Financial Markets

Special Report

Highlights So What? It is too soon to adopt a cyclical overweight position on Chinese equities. Remain overweight only tactically. Why? China is still maintaining a disciplined approach to economic stimulus. The US-China trade talks are making tentative progress, but there is still a 30% chance of tariff rate hikes this year. The House Democrats show that the US’s tougher approach to China is a bipartisan policy consensus. Feature China released preliminary 2018 GDP data on January 21. The annual real growth rate was recorded at 6.6%, a fall from the 6.9% of 2017, although the latter has now been revised down to 6.8% (Chart 1). The big picture in 2018 is the slowest credit growth on record, the slowest retail sales growth since 2003, the weakest manufacturing output since 2014, and a negative export shock due to trade war (Chart 2). Chart 1China’s Slowdown In Perspective Chart 2A Rocky Road For Beijing The immediate question for investors in 2019 is whether the downside risk has become so pressing that President Xi will shift the policy gear from growth stabilization to total reflation. So far the evidence suggests that the policy stance has not changed from last July. Official rhetoric continues to eschew opening the stimulus floodgates. This disciplined approach is clear when examining the most recent reflationary actions: Fiscal Easing: Local governments are allowed to start issuing 1.39 trillion RMB in new bonds from the beginning of the year, rather than waiting until April or May like usual (Chart 3). This will create a substantial new fiscal boost in the first half of the year that could help stabilize the economy in the second half.1 This 1.39 trillion RMB is not the full-year quota (last year’s was 2.18 trillion RMB). If the government had wanted to create a “big bang” effect, it would have announced a very large new quota for the full year all at once – something approaching 3.4 trillion RMB. This is what the year’s total would be if new issuance grew at the average 55% growth rate since 2015 (Chart 4). But so far the government is focusing on “frontloading” rather than “expanding” the amount of new bonds allowed to be issued. The full-year quota is important to watch in March. Anything above 2.9 trillion RMB would mean a looser fiscal stance from last year. Otherwise, fiscal easing is focusing on tax cuts for households, small businesses, and consumers rather than new loans to SOEs as in the past. The new tax cuts in 2019, for small and medium-sized enterprises (SMEs), amount to about 200 billion RMB, according to government statements. This comes on top of a 1.3 trillion RMB tax cut that took effect at the end of last year. Therefore the minimum tax relief in 2019 is 1.5 trillion RMB or 2% of GDP. The impact is positive for consumer demand but unlikely to produce a rapid V-shaped turnaround in the growth rate, as was once the case with huge bursts of new loans to the corporate sector. Finally, depending on monetary policy, increases to fiscal spending will mostly serve to offset weak credit growth and the resulting drag on economic activity. Monetary Easing: The People’s Bank of China is, on balance, injecting liquidity into the system (net negative sterilization). Injections via the medium-term lending facility are also growing (Chart 5). However, the interbank rate had increased recently, so that recent central bank injections are mostly maintaining the easy conditions of H2 2018 (Chart 6). The extraordinary liquidity injections of January are preemptive attempts to ensure ample liquidity ahead of the Lunar New Year, when funds are tight. Chart 5PBoC Remains Supportive Chart 6Interbank Rates Pushed Back Down   Cuts in banks’ required reserve ratios (RRRs) have not yet triggered a clear revival in credit growth. The twelve-month credit impulse has not yet bottomed, even though broad money impulses are positive or moving into positive territory (Chart 7). Shadow financing remains weak. Regulatory tightening is suppressing non-bank lenders while private business sentiment remains troubled (Chart 8). Chart 7No Clear Bottom In Credit Impulse Yet Chart 8Shadow Financing Still Under Pressure​​​​​​​ Once the credit impulse bottoms and turns upward, there will likely be a 6-9 month lag before it lifts overall economic activity. In March at the National People’s Congress session, Premier Li Keqiang is expected to set the official GDP growth target at a range of 6%-6.5% for 2019, lower than 2018’s “around 6.5%.” Several of China’s provinces are downgrading their growth targets for this year (Chart 9). The various stimulus measures are apparently seen as limiting downside risks rather than creating a new upside risk. ​​​​​​​ As a result of the policy easing that is taking place, our Global Investment Strategy expects Chinese growth to stabilize and global growth to recover after H1.2 Bottom Line: The clear implication is that the Xi administration remains disciplined in its use of macroeconomic tools to ease fiscal and monetary conditions. We have not yet seen a “whatever it takes” moment. Nevertheless, the accumulation of easing measures suggests that the economy could stabilize by mid-year. A Sign Of Progress In The Trade Talks The most likely basis for a “whatever it takes” moment is either a sudden and sharp deterioration in the economy despite the various easing measures, or a renewed escalation of the trade war. For the moment we will assume that the economy will respond to stimulus measures, albeit with a lag, which would be conducive to a bottoming in mid-2019. In this case, what is the likelihood that the trade war will escalate again, with President Trump increasing the Section 301 tariffs from their current level of 10% on $200 billion worth of imports? We maintain that the odds of the two sides agreeing to a framework trade deal by the March 1 negotiation deadline are about 45%. We upgraded the odds of a deal in December given the tariff ceasefire reached on December 1. Since then the news flow has generally suggested that the two sides are making progress in the 90-day talks: a US delegation in Beijing went into an extra day of talks, and was attended by Vice Premier Liu He, the top economics adviser of President Xi Jinping. However, given the difficulty of the negotiations – the thorny issues like forced tech transfer – we also give 25% odds to an extension of negotiations, prolonging the tariff ceasefire beyond March 1. This adds up to a 70% chance that tariffs will not increase this year. The remaining 30% is the chance that the trade war escalates again (Table 1). Table 1Updated Trade War Probabilities​​​​​​​ The key question going forward: How pragmatic are Donald Trump and Xi Jinping? We have evidence that President Trump is pragmatic. He rapidly shifted his approach to Iran, by issuing the waivers on oil sanctions in November, and to China, by agreeing to the tariff ceasefire. He softened his stance to avoid an oil price shock and equity bear market in Q4 last year. Equity bear markets tend to coincide with recessions (Chart 10). And a recession would dramatically reduce Trump’s chances of reelection in November 2020 (Chart 11). Hence Trump is pushing for a short-term trade deal. He is now reportedly even considering a rollback of some tariffs in return for Chinese concessions.3   Chart 11… And Presidents Lose Reelection Amid Recession What about Xi? We have argued that Xi is somewhat pragmatic – at least, more so than the consensus holds. It is undeniable that Xi is a hardliner who has reasserted his personal control, and Communist Party dominance, to a degree not seen in recent memory. He is also aggressive on foreign policy, unlike his predecessors. These trends are deeply concerning both for China’s governance and for relations with the West. They help to support our view that US-China relations are worsening on a secular basis. Nevertheless, as things currently stand, the weak domestic economy and negative sentiment seem to be encouraging Xi to play for time – which is, after all, the traditional Chinese play in trade tensions with the United States. His administration has offered a handful of concessions – on soybeans, auto tariffs, and goods imports – in order to push the negotiations along. The most important potential concession, however, is the new draft law on foreign investment. This is the one concession so far that addresses the US’s structural demands on technology transfer and intellectual property (the grievances that motivate the tariffs). China has one of the most restrictive environments for foreign investment in the world (Chart 12) and this is one of the US’s chief complaints: both because of the inherent denial of market access and because FDI restrictions are used as leverage to extract technology. The National People’s Congress released a new draft law on December 26, 2018, updating a draft law issued by the Ministry of Commerce in 2015 that was never passed.4 An extraordinary meeting of the Standing Committee occurred in January to speed this draft along. The law would ostensibly: Protect intellectual property rights of foreign firms; Prohibit forced technology transfers – including by replacing earlier laws that required companies to operate as “joint ventures,” often exposing them to forced tech transfer. Grant equal treatment to foreign-invested enterprises within China, compared to state-owned and state-controlled enterprises; Implement a negative investment list so that foreign investors could assume that they are free to invest in areas not explicitly proscribed; Allow foreign firms to raise funds, including through initial public offerings on China’s domestic equity market. This law confirms our view that the 90-day negotiation period is tied to the Trump administration’s emphasis on the implementation of any agreements: in early March, China’s National People’s Congress can enact new laws that will ostensibly address US concerns and thus put its concessions in ink. On paper this law would go some way in assuaging US and other foreign investor concerns. However, without a strong central government commitment to enforce the law, it is doubtful that it would reduce the trade and investment practices in China that offend the United States. After all, China’s methods of tech transfer and IP theft are mostly executive rather than legislative in nature – they stem from positive actions by central and local governments, and state-controlled companies, rather than from gaps or loopholes in the legal framework. Even taking the law at face value, its implementation – which is slated for a period of no fewer than five years – could be a mixed blessing for foreign investors.5 For instance, companies with a small foreign ownership stake will now be qualified as foreign-invested companies, which could bring difficulties if the new law is not implemented fairly or in good faith. Many foreign-invested enterprises would have to restructure their ownership and operations in order to fit into the new foreign investment framework (e.g. variable interest enterprises). While foreign enterprises are supposed to receive equal treatment even in government procurement, it is not clear whether they will in the quasi-government sector. Expropriation of foreign assets may still be justified very