Domestic Politics
Highlights Breadth within EM equity markets has been deteriorating both in absolute terms and relative to DM equities. This points to a major top in EM share prices. In Brazil, falling inflation has led to a relapse in nominal GDP growth. This has endangered the already-bad public debt dynamics. Without the social security reforms, the country needs to boost nominal growth to stabilize public debt dynamics. Currency depreciation will likely be required to achieve this. When the Brazilian currency sells off, the nation's financial markets perform poorly. Feature Deteriorating EM Equity Breadth Breadth within EM equity markets has been deteriorating, especially in relative terms, versus DM stock markets. This heralds a major downleg in EM versus DM relative share prices, at a minimum, and a relapse in EM share prices in absolute terms as well. Chart I-1 demonstrates that the relative performance of EM equal-weighted stock index versus the DM equal-weighted share price index has decoupled from the relative performance of EM versus DM market cap-weighted equity benchmarks. Such a gap has emerged for the first time since 1999, when MSCI's equal-weighted equity data became available. Chart I-1EM Equity Outperformance Narrowly Based Versus DM... Each stock has the same weight in the equal-weighted index, while the regular indexes are market-cap weighted. Hence, an equal-weighted index reflects performance of an average stock while the market cap-weighted ones are skewed by the performances of large-cap stocks. This confirms what many investors already know: that in 2017, EM outperformance versus DM has been largely due to the surge in four large-cap technology stocks in Asia. Comparing EM against the U.S. only on similar measures, the message is identical (Chart I-2). Chart I-3 illustrates the absolute performance of MSCI EM market cap-weighted and MSCI EM equal-weighted equity indexes. It appears that the EM equal-weighted stock index has failed to make new cyclical highs lately. Thereby, it has not confirmed the new high in the EM market-cap weighted equity benchmark (Chart I-3). Chart I-2...And U.S. Chart I-3EM Equal-Weighted Index Did Not ##br##Confirm EM Market-Cap Recent Highs Similarly, the rally in share prices of EM banks - an important macro-driven sector of the EM equity universe - has lately paused. As such, it has also not confirmed the new high in the overall EM equity benchmark (Chart I-4). Given EM tech stocks (29% of MSCI benchmark index) are extremely overbought, the EM equity rally can be sustained if leadership rotates to EM financials and commodities stocks, which account for 23% and 14% of market cap, respectively. The failure of both EM financials and commodities stocks to make new cyclical highs of late suggests the EM equity rally is wearing off. The advance-decline line for EM stocks has lately dropped below the 50 line (Chart I-5, top panel). By contrast, the DM measure is still above 50 (Chart I-5, bottom panel). This signals a major bout of EM underperformance versus DM, as well as downside risks to EM's absolute performance. Chart I-4EM Banks Also Did Not Confirm ##br##EM Market-Cap Recent Highs Chart I-5Poor Advance-Decline Line In EM Equities The weak technical profile for EM equities is consistent with our fundamental assessment that the main risks to global growth and share prices stem from EM/China rather than DM economies. Therefore, EM/China plays will be the first to roll over, while DM stocks will lag. Investors looking for signs of reversal in the rally in global risk assets should monitor EM/China plays. Finally, EM small cap stocks' relative performance against their DM counterparts has not confirmed the EM outperformance based on an aggregate index (Chart I-6). This is a negative signal as well, and heralds new lows in relative performance. This also corroborates that, outside those EM large-cap tech stocks that have gone exponential, the EM equity rally has been much less exuberant and vigorous. More importantly, the EM rally has recently shown signs of fatigue. Bottom Line: Breadth within EM equity markets has been deteriorating both in absolute terms and relative to DM equities. This implies that a major downturn in EM share prices as well as EM risk assets generally is approaching. Investors should stay put/underweight EM risk assets. Brazil: A Political Economy Dilemma The Nominal Impediment We are aware that the pace of economic activity in Brazil is presently gathering speed. Manufacturing, retail sales and hiring are all recovering (Chart I-7). Even capital spending that has been shrinking until recently is now starting to show signs of life. Chart I-6EM Small Caps Have Not Confirmed ##br##EM Large Cap Outperformance Chart I-7Brazil: Economic Activity Is Recovering Nevertheless, Brazil's public debt dynamics remain unsustainable. Nominal GDP growth has declined to its 2015 low - as falling inflation has more than offset the revival in real output (Chart I-8). Besides, real interest rates remain elevated and nominal GDP growth is well below the government's borrowing costs (Chart I-9). Chart I-8Brazil: Real Growth Is Recovering ##br##While Nominal Growth Is Relapsing Chart I-9Brazil: Borrowing Costs Are Still High Therefore, without full-fledged social security reforms and/or lowering ex-ante real interest rates substantially, the public debt trajectory will likely spin out of control. Interest rates in real terms are also elevated for the private sector. This suggests that credit stress among companies and households might not recede quickly, and high real interest rates might cap the recovery in loan growth (Chart I-10). Interestingly, Chart I-11 demonstrates that private banks' NPLs (non-performing loans) inversely correlate with nominal GDP growth (nominal GDP is inverted on the chart). This entails that the amelioration in Brazil's NPL cycle is at least due for a pause. Chart I-10Brazil: Bank Loan Growth Is Stabilizing Chart I-11Brazil: Nominal GDP & Bank NPLs In short, to stabilize public and private debt dynamics, higher nominal GDP growth and much lower borrowing costs in real terms are vital. The latter means an unexpected rise in inflation is required. Chart I-12Brazil In the Late 1990s To boost nominal growth considerably and finance government at lower real interest rates, a combination of quantitative easing (QE) and currency depreciation will be needed. This is not a forecast that the Brazilian central bank will certainly implement QE. Rather, our point is that without extensive social security reforms - which are politically unfeasible now (more on this below) - a meaningful currency depreciation and/or public debt monetization by the central bank will be necessary to stabilize public debt dynamics and put the economy on a sustainable expansion path. Remarkably, in the late 1990s, faced with low inflation and weak nominal growth, the Brazilian government opted for large currency devaluation, which boosted nominal GDP growth (Chart I-12). Notably, the currency was devalued despite the large share of public foreign currency debt. This ratio is now very low. Hence, currency depreciation will be less painful now than it was in 1998. A Political Economy Dilemma: Growth Versus Creditors Brazil's elected politicians (congressmen and senators) are facing a political economy dilemma: (a) Should they satisfy interests of government creditors (including foreign investors) - i.e., pursue painful fiscal reforms to make public debt sustainable? Or (b) Should they gratify the electorate - i.e., avoid austerity and stimulate the still-beleaguered economy? To put this in perspective, the economy is just exiting one of the worst recessions of the past century, and the unemployment rate is still at a decade high. Over the next several months, the government of President Michel Temer will try to pass a diluted version of the pension reform bill. The government is desperate to enact this bill to keep financial markets buoyant and preserve the ongoing economic recovery heading into the elections. Being already very unpopular, government officials realize this is the only way their candidate has a chance to get elected in the presidential elections next year. However, the diluted version will not be enough to ensure debt sustainability. Chart I-13Brazil's Median Voter Favors ##br##Anti-Government Candidates Moreover, many of the government's coalition partners have different incentives. Going into the general elections in October 2018, odds favor that the majority of congressmen and senators will likely vote for avoiding austerity. As a result, the pension reforms draft - even in its diluted form - will likely fail. The median voter in Brazil remains on the left. Chart I-13 reveals that according to the latest polls, 60% of voters support anti-market candidates. Hence, any politician who wants to be elected needs to heed to the electorate. Worsening Fiscal Dynamics Public debt sustainability has been worsening: The primary and overall deficits have lately widened to 2.9% and 9.3% of GDP, respectively (Chart I-14). Public debt sustainability necessitates that the primary fiscal balance swings into a surplus, and borrowing costs drop below nominal GDP. None of these requirements have been satisfied or are likely to be anytime soon. Meanwhile, central government total revenue growth has dwindled (Chart I-15, top panel). In turn, central government net revenue - i.e. excluding transfers to local governments - are mildly contracting due to the increase in revenue transfers to the latter (Chart I-15, bottom panel). Chart I-14Brazil: Fiscal Deficit Has Not Improved Chart I-15Central Government Revenues Are Very Weak Furthermore, the overall fiscal deficit excluding social security is at 6% of GDP and has widened over the past year (Chart I-14, bottom panel). Interest payments account for 32% of government spending and 6.4% of GDP. On the whole, without a large fiscal retrenchment and with real interest rates close to current levels, the gross public debt-to-GDP ratio will likely reach 85% by the end of 2018 and 92% in two years' time - even if nominal GDP growth recovers to 6-6.5%. This puts the impetus solely on the central bank to reflate nominal growth aggressively and/or bring down real interest rates. This can be achieved via currency depreciation or public debt monetization. The outcome of the latter will necessarily be a major drop in the currency's value. This, along with our negative view on commodities prices in general and iron ore prices in particular, prompts us to retain our bearish stance on the Brazilian real. Chart I-16 demonstrates that the currency is highly correlated with iron ore prices, and has no correlation with the level of and changes in the interest rate differential between Brazil and the U.S. Investment Implications The path of least resistance for the Brazilian real is down - it will depreciate more than 2% and 4% that are implied by 6- and 12-month forwards, respectively. Stay short. When the Brazilian currency sells off, the nation's financial markets perform poorly. In particular, Brazil's sovereign and corporate credit spreads are very narrow, and will widen as investors begin doubting public debt sustainability. In turn, currency depreciation will raise the cost of foreign currency debt for the private sector. Dedicated EM investors should underweight Brazilian sovereign and corporate credit relative to their benchmarks. The relapse in narrow money (M1) growth presages downside risk in share prices (Chart I-17). Chart I-16Driver Of BRL: Commodities Not Interest Rates Chart I-17Brazil: M1 Growth And Share Prices The broad stock market is not particularly cheap, given the magnitude of the rally that has considerably exceeded the EPS recovery. Finally, in the local fixed-income market we continue recommending a bet on yield curve flattening that typically happens when the currency sells off. Foreign investors should wait for currency depreciation to play out before going long local currency government bonds. Local investors should overweight local bonds versus stocks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Geopolitical risks were overstated in 2017, but have now become understated; If Donald Trump becomes an early "lame duck" president, he will seek relevance abroad; This could mean a protectionist White House, or increased geopolitical tensions with Iran and North Korea; North Korean internal stability could come into question as economic sanctions begin to bite; Political risks in the U.K. and Italy could rise with markets overly complacent on both; Emerging markets, particularly Brazil and Mexico, will see renewed political risk. Feature Buoyant global growth, political stability in Europe, and steady policymakers' hands in China have fueled risk assets in 2017. As the year draws to a close, investors also have tax cuts in the U.S. to celebrate. Our high conviction view that tax cuts would happen - and that they would be fiscally profligate - is near the finish line.1 In making this call, we ignored the failure to repeal Obamacare, the "wisdom" of old "D.C. hands," and direct intelligence from a source inside the White House circle who swore tax reform would be revenue neutral. Throughout the year, BCA's Geopolitical Strategy remained confident that the GOP would ignore its fiscal conservative credentials and focus on the midterm elections.2 That election is increasingly looking like a bloodbath-in-the-making for the Republican Party (Chart 1). What of the latest opinion polls showing that the tax cuts are unpopular with half of all Americans? The polls also show that a solid one-third of all Americans remain in support of the Republican plan (Chart 2). We suspect - as do Republican strategists - that those are the Republicans who vote in midterm elections. Given the atrociously low turnout in midterm elections - just 36.4% of Americans voted in 2014 - Republicans need their base to turn out in November. The tax cuts are not about the wider American public but the Republican base. Chart 1Midterm Election: A Bloodbath? Chart 2Republican Base Supports Tax Cuts As we close the book on 2017, we look with trepidation towards 2018. Our main theme for next year is that the combination of economic stimulus from the tax cuts in the U.S. and structural reforms in China will create a U.S.