Geopolitics

Highlights The EM carry trade - supported by a commodity price rally, falling bond yields, and a weak USD - have propped up South African assets; Investors have largely ignored politics and focused on personalities instead of political fundamentals; South Africa's socio-economic factors - governance, middle class wellbeing, productivity, and unemployment - have all regressed; The "median voter" has therefore turned more radical and left-wing; Stay short ZAR versus USD and MXN, stay underweight stocks, sovereign credit, and domestic bonds, and bet on yield-curve steepening. Feature Why do investors in Europe and the U.S. continue to invest in South Africa? - Every client in South Africa Our recent week-long trip to South Africa was revealing for two reasons. First, it reminded us of the promise and opportunity of this amazing country and its people. Second, it impressed upon us the deep pessimism of its entire financial community. As the quote at the top of this report suggests, every client we met over seven days was deeply puzzled by continued resilience of foreign inflows. Clients were surprised that foreign investors continued to find value in South Africa's fixed income and currency markets amidst a continued growth downtrend, soft commodity prices, and the ongoing political imbroglio (Chart I-1). The answer to the puzzle is simple: the main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart I-2). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart I-1ZAR Rally Amidst Economic##br## And Commodity Downturn ZAR Rally Amidst Economic And Commodity Downturn ZAR Rally Amidst Economic And Commodity Downturn Chart I-2EM Carry Trade Is ##br##Alive And Well EM Carry Trade Is Alive And Well EM Carry Trade Is Alive And Well How likely is it that the carry trade can continue? BCA's Global Investment Strategy and Emerging Markets Strategy both argue that U.S. growth will soon accelerate.1 The U.S. financial conditions have eased thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart I-3). Historically, an easing in financial conditions has foreshadowed faster growth (Chart I-4). Meanwhile, the relative U.S. growth underperformance versus DM is late and will turn around very soon (Chart I-5). As U.S. economic growth surprises pick up, investors will bid up the 10-year Treasury yield and the greenback, ushering in the end of the carry trade. Chart I-3U.S. Financial Conditions Have Eased... U.S. Financial Conditions Have Eased... U.S. Financial Conditions Have Eased... Chart I-4...U.S. Growth Should Therefore Sharply Rebound ...U.S. Growth Should Therefore Sharply Rebound ...U.S. Growth Should Therefore Sharply Rebound Chart I-5U.S. Underperformance Is Long-In-The-Tooth U.S. Underperformance Is Long-In-The-Tooth U.S. Underperformance Is Long-In-The-Tooth How resilient are South Africa's economic fundamentals and politics? In this report, we argue that they are not resilient at all. The country is facing considerable structural problems on both economic and political fronts. Even its sole silver lining - that it retains cyclical maneuvering room, i.e., it can adopt fiscal stimulus - will only encourage its leaders to double-down on a populist growth model that has already run out of steam. Cyclical Outlook: A Dark Cloud With A Silver Lining The cyclical outlook for South Africa has darkened as of late. All the drivers that pushed the rand to appreciate over the last 12 months are now showing signs of a reversal: The rand's rally in the past six months or so - a period when it decoupled from commodities prices - is often attributed to its higher interest rates. However, Chart I-6 demonstrates that higher local interest rates historically did not prevent the rand's selloff when metal prices fell. In short, we believe the last six months is an aberration rather than a new norm. Remarkably, hedged yields in South Africa are no longer attractive within the EM space. South Africa already offers the worst hedged returns, after Turkey and China, for the U.S. dollar and euro-based investors (Chart I-7 and Chart I-8).2 The situation will only get worse as the U.S. dollar appreciates and Treasury yields rise. Chart I-6High Local Interest Rates ##br##Are No Panacea For ZAR High Local Interest Rates Are No Panacea For ZAR High Local Interest Rates Are No Panacea For ZAR Chart I-7 Chart I-8 The drop in precious metal prices will force the rand to selloff (Chart I-9). The unprecedented resilience in the rand was supported by increasing financial flows. Now that these are decreasing, the historic correlation with precious metals should reemerge. The decoupling between the ZAR and AUD since early this year is unprecedented (Chart I-10). Both economies are leveraged to industrial and precious metals as well as coal prices, making both exchange rates correlated. Needless to say, Australia commands much better governance and politics than South Africa. In fact, higher interest rates in South Africa have never precluded the rand's depreciation when the AUD dropped. Chart I-9Is The Divergence With Precious Metals... Is The Divergence With Precious Metals... Is The Divergence With Precious Metals... Chart I-10...And AUD Sustainable? ...And AUD Sustainable? ...And AUD Sustainable? Therefore, we conclude that the rand's strength has not been warranted by any of its historic drivers. It has been due to nothing else than the blind search for yield. Over the medium and long run, the outlook for the rand remains bleak. The ongoing dynamic of high wage growth and negative productivity growth will assure a lingering stagflationary environment (Chart I-11). This is bearish for the rand. Surprisingly, despite a rising currency and falling bond yields over the last 12 months, the South African economy is still showing signs of weakness. The household sector, which represents 61% of the economy, is not showing signs of a recovery yet. Credit growth to households is still falling and private consumption is abysmal. (Chart I-12). On the corporate side, the situation is not reassuring either. Firms are not investing and business confidence has not shown any signs of a significant recovery (Chart I-13). Chart I-11Productivity Is Weak But Wages Are Strong Productivity Is Weak But Wages Are Strong Productivity Is Weak But Wages Are Strong Chart I-12Household Consumption Is Declining Household Consumption Is Declining Household Consumption Is Declining Chart I-13No Confidence, No Investment No Confidence, No Investment No Confidence, No Investment The one positive is that the government has fiscal room to maneuver. South African gross government debt is at a comfortable 51% of GDP. However, we suspect that the nature of fiscal spending will likely result in transfers to appease the population - especially ahead of key elections in late 2017 and 2018 - rather than investments that can genuinely improve productivity. In fact, fiscal spending in the form of transfers could very well entice consumers to import more and consequently widen the current account deficit, putting more downward pressure on the rand. Bottom Line: The commodity price rally in 2016 and falling bond yields failed to buoy the economy. While policymakers do retain fiscal room to stimulate, the problem is that such efforts will likely merely rekindle populist policies that have failed South Africa thus far. Structural Outlook: Late Innings Of The Crisis Of Expectations South Africa is not alone in the EM universe in having failed to improve governance over the past decade. Most EM economies have squandered the commodity bull market and Chinese industrialization, allowing their governance to stagnate or even worsen during the good times (Chart I-14).3 However, South Africa does stand alone when it comes to a tepid rise in middle class, as percent of total population (Chart I-15), and continued high income inequality (Chart I-16). Chart I-14Quality Of EM Governance Declined##br## Amidst The Good Times Quality Of EM Governance Declined Amidst The Good Times Quality Of EM Governance Declined Amidst The Good Times Chart I-15Middle Class Has ##br##Barely Budged... Middle Class Has Barely Budged... Middle Class Has Barely Budged... Chart I-16 The data is clear: South Africa is as unequal overall, and its middle class unchanged relative to overall population, as it was at the end of apartheid in the early 1990s. Governance in the country has continued to deteriorate, and while it remains higher than in Sub-Saharan Africa, the gap has astonishingly begun to narrow from both ends (Chart I-17). Chart I-17Governance Gap With Sub-Saharan ##br##Africa Is Closing! Governance Gap With Sub-Saharan Africa Is Closing! Governance Gap With Sub-Saharan Africa Is Closing! A major reason for the deterioration in governance is the "state capture" thesis that has become a popular one in characterizing President Jacob Zuma's rule.4 This process began early, as the country shifted its developmental program in 1996 away from a top-down, state-led, developmental model to one that encouraged a free-market economy balanced with welfare spending. This was a natural result of the global rise of laissez-faire capitalism, the Washington Consensus, and "Third Way" politics of left-leaning parties. A commitment to laissez-faire capitalism and free markets, combined with a strong welfare state, were seen as hallmarks of a successful economy. The problem with this approach is that it confused the symptoms of developed economies with their catalysts. South Africa needed a much more state-led approach to development, one that would have harnessed the resources of the state for productivity-enhancing investments. As such, the laissez-faire approach unsurprisingly failed to address the inequalities of the apartheid system and the country saw a decline in the middle class as percent of total population under both Presidents Nelson Mandela and Thabo Mbeki. This pivot towards free-market capitalism ended with the 2007 "Polokwane moment," which saw President Mbeki's free-market, reactive, attempt to address inequality between the white and black populations replaced with the proactive policy of Jacob Zuma. Zuma's more radical approach was to complement welfare transfers and high wage growth with an activist use of state owned enterprises (SOEs) as a vehicle for redistribution. This proactive policy meant using the government's tender system to doll out lucrative contracts to well-connected insiders, under the auspices of helping enfranchise black entrepreneurs and businesses. While the media has focused on the role that the Indian-born Gupta family has played in this process, it is highly unlikely that they are the only beneficiaries. Zuma's administration has, in the name of black enfranchisement and the fight against inequality, essentially rigged the entire government tender system for the sake of its own political preservation. The results of this process are unsurprising. First, government wages have outpaced those in both manufacturing and mining sectors (Chart I-18). Meanwhile, productivity has declined precipitously since 2007 and has been negative since 2012. South Africa has a lower productivity rate than both Latin American EM economies and its neighbors in sub-Saharan Africa (Chart I-19). Chart I-18Government Wages Have Outpaced All Others Government Wages Have Outpaced All Others Government Wages Have Outpaced All Others Chart I-19South African Productivity Has No Peer South African Productivity Has No Peer South African Productivity Has No Peer Financial media and investment research have continued to focus on the intricacies of the ruling African National Congress (ANC) politics. And we do so as well below. However, investors have to understand that South Africa's ills will not be fixed by the appointment of a pro-market finance minister or even the removal of Jacob Zuma from rule. South Africa has failed to develop inclusive economic institutions that engender creative destruction, which is at the heart of all successful development stories.5 South Africa ranked 74th in the World Bank's annual Doing Business report in 2017, an astonishing fall from grace over the past decade (Chart I-20). Compared to regional averages, South Africa barely beats the Sub-Saharan "distance to frontier" scores in several World Bank categories (Chart I-21). This is not due to the gross failure of the Zuma administration to do the "right thing." Rather, it exhibits a structural failing of South African political institutions. Chart I-20 Chart I-21 This development path is not unique to South Africa. Most sub-Saharan African states experienced a similar regression within 10-20 years of decolonization. Political scientist Robert Bates famously documented how African leaders co-opted colonial-era extractive economic institutions - such as the state marketing boards that purchased all cash crops and exported them on the global market - in order to generate enough revenue to industrialize their economies.6 While their intentions may have originally been noble, if misplaced, they quickly began to use control over marketing boards for political purposes. The rent generated from marketing boards became an immense source of political power for African leaders and they held on to it to the detriment of the economic development of their state. South Africa is far more developed than its sub-Saharan peers were in the 1970s. Nevertheless, its leaders are exhibiting similar rent-seeking behavior, albeit at a much higher level of development. It is also entering a dangerous period in its post-apartheid history: it has now been twenty years since South Africa's effective decolonization and it is facing its first serious economic downturn. Bottom Line: We doubt that anyone in the current leadership elite will be able to fully abandon the rent-seeking behavior of the Zuma administration and improve South Africa's economic institutions. The crisis of expectations among the country's voters is palpable and demands for greater redistribution are rising. This is not a context for pro-market reforms that will encourage creative destruction. Instead, we would expect a doubling-down of populism and greater emphasis on proactive redistribution, which will, at the same time, encourage greater out-migration of talent out of the country and rent seeking behavior from political elites. Can Any One Man Or Woman Fix South Africa? The African National Congress (ANC) will meet in December 2017 to decide the party candidate that will contest the 2019 general election (Diagram I-1). Given the ANC's stranglehold on the country's politics, it is likely that whoever emerges at the upcoming ANC Congress will be the next president of South Africa. Chart I- BCA's Geopolitical Strategy subscribes to the idea that policymakers are price takers in the political marketplace, not price makers. This is particularly the case in democracies, but it is also the case in some authoritarian regimes where public opinion is relevant. As such, the puzzle investors have to resolve is not what policymakers stand for, but rather what the median voter wants. In South Africa, the median voter lives in a rural area, works in the agriculture or service industry, and is a black citizen. The polls indicate that the main concerns of the median voter are a high structural unemployment rate (Chart I-22), endemic corruption (Chart I-23), poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. Chart I-22Crisis Of Expectations Structural Unemployment Is Egregious Structural Unemployment Is Egregious Chart I-23 Is this the profile of a median voter about to elect a pro-market reformer willing to pursue painful structural reforms? We do not think so. The two candidates vying for the ANC presidency are the ex-wife of Jacob Zuma and former Chair of the African Union, Nkosazana Dlamini-Zuma, and former Deputy President, Cyril Ramaphosa. Ramaphosa is the darling of the international investment community. This is because he has abandoned his previous union credentials - he founded the country's largest trade union, the National Union of Mineworkers in addition to founding the Congress of South African Trade Unions (COSATU) - and turned into a successful businessman. As such, the narrative among South Africa bulls (who are exclusively found in Europe and the U.S.) is that he would be able to bridge the divide between the demands for redistribution and pro-market reforms. To the median voter, however, Ramaphosa is alleged to be involved in the Marikana Massacre. Acting as the Deputy President, he ordered increased police presence at the mines and called for the use of force, which resulted in 47 deaths in August-September 2012. Dlamini-Zuma, on the other hand, speaks the language of the median voter while also not being seen as part of Zuma's corrupt entourage. Her credentials are bolstered by a successful tenure as Chair of the African Union and as a woman independent and strong enough to divorce President Zuma. She has not amassed personal wealth and does not hold strong loyalties to a particular faction within the ANC. However, she has begun to parrot Zuma's line that the country requires "radical economic transformation," which is a signal to left-leaning members of the ANC that she will continue much of economic policies begun under Zuma. Both the ANC Youth and Women's Leagues, which are left leaning, support her. The problem that investors face in South Africa is that there is no clear demand for pro-market reforms. Investors cheered the results of the August 2016 municipal election, for example, because the ANC lost in several key cities and saw its total vote share fall by 8%. However, few in the media or investment research community raised the obvious point that the centrist Democratic Alliance only saw its vote total rise by 3% compared to the 2011 election. It was the radically left-wing Economic Freedom Fighters, led by ex-Youth League leader Julius Malema, which saw the largest increase in vote share, by over 8%. In other words, ANC voters that did abandon Zuma most likely fell behind Malema, who is far more redistributionist. As such, we stick to our long-held view that Zuma and the ANC leadership are unlikely to do what investors want them to do given that the South African median voter is swinging further to the left. There is no demand for pro-market reforms and thus policymakers are more likely to double-down on populism. Bottom Line: Dlamini-Zuma is the likely winner of the upcoming ANC Congress, which will effectively decide the next president of South Africa. She has the sufficient left-leaning economic credentials to satisfy the demands for redistribution of the median voter. There is also a chance that she will attempt to clean up the corruption that has become endemic under Zuma, which would undoubtedly be a good thing for the country. However, it is unlikely that the macroeconomic context she will face will be positive, or that she will have the mandate to balance redistributive policies with painful pro-market reforms that would rebuild institutions required for creative destruction. Investment Implications South African assets are ultimately at the mercy of foreign inflows. When the dollar is weakening, U.S. bond yields falling, and Chinese growth stable, even the election of Julius Malema to the presidency would not dent foreign enthusiasm for yield in South African assets. Given the expected improvement in U.S. growth and the transitory nature of the drop in the U.S. inflation rate, we expect the global macro backdrop to worsen substantially for carry trades in general, and for South Africa in particular. China remains the wild card in our analysis, but its credit and fiscal impulse has rolled over, suggesting slower import growth over the next six months (Chart I-24). Even if Chinese policymakers react by re-stimulating the economy, the effects will only be felt in early 2018 given lead times. When the global carry trade reverses, it will not matter who is in charge of South Africa. Investors will realize that the country has failed to address serious socio-economic ills that have plagued South Africa since the end of apartheid. BCA's Emerging Markets Strategy continues to recommend the following investment positions: Chart I-24China Slowdown Is A Risk To EM China Slowdown Is A Risk To EM China Slowdown Is A Risk To EM Chart I-25Yield Curve Will Steepen Yield Curve Will Steepen Yield Curve Will Steepen Continue shorting ZAR versus USD and MXN. Underweight South African stocks, sovereign credit and domestic bonds relative to their respective EM benchmarks. A new trade: bet on yield-curve steepening (Chart I-25). The short end of the curve will be steady but populist politics, larger fiscal deficits/higher public debt, and an inflationary backdrop will push up long-end yields. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Beement Alemayehu, Research Assistant beementa@bcaresearch.com 1 Please see BCA Global Investment Strategy Weekly Report, "Stocks Are From Mars, Bonds Are From Venus?" dated June 23, 2017, available at gis.bcaresearch.com, and BCA Emerging Market Strategy Weekly Report, "EM: Contradictions And A Resolution," dated June 14, 2017, available at ems.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Special Report, "EM Local Bonds: Looking At Hedged Yields," dated May 10, 2017, available at ems.bcaresearch.com. 3 'Governance' is a catchall term that attempts to capture the quality of public service delivery, broadly defined. In essence, investors can consider governance as a factor that underpins the quality of political institutions. We rely on the World Bank's Development Indicators because the World Bank aggregates the work of several credible surveys on governance. These indicators are also useful because the World Bank standardizes the results in a way that allows cross-country/region comparisons. We then aggregate the scores across five different variables and look for trends and changes over time. 4 Please see State Capacity Research Project, "Betrayal Of The Promise: How South Africa Is Being Stolen," dated May 2017, available at pari.org.za. 5 Please see Daron Acemoglu and James A. Robinson, Why Nations Fail (New York: Crown Business, 2012). 6 Please see Robert H. Bates, Markets and States in Tropical Africa: The Political Basis of Agricultural Policies (Berkeley, University of California Press, 2014 edition). Geopolitical Calendar