broadly. The law could also be used as a substitute for lifting the caps on foreign equity ownership in enterprises and for resolving problems with intellectual property licensing and payment of royalties. Moreover, the law is likely to enshrine a tougher regime for national security risk reviews. The US has tightened scrutiny of Chinese investments through the Foreign Investment Risk Review Modernization Act (FIRRMA) over the past year, and China may wish to toughen its own stance. Ultimately China does not need a law to strike down foreign investments that it believes jeopardize national security, but the law could provide justification for retaliation when the US strikes down Chinese investment on similar grounds. Nevertheless, in general, this law is an example of the kind of concession that is necessary for Trump to save face if he is determined to agree to a short-term framework trade deal to help prevent a bear market. Will the US accept this new law as a substantial concession, worthy of rolling back tariffs? So far the feedback is not encouraging. The chief US negotiator, Trade Representative Robert Lighthizer, has reportedly told Senator Chuck Grassley that China has not made any “structural” concessions yet – which suggests that Lighthizer is not impressed by the mere rubber-stamping of a new law.6 Much will depend on the next round of negotiations, dated January 30-31, when Vice Premier Liu He will come to DC for the first time since his humiliation in May last year. At that time he negotiated a deal and the US and China released a joint statement, only to have Trump renege on it three days later. He would not be going back to the US if there were not a substantial commitment on both sides to seek progress. Ultimately Trump, not Lighthizer, will determine whether to pause or roll back the tariff rates. Trump may decide he needs a deal and therefore accept the new law as a sufficient concession. He would still have the possibility of disputing its implementation (or lack thereof) at a later date – for instance, just before the 2020 election. The durability of any framework deal will be measured in the irreversibility of China’s concessions and the extent to which Trump moderates the tariffs. At least some rollback would seem necessary to reciprocate China’s concessions if a framework deal is to be done. The tariffs were imposed in separate tranches with adjustable rates, so Trump can reduce the tariffs in various ways. Bottom Line: There is room for a short-term, tactical trade deal that allows for some tariff rollback, given that China is tentatively making concessions on core US demands. Talks could also be extended, with tariff rates remaining at their current levels. These two possibilities mean that a hike in tariff rates is not the likeliest scenario for most of 2019. However, the new law on foreign investment only tentatively answers what the US is really demanding. We continue to believe that US-China relations are getting worse on a secular basis and that improvements will be tactical (or at best cyclical) in nature. Democrats Are Not Pro-China One of the main reasons for thinking that Xi may offer short-term concessions to get a deal with Trump is also one of the main reasons for thinking that long-term concessions are out of reach: there is an across-the-board policy consensus taking shape in Washington demanding tougher policy on China. We have emphasized that this policy consensus is apparent not only from Trump’s election – as an avowed protectionist and China-basher within the Republican Party – but also from the hardening position of the US defense establishment, and the disillusionment of the corporate lobby, over the past decade (Chart 13). ​​​​​​​ It is also a bipartisan consensus in Congress. For instance, last year, the House draft of the aforementioned FIRRMA Act, tightening foreign investment scrutiny on China, passed by a 398-vote margin in June. The final version passed by a large margin in the House (359-54) and Senate (87-10) in the form of the John S. McCain Defense Authorization Act. The Taiwan Travel Act and the Asia Reassurance Initiative Act, which offended Beijing, both passed with unanimous consent in the Senate (and voice vote in the House). Now the new Democrat majority in the House is confirming that tougher rules on China are something that everyone can agree on. For example, the new Chairman of the House Ways and Means Committee, Representative Richard Neal (D, MA), has struck a hawkish tone on the 90-day trade talks. He has warned that the US Trade Representative has “an obligation to look beyond the political pressures of the moment and the easy, one-off transactions, and secure real and lasting change to China’s anti-competitive behavior.”7 Furthermore, Senator Chris Van Hollen (D, MD) and Representative Ruben Gallego (D, AZ) have joined with Republicans Tom Cotton (R, AR) and Mike Gallagher (R, WI) to propose legislation that would give “the death penalty” to Chinese tech companies such as Huawei and ZTE if they violate US sanctions laws or export controls.8 This is an extremely aggressive piece of legislation that President Trump will have to contain if he is to keep a deal with President Xi. This bipartisan effort should come as no surprise. The Democrats were the more skeptical party about both global free trade and China in recent decades. This is because they positioned themselves as the defenders of workers, wages, and manufacturing, notably in the Midwestern Rustbelt States. Democrats have also always criticized China’s human rights record, with President Bill Clinton famously calling China’s leaders “the Butchers of Beijing” during the 1992 presidential campaign (Chart 14). In the post-Cold War context, this protectionist strain was subdued as the free market consensus prevailed across the political spectrum. It was President Clinton who negotiated for China to enter the World Trade Organization – despite the opposition of many within his party, including current House Speaker Nancy Pelosi – in order to smooth the process of globalization underway. This context began to change after the Great Recession, as the US debt supercycle ended, China emerged as a major competitor, and the Barack Obama administration attempted to develop a Democrat response to new challenges. President Obama supported “Buy America” provisions in the crisis-era stimulus package and engaged in tit-for-tat tariffs with China. The Trans-Pacific Partnership (TPP) multilateral trade deal deliberately excluded China, particularly if it could not embrace the liberal reforms, and trade and cyber-security standards, included in the TPP’s provisions. Finally, President Obama and Secretary of State Hillary Clinton initiated the “Pivot to Asia,” an attempt to reduce US military commitments in the Middle East and reposition for a long-term strategic competition with China in the Asia Pacific. The Trump administration has continued the pivot to Asia in all but the TPP. Trump reportedly even considered naming Jim Webb, a Democratic former navy secretary and China hawk, as his new Secretary of Defense, to replace Secretary James Mattis. But the new policy consensus is best encapsulated by Mattis’s interim replacement, Pat Shanahan, who began his job as acting Defense Secretary this month by telling his staff to focus on “China, China, China.”9 Trump is now considering keeping Shanahan for a “long time.” Now, with Democrats coming back into power in the House, it is becoming even clearer that China faces hawkish trade policies from the Left as well as the Right. This has important implications. In the short term, this process suggests that President Xi may be incentivized to offer some concessions to President Trump, who wants to protect the business cycle and position himself as a successful dealmaker before 2020, rather than stonewalling and fueling the rise of the new anti-China consensus. In the long term, however, this process also suggests that Xi is unlikely to offer deep structural concessions, given that either Trump or a new Democratic administration could ultimately reject the terms of the deal. After all, if the stock market avoids a bear market and the economy strengthens, Trump could turn his back on the deal. In particular, the fired-up US economy is likely to widen the deficit, forcing Trump to give an explanation on the campaign trail (Chart 15).10 But if the economy goes into recession, Trump may have no other policy option to rally voters other than aggressive foreign policy – which could mean aggressive trade policy against China. Chart 15Trump Will Have To Explain This In 2020​​​​​​​ Subsequent to 2020, Trump will either have a renewed election mandate to pursue trade war – in which he is less vulnerable to recession timing – or a new Democratic administration will pick up where President Obama left off, with the Pivot to Asia … including the TPP and other multilateral initiatives. It is also entirely likely that the US and China could adhere to a framework trade deal and yet heighten their strategic standoff in other areas. First, the US is making progress in forming a coalition of nations against Huawei’s participation in 5G networks – China’s relations with Canada are deteriorating rapidly and now Germany, a critical swing player, is even considering a ban on Huawei.11 Second, Taiwan and the South China Sea could see more saber-rattling or incidents even as trade tensions stagnate. (North Korean diplomacy, by contrast, is continuing to progress as long as the US-China trade talks are progressing – Trump and Kim Jong Un are set to hold a second summit in late February.) Bottom Line: The “anti-China” turn in US policy is not limited to Trump. Rather, Trump was the catalyst for a new policy consensus that was already emerging in the Obama years. Democrats will likely take a tough stance on China trade, including pressuring Trump if he strikes a deal with Xi Jinping, in order to woo voters in the Midwest. Any future Democratic White House should be expected to continue pressing China on issues ranging from national security to cyber-security to human rights, while likely pursuing a more multilateral diplomatic approach than the current White House. Investment Implications BCA’s Geopolitical Strategy is tactically overweight Chinese equities ex-tech relative to emerging markets. We are closing our short China-exposed US companies relative to the S&P 500 for a gain of 1.7%. Meanwhile China Investment Strategy is tactically overweight Chinese equities relative to the MSCI World index. Tariffs remaining at their current level now appears to be the most likely scenario for this year. Holding all else constant, this scenario is positive for Chinese growth and China-related assets. But beyond a near-term pop for financial markets, we still need to see hard evidence that the accumulation of China’s easing measures will indeed stabilize its domestic economy. This suggests that it is too soon to give the “all clear” sign from a cyclical perspective. On the other hand, a verified failure of the current, substantive US-China attempt to negotiate a truce would have a deeper negative impact on sentiment and trade than the original outbreak of trade war in 2018, as there will no longer be a basis for optimism. The market will have to price an ultimate 25% tariff on $500 billion worth of goods. This will likely cause the CNY-USD exchange rate to plummet (Chart 16). This would, at least at first, send a deflationary impact across emerging markets and the world, causing another negative hit to global trade and hence a flight to quality. Chart 16A Trade War Escalation Will Send The Yuan Reeling​​​​​​​ The PBoC would most likely have to stage a defense of the currency while the State Council, judging by its actions in July 2018, would likely launch a large stimulus package of the sort that it has thus far avoided for fear of credit excesses. This would come at the cost of a still larger debt burden and misallocation of capital – undoing overnight the work that President Xi has put into mitigating these structural imbalances – but it would prevent a precipitous slowdown for the time being. A trade war-induced stimulus would ostensibly help reaccelerate the Chinese economy and global growth, but in our view financial markets would not respond all that happily to such a huge dose of volatility, trade uncertainty, and policy uncertainty at a time when the cycle will be very late anyway. The risk premium would go up sharply, at least for a time, raising the odds of a very sizeable earnings contraction before the economy begins to recover.