Geopolitical Regions

Special Report

Highlights So What? China’s January credit data suggest that stimulus is here. Why? January credit growth was a blowout number. Trade uncertainty is likely to be prolonged with an extension of talks. Equity bourses in South Korea and Russia are the most likely to benefit from Chinese stimulus. Industrial metals such as copper will also benefit – with a delay. Feature New credit data for China in January improves the chances that Beijing’s stimulus measures will overshoot this year, causing China’s economy to bottom in 2019 and jumpstart global growth. In our annual outlook for this year we argued that while China was stimulating the economy, the magnitude of stimulus would be the decisive factor for the global macro environment in 2019. We argued that the type of stimulus would remain primarily fiscal – tax cuts for households and small and medium-sized enterprises – and hence that it would be modest as fiscal easing would merely offset relatively weak credit growth. This view stemmed from our assessment of the Xi Jinping administration, highlighted in April 2017, as an “elitist” (not populist) administration. Its policy priorities are to discipline the Chinese economy, and in particular to contain systemic financial risk, which President Xi has cited as a national security threat. This view is not wrong, but the latest data clearly show that Xi has decided to pause these painful efforts at limiting leverage and rebalancing China’s economy. Witness January’s decisive uptick in both total social financing (total private credit) and local government bond issuance (Chart 1). Chart 1Higher Risk Of An Overshoot A massive spike in new credit is the single most important criterion in our “Checklist For A Stimulus Overshoot.” Thus, from a policy perspective, we are now at higher risk of an overshoot (Table 1). Not only credit as a whole but also informal lending saw a surge in January, implying that the government is relenting in its crackdown on the shadow banks. The approval of local government bond issuance for early in the year – and the People’s Bank of China’s announcement of a “Central Bank Bills Swap” program – reinforce this policy shift.1 Table 1Checklist For A Chinese Stimulus Overshoot In 2019   A stimulus overshoot is positive for Chinese demand in the short run but negative for potential GDP in the long run. A “traditional” credit surge of this nature cannot be surgically targeted at SMEs or households. It will go to state-owned enterprises, privileged corporations, property developers, and the like, which have always had the advantage in China’s financial system. SOEs have taken a much larger share of new loans than private companies in recent years,2 and the only silver lining of this trend was the possibility that tighter credit controls would discipline the SOEs. That silver lining is now fading, barring some new and surprising development on the reform front. China needs to create 26 trillion renminbi in new credit over the course of the year to avoid a corporate earnings contraction. These January numbers put China on track to do just that (Chart 2), assuming that President Xi and U.S. President Donald Trump agree to a short-term, framework trade deal this year. Chart 2On Track To Avoid An Earnings Contraction Of course, a few caveats are in order. First, January’s credit number is only one data point and credit growth is always abnormally strong in the first month of the year. Early in the year, banks seek to expand their assets rapidly in a bid to get as much market share as possible before administrative credit quotas kick in. Because of Chinese New Year, it is best to combine January and February data to get a sense of the rate of credit expansion in the first part of the year. To do that, investors will have to wait for mid-March when the February data is out. This year’s January numbers are very strong relative to previous Januaries (Chart 3) and the context is more accommodative than the 2017 January credit surge, when authorities were beginning to tighten rather than ease macroprudential policy. Still a rapid rate of credit expansion will have to be sustained in the coming months in order to meet the 26 trillion RMB requirement highlighted above. Second, there is some risk that China’s households and private businesses will not respond as positively today as in the past. The intensification of Communist Party control over the society and economy, President Xi’s cancellation of term limits, and the strategic confrontation with the United States have created a bearish sentiment in the private sector. Our Emerging Markets Strategy would point out that if the propensity to consume, and money velocity,3 do not accelerate, then a surge in new credit may fail to ignite a reacceleration in China (Chart 4). Chart 4Chinese Are Holding On To Their Money Still, what we now know is that Xi Jinping and his top economic adviser, Vice Premier Liu He, are not initiating the “assault phase of reform” that their predecessors initiated in the late 1990s in order to cleanse China’s economy of bad loans and zombie companies. Instead, they are likely reestablishing the “Socialist Put” in order to reverse the current deceleration, demonstrate China’s continued economic might and face down the United States’ threat of tariffs. Bottom Line: China’s stimulus measures are increasingly likely to overshoot, with positive implications for both Chinese and global growth. China is still facing a corporate earnings recession, but the odds of averting it are increasing.    Trade Deadline More Likely To Be Extended What of the trade war? First, we would warn clients that China’s annual credit origination is a much bigger factor for the global economy than China’s exports to the United States (Chart 5). The trade war can escalate from here and yet, if China’s stimulus works as it has in the past, the results will be manageable for China’s economy save for Chinese companies expressly exposed to the U.S. economy through exports. In reality, both the U.S. and China are now effectively stimulating their economies and in this sense global trade as a whole will benefit regardless of bilateral tariffs. Chart 5Watch China Credit, Not So Much The Trade War But it is possible that just as global equity markets ignored China’s economic slowdown and only sold off when the tariffs were levied (Chart 6), they may not continue to rally much on China’s credit data. Given the already considerable rally in global risk assets since October, markets may not be satisfied merely with one or two months of solid credit data out of China without a clear resolution to the trade conflict. After all, if a collapse in U.S.-China trade talks portends a new Cold War, then institutional investors may be justified in taking a wait-and-see approach despite China’s credit cycle upswing. Chart 6Will Equities Ignore China Data (Again)? In the past, we have highlighted that the U.S. and China are not economically prohibited from engaging in a trade war – the export exposure is too small – and China’s new stimulus reinforces this point. However, President Trump is concerned about causing a sell-off in the tech sector and hence the broad equity market which could translate into a bear market and raise the probability of a recession occurring prior to November 2020. Meanwhile, in China, given Beijing’s reported trade concessions, there is apparently a desire to pacify the relationship and discourage U.S. unilateral tariffs and sanctions that could become seriously destabilizing for the Chinese economy and society. The need to have a happy 2021 centenary celebration for the Communist Party may factor into policymakers’ thinking. The latest news flow is mildly positive for the odds of getting a framework deal sometime this year. President Trump visited the Chinese negotiators in Washington, D.C. while President Xi reciprocated with the American negotiators in Beijing. Trump has signaled that an extension of the March 1 deadline is possible, and a two-month extension is being bandied about in the press. China’s National People’s Congress is likely to pass a new Foreign Investment Law that ostensibly guarantees many of the American demands on forced tech transfer, intellectual property theft, and discriminatory treatment of U.S. companies (Table 2). Even the second Trump summit with Kim Jong Un, this time in Vietnam, should be seen as a mild positive for U.S.-China negotiations. Table 2New Foreign Investment Law Would Be A Positive For U.S.-China Negotiations However, Presidents Trump and Xi have yet to schedule a new summit, which is probably necessary for a final deal. And there are murmurs from the press suggesting that China’s new law and other concessions are not going to satisfy the U.S. negotiators on the critical point of “structural changes” and a verification process. This leaves us inclined to change our trade war probabilities to increase the odds of an extension (Table 3). The improvement in U.S. financial conditions and China’s stimulus, if anything, make it more likely that negotiations will be extended, as both sides feel their economic and financial constraints less acutely. Table 3Updated Trade War Probabilities Bottom Line: Global and Chinese risk assets should rally on China’s credit uptick, but the lack of resolution of the trade war could continue to inhibit animal spirits – and the odds of a March 1 resolution are declining. Who Are The Equity Winners Of China’s Stimulus? China’s strong January credit number is supportive of global equity markets. That much is obvious. But which equity markets will benefit the most? In what follows we examine the relationship between Chinese credit and MSCI equity returns of various countries. We find that Malaysian, Australian, South Korean, and Indonesian equities are the most highly correlated with Chinese credit growth and are thus most likely to benefit from the recent upturn (Chart 7). On the other hand, France and Italy stand out as countries whose bourses are more insulated. Out of the markets that are positively correlated, South Korea and Russia stand out as relatively cheap (Chart 8). Thus we expect these equities to do especially well. By contrast, while Indonesia and the Philippines are highly leveraged to China, these markets are currently relatively expensive. BCA’s Emerging Markets Strategy is currently overweight Korean and Russian equities within the EM space, neutral Turkey (although recently upgraded from underweight), and underweight Indonesia and the Philippines. In addition to credit stimulus, we expect Chinese household consumption to also gain support going forward. This will likely be driven by policy stimulus targeting the consumer specifically and is best exemplified by the recently announced tax cuts (Chart 9), which we expect to trickle down to greater consumer demand and growth in retail sales. Our base case calls for 8%-10% growth in household consumption over the coming 12 months, up from the current 3.5%. However, consumer sentiment in China is weak. BCA’s Emerging Markets Strategy’s proxy for household marginal propensity to spend ticked up recently, after falling since early last year (see Chart 4 above). A resumption in the decline would highlight that households are increasingly unwilling to spend, which would translate into weaker retail sales despite policy efforts to boost consumption. Such a scenario – in which credit growth accelerates without a substantial uptick in consumer spending – is plausible, given that it occurred between mid-2015 and mid-2016 (Chart 10). In any case, whether Chinese stimulus comes in the form of the traditional credit channel, or instead in the form of fiscal stimulus to household consumption, the same equity markets will generally benefit the most (Chart 11). Chart 10...But Flattish Retail Sales Are Also A Possibility Indeed, global equity markets react the same way regardless of the type of stimulus implemented. For instance, MSCI returns for the Philippines, Sweden, Malaysia, Indonesia, and Turkey are more closely correlated to both Chinese credit growth and retail sales growth compared to Italy, Japan, and France.  The same conclusion is reached when we look at the correlations between Chinese credit growth or consumption growth and individual MSCI sectors such as industrials and consumer discretionary (Chart 12). The relatively stronger correlation between Chinese credit growth and equity returns – as opposed to Chinese retail sales and equity returns – can be put down to the nature of Chinese imports. While industrial goods account for the bulk of China’s purchases of foreign goods, consumer goods excluding autos make up only 15% of China’s imports (Table 4). However, as Chart 12 illustrates, the relationship between China’s retail sales growth and global equities is much tighter in the case of the consumer discretionary sector, whether the latter is compared to global industrials sectors or the overall MSCI index. Table 4Import Composition Of Chinese Imports Equity market exposure to China is not always in line with the extent of each country’s trade exposure to China (Chart 13). There are some clear exceptions – most notably Mexico, which has the highest correlation coefficient with Chinese credit and consumption variables since 2010. However, this is likely due to idiosyncratic factors.4 Correlation does not imply causation, and we cannot conclude with certainty that Mexican equities will outperform amid China’s new round of stimulus. Nevertheless, given that Mexico is a very deeply liquid market that benefits amid EM bull markets, this may not be entirely coincidental. The correlations between global equity markets and Chinese credit peak two months after the stimulus measures are first implemented (Chart 14). This is more or less in line with adjusted total social financing’s correlation versus industrial metals. However BCA’s Commodity & Energy Strategy has shown that copper’s correlations versus other measures of Chinese money and credit peak after roughly three quarters (Chart 15).5 This is evident in both the 2012 and 2015-16 stimulus episodes in which the bottom in copper prices lagged the bottom in China’s credit growth. Thus we may witness a rebound in equity markets on the back of China’s credit splurge before we see an improvement in annual returns on copper prices.  Chart 15Copper Rallies Lag China Credit Stimulus Bottom Line: South Korean and Russian equities are best positioned to benefit from the positive surprise in China’s credit data. France and Italy are the worst positioned. Copper prices will rebound with a delay.  Investment Implications BCA’s Geopolitical Strategy recommends that investors stay long Chinese equities ex-tech relative to the emerging market benchmark. This is a tactical call initiated in August 2018 that is now becoming a cyclical call on the basis of the credit upswing. We also remain long the “China Play Index,” a basket of China-sensitive assets, and long China’s “Big Five” banks relative to other banks. A rebound in China’s credit data and stronger global growth will support copper demand. Prices are still 15% below the mid-2018 peak and are poised to benefit in this environment, especially given that global inventories are already falling. BCA’s Geopolitical Strategy recommends that investors go long copper. Meanwhile, BCA’s China Investment Strategy recommends (for now) staying only tactically overweight Chinese equities relative to the global benchmark, pending higher conviction that the pace of credit growth will be strong enough to overwhelm the negative ramifications of a continued deceleration in actual activity over the coming few months on sentiment and 12-month forward earnings expectations. Over the long run, Geopolitical Strategy would look to underweight Chinese equities, as we are not optimistic about China’s productivity and potential GDP. This is because of the negative structural consequences of continuing the Socialist Put (i.e., bad loans, zombie companies, trade protectionism).  We would expect CNY/USD to remain relatively buoyant in the context of both trade negotiations with the U.S. and fiscal-and-credit stimulus. The trade talks can hardly succeed if CNY/USD is falling. Depending on whether and how soon China’s stimulus results in a durable economic bottom, global growth could stabilize and the USD could see a substantial countertrend selloff.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com   Footnotes 1          Please see Emerging Markets Strategy Special Report titled “China: Prepping A Bazooka?” dated February 14, 2019 available at ems.bcaresearch.com 2      Please see Nicholas Lardy, “The State Strikes Back: The End Of Economic Reform In China?” Peterson Institute For International Economics, January 29, 2019, available at piie.com. 3          Please see Emerging Markets Strategy Weekly Report titled “Dissecting China’s Stimulus,” dated January 17, 2019 available at ems.bcaresearch.com 4       The 2012 election of President Enrique Peña Nieto caused Mexican equities to outperform their EM counterparts. Similarly in 2015-16, U.S. outperformance relative to EM also supported Mexico relative to EM because Mexico’s economy is highly leveraged to its northern neighbor. In both periods Mexico’s outperformance was not caused by – but instead coincided with – Chinese credit stimulus. These idiosyncratic events biased the correlation between Mexico’s equity markets and Chinese credit growth to the upside. 5      Please see Commodity & Energy Strategy Weekly Report titled “Trade Wars, China Credit Policy Will Roil Global Copper Markets,” dated June 21, 2018, available at ces.bcaresearch.com.                  

