Social Unrest

Highlights The United States has produced too many elites, while popular well-being has fallen; Elite-controlled institutions have failed to protect households from the negatives of globalization and technological change; Tribalism, polarization, and money politics are preventing political compromise; Trump won by assaulting the "elites" but neither his policies, Congress, nor the economy look to improve well-being; With recession likely by 2019, the U.S. will see a revolt of some kind by the 2020 election. Feature Crime is increasing Trigger happy policing Panic is spreading God knows where We're heading Oh, make me wanna holler They don't understand Make me wanna holler They don't understand - Marvin Gaye, "Inner City Blues," 1971 If we had to explain the election of Donald Trump and the decision by U.K. voters to exit the EU with one chart it would be Chart 1. It depicts the relationship between high income inequality and low generational mobility and suggests that highly unequal societies develop structures that perpetuate unequal income through generations.1 The U.S. and the U.K. stand at the extreme of the relationship, with Italy close behind. Chart 1 Not surprisingly, the common people, "the plebs," in all three countries are dissatisfied with the arrangement. Low social mobility perpetuates unequal economic outcomes, throwing middle- and low-income voters into a sense of desperation. They fear that both their children's lot in life and their own is already decided, i.e. cannot and will not improve. A pre-election Gallup study of 125,000 American adults confirms that President Trump's support was strongest among voters in communities with poor health and low generational mobility.2 Of no relevance was whether respondents came from areas supposed to suffer most heavily from the ills that Trump opposed, i.e. communities exposed to global competition via trade, or those with high levels of immigration, or areas with relatively high unemployment and low incomes. America is supposed to be immune to income inequality because of social mobility. Equality of opportunity matters more than equality of outcome. This is the trade-off that has existed at the heart of America since its founding. For decades this trade-off has atrophied. Donald Trump was then elected to bring the U.S. back to its default setting. In this report, we explain why it may be too late and what will happen if he fails. If BCA's House View is correct, that a recession will occur by the end of 2019 (if not earlier), then the economic and political conditions are ripe for serious socio-political instability by the 2020 election.3 The Dynamic Of Elite Overproduction In Why Nations Fail, economist Daron Acemoglu and political scientist James Robinson tell a story of "How Venice Became A Museum."4 From the eleventh to fourteenth century, Venice was one of the richest places in the world. Behind its rapid economic expansion was the commenda, an early form of a joint-stock company formed for the duration of a single trading mission. It spurred Venice's ambitious entrepreneurs to find new trading routes by allowing them to share in the profits with the owners of capital who funded the risky journeys. As new families enriched themselves, political institutions grew more inclusive to accommodate them: in 1032, for instance, Venice held elections for its doge, or leader. An independent judiciary, private contracts, and bankruptcy laws followed. By 1330, Venice was a wealthy and strikingly modern republic with a population as large as that of Paris. The commenda system, however, had a dark side: creative destruction. Each new wave of young, enterprising explorers reduced the political privileges and profits of the established elites. In the late thirteenth century, these elites began to restrict membership in the Great Council, or legislature. Such efforts culminated in La Serrata ("The Closure") in 1297, which severely restricted access to the Great Council for new members but expanded it for families of established elites. An economic serrata quickly followed the political one, and the commenda system that underpinned Venice's wealth was replaced by a state monopoly on trade in 1314. The rest is, as they say, history. Venice rapidly declined as the newly closed economic and political institutions failed to deal with the rise of Portugal and Spain, the revolution in navigation and discovery of new trade routes to the East, and various regional attempts to encroach on its wealth and power. After the seventeenth century this decline accelerated. Today, its only source of income is tourism, which parlays the pre-Serrata wonders - such as the Doge's Palace and St. Mark's Cathedral - for cash that the city desperately needs to keep itself afloat.5 Acemoglu and Robinson make the case in their research that societies with both politically and economically inclusive institutions are rare. They cite a number of reasons for this, but the one that is most relevant to this report is "elite overproduction." Elites have a perfectly human and rational desire to perpetuate their political and economic privileges and pass them on to their children. A society that truly promotes equality of opportunity is one that leaves its elites to the fates. The elite desire to pass on privileges to future generations is a constant, but human conflict and state collapse are cyclical. Peter Turchin, a biologist who studies human conflict, has noted that periods of intense conflict in societies tend to recur within 40-to-60-year cycles. He posits that elite overproduction - and its counterpart, low societal well-being - is to blame.6 In post-industrial societies, low and falling labor costs are one of the principal conditions for elite multiplication. International trade, immigration, technological advancements, and investment in human and physical capital all suppress labor costs, benefiting the consumers of labor, i.e. the elites. Globalization has played a particularly important role in suppressing wages in the modern developed world. It expanded the global supply of labor by opening up new populations to capitalism (Chart 2), leading to suppressed wage growth for the middle classes in advanced economies (Chart 3). This process has been reinforced by technological change, particularly innovation that is biased in favor of capital (i.e. saving on labor costs) (Chart 4). Chart 2Globalization Expanded ##br##The Global Supply Of Labor... Globalization Expanded The Global Supply Of Labor... Globalization Expanded The Global Supply Of Labor... Chart 3 Chart 4 As elites capture an ever-greater share of the economic pie (even a growing economic pie), they become accustomed to ever greater levels of consumption, which drives inter-elite competition for social status. Everyone tries to "keep up with the Joneses," which for many is only achievable by supplementing wages with debt (Chart 5).7 The demand for elite goods - say homes in the "right" zip codes - exhibits runaway growth as the cost of elite membership rises and as sub-elites with rising income levels compete for access (Chart 6). Chart 5Credit Supplanted Income Credit Supplanted Income Credit Supplanted Income Chart 6Middle Class Incomes Don't ##br##Buy Middle Class Goods Middle Class Incomes Don't Buy Middle Class Goods Middle Class Incomes Don't Buy Middle Class Goods Focusing on the U.S., Turchin shows that Americans are today living in the second "Gilded Age." His research shows that "elite overproduction" has not been this high, and "population well-being" this low, since the early twentieth century (Chart 7). He calculates population well-being as a combination of general health, family formation, and wage and employment prospects. All indicators are currently in decline relative to history, save for health. But even life expectancy is taking a hit, albeit for select demographic groups most negatively impacted by poor job and wage prospects (Chart 8). Chart 7 Chart 8 For elite overproduction, Turchin relies on standard measures: wealth inequality, university education cost, and political polarization. This makes intuitive sense, since major policies aimed at reversing entrenched inequality can only be enacted after polarization has fallen due to events that subdued elites, such as major economic calamities or geopolitical challenges - e.g. the New Deal following the Great Depression, or the Great Society following World War II and amidst the Cold War. The danger of extreme polarization between elite prosperity and general well-being is that it is theoretically and empirically associated with political polarization, social unrest, and war. Acemoglu and Robinson detail case after case - from ancient Mayans and Romans to modern French and Japanese - in which the competition for resources between elites and the general population led to civil strife or all-out warfare. Meanwhile Turchin's research shows that politically motivated violence in the U.S. (Chart 9), which last peaked 50 years ago in the late 1960s, is associated with large gaps in well-being between elites and the masses (Chart 10).8 Chart 9 Chart 10 Bottom Line: Elite overproduction has been identified by academic research as a constant source of social instability throughout human history. Elites subvert inclusive political and economic institutions in order to stifle creative destruction, which would enrich new entrepreneurs but dilute elite privileges. As such, societies that prevent elite overproduction and promote equality of opportunity (and creative destruction) are successful in perpetuating themselves over the long term. Repatrimonialization In The U.S. Chart 11Tax Rates Were High In The Roaring '50s Tax Rates Were High In The Roaring '50s Tax