-dollar-bullish policy mix that will combine into a headwind for global risk assets, particularly emerging market equities.3 However, in this report, we focus on some of the more exotic risks that investors may have to deal with. In particular we focus on five potential "black swans" - low probability, high market-impact events - that are neither on the market's radar nor the media's. To qualify for our list, the events must be: Unlikely: There must be less than a 20% probability that the event will occur in the next 12 months. Out of sight: The scenario we present should not be receiving media coverage, at least not as a serious market risk. Geopolitical: We must be able to identify the risk scenario through the lens of our geopolitical methodology. Genuinely unpredictable events - such as meteor strikes, pandemics, crippling cyber-attacks, solar flares, alien invasions, and failures in the computer program running the simulation that we call the universe - do not make the cut. Black Swan 1: Lame Duck Trump "Lame duck" presidents - leaders whose popularity late in their term has sunk so low that they can no longer affect policy - are said to be particularly adventurous in the foreign arena. While this adage has a spotty empirical record, there are several notable examples in recent memory.4 American presidents have few constitutional constraints when it comes to foreign policy. Therefore, when domestic constraints rise, U.S. presidents seek relevance abroad. Chart 3The Day After The Midterms, Trump's Overall Popularity Will Matter More Than That Among Republicans President Trump may become the earliest, and lamest, lame duck president in recent U.S. history. While his Republican support remains healthy, his overall popularity is well below the average presidential approval rating at this point in the political cycle (Chart 3). Based on these poll numbers, his party is likely to underperform in the upcoming midterm election (Chart 4). A Democrat-led House of Representatives would have the votes to begin impeachment, which we would then consider likely in 2019. As we have argued in our "impeachment handbook," the market impact of such a crisis would ultimately depend on market fundamentals and the global context, not political intrigue.5 Chart 4Trump Is Becoming A Liability For The GOP President Trump's political capital ahead of the midterm elections is based on his ability to influence Republican legislators. Despite low overall poll numbers, President Trump can use the threat of endorsing primary challengers against conservative peers in Congress to move his agenda in the legislature. He has effectively done this with tax cuts. However, the day after the midterm elections, President Trump's own numbers will matter for the GOP. Given that President Trump will be on the ballot in the 2020 general election, his low approval numbers with non-Republican voters will hang like an albatross around the party's neck. This is a serious issue, particularly given that 22 of the 33 Senators up for reelection in 2020 will be Republican.6 Robust economic growth and a roaring stock market have not boosted Trump's popularity so far. At the same time, a strong economy ready to translate into higher wages is about to be "pump-primed" by stimulative tax cuts (Chart 5). We would expect the result to be a stronger dollar, which should keep the U.S. trade deficit widening well into Trump's second year in office. At some point, this will become a sore political point, given Trump's protectionist rhetoric and his administration's focus on the trade balance as a key measure of U.S. power. Chart 5Wage Pressures Are Building What kind of adventures would we expect to see President Trump embark on in 2018? There are three prime candidates: China-U.S. trade war: The Trump administration started off with threats against China and then proceeded to negotiations. However, neither the North Korean situation nor the trade deficit has seen substantial improvement, and a lame duck Trump administration would be more likely to resort to serious punitive actions. Even improvements on the Korean peninsula would not necessarily prevent Washington from getting tougher on Beijing over trade, as the Trump administration will be driven by domestic politics. Investors should carefully watch whether the World Trade Organization deems China a "market economy," which could trigger a U.S. backlash, and whether the various investigations by U.S. Trade Representative Robert Lighthizer and Commerce Secretary Wilbur Ross result in anti-dumping and countervailing duties being imposed more frequently on specific Chinese exports. Thus far, the empirical evidence suggests that the Trump administration has picked up the pace of protectionist rulings (Chart 6). Notably, the Trump administration claims that the Comprehensive Economic Dialogue has "stalled," and it is reviving deeper, structural demands on Chinese policymakers.7 Iran Jingoism: Rumors that Secretary of State Rex Tillerson may be replaced by CIA Director Mike Pompeo - who would be replaced at the CIA by Senator Tom Cotton - can only mean one thing: the White House has Iran in its sights. Both Pompeo and Cotton are hawks on Iran. The administration may be preparing to shift its focus from North Korea, where American allies in the region are urging caution, to the Middle East, where American allies in the region are urging aggression. Investors should watch whether Tillerson is removed and especially how Congress reacts to President Trump's decision on October 15 to decertify the Iran nuclear agreement (also called the Joint Comprehensive Plan of Action or JCPOA). The Republican-controlled Congress has until December 15 to reimpose sanctions on Iran that were suspended as part of the deal, with merely a simple majority needed in both chambers. However, President Trump will also have an opportunity, as early as January, to end waivers on a slew of sanctions that were not covered under the JCPOA. North Korea: It would be natural to slot North Korea as first on our list of potential foreign policy adventures for President Trump. However, it does not really fit our qualification of a black swan. North Korea is not "out of sight." Additionally, President Trump has already broken with the tradition of previous administrations by upping the pressure on Pyongyang. In fact, a North Korean black swan would be if President Trump succeeded in breaking the regime in Pyongyang. To that scenario we turn next. Chart 6Trump: Game Changer In U.S. Trade Policy? Bottom Line: Geopolitics has not affected the markets in 2017, with risk assets reaching record highs and the VIX reaching record lows (Chart 7). This was our view throughout the year and we called for investors to "buy in May and have a nice day" as a result of our analysis.8 We do not see this as likely in 2018. The Trump administration has no credible legislative agenda after tax cuts. We expect Congress to stall as we enter the summer primary season and for the GOP to lose the House to the Democrats. President Trump is an astute political analyst and will sense these developments before they happen. There is a good chance that he will attempt to sway the election and pre-empt his lame duck status with an aggressive foreign policy. Chart 72017 Goldilocks: S&P 500 Up, VIX Down Investment implications are twofold. First, we continue to recommend an equally weighted basket of Swiss 10-year bonds and gold as a portfolio hedge.9 Second, risk premium for oil prices should rise in 2018. Not only is the supply-demand balance favorable for oil prices, but geopolitical risks are likely to rise as well. Black Swan 2: A Coup In Pyongyang Our colleague Peter Berezin, BCA's Chief Global Strategist, has suggested that a coup d'état against Supreme Leader Kim Jong-un could be a black swan trigger that spooks the markets.10 While Peter used the scenario as a tongue-in-cheek way to weave Kim into a narrative that tells of a late 2019 recession, we have long raised North Korean domestic politics as the true Korean black swan.11 Here we entertain Peter's idea for three reasons.12 First, China has upped the economic pressure on Pyongyang. Under Kim Jong-un, the North Korean state has attempted some limited economic "opening up," namely to China. But the attempt to finalize the nuclear deterrent has delayed an already precarious process. There has now been a $617 million drop in Chinese imports from the country since the beginning of the year (Chart 8), with coal imports particularly affected (Chart 9). China has also pulled back on tourism. Meanwhile, North Korea's imports of Chinese goods have risen, which suggests that the country's current account balance may be widening. At some point, if these trends continue, Pyongyang will run out of foreign currency with which to purchase Chinese and Russian imports. Chart 8China Is Turning The Screws On Pyongyang... Chart 9...Particularly On Coal Imports Second, Pyongyang is well aware of pressures against the regime. The assassination of Kim Jong-nam - the older half-brother of Kim Jong-un - in February of this year sent a message to the world, but especially to China, which kept Kim Jong-nam around as an alternative to the current Kim. That Pyongyang went to the extreme lengths of poisoning Kim Jong-nam with VX nerve agent in a foreign airport suggests that Kim Jong-un is still worried about threats to his rule.13 If Beijing's economic sanctions continue to tighten in 2018, the military could conceivably see the Supreme Leader's aggressive foreign policy as a risk to regime survival. Third, Pyongyang could miscalculate and create a crisis from which it cannot deescalate. A provocation that disrupts international infrastructure and commerce or kills civilians from the U.S. or Japan could trigger a downward spiral. For instance, an attack against international shipping in the Yellow Sea or Sea of Japan by North Korean submarines would be an unprecedented act that the U.S. and Japan would likely retaliate against.14 We could see the U.S. following the script from Operation Praying Mantis in the Persian Gulf in 1988 - the largest surface engagement by the U.S. Navy since the Second World War. In that incident, the U.S. sunk half of Iran's navy in retaliation for the mining of the guided missile frigate USS Samuel B. Roberts. In the case of North Korea, this would primarily mean taking out its approximately 20 Romeo-class submarines and an unknown number of domestically-produced - Yugoslav-designed - newly built submarines. Such a conflict is not our baseline case, but we assign much higher probability to it than an all-out war on the Korean Peninsula. How would Pyongyang react to the sinking of its submarines? Our best case is that the regime would do nothing. The leadership in Pyongyang is massively constrained by its quantifiable military inferiority. True, North Korea has around 6 million military personnel - about 25% of the total population is under arms - but unfortunately for Pyongyang, this large army is arrayed against one of the most sophisticated defenses ever constructed by man: the Demilitarized Zone (DMZ). To support its ground forces, North Korea would have at its disposal only about 20-30 Mig-29s. Countering two dozen jets would be South Korea's combined 177 F-15s and F-16s, plus American forces that would vary in size depending on how many aircraft carriers were deployed in the vicinity. Given that a single American aircraft carrier holds up to 48 fighter jets, North Koreans would quickly find themselves fighting a losing battle. Which is why they may never initiate one. If Kim Jong-un insists on retaliation, the military could remove and replace him with, for instance, his 30-year old sister, who has recently risen in party ranks, or his 36-year old brother Kim Jong-chul, who is apparently not entirely uninvolved in the regime despite living an unassuming life in Pyongyang. What would a regime change mean for the markets? It depends on whether it is successful or not. An unsuccessful coup could lead to a massive purge and likely a total break in Pyongyang's relations with the outside world, including China. This would seriously destabilize North Korea's decision-making. The global community would have to begin contemplating a total war on the Korean peninsula. Alternatively, a successful coup could lead to temporary volatility, yet long-term stability. The military regime in the North may even be open to reunification over the long term, depending on how U.S.-China relations evolve. Bottom Line: China does not want to cripple North Korea or throw a coup. But it is cooperating with sanctions and could therefore trigger one by mistake. At least two regimes have collapsed in the past when facing the pincer movement of economic sanctions and American military pressure - South Africa's apartheid regime in 1991 and Slobodan Miloševic's Yugoslavia in 1999. Kim Jong-un could face a similar fate, particularly if China applies excessive economic pressure. Black Swan 3: Prime Minister Jeremy Corbyn There is no election scheduled in the U.K. for 2018, but if one were to be held the ruling Tories would be in trouble (Chart 10). In fact, the combined anti-Brexit forces are currently in a solid lead over the pro-Brexit parties, Conservatives and the U.K. Independence Party (UKIP) (Chart 11). Chart 10Labour Is In The Lead... Chart 11...As Are Anti-Brexit Forces Writ-Large What could trigger such an election? Ultimately, the final exit deal may prompt a new election. More immediately, the ongoing negotiations over the status of the Irish border would be a prime candidate. As our colleague Dhaval Joshi, head of BCA's European Investment Strategy noted recently, Prime Minister Theresa May's government is propped up by the Northern Irish Unionists to whom May has promised that there will be no hard border between Northern Ireland and the Republic of Ireland. This will likely create a crisis as the EU negotiations may inadvertently threaten the Good Friday peace agreement. The Northern Ireland Unionists will not tolerate the border moving to the Irish Sea. This would effectively take Northern Ireland into the EU customs union and single market, and out of the U.K.'s domestic trading zone. It would also embolden Scotland's push for single market access. In essence, the Tory government may collapse because of differences within the U.K.'s "three kingdoms" before it even has the chance to collapse over differences with the EU.15 The market may cheer a Labour-Scottish National Party (SNP) coalition government, a potential winner of an early election, as it would mean that a new referendum on the U.K. leaving the EU could be held. The latest polls suggest that "Bremorse" (remorse for Brexit) has set in, as a clear majority in the U.K. thinks that Brexit was a bad idea (Chart 12). However, we suspect that it would take Prime Minister Jeremy Corbyn several months, if not over a year, before he called such a referendum. First, Corbyn is on record supporting a soft Brexit, not a new referendum, and he has only just begun to adjust this position. Second, a soft Brexit is far more difficult to achieve than the hard Brexit of Prime Minister Theresa May since it requires the U.K. to subvert its sovereignty in significant ways (i.e., accepting EU regulation) in order to access the EU Common Market. Third, the most politically palatable way to re-do the referendum is to put a U.K.