Highlights The EM carry trade - supported by a commodity price rally, falling bond yields, and a weak USD - have propped up South African assets; Investors have largely ignored politics and focused on personalities instead of political fundamentals; South Africa's socio-economic factors - governance, middle class wellbeing, productivity, and unemployment - have all regressed; The "median voter" has therefore turned more radical and left-wing; Stay short ZAR versus USD and MXN, stay underweight stocks, sovereign credit, and domestic bonds, and bet on yield-curve steepening. Feature Why do investors in Europe and the U.S. continue to invest in South Africa? - Every client in South Africa Our recent week-long trip to South Africa was revealing for two reasons. First, it reminded us of the promise and opportunity of this amazing country and its people. Second, it impressed upon us the deep pessimism of its entire financial community. As the quote at the top of this report suggests, every client we met over seven days was deeply puzzled by continued resilience of foreign inflows. Clients were surprised that foreign investors continued to find value in South Africa's fixed income and currency markets amidst a continued growth downtrend, soft commodity prices, and the ongoing political imbroglio (Chart I-1). The answer to the puzzle is simple: the main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart I-2). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart I-1ZAR Rally Amidst Economic##br## And Commodity Downturn ZAR Rally Amidst Economic And Commodity Downturn ZAR Rally Amidst Economic And Commodity Downturn Chart I-2EM Carry Trade Is ##br##Alive And Well EM Carry Trade Is Alive And Well EM Carry Trade Is Alive And Well How likely is it that the carry trade can continue? BCA's Global Investment Strategy and Emerging Markets Strategy both argue that U.S. growth will soon accelerate.1 The U.S. financial conditions have eased thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart I-3). Historically, an easing in financial conditions has foreshadowed faster growth (Chart I-4). Meanwhile, the relative U.S. growth underperformance versus DM is late and will turn around very soon (Chart I-5). As U.S. economic growth surprises pick up, investors will bid up the 10-year Treasury yield and the greenback, ushering in the end of the carry trade. Chart I-3U.S. Financial Conditions Have Eased... U.S. Financial Conditions Have Eased... U.S. Financial Conditions Have Eased... Chart I-4...U.S. Growth Should Therefore Sharply Rebound ...U.S. Growth Should Therefore Sharply Rebound ...U.S. Growth Should Therefore Sharply Rebound Chart I-5U.S. Underperformance Is Long-In-The-Tooth U.S. Underperformance Is Long-In-The-Tooth U.S. Underperformance Is Long-In-The-Tooth How resilient are South Africa's economic fundamentals and politics? In this report, we argue that they are not resilient at all. The country is facing considerable structural problems on both economic and political fronts. Even its sole silver lining - that it retains cyclical maneuvering room, i.e., it can adopt fiscal stimulus - will only encourage its leaders to double-down on a populist growth model that has already run out of steam. Cyclical Outlook: A Dark Cloud With A Silver Lining The cyclical outlook for South Africa has darkened as of late. All the drivers that pushed the rand to appreciate over the last 12 months are now showing signs of a reversal: The rand's rally in the past six months or so - a period when it decoupled from commodities prices - is often attributed to its higher interest rates. However, Chart I-6 demonstrates that higher local interest rates historically did not prevent the rand's selloff when metal prices fell. In short, we believe the last six months is an aberration rather than a new norm. Remarkably, hedged yields in South Africa are no longer attractive within the EM space. South Africa already offers the worst hedged returns, after Turkey and China, for the U.S. dollar and euro-based investors (Chart I-7 and Chart I-8).2 The situation will only get worse as the U.S. dollar appreciates and Treasury yields rise. Chart I-6High Local Interest Rates ##br##Are No Panacea For ZAR High Local Interest Rates Are No Panacea For ZAR High Local Interest Rates Are No Panacea For ZAR Chart I-7 Chart I-8 The drop in precious metal prices will force the rand to selloff (Chart I-9). The unprecedented resilience in the rand was supported by increasing financial flows. Now that these are decreasing, the historic correlation with precious metals should reemerge. The decoupling between the ZAR and AUD since early this year is unprecedented (Chart I-10). Both economies are leveraged to industrial and precious metals as well as coal prices, making both exchange rates correlated. Needless to say, Australia commands much better governance and politics than South Africa. In fact, higher interest rates in South Africa have never precluded the rand's depreciation when the AUD dropped. Chart I-9Is The Divergence With Precious Metals... Is The Divergence With Precious Metals... Is The Divergence With Precious Metals... Chart I-10...And AUD Sustainable? ...And AUD Sustainable? ...And AUD Sustainable? Therefore, we conclude that the rand's strength has not been warranted by any of its historic drivers. It has been due to nothing else than the blind search for yield. Over the medium and long run, the outlook for the rand remains bleak. The ongoing dynamic of high wage growth and negative productivity growth will assure a lingering stagflationary environment (Chart I-11). This is bearish for the rand. Surprisingly, despite a rising currency and falling bond yields over the last 12 months, the South African economy is still showing signs of weakness. The household sector, which represents 61% of the economy, is not showing signs of a recovery yet. Credit growth to households is still falling and private consumption is abysmal. (Chart I-12). On the corporate side, the situation is not reassuring either. Firms are not investing and business confidence has not shown any signs of a significant recovery (Chart I-13). Chart I-11Productivity Is Weak But Wages Are Strong Productivity Is Weak But Wages Are Strong Productivity Is Weak But Wages Are Strong Chart I-12Household Consumption Is Declining Household Consumption Is Declining Household Consumption Is Declining Chart I-13No Confidence, No Investment No Confidence, No Investment No Confidence, No Investment The one positive is that the government has fiscal room to maneuver. South African gross government debt is at a comfortable 51% of GDP. However, we suspect that the nature of fiscal spending will likely result in transfers to appease the population - especially ahead of key elections in late 2017 and 2018 - rather than investments that can genuinely improve productivity. In fact, fiscal spending in the form of transfers could very well entice consumers to import more and consequently widen the current account deficit, putting more downward pressure on the rand. Bottom Line: The commodity price rally in 2016 and falling bond yields failed to buoy the economy. While policymakers do retain fiscal room to stimulate, the problem is that such efforts will likely merely rekindle populist policies that have failed South Africa thus far. Structural Outlook: Late Innings Of The Crisis Of Expectations South Africa is not alone in the EM universe in having failed to improve governance over the past decade. Most EM economies have squandered the commodity bull market and Chinese industrialization, allowing their governance to stagnate or even worsen during the good times (Chart I-14).3 However, South Africa does stand alone when it comes to a tepid rise in middle class, as percent of total population (Chart I-15), and continued high income inequality (Chart I-16). Chart I-14Quality Of EM Governance Declined##br## Amidst The Good Times Quality Of EM Governance Declined Amidst The Good Times Quality Of EM Governance Declined Amidst The Good Times Chart I-15Middle Class Has ##br##Barely Budged... Middle Class Has Barely Budged... Middle Class Has Barely Budged... Chart I-16 The data is clear: South Africa is as unequal overall, and its middle class unchanged relative to overall population, as it was at the end of apartheid in the early 1990s. Governance in the country has continued to deteriorate, and while it remains higher than in Sub-Saharan Africa, the gap has astonishingly begun to narrow from both ends (Chart I-17). Chart I-17Governance Gap With Sub-Saharan ##br##Africa Is Closing! Governance Gap With Sub-Saharan Africa Is Closing! Governance Gap With Sub-Saharan Africa Is Closing! A major reason for the deterioration in governance is the "state capture" thesis that has become a popular one in characterizing President Jacob Zuma's rule.4 This process began early, as the country shifted its developmental program in 1996 away from a top-down, state-led, developmental model to one that encouraged a free-market economy balanced with welfare spending. This was a natural result of the global rise of laissez-faire capitalism, the Washington Consensus, and "Third Way" politics of left-leaning parties. A commitment to laissez-faire capitalism and free markets, combined with a strong welfare state, were seen as hallmarks of a successful economy. The problem with this approach is that it confused the symptoms of developed economies with their catalysts. South Africa needed a much more state-led approach to development, one that would have harnessed the resources of the state for productivity-enhancing investments. As such, the laissez-faire approach unsurprisingly failed to address the inequalities of the apartheid system and the country saw a decline in the middle class as percent of total population under both Presidents Nelson Mandela and Thabo Mbeki. This pivot towards free-market capitalism ended with the 2007 "Polokwane moment," which saw President Mbeki's free-market, reactive, attempt to address inequality between the white and black populations replaced with the proactive policy of Jacob Zuma. Zuma's more radical approach was to complement welfare transfers and high wage growth with an activist use of state owned enterprises (SOEs) as a vehicle for redistribution. This proactive policy meant using the government's tender system to doll out lucrative contracts to well-connected insiders, under the auspices of helping enfranchise black entrepreneurs and businesses. While the media has focused on the role that the Indian-born Gupta family has played in this process, it is highly unlikely that they are the only beneficiaries. Zuma's administration has, in the name of black enfranchisement and the fight against inequality, essentially rigged the entire government tender system for the sake of its own political preservation. The results of this process are unsurprising. First, government wages have outpaced those in both manufacturing and mining sectors (Chart I-18). Meanwhile, productivity has declined precipitously since 2007 and has been negative since 2012. South Africa has a lower productivity rate than both Latin American EM economies and its neighbors in sub-Saharan Africa (Chart I-19). Chart I-18Government Wages Have Outpaced All Others Government Wages Have Outpaced All Others Government Wages Have Outpaced All Others Chart I-19South African Productivity Has No Peer South African Productivity Has No Peer South African Productivity Has No Peer Financial media and investment research have continued to focus on the intricacies of the ruling African National Congress (ANC) politics. And we do so as well below. However, investors have to understand that South Africa's ills will not be fixed by the appointment of a pro-market finance minister or even the removal of Jacob Zuma from rule. South Africa has failed to develop inclusive economic institutions that engender creative destruction, which is at the heart of all successful development stories.5 South Africa ranked 74th in the World Bank's annual Doing Business report in 2017, an astonishing fall from grace over the past decade (Chart I-20). Compared to regional averages, South Africa barely beats the Sub-Saharan "distance to frontier" scores in several World Bank categories (Chart I-21). This is not due to the gross failure of the Zuma administration to do the "right thing." Rather, it exhibits a structural failing of South African political institutions. Chart I-20 Chart I-21 This development path is not unique to South Africa. Most sub-Saharan African states experienced a similar regression within 10-20 years of decolonization. Political scientist Robert Bates famously documented how African leaders co-opted colonial-era extractive economic institutions - such as the state marketing boards that purchased all cash crops and exported them on the global market - in order to generate enough revenue to industrialize their economies.6 While their intentions may have originally been noble, if misplaced, they quickly began to use control over marketing boards for political purposes. The rent generated from marketing boards became an immense source of political power for African leaders and they held on to it to the detriment of the economic development of their state. South Africa is far more developed than its sub-Saharan peers were in the 1970s. Nevertheless, its leaders are exhibiting similar rent-seeking behavior, albeit at a much higher level of development. It is also entering a dangerous period in its post-apartheid history: it has now been twenty years since South Africa's effective decolonization and it is facing its first serious economic downturn. Bottom Line: We doubt that anyone in the current leadership elite will be able to fully abandon the rent-seeking behavior of the Zuma administration and improve South Africa's economic institutions. The crisis of expectations among the country's voters is palpable and demands for greater redistribution are rising. This is not a context for pro-market reforms that will encourage creative destruction. Instead, we would expect a doubling-down of populism and greater emphasis on proactive redistribution, which will, at the same time, encourage greater out-migration of talent out of the country and rent seeking behavior from political elites. Can Any One Man Or Woman Fix South Africa? The African National Congress (ANC) will meet in December 2017 to decide the party candidate that will contest the 2019 general election (Diagram I-1). Given the ANC's stranglehold on the country's politics, it is likely that whoever emerges at the upcoming ANC Congress will be the next president of South Africa. Chart I- BCA's Geopolitical Strategy subscribes to the idea that policymakers are price takers in the political marketplace, not price makers. This is particularly the case in democracies, but it is also the case in some authoritarian regimes where public opinion is relevant. As such, the puzzle investors have to resolve is not what policymakers stand for, but rather what the median voter wants. In South Africa, the median voter lives in a rural area, works in the agriculture or service industry, and is a black citizen. The polls indicate that the main concerns of the median voter are a high structural unemployment rate (Chart I-22), endemic corruption (Chart I-23), poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. Chart I-22Crisis Of Expectations Structural Unemployment Is Egregious Structural Unemployment Is Egregious Chart I-23 Is this the profile of a median voter about to elect a pro-market reformer willing to pursue painful structural reforms? We do not think so. The two candidates vying for the ANC presidency are the ex-wife of Jacob Zuma and former Chair of the African Union, Nkosazana Dlamini-Zuma, and former Deputy President, Cyril Ramaphosa. Ramaphosa is the darling of the international investment community. This is because he has abandoned his previous union credentials - he founded the country's largest trade union, the National Union of Mineworkers in addition to founding the Congress of South African Trade Unions (COSATU) - and turned into a successful businessman. As such, the narrative among South Africa bulls (who are exclusively found in Europe and the U.S.) is that he would be able to bridge the divide between the demands for redistribution and pro-market reforms. To the median voter, however, Ramaphosa is alleged to be involved in the Marikana Massacre. Acting as the Deputy President, he ordered increased police presence at the mines and called for the use of force, which resulted in 47 deaths in August-September 2012. Dlamini-Zuma, on the other hand, speaks the language of the median voter while also not being seen as part of Zuma's corrupt entourage. Her credentials are bolstered by a successful tenure as Chair of the African Union and as a woman independent and strong enough to divorce President Zuma. She has not amassed personal wealth and does not hold strong loyalties to a particular faction within the ANC. However, she has begun to parrot Zuma's line that the country requires "radical economic transformation," which is a signal to left-leaning members of the ANC that she will continue much of economic policies begun under Zuma. Both the ANC Youth and Women's Leagues, which are left leaning, support her. The problem that investors face in South Africa is that there is no clear demand for pro-market reforms. Investors cheered the results of the August 2016 municipal election, for example, because the ANC lost in several key cities and saw its total vote share fall by 8%. However, few in the media or investment research community raised the obvious point that the centrist Democratic Alliance only saw its vote total rise by 3% compared to the 2011 election. It was the radically left-wing Economic Freedom Fighters, led by ex-Youth League leader Julius Malema, which saw the largest increase in vote share, by over 8%. In other words, ANC voters that did abandon Zuma most likely fell behind Malema, who is far more redistributionist. As such, we stick to our long-held view that Zuma and the ANC leadership are unlikely to do what investors want them to do given that the South African median voter is swinging further to the left. There is no demand for pro-market reforms and thus policymakers are more likely to double-down on populism. Bottom Line: Dlamini-Zuma is the likely winner of the upcoming ANC Congress, which will effectively decide the next president of South Africa. She has the sufficient left-leaning economic credentials to satisfy the demands for redistribution of the median voter. There is also a chance that she will attempt to clean up the corruption that has become endemic under Zuma, which would undoubtedly be a good thing for the country. However, it is unlikely that the macroeconomic context she will face will be positive, or that she will have the mandate to balance redistributive policies with painful pro-market reforms that would rebuild institutions required for creative destruction. Investment Implications South African assets are ultimately at the mercy of foreign inflows. When the dollar is weakening, U.S. bond yields falling, and Chinese growth stable, even the election of Julius Malema to the presidency would not dent foreign enthusiasm for yield in South African assets. Given the expected improvement in U.S. growth and the transitory nature of the drop in the U.S. inflation rate, we expect the global macro backdrop to worsen substantially for carry trades in general, and for South Africa in particular. China remains the wild card in our analysis, but its credit and fiscal impulse has rolled over, suggesting slower import growth over the next six months (Chart I-24). Even if Chinese policymakers react by re-stimulating the economy, the effects will only be felt in early 2018 given lead times. When the global carry trade reverses, it will not matter who is in charge of South Africa. Investors will realize that the country has failed to address serious socio-economic ills that have plagued South Africa since the end of apartheid. BCA's Emerging Markets Strategy continues to recommend the following investment positions: Chart I-24China Slowdown Is A Risk To EM China Slowdown Is A Risk To EM China Slowdown Is A Risk To EM Chart I-25Yield Curve Will Steepen Yield Curve Will Steepen Yield Curve Will Steepen Continue shorting ZAR versus USD and MXN. Underweight South African stocks, sovereign credit and domestic bonds relative to their respective EM benchmarks. A new trade: bet on yield-curve steepening (Chart I-25). The short end of the curve will be steady but populist politics, larger fiscal deficits/higher public debt, and an inflationary backdrop will push up long-end yields. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Beement Alemayehu, Research Assistant beementa@bcaresearch.com 1 Please see BCA Global Investment Strategy Weekly Report, "Stocks Are From Mars, Bonds Are From Venus?" dated June 23, 2017, available at gis.bcaresearch.com, and BCA Emerging Market Strategy Weekly Report, "EM: Contradictions And A Resolution," dated June 14, 2017, available at ems.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Special Report, "EM Local Bonds: Looking At Hedged Yields," dated May 10, 2017, available at ems.bcaresearch.com. 3 'Governance' is a catchall term that attempts to capture the quality of public service delivery, broadly defined. In essence, investors can consider governance as a factor that underpins the quality of political institutions. We rely on the World Bank's Development Indicators because the World Bank aggregates the work of several credible surveys on governance. These indicators are also useful because the World Bank standardizes the results in a way that allows cross-country/region comparisons. We then aggregate the scores across five different variables and look for trends and changes over time. 4 Please see State Capacity Research Project, "Betrayal Of The Promise: How South Africa Is Being Stolen," dated May 2017, available at pari.org.za. 5 Please see Daron Acemoglu and James A. Robinson, Why Nations Fail (New York: Crown Business, 2012). 6 Please see Robert H. Bates, Markets and States in Tropical Africa: The Political Basis of Agricultural Policies (Berkeley, University of California Press, 2014 edition). Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, We hope that you will find value in this report, a product of collaboration between BCA’s Geopolitical Strategy and EM Equity Sector Strategy. My colleagues Oleg Babanov and Matt Gertken look for investment opportunities in the recent geopolitical changes on the Korean Peninsula. The election of President Moon Jae-in will be a boon for domestic consumer sentiment and relations with China. This will produce a tailwind for the consumer-oriented South Korean stocks, which have high exposure to the country’s trade with China. We deliver this report to you both for its investment value and as an example of BCA Research commitment to seek alpha in the intersection of economics, markets, and geopolitics. Kindest Regards, Marko Papic Senior Vice President Chief Geopolitical Strategist Overweight South Korea Consumer Staples We are recommending an overweight position in select South Korean consumer staples on a long-term (one year-plus) time horizon. A decline in geopolitical tensions between South Korea and China, and a potential improvement on the Korean peninsula, will provide tailwinds to the performance of Korean consumer staples, which have high exposure to China. We expect Chinese tourist numbers to Korea to recover gradually, and sales of South Korean products in mainland China to pick up over the rest of the year. Presidential elections in South Korea and a slowly improving economy are bolstering consumer sentiment and aiding a turnaround in retail sales in the country, with companies in the consumer space displaying better earnings momentum and trading at more attractive valuations than their EM peers (Table 1). Image Sector Backdrop We are turning cautiously positive on consumer staples in South Korea. We believe the following factors will trigger a turnaround in consumer sentiment and support share price performance of consumer-oriented South Korean stocks. Geopolitics Image The election of President Moon Jae-in by a wide margin, as well as a geopolitical shift toward more accommodative policy on China, will alleviate geopolitical risks and help consumer sentiment. Moon has already kicked off his administration's tenure with considerable political capital. For one, his administration represents a return to stable and legitimate government after over a year of turmoil surrounding the scandal, impeachment and removal of former President Park Geun-hye - a relief for South Korean voters. What's more, voter turnout was higher than usual, at 77%, and Moon's margin of victory over his closest contender was over 15%, the second-highest since South Korea became a full-fledged democracy in 1987 (Chart 1). There are also institutional factors playing to Moon's advantage. He was the leading contender for the presidency even without Park being removed from office - but if she had not been removed, he would have taken office in January 2018. Now, Moon has half a year longer in office than he otherwise would have had before he faces his first serious political hurdle in the April 2020 legislative elections. This half year could make a difference. Since Korean presidents serve a single, five-year term, they often become lame ducks in the second half of their term, and therefore move rapidly on policy in the first half while their political capital is high. The only significant domestic political constraint on Moon is the rival left-of-center party, the People's Party. It holds the kingmaker position in the legislature, with the ability to give a majority to either Moon's ruling Democratic Party or to the conservative opposition (Chart 2). However, the People's Party has serious weaknesses and has been compelled by its voting base to cooperate on much of Moon's platform of expanding social spending and thawing relations with North Korea and China. Moreover, the conservative opposition is discredited and fractured. Thus, Moon has limited political constraints. Given that his administration is competent - i.e. the clear populist elements are not joined with a lack of experience or pragmatism - the key question is what policies he will prioritize while his political capital is high. Image Chart 3THAAD Deployment Hurt ##br##Bilateral China-Korea Trade THAAD Deployment Hurt Bilateral China-Korea Trade THAAD Deployment Hurt Bilateral China-Korea Trade It is our view that China-exposed companies stand to benefit in the short term as China eases sanctions over the recently deployed U.S. THAAD missile defense system (Chart 3), and as better relations with China benefit the economy more broadly (Chart 4). However, if Moon prioritizes China and North Korea excessively, he risks squandering his political capital. Korea remains stuck in the middle of U.S.