Geopolitics

Highlights European populism is a red herring in 2017; France is a buy, Le Pen is overrated; Merkel's demise would be an opportunity, not a risk; Yet Italy poses a real risk - elections will be crucial; Moreover, Euro breakup risk is rising over the long run. Feature Clients are nervous. Nationalist and Euroskeptic French presidential candidate Marine Le Pen continues to lead first-round polling in the elections. Meanwhile, one of her establishment opponents - François Fillon - is facing corruption charges while anti-police riots have flared up in the banlieue of Aulnay-sous-Bois, northeast of Paris. Everything seems to be falling in place for another "black swan" political outcome (Chart 1). With Brexit and President Trump's victory fresh in everyone's consciousness, it is unsurprising that Le Pen's election probability is more than double our own assessment of 15% (Chart 2). Chart 1Another Black Swan In The Making? Climbing The Wall Of Worry In Europe Climbing The Wall Of Worry In Europe Chart 2Brexit/Trump Drive Up Bets On Le Pen Brexit/Trump Drive Up Bets On Le Pen Brexit/Trump Drive Up Bets On Le Pen In this analysis, we take our clients around Europe in under 3,000 words. There is a lot happening on the continent this year. Yet, as we argued in our Strategic Outlook, Europe is setting up to be a massive red herring for investors.1 For example, France is more likely to have a free-market revolution than a populist one! It could be the chief investment opportunity in developed markets over the next several years.2 We are also optimistic about the Netherlands and Germany, despite alarms about populism. As such, we are going to play devil's advocate in this analysis and push our sanguine view to its limit. Where does our bullish logic break down? The Netherlands We begin with the Netherlands, which is the first to hit a busy electoral calendar in 2017. General elections are set for March 15 and the Euroskeptic Party for Freedom (PVV) of Geert Wilders will win a plurality of seats in the House of Representatives. According to the latest polls, Wilders' PVV will capture about 30 out of the 150 seats in the Tweede Kamer, the largest of any party. However, it is not enough to form a majority (Chart 3). Chart 3Dutch Populists A Minority In Parliament Climbing The Wall Of Worry In Europe Climbing The Wall Of Worry In Europe The problem for the centrist parties in the Netherlands is that there are too many of them. In Chart 3, we combine the center-left and center-right, pro-EU integration parties together. There are approximately ten such parties fighting over the pro-EU middle ground. None is expected to get to the 30-seat projected average of PVV. Given that the center-right and center-left parties split the establishment vote roughly in half (~60 seats each), it is likely that the Dutch pro-EU parties will need a cross-aisle "Grand Coalition" to produce a government. Coalitions take a long time to form in the Netherlands. In 2012, the process took 54 days, whereas in 2010 it took four months. The 2010 election is a good guide to this year's event, as it also produced a relatively complicated seat breakdown that ultimately forced the center-right to depend on PVV votes to govern. We suspect that the Netherlands will be deep into the coalition talks in the summer months, well after the French election is over. Investors take comfort in the fact that PVV cannot form an anti-EU/euro government on their own. This is true. We would also point out that the Dutch support the euro at a very high level (Chart 4) and that they surprisingly lack confidence in the country's future outside the EU (Chart 5). However, a "Grand Coalition" whose only purpose is to keep PVV out of government would cede the "opposition" ground to Wilders and his Euroskeptic government. And while this seems like a good idea today, while Europe's economic growth is rebounding and the migration crisis has abated (Chart 6), it could be a very bad idea once the next recession hits or the next geopolitical crisis reveals flaws in EU governance. Chart 4The Dutch Highly Approve Of The Euro... The Dutch Highly Approve Of The Euro... The Dutch Highly Approve Of The Euro... Chart 5...And See Little Future Outside The EU ...And See Little Future Outside The EU ...And See Little Future Outside The EU Chart 6Waning Migrant Crisis Undermines Populist Waning Migrant Crisis Undermines Populist Waning Migrant Crisis Undermines Populist France Constraints to a Le Pen victory in the upcoming presidential election - April 23 and May 7 - are considerable, and we expanded on them in our February 3rd Special Report "The French Revolution."3 Briefly, they are: Strong French support for the euro: Support appears to be inversely correlated with Le Pen's overall popularity, suggesting that her stance on the euro and EU creates a ceiling to her support level (Chart 7). Le Pen is weak in the polls: Le Pen continues to trail both centrist Emmanuel Macron and center-right François Fillon in the second-round polling, both by around 20% (Chart 8)! Comparing Le Pen's chances to those of Trump is a massive insult to the latter, given that Trump never trailed Clinton by more than 8% with three months to go. Bad omens for Le Pen's party: The December 2015 regional elections pose a troubling precedent for Le Pen and her National Front (FN). Her party was decimated in the two-round format, despite a slew of tailwinds at the time, including the largest terrorist attack in recent French history. Chart 7Le Pen Hobbled By Her Anti-Euro Stance Le Pen Hobbled By Her Anti-Euro Stance Le Pen Hobbled By Her Anti-Euro Stance Chart 8Le Pen Lags By ~20% In Key Second-Round Polls Climbing The Wall Of Worry In Europe Climbing The Wall Of Worry In Europe So, how does Le Pen win? We can imagine a scenario where a combination of another terrorist attack, banlieue rioting, and perhaps a restart of the migration crisis inspires enough voters to vote for Le Pen. Further, given that relatively liberal Macron is likely to make it to the second round, center-right voters may stay home or even shift to Le Pen in case of such a toxic brew. One problem with recent French electoral history is that it is replete with examples of center-left and left-wing voters strategically voting against Le Pen, yet little evidence exists that French conservative voters are willing to do the same and cast their vote for a left-leaning candidate. As such, despite better polling than Fillon in the second-round head-to-head against Le Pen, Macron remains vulnerable. What happens if Le Pen wins the election? This depends on whether FN wins the legislative elections set for June 11 and 18 - also a two-round election. Polls for the legislative election are sparse and unreliable, but it would be a shock if FN won a majority, especially given its performance in the December 2015 regional elections. As such, President Le Pen would have to co-habitate with an opposition-led parliament. The president of France has a lot of power, but it is checked by the National Assembly, the lower house of the parliament. For example, Le Pen's choice for prime minister would have to command a majority in the National Assembly in order to govern. And a number of constitutional powers - appointing members of the government, calling a referendum, dissolving the National Assembly, or ruling by decree - require the consent of the prime minister and cabinet. She would not even have a veto power over laws passed by parliament, as the French president can only delay legislation. Le Pen would only be unconstrained in matters of defense and foreign policy, where she could pursue several unorthodox policies. However, France's EU membership is written into the constitution (Article 88-1). Modifying the constitution would require an act of parliament (and potentially also a referendum, depending on a majority in parliament). In addition, France's membership in the euro is a legal obligation of its membership in the EU - given that France did not opt-out of the monetary union as Denmark and the U.K. did during the negotiations of the Maastricht Treaty. As such, it is unclear how Le Pen would be able to get the country out of the euro without pursuing the same procedure as the U.K. under Article 50 of the Lisbon Treaty, for which she would need to change the French constitution. All that said, these constraints may not be clear to the market if she is elected. We suspect that global markets would panic. A market riot, in fact, would be necessary to force Le Pen into orthodox policy, as it did with the surprise 1981 victory by socialist-leaning François Mitterrand. However, Mitterrand did not reverse policy until after two currency devaluations in the first year of his presidency, with the possibility of an IMF program openly discussed in Paris. The volte-face came after two years of sustained market pressure. It is not clear that France, or Europe for that matter, has that much time to dither today. Spain A referendum on the independence of Catalonia is expected by September. A referendum has been the main goal of the pro-independence government since Catalan elections in September 2015. The government combines far-left and center-right nationalists in an ungovernable coalition whose only common goal is independence. Chart 9Catalans Want Autonomy, Not Independence Catalans Want Autonomy, Not Independence Catalans Want Autonomy, Not Independence News flash to the markets: Catalans do not want independence, but rather a renegotiation of the region's relationship with Spain (Chart 9). And as we argued in our net assessment of the issue in 2014, a surge in internal migration since the Second World War has diluted the Catalan share of the total population.4 In fact, only 31% of the population identifies Catalan as their "first language," compared with 55% who identify with Spanish.5 Another 10% identify non-Iberian languages as their first language, suggesting that migrants will further dilute support for sovereignty, as they have done in other places (most recently: Quebec). According to the Spanish constitution, Catalonia does not have the legal right to call for an independence referendum. We suspect that the center-right government in Madrid will continue to deny the legitimacy of any referendum. Ironically, this will suppress the anti-independence turnout and hand the nationalists a victory in September. What then? A low-turnout vote, combined with no recognition from Madrid, means that the only way for the Catalan referendum to be relevant is if the nationalist government is willing to enforce sovereignty. The globally recognized definition of sovereignty is the "monopoly of the legitimate use of physical force within a defined territory." To put it bluntly: the Catalan government has to take up arms in order for its referendum to be relevant to markets (beyond the inevitable knee-jerk reactions surrounding the vote). Without recognition from Spain, and with no support from EU and NATO member states, Catalonia cannot win independence with a referendum alone. Germany General elections are set for September 24, with investors concerned that Chancellor Angela Merkel may face a tougher-than-expected challenge from the center-left Social Democratic Party (SPD). The new SPD Chancellor candidate, Martin Schulz, is polling very well and has even overtaken Merkel in the head-to-head polls (Chart 10). Schulz's overtly Europhile position - he has been the European Parliament Speaker since 2012 - appears to be winning over voters. The CDU held on to a double-digit lead over the SPD right up until Schulz took over as the primary challenger to Merkel (Chart 11). Chart 10Schulz Now Leads Merkel For Chancellor Climbing The Wall Of Worry In Europe Climbing The Wall Of Worry In Europe Chart 11Pro-Europe Sentiment Drives SPD Revival Pro-Europe Sentiment Drives SPD Revival Pro-Europe Sentiment Drives SPD Revival To some extent, CDU's drop in the polls was inevitable. It is correlated with a decline in Merkel's popularity (Chart 12). But we suspect there is more to it. Schulz's confidently pro-European attitude is a breath of fresh air for voters in Germany who have perhaps lost faith in Merkel's cautious approach to the euro crisis. Record-high support for the common currency in Germany suggests that we may be on to something (Chart 13). The German public is simply nowhere close to being as Euroskeptic as the financial media would have investors believe. And that is for good reason: euro area membership has clearly worked for Germany. Can Schulz and the Europhile SPD keep up the pressure on Merkel? Time will tell. But we take two messages from the polls. First, Euroskeptic parties are nowhere close to governing in Germany (Chart 14). Second, Merkel is a shrewd politician who has shamelessly pivoted on policy issues in the past. If Merkel senses that her lukewarm embrace of European integration can cost her the election, and that voters are buying Schulz's claim that she is to blame for the rise of populists in Europe, then she will pivot on Europe. This would be very bullish for markets as it would suggest that Berlin is ready and willing to apply fewer sticks and more carrots to its euro area peers. Chart 12Merkel's Popularity##br## In Decline Merkel's Popularity In Decline Merkel's Popularity In Decline Chart 13Germans See The Euro##br## As A Great Deal Germans See The Euro As A Great Deal Germans See The Euro As A Great Deal Chart 14There Is A Lot Of Daylight... ##br##Euroskeptic Parties Weak In Germany There Is A Lot Of Daylight... Euroskeptic Parties Weak In Germany There Is A Lot Of Daylight... Euroskeptic Parties Weak In Germany What if Schulz defeats Merkel and the SPD takes over the leadership of the grand coalition, or perhaps forms a coalition with left-leaning Greens and Die Linke? Is Merkel's demise not a risk to the markets? Most of our clients would see Merkel's retirement as a risk. We disagree. Investors are overstating Merkel's role as the "anchor" of euro area stability. She has, in fact, dithered multiple times throughout the crisis. In 2011, for example, Merkel delayed the decision on whether to set up a permanent euro area fiscal backstop mechanism due to upcoming Lander elections in Rhineland-Palatinate and Baden Württemberg. Her handling of the migration crisis also left much to be desired, to put it kindly. The SPD has picked up on this line of criticism and Schulz has begun to blame Merkel's cautious approach and insistence on austerity for the populism sweeping Europe. Given that polls suggest that Germans are not really in favor of austerity, this is potentially a winning strategy (Chart 15). Chart 15Germans Are Not Obsessed With Austerity Climbing The Wall Of Worry In Europe Climbing The Wall Of Worry In Europe We therefore believe that Merkel's demise is not being correctly priced by the markets. First, investors seem to believe that she will easily win another term. Second, those that fret about her future incorrectly price the downside risk. We actually see Merkel's retirement as an opportunity, not a risk. Whether the SPD takes over, or a more Europhile member of the CDU replaces an embarrassed Merkel as the leader of a grand coalition (Box 1), investors should contemplate what the continent will look like with a new Europhile chancellor. BOX 1 Likely Successors To German Chancellor Angela Merkel If Merkel decides to retire, who are her potential successors? Wolfgang Schäuble, Finance Minister (CDU): The bane of the financial community, Schäuble is seen as the least market-friendly option due to his hardline position on bailouts and the euro area. In our view, this is an incorrect interpretation of Schäuble's heavy-handedness. He is by all accounts a genuine Europhile who believes in the integrationist project. At 74 years old, he comes from a generation of policymakers who consider European integration a national security issue for Germany. He has pursued a tough negotiating position in order to ensure that the German population does not sour on European integration. Nonetheless, we doubt that he will choose to take on the chancellorship if Merkel retires. He suffered an assassination attempt in 1990 that left him paralyzed and he has occasionally had to be hospitalized due to health complications from this injury. As such, it is unlikely that he would replace Merkel, but he may stay on as Finance Minister and thus be as close to a "Vice President" role as possible in Germany. Ursula von der Leyen, Defense Minister (CDU): Most often cited as the likely replacement for Merkel, Leyen nonetheless is not seen favorably by most of the population. She is a strong advocate of further European integration and has supported the creation of a "United States of Europe." Leyen has gone so far as to say that the refugee crisis and the debt crisis are similar in that they will ultimately force Europe to integrate further. As a defense minister, she has promoted the creation of a robust EU army. She has also been a hardliner on Brexit, saying