Rates Were High In The Roaring '50s A sure sign that a society is in decline? When elites strive to hold onto their status and create barriers to entry for others. In the case of Venice, these barriers were overtly political. Le Serrata was followed by the introduction of Libro d'Oro (the "Golden Book"), which created an official registry of Venetian families that would be allowed to share in the deliberations of the Great Council. As the population revolted against such measures, Venice introduced a police force in 1310, with other coercive methods to follow. Today, the U.S. exhibits similar signs of institutional capture by the elites, albeit updated for the twenty-first century. Political theorist Francis Fukuyama calls this process "repatrimonialization." It occurs amidst long periods of economic prosperity and peace, as elites lose sight of their symbiotic relationship with fellow citizens and begin to serve their own "tribal" interests.9 Note in the above Chart 7 that elite overproduction, as defined by Turchin, reaches its peak after long periods of peace: the first high point came in 1902, 37 years after the Civil War, and the second came in 2007, 62 years after World War II. The latter case in particular suggests that as threats dissipate, elites lose sight of personal sacrifices - military service, income redistribution, public service, public works - that are required for geopolitical competition with peer challengers. At the height of the Cold War (1949 to 1962), for example, the top marginal tax rate in the U.S. was 92% (Chart 11).10 The point is not the tax rate, but that elites were far more acquiescent to fiscal sacrifices on behalf of the public. Fukuyama points to the U.K. and the U.S. as the two countries that have been the least politically responsive to the challenges of globalization and technological change in the developed world. In the case of the U.S., this is because interest groups are capable of steering policy towards further globalization and technological change. Both processes have also empowered elites, which have steered policy towards less redistribution and more austerity for the middle classes. The data is clear on this point. Despite Europe's being as exposed to globalization and technological advances as the U.S., European median wage growth has kept pace with GDP growth since 2000, whereas in the U.S. it not only failed to keep up but declined over the same time period (Chart 12). Chart 12Europe Shielded ##br##Households From Global Winds Europe Shielded Households From Global Winds Europe Shielded Households From Global Winds What are some of the mechanisms of repatrimonialization in the U.S. and can they be reversed? The good news is that elite capture of state institutions is now out in the open and easy to identify. Both Donald Trump and Democratic candidate Senator Bernie Sanders campaigned explicitly against it. The bad news is that it is unlikely to be reversed endogenously, at least not without a catalyst. What follows is a short description of the most salient problems facing the country as a result of elite entrenchment. Campaign Financing The 2010 Supreme Court decision Citizens United v. Federal Election Commission gave rise to political action committees, also known as Super PACs. These groups are allowed to receive unlimited contributions from individuals and corporations as long as they do not cooperate, coordinate, or directly contribute funding to actual candidates. This supposed firewall, however, is a fig leaf. The elimination of caps on this type of campaign financing allows single-issue groups and even single individuals with deep pockets to fund fringe candidates or support single-issue ballot measures that would otherwise lack sources of funding. This is especially important in primary elections where turnout is very low. In response, incumbent legislators have to tread carefully and avoid angering individual donors or Super PACs that could single-handedly fund a campaign against them in the primary elections, especially since the average cost of a congressional election campaign is relatively low at $1.4 million (a small amount compared to the funds that can be brought to bear by activist donors). In 2012, more than 40% of the campaign donations used in all federal elections was contributed by 0.01% of the voting-age population. That means that about 24,000 people were responsible for a near-majority of all contributions.11 Two other findings reported in the academic literature provide insight on how (and if) that money might steer policy. First, a study confirmed the general belief that the wealthiest Americans are much more conservative than the general public when it comes to tax policy and economic regulation.12 Second, another study found that when the policy preferences of the top 10% of income earners diverge from the preferences of the bottom 50%, the policy outcome is more likely to reflect the intentions of the former group.13 Polarization Political polarization benefits elites by impeding the democratic process and locking in rules that are beneficial to the status quo. Chart 13 shows that income inequality and political polarization in the sphere of economic policy are correlated.14 The simple reason the two are so highly correlated is because the right-of-center Republican Party increasingly opposes redistribution, while the left-of-center Democratic Party favors it. As the two parties diverge on matters of economic principle, compromises become virtually impossible, locking redistributive efforts at the current levels favored by the elites. Polarization is subsequently reinforced by electoral-district "gerrymandering" and an extremely bifurcated and increasingly distrusted news media. Over the last two decades, both the Democrats and Republicans (but mainly the latter due to their superior position at the state level) have redrawn administrative boundaries to create "ideologically pure" electoral districts. Of the 435 seats in the House of Representatives, only about 56 are truly competitive (Chart 14). Chart 13Inequality Fuels Political Polarization Inequality Fuels Political Polarization Inequality Fuels Political Polarization Chart 14Few Congressional Seats Truly Competitive Few Congressional Seats Truly Competitive Few Congressional Seats Truly Competitive Tribalization Elite overproduction often leads to the tribalization of society. Elites, to ensure that they are not torn asunder by the plebs, mobilize the population behind various causes that divert attention away from themselves, i.e. away from the real cause of social malaise. These causes are "wedge issues," in today's parlance. They can include identity politics, religious issues, as well as foreign policy. The Democratic Party has often relied on identity issues to mobilize support, but the effort kicked into high gear as it evolved from a redistributive "Old Left" party to the more centrist, "Third Way," neo-liberal orientation of Bill Clinton's presidency. Senator Bernie Sanders attempted to reverse this trend and overtly downplayed identity politics during his presidential campaign. He saw his party's neo-liberal turn as an elite-driven effort to distract from the real problems affecting low-income households. Hillary Clinton, the neo-liberal Democrat, by contrast, suffered as a result of the perception that she was an elite. Chart 15 The problem is that these wedge issues have begun to ossify into actual identities. For example, Pew Research showed in 2012 that the difference between Americans on a list of 48 values is the greatest between Republicans and Democrats, as opposed to other elements of identity. This has not always been the case, as Chart 15 shows. We suspect that this data will grow even starker after the divisive, borderline hysterical 2016 campaign. This means that "Republican" and "Democrat" labels have become almost tribal in nature. In fact, one's values are now determined more by one's party identification than race, education, income, religiosity, or gender! This is incredible, given America's history of racial and religious divisions. Bottom Line: America's repatrimonialization is advanced. The democratic process, which is supposed to adjudicate between interest groups and regulate elite economic and political privileges, has been drawn to a halt by polarization, the political influence of big money, and emerging tribalism between non-elites. It is extremely difficult to see how these hurdles can be overcome via America's regular political process. As such, they will be resolved only after some kind of crisis, whether endogenous or exogenous. Will Trump Fix It? President Donald Trump famously said in his nomination speech at the Republican Convention, "I alone can fix it." In a way, he may be correct. Although he is very much part of the American economic elite, he has no links to the D.C. establishment and owes no favors to special interest groups.15 His entire campaign personified the conclusions of this report: that the U.S. economy has been captured by economic and political elites and that the well-being of regular citizens is in the doldrums. It is unfair to judge President Trump's record and legacy based on a little over four months in office. However, we lean heavily towards the conclusion that his efforts to undermine American patricians will ultimately fail. Here is why: Policy President Trump does not have much of a legislative record. Nonetheless, his first major piece of legislation - the Obamacare repeal and replace bill - would, in its current form, leave 14 million people without health care - and an estimated 24 million by 2026. If not substantially revised, the bill is likely to impose a roughly $445 billion burden on U.S. households