-China tensions that are growing on a secular basis. Tensions with the U.S. will rise as a result of Moon's orientation, and North Korean political risks will remain elevated over the medium and long term. Moon's attempts to engage with North Korea will collide with Trump's efforts to ratchet up pressure against it. Image Therefore, Moon is likely to find the most success in his domestic agenda of increasing government spending, hiring more public workers, raising wages and instilling worker protections, expanding the social safety net and subsidizing small- and medium-sized enterprises. These measures will boost both public and private consumption. We do not have particularly high hopes for Moon's ability to reform the so-called 'chaebol', a South Korean term denoting large, typically family-owned corporate conglomerates, but his attempt to do so will add a modicum of corporate governance and competitiveness improvements that markets will likely cheer. Macroeconomics With improvement in the geopolitical situation, stabilization in the local political system following the Park Geun-hye scandal and new elections has aided in a recovery in consumer sentiment (Chart 5). Meanwhile, a rebound in total employment numbers together with a decline in household debt is providing support to consumer spending (Charts 6A, 6B, 6C). Chart 5Consumer Confidence Is ##br##Back To A Five-Year High Consumer Confidence Is Back To A Five-Year High Consumer Confidence Is Back To A Five-Year High Chart 6ANumber Of Employed ##br##Higher Than In 2015... Number Of Employed Higher Than In 2015... Number Of Employed Higher Than In 2015... Chart 6B...While The Household Debt ##br##Burden Is Slowly Declining... ...While The Household Debt Burden Is Slowly Declining... ...While The Household Debt Burden Is Slowly Declining... Chart 6C...Aiding A Recovery##br## In Retail Sales ...Aiding A Recovery In Retail Sales ...Aiding A Recovery In Retail Sales Sector Specifics From a sector perspective, South Korean consumer staples remain highly competitive, outperforming their EM peers (Chart 7). At the same time, valuations are attractive for South Korean companies (Charts 8A & 8B). Chart 7South Korean Consumer Stocks Outperforming EM Consumer Staples' Aggregate... South Korean Consumer Stocks Outperforming EM Consumer Staples' Aggregate... South Korean Consumer Stocks Outperforming EM Consumer Staples' Aggregate... Chart 8ASouth Korean Companies Trading At Cheaper ##br##Valuations Since Mid-2016... South Korean Companies Trading At Cheaper Valuations Since Mid-2016 South Korean Companies Trading At Cheaper Valuations Since Mid-2016 Chart 8B...And At One Standard Deviation Below ##br##Their Seven-Year Average ...And At One Standard Deviation Below Their Seven-Year Average ...And At One Standard Deviation Below Their Seven-Year Average Furthermore, bottom-line expansion of South Korean companies remains strong, supported by solid margin trends (Charts 9A, 9B, 9C). Chart 9A...Earnings Growth In South Korea##br## Is Outperforming EM Peers ...Earnings Growth In South Korea Is Outperforming EM Peers ...Earnings Growth In South Korea Is Outperforming EM Peers Chart 9B...With Gross Margin Nearly Twice ##br## The EM Industry Average... ...With Gross Margin Nearly Twice The EM Industry Average... ...With Gross Margin Nearly Twice The EM Industry Average... Chart 9C...And EBTIDA Margin Is Steadily ##br## Above EM Peers ...And EBTIDA Margin Is Steadily Above EM Peers ...And EBTIDA Margin Is Steadily Above EM Peers We also like the fact that the net debt level for South Korean consumer staples companies is low to negative, while companies have managed to generate excess free cash flow. One undesirable implication, however, is notoriously low dividend yields, which are discouraging investors and raising corporate governance issues (Charts 10A, 10B, 10C). Taking into account the factors listed above, we have created a portfolio of six South Korean consumer staples stocks (Table 2). Chart 10ADebt Levels Have Fallen Significantly ##br## Over The Past Seven Years... Debt Levels Have Fallen Significantly Over The Past Seven Years... Debt Levels Have Fallen Significantly Over The Past Seven Years... Chart 10B...While Cash Generation ##br## Has Recovered... ...While Cash Generation Has Recovered... ...While Cash Generation Has Recovered... Chart 10C...But Dividend Yields ##br## Remain Disappointing Low ...But Dividend Yields Remain Disappointing Low ...But Dividend Yields Remain Disappointing Low Image The Overweight Basket Chart 11Performance Since June 2016: ##br## Amorepacific Corp Vs. MSCI EM Performance Since June 2016: Amorepacific Corp Vs. MSCI EM Performance Since June 2016: Amorepacific Corp Vs. MSCI EM Amorepacific Corp (090430 KS): A leading beauty and cosmetics producer in South Korea (Chart 11). Founded in the 1940s by Yun Dok-jeong as a company distributing camellia oil for hair treatment, the company was inherited by Yun's son and later grandson, who became the second-richest man in South Korea, controlling directly 10% of the company's free float. Today, Amorepacific is the world's 14th largest cosmetics company, with oversight of some 33 brands around the world such as Etude House, Sulwhasoo and others. In terms of revenue, the bulk is generated by beauty and cosmetic products (91%), where luxury cosmetics constitute 43%, followed by premium brands with 18%. Personal care products contribute 9% to total revenue. Geographically, 70% of revenues are generated in South Korea, and another 19% in China. Amorepacific reported weaker-than-expected first-quarter 2017 financial results on April 24. Revenue increased by 5.7% year over year, with falling Chinese tourist numbers weighing on local sales, and weaker sales in mainland China. At the same time, cost of sales went up by 10.6% year over year, which resulted in gross margin compression by 100 basis points. As a result of an operating cost increase of 8.4% year over year, mainly driven by SG&A expansion (increased labor costs and one-off bonus payments), operating profit fell 6.2% year over year. Operating margin finished at 20.2% compared to 22.8% same period last year, while EBTDA margin contracted to 17.8% from 19.5% last year. Weak operating performance and disproportionate expense growth led to the bottom line falling 15% year over year. Amorepacific is currently trading at a forward P/E of 30.0x, while the market is forecasting an EPS CAGR of 13% over the next three years. We believe the share price will continue to recover strongly, taking into account that easing tensions with China will restore demand and organic volume growth as well as strong momentum in overseas sales, supporting an earnings recovery. Chart 12Performance Since June 2016: ##br## E-Mart Vs. MSCI EM Performance Since June 2016: E-Mart Vs. MSCI EM Performance Since June 2016: E-Mart Vs. MSCI EM E-Mart (139480 KS): Number one hypermarket brand in South Korea (Chart 12). E-Mart was established in 1993 and has grown into the largest hypermarket and discount store chain in South Korea, operating over 148 branch locations locally and another 16 in China. In 2006 the company also acquired its largest competitor in the country - Wal-Mart Korea - strengthening its market share. Additionally, E-Mart runs speciality shops such as "Emart" discount stores, the "Emart Mall" online store, "Emart Traders," an everyday low-price store, as well as pet and sports/outdoor stores. In terms of revenue breakdown, the flagship E-Mart brand is responsible for 78% of total revenue, followed by the food distribution and supermarket segment with 7% each respectively. From a geographic perspective, 98% of revenue originates in South Korea and only 2% in China. E-Mart reported first-quarter 2017 financial results on May 11, missing estimates. Revenue growth was solid, up 7.4% year over year, helped by 1% same-store sales growth in the main hypermarket segment, while cost of sales increased by 6.5% year over year, which resulted in gross margin falling slightly by 20 basis points to 28.2%. Operating profit increased by 2.8% year over year, weighed on by a year-on-year jump in operating expenses of 11.1%. Operating margin stood at 4.1%, down from 4.3% in 2016, while EBITDA margin finished virtually flat at 6.7%. Thanks to better operating performance, the bottom line improved by 5% year over year. The main detraction to performance came from one-off store opening expenses and a negative calendar effect. E-Mart is currently trading at a forward P/E of 14.0x, while the market is forecasting an EPS CAGR of 9% over the next three years. A store restructuring program is currently underway, and management has done well in accelerating closures of non-performing stores, which has already led to cost savings and margin turnaround. We expect this process to continue. Together with strong performance of the discount and online segments, this should warrant a further re-rating of the share price. Chart 13Performance Since June 2016: ##br## GS Retail Vs. MSCI EM Performance Since June 2016: GS Retail Vs. MSCI EM Performance Since June 2016: GS Retail Vs. MSCI EM GS Retail (007070 KS): Number one convenience store chain in South Korea (Chart 13). GS Retail is part of the GS Group, a former part of LG Group and the sixth-largest conglomerate in South Korea, which controls just under 66% of the company. GS Retail was incorporated back in 1971 and today operates GS25 - the largest convenience store brand in South Korea - as well as other brands such as GS Supermarkets, Watsons - a health and beauty chain, and Parnas Hotel. The largest contributor to total revenue is the convenience store segment, with 77%, followed by the supermarket business with 20% and the hotel operation with 3%. Geographically, all the revenue originates in South Korea. GS Retail reported first-quarter 2017 financial results on May 11. Revenue displayed strong growth, up 12.5% year over year, driven by solid performance in the convenience store segment (+21% year over year), while cost of sales increased by 12.3% year over year, which brought gross margin up by 20 basis points to 18.4%. A 15% year-over-year increase in operating costs due to the ongoing consolidation of the Watsons business brought operating income down slightly by 1.5% year over year, suppressing operating margin by 20 basis points to 1.4%. EBITDA margin stood at 5.9% compared to 6.2% a year ago. Despite weak operating performance, the bottom line grew by 18.8%, helped by a non-operating gain and lower interest expenses. GS Retail is currently trading at a forward P/E of 19.6x, while the market is forecasting an EPS CAGR of 14% over the next three years. We expect the non-convenience store segments to contribute more to performance in the second part of the year. Furthermore, non-performing supermarket store closedowns together with seasonally strong second and third quarters, where the summer weather typically helps sales, should support stock performance. Chart 14Performance Since June 2016: ##br## H&H Vs. MSCI EM Performance Since June 2016: H&H Vs. MSCI EM Performance Since June 2016: H&H Vs. MSCI EM LG Household & Healthcare (051900 KS): Producer of the very first cosmetic products in Korea (Chart 14). LG H&H was incorporated in 1947 by Koo In-Hwoi, the founder of LG Corp., and had the initial name Lucky Chemical Industrial Corp. The company produced the first-ever Korean cosmetic product, "Lucky Cream," followed by "Lucky Toothpaste." From 1995 to 2001, LG H&H was part of LG Chem before being spun off. In addition to the cosmetics and household goods businesses, the company also acquired Coca Cola Beverage in 2007, turning itself into an exclusive bottler and distributor of Coca Cola products in South Korea. In terms of revenue breakdown, the cosmetics business contributes 53% to overall revenue, followed by personal products with 27% and the soft drink division with 20%. Geographically, 84% of revenue originates in South Korea, followed by China with 8% and Japan with 4%. LG H&H reported better-than-expected first-quarter 2017 financial results on April 28. Revenue expanded by 5.3% year over year, driven by strong sales in the luxury cosmetics and beverage segments, while cost of sales grew by 4% year over year, bringing gross margin 50 basis points higher to 60.9%. Furthermore, operating income displayed strong growth, up 11.3%, helped by good management of operating expenses (+4.5% year over year). As a result, operating margin improved by 90 basis points to 16.2% and EBITDA margin finished at 16.9%, up from 15.7% last year. The bottom line increased by 11.9% year over year, helped by strong operating performance. LG H&H is currently trading at a forward P/E of 24.1x, while the market is forecasting an EPS CAGR of 8% over the next three years. As with Amorepacific, the trigger to a re-rating in the share price of LG H&H is the improving geopolitical situation. We expect tourist numbers to South Korea to gradually increase, which will aid in both sales recovery and earnings revisions, while strong momentum in the luxury cosmetics segment will contribute to further margin expansion. Chart 15Performance Since June 2016: ##br## KT&G Vs. MSCI EM Performance Since June 2016: KT&G Vs. MSCI EM Performance Since June 2016: KT&G Vs. MSCI EM KT&G Corp (033780 KS): Korea Tobacco & Ginseng (Chart 15). Initially founded as a government monopoly with the name "Korea Tobacco & Ginseng," the company was later privatized and rebranded as the "Korea Tomorrow & Global Corporation." Today, the company is the largest tobacco company in South Korea, controlling the majority of the local market. The company also has extensive exposure to Eastern European countries. In addition to the tobacco business, KT&G also has a pharma arm, the Korea Ginseng Corp. The revenue stream is broken down into the cigarette business, which contributes 60% to overall revenue, followed by the ginseng-pharma segment, adding another 30%. KT&G reported in-line first-quarter 2017 financial results on April 27. Revenue increased by a solid 8% year over year, helped by strong ginseng sales, which expanded despite a market contraction and were also alleviated by market share gain and higher prices. Cost of sales, meantime, were up 12.7%, bringing gross margin down to 59.4% from 61.1% previously. Due to a strong increase in operating costs (+11.3% year over year), driven by higher SG&A expenses, operating income edged up only 0.6% year over year. Operating margin fell 45 basis points from last year, while EBITDA margin stood at 35.5%, or 80 basis points lower compared to the same period last year. The bottom line fell by 17.5% year over year, weighted on by higher foreign exchange losses. KT&G is currently trading at a forward P/E of 12.8x, while the market is forecasting an EPS CAGR of 6.5% over the next three years. Several factors have been weighing on the company's share price recently, including the introduction of warning messages on cigarette packages and the introduction of e-cigarettes in the domestic market - making the stock one of the cheapest among its global peers (~20% discount). We believe that worries regarding e-cigarette introduction and projections of the Japanese experience are overstated due to differences in law (e.g. prohibition of smoking indoors), as well as the age composition of the market. Furthermore, we expect a strong revival in overseas sales in the second part of the year, with less headwinds from foreign exchange swings and double-digit growth due to low base effects - as well as an offset to flat local market expansion via higher selling prices. Chart 16Performance Since June 2016: ##br## Nongshim Vs. MSCI EM Performance Since June 2016: Nongshim Vs. MSCI EM Performance Since June 2016: Nongshim Vs. MSCI EM Nongshim (004370 KS): Farmer's Heart (Chart 16). Nongshim, or Farmer's Heart, was founded in 1965 under the name Lotte Food Industrial Company, and later changed its name. The company first focused on ramyun (instant noodle) production, later expanding into snacks - it was the first to introduce the "Shrimp Cracker" as well as beverages. Today, Nongshim is the largest ramyun and snack company in South Korea, selling to over 100 countries, with production facilities in Korea, China and the U.S. From a revenue perspective, ramyun products contribute 67% to total revenue, followed by other food products with 17.5% and snacks with 15.6%. Geographically, most sales occur in South Korea, with 80%, followed by the U.S. with 10% and China with 8%. Nongshim reported slightly better-than-expected first-quarter 2017 financial results on May 15. Revenue declined slightly by 2.2% year over year due to a fall in domestic ramyun sales by 9%, while cost of sales actually declined by 5% year over year, which led to a gross margin improvement by 190 basis points to 33.7% (helped by price increases.) Operating income was virtually flat year over year, as operating costs increased by 4%. Operating margin stood at 5.85% compared to 5.70% in 2016, while EBITDA margin declined to 7.9% from 9.4% last year. Nongshim is currently trading at a forward P/E of 18.5x, while the market is forecasting an EPS CAGR of 5.6% over the next three years. We expect a reversal of weak sales in China (-5% year over year) due to an easing of the geopolitical situation. Furthermore, Nongshim has already begun to claw back market share, helped by new starts and forced price hikes among its competition, which will continue to help turn around margins and improve profitability. How To Trade? The EMES team recommends gaining exposure to the sector through a basket of listed equities consisting of six overweight recommendations. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index-hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Amorepacific Corp (090430 KS); E-Mart (139480 KS); GS Retail (007070 KS); LG Household & Healthcare (051900 KS); KT&G Corp (033780 KS); Nongshim (004370 KS). ETFs: At the moment, there are no ETFs with significant consumer staples sector exposure for South Korea. Funds: At the moment, there are no funds with significant consumer staples sector exposure for South Korea. Please note this trade recommendation is long term (1Y+) and based on an overweight trade. We do not see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equal-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case We believe that one of the main risks is the geopolitical situation and further developments surrounding North Korea. Although the usual springtime tensions have passed, the underlying dynamic remains highly precarious. North Korea has not moderated its behavior despite President Moon's olive branch and U.S. President Trump continues to prioritize the issue and threaten bolder action. Any kind of escalation in tensions, whether they be driven by North Korea or the U.S., would negatively affect both Chinese interests and the new South Korean administration's attempts at engagement. Given that South Korea has not yet fully reversed the THAAD missile deployment, for instance, it is possible that China could maintain or intensify its informal sanctions on South Korea, such as travel and product bans, and that renewed tensions could depress overall consumer sentiment in South Korea. We are also cognizant that debt levels in the South Korean manufacturing sector as well mass layoffs in shipyards and a slowdown in exports could continue to create pressure on household disposable income levels and, in turn, spending. However, President Moon's efforts for a supplementary budget to support employment in the public sector, if approved, should alleviate some pain from layoffs. On a company level, we see increased price competition as one of the main risks to our investment case. Since many of the companies in the basket are market leaders, they will need to defend their market share aggressively in case of increased competition. Furthermore, for companies operating abroad, we see increased expansion costs as one of the risk factors for future performance. Finally, Chinese economic policy pose a risk to our view. The fiscal spending and credit impulse in China have rolled over, suggesting that demand will slow in the coming months. Moreover, the Communist Party’s ongoing “deleveraging campaign” – a crackdown on various risky financial practices and the shadow banking sector – raises the risks of a policy mistake. A slowdown in China would have negative repercussions for the South Korean companies most exposed to China and the broader Korean economy. Nevertheless, we think Chinese authorities are willing and able to meet their growth target this year. Oleg Babanov, Senior Editor obabanov@bcaresearch.co.uk Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.co.uk

Highlights Italy cannot rely on currency devaluation to make up for poor competitiveness, as it did before the euro; Italian voters are becoming more Euroskeptic - the elections due by May 2018 pose a serious risk, as do elections thereafter; Necessary structural reforms, not in the cards at present, would be painful and could exacerbate the Euroskeptic trend in Italy; The mere suggestion of a referendum on the euro would cause a banking crisis ... though voters would likely decide to stay in the Euro Area; The ECB will surprise on the dovish side; EUR/USD will weaken slightly below parity by mid-2018; European equities will continue to outperform U.S. equities. Feature European politics have been a boon to investors in 2017 (Chart 1). Instead of destabilizing populism, investors have gotten promises of pro-market reforms. This positive development is as we expected: we dubbed European politics "a trophy red herring" in our 2017 Strategic Outlook1 and predicted the pro-market turn in France.2 Alas, Italy remains a Sword of Damocles hanging over Europe's head. Whereas public sentiment in Europe has turned decisively in favor of integration since 2013, it remains indecisive in Italy (Chart 2). The Italian "median voter" continues to flirt with Euroskepticism, which explains why the country's anti-establishment parties have not softened their Euroskepticism to the same degree as their peers elsewhere in Europe. Chart 1European Stocks Outperform American European Stocks Outperform American European Stocks Outperform American Chart 2Italians Doubting The Euro Monetary Union Italians Doubting The Euro Monetary Union Italians Doubting The Euro Monetary Union In this report, we attempt to answer several questions concerning Italy: What is structurally wrong with Italy? Why is Euroskepticism appealing to Italian voters? What would happen if Euroskeptics won the upcoming election and called a referendum on Euro Area membership? What would happen if Italy left the Euro Area? Italy's Purgatory: Aversion To Creative Destruction Italy has a structural productivity problem (Chart 3). Given weak labor force and productivity growth, Italy will be in and out of recessions for much of the next decade as its growth rate oscillates around zero. Particularly concerning is the steep decline in the country's total factor productivity, which suggests that Italians struggle to make use of technological innovation and that the economy is extremely inefficient. Chart 3 There is a vast literature detailing the structural problems of the Italian economy.3 We focus on the three most important impediments: The unproductive South, the Mezzogiorno, remains Europe's backwater; The public sector is riven with inefficiencies; Education and innovation remain sub-par. The first problem with Italy is that it remains an extremely bifurcated economy. Its northern regions, particularly Lombardy, are as wealthy as any in Europe (Map 1). Productivity rates and education standards are on par with core Europe (Chart 4). However, the Mezzogiorno has consistently pulled the aggregate Italian averages down (Chart 5). Chart Chart 4 Chart 5 As the industrialized North was rebuilt after the Second World War, and as productivity and labor force growth rates surged, the backwardness of the Mezzogiorno was conveniently ignored. Since the late 1990s, however, productivity rates have declined in all of the developed world. For Italy, this means that the one-third of the population that lives in the unproductive South is no longer a rounding error. At its root, Italy's problem is that its unification in 1861, the Risorgimento, never went far enough to integrate the south and thus left a bifurcated economy that exemplifies the north-south divide in Europe as a whole.4 Several of the reform efforts undertaken by the Matteo Renzi-led Democratic Party (PD) government have sought to address the disparity between the North and the Mezzogiorno. However, these reforms will take time to bear fruit. Previous efforts have fallen short due to half-hearted implementation. The second structural problem is that Italy's public sector is large, riven with inefficiencies, and largely funded via corporate taxes due to poor overall tax collection. Italy's social security contributions are high, accounting for about 13% of GDP. Of this burden, the employer contribution rate is one of the highest in the world, only surpassed by France and Germany (Chart 6). Chart 6 Chart 7 Despite a developed-world tax burden, Italy has a developing-world system of tax collection. For example, its VAT revenue ratio is well below the OECD average, at the level of an emerging market (Chart 7).5 If the VAT revenue ratio was improved to the OECD average, Italy would see its VAT receipts rise by about €45 billion per year (enough to recapitalize all of its banks, for example, or reduce employers' social security contributions by a third). Not only is tax collection of poor quality, but paying taxes is exorbitantly difficult. The World Bank's "Paying Tax" indicator - which measures the cost and time of paying taxes - nestles Italy between Kenya and São Tomé at 126th out of 190 spots! For comparison sake, its Mediterranean peers Spain and Portugal are 37th and 38th respectively on the same index while even Greece is significantly better at 64th.6 Italy again ranks with EM countries on the World Bank's overall "Doing Business" report (Chart 8). It scores extremely low in the category of "enforcing contracts," where it finds itself sandwiched between the Gambia and Somalia, at the 108th rank! It takes more time - three years - to enforce a contract in Italy than in Pakistan, Egypt, and Mozambique. Chart 8 Public sector inefficiencies are not a result of nostalgia for Roman-era bureaucracy. Instead, Italy's administrative hurdles are a means to stifle domestic creative destruction and protect its numerous small and medium-sized businesses - many family-owned - from competition. Instead of fostering competition through innovation and investment, Italian industrial policy since the Second World War has largely relied on currency depreciation to boost competitiveness. This strategy ceased to be effective with the adoption of the euro, but the country never pushed through painful reforms to adjust to the new reality. While it is difficult to prove a counterfactual, we are not sure that even currency devaluation would have saved Italy from the onslaught of Asian manufacturing in the late 1990s. Euro Area imports from EM Asia have surged from less than 2% of total imports to nearly 10% in the last twenty years. Italy began losing market share to Asia well before the euro was introduced on January 1, 1999, as Chart 9 illustrates. Finally, Italy's educational system is in need of a massive overhaul. Some improvement in educational attainment was apparent by 2015 (Chart 10). However, the quality of Italian education is still woefully inadequate if measured by the results of post-secondary and tertiary education on literacy proficiency (Chart 11). Chart 9Italy Lost Market Share Amid Globalization Italy Lost Market Share Amid Globalization Italy Lost Market Share Amid Globalization Chart 10 Chart 11 Italian firms are not making up for the poor educational attainments of the labor force with higher investment in knowledge-based capital - software, research, training, or management (Chart 12). There are likely three reasons for this outcome. First, low productivity begets low potential GDP growth, which hurts firms' top line prospects and incentives to invest. Second, decades of reliance on currency devaluation for competitiveness has discouraged Italian corporates from investing in R&D. Third, a plethora of small Italian family-owned