that the U.K. will not re-enter the EU in her lifetime. The markets and pro-EU elites in Europe would love Leyen, who has handled U.S. President Trump's statements on Germany, Europe, Russia and NATO with notable tact. Thomas De Maizière, Interior Minister (CDU): Maizière is a former Defense Minister and a close confidant of Chancellor Merkel. He was her chief of staff from 2005 to 2009. Like Schäuble, he is somewhat of a hawk on euro area issues (he drove a hard bargain during negotiations to set up a fiscal backstop, the European Financial Stability Fund, in 2010) and as such could be a compromise candidate between the Europhiles and Eurohawks within the CDU ranks. Though he has been implicated in scandals as defense minister, his popularity as interior minister is surging at the moment as a result of his declared intention to overhaul immigration policy and internal security. Julia Klöckner, Executive Committee Member, Deputy Chair (CDU): A CDU politician from Rhineland-Palatinate, Klöckner is a socially conservative protégé of Merkel. While she has taken a more right-wing stance on the immigration crisis, she has remained loyal to Merkel otherwise. She is a staunch Europhile who has portrayed the Euroskeptic AfD as "dangerous, sometimes racist." We think that she would be a very pro-market choice as she combines a popular, market-irrelevant wariness about immigration with a market-relevant centrism that favors further European integration. Hermann Gröhe, Minister of Health (CDU): Gröhe is a former CDU secretary general and very close to Merkel. He is a staunch supporter of the euro and European integration. Markets would have no problem with Gröhe, although they may take some time to get to know who he is! Volker Bouffier, Minister President of Hesse (CDU): As Minister President of Hesse, home of Germany's financial center Frankfurt, Bouffier's handling of Brexit will attract much scrutiny. He is a heavyweight within the CDU's leadership and a staunch Europhile. Fritz Von Zusammenbruch, Hardline Euroskeptic (CDU): Significantly, no such candidate exists! Greece The financial media have begun to fret about the ongoing negotiations between Greece and its euro area creditors over further aid to the country. Greece faces a €7bn euro repayment in July, by which time the funding must be released or the government will run out of cash. The problem is that the IMF refuses to be involved in any deal that condones Greece's unsustainable debt path. Europeans are willing to turn a blind eye to the reality in Greece and project high growth and primary surpluses. The IMF is not. And yet both Germany and Finland have made their participation in the Greek rescue conditional on the IMF's involvement. Even if a crisis emerges, the likely outcome would be early elections in Greece. Prime Minister Alexis Tsipras is holding on to a three-seat majority in the parliament. This majority is at risk, especially in a repeat of the 2015 crisis. Investors should cheer new elections in Greece, not fret about them. Polling shows that the pro-euro and pro-EU New Democracy Party is polling well above SYRIZA, and would produce a stable, pro-reform government (Chart 16). And there is no longer any Euroskeptic alternative in Greece. Chart 16No More Euroskeptic Option In Greece No More Euroskeptic Option In Greece No More Euroskeptic Option In Greece Given Tsipras's limited choices and the upcoming German elections, we suspect that investors will not see a return of the Greek saga this year, at least not at the same level of intensity as two years ago. And is Greek debt sustainable? Yes, it is sustainable as long as the Europeans decide to pretend that it is sustainable. Italy Last but not least is Italy. Investors have recently received some clarity on the timing of the next election as former Prime Minister Matteo Renzi has called a new leadership race in the ruling Democratic Party (PD). Given that the party must hold an internal election sometime in the spring, it is unlikely that elections will occur by mid-June, as Renzi had hoped. The most likely date is therefore in autumn 2017, given that Italy shuts down in the summer. However, interim Prime Minister Paolo Gentiloni, along with a large minority of MPs, opposes Renzi's leadership and could see him defeated in the leadership race. If that happens, investors may be spared an election until closer to the formal due date of May 23, 2018. The election, whenever held, will be the main political risk for European markets in 2017. First, support for the common currency continues to plumb multi-decade lows in Italy (Chart 17), while Italian confidence in life outside the EU is perhaps the greatest on the continent (Chart 18). Second, rising negative sentiment towards the euro and the EU are reflected in very strong polling for Euroskeptic parties. Chart 19 shows that establishment parties are barely fending off the Euroskeptic challenge - and that is only because we include the Forza Italia of former Prime Minister Silvio Berlusconi in the pro-Europe camp. Meanwhile, the ruling PD and Euroskeptic Five Star Movement (M5S) are neck-and-neck in the disaggregated polls (Chart 20). Chart 17Italians Turning Against The Euro Italians Turning Against The Euro Italians Turning Against The Euro Chart 18Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU Chart 19Euroskeptic Parties##br## Strong In Italy Euroskeptic Parties Strong In Italy Euroskeptic Parties Strong In Italy Chart 20Five Star Movement Rivals##br## Ruling Democratic Party Five Star Movement Rivals Ruling Democratic Party Five Star Movement Rivals Ruling Democratic Party What happens if M5S wins the election? Given the recent Supreme Court ruling on the electoral law, it is essentially impossible for any party to win the majority in the next election, at least with the current polling numbers. As such, M5S would have to break its electoral pledge not to form coalition governments and either form one or rule with an unstable minority. It is highly possible that M5S would use support from other Euroskeptic parties - such as the nationalist Lega Nord - to pass a law on a non-binding referendum on the euro. While the Italian constitution prohibits referenda on international treaties - and membership in the monetary union is such a treaty - a vote against the euro in a non-binding referendum would give M5S legitimacy in pursuing an Italian exit from the euro area. At such a point, we would expect that a severe market riot would be needed to push Italy away from the brink. Our assessment is that M5S would ultimately back off, as Greece did in 2015. However, Italians in 2017 are more Euroskeptic than Greeks were in 2015. Whereas Greeks saw euro membership as a key link to their membership in the Western club, Italians appear to be a lot more confident in their ability to survive euro exit. That said, M5S is not a single-issue party. Rather, it is a protest movement against government corruption and incompetence that is also moderately Euroskeptic. As such, it is not clear that it would risk an economic crisis and a potential popular revolt over an issue that has split the Italian electorate. Rather, we suspect that M5S would use the threat of euro exit to win concessions on fiscal spending from the rest of Europe. As we explained in our September 2016 net assessment of Italian politics, European integration is vital for Rome both politically and economically.6 While Italy would theoretically benefit from currency devaluation by exiting the euro, it would in practice lose access to the common market as its euro membership is legally tied to its EU membership. Politically, it would also be highly unlikely that the other euro member states would allow such a large economy to devalue against them. Investment Implications European markets remain in a sweet spot in 2017. Global growth is showing signs of improvement, the ECB will remain dovish relative to the Fed, the EU Commission is calling for more expansionary fiscal policy, and valuations continue to favor European plays over other developed market plays. Will politics spoil the party? Of the six risks we reviewed in this report, Italy is the one where the devil's advocate argument is most convincing. Polls in the country have shown no improvement in support for the euro despite the continent-wide resurgence in support (Chart 21). The other five risks will likely remain limited to fodder for the news media, allowing markets to climb the proverbial wall of worry in 2017, especially if Italian elections are pushed off into 2018. But even if the slew of elections returns pro-euro governments, long-term political risks are mounting in Europe. As we pointed out in 2013, there is a danger in relying on "Grand Coalitions" between the center-right and center-left to sustain European integration.7 Such a centrist consensus cedes the opposition ground to the Euroskeptics. If - or rather, when - a major recession or geopolitical crisis occurs, voters will no longer have a pro-establishment political alternative to turn to. As such, we agree with our market gauge of euro area breakup probability - which measures the probability of a common currency breakup over the next five years. It currently stands at 30.2% (Chart 22). Chart 21Italy Poses Chief Risk ##br##To European Integration Italy Poses Chief Risk To European Integration Italy Poses Chief Risk To European Integration Chart 22Euro Breakup##br## Risk Is Rising Euro Breakup Risk Is Rising Euro Breakup Risk Is Rising Thankfully for investors, neither a recession nor a geopolitical crisis is on the horizon in 2017. The migration crisis has ended, as we expected (Chart 23).8 Given the geographical proximity of the Middle East and North Africa to Europe, another refugee deluge is possible. We suspect it would require the collapse of new states, such as Algeria or Egypt, not merely the ongoing crises in Libya and Syria. However, with the Middle East still in flux, a recession on the five-year horizon, and the first anti-EU president in the White House, risks are beginning to stack up against European integration. Chart 23Migrant Crisis Waning Migrant Crisis Waning Migrant Crisis Waning The key question for 2017 is the same as it has been since 2010: what will Germany do? If the Europhile turn in German politics is real, then the assumptions that investors have taken for granted may be shifting. A Germany more willing to shoulder the cost of economic rebalancing via higher inflation and debt relief would be a game changer for markets. Pessimists will say that Germans would never accept such costs. But with a 3.9% unemployment rate, an 8.5% of GDP current account surplus, and a budget surplus, Germany is firing at all cylinders. Ultimately, the question for German voters is whether they are willing to bear the costs of regional hegemony. If they are, then Europe's economy and markets are about to enter a multi-year bull market. If they are not, then the centrist victories in 2017 may be the calm before the storm. As BCA's Geopolitical Strategy argued in our aforementioned Special Report on the French election, we recommend going long French industrials versus German industrials, to capitalize on reforms we think are likely after the election (whereas Germany has already reformed). We are also sticking with our long German consumers versus exporters trade, reflecting the robust German economy and persistently dovish ECB. Finally, by contrast with these bullish trades, we maintain our more bearish tactical trade of matching every €1 of euro area equity exposure with 40 cents of VIX term structure, since the latter will spike if and when the various headline political risks cause market flutters. BCA is cyclically overweight euro-area equities relative to the U.S. in currency-hedged terms. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 Please see Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 2 Please see Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 3 See footnote 2 above. 4 Please see Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 2014, available at gps.bcaresearch.com. 5 Please see "Language Use of the Population of Catalonia," Generalitat de Catalunya Institut d'Estadustuca de Catalunya, dated 2013, available at web.gencat.cat. 6 Please see Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 7 Please see Geopolitical Strategy Monthly Report, "Austerity Is Kaputt," dated May 8, 2013, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com.

Highlights The USD bull case is now well known by the market, but this is not strong enough a hurdle to end the dollar's run. The behavior of positioning, the U.S. basic balance of payments, interest rate expectations, and relative central bank balance sheets suggest we are entering the overshoot phase of the rally. Volatility will increase and differentiation on the dollar's pairs is becoming more important. Reflation plays are especially in danger, and the euro could be handicapped by political risk. The yen remains the preferred mean to play the ongoing dollar correction. Feature The dollar bull market has been echoing the path traced in the 1990s (Chart I-1). The key question for investors now is whether the dollar can continue to follow this road map or is the bull market over. The dollar bullish arguments are now well known by market participants, increasing the risk that purchases of the dollar might exhaust themselves. We review the indicators that worry us most and conclude that the dollar bull market could run further. However, as the dollar is now moving into overshoot territory, we expect that the volatility of the rally will only grow. Also, divergences in the dollar on its pairs are becoming more likely. We remain short USD/JPY, and explore the risks to the euro's near-term outlook. Signs Of An Overshoot? Sentiment The first factor that worries us about the future of the USD bull market is the near universality of the positive disposition of investors toward the dollar. However, two observations are in order. First, both sentiment and net speculative positions are not nearly as stretched as they were at the top of the Clinton USD bull market (Chart I-2). Second, it took six years of elevated bullishness and long positioning to prompt the end of the bull market in 2002. Either way, the dollar can continue to climb despite this handicap. Chart I-1Will History Repeat Itself? Will History Repeat Itself? Will History Repeat Itself? Chart I-2In The 1990s, The Consensus Was Right In The 1990s, The Consensus Was Right In The 1990s, The Consensus Was Right This reflects the fact that currency markets can often fall victim to something called the "band-wagon" effect, where a strong trend attracts more funds and perpetuates itself. Chart I-3America Is Great Again, ##br##At Least According To Investors America Is Great Again, At Least According To Investors America Is Great Again, At Least According To Investors We think this is caused by two factors. Valuation signals in the currency market have a poor track record at making money on a less than 2-year basis. This means that such signals need to be extremely strong before investors act on them. The dollar being 10% overvalued does not fit this description, instead a 20% to 25% overvaluation would hit that mark. Also, a strong upward move in a currency attracts funds to that economy. This creates liquidity in that nation's banking sector, alleviating some of the economic pain created by a rising currency or the tighter monetary policy that often caused the currency in question to rise in the first place. Today, the U.S. economy fits this bill, as private investors are rapaciously grabbing U.S. assets (Chart I-3). The Basic Balance Of Payments We have been struggling with how to interpret a strong basic balance of payment position. On the one hand, an elevated basic balance suggests that there is buying out there supporting a nation's currency. On the other hand, a strong basic balance position, especially if not caused by a current account surplus, suggests that market participants have already implemented their purchases of that nation's currency's and assets. These investors thus need further positive shocks to buy even more of that currency in order to lift its exchange rate ever higher. Today, the basic balance of payments in the U.S. is at a record high of 3.8% of GDP, begging the question of how it can climb higher from here (Chart I-4). However, as the same chart reveals, each of the previous dollar bull markets ended a few years after the U.S. basic balance of payments had peaked. Thus, we currently continue to expect the dollar to strengthen even if the U.S. basic balance position were to deteriorate. Additionally, the euro area basic balance is very depressed today at -3.4% of GDP, despite a current account surplus of 3% of GDP. However, in 1999, the region's basic balance bottomed at -5.6% of GDP, and it took until 2002 before the euro could durably rally, at which point the euro area basic balance had move back near 