to further boost the trade deficit. This may partly explain the clumsy attempt to encourage the Fed to slow down its rate hikes in order to dampen the dollar's ascent. Of course, that will not work - the Fed will not be deflected from its policy course by political interference. Meanwhile, the administration's imposition of tariffs will not change the underlying drivers of the U.S. trade deficit. I have no way of knowing whether current trade skirmishes will degenerate into an all-out war. There are some glimmers of hope with the EU and U.S. promising to engage in talks about reducing trade barriers. But the more important issue is what happens with China. While China has an economic incentive to make concessions, I cannot imagine that President Xi wants to be seen as giving ground in the face of U.S. bullying. My rather unhelpful conclusion is that trade wars are a serious risk that need watching but are unforecastable at this stage. Earnings Galore, But... It's confession time. The performance of U.S. corporate earnings has been far better than I have been predicting during the past few years. In several previous reports, I argued that earnings growth was bound to slow sharply as labor's share of income eventually climbed from its historically low level. I certainly had not expected that the annual growth in S&P 500 operating earnings would average 20% in the two years to 2018 Q2 (Chart 5). In defense, my original argument was not completely wrong. Labor's share of corporate income bottomed in the third quarter of 2014 and that marked the peak in margins, based on national income data of pre-tax profits (Chart 6). Margins have fallen particularly sharply for the national income measure of non-financial profits before interest, taxes and depreciation (EBITD). I believe this is a good measure of the underlying performance of the corporate sector as it is unaffected by policy changes to taxes, depreciation rates and monetary policy. This measure of margins used to be very mean reverting but currently is still far above its historical average. Given the tightness in the labor market, there is still considerable downside in margins as wage costs edge higher. Chart 5Spectacular U.S. Earnings Growth Spectacular U.S. Earnings Growth Spectacular U.S. Earnings Growth Chart 6Profit Margins Have Peaked Profit Margins Have Peaked Profit Margins Have Peaked An unusually large gap has opened up in recent years between S&P earnings data and the national accounts numbers. While there are several definitional differences between the two datasets, this cannot explain the large divergence shown in Chart 7. The national income data are generally believed to be less susceptible to accounting gimmicks and are thus a better reflection of underlying trends. Analysts remain extraordinarily bullish on future earnings prospects. Not only are S&P 500 earnings forecast to rise a further 14% over the next 12 months, but the current expectation of 16% per annum long-run earnings growth was only exceeded at the peak of the tech bubble (Chart 8). And we know how that episode ended! Chart 7A Strange Divergence in Profit Data A Strange Divergence in Profit Data A Strange Divergence in Profit Data Chart 8Insanely Bullish Long-Term Earnings Expectations Insanely Bullish Long-Term Earnings Expectations Insanely Bullish Long-Term Earnings Expectations I am inclined to stick to my view that earnings surprises will disappoint over the next year. The impact of corporate tax cuts will disappear, and both borrowing costs and wage growth are headed higher. A marked slowdown in earnings growth will remove a major prop under the bull market. Brexit As a Brit, I am totally appalled with the Brexit fiasco. It was all so unnecessary. Yes, the EU has an intrusive bureaucracy that imposes some annoying rules and regulations on member countries. However, OECD data show that the U.K. is one of the world's least regulated economies and it scores high in the World Bank's Ease of Doing Business rankings. In other words, there is no compelling evidence that EU bureaucratic meddling has undermined business activity in the U.K. The vote for Brexit probably had more to do with immigration than anything else, and that also makes little sense given that the U.K. has a tight labor market and needs a plentiful supply of immigrant workers. History likely will dictate that former Prime Minister David Cameron's decision to call for the Brexit referendum was the U.K.'s greatest political miscalculation of the post-WWII period. Not only was the decision to hold the referendum a mistake, but it also was foolhardy to base such a momentous vote on a simple majority rather than a super-majority of at least 60%. Adjusting the referendum result by voter turnout, those backing Brexit represented only around 37% of the eligible voting public.3 Clearly, the government was unprepared for the vote result and divorce proceedings have moved ahead with no viable plan to achieve an acceptable separation. Meanwhile, the inevitable confusion has created huge uncertainty for businesses and is doing significant damage to the economy. This is not the place to get into the minutiae of the Brexit morass such as the Northern Ireland border issue and the difficulty of agreeing new trade relationships. Those have been well aired in the press and by many other commentators. My lingering hope is that the enormous challenges of coming up with a mutually acceptable deal with the EU will prove intractable, resulting in a new referendum or election that will consign the whole idea to its grave. We should not have to wait too long to discover whether that is a futile wish. Investment Strategy Chart 9The U.S. Equity Market Is Expensive The U.S. Equity Market Is Expensive The U.S. Equity Market Is Expensive Equities are still in a bull market and we are thus in a period where investors are biased to be optimistic. Bears have been discredited and the current strength of the economy gives greater credence to the market's cheerleaders. I have been in the forecasting business for long enough (45+ years) to be suitably humble about my ability to forecast where markets are headed. I am very sympathetic to the famous Keynes quote that "the market can stay irrational longer than you can stay solvent". Investors will have their own set of preferences and constraints about whether it makes sense to stay heavily invested during times when markets appear to have diverged from fundamentals. The U.S. equity market's price-earnings ratio (PER) currently is about 20% above historical averages, based on both trailing and 12-month forward earnings and more than 30% above based on cyclically-adjusted earnings (Chart 9). Yes, interest rates are low by historical standards, giving scope for higher PERs, but rates are going up and profit margins are at historically elevated levels with lots of downside potential. I fully accept that equity markets can continue to rise over the next year, beating the meagre returns available from cash and bonds. For those investors being measured by quarterly performance, it is difficult to stay on the sidelines while prices march higher. Nevertheless, I believe this is a time for caution. The perfect time for equity investing is when markets are cheap, earnings expectations are overly pessimistic and the monetary environment is highly accommodative. Currently, the opposite conditions exist: valuations are stretched, earnings expectations are euphoric and the Fed is in tightening mode. It does not seem a propitious time to be aggressive. The future is always shrouded in mist, but there currently is an unusually large number of important economic and political questions hanging over the market. These include the timing of the next recession, the related path of monetary policy, the outcome of the U.S. midterm elections, trade wars, U.S.-Sino relations and Brexit, just to name a few. The good news is that our Annual Investment Conference on September 24/25 will be tackling these issues head on with an incredible group of experts. I am looking forward to hearing, among others, from Janet Yellen on monetary policy, Leland Miller and Elizabeth Economy on China, Greg Valliere on U.S. politics, and Stephen King and Stephen Harper on global trade. It promises to be an exceptional event and I hope to see you there. Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com 1 BCA Special Report "Beware The 2019 Trump Recession," March 7, 2017. Available at bca.bcaresearch.com. 2 Source: Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters (www.philadelphiafed.org). 3 The referendum result was 51.9% in favor of Brexit, with a voter turnout of close to 72%.

Highlights If the EU27 pours cold water on Theresa May's much-hyped Brexit proposals, the immediate uncertainty around Brexit would increase. But a longer-term outcome that keeps the U.K. either in a protracted transition to exit, or attached to the EEA or EFTA would be benign for the U.K. economy. For U.K. gilts relative to other government bonds, it means bullish near-term, but bearish long-term. For the pound, it is the opposite: caution near-term, but scope for long-term appreciation, especially versus the dollar. Neutral FTSE100 in a European or global equity portfolio, given its large overweight to the technically extended oil and gas sector. The global 6-month credit impulse is still in a mini-downswing, which corroborates our successful underweight stance to the classical cyclical sectors. The dollar's recent rally is technically extended to a point which usually signals a tradeable reversal in the DXY. Feature Last week, we highlighted a surprising fact: wages in Europe and the U.S. are now growing at exactly the same pace, 2.7%. We also pointed out that wage growth in the euro area is running slightly lower than the EU28 average - which necessarily means that in a major European economy outside the euro area, wage growth is running considerably higher. That major European economy is the U.K. Chart of the WeekThe Pound Is A Function Of Relative Monetary Policy The Pound Is A Function Of Relative Monetary Policy The Pound Is A Function Of Relative Monetary Policy Absent Brexit, U.K. Interest Rates Would Be Much Higher U.K. wages are growing at 3.7% (Chart I-2). Total labour costs, which include other compensation such as employer pension contributions, are rising even faster, at 4.4%, a sharp acceleration from a year ago.1 Meanwhile, the unemployment rate is at a forty year low of 4.2% (Chart I-3). To put all of this into context, the U.K. metrics are broadly equal to, or more extreme than those in the U.S. where the Federal Reserve has already hiked the policy interest rate seven times! Chart I-2U.K. Wages Are Growing ##br##Faster Than In The U.S. U.K. Wages Are Growing Faster Than In The U.S. U.K. Wages Are Growing Faster Than In The U.S. Chart I-3The U.K. Unemployment Rate##br## Is As Low As In The U.S. The U.K. Unemployment Rate Is As Low As In The U.S. The U.K. Unemployment Rate Is As Low As In The U.S. You might think that the Bank of England would be emulating the Fed. Acknowledging "a tight labour market and gradually mounting pay pressure" Monetary Policy Committee member Andy Haldane did change his vote to a hike at the June 21 meeting. Yet the votes to remove ultra-accommodation remain in a minority of three to six. The BoE policy interest rate is still at 0.5%, only a fraction above its effective lower bound. And the tightening expected in the next couple of years remains very modest (Chart I-4). Why? Chart I-4Expectations For U.K. Rate ##br##Hikes Remain Subdued Expectations For U.K. Rate Hikes Remain Subdued Expectations For U.K. Rate Hikes Remain Subdued The BoE explains: "The main challenge continues to be to assess the economic implications of the United Kingdom withdrawing from the European Union and to identify the appropriate response to that changing outlook... ...those economic implications would be influenced significantly by the expectations of households, firms and financial markets about the United Kingdom's eventual relationships with the European Union and other countries, and the transition to them." The U.K./EU Relationship Has Only Three Possible Shapes Two years have passed since the U.K. voted to leave the EU, and the tomes that have been written on Brexit could have filled the British Library several times over. Yet on the crucial issue of what the U.K./EU relationship will look like, what we know today is little different to what we knew on the morning of June 24 2016. Just as then, we can say that the EU27 sees only three options for the long-term relationship between the U.K. and the EU. Stay in the EU. Plug into an off-the-shelf association, either the European Economic Area (EEA) or European Free Trade Association (EFTA), which already establishes the EU relationship with Norway, Iceland, Liechtenstein, and Switzerland. Become a 'third country' to the EU like, for example, Ukraine and Turkey. The first option, to stay in the EU, is politically impossible for the U.K. unless and until a second referendum overturned the result of the first referendum - a not inconceivable, but distant possibility. The second option, to join the EEA or EFTA, is impossible until the U.K. government exorcises the hard Brexiters within its ranks who regard this endpoint as 'Brino' (Brexit in name only). Nevertheless, this - or something equivalent - is the most likely ultimate outcome once it becomes clear that what is on offer in the third option is a considerably worse deal for the U.K., both politically and economically. Becoming a third country necessarily involves a hard border. For the U.K. this creates an insoluble trilemma: the U.K./EU land border between Northern Ireland and the Irish Republic; the Good Friday peace agreement requiring the absence of any physical border within Ireland; and the Northern Ireland unionists' refusal to countenance a U.K./EU border at the Irish Sea (which would require a border between Northern Ireland and the rest of the U.K.). The U.K. government might suggest a solution: leave the EU single market for services and free movement of people, but commit to stay in the single market for goods by aligning U.K. tariffs and regulations with the EU. The U.K. government would argue that this would abrogate the need for customs checks and a hard border within Ireland. The problem with this is that the distinction between goods and services has become increasingly blurred. For example, the sale of a car is no longer the sale of just a good. As car companies often structure the financing of the car purchase, a car purchase can be a hybrid of a good - the car itself, and a service - the financing package. Therefore, a single market for cars requires a single market for both goods and services. It follows that the EU27 will almost instantaneously reject such a division between goods and services as 'cherry-picking' from its indivisible four freedoms - goods, services, capital, and people. The rejection will be based not just on the EU's founding principles, but also on the practical realities of a modern economy. Hence, the U.K. government's much hyped and lofty Brexit proposals risk getting a cold shower. The Irish border trilemma will remain unsolved, leaving a 'backstop' option of Northern Ireland indefinitely remaining in the EU single market - an outcome that will be politically unpalatable. Meanwhile, the many U.K. firms which depend directly or indirectly on borderless EU supply chains for their livelihoods will fear a substantial disruption to their trade - an outcome that will be economically unpalatable. To mitigate these political and economic risks of becoming a third country to the EU, the U.K. would almost certainly need the safety net of a protracted transition period, which might become a never-ending 'rolling contract'. Throughout which, the U.K. would have to adhere almost fully to EU laws and regulations, an arrangement which a clear majority of the U.K. parliament supports (Figure I-1). Figure I-1Survey Of U.K. Members Of Parliament: ##br##Which Of These Would You Consider To Be Acceptable As Part Of A Transition Agreement? Crunch Time For Britain Crunch Time For Britain Then the reality might dawn: is it really worth going through a long transition to become a third country? Why not just attach to the EEA or EFTA instead? Although bereft of a seat at the EU top table, the carrot of EEA membership is that its Treaty Articles 112-114 enable a 'temporary brake' on the freedom of movement in particular economic sectors, satisfying a key demand of Brexit voters. The Investment Implications: Distinguish Near-Term From Long-Term If the EU27 pours cold water on Theresa May's much-hyped Brexit proposals, the immediate uncertainty around Brexit would increase. However, in the longer term any outcome that keeps the U.K. either in a protracted transition to exit or eventually attach to the EEA or EFTA would be benign for the U.K. economy and comfort the BoE. Hence, it is important to distinguish the near-term and long-term outlooks for U.K. investments. For U.K. gilts relative to other government bonds, it means bullish near-term, but bearish long-term (Chart I-5). Chart I-5Brexit Risks Have Constrained The BoE ##br##And Held Down U.K. Bond Yields Brexit Risks Have Constrained The BoE And Held Down U.K. Bond Yields Brexit Risks Have Constrained The BoE And Held Down U.K. Bond Yields For the pound, it is the opposite: caution near-term, but scope for long-term appreciation, especially versus the dollar (Chart of the Week). For the FTSE100 relative to other major equity indexes, there is another consideration: the FTSE100 is very overweight the oil and gas sector, whose outperformance appears technically extended. Hence, within a European or global equity portfolio, we recently downgraded the FTSE100 from overweight to neutral (Chart I-6). Chart I-6The FTSE100's Overweight To Oil And Gas##br## Drives Its Relative Performance The FTSE100's Overweight To Oil And Gas Drives Its Relative Performance The FTSE100's Overweight To Oil And Gas Drives Its Relative Performance We finish with two important charts outside the U.K.: The global 6-month credit impulse is still in a mini-downswing, which corroborates our successful on-going underweight stance to the classical cyclical sectors (Chart I-7). Chart I-7Underweight Cyclicals Whenever The Global 6-Month Credit Impulse Is In A Mini-Downswing Underweight Cyclicals Whenever The Global 6-Month Credit Impulse Is In A Mini-Downswing Underweight Cyclicals Whenever The Global 6-Month Credit Impulse Is In A Mini-Downswing Finally, the dollar's recent rally is technically extended to a point which usually signals a tradeable reversal in the DXY (Chart I-8). Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 As measured by Eurostat on a harmonized basis. Fractal Trading Model* As just discussed, this week's recommended trade is to position for a tradeable reversal in the trade-weighted dollar. Set a 2% profit target with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 Short Trade-Weighted Dollar Short Trade-Weighted Dollar The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights BCA's Geopolitical Power Index (GPI) confirms that we live in a multipolar world; Most of President Trump's policies are designed to strike out against this structural reality; Trade war with China is real and presents the premier geopolitical risk in 2018; President Trump's aggression towards G7 allies boils down to greater NAFTA risk; We remain bullish USD, bearish EM, maintain our short U.S. China-exposed equities and closing all our "bullish" NAFTA trades; Remain short GBP/USD, Theresa May's days appear numbered. Feature "We're going to win so much, you're going to be so sick and tired of winning." Candidate Donald Trump, May 26, 2016 In 2013, BCA's Geopolitical Strategy introduced the concept of multipolarity into our financial lexicon.1 Multipolarity is a term in political science that denotes when the number of states powerful enough to pursue an independent and globally relevant foreign policy is greater than one (unipolarity) or two (bipolarity). At the time, the evidence that U.S. global hegemony was in retreat was plentiful, but the idea of a U.S. decline was still far from consensus. By late 2016, however, President Donald Trump was overtly campaigning on it. His campaign slogan, "Make America Great Again," promised to reverse the process by striking out at the perceived causes of the decline: globalization, unchecked illegal immigration, and the ineffective foreign policy of the D.C. establishment. How can we quantitatively prove that the world is multipolar? We recently enhanced the classic National Capability Index (NCI) with our own measure, the Geopolitical Power Index (GPI). The original index, created for the Correlates of War project in 1963, had grown outdated. Its reliance on "military personnel" and "iron and steel production" harkened back to the late nineteenth century and overstated the power of China (Chart 1). Chart 1The National Capability Index Overstates China's Power The National Capability Index Overstates China's Power The National Capability Index Overstates China's Power Our own index avoids these pitfalls, while retaining the parsimony of the NCI, by focusing on six key factors: Population: We adapted the original population measure by penalizing countries with large dependency ratios. Yes, having a vast population matters, but having too many dependents (the elderly and youth) can strain resources otherwise available for global power projection. Global Economic Relevance: The original index failed to capture a country's relevance for the global economy. Designed at the height of the Cold War, the NCI did not foresee today's globalized future. As such, we modified the original index by introducing a measure that captures a country's contribution to global final demand. The more an economy imports, the greater its bargaining power in terms of trade and vis-à-vis its geopolitical rivals. Arms Exports: Having a large army is no longer as relevant now that wars have become a high-tech affair. To capture that reality, we replaced the NCI's focus on the number of soldiers with arms exports as a share of the global defense industry. We retained the original three variables that measure primary energy consumption, GDP, and overall military expenditure. Chart 2 shows the updated data. As expected, the U.S. is in decline, having lost nearly a third of its quantitatively measured geopolitical power since 1998. Over the same period, China has gone from having just 30% of U.S. geopolitical power to over 80%. Other countries, like Russia, India, Turkey, Iran, and Pakistan, have also seen an increase in geopolitical power over the same period, confirming their roles as regional powers (Chart 3). Chart 2BCA's Geopolitical Power Index Illustrates A Multipolar World BCA's Geopolitical Power Index Illustrates A Multipolar World BCA's Geopolitical Power Index Illustrates A Multipolar World Chart 3China Was Not The Only EM To Rise Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? President Trump was elected with the mandate of changing the trajectory of American power and getting the country back on a "winning" path. Investors can perceive nearly all the moves by the administration - from protectionist actions against China and traditional allies, to applying a "Maximum Pressure" doctrine against North Korea and Iran - as a fight against the structural decline of U.S. power. Isn't President Trump "tilting at windmills"? Fighting a vain battle against imaginary adversaries? Yes. The decline of the U.S. is a product of classic imperial overstretch combined with the natural lifecycle of any global hegemon. U.S. policymakers have made decisions that have hastened the decline, but the overarching American geopolitical trajectory would have been negative regardless: Global peace brought prosperity which strengthened Emerging Markets (EM), particularly China, relative to the U.S. That said, Trump is not as crazy as the media often imply. Chaos is not necessarily bad for a domestically driven economy secured by two oceans. The U.S. tends to outperform the rest of the world - economically, financially, and geopolitically - amid turbulence. Our own updated GPI shows that both World Wars were massively favorable for U.S. hegemony (Chart 4), although this time around the chaos is mostly self-inflicted. Chart 4America Profits From Chaos America Profits From Chaos America Profits From Chaos Similarly, Trump's economic populism at home is buoying sentiment and assuaging the negative consequences - real or imagined - of his protectionism. Meanwhile, the threat of tariffs is souring the mood abroad. This policy mix is causing U.S. assets to outperform (Chart 5). Most importantly, the U.S. dollar is now up 2.7% since the beginning of the year, putting pressure on EM assets. When combined with continued counter-cyclical structural reforms in China, we maintain that the overall macro and geopolitical context remains bearish for global risk assets. This is not the first time that an American president has deployed both an aggressive trade policy and an aggressive foreign policy. The difference, this time around, is that the world is multipolar. A defining feature of multipolarity is that it is less predictable and more likely to produce inter-state conflict (Chart 6). As more countries matter - geopolitically, economically, financially - the number of "veto players" rises, making stable equilibria more difficult to produce. As such, bullying as a negotiating tactic worked when used by Presidents Nixon, Reagan, Bush Jr., and Clinton, but may not work today. Investors should therefore prepare for a long period of uncertainty this summer as the world responds to a U.S. administration focused on "winning." Chart 5U.S. Assets Outperform U.S. Assets Outperform U.S. Assets Outperform Chart 6Multipolarity Produces Uncertainty Multipolarity Produces Uncertainty Multipolarity Produces Uncertainty Bottom Line: There is a clear logic behind President Trump's foreign and trade policy. He is trying to reverse a decline in U.S. hegemony. The problem is that his policy decisions are unlikely to address the structural causes of America's decline. What is much more likely is that his policy will cause the rest of the world to react in unpredictable ways. The U.S. may benefit, but that is not a forgone conclusion. Investors should position themselves for a volatile summer. Below we review three key issues, two negative and one positive. The U.S. Vs. China: The Trade War Is Real The Trump administration has announced that it will go ahead with tariffs on $50 billion worth of Chinese imports in retaliation for forced technology transfer and intellectual property theft under Section 301 of the 1974 Trade Act. The tariffs will come in two tranches beginning on July 6. China will respond proportionately, based on both its statements and its response to the steel and aluminum tariffs (Chart 7). If the two sides stop here, then perhaps the trade war can be delayed. But Trump is already saying he will impose tariffs on a further $200 billion worth of goods. At that point, if Beijing re-retaliates, China's proportionate response will cover more goods than the entire range of U.S. imports (Chart 8). Retaliation will have to occur elsewhere. Chart 7Trump's Steel/Aluminum Tariffs Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Chart 8Trump's Tariffs On China Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? We would expect the CNY/USD to weaken as negotiations fail. We would also expect tensions to continue spilling over into the South China Sea and other areas of strategic disagreement.2 The South China Sea or Taiwan could produce market-moving "black swan" geopolitical events this year or next.3 Chart 9Downside Risks Continue Downside Risks Continue Downside Risks Continue It is critical to distinguish between the U.S. trade conflict with China and the one with the G7. In the latter case, the U.S. political establishment will push against the Trump administration, encouraging him to compromise. With China, however, Congress is becoming the aggressor and we certainly do not expect the Defense Department or the intelligence community to play the peacemaker with Beijing. In particular, members of Congress are trying to cancel Trump's ZTE deal while expanding the powers of the Committee on Foreign Investment in the United States (CFIUS) to restrict Chinese investments.4 These congressional factors underscore our theme that U.S.-China tensions are structural and secular.5 Would China stimulate its economy to negate the effects of tariffs? We see nothing yet on the policy side to warrant a change in our fundamental view, which holds that any stimulus will be limited due to the agenda of containing systemic financial risk. Credit growth remains weak and fiscal spending has not yet perked up (Chart 9), portending weak Chinese imports and negative outcomes for EM. The risk to Chinese growth remains to the downside this year (and likely next year) as the government continues with the reforms. Critically, stimulus is not the only possible Chinese response to trade war. A trade war with the United States will provide Xi with a "foreign devil" on whom he can blame the pain of structural reforms. As such, it is entirely possible that Beijing doubles-down on reforms in light of an aggressive U.S. Bottom Line: The U.S.-China trade war is beginning and will cause additional market volatility and, potentially, a "black swan" event, especially ahead of the U.S. midterm elections. We do not expect 2015-style economic stimulus from Beijing. Stay long U.S. small caps relative to large caps; short U.S. China-exposed equities; and remain short EM equities relative to DM. The U.S. Vs. The G6: This Is About NAFTA There was little rhyme or reason to President Trump's smackdown of traditional U.S. allies at the G7 summit in Quebec. As our colleague Peter Berezin recently pointed out, the U.S. is throwing stones while living in a glass house.6 While the overall level of tariff barriers within developed countries is low, the U.S. actually stands at the top end of the spectrum (Chart 10). The decision to launch an investigation into whether automobile imports "threaten to impair the national security" of the U.S. - under Section 232 of the Trade Expansion Act of 1962 - falls into the same rubric of empty threats. The U.S. has had a 25% tariff on imported light trucks since 1964, a decision that likely caused its car companies to become addicted to domestic pickup truck demand to the detriment of global competitiveness. Meanwhile, only 15% of U.S. autos shipped to the EU were subject to the infamous European 10% surcharge on auto imports. This is because U.S. autos containing European parts are exempt from the tariff. Many foreign auto manufacturers have already adjusted to the U.S. market, setting up manufacturing inside the country (Chart 11). Tariffs would hurt luxury brands like BMW, Daimler, Volvo, and Jaguar.7 As such, we doubt the investment-relevance of Trump's threat against autos. Either way, the investigation is unlikely to be completed until the tail-end of Q1 2019. Chart 10Tariffs: Who Is Robbing The U.S.? Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Chart 11Car Imports? What Imports? Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Instead, investors should take Trump's aggressive comments from the G7 in the context of the ongoing NAFTA negotiations and the closing window for a deal. President Trump wants to get a NAFTA deal ahead of the U.S. midterms in November and prior to the new Mexican Congress being inaugurated on September 1.8 This means that a deal has to be concluded by late July, or early August, giving the "old" Mexican Congress enough time to ratify it before the new president - likely Andrés Manuel López Obrador - comes to power on December 1. This would conceivably give the U.S. Congress enough time to ratify a deal by December, assuming Republicans can remove some procedural hurdles before then. The rising probability of no resolution before the U.S. midterm election will increase the risk that Trump will trigger Article 2205 and announce the U.S.'s withdrawal. Trump has always had the option of triggering the six-month withdrawal period as a negotiating tactic to increase the pressure on Canada and Mexico. Withdrawing might fire up the base, while major concessions from Canada or Mexico might be presented as "victories" to voters. Anything short of these binary outcomes is useless to Trump on November 6. Therefore, if Canada and Mexico do not relent in the next month or two, the odds of Trump triggering Article 2205 will shoot up. The key is that Trump faces limited legal or economic constraints in withdrawing: Legal Constraints: Not only can Trump unilaterally withdraw from the agreement, triggering the six-month exit period, but Congress is unlikely to stop him. Announcing withdrawal automatically nullifies much of the 1993 NAFTA Implementation Act.9 Some provisions of NAFTA under this act may continue to be implemented, but the bulk would cease to have effect, and the White House could refuse to enforce the rest. Economic Constraints: The U.S. economy has far less exposure to Canada and Mexico than vice- versa (Chart 12). Certain states and industries would be heavily affected - ironically, the U.S. auto industry would be most severely impacted (Chart 13) - and they would lobby aggressively to save the agreement. But with the American economy hyper-charged with stimulus, the drag from leaving NAFTA is not prohibitive to Trump. Voters will feel any pocketbook consequences about three months late i.e., after the election. Chart 12U.S. Economy:##br## Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA Chart 13NAFTA Has Made U.S. Auto ##br##Manufacturing More Competitive Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? The potential saving grace for Canada is the Canada-U.S. Free Trade Agreement (CUSFTA), which took effect in 1989 and was incorporated into NAFTA. The U.S. and Canada agreed through an exchange of letters to suspend CUSFTA's operation when NAFTA took effect, but the suspension only lasts as long as NAFTA is in effect. However, reinstating CUSFTA is not straightforward. The NAFTA Implementation Act suspends some aspects of the CUSFTA and amends others (for instance, on customs fees), so there will not be an easy transition from NAFTA to a fully operational CUSFTA.10 Trump may well walk away from both CUSFTA and NAFTA in the same proclamation, or he could walk away from NAFTA while leaving CUSFTA in limbo. The latter would mitigate the negative impact on Canada, but it would still see rising tariffs, customs fees, and rising policy uncertainty. Bottom Line: We originally assigned a high probability to the abrogation of NAFTA.11 Subsequently, we lowered the probability due to positive comments from the White House and Trump's negotiating team. This was a mistake. As we initially posited, there are few constraints to abrogating NAFTA, particularly if President Trump intends to renegotiate the deal later, or conclude two separate bilateral deals that effectively maintain the same trade relationship. We are closing our trade favoring an equally-weighted basket of CAD/EUR and MXN/EUR. We are also closing our trade favoring Mexican local government bonds relative to EM. North Korea: A Geopolitical Opportunity, Not A Risk Not every move by the Trump administration is increasing geopolitical volatility. Trump's Maximum Pressure doctrine may have elevated risks on the Korean Peninsula in 2017, but it ultimately worked. The media is missing the big picture on the Singapore Summit. Diplomacy is on track and geopolitical risk - namely the risk of war on the peninsula - is fading. It is false to claim that President Trump got nothing in return for the summit. Since November 28, North Korea has moderated its belligerent threats, ceased conducting missile tests, released three U.S. political prisoners, and largely blocked off access to the Punggye-ri nuclear testing site. Now, North Korean leader Kim Jong-un has held the summit with Trump, reaffirmed his longstanding promise of "complete denuclearization," reaffirmed the peace-seeking April 2018 Panmunjom Declaration with South Korea, and pledged to dismantle a ballistic missile testing site and continue negotiations. In response, President Trump has given security guarantees to the North Korean regime and has pledged to discontinue U.S.-South Korea military drills for the duration of the negotiations. Trump has not yet eased economic sanctions and his administration has ruled out troop withdrawals from South Korea for now. There is much diplomatic work to be done. But the summit was undoubtedly a positive sign, dialogue is continuing at lower levels, and Kim is expected to visit the White House in the near future. Table 1 shows that the Singapore Summit is substantial when compared with major U.S.-North Korea agreements and inter-Korean summits - and it is unprecedented in that it was agreed between American and North Korean leaders. Table 1How The Singapore Summit Stacks Up To Previous Pacts With North Korea Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Because Trump demonstrated a credible military threat, and China enforced sanctions, the foundation is firmer than that of President Barack Obama's April 2012 agreement to provide food aid in payment for a cessation of nuclear and missile activity. It is much more similar to that of President Clinton and the "Agreed Framework" of 1994, which lasted until 2002, despite many serious failures on both the U.S. and North Korean sides. We should also bear in mind that it was originally U.S. Congress, not North Korea, which undermined the 1994 agreement. Aside from removing war risk, Korean diplomacy is of limited global significance. It marginally improves the outlook for South Korean industrials, energy, telecoms, and consumer staples relative to their EM peers (Chart 14). In the long run it should also be positive for the KRW. Chart 14Winners And Losers Of Inter-Korean Engagement Winners And Losers Of Inter-Korean Engagement Winners And Losers Of Inter-Korean Engagement We maintain that a U.S.-China trade war will not be prevented because of a Korean deal. But we do not expect China to spoil the negotiations. Geopolitically, China benefits from reducing the basis for U.S. forces to be stationed in South Korea. Bottom Line: Go long a "peace dividend" basket of South Korean equity sectors (industrials, energy, consumer staples, and telecoms) and short South Korean "loser" sectors (financials, IT, consumer discretionary, and health care), both relative to their EM peers. Stick to our Korean 2-year/10-year sovereign bond curve steepener trade. Brexit Update: A New Election Is Now In Play Prime Minister Theresa May is fending off a revolt within her Conservative Party this week that could set the course for a new election this year. May reneged on a "compromise" with soft-Brexit/Bremain Tory backbenchers on an amendment that would have given the House of Commons a meaningful vote on the final U.K.-EU Brexit deal. According to the press, the compromise was killed by her own Brexit Secretary, David Davis. There is a fundamental problem with Brexit. The current path towards a hard Brexit, pushed on May by hard-Brexit members of her cabinet and articulated in her January 2017 speech, is incompatible with her party's preferences. According to their pre-referendum preferences, a majority of Tory MPs identified with the Bremain campaign ahead of the referendum (Chart 15). That would suggest that a vast majority prefer a soft Brexit today, if not staying in the EU. We would go further. The current trajectory is incompatible with the democratic preferences of the U.K. public. First, polls are showing rising opposition to Brexit (Chart 16). Second, most voters who chose to vote for Brexit in 2016 did so under the assumption that the Conservative Party would pursue a soft Brexit, including continued membership in the Common Market. Boris Johnson, the most prominent supporter of Brexit ahead of the vote and now the foreign minister, famously stated right after the referendum that "there will continue to be free trade and access to the single market."12 Chart 15Westminster MPs Support Bremain! Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Chart 16Bremain On The Rise Bremain On The Rise Bremain On The Rise So what happens now? We expect the government to be defeated on the crucial amendment giving Westminster the right to vote on the final EU-U.K. deal. If that happens, PM May could be replaced by a hard-Brexit prime minister, most likely Davis. Given the lack of support for an actual hard-Brexit outcome - both in Westminster and among the public - we believe that a new election remains likely by March 2019. Bottom Line: Political risk remains elevated in the U.K. A new election could resolve this risk, but the potential for a Jeremy Corbyn-led Labour Party to win the election could add additional political risk to U.K. assets. We remain short GBP/USD. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013; and "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Pyongyang's Pivot To America," dated June 8, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan," dated March 30, 2018, available at gps.bcaresearch.com. 4 The Senate has passed a version of the National Defense Authorization Act with a rider that would boost CFIUS and maintain stringent restrictions on ZTE's business with the U.S. These restrictions have crippled the company but would have been removed under the Trump administration's snap deal in June. The White House claims it will remove the rider when the House and Senate hold a conference to resolve differences between their versions of the defense bill, but it is not clear that the White House will succeed. Congress could test Trump's veto. If Trump does not veto he will break a personal promise to Xi Jinping and escalate the trade war further than perhaps even he intended. 5 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 6 Please see BCA Global Investment Strategy Weekly Report, "Piggy Bank No More? Trump And The Dollar's Reserve Currency Status," dated June 15, 2018, available at gis.bcaresearch.com. 7 We do not include Porsche in this list as we would gladly pay the 25% tariff on top of its current price. 8 Mexican elections for both president and Congress will take place on July 1, but the new Congress will sit on September 1 while the new president will take office on December 1. 9 Please see Lori Wallach, "Presidential Authority to Terminate NAFTA Without Congressional Approval," Public Citizen's Global Trade Watch, November 13, 2017, available at www.citizen.org. 10 The National Customs Brokers and Forwarders Association of America, "Issues Surrounding US Withdrawal From NAFTA," available from GHY International at www.ghy.com. See also Dan Ciuriak, "What if the United States Walks Away From NAFTA?" C. D. Howe Institute Intelligence Memos, dated November 27, 2017, available at www.cdhowe.org. 11 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 12 Please see "U.K. will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. Geopolitical Calendar

Highlights Global Inflation has upside on a cyclical basis, but this narrative is well known and investors have already placed their bets accordingly, buying inflation protection in a wide swath of markets. However, global growth has not yet found its footing, suggesting a mini-deflation scare, at least relative to expectations, is likely this summer. The U.S. dollar will benefit in such a scenario, and NOK/SEK will depreciate. While GBP/USD has downside, the pound should rally versus the euro. Weakness in EUR/CAD has not yet fully played out; the recent bout of strength was only a countertrend move. Feature Inflation is coming back, and this will obviously have major consequences for both asset and currency markets. However, macro investing is not just about forecasting fundamentals correctly; often, just as importantly, it is about understanding how other investors have priced in these expected economic developments. Therein lies the problem. While we understand why inflation could pick up, so too have most investors, and they have positioned themselves accordingly. With global growth currently looking shaky, we believe a better entry point for long-inflation plays will emerge in the coming months. In the meanwhile, a defensive, pro-U.S. dollar posture still makes sense. Investors Are Long Inflation Bets We have long argued that inflation was likely to make a cyclical comeback, a return that would begin in the U.S. before spreading to the rest of the globe. This story is currently playing out. However, in response these developments, investors have placed their bets accordingly, and the story currently seems well baked in. Prices of assets traditionally levered to inflation have already moved to discount a significant pick-up in inflation. The most evident dynamics can be observed in the U.S. inflation breakevens. Both the 10-year breakevens as well as the 5-year/5-year forward breakevens just experienced some of their sharpest two-year changes of the past 20 years, notwithstanding the pricing out of a post-Lehman, depression-like outcome (Chart I-1). Breakevens are not alone. Other assets have displayed similar behavior. In the U.S., investors have aggressively sold their holdings of utilities stocks, which have been greatly outperformed by industrial stocks. Traditionally, investors lift the price of XLI relative to that of XLU when they anticipate global inflation to pick up (Chart I-2). Chart I-1Markets Are Positioning Themselves##br## For Higher Inflation Markets Are Positioning Themselves For Higher Inflation Markets Are Positioning Themselves For Higher Inflation Chart I-2U.S. Sectoral Performance Suggests Investors ##br##Have Already Bet On Higher Inflation... U.S. Sectoral Performance Suggests Investors Have Already Bet On Higher Inflation... U.S. Sectoral Performance Suggests Investors Have Already Bet On Higher Inflation... It is not just intra-equity market dynamics that support this assertion. The behavior of the U.S. stock market relative to Treasurys further buttresses the idea that investors have already aggressively discounted an upturn in global consumer prices (Chart I-3). Potentially, the best illustration of investors' preference for inflation protection is currently visible in EM assets. A seemingly paradoxical phenomenon has been puzzling us: How have EM equities managed to avoid the gravitational pull that has caused EM bonds to nearly flirt with the nadir of early 2016? After all, EM equities, EM currencies and EM bonds are normally closely correlated, driven by investors' wagers on the direction of global growth. A simple variable can explain this strange dichotomy: anticipated inflation. As Chart I-4 illustrates, the performance of a volatility adjusted long EM stocks / short EM bonds portfolio tends to anticipate fluctuations in global inflation. The current price action in this basket indicates that investors have made their bets, and they think inflation is going up. Chart I-3...So Does The Stock-To-Bond Ratio ...So Does The Stock-To-Bond Ratio ...So Does The Stock-To-Bond Ratio Chart I-4Inflation Bets Explain Why EM Stocks And EM Bond Prices Have Diverged Inflation Bets Explain Why EM Stocks And EM Bond Prices Have Diverged Inflation Bets Explain Why EM Stocks And EM Bond Prices Have Diverged Anecdotal evidence suggests that in recent quarters, pension plans have been aggressive buyers of commodities - a move that normally coincides with these long-term investors putting in place some inflation hedges. Moreover, positioning in the futures markets corroborates these stories: speculators are still very long commodities like copper and oil - commodities traditionally perceived as efficient protectors against inflation spikes (Chart I-5). Finally, despite the potentially deflationary risks created by Italy three weeks ago, speculators remain short U.S. Treasury futures, bond investors are underweight duration, and sentiment toward the bond market remains near its lowest levels of the past eight years (Chart I-6). Again, this behavior is consistent with investors being positioned for an inflationary environment. Chart I-5Money Has Flown Into Resources Money Has Flown Into Resources Money Has Flown Into Resources Chart I-6Bond Market Positioning Is Still Very Short Bond Market Positioning Is Still Very Short Bond Market Positioning Is Still Very Short Bottom Line: There is a well-defined case to be made that a global economy that was not so long ago defined by the presence of deflationary risks is now morphing into a world where inflation is on the upswing. However, based on inflation breakevens, sectoral relative performance, equities relative to bonds in both DM and EM as well as on the positioning of investors in commodity and bond markets, this changing state has been quickly discounted by investors. The Decks Are Stacked, But Where Does The Economic Risk Lie? The problem facing investors already long inflation protection every which way they can be is that the global economy is slowing, which normally elicits deflationary fears, not inflationary ones. This seems a recipe for disappointment, albeit one that is likely to help the dollar. Our global economic and financial A/D line, which tallies the proportion of key variables around the world moving in a growth-friendly fashion, has fallen precipitously. This normally heralds a slowdown in global economic activity (Chart I-7). Chart I-7Global Growth Is Losing Traction Global Growth Is Losing Traction Global Growth Is Losing Traction In similar vein, global leading economic indicators have also begun to roll over - a trend that could gain further vigor if the diffusion index of OECD economies experiencing rising versus contracting LEIs is to be believed (Chart I-8). The global liquidity picture has also deteriorated enough to warrant caution. Currency carry strategies - as approximated by the performance of EM carry trades funded in yen - have sagged violently. This tells us that funds are flowing out of EM economies and moving back to countries already replete with excess savings like Japan or Switzerland (Chart I-9). Historically, these kinds of negative developments for global liquidity have preceded industrial slowdowns, as EM now accounts for the lion's share of global IP growth. Finally, China doesn't yet look set to bail out the world's industrial sector. This month's money and credit numbers were weaker than anticipated, and our leading indicator for the Li-Keqiang index - our preferred gauge of industrial activity in the Middle Kingdom - points to further weakness (Chart I-10). This makes it unlikely that China's imports will rise, lifting global growth. Additionally, China has re-stocked in various commodities, suggesting it is front-running its own domestic demand, highlighting the risk that its commodities intake could become even weaker than what domestic growth implies. Chart I-8More Weakness In LEIs More Weakness In LEIs More Weakness In LEIs Chart I-9Global Liquidity Tightening Global Liquidity Tightening Global Liquidity Tightening Chart I-10China Not Yet Set To Bail Out The World China Not Yet Set To Bail Out The World China Not Yet Set To Bail Out The World With this kind of backdrop, we expect the current slowdown in global growth to run further before ebbing, probably in response to what will be a policy move out some kind from China to put a floor under growth. As a result, the current infatuation with inflation hedges among investors may wane for a bit as slower growth could shock inflation expectations downward, especially in a global context that has been defined by excess capacity since the late 1990s. An environment where global inflation expectations could be downgraded in response to slower growth is likely to be an environment where the dollar performs well, particularly as U.S. growth continues to outperform global growth (Chart I-11). This also confirms our analysis from two weeks ago that showed that when bonds rally the dollar tends to outperform most currencies, with the exception of the yen.1 Moreover, with the Federal Open Market Committee upgrading its path for interest rates by one additional hike in 2018, this reinforces the message from our previous work noting that once the fed funds rate moves in the vicinity of r-star, the dollar performs well, nearly eradicating the losses it incurred when the fed funds rate rises but is well below the neutral rate (Table I-1). This is especially true if vulnerability to higher rates rests outside - not inside - the U.S., as is currently the case.2 Chart I-11The Dollar Likes Lower Global Inflation The Dollar Likes Lower Global Inflation The Dollar Likes Lower Global Inflation Table I-1Fed And The Dollar: Where We Stand Matters As Much As The Direction Inflation Is In The Price Inflation Is In The Price Beyond the dollar, one particular currency cross has historically been a good correlate to investors betting on higher inflation: NOK/SEK. As Chart I-12 illustrates, when investors buy inflation hedges such as going long EM equities relative to EM bonds, this generates a rally in NOK/SEK. These dynamics played in our favor when we were long this cross earlier this year. However, not only are EM equities extended relative to EM bonds, the current economic environment portends a growing risk of investors curtailing these kinds of bets. The implication is bearish for NOK/SEK, and we recommend investors sell this cross at current levels. Chart I-12NOK/SEK Suffers If Inflation Bets Are Unwound NOK/SEK Suffers If Inflation Bets Are Unwound NOK/SEK Suffers If Inflation Bets Are Unwound Bottom Line: Investors have quickly and aggressively positioned themselves to protect their portfolios against upside inflation risks. However, the global economy is still slowing - a development that has further to run. As a result, this current anticipation of inflation could easily morph into a temporary fear of deflation, at least relative to lofty expectations. This would undo the dynamics previously seen in the market. This is historically an environment in which the dollar performs well, suggesting the greenback rally is not over. Moreover, NOK/SEK could suffer in this environment. The Bad News Is Baked Into The Pound There is no denying that the data flow out of the U.K. has been poor of late. In fact, despite what was already a low bar for expectations, the U.K. economy has managed to generate large negative surprises (Chart I-13). One of the direct drivers of this poor performance has been the complete meltdown in the British credit impulse (Chart I-14). Additionally, the slowdown in British manufacturing can be easily understood in the context of slowing global growth (Chart I-15). Chart I-13Anarchy In The U.K. Anarchy In The U.K. Anarchy In The U.K. Chart I-14The Credit Impulse Has Bitten The Credit Impulse Has Bitten The Credit Impulse Has Bitten Chart I-15U.K. Exports Are Slowing Because Of Global Growth U.K. Exports Are Slowing Because Of Global Growth U.K. Exports Are Slowing Because Of Global Growth But, the bad new seems well priced into the pound, especially when compared to the euro. Not only is the GBP trading at a discount to the EUR on our fundamental and Intermediate-term timing models, speculators have accumulated near-record short bets on the pound versus the euro (Chart I-16). This begs the question: Could any positive factor come in and surprise investors, resulting in a fall in EUR/GBP? We think the answer to this question is yes. First, despite the negatives already priced in, incremental bad news have had little traction in dragging the pound lower versus the euro in recent weeks, suggesting that EUR/GBP buying has become exhausted. Second, a falling EUR/USD tends to weigh on EUR/GBP, as the pound tends to act as a low-beta version of the euro (Chart I-17). Chart I-16Investors Are Well Aware Of Britain's Problems Investors Are Well Aware Of Britain's Problems Investors Are Well Aware Of Britain's Problems Chart I-17EUR/GBP Sags When EUR/USD Weakens EUR/GBP Sags When EUR/USD Weakens EUR/GBP Sags When EUR/USD Weakens Third, the economic outlook for the U.K. is improving. It is true that in the context of slowing global growth, the manufacturing and export sectors are unlikely to be a source of positive surprises for Great Britain. However, the domestic economy could well be. As Chart I-14 highlights, the credit impulse has collapsed, but the good news is that outside of the Great Financial Crisis it has never fallen much below current levels, suggesting that a reversion to the mean may be in offing. Additionally, U.K. inflation is peaking, which is lifting British real wages (Chart I-18). In response, depressed consumer confidence is picking up. This is crucial as consumer spending, which represents roughly 70% of the U.K.'s GDP, has been the key drag on growth since 2016. Any improvement on this front will lift the whole British economy, even if the manufacturing sector remains soft. Fourth, Brexit is progressing. This week's vote in the House of Commons was confusing, but it is important to note than an amendment that gives Westminster the right to force a renegotiation between the U.K. and the EU if no deal is reached in 2019 has been passed. This also decreases the risk of a completely economically catastrophic Brexit down the road, but increases the risk that PM Theresa May could be ousted over the next 12 months. Our positive view on the pound versus the euro (or negative EUR/GBP bias) is not mimicked in cable itself. Ultimately, despite the GBP/USD's beta to EUR/GBP being below one, it is nonetheless greater than zero. As such, it is unlikely that GBP/USD will be able to rally if the DXY rallies and the EUR/USD weakens (Chart I-19). Therefore, while we recommend selling EUR/GBP, we are not willing buyers of GBP/USD. Chart I-18A Crucial Support To Growth A Crucial Support To Growth A Crucial Support To Growth Chart I-19Cable Will Not Avoid The Downward Pull Of A Strong Dollar Cable Will Not Avoid The Downward Pull Of A Strong Dollar Cable Will Not Avoid The Downward Pull Of A Strong Dollar Bottom Line: The British economy has undergone a period of weakness, which is already reflected in the very negative positioning of investors in the GBP versus the EUR. However, the bad data points are losing their capacity to push EUR/GBP higher, and the British economy may begin to heal as consumer confidence is rebounding thanks to improving real wages. The low beta of GBP/USD to the euro also implies that a falling EUR/USD will weigh on EUR/GBP. However, while the pound has upside against the euro, it will continue to suffer against the dollar if EUR/USD experiences further downside. What To Do With EUR/CAD? One weeks ago, we were stopped out of our short EUR/CAD trade. Has EUR/CAD finished its fall, or was the recent rally a pause within a downward channel? We are inclined to think the latter. Heated rhetoric on trade has hit the CAD harder than the EUR, as exports to the U.S. represent a much larger share of Canada's GDP than of the euro area, forcing the pricing of a risk premium in the loonie. However, even after a rather explosive G7 meeting, we do believe that a compromise is still feasible and that NAFTA is not dead on arrival. A deal is still likely because, as Chart I-20 demonstrates, Canadian tariffs on U.S. imports are not only marginally in excess of U.S. tariffs on Canadian imports, they are also in line with international comparisons. This suggests only a small push is needed to arrive to a deal that salvages NAFTA, which ultimately is much more important to Canada than the dairy industry. Chart I-20Canada And The U.S. Can Find A Compromise Inflation Is In The Price Inflation Is In The Price Despite this reality, we cannot be too complacent, U.S. President Donald Trump is likely to be playing internal politics ahead of the upcoming mid-term elections. U.S. citizens are distrustful of free trade (Chart I-21), a trend especially pronounced among his base. However, a good result for the GOP in November is contingent on the Republican base showing up at the polls. Firing this base up with inflammatory trade rhetoric is a sure way to do so. This means that risks around NAFTA are still not nil. Chart I-21America Belongs To The Anti-Globalization Bloc Inflation Is In The Price Inflation Is In The Price However, EUR/CAD continues to trade at a substantial premium to fair-value on an intermediate-term horizon (Chart I-22). Moreover, as the last panel of the chart illustrates, speculators remain massively short the CAD against the EUR. This creates a cushion for the CAD versus the EUR if global growth slows. Moreover, technicals are still favorable of shorting EUR/CAD. Not only is EUR/CAD still overbought on a 52-week rate-of-change basis, it seems to be in the process of forming a five-wave downward pattern, with the fourth one - a countertrend wave - potentially ending (Chart I-23). Chart I-22EUR/CAD Is Still Vulnerable EUR/CAD Is Still Vulnerable EUR/CAD Is Still Vulnerable Chart I-23Wave Pattern Not Completed Wave Pattern Not Completed Wave Pattern Not Completed Finally, EUR/CAD tends to perform poorly when the USD strengthens, which fits with our current thematic for the remainder of 2018. Bottom Line: The headline risk surrounding NAFTA has weighed on the loonie against the euro, stopping us out of our short EUR/CAD trade with a small profit. However, the valuation, positioning and technical dynamics suggest the timing is ripe to short this cross once again. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Rome Is Burning: Is It The End?", dated June 1, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different", dated May 25, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was stellar: NFIB Business Optimism Index climbed to 107.8, outperforming expectations; the price changes and good times to expand components are also very strong; Headline and core PPI both outperformed expectations, auguring well for future consumer inflation; Headline and core retail sales grew by 0.8% and 0.9% in monthly terms, beating expectations; Both initial and continuing jobless claims also came out below expectations, highlighting that the labor market is still tightening, and wage growth could pick up further. The Fed raised interest rates this week to 2%, and added one additional rate hike to its guidance for 2018. FOMC members once again highlighted the "symmetric" target, suggesting that the Fed expects the economy to overheat slightly. An outperforming U.S. economy relative to the rest of the world is likely to propel the greenback this year. Report Links: This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Economic data was largely disappointing: Italian industrial output contracted by 1.2% on a monthly basis, and grew only by 1.9% on a yearly basis; The German ZEW Survey declined substantially across all metrics; European industrial production increased by 1.7% annually, less than the expected 2.8% increase; However, Spanish headline inflation spiked up from 1.1% to 2.1%. Yesterday, ECB President Mario Draghi announced the ECB's plan to taper asset purchases to EUR 15 bn a month in September, and phase them out completely by year-end. Moreover, Draghi highlighted that the ECB was not anticipating to implement its first hike until after the summer of 2019. Furthermore, the ECB President highlighted the current slowdown in global growth, as well as the rising protectionist risk from the U.S. potentially negatively impacting the European economy and the ECB's decisions going forward, suggesting that the plans are not set in stone. 2018 is likely to remain a volatile year for the euro. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Japanese data has been strong this week: Machine orders increased on a 9.6% annual basis, and a 10.1% monthly basis, in April, outperforming expectations by a large margin; The Domestic Corporate Goods Price Index also increased by 2.7% annually, higher than the expected 2.2% increase. As political and economic risks in Europe and South America having subsided for now, the yen has lost some of its glitter. However, with ongoing uncertainty on trade and populism across the globe, we maintain our tactically bullish stance on the yen, especially against commodity currencies and the euro. However, beyond the short-term horizon, the BoJ will remain determined to cap any excess appreciation in the yen, as a strong JPY tightens Japanese financial conditions, weighing on the BoJ's ability to hit its inflation target. This will ultimately limit the yen's upside on a cyclical basis. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Data from the U.K. was somewhat disappointing: Manufacturing and industrial production both increased less than expected, at 1.4% and 1.8%, respectively; The goods trade deficit widened to GBP 14.03bn from GBP 12bn, and the overall trade deficit widened to GBP 5.28bn from GBP 3.22bn; Average earnings grew by 2.8%, less than the expected 2.9%; However, headline inflation came in at 2.4%, less than the expected 2.5%, while retail price inflation also underperformed expectations. This means that the uptrend in real wages continues. Given the limited movement in the pound, it seems that a lot of the bad news was already priced in by last month's depreciation. However, Theresa May's ongoing blunders in parliament represent a continued source of risk for the pound. While the GBP has downside against the EUR, it is unlikely to see much upside against the greenback. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Do Not Get Flat-Footed By Politics - March 30, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was weak: NAB Business Confidence and Conditions surveys both declined, also underperforming expectations; Australian employment grew by 12,000, less than expected. Moreover, full-time employment contracted. While the unemployment rate dropped as a result, this was largely due to a fall in the participation rate. RBA's Governor Lowe, in a speech on Wednesday, announced that any increase in interest rates "still looks some time away" as the slack in the labor market does not seem to be diminishing. Annual wage growth has been constant at 2.1% for the past three quarters, and did not pick up despite an improvement in full-time employment earlier this year. We remain bearish on the AUD. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The NZD is likely to face significant downside against the greenback along with the other commodity currencies as global growth slows down. However, due to its weaker linkages to Chinese industrial demand, the kiwi is likely to see less downside than the AUD. Nevertheless, it is likely to weaken against the CAD and the NOK as the NZD is expensive against these oil currencies, and oil's is likely to continue to outperform other commodities will support this view. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 USD/CAD has been on an uptrend given the greenback generally strong performance since February year, a force magnified by the volatile rhetoric surrounding NAFTA negotiations. However, the Canadian economy has been accelerating this year, thanks to robust growth in the U.S., to a strong Quebecer economy, and to a pickup in Alberta. In addition, the Canadian labor market is tightening further and wage growth is above 3%. Furthermore, risks surrounding NAFTA seem already reflected in the CAD's behavior and valuation. There is more clarity on the CAD versus its crosses than on the CAD versus the USD. Outperforming U.S. and Canadian growth relative to the rest of the world mean that the CAD should outperform most other G10 currencies. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data out of Switzerland was decent: Industrial production increased by 9% in annual terms, albeit less than the previous 19.6% growth; Producer and import prices increased by 3.2% year on year, in line with expectations, however the monthly increase underperformed markets anticipations. With global trade tensions rising, and Germany having entered President Trump's line of sight, the CHF could experience additional upside against the euro in the coming months. However, the SNB is unlikely to deviate from its ultra-accommodative stance, which means that any downside in EUR/CHF will proved to be short lived. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Both headline and core inflation underperformed, coming in at 2.3% and 1.2%, respectively. However, the Regional Network Survey hinted at a pickup in capacity utilization as expectations for industrial output remained robust, as well as at an additional strength in employment. This led to a forecast of a resurgence in inflationary pressures. We expect the NOK to outperform the EUR. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish inflation rose from 1.7% to 1.9%, coming in line with expectations. Additionally, Prospera 1-year inflation expectations survey rose to 1.9% from 1.8% in the March survey. This is likely to provide the Riksbank with reasons to turn gradually more hawkish, which should support the very cheap krona. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Contagion risk from Italy to its European peers presents a buying opportunity; Italian policymakers are constrained by the bond market and avoiding brinkmanship; In a game of chicken between Berlin and Rome, Chancellor Angela Merkel is behind the wheel of a 2.5-ton SUV; Italy's ultimate constraint is its bifurcated economic system - staying in the EU helps manage this problem; Underweight Italian bonds in a global portfolio and short Italian bonds versus their Spanish equivalents. Feature Chart 1Is Contagion Warranted? Is Contagion Warranted? Is Contagion Warranted? On May 31, Italy formed the second overtly populist government in the Euro Area. The first was the short-lived SYRIZA government in Greece, which lasted from January to September 2015. Under the leadership of Prime Minister Alexis Tsipras and his colorful finance minister Yanis Varoufakis, Athens took Greece to the brink of Euro Area exit in the summer of 2015. Ultimately, Greek politicians blinked, folded, and re-ran the January election in September, transforming SYRIZA from an overtly euroskeptic party to a europhile party in just eight months. Investors are concerned that "this time will be different." We disagree. To use a poker analogy, Italian policymakers are better positioned to "bluff" their European counterparts as their chip stack is larger. But they are still holding a bad hand, and other players at the table still hold big stacks. The recent turbulence in Italian bond markets has spilled over into other Mediterranean countries (Chart 1). This contagion is unwarranted, as there has been much improvement across the region over the past few years, both politically and economically. As for Italy itself, it is positive that populists have come to power today, for several reasons. First, it will force them to actually run the country, a sobering process that often tempers anti-establishment zeal, as it did in Greece. Second, they will run the country at a time when popular support for the Euro Area and EU remains strong enough to deter an overt attempt to exit those institutions. Third, Italy remains massively constrained by material forces outside of their control, which will force compromises in negotiations with Brussels and fellow EU member states. There Will Be No Contagion From Italy Markets overreacted to the political risks emanating from Italy in recent weeks. Fundamentally, Italy's peripheral peers have emerged stronger from the Euro Area crisis. Since the onset of the Euro Area crisis, Greece, Portugal, Ireland, and Spain - the hardest-hit economies in 2010 - have seen their unit labor costs contract by an average of 8.7%. Over the same period, the rest of the Euro Area inflated its labor cost structure by around 10.9% (Chart 2). Italy remains saddled with a rigid, under-educated, and rather unproductive workforce that has seen no adjustment in labor costs.1 Meanwhile, its Mediterranean peers have practically closed their once-enormous unit labor-cost gap with Germany. Furthermore, all southern European countries now run primary surpluses, reducing the need for external funding (Chart 3). It is fair that the market should apply a fiscal premium to Italy, given the new government's plans to blow out the budget deficit. But no such fiscal plan is in the works in the rest of the Mediterranean. The cyclically-adjusted primary balance - for Italy, Spain, Portugal, and Greece - has gone from a deficit of 4.4% during the height of the debt crisis, to a surplus of 1.4% today. One can argue about whether such fiscal austerity was really necessary. The advantage, however, is that the improvement in structural budget balances has diminished the need for additional austerity measures and could also provide greater fiscal space during the next recession. Finally, household balance sheets have been on the mend for some time. Consumer debt levels as a percentage of disposable income in Spain, Portugal, and Ireland - the epicenter of the original Euro Area debt crisis - have now dipped below U.S. levels. In the case of Italy, importantly, the household sector was never over-indebted to begin with (Chart 4). Chart 2Italy Has Had No Labor-Cost Adjustment Italy Has Had No Labor-Cost Adjustment Italy Has Had No Labor-Cost Adjustment Chart 3Mediterranean Austerity Is Over Mediterranean Austerity Is Over Mediterranean Austerity Is Over Chart 4No Household Credit Bubble In Italy No Household Credit Bubble In Italy No Household Credit Bubble In Italy On the political front, Italians are clearly more euroskeptic than their Euro Area peers (Chart 5). Although only 30% of Italians oppose the common currency, in line with Greece, this is still considerably higher than in Spain and Portugal (Chart 6). Italians also feel less "European" than the Spanish or the Portuguese - i.e., they identify more exclusively with their unique nationality. Again this is in line with Greek sentiment (Chart 7). Italians were not always this way: in the early 1990s, they felt the most European. Chart 5Italy Lags In Support For The Euro... Italy Lags In Support For The Euro... Italy Lags In Support For The Euro... Chart 6...But Only 30% Of Italians Want Out ...But Only 30% Of Italians Want Out ...But Only 30% Of Italians Want Out Chart 7Italians Are Feeling More Italian Italians Are Feeling More Italian Italians Are Feeling More Italian In Portugal and Spain, parties across the political spectrum have responded to improving political and economic fundamentals. In Spain, the mildly euroskeptic Podemos is polling below its June 2016 election result. Its leadership has also abandoned any ambiguity on its support of the common currency, although it still campaigned in 2016 on restructuring Spain's foreign debt. The leading party in the Spanish polls is the centrist Ciudadanos (Chart 8), led by 38-year old Albert Rivera. Much like French President Emmanuel Macron, Rivera has a background in finance - he worked as a legal counsel at La Caixa - and presents a centrist vision for Europe, favoring more integration. The rise of Ciudadanos is important as Spain could have new elections soon. Conservative Prime Minister Mariano Rajoy resigned following a vote of no-confidence engineered by the Spanish Socialist Party (PSOE) leader Pedro Sánchez. However, PSOE only holds 84 seats of the 350-seat parliament. As such, it is unclear how the Socialist minority government will govern, particularly with the budget vote coming in early fall. But investors should welcome, not fear, early elections in Spain. With Ciudadanos set to join a governing coalition, it is clear that Spain's commitments to the Rajoy structural reforms will remain in place while no discussions of Spanish exit from European institutions is on any investment-relevant horizon. In Portugal, the minority government of Prime Minister António Costa has overseen a brisk economic recovery. Costa's center-left Socialist Party has received support in parliament from the far-left, euroskeptic Left Bloc, plus the Communists and Greens. Despite the involvement of the Left Bloc, the minority government has not initiated any euroskeptic policy. The latest polling suggests that Costa could win a majority in 2019. An election has to be held by October of that year, thus potentially strengthening the pro-European credentials of the Portuguese government (Chart 9). Finally, in Greece, the once overtly euroskeptic SYRIZA is polling well below their 2015 levels of support. Ardently europhile and centrist New Democracy (ND) is set to win the next election - which must be held by October 2019 - if polling remains stable (Chart 10). The fascist and euroskeptic Golden Dawn remains a feature of Greek politics, but has a support rate under 10%, as it has over the past decade. In fact, the rising player in Greek politics is the centrist and europhile Movement for Change, an alliance that includes the vestiges of the center-left PASOK, which polls around 10%. Chart 8There Is No Populism In Spain... There Is No Populism In Spain... There Is No Populism In Spain... Chart 9...Or Portugal... ...Or Portugal... ...Or Portugal... Chart 10...And Surprisingly None In Greece ...And Surprisingly None In Greece ...And Surprisingly None In Greece Bottom Line: Italy stands alone in the Mediterranean as a laggard on both economic and political fundamentals. Contagion risk from Italy to the rest of its European peers should be faded by investors. It represents a buying opportunity every time it manifests itself. What Car Is Italy Driving In This Game Of Chicken? The new ruling coalition in Rome has a democratic mandate for a confrontation with Brussels over fiscal spending. The coalition consists of the Five Star Movement (M5S) and the League (Lega), formerly known as the "Northern League." In his inaugural speech to the Italian Parliament, Prime Minister Guiseppe Conte emphasized that the mandate of the new coalition includes "reducing the public debt ... by increasing our wealth, not with austerity."2 So, the gloves are off! Not really. Almost immediately, Conte pointed out that "we are optimistic about the outcome of these discussions and confident of our negotiating power, because we are facing a situation in which Italy's interests... coincide with the general interests of Europe, with the aim of preventing its possible decline. Europe is our home." PM Conte subsequently focused in his speech on increasing social welfare payments to the poor, conditional on vocational training and job reintegration. Talk of a "flat tax" was replaced with an eponymous concept that is anything but a "flat tax."3 And there was no mention of overturning unpopular pension reforms, but merely "intervening in favor of retirees who do not have sufficient income to live in dignity."4 We may be reading too much into one speech. However, the time for brinkmanship is at the beginning of a government's mandate. And Conte's opening salvo suggests that the M5S-Lega coalition has already punted on three of its most populist promises: wholesale change to retirement reforms, a flat tax of 15%, and universal basic income. The back-of-the-envelope cost of these three proposals is €100bn, which would easily blow out Italy's budget deficit by 5% of GDP, putting the total at 7%. There was also no mention of issuing government IOUs that would create a sort of "parallel currency" in the country. Conte's relatively tame speech represents one of three concessions that Rome has made before it even engaged Brussels in brinkmanship. The two others were to replace the original economy minister designate - euroskeptic Paulo Savona - and to form a government in the first place. The latter is particularly telling. Polls have shown that the two populist parties would have an even stronger hand if they waited until the fall to re-run the election (Chart 11). In particular, Lega has seen its support rise by 9% since the election. It is politically illogical to form a governing coalition with less political capital when a new election would strengthen the hand of both populist parties. So why the