Middle East

Highlights The U.S. government shutdown showed that the path of least resistance is for more fiscal spending; President Trump is turning to trade and foreign policy amid a lack of popularity at home; North Korean diplomacy is on track, but U.S.-China relations and Taiwan are potential black swans; Iran and the U.S. are playing a risky double game that will add geopolitical risk premium to oil; NAFTA will be a bellwether for Trump's future actions on issues that carry greater constraints, like Iran and China; Book profits on French vs German industrials and China volatility; close U.S. curve steepener and long PHP/TWD. Feature This weekend, investors woke up to the nineteenth government shutdown since 1976, a product of "grand standing" on both sides of the aisle. Our low-conviction view, which we elucidated last week, is that President Donald Trump will be forced to migrate to the middle on policy as the midterm election approaches.1 Chart 1Trump Hitting (And Building!) A Wall Despite a roaring stock market, strong economic fundamentals, and decade-low unemployment, President Trump's popularity continues to flounder. There is now even a perceptible decline in his support among GOP voters. Key problems for Trump have been the failure to repeal the Affordable Care Act and the intensification of the Mueller investigation (Chart 1). We suspect that he will try to preempt an electoral disaster in November by means of bipartisan deal-making and more orthodox policies. The government shutdown, although not entirely unexpected, undermined the view that President Trump is thinking about moderating his stance. That said, the Democrats are as much, if not more, to blame. With the Republicans in charge of Congress and the White House, it is clear that the Democrats thought that voters would ultimately see the shutdown as the GOP's fault. This was a dangerous assumption given that current polling suggests the Democrats have more to lose. One positive about the short-lived imbroglio is that it was the first government shutdown in twenty years that had little to do with government spending, whether the appropriations bill explicitly or entitlements. While immigration is an intractable issue, the disagreement between Republicans and Democrats is not about dollars. This is good news for the markets as it means that more spending will likely be necessary to grease the wheels of compromise. Our mantra continues to be that the political path of least resistance will lead towards profligacy. While the media's focus is on domestic politics, the real risks remain in the international arena. The two are connected. As political science theory teaches us, policymakers often play "two-level games," with the domestic arena influencing what is possible in the international one. As Donald Trump loses political capital on the domestic front, his options for affecting policy will become constrained. However, the U.S. constitution places almost no constraints on the president when it comes to foreign policy. To this arena we turn, starting with China-U.S. relations and the other potential risks in Asia (the Korean Peninsula and Taiwan). We also briefly turn to Iran and NAFTA. What binds all these risks is that it is essentially up to President Trump whether they become market-relevant or not. Korean Diplomacy Is On Track In mid-September North Korean tensions peaked (Chart 2).2 Leader Kim Jong Un chose to demonstrate known missile capabilities rather than escalate the crisis. Chart 2Markets Have Called Kim's Bluff Chart 3North Korea Is Running Out Of Cash We expected this choice given Pyongyang's considerable military constraints. Kim is a rational actor following his father Kim Jong Il's nuclear negotiations playbook.3 Just as brinkmanship reached new highs, Kim Jong Un declared victory and offered to play nice. Specifically, he launched his most advanced missile yet on November 28 (the Hwasong-15) and immediately thereafter North Korean state media declared that North Korea has "finally realized the great historic cause of completing the state nuclear force," complete with a fireworks celebration in Pyongyang.4 Kim confirmed this message personally on January 1 while offering an olive branch to South Korea for the New Year. Apparently, then, Kim is responsive to the United States' threats of devastating military retaliation against any attack. Kim is also responsive to the fact that China's President Xi Jinping has joined the U.S. coalition imposing sanctions on the North (Chart 3), squeezing North Korea's economy. The deep drop in exports to China suggests that the North will run into foreign-exchange problems if it does not adjust its posture - not to mention shortages of goods like fuel that China is gradually cutting off (Chart 4). In short, the U.S. established a credible military threat in 2017, just as it did with Iran in 2012 (Chart 5). China responded to the U.S. and established a credible economic threat of its own. Kim has de-escalated. Kim said in his New Year declaration that he would only use his nuclear deterrent if the U.S. committed an act of aggression. Rhetoric about destroying American cities is gone. Meanwhile Kim has engaged South Korea in direct negotiations, with military-to-military talks possibly to follow, and both sides will make a display of friendship at the Olympic Games in South Korea in February. Chart 4China Is Enforcing Sanctions Chart 5Credible Threat Cycle: North Korea Mirrors Iran While our view that diplomacy will reduce tensions is on track, we caution that the underlying disagreement is driven by North Korea's weapon capabilities and remains unresolved. The North Korean issue is not a red herring and the diplomatic route may continue to be bumpy from time to time.5 Markets could still be rattled by surprise North Korean provocations. Nevertheless, we do not expect a replay of the 2017 level of "fire and fury" that caused the U.S. 10-year treasury yield to drop from 2.31% to 2.05% between June and September 2017. If the North should jerk back toward a belligerent posture and decisively throw away this opportunity for diplomacy, then we will watch closely to determine whether its provocations truly alter the status quo and whether the U.S. shows any sign of greater willingness to respond with force. Otherwise we will simply monitor the diplomatic talks and watch for any signs of internal stress in North Korea as global sanctions tighten.6 Bottom Line: Korean risks remain market-relevant as the crisis is not resolved and talks are just beginning. Nevertheless, diplomacy is taking shape. We remain long the Korean two-year government bond versus the ten-year on the back of global trends and continued de-escalation. China-U.S. Relations May Sour Anyway Over the past year we have warned clients that U.S.-China tensions are the fundamental source of geopolitical risk globally and in Asia Pacific; that North Korea is a derivative of this fact; and that China's cooperation in policing North Korea would only temporarily dissuade the Trump administration from imposing punitive measures on China over trade. Despite China's assistance with North Korea, Trump will be driven by domestic American politics to slap tariffs on China in addition to those levied on January 22.7 First, Trump is committed to an "America First" trade policy and to economic nationalist voters. Thus he may need to show more muscle against China ahead of the midterm elections. This is particularly true for the key rust-belt states that handed him the election in 2016, where four Democratic senators' seats are in competition in November (not to mention nine other senate seats that could be swayed for similar reasons) (Chart 6). It is politically embarrassing to Trump that China racked up its largest trade surplus ever with the U.S. in his first year in office and is on track to continue racking up surpluses (Chart 7). While Beijing has vowed to open up market access and import more goods and services, these promises have yet to impress (Chart 8). Chart 6Trump's Base Expects Protectionism Chart 7China's Exports To U.S. Are Growing... Administrative rulings on several trade disputes early this year will give Trump ample opportunity to take additional trade action against China. The critical question, however, is whether Trump will continue to focus on item-by-item trade remedies (perhaps at an accelerated pace), or whether he goes beyond previous administrations and demands that China make progress on structural and systemic issues. The latter is more politically difficult and would have greater macro consequences. The U.S. has recently suggested that it made a mistake by bringing China into the WTO. This comes after the December WTO meeting in which the administration was able to secure a joint statement with Japan and Europe that increased the pressure on China.8 At the same time, Trump is weighing a significant decision (due by August, but possible any day now) on China's alleged systemic intellectual property theft, which Trump says is likely to require a "fine" (penalty). And comments by White House officials suggest that the administration may be going after China's promotion of state-owned enterprises (SOEs) as well as forced technology transfers (Chart 9).9 These are structural demands on China that will create much bigger frictions than tariffs on a few sub-sectors. Chart 8...While Imports Remain Tepid Chart 9Foreign Firms Forced To Transfer Tech Second, assuming that the U.S. and international community reach some kind of deal to reduce Korean tensions over the next six-to-eighteen months - for instance, a missile-test moratorium and corresponding easing of sanctions. It is likely still to be a complicated and ugly deal, as Pyongyang has no intention of giving up its nuclear and missile capabilities. The U.S. will have to make unpopular compromises with a rogue regime, comparable to the Iranian nuclear deal of 2015. The deal will leave a bitter taste in Trump's mouth and the administration will likely blame China for failing to prevent the North from achieving its nuclear status. It will rotate to address other long-standing disagreements with China, and may well look for compensation for Korea by taking a harder line on trade. Bottom Line: Korean diplomacy may delay or soften Trump's trade policies but cannot change his domestic political calculus. The Trump administration is more, not less, likely to impose further punitive trade measures on China as the midterm election draws near. We expect Chinese equity volatility to remain high. We are closing our recommendation to go long the CBOE China ETF Volatility Index, which has appreciated by 26.5%. This is not an investable index but an indicator of volatility in ETFs. A Fourth Taiwan Strait Crisis? The rumor is going around that China and Taiwan are on the verge of a "Fourth Taiwan Strait Crisis." Clients all over the world - from Hong Kong to San Francisco to Toronto - are asking us about cross-strait tensions and the risk of war. As we go to press, Taiwanese President Tsai Ing-wen has just publicly acknowledged that war is possible. Taiwan could indeed be a geopolitical "black swan." It was one of our top five black swans for 2016,10 and several extraordinary events that year suggested that our concerns are warranted: China cut off all communication with the island; the Taiwanese navy accidentally fired a missile towards the mainland on the Communist Party's birthday; and a U.S. president-elect spoke directly with a Taiwanese president for the first time since 1979, creating an uproar in Beijing.11 Today, in the wake of Xi Jinping's concentration of power at the nineteenth National Party Congress,12 and Beijing's heavy-handed crackdown on Hong Kong throughout 2017,13 there is renewed concern that China is about to stage a major intervention to rein in Taiwan. There is even talk that China could be preparing to mount a surprise attack.14 The rumors are arising from a confluence of events. On the mainland side, Xi is personally powerful and has made it a priority to lead China into a "New Era" of greater Chinese influence globally. This means that a decision to take bolder action on Taiwan could come from individual whim rather than a collective decision within the party (which would tend to maintain the status quo). Xi has also taken personal control of the military through promotions, and reasserted that the "party controls the gun," making it less likely that he would meet institutional resistance in any major foreign policy initiative. Finally, Xi has hardened Communist Party policies toward Taiwan, reflected in increased military drills, controversial new air traffic routes, and tougher language in the five-year policy blueprint that he presented to the party congress. On the Taiwanese side, the Democratic Progressive Party (DPP), which is the party that leans toward independence from the mainland, dominates the country's politics. The DPP not only won the presidency but also won legislative control for the first time in the January 2016 election.15 The DPP is also the leading party on lower levels of government. And young Taiwanese people increasingly identify as exclusively Taiwanese.16 While President Tsai has been relatively pragmatic so far, her party has fewer domestic political constraints than in the past - leaving room for the party's more radical side to have more influence or for Tsai to overreach. Internationally, Tsai has allies in Trump and Prime Minister Shinzo Abe of Japan - both nationalists who favor Taiwan and harbor deep suspicions about the reviving communism emanating from Beijing. Hence we still see Taiwan as a potential black swan event in the coming years. However, we would put a near 0% subjective probability on the likelihood that China will spring a massive surprise attack in the near future. Why? Xi is not yet breaking the status quo: Xi has not yet shown himself to be a reckless revisionist. China's foreign policy assertiveness is a gradual process that began in the mid-2000s - it traces the country's growing economic importance and need for supply-line security (Chart 10). Xi has trod carefully in both the East and South China Seas, and both of these strategic thrusts are connected with China's security vis-à-vis Taiwan, as well as vis-à-vis the U.S. and Japan. There is no reason to think that China is ready to launch a multi-front attack against the combined forces of the U.S., Taiwan, Japan, and the rest of the American alliance system. North Korea's new missile capabilities do not tip the scales in China's favor either. Incidentally, even Xi's tougher rhetoric at the party congress echoed the 2005 "Anti-Secession" law, so that more evidence would be needed to conclude that a drastic policy shift is under way.17 China may even want to avoid antagonizing the Taiwanese ahead of local elections later this year. Trump is not yet breaking the status quo: Trump's Asia policy has been consistent with that of previous administrations.18 And Trump's moves to assure Taiwan of U.S. commitment to its defense are status quo. After all, the Democratic Party is historically more enthusiastic about supplying Taiwan with arms (Chart 11). Trump has assured Xi Jinping he will adhere to the "One China" policy; and it is rarely observed that Trump's controversial phone call with Taiwanese President Tsai followed the first-ever tête-à-tête between a Chinese president and his Taiwanese counterpart.19 As long as Trump upholds the norm, the U.S. remains committed to Taiwan's defense yet will refuse to let Taiwan lock it into excessive tensions with China. This policy actually reduces the probability of a miscalculation by Beijing or Taipei. By contrast, the probability would rise if China and Taiwan perceived that the U.S. was withdrawing from its commitments, as Taiwan might want to suck the U.S. back in, or China might see Taiwan as vulnerable. Incidentally, if the Trump administration is not rushing into conflict over Taiwan, then Japan's Abe administration certainly is not. Tsai is not yet breaking the status quo: President Tsai has so far played a pragmatic role. While she is dissatisfied with the "1992 Consensus," which holds that there is only "One China" but two different interpretations of it, she has not rejected the status quo, and she has not implied that Taiwan should be its own state (either of which would cause a huge reaction from the mainland). And there is no serious prospect of a popular independence referendum ("Twexit"?) on the horizon, which would assuredly prompt Beijing to aggressive measures. Chart 10China's Assertiveness Grows With Trade Chart 11Trump Has Not Changed Status Quo In order for us to increase the probability of a Taiwanese war, we would have to see one of these three players start behaving in a way that truly violates the status quo that has prevailed since the U.S. and China normalized relations in 1979. The real risk for Taiwan comes if the U.S. and China fail to arrest the secular decline in relations that began in the mid-2000s. A serious misunderstanding between these two would have a range of global repercussions, and could lead to miscalculation over Taiwan. Unfortunately, a miscalculation is conceivable within Trump's and Tsai's terms, which last until 2020. Consider the following scenario as an example. The U.S. is currently demanding that China assist with the North Korean problem, and may believe that it can compensate China by delaying any punitive trade measures. However, China may be expecting something else - it may be expecting the U.S. to downgrade relations with Taiwan. (In other words, China says, we diminish the North Korean threat to the U.S. mainland, you diminish the Taiwanese threat to the Chinese mainland.) Instead of giving China what it wants, the U.S. may provide Taiwan with new weapon capabilities in response to China's militarization of the South China Sea. In this way, U.S.