0% of GDP. Therefore, we would need to see a marked improvement in the euro area's basic balance in order to buy and hold the euro on a 12-to-18 months basis. Interest Rate Expectations Investors have rarely been as convinced as they are today that the Fed will increase interest rates over the coming months. This implies that the room for disappointment is large. However, as Chart I-5 illustrates, this is still not a reason to begin betting on an end to the dollar cyclical bull market. An overshoot in the dollar is marked by a fall in expectations of interest rate hikes as the strong dollar hurts the economy, preventing the Fed from hiking as much as anticipated. Moreover, except in 1994, a decreasing prevalence of rising rate expectations has lead dollar bear markets by more than a year. This suggests that there is room for the dollar to strengthen even if markets downgrade their U.S. rates expectations. Chart I-4The Basic Balance##br## Is A Small Hurdle The Basic Balance Is A Small Hurdle The Basic Balance Is A Small Hurdle Chart I-5In An Over Shoot, The Dollar Can Rally ##br##Even If Investors Doubt The Fed In An Over Shoot, The Dollar Can Rally Even If Investors Doubt The Fed In An Over Shoot, The Dollar Can Rally Even If Investors Doubt The Fed Even when looked comparatively, the broad consensus of investors regarding the continuation of monetary divergences between the Fed and the ECB is not yet a hurdle for the dollar to continue beating the euro on a 12-18 months basis. Not only is EUR/USD currently trading in line with relative expectations, previous euro rallies have been preceded by a big upgrade of the expected path of policy in Europe relative to the U.S. We currently expect the ECB to go out of its way to telegraph that even if asset purchases get curtailed in the second half of 2017, this will in no way foretell an imminent increase in European rates. Meanwhile, the Fed is in a firm position to increase rates as U.S. slack has dissipated (Chart I-6). Moreover, the proposed fiscal stimulus of the Trump administration should create inflationary pressures in this environment, solidifying the Fed's resolve to hike rates further. Chart I-6The Fed Pass Toward Higher Rates In Being Cleared The Fed Pass Toward Higher Rates In Being Cleared The Fed Pass Toward Higher Rates In Being Cleared Balance Sheet Positions One indicator concerns us more than the others at this point in time. As we wrote two weeks ago, one factor that has propelled the dollar higher has been its relative scarcity. The limited supply of dollar in the offshore markets - courtesy of the meltdown in the prime money-market funds industry and the heavier regulatory burden on banks - has caused cross-currency basis swap spreads to widen, pushing the greenback higher.1 Chart I-7Balance Sheet Dynamics And##br## The Scarcity Of Dollars Balance Sheet Dynamics And The Scarcity Of Dollars Balance Sheet Dynamics And The Scarcity Of Dollars Currently, the cross-currency basis swap spreads are hovering near record lows. However, as Chart I-7 illustrates, the surplus of euros created by the ECB's balance-sheet expansion as the Fed stopped its own purchases had a role to play in this phenomenon. While we expect the ECB to stand pat on the interest rate front for the foreseeable future, a further tapering of asset purchases in the second half of 2017 and beyond is very likely. This could limit the widening in cross-currency basis swap spreads that has been so helpful to the dollar, especially if the Fed elects not to curtail the size of its balance sheet. Net Net Many indicators suggest that the potential for dollar buying may be on the verge of exhausting itself. However, when looked closer, while these factors are a cause for concern, they still do not preclude an overshoot in the dollar. In fact, if anything, they suggest that the dollar is only now beginning its overshoot phase, a leg of the bull market that historically begins to inflict deeper pain on the U.S. economy as the dollar gets ever more dissociated from its fundamentals. So What? While the above indicators do not yet point to an end of the bull market, they in no way suggest that the dollar cannot suffer episodic corrections. We believe we are in the midst of such an event. Can the correction last further? Yes. To begin with, while the heavy net long positioning in the dollar does not represent much of a cyclical hurdle to beat, it does still constitute an important tactical risk. Our models corroborate this view. DXY is only currently fairly valued based on our intermediate-term timing model. Historically, tactical corrections fully play out once this model is in cheap territory (Chart I-8). Moreover, our capitulation index paints a similar story. This indicator has corrected some of its overbought excesses but remains above levels suggestive of an oversold environment. To the contrary, the fact that this index is still below its 13-week moving average points to additional selling pressures on the USD (Chart I-9). Chart I-8The Dollar Tactical Correction Is Not Over The Dollar Tactical Correction Is Not Over The Dollar Tactical Correction Is Not Over Chart I-9Confirming The Dollar Tactical Downside Confirming The Dollar Tactical Downside Confirming The Dollar Tactical Downside However, other factors suggest that the dollar could strengthen on certain pairs. The outlook seems especially grim for the reflation plays like the commodity currencies. Our reflation gauge, based on the prices of lumber, industrial metals, and platinum, has moved upward exactly as the U.S. dollar has rallied, a short-lived phenomenon that happened in 2001, 2002, and 2009. In all these cases, the Fed was easing policy and U.S. rates were softening relative to the rest of the world (Chart I-10). We doubt this phenomenon can continue much longer, especially as the Fed is currently tightening policy and U.S. rates are rising relative to the rest of the world. Moreover, Chinese fiscal stimulus was crucial in supporting this divergence in both 2009 and 2016. However, Chinese government spending went from growing at a 25% annual rate in November 2015, to a near 0% rate now. Moreover, the PBoC has already increased rates twice on its medium-term facilities and has also stopped injecting liquidity in the interbank market despite recent upward pressures on the SHIBOR. This tightening could prove problematic for natural resources like coking coal, iron ore, or copper, commodities highly levered to the Chinese real estate market and of which China recently accumulated large inventories (Chart I-11). Chart I-10An Unusual Move An Unusual Move An Unusual Move Chart I-11Elevated Chinese Metal Inventories Elevated Chinese Metal Inventories Elevated Chinese Metal Inventories Additionally, on the back of the longest expansion in the global credit impulse in a decade, G10 economic surprises have become very perky. However, it will be difficult to beat expectations going forward. Not only have investors ratcheted up their global growth expectations, the recent increase in global interest rates limits the capacity of the credit impulse to grow further. In fact, the recent tightening in U.S. banks credit standards for consumer loans, the fall in the quit rates in the U.S. labor market, and the underperformance of junk bonds relative to Treasurys since late January only re-inforce this message. Sagging global growth, even if temporary, is always a problem for commodities and commodity currencies. The euro faces its own risk: France. Last week, along with our colleagues from BCA's Geopolitical Strategy service, we wrote that the chance of a Le Pen electoral victory is still extremely low and we would buy the euro on any sell-off caused by a rising euro-area breakup risk premium.2 Yet, we are not oblivious to the risk that before the second round of the election is over on May 7th, investors can continue to place bets that Marine will win and that France will exit the euro area. The recent widening of the OAT/Bund spread reflects these exact dynamics as François Fillon's hardship and Macron's love life have taken center stage. So real has been the perception of this risk that spreads on Italian and Spanish bonds have followed suit (Chart I-12). While we are inclined to lean against this move, it is a risk that investors may want to bet on or hedge against. At the current juncture, the euro is fully pricing in these developments, and no mispricing is evident. However, as our model based on real rates differentials, commodity prices, and intra-European spreads shows, if France spreads were to widen further, EUR/USD could suffer (Chart I-13). In fact, if French spreads retest their 2011 levels, the euro could fall toward parity. Chart I-12Le Pen Is Causing A Repricing ##br##Of The Euro Area's Breakup Chance Le Pen Is Causing A Repricing Of The Euro Area's Breakup Chance Le Pen Is Causing A Repricing Of The Euro Area's Breakup Chance Chart I-13The Euro Will Suffer If French ##br##Bonds Underperform Further The Euro Will Suffer If French Bonds Underperform Further The Euro Will Suffer If French Bonds Underperform Further Investors wanting to speculate on the French election but wanting to avoid taking on some USD exposure can do so by shorting EUR/SEK, a very profitable strategy when the euro crisis was raging (Chart I-14) or could short EUR/GBP, as interest rates expectations have begun to move against the common currency and in favor of the pound (Chart I-15). While EUR/CHF tends to weaken during times of euro-duress, it is currently trading close to the unofficial SNB floor and we worry that growing intervention by the Swiss central bank will limit any downside on this pair. The currency that is likely to benefit the most against the dollar remains the yen. Not only are investors still very short the yen, but based on our intermediate-term timing model, the yen remains very attractive (Chart I-16). Moreover, the recent large improvement In the Japanese inventory-to-shipment ratio only highlights that the Japanese economy has gathered momentum, decreasing the likelihood of an enlargement of the current set of ultra-stimulative measures from the BoJ. Chart I-14Short EUR/SEK: A Hedge Against Le Pen Short EUR/SEK: A Hedge Against Le Pen Short EUR/SEK: A Hedge Against Le Pen Chart I-15Downside Risk For EUR/GBP Downside Risk For EUR/GBP Downside Risk For EUR/GBP Chart I-16Yen: Biggest Winner If USD Corrects Yen: Biggest Winner If USD Corrects Yen: Biggest Winner If USD Corrects Additionally, any risk-off event caused by a correction of the reflation trade would benefit the yen. Falling commodity prices will hurt Japanese inflation expectations and lift real rate differentials in favor of the yen. A correction in the reflation trade would also put downward pressure on global bond yields, which means that due to the low yield-beta of JGBs, Japanese nominal interest rates spread would further contribute to a narrowing of real interest rate differentials in favor of the JPY. Finally, if investors begin to bet even more aggressively on a breakup of the euro area fueled by the perceived prospects of a Le Pen electoral victory, the vicious wave of risk aversion unleashed around the globe by such an event would likely support the yen beyond our expectations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please refer to the Foreign Exchange Strategy Weekly Report, "Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism", dated January 27, 207, available at fes.bcaresearch.com 2 Please refer to the Foreign Exchange/ Geopolitical Strategy Special Report, "The French Revolution", dated February 3, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 As we highlighted in previous reports, DXY's losses extended no further than the 99-100 support range, and the index has rebounded since then. A key external driver of the USD is EUR, whose roll-over has coincided with the DXY's rebound. In the coming months, EUR/USD could display downside risk as markets price in election jitters. This could be bullish for the greenback. The budget plan is in discussion. Due in around a month, the tentative plan comprises tax cuts and defense spending mostly. While this is still speculative, this plan may be bullish for the dollar. Until then, it is likely that the DXY will follow in its seasonal trend and be largely unchanged with little upside this month. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Two main factors are weighing on the euro this week. Firstly, Draghi continues to retain his dovish stance. He stated that there is still "significant degree of labour market slack", which is limiting wage growth, a key contributor to underlying inflation. Secondly, and more substantial, are politically-induced anxieties in the run up to the European elections. In particular, French elections have increased risk premia, forcing the 10-year OAT-Bund spread to reach early-2014 highs. Greek 2-year yields have also spiked above 10%. Volatility is likely to be elevated in the lead up to the French election and possibly through Italian elections. The longer-term outlook will remain dictated by the development of the ECB's monetary policy stance. Report Links: The French Revolution - February 3, 2017 GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Then yen continues to rally, with USD/JPY already down by almost 5% this year. Uncertainty surrounding the European elections should help continue this trend, given that the yen should benefit from safe haven flows. Nevertheless, the outlook for the yen remains bearish on a cyclical basis, as the measures that the BoJ has taken, such as anchoring 10-year rates near 0, and switching to de facto price level targeting will eventually lower Japanese real rates vis-à-vis the rest of the world. The BoJ has taken these measures to kick start an economy plagued by deflation. Early returns from this policy are mixed: Machinery Orders grew by 6.7% YoY, outperforming expectations. However both housing starts growth and Nikkei Manufacturing PMI fell below expectations, coming at 3.9% and 52.7 respectively. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 On Wednesday, the U.K. House of Commons finally gave their approval to a bill authorizing the government to start exits talks with the European Union. The House of Lords will be the next hurdle that Brexit hopefuls will have to overcome. Although cable suffered from some volatility following the decision it has remained relatively unaffected. We continue to think that the pound has further upside, particularly against the euro, as the negative consequences of Brexit on the British economy are already well priced into cable. Furthermore, increasing uncertainty regarding the French elections should also be bearish for EUR/GBP. If the fear of a Le Pen presidency starts to increase, Brexit will become an afterthought as exiting the European Union takes on a completely different meaning if the integrity of the EU starts being put into question. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The RBA held rates at 1.5% this week on the basis of upbeat business and consumer confidence, and above-trend growth in advanced economies. This decision helped the AUD, as investors repriced dovish bets and interpreted a change in stance. While above-trend growth is possible, Chinese demand is particularly important for Australia. Last week, the PBoC silently tightened their 7-, 14-, and 28-day reverse repo rates by 10 bps each to help alleviate looming risks in the real estate market and general financial stability. This may signal an end to an easing cycle, which may limit demand growth going forward. Australia has its own financial worries. Household debt is at its highest ever, at 186% of disposable income, which would be catastrophic if rates are raised. Lowe also highlighted concerns about a strong AUD and its impact on Australia's economic transition. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The RBNZ decided to keep interest rates unchanged at 1.75% in their monetary policy meeting this Wednesday. Additionally, as expected, Governor Graeme Wheeler stated that the RBNZ had shifted from having a dovish bias to a having neutral one. Nevertheless, the kiwi has depreciated sharply since the announcement, not only because Governor Wheeler highlighted that the currency "remains higher than is sustainable for balanced growth" but also because the RBNZ showed a cautious approach by stating that "premature tightening of policy could undermine growth and forestall the anticipated gradual increase in inflation". However, we believe that the RBNZ will turn more hawkish, as inflationary forces in the economy will eventually put upward pressure on rates. This will lift the NZD, particularly against the AUD. Report Links: Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Uncertainty has come up as a key issue in the Bank of Canada's headlights, as Poloz remains nervous about the future of U.S.