concessions? Because Italian policymakers are not interested in brinkmanship. The populist campaign rhetoric and hints of euroskepticism were an act. And perhaps the act would have continued, but the bond market reaction was so quick and jarring (Chart 12) - including the largest day-to-day selloff since 1993 (Chart 13) - that it has disciplined Italy's policymakers almost immediately. Chart 11Lega Gave Up A Lot By Forming A Coalition Lega Gave Up A Lot By Forming A Coalition Lega Gave Up A Lot By Forming A Coalition Chart 12Bond Vigilantes Are... Bond Vigilantes Are... Bond Vigilantes Are... Chart 13...A Massive Constraint On Rome ...A Massive Constraint On Rome ...A Massive Constraint On Rome This is instructive for investors. In 2015, Greece decided to play the game of brinkmanship with Europe and ultimately lost. Our high-conviction view at the time was that Athens would back off from brinkmanship because it was massively constrained.5 Not only would an exit from the Euro Area mean a government default and the redenomination of all household saving into "monopoly money," but the level of euroskepticism in Greece was not high enough to support such a high-risk strategy. At the time, we pointed out that most investors - and practically all pundits - were wrong when they argued that brinkmanship between Greece and Brussels was "unpredictable." This conventional view was supported by an incorrect reading of game theory, particularly the "game of chicken." Game theory teaches us that a game of chicken is the most dangerous game because it can create an equilibrium in which all rational actors have an incentive to stick to their guns - to "keep driving" in the parlance of the game - despite the risks.6 In Diagram 1, we can see that continuing to drive carries the most risks, but it also carries the most reward, provided that your opponent swerves. Since all actors in a game of chicken assume the rationality of their opponents, they also expect them to eventually swerve. When this does not happen, the bottom-right quadrant emerges, one of chaos and deeply negative payouts for everyone involved in the crash. The problem with this analysis is that - as with most game theory - its parsimony belies deep complexity that often varies due to a number of factors. The first such factor is replayability. The decisions of Italian policymakers will be informed by the outcomes of the 2015 Greek episode, which did not go well for Athens. Another factor that obviously varies the payout matrix is the relative strength of each player; or, to stick with the analogy, the type of vehicle driven by each actor. Greece and its Euro Area peers were not driving the same car. The classic game of chicken only produces the payouts from Diagram 1 if all participants are driving the same vehicle. However, if Angela Merkel is behind the wheel of a Mercedes-Benz G-Class SUV, while Greek PM Alexis Tsipras is riding a tricycle, then the payouts are going to be much different in the case of a crash. In that case, the payouts should approximate something closer to Diagram 2. Diagram 1Regular Game Of Chicken Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? Diagram 2Greece Versus Euro Area In 2015 Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? So the crucial question for investors is what vehicle are Italian policymakers driving? We do not doubt that it is an actual car, unlike Tsipras's tricycle. But it is more likely to be a finely-crafted Italian sportscar, adept at hugging the twists and turns of Rome's policy, rather than an SUV capable of colliding with Merkel's ominous truck. Why doesn't Rome have more capability than Greece? Because of time horizons. An Italian exit from the Euro Area would undoubtedly shake the foundations of the common currency and the European integrationist project. But Rome actually has to exit in order to shake those foundations. As we have learned with Brexit, such an "exit" scenario could take months, if not years. In the process of trying to exit, the Italian banking system would become insolvent, turning household savings and retirements into linguini. This would occur immediately and would exert economic, financial, and - most importantly - political pressure on Italian policymakers instantaneously. Our colleague Dhaval Joshi, BCA's Chief European Strategist, has argued that a 4% Italian bond yield is the "line in the sand" regarding the survival of Italy's banks.7 As Dhaval points out, investors start to get nervous about a bank's solvency when equity capital no longer covers net non-performing loans (NPLs). Based on this rule, the largest Italian banks now have €165 billion of equity capital against €130 billion of net NPLs, implying excess capital of €35 billion (Chart 14). Although the net NPL figure has improved much from the peak in 2015, it remains large. It follows that there would be fresh doubts about Italian banks' mark-to-market solvency if their bond valuations sustained a drop of just a tenth from the recent peak. Dhaval estimates that this equates to the 10-year BTP yield breaching and remaining above 4% (Chart 15). Chart 14Italian Banks' Equity Capital ##br##Exceeds Net NPLs By Euro 35 Bn Italian Banks' Equity Capital Exceeds Net NPLs By Euro 35 Bn Italian Banks' Equity Capital Exceeds Net NPLs By Euro 35 Bn Chart 15Italian Banks' Solvency Would Be In ##br##Question If The 10-Year BTP Yield Breached 4% Italian Banks' Solvency Would Be In Question If The 10-Year BTP Yield Breached 4% Italian Banks' Solvency Would Be In Question If The 10-Year BTP Yield Breached 4% Additionally, while Italian support for the common currency is relatively low, there is still a majority of around 60% that support the euro. This is similar to the level of support for the euro in Greece in 2015. We would suspect that the support for the currency would rise - and that populist parties would decline in popularity - if Italian policymakers set off a bond market riot that caused the insolvency of Italian banks. Does this mean that the bond market is a permanent constraint on Italian exit from the Euro Area? No. At some point in the future, after a deep recession that raises unemployment levels substantively, popular support for the common currency could tank precipitously. But we are far from that point. In fact, Italy has enjoyed a relatively robust recovery over the past 18 months. As such, any economic crisis today will be blamed on the populist policymakers themselves, yet another reason for them to moderate and seek the path of calm negotiations with the EU. Bottom Line: With regards to any potential "game of chicken" negotiations with the rest of Europe, Italian policymakers are not riding a tricycle like their Greek counterparts were in 2015. Italians are behind the wheel of a finely-crafted, titanium-chassis, Italian roadster. Unfortunately, Chancellor Angela Merkel is still in a Mercedes SUV that weighs 2.5 tons. This is a high-conviction view based on the actions of Italian policymakers over the past month. Despite an improvement in polling, populists have backed off from calling for a new election (which would have been perfectly logical) and that would have been advantageous to them and have abandoned some of the most controversial - and expensive - platforms of their coalition agreement. Unlike their peers in Greece, Italian populists have proven to have little stomach for actual confrontation. The Ultimate Constraint: Risorgimento In a report published back in 2016, we argued that Italy's original sin was its unification in 1861.8 Risorgimento brought together the North and South in a political and economic union that made little sense. The North had developed a market economy during the Middle Ages (and gave the West its Renaissance!), while the South had remained under feudalism well into the early twentieth century. Given the limited resources, governance, and technology of the mid-nineteenth century, the scope, ambition, and yes, folly of uniting Italy were probably several orders of magnitude greater than the effort to forge a common currency union in Europe in the twenty-first century. To this day, Italy remains an economically bifurcated country. Map 1 shows that the four wealthiest and most-productive regions of Europe, outside of capital cities, are the German Rhineland, Bavaria, the Netherlands, and Northern Italy. Meanwhile, the Italian South - or Mezzogiorno - is as undeveloped as Greece and Eastern Europe. Map 1Core Europe Extends Well Into Northern Italy Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? The units of analysis in Map 1 are the so-called EU "nomenclature of territorial units for statistics" (NUTS).9 These regions matter because Brussels uses them to determine how much "structural funding" - essentially development aid - each country receives from the EU. The EU "regional and cohesion" funding - totaling €351.8 billion for the 2014-2020 budget period - is not distributed based on the aggregate wealth of each country, since that would favor the new entrants into the union. The EU's discerning eye when it comes to distributing development funds is not accidental. It is a product of decades of lobbying by Italy (and Spain) to prevent a shift of structural funding to Eastern European member states. From Rome's perspective, the real European development project is not in Poland or Greece, but in the Mezzogiorno. Chart 16Italy Shares The Burden Of The Mezzogiorno With The EU Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? To this day, Italy and Spain receive the second and third largest amount of EU development aid (Chart 16). Despite contributing, in gross terms, 13% to the EU's total revenues, Italy's net contribution per person is smaller than those of the Netherlands, Sweden, Denmark, Finland, and Austria (Chart 17). Given that Italy is a wealthy EU state, its net budget contribution of approximately €3 billion, 0.2% of GDP, essentially means that it gets the benefits of EU membership for free. Chart 17Italy Gets To Join The Club For Free Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? And EU membership comes with many benefits. Membership in the Euro Area - combined with sharing the same "lender of last resort" with Germany, the European Central Bank - allows Italy to finance its budget deficits at low interest rates and to issue government debt in the world's second largest reserve currency (Chart 18). These financial benefits are even greater than the rebate it gets from Europe. Access to cheap financing allows Italy to carry the costs of Mezzogiorno on its own. Chart 18The Big Difference Between 2011 & Today The Big Difference Between 2011 & Today The Big Difference Between 2011 & Today It is somewhat ironic that Lega is today preaching populism and euroskepticism. In the early 1990s, its main target of angst was not the EU and Brussels, but Italy's South and profligate Rome, which funneled the North's taxes to the South. This early iteration of the party was quite pro-EU, as it saw Italy's North as genuinely European and worthy of membership in EU institutions. Some of its politicians and voters hoped that Northern Italy could meld into the EU, leaving the Mezzogiorno to fend for itself. Hence there is no deep, ideological euroskepticism in Lega's DNA. The party's evolution also illustrates how opportunistic and pragmatic Italian policymakers can be. The reality is that if Italy were to act on its threat of "exit," it would undoubtedly become far worse off economically. Not only would Northern Italy have to support the Mezzogiorno alone, but any structural reforms that could lift productivity and education in the South would become far less likely as anti-establishment forces took hold. Bottom Line: Our high-conviction view is now the same as it was in 2016. Italy is "bluffing." Leaving the EU or the Euro Area makes no sense given its economic bifurcation, which is the result of Risorgimento. Both policymakers and voters understand this. The real intention in the game of chicken between Brussels and Rome is to see an easing of austerity. We expect that Italian policymakers will ultimately succeed in getting leniency from Brussels on allowing deficit-widening fiscal stimulus, but the stimulus will be much smaller than their original plans that spooked the bond market laid out. To European and Italian politicians, Italy's economic bifurcation is well understood. Jean-Claude Juncker, the President of the European Commission, specifically referred to it when he said, "Italians have to take care of the poor regions of Italy." He was later forced to apologize for his comments, with leaders of M5S and Lega faking outrage. But given that the ideological roots of Lega are precisely in the same intellectual vein as Juncker's comments, investors should understand that politicians in Rome are well aware of their fundamental constraints. Juncker's comments were a dog whistle to Rome. The actual message was: we know you are bluffing. Investment Implications Our analysis suggests that the path of least resistance for the M5S-Lega coalition is to negotiate some austerity relief from the EU Commission, but to definitively pivot away from talk of "exit" from European institutions. PM Conte has reaffirmed that exiting the euro is off the table and that it was never on the table to begin with. The new economy minister, Giovanni Tria, followed this up with a comment that "the position of this government is clear and unanimous... there are no discussions taking place about any proposal to leave the euro." Meanwhile, Lega leader and new Italian interior minister Matteo Salvini has focused his early efforts and commentary on the party's promise to check illegal immigration to Italy. This will be a policy upon which Lega will test its populist credentials, not a fight with Brussels. Is the worst of the crisis therefore "over"? Is it time to buy Italian assets? Not yet. Both Italian bonds and equities rallied throughout 2017. Italian equities, for example, have a higher Shiller P/E ratio than both Spanish and Portuguese stocks (Chart 19). As such, a sell-off was long overdue. Chart 19Why Did Italian Equities Rally So Much? Why Did Italian Equities Rally So Much? Why Did Italian Equities Rally So Much? Chart 20Italy's Binary Future Italy's Binary Future Italy's Binary Future Furthermore, we do not expect Rome's negotiations with Brussels to proceed smoothly. It is very likely that the bond market will have to continue to play the role of disciplinarian. The government debt-to-GDP ratio could quickly become unsustainable if the current primary budget balance is thrown into a deficit (Chart 20). According to the IMF and BCA Research calculations, Italian long-term debt dynamics are stable even with real interest rates rising to 2% - from just 0.5% today - and real GDP growth remaining at a muted 1%. But this stability requires the country to continue to run a primary budget surplus of around 2% of GDP (Chart 21). Conversely, running a persistent primary deficit of 2% would result in an explosive increase in Italy's debt dynamics. Even if that stimulus produces real GDP growth of 3%, the "bond vigilantes" could protest the surge in debt and drive real interest rates to 3.5% or higher. As such, the country's fiscal space will ultimately be determined by the bond market. Rome can afford to lower its primary budget surplus, but only so far as the bond market does not riot. Our colleague Dhaval Joshi believes that the math behind an Italian fiscal stimulus would make sense if it provides enough of a sustainable boost to economic growth without blowing out the budget deficit.10 We suspect that the bond market will eventually agree, but only if Brussels and Berlin bless the ultimate fiscal package as well. While investors wait to see the outcome of Rome-Brussels budget talks, which will likely last well into Q4, we prefer to play Mediterranean politics by shorting Italian government bonds versus their Spanish equivalents. BCA's Global Fixed Income Strategy initiated such a trade on December 16, 2016, which has produced a total return of 5.8%. The original logic for the trade was based on an assessment that Italy's medium-term growth potential, sovereign-debt fundamentals, and political stability were all much worse than those of Spain (Chart 22). These differences were not reflected in relative bond prices. Chart 21Three Factors Will Influence Italy's Debt Trajectory Three Factors Will Influence Italy's Debt Trajectory Three Factors Will Influence Italy's Debt Trajectory Chart 22Spain Trumps Italy On All Fronts Spain Trumps Italy On All Fronts Spain Trumps Italy On All Fronts Ongoing political turmoil in Italy has justified sticking with the trade. Looking ahead, there is potential for additional spread widening between Italy and Spain in the coming months. Spain is enjoying better economic growth; the deficit outlook will invariably worsen for Italy with the new coalition government; and Spanish support for the euro and establishment policymakers remains far higher and more buoyant than in Italy. All these factors justify a wider risk premium for Italian debt over Spanish bonds (Chart 23). Chart 23Stay Short 5-Year Italy Vs. 5-Year Spain Stay Short 5-Year Italy Vs. 5-Year Spain Stay Short 5-Year Italy Vs. 5-Year Spain Chart 24Stay Underweight Italian Debt Stay Underweight Italian Debt Stay Underweight Italian Debt One final critical point - the timing of any budget related uncertainty could not be worse for Italy. Economic growth is slowing and leading indicators say that this trend will continue, which suggests that Italian government bonds should continue to underperform global peers (Chart 24). Our Global Fixed Income Strategy team has argued that government debt in the European "periphery" should be treated more like corporate credit rather than sovereign debt.11 Faster economic growth leads to fewer worries about debt sustainability and increased risk-taking behavior by investors, both of which lead to reduced credit risk premiums and eventually, stronger growth. In other words, think of Italian BTPs as a BBB-rated corporate bond rather than a "risk-free" Euro Area government bond. So as long as the Italian economy continues to lose momentum, an underweight stance on Italian government bonds is justified. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 2 Please see Repubblica, "Il discorso di Conte in Senato, la versione integrale," dated June 6, 2018, available at repubblica.it. 3 Conte's exact quote was "the objective is the 'flat tax,' that is a tax reform characterized by the introduction of rates that are fixed, with a system of deductions that can guarantee that the tax code remains progressive." This is our own translation from Italian and therefore we may be missing something. However, a "flat tax" that has a number of different rates and that remains progressive is, by definition, not a flat tax. 4 In fact, the speech could be read with an eye towards some genuine supply-side reforms, particularly in bringing the country's youth into the labor force, improving governance, reforming the judiciary, cracking down on corruption and privileges of the political class, and generally de-bureaucratizing Italy. If successful, these would all be welcome reforms. 5 Please see BCA Geopolitical Strategy Monthly Report, "After Greece," July 8, 2015, available at gps.bcaresearch.com. 6 The game derives its name from a test of manhood by which two drivers drive towards each other on a collision course, preferably behind the wheel of a 1950s American muscle car. Whoever swerves loses. Whoever keeps driving, wins and gets the girl. 7 Please see BCA European Investment Strategy Weekly Report, "Italy's 'Line In The Sand,'" dated May 31, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 9 The acronym stands for Nomenclature des Unités Statistiques. 10 Please see BCA European Investment Strategy Special Report, "Italy Vs. Brussel: Who's Right?" dated May 24, 2018, available at eis.bcaresearch.com. 11 Please see BCA Global Fixed Income Strategy Weekly Report, "Is It Partly Sunny Or Mostly Cloudy?" dated May 22, 2018, available at gfis.bcaresearch.com.