-China competition could shift to the Taiwan Strait in the aftermath of any Korean settlement. In the meantime, we see Taiwan as vulnerable to China's discrete economic sanctions, which China has not hesitated to use in this or other diplomatic spats (Chart 12).20 Chart 12Mainland Tourists Punish Rebel Taiwan Bottom Line: What is clear to us is that U.S.-China tensions continue to grow and Taiwan could become more frightened, or more emboldened, in the "security dilemma" between them. But until we see signs that any of the relevant powers are actively attempting to break the status quo, we see war as a distant prospect. More likely, today's robust trade between China and Taiwan could suffer a hit due to politics, and tit-for-tat cross-strait sanctions could be imposed. We are closing our tactical trade of long Philippine peso / short Taiwanese dollar for a loss of 5%. This was a speculative play on the divergence in diplomatic relations with China. Taiwan has allowed its currency to rise to avoid antagonizing President Trump, while China and Taiwan have so far avoided the diplomatic crisis that we expect eventually to occur, as outlined above. Iran: Could America Pivot Back To The Middle East? BCA's Geopolitical Strategy correctly forecast the U.S.-Iran détente two years before the nuclear deal was agreed in the summer of 2015.21 At the heart of this call was our read of global forces, namely the paradigm shift in the global distribution of power away from American hegemony towards multipolarity (Chart 13). As the U.S. pivoted its geopolitical focus towards China, Iran became a thorn in its side, forcing it to maintain considerable presence in the Middle East. Without a formal détente with Iran - of which the Joint Comprehensive Plan of Action (JCPOA) is the fulcrum - such a pivot to Asia would be extremely difficult. On January 12, President Trump imperiled our forecast by threatening not to waive sanctions against Iran the next time they come due (May 12).22 To avoid that fate, President Trump wants to see three major changes to the JCPOA: An indefinite extension of limits on Iran's uranium enrichment; Immediate access for inspectors to all nuclear sites; Adding new provisions to limit development of ballistic missiles. These additions are likely to kill the deal, although Trump appears to have directed his comments to the European signatories only. This could potentially create a loophole in the crisis, by allowing Europe to agree to new thresholds for re-imposing sanctions outside of the deal's framework. Pressure from the U.S. president comes at a delicate time for Iran. Domestic unrest has been ongoing since December 28. Although protests have largely fizzled out, they have reopened the rift between the clerical regime, led by Supreme Leader Ayatollah Ali Khamenei, and moderate President Hassan Rouhani. In a surprising statement, President Rouhani said, "it would be a misrepresentation and also an insult to Iranian people to say they only had economic demands ... people had economic, political, and social demands." He went on to say that "We cannot pick a lifestyle and tell two generations after us to live like that ... The views of the young generation about life and the world is different than ours." We agree with President Rouhani. First, 49% of Iran's population is under the age of 30 (Chart 14). Meanwhile, the Supreme Leader and the twelve members of the "Guardian Council" - which has the power to veto parliamentary legislation and to vet presidential candidates - have an average age of 73.23 As with the 2009 Green Revolution, which was brutally repressed, Iran's demographics provide the kindling for a potential regime change. Chart 13American Hegemony Ended,##br## Global Multipolarity Ascending Chart 14Iran's Youth:##br## A National Security Risk Second, Iran's economy is clearly not the main reason for the angst. While unemployment is elevated at 12%, it is only slightly above its two-decade average. Meanwhile, inflation is well below its average, with real GDP growth at 5.8% by the end of 2016 (Chart 15). Considering that inflation peaked at 44%, and real GDP growth bottomed at -16% during the most severe sanctions, the current situation is not dire. What has irked the population is that while the private sector suffered throughout the sanctions ordeal, government spending remained elevated (Chart 16). This is not merely because of automatic stabilizers amidst a deep recession. Instead, Iran has elevated its military spending as new geopolitical opportunities presented themselves in the region (Chart 17). It currently spends more on its military as a percent of GDP than any peer in the region (save for Saudi Arabia, its chief rival). It is openly engaged in military conflict in both Syria, Iraq, and Yemen, while it continues to support allies militarily, economically, and diplomatically across the region, particularly Hezbollah in Lebanon. Chart 15Economic Situation Poor But Not Dire Chart 16Government Felt No Pain During Sanctions Chart 17Iran Overspends On Military Third, Chart 18 shows that Iran is becoming "dangerously wealthy." Both the 1979 Islamic Revolution and the 2009 Green Revolution occurred at, or near, the peak of Iran's wealth. The 25 years preceding each event saw the country's GDP per capita triple and double, respectively. Chart 18Wealth Is Also A National Security Risk Political scientists Ronald Inglehart and Christian Welzel have empirically shown that wealth changes people's basic values and beliefs, from political and economic beliefs to religion and sexual mores.24 This is the process of modernization. Economic development gives rise to cultural changes that make individual autonomy, gender equality, and even democracy likely. Iran has essentially come full circle since 1979. We suspect that the conservative hardliners in the regime understand the revolutionary context well. After all, they were themselves in their 30s when they rebelled against the old corrupt regime. As such, they will welcome President Trump's pressure as it gives them a raison d'être and an opportunity to undermine the moderate President Rouhani who staked his presidency on the success of the nuclear deal. The risk in this scenario is that the domestic arena of the ongoing "two-level game" will prevent both the U.S. and Iran from backing away from a confrontation. Iranian hardliners, who control part of the armed forces, could lash out in the Persian Gulf, either by rhetorically threatening to close the Straits of Hormuz - as they did repeatedly in 2011 - or by boarding foreign vessels in international waters.25 Geopolitical tensions would therefore serve to undermine President Rouhani's embrace of diplomacy and to de-legitimize any further protests, which would be deemed treasonous. For Trump, a belligerent Iranian response to his pressure would in turn legitimize his suspicion of the nuclear deal. What about the global constraints of multipolarity that compelled the U.S. to seek a détente with Iran in order to pivot to Asia? They remain in place. As such, President Trump's simultaneous pressure on Iran and China runs counter to U.S. strategy, given its limited material resources and diplomatic bandwidth. It is therefore unsustainable. What we cannot forecast, however, is whether the White House will realize this before or after it commits the U.S. to a serious confrontation. Bottom Line: Domestic political calculus in both Iran and the U.S. make further Tehran-Washington tensions likely. The two countries are playing a dangerous two-level game that could spiral out of control in the Middle East. For the time being, however, we expect merely a minor geopolitical risk premium to seep into the energy markets, supporting our bullish BCA House View on oil prices. NAFTA: Of Global Relevance On a recent client trip through Toronto and Ottawa we were unsurprisingly asked a lot of questions regarding the fate of NAFTA. The deal is not just of importance to Canada but to the world. It is a bellwether for our low-conviction view that President Trump is going to moderate to the middle on policy issues ahead of the midterm elections. We encourage clients to read our November Special Report titled "NAFTA - Populism Vs. Pluto-Populism."26 In it, we cautioned clients that the probability of NAFTA being abrogated by Trump is around 50%. Why so high? Because there are few constraints: Economic: The U.S. economy has been largely unaffected by NAFTA (Chart 19) and would likely experience no disruption if Trump abrogated the deal and began negotiations on bilateral trade agreements with Canada and Mexico. Political: Investors and the media are overstating the importance of the Midwest automotive and agricultural sectors to Trump's base. Trump's Midwest voters knew well his view on NAFTA when they voted for him. In fact, they voted for him because of his NAFTA view. Investors have to realize that Americans do not support unbridled free trade (Chart 20). Constitutional/Legal: There is an argument that Congress could stop President Trump from withdrawing from NAFTA, but the only way to do so would be to nullify his executive orders or legislate a law that prevents the president from withdrawing. However, given the point from above, Congress is afraid to go against the median voter. The immediate implications for investors are that both the CAD and MXN could face downside pressure following the Montreal round of negotiations ending January 29. Both fell by 1.2% and 1.9% respectively in the week of trading following the third round of negotiations in September (Chart 21). Chart 19U.S. Economy:##br## Largely Unaffected By NAFTA Chart 20America Belongs To##br## The Anti-Globalization Bloc Chart 21NAFTA Negotiations##br## Are FX-Relevant More broadly, NAFTA is an important bellwether for the direction of Trump's policy. He has practically no constraints to abrogating the deal. If his intention is to renegotiate two separate deals - or simply reactivate the 1988 Canada-U.S. Free Trade Agreement - then it makes sense for him to end NAFTA and score political points at home. As such, if he does not, it will indicate that the White House is not truly populist but has been captured by the Republican establishment. Bottom Line: If President Trump does not abrogate NAFTA, which comes with few constraints, then he has clearly decided to throw his lot in with the U.S. establishment, which has consistently been more pro-trade than the American voter. This would be highly bullish for investors as it would suggest that the (geo)political risk premium would dissipate going forward. In fact, the decision on NAFTA could be a broad indicator for future decisions on trade relations with China, Iranian sanctions, and policy writ large. For if Trump sides with the establishment on an issue with minimal constraints, then he is more likely to do so on issues with greater constraints. This month, we are closing our 2/30 curve steepener recommendation, which is down 90bps since inception. The two alternative ways we have played rising U.S. growth and inflation prospects - shorting the 10-year Treasury vs. the Bunds and shorting the Fed Funds December 2018 futures - are in the money, 27bps and 46bs respectively. We are keeping both open for now. In addition, we are closing our long French industrial equities relative to German industrials for a gain of 10.26%. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 3 The playbook is really Nikita Khruschev's. 4 Please see "NK celebrates completion of nuke arsenal with fireworks," The Korea Herald, December 2, 2017, available at www.koreaherald.com. 5 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 7 Trump decided to impose tariffs on solar panels and washing machine, mostly affecting China and South Korea, on January 22. On steel and aluminum, Trump has until late April to decide, i.e. 90 days after reports from the Commerce Department due Jan. 15 and Jan. 22. Please see Andrew Restuccia and Doug Palmer, "White House preparing for trade crackdown," Politico, dated January 7, 2018, available at www.politico.com. 8 The U.S. Trade Representative's latest edition of an annual report to Congress over China's compliance with World Trade Organization (WTO) commitments declares that the U.S. "erred in supporting China's entry into the WTO on terms that have proven to be ineffective in securing China's embrace of an open, market-oriented trade regime." Please see "Joint Statement by the United States, European Union and Japan at MC11," December 2017, and "USTR Releases Annual Reports on China's and Russia's WTO Compliance," dated January 2018, available at ustr.gov. 9 Please see Lesley Wroughton, "Trump administration says U.S. mistakenly backed China WTO accession in 2001," Reuters, January 19, 2018, available at www.reuters.com. 10 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 11 Please see "China cuts communication with Taiwan," Al Jazeera, June 25, 2016, available at www.aljazeera.com; "Taiwan mistakenly fires supersonic missile killing one," BBC, July 1, 2016, available at www.bbc.com; Mark Landler and David E. Sanger, "Trump Speaks With Taiwan's Leader, An Affront To China," New York Times, December 2, 2016, available at www.nytimes.com. 12 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 13 Please see "U.S.-China: From Rivalry To Proxy Wars" in BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 14 Xi Jinping is rumored to have told Communist Party leaders in 2012 that the country would invade Taiwan by 2020. Please see Ian Easton, The Chinese Invasion Threat: Taiwan's Defense and American Strategy in Asia (Project 2049 Institute, 2017). 15 Please see BCA Geopolitical Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 16 National Chengchi University's long-running data series on Taiwanese identity shows that 58% of Taiwanese people identify as Taiwanese, and 70% under the age of 40. However, 77.5% of twenty-year olds also support the political status quo, i.e. do not seek political independence. Please see Marie-Alice McLean-Dreyfus, "Taiwan: Is there a political generation gap?" dated June 9, 2017, available at lowyinstitute.org. 17 Please see Richard C. Bush, "What Xi Jinping Said About Taiwan At The 19th Party Congress," Brookings Institution, October 19, 2017, available at www.brookings.edu. 18 Even the North Korea threat portfolio was bequeathed to him from former President Barack Obama, and it is being managed largely by the Pentagon and navy. 19 In other words, the incoming Trump administration implied that if China's leader Xi Jinping can speak directly to Taiwan's leader Ma Ying-jeou, then U.S. President Donald Trump can speak to Taiwanese President Tsai Ing-wen. This is a sign that alliances are alive and well, and that there are tensions, but it is not a harbinger of war. 20 Please see BCA Geopolitical Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 22 The JCPOA did not actually legislate the removal of sanctions against Iran as the Obama administration was unable to get the Republican-controlled Senate to agree. Instead, the president has to use his executive authority to continue waiving sanctions against Iran. 23 That is only two years away from the average life expectancy in Iran. 24 Please see Ronald Inglehart and Christian Welzel, Modernization, Cultural Change, and Democracy, Cambridge: Cambridge University Press, 2005. 25 Iranian military personnel - almost always the Navy of the Iranian Revolutionary Guards - seized British Royal Navy personnel in 2007 and U.S. Navy personnel in 2016. 26 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com.