-EU deal up to the people to decide, which means that Corbyn first has to spend a long time negotiating that deal. Chart 12Bremorse Sets In The market may be disappointed to find out that PM Corbyn is not willing or able to put the question of the U.K.'s EU exit up to a vote right away. Instead, the market would have to deal with Corbyn's economic policies, which are markedly left-wing. Corbyn harkens back to the 110 Propositions pour la France of French President François Mitterrand, if not exactly to the ghastly 1970s of the U.K.'s own history. A brief sample platter of Labour's proposals under Corbyn includes: Increasing the U.K. corporate tax rate to 26% from 20%; Increasing the minimum wage; Forcing companies not to out-source operations; Nationalizing public infrastructure companies. How should investors play a Corbyn victory? We think that the U.K. pound would likely rally on a higher probability of reversing Brexit. However, this "no Brexit" rally would quickly dissipate as PM Corbyn reiterated his promise to fulfill the democratic desire of the population to exit the EU. While Corbyn's negotiating team set to work on getting a better Brexit deal out of Brussels, the market would quickly turn its attention to the reality that Corbyn is not kidding about socialism.16 The result would be a selloff in the pound. Bottom Line: BCA's Foreign Exchange Strategy has pointed out that the pound remains well below its fair value (Chart 13). However, as BCA's chief FX strategist Mathieu Savary points out, the valuation technicals may be misleading as the currency has entered a new economic, trade, and political paradigm. A Corbyn premiership is not clearly positive for Brexit, while opening up a completely different question: is the U.K. also exiting the free-market, laissez-faire paradigm that it has helped lead since May 1979? Black Swan 4: Italy Is A Black Swan Hiding In Plain Sight The spread between Italian and German 10-year government bonds has narrowed 72 basis points since April, suggesting that investors have grown comfortable with the risks associated with the Italian election due by May (Chart 14). There are three reasons why we agree with the market: Chart 13Pound Valuation Reflects Post-Brexit Paradigm Chart 14Investors Not Worried About Italy New electoral rules passed in October make it highly likely that a center-right alliance will take shape between the Forza Italia of former Prime Minister Silvio Berlusconi and the mildly Eurosketpic Lega Nord. These two could form a government alone, or in a grand coalition with the center-left Democratic Party (PD) (Chart 15). Both Lega Nord and the anti-establishment Five Star Movement (M5S) have moved to the center on the questions of European integration and membership in the currency union; The European migration crisis is over and its supposedly constant impact on Italy is waning (Chart 16). Meanwhile, Italy's economy is on the mend, with its banking sector finally following the Spanish trajectory with a drop in non-performing loans (Chart 17). Chart 15Italy Set For A Hung Parliament Chart 16Migration Crisis Is Over (Yes, Even In Italy) Chart 17Italian Recovery Is Just Starting That said, we continue to warn clients that the underlying support for the common currency is lagging in Italy. The support level is just above 55%, despite a strong rally in the rest of the Euro Area (Chart 18). Similarly, over 40% of Italians appear confident in the country's future outside of the EU (Chart 19). Chart 18Italians Stand Out For Distrust Of Euro Chart 19Italians Not Enthusiastic About EU Our baseline case is that Italian elections will produce a weak and ineffective government, though crucially not a Euroskeptic one. How could we be wrong? Easy: one of the three reasons why we agree with the market could shift. For example, M5S could alter its pledge to remain in the Euro Area and surprisingly win on a Euroskeptic platform. Why would the party do something like that? Because it makes sense! Polls are already showing that M5S's recent moderation on the euro is not paying political dividends, with its support sharply sliding since the summer. With power quickly slipping out of reach for the party, why wouldn't they put a down-payment on the next election by trusting the underlying trend in opinion polling and investing in a Euroskeptic platform that might pay political dividends in the future? If we think that this strategy makes sense based on the data, then the M5S leadership might as well. Chart 20Can MIB Keep Outperforming? Another scenario is a major terror attack perpetrated by recent migrants from North Africa. Italy has been spared from radical Islamic terror. As such, the country may not be as desensitized to it as other European nations. A strong showing by Lega Nord and the far-right Fratelli d'Italia could force Forza Italia to move to the right as well. On our travels, we have noticed that few investors want to talk about Italy. There is wide acknowledgement of the structural trends pointing to a rise of Euroskepticism in the country, but also an appearance of consensus that this is a problem for a later date. We agree with this consensus, but our conviction is low. Bottom Line: Italian election risk is completely unappreciated by the markets. The country's equity market is one of the best performing this year (Chart 20), while government bonds are pricing in no political risk as the election approaches. We believe that shorting both would present a good hedging opportunity. Black Swan 5: Bloodbath In Latin America Our last black swan risk is not really a black swan to us but a forecast we believe will happen. As we outlined last month, we fear that Chinese policy-induced credit contraction will be negative for emerging markets, as BCA's Emerging Markets Strategy data asserts (Chart 21). BCA's Foreign Exchange Strategy has pointed out in its latest missive that its "Carry Canary Indicator" - performance of EM/JPY crosses - is signaling that a sharp deceleration in global growth is coming in Q1 2018 (Chart 22).17 Latin America (especially Chile, Peru, and Brazil) is the region most exposed to the combination of a slowing China and a China-induced drop in commodity prices. Chart 21When China Sneezes, EM Gets The Flu Chart 22Ominous Signal From EM/JPY From a political perspective, this is most negative for Brazil and Mexico. Both countries hold elections in 2018, with the Mexican election further complicated by the ongoing NAFTA renegotiations. We believe that the future of NAFTA hangs in the balance, with a high probability that the Trump administration will decide to abrogate the deal.18 Currently, anti-market political forces are in the lead in both countries. In Brazil, no pro-market candidate is leading in the polls (Chart 23). In fact, anti-market options have a 48% lead on the centrists. Granted, there are ten months until the election, but we are skeptical that the Brazilian population will change its mind and support reformers. If the "median voter" in Brazil supported reforms, the current Temer administration would have passed them already. In Mexico, anti-establishment candidate Andrés Manuel López Obrador (also known as AMLO) is leading in the polls (Chart 24), as is his new party Morena (Chart 25). If Morena wins the most seats in the Mexican Congress, it will be more difficult for the opposition parties to combine to counter it.19 Chart 23There Is No Pro-Market Option In Brazil Chart 24AMLO Is In The Lead ... Chart 25...As Is Morena In 2017, we argued that politics were not a tailwind for EM asset performance. Instead, investors chased yield in the favorable economic context of Chinese economic stimulus, low developed market yields, and a weak U.S. dollar. In reality, politics was just as dire in much of EM as it was in prior years of asset underperformance, but the surge of global liquidity in 2018 masked the problems. We do not think the EM rally is sustainable in 2018. As the global economic and market context shifts, investors will start paying attention. Suddenly, political problems will enter into focus. Here we argue that Brazil and Mexico are likely to be the main targets of portfolio outflows, but a strong case could be made for South Africa and Turkey as well.20 Bottom Line: Political risk in Latin America will return. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy, "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, and "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, and "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 4 President Clinton launched the largest NATO military operation against Yugoslavia amidst impeachment proceedings against him while President George H. W. Bush ordered U.S. troops to Somalia a month after losing the 1992 election. Ironically, President George H. W. Bush intervened in Somalia in order to lock in the supposedly isolationist Bill Clinton, who had defeated him three weeks earlier, into an internationalist foreign policy. President George W. Bush ordered the "surge" of troops into Iraq in 2007 after losing both houses of Congress in 2006; President Obama arranged the Iranian nuclear deal after losing the Senate (and hence Congress) to the Republicans in 2014. 5 Please see BCA Geopolitical Strategy, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 6 Particularly vulnerable, in our view, will be Cory Gardner (R, Colorado), Joni Ernst (R, Iowa), Susan Collins (R, Maine), and Thom Tillis (R, North Carolina). 7 U.S. Treasury Under Secretary for International Affairs David Malpass recently claimed that high-level talks had "stalled" and re-emphasized the U.S.'s structural complaints: "We are concerned that China's economic liberalization seems to have slowed or reversed, with the role of the state increasing ... State-owned enterprises have not faced hard budget constraints and China's industrial policy has become more and more problematic for foreign firms. Huge export credits are flowing in non-economic ways that distort markets." The growing presence of Communist Party cells within corporations is another important structural concern that puts the administration at loggerheads with China's leaders. Please see Andrew Mayeda and Saleha Mohsin, "US Rebukes China For Backing Off Market Embrace," Bloomberg, November 30, 2017, available at www.bloomberg.com. 8 Please see BCA Geopolitical Strategy, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. 10 Please see BCA Global Investment Strategy, "A Timeline For The Next Five Years: Part II," dated December 1, 2017, available at gis.bcaresearch.com. 11 Please see "North Korea: From Overstated To Understated" in BCA Geopolitical Strategy, "Strategic Outlook 2016: Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. A notable coup attempt occurred in 1995-96 in North Hamgyong; something like a coup attempt may have occurred in 2013; and defectors from North Korea have reported various stories of plots and conspiracies against the regime. 12 After all, Peter predicted that Donald Trump would be a serious candidate for the U.S. presidency back in September 2015! 13 Still worried, that is, even after Kim Jong-un's supposed "consolidation of power" in 2013-14 when he executed his influential and China-aligned uncle, Jang Song Thaek, and purged the latter's faction. There were reports of rogue military operations at that time. With low troop morale reported by North Korean defectors, the possibility of insubordination cannot be ruled out. 14 A North Korean submarine sank the South Korean corvette Cheonan in 2010, and North Korean artillery shelled two islands killing South Korean civilians later that year, but these attacks were still within the norm of North Korean provocations. The two countries are still technically at war and have contested maritime as well as land borders. 15 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 16 To help investors get ready for a Corbyn premiership, we thought his appearance on President Nicolás Maduro's weekly radio show would be a good place to start: https://www.youtube.com/watch?v=7eL8_wtS-0I 17 Please see BCA Foreign Exchange Strategy, "Canaries In The Coal Mine Alert: EM/JPY Carry Trades," dated December 1, 2017, available at fes.bcaresearch.com. 18 Please see BCA Geopolitical Strategy and Global Investment Strategy, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy and Emerging Markets Strategy "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy, "South Africa: Crisis Of Expectations," dated June 28, 2017, and "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, available at gps.bcaresearch.com. Geopolitical Calendar
Highlights The centrist consensus is breaking down across the developed world; In its place is rising political plurality, with non-centrist and anti-establishment parties gathering support; This trend is not to be feared by the markets; Political systems that encourage political plurality - such as those of continental Europe - are more stable in the long run than those promoting political duopoly; Establishment parties in Europe can neuter single-issue parties by selectively adopting their agenda; Emergence of a third party in the U.S. would be positive for both the markets and the economy in the long run. Feature Chart 1European Border Enforcement Is Effective Germany's Social Democratic Party (SPD) signaled on November 23 a willingness to entertain another Grand Coalition with its rival the Christian Democratic Union (CDU). If coalition talks reproduce the centrist coalition that has ruled Germany since 2013, the risk of a new election will be averted. While European markets breathe a sigh of relief, there is much to be concerned about. First, the left-leaning, liberal Socialists will likely force Chancellor Angela Merkel to accept that family reunification for asylum claimants will remain an eligible migration route into the country. This means that the 1.3 million asylum seekers that have entered Germany since 2015 will be able to apply for family members to join them, swelling the numbers of migrants from Africa and the Middle East. This could raise tensions inside Germany and increase support for anti-establishment parties. This risk is overstated, as asylum seekers to Germany have collapsed since the EU stepped up enforcement of its borders after the 2015 crisis (Chart 1). Nonetheless, the perception that Merkel is soft on migrants will hound her for the remainder of what we believe will be her last term in power. Second, the SPD performed terribly in the September election, garnering only 20.5% of the popular vote, its worst performance since March 1933 (Chart 2).1 If the German Socialists enter another Grand Coalition, it will leave the anti-establishment, anti-immigrant, and anti-EU Alternative für Deutschland (AfD) in the ceremonial role of the leader of the opposition.2 Chart 2The Center-Left Has Collapsed In Germany This brings up the larger concern for investors: collapse of the centrist monopoly on political power in the West writ large. Germany is hardly the only country that is facing centrifugal forces that are eroding the hold on power by the center-left and center-right establishment parties. Across a number of critical economies, the center-left and center-right political behemoths are giving way to new entrants into the political system. This