Highlights The risk/reward balance for risk assets remains unappealing this month, even though our base-case outlook sees them outperforming cash and bonds over the next 6-12 months. The number of items that could take equity markets to new highs appears to fall well short of the number of potential landmines that could take markets down. Tensions vis-à-vis North Korea have eased, but the U.S./China trade war is heating up. Trump's voter base and many in Congress want the President to push China harder. Eurozone "breakup risk" has reared its ugly head once again. The Italian President is trying to install a technocratic government, but the interim between now and a likely summer election will extend the campaign period during which the two contending parties have an incentive to continue with hyperbolic fiscal proposals. The next Italian election is not a referendum on exiting the EU or Euro Area. Nonetheless, the risks posed by the Italian political situation may not have peaked, especially since Italy's economic growth appears set to slow. We are underweight both Italian government bonds and equities within global portfolios. It is also disconcerting that we have passed the point of maximum global growth momentum. We expect growth to remain above-trend in the advanced economies, but the economic data will be less supportive of global risk assets than was the case last year. One reason for the economic "soft patch" is that the Chinese economy continues to decelerate. Our indicators suggest that growth will moderate further, with negative implications for the broader emerging market complex. Dearer oil may also be starting to bite, although prices have not increased enough to derail the expansion in the developed economies. This is especially the case in the U.S., where the shale industry is gearing up. Last year's "global synchronized growth" story is showing signs of wear. While the U.S. economy will enjoy a strong rebound in the second quarter, leading economic indicators in most of the other major countries have rolled over. Similar divergences are occurring in the inflation data. The international growth and inflation decoupling is probably not over, which means that long-dollar positions should continue to pay off in the coming months. U.S. inflation is almost back to target and the FOMC signaled that an overshoot will be tolerated. Policymakers will likely transition from "normalizing" policy to targeting slower economic growth once long-term inflation expectations return to the 2.3%-2.5% range. The advanced stage of the U.S. business cycle, heightened geopolitical risks and our bias for capital preservation keep us tactically cautious on risk assets again this month. Feature The major stock indexes are struggling, even though 12-month forward earnings estimates continue to march higher (Chart I-1). One problem is that a lot of good earnings news was discounted early in the year. The number of items that could take markets to new highs appear to fall well short of the number of potential landmines that could take markets down. Not the least of which is ongoing pain in emerging markets and the return of financial stress in Eurozone debt markets. Last month's Overview highlighted the unappealing risk/reward balance for risk assets, even though our base-case outlook sees them outperforming cash and bonds over the next 6-12 months. The advanced stage of the business cycle and our bias for capital preservation motivated us to heed the recent warnings from our growth indicators and 'exit' timing checklist. We also were concerned about a raft of geopolitical tensions. Fast forward one month and the backdrop has not improved. Our Equity Scorecard Indicator edged up, but is still at a level that historically was consistent with poor returns to stocks and corporate bonds (see Chart I-1 in last month's Overview). Our 'exit' checklist is also signaling that caution is warranted (Table I-1). Meanwhile, the "global synchronized expansion" theme that helped to drive risk asset prices higher last year is beginning to unravel and trade tensions are escalating. Chart I-1Struggling To Make Headway Struggling To Make Headway Struggling To Make Headway Table I-1Exit Checklist For Risk Assets June 2018 June 2018 U.S./Sino Trade War Is Back? The "on again/off again" trade war between the U.S. and China is on again as we go to press. Investors breathed a sigh of relief in mid-May when the Trump Administration signaled that China's minor concessions were sufficient to avoid the imposition of onerous new tariffs. However, the proposed deal did not go down well with many in the U.S., including some in the Republican Party. The President was criticized for giving up too much in order to retain China's help in dealing with North Korea. Trump might have initially cancelled the summit with Kim in order to send a message to China that he is still prepared to play hard ball on trade, despite the North Korean situation. We expect that U.S./North Korean negotiations will soon begin, and that Pyongyang will not be a major threat to global financial markets for at least the near term. It is a different story for U.S./China relations. Trump's voter base and many in Congress on both sides of the isle want the President to push China harder. This is likely to be a headwind for risk assets at least until the U.S. mid-term elections. The Return Of Eurozone Breakup Risk Turning to the Eurozone, "breakup risk" has reared its ugly head once again. Italian President Sergio Mattarella's decision to reject a proposed cabinet minister has led to the collapse of the populist coalition between the anti-establishment Five Star Movement (M5S) and the euroskeptic League. President Mattarella's choice for interim-prime minister, Carlo Cottarelli, is unlikely to last long. It is highly unlikely that he will be able to receive parliamentary support for a technocratic mandate, given the fact that he cut government spending during a brief stint in government from 2013-14. As such, elections are likely this summer. Chart I-2Italy: No Euro Support Rebound Italy: No Euro Support Rebound Italy: No Euro Support Rebound Investors continue to fret for two reasons. First, the interim period will extend the campaign period during which both M5S and the League have an incentive to continue with hyperbolic fiscal proposals. Second, M5S has suggested that it will try to impeach Mattarella, a long and complicated process that would heighten political risk, though it will likely fail in our view. As our geopolitical strategists have emphasized throughout 2017, Italy will eventually be the source of a major global risk-off event because it is the one outstanding major European country capable of reigniting the Euro Area break-up crisis.1 While a majority of Italians support the euro, they are less supportive than any other major European country, including Greece (Chart I-2). Meanwhile a plurality of Italians is confident that the future would be brighter if Italy were an independent country outside of the EU. That said, the next election is not a referendum on exiting the EU or Euro Area. The current conflict arises from the coalition wanting to run large budget deficits in violation of Europe's Stability and Growth Pact fiscal rules. Given that the costs of attempting to exit the Euro Area are extremely severe for Italy's households and savers, and that even the Five Star Movement has moderated its previous skepticism about the euro for the time being, it is likely going to require a recession or another crisis to cause Italy seriously contemplate an exit. We are still several steps away from such a move. Nonetheless, the risks posed by the Italian political situation may not have peaked. Italy's leading economic indicator points to slowing growth, which will intensify the populist push for aggressive fiscal stimulus. We are underweight both Italian government bonds and equities within global portfolios. Global Growth Has Peaked Chart I-3Past The Point Of Max Growth Momentum Past The Point Of Max Growth Momentum Past The Point Of Max Growth Momentum It is also disconcerting that we have passed the point of maximum global growth momentum, as highlighted by the indicators shown in Chart I-3. We expect growth to remain above-trend in the advanced economies, but the economic data will be less supportive of global risk assets than was the case last year. What is behind this year's loss of momentum? First, growth in 2017 was flattered by a rebound from the oil-related manufacturing recession of 2015/16. That rebound is now topping out, while worries regarding a trade war are undoubtedly weighing on animal spirits and industrial activity. Second, the Eurozone economy was lifted last year by the previous recapitalization of parts of the banking system, which allowed some pent-up credit demand to be satiated. This growth impulse also appears to have peaked, which helps to explain the sharp drop in some of the Eurozone's key economic indicators. Still, we do not expect European growth to slip back below a trend pace on a sustained basis unless the Italian situation degenerates so much that contagion causes significantly tighter financial conditions for the entire Eurozone economy. The third factor contributing to the global growth moderation is China. The Chinese economy surged in 2017 in a lagged response to fiscal and monetary stimulus in 2016, as highlighted by the Li Keqiang Index (LKI) and import growth (Chart I-4). Both are now headed south as the policy backdrop turned less supportive. Downturns in China's credit and fiscal impulses herald a deceleration in capital spending and construction activity (Chart I-4, bottom panel). The LKI has a strong correlation with ex-tech earnings and import growth. In turn, the latter is important for the broader EM complex that trade heavily with China. Weaker Chinese import growth has also had a modest negative impact on the developed world (Chart I-5). We estimate that, for the major economies, the contribution to GDP growth of exports to China has fallen from 0.3 percentage points last year to 0.1 percentage points now.2 Japan and Australia have been hit the hardest, but the Eurozone has also been affected. Interestingly, U.S. exports to China have bucked the trend so far. Chart I-4China Growth Slowdown... China Growth Slowdown... China Growth Slowdown... Chart I-5...Is Weighing On Global Activity ...Is Weighing On Global Activity ...Is Weighing On Global Activity China is not the only story because the slowdown in global trade activity in the first quarter was broadly based (Chart I-5). Nonetheless, softer aggregate demand growth out of China helps to explain why manufacturing PMIs and industrial production growth in most of the major developed economies have cooled. Our model for the LKI is still moderating. We do not see a hard economic landing, but our analysis points to further weakening in Chinese imports and thus softness in global exports and manufacturing activity in the coming months. Oil's Impact On The Economy... Finally, oil prices are no doubt taking a bite out of consumer spending power as Brent fluctuates just below $80/bbl. Our energy experts expect the global crude market to continue tightening due to robust growth and ongoing geopolitical tensions. Chief among these are the continuing loss of Venezuelan crude production and the re-imposition of U.S. sanctions on Iran. At the same time, we expect OPEC 2.0 to keep its production cuts in place in the second half of the year. Increasing shale output will not be enough to prevent world oil prices from rising in this environment, and we expect oil prices to continue to trend higher through 2018 and into early 2019 (Chart I-6). Brent could touch $90/bbl next year. There are a few ways to gauge the size of the oil shock on the economy. Chart I-7 shows the U.S. and global 'oil bill' as a share of GDP. We believe that both the level and the rate of change are important. Price spikes, even from low levels, do not allow energy users the time to soften the blow by shifting to alternative energy sources. Chart I-6Oil: Stay Bullish Oil: Stay Bullish Oil: Stay Bullish Chart I-7The Oil Bill The Oil Bill The Oil Bill The level of the oil bill is not high by historical standards. The increase in the bill over the past year has been meaningful, both for the U.S. and at the global level, but is still a long way from the oil shocks of the 1970s. U.S. consumer spending on energy as a share of disposable income, at about 4%, is also near the lowest level observed over the past 4-5 decades (Chart I-8). The 2-year swing in this series shows that rapid increases in energy-related spending has preceded slowdowns in economic growth, even from low starting points. The swing is currently back above the zero line but, again, it is not at a level that historically was associated with a significant economic slowdown. Chart I-8Oil's Impact On U.S. Consumer Spending Oil's Impact On U.S. Consumer Spending Oil's Impact On U.S. Consumer Spending Moreover, the mushrooming shale oil and gas industry has altered the calculus of oil shocks for the U.S. The plunge in oil prices in 2014-16 was accompanied by a manufacturing and profit mini recession in the developed countries, providing a drag on overall GDP growth. Chart I-9 provides an estimate of the contribution to U.S. growth from the oil and gas industry. We have included capital spending and wages & salaries in the calculation, and scaled it up to include spillover effects on other industries. Chart I-9Oil's Impact On Consumer Spending And Shale Oil's Impact On Consumer Spending And Shale Oil's Impact On Consumer Spending And Shale The oil and gas contribution swung from +0.5 percentage points in 2012 to -0.4 percentage points in 2016. The contribution has since become only slightly positive again, but it is likely to rise further unless oil prices decline in the coming months. We have included the annual swing in consumer spending on energy as a percent of GDP in Chart I-9 (inverted) for comparison purposes. At the moment, the impact on growth from the shale industry is roughly offsetting the negative impact on consumer spending. The bottom line is that the rise in oil prices so far is enough to take the edge off of global growth, but it is not large enough to derail the expansion in the developed countries. This is especially the case in the U.S., where the shale industry is gearing up. ...And Asset Prices As for the impact on asset prices, it is important to ascertain whether rising oil prices represent more restrictive supply or expanding demand. A mild rise in oil prices might simply be a symptom of increased demand caused by accelerating global growth. Higher oil prices are thus reflective of robust demand, and thus should not be seen as a threat. In contrast, the 1970s experience shows that supply restrictions can send the economy into a tailspin. In order to separate the two drivers of prices, we regressed WTI oil prices on global oil demand, inventories and the U.S. dollar. By excluding supply-related factors such as production restrictions, the residual of the regression model gives an approximate gauge of supply shocks (panel 2, Chart I-10). This model clearly has limitations, but it also has one key benefit: it estimates not just actual disruptions in supply, but also the premium built into prices due to perceived or expected future supply disruptions. For example, the 1990 price spike appears as quite a substantial deviation from what could be explained by changes in demand alone. Similar negative supply shocks are evident in 2000 and 2008. Chart I-10Identifying Supply Shocks In The Oil Market Identifying Supply Shocks In The Oil Market Identifying Supply Shocks In The Oil Market We then examined the impact that supply shocks have on subsequent period returns for both Treasury and risk assets. We divided the Supply Shock Proxy into four quartiles corresponding to the four zones shown in Chart I-10: strong positive shock, mild positive shock, mild negative shock and strong negative shock; the last of these corresponds to the region above the upper dashed line, which we have shaded in the chart. The performance of risk assets does not vary significantly across the bottom three quartiles of the supply shock indicator (Chart I-11). However, performance drops off precipitously in the presence of a strong negative supply shock. This is consistent with the "choke point" argument: investors are initially unconcerned with a modest appreciation in oil prices. It is only when prices are driven sharply above the level consistent with the current demand backdrop that risk assets begin to discount a more pessimistic future. The total returns to the Treasury index behave in the opposite manner (Chart I-12). Treasury returns are below average when the oil shock indicator is below one (i.e. positive supply shock) and above average when oil prices rise into negative supply shock territory. In other words, an excess of oil supply is Treasury bearish, as it would tend to fuel more robust economic growth. Conversely, a supply shock that drives oil prices higher tends to be Treasury bullish. This may seem counterintuitive because higher oil prices can be inflationary and thus should be bond bearish in theory. However, large negative oil supply shocks have usually preceded recessions, which caused Treasurys to rally. Chart I-11Effect On Risk Assets June 2018 June 2018 Chart I-12Effect On Treasurys June 2018 June 2018 The model clearly shows that the drop in oil prices in 2014/15 was a positive supply shock, consistent with the oil consumption data that show demand growth was fairly stable through that period. The model indicator has moved up toward the neutral line in recent months, suggesting that the supply side of the market is tightening up, but it is still in "mild positive supply shock" territory. The latest data point available is April, which means that it does not capture the surge in oil prices over the past month. Some of the recent jump in prices is clearly related to the cancelled Iran deal and other supply-related factors, although demand continues to be supportive of prices. The implication of this model is that it will probably require a significant further surge in prices, without a corresponding ramp up in oil demand, for the model to signal that supply constraints are becoming a significant threat for risk assets. A rise in Brent above US$85 would signal trouble according to this model. As for government bonds, rising oil prices are bearish in the near term, irrespective of whether it reflects demand or supply factors. This is because of the positive correlation between oil prices and long-term inflation expectations. The oil bull phase will turn bond-bullish once it becomes clear that energy prices have hit an economic choke point. Desynchronization Last year's "global synchronized growth" story is showing signs of wear. First quarter U.S. GDP growth was underwhelming, but the long string of first-quarter disappointment points to seasonal adjustment problems. Higher frequency data are consistent with a robust rebound in the second quarter. Forward looking indicators, such as the OECD and Conference Board's Leading Economic Indicators, continue to climb. This is in contrast with some of the other major economies, such as the Eurozone, U.K., Australia and Japan (Chart I-13). First quarter real GDP growth was particularly soft in Japan and the Eurozone, and one cannot blame seasonal adjustment in these cases. Chart I-13Growth & Inflation Divergences Growth & Inflation Divergences Growth & Inflation Divergences The divergence in economic performance likely reflects Washington's fiscal stimulus that is shielding the U.S. from the global economic soft patch. Moreover, the U.S. is less exposed to the oil shock and the China slowdown than are the other major economies. Similar divergences are occurring in the inflation data. While U.S. inflation continues to drift higher, it has lost momentum in the euro area, Japan and the U.K. (Chart I-13). Renewed stresses in the Italian and Spanish bond markets have sparked a flight-to-quality in recent trading days, depressing yields in safe havens such as U.S. Treasurys and German bunds. Nonetheless, prior to that, the divergence in growth and inflation was reflected in widening bond yield spreads as U.S. Treasurys led the global yields higher. Long-term inflation expectations have risen everywhere, but real yields have increased the most in the U.S. (prior to the flight-to-quality bond rally at the end of May). This is consistent with the growth divergence story and with our country bond allocation: overweight the U.K., Australia and Japan, and underweight U.S. Treasurys within hedged global portfolios. The dollar lagged earlier this year, but is finally catching up to the widening in interest rate spreads. The international growth and inflation decoupling is probably not over, which means that long-dollar positions should continue to pay off in the coming months. Expect More Pain In EM Dollar strength and rising U.S. bond yields are a classic late-cycle combination that often spells trouble for emerging market assets. We do not see the recent selloff across EM asset classes as a buying opportunity since markets have only entered the first stage of the classic final chapter; EM assets underperform as U.S. bond yields and the dollar rise, but commodity prices are resilient. In the second phase, U.S. bond yields top out, but the U.S. dollar continues to firm and commodity prices begin their descent. If the current slowdown in Chinese growth continues, as we expect, it will begin to weigh on non-oil commodity prices. Thus, emerging economies may have to deal with a deadly combination of rising U.S. interest rates, a stronger greenback, falling commodity prices and slowing exports to China (Chart I-14). Which countries are most exposed to lower foreign funding? BCA's Emerging Market Strategy services has ranked EM countries based on foreign funding requirements (Chart I-15). The latter is calculated as the current account balance plus foreign debt that is due in the coming months. Chart I-14EM Currencies Exposed To China Slowdown EM Currencies Exposed To China Slowdown EM Currencies Exposed To China Slowdown Chart I-15Vulnerability Ranking: Dependence On Foreign Funding June 2018 June 2018 Turkey, Malaysia, Peru and Chile have the heaviest foreign funding requirements in the next six months. These mostly stem from foreign debt obligations by their banks and companies. Even though most companies and banks with foreign debt will not default, their credit spreads will likely widen as it becomes more difficult to service the foreign debt.3 It is too early to build positions even in Turkish