-Canada relations. CAD has recently displayed some strength despite this uncertainty. It has appreciated against USD, AUD and NZD. This is likely due to a brightening perception of the Canadian economy with the Ivey PMI recording a reading above 50 for January, at 52.3, above the previous 49.3. Additionally, housing starts beat expectations, dampening housing market concerns. Exports have been strong, which has also fed into this appreciation. A rapidly appreciating currency would exacerbate trade concerns further and adversely affect the Canadian economy. Therefore, it is likely that the BoC remains tilted to the dovish side, which will generate downside for the CAD through rate differentials. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF has reached its lowest level since August 2015. At around 1.065, this cross is hovering in the lower range of the implied floor set by the SNB. Increased uncertainty caused by the upcoming European elections cycle will continue to test this floor, as the increased odds of an Eurosceptic government in France will not only decrease the value of the euro but will also put upward pressure on the franc, given its safe haven status. Nevertheless, the SNB will do everything in its power to weaken its currency as the Swiss economy continues to be plagued by deflationary forces: After showing glimpses of a recovery last month Real retail sales contracted by 3.5% YoY, falling well short of expectations. The SVMI Purchasing Manager's Index also came below expectations coming in at 54.6. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 USD/NOK has rebounded after reaching 8.20, its lowest level since Trump got elected. Interestingly, the NOK has not been as correlated with oil prices since the start of 2017 as it has been in the past. This is a trend worth monitoring. The inflation picture remains complex, although core and headline inflation have deaccelerated slightly as of late, inflation expectations are at their highest level of the last 9 years. Additionally house prices are growing at nearly 20%, a pace not seen since before the 2008 crisis. The Norges Bank is now facing a tough dilemma between risking an inflation overshoot if they keep their dovish bias or raising rates in an economy where growth for employment, real retail sales and nominal GDP is still in negative territory. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The SEK continues to duplicate the dollar's movements, rolling over slightly from the 7% appreciation it saw over a month and a half. A more accurate measure of the SEK's value, EUR/SEK, paints a similar picture. These movements have been more or less in line with the Riksbank's desired developments, as it indicates a deceleration in the pace of recent appreciation. However, we believe that the rebound in EUR/SEK is not likely to run further. Political turbulence is being priced into the euro. After sustaining near oversold levels, the rebound could be nothing more than momentum exiting from oversold territories. Nevertheless, it is likely that EUR/SEK will correct in the coming months due to European elections. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights In this report, we outline our tactical, cyclical and long term views on French government bonds, linked to France's political situation, cyclical dynamics, and structural outlook. Tactical View: Marine Le Pen does not stand a realistic chance of winning France's presidency. As policy uncertainty recedes, the government bond yield differential between France and Germany will narrow. Go long French OATs versus German Bunds. Cyclical View: French GDP growth should surprise to the upside, while inflation will at least match the consensus expectation in 2017. Both of those trends will force French bond yields higher. To express that view, move to a below-benchmark duration stance within the French component of global hedged bond portfolios. Secular View: France has been, and will probably continue to be, difficult to reform. While a pro-reform government is our expectation from the upcoming election, boosting French productivity growth will be an uphill climb. Feature Chart 1Fade The France Spread Widening Fade The France Spread Widening Fade The France Spread Widening After the stunning political victories in the U.K. and U.S. last year, there has been considerable speculation as to which country will fall next to the "populist wave." With a major political party aiming to take the country out of the Euro Area, France has naturally popped up on investors' radar screens. While it is easy to draw a parallel from Brexit to Trump to a possible "Frexit", the political and economic realities in France are very different from those in the U.K. and U.S. The upcoming presidential election will not provide a similar surprise, but could impact the economy's long trajectory. Meanwhile, this economy should beat expectations in the next twelve months. In this Special Report, we lay out our views on France from a political, cyclical and structural perspective and introduce two French bond trade ideas to benefit in the short and medium term. Tactical View: No Political Shocker Ahead In the short term (3-6 months), the domestic political landscape will dictate a large part of France's bond market price action leading up to the two-round French presidential election in April and May. Lately, political uncertainty surrounding the election has had a clear negative impact on French government bond yields (Chart 1). The spread between the benchmark 10-year French OAT and German Bund has widened 46bps off of the 2016 lows and is now close to levels seen during the Global Financial Crisis in 2008-9. The spread is still well below the wides seen during the European debt crisis in 2011-12, when markets were pricing in a serious Eurozone break-up risk. The current more moderate level seems reasonable to us, as a significantly wider spread to compensate for the political risk of a potential "Frexit" is not required, given the long odds of a Trump/Brexit-like upset victory. Last week, our colleagues at the BCA Geopolitical Strategy and Foreign Exchange Strategy services published a joint Special Report updating their view on the election, and concluded that Le Pen's odds of victory now stand at 15%.1 Either Francois Fillon (who is currently embroiled in a corruption scandal) or Emanuel Macron will win the French presidency, both of whom are running on structural reform platforms that should be market friendly. Moreover, Marine Le Pen has only a long-shot possibility to win the French presidential election, for several reasons:2 Assuming Le Pen becomes one of the final two candidates in the run-off election after the first round of voting in April, her probability of winning is low, as she continues to trail her centrist opponents by a massive 20% in the polls. That lead would have to fall to 3-5%, within the margin of error of the polling data, before investors would have to worry seriously about a Le Pen victory. Le Pen's personal approval rating peaked in 2012 (Chart 2). It fell despite the European refugee crisis, multiple terrorist attacks in France, and sluggish economic growth over the past two years, all of which should have helped boost her popularity. The problem for Le Pen is that 70% of the French support the euro (bottom panel), and she is running on an explicit campaign promise to try and pull France out of the euro if she wins the presidency. Leaving the euro area would mean a redenomination cost for Baby Boomer retirees, higher interest rates, higher inflation, and a likely economic recession. Judging by the high level of support for the euro, we suspect that the French population understands these risks. Given BCA's relatively sanguine view of the true political risks of the French election, the recent spread widening represents a tactical trade opportunity to go the other way and position for French outperformance. A Le Pen defeat will cause French policy uncertainty to recede and French bond yields will converge back to German levels. Vanishing uncertainty and lower bond yields will further fuel the current economic recovery, as explained in the next section. Bottom Line: Marine Le Pen does not stand a realistic chance of winning France's presidency. As policy uncertainty recedes, the government bond yield differential between France and Germany will narrow. Go long French OATs versus German Bunds on a tactical basis (a trade we are adding to our Overlay Trades list on Page 20). Cyclical View: An Outperforming Economy Over the medium-term (6 to 12 months), the cyclical dynamics of French growth and inflation, as well as potential shifts in Euro Area monetary policy, will drive the evolution of French bond yields. On this basis, there is room for French yields to rise in absolute terms. Current pricing in the French forward curve has the 10-year government bond yield reaching 1.40% by the end of 2017, up 26bps from the current level. That yield target will be easily exceeded based on the budding upturns in French economic growth and inflation. A low growth hurdle to overcome The Bloomberg survey of economists currently pencils in a French GDP growth forecast of 1.3% in 2017, almost unchanged from 1.2% in 2016. That figure should be surpassed, in our view. The current situation component of the French ZEW economic sentiment survey has spiked recently but still sits far from previous peaks (Chart 3). As this unfinished economic cycle progresses, growth will drift inevitably higher. Chart 2Le Pen Is Not So Well-Liked Le Pen Is Not So Well-Liked Le Pen Is Not So Well-Liked Chart 3An Un-finished Cycle An Un-finished Cycle An Un-finished Cycle More specifically, the business sector could positively surprise in 2017. Business sentiment and industrial production already started to hook upward toward the end of 2016, and the December surge in the French Manufacturing PMI signals that the economy is accelerating. Even the previously lagging French service sector PMI has now caught up to the Euro Area average (Chart 4). This upturn looks very well supported. Firms' order books have been replenished, and corporations are now in a position to hike prices, indicating that pricing power has returned (Chart 5). This is a crucial development, it will allow for further increases in corporate profit margins, and, in turn, give them some leeway to lift wages, hire more workers and/or invest anew. Chart 4A Solid Economic Upturn A Solid Economic Upturn A Solid Economic Upturn Chart 5Improving Business Sector Outlook Improving Business Sector Outlook Improving Business Sector Outlook Moreover, business cycle dynamics should then boost consumption. An improving labor market has already translated into confidence-building momentum among households. Consumers' disposable income growth has risen steadily, while households' intentions to make important purchases have reached levels not seen since before the Global Financial Crisis (Chart 6). Also, labor slack is diminishing in France, with the number of job seekers falling for the first time in a decade (bottom panel). If French households remain upbeat, the broader economy should do well. Historically, the INSEE survey of households' assessment of the future economic situation has been closely linked to GDP growth. Advancing that series by three months clearly shows that France's growth is set to accelerate. Using a simple regression, growth could reach a 1.7% year-over-year pace in the first half of 2017 (Chart 7). Chart 6Better Fundamentals For French Consumers Better Fundamentals For French Consumers Better Fundamentals For French Consumers Chart 7GDP Will Beat Expectations GDP Will Beat Expectations GDP Will Beat Expectations One note of caution on this optimistic French economic outlook comes from capital spending. The elevated political uncertainties from the upcoming election, as well as the potential U.K.-E.U. Brexit negotiations, have left French firms less inclined to expand business through increased investments. However, robust activity in the housing market should support overall gross fixed capital formation, as housing permits sprang to life in 2016 (Chart 8). To ensure that this economic expansion gains momentum, ample credit growth will be paramount. This could be a potential headwind, as France's non-financial private sector credit has reached high levels, especially compared to its European peers (Chart 9). These excesses could act as a speed limit on the overall economy, at some point. Chart 8Housing To Support Overall Capital Formation Housing To Support Overall Capital Formation Housing To Support Overall Capital Formation Chart 9Private Non-Financial Leverage: High Private Non-Financial Leverage: High Private Non-Financial Leverage: High However, in the current cycle, this doesn't seem to be the case. Both money and loan growth are accelerating after several years of weakness (Chart 10, top panel). The ECB's Bank Lending Survey, which shows slowly increasing demand for credit (middle panel) and no tightening of lending standards (bottom panel) will help fuel this trend.3 The central bank's loose overall monetary stance will keep this positive credit impulse alive over the course of the year, while also helping exports by keeping the Euro weak. Finally, on the fiscal side, the IMF projects France's cyclically-adjusted primary budget balance to go from -0.6% of potential GDP in 2016 to -0.7% in 2017, representing a fiscal thrust of +0.1% (Chart 11). This modest number will obviously not supercharge the current cycle, but does represent a big change from the years of austerity since the last recession. Chart 10A Positive Credit Impulse A Positive Credit Impulse A Positive Credit Impulse Chart 11No More Austerity No More Austerity No More Austerity Building inflationary pressure The Bloomberg consensus forecast calls for French consumer price inflation to reach 1.2% in 2017, a modest advance from the current rate of 0.7%. That level should be reached, and likely surpassed, as most inflation measures have already entered an expansionary phase (Chart 12). That trend should persist in 2017 for several reasons: First, French unemployment will soon fall below the non-accelerating inflation rate of unemployment (NAIRU), which typically results in a rise in French underlying CPI inflation soon afterward (Chart 13). Chart 12Inflation Moving Higher Inflation Moving Higher Inflation Moving Higher Chart 13France Is Close To Full Employment France Is Close To Full Employment France Is Close To Full Employment Second, current French inflation appears about half a percentage point too low relative to the unemployment rate, based on the Phillips curve relationship since 2000 (Chart 14). Chart 14Inflation Should Be Higher Our Views On French Government Bonds Our Views On French Government Bonds Third, our French CPI diffusion index is well off the cyclical lows and points towards higher underlying inflation in the months ahead (Chart 15).4 In sum, French inflation will follow, and likely exceed, the current consensus expectation of 1.2%. This is important to appreciate, as inflation was a more important driver of higher nominal bond yields, relative to the real yield component, last year (Chart 15, bottom two panels). There is more to come in 2017. How to position for this view? In terms of valuation, French government bonds still appear quite expensive. Our bond valuation indicator shows that yields remain well below fair value, even after the recent backup (Chart 16). Combine this with our optimistic view on French growth and inflation, and investors should move to reduce duration within the French component of hedged global bond portfolios. Today, we open a new position in our model fixed income portfolio: reducing the exposure in the longest duration (+10 years) bucket in France, and placing the proceeds in the 1-3 year France bucket. This combination will lower our overall French duration exposure by one full year. If yields finish the year higher than currently priced on the forward curve, as we expect, this position will contribute positively to the excess return versus our benchmark. Bottom Line: French GDP growth should surprise to the upside, while inflation will at least match the consensus expectation in 2017. Both of those trends will force French bond yields higher this year. To express that view, move to a below-benchmark duration stance within the French component of global hedged bond portfolios. Chart 15Rising Inflation Will Push Yields Even Higher Rising Inflation Will Push Yields Even Higher Rising Inflation Will Push Yields Even Higher Chart 16French Bonds: Still Expensive French Bonds: Still Expensive French Bonds: Still Expensive Secular View: A Structural Ceiling On French Yields In the very long run (5 to 10 years), structural considerations are needed to forecast bond yields. Ten years ago, the French forward yield curve was implicitly forecasting that the 10-year French bond yield would be close to 4% today. Currently standing at 1.13%, the market missed the mark by 287bps! The forwards are now priced for