Highlights Multipolarity will peak in 2017 - geopolitical risks are spiking; Globalization is giving way to zero-sum mercantilism; U.S.-China relations are the chief risk to global stability; Turkey is the most likely state to get in a shooting war; Position for an inflation comeback; Go long defense, USD/EUR, and U.S. small caps vs. large caps. Feature Before the world grew mad, the Somme was a placid stream of Picardy, flowing gently through a broad and winding valley northwards to the English Channel. It watered a country of simple beauty. A. D. Gristwood, British soldier, later novelist. The twentieth century did not begin on January 1, 1900. Not as far as geopolitics is concerned. It began 100 years ago, on July 1, 1916. That day, 35,000 soldiers of the British Empire, Germany, and France died fighting over a couple of miles of territory in a single day. The 1916 Anglo-French offensive, also known as the Battle of the Somme, ultimately cost the three great European powers over a million and a half men in total casualties, of which 310,862 were killed in action over the four months of fighting. British historian A. J. P. Taylor put it aptly: idealism perished on the Somme. How did that happen? Nineteenth-century geopolitical, economic, and social institutions - carefully nurtured by a century of British hegemony - broke on the banks of the Somme in waves of human slaughter. What does this have to do with asset allocation? Calendars are human constructs devised to keep track of time. But an epoch is a period with a distinctive set of norms, institutions, and rules that order human activity. This "order of things" matters to investors because we take it for granted. It is a set of "Newtonian Laws" we assume will not change, allowing us to extrapolate the historical record into future returns.1 Since inception, BCA's Geopolitical Strategy has argued that the standard assumptions about our epoch no longer apply.2 Social orders are not linear, they are complex systems. And we are at the end of an epoch, one that defined the twentieth century by globalization, the spread of democracy, and American hegemony. Because the system is not linear, its break will cause non-linear outcomes. Since joining BCA's Editorial Team in 2011, we have argued that twentieth-century institutions are undergoing regime shifts. Our most critical themes have been: The rise of global multipolarity;3 The end of Sino-American symbiosis;4 The apex of globalization;5 The breakdown of laissez-faire economics;6 The passing of the emerging markets' "Goldilocks" era.7 Our view is that the world now stands at the dawn of the twenty-first century. The transition is not going to be pretty. Investors must stop talking themselves out of left-tail events by referring to twentieth-century institutions. Yes, the U.S. and China really could go to war in the next five years. No, their trade relationship will not prevent it. Was the slaughter at the Somme prevented by the U.K.-German economic relationship? In fact, our own strategy service may no longer make sense in the new epoch. "Geopolitics" is not some add-on to investor's asset-allocation process. It is as much a part of that process as are valuations, momentum, bottom-up analysis, and macroeconomics. To modify the infamous Milton Friedman quip, "We are all geopolitical strategists now." Five Decade Themes: We begin this Strategic Outlook by updating our old decade themes and introducing a few new ones. These will inform our strategic views over the next half-decade. Below, we also explain how they will impact investors in 2017. From Multipolarity To ... Making America Great Again Our central theme of global multipolarity will reach its dangerous apex in 2017. Multipolarity is the idea that the world has two or more "poles" of power - great nations - that pursue their interests independently. It heightens the risk of conflict. Since we identified this trend in 2012, the number of global conflicts has risen from 10 to 21, confirming our expectations (Chart 1). Political science theory is clear: a world without geopolitical leadership produces hegemonic instability. America's "hard power," declining in relative terms, created a vacuum that was filled by regional powers looking to pursue their own spheres of influence. Chart 1Frequency Of Geopolitical Conflicts Increases Under Multipolarity The investment implications of a multipolar world? The higher frequency of geopolitical crises has provided a tailwind to safe-haven assets such as U.S. Treasurys.8 Ironically, the relative decline of U.S. power is positive for U.S. assets.9 Although its geopolitical power has been in relative decline since 1990, the U.S. bond market has become more, not less, appealing over the same timeframe (Chart 2) Counterintuitively, it was American hegemony - i.e. global unipolarity after the Soviet collapse - that made the rise of China and other emerging markets possible. This created the conditions for globalization to flourish and for investors to leave the shores of developed markets in search of yield. It is the stated objective of President-elect Donald Trump, and a trend initiated under President Barack Obama, to reduce the United States' hegemonic responsibilities. As the U.S. withdraws, it leaves regional instability and geopolitical disequilibria in its wake, enhancing the value-proposition of holding on to low-beta American assets. We are now coming to the critical moment in this process, with neo-isolationist Trump doubling down on President Obama's aloof foreign policy. In 2017, therefore, multipolarity will reach its apex, leading several regional powers - from China to Turkey - to overextend themselves as they challenge the status quo. Chaos will ensue. (See below for more!) The inward shift in American policy will sow the seeds for the eventual reversal of multipolarity. America has always profited from geopolitical chaos. It benefits from being surrounded by two massive oceans, Canada, and the Sonora-Chihuahuan deserts. Following both the First and Second World Wars, the U.S.'s relative geopolitical power skyrocketed (Chart 3). Chart 2America Is A Safe-Haven,##br## Despite (Because Of?) Relative Decline Chart 3America Is Chaos-Proof Over the next 12-24 months, we expect the chief investment implications of multipolarity - volatility, tailwind to safe-haven assets, emerging-market underperformance, and de-globalization - to continue to bear fruit. However, as the U.S. comes to terms with multipolarity and withdraws support for critical twentieth-century institutions, it will create conditions that will ultimately reverse its relative decline and lead to a more unipolar tendency (or possibly bipolar, with China). Therefore, Donald Trump's curious mix of isolationism, anti-trade rhetoric, and domestic populism may, in the end, Make America Great Again. But not for the reasons he has promised-- not because the U.S. will outperform the rest of the world in an absolute sense. Rather, America will become great again in a relative sense, as the rest of the world drifts towards a much scarier, darker place without American hegemony. Bottom Line: For long-term investors, the apex of multipolarity means that investing in China and broader EM is generally a mistake. Europe and Japan make sense in the interim due to overstated political risks, relatively easy monetary policy, and valuations, but even there risks will mount due to their high-beta qualities. The U.S. will own the twenty-first century. From Globalization To ... Mercantilism "The industrial glory of England is departing, and England does not know it. There are spasmodic outcries against foreign competition, but the impression they leave is fleeting and vague ... German manufacturers ... are undeniably superiour to those produced by British houses. It is very dangerous for men to ignore facts that they may the better vaunt their theories ... This is poor patriotism." Ernest Edwin Williams, Made in Germany (1896) The seventy years of British hegemony that followed the 1815 Treaty of Paris ending the Napoleonic Wars were marked by an unprecedented level of global stability. Britain's cajoled enemies and budding rivals swallowed their wounded pride and geopolitical appetites and took advantage of the peace to focus inwards, industrialize, and eventually catch up to the U.K.'s economy. Britain, by providing expensive global public goods - security of sea lanes, off-shore balancing,10 a reserve currency, and financial capital - resolved the global collective-action dilemma and ushered in an era of dramatic economic globalization. Sound familiar? It should. As Chart 4 shows, we are at the conclusion of a similar period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. There are other forces at work, such as pernicious wage deflation that has soured the West's middle class on free trade and immigration. But the main threat to globalization is at heart geopolitical. The breakdown of twentieth-century institutions, norms, and rules will encourage regional powers to set up their own spheres of influence and to see the global economy as a zero-sum game instead of a cooperative one.11 Chart 4Multipolarity And De-Globalization Go Hand-In-Hand At the heart of this geopolitical process is the end of Sino-American symbiosis. We posited in February that Charts 5 and 6 are geopolitically unsustainable.12 China cannot keep capturing an ever-increasing global market share for exports while exporting deflation; particularly now that its exports are rising in complexity and encroaching on the markets of developed economies (Chart 7). China's economic policy might have been acceptable in an era of robust global growth and American geopolitical confidence, but we live in a world that is, for the time being, devoid of both. Chart 5China's Share Of Global##br## Exports Has Skyrocketed... Chart 6And Now China ##br##Is Exporting Deflation China and the U.S. are no longer in a symbiotic relationship. The close embrace between U.S. household leverage and Chinese export-led growth is over (Chart 8). Today the Chinese economy is domestically driven, with government stimulus and skyrocketing leverage playing a much more important role than external demand. Exports make up only 19% of China's GDP and 12% of U.S. GDP. The two leading economies are far less leveraged to globalization than the conventional wisdom would have it. Chart 7China's Steady Climb Up ##br##The Value Ladder Continues Chart 8Sino-American ##br##Symbiosis Is Over Chinese policymakers have a choice. They can double down on globalization and use competition and creative destruction to drive up productivity growth, moving the economy up the value chain. Or they can use protectionism - particularly non-tariff barriers, as they have been doing - to defend their domestic market from competition.13 We expect that they will do the latter, especially in an environment where anti-globalization rhetoric is rising in the West and protectionism is already on the march (Chart 9). Chart 9Protectionism On The March The problem with this likely choice, however, is that it breaks up the post-1979 quid-pro-quo between Washington and Beijing. The "quid" was the Chinese entry into the international economic order (including the WTO in 2001), which the U.S. supported; the "quo" was that Beijing would open its economy as it became wealthy. Today, 45% of China's population is middle-class, which makes China potentially the world's second-largest market after the EU. If China decides not to share its middle class with the rest of the world, then the world will quickly move towards mercantilism - particularly with regard to Chinese imports. Mercantilism was a long-dominant economic theory, in Europe and elsewhere, that perceived global trade to be a zero-sum game and economic policy to be an extension of the geopolitical "Great Game" between major powers. As such, net export growth was the only way to prosperity and spheres of influence were jealously guarded via trade barriers and gunboat diplomacy. What should investors do if mercantilism is back? In a recent joint report with the BCA's Global Alpha Sector Strategy, we argued that investors should pursue three broad strategies: Buy small caps (or microcaps) at the expense of large caps (or mega caps) across equity markets as the former are almost universally domestically focused; Favor closed economies levered on domestic consumption, both within DM and EM universes; Stay long global defense stocks; mercantilism will lead to more geopolitical risk (Chart 10). Chart 10Defense Stocks Are A No-Brainer Investors should also expect a more inflationary environment over the next decade. De-globalization will mean marginally less trade, less migration, and less free movement of capital across borders. These are all inflationary. Bottom Line: Mercantilism is back. Sino-American tensions and peak multipolarity will impair coordination. It will harden the zero-sum game that erodes globalization and deepens geopolitical tensions between the world's two largest economies.14 One way to play this theme is to go long domestic sectors and domestically-oriented economies relative to export sectors and globally-exposed economies. The real risk of mercantilism is that it is bedfellows with nationalism and jingoism. We began this section with a quote from an 1896 pamphlet titled "Made in Germany." In it, British writer E.E. Williams argued that the U.K. should abandon free trade policies due to industrial competition from Germany. Twenty years later, 350,000 men died in the inferno of the Somme. From Legal To ... Charismatic Authority Legal authority, the bedrock of modern democracy, is a critical pillar of civilization that investors take for granted. The concept was defined in 1922 by German sociologist Max Weber. Weber's seminal essay, "The Three Types of Legitimate Rule," argues that legal-rational authority flows from the institutions and laws that define it, not the individuals holding the office.15 This form of authority is investor-friendly because it reduces uncertainty. Investors can predict the behavior of policymakers and business leaders by learning the laws that govern their behavior. Developed markets are almost universally made up of countries with such norms of "good governance." Investors can largely ignore day-to-day politics in these systems, other than the occasional policy shift or regulatory push that affects sector performance. Weber's original essay outlined three forms of authority, however. The other two were "traditional" and "charismatic."16 Today we are witnessing the revival of charismatic authority, which is derived from the extraordinary characteristics of an individual. From Russia and the U.S. to Turkey, Hungary, the Philippines, and soon perhaps Italy, politicians are winning elections on the back of their messianic qualities. The reason for the decline of legal-rational authority is threefold: Elites that manage governing institutions have been discredited by the 2008 Great Recession and subsequent low-growth recovery. Discontent with governing institutions is widespread in the developed world (Chart 11). Elite corruption is on the rise. Francis Fukuyama, perhaps America's greatest political theorist, argues that American political institutions have devolved into a "system of legalized gift exchange, in which politicians respond to organized interest groups that are collectively unrepresentative of the public as a whole."17 Political gridlock across developed and emerging markets has forced legal-rational policymakers to perform like charismatic ones. European policymakers have broken laws throughout the euro-area crisis, with the intention of keeping the currency union alive. President Obama has issued numerous executive orders due to congressional gridlock. While the numbers of executive orders have declined under Obama, their economic significance has increased (Chart 12). Each time these policymakers reached around established rules and institutions in the name of contingencies and crises, they opened the door wider for future charismatic leaders to eschew the institutions entirely. Chart 11As Institutional Trust Declines, ##br##Voters Turn To Charismatic Leaders Chart 12Obama ##br##The Regulator Furthermore, a generational shift is underway. Millennials do not understand the value of legal-rational institutions and are beginning to doubt the benefits of democracy itself (Chart 13). The trend appears to be the most pronounced in the U.S. and U.K., perhaps because neither experienced the disastrous effects of populism and extremism of the 1930s. In fact, millennials in China appear to view democracy as more essential to the "good life" than their Anglo-Saxon peers. Chart 13Who Needs Democracy When You Have Tinder? Charismatic leaders can certainly outperform expectations. Donald Trump may end up being FDR. The problem for investors is that it is much more difficult to predict the behavior of a charismatic authority than a legal-rational one.18 For example, President-elect Trump has said that he will intervene in the U.S. economy throughout his four-year term, as he did with Carrier in Indiana. Whether these deals are good or bad, in a normative sense, is irrelevant. The point is that bottom-up investment analysis becomes useless when analysts must consider Trump's tweets, as well as company fundamentals, in their earnings projections! We suspect that the revival of charismatic leadership - and the danger that it might succeed in upcoming European elections - at least partly explains the record high levels of global policy uncertainty (Chart 14). Markets do not seem to have priced in the danger fully yet. Global bond spreads are particularely muted despite the high levels of uncertainty. This is unsustainable. Chart 14Are Assets Fully Pricing In Global Uncertainty? Bottom Line: The twenty-first century is witnessing the return of charismatic authority and erosion of legal-rational authority. This should be synonymous with uncertainty and market volatility over the next decade. In 2017, expect a rise in EuroStoxx volatility. From Laissez-Faire To ... Dirigisme The two economic pillars of the late twentieth century have been globalization and laissez-faire capitalism, or neo-liberalism. The collapse of the Soviet Union ended the communist challenge, anointing the U.S.