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Please see BCA Emerging Markets Strategy Weekly Report, “Dissecting China’s Stimulus,” January 17, 2019, available at www.bcaresearch.com. 2 Please see BCA Global Investment Strategy Weekly Report, “Patient Jay,” January 18, 2019, and “Low Odds Of An FCI Doom Loop,” January 4, 2019, available at www.bcaresearch.com. 3 Please see Steve Holland, Tom Brown, and Leslie Adler, “Trump says deal ‘could very well happen’ with China,” Reuters, January 19, 2019, available at af.reuters.com. 4 Please see “Foreign Investment Law of the People’s Republic of China (Draft) for comments,” National People’s Congress of the People’s Republic of China, December 26, 2018, available at www.npc.gov.cn. See also “Public Comments Sought on the Foreign Investment Law of the People’s Republic of China,” Ministry of Commerce, January 19, 2015, available at www.troutman.com. 5 Please see Lester Ross, Kenneth Zhou, and Tingting Liu, “China Rolls Out New Draft Foreign Investment Law,” January 10, 2019, available at www.wilmerhale.com. See also Manuel Torres and Diego D’Alma, “China Publishes New Draft Of Foreign Investment Law,” Garrigues, Commentary: Corporate China, January 17, 2019, available at www.garrigues.com. 6 Please see Humeyra Pamuk, “U.S. trade chief saw no progress on key issues in China talks: Senator,” Reuters, January 15, 2019, available at www.reuters.com. 7 Please see James Politi, “Washington’s China hawks fear Trump will yield in trade war,” Financial Times, January 12, 2019, available at www.ft.com. 8 Please see Diane Bartz and Christian Shepherd, “U.S. legislation steps up pressure on Huawei and ZTE, China calls it ‘hysteria,’” Reuters, January 16, 2019, available at ca.reuters.com. Note that Democrats have also joined proposals “to condemn gross human rights violations of ethnic Turkic Muslims in Xinjiang” and to restore Taiwan’s observer status in the World Health Organization in the first month of the congressional session. 9 Please see Robert Burns, “New Pentagon leader Shanahan says he is focusing on China,” Associated Press, January 2, 2019, available at www.pbs.org. 10 Please see BCA Global Investment Strategy Weekly Report, “The Next U.S. Recession: Waiting For Godot?” dated October 5, 2018, available at www.bcaresearch.com. 11 Please see Elizabeth Schulze, “Huawei could be banned from 5G in Germany,” CNBC, January 18, 2019, available at www.cnbc.com.  

Highlights Portfolio Strategy Vibrant and broad-based bank credit growth, pristine credit quality, pent up bank buyback demand and a V-shaped recovery in bank ROE more than offset the risk of 10/2 yield curve inversion, and suggest that the path of least resistance is higher for the S&P banks index. Rising residential construction versus stalling residential investment, easing interest rates, cheapened lumber prices, and alluring valuations and technicals all signal that more gains are in store for homebuilders at the expense of home improvement retailers. Recent Changes Initiate a long S&P homebuilding/short S&P home improvement retail pair trade today. Table 1 Feature Equities have retraced 50% of the peak-to-trough losses, and are still consolidating the post December Fed meeting tremor. Chart 1 shows that the VIX has been cut in half and the high-yield corporate bond option-adjusted spread has dropped 105bps. Retrenching volatility and deflating junk spreads suggest that the equity risk premium (ERP) remains uncharacteristically high. The path of least resistance is for the ERP to narrow in the coming months as we do not foresee recession in 2019. As a reminder, the ERP and the economy are inversely correlated. Chart 1Risk Premia Renormalization Nevertheless, in order for the reflex rebound since the late-December lows to morph into a durable rally, the macro/policy backdrop has to turn from a headwind to a tailwind. We are closely monitoring three potential positive catalysts: A definitively more dovish Fed, which would help restrain the greenback A positive U.S./China trade resolution A continuation of the earnings juggernaut With regard to the macro related catalysts, an update to our reflation gauge (RG) is in order. The trade-weighted U.S. dollar has been depreciating since early November, the 10-year U.S. Treasury yield has come undone since the early November peak and oil prices are 33% lower than the early-October peak. These three variables comprise our RG and the signal is unambiguously bullish. In other words, a reflationary impulse looms in the months ahead which should pave the way for a rebound in both plunging investor sentiment and the gloomy economic surprise index (RG shown advanced, Chart 2). Chart 2Reflating Away On the earnings front, last week we trimmed our end-2020 SPX EPS forecast to $181 while we sustained the multiple at 16.5 times which resulted in a 3,000 SPX target.1 Drilling beneath the surface and analyzing the composition of SPX profits is revealing. Table 2 highlights sell side analysts’ profit levels and growth projections on a per GICS1 sector basis and also their contribution to overall earnings along with each sector’s projected earnings weight and most recent market capitalization weight. Table 2S&P 500 Earnings Analysis Chart 3 shows that financials, health care and industrials are responsible for 61% of the SPX’s profit growth in 2019. Interestingly, technology’s contribution has fallen to a mere 7.2% and even if we add the new communication services sector’s 9.6% contribution it still falls well shy of the tech sector’s market cap and earnings weight. Another worthwhile observation is that energy profits are no longer off the charts, as base effects since the early-2016 $25/bbl oil trough have filtered out of the dataset. While the risk of disappointment surrounds financials, health care and industrials, there are high odds that tech surprises to the upside as it has borne the brunt of recent negative earnings revisions (Charts 4 & 5). In addition, if our Commodity & Energy Strategy service’s bullish oil forecast pans out this year, the negative energy sector contribution to SPX profit growth will get a sizable upward revision (please look forward to our GICS1 sector EPS growth models updates and profit margin analysis in next week’s report). Chart 4Earnings Revisions... Chart 5...Really Weigh On Tech​​​​​​​ In sum, if the Fed pauses its hiking cycle through at least the first half of the year, we see a positive U.S./China trade resolution and SPX profits sustain their upward trajectory, then the SPX budding recovery will morph into a durable rally. This week we are updating an interest rate sensitive index that is highly levered to the surging U.S. credit impulse (Chart 6) and are initiating an early cyclical intra-sector and intra-industry pair trade. Chart 6Heed The U.S. Credit Impulse Signal Stick With Banks While our overweight call in the S&P banks index suffered a setback last month, since inception it has moved laterally, and we continue to recommend an above benchmark allocation to this key financials sub group. Not only are the odds of recession low for this year, but narrowing credit spreads and a reversal in financial conditions are also waving the green flag (junk spread shown inverted & advanced, bottom panel, Chart 7). Chart 7Bank On Banks Unlike the previous three reporting seasons when banks revealed blowout numbers and stocks subsequently fell, this season some profit and top line growth misses have been greeted with rising bank stocks prices. Such a reaction suggests that the worst is behind this sector and a sustainable recovery looms. Importantly, on the loan growth front, our credit impulse diffusion index is reaccelerating (Chart 6) and the overall credit impulse is expanding (middle panel, Chart 7). Our total loans & leases growth model and BCA’s C&I loan growth model both corroborate this encouraging credit backdrop (second & bottom panels, Chart 8). The latter is significant given that C&I loans are the single biggest credit category in bank loan books (Chart 9). Importantly, C&I loans have gone vertical recently topping the 10.5% growth mark despite softening capex intentions and CEO confidence. Chart 8Credit Models Flashing Green Chart 9Credit Models Flashing Green Multi-decade highs in consumer confidence are offsetting the Fed’s tightening cycle and suggest that consumer loans, another key lending category, will also gain traction (third panel, Chart 8). The outlook for the second largest credit category, residential real estate, remains upbeat in spite of last quarter’s soft housing related data releases. The recent easing in monetary conditions has breathed life back into the mortgage purchase applications index and also house prices continue to expand at a healthy pace (Chart 10). The upshot is that first-time home buyers will show up this spring selling season. Chart 10Residential Loans Also On Solid Footing Beyond positive credit growth prospects, credit quality remains pristine. BCA’s no recession in 2019 view remains intact, thus NPLs and chargeoffs should stay muted. As a reminder, U.S. banks are the best capitalized banks in the world,2 and their reserve coverage ratio has returned to 124%, a level last seen in 2007 (Chart 11). Chart 11Pristine Credit Quality Another important source of support is equity retirement. Banks have been late to the buyback game as the GFC along with the new strict bank regulatory body, the Fed, really tied their hands with regard to shareholder friendly activities. In fact, according to flow of funds data, the financial sector is still a net equity issuer, albeit at a steeply decelerating pace especially relative to the non-financial corporate sector (Chart 12). Pent up financial sector buyback demand is a boon for bank EPS growth. Chart 12Pent Up Buyback Demand Getting Unleashed This is significant at a time when analysts have been swiftly downgrading EPS growth figures for the SPX. Encouragingly, our bank EPS growth model captures all these positive forces