political plurality means that post-World War Two era centrist duopolies are breaking down as new parties, many of them anti-establishment and populist, enter the scene. Should investors fear this development? The consensus says yes. We disagree. Even in the United States, we doubt that a "third party" would be a negative development. Introducing The Political Concentration Index Chart 3 shows the developed economy measure of our BCA Political Concentration Index (PCI), which we constructed using the Herfindahl-Hirschman index normally used to measure the level of monopoly in a particular industry.3 Our modified index measures political - rather than economic - monopoly. We replace "firms" with "parties" and "industry" with "political system" (i.e., country). A country with a single ruling party would register a 1 on the index, while a country with 10, equal-sized parties in its parliament would register a 0.1. Chart 3Political Plurality Is On The Rise In The Developed World As Chart 3 illustrates, the developed economy concentration of political power has declined considerably. Power is concentrated in the hands of more and more political parties. Chart 4 shows the PCI of ten major western economies, illustrating that the culprits for the overall collapse of political monopoly are Australia, Canada, Germany, Spain, Sweden, and the Netherlands. Our indicator would illustrate an even greater decline of political concentration if we excluded the U.S. and the U.K. Somewhat surprisingly, Italy is actually holding up well, with current levels of political concentration in line with the post-World War Two era and higher than the free-wheeling 1990s. Chart 4Political Concentration Is On The Decline Across The Developed World France also surprisingly illustrates rising political concentration, at least relative to the 1980-1990s. However, this result also reveals the weakness of our index. Our measure is ignorant of the rise and fall of major parties. As such, it has failed to take into account the massive political earthquake that has occurred in France, where President Emmanuel Macron's La République En Marche! (REM) has completely replaced the Socialist Party as the main center-left French party. This shift is not picked up by the index as the degree of concentration of political power in the French National Assembly remains unaltered. Overall, the data confirm the suspicions of many of our clients that the political consensus is breaking down across the western world. There are likely three culprits: The economic dimension is eroding in relevance: The post-World War Two organization of western political parties across the left-right economic spectrum echoed the late-nineteenth and early-twentieth century cleavages between the conservative bourgeoisie and revolutionary proletariat. The Industrial Revolution created immense wealth across Europe and North America, but also immense inequalities. As the urban proletariat grew in size, it demanded political and economic rights. For example, the German SPD remained committed to a radical proletariat revolution almost right up until the First World War. While the question of economic redistribution remains relevant today, the left-right economic axis is not as cogent in a world where living standards have risen massively since the turn of the last century. Culture wars: With the vast majority of western voters no longer responding to basic, Malthusian needs, identity issues are rising in prominence and drawing votes away from the centrist parties arrayed along the left-right economic spectrum. Several single-issue parties have found a permanent foothold in the political system, from the German Greens (since 1980) to the U.K. Independence Party (since 1993). A number of young and old parties have found particular success focusing on immigration, most prominently the Dutch Party for Freedom (founded in 2006), the Swedish Democrats (founded in 1988), the AfD (founded in 2013), and the New Zealand First party (founded in 1993). Generational cleavages: Voters born after the Cold War are particularly drawn to new and anti-establishment parties. Spain's Podemos and Italy's Five Star Movement (M5S) have had particular success appealing to young voters. Similarly, parties with a strong anti-immigration and anti-globalization focus have found success recruiting older voters. There is no single unifying theory that explains the erosion of the left-right economic spectrum as the defining political cleavage in the West. For example, France's Front National - anti-establishment, Euroskeptic, and anti-immigration - is particularly successful in recruiting young French voters, whereas its populist peers generally have not. Each country has its own set of idiosyncratic variables that explain how the political system is evolving. These range from endogenous factors (political system, demographics, ethnic makeup) to exogenous factors (economic crisis, membership in the EU, geopolitical risk, etc.). Even in the case of the U.S. - which shows no decline in political concentration (Chart 4), as Republicans and Democrats so far maintain a grip on their duopoly - numerous cleavages are evolving. Primary elections, particularly in the Republican Party, are pitting anti-establishment candidates - often ideologically aligned with the small government "Tea Party" - against establishment centrists. While these anti-establishment policymakers are officially aligned with the GOP, they often operate as an independent bloc in the House of Representatives. Bottom Line: For a number of reasons, different in each political system, the left-right economic spectrum is no longer driving voter preferences. Hence it should no longer serve as a starting point of analysis. Politicians who realize this - such as President Donald Trump or President Emmanuel Macron, both of whom challenged left-right orthodoxies on economic policy - are rewarded with surprising upsets. Our Political Concentration Index suggests that a trend is underway. Should investors fear the trend? The short answer is no. Political Plurality Is Stabilizing Political plurality should not be feared. True, in the short term, political plurality will produce political volatility. Aside from the ongoing German coalition talks, investors may remember the recent Spanish and Greek elections. Both countries had to hold two elections before producing a relatively stable political equilibrium due to the breakdown in what were traditionally two-party systems.4 Our PCI obviously suggests that similar outcomes are likely and to be expected. Germany could still become a case in point and Italy looms ominously in Q1 2018. However, there are three reasons why risks of more political plurality are overstated. The first is obvious. Chart 5 is the same as our Chart 3, but we have grafted onto it average GDP growth and unemployment rates. There is no clear difference in economic performance between periods of rising and falling political concentration. Chart 5The Economy Does Not Drive Political Concentration The second is also obvious from Chart 5. There appears to be a pattern in the rise and fall of political concentration. In other words, investors should not necessarily extrapolate today's low concentration into the future. We suspect that the reason for the natural oscillation in our index is also the third reason that more political plurality is not a risk to the markets and the economy. A field of multiple parties allows establishment, centrist politicians to steal certain popular aspects of the electoral platform of the anti-establishment parties. Over time - what appears to be a roughly 7-year interval, or two electoral cycles on our chart - the establishment simply swallows the most competitive portions of the anti-establishment platform, repackages it in a way that is palatable for the median voter, and rebrands it as an establishment policy. The recent Austrian election is a perfect case study. Austria held a general election this year in October and the anti-establishment Freedom Party (FPÖ) came in third with 26% of the vote, a 5.5% increase from its 2013 outcome. It was not, however, the best performance for the FPÖ, as it had several strong performances in the late 1990s (Chart 6). Furthermore, investors often make the mistake of only comparing the performance of a party to the last election. In case of Austria, that means that analysts are ignoring four years' worth of polling data. In the particular case of the FPÖ, that means ignoring that the party's 26% performance was an absolute crushing collapse. As Chart 7 shows, the FPÖ went from leading in the polls for much of 2016, at one point reaching 35% support, to coming in third. Why? Chart 6Austrian Populists Have Been Here Before Chart 7The Establishment Stole FPO's Thunder As we illustrate in Chart 7, the Austrian establishment was not stupid. The center-right People’s Party (ÖVP) appointed 31-year-old Sebastian Kurz as its leader in May 2017. Kurz promptly shifted the ÖVP towards the FPÖ’s policy on immigration while retaining centrist views on literally everything else. From that point until the election, the centrist ÖVP crushed the FPÖ in the polls (the ultimate vote swing was nearly 15%). What the Austrian example shows is that a plural political system allows establishment, centrist parties to co-opt portions of the anti-establishment agenda without bringing them on board. In the long term, single-issue parties that focus on anti-globalization, immigration, the environment, or low-income families could see their support erode as the establishment parties adopt portions of their electoral manifesto, without setting-off major political earthquakes. Our forecast is that anti-immigration, populist parties in Europe have likely seen their peak in 2017. Other center-right parties will observe Kurz's success.5 There is simply no reason for them to stand in favor of open borders for asylum seekers in Europe going forward, particularly since newly arrived immigrants cannot vote. As such, it is far more likely that Kurz becomes a model for conservatives rather than, say, Angela Merkel. We concede that Merkel may be the last conservative holdover on immigration. She appears to be stuck defending her decision made in 2015 and is unable to pivot away from that episode. Our strong conviction view is that her successor as head of the CDU will have no such qualms and that the next conservative Chancellor of Germany will close all non-European immigration avenues to the country. Bottom Line: BCA's Political Concentration Index illustrates that political pluralism abates every seven years, or two electoral cycles. This is because single-issue and anti-establishment parties introduce new ideas and policies into the political marketplace, allowing the establishment players to co-opt some of those ideas and win elections without causing a dramatic - and market shattering - break with the past. Beware Of Political Duopolies Is there nothing that investors should fear in our data? No, they should fear persistent political monopolies and duopolies. Take the U.S. and the U.K. It is interesting that the two countries that have experienced the most populist political outcomes in the past two years - Brexit, Trump - are also consistently rated as having the highest political concentration (see Chart 4 on page 4). Why? We suspect that it is because the establishment parties in both political systems try to be catch-all, "big tent" conglomerates that capture a wide array of ideological views on several issues.6 By trying to capture diverse positions, including some fringe ones, they are in danger of becoming entrapped by them. One of the reasons for the "big tent" nature of Anglo-Saxon parties is the "first-past-the-post" electoral system of individual electoral districts. Unlike proportional representation systems favored on the European continent, first-past-the-post electoral systems radically reduce the incentives for small parties to launch independent campaigns.7 For example, UKIP captured 12.7% of the vote in the 2015 election, but it was awarded only one seat in the House of Commons. Such a record of failure is difficult to maintain for any political entity over a long period of time. Eventually, small parties are swallowed whole by their big tent counterparts. The problem with swallowing the whole party, instead of merely biting off an anti-establishment issue here and there, is that the big tent parties often swallow more than they can chew. In the case of the U.K.'s Conservative Party (which has almost wholly swallowed the anti-establishment UKIP), it has been forced to push forward with Brexit, which is dragging on the economy and making it difficult to govern. In the case of the Republican Party in the U.S., the Republicans absorbed the anti-establishment Tea Party, but the two wings of the party are at risk of descending into open warfare. The particular danger for U.S. parties is that their primary elections are normally poorly attended, particularly in midterm election years that lack the star-power of presidential candidates. This means that a candidate representing the far-left or far-right fringe can often win a candidacy with merely 4%-7% of the electorate in each district (the average turnout for primary elections in a midterm year).8 They then can easily proceed to be elected to the House of Representatives due to the fact that so few American electoral districts are truly competitive (Chart 8). As these anti-establishment voices gather force in Congress - 41 members of the GOP belong to the Tea Party-aligned Freedom Caucus for example - they can heighten already considerable polarization by preventing compromise (Chart 9). Chart 8No Competitive Districts Left In The U.S. Chart 9Polarization In The U.S. Is Historically High A heightened state of political polarization, which persists throughout the term in office, is far more market-relevant than heightened volatility around an election produced by more political plurality. For the most part, Europe's political systems have weathered a severe double-dip recession (triple-dip in Italy's case!), a massive loss of political confidence in European institutions, and a Biblical migration crisis with relatively few early elections (Table 1). In this turbulent period, many European governments have pushed through draconian austerity measures, far-reaching economic structural reforms, and agreed to fund or receive costly bailout programs. When anti-establishment parties came to power - as they legitimately did in Greece - they quickly migrated to the middle in order to govern, needing the votes of other parties. Table 1Europe: Less Volatile Relative To Context Empirically speaking, there is no evidence that low political concentration is therefore inferior to the perceived stability of high political concentration exhibited in the U.S. and the U.K. The American and British economies both have seen generally better economic performances since 2008, yet they are struggling