-led "Washington Consensus" as the global "law of the land." The tenets of this epoch are free trade, fiscal discipline, low tax burden, and withdrawal of the state from the free market. Not all countries approached the new "order of things" with equal zeal, but most of them at least rhetorically committed themselves to asymptotically approaching the American ideal. Chart 15Debt Replaced Wages##br## In Laissez-Faire Economies The 2008 Great Recession put an end to the bull market in neo-liberal ideology. The main culprit has been the low-growth recovery, but that is not the full story. Tepid growth would have been digested without a political crisis had it not followed decades of stagnating wages. With no wage growth, households in the most laissez-faire economies of the West gorged themselves on debt (Chart 15) to keep up with rising cost of housing, education, healthcare, and childcare -- all staples of a middle-class lifestyle. As such, the low-growth context after 2008 has combined with a deflationary environment to produce the most pernicious of economic conditions: debt-deflation, which Irving Fisher warned of in 1933.19 It is unsurprising that globalization became the target of middle-class angst in this context. Globalization was one of the greatest supply-side shocks in recent history: it exerted a strong deflationary force on wages (Chart 16). While it certainly lifted hundreds of millions of people out of poverty in developing nations, globalization undermined those low-income and middle-class workers in the developed world whose jobs were most easily exported. World Bank economist Branko Milanovic's infamous "elephant trunk" shows the stagnation of real incomes since 1988 for the 75-95 percentile of the global income distribution - essentially the West's middle class (Chart 17).20 It is this section of the elephant trunk that increasingly supports populism and anti-globalization policies, while eschewing laissez faire liberalism. In our April report, "The End Of The Anglo-Saxon Economy," we posited that the pivot away from laissez-faire capitalism would be most pronounced in the economies of its greatest adherents, the U.S. and U.K. We warned that Brexit and the candidacy of Donald Trump should be taken seriously, while the populist movements in Europe would surprise to the downside. Why the gap between Europe and the U.S. and U.K.? Because Europe's cumbersome, expensive, inefficient, and onerous social-welfare state finally came through when it mattered: it mitigated the pernicious effects of globalization and redistributed enough of the gains to temper populist angst. Chart 16Globalization: A Deflationary Shock Chart 17Globalization: No Friend To DM Middle Class This view was prescient in 2016. The U.K. voted to leave the EU, Trump triumphed, while European populists stumbled in both the Spanish and Austrian elections. The Anglo-Saxon median voter has essentially moved to the left of the economic spectrum (Diagram 1).21 The Median Voter Theorem holds that policymakers will follow the shift to the left in order to capture as many voters as possible under the proverbial curve. In other words, Donald Trump and Bernie Sanders are not political price-makers but price-takers. Diagram 1The Median Voter Is Moving To The Left In The U.S. And U.K. How does laissez-faire capitalism end? In socialism or communism? No, the institutions that underpin capitalism in the West - private property, rule of law, representative government, and enforcement of contracts - remain strong. Instead, we expect to see more dirigisme, a form of capitalism where the state adopts a "directing" rather than merely regulatory role. In the U.S., Donald Trump unabashedly campaigned on dirigisme. We do not expand on the investment implications of American dirigisme in this report (we encourage clients to read our post-election treatment of Trump's domestic politics).22 But investors can clearly see the writing on the wall: a late-cycle fiscal stimulus will be positive for economic growth in the short term, but most likely more positive for inflation in the long term. Donald Trump's policies therefore are a risk to bonds, positive for equities (in the near term), and potentially negative for both in the long term if stagflation results from late-cycle stimulus. What about Europe? Is it not already quite dirigiste? It is! But in Europe, we see a marginal change towards the right, not the left. In Spain, the supply-side reforms of Prime Minister Mariano Rajoy will remain in place, as he won a second term this year. In France, right-wing reformer - and self-professed "Thatcherite" - François Fillon is likely to emerge victorious in the April-May presidential election. And in Germany, the status-quo Grand Coalition will likely prevail. Only in Italy are there risks, but even there we expect financial markets to force the country - kicking and screaming - down the path of reforms. Bottom Line: In 2017, the market will be shocked to find itself face-to-face with a marginally more laissez-faire Europe and a marginally more dirigiste America and Britain. Investors should overweight European assets in a global portfolio given valuations, relative monetary policy (which will remain accommodative in Europe), a weak euro, and economic fundamentals (Chart 18), and upcoming political surprises. For clients with low tolerance of risk and volatility, a better entry point may exist following the French presidential elections in the spring. From Bias To ... Conspiracies As with the printing press, the radio, film, and television before it, the Internet has created a super-cyclical boom in the supply and dissemination of information. The result of the sudden surge is that quality and accountability are declining. The mainstream media has dubbed this the "fake news" phenomenon, no doubt to differentiate the conspiracy theories coursing through Facebook and Twitter from the "real news" of CNN and MSNBC. The reality is that mainstream media has fallen far short of its own vaunted journalistic standards (Chart 19). Chart 18Europe's Economy Is Holding Up Chart 19 We are not interested in this debate, nor are we buying the media narrative that "fake news" delivered Trump the presidency. Instead, we are focused on how geopolitical and political information is disseminated to voters, investors, and ultimately priced by the market. We fear that markets will struggle to price information correctly due to three factors: Low barriers to entry: The Internet makes publishing easy. Information entrepreneurs - i.e. hack writers - and non-traditional publications ("rags") are proliferating. The result is greater output but a decrease in quality control. For example, Facebook is now the second most trusted source of news for Americans (Chart 20). Cost-cutting: The boom in supply has squeezed the media industry's finances. Newspapers have died in droves; news websites and social-media giants have mushroomed (Chart 21). News companies are pulling back on things like investigative reporting, editorial oversight, and foreign correspondent desks. Foreign meddling: In this context, governments have gained a new advantage because they can bring superior financial resources and command-and-control to an industry that is chaotic and cash-strapped. Russian news outlets like RT and Sputnik have mastered this game - attracting "clicks" around the world from users who are not aware they are reading Russian propaganda. China has also raised its media profile through Western-accessible propaganda like the Global Times, but more importantly it has grown more aggressive at monitoring, censoring, and manipulating foreign and domestic media. Chart 20Facebook Is The New Cronkite? Chart 21The Internet Has Killed Journalism The above points would be disruptive enough alone. But we know that technology is not the root cause of today's disruptions. Income inequality, the plight of the middle class, elite corruption, unchecked migration, and misguided foreign policy have combined to create a toxic mix of distrust and angst. In the West, the decline of the middle class has produced a lack of socio-political consensus that is fueling demand for media of a kind that traditional outlets can no longer satisfy. Media producers are scrambling to meet this demand while struggling with intense competition from all the new entrants and new platforms. What is missing is investment in downstream refining and processing to convert the oversupply of crude information into valuable product for voters and investors.23 Otherwise, the public loses access to "transparent" or baseline information. Obviously the baseline was never perfect. Both the Vietnam and Iraq wars began as gross impositions on the public's credulity: the Gulf of Tonkin Incident and Saddam Hussein's weapons of mass destruction. But there was a shared reference point across society. The difference today, as we see it, is that mass opinion will swing even more wildly during a crisis as a result of the poor quality of information that spreads online and mobilizes social networks more rapidly than ever before. We could have "flash mobs" in the voting booth - or on the steps of the Supreme Court - just like "flash crashes" in financial markets, i.e. mass movements borne of passing misconceptions rather than persistent misrule. Election results are more likely to strain the limits of the margin of error, while anti-establishment candidates are more likely to remain viable despite dubious platforms. What does this mean for investors? Fundamental analysis of a country's political and geopolitical risk is now an essential tool in the investor toolkit. If investors rely on the media, and the market prices what the media reports, then the same investors will continue to get blindsided by misleading probabilities, as with Brexit and Trump (Chart 22). While we did not predict these final outcomes, we consistently advised clients, for months in advance, that the market probabilities were too low and serious hedging was necessary. Those who heeded our advice cheered their returns, even as some lamented the electoral returns. Chart 22Get Used To Tail-Risk Events Bottom Line: Keep reading BCA's Geopolitical Strategy! Final Thoughts On The Next Decade The nineteenth century ended in the human carnage that was the Battle of the Somme. The First World War ushered in social, economic, political, geopolitical, demographic, and technological changes that drove the evolution of twentieth-century institutions, rules, and norms. It created the "order of things" that we all take for granted today. The coming decade will be the dawn of the new geopolitical century. We can begin to discern the ordering of this new epoch. It will see peak multipolarity lead to global conflict and disequilibrium, with globalization and laissez-faire economic consensus giving way to mercantilism and dirigisme. Investors will see the benevolent deflationary impulse of globalization evolve into state intervention in the domestic economy and the return of inflation. Globally oriented economies and sectors will underperform domestic ones. Developed markets will continue to outperform emerging markets, particularly as populism spreads to developing economies that fail to meet expectations of their rising middle classes. Over the next ten years, these changes will leave the U.S. as the most powerful country in the world. China and wider EM will struggle to adapt to a less globalized world, while Europe and Japan will focus inward. The U.S. is essentially a low-beta Great Power: its economy, markets, demographics, natural resources, and security are the least exposed to the vagaries of the rest of the world. As such, when the rest of the world descends into chaos, the U.S. will hide behind its Oceans, and Canada, and the deserts of Mexico, and flourish. Five Themes For 2017: Our decade themes inform our view of cyclical geopolitical events and crises, such as elections and geopolitical tensions. As such, they form our "net assessment" of the world and provide a prism through which we refract geopolitical events. Below we address five geopolitical themes that we expect to drive the news flow, and thus the markets, in 2017. Some themes are Red Herrings (overstated risks) and thus present investment opportunities, others are Black Swans (understated risks) and are therefore genuine risks. Europe In 2017: A Trophy Red Herring? Europe's electoral calendar is ominously packed (Table 1). Four of the euro area's five largest economies are likely to have elections in 2017. Another election could occur if Spain's shaky minority government collapses. Table 1 Europe In 2017 Will Be A Headline Risk We expect market volatility to be elevated throughout the year due to the busy calendar. In this context, we advise readers to follow our colleague Dhaval Joshi at BCA's European Investment Strategy. Dhaval recommends that BCA clients combine every €1 of equity exposure with 40 cents of exposure to VIX term-structure, which means going long the nearest-month VIX futures and equally short the subsequent month's contract. The logic is that the term structure will invert sharply if risks spike.24 While we expect elevated uncertainty and lots of headline risk, we do not believe the elections in 2017 will transform Europe's future. As we have posited since 2011, global multipolarity increases the logic for European integration.25 Crises driven by Russian assertiveness, Islamic terrorism, and the migration wave are not dealt with more effectively or easily by nation states acting on their own. Thus far, it appears that Europeans agree with this assessment: polling suggests that few are genuinely antagonistic towards the euro (Chart 23) or the EU (Chart 24). In our July report called "After BREXIT, N-EXIT?" we posited that the euro area will likely persevere over at least the next five years.26 Chart 23Support For The Euro Remains Stable Chart 24Few Europeans Want Out Of The EU Take the Spanish and Austrian elections in 2016. In Spain, Mariano Rajoy's right-wing People's Party managed to hold onto power despite four years of painful internal devaluations and supply-side reforms. In Austria, the establishment candidate for president, Alexander Van der Bellen, won the election despite Austria's elevated level of Euroskepticism (Chart 24), its central role in the migration crisis, and the almost comically unenthusiastic campaign of the out-of-touch Van der Bellen. In both cases, the centrist candidates survived because voters hesitated when confronted with an anti-establishment choice. Next year, we expect more of the same in three crucial elections: The Netherlands: The anti-establishment and Euroskeptic Party for Freedom (PVV) will likely perform better than it did in the last election, perhaps even doubling its 15% result in 2012. However, it has no chance of forming a government, given that all the other parties contesting the election are centrist and opposed to its Euroskeptic agenda (Chart 25). Furthermore, support for the euro remains at a very high level in the country (Chart 26). This is a reality that the PVV will have to confront if it wants to rule the Netherlands. Chart 25No Government For Dutch Euroskeptics Chart 26The Netherlands & Euro: Love Affair France: Our high conviction view is that Marine Le Pen, leader of the Euroskeptic National Front (FN), will be defeated in the second round of the presidential election.27 Despite three major terrorist attacks in the country, unchecked migration crisis, and tepid economic growth, Le Pen's popularity peaked in 2013 (Chart 27). She continues to poll poorly against her most likely opponents in the second round, François Fillon and Emmanuel Macron (Chart 28). Investors who doubt the polls should consider the FN's poor performance in the December 2015 regional elections, a critical case study for Le Pen's viability in 2017.28 Chart 27Le Pen's Polling: ##br##Head And Shoulder Formation? Chart 28Le Pen Will Not Be##br## Next French President Germany: Chancellor Angela Merkel's popularity is holding up (Chart 29), the migration crisis has abated (Chart 30), and there remains a lot of daylight between the German establishment and populist parties (Chart 31). The anti-establishment Alternative für Deutschland will enter parliament, but remain isolated. Chart 29Merkel's Approval Rating Has Stabilized Chart 30Migration Crisis Is Abating Chart 31There Is A Lot Of Daylight... The real risk in 2017 remains Italy. The country has failed to enact any structural reforms, being a laggard behind the reform poster-child Spain (Chart 32). Meanwhile, support for the euro remains in the high 50s, which is low compared to the euro-area average (Chart 33). Polls show that if elections were held today, the ruling Democratic Party would gain a narrow victory (Chart 34). However, it is not clear what electoral laws would apply to the contest. The reformed electoral system for the Chamber of Deputies remains under review by the Constitutional Court until at least February. This will make all the difference between further gridlock and a viable government. Chart 32Italy Is Europe's Chart 33Italy Lags Peers On Euro Support Chart 34Italy's Next Election Is Too Close To Call Investors should consider three factors when thinking about Italy in 2017: The December constitutional referendum was not a vote on the euro and thus cannot serve as a proxy for a future referendum.29 The market will punish Italy the moment it sniffs out even a whiff of a potential Itexit referendum. This will bring forward the future pain of redenomination, influencing voter choices. Benefits of the EU membership for Italy are considerable, especially as they allow the country to integrate its unproductive, poor, and expensive southern regions.30 Sans Europe, the Mezzogiorno (Southern Italy) is Rome's problem, and it is a big one. The larger question is whether the rest of Italy's euro-area peers will allow the country to remain mired in its unsustainable status quo. We think the answer is yes. First, Italy is too big to fail given the size of its economy and sovereign debt market. Second, how unsustainable is the Italian status quo? OECD projections for Italy's debt-to-GDP ratio are not ominous. Chart 35 shows four scenarios, the most likely one charting Italy's debt-to-GDP rise from 133% today to about 150% by 2060. Italy's GDP growth would essentially approximate 0%, but its impressive budget discipline would ensure that its debt load would only rise marginally (Chart 36). Chart 35So What If Italy's Debt-To-GDP Ends Up At 170%? Chart 36Italy Has Learned To Live With Its Debt This may seem like a dire prospect for Italy, but it ensures that the ECB has to maintain its accommodative stance in Europe even as the Fed continues its tightening cycle, a boon for euro-area equities as a whole. In other words, Italy's predicament would be unsustainable if the country were on its own. Its "sick man" status would be terminal if left to its own devices. But as a patient in the euro-area hospital, it can survive. And what happens to the euro area beyond our five-year forecasting horizon? We are not sure. Defeat of anti-establishment forces in 2017 will give centrist policymakers another electoral cycle to resolve the currency union's built-in flaws. If the Germans do not budge on greater fiscal integration over the next half-decade, then the future of the currency union will become murkier. Bottom Line: Remain long the nearest-month VIX futures and equally short the subsequent month's contract. We have held this position since September 14 and it has returned -0.84%. The advantage of this strategy is that it is a near-perfect hedge when risk assets sell off, but pays a low price for insurance. Investors with high risk tolerance who can stomach some volatility should take the plunge and overweight euro-area equities in a global equity portfolio. Solid global growth prospects, accommodative monetary policy, euro weakness, and valuations augur a solid year for euro-area equities. Politics will be a red herring as euro-area stocks climb the proverbial wall of worry in 2017. U.S.