Special Report

Highlights So What? India is overcoming the economic constraints to its strategic rise.  Why? India faces rising political risk once again as public opinion puts Modi’s tenure in power at risk. However, India will continue to improve its economy, as outside pressures will force it to act coherently as a nation. Stay on the sidelines for now but remain constructive over the long run. Feature “An enemy of my enemy is my friend.” This is to paraphrase Kautilya, a philosopher of the Mauryan Empire, circa 200 BC. Kautilya was the Indian Machiavelli and wrote the Arthashastra to give hard-nosed political advice to rulers who wanted to know how kingdoms and states really behave rather than how they ought to behave.1   The quotation is no less true today than it was in ancient times. It explains why risks are rising to our view that Prime Minister Narendra Modi will remain in power after the election in April or May. This reinforces our underweight position on Indian risk assets over a 12-month time horizon. The quotation also explains why China’s growing influence in South Asia will drive India to continue reforming its economy and befriend the United States, thus supporting an optimistic view of India’s economic and investment potential in the long run (Chart 1). What Is India’s Grand Strategy? India’s geopolitical predicament stems from the fact that it is a relatively rational geographic unit, but one whose political unity is extremely difficult to maintain. Almost every side of the subcontinent is demarcated by forbidding geology: the Himalayas, the Bay of Bengal, the Arabian Sea, the thick jungles of Burma. Even the northwest, the traditional route of invaders, hosts vast obstacles like the Hindu Kush and Thar Desert. Any kingdom that takes shape can soon dream of expanding its borders to a natural stopping place (Map 1). Yet formidable obstacles stand between the cradles of Indian civilization – the Indus and Ganges Rivers – and the river ways and coastal outlets of the south. The Vindhya-Satpura mountains, the Deccan plateau, and the eastern and western Ghats make it extremely difficult for a northern power to govern the various cultures of the southern cone.  This geography ensures that empires are always trying and failing to unify the subcontinent into a coherent whole. As a result, India rarely projects power beyond it. When it does, the projection is short-lived.2    Historically India has seen the rise of five major empires that dominated the subcontinent: the Mauryans, the Guptas, the Mughals, the British, and the modern Republic of India (Chart 2). The Mughals and many other invaders periodically streamed in from the northwest – most often from modern-day Afghanistan and northern Pakistan, but also from Iran and southern Pakistan. Meanwhile several European empires invaded from the sea and established coastal settlements. The British East India Company settled in Bengal and then drove west and south, cutting off the French who had settled on the southeastern shores.   The modern Republic of India, founded in 1947 after Mahatma Gandhi and his followers harassed the British into leaving, feared that the United States would follow in Britain’s footsteps, being the world’s preeminent naval power. The Indians also distrusted the U.S.’s constructive relations with China and Pakistan that aimed to “contain” the Soviet Union. The Soviets, by contrast, could apply great pressure on Pakistan’s flank in Afghanistan and thus proved useful to India. They could also sell India weapons and capital goods as founding Prime Minister Jawaharlal Nehru pursued a socialist path of economic development.  The collapse of the Soviet Union coincided with a balance-of-payments crisis in India in 1991 that resulted in the abandonment of the old command-style economy and the adoption of modern capitalism under the reforms of Narasimha Rao. India also supported the U.S.’s intervention in the region after September 11, 2001 as a way of maintaining pressure on Pakistan’s back door. From this brief history we can glean a few solid points about India’s grand strategy: An Indian empire must establish control along the Indus or Ganges rivers, or both; An Indian empire must assimilate or drive out foreign rulers and unify the north and south; An Indian empire must strive to become the kingmaker across the subcontinent, through influence if not conquest; An Indian empire must fend off an invasion from the sea. The result of Rao’s reforms, India’s achievement of nuclear status in 1998, and nearly three decades of economic growth have been an India that is clearly an emerging “great power.” According to our Geopolitical Power Index, India is today on the cusp of supplanting Russia as the world’s third most powerful state (Chart 3). It surpassed the U.K., its former colonial master, in 1993. Chart 3India On Cusp Of Overtaking Russia In Comprehensive National Power Like China in East Asia, India is modernizing its vast army, developing a blue-water navy, and carving out a sphere of influence in South Asia (Chart 4). Also like China, India’s ambitions of regional hegemony are frustrated by its neighbors. India’s rivalry with Pakistan is foundational and existential – it is as if China faced Taiwan with nuclear weapons. Chart 4India's Military Clout Quietly Rising Today the fragile world order that prevailed in the wake of the Cold War is under severe strain. China’s grand regional ambitions are provoking a harsh reaction from the United States, which is setting up a new “containment policy” to limit China’s technological advance. The U.S. is withdrawing military forces from the Middle East and South Asia as it becomes energy self-sufficient and looking to counter-balance China with its free hand. Meanwhile China’s influence on the subcontinent is growing – already it is a rival to India as a trade partner for India’s South Asian neighbors (Chart 5). The Sino-Indian rivalry has often been overstated – the Himalayas are more than a hindrance. But China’s Belt and Road Initiative (BRI) means that this logic is increasingly out of date. Historically, India faced overland invasions from the northwest and maritime invasions from the northeast. The Belt and Road – of which Pakistan is probably the most comprehensive beneficiary – potentially threatens India from both directions sometime in the future. Chart 5China Encroaching In India's Sphere Of Influence Of course the U.S. and India still face tensions between each other – foremost being the impending withdrawal from Afghanistan and the U.S. “maximum pressure” policy towards Iran (Chart 6). There are also trade tensions with the Trump administration and a broader problem of inconsistent U.S. outreach to India. Nevertheless the logic of “the enemy of my enemy is my friend” suggests that over the long run the U.S. will grow warmer with India as a regional counterweight to China, while India will wish to become less isolationist and cultivate its relationship with the U.S. as a counter both to Pakistan and China. Simply put, China is making historic advances into India’s neighborhood in South Asia and the Indian Ocean basin. Chart 6A Good Sign For U.S.-India Ties: Cooperation On Iran This logic also suggests that India will be driven to continue reforming its economic structure so as to preserve internal unity and South Asian influence. If its economy languishes, it will lose preponderance within its neighborhood and become vulnerable to foreign aggression. Bottom Line: India and the U.S. are likely to see an ever-strengthening strategic partnership. They will overcome hurdles to the relationship because of their mutual need to counter China’s regional ascendancy. India’s Economic Hang-Up India has been ineffective in establishing an international presence because it has only reluctantly and haltingly reformed its economy. Today India’s middle class – measured by the share of adults with total wealth from  $10,000 to $100,000 – is less than 10%, comparable to the Philippines and Thailand. China’s is now above 50%, according to Credit Suisse’s Global Wealth Report (Chart 7).    This weakness stems in great part from policy decisions, namely the dogged pursuit of socialism through the latter stages of the Cold War. The same ruling ideology that prized independence also prized self-sufficiency, doubling down on import-substitution and thus missing the chance to industrialize with the export-oriented Asian Tigers in the 1970s or China in the 1980s. The result of insufficient measures to limit the state, curtail monopolies, contain inflation, and promote trade and private enterprise has been a chronic shortfall of national savings (Chart 8), which are needed to invest in capital projects and boost productivity (Chart 9).3   Chart 8India Lacks National Savings Chart 9India's Lagging Productivity Many of these historic hang-ups have begun to change, however, first under the reforms of the 1990s-2000s and more recently under the government of Prime Minister Narendra Modi since 2014. As a result, there are a number of “truisms” about India’s economy that are no longer true. For instance, while India’s government is said to be small and weak due to its federal structure – which empowers the states – the truth is that its government is not notably smaller than that of other comparable emerging markets (Chart 10). There is no doubt that it is harder for India’s leaders to drive their agenda than it is for Russia’s and China’s leaders, but this is due to the type of government rather than the size. India inherited liberal democracy and rule of law from the British and its own revolutionary leaders built on this foundation, providing relative stability despite its patchwork of languages, ethnicities, and castes. Democratic checks and balances have led to better governance. Chart 10India's Government Neither Small Nor Weak The contrast has had clear effects on demography. India has a strong demographic foundation and hence a large internal market and robust labor force growth. China, by contrast, is suffering from the distortive effects of the “One Child Policy” on its working age population. As a result India’s population will increasingly provide the global labor force as China’s workers become scarcer and rise in cost (Chart 11) and as trade conflicts between China and the West drive investors to relocate supply chains. This is also a risk to India, of course, if job creation lags. But that is where other economic improvements come in. Cumulatively, Modi’s policies have improved the trajectory of a capital formation relative to consumption, which will increase productivity, potential growth, and job creation (Chart 12). Chart 12Modi Corrected India's Investment Trajectory On openness to trade, India has largely closed the gap with China and other comparable EMs like Indonesia (Chart 13). And while India has long been highly restrictive toward foreign investment, it is much less so than China (Chart 14), and a slew of policies to ease restrictions has resulted in a surge in foreign direct investment that only recently came off the boil (Chart 15). Chart 13India Not So Closed To Trade Anymore Chart 15Modi Opened India To Foreign Investment Further, while India remains broadly under-invested and has not managed to rebalance its overall economy toward manufacturing, it has created some bright spots within the manufacturing sector, such as autos (Chart 16).4 Modi’s government has significantly improved other conditions that will encourage private investment: the ease of doing business, global competitiveness, infrastructure effectiveness, and human capital (Chart 17). Chart 16Cars A Bright Spot In Indian Manufacturing Bottom Line: India’s grand strategy has historically suffered because internal unity and regional influence could not be achieved with a floundering economy. Over recent decades, however, India’s reforms have accumulated into substantial improvements – and the Modi administration has made some key improvements. But Will Modi Survive? Our baseline case for the general election due in April or May is that Modi and his ruling Bharatiya Janata Party (BJP), along with their allies in the National Democratic Alliance (NDA), will remain in power, if narrowly. However, in recent weeks the public opinion polling has taken a turn for the worse for Modi (Chart 18), raising the odds of a hung parliament or opposition victory. Modi still remains well ahead of Rahul Gandhi, the dynastic leader of the opposition Indian National Congress and its United Progressive Alliance (UPA), in terms of popularity (Chart 19). But in some polling he is barely holding onto a double-digit lead. Meanwhile Gandhi’s sudden viability as a candidate is a significant change from only a year ago. Nevertheless the range of seat projections for the lower house of parliament, the Lok Sabha, is very wide and suggests that Modi’s coalition could still win a majority, as long as the opposition’s current rally breaks (Chart 20).   A critical election dynamic points back to Kautilya’s ancient advice. Recently, two major parties in Uttar Pradesh – the key bellwether state – have joined forces to avoid stealing each other’s votes and thus help the opposition take seats. If this scheme works, then the NDA could be outmatched at the polls.5 For investors, however, the key takeaway is that Modi’s reform agenda is past its peak and policy uncertainty can only rise from here: Modi’s seats will certainly shrink from the landslide of 2014 – the BJP is likely to lose its single-party majority, weakening Modi and his party members on their reform agenda. The support of their NDA allies will have to be bought with favorable policy tradeoffs (Chart 21); The high tide of Modi’s movement has already come and gone in the state governments, where the BJP recently lost Madhya Pradesh, Rajasthan, and Chhattisgarh, among others (Map 2). It is possible to lose these states and still win the general election, as largely occurred in 2004 and 2009, but state governments are a decisive factor in implementing federal policies and Modi’s influence is now clearly on the wane; Estimates of the NDA’s future gains in the Rajya Sabha, the upper house, suggest that even if Modi stays in power, he will never obtain a majority there (Diagram 1) – meaning that lower house bills other than supply bills will be subject to a veto; Diagram 1Modi Unlikely To Gain Majority In Upper House … Ever Modi is unlikely to have enough seats in the two houses to have the option of driving key legislation through a joint session of parliament. This is a rare occurrence but it would be a valuable ace up the sleeve. Modi’s reform movement has already seen high tide. He will struggle to institute reforms if he is weakened in parliament and the states. This is even truer if a hung parliament occurs, or if the UPA ekes out a slim majority. In essence, the next Indian government will likely be hobbled if Modi’s polling and performance do not recover from here – and even then he will not reclaim the political capital of his first term in office. It would be a mistake, however, to believe that reforms cannot get done without Modi. Prime Minister Rao came from the Congress Party, after all. Moreover, it is possible for India to undertake major reforms with a weak coalition or minority government. This was the backdrop of the critical pro-market reforms of the 1990s. But this implies that there would need to be a market riot to induce additional reform momentum, as was the case at that time, and India is not at a comparable crisis point today.  Bottom Line: Modi’s reform momentum is over. The next government will be weaker and less able to drive major pro-productivity reforms. But eventually reform momentum will recover, driven by the geopolitical forces outlined above. Does Modi Matter? What is the basis for Modi’s loss of momentum? The gist of the problem is that Modi’s reforms were structural and therefore entailed substantial economic and social costs. As a result, Modi has lost support. The good news is that Modi’s achievements thus far will continue to yield benefits for India. To highlight a few: The creation of a single market by means of the Goods and Services Tax (GST) is a significant reform that will ensure a strong legacy for Modi in the long run. However, the new tax obviously does not get voters enthused. The new Bankruptcy Law has helped to cleanse economic inefficiencies. But it has resulted in layoffs and financial deleveraging, weighing on credit growth and the broader economy. Demonetization, the sudden replacement of key denominations of money in circulation, has helped to formalize gray and black parts of the economy. But it was executed in a hugely disruptive manner and various scandals have arisen in the wake of it, hurting the ruling party. Controlling the fiscal deficit has been a federal government objective that has had some success. However, Modi and the state governments are more recently boosting spending ahead of the election to avoid what otherwise would be a negative fiscal thrust this year. This is a factor that should play to Modi’s advantage, although it has not so far. It also highlights the difficulty of fiscal consolidation over the long run (Chart 22). Chart 22Election Cycle Fiscal Easing Is The Norm More concerning, both for Modi and for India, is the unemployment rate. Even the official unemployment rate is rising despite the fast clip of economic growth and the pro-growth reforms (Chart 23). A leaked government statistical report suggests that unemployment has indeed gone up and labor participation has fallen more than the government is willing to admit. Chart 23Even Official Unemployment Is Rising The jury is still out on the extent of the current growth slowdown. Some estimates suggest that the output gap is closed, others say slightly negative. While there has been a soft patch in wage growth – particularly among the important 40% of the population that still works on the farm (Chart 24) – the latest data show improvement. Unit labor costs are ebullient and suggest that employee compensation is rising (Chart 25). The reality could make all the difference for Modi’s coalition at the ballot box. Chart 24Rural Wages Improving... But Is It Enough? Chart 25Will Workers Reward Modi? More importantly, if India cannot keep unemployment down amidst significant labor force growth, then Modi will only become the near-term casualty of a more profound problematic trend. Another long-term concern is Modi’s political pressure on the Reserve Bank of India. This has resulted in the replacement of two orthodox and credible central bankers under Modi’s watch. The result is a noticeably dovish policy shift, as confirmed by the cut of the repo rate to 6.25% (from 6.5%) on February 7. This cut and later cuts may be supported by global growth fears but will raise suspicions of political influence. Any damage to the central bank’s credibility will have lasting negative effects since the election result cannot reverse it (at least not fully). It will feed inflation expectations marginally and insofar as it does it will worsen the conditions for sustainable private sector capital investment. However, inflation is currently low and other reforms – such as the RBI’s adoption of inflation-targeting and ample domestic grain production – will help to offset any new monetary policy risk. Bottom Line: Modi’s reform legacy is mostly positive for India structurally, although the erosion of central bank independence is a critical exception. Investment Implications In the short run, cooperation among Modi’s political opponents poses a risk of removing him from power and short-circuiting his reform agenda. In the long run, cooperation between China and India’s South Asian neighbors poses a risk of undermining India’s grand strategy, driving it into the arms of the United States. In both cases Kautilya’s ancient wisdom is on display.   In the first case, a Modi defeat would be negative for India’s policy continuity, currency, and risk assets. The upside to our baseline view of a Modi victory is not high, however, unless Modi and the BJP surprise to the upside and win a substantial majority. This is unlikely unless the polling changes. In the second case, the geopolitical environment will pressure India to continue reforming and improving its economy so as to maintain internal stability, influence its neighbors, and ward off unwanted foreign influence. With China’s Belt and Road putting pressure on India’s strategic interests, leaders in New Delhi will have a continual motivation to focus on improving the economy as well as seeking alliances. This is the only way to ensure India retains its influence within its neighborhood.  For now, investors should steer clear of the Indian currency and risk assets in absolute terms because Modi’s reforms are priced in; election cycle dynamics are undermining monetary and fiscal policy; and the risk of sharp policy discontinuity is rising. On a relative basis, India may also underperform EM in the short term while oil prices rise: oil prices and India’s equity performance relative to EM are negatively correlated.6 Beyond that, however, India is a structural opportunity. Capital investment in China, which has powered much of the structural bull market in commodities and EM assets over the past two decades, is declining, while India’s is improving (Chart 26). Capex is the key to improving India’s productivity and keeping inflation in check even as the demographic dividend pushes up growth rates. Although many EM economies will suffer from a slowdown in Chinese capex, India is not overly exposed to China or global trade, and it is further along than other EMs in its process of bank deleveraging, which opens the prospect of a new credit cycle that will improve its investment outlook (Chart 27).    Chart 26China Capex Down, India Capex Up Chart 27Deleveraging Enables A New Credit Cycle   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      Kajari Kamal, “Kautilya’s Arthashastra: Indian Strategic Culture and Grand Strategic Preferences,” Journal of Defence Studies 12:3 (2018), pp. 27-54, available at idsa.in 2      The medieval Chola Kingdom sailed across the Bay of Bengal and as far as Malacca in 1025. Please see  Manjeet Singh Pardesi, “Deducing India’s Grand Strategy of Regional Hegemony from Historical and Conceptual Perspectives,” Institute of Defense and Strategic Studies, Working Paper 76 (April 2005), available at www.rsis.edu. For an in-depth study of India’s strategic history, see Graham P. Chapman, The Geopolitics of South Asia: From Early Empires to the Nuclear Age (Burlington, VT: Ashgate, 2009). 3      Please see BCA Emerging Market Strategy Special Report, “Capital Rationing Is Deterring Growth,” February 28, 2012, and “India’s Inflation: How Serious Is The Problem?” January 26, 2010, available at www.bcaresearch.com. 4      Please see BCA Commodity and Energy Strategy Weekly Report, “India’s Commodity Demand, With Or Without Modi,” February 7, 2019, available at ces.bcaresearch.com. 5      Please see Milan Vaishnav and Jamie Hintson, “As Uttar Pradesh Goes, So Goes India,” Carnegie Endowment for International Peace, February 5, 2019, available at carnegieendowment.org. 6      Please see BCA Emerging Markets Strategy Weekly Report, “EM: Sustained Decoupling, Or Domino Effect?”June 14, 2018, available at ems.bcaresearch.com.  

Highlights So What? The late-cycle rally faces non-trivial political hurdles. Why? The rally is based on a too-sanguine view of the Fed, China, and the trade war. Other issues – like Brexit and the U.S. border showdown – are also problematic. Venezuela still has the potential to push oil prices sharply upwards. Feature All is well. Global equities are on the path of recovery, as should be the case at the end of an economic cycle. The U.S. S&P 500 has gained 16% since the bottom on December 24, with healthy technicals suggesting a breakout is ahead (Chart 1). The S&P 500 may be entering one of its typical late-cycle rallies, which tend to be the second best-performing decile of a bull market (Chart 2).1 Meanwhile, emerging market equities and currencies are outperforming developed market peers (Chart 3), a reversal from 2018 Chart 1Late Cycle Rally Ahead?   Chart 3...As Does Current Global Outperformance Typically, global risk assets outperform American risk assets at the end of an economic cycle. While institutional investors can use these rallies to lighten the load ahead of a recession, most investors cannot afford to miss such a rally. As such, BCA (and others) are calling for investors to play what is expected to be a yearlong rally in global risk assets and the S&P 500. Our view at BCA Geopolitical Strategy is more cautious, perhaps because it is informed by a methodological bias rooted in geopolitics. We believe that the reversal in U.S. outperformance relative to global risk assets rests on three pillars: The Federal Reserve remains dovish throughout 2019; China begins a major reflationary effort;  The U.S.-China tariff truce results in a trade deal. In addition, a consensus is emerging that a “no deal” Brexit will not occur, that U.S. polarization cannot get worse, and that President Trump eschews foreign interventionism. While we hold a nuanced view on each of these assertions, the mix is far less bullish than investors may think. We see a witches’ brew of factors that is murky at best and bearish at worst. The Three Pillars Of The Bullish View Before we turn to geopolitics, let us examine the three pillars underpinning the bullish view. Our colleague Peter Berezin, BCA’s Chief Global Strategist, remains bullish on the U.S. economy and expects the Fed to resume hiking rates by mid-year.2 The Conference Board’s Leading Credit Index remains in expansionary territory (Chart 4). While business capex intention surveys have come off their highs, they still point to robust spending plans over the next few quarters (Chart 5). Chart 4Little Sign Of A Looming Credit Crunch Chart 5Capex Plans Still Solid It is no surprise that the BCA Fed Monitor continues to suggest that “tighter monetary policy is required” (Chart 6). This is a far cry from 2016, when our indicator was in deeply “tightening” territory and the Fed paused for 12 months. If we compare 2019 to 2016, it is difficult to see how the market expectation of 4.72 bps of rate cuts will occur over the next 12 months (Chart 7). Of the three components that make up the BCA Fed Monitor, only the financial conditions have fallen into “easing required” territory (Chart 8), and they are already shifting back to “tightening required” territory with the stock market rally underway (Chart 9). Chart 6A Hawkish Fed Is Needed Chart 8BCA Fed Monitor Calls For Tighter Policy Chart 9Financial Conditions Starting To Ease In addition, in 2016 the Fed was not contracting its balance sheet. Today it is doing so, although the pace has moderated. As such, the Fed’s rate hike pause is occurring amidst an ongoing effort to normalize monetary policy and to transfer rate risks back to the private sector. By chance, this is also occurring at a time when the Treasury Department must issue more debt to cover a larger deficit, a process that could significantly pull U.S. rates higher and, by extension, yields on assets further down the risk curve. This would be a particular problem for global risk assets given the exposure of several EM economies to dollar-denominated debt.  The bottom line for investors is that a rate hike pause is not a pause in the overall hawkish policy of the U.S. Fed, which acts as a global central bank. The fall in the amount of dollars available for the international financial system acts as a brake on growth. Over the past 10 years, each time money supply growth fell below the loan uptake of the U.S. corporate sector, BCA’s Global Industrial Activity Nowcast, BCA’s Global Leading Economic Indicator, Korean exports, and global export prices all deteriorated considerably (Chart 10). Chart 10Deteriorating Excess Liquidity Hurts Global Growth Our muted view on Chinese reflation is unnecessary to repeat here. There is no doubt that Chinese policymakers are stimulating the economy, but the question is whether they are willing to pull the credit lever as aggressively as they have done in the past (Chart 11).So far, all of the evidence we have reviewed point to a cautious effort to stabilize growth, not reflate the entire planetary economy as Beijing did in 2016. If our BCA House View on the Fed is correct, a tepid Chinese effort to stimulate the domestic economy will fall short of lighting the flame of a global risk rally in 2019. Chart 11Compare Any Stimulus To Previous Efforts The BCA China Play Index, which in the past has tracked EM vs. DM equity outperformance, is sending mixed signals today (Chart 12). Enthusiasm for global risk assets has not been confirmed by the most China-sensitive plays. Chart 12Mixed Signals From China-Sensitive Plays Finally, there is the trade truce that should produce a trade deal. The logic is clear: President Trump sets aside the political constraints working against a deal and focuses on ensuring that he wins 2020 by avoiding a recession. The near bear market in the S&P 500 was a game changer that focused the White House on averting any further downside to markets and the economy from the trade war. But if the current rally proves that the selloff in December was a temporary pullback, the White House may be emboldened to play hard-to-get with China. After all, the electorate is generally supportive of getting tough on China (Chart 13) and there is no demand from either Trump voters or Democrats for a quick deal. The Fed pause and lower oil prices also give Trump some space to push negotiations a bit harder. Already there are leaks from the negotiations that the U.S. is asking for a lot from China, which could prolong the talks. This includes genuine structural changes to the economic relationship that would address long-standing U.S. concerns of forced technology transfers, intellectual property theft, and foreign investor access to the Chinese domestic market. It also includes U.S. demands that these changes be verifiable and enforceable. China is likely to balk at some of the U.S. demands, particularly if the U.S. is indeed pushing for regular reviews of China’s progress, a condition that implicitly creates a hierarchy between the two economies and would thus represent a loss of face for Beijing.3 Table 1 presents our latest expectations of where the U.S. and China will be on March 1. We assign only 10% each to “black and white” outcomes, a “Grand Compromise” and “No deal, with major escalation.” The remaining 80% is divided between “mushy” outcomes, including a 25% probability that negotiations simply continue. Table 1Updated U.S.-China Trade War Probabilities How would the market react to such uncertain outcomes? We think that almost anything other than a “Grand Compromise” would be greeted with limited relief, if not outright market correction. A vaguely positive meeting between Presidents Trump and Xi, and a memorandum of understanding, would not remove long-term risks in the relationship, especially if the parallel “tech war” is not resolved. On top of the ongoing U.S.-China negotiations, there is one remaining trade issue that investors should keep in mind: auto tariffs. The Section 232 investigation into whether auto imports are a national security threat is ongoing and U.S. authorities are expected to present their conclusions on February 17. We fear that the Trump administration could still stage a surprise and impose tariffs on auto imports. This is because the just-concluded NAFTA deal likely raised the cost of vehicle production within the trade bloc, necessitating import tariffs in order for the deal to make sense from President Trump’s set of political priorities. An extended truce with China could provide the opportunity. The Trump administration may not have the stomach for a long-term trade war with Europe, but the timing of this decision could upset the market’s perception of Trump’s commitment to free trade once again. Bottom Line: The conventional narrative is that global markets are experiencing a late-cycle rally, one that is worth playing given its usual duration and amplitude. This view rests on three pillars: that the Fed has backed off from tightening, that China is stimulating in earnest, and that the trade deal will produce a definitive outcome. We fear that all three pillars are shaky. First, the Fed is not easing. Its balance sheet contraction process, which is ongoing, is a form of tightening. And the U.S. economy remains healthy. As such, the expectation of a 12-month Fed pause is overly optimistic. Second, China is stimulating, but only tepidly. Third, “black and white,” definitive outcomes are unlikely in the U.S.-China negotiations. In fact, more protectionism could be around the corner if U.S.-China tech issues continue to flare or if the U.S. announces the conclusion of its investigation into auto imports. Geopolitical Factors To Monitor Aside from shaky pillars, markets will also have to contend with several uncertain geopolitical processes this year. While we are not necessarily bearish on each one, we are concerned that the collective investment community is overly bullish. Take Brexit. We agree with the conventional view that the chances of a no-deal Brexit outcome are below 10%. Political betting markets have only priced in an actual exit on March 29, which is in ink in British legislation, at just above 30% (Chart 14). Chart 14Online Betters Expect A Brexit Delay The problem is not with the conventional view but with its timing. While Prime Minister Theresa May will ultimately be forced to extend the Article 50 deadline, it may take a lot of brinkmanship and eleventh hour negotiations to do so. Getting from here – collective bullishness – to there – an actual extension of Article 50 – may require a downturn in GBP/USD or other U.K. assets. Furthermore, several scenarios could produce a downturn in GBP/USD (Diagram 1). For example, the Labour Party remains neck-and-neck with the Tories in the polls, despite being led by the most left-leaning leader since the 1970s. Although a new election that produces a Labour government would likely reduce the odds of Brexit eventually occurring, it would raise the odds of Corbyn pursuing unorthodox economic policy while also trying to negotiate his own version of Brexit with the EU. Diagram 1Brexit: The Path To Salvation Remains Fraught With Dangers The point is that it is tough to recommend that investors close their eyes and buy GBP/USD, no matter how cheap the currency may look, unless one has a very long time horizon and a high threshold for pain. The second issue where we take a more nuanced position is the ongoing U.S. executive-legislative standoff over the border. The government shutdown is only on pause until February 15. The House Democrats are demanding that a solution be found by Friday, February 8 if it is to be voted on in time. Meanwhile President Trump’s popularity is in the doldrums (Chart 15). His supporters note that President Reagan was even less popular at this point in his term, but that is because unemployment hit 10.4% in January 1983 (Chart 16). The grave risk for President Trump is that he is as unpopular as Reagan, even though unemployment is at 4% and the U.S. economy is on fire. Chart 15President Trump Is Unpopular... Chart 16...And It Can't Be Blamed On Unemployment As such, the real risk is not another shutdown, but rather political dysfunction in Congress that imperils the legislative process. The current two-year budget deal, which raised spending levels in January 2018, is set to expire when the FY2019 ends. Democrats and Trump have to come to an agreement to avert the “stimulus cliff” expected in 2020 (Chart 17). If they cannot conclude the border issue and the FY2019 appropriations, then Trump may declare a national emergency (or act unilaterally in other ways) and spark a new conflict with the courts. He could also threaten not to raise the debt ceiling in spring or summer. This is not an atmosphere in which a FY2020 deal looks very easy. Chart 17Stimulus Cliff Ahead Ultimately, we expect Democrats to succumb to the pressure from their voters for more spending. But a total failure to cooperate is a risk. Furthermore, the greatest political risk in the U.S. is that the 2020 election will not be contested on the same issues as in 2016: trade and immigration. Instead, income inequality is rearing its head, as Democratic candidates jostle for attention and as they test various messages on focus groups. If income inequality catches fire as the issue of 2020, we will know it soon. And it may begin to impact the markets as Democrats begin to campaign on, for instance, reversing President Trump’s income tax cuts. While the market may ignore headline election risks for some time, we do not think that non-financial corporates can do the same. Any hint that President Trump’s pro-business policies will be reversed could send shivers down the spines of CEOs and negatively impact capex intentions, hurting the real economy well before the next election. Finally, there is the issue of foreign policy. President Trump has abandoned his maximum pressure tactic on Iran and has begun withdrawing the remaining troops in the Middle East. These trends are likely to continue in 2019 as President Trump focuses on China and lesser issues like Venezuela. There is one important area of alignment between him and the defense and intelligence community, notwithstanding recent scuffles: less focus on the Middle East means more focus on Asia and specifically China. However, President Trump is facing a dilemma. Despite an extraordinary economic performance, his popularity remains in the doldrums. When faced with similar situations in the past, presidents far more orthodox than Trump have sought relevance abroad, by means of military interventions. A convenient opportunity has presented itself in Venezuela, where a revolution against Chavismo could give the U.S. an opening to intervene. On paper, we see how such a scenario could look appealing for a quick, and relatively painless, intervention. The problem is that it could also get messy and, in the analysis of BCA’s Commodity & Energy Strategy, raise oil prices to nearly $100 per barrel by mid-year if a total loss of Venezuelan production ensues (Chart 18). This is a non-negligible risk. Chart 18A Venezuela Collapse Could Send Brent Crude Prices Toward $100/Bbl Bottom Line: Geopolitical risks still abound. We are not alarmist. However, there is little reason to believe that Brexit, U.S. polarization, U.S.-China tensions, or a potential U.S. intervention in Venezuela will end painlessly for the market. An unpopular U.S. president is seeking to remain relevant and a global populist wave is continuing to create unorthodox and anti-establishment policy prescriptions. Given that the current rally is supported by three shaky pillars, any one of these geopolitical risks could catalyze a relapse, the history of late-cycle rallies be damned.   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      Please see BCA U.S. Investment Strategy Weekly Report, “Late-Cycle Blues,” dated October 29, 2018, available at usis.bcaresearch.com. 2      Please see BCA Global Investment Strategy Weekly Report, “Patient Jay,” dated January 18, 2019, available at gis.bcaresearch.com. 3      Please see Reuters, “Exclusive: U.S. demands regular review of China trade reform,” dated January 18, 2019, available at reuters.com.   Geopolitical Calendar