the 10-year bond yield to reach 2.84% in ten years, possibly making the same mistake of over-estimating future bond yields. To gauge a fair value of the 10-year bond yield, using nominal potential GDP growth has proved to be useful in the past. From 2004 to 2014, and before the deflationary shock experienced since, France's 10-year bond yield was indeed trading very close to growth in French nominal potential GDP (Chart 17, shaded portion). Chart 17Low Potential Growth Is A Long-Term Cap On French Yields Low Potential Growth Is A Long-Term Cap On French Yields Low Potential Growth Is A Long-Term Cap On French Yields As inflation will most likely return to more "normal" levels in the next few years, the relationship between the two should be reestablished soon. If so, the current 2.84% level on the 10-year French government bond yield, 10-years forward should translate to a nominal potential growth rate of around 2.8% in ten years' time (Chart 17). This outcome would represent an 80bp increase in the rate of trend French nominal potential growth from current levels, which could be difficult to achieve, in our view. Lots of work to do... Most likely, France's nominal potential growth will only slowly grind lower. Faster potential growth could be achieved either through increasing demographic growth or improving productivity. Unfortunately, neither outcome appears imminent. Since the French working age population is already expanding at a very slow pace, and is projected to decelerate in the years ahead, productivity increases are the only candidate to improve potential growth. On that front, a lot needs to be done; many structural weaknesses in the French economy have to be addressed. For years, France has been plagued by weak productivity, which has constrained growth. Compared to its European peers, inefficient use of available capital has led to a loss of competitiveness through higher unit labor costs. Clearly, France needs to improve workers' skills to lift total factor productivity growth (Chart 18). This will become increasingly difficult as France now faces - more than ever - difficulty attracting and retaining talent due to the recent turmoil that has hit the country such as the terrible rise in terrorist attacks. At the source, the poor productivity performance in France is grounded in the overly protective employment system. Like other European countries, high employment costs have led to misallocation of capital, potentially affecting the optimal capital labor input mix and total factor productivity.5 Indeed, friction in the labor market is often cited as the source of the problem. We tend to agree. French workers work too few hours, even fewer than in the Peripheral European economies. As the divide between the unemployment rate of persons under and over 25 years old gets larger, resolving the growing generational disparities has become paramount. Plus, upward mobility opportunities are scant - not everyone gets an equal chance to rise in status in French society (Chart 19). Chart 18Productivity Unlikely To Lift Potential Growth Productivity Unlikely To Lift Potential Growth Productivity Unlikely To Lift Potential Growth Chart 19Friction In The Labor Market Friction In The Labor Market Friction In The Labor Market Recent reforms have the potential to fix some problems. The Pacte de Responsabilité et Solidarité (PRS) and the Crédit d'impôt compétitivité emploi (CICE) should help reduce unit labor costs through a reduced labor tax wedge.6 The Macron Law could raise real GDP growth by 0.3 percent per year through 2020, according to the OECD. However, the effectiveness might be fleeting in some other cases. For example, studies by the IMF suggest that the El Khomri Law - aimed at making the labor market more flexible - might have little impact on overall French unemployment, potentially reducing it by only 0.14 percentage points.7 Meanwhile, France's enormous public sector continues to crowd out the private sector. At 54% of GDP, government expenditures are simply too big, forcing the government to tax profits at a whopping 63% rate. This leaves little space for national savings - which now sit at a lowly 21.4% of GDP - to increase (Chart 20). Additionally, France ranks 115th out 136 countries in the Global Competitiveness Report in terms of the burden of government regulation, which further constrains productivity-enhancing investments.8 In sum, boosting potential GDP growth will remain an uphill battle. Everyone agrees that reforms are necessary. But will they happen? ...and France still has a tough crowd to win over It is not impossible that the next president will have a serious structural reform agenda. For example, the most reformist presidential contender, Francois Fillon, has made these proposals in his campaign platform: Abandon the national limit on weekly hours worked and leave that decision to individual companies; Decrease corporate taxation; Allow companies to fire employees when undergoing structural/managerial changes; Extend the retirement age; Cut public spending; Reduce the size of the state by cutting government employees. From a structural perspective, these measures would surely be promising for the future, and would lift French potential GDP growth over time. However, in the populist world we live in, we are skeptical that the electorate will give him an unambiguous mandate of this sort. That kind of mandate usually comes after a crisis, not before. More pain might be needed. Chart 20France's Government: Crowding Out The Private Sector France's Government: Crowding Out The Private Sector France's Government: Crowding Out The Private Sector Chart 21"Silent Majority" Wants Reform Our Views On French Government Bonds Our Views On French Government Bonds Moreover, reforming France has always proved very challenging. As such, will Mr. Fillon (or Mr. Macron) really be able to comply with his campaign promises, if elected? Winning a majority at the parliamentary election would be a necessary precondition. Although every President has been given a parliamentary majority since 2002, the elections have not happened yet. Confronting the unions on these measures will prove difficult for the next French president. The latest labor market reform push unveiled last year was met with massive resistance. Surely, deregulation that makes it easier to fire workers will inevitably dissatisfy insiders that benefit from high barriers to entry for new employees. This obstacle will be difficult to remove. In any case, it has always been puzzling why things have to be this way in France. According to economists Yann Algan and Pierre Cahuc, one possible response might lie in the French tendency to distrust their fellow citizen. Their theory, introduced more than ten years ago, posits the following: ...the French people's lack of trust gets in the way of their ability to cooperate, which brings the State to regulate work relations in minute detail. By emptying social dialogue of its content, these interventions prevent the adoption of favorable reforms to improve the function of the job market. Distrust even induces a fear of competition, leading to the set-up of regulatory barriers-to-entry, that create rent-seeking which favors corruption and mutual distrust. The French social model fosters a truly vicious circle. Corporatism and state intervention undermine the mechanisms of solidarity, destroy social dialogue and reinforce mutual distrust - that which in turn feeds categorical demands and the constant call for regulation, and thereby favors the expansion of corporatism and state intervention.9 Of course, their angle on things could sound somewhat extreme. But it might also explain why the issues discussed ten or twenty years ago concerning France's predicament remain mostly the same today. There might be something else besides pure rational thinking at play behind the French citizenry's propensity to stiff-arm reforms. Nonetheless, if these authors are correct, true changes will continue to be hard to come by in France. Meaning this invisible hand of distrust will continue to lead potential GDP growth lower, and, as history dictates, will represent a ceiling on how high long-term French bond yields can ever rise. That said, maybe our view could prove to be too backward looking. The new report co-written by our Geopolitical Strategy and Foreign Exchange Strategy teams takes a more optimistic view on the chances of French economic reform. They argue that France's recent economic underperformance will motivate its citizens to demand real action from their politicians, as occurred in Australia during the mid-1980s and 1990s and Germany in the 2000s - episodes of real structural reform occurring without any dramatic crisis to prompt them. A desire to compete with Germany economically, combined with government spending excesses and protest fatigue, could be leading France to elect a pro-reform government. As the French polling data shows, there is a "silent majority" in France that would favor supply side reforms (Chart 21). Plus, even those that traditionally favor the status quo, like "blue collar" and "left leaning" employees, are opposing reforms by extremely narrow margins. Undoubtedly, our colleagues raise very good points. As such, we will be watchful to see if reforms gain a greater chance of meaningfully transforming France in the next few years. The onus will be on the reformers to change the system. Bottom Line: France has been, and will probably continue to be, difficult to reform. While a pro-reform government is our expectation from the upcoming election, boosting French productivity growth will be an uphill climb. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy/Foreign Exchange Strategy Special Report, "The French Revolution", dated February 3, 2017, available at gps.bcaresearch.com and fes.bcaresearch.com 2 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?", dated November 16, 2016, available at gps.bcaresearch.com 3 https://www.ecb.europa.eu/stats/pdf/blssurvey_201701.pdf?6c44eff3bac4b858969b9cb71bd4a8fa 4 The diffusion index is the percentage of sectors within the French Consumer Price Index that are growing faster than their 24-month moving average. This indicator leads underlying inflation by 10 months. 5 For further details on this idea, please see "Employment Protection Legislation, Capital Investment and Access to Credit: Evidence from Italy", available at https://ideas.repec.org/p/sef/csefwp/337.html 6 https://www.imf.org/external/pubs/cat/longres.aspx?sk=44080.0 7 https://www.imf.org/external/pubs/cat/longres.aspx?sk=44081. 8 http://www3.weforum.org/docs GCR2016-2017/05FullReport TheGlobalCompetitivenessReport2016-2017_FINAL.pdf 9 http://voxeu.org/article/france-price-suspicion and more on these authors theory on the impact of trust on economic development can be found here: http://econ.sciences-po.fr/sites/default/files/file/yann%20algan/HB_FinalVersion1.pdf The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Our Views On French Government Bonds Our Views On French Government Bonds Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights France is on the verge of pro-market structural reforms; Marine Le Pen will not win the presidency. Her odds are 15%; The French economic upswing will continue to surprise; Overweight French stocks relative to German; Buy the euro on any election-related dip. Feature Le courage consiste à savoir choisir le moindre mal, si affreux soit-il encore. - Stendhal La France ne peut être la France sans la grandeur. - Charles de Gaulle Every decade, a country defies stereotypes and surprises investors with ambitious, pro-market and pro-business, structural reforms (Chart 1). Margaret Thatcher's laissez-faire reforms pulled Britain out of the ghastly 1970s and into the wild 1980s. Sweden surprised the world in the 1990s when voters turned against the generous social welfare system under the stewardship of the center-right Moderate Party. At the turn of the century, Germany's Social Democratic Party (SPD) defied its own label and moved the country to the right of the economic spectrum. Finally, this decade's reform surprise is Spain, which undertook painful labor and pension reforms that have underpinned its impressive recovery. What do all of these episodes have in common? Investors - and the public at large - didn't see them coming. Our favorite example is the Hartz IV labor reforms in Germany. The SPD government of Gerhardt Schröder completely re-wired Germany's labor market, leading to the export boom that has lasted to this day (Chart 2). And yet The Economist welcomed the Schroeder government with a scathing critique that is a textbook example of how the media often confuses stereotyping for data-driven analysis.1 Chart 1Each Decade Has A Reform Surprise Each Decade Has A Reform Surprise Each Decade Has A Reform Surprise Chart 2The German Miracle The German Miracle The German Miracle We think that this decade will belong to France. Yes, France. While the dominant narrative today is whether Marine Le Pen will win the presidential elections on April 23 (with a possible runoff on May 7), we think the real story is that the two other serious candidates are pro-growth, pro-reform, pro-market candidates. François Fillon and Emmanuel Macron are both running platforms of structural reforms. They are not hiding the fact that the reforms would be painful. On the contrary, their campaigns revel in the self-flagellation narrative. Most of our clients either politely roll their eyes when we present this view or counter that the French are ______ (insert favorite stereotype). We welcome the pessimism! It shows that the market is not yet pricing in a pro-market revolution that guillotines a long list of French inefficiencies. In this analysis, we present what is wrong with France, whether the presidential candidates running in the election plan to fix the problems, and our view of who is likely to win. Forecasting elections is a Bayesian process, which means that the probabilities must be constantly updated with new information. As such, we intend to keep a very close eye on the developments in the country over the next four months. What Is Wrong With France? France has a growth problem. While this is partly a cyclical issue, the reality is that its real per-capita GDP growth has been closer to Greek levels than German over the last two decades (Chart 3). In addition, France has lost competitiveness in the global marketplace, judging by its falling share of global exports relative to peers (Chart 4). Chart 3France's Lost Millennium The French Revolution The French Revolution Chart 4Export Performance Is A Disaster Export Performance Is A Disaster Export Performance Is A Disaster Three issues underpin the French malaise of the past two decades: The state is too large; The cost of financing the large state falls on the corporate sector; The labor market is inflexible. First, the French state relative to GDP is the largest in the developed world. In 2016, public spending was estimated to be 56% of GDP, compared with 44% of GDP in Germany and just 36% in the U.S. (Chart 5)! What is most concerning is that the state has actually grown in the past two decades from already unsustainable levels (Chart 6). Government employment as share of total employment is naturally very high (Chart 7). Chart 5The French State Is Large... The French Revolution The French Revolution Chart 6... And Continues To Be In Charge The French Revolution The French Revolution Chart 7French Talent Is Wasted In The Public Sector The French Revolution The French Revolution Such a large public sector requires very high levels of taxation. Government tax revenues are also second-largest in the developed world at 45% of GDP (Chart 8) and, like the size of the overall public sector, continue to grow (Chart 9). Chart 8French Tax Burden Is Large... The French Revolution The French Revolution Chart 9...And Growing The French Revolution The French Revolution Part of the problem is the labyrinth of administrative layers beneath the central government. France has 13 regional governments, 96 departments, 343 arrondissements, 4,058 cantons, and 35,699 municipalities.2 What do they all do? We have no idea. Reforms in 2015 have sought to reduce the number of sub-federal layers, but the process ought to go much further and faster. The French social welfare state is also inefficient. To be fair, it has kept income inequality in check, which has not been the case in more laissez-faire countries (Chart 10). This is an important part of our political analysis. French "socialism" is what keeps populism at bay, which was the intention of the expensive welfare state in the first place.3 However, there is a lot of room to trim the fat. The French welfare state is essentially an "insurance program" for the middle class, with more transfers going to the households in the top 30% income bracket than in the bottom 30% (Chart 11)! France could cut its massive social spending by means-testing the benefits