-Russia Détente: A Genuine Investment Opportunity Trump's election is good news for Russia. Over the past 16 years, Russia has methodically attempted to collect the pieces from the Soviet collapse. Putin sought to defend the Russian sphere of influence from outside powers (Ukraine and Belarus, the Caucasus, Central Asia). Putin also needed to rally popular support at various times by distracting the public. We view Ukraine and Syria through this prism. Lastly, Russia acted aggressively because it needed to reassure its allies that it would stand up for them.31 And yet the U.S. can live with a "strong" Russia. It can make a deal if the Trump administration recognizes some core interests (e.g. Crimea) and calls off the promotion of democracy in Russia's sphere, which Putin considers an attempt to undermine his rule. As we argued during the Ukraine invasion, it is the U.S., not Russia, which poses the greatest risk of destabilization.32 The U.S. lacks constraints in this theater. It can be aggressive towards Russia and face zero consequences: it has no economic relationship with Russia and does not stand directly in the way of any Russian reprisals, unlike Europe. That is why we think Trump and Putin will reset relations. Trump's team may be comfortable with Russia having a sphere of influence, unlike the Obama administration, which explicitly rejected this idea. The U.S. could even pledge not to expand NATO further, given that it has already expanded as far as it can feasibly and credibly go. Note, however, that a Russo-American truce may not last long. George W. Bush famously "looked into Putin's eyes and ... saw his soul," but relations soured nonetheless. Obama went further with his "Russian reset," removing European missile defense plans from Poland and the Czech Republic. These are avowed NATO allies, and this occurred merely one year after Russian troops marched on Georgia. And yet Moscow and Washington ended up rattling sabers and meddling in each other's internal affairs anyway. Chart 37Thaw In Russian-West##br## Cold War Is Bullish Europe Ultimately, U.S. resets fail because Russia is in structural decline and attempting to hold onto a very large sphere of influence whose citizens are not entirely willing participants.33 Because Moscow must often use blunt force to prevent the revolt of its vassal states (e.g. Georgia in 2008, Ukraine in 2014), it periodically revives tensions with the West. Unless Russia strengthens significantly in the next few years, which we do not expect, then the cycle of tensions will continue. On the horizon may be Ukraine-like incidents in neighboring Belarus and Kazakhstan, both key components of the Russian sphere of influence. Bottom Line: Russia will get a reprieve from U.S. pressure. While we expect Europe to extend sanctions through 2017, a rapprochement with Washington will ultimately thaw relations between Europe and Russia by the end of that year. Europe will benefit from resuming business as usual. It will face less of a risk of Russian provocations via the Middle East and cybersecurity. The ebbing of the Russian geopolitical risk premium will have a positive effect on Europe, given its close correlation with European risk assets since the crisis in Ukraine (Chart 37). Investors who want exposure to Russia may consider overweighing Russian equities to Malaysian. BCA's Emerging Market Strategy has initiated this position for a 55.6% gain since March 2016 and our EM strategists believe there is more room to run for this trade. We recommend that investors simply go long Russia relative to the broad basket of EM equities. The rally in oil prices, easing of the geopolitical risk premium, and hints of pro-market reforms from the Kremlin will buoy Russian equities further in 2017. Middle East: ISIS Defeat Is A Black Swan In February 2016, we made two bold predictions about the Middle East: Iran-Saudi tensions had peaked;34 The defeat of ISIS would entice Turkey to intervene militarily in both Iraq and Syria.35 The first prediction was based on a simple maxim: sustained geopolitical conflict requires resources and thus Saudi military expenditures are unsustainable when a barrel of oil costs less than $100. Saudi Arabia overtook Russia in 2015 as the globe's third-largest defense spender (Chart 38)! Chart 38Saudi Arabia: Lock And Load The mini-détente between Iran and Saudi Arabia concluded in 2016 with the announced OPEC production cut and freeze. While we continue to see the OPEC deal as more of a recognition of the status quo than an actual cut (because OPEC production has most likely reached its limits), nevertheless it is significant as it will slightly hasten the pace of oil-market rebalancing. On the margin, the OPEC deal is therefore bullish for oil prices. Our second prediction, that ISIS is more of a risk to the region in defeat than in glory, was highly controversial. However, it has since become consensus, with several Western intelligence agencies essentially making the same claim. But while our peers in the intelligence community have focused on the risk posed by returning militants to Europe and elsewhere, our focus remains on the Middle East. In particular, we fear that Turkey will become embroiled in conflicts in Syria and Iraq, potentially in a proxy war with Iran and Russia. The reason for this concern is that the defeat of the Islamic State will create a vacuum in the Middle East that the Syrian and Iraqi Kurds are most likely to fill. This is unacceptable to Turkey, which has intervened militarily to counter Kurdish gains and may do so in the future. We are particularly concerned about three potential dynamics: Direct intervention in Syria and Iraq: The Turkish military entered Syria in August, launching operation "Euphrates Shield." Turkey also reinforced a small military base in Bashiqa, Iraq, only 15 kilometers north of Mosul. Both operations were ostensibly undertaken against the Islamic State, but the real intention is to limit the Syrian and Iraqi Kurds. As Map 1 illustrates, Kurds have expanded their territorial control in both countries. Map 1Kurdish Gains In Syria & Iraq Conflict with Russia and Iran: President Recep Erdogan has stated that Turkey's objective in Syria is to remove President Bashar al-Assad from power.36 Yet Russia and Iran are both involved militarily in the country - the latter with regular ground troops - to keep Assad in power. Russia and Turkey did manage to cool tensions recently. Yet the Turkish ground incursion into Syria increases the probability that tensions will re-emerge. Meanwhile, in Iraq, Erdogan has cast himself as a defender of Sunni Arabs and has suggested that Turkey still has a territorial claim to northern Iraq. This stance would put Ankara in direct confrontation with the Shia-dominated Iraqi government, allied with Iran. Turkey-NATO/EU tensions: Tensions have increased between Turkey and the EU over the migration deal they signed in March 2016. Turkey claims that the deal has stemmed the flow of migrants to Europe, which is dubious given that the flow abated well before the deal was struck. Since then, Turkey has threatened to open the spigot and let millions of Syrian refugees into Europe. This is likely a bluff as Turkey depends on European tourists, import demand, and FDI for hard currency (Chart 39). If Erdogan acted on his threat and unleashed Syrian refugees into Europe, the EU could abrogate the 1995 EU-Turkey customs union agreement and impose economic sanctions. The Turkish foray into the Middle East poses the chief risk of a "shooting war" that could impact global investors in 2017. While there are much greater geopolitical games afoot - such as increasing Sino-American tensions - this one is the most likely to produce military conflict between serious powers. It would be disastrous for Turkey. The broader point is that the redrawing of the Middle East map is not yet complete. As the Islamic State is defeated, the Sunni population of Iraq and Syria will remain at risk of Shia domination. As such, countries like Turkey and Saudi Arabia could be drawn into renewed proxy conflicts to prevent complete marginalization of the Sunni population. While tensions between Turkey, Russia, and Iran will not spill over into oil-producing regions of the Middle East, they may cloud Iraq's future. Since 2010, Iraq has increased oil production by 1.6 million barrels per day. This is about half of the U.S. shale production increase over the same time frame. As such, Iraq's production "surprise" has been a major contributor to the 2014-2015 oil-supply glut. However, Iraq needs a steady inflow of FDI in order to boost production further (Chart 40). Proxy warfare between Turkey, Russia, and Iran - all major conventional military powers - on its territory will go a long way to sour potential investors interested in Iraqi production. Chart 39Turkey Is Heavily Dependent On The EU Chart 40Iraq Is The Big, And Cheap, Hope This is a real problem for global oil supply. The International Energy Agency sees Iraq as a critical source of future global oil production. Chart 41 shows that Iraq is expected to contribute the second-largest increase in oil production by 2020. And given Iraq's low breakeven production cost, it may be the last piece of real estate - along with Iran - where the world can get a brand-new barrel of oil for under $13. In addition to the risk of expanding Turkish involvement in the region, investors will also have to deal with the headline risk of a hawkish U.S. administration pursuing diplomatic brinkmanship against Iran. We do not expect the Trump administration to abrogate the Iran nuclear deal due to several constraints. First, American allies will not go along with new sanctions. Second, Trump's focus is squarely on China. Third, the U.S. does not have alternatives to diplomacy, since bombing Iran would be an exceedingly complex operation that would bog down American forces in the Middle East. When we put all the risks together, a geopolitical risk premium will likely seep into oil markets in 2017. BCA's Commodity & Energy Strategy argues that the physical oil market is already balanced (Chart 42) and that the OPEC deal will help draw down bloated inventories in 2017. This means that global oil spare capacity will be very low next year, with essentially no margin of safety in case of a major supply loss. Given the political risks of major oil producers like Nigeria and Venezuela, this is a precarious situation for the oil markets. Chart 41Iraq Really Matters For Global Oil Production Chart 42Oil Supply Glut Is Gone In 2017 Bottom Line: Given our geopolitical view of risks in the Middle East, balanced oil markets, lack of global spare capacity, the OPEC production cut, and ongoing capex reductions, we recommend clients to follow BCA's Commodity & Energy Strategy view of expecting widening backwardation in the new year.37 U.S.-China: From Rivalry To Proxy Wars President-elect Trump has called into question the U.S.'s adherence to the "One China policy," which holds that "there is but one China and Taiwan is part of China" and that the U.S. recognizes only the People's Republic of China as the legitimate Chinese government. There is widespread alarm about Trump's willingness to use this policy, the very premise of U.S.-China relations since 1978, as a negotiating tool. And indeed, Sino-U.S. relations are very alarming, as we have warned our readers since 2012.38 Trump is a dramatic new agent reinforcing this trend. Trump's suggestion that the policy could be discarded - and his break with convention in speaking to the Taiwanese president - are very deliberate. Observe that in the same diplomatic document that establishes the One China policy, the United States and China also agreed that "neither should seek hegemony in the Asia-Pacific region or in any other region." Trump is initiating a change in U.S. policy by which the U.S. accuses China of seeking hegemony in Asia, a violation of the foundation of their relationship. The U.S. is not seeking unilaterally to cancel the One China policy, but asking China to give new and durable assurances that it does not seek hegemony and will play by international rules. Otherwise, the U.S. is saying, the entire relationship will have to be revisited and nothing (not even Taiwan) will be off limits. The assurances that China is expected to give relate not only to trade, but also, as Trump signaled, to the South China Sea and North Korea. Therefore we are entering a new era in U.S-China relations. China Is Toast Asia Pacific is a region of frozen conflicts. Russia and Japan never signed a peace treaty. Nor did China and Taiwan. Nor did the Koreas. Why have these conflicts lain dormant over the past seventy years? Need we ask? Japan, South Korea, Taiwan, and Hong Kong have seen their GDP per capita rise 14 times since 1950. China has seen its own rise 21 times (Chart 43). Since the wars in Vietnam over forty years ago, no manner of conflict, terrorism, or geopolitical crisis has fundamentally disrupted this manifestly beneficial status quo. As a result, Asia has been a region synonymous with economics - not geopolitics. It developed this reputation because its various large economies all followed Japan's path of dirigisme: export-oriented, state-backed, investment-led capitalism. This era of stability is over. The region has become the chief source of geopolitical risk and potential "Black Swan" events.39 The reason is deteriorating U.S.-China relations and the decline in China's integration with other economies. The Asian state-led economic model was underpinned by the Pax Americana. Two factors were foundational: America's commitment to free trade and its military supremacy. China was not technically an ally, like Japan and Korea, but after 1979 it sure looked like one in terms of trade surpluses and military spending (Chart 44).40 For the sake of containing the Soviet Union, the U.S. wrapped East Asia under its aegis. Chart 43The Twentieth Century Was Kind To East Asia Chart 44Asia Sells, America Rules It is well known, however, that Japan's economic model led it smack into a confrontation with the U.S. in the 1980s over its suppressed currency and giant trade surpluses. President Ronald Reagan's economic team forced Japan to reform, but the result was ultimately financial crisis as the artificial supports of its economic model fell away (Chart 45). Astute investors have always suspected that a similar fate awaited China. It is unsustainable for China to seize ever greater market share and drive down manufacturing prices without reforming its economy to match G7 standards, especially if it denies the U.S. access to its vast consumer market. Today there are signs that the time for confrontation is upon us: Since the Great Recession, U.S. household debt and Chinese exports have declined as a share of GDP, falling harder in the latter than the former, in a sign of shattered symbiosis (see Chart 8 above). Chinese holdings of U.S. Treasurys have begun to decline (Chart 46). China's exports to the U.S., both as a share of total exports and of GDP, have rolled over, and are at levels comparable to Japan's 1980s peaks (Chart 47). China is wading into high-tech and advanced industries, threatening the core advantages of the developed markets. The U.S. just elected a populist president whose platform included aggressive trade protectionism against China. Protectionist "Rust Belt" voters were pivotal to Trump's win and will remain so in future elections. China is apparently reneging on every major economic promise it has made in recent years: the RMB is depreciating, not appreciating, whatever the reason; China is closing, not opening, its capital account; it is reinforcing, not reforming, its state-owned companies; and it is shutting, not widening, access to its domestic market (Chart 48). Chart 45Japan's Crisis Followed Currency Spike Chart 46China Backing Away From U.S. Treasuries There is a critical difference between the "Japan bashing" of the 1980s-90s and the increasingly potent "China bashing" of today. Japan and the U.S. had established a strategic hierarchy in World War II. That is not the case for the U.S. and China in 2017. Unlike Japan, Korea, or any of the other Asian tigers, China cannot trust the United States to preserve its security. Far from it - China has no greater security threat than the United States. The American navy threatens Chinese access to critical commodities and export markets via the South China Sea. In a world that is evolving into a zero-sum game, these things suddenly matter. Chart 47The U.S. Will Get Tougher On China Trade Chart 48China Is De-Globalizing That means that when the Trump administration tries to "get tough" on longstanding American demands, these demands will not be taken as well-intentioned or trustworthy. We see Sino-American rivalry as the chief geopolitical risk to investors in 2017: Trump will initiate a more assertive U.S. policy toward China;41 It will begin with symbolic or minor punitive actions - a "shot across the bow" like charging China with currency manipulation or imposing duties on specific goods.42 It will be critical to see whether Trump acts arbitrarily through executive power, or systematically through procedures laid out by Congress. The two countries will proceed to a series of high-level, bilateral negotiations through which the Trump administration will aim to get a "better deal" from the Xi administration on trade, investment, and other issues. The key to the negotiations will be whether the Trump team settles for technical concessions or instead demands progress on long-delayed structural issues that are more difficult and risky for China to undertake. Too much pressure on the latter could trigger a confrontation and broader economic instability. Chart 49China's Demographic Dividend Is Gone The coming year may see U.S.