Special Report

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

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

Special Report

Highlights So What? Our “Black Swan” risks for the year reveal several potential wars. Why? While we think it is premature to expect armed conflict over Taiwan, an outbreak of serious tensions is possible. Russia and Ukraine may have a shared incentive to go renew hostilities this year. Saudi Arabia has received a “blank cheque” from Donald Trump, so it may continue to be provocative. Everyone has forgotten about the Balkans … but tensions are building. A “Lame Duck” Trump could stage a military intervention in Venezuela. Feature Over the past three years, we have compiled a list of five geopolitical “Black Swans.” These are low-probability events whose market impact would be significant enough to matter for global investors. Unlike the great Byron Wien’s list of “Ten Surprises for 2018,” we do not assign these events a “better than 50% likelihood of happening.”1 Instead, we believe that the market is seriously underpricing these risks by assigning them only single-digit probabilities when the reality is closer to 10%-15%, a level at which a risk premium ought to be assigned. Furthermore, some of our events below are obscure enough that it is unclear how exactly to price them. But before we get to our list of the five things that keep us up at night,2 a quick note on the question for financial markets in 2019: Will the economic policy divergence between the U.S. and China continue? At the moment, momentum is building behind the narrative that both the U.S. and China have decided to reflate. In anticipation of this narrative switch, we closed our long DM / short EM equity trade on December 3, 2018 for a 15.70% return (originally opened on March 6, 2018). How sustainable is the EM outperformance relative to DM? Will the rest of the world “catch up” to U.S. growth momentum, thus hurting the U.S. dollar in the process? The global central bank – the Fed – is already expected to “back off,” even though members of the FOMC have simply pointed out that they remain data-dependent. Granting our BCA House View that the U.S. economy remains in decent health, U.S. economic data will continue to come in strong through the course of the year. This means that there is scope for a hawkish Fed surprise for the markets, given that the interest rate market already has dovish expectations, anticipating 4.33 basis points and 16.74 basis points of cuts over the next 12 and 24 months respectively (Chart 1). Meanwhile, the global demand engine – China – may disappoint in its reflationary efforts. We refer to China as the “global demand engine” because the combined imports and capex of China and other emerging markets dwarf that of the U.S. and EU (Chart 2 and Chart 3).3 Chinese imports alone make up $1.6 trillion, constituting 23% of the $7 trillion total of EM imports and about half of EM investment expenditures. Given that large swaths of EM are high-beta to the Chinese economy, the EM-plus-China slice of the global demand pie is leveraged to Beijing’s reflationary policies. Chart 2EM/China Imports Are Much Larger Than U.S.'s And EU's Combined Chart 3EM/China Capex Is As Large As U.S.'s And EU's Combined Chinese policymakers have gestured toward greater support for the economy. The communiqué published following the Central Economic Work Conference (CEWC) in December called for a broad stabilization of aggregate demand as a focus of macro policy over the course of 2019. The language was still not very expansionary, but Beijing has launched stimulus despite relatively muted communiqués in the past. The massive stimulus of early 2016, for instance, followed a mixed CEWC communiqué in December 2015. So everything depends on the forthcoming data. Broad money and credit growth improved marginally in December, while the State Council announced that local government bond issuance could begin at the start of the year rather than waiting until spring. Meanwhile, a coordinated announcement by the People’s Bank of China, the Ministry of Finance, and the National Development and Reform Commission declares that a larger tax cut is forthcoming – that is, in addition to the roughly 1% of GDP household tax cuts that went into effect starting late last year. Monetary policy remains very lax with liquidity injections and additional RRR cuts. Before investors become overly bullish, however, we would note that Chinese policymakers are focusing their reflationary efforts on fiscal spending and supply-side reforms like tax cuts. The problem with the latter is that household tax cuts will not add much to global demand, given that consumer goods make up just 15% of China’s imports (Table 1). The vast majority of Chinese imports stem from the country’s capital spending. Table 1China’s Consumer-Oriented Stimulus Will Boost Different Imports Than Past Stimulus Fiscal spending, meanwhile, is as large as the overall credit origination in the Chinese economy (Chart 4). But without a revival in credit growth, more spending will mainly serve to stabilize the economy, not light it on fire. It is likely that part of the fiscal pump-priming will be greater issuance of local government bonds. However, even the recently announced 1.39 trillion RMB quota for new bonds this year is not impressive. And even a 2 trillion RMB increase would only be equivalent to a single month of large credit expansion (Chart 5). Chart 4China: Credit Origination Is As Large As Government Spending   As such, tactically nimble investors could profit from a reflationary narrative that sees both the global central bank – the Fed – and the global fiscal engine – China – turning more dovish and supportive of growth. However, we agree with BCA’s Emerging Markets Chief Strategist Arthur Budaghyan, who is on record saying that “Going Tactically Long EM Is Akin To Collecting Pennies In Front Of A Steamroller.” The bottom line for investors is that 2019 is the first year in a decade where the collective intention of policymakers – across the world – is to prepare for the next recession, rather than to prevent a deflationary relapse. This cognitive shift may be slight, but it is important. The Fed and Beijing are engaged in a macroeconomic game of chicken. Each camp is trying to avoid having to over-reflate at the end of the cycle. For the Fed, the goal is to have room to cut rates sufficiently when the recession finally hits. For China, the goal is to ensure that its leverage does not get out of hand. Into this uncertain macroeconomic context we now insert the five Black Swans for 2019. 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 BCA’s 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: China Goes To War With Taiwan One could argue that a military conflict between China and Taiwan in 2019 should not technically qualify for our list, as there has been chatter in the media about such an outcome. Indeed, our recent travels across Asia revealed that clients are taking a much greater interest in our longstanding view – since January 2016 – that Taiwan is the premier geopolitical Black Swan. We established this view well before President Trump won the election and received a congratulatory call from Taiwanese President Tsai Ing-wen, breaking diplomatic practice since 1979. Now, at the beginning of 2019, the exchange of barbs between the Chinese and Taiwanese presidents has raised tensions anew (Chart 6).4 Chart 6Taiwanese Geopolitical Risk Likely To Rise From Here Nonetheless, Taiwan makes the cut here because we doubt that most of our global clients take the issue seriously. Furthermore, we are concerned that – with fair odds of a U.S.-China trade truce lasting through 2019 – cross-strait tensions could fall out of sight. The basis of our view is that there is a unique confluence of political developments in Beijing, Washington, and Taipei that is conducive toward a diplomatic or military incident that could escalate tensions: Taiwan’s pro-independence Democratic Progressive Party (DPP), in addition to taking the presidency in 2016, won control of the legislature for the first time ever (Chart 7). This means that domestic political constraints on President Tsai Ing-wen’s administration are lower than usual. Tsai has angered Beijing by seeking stronger relations with the U.S. and refusing to endorse the 1992 Consensus, which holds that there is only “One China” albeit two interpretations. China’s General Secretary Xi Jinping has removed term limits and placed greater emphasis on the reunification of Taiwan. Xi has consolidated power domestically and has pursued a more aggressive foreign policy throughout his term, including in the South China Sea, where greater naval control would enable China to threaten Taiwan’s supply security. Xi’s blueprint for his “New Era” includes the reunification of China, and some have argued that there is a fixed timetable for reunification with Taiwan by 2050 or even 2035.5 Some recent military drills can be seen as warnings to Taiwan. U.S. President Trump called the One China Policy into question at the outset of his term in office (only later reaffirming it), and has presided over an increase in U.S. strategic pressure against China, such as the trade war and freedom of navigation operations, including in the Taiwan Strait. Trump’s National Security Adviser John Bolton and Assistant Defense Secretary Randall Schriver are seen as Taiwan hawks, while the just-concluded Republican Congress passed the Taiwan Travel Act and the Asia Reassurance Initiative Act (ARIA), which imply an upgrade to the U.S. commitment to Taiwan’s democracy and security.6 These three factors suggest that, cyclically, there is larger room than usual for incidents to occur that initiate a vicious cycle of tensions. The odds of a full-fledged war are still very low – the U.S. has reaffirmed the One China Policy in its recent negotiations with Beijing, which seem to be progressing, while China has not changed its official position on Taiwan. Beijing’s reunification timetable still has a comfortable 30 years to go. The Chinese economy has not collapsed, so there is no immediate need for Beijing to dive headlong into a nationalist foreign policy adventure that could bring on World War III. However, the odds of diplomatic incidents, or military saber rattling, that then trigger a dangerous escalation and a multi-month period of extremely elevated tensions are much higher than the market recognizes. This is because the U.S. and China may still see strategic tensions flare even if they make progress on a trade deal, while a failure on the trade front could spark a spillover into strategic areas. Any cross-strait incident would be relevant to global investors – and not just Taiwanese assets, which would suffer the brunt of economic sanctions – because the slightest increase in the odds of a full-scale war would be extremely negative for global risk appetite. Over the next 12 months, we would mostly expect Beijing to eschew high-profile provocations. The reason is that President Tsai is unpopular and the recent local elections in Taiwan saw her DPP lose seats to the more China-friendly Kuomintang (Chart 8). An aggressive posture could revive the DPP ahead of the January 2020 presidential election, the opposite of what Beijing wants.7 On the other hand, Beijing could decide to ignore the 1996 precedent and choose outright military intimidation. Or it could attempt to meddle in Taiwan’s domestic politics, as it has been accused of doing in the recent local elections.8 Meanwhile, the U.S. and Taiwan are the more likely instigators of an incident over these 12 months, knowingly or not. Washington and Taipei have a window of opportunity to achieve a few concrete objectives while Presidents Tsai and Trump are still in office – which cannot be guaranteed after 2020. A similar window of opportunity caused a market-relevant spike in China-South Korea tensions back in 2015-17, when the United States, seeing that the right-wing Park Geun-hye administration was falling out of power, attempted to rush through the deployment of the Terminal High Altitude Area Defense (THAAD) missile system in South Korea. As a result, China imposed economic sanctions on its neighbor (Chart 9). Chart 9China Hits South Korea Over THAAD Something similar could transpire over the next year if the U.S. sends a high-level official – say, Bolton, or Secretary of State Mike Pompeo, or even Vice President Mike Pence – to hold talks in Taiwan. Or if the U.S. stages a major show of force in the Taiwan Strait, as it threatened in October, or U.S. naval vessels call on Taiwanese ports. The U.S. could also announce bigger or better arms packages (Chart 10), such as submarine systems, which have been cleared by the Department of State. Given the elevated U.S.-China and China-Taiwan tensions overall, such an incident could cause a bigger escalation than the different participants expect – and even more so than the market currently expects. Chart 10U.S. Arms Sales To Taiwan Could Provoke Beijing Bottom Line: Cyclically, the period between now and the inauguration of the next Taiwanese president in May 2020 brings heightened risk of a geopolitical incident. Depending on what happens in 2020, tensions could rise or fall for a time. Yet structurally, as Sino-American strategic distrust continues to build, Taiwan will continually find itself at the center of the storm. Black Swan 2: Russia And Ukraine Agree To Go To War Tensions are mounting between Russia and Ukraine in the run-up to the March 31 Ukrainian presidential election. Incumbent President, Petro Poroshenko, has been trailing in the polls for a year. His rival is the populist Yulia Tymoshenko, who has been leading both first-round and second-round polling. Both Poroshenko and Tymoshenko have, at various points in their careers, been accused of being pro-Russian. Poroshenko’s business interests, as with most successful Ukrainian businesspeople, include considerable holdings in Russia. Tymoshenko, on the other hand, was imprisoned from 2011 to 2014 for negotiating a gas imports contract with Russia that allegedly hurt Ukrainian interests. With the most pro-Russian parts of Ukraine either cleaved off (Crimea) or in a state of lawlessness (Donetsk and Luhansk), the median voter in the country has become considerably more nationalist and anti-Russian. It therefore serves no purpose for any politician to campaign on a platform of normalizing relations with Moscow. In this context, the decision by the Patriarchate of Constantinople – the first-among-equals of the Christian Orthodox churches – to grant autocephaly (sovereignty) to the Orthodox Church of Ukraine in January is part of the ongoing evolution of Ukraine into an independent entity from Russia. This process could create tensions, particularly as parts of the country continue to be engaged in military conflict (Map 1). From Moscow’s perspective, the autocephaly grants Ukraine religious – and therefore some semblance of cultural – independence from Russia. This solidifies the loss of a 43-million person crown jewel from the Russian sphere of influence. Moscow is also not averse to stoking tensions. Although President Putin’s mandate will last until 2024, his popularity is nearly at the lowest level this decade. Orthodox monetary and fiscal policy, along with pension reforms, have sapped his political capital at home. In 2014, tensions over Ukraine spurred nationalist sentiment in Russia, rapidly increased popular support for both Putin and his government (Chart 11). Putin may calculate that another such recapitalization may be needed. Chart 11Non-Negligible Risk Of Russian Aggression The danger is therefore that domestic politics in both Ukraine and Russia may create a window of opportunity for a skirmish this quarter. Perhaps something akin to the naval tensions around the Kerch Strait that ultimately cost President Putin a summit with President Trump at the G20 meeting in December. While these incidents may benefit both sides domestically, and may even appear carefully orchestrated, they could also get out of hand in unpredictable ways. Bottom Line: While both Kiev and Russia may see a short-termed conflict as domestically beneficial, such an outcome could have unforeseen consequences. At the very least, it could sap already poor business confidence in neighboring Europe, as it did in 2014-2015. Black Swan 3: Saudi Arabia With A Blank Cheque One of the greatest geopolitical blunders of the twentieth century was Berlin’s decision to give its ally Austro-Hungary a “blank cheque.” Austro-Hungary was an anachronism at the turn of the century – a multiethnic empire held together by allegiance to a royal family. As such, the ideology of nationalism represented an existential threat, particularly given that 60% of the empire’s population was neither Austrian nor Hungarian. Following the assassination of its crown prince Archduke Franz Ferdinand by a pan-Slavist terrorist in Sarajevo, Vienna decided that a total destruction of Serbia was necessary for geopolitical and domestic political reasons. Today, Saudi Arabia is in many ways an anachronism itself. It is the world’s last feudal monarchy. Its leaders understand the risks and have begun an ambitious and multifaceted reform effort. Unlike Austro-Hungary, Saudi Arabia has learned to embrace nationalism. Riyadh is using the war in Yemen, as well as targeted actions against its own royal family and the religious establishment, to build a modern nation-state. The problem is that, much as nationalism was an ideological kryptonite for Vienna, democratic Islamism is an existential problem for Riyadh and its peers among the Gulf monarchies. Neighboring Qatar, a tiny peninsular kingdom enjoying an oversized geopolitical influence due to its natural gas wealth, has supported various groups across the Middle East that believe that democracy and conservative Islam are compatible. Turkey and Qatar have often cooperated in this effort, as the ruling Justice and Development Party (AKP) of Turkey has served as a model for many such Islamist parties in the region. Why Qatar hitched its geopolitical wagon to democratic Islamism is not clear. Perhaps its leaders felt that it was the only option unclaimed by an energy-rich sponsor. Regardless, Qatar’s support of the Muslim Brotherhood and other such groups has clearly irked Saudi Arabia and other Gulf monarchies, enough for them to kick Qatar out of the Gulf Cooperation Council (GCC). In 2017, with the pro-Saudi Trump administration ascendant in the White House, Riyadh felt emboldened enough to break off all diplomatic relations with Qatar and impose an economic blockade. Since 2014, another dynamic has emerged in the region that raises further concerns: a scramble for material resources brought on by the end of +$100 per barrel oil prices. Saudi public expenditures have been steadily rising since 2008, both due to population growth, social welfare spending in the wake of Arab Spring rebellions, and astronomical defense spending to counter the rising influence of Iran. And yet, 2014 saw oil prices plunge to decade lows in a matter of months. Saudi Arabia’s fiscal breakeven oil price has doubled, in a decade, from under $40 per barrel to $83 per barrel in 2018 (Chart 12). Meanwhile, Qatar’s GDP is a quarter of that of Saudi Arabia, even though its population is less than 2% of Saudi Arabia’s. Chart 12Saudi Arabia Has A Fiscal Problem Rumors that the U.S. Defense Secretary James Mattis prevented a Saudi invasion of Qatar in 2018 have largely been dismissed by the mainstream media. But should they be? If allegedly “rogue elements” of the Saudi intelligence establishment can dismember a journalist in a consulate, why couldn’t “rogue elements” of its military stage a coup – or an outright invasion – in neighboring Qatar? Such an outcome would truly be extraordinary, but so was the annexation of Crimea in 2014. Meanwhile, President Trump offered an extraordinary level of support for Riyadh by issuing what we can only refer to as a “blank cheque” following Khashoggi’s murder. In the November 20 statement, President Trump essentially created a new policy doctrine of standing with Saudi Arabia “no matter what.”9 Two weeks later, Riyadh “thanked” the U.S. President by slashing the OPEC oil output by 1.2 million barrels per day. From this dynamic, it appears that Washington has made a similar strategic blunder in 2018 that Berlin did in 1914. A weakened, stressed, and threatened ally has been given a “blank cheque” by its stronger ally. Such a sweeping offer of support may lead to unintended consequences as the weaker ally feels that its material and geopolitical constraints can be overcome. In Saudi Arabia’s case, that could mean a more aggressive policy towards Qatar, or perhaps Iran. Particularly now that the White House has seen several realist members of the Trump cabinet – such as Mattis and former Secretary of State Rex Tillerson – replaced by Iran hawks and Trump loyalists. Bottom Line: A combination of less independent-minded cabinet members in the White House and a clear “blank cheque” from President Trump to Saudi Arabia could cause geopolitical risk to re-emerge in the Middle East. In the near term, this could increase the geopolitical risk premium on oil prices – as measured by the residual in Chart 13. Black Swan 4: The Balkans Become A Powder Keg … Again Bismarck famously said in 1888 – 26 years before the outbreak of the Great War, that “one day the great European War will come out of some damned foolish thing in the Balkans.” The Balkans are far less geopolitically relevant today than in the early twentieth century. They are also exhausted following a decade-long Yugoslav rigor mortis in the 1990s which yielded at least three regional wars and now six (or seven, depending who is counting) independent states. The problem is that tensions have not disappeared. Two frozen conflicts remain. First, Bosnia and Herzegovina is a sovereign country made up of two political entities, with the Serb-dominated Republika Srpska agitating for independence and aligning with Russia. Second, tensions between Serbia and Kosovo took a turn for the worse late last year as Kosovo imposed an economic embargo on trade with Serbia and called for the creation of a military. Has anything really changed over the course of the decade? We think there are three causes for alarm: Tensions between Russia and the West have become serious, with both camps looking to score tactical and strategic wins across the globe. With the Syrian Civil War all but over, a new battleground may emerge. While Republika Srpska is essentially an outright ally of Russia, Serbia continues to try to straddle the fine line between an EU enlargement candidate and geopolitical neutrality. However, this high-wire act is becoming untenable as… Enlargement fatigue sets in the EU. There is no doubt that the EU enlargement process froze Balkan conflicts. Countries like Serbia and Kosovo have an incentive to be on their best behavior so long as the prospect of eventual EU membership remains. But in the current environment of introspection, the EU may not have enough of a coherent geopolitical vision to deal with the Balkans without a crisis. The global economic cycle may be ending, leading to a global recession in the next 12-to-24 months. While our BCA House View remains that the next recession will be a mild one in the U.S., we think that EM and, by extension, frontier markets could be the eye of the storm in the next downturn. As investors abandon their “search for yield” in riskier geographies, they could exacerbate poor governance, political tensions, and geopolitical cleavages that have been frozen in place by the last economic cycle. Finally, U.S. policy towards the Balkans is unclear. In the past, the U.S. asked all countries in the region to accept the status quo and prepare for EU integration. But with the U.S. now adopting an antagonistic view towards the EU bloc, it is unclear what Washington’s message to the Balkans will be. After all, Trump has personally encouraged all other world leaders to don their own version of the “America First” slogan. The only problem in a place like the Balkans is that “Serbia first” – or Croatia and Kosovo first – is unlikely to go down smoothly in the neighborhood, given the last twenty – or even hundred – years. Bottom Line: The powder keg that is the Balkans has not been dried for decades. However, several tailwinds of stability are gone, replaced with macro headwinds. A renewed conflict on Europe’s doorstep could be the next great geopolitical crisis. If this were to occur, we would bank on greater European integration, especially in terms of military and foreign policy. However, it could also mark the first break in U.S.-EU foreign policy if the two decide to pick opposing sides in the region. Black Swan 5: Lame Duck Trump For our final Black Swan, we are sticking with one of our 2018 choices: a “Lame duck” presidency. “Lame duck” presidents – leaders whose popularity late in their terms have 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.10 American presidents have few constitutional constraints when it comes to foreign policy. Therefore, when domestic constraints rise, U.S. presidents can seek relevance abroad. President Trump may become the earliest, and lamest, lame duck president in recent U.S. history. While his Republican support remains strong (Chart 14), his overall popularity is well below the average presidential approval rating at this point in the political cycle (Chart 15). Now there is also a Democrat-led House of Representatives to stymie his domestic policy and launch independent investigations into both his administration’s conduct and his personal finances and dealings. We would also add the Senate to the list of problems for President Trump. The electoral math was friendly towards the Republicans in 2018, with Democrats defending 10 Senate seats in states that President Trump won in 2016. In 2020, however, two-thirds of the races will be for Republican-held seats. As such, many Republican senators may begin campaigning early by moving away from President Trump. What kind of adventures would we expect to see President Trump embark on in 2019? Last year, we identified “China-U.S. trade war,” “Iran jingoism,” and “North Korea” as potentials. In many ways, 2018 was the year when all three mattered. Going forward, however, we think that trade war and the Middle East might take a backseat. First, the bear market in equities has raised the odds of a recession. As such, the potential cost of pursuing the trade war further has been increased. So has an aggressive policy towards Iran that dramatically boosts oil prices. Furthermore, President Trump has signaled that he is willing to withdraw from the Middle East, calling for a full withdrawal from Syria and telegraphing one from Afghanistan. Instead, we see President Trump potentially following in the footsteps of previous U.S. administrations and finding relevance in Latin America. A military intervention in Venezuela, to ostensibly support a coup against the current regime, would find little opposition domestically. First, there is no doubt that Venezuela has become a genuine humanitarian disaster. Second, its oil output is on a downward spiral already, with only 1 million b/d of production at risk due to a potential military conflict (Chart 16). Third, the new Bolsonaro administration in Brazil may even support an intervention, as well as neighboring Colombia. This is a change from the last twenty years, in which Latin American countries largely stuck together, despite ideological differences, in opposition to U.S. interference in the continent’s domestic affairs. Chart 16On A Downward Spiral Finally, even the anti-Trump U.S. foreign policy establishment may support an intervention. Not only is there the issue of human suffering, but Russia and China have used Venezuela as an anchor to build out influence in America’s sphere of influence. Furthermore, the potential promise of Venezuela’s eventual energy production is another reason to consider an American intervention (Chart 17). Bottom Line: American presidents rarely decide to go softly into that good night. It is very difficult to see President Trump become irrelevant. With tensions with China carrying a high economic cost and military interventions in the Middle East remaining politically toxic in the wake of Iraq and Afghanistan wars, perhaps President Trump will decide to go “retro,” in the sense of a throwback Latin America intervention.   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Please see, Blackstone, “Byron Wien Announces Ten Surprises For 2018,” dated January 2, 2018, available at blackstone.com. 2 A shoutout to another doyen of the financial industry, Alastair Newton! 3 Please see BCA Emerging Markets Strategy Special Report, “Deciphering Global Trade Linkages,” dated September 27, 2018, available at ems.bcaresearch.com. 4 Please see “Highlights of Xi’s speech at Taiwan message anniversary event,” China Daily, January 2, 2019, available at www.chinadaily.com.cn; and “President Tsai Issues Statement On China’s President Xi’s ‘Message To Compatriots In Taiwan,’” Office of the President, Republic of China (Taiwan), January 2, 2019, available at english.president.gov.tw. 5 Please see Xi Jinping, “Secure a Decisive Victory in Building a Moderately Prosperous Society in All Respects and Strive for the Great Success of Socialism with Chinese Characteristics for a New Era,” section 3.12, October 18, 2017, available at www.xinhuanet.com; and Deng Yuwen, “Is China Planning To Take Taiwan By Force In 2020?” South China Morning Post, July 20, 2018, available at beta.scmp.com. 6 Please see United States, H.R. 535, Taiwan Travel Act, 115th Congress (2017-18), available at www.congress.gov and S. 2736, Asia Reassurance Initiative Act of 2018, 115th Congress (2017-18), available at www.congress.gov. 7 This is precisely what occurred when China chose missile tests in 1995-96 and drove voters toward the very candidate, Lee Teng-hui, that Beijing least desired. The popular Taipei Mayor Ko Wen-je may run for president in 2020, and Beijing may see him as preferable to President Tsai. He has spoken of China and Taiwan as being part of the same family and he has held city-to-city talks between Shanghai and Taipei despite the shutdown in direct talks between Beijing and Taipei. 8 Please see Andrew Sharp, “Beijing likely meddled in Taiwan elections, US cybersecurity firm says,” Nikkei Asian Review, November 28, 2018, available at asia.nikkei.com. 9 Please see “Statement from President Donald J. Trump on Standing with Saudi Arabia,” The White House, dated November 20, 2018, available at whitehouse.org. 10 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.   Geopolitical Calendar