and while it is decelerating it still suggests that profit growth will be stellar in 2019 and easily outpace the overall market (Chart 13). Chart 13Banks EPS Growth Will Outpace The Market Despite all this enticing news, bank valuations remain anchored near rock bottom levels and a resurgent ROE is signaling that a re-rating phase looms (Chart 14). Chart 14Rerating In Still In The Early Innings Nevertheless, there is one headwind banks face as the business cycle is long in the tooth and on track to become the longest expansion on record: the price of credit. One reason for the deflating relative stock price ratio since the January 2018 peak has been the yield curve slope flattening (Chart 15), as it suppresses bank net interest margins. Banks have been fighting this off partly by keeping their source of funding ultra-low judging by still anemic CD rates, according to Bankrate’s national average (bottom panel, Chart 15). Chart 15One Minor Headwind While yield curve inversions have widened all the way out to the 7/1 slope, the key 10/2 slope has yet to invert. Were the 10-year U.S. treasury to resume its selloff, even a mild yield curve steepening will go a long way, as BCA’s bond strategists expect. Clearly a flattening curve is a risk to our sanguine bank view, but the rest of the positives we outlined above more than offset the yield curve blues. Adding it all up, vibrant and broad-based bank credit growth, pristine credit quality, pent up bank buyback demand and a V-shaped recovery in bank ROE more than offset the risk of the 10/2 yield curve inversion, and suggest that the path of least resistance is higher for the S&P banks index. Bottom Line: Maintain the overweight stance in the S&P banks index. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB, FRC, . Buy Homebuilders/Sell Home Improvement Retailers While we reiterate our recent overweight call on the S&P homebuilding index3 and the high-conviction underweight call on the S&P home improvement retail (HIR) group,4 it also makes sense to initiate a market neutral trade: long homebuilders/short HIR. This pair trade is levered on the swings of residential construction compared with residential investment. Currently the former is significantly outpacing the latter and suggests that relative share prices have ample room to run (top panel, Chart 16). Chart 16A Play On Residential Construction Vs. Investment Put differently, this share price ratio moves in tandem with homebuilders breaking new ground versus home owners renovating their existing house. Chart 17 shows the NAHB’s homebuilder sales expectations survey compared with the remodeling expectations survey. This relative sentiment gauge has ticked up recently, confirming the message from national accounts that residential construction has the upper hand over residential investment. The upshot is that the bull market in relative share prices is in the early innings. Chart 17Relative Survey Expectations... Keep in mind that housing starts and building permits are extremely sensitive to interest rates, depend on first time home buyers and move in lockstep with the homeownership rate. Currently, interest rates are easing, the homeownership rate is coming out of its GFC funk and first time home buyers are slated to make a comeback this spring selling season. This is a boon for homebuilders at the expense of HIR (middle & bottom panels, Chart 16). More specifically on the interest rate front, while both groups move with the oscillation of lending rates, new home sales are more sensitive than HIR sales to the price of credit. Our proxy of mortgage application purchase to refinance index does an excellent job in capturing this relative interest rate sensitivity and the recent jump signals that a catch up phase looms in the relative share price ratio (top panel, Chart 18). Chart 18...Easing Interest Rates... Relative loan growth activity also corroborates that demand for residential real estate is outpacing demand for home renovation (bottom panel, Chart 18). Beyond these macro tailwinds for this intra-sector trade, the price of lumber is a key determinant of relative profitability: lumber represents an input cost to homebuilders whereas it is an important selling item in Big Box building & supply retailers that make a set margin on it. In other words, rising lumber prices are a boon for HIR and a bane to homebuilders and vice versa. The recent drubbing in lumber prices should ease margin pressures on homebuilders but eat into HIR profits (Chart 19). Chart 19...And Cheapened Lumber Prices Favor Homebuilders Over HIR Finally, oversold relative technicals, depressed valuations and extreme sell side analysts’ relative profit pessimism, offer a very compelling entry point in the pair trade for fresh capital (Chart 20). Chart 20Oversold And Unloved Netting it all out, rising residential construction versus stalling residential investment, easing interest rates, cheapened lumber prices, and relative alluring valuations and technicals all signal that more gains are in store for homebuilders at the expense of home improvement retailers. Bottom Line: Initiate a new long S&P homebuilding/short S&P home improvement retail pair trade today. The ticker symbols for the stocks in these indexes are: BLBG: S5HOME – DHI, LEN and PHM, and BLBG: S5HOMI – HD and LOW, respectively.   Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com footnotes 1 Please see BCA U.S. Equity Strategy Report, “Catharsis” dated January 14, 2019, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, “Top 10 Reasons We Still Like Banks” dated March 5, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Report, “Indurated” dated September 24, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Report, “2019 Key Views: High-Conviction Calls” dated December 3, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights 2018 Performance Breakdown: Our recommended model bond portfolio generated a modest outperformance versus the custom benchmark index of +6bps for all of 2018. Winners & Losers: The outperformance of our model bond portfolio in 2018 mostly came from country selection on our government bond portfolio (underweight U.S. Treasuries, overweight the U.K. and Australia). However, our below-benchmark overall duration stance, as well as our bias favoring U.S. credit over non-U.S. corporates, were drags on performance during the risk-off moves at the end of 2018. Scenario Analysis For 2019: The tactical upgrade to global corporates that we initiated last week is projected to generate outperformance versus the model portfolio benchmark index in the next six months - both from below-benchmark duration positioning and higher exposure to U.S. corporates. Feature 2019 has gotten off to a very busy start, with significant news and market moves forcing us to devote our first two Weekly Reports of the year to analysis and even changes to our views. This week, we belatedly take care of one final piece of housekeeping for 2018 – reporting the performance of the BCA Global Fixed Income Strategy (GFIS) model bond portfolio for the fourth quarter and for the entire calendar year. We also present an updated scenario return analysis for the next six months after the tactical upgrade to global corporate bonds that we initiated last week.1 As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. This is done by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. A Quick Summary Of The Full Year Performance For 2018 The 2018 performance of the model portfolio can really be broken up into two periods: the first ten months of the year and November/December. This is an unsurprising consequence of the severe market moves around year-end that went contrary to our two most significant recommendations – maintaining a below-benchmark stance on overall portfolio duration and overweighting U.S. investment grade corporate debt versus non-U.S. equivalents in Europe and emerging markets (EM). The overall portfolio return in 2018 was +1.10% (hedged into USD), which outperformed our custom benchmark index by +6bps (Chart of the Week).2 That outperformance was considerably higher before the year-end plunge in global bond yields, reaching a peak of +32bps on November 20. In terms of the breakdown of outperformance, our recommended positioning on government bonds (duration and country allocation) contributed +22bps, while our credit tilts (by country and broadly defined credit sectors) were a drag on performance to the tune of -16bps. Chart of the WeekA Small Gain For 2018 After A Q4 Round-Trip The full breakdown of the full-year 2018 performance can be found in the Appendix tables and charts on Pages 14-16. For the government bond portion of the portfolio the full-year outperformers by country were the U.S. (+18bps), Germany (+10bps), Australia (+4bps) and the U.K. (+3bps). These are in line with our long-standing underweight position on the U.S. versus Germany, and our recommended overweights on Australia and the U.K. The laggards were relatively modest, led by our overweight stance on Japan (-4bps) and underweights on France (-3bps) and Italy (-3bps). For the credit portion of the portfolio, the winners were EM USD-denominated corporates (+7bps), U.S. B-rated high-yield (HY) corporates (+3bps) and U.S. Caa-rated high-yield (HY) corporates (+2bps). This was in line with our long-standing bias to favor U.S. junk bonds over EM credit. The losers were our overweights on U.S. investment grade (IG) financials (-15bps), U.S. IG industrials (-8bps), U.S. Ba-rated HY (-4bps), and euro area IG corporates (-2bps). Our overweight tilts on U.S. IG were the issue here. Q4/2018 Model Portfolio Performance Breakdown: A “Risk-Off” Hit To Our Core Recommendations The detailed data on our model bond performance for Q4/2018 only can be found in Table 1. Table 1GFIS Model Bond Portfolio Q4/2018 Overall Return Attribution The total return of the GFIS model bond portfolio was +1.5% (hedged into USD) in Q4, which underperformed the custom benchmark index by a mere -1bp. The main cause for the slight underperformance is from our below-benchmark duration positioning with the Bloomberg Barclays Global Treasury Index yield falling by 20bps over the full quarter. In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -2bps of underperformance versus our custom benchmark index while the latter outperformed by just +1bp. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3.   The main individual sectors of the portfolio that drove the excess returns were the following: Biggest outperformers Underweight U.S. government bonds with maturities between 5-7 years (+12bps) Overweight Japanese government bonds (JGBs) with maturities between 7-10 years (+5bps) Underweight Germany government bonds with maturities between 7-10 years (+3bps) Overweight U.K. government bonds with maturities between 5-7 years (+2bps) Biggest underperformers Overweight Japanese government bonds (JGBs) with maturities beyond 10 years (-15bps) Underweight U.S. government bonds with maturities beyond 10 years (-8bps) Underweight Italy government bonds with maturities beyond 10 years (-3bps) Underweight France government bonds with maturities beyond 10 years (-2bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q4/2018. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and are adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during Q4/2018 (red for underweight, blue for overweight, gray for neutral). Government bonds are dominating the left half of the chart, as yields declined in the final months of 2018. This was a drag on our model portfolio performance. However, the best performing sector was U.K. government bonds, generating a total return of 4.7% in Q4/2018 (on a currency-hedged and duration-matched basis). The GFIS model portfolio benefited from this move, given our long-standing overweight bias for U.K. Gilts. The right side of Chart 4 is occupied by global spread product, where currency-hedged returns were flat-to-negative in Q4. This was due to credit spread widening as investors feared both slower global growth and additional Fed tightening. The riskier parts of the corporate bond universe – high-yield, EM corporates – suffered the largest losses. The total return of Bloomberg Barclays U.S. High-Yield Index (currency-hedged into USD) for Q4 was -2.7%, as the option-adjusted spread (OAS) widened by +206bps. Unfortunately for our model portfolio, our preference for U.S. corporate bonds over European and EM credit hurt performance, although not by as much as the below-benchmark duration stance. We are disappointed by the final result for the year, although we are still pleased to generate even a small positive outperformance given the ferocity of the market moves seen at the end of 2018. We can attribute that to lingering gains from good calls made earlier in 2018, but also from our recommended cautious stance on overall portfolio risk (i.e. tracking error) in a more-volatile investment environment. Bottom Line: The outperformance of our model bond portfolio in 2018 mostly came from country selection on our government bond portfolio (underweight U.S. Treasuries, overweight the U.K. and Australia). However, our below-benchmark overall duration stance, as well as our bias favoring U.S. credit over non-U.S. corporates, were drags on performance during the risk-off moves at the end of 2018. Future Drivers Of Portfolio Returns Looking ahead, the performance of the model bond portfolio will benefit from two main factors: our below-benchmark duration bias and our underweight stance on global government bonds versus corporate debt. In terms of specific weighting in the GFIS model bond portfolio, we now have a tactical bias favoring global corporate debt over government debt coming on top of our below-benchmark duration stance (Chart 5). We are sticking with the latter position, about one full year short of the duration of our benchmark index, with global yield curves priced for inflation expectations that are too low and with no rate hikes discounted for 2019 in all major developed markets. Chart 5Portfolio Duration: Staying Below-Benchmark However, we are also keeping our current country allocations on the government bond side of the model portfolio, even after our tactical credit upgrade. That means staying underweight countries where policymakers are only pausing on rate hiking cycles (U.S. and Canada), while overweighting countries that are likely to keep rates on hold for all of 2019 (Japan, U.K., Australia). Our decision to upgrade global credit exposure helps boost the yield of our model portfolio (Chart 6). However, the portfolio is still yielding less than the benchmark thanks to our bear-steepening bias on government yield curves that involves underweights to longer-maturity bonds with higher yields. Chart 6Portfolio Yield: Credit Upgrade Helps Offset Defensive Duration Tilt Importantly, all the changes that were made to our portfolio allocations last week – raising weights on all global corporate bond markets, cutting exposure to government debt in the U.S., Germany and France – did not materially change the tracking error (relative volatility versus the benchmark) of the model portfolio. We do not see the current backdrop as being conducive to taking high levels of overall portfolio risk, even given our tactical view that the U.S. monetary policy will be on hold for the next 3-6 months. We prefer to recommend more relative value positioning via country and credit allocations that help dampen overall portfolio risk and reduce exposure to the kind of volatility spikes that became more frequent in 2018. Thus, we will continue to target a tracking error for the model portfolio of 40-60bps, well below our self-imposed 100bps ceiling (Chart 7). Chart 7Portfolio Risk Budget Usage: Staying Cautious Scenario Analysis & Return Forecasts In April 2018, we introduced a framework for estimating total returns for all government bond markets and spread product sectors, based on common risk factors.3 For credit, returns are estimated as a function of changes in the U.S. dollar, the Fed funds rate, oil prices and market volatility as proxied by the VIX index (Table 2A). For government bonds, non-U.S. yield changes are estimated using historical betas to changes in U.S. Treasury yields (Table 2B). This framework allows us to conduct scenario analysis of projected returns for each asset class in the model bond portfolio by making assumptions on those individual risk factors.   In Tables 3A & 3B, we present three differing scenarios, with all the following changes occurring over a six-month horizon. Note that this differs from how we have typically presented these scenario analyses, with projections over the subsequent twelve months. Given that the changes to our recommended allocations introduced last week were tactical in nature (i.e. up to six months), we are shortening our forecast window for this particular scenario analysis to line up with that shorter investment horizon.   The scenarios are all driven by what we believe will be the most important driver of market returns in 2019 – the path of U.S. monetary policy. Our Base Case: the Fed stays on hold, the U.S. dollar remain flat, oil prices rise by +10%, the VIX index falls to 15, and there is a bear-steepening of the U.S. Treasury curve. This scenario is the one we laid out in last week’s report, with the Fed taking a pause through at least the March FOMC meeting, allowing market volatility to drift lower as U.S. monetary and financial conditions ease. A Very Hawkish Fed: the Fed does a surprise +25bps rate hike in March, the U.S. dollar rises by +5%, oil prices increase +20%, the VIX index climbs to 25 and there is a sharp bear-flattening of the U.S. Treasury curve. This would be the case if the U.S. economy maintains firm growth, the global growth downturn stabilizes, U.S. inflation expectations increase and market volatility increases from a surprisingly hawkish Fed. A Very Dovish Fed: the Fed cuts the funds rate by -25bps, the U.S. dollar falls by -5%, oil prices decline -20%, the VIX index increases to 35 and there is a sharp bull steepening of the U.S. Treasury curve. This is a scenario where U.S./global growth slows rapidly from the current pace and the Fed has no choice but to ease monetary policy as market volatility surges alongside elevated recession risks. The model bond portfolio is expected to outperform the custom benchmark index by +19bps in our Base Case scenario. This comes from the relative outperformance of credit versus government bonds in an environment of rising bond yields (which also benefits our below-benchmark duration stance), and tighter credit spreads. In the Very Hawkish Fed scenario, our model portfolio is expected to outperform the benchmark by +29bps. This is not only due to our duration tilt and our corporates-versus-governments bias. As in the Base Case, the relative stance favoring U.S. corporates over EM credit would benefit from a backdrop of tightening U.S. monetary conditions and rising market volatility (Chart 8) – both of which are worse for EM credit. Chart 8Risk Factors Assumptions For The Scenario Analysis In the Very Dovish Fed scenario, our portfolio is projected to underperform the benchmark index by -26bps, with falling bond yields (Chart 9) hitting both our defensive duration bias and the overweight on corporates relative to governments. Chart 9UST Yield Assumptions For The Scenario Analysis In all three scenarios, there is a drag on expected performance from the relative carry of the model portfolio versus the benchmark (-17bps). This comes mostly from the below-benchmark overall duration stance that involves reduced exposure to longer-maturity government bonds with higher yields. The drag on carry also comes from the underweight positioning on high-yielding EM debt. We are maintaining that tilt given our concerns that China’s policymakers will be unable to provide enough stimulus to benefit EM economies through greater Chinese demand. Importantly, our recommended allocations win in scenarios that do not involve Fed rate cuts, a very low probability outcome in 2019, in our view. Thus, we expect our current allocations to generate alpha in the first half of the year, even if the Fed returns to a hawkish bias faster than we currently anticipate. Bottom Line: The tactical upgrade to global corporates that we initiated last week is projected to generate outperformance versus the model portfolio benchmark index in the next six months - both from below-benchmark duration positioning and higher exposure to U.S. corporates.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis”, dated January 15th 2019, available at gfis.bcareseach.com. 2 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 3 Please see BCA Global Fixed Income Strategy Weekly Report, “GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start”, dated April 10th 2018, available at gfis.bcareseach.com. Appendix     Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Highlights MLPs’ one-of-a-kind legal structure offers investors gaudy distribution yields and tax-saving advantages. They boomed alongside fracking, enjoying spectacular growth between 2009 and 2014. MLPs used to exhibit a high correlation with utilities, but since the 2014 oil bust, they have performed in step with the rest of the energy sector. Improved valuations have recently put MLPs back on investors’ radar. However, structural impediments and heterogeneous balance-sheet quality argue against broad index exposure. Investors would be better served by concentrating their efforts on picking individual stocks. Opportunities reside within smaller-cap MLPs and MLPs exposed to the Permian basin. Feature Dear Client, In place of a Weekly Report written from South Africa, where I have been meeting with clients, we are sending you this Special Report on Master Limited Partnerships (MLPs), written by my colleague Jennifer Lacombe.* Like mortgage REITs, which U.S. Investment Strategy followed from 2011 to 2013, MLPs are a yield play that investors might find to be an appealing bond alternative. We trust that you will find this report interesting and informative. Best regards, Doug Peta, Senior Vice President U.S. Investment Strategy * This report was initially published by our Global ETF Strategy service on November 15, 2018. It has been lightly revised to update charts and reflect subsequent market developments.   