with dramatic bouts of populism in 2016.9 In the U.K.'s case, Brexit will reduce potential GDP. In the U.S.'s case, Trump's tax cuts will be inflationary, could hasten the next recession, and will likely exacerbate income inequality. We do not have a view on whether a third party will emerge in the U.S. Political polarization is a powerful trend at present, and since by definition it promotes the existence of two opposing ideological camps, it reinforces the two-party system. Republicans want to maintain control of the conservative base and hence cannot afford to let the Tea Party split off, while Democrats want to control the liberal base and cannot afford to let the progressive wing split off. If either party fractures, the other benefits. Nevertheless, there is nothing unique about the U.S. electoral system that would prevent a breakdown of the American political duopoly: other first-past-the-post systems exhibit political plurality, most notably in Canada. If a third party does emerge, we would wager that it would increase, not decrease, political stability; and reduce, not increase, political polarization. For example, if Tea Party policymakers were to run as independent candidates, it would free up both Tea Partiers and centrist Republicans to pursue their preferred policies in Congress. Centrist Republicans could vote with the Tea Party on matters of common concern and vote with the Democrats on issues where the Tea Party is deemed to be on the fringe. The basic ability to pass a budget would not be hindered by the Tea Party's single-mindedness on government spending, yet voters demanding tighter budgets would not be denied representation. Alternatively, if a new single-issue party emerged, say one favoring tighter immigration policy, Republicans would be free to co-opt aspects of its view on immigration and neutralize the threat of losing votes. They would not be forced to absorb the entire party and pursue hardline policies that would cause gridlock with Democrats. Bottom Line: Empirical evidence since the 2008 Great Financial Crisis does not support the conventional wisdom that low political concentration (i.e., political plurality) is less favorable for investors than high political concentration. Both the U.S. and the U.K., which score the highest on our PCI, have produced highly volatile political outcomes. Investment Implications Investors should not worry about the emergence of new parties in Europe. Particularly harmless are single-issue parties, specifically those focusing on tighter immigration controls. Conservative parties across Europe have already adopted more stringent immigration policies while still sounding sane, a potent electoral mix relative to some of the populist anti-immigrant parties currently vying for the votes of concerned citizens on the continent. Meanwhile, we do not fear the emergence of a third, or fourth, party in the U.S. In fact, such a development could play a role in reducing historically high political polarization in the country. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Yes. That 1933 election. 2 There is no official "leader of the opposition" in Germany and as such the AfD leadership is merely ceremonial. The left-wing Die Linke was in the same position from 2013-2017 with little effect. In fact, Die Linke saw only an incremental increase in its support (0.6%) between the two elections. 3 Regular readers of Geopolitical Strategy will know that we are big fans of the Herfindahl-Hirschman index. We have applied it before to measure geopolitical hegemony. Originally, the index was designed to assist in competition law and antitrust cases as it is an indicator of the amount of competition between firms in a particular sector. The formula for the index is shown below, where si is the market share of firm i in the market, and the N is the number of firms; 4 Spain held an election in December 2015 and another in June 2016. The latter produced a minority government led by the center-right People's Party that is essentially supported by the Spanish Socialists Workers' Party (PSOE). Greece similarly held two elections, one in January 2015 and another in September of that year. 5 The German, establishment, Free Democratic Party (FDP) did so in the most recent election, copying ÖVP's focus on tight immigration policy. It has seen its support rise to 10.7%, a substantive increase from 2013. 6 We admit that the case for the U.K. as a political duopoly is harder to make given that there are third (and fourth) parties; although both the Labour Party and the Conservative Party have cleavages on the economy, globalization, and European integration that few European peers have. This is largely due to both parties' attempt to capture a diverse coalition of views. 7 First-past-the-post refers to an electoral system where the country is divided into electoral districts. In each electoral district, the party that wins the most votes generally sends its candidate to the legislature. While there are some variations on this model, and some mixed systems, this electoral system tends to favor political duopolies. In political science, this tendency has often been referred to as Duverger's law (named after the French sociologist Maurice Duverger who first observed this phenomenon). 8 Please see Elaine C. Kamarck, "Increasing Turnout In Congressional Primaries," Center for Effective Public Management at Brookings, dated July 2014, available at brookings.edu. 9 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com.
Highlights Overstated geopolitical risks in 2017 are giving way to understated risks in 2018; The reshuffle of China's government raises policy headwinds for global growth and EM assets; U.S. politics will be roiled by a leftward turn and Trump's protectionism and foreign policy; Italian politics, more than German, is the chief threat to European risk assets; Volatility and the USD will rise; shift to neutral on European risk assets; close tactical long on Chinese Big Banks. Feature BCA's Geopolitical Strategy has operated this year on a high conviction view that geopolitical risks would be overstated, thus generating considerable upside for risk assets. Our analysis focused on three particular "red herrings": European populism, U.S. politics, and Brexit.1 Meanwhile we identified North Korea as a genuine geopolitical risk, though not one that would cause us to change our "risk on" outlook. We therefore take issue - and perhaps offense - with the contemporary narrative that "geopolitics did not matter" in a year when the S&P 500 rose by 15% and VIX plumbed historic lows (Chart 1). Stocks rose and the VIX stayed muted precisely because geopolitical risks were overstated earlier in the year. Investors who correctly assessed the balance of geopolitical risks and opportunities would have known to "buy in May and enjoy your day."2 At the same time that we encouraged investors to load up on risk this year, we cautioned that 2018 would be a challenging year.3 Three themes are now coming into focus as 2017 draws to a close: Politics has become a headwind to growth in China as Beijing intensifies deleveraging and structural reforms; U.S. fiscal and monetary policy favor the USD, which will reignite trade protectionism from Washington D.C.; Italian elections may reignite Euro Area breakup risk. In this report, we update our view on these three risks. Data out of China are particularly concerning: broad money (M3) growth has decelerated sharply with negative implications for the economy (Chart 2).4 M3 is at last ticking up but the consequences of its steep drop have not yet translated to the economy. Our message to clients since 2016 has been that the nineteenth Party Congress would mark a turning point in President Xi Jinping's tenure, that he would see his political capital replenished, and that Beijing's pain threshold would therefore rise appreciably in 2018. Hence we do not expect any new stimulus to be quick in coming or very large. Chart 1Buy In May And Enjoy Your Day Chart 2China's Money Impulse Spells Slowdown What happens in China will not stay in China. Signs of cracks are emerging in the buoyant global growth narrative (Chart 3), with potentially serious consequences for emerging markets (EM) (Chart 4).5 Chart 3Signs Of Cracks Forming Chart 4EM Manufacturing: Rolling Over China: Ramping Up For The New Year Crackdown The aftermath of the Communist Party's nineteenth National Party Congress is unfolding largely as we expected: with a reboot of President Xi Jinping's reform agenda. Chinese economic data are starting to reflect the consequences of tighter policy since late last year (Chart 5), and BCA's China Investment Strategy has shown consumer-oriented sectors outperforming industrials and materials since the party congress, as the reform drive would have one expect.6 China's policymakers have already allowed the monetary impulse - the rate of growth in the supply of money - to slow to the lowest levels in recent memory. This bodes ill for Chinese imports and base metal prices (Chart 6), as BCA's Emerging Market Strategy has emphasized.7 Chart 5Expect More Disappointments From China Chart 6Chinese Imports And Base Metals At Risk It is true that policymakers will re-stimulate the economy when they reach their pain threshold, but with Xi Jinping's political capital replenished and the party and state unified under him, we expect that threshold to have moved higher than financial markets expect. Yes, the government will try to prevent its policies from being highly disruptive and destabilizing - as with the People's Bank of China injecting liquidity to ease rapidly rising bond yields (Chart 7) - but the bottom line is that it is pressing forward with tightening. How can we be so sure that this policy trajectory is set? The initiatives in the early stages of implementation after the congress confirm our view that the central government is hardening the line on several key economic-political fronts: Financial regulatory overhaul: People's Bank Governor Zhou Xiaochuan has made a series of dire comments about China's financial risks and the danger that it is reaching a "Minsky Moment," or accumulation of risks that will end in a catastrophe.8 Zhou's likeliest replacements are both financial reformers, and one of them, Guo Shuqing, is the hawkish regulator who has led the crackdown on shadow lending this year (Chart 8). Moreover, whoever heads the central bank will have the benefit of new financial oversight capabilities. The Financial Stability and Development Commission (FSDC), a new entity charged with coordinating the country's various financial regulatory agencies, has just held its first meeting. Its inaugural chairman, Vice-Premier Ma Kai, is likely to retire soon, but rumors are swirling that his replacement will be Liu He, President Xi's top economic thinker and a reformist, who wrote an ominous article about excessive leverage in the People's Daily in May 2016 and has now made it onto the Politburo. If Liu He takes charge, given his very close relationship with Xi, the FSDC will be irresistible. If not, the FSDC will still be effective, judging by the fact that Ma Kai's replacement will likely be someone, like Ma, who sits on both the Politburo and State Council. Chart 7China's Bond Yields Rising Sharply Chart 8Shadow Banking Has Peaked Local government crackdown: Local government officials in two cities in Inner Mongolia have canceled urban metro projects due to excessive debt, reportedly under orders from the central government. Other cities in other provinces have suggested that approvals for such projects are being delayed.9 In other words, the central government is no longer endlessly accommodating debt-financed local government projects, even projects that support priority goals like urbanization and interior development. This news, so soon after the party congress, is likely to be the tip of the iceberg, which suggests that local government spending cannot be assumed to shake off its weakening trend anytime soon (Chart 9). Top officials pointed out local government leverage as a systemic risk, along with shadow banking, at the National Financial Work Conference in July, and both the outgoing finance minister and the outgoing central bank chief have called for reining in local governments. The latter's comments were formally endorsed by being included in the Communist Party's official "party congress study guide," suggesting that they are more than just the parting advice of a soon-to-be retiree. Property tightening: China's real estate sector, which provides 22% of investment in the country, is feeling the squeeze from financial tightening and targeted measures to drive out speculation since October 2016 (Chart 10). More, not less, of a squeeze is expected in both the short and long term. In the short term, inspections of commercial housing for corruption and speculative excesses could exert an additional dampening effect. In the medium and long term, the Xi administration plans to roll out a nationwide property tax, according to Huang Qifan, an economic policymaker tied to the legislature, "in the near future, not ... 