businesses lack the resources to leverage their intellectual property with management and technology to become globally competitive. Chart 12 Last time Italy faced a painful recession - 1992-1995 - it did what had worked best since the Second World War: it devalued its way out of trouble (Chart 13A). Yet a comparable devaluation did not work for Italy in recent years, with exports failing to lead the way to recovery despite a 20% drop in EUR/USD since mid-2014 (Chart 13B). Why? Chart 13ACurrency Devaluation Has Not ##br##Worked This Time Around (I) Currency Devaluation Has Not Worked This Time Around (I) Currency Devaluation Has Not Worked This Time Around (I) Chart 13BCurrency Devaluation Has Not ##br##Worked This Time Around (II) Currency Devaluation Has Not Worked This Time Around (II) Currency Devaluation Has Not Worked This Time Around (II) Many of Italy's exports go to Euro Area peers. In 1995, the percentage was 48%, today it is 41%. As such, the devaluation in the 1990s was against those peers, allowing Italian exports to the EU Common Market to surge. Nonetheless, the lack of any growth in exports still does not make sense, given the large depreciation in the euro and the fact that 60% of Italy's exports are still destined for non-Euro Area markets. Bottom Line: Italy has failed to keep up in competitiveness over the past twenty years precisely because its reliance on devaluation worked wonders for the economy in the pre-euro era. Instead of committing itself to structural reforms, Italy has preserved its post-Second World War institutions that were expressly designed to limit creative destruction and domestic competition. Unlike France, which has largely an arithmetic problem, Italy has a genuine productivity problem. For Italy to boost economic growth, it will have to do a lot more than adjust a few labor laws or raise the retirement age (both of which it has already done!). It needs deep structural reforms that are impossible without a strong electoral mandate that gives the next government sufficient political capital for reforms. Such a mandate is unlikely to come in the next election, leaving Italy in a purgatory of its own making. Political Risks: An Assessment Current polls show that the ruling, center-left PD is running neck-and-neck with the anti-establishment and Euroskeptic Five Star Movement (M5S) (Chart 14). Also in the mix are the center-right Forza Italia (FI), of former Prime Minister Silvio Berlusconi, which has itself flirted with mild Euroskepticism, and the staunchly anti-EU Lega Nord (LN). The power of Italy's establishment and Euroskeptic parties is perfectly balanced (Chart 15) ahead of the general election, which has to take place before May 20, 2018. The exact date is as yet unclear, with President Sergio Mattarella insisting that it take place after parliament passes a new electoral law that will make the electoral system uniform for both houses of parliament. A recent agreement between the main four parties on an electoral bill broke down, again pushing the date to the second quarter of next year. With the election now likely a year away - and with European populists in retreat across the continent - should investors breathe a sigh of relief? Chart 14Euroskeptic Five Star Movement Challenges Ruling Democrats Euroskeptic Five Star Movement Challenges Ruling Democrats Euroskeptic Five Star Movement Challenges Ruling Democrats Chart 15Euroskeptics Roughly Equal To Establishment Parties In Polls Euroskeptics Roughly Equal To Establishment Parties In Polls Euroskeptics Roughly Equal To Establishment Parties In Polls No. Italy remains the political risk in Europe. There are three broad reasons we remain concerned about Italian politics: The Median Italian Voter Is Flirting With Euroskepticism Policymakers are not price makers in the political marketplace, but price takers. The price maker is the median voter.7 In Europe, the Euroskepticism of the median voter has been massively overstated by the media and markets. Across the Euro Area, support for the common currency has surged since 2013 (Chart 16), likely reflecting an improving economy and the deeply held belief among European voters that continental integration is an intrinsic good. It took some time for anti-establishment politicians to sound off the median voter, but when they did, they adjusted their stances. As such, initially Euroskeptic anti-establishment parties across the continent - from Greece's SYRIZA and Spain's Podemos to Finland's "Finns Party" - have abandoned overt Euroskepticism and moved towards the middle ground on European integration. Politicians who have refused to be price takers - and insisted on campaigning from an inflexible, Euroskeptic position - were punished by the political marketplace (case in point: Marine Le Pen). Italy, however, has not seen a recovery in support for European integration. This is in large part due to the fact that the Italian economy has remained a laggard since 2012 (Chart 17). But it may also reflect the fact that the siren song of currency depreciation remains appealing to a large segment of the Italian electorate. Both M5S and Lega Nord have been vociferously arguing that Italy was far more competitive before joining the Euro Area and that simple currency devaluation would turn Italy from a land of locusts into a land of milk and honey. Chart 16Support For The Euro Has Risen Everywhere Else Support For The Euro Has Risen Everywhere Else Support For The Euro Has Risen Everywhere Else Chart 17Lagging Economy Has Hurt Support For The Euro Lagging Economy Has Hurt Support For The Euro Lagging Economy Has Hurt Support For The Euro Italy's Relationship With The EU Is Transactional We have long contended that both European patricians and plebeians support further integration.8 Chart 18 shows that a strong majority of Europeans is outright pessimistic about the future of their country outside of the EU. Why? Because, as Chart 19 suggests, the EU stands for geopolitical stability and a stronger say in the world. Chart 18Most Europeans Fear Life Outside The EU Most Europeans Fear Life Outside The EU Most Europeans Fear Life Outside The EU Chart 19 For a majority of Europeans, the European project is essential for peace and stability in Europe. We would argue that this is not just a product of two world wars in the twentieth century. It is also a product of newfound Russian assertiveness, migration crisis, and a growing ideological distance between Europe and its former security guarantor, the U.S. Italians, on the other hand, appear to be significantly more "transactional" than their European peers. For example, Chart 19 shows that Italians stand apart in being significantly less concerned about "peace" and having a "stronger say in the world." A plurality of Italians has also become confident in the country's future outside of the EU (Chart 20). Italians also appear to have the most negative perception of immigrants, perhaps due to the fact that they are at the frontline of Europe's migration crisis (Chart 21). Chart 20Italians Not So Afraid Of Life Outside The EU Italians Not So Afraid Of Life Outside The EU Italians Not So Afraid Of Life Outside The EU Chart 21 Why such a discrepancy in views between Italy and the rest of the continent? First, Italians have traditionally had a much more parochial view of the world. Regional differences matter a lot more to Italians than continental ones. Italians are already being asked to subsume one identity (regional) for another (national), so going a step further (supranational) may be too much. Data suggests that about half of all Italians are unwilling to go further (Chart 22). Second, Italy joined the EU as a considerably less developed economy than its core European peers. As such, membership was always sold to Italians from a transactional perspective and thus they do not give supremacy to geopolitical over economic forces. Chart 22Italians Less Likely To See Themselves As Europeans Italians Less Likely To See Themselves As Europeans Italians Less Likely To See Themselves As Europeans Elections Are Unlikely To Be Cathartic Italian Euroskeptics have consistently performed well in the polls for well over a year. Short of a significant surge in support for Matteo Renzi's PD, which we doubt will happen, polls are likely to continue to be tight until the election. The anti-establishment M5S performed extremely poorly in the June 11 municipal elections, failing to make the second-round run-off of the mayoral election in any of the major cities. However, we would fade the significance of this result given the national polls. As such, the best hope for investors is that anti-establishment forces suffer a modest defeat in next year's election. Short of a strong economic recovery that significantly reduces unemployment, an election win for the Italian establishment will not be as cathartic as the just-concluded election in France. And what are the odds of an outright Euroskeptic win? They are low, below 20%. M5S has no incentive to form a weak minority government, support an establishment-led government, or enter a risky coalition with Euroskeptic Lega Nord. It understands that remaining in the opposition would allow it to reap the benefits when the eventual coalition between establishment parties loses steam. The most likely scenario in next year's election is either an establishment Grand Coalition (40%), or a minority center-left government led by the ruling PD and supported on a case-by-case basis by the other parties (40%).9 Neither outcome is likely to survive the entire length of the mandate. Bottom Line: The long-term problem for investors is that the Euroskeptic narrative appears to be quite appealing to a large proportion of the Italian public. As such, even if the market avoids a crisis in 2018, one will likely emerge by 2020. The only way to avoid it would be a strong electoral mandate for deep structural reforms that boost productivity, which is not a likely outcome of the next election. But even if such reforms were initiated, we assume that their short-term consequences would be economic and political pain, which would sour support for establishment parties further and potentially deepen Euroskeptic sentiment in the country. As such, in the rest of the report, we examine what investors should expect in case the anti-establishment parties eventually take power in Italy. While such an outcome is unlikely in 2018, it may happen eventually. Leaving The Euro Is A Panacea... The political analysis above begs a simple question: Why are Italians more likely to be lured by the sirens of leaving the Euro Area than the French or Spanish have been? Fundamentally, the Italian experience is one of relatively successful devaluations. In the early 1990s, Italy was also suffering from a period of un-competitiveness, which prompted the current account to move from a 0.6% of GDP surplus in 1987 to a 2.5% of GDP deficit in 1992 (Chart 23). This deterioration reflected two factors. One was the notorious European Exchange Rate Mechanism (ERM), which forced European currencies to move in lockstep with each other. The second was the fact that Italian unit labor costs had been in a bull market relative to the rest of the European community countries, rising by 380%, 140%, and 370% against German, France, and the Netherlands, respectively, between 1970 and 1991. Thanks to this confluence of events, Italy was in a bind. By early 1992, Italian real wages were contracting. More than a surge in inflation, this contraction reflected intensifying competitive pressures and the implementation of fiscal austerity (Chart 24). Investors ended up punishing Italian assets; Italian yields moved up, with spreads relative to Germany widening from 350 basis points to 750 basis points by September 1992. Chart 23Lack Of Competitiveness Caused Current Account Deficits... Lack Of Competitiveness Caused Current Account Deficits... Lack Of Competitiveness Caused Current Account Deficits... Chart 24...And Contributed To Falling Real Wages ...And Contributed To Falling Real Wages ...And Contributed To Falling Real Wages By that point, Italian authorities chose to let the previously stable lira fall, resulting in a 30% devaluation versus the deutschemark by the end of Q1 1993. Thanks to this easing, by the beginning of 1994 Italian spreads had fallen back below 300 basis points. However, the Italian economy was still under duress, real wages were still contracting, and financial markets revolted again. By February 1995, Italian spreads had gone back up to 480 basis points. In the spring of 1995, the pressures came to a boiling point and the lira was once again devalued versus the deutschemark, suddenly plunging by an additional 20% or so. After this painful adjustment, real wage growth moved back into positive territory, the current account deficit morphed into a surplus, and the economy recovered. Moreover, thanks to the previous wave of fiscal austerity and the rebound of the economy, the government's primary balance, which stood at a deficit of nearly 4% of GDP in 1987, hit a 5% surplus by 1998. Chart 25Domestic Demand Never Recovered From Financial Crisis Domestic Demand Never Recovered From Financial Crisis Domestic Demand Never Recovered From Financial Crisis So why is this experience so important? Today, Italy already runs a large current account surplus of 2.5% of GDP. But unlike in the 1990s, this improvement reflects first and foremost a contraction in imports, itself the symptom of an ill domestic economy. However, like in the early 1990s, the Italian economy remains tired. Real GDP is still 7% below its 2008 peak, while domestic demand continues to linger at a stunning 8.5% below its pre-GFC levels (Chart 25). Real wages are contracting at a 1.4% pace as the unemployment rate remains more than 2.5% above the OECD's estimate of NAIRU. Real estate prices, after having contracted from 2012 to 2016, are only growing in the low single digits. Capex generally is also tepid. This situation suggests that Italy needs even easier monetary policy than what it is getting from the ECB. As the argument goes, if Italy were to devalue its currency today, it would be able to boost its exports, ease domestic monetary conditions, and create the ideal circumstances for generating growth. Moreover, to push the argument to its extreme - something populist politicians are prone to do - Italy should ditch the euro and re-dominate its debt in lira. The Bank of Italy could then monetize this debt to keep interest rates low. Since Italy runs a primary fiscal surplus of 1.4% of GDP, Italy does not need to access the debt market for a few years, and thus it would be irrelevant if it loses access to the market. In other words, outside of the euro, a world of Chianti and creamy cannolis awaits the Italians. ... Well, Maybe Not If this seems too nice to be true, that is because it is. The exit-and-devalue narrative misses the point that financial markets and conditions matter a great deal. The problem with this story is the banking sector. The Italian banking sector is presently saddled with NPLs of €330bn, representing 74% of the banking system's capital and reserves (Chart 26). In and of itself, this is a big problem. However, it is a manageable one, especially with the backstops created by European institutions, notably the support of the ECB. However, without Europe's backstop, this debt load becomes a lot harder to manage. And that's only part of the problem. A deeper issue is the large holdings of treasury bonds (BTPs) of Italian banks. Currently, Italian banks hold 10% of their assets in BTPs, an amount equivalent to 90% of their capital and reserves (Chart 27). In 2011, when the Euro Area crisis was raging, Italian 10-year yields hit 7%, or a spread of more than 500 basis points over German bunds. This was equivalent to an implied probability of breakup - as estimated by Dhaval Joshi who writes our European Investment Strategy sister service - of 20% over the subsequent five years (Chart 28).10 Chart 26Italian Banks Carry Loads Of Bad Loans Italian Banks Carry Loads Of Bad Loans Italian Banks Carry Loads Of Bad Loans Chart 27Italian Banks Also Hold Too Many BTPs Italian Banks Also Hold Too Many BTPs Italian Banks Also Hold Too Many BTPs Chart 28Italian Spreads Signal Euro Break-Up Threat Italian Spreads Signal Euro Break-Up Threat Italian Spreads Signal Euro Break-Up Threat Now, if Italy comes to be governed by Beppe Grillo's M5S, markets will move fast to discount an eventual referendum on Italy's euro membership - even if only a non-binding and consultative referendum, which would still have a powerful political effect.11 In this environment, it is unlikely that the ECB would support Italian assets. The ECB has already played an active role in Italian politics. It was a September 2011 letter by Mario Draghi and Jean-Claude Trichet that prompted the resignation of Berlusconi in November 2011. It was only after Italian policymakers committed to structural reforms that Draghi was willing to utter his famous "whatever it takes" pledge of ECB support. There is practically no chance that the ECB would extend such a guarantee to an M5S-led government looking to play chicken with the Euro Area and default on Italian debt. Chart 29A Drop In Credit Impulse Would Herald Recession A Drop In Credit Impulse Would Herald Recession A Drop In Credit Impulse Would Herald Recession This is why the situation could become nasty, and fast. With only 53% of Italians in favor of the euro, pricing in a 50% probability of Italy leaving the Euro Area would result in BTP-bund spreads of around 900 basis points! In the process, Italian bonds could lose 40% to 50% of their value - assuming that German bunds rally on risk aversion flows - which would result in a potential 35% to 45% hit to Italian banks' capital and reserves. Even if markets remained relatively calm, and BTP prices only fell by 25% to 30%, investors would discount bank capital by around 25%. With the large overhang of NPLs, Italian banks would be for all intent and purposes insolvent. We already expect the Italian credit impulse to become a drag on Italian growth in 2018, but if banks are threatened with insolvency as a result of political dynamics, this same credit impulse is likely to fall at rates not experienced since the GFC. This would result in yet another recession in Italy (Chart 29). Like in Greece in 2015, we would expect that this economic pain would prompt Italian voters to rethink their inclination to leave the Euro Area. In other words, the mere thought of exiting the Euro Area would bring forward the cost of such a strategy, giving voters essentially a preview of their future pain. Moreover, with 45% of BTPs held in private hands outside of Italy, and Italy's foreign debt hanging at 126% of GDP, Europeans outside of Italy have a lot of Italian exposure. This suggests that the financial channel of transmission would cause stress in the European banking sector outside of Italy as well. As a result, in all likelihood, this threat would prompt the return of dovish language by the ECB that could weigh on the euro. The fall in the euro would also nullify Italians' need to exit the Eurozone. Even if the scenario above looks remote, the euro could fall as soon as markets begin discounting an M5S victory. For example, in Canada, the Parti Quebecois won the 1994 election promising a referendum on the question of Quebec independence. As a result of that electoral victory, the loonie quickly dipped by 6%. A move back to EUR/USD 1.05 in case of a Beppe Grillo victory thus sounds reasonable as the market would quickly move to discount some probability of an eventual euro referendum in Italy. Bottom Line: The mere suggestion of a referendum on the euro in Italy would have immediate market consequences. The result would be the almost instantaneous insolvency of large portions of the country's banking system, the loss of ECB support, deposit flight, and an almost certain recession. The relationship between politics, markets, and the economy is therefore dynamic, with non-linear outcomes. As markets discount a higher probability of Italian Euro Area exit, voters will discount a higher probability of non-optimal economic outcomes. As such, we highly doubt that Italian voters - who remember, are only flirting with Euroskepticism - would commit to a future outside of the Euro Area. What If Italy Says Arrivederci? What if we have misjudged Italian voters and they vote to exit the Euro Area regardless of the costs? Based on the IMF's External Sector Report's Individual Economy Assessments, the Italian real effective exchange rate is overvalued by around 25% against Germany alone and around 15% against a GDP-weighted average of Germany, France, Spain, Netherlands, and Belgium. However, these amounts grossly underestimate the potential fall in the lira. These estimates are based on competitiveness measures alone, and they do not take into account the negative domestic economic developments associated with falling BTP prices and impairments to banks' balance sheets. Such economic malaise would prompt a massive easing of policy by the newly empowered Bank of Italy, which would also weigh on the lira. Additionally, the Bank of Italy would have little credibility. This would be doubly so in a M5S-led government intent on pursuing unorthodox policy choices. Historically, Italy has been tolerant of elevated inflation, which means that investors would likely bid up inflation protection on Italian assets, a process that would weigh on Italian real interest rates. Additionally, Italian households and businesses would likely ratchet up their own inflation expectations. As a result, this would drive Italian inflation higher and prompt even more downward pressure on real rates. This is the perfect recipe for a downward spiral in the lira against the euro. In this kind of environment, the lira could fall 75% against the euro. Would Italy become a trade champion with this magnitude of currency devaluation? Doubtful. As we have mentioned, Italy's competitiveness problems are not just a function of domestic labor costs relative to those of the rest of the Euro Area. They also reflect the fact that Italy has not moved up the value chain and is competing head-to-head with EM nations that have a much lower cost base. Additionally, the purpose of the euro was to prevent precisely the kind of competitive currency devaluation that plagued Europe in the post-war period. If Italy ditches the euro and devalues its currency by 50% or more, then the other European nations are likely to punish Italy with tariffs, defeating one of the key reasons to re-introduce the lira in the first place. The last thing Europeans would want to establish is a precedent of a major European economy massively devaluing against its Common Market peers for economic gain. This would be the undoing of not just the Euro Area, but European integration itself. In fact, Italy is contractually obligated - as is every EU member state other than Denmark and the U.K. - to obtain EMU membership under the Maastricht Treaty that establishes the European Union. While such a contractual obligation is irrelevant in the face of a sovereign nation's decision to abrogate an international treaty, it does give Italy's EU peers the legal cover to evict Italy from the Common Market should it break its Maastricht pledges. What about the dynamics of the euro itself? After all, without its weakest major member, the Euro Area will be stronger and the euro will become more competitive. However, the early 1990s experience is once again instructive. During the first phase of devaluation of the lira from 1992 to 1994, the deutschemark too came under pressure. This pressure also reflected the fact that the USD was rising between Q3 1992 and the beginning of 1994. However, by early 1995 the deutschmark had recouped all its loss versus the USD (Chart 30). We would expect similar dynamics to be at play, and again, a lot will depend on the dollar's trend. We expect the dollar index (DXY) to peak in 2018 around 108-110, or a bit more than 10% above current levels. This would hurt the euro. Moreover, the likely need for a dovish ECB to ease the blow to the European banking system (from potentially large losses on any Italian assets) would add to the downward pressure on the euro. As a result, an Italian exit should result in a fall to EUR/USD 0.9. However, this would represent a massive buying opportunity. The euro would be extremely cheap, and the economy would ultimately handle the Italian shock (Chart 31). Chart 30Lira Devaluation Temporarily Dragged Down The Deutschemark Lira Devaluation Temporarily Dragged Down The Deutschemark Lira Devaluation Temporarily Dragged Down The Deutschemark Chart 31An Italian-Inspired Drop In The Euro Would Present A Buying Opportunity An Italian-Inspired Drop In The Euro Would Present A Buying Opportunity An Italian-Inspired Drop In The Euro Would Present A Buying Opportunity Additionally, the pain that Italy would incur as it faced currency collapse, runaway inflation, and loss of market access to the EU Common Market should act as a strong deterrent for future Euro Area exit attempts. As such, while the probability of Italy's Euro Area exit may be higher than zero, the probability of any subsequent exits is essentially zero. We would therefore expect any euro selloff to be violent but brief. Chart 32Italian Public Debt: Stuck In Muck Italian Public Debt: Stuck In Muck Italian Public Debt: Stuck In Muck Bottom Line: We doubt Italy will ever leave the euro. In all likelihood, the economic pain caused by the mere thought of a referendum would be enough to deter Italians from voting for what would amount to economic suicide. Instead, we would expect Italy to muddle through: its public debt dynamics will worsen, but it will not implode. The IMF expects the government debt-to-GDP ratio to fall toward 125% of GDP by 2022 (Chart 32). We think this is too optimistic. It relies on a big drop in the private sector's investment-saving gap. We think that Italy's entrenched productivity deficit and lack of investment opportunities south of the Alps will ensure that savings remain in excess of investment by a similar degree as today. This would cause the public debt-to-GDP ratio to move toward 140% of GDP by the middle of next decade. This is not a great scenario, but it is not a catastrophe either. In exchange for modest reforms, the ECB would continue to support Italy with dovish monetary policy and unfettered access to emergency liquidity. As a result, we expect European interest rates to remain slightly below what average Eurozone numbers would justify. As such, we continue to anticipate no hike in the ECB's repo rate for the foreseeable future. This, along with greater labor market slack in Europe than the U.S., underpins our view that EUR/USD will ultimately weaken slightly below parity. Investment Conclusions All other things being equal, currency devaluation is a valuable reflationary tool. In Italy's case, however, there are two impediments to using it. First, Italy has lost competitiveness precisely because it relied on the FX lever in the past. Its governance, education, and economic institutions have atrophied as domestic interest groups favored protecting themselves against creative destruction. Second, when it comes to politics, "all other things are rarely equal." It is highly unlikely that the rest of Europe would idly stand back while Italy switched to the lira and devalued it against the euro. This is for three reasons: First, it would set a dangerous precedent for other EU member states if Italy, the Euro Area's third-largest economy and the world's eighth largest, was allowed to reflate via competitive devaluation. Second, it is unlikely that Euro Area peers would accept Italy's devaluation amidst a globally low growth context where export market share is already tough to come by. Third, Italy's government would likely be led by populist, anti-establishment policymakers who would represent a domestic political threat to Italy's European neighbors. As such, it would be in the interest of the rest of Europe to ensure that a M5S-led Italy collapsed after leaving the Euro Area, and then begged to re-enter the core European club. The investment conclusions from the analysis above are very state dependent and represent a playbook for investors going forward. Right now, with the probability of an outright M5S victory low, our base case scenario remains unchanged. The euro will weaken by mid-2018 to slightly below parity as the ECB will maintain a more dovish policy stance than the Fed. European equities are likely to continue to outperform U.S. equities. However, if Beppe Grillo manages to eke out a majority in 2018 or later, investors might be in for a bumpy ride. The euro's fall from grace is likely to be much swifter and European assets could suffer a period of volatility and underperformance relative to the U.S. Ultimately, European stocks will resume their upward relative trajectory as any Italian referendum is likely to result in Italy staying in the euro. Finally, in the highly unlikely case that Italy votes to leave the Euro Area, the euro could plunge to EUR/USD 0.9; European assets, banks especially, could suffer greatly against their U.S. counterparts; and bund yields would likely fall below 0%. The lira would fall by 75% against the euro and Italian bonds would suffer losses north of 50%, in local currency terms. As Italy plunged to its post-Euro Area Inferno, however, we would expect European assets to represent the buying opportunity of a lifetime. Italy's fall from grace would only tighten European integration going forward. 