that accrue to the upper middle class.4 Somebody ultimately must pay for the enormous public sector. In France, a large burden falls on employers. The French "tax wedge" - the difference between the cost of labor for the employer and the take-home pay of the employee as a percent of total remuneration - is one of the largest in the OECD (Chart 12). The heavy tax burden on employers, combined with a relatively high minimum wage, means that business owners are wary of hiring new workers. The tax wedge is ultimately passed on to the consumer by businesses, which hurts competitiveness and contributes to the poor performance of French exports.5 Chart 10A Positive: ##br##No Income Inequality A Positive: No Income Inequality A Positive: No Income Inequality Chart 11French Welfare State##br## Protects...The Rich! The French Revolution The French Revolution Chart 12Employees Are Too Expensive ##br##For Employers The French Revolution The French Revolution The French labor market remains inflexible and overprotected (Chart 13), which not only hurts competitiveness but also discourages youth employment (Chart 14). According to the OECD Employment Protection Index, both regular and temporary contracts have some of the highest levels of protection in the developed world. Germany actually has a higher level of protection in regular contracts, but not in temporary employment, thanks to ambitious reforms. Chart 13French Labor Market##br## Is Too Rigid The French Revolution The French Revolution Chart 14French Youth Underperforms ##br##OECD Peers The French Revolution The French Revolution Chart 15Starting A Business In France? ##br##Bonne Chance! The French Revolution The French Revolution Finally, France suffers from too much red-tape (Chart 15), too much regulation (Chart 16), high wealth taxes that force capital out of the country, and too many barriers to entry for medium-sized enterprises, the lifeblood of innovation and productivity gains (Chart 17). Part of the reason that France suffers from a lack of German-styled Mittelstand (small and medium-sized enterprises) is that the effective tax rate of the medium-sized businesses is greater than that of large enterprises (Chart 18). This is a problem given the already high levels of corporate tax rates in the country (Chart 19).6 Chart 16Too Much Regulation The French Revolution The French Revolution Chart 17France Needs A Mittelstand The French Revolution The French Revolution François Hollande's government tried to address many problems facing France. However, Hollande largely spent his term treating the symptoms and not trying to cure the disease. France can reduce regulatory barriers and tinker with labor flexibility. It can even shift the tax burden from employers to consumers. But the fundamental problem is the large state, which forces the government to raise lots of taxes one way or another. Chart 18French SMEs Are Punished ##br##With High Taxes The French Revolution The French Revolution Chart 19French Corporate Taxes ##br## Are High By European Standards The French Revolution The French Revolution Bottom Line: The French state is too big. Up to this point, reforms have largely focused on tinkering with how the government raises funds for the welfare state. But what France needs is to alleviate the tax burden in the first place. The state, therefore, must be cut. Why Will France Reform? Our clients and colleagues challenge our view on France by rightly pointing out that painful structural reforms are easiest following a "market riot" or deep recession. Neither has befallen France. It actually did remarkably well in weathering the 2008 Great Recession, compared to OECD peers, and it has not faced the extraordinary housing or unemployment busts of neighboring Spain. Yet crises are not necessarily a must for successful reforms. Australia, starting in the mid-1980s and throughout the 1990s, pursued broad-based reforms due to a prolonged period of mediocre growth.7 So did Germany in the 2000s. We think that it is precisely this underperformance that is today motivating France. In particular we see three broad motivations: Competition with Germany: France did not lead the creation of European institutions in the twentieth century in order to cede leadership to Germany. As Charles de Gaulle said, "France is not France without greatness." The economic underperformance versus Germany is not geopolitically sustainable (Chart 20). If France continues to lose economic ground to Germany, it will continue to play second-fiddle to Berlin in the governing of the EU. At some point, but not likely in 2017, this will reinforce the populist logic that France should go it alone, sans the European institutions. Change impetus: It is difficult to imagine how François Fillon and Emmanuel Macron can run on an anti-establishment, "change" platform. Fillon proudly calls himself a Thatcherite (in 2017!) and Macron is a former Rothschild investment banker. And yet they are doing so. This is especially astonishing after the successes of Donald Trump and the Brexit campaign, which specifically targeted elitist policymakers like Fillon and Macron. But in France, the status quo is a large state, dirigiste economy, and a generous welfare system. In other words, the French are turning against their status quo. Laissez-faire is change in France. Social welfare fatigue: Our colleague Peter Berezin argued in a recent Special Report that Europeans will turn against the welfare state due to the breakdown in social cohesion. Significant populations of immigrant descent - as well as recent arrivals - fail to properly integrate in countries where the welfare state is large.8 Resentment against immigrants, and citizens of immigrant descent, could therefore be fueling resentment against the expensive welfare state. Chart 20France Is Not France Without Greatness France Is Not France Without Greatness France Is Not France Without Greatness Chart 21"Silent Majority" Wants Reform The French Revolution The French Revolution Polls suggest that we are on to something. Chart 21 illustrates that there may be a Nixonian "silent majority" in France favoring supply side reforms. Per January 2017 polling, "blue collar" and "left leaning" employees oppose reforms. But surprisingly by extremely narrow margins (Chart 21, bottom panel)! Thus, there is demand for structural reforms, but is there supply? According to a review of the platforms of Macron and Fillon, we think the answer is a resounding yes (Table 1). Generally speaking, François Fillon's proposed reforms are the deepest, but Macron would also pursue reforms aimed at reducing the size of the state. Marine Le Pen, too, promises to reduce the size of the public sector, suggesting that the narrative of reform is now universal. However, it is not clear how she would do so. Her views on the EU and the euro are also not positive for growth or the markets, as they would precipitate a recession and an immediate redenomination crisis. As we discuss below, it is likely that her opposition to European integration is precisely what is preventing her from being a much more competitive opponent against Fillon and Macron in the second round. Table 1French Presidential Election: Policy Positions Of Chief Contenders The French Revolution The French Revolution What of implementation? In France, several reform efforts - the 1995 Juppé Plan, 2006 labor reforms and 2010 Sarkozy pension reforms in particular - prompted significant social unrest. However, unrest is having diminishing returns for unions and left-wing activists. While unrest forced the government to fully reverse both the 1995 Juppé Plan and the 2006 labor reforms, it did not manage to hold back retirement reforms in 2010. The Sarkozy government made some concessions, but the core of the reforms remained in place despite severe unrest that brought the country to a standstill. Most recently, in spring 2016, the El Khomri law - proposing modest changes to the French labor code - was rammed through by Prime Minister Manuel Valls using Article 49.3 of the French constitution. Despite significant unrest, the law passed and became law in August. Protests remained peaceful - unlike the 2010 unrest - and eventually fizzled out. Investors should not be afraid of unrest. Unrest is a sign that reforms are being enacted. We would be far more concerned if the election of Fillon or Macron did not lead to strikes and protests! That would be a sign that their reform efforts are not ambitious. But our review of the unrest and strikes in France since 1995 suggests that the last two events - in 2010 and 2016 - ultimately did lead to reforms. In addition, most significant international reform efforts lead to protests. The U.K. miners' strike (1984-85) led to over 10,000 arrests and significant violence. German labor reforms in the 2000s led to a spike in strikes. And the 2011 Spanish reforms under PM Rajoy led to the rise of Indignados, student protesters occupying public spaces, who ultimately gave the world Occupy Wall Street. When it comes to reforms, the adage "no pain, no gain" rings true. Most effective reforms, however, will come right after the election. The incoming president will have about 12 months to convince investors that he is serious about reforms, as this is when the new government has the most political capital and legitimacy for reforms. In addition, much will depend on whether Fillon and Macron have parliamentary majorities with which to work to enact reforms. France's parliamentary election will follow the presidential (two rounds, June 10 and 17). Every president has managed to gain the majority in parliament since the two elections were brought to the same year (2002). Macron's new third party - En Marche! - will likely struggle to gain a foothold in the parliament, even if he wins. However, we suspect that both Les Républicains and centrist members of the Socialist Party will support his reforms. Macron's reforms are more modest than Fillon, at least according to Table 1 and his rhetoric, but they would still be a net positive. Ultimately, investors will have plenty of opportunity to reassess the reform efforts as the new government proposes them. In this analysis, we have sought to simplify what we think is wrong with France. If the government does not address our three core issues - how big is the state, how the state is funded, and the flexibility of the labor market - then we will know that our optimism was misplaced. Bottom Line: We believe that the support for reform exists. A review of electoral platforms reveals that all three major candidates are promising reforms that reduce the size of the French state. This can only mean that French politicians recognize that the "median voter" wants it to be reduced.9 Can Le Pen Win? Although Marine Le Pen, leader of National Front (FN), wants to reduce the size of the state as much as her counterparts, her broader approach poses an obvious risk to the stability of France, Europe, and potentially the world. Her position on the EU and the euro is extreme. She seeks to replace the EU with a strategic alliance with Russia, that she thinks would then include Germany. In the process, the euro would be abandoned. The extreme nature of Le Pen's proposals may ironically increase the likelihood of pro-market reforms in France. François Fillon's problem - aside from the ongoing corruption scandal involving his wife - is that 62% of the French public believes that "his program is worrisome."10 He may therefore win purely because Le Pen's proposal of dissolving the EU and the euro is even more worrisome. What are Le Pen's chances of overcoming the population's fear of abandoning the euro and EU institutions? We think they are very slim. Fillon's corruption scandal could grow, but we think that it is too little too early. With three months ahead of the first round, the spotlight on Fillon may have come too soon. Meanwhile, Le Pen's FN is not without skeletons in her closet. The party's main financial backer has been a Russian bank whose license was revoked by Russia's central bank in June. Le Pen refuses to disclose the details of her campaign funding, unlike Fillon and Macron.11 So what are the chances of a Le Pen presidency? Following the U.S. election, many of our clients wonder where populism will triumph next. In meetings and at conference panels, clients ask whether Marine Le Pen can replicate the success of Donald Trump and the anti-establishment Brexit campaign. Our view has not changed since our Client Note on the topic last November: Le Pen has a very low probability of winning.12 Our subjective figure is 15%. This view is not necessarily based on the strength of her opponents. In other words, if François Fillon stumbles in the first round, we believe that Emmanuel Macron will win in the second round. Our view is focused more on the structural constraints that Le Pen faces. There are three reasons for this view: The Euro The French support the euro at a high level. Marine Le Pen wants to take France out of the euro. Thus, her popularity is inversely correlated with the support for the euro (Chart 22). Euro support bottomed in France in 2013 at 62%, the same year when Le Pen's popularity peaked at 36%. The populist and nationalist Le Pen has not regained her 2013 levels of support despite a massive immigration crisis in Europe and numerous terrorist attacks against French citizens. This is surprising and important. Chart 22The Euro Is Le Pen's Foil The Euro Is Le Pen's Foil The Euro Is Le Pen's Foil The only way we can explain her lackluster performance in the face of crises that should have helped her popularity is her ideological and rhetorical consistency on the euro. For several different reasons,13 the French public supports the common currency as well as the EU - like most Europeans. Le Pen's insistence on "Frexit" is a major hurdle to her chances of winning. The Polls Before we dive into the French presidential polls we should remind our readers of our view that polls did not get Brexit and Trump wrong. Pundits, the media, and data-journalists did. Polls were actually showing the Brexit camp ahead throughout the first two weeks of June. It was only once MP Jo Cox was tragically murdered on June 16 that polls favored the "Stay" vote for the final days of the campaign. Yet on the day of the vote, the "Stay" camp was ahead by only 4%. That should not have given investors the level of confidence they had in the pro-EU vote. The probability of Brexit, in other words, should have been a lot higher than the 30% estimated by the markets (Chart 23). Chart 23ASmart Money Got Brexit Wrong... Smart Money Got Brexit Wrong... Smart Money Got Brexit Wrong... Chart 23B...Despite Close Polling ...Despite Close Polling ...Despite Close Polling Similarly, the national polls in the U.S. election were not wrong. Rather, the pundits and quantitative models overstated the probability of a Clinton victory. What the modelers missed was the unfavorable structural backdrop for Clinton: the challenges associated with one party holding the White House for three terms, lackluster economic growth, lukewarm approval ratings for Barack Obama and his policies, and general discontent, partly signaled by the non-negligible polling of third-party challengers. In addition, the modelers ignored that American polls have a track record of underestimating, or overestimating, performance by about 2-3% (Chart 24). And crucially, the 2016 election was different in that the number of undecided voters at the cusp of the vote was nearly triple the average of the previous three elections (Chart 25). Chart 24Election Polls Usually Miss By A Few Points The French Revolution The French Revolution Chart 25Undecided Voters Decided The Election Undecided Voters Decided The Election Undecided Voters Decided The Election The polls were much closer, in other words, than the dominant media narrative revealed. With four months until the election, Donald Trump actually took a slight lead against Hillary Clinton, following the July GOP convention. In aggregate polling, he never trailed Clinton by more than 7% from that point onwards (Chart 26). With four months until the second round of the French election in May, Marine Le Pen is trailing her two centrist opponents by 20-30% (Chart 27)! In other words, Trump at this point in the campaign was roughly three times more competitive than Le Pen! Chart 26Le Pen Is No Trump Le Pen Is No Trump Le Pen Is No Trump Chart 27Second Round Polls Are All That Matters The French Revolution The French Revolution We will therefore agree with the narrative that Le Pen could be the next Trump or Brexit when she starts performing in the polls as well as Trump and Brexit! Right now, she is nowhere close to that. Could Marine Le Pen close the gap in the next four months? It is unlikely. Le Pen is not a political "unknown" like Trump. She is not going to "surprise" voters into voting for her in 2017. She was her party's presidential candidate in the 2012 election. Her father, Jean-Marie