Q: What are MLPs and their tax benefits? Master Limited Partnerships (MLPs) are publicly listed partnerships involving two classes of partners. A General Partner (GP) controls the assets and manages the daily operations of the business. Limited Partners (LPs) - and public investors - provide the capital and collect cash flow distributions. Unlike corporations, which pay corporate taxes on their income, MLPs have the ability to pass through all of their income to their owners, along with deductible items like amortization and depreciation expenses. MLP investors, in turn pay income tax at their own individual marginal tax rates. MLP owners are thereby shielded from the double taxation that would otherwise apply when the corporation paid taxes on its income, and the shareholder paid taxes on the dividend distributed from the corporation’s income. Q: Why are they predominantly found in the energy sector? Concerns about the potential loss of federal income led Congress to limit MLP eligibility to companies in the energy and real estate sectors when it overhauled the tax code in 1986. Since the 1986 Act took effect, MLPs have had to generate at least 90% of “qualifying income” from their energy or real estate operations. Section 7704 of the Internal Revenue Code defines “qualifying income” as income derived from exploration, development, mining or production, processing, refining, transportation or marketing of any mineral or natural resource, as well as certain passive-type income including interest, dividends and real property rents. Over the years, the shale revolution and the rise of new technologies, such as horizontal drilling and fracturing, created elevated demand for energy infrastructure. Today, MLPs almost exclusively operate in the natural resources space (Chart 1). Q: Why did MLPs outperform assets of all stripes following the Great Financial Crisis? A combination of several factors led MLPs to record stunning returns between 2009 and 2014. The Alerian MLP Total Return Index grew by a whopping annualized rate of 38% during that time. Decreasing interest-rate environments are typically supportive of yield plays’ outperformance. Powered by high single-digit to double-digit distribution yields, MLPs led Treasuries, utilities stocks, high-yield bonds and even the S&P 500 over that six-year stretch (Chart 2). With the shale revolution in full swing, sustaining strong demand for pipelines and other energy infrastructure, investors’ funds flowed abundantly into the energy MLP space (Chart 3). Prices - a mathematical function of multiples and earnings - soared as money kept pouring in and P/E tripled in the first 7 years following the Great Financial Crisis (Chart 4). Chart 2Decreasing Interest Rates Are A Boon To Yield Plays   Chart 3Horizontal Drilling Attracted A Lot Of Money...   Chart 4...Sending Multiples Soaring Q: Why has such outperformance not attracted more institutional and foreign investors? Because of U.S. tax rules, MLPs are relatively unattractive to tax-exempt investors and non-U.S. investors. The tax rule for U.S. tax-exempt investors – institutional investors such as pension funds, university endowments, charities and IRAs – treats MLP earnings as unrelated business taxable income (UBTI), making them subject to income tax. Moreover, to retain their own pass-through status and tax shield, open-ended funds – like many mutual funds and ETFs – can allocate no more than 25% of their total holdings to MLPs, and no more than 10% to a single MLP. U.S. tax rules consider foreign owners of MLPs to be engaged in a business in the U.S., and require them to file and pay U.S. federal income tax. Therefore, only U.S. individuals can truly reap the full benefits of the MLP structure. Though they easily access these securities on public exchanges, the tax shield comes at the price of convoluted accounting treatments. Unitholders receive Schedule K-1 tax forms that can be complicated enough to result in significant accounting costs. They are most suited for high net worth investors’ portfolios, although smaller investors who are not daunted by accounting burdens have also embraced the vehicle. Q: Why are MLP yields so high? The typical MLP partnership agreement incentivizes a GP to distribute all available cash to unitholders, after retaining reserves for business operations and liabilities. Not only does the corporate tax exemption increase the amount of available cash, but the General Partner also has wide discretion over the amount of retained reserves. Because distributions are the main determinant of any yield play’s performance, GPs have historically emphasized distribution yields – sometimes at the expense of retained earnings. The more assurance investors have that they will receive reliable cash flows, the better the MLP will perform in the market. Q: Do MLPs trade like other bond proxies? The distribution model worked beautifully during the shale-oil boom. Low retained reserves never became an issue because MLPs collected steady revenues – a function of prices and volumes of oil or gas processed - and could fund distributions in excess of operating cash flow by issuing new debt or equity. Investors were so eager to invest that GPs found themselves at the controls of a positive feedback loop in which the more cash they distributed to investors, the more capital flowed in to fund even higher distributions. The infrastructure-heavy business model and high payout ratios echoed companies in the utilities sector and, indeed, MLP returns correlated strongly with utilities stocks. However, the discretion embedded in the MLP model reached a breaking point soon after the oil bust arrived in mid-2014. The price-led decline in revenues necessitated distribution cuts and severed the correlation with utilities (Chart 5). Chart 5A Utilities Proxy No More... Q: Were MLPs immune to energy price swings before the 2014 bust? Conventional investor wisdom maintains that MLPs are immune to commodity price swings in the aggregate because of their utility-like characteristics and because long-term contracts lock in selling prices. Actually, however, MLP revenue structures differ greatly from one line of activity to the other. Natural gas pipeline transportation accounts for a quarter of aggregate MLP activity. Prices per unit of volume transited are contractually locked in 5-to-20-year contracts, providing immunity to spot price moves during the entire duration of the contract. Storage (natural gas not immediately needed, or crude oil waiting to be refined) accounts for another quarter of aggregate activity and is subject to a similar pricing model as natural gas pipelines. Only the contract lengths are much shorter, ranging from 1 to 5 years. Petroleum pipeline transportation accounts for 44% of MLP activity. Contracts locking prices over the long run are not typical in this line of business. The Federal Energy Regulatory Commission (FERC) also imposes a yearly price increase amounting to the Producer Price Index for Finished Goods, plus a 1.23% adjustment. MLP revenue structures are therefore varied, and only natural gas pipeline transportation’s revenue streams - a quarter of the sector – are truly immune to fluctuations in spot prices, thanks to their long-term contracts. It follows that MLPs in aggregate are indeed correlated with energy price swings and trade closely in line with energy stocks (Chart 6). Chart 6...An Energy Proxy Instead Up until recently, their correlation to spot oil prices in particular was even more striking. However, they failed to match the 2017-18 recovery in oil markets (Chart 8). Because cash flow reliability is a key driver of the investment decision for any yield play, distribution cuts are bound to make any MLP investors skittish, and oil prices may have to enter an extended bull market before they overcome their fears (Chart 7).   Chart 8...Kept MLPs Depressed In Spite Of Oil Price Recovery Q: So, how cheap are they now? Since its peak in the summer of 2014, the Alerian MLP Total Return index has declined by 38% and is now flirting with the two-standard-deviation-cheap zone (Chart 9). Their profit margins have also strongly recovered (Chart 10). Chart 9Cheap Valuations...   Chart 10...Amid Recovering Profit Margins Because of the infrastructure-heavy nature of MLPs, traditional valuation metrics such as price-to-earnings can be misleading. High depreciation charges have significant impacts on earnings. Cash flows are an appropriate measure as they best inform a firm’s ability to maintain its distributions. Q: Great! So which ETF should I buy? The Alerian MLP index’s low multiples and recovering profit margins are not sufficient endorsements in themselves. An index is not an investible vehicle and even the best of index-tracking instruments can only imperfectly replicate an exposure. In the MLP space in particular, structural impediments reduce the attractiveness of exchange-traded products. Because ETFs are subject to the previously mentioned 25% cap on MLP holdings, many supplement their portfolios with regular pipeline or infrastructure stocks. Although the overall fund provides a decent exposure to the energy infrastructure sector, the diluted MLP exposure does not offer distribution yields anywhere comparable to the yields direct MLP owners receive. An alternative is to opt for a C-corporation structure. The flagship Alerian MLP ETF (ticker: AMLP) falls into this category. This structure allows for an undiluted exposure to MLPs, all the while relieving an ETF shareholder from having to deal with the complicated and costly accounting treatment that direct MLP ownership involves. However, C-corporations are subject to corporate income taxes, which cancels out the tax benefits of investing in MLPs in the first place. The resulting cumulative tax drag on returns can become substantial over time (Chart 11). Investors seek MLP exposure for the high distribution yields made possible by tax advantages. A fund will indeed provide diversification and accounting relief, but at the cost of surrendering either some yield or some of the tax advantages. This is not to mention that the bulk of the exchange-traded vehicles are Exchange Traded Notes (ETNs). Unlike ETFs, they do not own any underlying shares or units of securities. Instead, they are instruments issued and backed by financial institutions. Even in the case of well-established lending institutions, we shy away from these types of products, as we are not keen on taking unnecessary counterparty risk. Many MLP exchange-traded products are also illiquid, or have not gathered a significant mass of assets under management. The expense ratios are also high in the MLP exchange-traded product space, a result of the complicated accounting treatment of K-1 forms that are borne by the ETF or ETN sponsor (Table 1). Table 1ETNs Constitute Two Thirds Of A Relatively Illiquid Universe Q: What about the flagship Alerian MLP ETF? It’s clearly well-established. The flagship Alerian MLP ETF (ticker: AMLP) tracks the Alerian MLP Infrastructure Index and has gathered close to USD 10bn of AUM under its belt since its inception in 2010. Amid all the above limitations, it is the only viable option. However, it comes with its own set of yellow flags. Because it tracks a market-capitalization weighted index, half of the fund’s assets under management are concentrated in its five largest holdings. As we go to press, these are Magellan Midstream Partners LP, Enterprise Products Partners LP, Energy Transfer LP, Plains All American Pipeline LP and MPLX LP. These companies’ distribution yields have recovered since the 2014 oil crash, but the question of the sustainability of these cash flows is of utmost importance. Although retained earnings are at all-time highs, so is the level of debt (Chart 12). The fact that 50% of the fund is concentrated in these top 5 constituents dilutes the diversification benefits of index investing. Chart 12Distributions Are Financed By Cash Flows...And A Lot Of Debt Q: So, what are my options? The MLP universe is heterogeneous. Wide disparity in valuation (Chart 13), debt levels (Chart 14) and performance (Chart 15) indicate that opportunities reside further down the capitalization scale.     