Special Report

Highlights So What? Our best and worst calls of 2018 cast light on our methodology and 2019 forecasts. Why? Our clients took us to task for violating our own methodology on the Iranian oil sanctions. Sticking to our guns would have paid off with long Russian equities versus EM. We correctly called China’s domestic policy, the U.S.-China trade war, Europe, the U.S. midterms, and relative winners in emerging markets. Feature It has been a tradition for BCA’s Geopolitical Strategy, since our launch in 2012, to highlight our best and worst forecasts of the year.1 This will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 9, when we return to our regular publication schedule. We wish all of our clients a great Holiday Season. And especially all the very best in 2019: lots of happiness, health, and hefty returns. Good luck and good hunting. The Worst Calls Of 2018 A forecasting mistake is wasted if one learns nothing from the error. This is why we take our mistakes seriously and why we always begin the report card with our zingers. Our overall performance in 2018 was … one of our best. The successes below will testify to this. However, we made three notable errors. A Schizophrenic Russia View Our worst call of the year was to panic and close our long Russian equities relative to emerging markets trade in the face of headline geopolitical risks. In early March, we posited that Russia was a “buy” relative to the broad EM equity index due to a combination of cheap valuations, strong macro fundamentals, orthodox policy, and an end to large-scale geopolitical adventurism. This call ultimately proved to be correct (Chart 1). Chart 1Russian Stocks Outperformed In The End What went wrong? The main risk to our view, that the U.S. Congress would pursue an anti-Russia agenda regardless of any Russian sympathies in the Trump White House, materialized in the wake of the poisoning of former Russian military intelligence officer Sergei Skripal with a Novichok nerve agent in the United Kingdom. As fate would have it, the incident occurred just before our bullish report went to clients! The ensuing international uproar and sanctions caused a selloff. Our bullish thesis did not rest exclusively on geopolitics, but a thaw in West-Russia relations did form the main pillar of the view. Our Russia Geopolitical Risk Index, which had served us well in the past, was pricing as low of a level of geopolitical risk as one could hope for in the post-Crimea environment (Chart 2). Naturally the measure jumped into action following the Skripal incident. Chart 2Geopolitical Risk Was Low Prior To Skripal The timing of our call was therefore off, but we should have stuck with the overall view. The U.S. imposed preliminary sanctions that lacked teeth. While Washington accepted the U.K.’s assessment that Moscow was behind the poisoning, the weakness of the sanctions also signaled that the U.S. did not consider the incident worthy of a tougher position. There are now two parallel sanction processes under way. The first round of sanctions announced in August gave Russia 90 days to comply and adopt “remedial measures” regarding the use of chemical and biological weapons. On November 9, the U.S. State Department noted that Russia had not complied with the deadline. The U.S. is now expected to impose a second round of sanctions that will include at least three of six punitive actions: Opposition to development aid and assistance by international financial institutions (think the IMF and the World Bank); Downgrading diplomatic relations; Additional restrictions on exports to Russia (high-tech exports have already been barred by the first round of sanctions); Restrictions on imports from Russia; A ban on landing rights in the U.S. for Russian state-owned airlines; Prohibiting U.S. banks from purchasing Russian government debt. While the White House was expected to have such sanctions ready to go on the November 9 deadline, it has dragged its feet for almost two months now. This suggests that President Trump continues to hold out for improved relations with President Putin. A visit by President Putin to Washington remains possible in Q1 2019. As such, we would expect the White House to adopt some mix of the first five items on the above list, hardly a crushing response from Moscow’s perspective. The U.S. Congress, however, has a parallel process in the form of the Defending American Security from Kremlin Aggression Act of 2018 (DASKAA). Introduced in August by Senator Lindsey Graham, a Russia hawk, the legislation would put restrictions on Americans buying Russian sovereign debt and curb investments in Russian energy projects. The bill also includes secondary sanctions on investing in the Russian oil sector, which would potentially ensnare European energy companies collaborating with Russia in the energy sector. There was some expectation that Congress would take up the bill ahead of the midterm election, but nothing came of it. Even with the latest incident – the seizing of two Ukrainian naval vessels in the Kerch Strait – we have yet to see action. While we expect the U.S. to do something eventually, the White House approach is likely to be tepid while the congressional approach may be too draconian to pass into law. And with Democrats about to take over the House, and likely demand even tougher sanctions against Russia, the ultimate legislation may be too bold for President Trump to sign into legislation. The point is that Russia has acted antagonistically towards the West in 2018, but in small enough increments that the response has been tepid. Given the paucity of Russian financial and trade links with the U.S., Washington’s sanctions would only bite if they included the dreaded “secondary sanction” implications for third party sovereigns and firms – particularly European, which do have a lot of business in Russia. This is highly unlikely without major Russian aggression. We cannot completely ignore the potential for such aggression in 2019, especially with President Putin’s popularity in the doldrums (Chart 3) and a contentious Ukrainian election due for March 31. However, we outlined the constraints against Russia in 2014, amidst the Ukrainian crisis, and we do not think that these constraints have been reduced (they may have only grown since then). Chart 3Non-Negligible Risk Of Russian Aggression Regardless of the big picture for 2019, we could have faded the risks in 2018 and stuck to the fundamentals. Russia is up 17.2% against EM year-to-date. The lesson here, therefore, is to find re-entry points into a well-founded view despite market volatility. Chart 1 shows that Russian equities climbed the proverbial “wall of worry” relative to EM in 2018. Doubting Jair Bolsonaro Our list of mistakes keeps us in the EM universe where we underestimated Jair Bolsonaro’s chances of winning the presidency in Brazil. The answer to the question we posed in the title of our September report – “Brazil: Can The Election Change Anything?” – was a definitive “yes.” Since the publication of that report, BRL/USD is up 2.9% and Brazilian equities are up 18.5% relative to EM (Chart 4). Chart 4Bolsonaro Rally Losing Its Luster Already To our credit, the question of Bolsonaro’s electoral chances elicited passionate and pointed internal debate. But our clients did not see the internal struggle, just the incorrect external output! A bad call is a bad call, no matter how it is assembled on the intellectual assembly line. That said, we still think that our report is valuable. It sets out the constraints facing Bolsonaro in 2019. He has to convince the left-leaning median voter that meaningful pension reform is needed; bully a fractured Congress into painful structural reforms; and overcome an unforgiving macro context of tepid Chinese stimulus and a strong USD. If the Bolsonaro administration wastes the good will of the investment community over the next six months, we expect the market’s punishment to be swift and painful. In fact, Chart 4 notes that the initial Bolsonaro rally has already lost most of its shine. Brazilian assets are still up since the election, but the gentle slope could become a steep fall if Bolsonaro stumbles. The market is priced for political perfection. To be clear, we are not bearish on Bolsonaro. We believe that, relative to EM, he will be a positive for Brazil. However, the market is currently betting that he will win by two touchdowns, whereas we think he will squeak by with a last-second field goal. The difference between the two forecasts is compelling and we have expressed it by being long MXN/BRL.2 Not Sticking To Our Method In The Case Of Iran Throughout late-2017 and 2018 we pointed out that President Trump’s successful application of “maximum pressure” against North Korea could become a market-relevant risk if he were emboldened to try the same strategy against Iran. For much of the year, this view was prescient. As investors realized the seriousness of President Trump’s strategy, a geopolitical risk premium began to seep into oil prices, as illustrated in Chart 5 by the red bar. Every time we spoke to clients or published reports on this topic, we highlighted just how dangerous a “maximum pressure” strategy would be in the case of Iran. We stressed that Iran could wreak havoc across Iraq and other parts of the Middle East and even drive up oil prices to the point of causing a “geopolitical recession in 2019.” In other words, we stressed the extraordinary constraints that President Trump would face. To their credit many of our clients called us out on the inconsistency: our market call was über bullish oil prices, while our methodology emphasized constraints over preferences. We were constantly fielding questions such as: Why would President Trump face down such overwhelming constraints? We did not have a very good answer to this question other than that he was ideologically committed to overturning the Iranian nuclear deal. In essence, we doubted President Trump’s own ideological flexibility and realism. That was a mistake and we tip our hat to the White House for recognizing the complex constraints arrayed against it. President Trump realized by October how dangerous those constraints were and began floating the idea of sanction waivers, causing the geopolitical risk premium to drain from the market (Chart 6). To our credit, we highlighted sanction waivers as a key risk to our view and thus took profit on our bullish energy call early. Chart 6Sanction Waivers Caused A Collapse In Oil Prices That said, our clients have taken the argument further, pointing out that if we were wrong on Trump’s ideological flexibility with Iran, we may be making the same mistake when it comes to China. However, there is a critical difference. Americans are more concerned about conflict with North Korea than with Iran (Chart 7), while China is the major concern about trade (Chart 8). Second, railing against the Iran deal did not get President Trump elected, whereas his protectionist rhetoric – specifically regarding China – did (Chart 9). Getting anything less than the mother-of-all-deals with Beijing will draw down Trump’s political capital ahead of 2020 and open him to accusations of being “weak” and “surrendering to China.” These are accusations that the country’s other set of protectionists – the Democrats – will wantonly employ against him in the next general election. Chart 9Protectionism, Not Iran, Helped Trump Get Elected Ultimately, if we have to be wrong, we are at least satisfied that our method stood firm in the face of our own fallibility. We are doubly glad to see our clients using our own method against our views. This is precisely what we wanted to accomplish when we began BCA’s Geopolitical Strategy in March 2012: to revolutionize finance by raising the sophistication with which it approaches geopolitics. That was a lofty goal, but we do not pretend to hold the monopoly on our constraint-based methodology. In the end, our market calls did not suffer due to our error. We closed our long EM energy-producer equities / EM equities for a gain of 4.67% and our long Brent / short S&P 500 for a gain of 6.01%. However, our latter call, shorting the S&P 500 in September, was based on several reasons, including concerns regarding FAANG stocks, overstretched valuations, and an escalation of the trade war. Had we paired our S&P 500 short with a better long, we would have added far more value to our clients. It is that lost opportunity that has kept us up at night throughout this quarter. We essentially timed the S&P 500 correction, but paired it with a wayward long. The Best Calls Of 2018 BCA’s Geopolitical Strategy had a strong year. We are not going to list all of our calls here, but only those most relevant to our clients. Our best 2018 forecast originally appeared in 2017, when in April of that year we predicted that “Political Risks Are Understated In 2018.” Our reasoning was bang on: U.S. fiscal policy would turn strongly stimulative (the tax cuts would pass and Trump would be a big spender) and thus cause the Fed to turn hawkish and the USD to rally, tightening global monetary policy; Trump’s trade war would re-emerge in 2018; China would reboot its structural reform efforts by focusing on containing leverage, thus tightening global “fiscal” policy. In the same report we also predicted that Italian elections in 2018 would reignite Euro Area breakup risks, but that Italian policymakers would ultimately be found to be bluffing, as has been our long-running assertion. Throughout 2018, our team largely maintained and curated the forecasts expressed in that early 2017 report. We start the list of the best calls with the one call that was by far the most important for global assets in 2018: economic policy in China. The Chinese Would Over-Tighten, Then Under-Stimulate Getting Chinese policy right required us, first, to predict that policy would bring negative economic surprises this year, and second, once policy began to ease, to convince clients and colleagues that “this time would be different” and the stimulus would not be very stimulating. In other words, this time, China would not panic and reach for the credit lever of the post-2008 years (Chart 10), but would maintain its relatively tight economic, financial, environmental, and macro-prudential oversight, while easing only on the margin. Chart 10No Massive Credit Stimulus In 2018 This is precisely what occurred. BCA Foreign Exchange Strategy’s “China Play Index,” which is designed to capture any reflation out of Beijing, collapsed in 2018 and has hardly ticked up since the policy easing announced in July (Chart 11). Chart 11Weak Reflation Signal From China Our view was based on an understanding of Chinese politics that we can confidently say has been unique: From March 2017, we highlighted the importance of the 2017 October Party Congress, arguing that President Xi Jinping would consolidate his power and redouble his attempts to “reform” the economy by reining in dangerous imbalances. We explicitly characterized the containment of leverage as the most market-relevant reform to focus on. We stringently ignored the ideological debate about the nature of reform in China, focusing instead on the major policy changes afoot. We identified very early on how the rising odds of a U.S.-China conflict would embolden Chinese leadership to double-down on painful structural reforms. Will China maintain this disciplined approach in 2019? That is yet to be seen. But we are arming ourselves and clients with critical ways to identify when and whether Beijing’s policy easing transforms into a full-blown “stimulus overshoot”: First, we need to see a clear upturn in shadow financing to believe that the Xi administration has given up on preventing excess debt. Assuming that such a shift occurs, and that overall credit improves, it will enable us to turn bullish on global growth and global risk assets on a cyclical, i.e., not merely tactical, horizon (Chart 12). Chart 12A Shadow Lending Surge Would Mean A Big Policy Shift Second, our qualitative checklist will need to see a lot more “checks” in order to change our mind. Short of an extraordinary surge in bank and shadow bank credit, there needs to be a splurge in central and especially local government spending (Table 1). The mid-year spike in local governments’ new bond issuance in 2018 was fleeting and fell far short of the surge that initiated the large-scale stimulus of 2015. Frontloading these bonds in 2019 will depend on timing and magnitude. Table 1A Credit Splurge, Or Government Spending Splurge, Is Necessary For Stimulus To Overshoot Third, we would need to see President Xi Jinping make a shift in rhetoric away from the “Three Battles” of financial risk, pollution, and poverty. Having identified systemic financial risk as the first of the three ills, Xi needs to make a dramatic reversal of this three-year action plan if he is to clear the way for another credit blowout. Trade War Would Reignite In 2018 It paid off to stick with our trade war alarmism in 2018. We correctly forecast that the U.S. and China would collide over trade and that their initial trade agreement – on May 20 – was insubstantial and would not last. In the event it lasted three days. Our one setback on the trade front was to doubt the two sides would agree to a trade truce at the G20. However, by assigning a subjective 40% probability, we correctly noted the fair odds of a truce. We also insisted that any truce would be temporary, which ended up being the case. We may yet be vindicated if the March 1 deadline produces no sustainable deal, as we forecast in last week’s Strategic Outlook. That said, correct geopolitical calls do not butter our bread at BCA. Rather, we are paid to make market calls. To that end, we would point out that we correctly assessed the market-relevance of the trade conflict, fading S&P 500 risks and focusing on the effect on global risk assets. Will this continue into 2019? We think so. We do not see trade conflict as the originator of ongoing market turbulence (Chart 13) and would expect the U.S. to outperform global equities again over the course of 2019 (Chart 14). This view may appear wrong in Q1, as the market digests the Fed backing off from hawkish rhetoric, the ongoing trade negotiations, and the likely seasonal uptick in Chinese credit data in the beginning of the calendar year. Chart 13Yields, Not Trade War, Drove Stocks Chart 14U.S. Stocks Will Resume Outperformance However, any stabilization in equity markets would likely serve to ease financial conditions in the U.S., where economic and inflation conditions remain firmly in tightening territory (Chart 15). As such, the Fed pause is likely to last no more than a quarter, maybe two at best, leading to renewed carnage in global risk assets if our view on Chinese policy stimulus – tepid – remains valid through the course of 2019. Chart 15If Financial Conditions Ease, Tightening Will Be Back On Europe (All Of It… Again) In 2017, our forecasting track record for Europe was stellar. This continued in 2018, with no major setbacks: Populism in Italy: Our long-held view has been that Europe’s chief remaining risks lay in Italian populists coming to power. We predicted in 2016 that this would eventually happen and that they would then be proven to be bluffing. This is essentially what happened in 2018. Matteo Salvini’s Lega is surging in the polls because its leader has realized that a combination of hard anti-immigrant policy and the softest-of-soft Euroskepticism is a winning combination. We believe that investors can live with this combination. Our only major fault in forecasting European politics and assets this year was to close our bearish Italy call too early: we booked our long Spanish / short Italian 10-year government bond trade for a small loss in August, before the spread between the two Mediterranean countries blew out to record levels. That missed opportunity could have also made it on our “worst calls” list as well. Pluralism in Europe: To get the call on Italy right, we had to dabble in some theoretical work. In a somewhat academic report, we showed that political concentration was on the decline in the developed world (Chart 16), but especially in Europe (Chart 17). Put simply, lower political concentration suggests that a duopoly between the traditional center-left and center-right parties is breaking down. Contrary to the conventional wisdom, we argued that Europe’s parliamentary systems would enable centrist parties to adopt elements of the populist agenda, particularly on immigration, without compromising the overall stability of European institutions. As such, political pluralism, or low political concentration, is positive for markets. Immigration crisis is over: For centrist parties to be able to successfully adopt populist immigration policy, they needed a pause in the immigration crisis. This was empirically verifiable in 2018 (Chart 18). Chart 18European Migration Crisis Is Over Merkel’s time has run out: Since early 2017, we had cautioned clients that Angela Merkel’s demise was afoot, but that it would be an opportunity, rather than a risk, when it came. It finally happened in 2018 and it was not a market moving event. The main question for 2019 is whether German policymakers, and Europe as a whole, will use the infusion of fresh blood in Berlin to reaccelerate crucial reforms ahead of the next global recession. Brexit: Since early 2016, we have been right on Brexit. More specifically, we were corrent in cautioning investors that, were Brexit to occur, “the biggest loser would be the Conservative Party, not the EU.” As with the previous two Conservative Party prime ministers, it appears that the question of the U.K.’s relationship with the EU has completely drained any political capital out of Prime Minister Theresa May’s reign. We suspect that the only factor propping up the Tories in the polls is that Jeremy Corbyn is the leader of Her Majesty’s Most Loyal Opposition. We have also argued that soft Brexit would ultimately prove to be “illogical” and that “Bregret” would begin to seep in, as it now most clearly has. We parlayed these rising geopolitical risks and uncertainties by shorting cable in the first half of the year for a 6.21% gain. Malaysia Over Turkey And India Over Brazil Not all was lost for our EM calls this year. We played Malaysia against Turkey in the currency markets for a 17.44% gain, largely thanks to massively divergent governance and structural reform trajectories after Malaysia’s opposition won power for the first time in the country’s history. Second, we initiated a long Indian / short Brazilian equity view in March that returned 27.54% by August. This was a similar play on divergent structural reforms, but it was also a way to hedge our alarmist view on trade. Given India’s isolation from global trade and insular financial markets, we identified India as one of the EM markets that would remain aloof of protectionist risks. We could have closed the trade earlier for greater gain, but did not time the exit properly. Midterm Election: A Major Democratic Victory Our midterm election forecast was correct: Democrats won a substantial victory. Even our initial call on the Senate, that Democrats had a surprisingly large probability of picking up seats, proved to be correct, with Republicans eking out just two gains in a year when Democrats were defending 10 seats in states that Trump carried in 2016. What about our all-important call that the election would have no impact on the markets? That is more difficult to assess, given that the S&P 500 has in fact collapsed in the lead-up to and aftermath of the election. However, we see little connection between the election outcome and the stock market’s performance. Neither do our colleagues or clients, who have largely stopped asking about the Democrats’ policy designs. In 2019, domestic politics may play a role in the markets. Impeachment risk is low, but, if it rears its head, it could prompt President Trump to seek relevance abroad, as his predecessors have done when they lost control of domestic policy. In addition, the Democratic Party’s sweeping House victory may suggest a political pendulum swing to the left in the 2020 presidential election. We will discuss both risks as part of our annual Five Black Swans report in early 2019. U.S. domestic politics was a collection of Red Herrings during much of President Obama’s presidency, and has produced strong tailwinds under President Trump (tax cuts in particular). This may change in 2019, with considerable risk to investors, and asset prices, ahead.     Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com   Footnotes 1      For our 2019 Outlook, please see BCA Geopolitical Strategy Strategic Outlook, “2019 Key Views: Balanced On A Knife’s Edge,” dated December 14, 2018, available at gps.bcaresearch.com. For our past Strategic Outlooks, please visit gps.bcaresearch.com. 2      In part we like this cross because we also think that Mexico’s newly elected president, Andrés Manuel López Obrador, is priced to lose by two touchdowns, whereas he may merely lose by a last-second field goal.    