10-20 years. It could happen in the next several years."10 The tax was delayed in 2016 amid economic turmoil. A national property tax would be an important fiscal reform that would tamp down on the asset bubble, rebalance the growth model, and enable the government to redistribute wealth from multiple homeowners to lower income groups. Chart 9Local Government Spending Is Weak Chart 10Property Tightening Continues Industrial restructuring: Environmental curbs on outdated and excess industrial capacity are continuing. Although China aggressively cut overcapacity in coal, steel and other sub-sectors over the past twelve months, it continues to face larger overcapacity than other economies (Chart 11), particularly in glass, cement, chemical fertilizers, electricity generation and home construction. It is also possible that SOE restructuring will become more aggressive. Currently, SOEs listed on the Shanghai exchange are rallying relative to the A-share market, as they have tended to do when the Communist Party reaffirms its backing of the state sector (Chart 12). However, announcements of SOE reforms in this administration have also triggered phases of under-performance. SOEs targeted for reforms face greater scrutiny of their finances and operations.11 Moreover, any SOE is vulnerable to the new wave of the anti-corruption campaign.12 National Supervision Commission: The new anti-corruption czar, Zhao Leji, will be a very influential figure if he is even to hold a candle to his predecessor, Wang Qishan. Zhao is to oversee the creation of a nationwide anti-corruption system that targets not only the Communist Party, as before, but every public official. The new commission will have branches at each level of administration (city, province, central government) and will combine the various existing anti-corruption agencies under one head. The purpose is not merely to root out political enemies (as administration critics, with some justice, would argue) but also to improve the effectiveness of policy implementation and address public grievances that threaten to undermine the regime. The latest environmental curbs have shown that employing anti-corruption teams to help enforce broader economic policy can be highly effective. Xi and Zhao Leji look set to extend this practice to state ministries, including financial regulators.13 It is not clear whether they will succeed in rebuilding the regime's legitimacy in public eyes, but in the short term an initiative like this should send a chilling effect throughout the state bureaucracy, similar to that which occurred among local government party chiefs in 2014 after the initial anti-corruption campaign was launched.14 Chart 11Overcapacity Still A Problem For China Chart 12SOEs Preserved, But Face Reforms In short, preparations are under way for Xi's second five-year term in office. (Perhaps not his last term, as the party congress also made clear.)15 New agencies and personnel suggest that the administration is embarking on an intensification of policy tightening. Tougher policy is viewed as necessary, not optional: top leadership has repeatedly stated that a lack of action on systemic threats will lead to regime-threatening crises down the road.16 Chart 13China's Impact On Global Growth How will this agenda impact the rest of the world? Our colleagues at China Investment Strategy hold that China may step up reforms but will not do so in a way that will negatively impact China's imports or key assets like base metal prices.17 However, from a political perspective, we view the combination of Xi's political capital with the new financial and anti-corruption commissions as likely to increase policy effectiveness to an extent that causes banks to lend less eagerly and local governments and SOEs to err on the side of less borrowing and spending. This will reduce demand for imports and commodities and will also raise the tail-risk of excessive tightening. China's contribution to global growth had fallen over the years, but has recently rebounded on the back of stimulus in 2015-16 (Chart 13). As such, it will not take much of a drag on import growth in 2018 to have a global impact. The most exposed commodity exporters to China (outside of oil) are Brazil, Chile and Peru (with Indonesia and South Africa also at risk), while the most exposed exporters of capital goods are Taiwan and South Korea, followed by Southeast Asia (the Philippines, Malaysia, Vietnam and Thailand). Looking at the China-exposed countries whose stocks rallied the most while China stimulated in 2016, the prime candidates for a negative impact in 2018 will be Brazil and Peru, and less so Hungary and Thailand. Bottom Line: The Xi administration is rebooting its reform agenda and has a higher tolerance for pain than the market yet realizes. Centralization, deleveraging and industrial restructuring have been deemed necessary to secure the long-term stability of the regime. China's policy risks are understated and the next wave of stimulus will not be as rapidly forthcoming as financial markets expect. U.S.: Trouble In (GOP) Paradise Markets have rallied throughout the year despite a lack of policy initiatives from the U.S. Congress. Judging by the performance of highly taxed S&P 500 equities, the rally this year has not been about the prospects of tax reform (Chart 14).18 Rather, markets have responded to strong earnings data and a lack of policy initiatives. Wait, what? Yes, markets have rallied because nothing has been accomplished. Investors just want President Trump and the Republican-held Congress to maintain a pro-business regulatory stance (Chart 15) and not do anything anti-corporate. Doing nothing is just fine. Chart 14Market Has Doubted Tax Reform Chart 15Market Has Cheered De-Regulation Here Come The Socialists Dems The Democratic Party leads the 2018 generic Congressional vote polling by 10.8%, up from 5.9% in May (Chart 16). The generic ballot polling is notoriously unreliable as most U.S. electoral districts are politically designed to be safe seats - "gerrymandered" - and as such are unlikely to respond to nation-wide polling (Chart 17). However, Republican support has fallen and Democratic candidates have performed extremely well this year. Chart 16U.S. Public Leans Democratic Chart 17Electoral System Reduces Competition First, candidates for governor in Virginia and New Jersey have outperformed their polling in November elections. Second, in the four special elections this summer, Democrats narrowed Republican leads by 18%. If the electoral results from Table 1 are replicated in 2018, Republicans could face a massacre in the House of Representatives. In addition, Republicans are suddenly vulnerable in Alabama, where the anti-establishment Senate candidate, and Breitbart-endorsee, Roy Moore is struggling with accusations of pedophilia (Chart 18). Table 12017 Special Elections Are Ominous For The GOP Chart 18Republican Senate Majority May Lose A Seat Why should investors fear a Democratic takeover of the House of Representatives? Yes, the odds of impeachment proceedings against President Trump would rise, but we are on record saying that investors should fade any impeachment risk to assets.19 The greater risk is that the Democratic Party has turned firmly to the left with its new manifesto, "A Better Deal." A strong performance by unusually left-of-center Democratic candidates could spook financial markets that have been lulled into complacency by the lack of genuine populism from the (thus far) pluto-populist president. Protectionism While most investors are focused on the ongoing NAFTA negotiations - which we addressed in last week's Special Report20 - we would draw attention again to the shift towards protectionism by the Republicans in the Senate. Normally a bastion of pro-business free-traders, the Senate has turned to the left on free trade. Senator John Cornyn (R, Texas) has introduced a bill to make significant reforms to the process by which the United States reviews foreign investments for national security, led by the Committee on Foreign Investment in the United States (CFIUS). Two further bills, one in the House and another in the Senate, would also significantly tighten access to the U.S. by foreign investors. China is foremost in their sights. In early 2018, investors will also be greeted by two significant decisions. First, on tariffs: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. The International Trade Commission has already determined that imports of these goods can cause material injury to U.S. industries, so Trump merely has to decide whether to impose tariffs (likely from 35% to 50%), import quotas (which have never received limits from courts), or bilaterally negotiated export limitations from trade partners.21 The consequences would go beyond the current, country-specific tariffs on these items, setting a precedent that would expose a wide range of similar imports to punitive action, and more broadly would signal to the world that the U.S.'s protectionist turn under Trump is real.22 Second, the White House has allegedly completed a comprehensive review of China policy under way since June.23 The review is said to focus on economic rather than strategic matters and to call for the use of punitive measures to insist that China alter tactics long complained about by the United States, including intellectual property theft, export subsidies, and forced tech transfer from joint ventures in China. Already the U.S. is investigating China for intellectual property theft under Section 301 of the 1974 Trade Act, with results that could prompt tariffs no later than August 2018.24 As if on cue, Wang Yang, a new inductee on China's Politburo Standing Committee and a prominent reformer, wrote an editorial in the People's Daily declaring that China should protect intellectual property, not require tech transfers, and give foreign firms equal treatment under the "Made in China 2025" plan.25 China has made similar promises and the U.S. has made similar threats many times before, so decisions in the coming months will be telling. Ultimately we fear that President Trump may feel compelled to ratchet up protectionism in 2018 for two reasons. First, Americans within his populist base will grow restless as they do the math on the tax legislation and realize that their champion is not quite the populist they voted for. Trump will need to re-convince them of his protectionist credentials and independence from Washington elites and the policy status quo. Second, if our view on Chinese slowdown and American fiscal thrust is correct, the USD bull market should restart in 2018. This would hurt U.S. export competitiveness, expand the trade deficit, and motivate U.S. companies to invest abroad, a paradox of President Trump's tax and fiscal policy. The White House may, therefore, be compelled to reach for mercantilist solutions to an FX problem. Foreign Policy The final reason to worry is a "Lame Duck" presidency. Far more predictable presidents sought relevancy abroad late in their mandate. For example, President George H. W. Bush committed troops to Somalia on his way out of the White House. President Bill Clinton bombed Yugoslavia. Given Trump's dismal approval polling and a potentially historic "wave" election for the Democrats in November, President Trump could similarly shift focus to geopolitics. If that shift includes confronting regional powers like China (and/or North Korea), or Iran, risk premiums may rise. In the meantime, we expect tax cuts to pass. The going is getting tougher in the Senate. The decision to include the repeal of the Obamacare individual mandate - designed to cut another $300 billion in government spending over the next ten years - will make it more difficult to secure 51 Senate votes. We maintain our view that the final legislation may need until Q1 to pass. Between now and then, legislators may need a failure or two in order to realize that the clock is ticking toward the midterms. Bottom Line: Markets have cheered lack of action from the Congress. However, the going will get tougher in 2018 as investors fret about protectionism, President Trump's itch to remain relevant, and a potential takeover of the House by the most left-of-center Democratic Party in a generation. Europe: Germany Is A Passing Risk, Focus On Italy The collapse of coalition talks in Germany is not a structural concern for Europe. The breakdown in the negotiations occurred because of the immigration debate, in which the right-of-center Christian Social Union (CSU) and the Free Democratic Party (FDP) struck out a different position from the ruling Christian Democratic Union (CDU) and the liberal Green Party. Of course, the disagreement is not about immigration today, given that inflows of asylum seekers this year has been well below past flows (Chart 19A). Rather, the fundamental disagreement is over how the CDU and its leader Angela Merkel handled the 2015 migration crisis and how it will be handled in the future. Chart 19ANo Immigration Crisis Today Chart 19BGermans Love Europe For investors, what matters is that there is no substantive disagreement over the EU, European integration, or Germany's role in it. The mildly euroskeptic FDP did not draw any red lines. The reason is obvious: the German euroskeptic constituency is small, shrinking, and largely already captured by the Alternative for Germany (AfD) anti-establishment party (Chart 19B). Germans are objectively the most europhile people in Europe. Going forward, a new election would cause further political uncertainty. On the margin, it could cause business confidence to stall. However, Germany runs a 14 billion euro budget surplus and is not expected to launch any structural reforms or fundamental economic changes. As such, if the formation of a government is delayed by three-to-six months, the economic implications will be fleeting. In fact, the result of a new election could be a Grand Coalition between the CDU and Socialists, which would be positive for European integration. However, as we have argued before, hopes for a significant restart of integration have probably run ahead of reality.26 For us, Italy is the immediate concern. Italy passed a new electoral law in late October, setting the stage for the election due by May 2018. The consensus in the news media is that the president will call elections in January, with the vote taking place sometime in March.27 The consensus is that the new law will make it more difficult for the populist Five Star Movement (M5S) to win a majority of seats in the Italian Parliament. In addition, it will give a lift to the parties with strong regional ties - such as the governing Democratic Party (PD) and Lega Nord. Chart 20Italy Set For A Hung Parliament The nuances of the new law are largely irrelevant, however, given the close polling of the three electoral blocs. The most likely outcome will be a hung parliament (Chart 20). Nonetheless, we can still learn something from the law: the Italian establishment parties are cooperating to subvert the electoral chances of M5S. The ruling PD and the center-right Forza Italia of former Prime Minister Silvio Berlusconi are working together to design an electoral system that favors the pre-election norm of coalition-building and parties with strong regional representation. Neither of these factors fits M5S's profile. This suggests that the two centrist blocs will be able to put together an establishment coalition following the election. On one hand, this will give stability to the Euro Area for at least the duration of that government. On the other hand, the underlying data continues to point to structural euroskepticism in Italy. Unlike their European peers, Italians seem to be flirting with overt euroskepticism. When it comes to support for the common currency, Italians are clear outliers, with support levels around 55% (Chart 21). Similarly, over 40% of Italians appears to be confident in the country's future outside the EU (Chart 22). These are ominous signs for the future. Still, both M5S and the mildly euroskeptic Lega Nord have tempered their demands for an exit from the common currency union. The official stance of the M5S is that the exit from the Euro Area is only "option B," that is, an option if the bloc is not reformed. Meanwhile, Lega Nord is on record opposing a referendum on membership in the currency union because it is illegal.28 Chart 21Italians Stand Out For Distrust Of Euro Chart 22Italians Not Enthusiastic About EU The stance of Italy's euroskeptics will change as soon as it is convenient. The country's establishment is likely making a mistake by contemplating a grand coalition alliance. Unless such a government develops a serious plan for painful structural reforms - it will not - it will likely waste its mandate and fall at the first sign of recession or crisis. At that point, the only alternative will be the M5S, which will