-China relations start with a bang and end with a whimper, as Trump's initial combativeness gives way to talks. But make no mistake: Sino-U.S. rivalry and distrust will worsen over the long run. That is because China faces a confluence of negative trends: The U.S. is turning against it. Geopolitical problems with its periphery are worsening. It is at high risk of a financial crisis due to excessive leverage. The middle class is a growing political constraint on the regime. Demographics are now a long-term headwind (Chart 49). The Chinese regime will be especially sensitive to these trends because the Xi administration will want stability in the lead up to the CCP's National Party Congress in the fall, which promises to see at least some factional trouble.43 It no longer appears as if the rotation of party leaders will leave Xi in the minority on the Politburo Standing Committee for 2017-22, as it did in 2012.44 More likely, he will solidify power within the highest decision-making body. This removes an impediment to his policy agenda in 2017-22, though any reforms will still take a back seat to stability, since leadership changes and policy debates will absorb a great deal of policymakers' attention at all levels for most of the year.45 Xi will also put in place his successors for 2022, putting a cap on rumors that he intends to eschew informal term limits. Failing this, market uncertainty over China's future will explode upward. The midterm party congress will thus reaffirm the fact that China's ruling party and regime are relatively unified and centralized, and hence that China has relatively strong political capabilities for dealing with crises. Evidence does not support the popular belief that China massively stimulates the economy prior to five-year party congresses (Chart 50), but we would expect all means to be employed to prevent a major downturn. Chart 50Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses What this means is that the real risks of the U.S.-China relationship in 2017 will emanate from China's periphery. Asia's Frozen Conflicts Are Thawing Today the Trump administration seems willing to allow China to carve a sphere of influence - but it is entirely unclear whether and where existing boundaries would be redrawn. Here are the key regional dynamics:46 The Koreas: The U.S. and Japan are increasingly concerned about North Korea's missile advances but will find their attempts to deal with the problem blocked by China and likely by the new government in South Korea.47 U.S. threats of sanctioning China over North Korea will increase market uncertainty, as will South Korea's political turmoil and (likely) souring relations with the U.S. Taiwan: Taiwan's ruling party has very few domestic political constraints and therefore could make a mistake, especially when emboldened by an audacious U.S. leadership.48 The same combination could convince China that it has to abandon the post-2000 policy of playing "nice" with Taiwan.49 China will employ discrete sanctions against Taiwan. Hong Kong: Mainland forces will bring down the hammer on the pro-independence movement. The election of a new chief executive will appear to reinforce the status quo but in reality Beijing will tighten its legal, political, and security grip. Large protests are likely; political uncertainty will remain high.50 Japan: Japan will effectively receive a waiver from Trump's protectionism and will benefit from U.S. stimulus efforts; it will continue reflating at home in order to generate enough popular support to pass constitutional revisions in 2018; and it will not shy away from regional confrontations, since these will enhance the need for the hawkish defense component of the same revisions. Vietnam: The above issues may provide Vietnam with a chance to improve its strategic position at China's expense, whether by courting U.S. market access or improving its position in the South China Sea. But the absence of an alliance with the U.S. leaves it highly exposed to Chinese reprisals if it pushes too far. Russia: Russia will become more important to the region because its relations with the U.S. are improving and it may forge a peace deal with Japan, giving it more leverage in energy negotiations with China.51 This may also reinforce the view in Beijing that the U.S. is circling the wagons around China. What these dynamics have in common is the emergence of U.S.-China proxy conflicts. China has long suspected that the Obama administration's "Pivot to Asia" was a Cold War "containment" strategy. The fear is well-grounded but the reality takes time to materialize, which is what we will see playing out in the coming years. The reason we say "proxy wars" is because several American allies are conspicuously warming up to China: Thailand, the Philippines, and soon South Korea. They are not abandoning the U.S. but keeping their options open. The other ASEAN states also stand to benefit as the U.S. seeks economic substitutes for China while the latter courts their allegiance.52 The problem is that as U.S.-China tensions rise, these small states run greater risks in playing both sides. Bottom Line: The overarching investment implications of U.S.-China proxy wars all derive from de-globalization. China was by far the biggest winner of globalization and will suffer accordingly (Chart 51). But it will not be the biggest loser, since it is politically unified, its economy is domestically driven, and it has room to maneuver on policy. Hong Kong, Taiwan, South Korea, and Singapore are all chiefly at risk from de-globalization over the long run. Chart 51Globalization's Winners Will Be De-Globalization's Losers Japan is best situated to prosper in 2017. We have argued since well before the Bank of Japan's September monetary policy shift that unconventional reflation will continue, with geopolitics as the primary motivation for the country's "pedal to the metal" strategy.53 We will look to re-initiate our long Japanese equities position in early 2017. ASEAN countries offer an opportunity, though country-by-country fundamentals are essential. Brexit: The Three Kingdoms The striking thing about the Brexit vote's aftermath is that no recession followed the spike in uncertainty, no infighting debilitated the Tory party, and no reversal occurred in popular opinion. The authorities stimulated the economy, the people rallied around the flag (and ruling party), and the media's "Bregret" narrative flopped. That said, Brexit also hasn't happened yet.54 Formal negotiations with Europe begin in March, which means uncertainty will persist for much of the year as the U.K. and EU posture around their demands for a post-exit deal. However, improving growth prospects for Britain, Europe, and the U.S. all suggest that the negotiations are less likely to take place in an atmosphere of crisis. That does not mean that EU negotiators will be soft. With each successive electoral victory for the political establishment in 2017, the European negotiating position will harden. This will create a collision of Triumphant Tories and Triumphant Brussels. Still, the tide is not turning much further against the U.K. than was already the case, given how badly the U.K. needs a decent deal. Tightercontrol over the movement of people will be the core demand of Westminster, but it is not necessarily mutually exclusive with access to the common market. The major EU states have an incentive to compromise on immigration with the U.K. because they would benefit from tighter immigration controls that send highly qualified EU nationals away from the U.K. labor market and into their own. But the EU will exact a steep price for granting the U.K. the gist of what it wants on immigration and market access. This could be a hefty fee or - more troublingly for Britain - curbs on British financial-service access to euro markets. Though other EU states are not likely to exit, the European Council will not want to leave any doubt about the pain of doing so. The Tories may have to accept this outcome. Tory strength is now the Brexit voter base. That base is uncompromising on cutting immigration, and it is indifferent, or even hostile, to the City. So it stands to reason that Prime Minister Theresa May will sacrifice the U.K.'s financial sector in the coming negotiations. The bigger question is what happens to the U.K. economy in the medium and long term. First, it is unclear how the U.K. will revive productivity as lower labor-force growth and FDI, and higher inflation, take shape. Government "guidance" of the economy - dirigisme again - is clearly the Tory answer. But it remains to be seen how effectively it will be done. Second, what happens to the United Kingdom as a nation? Another Scottish independence referendum is likely after the contours of the exit deal take shape, especially as oil prices gin up Scottish courage to revisit the issue. The entire question of Scotland and Northern Ireland (both of which voted to stay in the EU) puts deeper constitutional and governmental restructuring on the horizon. Westminster is facing a situation where it drastically loses influence on the global stage as it not only exits the European "superstate" but also struggles to maintain a semblance of order among the "three kingdoms." Bottom Line: The two-year timeframe for exit negotiations ensures that posturing will ratchet up tensions and uncertainty throughout the year - invoking the abyss of a no-deal exit - but our optimistic outlook on the end-game (eventual "soft Brexit") suggests that investors should fade the various crisis points. That said, the pound is no longer a buy as it rises to around 1.30. Investment Views De-globalization, dirigisme, and the ascendancy of charismatic authority will all prove to be inflationary. On the margin, we expect less trade, less free movement of people, and more direct intervention in the economy. Given that these are all marginally more inflationary, it makes sense to expect the "End Of The 35-Year Bond Bull Market," as our colleague Peter Berezin argued in July.55 That said, Peter does not expect the bond bull market to end in a crash - and neither do we. There are many macroeconomic factors that will continue to suppress global yields: the savings glut, search for yield, and economic secular stagnation. In addition, we expect peak multipolarity in 2017 and thus a rise in geopolitical conflict. This geopolitical context will keep the U.S. Treasury market well bid. However, clients may want to begin switching their safe-haven exposure to gold. In a recent research report on safe havens, we showed that gold and Treasurys have changed places as safe havens in the past.56 Only after 2000 did Treasurys start providing a good hedge to equity corrections due to geopolitical and financial risks. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but has since become correlated with S&P 500 total returns. As deflationary risks abate in the future, we suspect that gold will return to its safe-haven status. In addition to safe havens, U.S. and global defense stocks will be well bid due to global multipolarity. We recommend that clients go long S&P 500 aerospace and defense relative to global equities on a strategic basis. We are also sticking with our tactical trade of long U.S. defense / short U.S. aerospace. On the equity front, we have closed our post-election bullish trade of long S&P 500 / short gold position for an 11.53% gain in just 22 days of trading. We are also closing our long S&P 600 / short S&P 100 position - a play on de-globalization - for an 8.4% gain. Instead, we are initiating a strategic long U.S. small caps / short U.S. large caps, recommended jointly with our colleague Anastasios Avgeriou of the BCA Global Alpha Sector Strategy. We are keeping our EuroStoxx VIX term-structure hedge due to mounting political risk in Europe. However, we are looking for an opening into European stocks in early 2017. For now, we are maintaining our long USD/EUR - return 4.2% since July - and long USD/SEK - return 2.25% since November. The first is a strategic play on our view that the ECB has to remain accommodative due to political risks in the European periphery. The latter is a way to articulate de-globalization via currencies, given that Sweden is one of the most open economies in the world. We are converting it from a tactical to a strategic recommendation. Finally, we are keeping our RMB short in place - via 12-month NDF. We do not think that Beijing will "blink" and defend its currency more aggressively just because Donald Trump is in charge of America. China is a much more powerful country than in the past, and cannot allow RMB appreciation at America's bidding. Our trade has returned 7.14% since December 2015. With the dollar bull market expected to continue and RMB depreciating, the biggest loser will be emerging markets. We are therefore keeping our strategic long DM / short EM recommendation, which has returned 56.5% since November 2012. We are particularly fond of shorting Brazilian and Turkish equities and are keeping both trades in place. However, we are initiating a long Russian equities / short EM equities. As an oil producer, Russia will benefit from the OPEC deal and the ongoing risks to Iraqi stability. In addition, we expect that removing sanctions against Russia will be on table for 2017. Europe will likely extend the sanctions for another six months, but beyond that the unity of the European position will be in question. And the United States is looking at a different approach. We wish our clients all the best in health, family, and investing in 2017. Thank you for your confidence in BCA's Geopolitical Strategy. Marko Papic Senior Vice President Matt Gertken Associate Editor Jesse Anak Kurri Research Analyst 1 In Michel Foucault's famous The Order of Things (1966), he argues that each period of human history has its own "episteme," or set of ordering conditions that define that epoch's "truth" and discourse. The premise is comparable to Thomas Kuhn's notion of "paradigms," which we have referenced in previous Strategic Outlooks. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2012," dated January 27, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2013," dated January 16, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com and Global Investment Strategy Special Report, "Underestimating Sino-American Tensions," dated November 6, 2015, available at gis.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, and "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2014 - Stay The Course: EM Risk - DM Reward," dated January 23, 2014, and Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 8 Please see BCA The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 10 A military-security strategy necessary for British self-defense that also preserved peace on the European continent by undermining potential aggressors. 11 Please see BCA Global Investment Strategy Special Report, "Trump And Trade," dated December 8, 2016, available at gis.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see Max Weber, "The Three Types Of Legitimate Rule," Berkeley Publications in Society and Institutions 4 (1): 1-11 (1958). Translated by Hans Gerth. Originally published in German in the journal Preussische Jahrbücher 182, 1-2 (1922). 16 We do not concern ourselves with traditional authority here, but the obvious examples are Persian Gulf monarchies. 17 Please see Francis Fukuyama, Political Order And Political Decay (New York: Farrar, Straus and Giroux, 2014). See also our review of this book, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 19 Please see Irving Fisher, "The Debt-deflation Theory of Great Depressions," Econometrica 1(4) (1933): 337-357, available at fraser.stlouisfed.org. 20 Please see Milanovic, Branko, "Global Income Inequality by the Numbers: in History and Now," dated November 2012, Policy Research Working Paper 6250, World Bank, available at worldbank.org. 21 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," June 8, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 23 In some way, BCA's Geopolitical Strategy was designed precisely to fill this role. It is difficult to see what would be the point of this service if our clients could get unbiased, investment-relevant, prescient, high-quality geopolitical news and analysis from the press. 