assets. Our EM strategists believe that it will require an additional 15% depreciation in the lira versus an equal-weighted basket of the dollar and euro, in combination with 200-250 basis points hike in the policy rate, and a 20% drop in share prices in local currency terms, to create a buying opportunity in Turkish financial instruments. FOMC Expects Inflation Overshoot Escalating turmoil in EM financial markets could potentially lead the Federal Reserve to put the rate hike campaign on hold. However, that would require some signs of either domestic financial stress or slowing growth. The FOMC is monitoring stress in emerging markets and in the Eurozone, but is sticking with its "gradual" tightening pace for now (i.e. 25 basis points per quarter). May's FOMC minutes signaled a rate hike in June. However, the minutes did not suggest that the Fed is getting more hawkish, despite the Staff's forecast that growth will remain above trend and that the labor market will continue to tighten at a time when core inflation is already pretty much back to target. Some inflation indicators, such as the New York Fed's Inflation Gauge, suggest that core inflation will overshoot. The minutes signaled that policymakers are generally comfortable with a modest overshoot of the 2% inflation target because many see it as necessary in order to shift long-term inflation expectations higher, into a range that is consistent with meeting the 2% inflation target on a "sustained" basis (we estimate this range to be 2.3-2.5% for the 10-year inflation breakeven rate). The fact that the FOMC took a fairly dovish tone and did not try to guide rate expectations higher contributed to some retracement of the Treasury selloff in recent weeks. Nonetheless, an inflation overshoot and rising inflation expectations will ultimately be bond-bearish, especially when the FOMC is forced to clamp down on growth as long-term inflation expectations reach the target range. As discussed in BCA's Outlook 2018, one of our key themes for the year is that risk assets are on a collision course with monetary policy because the FOMC will eventually have to transition from simply removing accommodation to targeting slower growth. Timing that transition will be difficult, and depends importantly on how much of an inflation overshoot the FOMC is prepared to tolerate. Is 2½% reasonable? Or could inflation go to 3%? The makeup of the FOMC has changed, but we expect Janet L. Yellen4 to shed light on this question when she speaks at the BCA Annual Investment Conference in September. Investment Conclusions The risks facing investors have shifted, but we do not feel any less cautious than we did last month. Geopolitical tensions vis-à-vis North Korea have perhaps eased. But trade tensions are escalating and investors are suddenly faced with another chapter in the Eurozone financial crisis. The major fear in the first and second chapters was that bond investors would attack Italy, given the sheer size of that economy and the size of Italian government debt. That dreadful day has arrived. The profit backdrop in the major economies remains constructive for equity markets. However, even there, the bloom is coming off the rose. Global growth is no longer synchronized and the advanced economies have hit a soft patch with the possible exception of the U.S. While far from disastrous, our short-term profit models appear to be peaking across the major countries (Chart I-16). Chart I-16Profit Growth: Solid, But Peaking Profit Growth: Solid, But Peaking Profit Growth: Solid, But Peaking The typical U.S. late cycle dynamics are also threatening emerging markets, at a time when investors are generally overweight and many EM countries have accumulated a pile of debt. U.S. inflation is set to overshoot the target, the FOMC is tightening and the dollar is rising. Throw in slowing Chinese demand and the EM space looks highly vulnerable. If the global economic slowdown is pronounced and drags the U.S. down with it, then bonds will rally and risk assets will take a hit. If, instead, the soft patch is short-lived and growth re-accelerates, then the U.S. Treasury bear market will resume. Stock indexes and corporate bond excess returns would enjoy one last upleg in this scenario, but downside risks would escalate once the Fed begins to target slower economic growth. Either way, EM assets would be hit. Our base case remains that stocks will beat government bonds and cash on a 6-12 month horizon. However, the risk/reward balance is unattractive given the geopolitical backdrop. Thus, we remain tactically cautious on risk assets for the near term. We still expect that the 10-year Treasury yield will peak at close to 3½% before this economic expansion is over. Nonetheless, this would require a calming of geopolitical tensions and an upturn in the growth indicators in the developed world. The risk/reward tradeoff for corporate bonds is no better than for equities and we urge caution in the near term. On a 6-12 month cyclical horizon, we still expect corporate bonds to outperform government bonds, at least in the U.S. European corporates are subject to the ebb and flow of the Italian bond crisis, and face the added risk that the ECB will likely end its QE program later this year. Looking further ahead, this month's Special Report, beginning on page 19, analyzes the Eurozone corporate sector's vulnerability to the end of the cycle that includes rising interest rates and, ultimately, a recession. We find that domestic issuers into the Eurozone market are far less exposed than are foreign issuers. Mark McClellan Senior Vice President The Bank Credit Analyst May 31, 2018 Next Report: June 28, 2018 1 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016, available on gps.bcaresearch.com 2 This underestimates the impact on the major countries because it does not account for third country effects (i.e. trade with other countries that trade with China). 3 For more information, please see BCA Emerging Market Strategy Weekly Report, "The Dollar Rally And China's Imports," dated May 24, 2018, available on ems.bcaresearch.com 4 Janet L. Yellen, Chair, Board of Governors, Federal Reserve System (2014-2018). II. Leverage And Sensitivity To Rising Rates: The Eurozone Corporate Sector As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. We previously identified the U.S. corporate bond market as a definite candidate. This month we look at European corporates. European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. Foreign issuers are much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond relative returns this year. More important will be the end of the ECB's asset purchase program. We recommend an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Risk assets remain on a collision course with monetary policy, which is the main reason why the "return of vol" is a key theme in the BCA 2018 Outlook. In the U.S., rising inflation is expected to limit the FOMC's ability to cushion soft patches in the economic data or negative shocks from abroad. We expect that ECB tapering will add to market stress, especially now that Eurozone breakup risks are again a concern. We also believe that geopolitics will remain a major source of uncertainty and volatility. All this comes at a time when corporate bond spreads offer only a thin buffer against bad news. On a positive note, we remain upbeat on the earnings outlook in the major countries. The U.S. recession that we foresaw in 2019 has been delayed into 2020 by fiscal stimulus. The longer runway for earnings to grow keeps us nervously overweight corporate bonds, at least in the U.S. That said, corporates are no more than a carry trade now that the lows in spreads are in place for the cycle. We are keeping a close eye on a number of indicators that will help us to time the next downgrade to our global corporate bond allocation. Profitability is just one, albeit important, aspect of the financial backdrop. What about the broader trend in financial health? Does the trend justify wider spreads even if the economy and profits hold up over the next year? We reviewed U.S. corporate financial health in the March 2018 monthly Bank Credit Analyst, using our bottom-up sample of companies. We also stress-tested these companies for higher interest rates and a medium-sized recession. We concluded that the U.S. corporate sector's heavy accumulation of debt in this expansion will result in rampant downgrade activity during the next economic downturn. As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. The U.S. corporate bond market is a definite candidate. This month we extend the analysis to the European corporate sector. The European Corporate Health Monitor The bottom-up version of the Corporate Health Monitor (CHM) is a complement to our top-down CHM, which uses macro data from the ECB to construct an index of six financial ratios for the non-financial corporate sector. While useful as an indicator of the overall trend in corporate financial health, it does not shed light on underlying trends across credit quality, countries and sectors. It also fails to distinguish between domestic versus foreign issuers in the Eurozone market. A number of features of the European market limit the bottom-up analysis to some extent relative to what we are able to do for the U.S.: the Eurozone market is significantly smaller and company data typically do not have as much history; foreign issuers comprise almost 50% of the market, a much higher percentage than in the U.S.; and the Financial sector features more prominently in the Eurozone index, but we exclude it because our CHM methodology does not lend itself well to this sector. We analyzed only domestic issuers in our study of U.S. corporate health. However, we decided to include foreign issuers in our Eurozone analysis in order to maximize the sample size. Moreover, it is appropriate for some bond investors to consider the whole picture, given that important benchmarks such as Barclay's corporate indexes include both foreign and domestic issuers. The relative composition of domestic versus foreign, investment-grade versus high-yield, and industrial sectors in our sample are comparable with the weights used in the Barclay's index. The CHM is calculated using the median value for each of six financial ratios (Table II-1). We then standardize1 the median values for the six ratios and aggregate them into a composite index using a simple average. The result is an index that fluctuates between +/- 2 standard deviations. A rising index indicates deteriorating health, while a downtrend signals improving health. We defined it this way in order to facilitate comparison with trends in corporate spreads. Table II-1Definitions Of Ratios That Go Into The CHMs June 2018 June 2018 One has to be careful in interpreting our Eurozone Monitor. The bottom-up version only dates back to 2005. Thus, while both the level and change in the U.S. CHM provide important information regarding balance sheet health, for the Eurozone Monitor we focus more on the change. Whether it is a little above or below the zero line is less important than the trend. Top-Down Versus Bottom-Up Chart II-1 compares the top-down and bottom-up Eurozone CHMs for the entire non-financial corporate sector.2 The levels are different, although the broad trends are similar. Key differences that help to explain the divergence include the following: the top-down CHM defines leverage to be total debt as a percent of the market value of equity, while our bottom-up CHM defines it to be total debt as a percent of the book value of the company. The second panel of Chart II-1 highlights that the two measures of leverage have diverged significantly since 2012; the top-down CHM defines profit margins as total cash flow as a percent of sales. For data-availability reasons, our bottom-up version uses operating income/total sales; and most importantly, the top-down CHM uses ECB data, which includes only companies that are domiciled in the Eurozone. Thus, it excludes foreign issuers that make up a large part of our company sample and the Barclay's index. When we recalculate the bottom-up CHM using only domestic investment-grade issuers, the result is much closer to the top-down version (Chart II-2). Both CHMs have been in 'improving health' territory since the end of the Great Financial Crisis. The erosion in the profitability components during this period was offset by declining leverage, rising liquidity and improving interest coverage for domestic issuers. Chart II-1Top-Down Vs. Bottom-Up Top-Down Vs. Bottom-Up Top-Down Vs. Bottom-Up Chart II-2Top-Down Vs. Domestic Bottom-Up Top-Down Vs. Domestic Bottom-Up Top-Down Vs. Domestic Bottom-Up It has been a different story for foreign IG issuers (Chart II-3). These firms have historically enjoyed a higher return on capital, operating margins, interest coverage, debt coverage and liquidity. Nonetheless, heavy debt accumulation has undermined their interest- and debt-coverage ratios in absolute terms and relative to their domestic peers until very recently. In other words, while domestic issuers have made an effort to clean up their balance sheets since the Great Recession, financial trends among foreign issuers look more like the trends observed in the U.S. No doubt, this is in part due to U.S. companies issuing Euro-denominated debt, but there are many other foreign issuers in our sample as well. Some analysts prefer total debt/total assets to the leverage measure we use in constructing our CHMs. However, the picture is much the same; leverage among IG domestic and foreign firms has diverged dramatically since 2010 (Chart II-4). Chart II-3Bottom-Up: Domestic Vs. Foreign IG Bottom-Up: Domestic Vs. Foreign IG Bottom-Up: Domestic Vs. Foreign IG Chart II-4Diverging Leverage Trends Diverging Leverage Trends Diverging Leverage Trends Over the past year or so there has been some reversal in the post-Lehman trends; domestic health has stabilized, while that of foreign issuers has improved. Leverage among foreign companies has leveled off, while margins and the liquidity ratio have bounced. The results for high-yield (HY) issuers must be taken with a grain of salt because of the small sample size. Chart II-5 highlights that the HY CHM is improving for both domestic and foreign issuers. Impressively, leverage is declining for both the domestic and foreign components. The return on capital, interest coverage, and debt coverage have also improved, although only for foreign issuers. Chart II-5Bottom-Up: Domestic Vs. Foreign HY Bottom-Up: Domestic Vs. Foreign HY Bottom-Up: Domestic Vs. Foreign HY Corporate Sensitivity The bottom line is that, while there have been some relative shifts below the surface, the European corporate sector's finances are generally in good shape in absolute terms and relative to the U.S. This is particularly the case for domestic issuers that have yet to catch the equity buyback bug. However, less accommodative monetary policy and rising borrowing rates have focused investor attention on corporate sector vulnerability. Downgrade risk will mushroom if corporate borrowing rates continue rising and, especially, if the economy contracts. If there is a recession in Europe in the next few years it will likely be as a result of a downturn in the U.S. We expect a traditional end to the U.S. business cycle; the Fed overdoes the rate hike cycle, sending the economy into a tailspin. The U.S. downturn would spill over to the rest of the world and could drag the Eurozone into a mild contraction. We estimated the change in the interest coverage ratio for the companies in our bottom-up European sample for a 100 basis-point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt (i.e. the coupons reset only for the bonds, notes and loans that mature in the next three years). We make the simplifying assumptions that all debt and loans maturing in the next three years are rolled over, but that companies do not take on net new obligations. We also assume that EBIT is unchanged in order to isolate the impact of higher interest rates. The 'x' in Chart II-6 denotes the result of the interest rate shock only. The 'o' combines the interest rate shock with a recession scenario, in which EBIT contracts by 15%. The interest coverage ratio declines sharply when rates rise by 100 basis points, but the ratio moves to a new post-2000 low only for foreign issuers. The ratio for domestic issuers falls back to the range that existed between 2009 and 2013. The median interest coverage ratio drops further when we combine this with a 15% earnings contraction in the recession scenario. Again, the outcome is far worse for foreign than it is for domestic issuers. Chart II-7 presents a shock to the median debt coverage ratio. Since debt coverage (cash flow divided by total debt) does not include interest payments, we show only the recession scenario result that reflects the decline in profits. Once again, foreign issuers appear to be far more exposed to an economic downturn than their domestic brethren. Chart II-6Interest Coverage Shocks Interest Coverage Shocks Interest Coverage Shocks Chart II-7Debt Coverage Shock Debt Coverage Shock Debt Coverage Shock Indeed, the results for foreign issuers are qualitatively similar to the shocks we previous published for our bottom-up sample of IG corporates in the U.S. (Chart II-8 and Chart II-9). In both cases, higher interest rates and contracting earnings will take the interest coverage and debt coverage ratios into uncharted territory. Chart II-8U.S. Interest Coverage Shocks U.S. Interest Coverage Shocks U.S. Interest Coverage Shocks Chart II-9U.S. Debt Coverage Shock U.S. Debt Coverage Shock U.S. Debt Coverage Shock Conclusions European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers, where balance sheet activity has focused on lifting shareholder value since the last recession. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. There has been a small convergence of financial health between Eurozone domestic and foreign issuers over the past year or so, but the latter are still much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond returns relative to European government bonds or to U.S. corporates this year. More important will be the end of the ECB's asset purchase program later in 2018. We expect spreads to widen as this important liquidity tailwind fades. For the moment, our Global Fixed Income Strategy service recommends an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Standardizing involves taking the deviation of the series from the 18 quarter moving average and dividing by the standard deviation of the series. 2 Note that a rising CHM indicates deteriorating health to facilitate comparison with quality spreads. III. Indicators And Reference Charts The divergence between the U.S. corporate earnings data and our equity-related indicators continued in May. We remain cautious, despite the supportive profit backdrop. The U.S. net earnings revisions ratio fell a bit in May, but it remains well in positive territory. Forward earnings continued their ascent, and the net earnings surprise index rose further to within striking distance of the highest levels in the history of the series. Normally, an earnings backdrop this strong would justify an overweight equity allocation within a balanced portfolio. Unfortunately, a lot of good earnings news is discounted based on our Composite Valuation Indicator and extremely elevated 5-year bottom-up earnings growth expectations (see the Bank Credit Analyst Overview, May 2018). Moreover, our equity indicators are sending a cautious signal. Our U.S. Willingness-to-Pay indicator continued to decline in May. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. U.S. flows have clearly turned negative for equities, although flows into European and Japanese markets are holding up for now. Our Revealed Preference Indicator (RPI) for stocks remained on its 'sell' signal in May, for the second month in a row. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. Moreover, our composite equity Technical Indicator is on the verge of breaking down and our Monetary Indicator moved further into negative territory in May. Meanwhile, market froth has not been completely extinguished according to our Speculation Indicator (which is a negative sign for stocks from a contrary perspective). As for bonds, the powerful rally at the end of May has undermined valuation, but the 10-year Treasury is not yet in expensive territory. Our technical indicator suggests that previously oversold conditions are easing, but bonds are a long way from overbought. This means that yields have room to fall further in the event of more bad news on Italy or on the broader geopolitical scene. The dollar has not yet reached overbought territory according to our technical indicator. 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-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

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