stand alone in opposition to such an ineffective government. Investors can therefore breathe a sigh of relief in the medium term. Italy will likely not be a source of risk-off in 2018 or even 2019, although it is still the main risk in Europe for next year and bears monitoring. However, in the long term, we maintain that Italy will be a catalyst for a serious global risk-off episode within the next five years. We remain optimistic that such a crisis will ultimately strengthen Italy's commitment to the Euro Area, as we outlined in a recent Special Report.29 But that is a low conviction view that will require constant monitoring. Could there be another scenario? Several clients have asked us if an Emmanuel Macron could emerge in Italy? Our answer is that there already was an Emmanuel Macron: Matteo Renzi, the former prime minister and current PD leader, was Macron before Macron. And yet he failed to enact significant structural and constitutional reforms. Yet two potential candidates may be ready to swoop in from the "radical center" position that Renzi and Macron characterize. The first is ECB President Mario Draghi. He is widely respected in Italy and is seen as someone who not only allayed the Euro Area sovereign debt crisis, but also stood up to German monetarist demands in doing so. The second is Fiat-Chrysler CEO Sergio Marchionne, one of the world's most recognizable business leaders and a media star inside and outside Italy. If the centrist coalition begins to fray by the end of 2019, both of these individuals may be available to launch a star-studded campaign to "save Italy." Bottom Line: We remain cautiously optimistic about the upcoming Italian elections. While our baseline case is that Italian elections will produce a weak and ineffective government, though crucially not a euroskeptic one, nevertheless risks abound and require monitoring. Investment Implications There are a lot of unknowns heading into 2018. What will become of U.S. tax cuts? How deep will the policy-induced slowdown become in China? What will President Trump do if he becomes the earliest "Lame Duck" president in recent U.S. history? Will he embark on military or protectionist adventures abroad? Asset implications are unclear, but we offer several broad takeaways. First, the VIX will not stay low in 2018. Second, the USD should rally. Both should happen because investors are far too complacent about the Fed's pace of hikes and because of potential global growth disappointments as Beijing tinkers with the financial and industrial sectors. Chart 23AEuro Area Versus U.S. Growth: Don't Ignore China (I) Chart 23BEuro Area Versus U.S. Growth: Don't Ignore China (II) Third, it is time to close our recommendation to be overweight European risk assets. European equities have a higher beta to global growth due to the continent's link to Chinese demand. As our colleague Mathieu Savary has pointed out, when Chinese investment slows, Europe feels it more acutely than the U.S. (Chart 23). Chart 24U.S. Dollar Rebound = EM Pullback We are also closing our tactical long position on China's big banks versus its small-to-medium-sized banks. This position has been stopped out at a loss of 5%, despite the riskier profile of the latter banks and the fact that their non-performing loans are rising. Faced with these challenges, Beijing decided to open the door to foreign investment and too ease regulations on these banks so that they can lend to small cap companies as part of the reform drive. These actions inspired a rally relative to the Big Banks that worked against our trade. As financial tightening will continue, however, we expect this rally to be short-lived, and for big banks to benefit from state backing. Our highest conviction view is that it is time to short emerging markets. Our two core views - that politics will become a tailwind to growth in the U.S. and a headwind to growth in China - should create a policy mix that will act as a headwind to EM (Chart 24). The year 2017 may therefore turn out to have been an anomaly. Emerging markets outperformed as China aggressively stimulated in 2016 and as both the U.S. dollar and bond yields declined. This mix of global fiscal and liquidity conditions proved to be a boon for EM, giving it a liquidity-driven year to remember. That year is now coming to an end. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day," dated April 26, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 4 China's official broad money (M2) measure has also sharply decelerated, as have all measures of China's money. We prefer BCA's Emerging Market Strategy's broader M3 measure. The official M2 has underestimated the amount of new money in China because banks and shadow banks have done extensive off balance sheet lending. The M3 measure includes bank liabilities excluded from M2, it is calculated by taking the total of non-financial institution and household deposits, plus other financial corporation deposits, and other liabilities. Please see BCA Emerging Market Strategy, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com. 5 Please see BCA Foreign Exchange Strategy Weekly Report, "Temporary Short-Term Risks," dated November 10, 2017, available at fes.bcaresearch.com and BCA Emerging Markets Strategy Weekly Report, "EM: Cracks Are Appearing," dated November 15, 2017, available at ems.bcaresearch.com. 6 Please see BCA China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress," dated November 16, 2017, available at cis.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Special Report, "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, available at ems.bcaresearch.com. 8 Zhou's comments should not be interpreted merely as a farewell speech of a retiring central bank governor, since they echo the general policy shift in the administration since December 2016's Central Economic Work Conference, and April 2016's Politburo meeting, toward tackling financial risk. For Zhou's comments, please see "China's central bank chief lays out plans to avert future financial crisis," South China Morning Post, November 4, 2017, available at www.scmp.com. 9 Xianyang in Shaanxi, and Wuhan in Hubei. Please see Wu Hongyuran and Han Wei, "Another City Halts Subway Projects Amid Financing Concerns," Caixin, November 13, 2017, available at www.caixinglobal.com. 10 Please see Kevin Yao, "China central bank adviser expects less forceful deleveraging in 2018," Reuters, November 15, 2017, available at www.reuters.com. 11 The latest official announcement claims that an additional 31 SOEs will be listed for restructuring. Please see "More SOEs to be included in reform plan," People's Daily, November 16, 2017, available at en.people.cn. 12 We fully expect SOEs to be subjected to rigorous treatment from the National Supervision Commission. Note that the crackdown on overseas investment earlier this year merely touches the tip of the iceberg in terms of the SOE corruption that could be revealed by probes. See, for example, the following report on the National Audit Office's public notice on SOE fraud and irregularities, "20 Central Enterprises Overseas Investment Audit Revealed A Lot Of Problems," Pengpai News (Shanghai), June 26, 2017, available at news.163.com. 13 Please see BCA Geopolitical Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 14 Please see BCA China Investment Strategy Weekly Report, "Policy Mistakes And Silver Linings," dated October 7, 2015, and "Legacies Of 2014," dated December 17, 2014, available at cis.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 16 Xi Jinping has called financial security an important part of national security and declared that "safeguarding financial security is a strategic and fundamental task in the economic and social development of our country." Please see Wang Yanfei, "Leaders aim to fend off financial risks," China Daily, April 26, 2017, available at www.chinadailyasia.com. For Zhao Leji's post-congress comments on this topic in the People's Daily, please see "China faces historic corruption battle, new graft buster says," The Guardian, November 11, 2017, available at www.theguardian.com. 17 See footnote 6. 18 More anecdotally, a clear majority of our clients disagrees with our bullish prospects of tax cuts. 19 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 21 Please see Chad P. Bown, "Donald Trump Now Has The Excuse He Needs To Open The Floodgates Of Protectionism," Peterson Institute of International Economics, October 9, 2017, available at piie.com. 22 Other measures could follow thereafter. For instance, the Commerce Department will issue its final report on steel and aluminum in January and Trump could decide to take punitive actions on these goods under Section 232 of the 1962 Trade Expansion Act. Please see Ana Swanson, "Democrats Pressure Trump to Fulfill Promise to Impose Steel Tariffs," New York Times, October 26, 2017, available at www.nytimes.com. 23 The review itself began in June, around the time when Trump's and Xi's initial "100-day plan" to improve trade relations expired. The report that the review is completed is from Lingling Wei et al, "Beyond Trump-Xi Bond, White House Looks to Toughen China Policy," Fox Business News, November 19, 2017, available at www.foxbusiness.com. See also Adam Behsudi et al, "White House conducting wide-ranging review of China policy," Politico, September 28, 2017, available at www.politico.com. 24 The U.S. Trade Representative Robert Lighthizer is supposed to finish his investigation into intellectual property under Section 301 of the 1974 Trade Act within a year of August 18, 2017. Please see Gary M. Hnath and Jing Zhang, "Trump Administration Initiates Section 301 Investigation of China's Acts, Policies and Practices Related to Technology Transfer, Intellectual Property and Innovation," dated August 25, 2017, available at www.lexology.com. 25 Please see "Chinese vice premier pledges fair treatment of foreign firms as China opens up," Reuters, November 10, 2017, available at www.reuters.com. 26 Please see BCA Geopolitical Strategy Weekly Report, "Stick To The Macro(n) Picture," dated May 10, 2017, available at gps.bcaresearch.com. 27 Just in time to get a new government in place ahead of the World Cup! Oh wait... Too soon? 28 Which is an odd position to take given their supposed anti-establishment orientation. For example, the U.K. referendum on EU membership was non-binding, and yet it took place and had relatively binding political consequences. 29 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com.
Highlights The bill is bullish for growth and therefore for the equity markets and the U.S. dollar; The bill consists mostly of tax cuts, not reforms, that favor corporations and the wealthiest taxpayers; The bill is bullish for growth in the short term, but also inflationary and hence a risk to growth in the medium term; A non-populist White House is a relief to the markets, particularly on trade policy, but may mean a more hawkish foreign policy. Feature Chart 1Trump: A Boon For##BR##Main Street And Wall Street Since the November 2016 election, and particularly since President Donald Trump's inauguration, financial markets have celebrated. This is ironic given that on the campaign trail, Trump often adopted populist rhetoric indistinguishable from that of Bernie Sanders, the bête noire of the business community. Trump's cabinet, however, quickly took on a pro-business outlook following the inauguration. Despite appointing several notable trade hawks, the administration sported half a dozen former Goldman Sachs employees. Business confidence soared, especially among small businesses, while regulatory worries hanging over CEO's melted away (Chart 1). Both Wall Street and Main Street took one look at President Trump's cabinet at the end of January and decided that there was not an iota of genuine populism in the White House. This view was reinforced by three early decisions by the Trump administration: China: President Trump reneged on his promise to designate China a currency manipulator formally on day one of his administration.1 Instead, he hosted President Xi Jinping at the Mar-A-Lago Summit in April and agreed to engage in trade talks over the rest of the year. (He again declined to accuse China of currency manipulation in October.) Budget: President Trump's "skinny budget" proposal in May oozed with Republican Party orthodoxy, bolstering spending on defense and border security, while calling for drastic cuts to domestic programs. The implication was that future tax cuts would ultimately be "paid for" via draconian fiscal austerity in the distant future. "Breitbart clique" ousted: Steve Bannon, the White House Chief Strategist and self-described economic nationalist, was fired in mid-August, with several prominent allies ousted in the wake of his departure. Bannon's departure left Treasury Secretary Steven Mnuchin, chief economic advisor Gary Cohn, and Commerce Secretary Wilbur Ross firmly in charge of economic policy. Enter Tax Cuts The coup-de-grâce of Republican orthodoxy is the just-proposed tax cut plan. The proposal by the House Ways and Means Committee is heavily stacked in favor of corporations and the top-income brackets. As Table 1 clearly illustrates, the household component of the plan is nearly balanced - and therefore deserving of the moniker "reform" - whereas the corporate side of the ledger is closer to a pure and simple cut. Table 12017-2018 Republican Tax Cut Proposal - House Ways And Means Committee (Oct. 2017) Some of the more prominent measures proposed by the House and Ways Committee are: Household Income The highest tax rate remains 39.6%, but would now only kick in at $1 million in taxable income;2 The Alternative Minimum Tax (AMT) will be repealed, which hurts the upper middle class and wealthy by limiting tax benefits from a variety of deductions; The estate tax will be fully eliminated by 2024; The standard deduction will be doubled from $12,700 to $24,000, one of the few direct benefits to lower-income families; The plan would repeal the state and local income and sales tax deductions, while capping the state and local property tax deduction to $10,000; Almost all itemized deductions will be eliminated - such as medical expenses, property losses, casualty losses, etc.; The mortgage interest rate deduction for future home purchases will be capped, with only homes up to $500,000 covered. Corporate Income The corporate tax rate will be cut from 35% to 20%; Companies will be able to deduct the full amount of business investments in the year that they are made, although the provision would expire at the end of 2022; The tax rate on income from pass-through businesses would fall to 25%, considerably below the top household income tax rate; Several deductions would be eliminated, including the deduction of interest on debt; The "worldwide" tax system would be overhauled and foreign earnings repatriated: U.S. multinational corporations would pay a 12% tax rate on past profits that they repatriate, while future overseas earnings