24 Please see BCA European Investment Strategy Weekly Report, "Roller Coaster," dated March 31, 2016, available at eis.bcaresearch.com. 25 Please see The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at bca.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Client Note, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 28 Despite winning an extraordinary six of the 13 continental regions in France in the first round, FN ended up winning zero in the second round. This even though the election occurred after the November 13 terrorist attack that ought to have buoyed the anti-migration, law and order, anti-establishment FN. The regional election is an instructive case of how the French two-round electoral system enables the establishment to remain in power. 29 Please see BCA European Investment Strategy Weekly Report, "Italy: Asking The Wrong Question," dated December 1, 2016, available at eis.bcaresearch.com. 30 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 31 Please see BCA Geopolitical Strategy Special Report, "Cold War Redux?" dated March 12, 2014, and Geopolitical Strategy Special Report, "Russia: To Buy Or Not To Buy?" dated March 20, 2015, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Russia-West Showdown: The West, Not Putin, Is The 'Wild Card,'" dated July 31, 2014, available at gps.bcaresearch.com. 33 Please see BCA's Emerging Markets Strategy Special Report, "Russia's Trilemma And The Coming Power Paralysis," dated February 21, 2012, available at ems.bcaresearch.com. 34 Please see BCA Geopolitical Strategy, "Middle East: Saudi-Iranian Tensions Have Peaked," in Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 35 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 36 President Erdogan, speaking at the first Inter-Parliamentary Jerusalem Platform Symposium in Istanbul in November 2016, said that Turkey "entered [Syria] to end the rule of the tyrant al-Assad who terrorizes with state terror... We do not have an eye on Syrian soil. The issue is to provide lands to their real owners. That is to say we are there for the establishment of justice." 37 Please see BCA Commodity & Energy Strategy Weekly Report, "2017 Commodity Outlook: Energy," dated December 8, 2016, available at ces.bcaresearch.com. 38 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 39 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 40 In recent years, however, China's "official" defense budget statistics have understated its real spending, possibly by as much as half. 41 Please see "U.S. Election Update: Trump, Presidential Powers, And Investment Implications" in BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 42 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 43 Please see BCA Geopolitical Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 44 Please see BCA Geopolitical Strategy Monthly Report, "China: Two Factions, One Party - Part II," dated September 2012, available at gps.bcaresearch.com. 45 The National Financial Work Conference will be one key event to watch for an updated reform agenda. 46 Please see "East Asia: Tensions Simmer ... Will They Boil?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 47 Please see "North Korea: A Red Herring No More?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 48 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, and "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 49 The Trump administration has signaled a policy shift through Trump's phone conversation with Taiwanese President Tsai Ing-wen. The "One China policy" is the foundation of China-Taiwan relations, and U.S.-China relations depend on Washington's acceptance of it. The risk, then, is not so much an overt change to One China, a sure path to conflict, but the dynamic described above. 50 Please see BCA China Investment Strategy Weekly Report, "Hong Kong: From Politics To Political Economy," dated September 8, 2016, available at cis.bcaresearch.com. 51 Please see BCA Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 52 Please see "Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW" in BCA Emerging Markets Strategy Weekly Report, "The EM Rally: Running Out Of Steam?" dated October 19, 2016, and Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 53 Please see BCA Geopolitical Strategy Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, and "Unleash The Kraken: Debt Monetization And Politics," dated September 26, 2016, available at gps.bcaresearch.com. 54 Please see BCA Geopolitical Strategy Special Report, "BREXIT Update: Brexit Means Brexit, Until Brexit," dated September 16, 2016, available at gps.bcaresearch.com. 55 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 56 Please see Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 15, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

Special Report

Highlights Trump's foreign policy proposals will exacerbate geopolitical risks. Sino-American relations are the chief risk - they will determine global stability. A Russian reset will benefit Europe, especially outside the Russian periphery. Trump will retain the gist of the Iran nuclear deal. Turkey and North Korea are wildcards. Feature Chart 1Market Rally Redoubled After Trump's Win Financial markets rallied sharply after the election of Donald Trump and the resulting prospect of lower taxes, fewer regulations, and greater fiscal thrust (Chart 1). But is the euphoria justified in light of Trump's unorthodox views on U.S. foreign policy and trade? Is Trump's "normalization" amid the transition to the White House a reliable indicator that the geopolitical status quo will largely be preserved? We believe Trump's election marks a substantial increase in geopolitical risk that is being understated by markets.1 This is not because of his personality, though that is not particularly reassuring, but rather because of his policy proposals. If acted on, Trump's geopolitical agenda would exacerbate global trends that are already underway: Waning U.S. Dominance: American power, relative to other nations, has been declining in recent years as a result of the emergence of new economic and military powers like China and India (Chart 2). If Trump allows himself to be sucked into another conflict despite his campaign promises - say, by overturning the nuclear deal with Iran - he could embroil the U.S. at a time when it is relatively weak. Multipolarity: America's relative decline has emboldened various other nations to pursue their interests independently, increasing global friction and creating a world with multiple "poles" of influence.2 If Trump keeps his word on reducing foreign commitments he will speed along this historically dangerous process. Lesser powers like Russia and Turkey will try to fill vacuums created by the U.S. with their own ambitions, with competition for spheres of influence potentially sparking conflict. Multipolarity has already increased the incidence of global conflicts (Chart 3). De-Globalization: The greatest risk of the incoming administration is protectionism. Trump ran on an overtly protectionist platform. Democratic-leaning economic patriots in the American "Rust Belt" handed him the victory (Chart 4), and he will enact policies to maintain these pivotal supporters in 2018 and 2020 elections. This will hasten the decline of trade globalization, which we signaled was peaking back in 2014.3 It does not help that multipolarity and collapse of globalization have tended to go hand in hand in the past. And historically speaking, big reversals in global trade do not end well (Chart 5). Chart 2U.S. Power Eroding In A Relative Sense Chart 3Multipolarity Increases Conflict Frequency Chart 5Declines In Global Trade Preceded World Wars In what follows we assess what we think are likely to be the most important geopolitical effects of Trump's "America First" policies. We see Russia and Europe as the chief beneficiaries, and China and Iran as the chief risks. A tougher stance on China, in particular, will feed broader strategic distrust; the combination of internal and external pressures on China will ensure that the latter will not be as flexible as in the past. For the past five years, BCA's Geopolitical Strategy has stressed that the deterioration in Sino-American cooperation is the greatest geopolitical risk for investors - and the world. Trump's election will accelerate this process. Trump And Eurasia Trump's election is clearly a boon for Russia. Over the past 16 years, Russia has methodically attempted to collect the pieces from the Soviet collapse. The purpose of Putin's assertiveness has been to defend the Russian sphere of influence (namely Ukraine and Belarus in Europe, the Caucasus, and Central Asia) from outside powers: the U.S. and NATO seemed eager to "move in for the kill" after Russia emerged from the ashes. Putin also needed to rally popular support at various times by distracting the public with "rally around the flag" operations. We view Ukraine and Syria through this analytical prism. Lastly, Russia acted aggressively because it needed to reassure its allies that it would stand up for them.4 And yet the U.S. can live with a "strong" Russia. It can make a deal with Russia if the Trump administration recognizes some core interests (e.g. Crimea) and calls off the "democracy promotion" activities that Putin considers to be directly aimed at the Kremlin. As we argued during the Ukraine invasion, it is the U.S., not Russia, which poses the greatest risk of destabilization.5 That is because the U.S. lacks constraints. It can be aggressive towards Russia and face zero consequences: it has no economic relationship with Russia (Chart 6) and does not stand directly in the way of any retaliation, as Europe does. That is why we think Trump and Putin will manage to reset relations. The U.S. can step back and allow Russia to control its sphere of influence. Trump's team may be comfortable with the concept, unlike the Obama administration, whose Vice-President Joe Biden famously pronounced that America "will not recognize any nation having a sphere of influence." We could even see the U.S. pledging not to expand NATO from this point onwards, given that it has already expanded as far as it can feasibly and credibly go. Note, however, that a Russo-American truce may not last long. George W. Bush famously "looked into Putin's eyes and ... saw his soul," but relations soured nonetheless. Obama went further with his "Russian reset," removing European missile defense plans from avowed NATO allies Poland and Czech Republic merely one year after Russian troops invaded Georgia. And yet Moscow and Washington ended up rattling sabers and meddling in each other's internal affairs. Ultimately, U.S. resets fail because Russia is in a structural decline as a great power and is attempting to hold on to a very large sphere of influence whose denizens are not entirely willing participants.6 Because Moscow often must use blunt force to prevent the revolt of its vassal states (e.g. Georgia in 2008, Ukraine in 2014), it renews tensions with the West. Unless Russia strengthens significantly in the next few years, we would expect the cycle to continue. On the horizon may be Ukraine-like incidents in neighboring Belarus and Kazakhstan, both key components of the Russian sphere of influence. Bottom Line: Russia will get a reprieve from U.S. pressure under Trump. While we expect Europe to extend sanctions through the end of 2017, a rapprochement with Washington could ultimately thaw relations by the end of next year. Europe stands to benefit, being able to resume business as usual with Russia and face less of a risk of Russian provocations via the Middle East, like in Syria. The recent decline in refugee flows will be made permanent with Russia's cooperation. The losers will be states in the Russian periphery that will feel less secure about American, EU and NATO backing, particularly Ukraine, but also Turkey. Countries like Belarus, which enjoyed playing Moscow against the West in the past, will lose the ability to do so. Once the U.S. abandons plans to prop up pro-West regimes in the Russian sphere of influence, Europeans will drop their designs to do the same as well. Trump And The Middle East Trump's "America First" foreign policy promises to be Obama's "geopolitical deleveraging" on steroids. He is opposed to American adventurism and laser-focused on counter-terrorism and U.S. domestic security. He also wants to deregulate the U.S. energy sector aggressively to encourage even greater energy independence (Chart 7). The chief difference from Obama - and a major risk to global stability - is Iran, where Trump could overturn the Obama administration's 2015 nuclear deal, potentially setting the two countries back onto the path of confrontation. Nevertheless, this deal never depended on Obama's preferences but was rooted in a strategic logic that still holds:7 Iraqi stability: The U.S. needed to withdraw troops from Iraq without creating a power vacuum that would open up a regional war or vast terrorist safe haven. With the advent of the Islamic State, this plan clearly failed. However, Iran did provide a Shia-led central government that has maintained security for investments and oil outflows (Chart 8). Iranian defenses: Bombing Iran is extremely difficult logistically, and the U.S. did not want to force the country into a corner where asymmetric warfare, like cutting off shipping in the Straits of Hormuz, seemed necessary. Despite growing American oil production, the U.S. will always care about the transit of oil through the Straits of Hormuz, as this impacts global oil prices.8 China's emergence: Strategic threats grew rapidly in Asia while the U.S. was preoccupied in Iraq and Afghanistan. China has emerged as a more technologically advanced and assertive global power that threatens to establish hegemony in the region. The deal with Iran was therefore a crucial piece of President Obama's "Pivot to Asia" strategy. Chart 7U.S. Becoming More Energy Independent Chart 8U.S. Policy Boosts Iraqi And Iranian Oil None of the above will change with Obama's moving on. Nor will the other powers that participated in sanctioning Iran (Germany, France, the U.K., Russia, and China) be convinced to re-impose sanctions now, just as they gain access to Iranian resources and markets. It is also not clear why Trump would seek confrontation with Iran in light of his desire to improve relations with Russia and concentrate U.S. firepower on ISIS - both objectives make Iran the ideal and obvious partner. Trump will therefore begrudgingly agree to the détente with Iran, perhaps after tweaking some aspects of the deal to save face. Meanwhile, it will serve the hawks in both countries if they can go back to calling each other "Satan." Iran itself is comfortable with the current situation, so it does not have an incentive to reverse the deal. It controls almost half of Iraq (and specifically the portion of Iraq that produces oil), its ally Hezbollah is safe in Lebanon, its ally Bashar Assad will win in Syria (more so with Trump in charge!), and its allies in Yemen (Houthi rebels) are a status quo power secure in a mountain fortress in the north of the country. It is hard to see where Trump would dislodge Iranian influence if he sought to do so. The U.S. is a powerful country that could put a lot of resources into rolling back Iranian influence, but the logic for such a move simply does not exist. Trump will also maintain Obama's aloof policy toward Saudi Arabia, which keeps it constrained (Chart 9).9 The country is in some ways the stereotype of the "ungrateful ally" that Trump wants to downgrade. For instance, Trump supported the law allowing victims of the September 11 attacks to sue the kingdom (a law that Obama tried unsuccessfully to veto). He has blamed the Saudis for the rise of ISIS and the failure to take care of Syrian refugees. His primary focus is on preventing terrorists from striking the U.S., and to that end he wants to cooperate with Russia and stabilize the region's regimes. This entails the relative neglect of Sunni groups under Shia rule in Syria and Iraq. Indeed, the few issues where the Saudis will welcome Trump - opposition to the Iran nuclear deal, support for Egypt's military ruler Abdel Fattah el-Sisi, and opposition to aggressive democracy promotion - are so far rhetorical, not concrete, commitments. Chart 9Saudi Arabia Sees The U.S. Stepping Back Will Trump get sucked into the region to intervene against ISIS? We do not think so. A bigger risk is Turkey.10 President Recep Erdogan may think that Trump will either be too complacent about Turkish interests in Syria, or that Trump is in fact a "kindred nationalist spirit" who will not prevent Turkey from pursuing its own sphere of influence in Syria and northern Iraq. Trump's foreign policy of "offshore balancing" would call for the U.S. to prevent Turkey from resurrecting any kind of regional empire, especially if it risks a war with Russia and Iran or comes at the cost of regional influence for American allies like the Kurds.11 Turkey will also be starkly at odds on Syria and ISIS. This means Turkey and the U.S. could see already tense relations get substantially worse in 2017. We would not be surprised to see President Trump threaten Erdogan with expulsion from NATO within his first term. Bottom Line: The biggest risk to our view is that Trump rejects the consensus of the intelligence and defense establishment and pushes Iran too far, leading to conflict. We do not think this will happen, but his rhetoric on the nuclear deal has been consistently negative and he seems likely to favor "Middle East hands" for top cabinet positions. He could involve the country in new Middle East entanglements if he does not show discipline in adhering to his non-interventionist preferences - particularly if he overreacts to an attack. Nonetheless, we believe that America's policy of geopolitical deleveraging from the Middle East will continue. Trump may have a mandate to be tough on terrorism