1 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 3 Please see OECD, "Economic Surveys: Italy 2017," available at oecd.org; and Sara Calligaris, et al.,"Italy's Productivity Conundrum," European Commission, dated May 2016, available at ec.europa.eu. 4 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 5 The VAT revenue ratio (VRR) is defined as the ratio between the actual value-added tax (VAT) revenue collected and the revenue that would theoretically be raised if VAT was applied at the standard rate to all final consumption. This ratio gives an indication of the efficiency and the broadness of the tax base of the VAT regime in a country compared to a standard norm. 6 Please see World Bank Group and PwC, "Paying Taxes 2017," available at www.pwc.com. 7 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 3, 2011, and Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 9 A minority government would, however, have to obtain a confidence vote in both chambers of the Italian Parliament in order to govern, as per Article 94 of the Italian Constitution. 10 Please see BCA European Investment Strategy Weekly Report, "Threats And Opportunities In The Bond Market," dated April 7, 2016, available at eis.bcaresearch.com. 11 According to Article 75 of the Italian Constitution, referendums are not permitted in the "case of tax, budget, amnesty and pardon laws, in authorization or ratification of international treaties." Nonetheless, a Euroskeptic government could still call for a non-binding referendum on the euro. While its result would not create a legal reality for Italian exit from the Euro Area, it would create a political one. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com We Read (And Liked) ... Why Nations Fail - The Origins Of Power, Prosperity, And Poverty Why Nations Fail is as much about why nations succeed as why they fail.1 World history is replete with examples of the latter, whereas the former is a rarity even today. Economist Daren Acemoglu and political scientist James A. Robinson seek to answer why that is so. Distilling the book to its bottom line is challenging. There is no neat theory of how the world works. Instead, the authors tell their story through case studies replete with "critical junctures," "path dependency," and "small differences." Acemoglu and Robinson do not peddle in false parsimony, but rather try to develop a narrative that explains a complex process. While they never make the point explicitly, the authors define success as a combination of geopolitical relevance (power), escaping the "middle income trap" (prosperity), and some level of equality (escaping poverty). A country that achieves some semblance of all three, and maintains it for a long time, is "successful." At the heart of successful economies is the process of creative destruction. And at the heart of each example of failed states - from the Roman Empire to the Soviet Union - are impediments to such destruction. The recipe to success therefore boils down to "having an idea, starting a firm, and getting a loan." The discipline of economics - and its disciples at the IMF and the World Bank - would appear to be more than capable of taking it from there. But they are not. Why? For Acemoglu and Robinson, the empirical evidence is overwhelmingly stacked against economics and its practitioners. Armies of developmental economists have failed to bring billions of people out of poverty and many of their suggestions have in fact been detrimental. Economics is incapable of resolving the problem of development because it "has gained the title Queen of the Social Sciences by choosing solved political problems as its domain."2 And societal development is a political problem. The first such political problem that Acemoglu and Robinson attempt to explain is the paradox of development. Why don't leaders always choose prosperity? History is replete with examples of how elites actively subvert creative destruction, which is paradoxical given that it would make their societies wealthier and more powerful in the collective sense. From the patricians of Rome, elites of Venice, the szlachta of Poland, the samurai of Japan, to the landed aristocracy of England prior to the Glorious Revolution, those in positions of power consciously limit economic progress. The answer lies in political institutions. When political power is exclusive, unchecked, and limited to a select-group, its value increases. The more power one gains, the greater the political, economic, and societal rewards one can extract from it. The reverse is true when political institutions are inclusive, checked, and open to upwardly mobile entrepreneurs. In that case, the value of political power declines and thus elites are less likely to expend resources to protect their access to it. As such, the key conditions for economic development are inclusive political institutions that allow non-elites to petition the government, keep it in check through an independent judiciary, call it to account with free media, and eventually participate in governing directly. These inclusive political institutions are, in turn, more likely to give rise to inclusive economic institutions, which enshrine the process of creative destruction at the heart of the country's political and economic system. Why is it so difficult to engineer development? Because most trained economists working for international developmental agencies are focused on changing economic institutions. They take the politics of a country as an a priori. However, it is politics that determines economics, not the other way around. A powerful example in the book is the process of de-colonization in Africa. Despite a dramatic change of political leadership, post-colonial governments preserved the extractive economic institutions set up by their former colonial masters. Why? Because they never bothered to truly enfranchise their citizens. In other words, they kept the exclusive political institutions of colonialism largely in place. Once that decision was made, it was inevitable that extractive economic institutions would remain in place as well. In fact, in most examples, economic institutions became more extractive and political institutions more exclusive. Acemoglu and Robinson published their book in 2012, at the height of the "Beijing Consensus" narrative. It is easy to see how most of their examples are applicable to China today, particularly the chapter dealing with the decline of the Soviet Union. The message is that rapid economic growth under exclusive political institutions is possible, but unsustainable. China will therefore either evolve its political institutions or face the fate of the Soviet Union. We generally tend to agree with this analysis, but time horizons are difficult to gauge. For example, Acemoglu and Robinson themselves admit that the Soviet Union grew rapidly for 40 years before it faced limits and 60 years before it collapsed. By those measures, Chinese policymakers may still have decades before crisis forces their hand. A much more interesting question, one that Acemoglu and Robinson spend very little time discussing, is what happens to societies where elites capture political institutions and alter them from inclusive to exclusive? Two examples they detail briefly are the Roman and Venetian republics. In both, relatively inclusive political systems with inclusive economic institutions were captured by rapacious elites who then proceeded to limit access to both with the particular intention of limiting creative destruction. For global investors, this is the process that will have greater implications than the run-of-the-mill collapse of authoritarian and semi-authoritarian regimes. The entire global financial system today depends on the domestic stability of countries like the U.S. and the U.K., perhaps the most successful political systems in the world. And yet, voters in both are itching for radical change as a reaction to elite overproduction and growing income inequality. On one hand, voter discontent could lead to a messy political process, if not an outright revolution, that reestablishes the inclusive institutions that have underpinned their prosperity and power for centuries. On the other, it could lead to the collapse of the inclusive republic and the rise of an exclusive empire. 1 Daron Acemoglu and James A. Robinson, Why Nations Fail (New York: Crown Business, 2012). 2 Economist Abba Lerner, quoted at the end of Chapter 2 by the authors. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com

Highlights The U.K. and EU may get a technical divorce, but the underlying economic and financial relationship may not end up changing dramatically - which is good news for the pound in the long term. Our 6-12 month preference for currencies is euro first, pound second, dollar third. The euro area economy will perform at least in line with the U.S. economy through 2017, so the T-bond/German bund yield spread will continue to compress. Long euro area retailers, short U.S. retailers has catch-up potential. The focussed stock pair-trade would be long Hornbach (Germany), short Home Depot (U.S.) Feature Brexit Will Become A Fake Divorce Theresa May's stinging reversal at the ballot box last Thursday has left some people wondering: will Brexit actually happen? The answer is very likely yes, but this is no longer the right question to ask. Chart I-1 Jeremy Corbyn's resurgent Labour Party, the Scottish National Party, the Liberal Democrats and pro-European Conservatives now form a parliamentary majority which proposes that a non-EU U.K. negotiates tariff-free access to the single market and customs union.1 In such an arrangement, the U.K. and EU would be technically divorced. But economically and financially, the relationship would not be so different to being married. In effect, Brexit would become a fake divorce. Unfortunately, there is a flipside. The U.K. would be unable to reclaim swathes of sovereignty over its borders and its law. This is because the tariff-free movement of goods, services and capital is, in theory, indivisible from the free movement of people. Furthermore, EU law would transcend national law in the regulation and policing of the single market's so-called 'four freedoms'. Admittedly, the four freedoms are an unachieved - and arguably unachievable - ideal. But they are an aspiration which EU policymakers do not want Brexit to threaten. Angela Merkel recently put it in very strong terms: "Cherry-picking (from the four freedoms) would have disastrous consequences for the other 27 member countries... Tariff-free access to the single market can only be possible on the conditions of respecting the four basic freedoms. Otherwise one has to talk about limits to access" Hence, Brexit reduces to a trade-off between the extent of tariff-free access to the European single market that the U.K. wants to keep, and the extent of national sovereignty it is willing to concede (Chart of the Week). Economically and financially, it is largely irrelevant whether the U.K. gets tariff-free access to the single market via a bespoke free-trade arrangement or via membership of an off-the-shelf structure like EFTA or the EEA.2 The much bigger question is: in order to keep most of its tariff-free access to the single market, will the U.K. now downgrade its plans to "take back full control" of its borders and law? Following last Thursday's stunning election result - and its impact on parliamentary composition (Chart I-2 and Chart I-3) - the answer seems to be yes. The U.K. and EU may get a technical divorce, but the underlying economic and financial relationship might not end up changing dramatically. Chart I-2 Chart I-3 Euro First, Pound Second, Dollar Third Avoiding a dramatic change in the U.K./EU economic and financial relationship reduces the risk of a major disruption to the U.K. economy and the need for further emergency easing from the Bank of England. Thereby, it is good news for the pound in the long term. That said, our 6-12 month preference for currencies is euro first, pound second, dollar third. The crucial point is that currencies and bond market relative performance depends front and centre on the evolution of relative interest rate expectations. In turn, the evolution of relative interest rate expectations must ultimately follow relative economic performance, as evidenced in hard data such as GDP growth, inflation and job creation. Over a period of a few months, central banks can look through hard data on the basis that the data is noisy or "transient". But over periods of 6 months and longer, the noisy and transient excuse wears thin. Central banks' strong commitment to data-dependency means that their actions and/or words must follow the hard data. No ifs, buts or maybes. Hence, relative interest rate expectations ultimately follow relative economic performance (Chart I-4 and Chart I-5). We are unashamedly republishing these two charts from last week because they prove the point so powerfully. Based on the latest PMIs which capture current economic sentiment, and on 6-month credit impulses which lead activity, euro area hard data will continue to perform at least in line with those in the U.S. (Chart I-6). In which case, relative interest rate expectations will continue to converge, the T-bond/German bund yield spread will continue to compress, and euro/dollar will ultimately drift higher. Chart I-4Relative Interest Rate Expectations Must Follow ##br##Relative Economic Performance Relative Interest Rate Expectations Must Follow Relative Economic Performance Relative Interest Rate Expectations Must Follow Relative Economic Performance Chart I-5Relative Bond Yields Must Follow Relative##br## Economic Performance Relative Bond Yields Must Follow Relative Economic Performance Relative Bond Yields Must Follow Relative Economic Performance Chart I-6Only A Modest Decline In The Euro Area ##br##6-Month Credit Impulse Only A Modest Decline In The Euro Area 6-Month Credit Impulse Only A Modest Decline In The Euro Area 6-Month Credit Impulse The Eurostoxx50 Is Not A Play On The Euro Area Economy. So What Is? Does it follow that the Eurostoxx50 equity index will outperform? Not necessarily. Unlike for currencies, interest rates and bond yields, the connection between relative economic performance and relative equity market performance is weak, or even non-existent. Note that the Eurostoxx50 has underperformed the S&P500 this year even though the euro area economy has outperformed. Chart I-7The Global Growth Pause ##br##Has Hurt Cyclicals The Global Growth Pause Has Hurt Cyclicals The Global Growth Pause Has Hurt Cyclicals The reason is that the over-arching driver of an equity market's relative performance is its skew to dominant international sectors and international stocks. The Eurostoxx50 has a higher exposure to the global growth cycle via its dominant weighting in Financials and Resources; conversely the S&P500 has a higher exposure to the less globally-sensitive Technology and Healthcare sectors. The defining sector skew has penalised the Eurostoxx50 versus the S&P500 because globally-sensitive cyclicals have strongly underperformed in a very clear global growth pause. Furthermore, the ever-reliable global 6-month credit impulse strongly suggests that the global growth pause will persist through the summer (Chart I-7). This begs the question: is there a way for equity investors to play the resilient performance of the euro area economy? The answer is yes. But before explaining how, a quick note of caution. An aggregate small cap equity index is not a good way to play a domestic economy. This is because the dominant characteristic of small cap stocks - in aggregate - is their very high beta. Hence, rather than a strong play on the domestic economy, investors are effectively buying highly leveraged exposure to market direction. Great when markets are rising, but painful when they are falling, irrespective of how the domestic economy is faring. Instead, a good equity play on relative economic performance is the relative performance of retailers (Chart I-8). Drilling down further, the relative performance of home improvement retailers is an even purer play (Chart I-9) - given that household spending on home improvement is closely tied to the domestic economic cycle. Chart I-8Retailers Are A Good Play On Relative ##br##Economic Performance Retailers Are A Good Play On Relative Economic Performance Retailers Are A Good Play On Relative Economic Performance Chart I-9Euro Area Home Improvement Retailers ##br##Can Now Ourperform Those In The U.S. Euro Area Home Improvement Retailers Can Now Outperform Those In The U.S. Euro Area Home Improvement Retailers Can Now Outperform Those In The U.S. On the expectation that the euro area economy will perform at least in line with the U.S. economy,3 the equity market play would be long euro area retailers, short U.S. retailers. In particular, long euro area home improvement retailers, short U.S. home improvement retailers has a lot of catch-up potential. And the focussed stock pair-trade would be long Hornbach (Germany), short Home Depot (U.S.) Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In simple terms, the single market defines the zone of tariff-free trade for European countries with each other. Whereas the customs union defines the zone of a single set of rules and tariffs for European countries to trade with the rest of the world. Membership of the customs union allows goods and services that enter from the rest of the world to then move around Europe unhindered. 2 The European Free Trade Association (EFTA) is a free trade area consisting of Iceland, Liechtenstein, Norway and Switzerland. Iceland, Liechtenstein, and Norway participate in the EU single market through their membership of the European Economic Area (EEA). Whereas Switzerland participates through a set of bilateral agreements with the EU. 3 Based on growth in real GDP per head. Fractal Trading Model* Long nickel / short tin hit its 6.5% profit target and is now closed. This week's trade is to switch to long nickel / short palladium with a 10% profit target. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Long Nickel / Short Palladium Long Nickel / Short Palladium The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Trump's failures have helped fuel the bull market; Yet inflation and Trump legislative wins will embolden the Fed; The U.K. will have yet another election by 2019; Dodd-Frank repeal is a no go ... but small banks may get relief; The Tea Party just found its hard constraint ... in Kansas. Feature Investors in South Africa surprised us last week. The first question on everyone's mind was "Will Trump be impeached?" Our answer that impeachment is highly unlikely at least until the midterm elections was received with suspicion.1 The perspective of our South African clients is understandable. Their domestic assets have been underpinned since Trump's election by a phenomenon we like to call "the Trump put." The thesis posits that U.S. politics will remain a mess for much of the year, delaying any progress on populist economic policies that would have buoyed U.S. nominal GDP growth and given the Fed a reason to hike interest rates more aggressively. The result is a weak dollar, lower 10-year Treasury yields, and a rally in global risk assets (Chart 1). Of course, stubbornly weak inflation and disappointing Q1 GDP numbers bear responsibility as well as Trump (Chart 2). Chart 1The 'Trump Put' The 'Trump Put' The 'Trump Put' Chart 2Weak Inflation Fueling Bull Market Weak Inflation Fueling Bull Market Weak Inflation Fueling Bull Market For our South African clients, the fate of President Trump is irrelevant. What matters is that the American political imbroglio continues, reducing the likelihood of a hawkish mistake from the Fed, and thus keeping EM risk assets well bid. The market has generally agreed. Several assets associated with Trump's populist agenda have reversed their gains since the election. The yield curve, small caps, and high tax rate equities have all shown signs of disappointment with the Trump agenda (Chart 3). If the Trump put were to continue, we would expect U.S. bonds and stocks to rally, DXY to continue to face headwinds, and international stocks to outperform U.S. stocks. That said, the proxies for Trump's agenda in Chart 3 are starting to perk up. They may be sniffing out some positive political signs, such as the movement in the Senate on the bill repealing the Affordable Care Act (Obamacare). The budget reconciliation procedure - a process by which Republicans in Congress intend to avoid the Democrat filibuster in the Senate - requires Obamacare to be resolved before the House and the Senate can take up tax reform.2 If Obamacare clears Congress's calendar by the August recess, the odds of tax reform (or merely tax cuts) being passed by the end of 2017 will rise considerably. Second, former Director of the FBI James Comey's testimony was a non-event. We refused to cover it in these pages as we expected it to be theatre. The market had already digested everything that Comey was going to say, given that he had leaked the juiciest components of his testimony weeks ahead of the event. Chart 3Consensus On Trump Policy Failure? Consensus On Trump Policy Failure? Consensus On Trump Policy Failure? Chart 4 Third, President Trump's approval rating with Republican voters remains resilient (Chart 4). If the worst has passed with the Russian collusion investigation - which we expect to be the case now that Comey's testimony has come and gone with little relevance - we could see GOP voters rally around the president. Several clients have pointed out that our measure is less relevant given the decline in voters who identify as Republicans (Chart 5). We disagree. As long as Republican voters vote in Republican primaries, they can act as a constraint on GOP members in Congress who are thinking of abandoning the president's populist agenda. This brings us to the main event: the economy. Our colleague Ryan Swift, who writes BCA's U.S. Bond Strategy, could not care less about the ongoing political drama. As Ryan has argued in a cogent report that we highly recommend to clients, the Fed's median projection for two