in order to pay for the "hyuge" tax cuts that Trump has promised (Chart 16). Further throwing Trump's plebeian credentials into doubt is his second signature legislative act: tax reform. His campaign proposal fell largely in line with previous Republican efforts, which, it should be noted, have contributed greatly to elite overproduction in the U.S. (Chart 17). Trump's original proposal would cut the top marginal rate from 39.6% to 33%, but would also leave a significant number of middle-class Americans with an increase, or no change, to their marginal tax rate.16 We expect that his White House team will adjust this original plan to offer middle-class tax cuts, but the main thrust of the effort is still to eliminate estate taxes and lower the top marginal rates significantly. Chart 16 Chart 17Tax Reform Always Benefits Elites Tax Reform Always Benefits Elites Tax Reform Always Benefits Elites On trade and immigration, Trump has little record to show. His meeting with President Xi Jinping of China revealed that he is like previous presidents in talking tough about Chinese trade on the campaign trail yet lacking the desire to take aggressive action once in office. We expect that Trump will eventually pivot towards greater protectionism, but it is not clear that it will be executed in a way that actually improves household well-being.17 Congress So far Trump has shown that he is more interested in getting legislation passed than shaping it in a populist way. For example, he has urged Congress to pass the Obamacare replacement even though many conservative Senators are wary of its negative impact on households. If he adopts the same strategy with tax reform, we would suspect that he will err on the side of "getting things done," rather than fulfilling his campaign pledges to blue-collar workers. The problem for Trump is the same problem President Obama had: polarization. Trump would be far more successful in passing populist legislation if he developed a working relationship with Democrats, who ostensibly have discarded the elitism of the Clinton years. Yet to do so he would have to "betray" his only friends, leaving himself vulnerable should the Democrats refuse to play ball. He is thus stuck with partisan Republican policies, which means voters are stuck with a lack of compromise. Macroeconomics Populists everywhere have one overarching goal when they come to power: boosting nominal GDP growth (Chart 18). We suspect that Trump will ultimately get tax reform through Congress and that it will be moderately stimulative.18 Chart 18 The problem is that the U.S. economic recovery is already far advanced. As such, even moderate stimulus could hasten the timing of an economic recession. Given the lack of major economic imbalances, it is unlikely that such a recession would freeze the financial system and be as painful as that of 2008-9. Nonetheless, the trade-off between moderate stimulus and a quicker recession is unlikely to benefit Trump's voters. Bottom Line: Donald Trump has tapped into the deep social malaise in the U.S. and responded to the populace's demands that elite overproduction be curbed. Unfortunately, his track record during the campaign and as president gives little evidence that he will be successful in restraining America's elites. Especially because he is forced to cooperate with them through Congress, and in a way that does not encourage broad compromise. Investment Implications We suspect that polarization will grow throughout Trump's term and that he will largely be unsuccessful in pursuing an agenda that genuinely increases opportunity or well-being. In fact, we would bet that most of his policies will contribute to, not reduce, elite overproduction in the U.S. What happens when Donald Trump fails to reform America and resolve its elite overproduction problem? If a recession occurs by 2019 - our House View at BCA - then the economic and political conditions suggest that a serious revolt is in the cards by the time of the 2020 election. By this we mean not just an electoral revolt, like Trump's election, but also a concrete increase in social tension and unrest. A repeat of the 2011 Occupy Wall Street protests, yet more violent, could be in cards. By the 2020 election, we would also suspect that our clients may look back fondly, with nostalgia, for Senator Bernie Sander's campaign platform, which by that point may look downright centrist. Investors should prepare for an increase in economic populist policy proposals, from both the left and the right. If economic policy begins to steer towards populism, investors should bet on higher inflation and thus higher nominal - but potentially lower real - Treasury yields. The independence of the Fed could also suffer, putting considerable downward pressure on the USD. In this environment, equities will outperform bonds, but global assets should outperform those of the U.S. Gold, which has failed as a safe-haven asset in the contemporary deflationary era, should become attractive once again.19 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see Miles Corak, "Income Inequality, Equality of Opportunity, and Intergenerational Mobility," Forschungsinstitut zur Zukunft der Arbeit, Discussion paper no. 7520, July 2013, available at iza.org. 2 Please see Jonathan Rothwell and Pablo Diego-Rosell, "Explaining Nationalist Political Views: The Case Of Donald Trump," Gallup, dated November 2, 2016, available at papers.ssrn.com. 3 Please see BCA's The Bank Credit Analyst Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, available at bca.bcaresearch.com, and Global Investment Strategy Outlook, "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. 4 Please see Daren Acemoglu and James A. Robinson, Why Nations Fail (New York: Crown Publishers, 2012). 5 Literally. 6 Please see Peter Turchin and Sergey Nefedov, Secular Cycles (Princeton, NJ: Princeton University Press, 2009). 7 Please see Neal Fligstein et al, "Keeping up with the Joneses: Inequality and Indebtedness, in the Era of the Housing Price Bubble, 1999-2007," presented at the Annual Meetings of the American Sociological Association, August 2015. 8 Please see Peter Turchin, "Dynamics of political instability in the United States, 1780-2010," Journal of Peace Research 49:4 (2012), pp. 577-91. 9 Please see Francis Fukuyama, Political Order And Political Decay (New York: Farrar, Straus, and Giroux, 2014). 10 Today's dispersed terrorist threat does not even come close to approximating the threat that the Soviet Union during the Cold War presented to the U.S., and as such we do not consider it seriously as an existential threat to either the U.S. or the West. Please see BCA Global Investment Strategy and Geopolitical Strategy, "A Bull Market For Terror," dated August 5, 2016, available at gis.bcaresearch.com. 11 Please see Adam Bonica et al., "Why Hasn't Democracy Slowed Rising Inequality?" Journal of Economic Perspectives 27:3 (Summer 2013), pp. 103-24. 12 Please see Benjamin Page et al., "Democracy And The Policy Preferences Of Wealthy Americans," Perspectives On Politics 11:1 (March 2013), pp. 51-73. 13 Please see Martin Gilens, "Inequality And Democratic Responsiveness," Public Opinion Quarterly 69:5 (2005), pp. 778-796. 14 The latter measure of polarization is one of Turchin's factors in elite overproduction. 15 Save for the Kremlin! We jest, we jest. At least, we think we jest ... 16 Several groups would have seen no substantial tax cuts under his original campaign plan. Those making $15,000-$19,000 would have seen their tax rate increase from 10% to 12%. Those making $52,500-101,500 would have seen their rate stay the same at 25%, while those making $127,500-$200,500 would have seen their rate rise from 28% to 33%. Please see Jim Nunns et al, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016, available at www.taxpolicycenter.org. For our original discussion, see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day," dated April 26, 2017, available at gps.bcaresearch.com. 19 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com.

Highlights Venezuela's economic implosion accelerated with the oil price crash. The petrodollar collapse is suffocating consumption as well as oilfield investment, creating a "death spiral" of falling production. The military has already begun assuming more powers as Maduro becomes increasingly vulnerable, and will likely take over before long. OPEC's cuts may help Maduro delay, but not avoid, deposition. Civil unrest/revolution could cause a disruption in oil production, profoundly impacting oil markets. Feature The wheels on the bus go round and round, Round and round, Round and round ... The story of Venezuela's decline under the revolutionary socialist government of deceased dictator Hugo Chavez is well known. The country went from being one of the richest South American states to one of the poorest and from being reliant on oil exports to being entirely dependent on them (Chart 1). The straw that broke the back of Chavismo was the end of the global commodity bull market in 2014 (Chart 2). Widespread shortages of essential goods, mass protests, opposition political victories, and a slide into overt military dictatorship have ensued.1 Chart 1Venezuela Suffers Under Chavismo Venezuela Suffers Under Chavismo Venezuela Suffers Under Chavismo Chart 2Commodity Bull Market Ended Commodity Bull Market Ended Commodity Bull Market Ended The acute social unrest at the end of 2016 and beginning of 2017 raises the question of whether Venezuela will cause global oil-supply disruptions that boost prices this year.2 One of the reasons we have been bullish oil prices is the fact that the world has little spare production capacity (Chart 3). This means that political turmoil