Highlights So What? Our best and worst calls of 2018 cast light on our methodology and 2019 forecasts. Why? Our clients took us to task for violating our own methodology on the Iranian oil sanctions. Sticking to our guns would have paid off with long Russian equities versus EM. We correctly called China’s domestic policy, the U.S.-China trade war, Europe, the U.S. midterms, and relative winners in emerging markets. Feature It has been a tradition for BCA’s Geopolitical Strategy, since our launch in 2012, to highlight our best and worst forecasts of the year.1 This will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 9, when we return to our regular publication schedule. We wish all of our clients a great Holiday Season. And especially all the very best in 2019: lots of happiness, health, and hefty returns. Good luck and good hunting. The Worst Calls Of 2018 A forecasting mistake is wasted if one learns nothing from the error. This is why we take our mistakes seriously and why we always begin the report card with our zingers. Our overall performance in 2018 was … one of our best. The successes below will testify to this. However, we made three notable errors. A Schizophrenic Russia View Our worst call of the year was to panic and close our long Russian equities relative to emerging markets trade in the face of headline geopolitical risks. In early March, we posited that Russia was a “buy” relative to the broad EM equity index due to a combination of cheap valuations, strong macro fundamentals, orthodox policy, and an end to large-scale geopolitical adventurism. This call ultimately proved to be correct (Chart 1). Chart 1Russian Stocks Outperformed In The End What went wrong? The main risk to our view, that the U.S. Congress would pursue an anti-Russia agenda regardless of any Russian sympathies in the Trump White House, materialized in the wake of the poisoning of former Russian military intelligence officer Sergei Skripal with a Novichok nerve agent in the United Kingdom. As fate would have it, the incident occurred just before our bullish report went to clients! The ensuing international uproar and sanctions caused a selloff. Our bullish thesis did not rest exclusively on geopolitics, but a thaw in West-Russia relations did form the main pillar of the view. Our Russia Geopolitical Risk Index, which had served us well in the past, was pricing as low of a level of geopolitical risk as one could hope for in the post-Crimea environment (Chart 2). Naturally the measure jumped into action following the Skripal incident. Chart 2Geopolitical Risk Was Low Prior To Skripal The timing of our call was therefore off, but we should have stuck with the overall view. The U.S. imposed preliminary sanctions that lacked teeth. While Washington accepted the U.K.’s assessment that Moscow was behind the poisoning, the weakness of the sanctions also signaled that the U.S. did not consider the incident worthy of a tougher position. There are now two parallel sanction processes under way. The first round of sanctions announced in August gave Russia 90 days to comply and adopt “remedial measures” regarding the use of chemical and biological weapons. On November 9, the U.S. State Department noted that Russia had not complied with the deadline. The U.S. is now expected to impose a second round of sanctions that will include at least three of six punitive actions: Opposition to development aid and assistance by international financial institutions (think the IMF and the World Bank); Downgrading diplomatic relations; Additional restrictions on exports to Russia (high-tech exports have already been barred by the first round of sanctions); Restrictions on imports from Russia; A ban on landing rights in the U.S. for Russian state-owned airlines; Prohibiting U.S. banks from purchasing Russian government debt. While the White House was expected to have such sanctions ready to go on the November 9 deadline, it has dragged its feet for almost two months now. This suggests that President Trump continues to hold out for improved relations with President Putin. A visit by President Putin to Washington remains possible in Q1 2019. As such, we would expect the White House to adopt some mix of the first five items on the above list, hardly a crushing response from Moscow’s perspective. The U.S. Congress, however, has a parallel process in the form of the Defending American Security from Kremlin Aggression Act of 2018 (DASKAA). Introduced in August by Senator Lindsey Graham, a Russia hawk, the legislation would put restrictions on Americans buying Russian sovereign debt and curb investments in Russian energy projects. The bill also includes secondary sanctions on investing in the Russian oil sector, which would potentially ensnare European energy companies collaborating with Russia in the energy sector. There was some expectation that Congress would take up the bill ahead of the midterm election, but nothing came of it. Even with the latest incident – the seizing of two Ukrainian naval vessels in the Kerch Strait – we have yet to see action. While we expect the U.S. to do something eventually, the White House approach is likely to be tepid while the congressional approach may be too draconian to pass into law. And with Democrats about to take over the House, and likely demand even tougher sanctions against Russia, the ultimate legislation may be too bold for President Trump to sign into legislation. The point is that Russia has acted antagonistically towards the West in 2018, but in small enough increments that the response has been tepid. Given the paucity of Russian financial and trade links with the U.S., Washington’s sanctions would only bite if they included the dreaded “secondary sanction” implications for third party sovereigns and firms – particularly European, which do have a lot of business in Russia. This is highly unlikely without major Russian aggression. We cannot completely ignore the potential for such aggression in 2019, especially with President Putin’s popularity in the doldrums (Chart 3) and a contentious Ukrainian election due for March 31. However, we outlined the constraints against Russia in 2014, amidst the Ukrainian crisis, and we do not think that these constraints have been reduced (they may have only grown since then). Chart 3Non-Negligible Risk Of Russian Aggression Regardless of the big picture for 2019, we could have faded the risks in 2018 and stuck to the fundamentals. Russia is up 17.2% against EM year-to-date. The lesson here, therefore, is to find re-entry points into a well-founded view despite market volatility. Chart 1 shows that Russian equities climbed the proverbial “wall of worry” relative to EM in 2018. Doubting Jair Bolsonaro Our list of mistakes keeps us in the EM universe where we underestimated Jair Bolsonaro’s chances of winning the presidency in Brazil. The answer to the question we posed in the title of our September report – “Brazil: Can The Election Change Anything?” – was a definitive “yes.” Since the publication of that report, BRL/USD is up 2.9% and Brazilian equities are up 18.5% relative to EM (Chart 4). Chart 4Bolsonaro Rally Losing Its Luster Already To our credit, the question of Bolsonaro’s electoral chances elicited passionate and pointed internal debate. But our clients did not see the internal struggle, just the incorrect external output! A bad call is a bad call, no matter how it is assembled on the intellectual assembly line. That said, we still think that our report is valuable. It sets out the constraints facing Bolsonaro in 2019. He has to convince the left-leaning median voter that meaningful pension reform is needed; bully a fractured Congress into painful structural reforms; and overcome an unforgiving macro context of tepid Chinese stimulus and a strong USD. If the Bolsonaro administration wastes the good will of the investment community over the next six months, we expect the market’s punishment to be swift and painful. In fact, Chart 4 notes that the initial Bolsonaro rally has already lost most of its shine. Brazilian assets are still up since the election, but the gentle slope could become a steep fall if Bolsonaro stumbles. The market is priced for political perfection. To be clear, we are not bearish on Bolsonaro. We believe that, relative to EM, he will be a positive for Brazil. However, the market is currently betting that he will win by two touchdowns, whereas we think he will squeak by with a last-second field goal. The difference between the two forecasts is compelling and we have expressed it by being long MXN/BRL.2 Not Sticking To Our Method In The Case Of Iran Throughout late-2017 and 2018 we pointed out that President Trump’s successful application of “maximum pressure” against North Korea could become a market-relevant risk if he were emboldened to try the same strategy against Iran. For much of the year, this view was prescient. As investors realized the seriousness of President Trump’s strategy, a geopolitical risk premium began to seep into oil prices, as illustrated in Chart 5 by the red bar. Every time we spoke to clients or published reports on this topic, we highlighted just how dangerous a “maximum pressure” strategy would be in the case of Iran. We stressed that Iran could wreak havoc across Iraq and other parts of the Middle East and even drive up oil prices to the point of causing a “geopolitical recession in 2019.” In other words, we stressed the extraordinary constraints that President Trump would face. To their credit many of our clients called us out on the inconsistency: our market call was über bullish oil prices, while our methodology emphasized constraints over preferences. We were constantly fielding questions such as: Why would President Trump face down such overwhelming constraints? We did not have a very good answer to this question other than that he was ideologically committed to overturning the Iranian nuclear deal. In essence, we doubted President Trump’s own ideological flexibility and realism. That was a mistake and we tip our hat to the White House for recognizing the complex constraints arrayed against it. President Trump realized by October how dangerous those constraints were and began floating the idea of sanction waivers, causing the geopolitical risk premium to drain from the market (Chart 6). To our credit, we highlighted sanction waivers as a key risk to our view and thus took profit on our bullish energy call early. Chart 6Sanction Waivers Caused A Collapse In Oil Prices That said, our clients have taken the argument further, pointing out that if we were wrong on Trump’s ideological flexibility with Iran, we may be making the same mistake when it comes to China. However, there is a critical difference. Americans are more concerned about conflict with North Korea than with Iran (Chart 7), while China is the major concern about trade (Chart 8). Second, railing against the Iran deal did not get President Trump elected, whereas his protectionist rhetoric – specifically regarding China – did (Chart 9). Getting anything less than the mother-of-all-deals with Beijing will draw down Trump’s political capital ahead of 2020 and open him to accusations of being “weak” and “surrendering to China.” These are accusations that the country’s other set of protectionists – the Democrats – will wantonly employ against him in the next general election. Chart 9Protectionism, Not Iran, Helped Trump Get Elected Ultimately, if we have to be wrong, we are at least satisfied that our method stood firm in the face of our own fallibility. We are doubly glad to see our clients using our own method against our views. This is precisely what we wanted to accomplish when we began BCA’s Geopolitical Strategy in March 2012: to revolutionize finance by raising the sophistication with which it approaches geopolitics. That was a lofty goal, but we do not pretend to hold the monopoly on our constraint-based methodology. In the end, our market calls did not suffer due to our error. We closed our long EM energy-producer equities / EM equities for a gain of 4.67% and our long Brent / short S&P 500 for a gain of 6.01%. However, our latter call, shorting the S&P 500 in September, was based on several reasons, including concerns regarding FAANG stocks, overstretched valuations, and an escalation of the trade war. Had we paired our S&P 500 short with a better long, we would have added far more value to our clients. It is that lost opportunity that has kept us up at night throughout this quarter. We essentially timed the S&P 500 correction, but paired it with a wayward long. The Best Calls Of 2018 BCA’s Geopolitical Strategy had a strong year. We are not going to list all of our calls here, but only those most relevant to our clients. Our best 2018 forecast originally appeared in 2017, when in April of that year we predicted that “Political Risks Are Understated In 2018.” Our reasoning was bang on: U.S. fiscal policy would turn strongly stimulative (the tax cuts would pass and Trump would be a big spender) and thus cause the Fed to turn hawkish and the USD to rally, tightening global monetary policy; Trump’s trade war would re-emerge in 2018; China would reboot its structural reform efforts by focusing on containing leverage, thus tightening global “fiscal” policy. In the same report we also predicted that Italian elections in 2018 would reignite Euro Area breakup risks, but that Italian policymakers would ultimately be found to be bluffing, as has been our long-running assertion. Throughout 2018, our team largely maintained and curated the forecasts expressed in that early 2017 report. We start the list of the best calls with the one call that was by far the most important for global assets in 2018: economic policy in China. The Chinese Would Over-Tighten, Then Under-Stimulate Getting Chinese policy right required us, first, to predict that policy would bring negative economic surprises this year, and second, once policy began to ease, to convince clients and colleagues that “this time would be different” and the stimulus would not be very stimulating. In other words, this time, China would not panic and reach for the credit lever of the post-2008 years (Chart 10), but would maintain its relatively tight economic, financial, environmental, and macro-prudential oversight, while easing only on the margin. Chart 10No Massive Credit Stimulus In 2018 This is precisely what occurred. BCA Foreign Exchange Strategy’s “China Play Index,” which is designed to capture any reflation out of Beijing, collapsed in 2018 and has hardly ticked up since the policy easing announced in July (Chart 11). Chart 11Weak Reflation Signal From China Our view was based on an understanding of Chinese politics that we can confidently say has been unique: From March 2017, we highlighted the importance of the 2017 October Party Congress, arguing that President Xi Jinping would consolidate his power and redouble his attempts to “reform” the economy by reining in dangerous imbalances. We explicitly characterized the containment of leverage as the most market-relevant reform to focus on. We stringently ignored the ideological debate about the nature of reform in China, focusing instead on the major policy changes afoot. We identified very early on how the rising odds of a U.S.-China conflict would embolden Chinese leadership to double-down on painful structural reforms. Will China maintain this disciplined approach in 2019? That is yet to be seen. But we are arming ourselves and clients with critical ways to identify when and whether Beijing’s policy easing transforms into a full-blown “stimulus overshoot”: First, we need to see a clear upturn in shadow financing to believe that the Xi administration has given up on preventing excess debt. Assuming that such a shift occurs, and that overall credit improves, it will enable us to turn bullish on global growth and global risk assets on a cyclical, i.e., not merely tactical, horizon (Chart 12). Chart 12A Shadow Lending Surge Would Mean A Big Policy Shift Second, our qualitative checklist will need to see a lot more “checks” in order to change our mind. Short of an extraordinary surge in bank and shadow bank credit, there needs to be a splurge in central and especially local government spending (Table 1). The mid-year spike in local governments’ new bond issuance in 2018 was fleeting and fell far short of the surge that initiated the large-scale stimulus of 2015. Frontloading these bonds in 2019 will depend on timing and magnitude. Table 1A Credit Splurge, Or Government Spending Splurge, Is Necessary For Stimulus To Overshoot Third, we would need to see President Xi Jinping make a shift in rhetoric away from the “Three Battles” of financial risk, pollution, and poverty. Having identified systemic financial risk as the first of the three ills, Xi needs to make a dramatic reversal of this three-year action plan if he is to clear the way for another credit blowout. Trade War Would Reignite In 2018 It paid off to stick with our trade war alarmism in 2018. We correctly forecast that the U.S. and China would collide over trade and that their initial trade agreement – on May 20 – was insubstantial and would not last. In the event it lasted three days. Our one setback on the trade front was to doubt the two sides would agree to a trade truce at the G20. However, by assigning a subjective 40% probability, we correctly noted the fair odds of a truce. We also insisted that any truce would be temporary, which ended up being the case. We may yet be vindicated if the March 1 deadline produces no sustainable deal, as we forecast in last week’s Strategic Outlook. That said, correct geopolitical calls do not butter our bread at BCA. Rather, we are paid to make market calls. To that end, we would point out that we correctly assessed the market-relevance of the trade conflict, fading S&P 500 risks and focusing on the effect on global risk assets. Will this continue into 2019? We think so. We do not see trade conflict as the originator of ongoing market turbulence (Chart 13) and would expect the U.S. to outperform global equities again over the course of 2019 (Chart 14). This view may appear wrong in Q1, as the market digests the Fed backing off from hawkish rhetoric, the ongoing trade negotiations, and the likely seasonal uptick in Chinese credit data in the beginning of the calendar year. Chart 13Yields, Not Trade War, Drove Stocks Chart 14U.S. Stocks Will Resume Outperformance However, any stabilization in equity markets would likely serve to ease financial conditions in the U.S., where economic and inflation conditions remain firmly in tightening territory (Chart 15). As such, the Fed pause is likely to last no more than a quarter, maybe two at best, leading to renewed carnage in global risk assets if our view on Chinese policy stimulus – tepid – remains valid through the course of 2019. Chart 15If Financial Conditions Ease, Tightening Will Be Back On Europe (All Of It… Again) In 2017, our forecasting track record for Europe was stellar. This continued in 2018, with no major setbacks: Populism in Italy: Our long-held view has been that Europe’s chief remaining risks lay in Italian populists coming to power. We predicted in 2016 that this would eventually happen and that they would then be proven to be bluffing. This is essentially what happened in 2018. Matteo Salvini’s Lega is surging in the polls because its leader has realized that a combination of hard anti-immigrant policy and the softest-of-soft Euroskepticism is a winning combination. We believe that investors can live with this combination. Our only major fault in forecasting European politics and assets this year was to close our bearish Italy call too early: we booked our long Spanish / short Italian 10-year government bond trade for a small loss in August, before the spread between the two Mediterranean countries blew out to record levels. That missed opportunity could have also made it on our “worst calls” list as well. Pluralism in Europe: To get the call on Italy right, we had to dabble in some theoretical work. In a somewhat academic report, we showed that political concentration was on the decline in the developed world (Chart 16), but especially in Europe (Chart 17). Put simply, lower political concentration suggests that a duopoly between the traditional center-left and center-right parties is breaking down. Contrary to the conventional wisdom, we argued that Europe’s parliamentary systems would enable centrist parties to adopt elements of the populist agenda, particularly on immigration, without compromising the overall stability of European institutions. As such, political pluralism, or low political concentration, is positive for markets. Immigration crisis is over: For centrist parties to be able to successfully adopt populist immigration policy, they needed a pause in the immigration crisis. This was empirically verifiable in 2018 (Chart 18). Chart 18European Migration Crisis Is Over Merkel’s time has run out: Since early 2017, we had cautioned clients that Angela Merkel’s demise was afoot, but that it would be an opportunity, rather than a risk, when it came. It finally happened in 2018 and it was not a market moving event. The main question for 2019 is whether German policymakers, and Europe as a whole, will use the infusion of fresh blood in Berlin to reaccelerate crucial reforms ahead of the next global recession. Brexit: Since early 2016, we have been right on Brexit. More specifically, we were corrent in cautioning investors that, were Brexit to occur, “the biggest loser would be the Conservative Party, not the EU.” As with the previous two Conservative Party prime ministers, it appears that the question of the U.K.’s relationship with the EU has completely drained any political capital out of Prime Minister Theresa May’s reign. We suspect that the only factor propping up the Tories in the polls is that Jeremy Corbyn is the leader of Her Majesty’s Most Loyal Opposition. We have also argued that soft Brexit would ultimately prove to be “illogical” and that “Bregret” would begin to seep in, as it now most clearly has. We parlayed these rising geopolitical risks and uncertainties by shorting cable in the first half of the year for a 6.21% gain. Malaysia Over Turkey And India Over Brazil Not all was lost for our EM calls this year. We played Malaysia against Turkey in the currency markets for a 17.44% gain, largely thanks to massively divergent governance and structural reform trajectories after Malaysia’s opposition won power for the first time in the country’s history. Second, we initiated a long Indian / short Brazilian equity view in March that returned 27.54% by August. This was a similar play on divergent structural reforms, but it was also a way to hedge our alarmist view on trade. Given India’s isolation from global trade and insular financial markets, we identified India as one of the EM markets that would remain aloof of protectionist risks. We could have closed the trade earlier for greater gain, but did not time the exit properly. Midterm Election: A Major Democratic Victory Our midterm election forecast was correct: Democrats won a substantial victory. Even our initial call on the Senate, that Democrats had a surprisingly large probability of picking up seats, proved to be correct, with Republicans eking out just two gains in a year when Democrats were defending 10 seats in states that Trump carried in 2016. What about our all-important call that the election would have no impact on the markets? That is more difficult to assess, given that the S&P 500 has in fact collapsed in the lead-up to and aftermath of the election. However, we see little connection between the election outcome and the stock market’s performance. Neither do our colleagues or clients, who have largely stopped asking about the Democrats’ policy designs. In 2019, domestic politics may play a role in the markets. Impeachment risk is low, but, if it rears its head, it could prompt President Trump to seek relevance abroad, as his predecessors have done when they lost control of domestic policy. In addition, the Democratic Party’s sweeping House victory may suggest a political pendulum swing to the left in the 2020 presidential election. We will discuss both risks as part of our annual Five Black Swans report in early 2019. U.S. domestic politics was a collection of Red Herrings during much of President Obama’s presidency, and has produced strong tailwinds under President Trump (tax cuts in particular). This may change in 2019, with considerable risk to investors, and asset prices, ahead.     Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com   Footnotes 1      For our 2019 Outlook, please see BCA Geopolitical Strategy Strategic Outlook, “2019 Key Views: Balanced On A Knife’s Edge,” dated December 14, 2018, available at gps.bcaresearch.com. For our past Strategic Outlooks, please visit gps.bcaresearch.com. 2      In part we like this cross because we also think that Mexico’s newly elected president, Andrés Manuel López Obrador, is priced to lose by two touchdowns, whereas he may merely lose by a last-second field goal.    