Because an index is a weighted average, a heterogeneous market does not warrant broad-index exposure, especially when the smallest constituents offer the best opportunities. Amalgamation is always a process of blending wheat and chaff together, but in this case it disproportionately favors the chaff. Stock picking thrives against this backdrop. Our expertise does not extend to evaluating individual energy MLPs. We leave the honor of recommending the best-in-class opportunities to the professional bottom-up analysts, backed by thorough and diligent review of company fundamentals and management capabilities. Where we can add value is in the analysis of economic cycles and secular macroeconomic forces. Despite the sharp fall in prices over the past two months, brought about by the surprise eleventh-hour waivers granted to Iranian oil importers, BCA’s Commodity & Energy Strategy service believes the global oil market remains tight. Our strategists expect that oil prices will recover in 2019 as OPEC producers, Russia, and Canada reduce output by an aggregate 1.4 million barrels a day, and the Iran-driven supply glut is worked off. While a 2019 oil spike would be a tailwind to petroleum pipeline MLPs, surging production in U.S. shales – led by the Permian Basin in West Texas – means the new pipeline capacity being built to accommodate higher output will find a ready market. Regardless of what happens with prices, our energy strategists foresee a localized surge in demand for transportation and other midstream services in the U.S. shales. In line with IEA projections, they expect U.S. crude oil production to grow by approximately 1.3 million barrels a day in 2019 once the constraints imposed by a lack of pipeline capacity in the fecund Permian basin ease. MLPs positioned to resolve the transportation bottleneck should be able to count on a bright near-term future. “Location, location, location” applies to pipelines as well as real estate, and reinforces a bottom-up focus when selecting MLPs.   Jennifer Lacombe, Senior Analyst jenniferl@bcaresearch.com

Highlights After this week’s drama, the Brexit political process remains extremely complex, but the probability of a hard Brexit is still below 10%. No easy compromise will come through as Brexit suffers a fundamental contradiction: balancing the desire to maximize British sovereignty versus minimizing the pain of leaving the common market. While cross-party talks will prove unfruitful, an extension of the Article 50 deadline is very likely. A new referendum is the most probable solution to the current impasse, but it will likely require a new election. The pound is cheap, but volatility will stay elevated. Buying the pound versus the euro on politically induced drawdowns remains the optimal strategy to gain exposure. Long-term GBP/USD calls are also attractive. The dollar cyclical bull market is intact, but the greenback correction is likely to deepen, especially against growth-sensitive currencies, the AUD in particular. Feature Theresa May’s soft Brexit deal has suffered the largest defeat since 1924 for a bill submitted by a sitting government. The proposed EU Withdrawal Agreement was voted down by 432 members of Parliament, including a whopping 118 members of the Conservative Party. This suggests that both hard Brexit and Bremain Tories voted against May. What lies at the heart of this historic collapse? The fundamental problem is that a soft Brexit is incompatible with the principal demand of Brexit voters: Sovereignty. Any relationship entailing continued access to EU institutions and markets will require two elements that reduce sovereignty: Paying an access fee and accepting the acquis communautaire of the EU without having a say in how it is formulated.1 We do not see how this impasse will be overcome. The financial community’s preferred option – that Prime Minister May breaks ranks and appeals to the Labour Party for a super-soft “Norway Plus” option – is a fantasy. First, the Labour Party smells blood and will likely oppose any deal. Second, a Norway Plus option would entail the highest loss of sovereignty imaginable, given that the U.K. would essentially pay full EU membership fees with no ability to influence the regulatory policies that London would have to abide by. There is also a debate as to whether London would be able to constrict immigration from the EU under that option over the long term, a key demand of Brexiters.2 Members of Parliament may also be getting cold feet due to the shifting poll numbers, which have slowly but steadily increased the gap between those who think that Brexit was the right choice and those who think it was the wrong choice to just under double digits (Chart I-1). This gap reveals that the U.K. public is having second thoughts, no doubt influenced by the incoherent process itself, but also by the combination of geopolitical factors that have changed the appeal of “going it alone.” Chart I-1A Serious Case Of Bregret First, the EU is no longer mired in an epic migration crisis, as it was in the months before the referendum (Chart I-2). Second, terrorist attacks committed by home-grown Islamic State adherents have abated in continental Europe, whereas they seemed to be a monthly affair ahead of the June 2016 vote. Third, the U.K.’s main ally, the United States, which is often cited as a key post-Brexit partner, has elected a president who is unpopular in the U.K. (Chart I-3), putting the “special relationship” in doubt. Chart I-2The Refugee Crisis Is Over   Since the fateful referendum in 2016, the world has become less stable. As such, voters in the U.K. are no doubt wondering whether leaving the EU really would entail greater sovereignty – or whether “going it alone” would mean having to take the fait accompli of large powers such as the U.S., China, and Russia – whose values they share even less than those of their fellow Europeans across the Channel. Sovereignty, in other words, does not operate under Newtonian laws, but is rather relative to one’s vantage point. In short, Brexit cannot be resolved merely with an extension of the negotiating period. Furthermore, our high-conviction view is that even if it were possible to pass the withdrawal agreement today by promising an even softer exit, the process will ultimately fail when, in two- or three-years’ time, Westminster pushes to vote on implementing such an arrangement. Investors should remember that there is another vote waiting after the transition period. In the meantime, we see the following options as a way to resolve the current impasse (Diagram I-1): Article 50 extension: The EU is on record stating that it would agree to extend the Article 50 deadline, currently set at March 29. The EU can do so with a unanimous vote of the EU Council. If there is one thing that the Euro Area crisis has taught investors, it is that deadlines are set in policy and legislation, not in stone. London can extend Article 50 with a simple legislative act, amending the March 29 deadline set in the EU Withdrawal Act (passed in June 2018). The EU is on record stating that it would be simple to extend the current negotiating period until July, when a new European Parliament (EP) would sit in its first session. Any extension beyond July would require U.K. members of European parliament (MEPs) to sit in the legislative body, as the country would remain part of the EU. This would mean that the U.K. would have to hold EP elections. We think this is a minor technicality. But it would be highly embarrassing for PM May if she had to organize EP elections a few months from now, especially if it galvanized the Bremain movement to turn out en masse and send Europhile MEPs to Strasbourg. The bigger question is what the extra time would accomplish. Given the size of the loss for the government on its Brexit bill, we think that both Labour Party members and Bremain supporters have been emboldened and will hold out for either a new election or a new referendum, or in case of Labour Party members, both.   New referendum: A new referendum would require an Article 50 extension. The rules for referendums are set out in the Political Parties, Elections, And Referendums Act of 2000. Westminster would have to pass legislation, which would then have to be considered by the Electoral Commission. The process would very likely go beyond March. The easiest path to a new referendum is through a Labour Party victory in an early election. For PM May to reverse her longstanding policy and call a new referendum, we would need another round of negotiations to fail. As such, it is difficult to see PM May concede to a second referendum, at least not until late in 2019.   A new election: Even though the January 16 vote of no confidence against the government failed, PM May could decide that she needs an early election. Why would she take this route? Because it could give her a political mandate with which to pursue renewed negotiations with the EU and her version of soft Brexit. Under the terms of the Fixed Term Parliaments Act, May would need two-thirds of all MPs in the House of Commons to approve a new election. Current polls show that the election would be too close to call (Chart I-4). We think May would stand a good chance of renewing her mandate by painting Opposition Leader Jeremy Corbyn as too left-leaning and as indecisive on Brexit. Chart I-4An Election May Not Provide A Clear Answer One option not on the table is another leadership challenge to PM May. She already survived the challenge in December and is therefore safe from a new one for 12 months. These rules could of course be changed or PM May could simply resign, but we do not expect either option. Simply put, a change of leadership in the Conservative Party is unlikely as hard Brexit supporters cannot get a majority of Tory MPs to support them, while soft Brexit MPs continue to support May. Could a no-deal Brexit occur? Technically, yes. According to the EU Withdrawal Act, the U.K. will leave the EU on March 29. As such, with no further legislative acts, the U.K. could “sleepwalk” into a hard Brexit. However, we believe that the probability of this is under 10%. There is not even close to a majority in Westminster for a hard Brexit. We estimate that, at most, only 10% of 650 MPs in the House of Commons favor a hard Brexit. As such, the government would certainly win a large majority for a piece of legislation that extends the deadline. And, according to the European Court of Justice ruling in December, London could stop the Article 50 process unilaterally, without EU approval. If the probability of