would be taxed at the new 20% corporate rate. We would caution clients from parsing too carefully through the proposal, lest they waste their time. The Senate is likely to pass a completely different set of proposals. The GOP plan is to get to a "conference committee" as fast as possible, where a new draft legislation can be hammered out from the two disparate proposals. We suspect that this entire process will miss the self-imposed target of "before Christmas," and probably last until the end of the first quarter.3 Nonetheless, we can discern the priorities of the House Republicans by gauging the winners and losers of their proposal. Our immediate take is that the tax cuts greatly benefit upper-income filers (households making over $423,000), moderately hurt upper-middle-class / lower-upper-class filers (those making between $260,000 and $423,000), and are largely neutral for the rest of households. First, the highest income groups are the clear beneficiaries: households making between roughly $450,000 and $1,000,000 will see their income tax rates fall by nearly 5%, by far the largest decrease planned. And, obviously, it is upper-income households that benefit from repealing the estate tax. Meanwhile, the upper middle class takes on the brunt of the burden of "reform": households making between $260,000 and $423,000 will see far fewer benefits under the proposed legislation. First, they are the only income bracket that will see a tax increase, from 33% to 35%. Second, they will not necessarily have the wherewithal to reclassify their income as pass-through business income. Third, many of the itemized deductions that will be eliminated will make a real difference in their filings. Fourth, they were the most likely to purchase homes between $500,000 and $1,000,000, which will no longer be eligible for interest-rate deduction. Fifth, the repeal of the estate tax will make less of a difference for this income group. Sixth, if they are domiciled in high-tax rate states and municipalities, these households will now be limited to how much they can deduct from federal taxes.4 Overall, the proposed tax cut plan fits general Republican orthodoxy.5 It tries to stimulate growth by favoring corporations and the wealthy. For economic growth, the plan is bullish in the short term. Particularly bullish is the ability of corporations to fully deduct the amount of business investment for the next five years. This provision could significantly increase investment in the short term, especially given the implicit threat that the opportunity will expire in 2022.6 Will the plan fail? It could, if enough Republican voters turn against it. The latest polling from Pew research - albeit from April of this year - shows that Americans no longer think that they pay too much in taxes (Chart 2). On the other hand, Republican and Republican-leaning voters do have a problem with the complexity of the tax code (Chart 3), and the proposed plan simplifies taxes for some middle-income households by doubling the standard deduction and repealing the AMT. The White House has already begun stressing this feature given that it polls well with voters. Chart 2American Voters Think Taxes Are Fair... Chart 3...But Republican Voters Think They Are Too Complex Polling suggests that President Trump remains relatively popular with Republican voters despite his dismal polling with the general public (Chart 4). He is polling only slightly below the average of previous Republican presidents at this point in his term in office. As long as Trump remains more popular with Republican voters than his Republican peers in Congress, we think that he will be able to force the tax plan through both the Senate and the House. In fact, we could even see some Democrats in the Senate supporting these tax cuts. Table 2 lists the 2018 Senate races to watch, particularly the vulnerable Democrats campaigning in red states that President Trump carried in 2016. Senators Nelson (D - Florida), Donnelly (D - Indiana), McCaskill (D - Missouri), Tester (D - Montana), Heitkamp (D - North Dakota), Brown (D - Ohio), and Baldwin (D - Wisconsin) are especially vulnerable. That makes seven potential votes for the Trump tax cut, potentially enough "slack" for the Republicans in the Senate to lose one or two votes on the tax bill. Chart 4Trump Remains Popular With GOP Voters Table 22018 Senate Races To Watch Is it even worthwhile to contemplate a scenario in which Republicans pass the tax cuts with Democrat support in the Senate? The short answer is yes. The 2001 Economic Growth and Tax Relief Reconciliation Act, the first of two Bush-era tax cuts, passed with 58 votes in favor, including 12 Democrats. Of the 12 that voted with Republicans, only three were from blue states, while the other nine were from red states that President Bush had carried in 2000. The 2003 tax-cut bill, Jobs and Growth Tax Relief Reconciliation Act of 2003, also passed with Democratic support with only 51 votes in favor. Senators Bayh (D - Indiana), Miller (D - Georgia), and Nelson (D - Nebraska) all crossed the aisle. Bayh was facing reelection in 2004, as was Nelson in 2006, in their respective red states. Bottom Line: The proposed tax cuts will benefit corporations and the upper-income Americans. The Senate may make some symbolic changes to the proposal to make it more palatable to the median American - given that senators have to capture the median voter in their state to win reelection. For example, the estate tax repeal may be scrapped and rules on deducting state and local taxes may be modified. Regardless of how the horse-trading goes, we believe that the U.S. economy will receive a modest stimulus in the form of a roughly $1.5 trillion tax cut (over ten years). Given that the U.S. economy is at full employment and firing on all cylinders, the proposed tax cuts should be marginally bullish for growth and inflation (Chart 5). Chart 5Regardless Of Tax Cuts, U.S. Economy Is Ripped What Do The Tax Cuts Tell Us About President Trump? We are big believers in the theory of "revealed preferences." While this concept was formally applied by economist Paul Samuelson to consumer behavior, we like to apply it to policymakers. The idea is to ignore the rhetoric and focus on what patterns of behavior reveal about genuine preferences. Politicians talk a lot, particularly during an election campaign. As a presidential candidate, Donald Trump was a clear populist candidate. He only revealed his tax reform plan in late September 2015 and then rarely mentioned it on the campaign trail. While his tax cut proposal languished on the campaign website, Trump focused on rallying voters around a combination of populist promises. These were, in no particular order, to build the border wall (and make Mexico pay for it), to rebuild American infrastructure, to repeal Obamacare, to destroy the Islamic State terrorist movement while disengaging the U.S. from global affairs, and to punish the unfair practices of trade partners like China and Mexico. Fast forward 12 months and we are now half-way to the 2018 mid-term election, with the Republicans controlling all three branches of government, and yet the only electoral promise that President Trump is even close to achieving is the just-announced tax cut.7 The revealed preference of the Trump administration, at least at this point, is Republican orthodoxy. Trump is a pro-growth, pro-business, anti-tax, anti-spending, red-blooded Republican. He has eschewed trade conflict with China, ignored infrastructure proposals, largely toed-the-line of foreign policy orthodoxy, and left hedge fund managers - a punching bag on the campaign trail - alone.8 To put it bluntly, Trump's behavior thus far suggests that he is a pluto-populist. A pluto-populist is someone who rules on the behalf of a plutocracy - an oligarchy controlled by the wealthiest citizens - but whose main tactic is to rally the plebeians (the common people) through populist policies. The House's draft tax plan provides sweeping gains for the wealthiest. It also preserves or expands some benefits for the poorest groups, so as to make it politically achievable. The upper middle class - the professional class - stands to suffer the most under the new tax scheme. If this analysis is correct, what does it reveal about President Trump's strategy going forward? Anti-globalization rhetoric is just talk: The fourth round of NAFTA renegotiations ended with a bang: the U.S. delivered four new demands, two of which both Ottawa and Mexico City have identified as non-starters.9 However, in the pluto-populist scenario, even if NAFTA is ultimately abrogated, the Trump administration will ensure that the critical components are preserved in bilateral agreements with Canada and Mexico. While those agreements are negotiated, the Trump Administration will not raise tariffs to the maximum, "bounded," level as allowed by the WTO. Meanwhile, trade relations with China may still sour in 2018, but they will not produce a trade war. Social unrest could increase: As we argued in a recent Special Report, the American structural context is ripe for more social unrest due to "elite overproduction."10 Trump's policies are likely to feed this condition. Meanwhile, his rhetoric and symbolic gestures will fuel the flames of division in order to play to his base, and force Democrats to argue about how to respond. This would be the populist part of pluto-populism. Hawkish foreign policy: With most of his domestic policies stymied, President Trump will pivot to the foreign theatre. We would particularly watch the growing tensions in the Middle East between Saudi Arabia and Iran, which could soon involve Lebanon.11 President Trump has also decertified the Iran nuclear deal, setting the stage for Congress to decide whether it will impose new sanctions and thus abrogate the deal. Plus, there is always North Korea. Bottom Line: Essentially, President Trump's strategy will be to pass pro-business, pro-market economic policies while distracting his largely anti-business, anti-market voters through ancillary issues. Investment Implications On the one hand, this analysis implies a very bullish policy mix as the Trump administration will not do anything domestically that hurts the ongoing bull market. On the other hand, some of those "ancillary" issues could flare up and impact the market, particularly if they involve a ratcheting up of tensions with Iran and North Korea. Chart 6No Debate: There Is No##BR##Trickle-Down From Tax Cuts The one risk that we remain concerned about is protectionism. We expected Trump to be more disruptive this year, and the above analysis suggests that protectionism, too, is merely hot air. However, Trump has only been in office for ten months. The absence of trade tensions with China may be a function of ongoing negotiations with North Korea: the U.S. needs China's cooperation in order to force North Korean leader Kim Jong-Un to the table. Ironically, then, a resolution of North Korean tensions could increase America's maneuvering vis-à-vis China, allowing Trump to become a lot more protectionist in 2018.12 Moreover, investors may be overemphasizing headline trade negotiations such as NAFTA or the China talks. The Trump administration may pursue protectionist aims through selective tariffs, such as countervailing and anti-dumping duties, in selective fashion. In other words, investors should pay attention to individual tariff decisions rather than overall negotiations.13 As for his electoral base, as long as President Trump can continue to ensure that they are focused on social disputes at home and hawkish rhetoric abroad, they may not notice the lack of movement on domestic promises. In particular, we have a high-conviction view that the just-proposed tax cuts will do nothing to curb income inequality in the U.S., and will likely deepen it, as previous such GOP-efforts did (Chart 6). Will this hurt President Trump in his 2020 reelection bid? We doubt it. But it does portend still greater socio-economic tensions and political populism in the long run. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 The promise was made in a Wall Street Journal opinion piece that then-candidate Trump penned on November 9, 2015. Please see Donald J. Trump, "Ending China's Currency Manipulation," dated November 9, 2015, available at wsj.com. 2 The top marginal tax rate of 39.6% is currently applied to single individuals making more than $418,401, a head of household making more than $444,501, and married couples, filing jointly, making more than $470,701. Technically, according to the current draft bill, the top tax rate in the House plan is supposedly about 45.6% between $1-$1.2 million, after which it falls back to 39.6%. A quirk in the proposal holds that once a filer hits $1 million of income, the IRS starts clawing back the $12,000 that the filer saved from having a 12% tax rate on his first $90,000 of income instead of a 25% tax rate. That clawback comes in the form of 6% surtax on income above $1 million. The $12,000 is completely reclaimed once the filer hits $1.2 million. By extension, everyone who makes over $1.2 million has had to pay that extra $12,000 in taxes. 3 For more on how the reconciliation process works, and how it will affect the timeline, please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 4 From a political perspective, the GOP may have simply made a bet that high-tax-rate, blue-state households making $260,000-to-$430,000 do not vote Republican. 5 The congressional budget resolution that sets out the reconciliation instructions for these tax cuts also includes draconian spending cuts, which would presumably help balance the books. Although none of those cuts will pass Congress, they reveal the traditional preference of the Republican party: cut taxes, pay for the cuts by means of a smaller government delivering fewer services. 6 And perhaps this investment boost will come just in time to help re-elect Trump in 2020! 7 Although he deserves some credit for bringing to conclusion the pre-existing fight against the Islamic State. 8 In fact, the House tax bill leaves the "carried interest" tax break in the code. 9 For more on NAFTA, please see our upcoming Special Report with BCA's Global Investment Strategy, to be published on November 10. 10 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 11 Lebanese Sunni Prime Minister Saad Harriri recently resigned while visiting Saudi Arabia, claiming that he feared for his life due to Iranian influence in Lebanon; Saudi Arabia itself is engaged in deep political struggle. 12 Indeed, in our original forecast of Trump's trade policy, we surmised that 2017 would largely be a year of negotiations, while 2018 would see the real fireworks. Please see BCA Geopolitical Strategy, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 13 An important such decision looms by January 12, 2018, which is the deadline by which President Trump must decide whether to impose "safeguard" tariffs on imports of solar panels and washing machines.