Highlights So What? Global divergence will persist beyond the near term. Why? China’s stimulus will be disappointing unless things get much worse. U.S.-China trade war will reignite and strategic tensions will continue. European risks are limited short-term, but will surge without reform. U.S. assets will outperform; oil and the yen will rise; the pound is a long-term play; EM pain will continue. Feature The year 2019 will be one of considerable geopolitical uncertainty. Three issues dominate our Outlook, with low-conviction views on all three questions: Question 1: How much will China stimulate? Question 2: Will the trade war abate? Question 3: Is Europe a Black Swan or a Red Herring? The main story in 2018 was policy divergence. American policymakers ramped up stimulus – both through the profligate tax cuts and fiscal spending – at the same time that Chinese policymakers stuck to their guns on de-levering the economy. The consequence of this policy mix was that the synchronized global recovery of late 2016 and 2017 evolved into a massive outperformance by the U.S. economy (Chart 1). The Fed responded to the bullish domestic conditions with little regard for the global economy, causing the DXY to rally from a 2018 low of 88.59 in February to 97.04 today. While the policy divergence narrative appears to be macroeconomic in nature, it is purely political. There is nothing cyclical about the ‘U.S.’ economic outperformance in 2018. President Donald Trump campaigned on an economic populist agenda and then proceeded to deliver on it throughout 2017 and 2018. He faced little opposition from fiscal conservatives, mainly because fiscal conservativism melts away from the public discourse when budget deficits are low (Chart 2) and when the president is a Republican (Chart 3). Meanwhile, Chinese policymakers have decided to tolerate greater economic pain in an effort to escape the Middle Income Trap (Chart 4). They believe this trap will envelop them if they cannot grow the economy without expanding the already-massive build-up of leverage (Chart 5). Geopolitics is not just about “things blowing up somewhere in the desert.” In today’s world, emblematized by paradigm shifts, politicians are more than ever in the driver’s seat. While technocrats respond to macroeconomic factors, politicians respond to political and geopolitical constraints. Few investment narratives last much longer than a year and policy divergence is coming to a close. Will the Fed pause given the turn in global growth? Will China respond with effective stimulus in 2019? If the answer to both questions is yes, global risk assets could light up in the next quarter and potentially beyond. Already EM has outperformed DM assets for a month and some canaries in the coal mine for global growth – like the performance of Swedish economic indicators – signal that the outperformance is real. We are skeptical that the move is sustainable beyond a quarter or two (Chart 6). As our colleague Peter Berezin has highlighted, the market is pricing less than one hike in 2019 (Chart 7). Regardless, the impact on the U.S. dollar, remains muted, with the DXY at 97.04. This suggests that the backing off that the Fed may or may not have already done is still not enough from the perspective of weakening global growth (Chart 8). Global risk assets need more from the Fed than what the market is already pricing. And with U.S. inflationary pressures building (Chart 9), the BCA House View expects to see multiple Fed hikes in 2019, disappointing investors bullish on EM and global risk assets. With our Fed view set by the House View, we therefore turn to where we can add value. To this end, the most important question of 2018 largely remains the same in 2019: How much will China stimulate? Question 1: How Much Will China Stimulate In 2019? China is undoubtedly already stimulating, with a surge in local government bond issuance earlier this year and a bottoming in the broad money impulse (Chart 10). M2 is in positive territory. However, the effort can best be characterized as tepid, with a late-year collapse in bond issuance (Chart 11) and a still-negative total social financing (TSF) impulse (Chart 12). TSF is the broadest measure of private credit in China’s economy.   We expect a surge in TSF in Q1, but this is a normal seasonal effect. A typical Q1 credit surge will not be enough to set global risk assets alight for very long, particularly if the market has already priced in as much of a “pause” from the Fed as we are going to get. Investors should specifically focus on new local government bond issuance and whether the “shadow financing” component of TSF gets a bid, since the primary reason for the weakness in TSF over the past year is the government’s crackdown on shadow lending. As Chart 13A & B shows, it was new local government bonds that led the way for stimulus efforts in 2015, followed by a surge in both bank lending and shadow lending in 2016. We would also expect further monetary policy easing, with extra RRR cuts or even a benchmark policy rate cut. However, monetary policy has been easy all year and yet the impact on credit growth has remained muted. This begs two important questions: Is the credit channel impaired? A slew of macroprudential reforms – which we have dubbed China’s “Preemptive Dodd-Frank” – may have impaired the flow of credit in the system. The official policy of “opening the front door, closing the back door” has seen bank loans pick up modestly but shadow lending has been curtailed (Chart 14A & B). This way of controlling the rise of leverage has its costs. For private enterprises – with poor access to the official banking sector – the shadow financial system was an important source of funding over the past several years. Is policy pushing on a string? An even more dire scenario would be if China’s credit channel is not technically, but rather psychologically, impaired. Multiple reasons may be to blame: a negative net return on the assets of state-owned enterprises (Chart 15); widespread trade war worries; mixed signals from policymakers; or a general lack of confidence in the political direction of the country. The rising M2/M1 ratio suggests that the overall economy’s “propensity to save” is rising (Chart 16). Why would Chinese policymakers keep their cool despite a slow pickup in credit growth? Are they not concerned about unemployment, social unrest, and instability? Of course, they are. But Chinese policymakers are not myopic. They also want to improve potential GDP over the long run. Table 1China: The Trend In Domestic Demand, And The Outlook For Trade, Is Negative So far, the economy has weathered the storm relatively well. First, eight out of ten of our China Investment Strategy’s housing price indicators (Table 1) are flat-to-up – although it is true that the October deterioration in floor space started and especially floor space sold (Chart 17) is cause for concern. If and when the housing market weakens further, stimulus will be used to offset it, despite the fact that the government is attempting to prevent a sharp increase in prices at the same time. With so much of China’s middle-class savings invested in the housing market, the key pillar of socio-economic stability is therefore real estate. Second, credit has fueled China’s “old economy,” but policymakers want to buoy “new China” (Chart 18). This means that measures to boost consumption and the service sector economy will be emphasized in new rounds of stimulus, as has occurred thus far (tax cuts, tariff cuts, deregulation, etc). This kind of stimulus is not great news for global risk assets leveraged to “old China,” such as EM and industrial metals. Third, policymakers are not exclusively focused on day-to-day stability but are also focused on the decades-long perseverance of China’s political model. And that means moving away from leverage and credit as the sole fuel for the economy. This is not just about the Middle Income Trap, it is also about national security and ultimately sovereignty. Relying on corporate re-levering for stimulus simply doubles-down on the current economic model, which is still export-oriented given that most investment is geared toward the export sector. But this also means that China will be held hostage to foreign demand and thus geopolitical pressures, a fact that has been revealed this year through the protectionism of the White House. As such, moving away from the investment-led growth model and towards a more endogenous, consumer-led model is not just good macro policy, it makes sense geopolitically as well. Will the trade war – or the current period of trade truce – change Chinese policymakers’ decision-making? We do not see why it would. First, if the trade truce evolves into a trade deal, the expected export shock will not happen (Chart 19) and thus major stimulative measures would be less necessary. Second, if we understand correctly why policymakers have cited leverage as an “ill” in the first place, then we would assume that they would use the trade war as an excuse for the pain that they themselves have instigated. In other words, the trade war with the U.S. gives President Xi Jinping the perfect excuse for the slowdown, one that draws attention from the real culprit: domestic rebalancing. Bottom Line: Since mid-2018, we have been asking clients to focus on our “Stimulus Overshoot” checklist (Table 2). We give the first item – “broad money and/or total credit growth spike” – a premier spot on the list. If a surge in total credit occurs, we will know that policymakers are throwing in the towel and stimulating in a major way. It will be time to turn super-positive on global risk assets, beyond a mere tactical trade, as a cyclical view at that point. Note that if one had gone long EM in early February 2016, when January data revealed a truly epic TSF splurge, one would not have been late to the rally. Table 2Will China’s Stimulus Overshoot In 2019? Our low-conviction view, at the moment, is that the increase in credit growth that we will see in Q1 will be seasonal – the usual frontloading of lending at the beginning of the year – rather than an extraordinary surge that would signal a policy change. A modest increase in credit growth will not be enough to spark a sustainable – year-long – rally in global risk assets. The Fed has already backed off as far as the market is concerned. As such, a pickup in Chinese credit could temporarily excite investors. But global stabilization may only embolden the Fed to refocus on tightening after a Q1 pause. Question 2: Will The Trade War Abate? The first question for investors when it comes to the trade war is “Why should we care?” Sure, trade policy uncertainty appears to have correlated with the underperformance of global equity indices relative to the U.S. (Chart 20). However, such market action was as much caused by our policy divergence story – being as it is deeply negative for EM assets – as by a trade war whose impact on the real economy has not yet been felt. Nonetheless, we do believe that getting the trade war “right” is a big call for 2019. First, while the impact of the U.S.-China trade war has been minimal thus far, it is only because China front-loaded its exports ahead of the expected tariffs, cut interbank rates and RRRs, accelerated local government spending, and allowed CNY/USD to depreciate by 10%. A restart of trade tensions that leads to further tariffs will make frontloading untenable over time, whereas further currency depreciation would be severely debilitating for EMs. We doubt the sustainability of the trade truce for three reasons: U.S. domestic politics: The just-concluded midterm election saw no opposition to President Trump on trade. The Democratic Party candidates campaigned against the president on a range of issues, but not on his aggressive China policy. Polling from the summer also shows that a majority of American voters consider trade with China unfair (Chart 21). In addition, President Trump will walk into the 2020 election with a wider trade deficit, due to his own stimulative economic policy (Chart 22). He will need to explain why he is “losing” on the one measure of national power that he campaigned on in 2016. Structural trade tensions: Ahead of the G20 truce, the U.S. Trade Representative Robert Lighthizer issued a hawkish report that concluded that China has not substantively changed any of the trade practices that initiated U.S. tariffs. Lighthizer has been put in charge of the current trade negotiations, which is a step-up in intensity from Treasury Secretary Steven Mnuchin, who was in charge of the failed May 2018 round. Geopolitical tensions: The G20 truce did not contain any substantive resolution to the ongoing strategic tensions between the U.S. and China, such as in the South China Sea. Beyond traditional geopolitics, tensions are increasingly involving high-tech trade and investment between the two countries and American allegations of cyber theft and spying by China. The recent arrest of Huawei’s CFO in Canada, on an American warrant, will likely deepen this high-tech conflict in the short term. Since the G20 truce with Xi, President Trump has seen no significant pickup in approval ratings (Chart 23). Given that the median American voter has embraced protectionism – against China at least – we would not expect any. Meanwhile, U.S. equities have sold off, contrary to what President Trump, or his pro-trade advisors, likely expected in making the G20 decision to delay tariffs. At some point, President Trump will realize that he risks considerable political capital on a trade deal with China that very few voters actually want or that the U.S. intelligence and defense community supports. Democrats did not oppose his aggressive China policy in the midterm election because they know that the median voter does not want it. As such, it is guaranteed that Trump’s 2020 Democratic Party opponent will accuse him of “surrender,” or at least “weakness.” If, over the next quarter, the economic and market returns on his gambit are paltry, we would expect President Trump to end the truce. Furthermore, we believe that a substantive, and long-lasting, trade deal is unlikely given the mounting tensions between China and the U.S. These tensions are not a product of President Trump, but are rather a long-run, structural feature of the twenty-first century that we have been tracking since 2012.1 Tensions are likely to rise in parallel to the trade talks on the technology front. We expect 2019 to be the year when investors price in what we have called Bifurcated Capitalism: the segmentation of capital, labor, and trade flows into geopolitically adversarial – and yet capitalist in nature – economic blocs. Entire countries and sectors may become off-limits to Western investors and vice-versa for their Chinese counterparts. Countries will fall into either the Tencent and Huawei bloc or the Apple and Ericsson bloc. This development is different from the Cold War. Note our emphasis on capitalism in the term Bifurcated Capitalism. The Soviet Union was obviously not capitalist, and clients of BCA did not have interests in its assets in the 1970s and 1980s. Trade between Cold War economic blocs was also limited, particularly outside of commodities. The closest comparison to the world we now inhabit is that of the nineteenth century. Almost all global powers were quite capitalist at the time, but they engaged in imperialism in order to expand their economic spheres of influence and thus economies of scale. In the twenty-first century, Africa and Asia – the targets of nineteenth century imperialism – may be replaced with market share wars in novel technologies and the Internet. This will put a ceiling on how much expansion tech and telecommunication companies can expect in the competing parts of Bifurcated Capitalism. The investment consequences of this concept are still unclear. But what is clear is that American policymakers are already planning for some version of the world we are describing. The orchestrated effort by the U.S. intelligence community to encourage its geopolitical allies to ban the use of Huawei equipment in their 5G mobile networks suggests that there are limits to the current truce ever becoming a sustainable deal. So does the repeated use of economic sanctions originally designed for Iran and Russia against Chinese companies. President Trump sets short- and medium-term policies given that he is the president. However, the intelligence and defense communities have “pivoted to Asia” gradually since 2012. This shift has occurred because the U.S. increasingly sees China as a peer competitor, for the time being confined in East Asia but with intentions of projecting power globally. To what extent could President Trump produce a trade deal with Xi that also encompasses a change in the U.S. perception of China as an adversary? We assign a low probability to it. As such, President Xi has little reason to give in to U.S. pressure on trade, as he knows that the geopolitical and technology pressure will continue. In fact, President Xi may have all the reason to double-down on his transformative reforms, which would mean more pain for high-beta global plays. Bottom Line: What may have appeared as merely a trade conflict has evolved into a broad geopolitical confrontation. President Trump has little reason to conclude a deal with China by March. Domestic political pressures are not pushing in the direction of the deal, while America’s “Deep State” is eager for a confrontation with China. Furthermore, with President Trump “blinking” on Iranian sanctions, his administration has implicitly acknowledged the constraints discouraging a deeper involvement in the Middle East. This puts the geopolitical focus squarely on China. Question 3: Is Europe a Black Swan or a Red Herring? The last two years have been a dud in Europe. Since the Brexit referendum in mid-2016, European politics have not been a catalyst for global markets, save for an Italy-induced sell-off or two. This could substantively change in 2019. And, as with the first two questions, the results could be binary. On one hand, there is the positive scenario where the stalled and scaled-back reforms on the banking union and Euro Area budget get a shot in the arm in the middle of the year. On the other hand, the negative scenario would see European-wide reforms stall, leaving the continent particularly vulnerable as the next global recession inevitably nears. At the heart of the binary distribution is the broader question of whether populism in Europe is trending higher. Most commentators and our clients would say yes, especially after the protests and rioting in Paris over the course of November. But the answer is more complicated than that. While populists have found considerable success in the ballot box (Chart 24), they have not managed to turn sentiment in Europe against the currency union (Chart 25). Even in Italy, which has a populist coalition government in power, the support for currency union is at 61%, the highest since 2012. This number has apparently risen since populists took over. What explains this divergence? Effectively, Europe’s establishment parties are being blamed for a lot of alleged ills, liberal immigration policy first amongst them. However, European integration remains favored across the ideological spectrum. Few parties that solely focus on Euroskepticism have any chance of winning power, something that both Lega and Five Star Movement found out in Italy. Italy’s Deputy Prime Minister Matteo Salvini confirmed his conversion away from Euroskepticism by stating that he wants to “reform the EU from the inside” and that it was time to give the “Rome-Berlin axis” another go.2 Salvini is making a bet – correct in our view – that by moderating Lega’s populism on Europe, he can capture the center ground and win the majority in the next Italian election, which could happen as soon as 2019. As such, we don’t think that the “rise of populism” in Europe is either dramatic or market-relevant. In fact, mainstream parties are quickly adopting parts of the anti-establishment agenda, particularly on immigration, in a bid to recoup lost voters. A much bigger risk for Europe than populism is stagnation on the reform front, a perpetual Eurosclerosis that leaves the bloc vulnerable in the next recession. What Europe needs is the completion of a backstop to prevent contagion. Such a backstop necessitates greatly enhancing the just-passed banking union reforms. The watered-down reforms did not include a common backstop to the EU’s single resolution fund nor a deposit union. A working group will report on both by June 2019, with a potential legislative act set for some time in 2024. What could be a sign that the EU is close to a grand package of reforms in 2019? We see three main avenues. First, a political shift in Germany. Investors almost had one, with conservative Friedrich Merz coming close to defeating Merkel’s hand-picked successor Annegret Kramp-Karrenbauer (also known as AKK) for the leadership of the ruling Christian Democratic Union (CDU). Merz combined a right-leaning anti-immigrant stance with staunch pro-European integration outlook. It is unclear whether AKK will be willing to make the same type of “grand bargain” with the more conservative factions of the CDU electorate. However, AKK may not have a choice, with both Alternative for Germany (AfD) and the Green Party nibbling at the heels of the right-of-center CDU and left-of-center Social-Democratic Party (SPD) (Chart 26). The rise of the Green party is particularly extraordinary, suggesting that a larger portion of the German electorate is radically Europhile rather than Euroskeptic. AKK may have to adopt Merz’s platform and then push for EU reforms. Second, French President Emmanuel Macron may have to look abroad for relevance. With his reform agenda stalled and political capital drained, it would make sense for Macron to spend 2019 and beyond on European reforms. Third, a resolution of the Brexit debacle. The longer the saga with the U.K. drags on, the less focus there will be in Europe on integration of the Euro Area. If the U.K. decides to extend the current negotiating period, it may even have to hold elections for the European Parliament. As such, we are not focusing on the budget crisis in Italy – our view that Rome is “bluffing” is coming to fruition –or a potential early election in Spain. And we are definitely not focusing on the EU Parliamentary election in May. These will largely be red herrings. The real question is whether European policymakers will finally have a window of opportunity for strategic reforms. And that will require Merkel, AKK, and Macron to expend whatever little political capital they have left and invest it in restructuring European institutions. Finally, a word on Europe’s role in the global trade war. While Europe is a natural ally for the U.S. against China – given its institutional connections, existing alliance, and trade surplus with the latter and deficit with the former (Chart 27) – we believe that the odds are rising of a unilateral tariff action by the U.S. on car imports. This is because the just-concluded NAFTA deal likely raised the cost of vehicle production in the trade bloc, necessitating import tariffs in order for the deal to make sense from President Trump’s set of political priorities. The Trump administration may not have the stomach for a long-term trade war with Europe, but it can shake up the markets with actions in that direction. Bottom Line: In the near term, there are no existential political risks in Europe in 2019. As such, investors who are bullish on European assets should not let geopolitics stand in the way of executing on their sentiment. We remain cautious for macroeconomic reasons, namely that Europe is a high-beta DM play that needs global growth to outperform in order to catch a bid. However, 2019 is a make-or-break year on key structural reforms in Europe. Without more work on the banking union – and without greater burden sharing, broadly defined – the Euro Area will remain woefully unprepared for the next global recession. Question 4: Will Brexit Happen? Given the volume of market-relevant geopolitical issues, we have decided to pose (and attempt to answer) five additional questions for 2019. We start with Brexit. Prime Minister Theresa May has asked for a delay to the vote in the House of Commons on the Withdrawal Treaty, which she would have inevitably lost. The defeat of the subsequent leadership challenge is not confidence-inspiring as the vote was close and a third of Tory MPs voted against her. May likely has until sometime in January to pass the EU Withdrawal Agreement setting out the terms of Brexit, given that all other EU member states have to get it through their parliaments before the Brexit date on March 29. The real question is whether any deal can get through Westminster. The numbers are there for the softest of soft Brexits, the so-called Norway+ option where the U.K. effectively gets the same deal as Norway, if May convinces the Labour Party to break ranks. Such a deal would entail Common Market access, but at the cost of having to pay essentially for full EU membership with no ability to influence the regulatory policies that London would have to abide by. The alternative is to call for a new election – which may usher the even less pro-Brexit Labour Party into power – or to delay Brexit for a more substantive period of time, or simply to buckle under the pressure and call for a second referendum. We disagree that the delay signals that the “no deal Brexit,” or the “Brexit cliff,” is nigh. Such an outcome is in nobody’s interest and both May and the EU can offer delays to ensure that it does not happen. Whatever happens, one thing is clear: the median voter is turning forcefully towards Bremain (Chart 28). It will soon become untenable to delay the second referendum. And even if the House of Commons passes the softest of Soft Brexit deals, we expect that the Norway+ option will prove to be unacceptable when Westminster has to vote on it again in two or three year’s time. Is it time to buy the pound, particularly cable, which is cheap on a long-term basis (Chart 29)? It is a tough call. On one hand, our confidence that the U.K. ultimately has to remain in the EU is rising. However, to get there, the U.K. may need one last major dose of volatility, either in the form of a slow-burn crisis caused by Tory indecision or in the form of a far-left Labour government that tries its own hand at Brexit while pursuing a 1970s style left-wing economic agenda. Can any investor withstand this kind of volatility in the short and potentially long-ish term? Only the longest of the long-term investors can.  Question 5: Will Oil Prices Rally Substantively In 2019? Several risks to oil supply remain for 2019. First, there is little basis for stabilization in Venezuelan oil production, and further deterioration is likely (Chart 30). Second, sectarian tensions in Iraq remain unresolved. Third, supply risks in other geopolitical hot spots – like Nigeria and Libya – could surprise in 2019. The most pressing geopolitical issue, however, is a decision on the Iranian sanction waivers. President Trump induced considerable market-volatility in 2019 by signaling that he would use “maximum pressure” against Iran. As a result, the risk premium contribution to the oil price – illustrated in Chart 31 by the red bar – rose throughout 2018, only to collapse as the White House offered six-month sanction waivers. Not only did the risk premium dissipate, but Saudi Arabia then scrambled to reverse the production surge it had instituted to offset the Iran sanctions. We agree with BCA’s Commodity & Energy Strategy that oil market fundamentals are tight and numerous supply risks loom. We also struggle to see why President Trump will seek to pick a fight with Iran in the summer of 2019. Our suspicion is that if President Trump was afraid of a gasoline-price spike right after the midterm election, why would he not “blink” at the end of the spring? Not only will the U.S. summer driving season be in full swing – a time of peak U.S. gasoline demand – but the 2020 election primaries will only be six months away. Furthermore, it is highly unlikely that OPEC and Russia will do the U.S. president’s bidding by turning on the taps to offset any unforeseen supply losses in 2019. They did not do so even when President Trump asked, very nicely, ahead of the just-concluded Vienna meeting. Once Trump prioritized domestic politics over Saudi geopolitical interests – by backing away from his maximum pressure tactic against Iran – he illustrated to Riyadh that his administration is about as reliable of an ally as the Obama White House. Meanwhile, his ardent defense of Riyadh in the Khashoggi affair, at a cost of domestic political capital, means that he lost the very leverage that he could have used to pressure Saudi Arabia. We therefore remain cautiously bullish on oil prices in 2019, but with the caveat that a big-bang surge in prices due to a U.S.-Iran confrontation – our main risk for 2019 just a few months ago – is now less likely. Question 6: Will Impeachment Become A Risk In 2019? While we have no way to forecast the Mueller investigation, it is undoubtedly clear that risks are rising on the U.S. domestic front. President Trump’s popularity among GOP voters is elevated and far from levels needed to convince enough senators to remove him from power (Chart 32). However, a substantive finding by Mueller may leave the moderate Democrats in the House with no choice but to pursue impeachment. This may rattle the market for both headline and fundamental reasons. The headline reasons are obvious. The fundamental reasons have to do with the looming stimulus cliff in 2020. A pitched battle between the House Democrats and the White House would make cooperation on another substantive stimulus effort less likely and thus a recession in 2020 more likely. The market may start pricing in such an outcome at some point in 2019. Furthermore, sentiment could be significantly impacted by a protracted domestic battle that impairs Trump’s domestic agenda. President Bill Clinton sought relevance abroad amidst his impeachment proceedings by initiating an air war against Yugoslavia. President Trump may do something similar. There is also an unclear relationship between domestic tensions and trade war. On one hand, President Trump may want a clear win and so hasten a deal. On the other hand, he may want to extend the trade war to encourage citizens to “rally around the flag” and show his geopolitical mettle amidst a distracting “witch hunt.” While we have faded these domestic risks in 2017 and 2018, we think that it may be difficult to do so in 2019. We stick by our view that previous impeachment bouts in the U.S. have had a temporary effect on the markets. But if market sentiment is already weakened by global growth and end of cycle concerns, a political crisis may become a bearish catalyst.  Question 7: What About Japan? Japan faces higher policy uncertainty in 2019, after a period of calm following the 2015-16 global turmoil. We expect to see “peak Shinzo Abe” – in the sense that after this year, his political capital will be spent and all that will remain will be for him to preside over the 2020 Tokyo Olympics. The primary challenge for Abe is getting his proposed constitutional revisions passed despite economic headwinds. Assuming he goes forward, he must get a two-thirds vote in both houses of parliament plus a majority vote in a popular referendum. The referendum is unscheduled but could coincide with the July upper house elections. This will be a knife’s edge vote according to polling. If he holds the referendum and it passes, he will have achieved the historic goal of making Japan a more “normal” country, i.e. capable of revising its own constitution and maintaining armed forces. He will never outdo this. If he fails, he will become a lame duck – if he does not retire immediately like David Cameron or Matteo Renzi. And if he delays the revisions, he could miss his window of opportunity.   This uncertain domestic political context will combine with China/EM and trade issues that entail significant risks for Japan and upward pressure on the yen. Hence government policy will resume its decidedly reflationary tilt in 2019. It makes little sense for Abe, looking to his legacy, to abandon his constitutional dream while agreeing to raise the consumption tax from 8% to 10% as expected in October. We would take the opposite side of the bet: he is more likely to delay the tax hike than he is to abandon constitutional revision. If Abe becomes a lame duck, whether through a failed referendum, a disappointing election, or a consumption tax hike amid a slowdown, it is important for investors to remember that “Abenomics” will smell just as sweet by any other name. Japan experienced a paradigm shift after a series of “earthquakes” from 2008-12. No leader is likely to raise taxes or cut spending aggressively, and monetary policy will remain ultra-easy for quite some time. The global backdrop is negative for Japan but its policy framework will act as a salve. Question 8: Are There Any Winners In EM? We think that EM and global risk assets could have a window of outperformance in early 2019. However, given the persistence of the policy divergence narrative, it will be difficult to see EM substantively outperforming DM over the course of 2019. Mexico Over Brazil That said, we do like a few EM plays in 2019. In particular, we believe that investors are overly bullish on Brazil and overly bearish on Mexico. In both countries, we think that voters turned to anti-establishment candidates due to concerns over violence and corruption. However, Brazilian President-elect Jair Bolsonaro has a high hurdle to clear. He must convince a traditionally fractured Congress to pass a complex and painful pension reform. In other words, Bolsonaro must show that he can do something in order to justify a rally that has already happened in Brazilian assets. In Mexico, on the other hand, Mexican President Andrés Manuel López Obrador (AMLO) remains constrained by the constitution (which he will be unable to change), the National Supreme Court of Justice, and political convention that Mexico is right-of-center on economic policy (an outwardly left-wing president has not won an election since 1924). In other words, AMLO has to show that he can get out of his constraints in order to justify a selloff that has already happened. To be clear, we are not saying that AMLO is a positive, in the absolute, for Mexico. The decision to scrap the Mexico City airport plans, to sideline the finance ministry from key economic decisions, and to threaten a return to an old-school PRI-era statism is deeply concerning. At the same time, we are not of the view that Bolsonaro is, in the absolute, a negative for Brazil. Rather, we are pointing out that the relative investor sentiment is overly bullish Bolsonaro versus AMLO. Especially given that both presidents remain constrained by domestic political intricacies and largely campaigned on the same set of issues that have little to do with their perceived economic preferences. They also face respective median voters that are diametrically opposed to their economic agendas – Bolsonaro, we think, is facing a left-leaning median voter, whereas the Mexican median voter is center-right. The macroeconomic perspective also supports our relative call. If our view on China and the Fed is correct, high-beta plays like Brazil will suffer, while an economy that is tied-to-the-hip of the U.S., like Mexico, ought to outperform EM peers. As such, we are putting a long MXN/BRL trade on, to capture this sentiment gap between the two EM markets. Investors will be receiving positive carry on Mexico relative to Brazil for the first time in a long time (Chart 33). The relative change in the current account balance also favors Mexico (Chart 34). Finally, the technicals of the trade look good as well (Chart 35). South Korea Over Taiwan  Diplomacy remains on track on the Korean peninsula, despite U.S.-China tensions in other areas. Ultimately China believes that peace on the peninsula will remove the raison d’être of American troops stationed there. Moreover, Beijing has witnessed the U.S.’s resolve in deterring North Korean nuclear and missile tests and belligerent rhetoric. It will want to trade North Korean cooperation for a trade truce. By contrast, if Trump’s signature foreign policy effort fails, he may well lash out. We view deeply discounted South Korean equities as a long-term buy relative to other EMs. Taiwan, by contrast, is a similar EM economy but faces even greater short-term risks than South Korea. In the next 13-month period, the Tsai Ing-wen administration, along with the Trump administration, could try to seize a rare chance to upgrade diplomatic and military relations. This could heighten cross-strait tensions and lead to a geopolitical incident or crisis. More broadly, U.S.-China trade and tech tensions create a negative investment outlook for Taiwan. Thailand Over India Five state elections this fall have turned out very badly for Prime Minister Narendra Modi and his National Democratic Alliance (NDA). These local elections have a negative impact, albeit a limited one, on Modi’s and the NDA’s reelection chances in the federal election due in April (or May). Nevertheless, it is entirely possible to lose Chhattisgarh, Madhya Pradesh, and Rajasthan while still winning a majority in the Lok Sabha – this is what happened to the Indian National Congress in 2004 and 2009. So far federal election opinion polling suggests anything from a hung parliament to a smaller, but still substantial, BJP majority. Modi was never likely to maintain control of 20 out of 29 states for very long, nor to repeat his party’s sweeping 2014 victory. He was also never likely to continue his reform push uninhibited in the lead up to the general election. Nevertheless, the resignation of Reserve Bank of India Governor Urjit Patel on December 10 is a very worrisome sign. Given that Indian stocks are richly valued, and that we expect oil prices to drift upwards, we remain negative on India until the opportunity emerges to upgrade in accordance with our long-term bullish outlook. By contrast, we see the return to civilian rule in Thailand as a market-positive event in the context of favorable macro fundamentals. Thai elections always favor the rural populist “red” movement of the Shinawatra family, but presumably the military junta would not hold elections if it thought it had not sufficiently adjusted the electoral system in favor of itself and its political proxies. Either way, the cycle of polarization and social unrest will only reemerge gradually, so next year Thailand will largely maintain policy continuity and its risk assets will hold up better than most other EMs.   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor Strategist roukayai@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com   Footnotes 1      Please see Geopolitical Strategy Special Report, “Power And Politics In East Asia: Cold War 2.0?” dated September 25, 2012, Global Investment Strategy Special Report, “Searing Sun: Japan-China Conflict Heating Up,” dated January 25, 2013, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, and “The South China Sea: Smooth Sailing?” dated March 28, 2017, available at gps.bcaresearch.com. 2      Yes. He literally said that.   Geopolitical Calendar