in Venezuela, Libya, Nigeria, or other oil-producing countries could take enough supply out of the market to accelerate the global rebalancing process and drawdown of inventories, pushing up prices. Image Image The longer oil prices stay below the budget break-even levels of the politically unstable petro-states (mostly $80/bbl and above), the more likely some of them will be to fail. Venezuela, with a break-even of $350/bbl, has long been one of our prime candidates (Chart 4).3 Venezuela is on the verge of total regime collapse and a massive oil production shutdown. This is not a low-probability outcome. However, the fact that the military is already taking control of the situation, combined with our belief that OPEC and Russia will continue cutting oil production to shore up prices, suggest that the regime may be able to limp along. Therefore a continuation of the gradual decline in oil output is more likely than a sharp cutoff this year. Investors should stay short Venezuelan 10-year sovereign bonds and be aware of the upside risks to global oil prices. A Brief History Of PDVSA State-owned oil company PDVSA is the lifeblood of Venezuela. It once was a well-run company that allowed foreign investment with a reasonable government take, but now it is shut off from direct foreign investment. In 1996-1997, prior to Chavez being elected in late 1998, Venezuela was a rampant cheater on its OPEC quota, producing 3.1-3.3 MMB/d versus a quota of ~2.4 MMB/d in 1996 and ~2.8 in 1997. The oil-price crash that started in late 1997 and bottomed in early 1999 (remember the Economist's "Drowning In Oil" cover story on March 4, 1999 predicting $5 per barrel crude prices?) was a critical event propelling the rise of Chavez (Chart 5). One of the planks in Chavez's platform was that Venezuela had to stop cheating on OPEC quotas because that strategy had helped cause the oil-price decline and subsequent economic misery. Without the oil-price crash, Chavez would not have had such strong public support in the run-up to the 1998 elections, which he won. Chavez did in fact rein in Venezuela's production to 2.8 MMB/d in 1999, which had a positive impact on oil prices and reinforced OPEC. In 2002 and 2003, there were two labor strikes at PDVSA and a two-day coup that displaced Chavez. When Chavez returned to power, he fired 18,000 experienced workers at PDVSA and replaced them with political loyalists. Since then, the total number of employees at PDVSA has swelled from about 46,000 people in 2002, when PDVSA was producing 3.2 MMB/d, to about 140,000 people today, when it is producing slightly below 2 MMB/d. Average oil revenue per employee was over $500,000/person in 2002 at $20 oil, versus about $100,000/person today at $50 oil. Suffice it to say, PDVSA is stuffed to the gills with political patronage, and a strike or a revolution inside PDVSA against President Nicolas Maduro is unlikely. However, if opposition forces manage to seize control of government, the Chavistas in control of PDVSA may attempt to shut down operations to deprive them of oil revenues and blackmail them into a better deal going forward. Chart 5Oil Bust Catapulted Chavez Oil Bust Catapulted Chavez Oil Bust Catapulted Chavez Image Venezuela is estimated to have the world's largest proved oil reserves at about 300 billion barrels (Chart 6). In addition, there are 1.2-1.4 trillion barrels estimated to rest in heavy-oil deposits in the Orinoco Petroleum Belt (at the mouth of the Orinoco river) that is difficult to extract and has barely been touched. Chart 7Venezuela Cuts Forced By Economic Disaster Venezuela Cuts Forced By Economic Disaster Venezuela Cuts Forced By Economic Disaster These reserves are somewhat similar to Canada's oil sands. It is estimated that 300-500 billion barrels are technically recoverable. In the early 2000s, there were four international consortiums involved in developing these reserves: Petrozuata (COP-50%), Cerro Negro (XOM), Sincor (TOT, STO) and Hamaca (COP-40%). However, Chavez nationalized the Orinoco projects in 2007, paying the international oil companies (IOCs) a pittance. XOM and COP contested the taking and "sued" Venezuela at the World Bank. XOM sought $14.7 billion and won an arbitrated decision for a $1.6 billion settlement in 2014. Venezuela continues to litigate the case and the amount awarded to investors has apparently been reduced by a recent ruling. Over the past decade, as Venezuelan industry declined due to dramatic anti-free market laws, including aggressive fixed exchange rates absurdly out of keeping with black market rates, the government nationalized more and more private assets in order to get the wealth they needed to maintain profligate spending policies. The underlying point of these policies is to garner support from low-income Venezuelans, the Chavista political base. In addition to the Orinoco nationalization, the government appropriated equipment and drilling rigs from several oilfield service companies that had stopped working on account of not being properly paid. In 2009, Petrosucre (a subsidiary of PDVSA) appropriated the ENSCO 69 jackup rig, although the rig was returned in 2010. In 2010, the Venezuelan government seized 11 high-quality land rigs from Helmerich & Payne, resulting in nearly $200MM of losses for the company. These rigs were "easy" for Venezuela to appropriate because they did not require much private-sector expertise to operate. As payment failures continued, relationships with the country's remaining contractors continued to be strained. In 2013, Schlumberger (SLB), the largest energy service company in the world, threatened to stop working for PDVSA due to lack of payment in hard currency. PDVSA paid them in depreciating Venezuelan bolivares, but tightened controls over conversion into U.S. dollars. Some accounts receivables were partially converted into interest-bearing government notes. Promises for payment were made and broken. SLB has taken over $600MM of write-downs for the collapse of the bolivar (Haliburton, HAL, has taken ~$150MM in losses). With accounts receivable balances now stratospherically high at approximately $1.2 billion for SLB, $636 million for HAL (plus $200 million face amount in other notes), and $225 million for Weatherford International, the service companies have already taken write-offs on what they are owed and have refused to extend Venezuela additional credit. Unlike the "dumb iron" of drilling rigs, the service companies provide highly technical proprietary goods and services, from drill bits and fluids to measuring services. The lack of these proprietary technical services diminishes PDVSA's ability to drill new wells and properly maintain its legacy production infrastructure. Venezuela's production started falling in late 2015 - well before OPEC and Russia coordinated their January 2017 production cuts (Chart 7). Drought contributed to the problem in 2016 by causing electricity shortages and forced rationing of electricity (60-70% of Venezuela's electricity generation is hydro); water levels at key dams are still very low, but the condition has eased a bit in 2017. After watching crude oil production fall from 2.4 MMB/d in 2015 to 2.05 MMB/d in 2016, OPEC gave Venezuela a production quota of 1.97 MMB/d for the first half of 2017, which is about what they were expected to be capable of producing. In essence, Venezuela was exempt from production cuts, like other compromised OPEC producers Libya, Nigeria and Iran. So far, Venezuela has produced 1.99 MMB/d in the first quarter, according to EIA. Venezuela's falling production is not cartel behavior but indicative of broader economic and political instability. Venezuela is losing control of oil output, the pillar of regime stability. Bottom Line: The double-edged sword for energy companies is that if the regime utterly fails, the country's 2MM b/d of production may be disrupted. However, if government policy shifts - whether through the political opposition finally gaining de facto power or through the military imposing reforms - Venezuela could ramp up its production, perhaps by 1MMB/d within five years, and more after that if Orinoco is developed. How Long Can Maduro Last? Chavez's model worked like that of Louis XIV, who famously said, "après nous, le déluge." Chavez benefited from high oil prices throughout his reign and died in 2013 just before the country's descent into depression began (Chart 8). He won his last election in 2012 by a margin of 10.8%, while Maduro, his hand-picked successor, won a special election only half a year later by a 1.5% margin, which was contested for all kinds of fraud (Chart 9). Chart 8A Hyperflationary Depression A Hyperflationary Depression A Hyperflationary Depression Image Thus Maduro has suffered from "inept successor" syndrome from the beginning, compounding the fears of the ruling United Socialist Party of Venezuela (PSUV) that the succession would be rocky. Maduro lacked both the political capital and the originality to launch orthodox economic reforms to address the country's mounting inflation and weak productivity, but instead doubled down on Chavez's rapid expansion of money and credit to lift domestic consumption (Chart 10).4 Chart 10Excessive Monetary And Credit Expansion Excessive Monetary And Credit Expansion Excessive Monetary And Credit Expansion Chart 11Exports Recovered, Reserves Did Not Exports Recovered, Reserves Did Not Exports Recovered, Reserves Did Not The economic collapse was well under way even before commodities pulled the rug out from under the government.5 Remarkably, the recovery in export revenue since 2010 did not occasion a recovery in foreign exchange reserves - these two decoupled, as Venezuela chewed through its reserves to finance its