from his voters, but he definitely does not have a free hand to commit military resources to the region. Trump And Asia Trump criticized China furiously during the campaign, declaring that he would name China a currency manipulator on his first day in office and threatening to impose a 45% tariff on Chinese imports. However, there is a familiar pattern of China bashing in U.S. presidential elections that leads to no sharp changes in policy.12 Will Trump be different? Some would argue that relations may actually improve, given how bad they already are. First, Trump's chief concern is to fire up the U.S. economy's animal spirits, and that would support China's ailing economy as long as he does not couple his tax cuts and fiscal stimulus with aggressive protectionist measures (Chart 10). Proponents of this view would point out that Trump's tougher measures may be called off when he realizes that the Chinese current account surplus has fallen sharply in recent years (Chart 11), and that the PBoC is propping up the RMB, not suppressing it. Similarly, Trump's China-bashing trade advisor, the former steel executive Dan DiMicco, may not get much traction given that the U.S. has largely shifted to Brazilian steel imports (Chart 12). In short, the U.S. could take a somewhat tougher stance on specific trade spats without provoking a vicious spiral of discriminatory actions. The fact that the U.S. is more exposed than ever to trade with emerging markets only reinforces the idea that it does not want to spark a real trade war (Chart 13). Chart 10A Trump Boom, Sans Protectionism, Would Lift Chinese Growth Chart 11China's Economy Rebalancing Chart 12China Already Lost The Chart 13A Reason To Eschew Protectionism Second, the Obama administration's "Pivot to Asia" and attempts to undermine China's economic influence in the region through the Trans-Pacific Partnership (TPP) have aggravated China with little substantive gain. By contrast, Trump may emphasize American business access to China over Chinese citizens' freedoms - which could reduce the risk of conflict. He may not go beyond symbolic protectionist moves, like the currency manipulation charge, and meanwhile canceling the never-ratified TPP would be a net gain for China.13 In essence, Trump, despite his populist rhetoric, could prove both pragmatic and willing to inherit the traditional Republican stance of business-oriented positive engagement with China. This is a compelling argument and we take it seriously. But it is not our baseline case. Rather, we think Trump will eventually take concrete populist steps that will mark a departure from U.S. policy in recent memory. As mentioned, it was protectionist blue-collar voters in the Midwest who gave Trump the White House, and he will need to retain their loyalty in coming elections. Moreover, the secular flatlining of American wages and the growth of income inequality have moved the median U.S. voter to the left of the economic spectrum, as we have argued.14 Neo-liberal economic policy has fewer powerful proponents than in the recent past. Thus, in the long run, we expect the grand renegotiation with China to fall short of market hopes, and Sino-American tensions to resume their upward trajectory.15 Why are we so pessimistic? Three main reasons: The "Thucydides Trap": Sino-U.S. tensions are fundamentally driven not by trade disputes but by the U.S.'s fear of China's growing capability and ambition.16 Great conflicts in history have often occurred when a new economic and military power emerged and tried to alter the regional political arrangements set up by the dominant power. This was as true in late nineteenth-century Europe, with the rise of Germany vis-à-vis the U.K. and France (Chart 14), as it was in ancient Greece. The rise of Japan in the first half of the twentieth century had a similar effect in Asia (Chart 15). Trump could, of course, endorse Xi's idea of a "new type of great power relations," which is supposed to avoid this problem. But nobody knows what that would look like, and greater trade openness is the only conceivable foundation for it. Chart 15AThe Disruptive Rise Of Germany Chart 15BThe Disruptive Rise Of Japan China's economic imbalances: A caustic dose of trade remedies from the Trump administration will compound internal economic pressures in China resulting from rampant credit expansion, misallocation of capital, excessive money printing, and capital outflows (Chart 16).17 The combination of internal and external pressures is potentially fatal and China's leaders will fight it. Otherwise, they risk either the fate of the Soviets or of the Asian strongman regimes that succumbed to democracy after embracing capitalism fully. Instead, China will avoid rushing its structural reforms (it is, after all, currently closing its capital account), and protect its consumer market, which it hopes to be the growth engine going forward. This is not a strong basis for the "better deal" that Trump will demand. President Trump will want China to open up further to U.S. manufacturing, tech, and service exports. Economics and the security dilemma: China and the U.S. will not be able to prevent economic tensions from spilling over into broader strategic tensions. Compare the spike in trade tensions with Japan in the 1980s, when Japanese exports to the U.S. peaked and the U.S. strong-armed Japan into appreciating its currency (Chart 17). The U.S. had nurtured Japan and South Korea out of their post-war devastation by running large trade deficits and enabling them to focus on manufacturing exports while minimizing spending on defense. China joined this system in the 1980s and has largely resembled the formal U.S. allies (Chart 18). Given that China has largely followed Japan's path, it was inevitable that the U.S. would eventually lose patience and become more competitive with China. China has seized a greater share of the U.S. market than Japan had done at that time, and its exports are even more important to the U.S. as a share of GDP (Chart 19). Comparing the exchange rates then and now, the Trump administration will be able to argue that China's currency is overdue for appreciation (Chart 20). However, in the 1980s, the U.S. and Japan faced no risk of military conflict - their strategic hierarchy was entirely settled in 1945. The U.S. and China have no such understanding. There is no way of assuring China that U.S. economic pressure is not about strategic dominance. In fact, it is about that. So while China may be cajoled into promising faster reforms - given that its trade surplus with the U.S. is the only thing that stands between it and current account deficits (Chart 21) - nevertheless it will tend to dilute and postpone these reforms for the sake of its own security, putting Trump's resolve to the test. Chart 16Flashing Red Light On China's Economy Chart 17The U.S. Forced Structural Changes On Japan Chart 18Asia Sells, America Rules Chart 19The U.S. Will Get Tougher On China Trade Chart 20China Drags Its Feet On RMB Appreciation Chart 21A Reason For China To Kowtow Trump's victory may also heighten Beijing's fears that it is being surrounded by the U.S. and its partners. That is because Trump will make the following developments more likely: Better Russian relations: From a bird's eye view, Trump's thaw with Putin could mark an inversion of Nixon's thaw with Mao. China is the only power today that can stand a comparison with the Soviet Union during the Cold War. The U.S. at least needs to make sure the Sino-Russian relationship does not become too warm (Chart 22).18 Russo-Japanese peace treaty: The two sides are already working on a treaty, never signed after World War II. Aside from their historic territorial dispute, the U.S. has been the main impediment by demanding Japan help penalize Russia after the invasion of Ukraine. Yet negotiations have advanced regardless, and Japanese air force scrambles against Russia have fallen while those against China have continued to spike (Chart 23). The best chance for a deal since the 1950s is now, with Abe and Putin both solidly in power until 2018. This would reduce Russian dependency on China for energy markets and capital investment, and free up Japan's security establishment to focus on China and North Korea. American allies are not defecting: The United States armed forces are deeply embedded in the Asia Pacific region and setbacks to the "pivot" policy should not be mistaken for setbacks to U.S. power in the absolute.19 U.S. allies like Thailand, the Philippines, and (soon) South Korea are in the headlines for seeking to warm up ties with China, but there is no hard evidence that they will turn away from the U.S. security umbrella. Rather, the pivot reassured them of U.S. commitment, giving them the flexibility to focus on boosting their economies, which means sending emissaries to Beijing. The problem is that Beijing knows this and will therefore still suspect that a "containment" strategy is underfoot over time. Better Indian relations: The Bush administration made considerable progress in improving ties with India. Trump also seems India-friendly, which would be supported by better ties with Russia and Iran. India could therefore become a greater obstacle to China's influence in South and Southeast Asia. Chart 22Energy A Solid Foundation For Sino-Russian Ties Chart 23Japan's Strategic Predicament From the above, we can draw three main conclusions: The U.S. role in the Pacific will determine global geopolitical stability under the Trump administration. The primary question is whether China is willing and able to accede to enough of Trump's demands to ensure that the U.S. and China have at least "one more fling," a further extension to the post-1979 trade relationship. It is possible that China is simply unable to do so and in the face of any concrete sanctions by Trump, will batten down the hatches, rally people around the flag, and shore up the state-led economy. There may be a tactical U.S.-China "improvement" over the next year - relative to the worst fears of trade war under Trump - but it will not be durable. The year 2017 will be the year of Trump's "honeymoon," while Xi Jinping will be focused on internal politics ahead of the Communist Party's crucial National Party Congress in the fall.20 Thus, after Trump gives China a "shot across the bow," like charging it with currency manipulation, the two sides will likely settle down at the negotiating table and send positive signals to the world about their time-tried ability to manage tensions. Financial markets will see through Trump's initially symbolic actions and begin to behave as if nothing has changed in U.S.-China relations. However, this calm will be deceiving, since economic and security tensions will eventually rise to the surface again, likely in a more disruptive way than ever before. China's periphery will be decisive, especially the Korean peninsula. The Koreas could become the locus of East Asia tensions for two reasons. First, North Korea's nuclear weaponization has reached a level that is truly alarming to the U.S. and Japan.21 New sanctions, if enforced, have real teeth because they target commodity exports (Chart 24). The problem is that China is unlikely to enforce them and South Korean politics are likely to turn more China-friendly and more pacific toward the North with the impending change of ruling parties. This will leave the U.S. and Japan with legitimate security grievances but less of an ability to change the outcome through non-military means. That is an arrangement ripe for confrontation. Separately, China's worsening relations with Taiwan, Vietnam's resistance to China's power-grab in the South China Sea, and conflicts between India and Pakistan will be key barometers of regional stability vis-à-vis China. Chart 24Will China Cut Imports From Here? The risk to this view, again, is that a Middle East crisis could distract the Trump administration. This would mark an excellent opportunity for China to build on its growing regional sway, and it would delay our baseline view that the Asia Pacific is now the chief source of geopolitical risk in the world. Investment Conclusions There is no geopolitical risk premium associated with Sino-American tensions. Our clients, colleagues, and friends in the industry are at a loss when we ask how one should hedge tensions in the region. This is a major risk for investors as the market will have to price emerging tensions quickly. Broadly speaking, Sino-American tensions will reinforce the ongoing de-globalization. If the top two global economies are at geopolitical loggerheads, they are more likely to see their geopolitical tensions spill over to the economic sphere. Unwinding globalization implies that inflation will make a comeback, as the reduction in flows of goods, services, capital, and people gradually increases supply constraints. This is primarily bad for bonds, which have enjoyed a bull market for the past three decades that we see reversing.22 At the same time, these trends suggest that investors should favor consumer-oriented sectors and countries relative to their export-reliant counterparts, and small-to-medium sized businesses over externally-exposed multinationals. BCA Geopolitical Strategy's long S&P 600 / short S&P 100 trade is up 7.4% since inceptionon November 9. Finally, these trends, combined with the associated geopolitical risks of various powers struggling for elbow room, warrant a continuation of the Geopolitical Strategy theme of favoring Developed Markets over Emerging Markets, which has made a 45.5% return since inception in November 2012. The centrality of China risk only reinforces this view. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 Please see our initial discussion of Trump's foreign policy, "U.S. Election Update: Trump, Presidential Powers, And Investment Implications," in BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization: All Downhill From Here," dated November 12, 2014, and, more recently, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 4 Please see "In Focus - Cold War Redux?" in BCA Geopolitical Strategy Monthly Report, "It's A Long Way Down From The 'Wall Of Worry,'" dated March 2014, and Geopolitical Strategy Special Report, "Russia: To Buy Or Not To Buy?" dated March 20, 2015, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Russia-West Showdown: The West, Not Putin, Is The 'Wild Card,'" dated July 31, 2014, available at gps.bcaresearch.com. 6 Please see BCA's Emerging Markets Strategy Special Report, "Russia's Trilemma And The Coming Power Paralysis," dated February 21, 2012, available at ems.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "End Of An Era For Oil And The Middle East," dated April 8, 2015, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "Saudi Arabia's Choice: Modernity Or Bust," dated May 11, 2016, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "Turkey: Strategy After The Attempted Coup," dated July 18, 2016, available at gps.bcaresearch.com. 11 Please see John J. Meirsheimer and Stephen M. Walt, "The Case For Offshore Balancing: A Superior U.S. Grand Strategy," Foreign Affairs, July/August 2016, available at www.foreignaffairs.com. 12 Please see BCA China Investment Strategy, "China As A Currency Manipulator?" dated November 24, 2016, available at cis.bcaresearch.com. 13 One of his foreign policy advisors, former CIA head James Woolsey, has floated the idea that the U.S. could turn positive about Chinese initiatives like the Asian Infrastructure Investment Bank and the One Belt One Road program to link Eurasian economies. Please see Woolsey, "Under Donald Trump, the US will accept China's rise - as long as it doesn't challenge the status quo," South China Morning Post, dated November 10, 2016, available at www.scmp.com. 14 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy and Global Investment Strategy Joint Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 16 Please see Graham Allison, "The Thucydides Trap: Are The U.S. And China Headed For War?" The Atlantic, September 24, 2015, available at www.theatlantic.com. 17 Please see BCA Emerging Markets Strategy Special Report, "China's Money Creation Redux And The RMB," dated November 23, 2016, available at ems.bcaresearch.com. 18 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 21 Please see "North Korea: A Red Herring No More?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 22 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com.

The median voter moving to the left has spurred paradigm shifts. These new regimes are giving way to transformational leaders who seek change by breaking convention. As they test their constraints and pursue their preferences, a cautious stance towards risk assets is warranted. In this Monthly Report, BCA's Geopolitical Strategy discusses Trump's recent comeback, rising EM political risk, and Italy's upcoming constitutional referendum.

Special Report

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

Special Report

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

The reflation rally continues. Despite our bearish outlook for the year, we think the risks of the current rally lie to the upside given China's redoubling of stimulus at the expense of reform. Populist troubles are picking up in Europe, but we maintain our positive structural view and note that the migration crisis is slackening. Rather, the greatest risks of populism continue to flourish in the Anglo-Saxon world with Brexit and Trump.

In recent travel, our clients remain focused on downside risks to today's range-bound markets. And for good reason. Uncertainty regarding Chinese reaction function is the biggest source of political risk in today's markets. We discuss it in detail in this month's report, along with an update on our views of Brazil, Russia, and Turkey. In addition, we examine the potential casualties of the European immigration crisis and the likelihood of Donald Trump becoming the president of the United States.

Special Report

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

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