Special Report

Highlights So What? Global divergence will persist beyond the near term. Why? China’s stimulus will be disappointing unless things get much worse. U.S.-China trade war will reignite and strategic tensions will continue. European risks are limited short-term, but will surge without reform. U.S. assets will outperform; oil and the yen will rise; the pound is a long-term play; EM pain will continue. Feature The year 2019 will be one of considerable geopolitical uncertainty. Three issues dominate our Outlook, with low-conviction views on all three questions: Question 1: How much will China stimulate? Question 2: Will the trade war abate? Question 3: Is Europe a Black Swan or a Red Herring? Chart 1U.S. Outperformance Should Be Bullish USD The main story in 2018 was policy divergence. American policymakers ramped up stimulus – both through the profligate tax cuts and fiscal spending – at the same time that Chinese policymakers stuck to their guns on de-levering the economy. The consequence of this policy mix was that the synchronized global recovery of late 2016 and 2017 evolved into a massive outperformance by the U.S. economy (Chart 1). The Fed responded to the bullish domestic conditions with little regard for the global economy, causing the DXY to rally from a 2018 low of 88.59 in February to 97.04 today. Chart 2Fiscal Conservatism Melts Away Chart 3Republicans Change Their Minds When In Power While the policy divergence narrative appears to be macroeconomic in nature, it is purely political. There is nothing cyclical about the ‘U.S.’ economic outperformance in 2018. President Donald Trump campaigned on an economic populist agenda and then proceeded to deliver on it throughout 2017 and 2018. He faced little opposition from fiscal conservatives, mainly because fiscal conservativism melts away from the public discourse when budget deficits are low (Chart 2) and when the president is a Republican (Chart 3). Meanwhile, Chinese policymakers have decided to tolerate greater economic pain in an effort to escape the Middle Income Trap (Chart 4). They believe this trap will envelop them if they cannot grow the economy without expanding the already-massive build-up of leverage (Chart 5). Chart 4Policymakers Fear The Middle Income Trap Chart 5Debt Still Rising Geopolitics is not just about “things blowing up somewhere in the desert.” In today’s world, emblematized by paradigm shifts, politicians are more than ever in the driver’s seat. While technocrats respond to macroeconomic factors, politicians respond to political and geopolitical constraints. Few investment narratives last much longer than a year and policy divergence is coming to a close. Will the Fed pause given the turn in global growth? Will China respond with effective stimulus in 2019? If the answer to both questions is yes, global risk assets could light up in the next quarter and potentially beyond. Already EM has outperformed DM assets for a month and some canaries in the coal mine for global growth – like the performance of Swedish economic indicators – signal that the outperformance is real. Chart 6Global Economic Divergence Will Continue Chart 7The Market Has Already Priced-In A Fed Pause We are skeptical that the move is sustainable beyond a quarter or two (Chart 6). As our colleague Peter Berezin has highlighted, the market is pricing less than one hike in 2019 (Chart 7). Regardless, the impact on the U.S. dollar, remains muted, with the DXY at 97.04. This suggests that the backing off that the Fed may or may not have already done is still not enough from the perspective of weakening global growth (Chart 8). Global risk assets need more from the Fed than what the market is already pricing. And with U.S. inflationary pressures building (Chart 9), the BCA House View expects to see multiple Fed hikes in 2019, disappointing investors bullish on EM and global risk assets. Chart 8Global Growth Leading Indicators Chart 9Does The Fed Like It Hot? With our Fed view set by the House View, we therefore turn to where we can add value. To this end, the most important question of 2018 largely remains the same in 2019: How much will China stimulate? Question 1: How Much Will China Stimulate In 2019? Chart 10A Ray Of Hope From Broad Money China is undoubtedly already stimulating, with a surge in local government bond issuance earlier this year and a bottoming in the broad money impulse (Chart 10). M2 is in positive territory. However, the effort can best be characterized as tepid, with a late-year collapse in bond issuance (Chart 11) and a still-negative total social financing (TSF) impulse (Chart 12). TSF is the broadest measure of private credit in China’s economy.   Chart 11Fiscal Policy Becomes More Proactive? Chart 12China's Total Credit Is Weak We expect a surge in TSF in Q1, but this is a normal seasonal effect. A typical Q1 credit surge will not be enough to set global risk assets alight for very long, particularly if the market has already priced in as much of a “pause” from the Fed as we are going to get. Investors should specifically focus on new local government bond issuance and whether the “shadow financing” component of TSF gets a bid, since the primary reason for the weakness in TSF over the past year is the government’s crackdown on shadow lending. As Chart 13A & B shows, it was new local government bonds that led the way for stimulus efforts in 2015, followed by a surge in both bank lending and shadow lending in 2016. Chart 13ADon't Focus Just On TSF... Chart 13B...But Shadow Financing In Particular We would also expect further monetary policy easing, with extra RRR cuts or even a benchmark policy rate cut. However, monetary policy has been easy all year and yet the impact on credit growth has remained muted. This begs two important questions: Is the credit channel impaired? A slew of macroprudential reforms – which we have dubbed China’s “Preemptive Dodd-Frank” – may have impaired the flow of credit in the system. The official policy of “opening the front door, closing the back door” has seen bank loans pick up modestly but shadow lending has been curtailed (Chart 14A & B). This way of controlling the rise of leverage has its costs. For private enterprises – with poor access to the official banking sector – the shadow financial system was an important source of funding over the past several years. Chart 14AOpening The Front Door... Chart 14B...Closing The Back Door Is policy pushing on a string? An even more dire scenario would be if China’s credit channel is not technically, but rather psychologically, impaired. Multiple reasons may be to blame: a negative net return on the assets of state-owned enterprises (Chart 15); widespread trade war worries; mixed signals from policymakers; or a general lack of confidence in the political direction of the country. The rising M2/M1 ratio suggests that the overall economy’s “propensity to save” is rising (Chart 16). Chart 15Old China Is A Zombie China Chart 16Propensity To Save Why would Chinese policymakers keep their cool despite a slow pickup in credit growth? Are they not concerned about unemployment, social unrest, and instability? Of course, they are. But Chinese policymakers are not myopic. They also want to improve potential GDP over the long run. Table 1China: The Trend In Domestic Demand, And The Outlook For Trade, Is Negative So far, the economy has weathered the storm relatively well. First, eight out of ten of our China Investment Strategy’s housing price indicators (Table 1) are flat-to-up – although it is true that the October deterioration in floor space started and especially floor space sold (Chart 17) is cause for concern. If and when the housing market weakens further, stimulus will be used to offset it, despite the fact that the government is attempting to prevent a sharp increase in prices at the same time. With so much of China’s middle-class savings invested in the housing market, the key pillar of socio-economic stability is therefore real estate. Chart 17A Possible Clue For China Stimulusr Second, credit has fueled China’s “old economy,” but policymakers want to buoy “new China” (Chart 18). This means that measures to boost consumption and the service sector economy will be emphasized in new rounds of stimulus, as has occurred thus far (tax cuts, tariff cuts, deregulation, etc). This kind of stimulus is not great news for global risk assets leveraged to “old China,” such as EM and industrial metals. Chart 18Rebalancing Of The Chinese Economy Third, policymakers are not exclusively focused on day-to-day stability but are also focused on the decades-long perseverance of China’s political model. And that means moving away from leverage and credit as the sole fuel for the economy. This is not just about the Middle Income Trap, it is also about national security and ultimately sovereignty. Relying on corporate re-levering for stimulus simply doubles-down on the current economic model, which is still export-oriented given that most investment is geared toward the export sector. But this also means that China will be held hostage to foreign demand and thus geopolitical pressures, a fact that has been revealed this year through the protectionism of the White House. As such, moving away from the investment-led growth model and towards a more endogenous, consumer-led model is not just good macro policy, it makes sense geopolitically as well. Will the trade war – or the current period of trade truce – change Chinese policymakers’ decision-making? We do not see why it would. First, if the trade truce evolves into a trade deal, the expected export shock will not happen (Chart 19) and thus major stimulative measures would be less necessary. Second, if we understand correctly why policymakers have cited leverage as an “ill” in the first place, then we would assume that they would use the trade war as an excuse for the pain that they themselves have instigated. In other words, the trade war with the U.S. gives President Xi Jinping the perfect excuse for the slowdown, one that draws attention from the real culprit: domestic rebalancing. Chart 19Trump's Initial Tariffs Soon To Be Felt Bottom Line: Since mid-2018, we have been asking clients to focus on our “Stimulus Overshoot” checklist (Table 2). We give the first item – “broad money and/or total credit growth spike” – a premier spot on the list. If a surge in total credit occurs, we will know that policymakers are throwing in the towel and stimulating in a major way. It will be time to turn super-positive on global risk assets, beyond a mere tactical trade, as a cyclical view at that point. Note that if one had gone long EM in early February 2016, when January data revealed a truly epic TSF splurge, one would not have been late to the rally. Table 2Will China’s Stimulus Overshoot In 2019? Our low-conviction view, at the moment, is that the increase in credit growth that we will see in Q1 will be seasonal – the usual frontloading of lending at the beginning of the year – rather than an extraordinary surge that would signal a policy change. A modest increase in credit growth will not be enough to spark a sustainable – year-long – rally in global risk assets. The Fed has already backed off as far as the market is concerned. As such, a pickup in Chinese credit could temporarily excite investors. But global stabilization may only embolden the Fed to refocus on tightening after a Q1 pause. Question 2: Will The Trade War Abate? The first question for investors when it comes to the trade war is “Why should we care?” Sure, trade policy uncertainty appears to have correlated with the underperformance of global equity indices relative to the U.S. (Chart 20). However, such market action was as much caused by our policy divergence story – being as it is deeply negative for EM assets – as by a trade war whose impact on the real economy has not yet been felt. Chart 20U.S. Is 'Winning' The Trade War Nonetheless, we do believe that getting the trade war “right” is a big call for 2019. First, while the impact of the U.S.-China trade war has been minimal thus far, it is only because China front-loaded its exports ahead of the expected tariffs, cut interbank rates and RRRs, accelerated local government spending, and allowed CNY/USD to depreciate by 10%. A restart of trade tensions that leads to further tariffs will make frontloading untenable over time, whereas further currency depreciation would be severely debilitating for EMs. We doubt the sustainability of the trade truce for three reasons: U.S. domestic politics: The just-concluded midterm election saw no opposition to President Trump on trade. The Democratic Party candidates campaigned against the president on a range of issues, but not on his aggressive China policy. Polling from the summer also shows that a majority of American voters consider trade with China unfair (Chart 21). In addition, President Trump will walk into the 2020 election with a wider trade deficit, due to his own stimulative economic policy (Chart 22). He will need to explain why he is “losing” on the one measure of national power that he campaigned on in 2016. Structural trade tensions: Ahead of the G20 truce, the U.S. Trade Representative Robert Lighthizer issued a hawkish report that concluded that China has not substantively changed any of the trade practices that initiated U.S. tariffs. Lighthizer has been put in charge of the current trade negotiations, which is a step-up in intensity from Treasury Secretary Steven Mnuchin, who was in charge of the failed May 2018 round. Geopolitical tensions: The G20 truce did not contain any substantive resolution to the ongoing strategic tensions between the U.S. and China, such as in the South China Sea. Beyond traditional geopolitics, tensions are increasingly involving high-tech trade and investment between the two countries and American allegations of cyber theft and spying by China. The recent arrest of Huawei’s CFO in Canada, on an American warrant, will likely deepen this high-tech conflict in the short term. Chart 21Americans Are Focused On China As Unfair Chart 22Trade Deficit To Rise Despite Tariffs Since the G20 truce with Xi, President Trump has seen no significant pickup in approval ratings (Chart 23). Given that the median American voter has embraced protectionism – against China at least – we would not expect any. Meanwhile, U.S. equities have sold off, contrary to what President Trump, or his pro-trade advisors, likely expected in making the G20 decision to delay tariffs. Chart 23Appeasing China Doesn't Pay At some point, President Trump will realize that he risks considerable political capital on a trade deal with China that very few voters actually want or that the U.S. intelligence and defense community supports. Democrats did not oppose his aggressive China policy in the midterm election because they know that the median voter does not want it. As such, it is guaranteed that Trump’s 2020 Democratic Party opponent will accuse him of “surrender,” or at least “weakness.” If, over the next quarter, the economic and market returns on his gambit are paltry, we would expect President Trump to end the truce. Furthermore, we believe that a substantive, and long-lasting, trade deal is unlikely given the mounting tensions between China and the U.S. These tensions are not a product of President Trump, but are rather a long-run, structural feature of the twenty-first century that we have been tracking since 2012.1 Tensions are likely to rise in parallel to the trade talks on the technology front. We expect 2019 to be the year when investors price in what we have called Bifurcated Capitalism: the segmentation of capital, labor, and trade flows into geopolitically adversarial – and yet capitalist in nature – economic blocs. Entire countries and sectors may become off-limits to Western investors and vice-versa for their Chinese counterparts. Countries will fall into either the Tencent and Huawei bloc or the Apple and Ericsson bloc. This development is different from the Cold War. Note our emphasis on capitalism in the term Bifurcated Capitalism. The Soviet Union was obviously not capitalist, and clients of BCA did not have interests in its assets in the 1970s and 1980s. Trade between Cold War economic blocs was also limited, particularly outside of commodities. The closest comparison to the world we now inhabit is that of the nineteenth century. Almost all global powers were quite capitalist at the time, but they engaged in imperialism in order to expand their economic spheres of influence and thus economies of scale. In the twenty-first century, Africa and Asia – the targets of nineteenth century imperialism – may be replaced with market share wars in novel technologies and the Internet. This will put a ceiling on how much expansion tech and telecommunication companies can expect in the competing parts of Bifurcated Capitalism. The investment consequences of this concept are still unclear. But what is clear is that American policymakers are already planning for some version of the world we are describing. The orchestrated effort by the U.S. intelligence community to encourage its geopolitical allies to ban the use of Huawei equipment in their 5G mobile networks suggests that there are limits to the current truce ever becoming a sustainable deal. So does the repeated use of economic sanctions originally designed for Iran and Russia against Chinese companies. President Trump sets short- and medium-term policies given that he is the president. However, the intelligence and defense communities have “pivoted to Asia” gradually since 2012. This shift has occurred because the U.S. increasingly sees China as a peer competitor, for the time being confined in East Asia but with intentions of projecting power globally. To what extent could President Trump produce a trade deal with Xi that also encompasses a change in the U.S. perception of China as an adversary? We assign a low probability to it. As such, President Xi has little reason to give in to U.S. pressure on trade, as he knows that the geopolitical and technology pressure will continue. In fact, President Xi may have all the reason to double-down on his transformative reforms, which would mean more pain for high-beta global plays. Bottom Line: What may have appeared as merely a trade conflict has evolved into a broad geopolitical confrontation. President Trump has little reason to conclude a deal with China by March. Domestic political pressures are not pushing in the direction of the deal, while America’s “Deep State” is eager for a confrontation with China. Furthermore, with President Trump “blinking” on Iranian sanctions, his administration has implicitly acknowledged the constraints discouraging a deeper involvement in the Middle East. This puts the geopolitical focus squarely on China. Question 3: Is Europe a Black Swan or a Red Herring? The last two years have been a dud in Europe. Since the Brexit referendum in mid-2016, European politics have not been a catalyst for global markets, save for an Italy-induced sell-off or two. This could substantively change in 2019. And, as with the first two questions, the results could be binary. On one hand, there is the positive scenario where the stalled and scaled-back reforms on the banking union and Euro Area budget get a shot in the arm in the middle of the year. On the other hand, the negative scenario would see European-wide reforms stall, leaving the continent particularly vulnerable as the next global recession inevitably nears. At the heart of the binary distribution is the broader question of whether populism in Europe is trending higher. Most commentators and our clients would say yes, especially after the protests and rioting in Paris over the course of November. But the answer is more complicated than that. While populists have found considerable success in the ballot box (Chart 24), they have not managed to turn sentiment in Europe against the currency union (Chart 25). Even in Italy, which has a populist coalition government in power, the support for currency union is at 61%, the highest since 2012. This number has apparently risen since populists took over. Chart 24Anti-Establishment Parties Are Rising... Chart 25...But Euroskepticism Is A Failed Strategy What explains this divergence? Effectively, Europe’s establishment parties are being blamed for a lot of alleged ills, liberal immigration policy first amongst them. However, European integration remains favored across the ideological spectrum. Few parties that solely focus on Euroskepticism have any chance of winning