growing domestic costs (Chart 11). This means Venezuela's ability to recover even in the most optimistic oil scenarios is limited. Another sign that the economic break is irreversible is the fact that, since 2013, private consumption has fallen faster than oil output - a reversal of the populist model that boosted consumption (Chart 12). Chart 12Consumption Falls Faster Than Oil Output Consumption Falls Faster Than Oil Output Consumption Falls Faster Than Oil Output Chart 13Oil-Price Crash Hobbles Maduro Oil-Price Crash Hobbles Maduro Oil-Price Crash Hobbles Maduro Critically, the external environment turned against Maduro and PSUV as oil prices declined after June 2014. In November 2014 Saudi Arabia launched its market-share war against Iran and U.S. shale producers, expanding production into a looming global supply overbalance. Brent crude prices collapsed to $29/bbl by early 2016 (Chart 13). This pushed Venezuela over the brink.6 First, hyperinflation: Currency in circulation - already expanding excessively - has exploded upward since 2014. The 100 bolivar note has exploded in usage while notes of lower denominations have dropped out of usage. Total deposits in the banking system are growing at a pace of over 200%, narrow money (M1) at 140%, and consumer price index at 150% (see Chart 10 above). Real interest rates have plunged into an abyss, with devastating results for the financial system. The real effective exchange rate illustrates the annihilation of the currency's value. Monetary authorities have repeatedly devalued the official exchange rate of the bolivar against the dollar (Chart 14). However, the currency remains overvalued, which creates a huge gap between the official rate and the black market rate, which currently stands at about 5,400 bolivares to the dollar. Regime allies have access to hard USD, for which they charge high rents, and the rest suffer. Chart 14Official Forex Devaluations Official Forex Devaluations Official Forex Devaluations Chart 15Domestic Demand Collapses Domestic Demand Collapses Domestic Demand Collapses Second, the real economy has gone from depression to worse: Exports peaked in October 2008, nearly recovered in March 2012, and plummeted thereafter. Imports have fallen faster as domestic demand contracted (Chart 15). Venezuela must import almost everything and the currency collapse means staples are either unavailable or exorbitantly expensive. Venezuelan exports to China reached 20% of total exports in 2012 but have declined to about 14% (Chart 16). This means that Venezuela has lost a precious $10 billion per year. The state has also been trading oil output for loans from China, resulting in an ever higher share of shrinking oil output devoted to paying back the loans, leaving less and less exported production to bring in hard currency needed to pay for production, imports, and debt servicing. Both private and government consumption are shrinking, according to official statistics (Chart 17). Again, the consumption slump removes a key regime support. Chart 16Chinese Demand Is Limited Chinese Demand Is Limited Chinese Demand Is Limited Chart 17Public And Private Consumption Shrink Public And Private Consumption Shrink Public And Private Consumption Shrink Third, Venezuela is rapidly becoming insolvent: Venezuela's total public debt is high. It stood at 102% of GDP as of August 2014, and GDP has declined by 25%-plus since then. Total external debt, which becomes costlier to service as the currency depreciates, was about $139 billion, or 71% of GDP, in Q3 2015 (Chart 18). It has risen sharply ever since the fall in export revenues post-2011. The destruction of the currency by definition makes the foreign debt burden grow. Chart 18External Debt Soars... External Debt Soars... External Debt Soars... Chart 19...While Forex Reserves Dwindle ...While Forex Reserves Dwindle ...While Forex Reserves Dwindle The regime's hard currency reserves are rapidly drying up - they have fallen from nearly $30 billion in 2013 to just $10 billion today (Chart 19). Without hard cash, Venezuela will be unable to meet import costs and external debt payments. In Table 1, we assess the country's ability to make these payments at different oil-price and output levels. Assuming the YTD average Venezuelan crude price of $44/bbl, export revenue should hit about $32 billion this year, while imports should hover around $21 billion, leaving $11 billion for debt servicing costs of roughly $10 billion (combining the state's $8 billion with PDVSA's $2 billion). Thus if global oil prices hold up - as we think they will - the regime may be able to squeak by another year. Image In short, the regime could have about $11 billion in revenues left at the end of the year if the Venezuela oil basket hovers around $44/bbl and production remains at about 2 MMB/d. That is a "minimum cash" scenario for the regime this year, though it by no means guarantees regime survival amid the widespread economic distress of the population. Chart 20Foreign Asset Sales Will Continue Foreign Asset Sales Will Continue Foreign Asset Sales Will Continue If production drops to 1.25 MMb/d or lower as a result of the economic crisis - or if Venezuelan oil prices settle at $28/bbl or below - the regime will be unable to meet its import costs and debt payments. It will have to sell off more of its international assets as rapidly as it can (Chart 20), restrict imports further, and eventually default. Moreover, the calculation becomes much more negative for Venezuela if we assume, conservatively, $10 billion in capital outflows, which is far from unreasonable. Outflows could easily wipe out any small remainder of foreign reserves. So far, the government has chosen to deprive the populace of imports rather than default on external debt, wagering that the military and other state security forces can suppress domestic opposition for longer than the regime can survive under an international financial embargo. This strategy is fueling mass protests, riots, and clashes with the National Guard and Bolivarian colectivos (militias). An extension of the OPEC-Russia production cuts in late May, which we expect, will bring much-needed relief for Venezuela's budget. Thus, there is a clear path for regime survival through 2017 on a purely fiscal basis, though it is a highly precarious one - the reality is that the state is bound to default sooner or later. Moreover, the socio-political crisis has already spiraled far enough that a modest boost to oil prices this year will probably be too little, too late to save Maduro and the PSUV in its current form. As we discuss below, the question is only whether the military takes greater control to perpetuate the current regime, or the opposition is gradually allowed to take power and renovate the constitutional order. Bottom Line: Even if oil production holds up, and oil prices average above $44/bbl as we expect, the country's leaders will have to take extreme measures to avoid default. Domestic shortages and military-enforced rationing will compound. As economic contraction persists, social unrest will intensify. Will The Military Throw A Coup? Explosive popular discontent this year shows no sign of abating. It is a continuation of the mass protests and sporadic violence since the economic crisis fully erupted in 2014. However, as recession deepens - and food, fuel, and medicine shortages become even more widespread - unrest will spread to a broader geographic and demographic base. Protests since September 2016 have drawn numbers in the upper hundreds of thousands, possibly over a million on two occasions. Security forces have increasingly cracked down on civilians, raising the death toll and provoking a nasty feedback loop with protesters. Reports suggest that the poorest people - the Chavista base - are increasingly joining the protests, which is a new trend and bodes ill for the ruling party's survival. Already the public has turned against the United Socialist Party, as evinced by the December 2015 legislative election results and a range of public opinion polls, which show Maduro's support in the low-20% range. In the 2015 vote, the opposition defeated the Chavistas for the first time since 1998. The Democratic Unity Roundtable won a majority of the popular vote and a supermajority of the seats in the National Assembly. Since then, however, Maduro has used party-controlled civilian institutions like the Supreme Court and National Electoral Council - backed by the military and state security - to prevent the opposition's exercise of its newfound legislative power. Key signposts to watch will be whether Maduro is pressured into restoring the electoral calendar. The opposition has so far been denied local elections (supposedly rescheduled for later this year) and a popular referendum on recalling Maduro. So it has little reason to expect that the government will hold the October 2018 elections on time. The government is likely to keep delaying these votes because it knows it will lose them. In the meantime, the opposition has few choices other than protests and street tactics to try to pressure the government into allowing elections after all. Further, oil prices are low, so the regime is vulnerable, which means that the opposition has every incentive to step up the pressure now. If it waits, higher prices could give Maduro a new infusion of revenues and the ability to prolong his time in power. The question at this point is: will the military defect from the government? The military is the historical arbiter of power in the country. Maduro - who unlike Chavez does not hail from a military background - has only managed to make it this far by granting his top brass more power. Crucially, in July 2016, Maduro handed