more 25 basis point rate hikes before the end of the year, and for PCE inflation to reach 1.9% (Chart 6), is not going to happen if inflation continues to disappoint over the summer.3 The market seems to be saying that a PCE of 1.9% is unlikely. Core PCE inflation is running at only 1.54% year-over-year through April, and will probably stay low in May given that year-over-year core CPI fell from 2% in March to 1.89% in April. Chart 5Fewer People Call Themselves Republicans Fewer People Call Themselves Republicans Fewer People Call Themselves Republicans Chart 6Inflation Relapse Would Scratch Fed Hikes Inflation Relapse Would Scratch Fed Hikes Inflation Relapse Would Scratch Fed Hikes Ryan's Philips Curve model, however, disagrees with the market. The model looks to approximate Chair Yellen's own philosophy for forecasting inflation, which she outlined in a September 2015 speech.4 Specifically, BCA's U.S. Bond Strategy models core PCE as a function of: 12-month lag of core PCE; Long-run inflation expectations from the Survey of Professional Forecasters; Resource utilization; Non-oil import prices relative to overall core PCE. BCA's core PCE model is sending a strong signal that the market's inflation expectations are overly pessimistic (Chart 7). Even after stressing the model under several adverse scenarios, Ryan concludes that it is very likely that core PCE inflation will indeed approach the Fed's 1.9% forecast by year-end. The U.S. economy is quickly running out of slack, with unemployment at a 16-year low of 4.3%. The broader U-6 rate, which includes marginally attached workers and those in part-time employment purely for economic reasons, has dropped to its pre-recession print of 8.4% (Chart 8). Chart 7Market Too Pessimistic On Inflation Market Too Pessimistic On Inflation Market Too Pessimistic On Inflation Chart 8U.S. Labor Market Running Out Of Slack U.S. Labor Market Running Out Of Slack U.S. Labor Market Running Out Of Slack Wages are also rising, with the underlying trend in wage growth having accelerated from 1.2% in 2010 to 2.4% (Chart 9). The acceleration has been broad-based, occurring across most industries, regions, and worker characteristics (Chart 10). Chart 9Wages Heating Up Wages Heating Up Wages Heating Up Chart 10Wage Improvements Broad-Based Wage Improvements Broad-Based Wage Improvements Broad-Based BCA's Chief Global Strategist, Peter Berezin, therefore expects the Fed to raise rates in line with its own expectations. In fact, the Fed could expedite the pace of rate hikes if aggregate demand accelerates later in the year.5 It will be difficult for the Fed to ignore macroeconomic data, even if, from a political perspective, the Trump put continues. The analogy we use with clients in meetings is that of the U.S. economy as a camp fire around which the various market participants - bond and equity investors, foreign and domestic, etc. - are huddled. According to our sister publications that conduct macroeconomic research, that campfire is well lit. And according to our political research, "Uncle Donny" had a few too many drinks and is about to pour some bourbon on the fire to show the kids a good time. Chart 11Bond Bulls Feeding On Trump Failures Bond Bulls Feeding On Trump Failures Bond Bulls Feeding On Trump Failures For the Trump put to continue, we would have to see a combination of the following: GOP voters begin to abandon President Trump; Congress remains embroiled in Obamacare debates through FY2017, only seriously picking up on tax reform and other agenda items in FY2018. Greater doubts would undermine the recent uptick in assets tied to Trump's policy agenda (Chart 11). Impeachment concerns heat up again due to new revelations that implicate President Trump directly. So far impeachment talk has not correlated with the rally in Treasuries but it could do so if new evidence comes to light. Perhaps Robert Mueller, the former FBI director and special counsel investigating Russia's role in the election, will drop another bombshell later this year. In addition, for the Trump put to continue our colleagues Ryan and Peter would have to be wrong about the economy and inflation. For investors interested in playing the Trump put, and allocating funds to EM assets in particular, we would caution against it. However, given that BCA's bond and FX views have been challenged over the past several months by the Trump put, we understand why many of our clients are itching to chase the global asset rally. The summer months will be critical. Does Brexit Still Mean Brexit? We posited last week that the extraordinary election in the U.K. was about austerity and, more importantly, about repudiating the Conservative Party's fiscal policies.6 This remains our view. The most investment-relevant message to take from the election is that U.K. fiscal policy will become easier over the life of the coalition government, while monetary policy remains stuck in D - for dovish. This should weigh on the pound over the course of the year. That said, investors will begin to wonder about the longevity of the coalition between the U.K. Conservative Party and Northern Ireland's Democratic Unionist Party (DUP). In practice the coalition will have only a five-seat majority, which would be tied for the second-smallest margin since Harold Wilson in 1964 (Chart 12). Technically it is an even smaller one-seat majority. U.K. governments with a majority of fewer than ten seats are rare and usually only last one-to-two years (Harold Wilson's four-seat 1974-79 run is an exception). This bodes ill for May's government - that is, if she survives today's brewing leadership challenge from within her party. Chart 12 We have no idea if the election means a softer Brexit as we have no idea - and neither does anyone else - what that means. Generally speaking, the wafer-thin majority for the Tories means the following: "No deal is better than a bad deal" is no longer going to be acceptable to the government or the public; London will end up paying a larger "exit fee" than it probably thinks it will; There will be no favorable deal for the U.K.'s financial industry. In essence, the U.K. clearly has the weaker hand in the upcoming negotiations. Cheers went up in Brussels. Does this change anything? First, we never bought the argument that the U.K. had a strong negotiating position because continental Europeans want to export BMWs to consumers in Britain. The EU is a far bigger market for the U.K. than the U.K. is for the EU (Chart 13). On this measure alone, the U.K. was always going to be the underdog in the negotiations. Chart 13The U.K. Lacks Leverage The U.K. Lacks Leverage The U.K. Lacks Leverage Chart 14 Second, the influence of Tory Euroskeptics has been reduced. That might appear counterintuitive, given that May wanted to reduce their influence by getting a bigger majority. However, it is highly unlikely that she will get the ultimate EU deal through Westminster, with a five-seat majority, without at least some votes from the opposition. Euroskeptics will therefore either remain quiet and compliant or force May to seek a deal that Labour MPs could agree to. Which brings us to the very likely scenario that the final deal will not pass Westminster without a new election. As we argued right after the referendum, the U.K. will likely have a "Brexit election" sometime in 2019.7 There is no way around it now. At very least the ruling alliance will face a contradiction in trying to soften Brexit while maintaining a strict stance on immigration. And given the weak majority, if Labour does not play ball, the Tories will have to call a new election on the basis of the deal they conclude. Chart 15 The good news for the Conservative Party is that the polls continue to show that a majority of U.K. voters support Brexit (Chart 14). Furthermore, the two Brexit-lite campaign promises by the Labour Party and the Liberal Democrats were the least preferred policies ahead of the election (Chart 15, see next page). However, the election also saw a complete collapse in support for Euroskeptic-leaning parties, in terms of share of the overall vote (Chart 16). Could Brexit ultimately be reversed? Certainly the odds have risen. Furthermore, there does appear to be some regret amongst U.K. voters, with a recent survey showing a decline in national identification: now more Britons identify as "also European" than ever (Chart 17). Nonetheless, a full reversal of Brexit will still require an exogenous shock, such as a recession or a geopolitical calamity that convinces the U.K. that they need Europe. Investors should remain vigilant of the polls. A clear trend reversal in Chart 14 would constitute a political opportunity for the opposition parties to campaign on a new referendum. Chart 16Euroskeptics Collapsed In The U.K. Euroskeptics Collapsed In The U.K. Euroskeptics Collapsed In The U.K. Chart 17 Bottom Line: Odds of a softer Brexit have certainly risen as the Tories face considerable domestic constraints in their negotiating strategy with the EU. We continue to believe that the negotiations will not be acrimonious and therefore the pound will not fall below its lows on January 16. However, it may re-test that 1.2 level due to a coming mix of easy fiscal and monetary policy over the course of the year. U.S.: Doing A Number On Dodd-Frank Better put a strong fence 'round the top of the cliff, Than an ambulance down in the valley! - Joseph Malins, "The Fence or the Ambulance," 1895 The Republican-controlled U.S. House of Representatives passed the Financial CHOICE Act of 2017 by a vote of 233-186 on June 8. This is the GOP's second major attempt, after the Affordable Care Act, to rewrite a signature law of President Obama's administration. This time it is the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, known simply as "Dodd-Frank," that is on the docket. The bill's prospects in the Senate are dim. President Trump promised to "do a number" on Dodd-Frank shortly after coming into office, by which he meant dismantling the law. The so-called "CHOICE Act" put forward by Jeb Hensarling (R-TX) now goes to the Senate, where it faces a high hurdle because Democrats can filibuster it, forcing the GOP to summon 60 votes. So the question is what kind of a "number" can the GOP actually do to Dodd-Frank, and does it matter? First a little bit of background.8 Dodd-Frank cleared Congress in the wake of the subprime financial crisis, July 2010. It had both a quixotic and a more pragmatic aim: the first to reduce the likelihood of future financial crises, and the second to improve the ability of regulators to stem risks as they emerge. The law has never been fully implemented and is best understood as a work in progress. The law grants the Federal Reserve and other agencies greater powers of oversight, prevention, and crisis management. In particular it ensures that the Fed would regulate not only banks but also non-bank investment companies and other financial firms (such as the giant insurance company AIG that had to be bailed out at the height of the crisis). It also frees the Fed of the responsibility to rescue failing institutions or dismantle them, handing those duties over to others, while still enabling the Fed to act as lender of last resort. The key provisions are as follows: Impose tougher capital standards: In keeping with the international Basel III banking reforms,9 Dodd-Frank tried to ensure that banks were better fortified against liquidity shortages in future. The new standards would apply both to domestic banks and foreign banks with American subsidiaries. Orderly Liquidation Authority: The Federal Deposit Insurance Corporation (FDIC), a major institution born amidst the Great Depression, would take over the responsibility of liquidating failing firms in the event of a crisis - assuming Treasury's go-ahead due to the systemic importance of the failing firm. Additional measures would hold the entire financial sector responsible for the bill if the FDIC made losses in the process. Each firm would have to maintain a "living will" to make the resolution process easier in the event of disaster. A new Financial Stability Oversight Council: Chaired by the Treasury Secretary and consisting of the various financial regulatory bodies, this council would identify systemically important financial companies, monitor them, and take actions to prevent crises. A new Consumer Financial Protection Bureau: The brainchild of Senator Elizabeth Warren (D-MA), the anti-Wall Street firebrand, the bureau would be funded by the Fed but otherwise entirely independent of it, and tasked with patrolling the banks on behalf of consumers. The Volcker Rule: The rule, named after former Fed Chair Paul Volcker, would force banks to curtail a number of short-term, high-risk trading activities on their own accounts, including derivatives, futures, and options, unless to hedge risks or serve bank customers. This was viewed as a partial reinstatement of the Glass-Steagall law, a Depression-era law that separated commercial and investment banking but was repealed by President Clinton in 1999. Republicans want to overturn Dodd-Frank to increase financial sector profits, credit growth, economic growth, and animal spirits. Lending has arguably suffered as a result of the new regulations (Chart 18). The share of bank loans to overall bank credit has remained subdued, reflecting bank behavior under QE and possibly also risk-aversion under tighter regulation (Chart 19). Chart 18Lending Growth Hampered By Dodd-Frank? Lending Growth Hampered By Dodd-Frank? Lending Growth Hampered By Dodd-Frank? Chart 19Banks Holding Reserves Instead Of Lending Banks Holding Reserves Instead Of Lending Banks Holding Reserves Instead Of Lending Republicans would also satisfy an ideological goal of reducing state involvement, which grew as a result of the law. In addition, the CBO estimates that the proposed rewrite would cut the budget deficit by a net $22.3 billion over a ten-year period.10 A very small amount, but again in line with GOP's political bent. The way the CHOICE Act would work is to create an "escape hatch" that would allow banks that maintain capital-to-asset ratio of over 10% to bypass Dodd-Frank regulations. Financial companies that do not meet the 10% leverage ratio could either raise funds or remain subject to Dodd-Frank oversight, including required capital ratios, stress tests, living wills, and other regulations. Critically, the 10% leverage ratio for those banks that opt out of Dodd-Frank would not be calculated using risk-weightings for different assets (whereas Dodd-Frank requires both risk-weighted and non-risk-weighted capital ratios to be maintained). Therefore, banks that opt out would be able to take on greater risk while still fulfilling minimum capital requirements. This is supposed to boost lending, earnings, and growth. About 70% of the $18 trillion in U.S. banking assets belongs to banks defined by Dodd-Frank as "systemically important." The eight U.S. banks defined as "globally systemic important banks" account for about $9 trillion in assets and are unlikely to take advantage of the Republicans' escape hatch because they would then have to raise new capital and yet would still be subject to international Basel III regulations even if exempted from Dodd-Frank. The CBO estimates that banks holding about 2% of the bank assets held by systemically important banks (i.e. $252 billion) would opt out of Dodd-Frank (Chart 20). Chart 20 Further, the CBO estimates that, among non-systemically important banks (30% of $18 trillion total banking assets), the banks that both meet the 10% leverage ratio and would opt out of Dodd-Frank account for about 7% of U.S. banking assets ($1.26 trillion) (see Chart 20 above). Community banks (with assets under $10 billion each) and credit unions are especially likely to do so. Therefore, if the Republican bill were to become law, banks comprising something like $1.5 trillion in U.S. banking assets would become less restricted and eligible to adopt riskier trading practices free of Dodd-Frank policing. The greatest impact will be in areas with a higher concentration of small banks and credit unions than elsewhere. These U.S. banks would also, arguably, become more likely to take excessive risks and fail at some future point. Using probabilistic models for bank failures, the CBO found that the U.S.'s Deposit Insurance Fund would only suffer an additional $600 million in losses over the next ten years as a result of this increase in risk. It is a credible estimate but the reality could be far costlier if more and more banks gain the ability to bypass regulation or if banks significantly change their behavior to take advantage of the regulatory loophole. Other aspects of the bill would: Repeal the FDIC's orderly liquidation fund: The private sector would largely take over the responsibility for managing liquidations. The CBO estimates that the federal government would save an estimated $14.5 billion in liquidation costs over ten years. Eliminate the Volcker Rule: Banks would be able to trade riskier assets on their own accounts and forge closer relationships with private equity and hedge funds. Audit the Fed: Within one year of passage, the Government Accountability Office (GAO) would audit the Fed's board of governors and the Federal Reserve regional banks, including their handling of monetary policy. The Fed's open market committee (FOMC) would also have to establish a new interest rate target, based on economic parameters, which the GAO would monitor. Reshape the Consumer Financial Protection Board: The agency would have its powers neutered and funding dependent on the Congress, rather than transfers from the Fed. It would be re-branded as the Consumer Law Enforcement Agency and have its power to oversee institutions with more than $10 billion in assets taken away, making it, in effect, a monitor of small banks only. Cut penalties for violating regulations: However, outright criminality would be punished more severely. Various authorities and institutions would be tweaked, mostly in accordance with the general aim of reducing regulatory burdens on the financial sector. So, what options do the Republicans have going forward?11 Republicans either need 60 votes to defeat a Senate filibuster or they need procedural work-arounds like budget reconciliation. Chart 21Small Banks Benefit From Dodd-Frank Repeal Small Banks Benefit From Dodd-Frank Repeal Small Banks Benefit From Dodd-Frank Repeal Some Republicans claim that certain elements of the rewrite can be tucked into a reconciliation bill. However, reconciliation requires a single, concentrated policy focus. The GOP is currently undertaking an unprecedented two budget reconciliation bills in a single year: first, the FY2017 reconciliation procedure to repeal Obamacare, and second, the FY2018 procedure to cut taxes. Rewriting Dodd-Frank is a far cry from either health care or tax reform. Dodd-Frank measures crammed into either of these bills would likely be revoked under the so-called "Byrd Rule" which keeps the reconciliation process focused and excludes extraneous material.12 So it is unlikely that this method will work. The FY2018 budget resolution will be a critical signpost. Second, it is hard to see how a bipartisan rewrite of Dodd-Frank is possible. Dodd-Frank was the Democrats' signature response to the subprime mortgage debacle and broader financial crisis. They will not participate in dismantling it. We cannot see eight Democrats joining Republicans in the Senate for what Senator Sherrod Brown (D-OH) has called "collective amnesia." However, there is one general principle that could find its way into law: the idea of giving small, regional banks a reprieve from Dodd-Frank requirements. Even Fed Chair Janet Yellen has tentatively supported giving these banks a break.13 These banks, with under $10 billion in assets, face the most difficulty in meeting Dodd-Frank's requirements and yet tend to meet the 10% leverage ratio. Politicians could at least attempt to make a popular argument for easing the burden on small community banks and credit unions, which are often vital to local communities. The same cannot be said for the Dodd-Frank rewrite as a whole, which smacks of granting impunity to Wall Street. Still, we think that even a bill focused exclusively on helping small banks would have trouble passing on its own. The legislative agenda is too busy in 2017; while 2018 will see midterm elections, when few candidates will want to appear soft on Wall Street. Instead, a provision helping small banks could pass if tacked onto the larger budget bill or bills for FY2018, if not later. It would have to be made palatable to Democrats, or else it would be perceived as a "poison pill" and risk adding to the numerous risks of government shutdown over the budget this fall. Other than these legislative options, the Trump administration can ease regulation, or relax enforcement, through executive action, as it has already promised to do. Assuming America's financial sector will get a reprieve, investors could capitalize on it by favoring small U.S. bank equities over large bank equities. The share price of small banks relative to large banks, which rallied in the aftermath of Trump's election only to fall back in the subsequent months, has recently perked up (Chart 21). Relative earnings have been flat over the same period. If Dodd-Frank is partially watered down, these banks should see earnings improve, which should drive up their share prices. Our colleagues at BCA's U.S. Equity Strategy are positive on global bank equities, particularly European and American ones. The latter are still relatively affordable as they undertake the long trek of recovery after a once-in-a-generation crisis (Chart 22). U.S. banks have notably better fundamentals than peers in Europe and Japan - more capital, higher net interest margins, lower or equal NPL ratios. They also stand to benefit from relatively faster rising interest rates (Chart 23).14 Chart 22The Long, Hard Road Of Recovery The Long, Hard Road Of Recovery The Long, Hard Road Of Recovery Chart 23U.S. Banks Well Positioned Globally U.S. Banks Well Positioned Globally U.S. Banks Well Positioned Globally In addition, the FiscalNote Financial Sector Index suggests that the flow of legislative and regulatory proposals has been steadily getting less onerous on the financial sector.15 Chart 24 is an aggregation of the favorability scores - which assess whether the bill is likely to be favorable or unfavorable to the sector - for all U.S. Congressional legislation that is determined to be relevant to the financial sector since 2006. It provides a snapshot of the regulatory environment for the financial sector at any given point in time. Chart 24Financial Sector Scrutiny Softening Financial Sector Scrutiny Softening Financial Sector Scrutiny Softening Risks to the view? Republicans could somehow squeeze a broader Dodd-Frank rewrite through the budget reconciliation process. We think the probability of this is less than 10%. Financially, this would deliver a bigger jolt to the financial sector, and financial stocks, than currently expected. But it would still benefit small banks more than large ones. Politically, a full repeal could add to Republican woes in 2018 - particularly if it is their only legislative achievement. It may well be political suicide to contest the 2018 midterm election on two pieces of legislation: one that denies millions of Americans health insurance and another that favors Wall Street. A full rewrite would also probably increase systemic financial risks. Even deregulation just for the small banks would do so. Lawmakers, focused on restraining the "too big to fail" giants, could end up clearing the way for excesses among the pygmies. That said, excessive regulation can also fuel shadow banking, a risk in itself. And the next crisis may well emanate from somewhere other than the financial sector. Bottom Line: Repealing Dodd-Frank faces procedural hurdles and would yield few political benefits even for Republicans in an environment of populism. However, a bill focused on lightening the regulatory load on small banks has a chance of passing if tacked onto the budget process. Large banks would remain subject to closer scrutiny and stricter international standards. The Trump election rally for bank stocks has mostly fallen back. Now is an opportunity to favor small banks versus large ones on expectations of Trump getting tax cuts passed and regulatory easing of some kind. Kansas: Where Seldom Is Heard A Discouraging Word A chill went through the Tea Party's collective spine on June 6 when two-thirds of the GOP-controlled Kansas legislature overrode the veto of GOP Governor Sam Brownback to repeal a 2012 budget law that slashed taxes on income, small business, and retail sales. You heard that right: Republicans in one of America's reddest states just overrode their leader in order to increase taxes. And it was the largest tax hike in state history. We will spare our readers the nitty-gritty details of the Brownback saga. Suffice it to say that the Tea Party-friendly Kansas legislature slashed state taxes and spending under Brownback's leadership in May 2012. Brownback called it a "real live experiment" of conservative economic principles and argued that the tax cuts would pay for themselves through faster growth. Art Laffer, of "Laffer Curve" fame, allegedly consulted on these measures via the conservative American Legislative Exchange Council. The medicine proved more dangerous than the illness. Since 2012, the state has burned through a budget surplus and growth has slowed (Chart 25). Both Moody's and S&P downgraded Kansas debt. Employment gains have lagged those of neighboring states. Beginning in October 2013, Brownback began to slip in public opinion polls (Chart 26). Cuts to core government services, especially education, caused a tide of criticism. In an extraordinary development, a hundred establishment Republicans supported his Democratic opponent in the 2014 gubernatorial election. He won by a margin of 3.7% but soon afterwards fell out of favor with the public. Chart 25 Chart 26 A series of confrontations with the Kansas Supreme Court hastened his decline, mostly over education funding, which is guaranteed by the state constitution. Brownback, the legislature, and various activist groups attempted to strong-arm the courts, including by ousting four members of the Supreme Court in the 2016 elections. All four retained their posts. The new budget law raises $1.2 billion in income taxes over two years by revoking swathes of the 2012 law, particularly the income tax exemption for business owners and professionals. Brownback duly vetoed the legislation and was promptly overridden by two-thirds of a legislature that is 70% Republican. This is a remarkable event for a state as ideologically conservative as Kansas. What does it mean nationally? There are two reasons that the Kansas experiment will have a limited impact on Republican thinking nationally: Kansas has a balanced budget law (Section 75-3722), while D.C. does not ... and this helped increase the pressure on the administration; Brownback is the least popular governor of any governor in the United States (Chart 27). The blame for the whole fiasco may fall on him personally, distracting from the policy failure. Chart 27 Nevertheless, we think Kansas has set the high-water mark for an aggressive Tea Party agenda in the U.S. that focuses on fiscal conservativism to the exclusion of everything else. Republicans will take note that even as conservative of a state as Kansas has a limit when it comes to spending cuts. It was the cuts to education - which resulted in shorter schoolyears in some districts, and various other disruptions - that fatally wounded Brownback's public standing. Thus public demand for core services is a real constraint on the extent to which taxes can be slashed. Bottom Line: We expect the Trump administration to go forward with tax cuts. But we also think that Trump will get far less in spending cuts than his budget proposals pretend. As such, we expect the GOP tax reform agenda to blow out the budget deficit, a path that Kansas could not legally (or politically) take. This will be the path of least resistance for Congressional Republicans who want to slash taxes yet fear they may not survive the spending cuts necessary to pay for them.16 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jim Mylonas, Vice President Client Advisory & BCA Academy jim@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 3 Please see BCA U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers," dated May 23, 2017, available at usbs.bcaresearch.com. 4 Please see Janet L. Yellen, "Inflation Dynamics and Monetary Policy," Philip Gamble Memorial Lecture, University of Massachusetts-Amherst, September 24, 2015, available at www.federalreserve.gov. 5 Please see BCA Global Investment Strategy Weekly Report, "When Doves Cry," dated June 9, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Client Note, "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, and Geopolitical Strategy Weekly Report, "Has Europe Switched From Reward To Risk?" dated June 7, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Brexit - Next Steps," dated July 1, 2016, available at gps.bcaresearch.com. 8 We are particularly indebted to Ben S. Bernanke's account in The Courage To Act: A Memoir Of A Crisis And Its Aftermath (New York: Norton, 2015), pp. 435-66. 