Highlights With North Korean diplomacy on track, Taiwan is the country most exposed to U.S.-China trade and strategic tensions. The Taiwanese public supports the status quo; however, a majority sees itself as exclusively Taiwanese, and the desire for independence may grow over time. Domestic political changes in mainland China and in the United States are also conducive to greater geopolitical tensions affecting Taiwan. Beijing will likely refrain from excessive pressure in the lead-up to Taiwan's November local elections ... but an independence-leaning outcome could change that. Stay overweight Taiwan within Emerging Market portfolios, but be prepared to downgrade if latent geopolitical risks begin to materialize. Feature The decision by the United States to toughen its enforcement of trade rules with China marks a shift that will have lasting ramifications.1 The U.S. is concerned not only about the trade imbalance but also the national security risk posed by China's economic might and increasing technological prowess. Hence President Donald Trump has imposed trade measures on China despite Chinese President Xi Jinping's cooperation on North Korea. Xi has enforced sanctions on the North and thus forced Kim Jong Un to the negotiating table, even getting him to consider denuclearization (Chart 1). Global financial markets may "climb the wall of worry" about the latest tariffs because the Trump administration has moderated its rhetoric in practice, notably by choosing to prosecute China in the World Trade Organization. However, the protectionist shift in U.S. policy is a lasting one. American power is declining relative to China, and the two countries no longer share the same economic interdependency that acted as a deterrent to conflict in the past (Chart 2).2 Chart 1China Gives Kim To Trump China Gives Kim To Trump China Gives Kim To Trump Chart 2Structural Increase In U.S.-China Tensions Structural Increase In U.S.-China Tensions Structural Increase In U.S.-China Tensions Taiwan is the country that is most exposed to both trade and strategic tensions between the U.S. and China (Chart 3). Indeed, BCA's Geopolitical Strategy has held since January 2016 that Taiwan is a potential geopolitical black swan.3 Does this warrant shifting to an underweight stance in EM portfolios? Not yet. But it is a left tail risk that investors should have on their radar. Taiwan Is Filled With Dry Powder There are three reasons to suspect that Taiwan geopolitical risk is understated. First, Chinese President Xi Jinping has consolidated power and made himself into Chairman Mao Zedong's peer in the Communist Party's ideological hierarchy. He is in power indefinitely. Xi has also followed his predecessor Jiang Zemin, in the 1990s, in taking a tough approach to security and defense. Implicitly he wants to make sure that unification occurs by 2049, but some argue that he wants to achieve it within his lifetime, namely by 2035. The Taiwanese public is resolutely opposed to any timetable. The fundamental risk is that economic slowdown could disappoint the aspirations of a big and ambitious middle class, which could force Xi to pursue nationalism and foreign aggression as a way to maintain domestic control (Chart 4). Beijing is still unlikely to attack Taiwan other than as a last resort, due to the American alliance system protecting it: this remains a hard constraint for now. But aggressive economic sanctions and military posturing with the intention to coerce Taiwan are much more likely than investors realize today. Chart 3Taiwan's Economy As Well As Security On The Line Taiwan's Economy As Well As Security On The Line Taiwan's Economy As Well As Security On The Line Chart 4China's Stability Vulnerable To Growth Slowdown China's Stability Vulnerable To Growth Slowdown China's Stability Vulnerable To Growth Slowdown Second, Taiwan's independence-leaning Democratic Progressive Party (DPP) has gained control of every level of government on the island - the presidency, the legislature, the municipalities - since the large-scale, anti-mainland "Sunflower" protests of 2014. President Tsai Ing-wen, who replaced the outspokenly pro-China President Ma Ying-jeou, is vocally uncomfortable with the status quo. She has refused to positively affirm the "1992 Consensus," which holds that there is only "One China" but two interpretations. Beijing sees this idea as the basis of smooth cross-strait relations. Tsai has not in practice tried to break the status quo, but she is clearly interested in enhancing Taiwan's autonomy. Moreover, a youthful "Third Force" has emerged in Taiwanese politics, with the backing of former presidents Lee Teng-hui and Chen Shui-bian, arguing for independence and the right to hold popular referendums on the question of sovereignty. Any success of this movement will provoke a massive response from China. Third, U.S. President Trump has suggested in several poignant ways that his tougher approach to China will entail a more robust American guarantee of Taiwan's security. While he has promised Xi to uphold the "One China policy," he is actively upgrading diplomatic and possibly naval relations with Taiwan and considering more substantial arms sales to Taiwan.4 His negotiation style suggests that he is not afraid to touch this "third rail" in Sino-American relations. Moreover, in the wake of the 1995-96 Third Taiwan Strait Crisis, and again in the wake of the Global Financial Crisis, a hugely important shift in Taiwanese national identity accelerated. Today the public mostly identifies solely as Taiwanese, as opposed to both Taiwanese and Chinese (Chart 5). This trend has abated somewhat since the DPP rose to full control in 2014-16, but a 55% majority still sees itself as exclusively Taiwanese. Among the youth, that number is 70%. This dynamic raises the possibility that a political independence movement could one day emerge. Beijing, at any rate, is watching with great concern. Of course, this shift in national identity does not imply that Taiwanese want to declare independence for the state of Taiwan anytime soon. Only about 22% want the country to move toward formal independence, and only 5% want to declare independence today. Whereas 69% are comfortable maintaining the status quo for a long time (Chart 6). The Taiwanese want to preserve their de facto independence and continue to prosper. But support for independence has grown faster than support for the status quo since the 1994 consensus. The status quo barely, if at all, holds majority support if one removes from its ranks those who eventually want to see the country declare independence. And younger cohorts have larger majorities than older cohorts in favor of independence. Chart 5Majority Of Taiwanese Are Exclusively Taiwanese ... Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan Chart 6... Yet Majority Support Status Quo For Now Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan The point is that there is a lot of "dry powder" in Taiwanese public opinion that could be ignited against China in the event of a change of circumstances, i.e. another military crisis or economic shock. Essentially, China is worried that someday this national identity could be weaponized. Chart 7China Gains Leverage Over Time China Gains Leverage Over Time China Gains Leverage Over Time How will China respond to the situation? So far it has not overreacted. Xi Jinping has launched more intimidating military drills and has hardened his rhetoric - including in key reports at the 2017 party congress and this year's National People's Congress. His administration has also pursued policies to emphasize its dominance, such as setting up new air traffic routes over the strait that Taiwan claims violate its rights.5 Nevertheless, the cross-strait status quo has not yet changed in any fundamental way that would suggest relations are about to explode. And this is fitting because the status quo is beneficial to the mainland, having created a vast imbalance of economic influence over Taiwan (Chart 7). This imbalance gives China the ability to use economic coercion to dissuade Taiwan's leaders from trying anything too daring. This year, in particular, there is reason to think that Xi Jinping may want to limit any provocations. Taiwan will hold local elections on November 24, an opportunity for the pro-China Kuomintang (KMT) to at least begin to claw back the political stature it has lost (Chart 8). A good showing in 2018 is essential for the KMT if it is to rebuild momentum for the 2020 general election. Tsai's and the DPP's approval ratings have fallen precipitously since her inauguration (Chart 9). Xi may deem that saber-rattling would be counterproductive by giving Tsai and the DPP a foil, when in fact the tide is already working against them. If the KMT's performance is abysmal in the November elections, then Beijing faces a problem. Its strategy of gaining influence over Taiwan through economic integration has not prevented the emergence of an exclusively Taiwanese identity. So far Beijing has not given up on this strategy but that might become a concern if the Xi administration treads softly this year and yet the DPP broadens its control of local offices. Worse still for Beijing would be sweeping gains for outspoken, pro-independence candidates, since China cannot expel them from the legislature as easily as it did their peers in Hong Kong. Chart 8Kuomintang Needs A Win In 2018 Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan Chart 9DPP Only Leads KMT By A Little Now Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan Bottom Line: Political changes in China, Taiwan, and the United States are conducive to souring relations across the strait. Moreover, Taiwanese national identity is dry powder that Beijing fears could be exploited by independence-leaning politicians - potentially with American backing from an aggressive President Trump. This three-way dynamic means that Taiwanese geopolitical risk is understated, despite the fact that these powers are all familiar with the dynamics and Beijing may not want to overly provoke voters ahead of local elections, knowing that heavy-handedness in 1995-96 encouraged Taiwanese uniqueness. Macro Backdrop And Trade Tensions Undermine DPP The problem for President Tsai and the ruling DPP, as local elections approach, is that the Taiwanese economy faces headwinds as Chinese and Asian trade slows down and as the Trump administration converts its protectionist rhetoric into action. Since last year, China has tightened financial conditions and regulation and has cracked down on corruption in the financial sector. The result is a slump in broad money supply that is now pointing to a drop in EM and Taiwanese exports (Chart 10). Indeed, a cyclical slowdown is emerging in Taiwan: The short-term loans impulse is weakening which suggests that Taiwanese export growth will slow further (Chart 11, top panel). The basis for this relationship is that short-term loans are used by Taiwanese businesses to fund their working capital needs as well as purchase inputs to fill their export orders. Further, broad money is also weak (Chart 11, bottom panel). Chart 10China Slowdown Spells Trouble For Taiwan bca.gps_sr_2018_03_30_c10 bca.gps_sr_2018_03_30_c10 Chart 11Taiwanese Money/Credit Growth Slowing Taiwanese Money/Credit Growth Slowing Taiwanese Money/Credit Growth Slowing The manufacturing sector is slowing, with the shipments-to-inventories ratio weak and manufacturing PMI dipping sharply (Chart 12). Worryingly, the new orders, export orders, and electronic-sector employment components of the manufacturing PMI are approaching a precarious level. Various prices of semiconductors are also starting to show signs of weakness globally which does not bode well for a market that relies heavily on this trade. The semiconductor shipment-to-inventory ratio has rolled over (Chart 13). Taiwanese exports to ASEAN are also slowing, which signifies that final demand for semiconductors is softening, as ASEAN economies lie at the final stage of the semiconductor supply chain process. Chart 12Manufacturing Indicators Rolling Over Manufacturing Indicators Rolling Over Manufacturing Indicators Rolling Over Chart 13Softness In Key Semiconductor Exports Softness In Key Semiconductor Exports Softness In Key Semiconductor Exports Further, global trade tensions have the potential to harm global growth and especially heavily trade-exposed economies like Taiwan. Taiwan is not guaranteed to benefit from the U.S.'s more aggressive posture toward China. Theoretically, if the U.S. imposes tariffs on goods from China that can be substituted by Taiwan, then Taiwan will benefit. But in practice, the U.S. is using tariffs as a threat to force China to open its market more to U.S. exports. One way that Beijing may respond is by purchasing American goods instead of goods that come from American allies like Taiwan. Beijing has already attempted this strategy by offering to increase imports of American semiconductors at the expense of Taiwan and South Korea. At the moment there are no details on how much of an increase China is proposing. In Table 1 we show several scenarios to assess the damage that could be inflicted on Taiwan if China substituted away from it. The impact on Taiwan's exports is not negligible. For instance, under the benign scenario, if U.S.'s share of semiconductor exports to China rise from 4%6 to 10%, then Taiwan's share of semiconductor exports to China would drop from 15% to 12%. That would amount to a $4 billion loss for Taiwan, approximately, which represents 1.4% share of its total exports and 4% of its overall semiconductor exports. This analysis assumes that the trade losses resulting from China's shift to its semiconductor import mix would harm Taiwan somewhat more than Korea. The latter holds a competitive advantage on Taiwan as Korea designs and manufactures unique semiconductors that are not as easily substitutable. At any rate, the damage to Taiwan's geopolitical and trade outlook would be more concerning than the loss of revenue. Table 1China's Trade Concessions To U.S. Could Impose Costs On U.S. Allies Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan It is unlikely that the Trump administration is willing to accept such a deal, which is flagrantly designed to appease the U.S. at the expense of its allies. But the exercise illustrates a broader dynamic in which U.S. negotiations with China threaten to disrupt trade relationships and supply chains that have benefited Taiwan in recent decades. The result will be greater uncertainty and a higher potential for negative shocks. Chart 14China Punishes Taiwan For 2016 Election China Punishes Taiwan For 2016 Election China Punishes Taiwan For 2016 Election Moreover, the Trump administration has not entirely exempted allies from trade pressure. For instance, Taiwan has appreciated the dollar a bit in response to the threat of punishment for currency manipulation from the U.S. Washington has also just secured assurances from South Korea that it will not competitively depreciate the won. If agreements like these stand, and yet China makes less robust or less permanent agreements regarding its own currency, South Korea and Taiwan could suffer marginal losses of competitiveness. Taiwan is also exposed to coercive economic measures from China. Since Tsai's election, Beijing has made a notable effort to reduce tourist travel to Taiwan, which is reflected in tourism and flight data (Chart 14). Given the context of political tensions, the risk of discrete sanctions will persist and could flare up at any time if an incident occurs that aggravates the distrust between the two governments. How will investors know if Taiwanese geopolitical risk is about to spike upwards? At the moment, geopolitical risk is subdued, according to a proxy based on USD/JPY and USD/KRW exchange rates and relative Taiwanese/American inflation (Chart 15). This indicator tracks well with previous cross-strait crises. It even jumped upon the heightened tensions around the 2016 election of Tsai, and her controversial phone call with Donald Trump after his election. At the moment it suggests that cross-strait tensions have subsided significantly, despite the cutoff in formal diplomatic communication. However, the low point of the measure, and the underlying political factors outlined in the previous section, suggest that it should rise going forward. Chart 15Taiwanese Geopolitical Risk Likely To Rise From Here Taiwanese Geopolitical Risk Likely To Rise From Here Taiwanese Geopolitical Risk Likely To Rise From Here In the short run, it will be important to watch the Trump administration's handling of diplomatic visits and arms sales to Taiwan. Trump's signing of the Taiwan Travel Act has elevated diplomatic exchanges in a way that is mostly symbolic but could still spark an episode of heightened tension with China that would result in economic sanctions. An unprecedented naval port call could turn into an incident. At the same time, the U.S. guarantees Taiwan's security and in token of that guarantee periodically provides Taiwan with weapons packages. Beijing, for its part, always protests these sales, more or less vigorously depending on the military capabilities in question. The currently slated one is not too big but there is a rumor that it will include F-35 stealth fighter jets; other surprises could occur. Traditionally, the biggest spikes in sales have fallen under Democratic, not Republican, administrations. However, Trump may change that. There is a consensus in Washington that policy toward China should get tougher. The Taiwan Travel Act, upgrading diplomatic ties, passed with unanimous consent in both the House and Senate. Taiwanese governments have a record of increasing military spending when Republican presidents sit in Washington. And the first DPP government, under Chen Shui-bian from 2000-08, marked a clear upturn in Taiwanese military spending growth (Chart 16). If the Trump administration decides to sell Taiwan weapon systems that make a qualitative difference in the military balance, it will raise tensions with Beijing and likely prompt economic sanctions against Taiwan. Chart 16Arms Sales Could Reemerge As An Irritant Arms Sales Could Reemerge As An Irritant Arms Sales Could Reemerge As An Irritant In the long run, there are three key negotiations taking place in the region that could increase Taiwanese geopolitical risk: U.S.-China trade negotiations: Taiwan has benefited from China's engagement with the U.S., and with the West more broadly, and stands to suffer if they disengage. That would herald rising strategic tensions that would put Taiwan's trade and security in jeopardy. Geopolitical risk would go up. North Korean diplomacy: Kim Jong Un has met with Xi Jinping and formally agreed to hold bilateral summits with Presidents Trump and Moon Jae-in of South Korea. He has also indicated that denuclearization is on the table. If the different parties enter onto a path towards a peace treaty and denuclearization, then Taiwan might worry that the U.S. will eventually remove troops from the peninsula - far-fetched but not out of the question. Taiwan would fear abandonment and could attempt to entangle the U.S. For its part, China could believe that cooperation on North Korea requires the U.S. to give China greater sway over Taiwan. Geopolitical risk would go up. The South China Sea: These sea lanes are vital to Taiwan as well as China, South Korea, and Japan. If the U.S. washes its hands of the matter, ceding China a maritime sphere of influence, Taiwan will face both greater supply risk and greater anxiety about American commitment to its security. Beijing might be emboldened to pressure Taiwan, or Taiwan might act out to try to secure American support. Geopolitical risk would go up. Bottom Line: Taiwan's economy is entering a cyclical slowdown on the back of China's slowdown and rollover in the semiconductor industry. At the same time, trade tensions emanating from the U.S.-China negotiations and political tensions emanating from the other side of the strait suggest that Taiwan's geopolitical risk premium will rise. Over the short term, Taiwan's local elections, the referendum movement, or U.S. diplomacy or arms sales could provide a catalyst for a cross-strait crisis. Over the long term, significant changes in U.S.-China relations, North Korea, or the South China Sea could put Taiwan in a more precarious position. Investment Conclusions While the absolute outlook for Taiwanese stock prices is negative, the potential downside in share prices in U.S. dollar terms is lower than for the EM benchmark. BCA's Emerging Markets Strategy recommends that EM-dedicated investors remain overweight Taiwanese risk assets relative to the EM benchmark. First, the epicenter of China's slowdown is capital spending in general and construction in particular. Various Chinese industrial activity indicators have already begun decelerating. This is negative for industrial commodity prices and countries that produce them. Taiwan is less exposed to China's construction slump than many other EM economies. Second, China's spending on technology will not slow much. As a part of its ongoing reforms, Beijing will encourage more investment in technology as well as upgrading industries across the value-added curve. Hence, China's tech spending will outperform its expenditure on construction and infrastructure. Taiwan is poised to benefit from this relative shift in China's growth priorities. Third, there are no fresh credit excesses in Taiwan like in some other EMs. Taiwan's banking system worked out bad assets extensively following the credit excesses of the 1980s-90s. Hence it is less vulnerable than its peers in the developing world. Finally, Taiwan has an enormous current account surplus of 14% of GDP and, contrary to many other EMs, foreign investors hold few Taiwanese local bonds. When outflows from EM occur, the Taiwanese currency will fall under less pressure and its financial system under much less stress. This will allow Taiwanese stocks to act as a low-beta defensive play. Crucially, despite some appreciation to appease Trump, the Taiwanese dollar is among the cheapest currencies in EM (Chart 17). Chart 17Cheap Taiwanese Dollar Removes Risk Cheap Taiwanese Dollar Removes Risk Cheap Taiwanese Dollar Removes Risk As for heightened geopolitical risk, BCA's Geopolitical Strategy would note that while we view Taiwan as a potential "black swan," nevertheless tail risks are not the proper basis for an investment strategy. We will continue to monitor the situation so that we can alert clients when a major, market-relevant deterioration in cross-strait relations appears imminent, based largely on the factors highlighted above. If the DPP remains dominant after the local elections later this year, or if "Third Forces" make notable gains, we would suspect that the Xi administration will shift to using more sticks than carrots. This could include economic sanctions and military saber-rattling. The question then will be whether Beijing (or Washington or Taipei) attempts a material change to the status quo. Ultimately - from a bird's eye point of view - a war is more likely in the wake of Xi Jinping's elimination of term limits, consolidation of power, and the secular slowdown in China's economy and rise of Chinese nationalism. But we see no reason to fear such a catastrophic outcome in the near term. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, and "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 4 Trump began, as president-elect, by holding an unprecedented telephone call with the Taiwanese president. His administration has since requested a new $1.4 billion arms package, opened legal space for port calls (including potentially naval port calls) in the 2018 Defense Authorization Act, and for higher-level diplomatic meetings via the Taiwan Travel Act, which became public law on March 16, 2018. 5 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. Military drills have involved symbolic shows, like sailing China's only operational aircraft carrier along the mid-line of the Taiwan Strait, as well as more poignant maneuvers, like drilling north and south of Taiwan simultaneously. As for rhetoric, Xi omitted from his 2017 party congress speech any reference to hopes that the Taiwanese "people" would bring about unification; in his speech after the March National People's Congress, he warned of the "punishment of history" for those who would promote secession. 6 Shown as the average of 2015 and 2017.