army chief Vladimir Padrino Lopez control over the country's critical transportation and distribution networks, including for food supplies. He has also carved out large tracts of land for a vast new mining venture, supposed to focus on gold, which the military will oversee and profit from.7 What this means is that the government and military are becoming more, not less, integrated at the moment. The army has a vested interest in the current regime. It is also internally coherent, as recent political science research shows, in the sense that the upper-most and lower-most ranks are devoted to Chavismo.8 Economic sanctions and human rights allegations from the U.S. and international community reinforce this point, making it so that officials have no future outside of the regime and therefore fight harder for the regime to survive.9 Still, there are fractures within the military that could get worse over time. Divisions within the ranks: An analysis of the Arab Spring shows that militaries that defected from the government (Egypt, Tunisia), or split up and made war on each other (Syria, Libya, Yemen), exhibited certain key divisions within their ranks.10 Looking at these variables, Venezuela's military lacks critical ethno-sectarian divisions, but does suffer from important differences between the military branches, between the army and the other state security forces, and between the ideological and socio-economic factions that are entirely devoted to Chavismo versus the rest. Thus, for example, it is possible that Bolivarian militias committing atrocities against unarmed civilians could eventually force the military to change its position to preserve its reputation.11 Popular opinion: Massive protests have approached 1 million people by some counts (of a population of 31 million) and have combined a range of elements within the society - not only young men or violent rebels/anarchists. Also, public opinion surveys suggest that supporters of Maduro have a more favorable view of the army, and opponents have a less favorable view.12 This implies that Maduro's extreme lack of popular support is a liability that will weigh on the military over time. Military funds shrinking: Because of the economic crisis, Maduro has been forced to slash military spending by a roughly estimated 56% over the past year (Chart 21). The military may eventually decide it needs to fix the economy in order to fix its budget. Image Autonomous military leader: That General Lopez has considerable autonomy is another variable that increases the risk of military defection or fracture. As the country slides out of control Lopez will likely intervene more often. He already did so recently when the Chavista-aligned Supreme Court tried to usurp the National Assembly's legislative function. The attorney general, Luisa Ortega Diaz, broke with party norms by criticizing the court's ruling. Maduro was forced to order the court to reverse it, at least nominally restoring the National Assembly's authority. Lopez supposedly had encouraged Maduro to backtrack in this way, contrary to the advice of two notable Chavistas, Diosdado Cabello and Vice President Tareck El Aissami. Ultimately, military rule for extended periods is common in Venezuelan history. Chavez always deeply integrated the party and military leadership, so the regime could persist through greater military assertion within it, or the military could take over and initiate topical political changes. Finally, if Lopez is ready to stage a coup, he may still wait for oil prices to recover. It makes more sense to let the already discredited ruling party suffer the public consequences of the recession than to seize power when the country is in shambles. Previous coup attempts have occurred not only when oil prices were bottoming but also when they bounded back after bottoming (Chart 22). It would appear that the Venezuelan military is as good at forecasting oil prices as any Wall Street analyst! For oil markets, the military's strong grip over the country suggests that even if Maduro and the PSUV collapse, the party loyalists at PDVSA may not have the option of going on strike. The military will still need the petro dollars to stay in power, and it will have the guns to insist that production keeps up, as long as economic destitution does not force operations to a halt. Bottom Line: There is a high probability that the military will expand its overt control over the country. As long as the leaders avoid fundamental economic reforms, the result of any full-out military coup against Maduro may just mean more of the same, which would be politically and economically unsustainable. Chart 22Coups Can Come After Oil Price Recovers Coups Can Come After Oil Price Recovers Coups Can Come After Oil Price Recovers Chart 23Stay Short Venezuelan Sovereign Bonds Stay Short Venezuelan Sovereign Bonds Stay Short Venezuelan Sovereign Bonds Investment Implications Any rebound in oil prices as a result of an extension of OPEC's and Russia's production cuts at the OPEC meeting on May 25 will be "too little, too late" in terms of saving Maduro and the PSUV. They may be able to play for time, but their legitimacy has been destroyed - they will only survive as long as the military sustains them. To a great extent, the ruling party has already handed the keys over to the military, and military rule can persist for some time. Hence oil production is more likely to continue its slow decline than experience a sudden shutdown, at least this year. This is because it is likely that military control will tighten, not diminish, when Maduro falls. Incidentally, the military is also more capable than the current weak civilian government of forcing through wrenching policy adjustments that are necessary to begin the process of normalizing economic policy - such as floating the currency and cutting public spending. But any such process would bring even more economic pain and unrest in the short term, and it has not begun yet. Even if the ruling party avoids defaulting on government debts this year - which is possible given our budget calculations - it is on the path to default before long. We remain short Venezuelan 10-year sovereign bonds versus emerging market peers. This trade is down 330 basis points since initiation in June 2015, but Venezuelan bonds have rolled over and the outlook is dim (Chart 23). Within the oil markets, our base case is that global oil producers have benefitted and will benefit from the marginally higher prices derived from Venezuela's slow production deterioration. Should a more sudden and severe production collapse occur, the upward price response would be much more acute. A sustained outage of Venezuelan production would send oil prices quickly towards $80-$100/bbl as a necessary price signal to curb demand growth, creating a meaningful recessionary force around the globe. Oil producers, specifically U.S. shale producers that can react quickly to these price signals, would stand to benefit temporarily from the higher prices, but would again suffer from falling oil prices in the inevitable post-crisis denouement. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com 1 For the military takeover, please see "Venezuelan Debt: The Rally Is Late," in BCA Emerging Markets Strategy, "EM: From Liquidity To Growth?" dated August 24, 2016, available at ems.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "The Energy Spring," dated December 10, 2014, available at gps.bcaresearch.com; BCA Commodity and Energy Strategy Weekly Report, "Tactical Focus Again Required In 2017," dated January 5, 2017, available at ces.bcaresearch.com; and Energy Sector Strategy Weekly Report, "The Other Guys In The Oil Market," dated April 5, 2017, available at nrg.bcaresearch.com. 4 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Venezuelan Chavismo: Life After Death," dated April 2, 2013, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy, "Strategic Outlook 2013," dated January 16, 2013, and Monthly Report, "The Reflation Era," dated December 10, 2014, available at gps.bcaresearch.com. 6 Please see BCA Emerging Markets Strategy Weekly Report, "Assessing Political And Financial Landscapes In Argentina, Venezuela And Brazil," dated January 6, 2016, available at ems.bcaresearch.com. 7 For Lopez's taking control, please see "Venezuelan Debt: The Rally Is Late" in BCA Emerging Markets Strategy Weekly Report, "EM: From Liquidity To Growth?" dated August 24, 2016, available at ems.bcaresearch.com. For the gold mine, please see Edgardo Lander, "The Implosion of Venezuela's Rentier State," Transnational Institute, New Politics Papers 1, September 2016, available at www.tni.org. 8 The junior officers have advanced through special military schools set up by Chavez, while the senior officials have been carefully selected over the years for their loyalty and ideological purity. Please see Brian Fonseca, John Polga-Hecimovich, and Harold A. Trinkunas, "Venezuelan Military Culture," FIU-USSOUTHCOM Military Culture Series, May 2016, available at www.johnpolga.com. 9 Please see David Smilde, "Venezuela: Options for U.S. Policy," Testimony before the United States Senate Committee on Foreign Relations, March 2, 2017, available at www.foreign.senate.gov. 10 Please see Timothy Hazen, "Defect Or Defend? Explaining Military Responses During The Arab Uprisings," doctoral dissertation, Loyola University Chicago, December 2016, available at ecommons.luc.edu. 11 Civilian deaths caused by the National Guard and Chavez's loyalist militias triggered the aborted 2002 military coup. Please see Steven Barracca, "Military coups in the post-cold war era: Pakistan, Ecuador and Venezuela," Third World Quarterly 28: 1 (2007), pp. 137-54. 12 See footnote 8 above.