9 Please see BCA U.S. Investment Strategy Special Report, "Preparing For Basel III: Who Will Win, Who Will Lose?" dated September 12, 2011, available at usis.bcaresearch.com. 10 Congressional Budget Office, "H.R. 10, Financial CHOICE Act of 2017," CBO Cost Estimate, May 18, 2017, available at www.cbo.gov. 11 The Republicans managed to repeal one aspect of Dodd-Frank with a simple majority via the Congressional Review Act, an option that is now closed. U.S. oil, gas, and mineral companies can now be somewhat less transparent about payments made to foreign governments to gain access to resources. Proponents claim U.S. resource companies will gain competitiveness; opponents claim corruption will increase, particularly in foreign countries. 12 Please see Bill Heniff Jr., "The Budget Reconciliation Process: The Senate's 'Byrd Rule,'" Congressional Research Service, November 22, 2016, available at fas.org. 13 Please see Yellen's February testimony to the Senate Banking Committee, e.g. "Yellen Wants To Ease Regulations For Small Banks," Associated Press, February 14, 2017, available at www.usnews.com. 14 Please see BCA U.S. Equity Strategy Weekly Report, "Girding For A Breakout," dated May 1, 2017, available at uses.bcaresearch.com, and Global Alpha Sector Strategy Weekly Report, "Buy The Breakout," dated May 5, 2017, and "Wind Of Change," dated November 11, 2016, available at gss.bcaresearch.com. 15 The FiscalNote Policy Index measures regulatory risk daily for sectors, industries, and individual companies from every legislative and regulatory proposal. Using proprietary machine-learning-enabled natural language processing algorithms, FiscalNote ingests and processes thousands of legislative and regulatory policy events, scoring each for relevance, favorability, and importance to affected sectors. 16 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com.

Highlights The current economic and profit environment supports our stance of favoring stocks over bonds. The Fed will need to see more evidence to alter its gradual path for rates. Although valuations remain elevated, they are not a great market timing tool. Margins are expanding according to the S&P 500 data, and we expect this to continue in the second half of the year. But a peak in margins next year could be the justification to scale back on overweight positions in stocks, in anticipation of slower EPS growth. Corporate balance sheets continued to deteriorate in the first quarter, but that is not enough to warrant cutting back on corporate bond positions within fixed-income portfolios. Watch real short-term rates and bank C&I lending standards, as an exit warning. Feature Environment Remains Supportive For Stocks Over Bonds Investors are wondering whether the equity and currency/bond markets are living on different planets. The dollar and Treasurys seem to be priced for sluggish economic growth, less inflation and no fiscal stimulus. Yet, the S&P 500 is stubbornly holding above the 2,400 level. Many believe that the only reason that stocks got to this level in the first place is the prospect of tax cuts, deregulation and infrastructure spending. If true, then it is only a matter of time before equity investors capitulate. We look at it another way. Yes, equities initially received a boost following the U.S. election on hopes for tax reform. But indicators such as the ratio of small-to-large-cap stocks, or high-tax companies relative to the S&P 500, suggest that the stock market has priced out all chances of any tax reform. The overall stock market has performed well despite this because of the favorable profit backdrop. The fact that Corporate America can generate such profits despite a lackluster economy is impressive. Moreover, the recent softening in inflation has led many to believe that the Fed can proceed even more slowly than the market previously believed, leading to a bond rally. This is quite a bullish backdrop for equities. One does not have to conclude that the bond and stock markets are living on different planets. The backdrop is also positive for corporate bonds versus Treasurys, despite the fact that corporate health continues to deteriorate (see below). Turning to politics, the political consequences of the extraordinary U.K. general election are still not clear. The outcome of the election does not change our core views on the U.S. dollar, equity or bond markets. The dollar has rallied, Treasury yields are higher and U.S. equity prices moved up as this report was being prepared on Friday, June 9. Looking ahead, the coalition-building process in the U.K. will take time as the horse-trading between parties proceeds. Nonetheless, our high conviction view is that the investment implications are in fact already self-evident and do not require foresight into the eventual make-up of the U.K. government. A key takeaway for investors is that, aside from Brexit, domestic fiscal policy is the driving issue in British politics. Austerity is dead in Britain and investors should expect its economic policy - under whatever leadership ultimately gains power - to swing firmly to the left on fiscal, trade, and regulatory policy. Moreover, the Brexit process will continue, albeit of a potentially more "softer" variety and with a somewhat higher probability of eventual reversal.1 Will They Or Won't They? A 25-basis point rate hike is likely this week, but the FOMC will need more evidence on the direction of inflation and the economy before significantly changing the timing and pace of rate hikes or economic forecasts. The market is fully pricing in the anticipated 25-basis point rate bump, but beyond that, there is not much agreement between the Fed and the market on interest rates or economic projections. Nonetheless, as the Fed prepares its June forecast and dot plots, policymakers and the market are on the same page in terms of the labor market, inflation, and the economy in the next few years. The unemployment rate (4.3% in May 2017) is below the Fed's forecasts for 2017 (4.5%) and longer run (4.7%). The consensus outlook for the unemployment rate keeps it below the Fed's path through the end of 2018 (Chart 1, panel 3). Even assuming that the 120,000 pace of job growth in the past three months persists, the unemployment rate would remain below the Fed's view of NAIRU (Chart 2). Our unemployment rate projections are based on a stable labor force participation rate and a 1% gain in the working age population. Chart 1Fed, Market And Reality##BR##Not Too Far Apart Fed, Market And Reality Not Too Far Apart Fed, Market And Reality Not Too Far Apart Chart 2The Unemployment Rate##BR##Under Various Monthly Job Count Scenarios The Unemployment Rate Under Various Monthly Job Count Scenarios The Unemployment Rate Under Various Monthly Job Count Scenarios However, a closer look at what policymakers have said about prices and the trajectory of inflation in recent years suggests that the market and the Fed are not that far apart. At +1.7% in April, the PCE deflator remains near the FOMC's projection of 1.9% for this year and 2.0% in the long run. Bloomberg consensus estimates for inflation for this year and next are above the top end of the Fed's forecast range (Chart 1, panel 2). The FOMC's May minutes state that "participants generally continued to expect that inflation would stabilize around the Committee's two percent objective over the medium run as the effects of transitory factors waned." The market is still concerned that the traditional Phillips curve model may be broken and that inflation may never accelerate even with the economy below the Fed's estimate of full employment. We will discuss the Phillips curve in a post-GFC world in an upcoming edition of The Bank Credit Analyst. As we discussed in last week's report,2 GDP growth in 2017 is on track to exceed the Fed's 2017 target (2.1%) and is already running ahead of the Fed's GDP projection (1.8%) for the long term. The consensus forecast for GDP in 2018 and 2019 is at the upper end of the Fed's range set in March (Chart 1, panel 1). Despite the general agreement between the Fed and the market on certain aspects, they diverge on the outlook for the fed funds rate in the next 18 months (Chart 3). As of June 9, the Fed sees a total of six quarter-point rate hikes by the end of 2018. The market sees just two in the same period. The Fed and market are still far apart on rates in 2019. However, the disconnect between the Fed and the market is not as large as it was in early 2015. This disagreement was a major factor in the equity market pullback in the first few months of 2016 (Chart 3). Neither the recent weakness in the economic data nor softer-than-expected inflation readings will be enough to prompt a significant shift from the Fed in terms of the 'dot plot'. The economic surprise index has been declining for 63 days since peaking in early- to mid-March, but remains consistent with slow growth, not a recession. Economic data tends to disappoint for an average of 90 days after the economic surprise index is above 40, as it was in late 2016/early 2017 in the wake of the U.S. election (Chart 4). Chart 3Disconnect Between Fed##BR##And Market On Rates Disconnect Between Fed And Market On Rates Disconnect Between Fed And Market On Rates Chart 4Economic Surprise Index Has Rolled Over##BR##Since Early To Mid March Economic Surprise Index Has Rolled Over Since Early To Mid March Economic Surprise Index Has Rolled Over Since Early To Mid March Bottom Line: It would take a significant deterioration in the economy and labor market and in the benign inflation environment to alter the Fed's gradual rate hike plan. A backdrop of gradual hikes and eventually, a smaller balance sheet, will continue to foster the conditions under which stocks have outperformed bonds since 2009. We believe that the recent Treasury rally is overdone because the market has gone too far in revising down the path of Fed rate hikes. A re-evaluation of the outlook could see bond yields jump, sparking a small equity correction. This is not enough of a risk to scale back on equities versus bonds. Valuations, Earnings And Margins: An Update U.S. equities remain overvalued and would be even more extended if not for low rates. However, they are attractively priced relative to competing assets, such as corporate bonds and Treasurys. Valuation is not a great tool to time market turning points and, absent a significant deterioration in the economic, profit and margin environment, we don't foresee a sustained pullback in stocks. Looking beyond our tactical 6-12 month window, above-average market multiples alone imply below-average returns for stocks across a strategic time horizon. Our BCA valuation indicator has deteriorated since we last published it in March 2017 and shows that U.S. equities remain expensive.3 Individually, two of the three components of the Valuation index remain in overvalued territory. The Earnings Group remains at a record high (aside from the tech bubble). The Balance Sheet group shows the same profile. Only the Yield Group, which compares stock prices with various nominal and real interest rates, suggests that equities are undervalued. Thus, U.S. stock prices are vulnerable to a sharp jump in rates, which supports our view that U.S. equity markets will perform well in an economic and inflation backdrop that allows the Fed to raise interest rates and unwind its balance sheet gradually (Chart 5). While tax cuts and infrastructure spending might provide the equity market with a "sugar high", it probably would not last long because fiscal stimulus would bring forward Fed rate hikes. Moreover, Chart 6 shows that U.S. stocks remain favorably priced relative to competing assets such as corporate bonds, Treasurys and residential housing. That said, equity valuation measures such as price-to-book or price-to-sales make the market vulnerable to shocks. Chart 5U.S. Stocks##BR##Are Overvalued... U.S. Stocks Are Overvalued... U.S. Stocks Are Overvalued... Chart 6Stocks Look Less Expensive##BR##Relative To Competing Assets Stocks Look Less Expensive Relative To Competing Assets Stocks Look Less Expensive Relative To Competing Assets Inflated valuations alone are not enough to trigger a bear market or even a significant correction in U.S. equities. Outside of aggressive Fed tightening, we will become more defensive when profits come under pressure. On this score, the decline in Q4 profits according to the NIPA data is concerning. We are in a period where margins based on the NIPA data are diverging from the S&P's measure. Like corporate earnings, there is more than one data source for profit margin data, and the data itself is a mix of art and science. In the long run, the S&P-based margin data and the data derived from the NIPA accounts tend to move together. Over shorter time horizons, however, these two metrics may diverge. The NIPA margins peaked in 2014 and have moved steadily lower since then, but the BEA-derived profit data are not closely watched by investors and are subject to significant revision. On the other hand, margins based on S&P data are followed closely by the markets, are not subject to revision and have been moving higher since end of 2015. In the past 55 years, the peak in NIPA margins has often led the S&P data at peaks; the caveat is that it is unclear whether the NIPA data led in real time because of the endless revision process for GDP and profit data.4 The margin series based on S&P data tends to lead heading into margin troughs, but it is not a reliable signal. During the long economic expansion in the 1960s, both indicators topped out around the same time (1966-67). The NIPA derived margins peaked in 1975 as the S&P margins troughed, and later in the decade, the zenith in NIPA margins peaked three years before the S&P version. Similar to the current decade the long expansion in the 1980s saw a mid-decade collapse in oil prices and margins. In the late 80s, NIPA and S&P measures peaked almost simultaneously, which was three years before the crest in equity prices. The 1990s saw unabated margin expansion through 1997 for NIPA margins; the expansion in S&P-based margins lasted until 1999 (Chart 7). Chart 7Margins, Like Profits Are Mix Of Art & Science Margins, Like Profits, Are Mix Of Art & Science Margins, Like Profits, Are Mix Of Art & Science History also shows that falling margins do not always mean declining EPS growth. In the past 40 years, when the U.S. economy was not in recession, corporate EPS growth was very high on average when margins rose. It was mostly a wash when margins dropped, with slightly negative EPS growth on average. There were two episodes (late-1990s and mid-2000s) when margins fell, but EPS growth was strongly positive (Chart 8). The stock market can also rise significantly even after margins peak for the cycle. Chart 8EPS Can Grow Even As Margins Contract EPS Can Grow Even As Margins Contract EPS Can Grow Even As Margins Contract According to S&P data we are in a phase of climbing margins and we expect EPS growth to further accelerate into year end, peaking at just under 20%, before moderating in 2018. If profit growth decelerates in 2018 and the S&P measure of margins begins to narrow again, it would send a strong signal to trim exposure, especially given lofty equity valuations (Chart 9). Chart 9Profit Growth And Margins Both Rising Profit Growth And Margins Both Rising Profit Growth And Margins Both Rising Bottom Line: Rich valuations in U.S. equities will be overlooked as most investors are focused on the S&P and not the NIPA margins. EPS growth will decelerate sharply when margins resume their mean reversion, which could be the catalyst for a major correction or bear market in stock prices. We do not expect this scenario to play out until 2018 at the earliest. Meanwhile, rising margins and profits trump expensive multiples for U.S. equities. Stay long. Corporate Bonds: Kindling And Sparks Last week's U.S. Flow of Funds release allows us to update BCA's Corporate Health Monitor (CHM) for the first quarter (Chart 10). The level of the CHM moved slightly deeper into "deteriorating health territory." The deterioration in the Monitor over the past few years is largely reflected in the profit-related components of the CHM, including the return on capital, cash flow coverage and free cash flow-to-total debt. Chart 10Deteriorating Since 2015, But... Deteriorating Since 2015, But... Deteriorating Since 2015, But... The Monitor has been a reliable indicator for the trend in corporate bond spreads over the years. Indeed, it is one of the oldest and most reliable indicators in BCA's stable of indicators. However, spreads have trended tighter over the past year even as the CHM began to signal deteriorating health in early 2015. Why the divergence? The CHM is only one of three key items on our checklist to underweight corporate bonds versus Treasurys. The other two are tight Fed policy (i.e. real interest rates that are above the neutral level) and the direction of bank lending standards for C&I loans. On its own, balance sheet deterioration only provides the kindling for a spread blowout. A blowout requires a spark. Investors do not worry about high leverage or a profit margin squeeze, for example, until the outlook for defaults sours. The latter occurs once inflation starts to rise and the Fed actively targets slower growth via higher interest rates. Banks see trouble on the horizon and respond by tightening lending standards, thereby restricting the flow of credit to the business sector. Defaults start to rise, buttressing banks' bias to curtail lending in a self-reinforcing negative feedback loop. The three items on the checklist usually occurred at roughly the same time in previous cycles because a deteriorating CHM is typically a late-cycle phenomenon. But this has been a very different cycle. High stock prices and rock-bottom bond yields have encouraged the corporate sector to leverage up and repurchase stock. At the same time, the subpar, stretched-out recovery has meant that it has taken longer than usual for the economy to reach full employment. Even now, inflationary pressures are so muted that the Fed can proceed quite slowly. It will be some time before real short-term interest rates are in restrictive territory. As for banks, they tightened lending standards a little in 2015/16 due to the collapse of energy prices, but this has since reversed. As an aside, recent weakness in the growth rate of C&I loans has contributed to concerns over the health of the U.S. recovery. However, the easing in lending standards this year points to an imminent rebound in C&I loan growth (Chart 11). Our model for C&I loans, based on non-residential fixed investment, small business optimism and the speculative-grade default rate, supports this view. Chart 11C&I Loan Growth Set To Rebound C&I Loan Growth Set To Rebound C&I Loan Growth Set To Rebound The implication is that, while corporate health has deteriorated, we do not have the spark for a sustained corporate bond spread widening. Indeed, Moody's expects that the 12-month default rate will trend lower over the next year, which is consistent with constructive trends in corporate lending standards, industrial production and job cut announcements (all good indicators for defaults). Chart 12 presents a valuation metric that adjusts the HY OAS for 12-month trailing default losses (i.e. it is an ex-post measure). In the forecast period, we hold today's OAS constant, but the 12-month default losses are a shifting blend of historical losses and Moody's forecast. The endpoint suggests that the market is offering about 200 basis points of default-adjusted excess yield over the Treasury curve for the next 12 months. This is roughly in line with the mid-point of the historical data. In the past, a default-adjusted spread of around 200 basis points provided positive 12-month excess returns to high-yield bonds 74% of the time, with an average return of 82 basis points. It is also a positive sign for corporate bonds that the net transfer to shareholders, in the form of buybacks, dividends and M&A activity, has eased on a 4-quarter moving average basis (although it ticked up in Q1 on a 2-quarter basis; Chart 13). As a result, ratings migration has improved (i.e. easing net downgrades), especially for shareholder-friendly rating action, which is a better indicator for corporate spreads. The moderating appetite to "return cash to shareholders" may not last long, but for now it supports our overweight in both investment- and speculative-grade bonds versus Treasurys. That said, excess returns are likely to be limited to the carry given little room for spread compression. Chart 12Still Some Value In##BR##High-Yield Corporates Still Some Value In High-Yield Corporates Still Some Value In High-Yield Corporates Chart 13Net Transfers To Shareholders##BR##Eased In Past Two Quarters Net Transfers To Shareholders Eased In Past Two Quarters Net Transfers To Shareholders Eased In Past Two Quarters Within balanced portfolios, we recommend favoring equities to high-yield at this stage of the cycle, for reasons we outlined in the April 17, 2017 Weekly Report. In a nutshell, value is not good enough in HY relative to stocks to expect any sustained period of outperformance in the former, assuming that the bull market in risk assets continues. Bottom Line: Corporate balance sheets are still deteriorating but risk assets, including corporate bonds, should continue to outperform Treasurys and cash in the near term. We will look to downgrade risk assets when core inflation moves closer to the Fed's 2% target, which would trigger a more aggressive FOMC tightening campaign and tighter bank lending standards. Favor equities to high yield, but within fixed-income portfolios, overweight investment- and speculative-grade corporates versus Treasurys. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see the Geopolitical Strategy Client Note "U.K. Election: The Median Voter Has Spoken, published on June 9, 2017. Available at gps.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Report, "Can The Service Sector Save The Day?" June 5, 2017. Available at usis.bcaresearch.com. 3 Please see U.S. Investment Strategy Weekly Report "How Expensive Are U.S. Stocks", dated March 13, 2017 available at usis.bcaresearch.com. 4 Please see U.S. Investment Strategy Weekly Report, "Growth, Inflation and the Fed", May 8, 2017. Available at usis.bcaresearch.com.