power, something that both Lega and Five Star Movement found out in Italy. Italy’s Deputy Prime Minister Matteo Salvini confirmed his conversion away from Euroskepticism by stating that he wants to “reform the EU from the inside” and that it was time to give the “Rome-Berlin axis” another go.2 Salvini is making a bet – correct in our view – that by moderating Lega’s populism on Europe, he can capture the center ground and win the majority in the next Italian election, which could happen as soon as 2019. As such, we don’t think that the “rise of populism” in Europe is either dramatic or market-relevant. In fact, mainstream parties are quickly adopting parts of the anti-establishment agenda, particularly on immigration, in a bid to recoup lost voters. A much bigger risk for Europe than populism is stagnation on the reform front, a perpetual Eurosclerosis that leaves the bloc vulnerable in the next recession. What Europe needs is the completion of a backstop to prevent contagion. Such a backstop necessitates greatly enhancing the just-passed banking union reforms. The watered-down reforms did not include a common backstop to the EU’s single resolution fund nor a deposit union. A working group will report on both by June 2019, with a potential legislative act set for some time in 2024. What could be a sign that the EU is close to a grand package of reforms in 2019? We see three main avenues. First, a political shift in Germany. Investors almost had one, with conservative Friedrich Merz coming close to defeating Merkel’s hand-picked successor Annegret Kramp-Karrenbauer (also known as AKK) for the leadership of the ruling Christian Democratic Union (CDU). Merz combined a right-leaning anti-immigrant stance with staunch pro-European integration outlook. It is unclear whether AKK will be willing to make the same type of “grand bargain” with the more conservative factions of the CDU electorate. However, AKK may not have a choice, with both Alternative for Germany (AfD) and the Green Party nibbling at the heels of the right-of-center CDU and left-of-center Social-Democratic Party (SPD) (Chart 26). The rise of the Green party is particularly extraordinary, suggesting that a larger portion of the German electorate is radically Europhile rather than Euroskeptic. AKK may have to adopt Merz’s platform and then push for EU reforms. Chart 26Challengers To The Established Parties Second, French President Emmanuel Macron may have to look abroad for relevance. With his reform agenda stalled and political capital drained, it would make sense for Macron to spend 2019 and beyond on European reforms. Third, a resolution of the Brexit debacle. The longer the saga with the U.K. drags on, the less focus there will be in Europe on integration of the Euro Area. If the U.K. decides to extend the current negotiating period, it may even have to hold elections for the European Parliament. As such, we are not focusing on the budget crisis in Italy – our view that Rome is “bluffing” is coming to fruition –or a potential early election in Spain. And we are definitely not focusing on the EU Parliamentary election in May. These will largely be red herrings. The real question is whether European policymakers will finally have a window of opportunity for strategic reforms. And that will require Merkel, AKK, and Macron to expend whatever little political capital they have left and invest it in restructuring European institutions. Finally, a word on Europe’s role in the global trade war. While Europe is a natural ally for the U.S. against China – given its institutional connections, existing alliance, and trade surplus with the latter and deficit with the former (Chart 27) – we believe that the odds are rising of a unilateral tariff action by the U.S. on car imports. Chart 27EU Surplus With U.S. Pays For Deficit With China This is because the just-concluded NAFTA deal likely raised the cost of vehicle production in the trade bloc, necessitating import tariffs in order for the deal to make sense from President Trump’s set of political priorities. The Trump administration may not have the stomach for a long-term trade war with Europe, but it can shake up the markets with actions in that direction. Bottom Line: In the near term, there are no existential political risks in Europe in 2019. As such, investors who are bullish on European assets should not let geopolitics stand in the way of executing on their sentiment. We remain cautious for macroeconomic reasons, namely that Europe is a high-beta DM play that needs global growth to outperform in order to catch a bid. However, 2019 is a make-or-break year on key structural reforms in Europe. Without more work on the banking union – and without greater burden sharing, broadly defined – the Euro Area will remain woefully unprepared for the next global recession. Question 4: Will Brexit Happen? Given the volume of market-relevant geopolitical issues, we have decided to pose (and attempt to answer) five additional questions for 2019. We start with Brexit. Prime Minister Theresa May has asked for a delay to the vote in the House of Commons on the Withdrawal Treaty, which she would have inevitably lost. The defeat of the subsequent leadership challenge is not confidence-inspiring as the vote was close and a third of Tory MPs voted against her. May likely has until sometime in January to pass the EU Withdrawal Agreement setting out the terms of Brexit, given that all other EU member states have to get it through their parliaments before the Brexit date on March 29. The real question is whether any deal can get through Westminster. The numbers are there for the softest of soft Brexits, the so-called Norway+ option where the U.K. effectively gets the same deal as Norway, if May convinces the Labour Party to break ranks. Such a deal would entail Common Market access, but at the cost of having to pay essentially for full EU membership with no ability to influence the regulatory policies that London would have to abide by. The alternative is to call for a new election – which may usher the even less pro-Brexit Labour Party into power – or to delay Brexit for a more substantive period of time, or simply to buckle under the pressure and call for a second referendum. We disagree that the delay signals that the “no deal Brexit,” or the “Brexit cliff,” is nigh. Such an outcome is in nobody’s interest and both May and the EU can offer delays to ensure that it does not happen. Whatever happens, one thing is clear: the median voter is turning forcefully towards Bremain (Chart 28). It will soon become untenable to delay the second referendum. And even if the House of Commons passes the softest of Soft Brexit deals, we expect that the Norway+ option will prove to be unacceptable when Westminster has to vote on it again in two or three year’s time. Chart 28Bremain Surging Structurally Is it time to buy the pound, particularly cable, which is cheap on a long-term basis (Chart 29)? It is a tough call. On one hand, our confidence that the U.K. ultimately has to remain in the EU is rising. However, to get there, the U.K. may need one last major dose of volatility, either in the form of a slow-burn crisis caused by Tory indecision or in the form of a far-left Labour government that tries its own hand at Brexit while pursuing a 1970s style left-wing economic agenda. Can any investor withstand this kind of volatility in the short and potentially long-ish term? Only the longest of the long-term investors can.  Chart 29Start Buying The Pound Question 5: Will Oil Prices Rally Substantively In 2019? Several risks to oil supply remain for 2019. First, there is little basis for stabilization in Venezuelan oil production, and further deterioration is likely (Chart 30). Second, sectarian tensions in Iraq remain unresolved. Third, supply risks in other geopolitical hot spots – like Nigeria and Libya – could surprise in 2019. Chart 30Venezuela: On A Downward Spiral The most pressing geopolitical issue, however, is a decision on the Iranian sanction waivers. President Trump induced considerable market-volatility in 2019 by signaling that he would use “maximum pressure” against Iran. As a result, the risk premium contribution to the oil price – illustrated in Chart 31 by the red bar – rose throughout 2018, only to collapse as the White House offered six-month sanction waivers. Not only did the risk premium dissipate, but Saudi Arabia then scrambled to reverse the production surge it had instituted to offset the Iran sanctions. Chart 31Trump Sanctions Boosted Risk Premium We agree with BCA’s Commodity & Energy Strategy that oil market fundamentals are tight and numerous supply risks loom. We also struggle to see why President Trump will seek to pick a fight with Iran in the summer of 2019. Our suspicion is that if President Trump was afraid of a gasoline-price spike right after the midterm election, why would he not “blink” at the end of the spring? Not only will the U.S. summer driving season be in full swing – a time of peak U.S. gasoline demand – but the 2020 election primaries will only be six months away. Furthermore, it is highly unlikely that OPEC and Russia will do the U.S. president’s bidding by turning on the taps to offset any unforeseen supply losses in 2019. They did not do so even when President Trump asked, very nicely, ahead of the just-concluded Vienna meeting. Once Trump prioritized domestic politics over Saudi geopolitical interests – by backing away from his maximum pressure tactic against Iran – he illustrated to Riyadh that his administration is about as reliable of an ally as the Obama White House. Meanwhile, his ardent defense of Riyadh in the Khashoggi affair, at a cost of domestic political capital, means that he lost the very leverage that he could have used to pressure Saudi Arabia. We therefore remain cautiously bullish on oil prices in 2019, but with the caveat that a big-bang surge in prices due to a U.S.-Iran confrontation – our main risk for 2019 just a few months ago – is now less likely. Question 6: Will Impeachment Become A Risk In 2019? While we have no way to forecast the Mueller investigation, it is undoubtedly clear that risks are rising on the U.S. domestic front. President Trump’s popularity among GOP voters is elevated and far from levels needed to convince enough senators to remove him from power (Chart 32). However, a substantive finding by Mueller may leave the moderate Democrats in the House with no choice but to pursue impeachment. Chart 32Barometer Of Trump’s Survival This may rattle the market for both headline and fundamental reasons. The headline reasons are obvious. The fundamental reasons have to do with the looming stimulus cliff in 2020. A pitched battle between the House Democrats and the White House would make cooperation on another substantive stimulus effort less likely and thus a recession in 2020 more likely. The market may start pricing in such an outcome at some point in 2019. Furthermore, sentiment could be significantly impacted by a protracted domestic battle that impairs Trump’s domestic agenda. President Bill Clinton sought relevance abroad amidst his impeachment proceedings by initiating an air war against Yugoslavia. President Trump may do something similar. There is also an unclear relationship between domestic tensions and trade war. On one hand, President Trump may want a clear win and so hasten a deal. On the other hand, he may want to extend the trade war to encourage citizens to “rally around the flag” and show his geopolitical mettle amidst a distracting “witch hunt.” While we have faded these domestic risks in 2017 and 2018, we think that it may be difficult to do so in 2019. We stick by our view that previous impeachment bouts in the U.S. have had a temporary effect on the markets. But if market sentiment is already weakened by global growth and end of cycle concerns, a political crisis may become a bearish catalyst.  Question 7: What About Japan? Japan faces higher policy uncertainty in 2019, after a period of calm following the 2015-16 global turmoil. We expect to see “peak Shinzo Abe” – in the sense that after this year, his political capital will be spent and all that will remain will be for him to preside over the 2020 Tokyo Olympics. The primary challenge for Abe is getting his proposed constitutional revisions passed despite economic headwinds. Assuming he goes forward, he must get a two-thirds vote in both houses of parliament plus a majority vote in a popular referendum. The referendum is unscheduled but could coincide with the July upper house elections. This will be a knife’s edge vote according to polling. If he holds the referendum and it passes, he will have achieved the historic goal of making Japan a more “normal” country, i.e. capable of revising its own constitution and maintaining armed forces. He will never outdo this. If he fails, he will become a lame duck – if he does not retire immediately like David Cameron or Matteo Renzi. And if he delays the revisions, he could miss his window of opportunity.   This uncertain domestic political context will combine with China/EM and trade issues that entail significant risks for Japan and upward pressure on the yen. Hence government policy will resume its decidedly reflationary tilt in 2019. It makes little sense for Abe, looking to his legacy, to abandon his constitutional dream while agreeing to raise the consumption tax from 8% to 10% as expected in October. We would take the opposite side of the bet: he is more likely to delay the tax hike than he is to abandon constitutional revision. If Abe becomes a lame duck, whether through a failed referendum, a disappointing election, or a consumption tax hike amid a slowdown, it is important for investors to remember that “Abenomics” will smell just as sweet by any other name. Japan experienced a paradigm shift after a series of “earthquakes” from 2008-12. No leader is likely to raise taxes or cut spending aggressively, and monetary policy will remain ultra-easy for quite some time. The global backdrop is negative for Japan but its policy framework will act as a salve. Question 8: Are There Any Winners In EM? We think that EM and global risk assets could have a window of outperformance in early 2019. However, given the persistence of the policy divergence narrative, it will be difficult to see EM substantively outperforming DM over the course of 2019. Mexico Over Brazil That said, we do like a few EM plays in 2019. In particular, we believe that investors are overly bullish on Brazil and overly bearish on Mexico. In both countries, we think that voters turned to anti-establishment candidates due to concerns over violence and corruption. However, Brazilian President-elect Jair Bolsonaro has a high hurdle to clear. He must convince a traditionally fractured Congress to pass a complex and painful pension reform. In other words, Bolsonaro must show that he can do something in order to justify a rally that has already happened in Brazilian assets. In Mexico, on the other hand, Mexican President Andrés Manuel López Obrador (AMLO) remains constrained by the constitution (which he will be unable to change), the National Supreme Court of Justice, and political convention that Mexico is right-of-center on economic policy (an outwardly left-wing president has not won an election since 1924). In other words, AMLO has to show that he can get out of his constraints in order to justify a selloff that has already happened. To be clear, we are not saying that AMLO is a positive, in the absolute, for Mexico. The decision to scrap the Mexico City airport plans, to sideline the finance ministry from key economic decisions, and to threaten a return to an old-school PRI-era statism is deeply concerning. At the same time, we are not of the view that Bolsonaro is, in the absolute, a negative for Brazil. Rather, we are pointing out that the relative investor sentiment is overly bullish Bolsonaro versus AMLO. Especially given that both presidents remain constrained by domestic political intricacies and largely campaigned on the same set of issues that have little to do with their perceived economic preferences. They also face respective median voters that are diametrically opposed to their economic agendas – Bolsonaro, we think, is facing a left-leaning median voter, whereas the Mexican median voter is center-right. The macroeconomic perspective also supports our relative call. If our view on China and the Fed is correct, high-beta plays like Brazil will suffer, while an economy that is tied-to-the-hip of the U.S., like Mexico, ought to outperform EM peers. Chart 33Mexico Finally Has Some Positive Carry As such, we are putting a long MXN/BRL trade on, to capture this sentiment gap between the two EM markets. Investors will be receiving positive carry on Mexico relative to Brazil for the first time in a long time (Chart 33). The relative change in the current account balance also favors Mexico (Chart 34). Finally, the technicals of the trade look good as well (Chart 35). Chart 34Mexico Looks Good On Current Account Chart 35Technicals Look Good Too South Korea Over Taiwan  Diplomacy remains on track on the Korean peninsula, despite U.S.-China tensions in other areas. Ultimately China believes that peace on the peninsula will remove the raison d’être of American troops stationed there. Moreover, Beijing has witnessed the U.S.’s resolve in deterring North Korean nuclear and missile tests and belligerent rhetoric. It will want to trade North Korean cooperation for a trade truce. By contrast, if Trump’s signature foreign policy effort fails, he may well lash out. We view deeply discounted South Korean equities as a long-term buy relative to other EMs. Taiwan, by contrast, is a similar EM economy but faces even greater short-term risks than South Korea. In the next 13-month period, the Tsai Ing-wen administration, along with the Trump administration, could try to seize a rare chance to upgrade diplomatic and military relations. This could heighten cross-strait tensions and lead to a geopolitical incident or crisis. More broadly, U.S.-China trade and tech tensions create a negative investment outlook for Taiwan. Thailand Over India Five state elections this fall have turned out very badly for Prime Minister Narendra Modi and his National Democratic Alliance (NDA). These local elections have a negative impact, albeit a limited one, on Modi’s and the NDA’s reelection chances in the federal election due in April (or May). Nevertheless, it is entirely possible to lose Chhattisgarh, Madhya Pradesh, and Rajasthan while still winning a majority in the Lok Sabha – this is what happened to the Indian National Congress in 2004 and 2009. So far federal election opinion polling suggests anything from a hung parliament to a smaller, but still substantial, BJP majority. Modi was never likely to maintain control of 20 out of 29 states for very long, nor to repeat his party’s sweeping 2014 victory. He was also never likely to continue his reform push uninhibited in the lead up to the general election. Nevertheless, the resignation of Reserve Bank of India Governor Urjit Patel on December 10 is a very worrisome sign. Given that Indian stocks are richly valued, and that we expect oil prices to drift upwards, we remain negative on India until the opportunity emerges to upgrade in accordance with our long-term bullish outlook. By contrast, we see the return to civilian rule in Thailand as a market-positive event in the context of favorable macro fundamentals. Thai elections always favor the rural populist “red” movement of the Shinawatra family, but presumably the military junta would not hold elections if it thought it had not sufficiently adjusted the electoral system in favor of itself and its political proxies. Either way, the cycle of polarization and social unrest will only reemerge gradually, so next year Thailand will largely maintain policy continuity and its risk assets will hold up better than most other EMs.   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor Strategist roukayai@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com   Footnotes 1      Please see Geopolitical Strategy Special Report, “Power And Politics In East Asia: Cold War 2.0?” dated September 25, 2012, Global Investment Strategy Special Report, “Searing Sun: Japan-China Conflict Heating Up,” dated January 25, 2013, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, and “The South China Sea: Smooth Sailing?” dated March 28, 2017, available at gps.bcaresearch.com. 2      Yes. He literally said that.   Geopolitical Calendar