Highlights EM tech stocks are overbought while banks are fundamentally vulnerable due to bad-loan overhang. EM stocks have never decoupled from the U.S. dollar and commodities prices. There has been no recovery in EM corporate profitability and EPS. We reiterate two equity trades: short EM banks / long U.S. banks, and short Chinese property developers / long U.S. homebuilders. Upgrade Thai stocks to overweight within the EM equity benchmark and go long THB versus KRW. Feature Our Reflation Confirming Indicator - an equal-weighted aggregate of platinum prices (a proxy for global reflation), industrial metals prices (a proxy for China growth) and U.S. lumber prices (a proxy for U.S. reflation) - has decisively rolled over, and is spelling trouble for emerging market (EM) equities (Chart I-1). In particular, platinum prices have relapsed after hitting a major resistance at their 800-day moving average (Chart I-2). Such a technical pattern often leads to new lows. If so, it could presage a major selloff in EM markets in the months ahead. Chart I-1A Red Flag From ##br##Reflation Confirming Indicator A Red Flag From Reflation Confirming Indicator A Red Flag From Reflation Confirming Indicator Chart I-2Platinum: A Canary##br## In A Coal Mine? bca.ems_wr_2016_10_19_s1_c2 bca.ems_wr_2016_10_19_s1_c2 The rationale behind using platinum rather than gold or silver prices is because platinum is a precious metal that also has industrial uses. Besides, we have found that platinum prices correlate with EM stocks better than gold or silver. The latter two sometimes rally due to global demand for safety, even as EM markets tank. Finally, platinum seems to be the most high-beta precious metal in the sense that it "catches a cold" sooner and, thus, might be leading other reflationary plays. In short, EM share prices have been flat since August 15, and odds are that they are topping out and the next large move will be to the downside. Can EM De-Couple From The U.S. Dollar? Many investors are asking whether EM risk assets can rally if the greenback continues to rebound. Chart I-3 illustrates that since the early 1980s, there have been no periods when EM share prices rallied amid strength in the real broad trade-weighted U.S. dollar (the dollar is shown inverted on this and the proceeding charts). The same holds true if one uses the nominal narrow trade-weighted U.S. dollar1 (Chart I-4). Chart I-3Real Trade-Weighted ##br##U.S. Dollar And EM Stocks Real Trade-Weighted U.S. Dollar And EM Stocks Real Trade-Weighted U.S. Dollar And EM Stocks Chart I-4Nominal Trade-Weighted ##br##U.S. Dollar And EM Stocks Nominal Trade-Weighted U.S. Dollar And EM Stocks Nominal Trade-Weighted U.S. Dollar And EM Stocks One could disregard these charts and argue that this time around is different. We don't quite see it that way. Chart I-5Nominal Trade-Weighted ##br##U.S. Dollar And Commodities Nominal Trade-Weighted U.S. Dollar And Commodities Nominal Trade-Weighted U.S. Dollar And Commodities Notably, the narrative behind the EM rally since February's lows has been based on the Federal Reserve backing off from rate hikes and the U.S. dollar weakening - with the latter propelling a rally in commodities prices. These arguments appear to be reversing: the U.S. dollar is already firming up and commodities prices are at best mixed. The broad index for commodities prices always drops when the U.S. dollar rallies (Chart I-5). In recent months, the advance in commodities prices has been uneven and narrow based. While oil prices have spiked substantially, industrial metals prices have advanced very little. The current oil price rally is proving a bit more durable and lasting than we thought a few months ago. Nevertheless, China's apparent consumption of petroleum products is beginning to contract (Chart I-6). Consequently, resurfacing worries about EM/China's demand for commodities will lead to a meaningful pullback in crude prices in the months ahead, especially since the likelihood that oil producers act to restrain supply at the current prices is very low. As for commodities trading in China such as steel, iron ore, rubber, plate glass and others, they have been on a roller-coaster ride in recent months (Chart I-7). Chart I-6China's Demand For Oil Products Is Very Weak China's Demand For Oil Products Is Very Weak China's Demand For Oil Products Is Very Weak Chart I-7Commodities Prices In China Commodities Prices In China Commodities Prices In China Bottom Line: There are reasonably high odds that as the U.S. dollar strengthens and commodities prices roll over, EM risk assets (stocks, currencies and credit markets) will start to relapse. EM Beyond Commodities: Still Shrinking Profits Table I-1EM Sectors Weights: In 2011 And Now The EM Rally: Running Out Of Steam? The EM Rally: Running Out Of Steam? Another question that many investors have been asking is as follows: Is there not a positive story in EM beyond commodities? Given that the weight of the EM equity market benchmark in commodities stocks - energy and materials - has drastically declined in recent years, from 29.2% in 2011 to 13.7% now (Table I-1), and the weight in technology stocks has risen substantially (from 12.9% in 2011 to 23.9% now), couldn't non-commodities stocks drive the index higher? In this regard, we have the following observations: Information technology stocks are overbought. The EM information technology equity index has surged to its previous highs (Chart I-8, top panel). This sector is dominated by five companies that have a very large weight also in the overall EM benchmark: Samsung (3.6% weight in the EM equity benchmark), TMSC (3.5%), Alibaba (2.9%), Hon Hai Precision (1%) and Tencent (3.8%). Their share price performance has been spectacular, and some of them have gone ballistic (Chart I-9). TMSC and to a lesser extent Samsung have benefited from the rising prices of semiconductors (Chart I-9, second panel from top). However, it is not assured that semiconductor prices will continue soaring from these levels as global aggregate demand remains very weak. In short, the outlook for semi stocks is by and large a semiconductor industry call, not a macro one. As for Alibaba and Tencent, they are bottom-up stories - not macro bets at all. At the macro level, we reassert that EM/China demand for technology goods and services as well as for health care will stay robust. Hence, from a revenue perspective, technology and health care companies will outperform other EM sectors. This still warrants an overweight allocation to technology and health care stocks, a recommendation that we have had in place since June 2010 (Chart I-8, bottom panel). Odds are that tech outperformance will persist, but we are not sure about absolute performance, given overbought conditions and not-so-cheap valuations. Excluding information technology, the EM benchmark is somewhat weaker (Chart I-10). Chart I-8EM Technology Stocks: Sky Is Limit? bca.ems_wr_2016_10_19_s1_c8 bca.ems_wr_2016_10_19_s1_c8 Chart I-9Individual Tech Names Are Overbought Individual Tech Names Are Overbought Individual Tech Names Are Overbought Chart I-10EM Equities: Overall And Excluding Tech EM Equities: Overall And Excluding Tech EM Equities: Overall And Excluding Tech There is no improvement in EM corporate profitability The return on equity (RoE) for EM non-financial listed companies has stabilized at very low levels, but it has not improved at all (Chart I-11, top panel). The reason we use non-financials' RoE rather than overall RoE is because in EM the latter is artificially inflated at the moment, as banks are originating a lot of new loans but are not sufficiently provisioning for bad loans. Among the three components of non-financials RoE, net profit margins have stabilized but asset turnover is falling and leverage continues to mushroom (Chart I-11, bottom two panels). Remarkably, the relative performance between EM and U.S. stocks has historically been driven by relative RoE. When non-financial RoE in EM is above that of the U.S., EM stocks outperform U.S. ones, and vice-versa (Chart I-12). This relationships argues for EM stocks underperformance versus the S&P 500. Chart I-11EM Non-Financials: ##br##RoE And Its Components EM Non-Financials: RoE And Its Components EM Non-Financials: RoE And Its Components Chart I-12EM Versus U.S.: ##br##Relative RoE And Share Prices EM Versus U.S.: Relative RoE And Share Prices EM Versus U.S.: Relative RoE And Share Prices Overall EM EPS is still contracting in both local currency and U.S. dollar terms (Chart I-13). Even though the rate of contraction is easing for EPS in U.S. dollar terms, it is due to EM exchange rate appreciation versus the greenback this year. Furthermore, EPS in U.S. dollars is contracting in a majority of non-commodities sectors (Chart I-13A, Chart I-13B). The exceptions are utilities and industrials, which both exhibit strong EPS growth despite poor share price performance. The latter could be a sign that strong industrials and utilities EPS have been due to temporary factors and are not sustainable. Chart I-13AEM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector Chart I-13BEM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector Banks hold the key. Apart from commodities/the U.S. dollar and tech stocks, EM banks' share prices are probably the most important precursor to the direction of the overall EM benchmark. Financials are the second-largest sector in the EM equity benchmark (26.4% weight), so if bank share prices break down, the broader EM index will likely relapse. Our analysis of bank health in various EM countries leads us to believe that banks are under-provisioned for non-performing loans (NPL) (Chart I-14A, Chart I-14B). As EM growth disappointments resurface, investors will question the quality of banks' balance sheets and push down bank equity valuation. Hence, odds are bank share prices will drop sooner than later. Chart I-14AEM NPLs Are Unrecognized ##br##And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned Chart I-14BEM NPLs Are Unrecognized ##br##And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned In turn, concerns about EM banks will heighten doubts about overall EM growth and the EM equity benchmark will sell off. Bottom Line: EM tech stocks are overbought, while banks are fundamentally vulnerable due to the bad-loan overhang. As commodities prices relapse anew and worries about the EM credit cycle resurface, the EM benchmark will drop considerably. An Update On Two Relative Equity Trades We reiterate two relative equity trades: short EM banks / long U.S. banks, and short Chinese property developers / long U.S. homebuilders. For investors who do not have these positions, now is a good time to initiate them. Short EM banks / long U.S. banks (Chart I-15). The credit cycle in EM/China will undergo a further downturn: credit growth is set to decelerate as banks recognize NPLs and seek to raise capital. Even if a crisis is avoided, the need to raise substantial amounts of equity will considerably erode the value of EM bank shares. Meanwhile, risks to U.S. banks such