Highlights The U.K. election was about austerity, not Brexit; The median voter in the U.K. and the U.S. has moved to the left; Nationalism will not satisfy the popular revolt in these countries; The pound is not likely to fall much below GBP/USD 1.2. Feature The political consequences of the extraordinary U.K. general election are still not clear. The coalition-building process will take time as the horse-trading between parties proceeds over the weekend. Our high-conviction view, however, is that the investment implications were in fact already self-evident and do not require foresight into the eventual make-up of the U.K. government. How can that be? Last year, in anticipation of unorthodox electoral results, we introduced the "Median Voter Theory."1 This theory in political science posits that policymakers are not price-makers but price takers in the political marketplace. The price maker is the median voter. Policymakers, of all stripes and colors, will attempt to approximate the policy demands of the median voter in order to win over as many voters as they can in the marketplace. Further, we argued that the median voter in the two most laissez-faire economies, the U.S. and the U.K., had moved to the left of the economic spectrum.2 The U.K. election confirms this argument. It also confirms our suspicion that the plebian revolts in these two bastions of free-market capitalism will not be extinguished merely by rallying the public around the flag and promoting nationalist themes of de-globalization.3 As such, the two trends we believe will emerge from this election, regardless of the ultimate political outcome, are: The Brexit process will continue, albeit toward a "softer" variety and with a somewhat higher probability of eventual reversal; Fiscal austerity is dead in Britain and investors should expect its economic policy - under whatever leadership ultimately gains power - to swing firmly to the left on fiscal, trade, and regulatory policy. Because of this mix of policy outcomes, we expect the GBP to suffer little in the post-election environment, though heading back towards its January lows versus the USD later this year. The market will have to price in much looser fiscal policy out of the U.K. over the course of the next government, with expectations that the BoE will continue to stand pat. This Election Was About Austerity And Globalization, Not Brexit It is absolutely crucial for investors to understand that the Labour Party did not, in any way whatsoever, focus its campaign on the results of the Brexit referendum. Labour leader Jeremy Corbyn's strategy was not only to accept Brexit as a done deal, but ostensibly even to accept the "hard Brexit" of keeping the U.K. out of the Common Market, which PM Theresa May announced in a major policy speech on January 17. The three policy positions of the Labour Party on Brexit during the campaign were: Gain "tariff-free access" to the EU single market, while accepting that Common Market membership was off the table; Keep the option of negotiating a customs union - which would prohibit the U.K. from negotiating its own trade deals - on the table; Refuse the mantra that "no deal" is better than a "bad deal." Overall, these points are not too far from Tory strategy, although they are devoid of nationalist rhetoric. More importantly, the key difference between the Labour and Tory approach to Brexit was that Labour was not trying to entice blue-collar voters, battered by the winds of globalization, with promises of free-trade agreements with India and China. If last year's Brexit voters did not want a free-trade tie-up with Europe, why on earth would they support a Tory vision of free trade deals with China and India?! Jeremy Corbyn's Labour has, in other words, a much better handle on what the Brexit referendum was all about. As we concluded in our net assessment ahead of the referendum in March of last year, the vote would ultimately be about globalization and its impact on the economic wellbeing of the median voter in the U.K. (Chart 1), not the angst over the EU's technocratic elites and bureaucratic overreach.4 Yes, the latter also mattered, but not to the blue-collar voters who crossed the aisle to support the Tory/UKIP vision on Brexit. For them, Brexit was a vote against elites that have profited from globalization. Election polls gave investors a hint that blue-collar Brexit voters would shift back to Labour. Tories began to see a drop in support almost immediately after they called the election on April 18 - i.e. before May's various mistakes (Chart 2). All the subsequent gaffes by May reinforced the trend, but the trend started on the first day of campaigning. This suggested that traditional Labour voters were turning back to their bread-and-butter economic demands immediately as the campaign began. Chart 1Brits Exposed To Harsher Change Brits Exposed To Harsher Change Brits Exposed To Harsher Change Chart 2Labour Rally Began When Election Called Labour Rally Began When Election Called Labour Rally Began When Election Called Corbyn, who has been underestimated by the media for over a year, was quick to press the gas pedal on left-wing economic issues, steering clear of Brexit. In fact, if one was unfamiliar with British politics, and only focused on the Labour campaign rhetoric, one would hardly know that a referendum on EU membership had even taken place. Corbyn's campaign was straight out of the Labour playbook of the 1980s. He gambled that the median voter had swung to the left. In particular, the Labour campaign pounced on three policy issues that isolated Tory tone-deafness on the unpopularity of austerity: "Dementia tax" - May's quip that the elderly would be means-tested by including the value of their homes in assessing government support for social care ultimately proved to be profoundly self-harming. At the moment when she made the gaffe, Tories were up 11% on Labour in the polls. "Triple Lock" - May hesitated and waffled over the triple lock pension system - which was introduced by the Conservative and Liberal Democratic coalition from 2010-15. It guaranteed that government pension payouts would rise annually at the highest rate of inflation, 2.5% per year, or wage growth. She did so even as inflationary pressures built up as a result of Brexit, which similarly fell flat with voters. This is unsurprising, given that it was the Euroskeptic Tories and UKIP plan to exit the EU that caused inflationary pressures in the economy in the first place. That they then asked low-income elderly to shoulder the costs of Brexit also illustrates a profound misunderstanding of what the Brexit referendum was about. Police funding - May thought that the Manchester and London Bridge terrorist attacks would swing the vote towards the center-right, security-conscious party. She went so far as to announce that human rights concerns would not stand in the way of Britain's fight against terrorism, doubling down on nationalist rhetoric.5 Corbyn stuck to the strategy of tying everything to austerity: he condemned the attacks but criticized the Tories for significant cuts to police forces under May's watch as Home Secretary, claiming that these imperiled law enforcement's ability to keep U.K. citizens safe. Following Brexit, May did try to shift policy to the left. For example, her October 2016 speech - her first major address as the U.K. Prime Minister - blamed "globalized elites" for the pain incurred by Britain's low and medium income households. However, Tories could not help to subsequently promise corporate tax cuts and budget-saving measures. And her gaffes during the election convinced voters - many of whom may have voted for Brexit - that Tories were stereotypical Tories; i.e., not concerned for the plight of the common man. All that said, the Conservative Party will still win around 57 seats more than the Labour Party. In any previous election, that would be considered a decent, if not commanding, result. What we want to stress to clients is that the Conservative Party in fact only won 22 more seats than the combined result of the most left-wing Labour Party in half a century and an extremely left-leaning Scottish National Party. When seen from that perspective, and when we consider the Tories' 22% lead in polls at the onset of the electoral campaign, the result on June 8 is an unmitigated disaster for the party and a wake-up call: the economic preferences of the U.K.'s median voter are as left wing as they have been since the mid-1920s. Bottom Line: The U.K. election was not contested solely on Brexit. As such, investors should not overthink the implications of the election on the Brexit process and hence the implications for the pound and U.K. assets. Labour gained around 29 more seats despite firmly accepting the Brexit referendum. This is not to say that the Labour Party, were it to cobble together a governing coalition with the SNP and others, would not be quick to reverse the Brexit process and call a second referendum if the economic costs of Brexit were to rise over the course of its mandate. That is a possible scenario. But the bigger picture is that Labour's opposition to austerity politics is what made all the difference in this election. Likely Government Formation Scenarios At the time of publication of this Client Note, May's comments and the distribution of seats favor a Tory minority government (or perhaps a formal coalition) supported by the Democratic Unionist Party (DUP) of Northern Ireland. As we discussed in our just-published Weekly Report, the Northern Irish have not exercised real power in Westminster in a century, literally.6 The party won ten seats, which makes for a majority with the Tories, and thus could provide just enough support to accomplish the single goal of a Tory-led Brexit. Tories and the DUP have already been in an informal coalition due to the Tories' attempts to increase their earlier majority of only 17 seats. Nonetheless, such a coalition will be controversial and will lead to uncertainties about parliament's ability to pass a final Brexit deal in 2019. Currently, such an arrangement would see a Tory government depend on the slimmest of majorities, around two seats over the 326 needed for a nominal majority. However, because the Irish nationalist Sinn Fein MPs (who gained seven seats this time around) normally do not sit in the parliament, and because the speaker and deputy speakers do not vote, Tory's would have some buffer. (And yet the extraordinary circumstances suggest that one should not rule out Sinn Fein taking up their seats!) How much political capital would a May-led government have? Extremely little. First of all, not only did the Tories squander an extraordinary lead in the polls, but their ultimate share of the total population's vote is merely 2.4% above Labour's haul (Chart 3). In fact, the only thing that saved the Tories from opposition is the U.K.'s first-past-the-post electoral system, which allowed them to win more seats merely by being the only right-of-center option for British voters. Chart 3 In addition, it is now clear that May failed to get all of the UKIP voters to swing to the center-right, establishment party. The UKIP vote declined by over 11% in the election, but the Tory net gain in percentage terms from the last election is only half that figure. This supports our view from above that many blue-collar voters, who voted for Brexit, swung back to the Labour party the minute the election was announced, reflecting deep distrust of the Tory Party on bread-and-butter, non-Brexit issues. A slim government majority made possible by a Euroskeptic Northern Irish Party will ensure that the Brexit process continues. Would Euroskeptic Tories have a bigger say in such a government, forcing May to swing further to the nationalist right and leading to acrimony with Europe? Normally we would say "yes." However, it was May's turn to the nationalist right at the expense of nurturing left-leaning economic policies that cost her a majority. As such, we doubt that she, or her potential replacement in the wake of the disastrous result, would double-down on more Euroskepticism. That would be a profound error following a clear signal from the electorate that nationalist rhetoric and Brexit chest-beating is insufficient to bolster the Conservative Party in the post-Brexit environment. As May herself said, Brexit means Brexit. The median voter appears to agree and now wants the government to move on by turning the U.K. away from austere economic policies. We suspect the Tories understand this now. As for a potential Labour coalition with the SNP and Liberal Democratic Party, the numbers do not add up at the moment. Nonetheless, if we combine all the left-of-center parties in the U.K., their share of total vote is 52%. As such, we expect the Tories, assuming they govern, to tilt to the left on the economic front. Bottom Line: Tories are likely to produce a government in some kind of coalition with Northern Irish DUP. We highly doubt that they will double down on Euroskepticism after that strategy proved so disastrous in the election. The U.K. voters have moved on from Brexit and are not interested in re-litigating the reasons for it. They are, however, interested in seeing a definitive end to austerity. Investment Implications Another reason this election is not a game changer on anything other than domestic economic policy is that the Scottish National Party sustained serious losses of 21 seats. Former banner-bearing member Alex Salmond even lost his seat. Voters are simply not interested in the constitutional struggles within the U.K. or the EU at this point. The key takeaway for investors is that fiscal policy is the driving issue in British politics. Brexit was not only a vote about sovereignty and immigration, it was also a demand from the lower and middle classes for an end to second-class status. That is why May highlighted the need for government to moderate the forces of globalization and capitalism and make the economy "work for everyone" in her October 2016 speech at the Conservative Party conference and in her rhetoric since then. She lost sight of her own message and squandered her massive lead. The Tories had started to ease fiscal policy ahead of the election. In his first Autumn Statement, Chancellor Philip Hammond abandoned his predecessor George Osborne's promise to eliminate the budget deficit by 2019, pushing the timeline beyond 2022 (Chart 4). The latest budget projections by the Office for Budget Responsibility show that the current government is projecting more spending than its predecessor (Chart 5). Chart 4 Chart 5 Thus monetary and fiscal conditions are both accommodative in the short and medium term. Given that we do not expect the European Union to exact crippling measures on the Brits for leaving, as we have outlined in previous reports, the result is a relatively benign environment for the U.K., at least until the business cycle turns, the effects of Brexit begin to bite, and/or global growth slows down. The combination of fiscal stimulus and easy monetary policy, however, should weigh on the pound regardless of the election outcome. We do not expect the GBP to retest its January 16, 2016 lows against the USD in the near term, but the large amount of uncertainty injected into the British political sphere will nonetheless result in a few more days of cable weakness that can be exploited by short-term traders. The competing crosswinds confusing investors in the immediacy of the election are as follow: Jeremy Corbyn's Labour is as left-wing as any major center-left party has become in the West. Yet it just won over 40% of the vote in the U.K.; Brexit remains the likely outcome of U.K.-EU negotiations, but the chances of a "super hard Brexit" or some sort of a "Brexit cliff" have been reduced as voters have repudiated May's hard right turn; The pound has already fallen on every gaffe and misstep by the Tories, suggesting that the current disappointing result, although not fully priced, was partly anticipated by the FX markets. In the long term, however, a reversal of austerity and a relatively dovish monetary policy from the BoE should be negative for the pound. While less austerity is a big plus for the economy, the inflationary momentum experienced in recent months should increase further and dampen the fiscal dividend as higher prices hurt real spending (Chart 6). This puts the BoE in a bind, in which it will be hard to move away from its super-accommodative stance even if inflation is becoming dangerous. Thanks to these dynamics, the leftward tilt for one of the previously most laissez-faire economies in the world could see the GBP ultimately retest its January 16 lows over the medium term as the recent surge in FDI could peter off, increasing the cost of financing the U.K.'s large current-account deficit. Moreover, BCA's House View calls for a higher dollar by year's end, another negative for cable. Yet a fall much below GBP/USD 1.2 is unlikely, given that uncertainty over Brexit negotiations with the EU were overstated to begin with and likely to be resolved towards a "softer Brexit" outcome over the life of the next government. Additionally, the pound is now cheap, and another pullback would result in a more than 1-sigma undervaluation relative to long-term fundamentals (Chart 7). Chart 6The BOE's Dilemma The BOE's Dilemma The BOE's Dilemma Chart 7The Pound Enjoys A Valuation Cushion The Pound Enjoys A Valuation Cushion The Pound Enjoys A Valuation Cushion Is there a message for the rest of the world from the U.K. election? Absolutely. It signals that the voters who did not benefit from globalization are singularly focused on economic issues and that distracting them with nationalism will only go so far. This is a message that the Trump administration in the U.S. will either heed over the next three years or ignore and suffer a left-wing backlash in the 2020 election that will unsettle the markets in a fundamental way.7 The bastions of laissez-faire economics - the U.K. and the U.S. - are swinging to the left. We continue to believe that investors are unprepared for the consequences of this reality. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy," dated April 13, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 5 The failure of May's tough rhetoric on terrorism to help her in the polls suggests, along with other evidence, that Europeans are becoming desensitized to terror attacks. Please see BCA Geopolitical Strategy Special Report, "A Bull Market For Terror," dated August 5, 2016, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Has Europe Switched From Reward To Risk?" dated June 7, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com.

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

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