hard Brexit is below 10%, isn’t the pound a screaming buy at this point? After all, if the probability of a major dislocation in the economic relationship between the U.K. and the continent is so low, it also means the probability that the Bank of England maintains as easy a monetary policy as its current one is minimal. Our low-conviction answer to this question is yes, the pound is indeed attractive. The reason why buying the pound is a low-conviction view is that one of the three alternative scenarios listed above could have mixed implications for the British economy as well as U.K. assets and the pound: A new election that produces a Labour government. Corbyn’s legislative agenda is the most left-leaning that Europe has seen since François Mitterrand. He is also on record stating that he would pursue his own negotiations with Brussels. Corbyn’s government would therefore prolong the uncertainty of Brexit while enacting an ambitious left-wing agenda. Ultimately, he may reverse both of these positions: succumbing to pressure to call a new referendum while moderating his economic policy. However, as was the case with Mitterrand in the early 1980s, it would require a deep market riot to force him to do so, which means that closing one’s eyes and buying the pound at these levels is not for risk-averse investors. Bottom Line: The political battle for Brexit is far from over. The risk of a hard Brexit has receded considerably to a less than 10% probability, but volatility will continue due to the inherent conflict between the desire to maximize British sovereignty and the objective to minimize economic pain. While cross-party talks are unlikely to yield any decisive changes, an extension of the Article 50 deadline is likely. A new referendum is the most probable end game of this saga, but it will probably require a new election. While the pound is an attractive long-term play, GBP pairs will continue to suffer from politically induced volatility. Investment Implications In September, we argued that the geopolitical risk premium in the GBP was too low in the face of the uncertainty ahead. Moreover, we recognized that the pound was cheap on many long-term metrics, limiting its downside potential. As a result, instead of shorting GBP outright, we recommended investors buy GBP-volatility, a view that panned out well for us. We closed this recommendation in mid-November, when Cabinet Ministers McVey, Raab, and Vara resigned from the government. Since that time, GBP volatility has receded as investors have increasingly agreed with our assessment that the probability of a hard Brexit is very low. However, the political reality in London continues to suggest that the GBP will trade in a volatile fashion, even if its long-term attractiveness remains alive. Hence, we continue to recommend investors use dips in the GBP to slowly begin moving capital into sterling. Practically, we have expressed this view by selling EUR/GBP. EUR/GBP trades toward the top end of its historical distribution (Chart I-5) and is likely to sell off violently on any whiff that a resolution of any kind is coming. Furthermore, since British interest rates are higher than in the euro area, investors are paid to wait while shorting this cross. Chart I-5EUR/GBP Is A Coiled Spring The pound is particularly cheap against the U.S. dollar (Chart I-6). As a result, buying GBP/USD offers the most attractive long-term potential. However, the intermediate-term hurdles for this position are greater than those present in selling EUR/GBP. First, long cable offers a negative carry of 1.89%, thus buying GBP/USD means that investors are paying to take on a lot of volatility. Second, our negative intermediate-term outlook for the global economy implies a strong dollar over the coming six to nine months, creating risks for GBP/USD holders while helping the profile of selling EUR/GBP (Chart I-7). Finally, since Brexit risks are weighing on the euro as well as the pound, if a hard Brexit were indeed to materialize, GBP would suffer much deeper losses against the dollar than against the euro. Chart I-6Lot Of Value In Cable   Chart I-7Our Strong Dollar Theme Favors Shorting EUR/GBP To Play Rebounds In Sterling This inherent conflict in GBP/USD between potentially large long-term gains but heightened short-term risk suggests that the best way to play cable is to buy long-term call options on this pair. As Chart I-8 shows, the implied volatility on 2-year GBP/USD options is elevated, but has been much higher in the past. Additionally, the implied volatility on these long-term options is abnormally low relative to that offered by 3-month options (Chart I-8, bottom panel), suggesting they are comparatively cheap. Thus, since the long-term outlook for cable is much more attractive than the short-term one, favoring long-term options as a vehicle to gain exposure to GBP/USD makes sense. It is a risky bet only deserving of a small portfolio allocation. Chart I-8Long-Term Call Options On Cable Are Attractive Bottom Line: Only investors with either long-term horizons or a deep capacity to handle volatility should begin garnering some exposure to the pound. Selling EUR/GBP when the pound weakens in response to political shocks remains the best vehicle to do so. While buying cable offers more attractive long-term potential returns than selling EUR/GBP, it is a riskier bet over a six- to nine-month horizon. Nonetheless, investors wanting to get some pound exposure via buying GBP/USD should allocate funds to 2-year GBP/USD call options. Short-Term Risks For The Greenback As we argued last week, continued downside in global growth as well as U.S. interest rate markets having already priced in a year-long pause by the Fed together point to continued upside for the dollar. However, we also highlighted that the dollar currently possesses significant tactical downside, especially against commodity currencies. Five reasons underpin our cautious tactically view: First, the dollar is currently over-owned. Both net speculative positions in the dollar and sentiment toward the DXY are near bullish extremes (Chart I-9). The dollar is a momentum currency, hence the progressive deterioration in our favored momentum signal for the greenback – the crossover of the one-month and six-month moving averages – suggests that the dollar could soon experience a momentum-induced liquidation. Chart I-9If Our Dollar Momentum Signal Turns Negative, There Is No Shortage Of USD Sellers Second, the most recent BAML Investor survey not only showed that investors are more pessimistic on global growth than at any point in the past decade, but also that a trade war was highest on the list of concerns. Today, the probability of a truce in Sino-U.S. trade relations is growing. A declining trade-war risk should temporarily support assets levered to global growth and hurt the defensive U.S. dollar. Moreover, a consequence of the warm-up between Beijing and Washington has been a weakening USD/CNY. Historically, a strengthening RMB is associated with rebounding commodity currencies (Chart I-10). Chart I-10A Strong CNY Points To Stronger Commodity Currencies Third, global growth could also temporarily positively surprise beaten-down expectations. Today, the highly mean-reverting Citi Economic Surprise Index is very stretched to the downside, suggesting scope for a reversal (Chart I-11). With Chinese fiscal stimulus building up, and the recent pick-up in the six-month Chinese credit impulse, a temporary bout of positive economic surprises is a growing risk for dollar bulls. Chart I-11There Is Scope For Economic Surprises To Rebound Fourth, our China Investment Strategy service’s Market-Based China Growth Indicator has rebounded (Chart I-12). This further reinforces the risk that global growth could positively surprise abysmal expectations. Chart I-12Markets Signalling A Pause In The Economic Slowdown Fifth, gold prices have rebounded significantly, implying an improvement in the global liquidity backdrop (Chart I-13). Since tightening global liquidity was a contributor to the deterioration in non-U.S. growth, rebounding gold prices also confirm that the slowdown in international economic activity may take a breather. Chart I-13Gold As A Liquidity Gauge Altogether, these five factors suggest that the corrective episode in the countercyclical dollar may deepen. Because Chinese reflation and a truce in Sino-U.S. tensions lie at the crux of the potential for positive economic surprises, the growth-sensitive currencies like the AUD, the CAD and EM currencies should outperform, especially vis-à-vis the yen. In this environment, Scandinavian currencies should also rise versus the euro. EUR/CHF is set to benefit from this backdrop. For the time being, we continue to view any weakness in the dollar as a correction, not the end of the bull market. Ultimately, the respite in the Chinese economy is likely to prove transitory. The six-month credit impulse is improving, but the 12-month credit impulse is not, even when fiscal stimulus is taken into account (Chart I-14). Since the noise-to-signal ratio is much greater in the six-month impulse than in the 12-month one, we believe that only once the longer-term credit impulse rebounds will Chinese economic activity form a durable bottom. Moreover, Chinese exports are beginning to suffer from a payback period after having been artificially supported by front-running ahead of the trade sanctions. As things stand today, the recent weakness in Chinese export growth looks set to worsen (Chart I-15). This will cause yet another shock to Chinese growth, one likely to percolate to domestic demand. Once it does, global industrial activity should soften again, creating a strong support for the dollar. Chart I-14China's 12-Month Credit Impulse Doesn't Point To An Imminent Economic Turnaround... Chart I-15 ...And Exports Are Set To Become A Significant Drag Bottom Line: Cyclically, fundamentals remain supportive for the greenback. However, the tactical picture shows that the dollar should correct further, especially against growth-sensitive currencies like the AUD, which could rally to 0.75. This view is because the dollar’s momentum is deteriorating sharply, the yuan is rising on the back of a growing likelihood of a trade truce, global economic surprises have room to brighten, China is implementing some reflationary efforts, and global liquidity is improving at the margin.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Footnotes 1 The acquis communautaire refers to the collection of accumulated legislation, legal acts, and judicial decisions that constitute the body of the EU law. 2 Proponents of the Norway Plus option point out that Article 112(1) of the European Economic Area (EEA) Agreement allows for restriction of movement of people within the area. However, these restrictions are intended to be used in times of “serious economic, societal or environmental difficulties.” It certainly appears to be an option for London to restrict EU migration, but it is not clear whether Europe would agree for this to be a permanent solution. Liechtenstein has been using Article 112 to impose quantitative limitations on immigration for decades, but that is because its tiny geographical area is recognized as a “specific situation” that justifies such restrictions.