as a flat yield curve and a possible spillover effect from European banking tremors are considerably less severe than the problems faced by EM banks. Importantly, unlike EM banks, U.S. banks' balance sheets are very healthy. Short Chinese property developers / long U.S. homebuilders (Chart I-16). Chart I-15Stay Short EM Banks##br## Versus U.S. Banks Stay Short EM Banks Versus U.S. Banks Stay Short EM Banks Versus U.S. Banks Chart I-16Stay Short Chinese Property ##br##Developers Versus U.S. Homebuilders Stay Short Chinese Property Developers Versus U.S. Homebuilders Stay Short Chinese Property Developers Versus U.S. Homebuilders Chinese property developers are on the verge of another downturn, as the authorities have tightened policy surrounding housing. Residential and non-residential property sales have boomed in the past 12 months, but starts have been less robust (Chart I-17). The upshot could still be high shadow inventories. Going forward, as speculative demand for housing cools off, property developers' chronic malaise - high leverage and lack of cash flow - will come back to play. Remarkably, property stocks trading in Hong Kong have failed to break out amid the buoyant residential market frenzy in the past 12 months, and are likely to break down as demand growth falters in the coming months (Chart I-18). Chart I-17China's Real Estate: ##br##Sales And Starts Will Contract China's Real Estate: Sales And Starts Will Contract China's Real Estate: Sales And Starts Will Contract Chart I-18Chinese Property Developers: ##br##On A Verge Of Breakdown? Chinese Property Developers: On A Verge Of Breakdown? Chinese Property Developers: On A Verge Of Breakdown? Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW The death of King Bhumibol Adulyadej marks the end of an era not only because he symbolized national unity but also because his entire generation is passing. This generational shift has far-reaching consequences for Thailand's political establishment: in the long run it could hurt the Thai military's - and its allies' - attempt to cement their dominance over parliament. However, as Box II-1 (on page 17) explains, there is a low probability of serious domestic instability over the next 12 months2 - although beyond that risks will be heating up. For now, the military junta faces no major political or economic constraints: The junta has already consolidated control over all major organs of government and has purged or intimidated political enemies. The military will have to turn power back to parliament, or make a major policy mistake, for the opposition movement to rise again. The government's fiscal deficit has been stable (around 3% of GDP) over the past few years, public debt is at 33% of GDP, government bond yields are low and debt servicing costs are at 5% of total expenditures (Chart II-1). Hence, the military government can ramp up expenditures further to appease the disaffected. Indeed, the military junta has already accelerated public capital expenditures (Chart II-2) and investments have poured into the Northeast, a populous base of opposition to the junta. Chart II-1Thailand: More Room ##br##For Fiscal Stimulus Thailand: More Room For Fiscal Stimulus Thailand: More Room For Fiscal Stimulus Chart II-2Thailand: Government ##br##Capex Has Been Booming bca.ems_wr_2016_10_19_s2_c2 bca.ems_wr_2016_10_19_s2_c2 Likewise, fiscal expenditure has also accelerated in areas such as general public services, defense, and social protection (Chart II-3). Additionally, the Bank of Thailand (BoT) has scope to cut interest rates as the policy rate is still above a very low inflation rate (Chart II-4). This will limit the downside for credit growth and contribute to economic and political stability. Chart II-3Rising Public Spending bca.ems_wr_2016_10_19_s2_c3 bca.ems_wr_2016_10_19_s2_c3 Chart II-4Thailand: No Inflation; Room To Cut Rates bca.ems_wr_2016_10_19_s2_c4 bca.ems_wr_2016_10_19_s2_c4 The large current account surplus - standing at 11% of GDP - provides the authorities with plenty of fiscal and monetary maneuverability without having to worry about a major depreciation in the Thai baht (Chart II-5). Amid this sensitive political transition, the central bank will likely defend the currency if downward pressure on the baht emerges due to U.S. dollar strength. Therefore, we recommend traders to go long the Thai baht versus the Korean won (Chart II-6). Despite Korea's enormous current account, the won is at risk from depreciation in the RMB and the Japanese yen. Chart II-5Enormous Current Account ##br##Surplus Will Support The Baht Enormous Current Account Surplus Will Support The Baht Enormous Current Account Surplus Will Support The Baht Chart II-6Go Long THB Against KRW bca.ems_wr_2016_10_19_s2_c6 bca.ems_wr_2016_10_19_s2_c6 On the whole, although the Thai economy has been stagnant (Chart II-7), fiscal spending and low interest rates will limit the downside in growth. Bottom Line: We expect relative calm on the political surface in Thailand over the next 12 months and a stable macro backdrop. Therefore, we are using the latest weakness to upgrade this bourse from neutral to overweight within an EM equity portfolio (Chart II-8). Chart II-7Thai Growth Has Been Stagnant bca.ems_wr_2016_10_19_s2_c7 bca.ems_wr_2016_10_19_s2_c7 Chart II-8Upgrade Thai Stocks ##br##From Neutral To Overweight Upgrade Thai Stocks From Neutral To Overweight Upgrade Thai Stocks From Neutral To Overweight In addition, currency traders should go long THB versus KRW. Ayman Kawtharani, Research Analyst aymank@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com BOX 1 The Military Coup In 2014 Pre-empted The King's Death... The May 2014 military coup was timed to pre-empt this event. The king's health had been declining for years and it was only a matter of time until he died. This raised the prospect of an intense political struggle that could have escalated into a full-blown succession crisis. Thus the military moved preemptively so that it would be in control of the country ahead of the king's death and could reshape the constitutional system in the military's favor before his death, as it has done. ... And This Means Stability For Now If the populist, anti-royalist faction had been in control of government at the time of the king's death, it could have attempted to manipulate the less popular new king and take advantage of the vacuum of royal authority in order to reduce the role of the military and their allies. That in turn could have sparked a wave of mass protests from royalists, pressuring the government to collapse, or a military coup that would not have carried the king's implicit approval like the 2014 coup. That would have fed the narrative that a final showdown between the factions was finally emerging, and would have been highly alarming to foreign investors. But Risks Still Linger Make no mistake: a new long-term cycle of political instability is now emerging. Potential military mistakes and the return to parliamentary rule are potential dangers. The country's deep divisions - between (1) the Bangkok-centered royalist bureaucratic and military establishment and (2) the provincial opposition -have not been healed but aggravated since the 2014 coup and the new pro-military constitution: The junta's constitutional and electoral reforms will weaken the representation of the largest opposition party, the Pheu Thai Party, and will marginalize a large share of the 65% of the country's population that lives in the opposition-sympathetic provinces. It is also conceivable that the new king could trigger conflict by lending support to the populist opposition. For instance, he could pardon the exiled leader of the rural opposition movement, or he could transform the powerful Privy Council. However, we do not expect discontent to flare up significantly until late 2017 or 2018 when the military steps back and a new election cycle begins.3 We will reassess and alert investors if we foresee a rapid deterioration in the palace-military network, or in the military's ability to prevent seething resistance in the provinces. 1 The narrow U.S. dollar is a trade-weighted exchange rate versus the euro, Canadian dollar, Japanese yen, British pound, Swiss franc, Australian dollar, and Swedish krona. Source: The Federal Reserve. 2 The exception is that isolated acts of terrorism remain likely and could well strike key areas in Bangkok, signaling the reality that the underground opposition to military dictatorship remains alive and well. 3 The junta will use the one-year national period of mourning to its advantage and opposition forces will not want to be targeted for causing any trouble during a time of mourning. The junta could very easily delay the transition to nominal civilian rule, including the elections slated for November 2017. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Hong Kong's growing political awareness and rising sensitivity to public policy underscores brewing social tensions brought about by decades of <i>Laissez-Faire</i> capitalism. Social policies will likely become progressively more redistributive, with potentially a longer-term negative impact on asset prices.

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

Against a backdrop of continuing supply destruction, particularly in the U.S., and a pick-up in crude demand, markets will remain in balance this quarter and go into a deficit in 2016H2.

A combination of physical rebalancing in the oil markets and geopolitical risk have pushed oil prices above $50/bbl. We therefore close our recommendation - made jointly with BCA's Commodity & Energy Strategy team - to long a December 2016 WTI $50/$55 call spread for a 106.3% gain.

Global trade is plummeting as commodity prices remain depressed and emerging markets unravel. Even if oil were not plumbing new lows, we would remain bearish on EM economies, where poor governance and low efficiency suggest that more crises will rear their heads. Above all, we are watching China for policy clarity. After seizing 14% of global exports in recent years, it is now exporting surplus goods into an already deflationary world. Protectionism - not a coordinated response among leading countries - is the likely result. In essence, we reiterate our theme that globalization has peaked. Along the way, we call attention to five geopolitical "Black Swans" that <i>no one</i> is talking about.

Global trade is plummeting as commodity prices remain depressed and emerging markets unravel. Even if oil were not plumbing new lows, we would remain bearish on EM economies, where poor governance and low efficiency suggest that more crises will rear their heads. Above all, we are watching China for policy clarity. After seizing 14% of global exports in recent years, it is now exporting surplus goods into an already deflationary world. Protectionism - not a coordinated response among leading countries - is the likely result. In essence, we reiterate our theme that globalization has peaked. Along the way, we call attention to five geopolitical "Black Swans" that <i>no one</i> is talking about.