Le Pen, contested elections in 1988, 1995, 2002, and 2007. The National Front has contested elections in France since the 1970s. Voters know what they are getting with Le Pen. The best-case scenario for Le Pen is that Fillon gets into the second round, and then during the two-week interval between the first and second rounds (April 23, May 7) more corruption is revealed by Fillon and his popularity tanks. This is the "Clinton model" and it is certainly plausible. But it would have to be egregious corruption given that Le Pen's popularity ceiling appears to be the same percentage of French population not in favor of the euro. We suspect that this ceiling is hard. Which is why we have Le Pen's probability of winning the election at only 15%. In addition, there is no vast pool of the undecided in France. French turnouts for the presidential election are consistently 80%. Therefore, translating polling data to actual turnout data will be relatively straightforward. The polls are real. Le Pen may be able to outperform her polls by several points. But not by the 20-30% by which she trails Fillon and Macron in polling for the crucial second round. In fact, Le Pen could even struggle to get into the second round given that the winner of the Socialist Party primary - Benoit Hamon - could bleed left-wing voters away from Le Pen, leaving Fillon and Macron to enter the second round instead. At that point, the election becomes a coin toss between two reformers, but we would give the less "worrisome" Macron a slight edge. Precedent History is important because there is a precedent for solid Euroskpetic performances in France. In fact, Euroskeptic candidates - broadly defined - have won around 32% of the vote in the first round of the presidential election since 1995 (Chart 28). As such, Le Pen's current polling in the first round - 26% level of support - and second round - 37% of support - is within the historical average. It is on the high end, but still within the norm. Her father, for example, got 17% in the first round of the 2002 election and 18% in the second. Chart 28French Euroskepticism ##br##Is Not A Novel Concept The French Revolution The French Revolution We also have a very good recent case study - a natural experiment if you will - of the anti-establishment's electoral performance: the December 2015 regional elections. The two-round regional elections occurred only 23 days following the November 2015 terrorist attack in Paris and at the height of that year's migration crisis. They should have favored the Front National (FN). They also should have favored the FN for these technical and political reasons: Rules: The second round in the regional elections has a participation threshold of 10%, unlike the presidential and parliamentary elections which eliminate all but the top two candidates. This means that FN faced off against multiple candidates, reducing the probability that "strategic voting" drove centrist voters to choose the one remaining establishment candidate over the anti-establishment candidate, as will be the case in the upcoming presidential election. Protest vote: The regions of France have no authority to negotiate international treaties. As such, voters could freely vote for the anti-establishment FN as a sign of protest, without fear that the FN councilors would then take the country out of the euro and the EU. Voters faced no clear downside risk of sending a harsh message to the establishment. Context: Both the ruling Socialists and the opposition Union for a Popular Movement (now renamed Les Républicains) were in disarray ahead of the regional elections for a number of reasons, including the aforementioned terrorist attacks, unpopularity of President Hollande, leadership struggle within UMP, and EU mismanagement of the migration crisis. The National Front ended the first round with a slight lead in total votes, but captured the lead in six out of the 13 regions. The financial press went wild, calling it an extraordinary win for the anti-establishment in France. Yet despite the near optimal circumstances and a strong showing in the first round, FN was obliterated in the second round, a mere one week later. The populists won none of the regions that they captured in the first round! Why? Participation increased in the second round from 49% to 59%, signaling that many French voters were motivated to vote in less-relevant regional elections purely to keep FN out of power. The National Front share of the total vote remained stable at 27%, despite the increase in the turnout. This means that almost none of the "new" voters cast their support for FN, an incredible development. Socialist Party candidates withdrew from the contest in several regions where FN candidates were high profile politicians (Nord Pas de Calais led by Marine Le Pen herself and Province Alpes Cote d'Azur led by Le Pen's niece Marion Marechal Le Pen). Most importantly, Socialist voters did not swing to the economically left-leaning FN in these contest, but rather either stayed home or swung to the center-right rival, the UMP. If French voters decided to cast a strategic vote against FN in an election where the downside risk to a protest vote was non-existent, why would they do any different in a vote that clearly and presently matters? Furthermore, the fact that the higher turnout hurt FN should concern Le Pen. As we mentioned above, presidential election turnouts in France are around 80%. The 2015 election also should teach us an important lesson about France: polls work. Based on IFOP polling conducted two weeks before the election, the average polling error in the December 2015 regional election was 2.5%. Bottom Line: Marine Le Pen's support is precisely the inverse of the French support for the euro. Her anti-European stance is apparently a "deal breaker" for many voters who would otherwise support her candidacy. If she asked us for advice, we would say to flip-flop on the euro. It would make her far more competitive in 2017. Le Pen is trailing her centrist opponents by a massive margin in the second round. Polls can be wrong when they suggest that the contest is within the margin of error. But that is definitely not the case in the upcoming French election. Finally, the 2015 election teaches us that strategic voting continues in France, even when the establishment parties are in disarray and the geopolitical and political context favors populists. Cyclical View The French economy is currently experiencing an economic upswing. This upswing is not much of a mystery. It is explained by three factors: Easing monetary conditions in Europe, pent-up demand, and reflationary policies in China. Let's start with monetary conditions. The easing began in July 2012, with ECB president Mario Draghi's now famous pronouncement that he would do "Whatever it takes" to ensure the survival of the euro. Thanks to these soothing words, risk premia in the region collapsed, with a massive narrowing of government bond spreads between the periphery and Germany. France too benefited from that phenomenon, with its own spreads moving from a max of 190 basis points in late 2011, to 21 basis points seven months ago. Thanks to this normalization, lending rates to the private sector collapsed from 4.6% to 2% (Chart 29) This meant that the fall in the repo rate engineered by the ECB was finally passed on to the private sector. Additionally, the ECB stress tests of 2014 played a major role. In anticipation of that exercise, euro area banks curtailed credit in order to clean up their balance sheets. This resulted in a large contraction of the European credit impulse. However, once the tests were passed, euro area banks, with somewhat healthier balance sheets, normalized credit conditions, letting credit growth move closer in line with trend GDP growth. The result was a surge in the credit impulse that lifted growth in Europe (Chart 30). Chart 29Whatever It Takes Equals##br## Lower Private Sector Rates Whatever It Takes Equals Lower Private Sector Rates Whatever It Takes Equals Lower Private Sector Rates Chart 30Credit Impulse Dynamics##br## And Growth Credit Impulse Dynamics And Growth Credit Impulse Dynamics And Growth The euro also was an important factor. In mid-2014, investors started to speculate on a major easing by the ECB, maybe even QE. Through this discounting process, the euro collapsed from a high of 1.39 in May 2014 to a low of 1.05 in March 2015, when the ECB indeed began implementing asset purchases. This incredible 25% collapse in the currency boosted net exports, and helped GDP, while limiting existing deflationary pressures in Europe. The final reflationary impulse came from fiscal policy. In the wake of 2008, French fiscal deficits ballooned. As a result, from 2011 to 2013, the French fiscal thrust was negative and subtracted an average 1% from GDP growth. However, starting 2014, this drag vanished, arithmetically lifting growth in the country (Chart 31). Ultimately, with the accumulated pent-up demand resulting from the double-dip recession, France was able to capitalize on these developments. First, after having contracted by 14% between 2008 and 2009, and then by another 3% between 2011 and 2013, capex growth was able to resume in earnest in 2015 . This was necessary because, due to the subpar growth in capital stock, even the current tepid economic improvement was able to push capacity utilization above its 5-year moving average. When this happens, the economy ends up displaying the clearest sign of capacity constraint, i.e. higher prices, which we are seeing today. It also results in growing orders (Chart 32). Chart 31The Vanishing Of ##br##French Fiscal Drag The Vanishing Of French Fiscal Drag The Vanishing Of French Fiscal Drag Chart 32French Capacity Utilization Has Tightened ##br##And Orders Are Improving French Capacity Utilization Has Tightened And Orders Are Improving French Capacity Utilization Has Tightened And Orders Are Improving Second, we have witnessed a stabilization in employment and wages. The unemployment rate has fallen by 1% from 10.5% in 2015 to 9.5% today. Most importantly, our wage and employment models are pointing toward higher salaries and job growth in the coming quarters (Chart 33). This is crucial. The French economy remains fundamentally driven by domestic demand and household consumption in particular. In fact, these signs of coming higher household income suggest that the consumer can once again begin to support economic activity in France. First, we expect real retail sales to improve in the coming quarter. Second, because of the combined effect of rising labor income, consumer confidence, and housing prices, the recent upswing in housing activity should gather momentum (Chart 34), creating a further floor under economic activity. Chart 33Improving French Labor Market Conditions Improving French Labor Market Conditions Improving French Labor Market Conditions Chart 34Housing Will Contribute More To Growth Housing Will Contribute More To Growth Housing Will Contribute More To Growth Third, the improvement in credit growth corroborates these developments. In fact, being supported by easing credit standards, it even suggests that broad economic activity in France could accelerate further in the coming months. The key question mark at this point in time is China. France exports to China are only 3.7% of total exports, or 0.7% of GDP, below Belgium. However, the largest single export market for France is Germany, at 16.2% of total exports or 3.3% of GDP (Chart 35). Most interestingly, combined French exports to Germany and China are an important source of economic volatility for France. However, because French exports to Germany are a function of broader German income shocks and demand for German exports, the result is that French exports to Germany and China are a direct function of Chinese industrial activity, as illustrated with their tight correlation with the Keqiang index (Chart 36). As a result, French manufacturing conditions have displayed co-relationship with Chinese LEIs since 2002. Chart 35French Export ##br## Distribution The French Revolution The French Revolution Chart 36French Business Cycle And China: ##br##Germany Is The Key Link French Business Cycle And China: Germany Is The Key Link French Business Cycle And China: Germany Is The Key Link So going forward, what to expect? The recent surge in the ZEW expectation index is likely to be validated and French GDP growth is likely to improve from 1% today to nearly 2% in mid-2017, well above the current expectation of 1.3%. We are more confident about the robustness of domestic demand than international demand. The support created by higher wages and rising credit will have a lagged effect for a few more quarters. In fact, the up-tick to 0.5% from -0.2% in underlying inflation suggests that French real borrowing costs for the private sector should remain well contained despite the recent improvement in capacity utilization. This means the support to housing activity remains solid, especially as France has some of the strongest demographics of the whole euro zone, and thus demand for housing is solid. Chart 37France Too Would Be Affected##br## By A Chinese Deceleration France Too Would Be Affected By A Chinese Deceleration France Too Would Be Affected By A Chinese Deceleration Fillon's threat to cut public sector employment by 500,000 thousand could at face value derail the improvement in the labor market - if such measures were implemented today and in one shot, the unemployment rate would spike from 9.5% to 11.2%. However, Fillon's victory is not yet baked in the cake, and even if he wins, this risk is unlikely to materialize in 2017 as it will take time to get the required laws passed. Moreover, the progressive nature of the cut, along with the tax cuts and regulatory easing for the private sector, suggest that firms would likely create many jobs during the same time frame, mitigating the pain created by such drastic job cutting. Nonetheless, some downside to growth should be expected from Fillon's policies. China and EM represent a more palpable risk. The Chinese uptake of machinery has recently spiked and real estate activity and prices have surged (Chart 37). Beijing is currently uneasy with this development and the PBoC has already increased medium-term lending-facility rates in recent weeks despite low loan demand and disappointing fixed-asset investment numbers. Moreover, China has also massively curtailed the fiscal stimulus that has been a key component of its recent powerful rebound in industrial activity. Finally, the strength in the dollar along with rising real rates globally could put a lid on commodity price appreciation, which means that the rise in Chinese producer prices that has greatly contributed to lower Chinese real rates and thus easier Chinese monetary conditions could be waning. French exports to Germany and China might be seeing their heyday as we write. Bottom Line: The French economy is enjoying a healthy upswing powered by easier monetary conditions in Europe, slight fiscal thrust, pent-up demand and improving credit conditions. While these domestic factors will prove durable, the improvement in external demand faced by France in 2016 raises a slight question mark. Nonetheless, we expect French economic growth to move toward 2% in 2017, a sharp beat of currently depressed expectations. On the political front, robust growth should help centrist candidates and hurt the anti-establishment Le Pen. Investment Implications While reforms, tax cuts, strong domestic demand, and potentially falling political risk premia point to an outperformance of French small cap equities, the story is more complex. Indeed, French small caps are heavily weighted toward IT and biotech firms, and have been mimicking the performance of the Nasdaq, corrected for currency developments (Chart 38). Thus, they do not represent a play on the story above. Instead, we favor buying French industrial equities relative to Germany's. Both sectors are exposed to similar global risk factors as their sales are a function of commodity prices and EM developments. However, French unit labor costs should be contained relative to German ones going forward. French competitiveness has been hampered by decades of rigidities while German competitiveness benefited greatly following the implementation of the Hartz IV labor reforms. Not only should the potential for reform help France over Germany, but the fact that the French unemployment rate remains elevated while that of Germany is at generational lows points also toward rising German labor costs vis-à-vis France (Chart 39). Additionally, our secular theme of overweighting defense stocks plays in France's favor, given that France is the world's fourth largest global defense exporter.14 Finally, adding to the attractiveness of the trade, French industrial equities are trading near the low of their 12-year trading range against German ones (Chart 40). Chart 38French Small Cap Equals Nasdaq##br## (And The Euro, Of Course) French Small Cap Equals Nasdaq (And The Euro, Of Course) French Small Cap Equals Nasdaq (And The Euro, Of Course) Chart 39Reforms Could ##br##Close This Gap Reforms Could Close This Gap Reforms Could Close This Gap Chart 40Industrials: Buy France / ##br##Short Germany Industrials: Buy France / Short Germany Industrials: Buy France / Short Germany In a broader sense, the implementation of the Hartz IV reforms in Germany resulted in a general outperformance of German stocks over French stocks. Now that reforms have been fully implemented and priced in Germany, while investors remain highly skeptical of the outlook for French reforms (and indeed, fear an anti-establishment revolution), today may be the time to begin overweighting French equities at the expense of German ones in European portfolios on a structural basis. Finally, the spike in French yield differentials against German suggest that investors are imbedding a risk premium for the probability of a Le Pen win in the May election. A Le Pen victory would represent a death knell for the euro. As such, the euro countertrend bounce could find further support from a falling risk premium. Any selloff in the euro if Le Pen wins the first round of the election would represent a tactical buying opportunity in EUR/USD. Bottom Line: French industrials should be the key outperformers vis-a-vis Germany in the event of a Fillon or Macron electoral victory. However, French stocks in general should be able to outperform. Buy the euro on any election-related dip, particularly following the first round of the election on April 23. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see The Economist, "The sick man of the euro," dated June 3, 1999, available at economist.com. 2 The figures presented here are actually the reduced numbers from the 2013 Acte III de la decentralization. 3 Please see BCA Research Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 4 A generous pension system is part of the problem. The effective retirement age is around 61 years, well below the legal age of 65. According to the OECD, the French spend 25 years in retirement, the longest in the developed world. 5 To address this problem, President François Hollande's Responsibility and Solidarity Pact has begun to shift the burden of financing the public purse away from payroll taxes and onto consumption (via higher VAT taxes). But a greater effort is needed. 6 Oddly, France does not do that badly in the World Bank Ease of Doing Business ranking - it is 29th out of 190, ahead of Switzerland and Japan and only one place behind the Netherlands. 7 Please see Gary Banks, OECD, "Structural reform Australian-style: lessons for others?" presentations to the IMF and World Bank, May 26-27, 2005, and OECD, May 31, 2005, available at oecd.org. 8 Please see BCA Research Global Investment Strategy, "Après Paris," dated November 20, 2015, available at gis.bcaresearch.com. 9 Please see Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 10 IFOP poll from December 2016. 11 To be fair, French law does not require parties to publish their donations and spending. Please see Bloomberg, "Le Pen Struggling to Fund French Race as Russian Bank Fails," dated December 22, 2016, available at Bloomberg.com. 12 Please see Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 13 Please see BCA Research Geopolitical Strategy Special Report, "After BREXIT, N-Exit?" dated July 13, 2016, and The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at gps.bcaresearch.com. 14 Please see Global Alpha Sector Strategy and Geopolitical Strategy Special Report, "Brothers In Arms," dated January 11, 2017, available at gps.bcaresearch.com.

Highlights Three emerging macro factors bode poorly for Taiwan's growth outlook and asset prices. Despite the worrying economic and geopolitical backdrop, global investors appear complacent. Foreign ownership in Taiwanese stocks has reached a new record high. Remain cautious on Taiwanese stocks. Short the TSE versus Chinese investable shares. Feature Taiwan's economy and financial markets have shown remarkable resilience of late. Last week's advance GDP release confirmed that the Taiwanese economy continued to accelerate in the final quarter of the year. The Taiwanese dollar (TWD) is among the few currencies that have strengthened since early last year, not only in trade-weighted terms but also against the mighty greenback. Taiwanese stocks have been a bright spot in the emerging market universe, which has been plagued with structural challenges and political instability in recent years. Taiwan's remarkable strength of late is notwithstanding the sudden deterioration in its relationship with mainland China since the DPP party regained power last year, and more recently brewing trade tensions among the major global economies kicked off by the Trump Administration. This highlights the growing disconnect between Taiwan's macro outlook and its financial asset performance, offering a particularly poor risk-return profile. We remain underweight Taiwan among the greater China bourses, and recommend a short position in the TSE versus Chinese H shares. Macro Risks Are Rising... In a nutshell, three emerging macro factors bode poorly for Taiwan's growth outlook and asset prices. First, Taiwan is among the most open economies in the world, and will suffer disportionally in any disruption in global trade (Chart 1). Although having fallen sharply since the global financial crisis, exports of goods and services still account for over 60% of Taiwan's GDP, among the highest of the major economies. Therefore, Taiwan's growth outlook is almost completely dictated by global demand, making it particualrly vulnerable at times of rising global uncertainty. Indeed, Taiwan's growth acceleration since mid-last year has been entirely driven by a synchronized acceleration in overseas demand. Both China and the U.S. have been strengthening, which will likely continue to support Taiwan's growth outlook in the near term.1 However, the strength in the Taiwanese currency is worrisome, as the exchange rate has historically been tightly correlated with overseas new orders and domestic producer prices. Chart 2 shows that the strong TWD has the potential to lead to a sudden deterioration in deflation as well as new export orders. Chart 1Taiwanese Growth: All About Exports Taiwanese Growth: All About Exports Taiwanese Growth: All About Exports Chart 2TWD Strength Is A Headwind For Exports TWD Strength Is A Headwind For Exports TWD Strength Is A Headwind For Exports Second, the cross-strait relationship has already deteriorated notably, and a vicious feedback loop appears to be developing. On the one hand, the Chinese authorities are worried that incumbent President Tsai Ing-wen will not uphold the "1992 Consensus" that forms the foundation of cross-straight integration,2 and will step up efforts to contain her "pro-independence" initiatives. On the other hand, the Taiwanese government, faced with increasing pressure from the mainland, feels the urge to reach out to a broader global audience, which in turn may be perceived by Beijing as provocative. President Tsai's controversial phone call with Donald Trump, her stop-over visit to the U.S. en route to South America and the attendance of the government's delegation to President Trump's inauguration have only further reinforced Beijing's suspicion - and propelled forward a self-feeding negative dynamic in the cross-strait relationship that is difficult to reverse. The consequence of a military conflict between the mainland and Taiwan is unimaginably costly, and still extremely unlikely. However, the economic ties between the two will continue to cool. A telltale sign is that number of mainland Chinese visitors to Taiwan has already dropped precipitously since early last year, causing visible stress in Taiwan's tourism industry (Chart 3). Furthermore, exports to China account for over 40% of total Taiwanese exports, far higher than to any other market, and its trade surplus with China accounts for 5% of Taiwanese GDP - both of which are at risk should cross-strait tensions continue to rise (Chart 4). Moreover, the deteriorating relationship with the mainland is also hurting domestic confidence. Chart 5 shows that Taiwanese consumer confidence has historically been tightly linked with stock market performance, but a widening gap has developed since early last year when stocks began to rebound but confidence continued to weaken, which we suspect is to some extent attributable to the DPP party's dealings with the mainland. Weakening confidence bodes poorly for consumption, making the economy even more vulnerable to external shocks. Chart 3Cross - Strait Relationship ##br##Has Cooled Sharply Cross - Strait Relationship Has Cooled Sharply Cross - Strait Relationship Has Cooled Sharply Chart 4China Trade ##br##Is Crucial For Taiwan China Trade Is Crucial For Taiwan China Trade Is Crucial For Taiwan Chart 5Cooling China - ties##br## Also Hurts Domestic Confidence Cooling China - ties Also Hurts Domestic Confidence Cooling China - ties Also Hurts Domestic Confidence Finally, tensions between China and the U.S. are bound to rise under President Trump, and Taiwan may fall victim to the "clash of the Titans." Trump has openly questioned the "One China" policy that fundamentally underpins the Sino-U.S. relationship. John Bolton, a top adviser to President Trump, has even recommended positioning U.S. troops in Taiwan to counter the mainland. It is likely that Trump is using the "Taiwan card" as a bargaining chip to win concessions from China on trade-related issues.3 However, these remarks are dangerously provocative. Any miscalculation could lead to a drastic escalation in tensions across the Taiwan Strait, and the Taiwanese economy will suffer profoundly. Even if trade tensions are contained between China and the U.S., Taiwan will also suffer because it is a critical part of the highly complex and integrated supply chain in the global technology and electronics industries. It is premature and overly alarmist to predict any "war-like" scenario, but stakes are exceedingly high for Taiwan, and any move in this direction should be monitored extremely carefully. ...But Investors Appear Complacent Despite the worrying economic and geopolitical backdrop, global investors still appear comfortable in Taiwanese stocks. Foreign capital has continued to flock to Taiwan, despite gloomy sentiment among global investors on emerging markets overall. Net foreign purchases of Taiwanese stocks, historically tightly linked with fund flows to U.S. emerging market mutual funds, have rebounded sharply, while EM mutual fund sales have weakened, a rare divergence historically (Chart 6). Cumulative foreign net purchases of Taiwanese stocks have pushed foreign ownership in Taiwanese stocks to 37%, a new all-time high (Chart 7). Foreign fund flows have been a key reason behind the relative strength of both Taiwanese stocks and its exchange rate of late. Chart 6Diverging Fund Flows To EM And Taiwan Diverging Fund Flows To EM And Taiwan Diverging Fund Flows To EM And Taiwan Chart 7Rising Foreign Ownership In Taiwanese Stocks Rising Foreign Ownership In Taiwanese Stocks Rising Foreign Ownership In Taiwanese Stocks Granted, Taiwan's macroeconomic conditions are largely stable, characterized by its massive current account surplus, small fiscal deficit and low government debt - which make it stand out in an otherwise perilous, crisis-prone EM world. However, we suspect large foreign flows to Taiwan in recent years are also due to the tech-heavy nature of its stock market. Chart 8 shows the relative performance of global tech stocks bear a strong resemblance to Taiwan's relative performance against the EM benchmark after the global financial crisis. In other words, investors are largely attracted to the Taiwanese market as a way to play the global tech rally rather than because of any specific macro factors unique to Taiwan. This also means that investors could be blindsided by any escalation of trade or geopolitical tensions across the Taiwan Strait. Moreover, the large percentage of foreign ownership in Taiwanese stocks risks a disorderly unwinding and sudden exodus - and an ensuing sharp spike in volatility. The last episode of military tension between Taiwan and the mainland in the mid-1990s offers the only precedent in terms of how financial markets might respond. China reacted to the U.S. visit of Taiwan's then President Lee-Teng-hui with aggressive saber-rattling by mobilizing troops and firing missiles, which led to the "third Taiwan Strait Crisis" (Chart 9). Even though the crisis officially lasted from July 1995 to March 1996, Taiwanese stocks tumbled well in advance when the tensions first began to emerge. In fact, the crisis itself, and the resolution of it, marked the bottom in Taiwanese stock prices. Chart 8Taiwanese Stocks As A Tech Play Taiwanese Stocks As A Tech Play Taiwanese Stocks As A Tech Play Chart 9The Last Episode Of Cross - Strait Tension The Last Episode Of Cross - Strait Tension The Last Episode Of Cross - Strait Tension Long H Shares, Short Taiwan Taiwanese stocks are the most vulnerable bourse in the Greater China region. A short position of the TSE versus Chinese H shares offers an attractive risk-return profile. Chinese stocks have long been punished by various macro concerns, and are likely under-owned by global investors. Investor sentiment on Taiwan, on the other hand, appear to be unduly complacent, and Taiwanese stocks have likely been overweighted and over-owned. Chinese stocks are much less exposed to global trade than their Taiwanese counterparts. Even though tech stocks are the largest sectors for both markets, the largest Chinese tech companies such as Tencent, Alibaba and Baidu are mainly software and service providers, and derive the majority of their revenue from the domestic market.4 In contrast, Taiwanese tech companies, also the largest constituents in the Taiwanese index, such as TSMC, Hon Hai and Largan, are all hardware producers, and are overwhelmingly dependent on the global market, making them more vulnerable to any disruption in global trade flows. Valuations of Taiwanese stocks are not particularly demanding by global comparison, but they are trading at a premium to their mainland peers (Chart 10, bottom panel). Moreover, the recent improvement in Taiwanese earnings will be tested, given the strength of the TWD and deterioration in terms of trade (Chart 11). Historically, Taiwanese earnings have been highly cyclical and prone to sharp swings, led by global business cycles. Technically speaking, the multi-year underperformance of Chinese investable shares against the Taiwanese market has become very advanced and appears to have formed an enduring bottom (Chart 10, top panel). Chart 10Chinese H Shares Vs Taiwanese Stocks: ##br##Valuation And Technical Perspective Chinese H Shares Vs Taiwanese Stocks: Valuation And Technical Perspective Chinese H Shares Vs Taiwanese Stocks: Valuation And Technical Perspective Chart 11Taiwanese Earnings Improvement##br## Will Be Tested Taiwanese Earnings Improvement Will Be Tested Taiwanese Earnings Improvement Will Be Tested Bottom Line: Remain cautious on Taiwanese stocks. Short the TSE versus Chinese investable shares as a trade. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard," dated January 12, 2017, available at cis.bcaresearch.com. 2 The "1992 Consensus" refers to the outcome of a meeting in 1992 between China and Taiwan's then ruling party KMT. The terms means that both sides recognize there is only one "China": both mainland China and Taiwan belong to the same China, but both sides agree to interpret the meaning of that one China according to their own definition. 3,4 Please see China Investment Strategy Special Report, "Dealing With The Trump Wildcard," dated January 26, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The U.S. has two geopolitical imperatives: domination of the world's oceans and ensuring the disunity of Eurasia; The Trump Doctrine, as currently defined, has no room for transatlantic alliances; President Trump is pursuing both mercantilism and an isolationist foreign policy; This combination imperils the transatlantic alliance and thus the American anchor in Eurasia; If pursued to its logical conclusion, the Trump Doctrine will end American global hegemony. Feature "Who rules East Europe commands the Heartland; Who rules the Heartland commands the World-Island; Who rules the World-Island commands the world." - Sir Halford John Mackinder Geopolitics is parsimonious and predictive because it posits that states are imprisoned by their geography. For academia, geopolitics is too parsimonious. And the professors are correct! Mountainous terrain combined with ethno-linguistic heterogeneity has destined Afghanistan and Bosnia to centuries of conflict, but Switzerland seems to be doing just fine. As such, BCA's Geopolitical Strategy, despite our name, very rarely relies on pure geopolitics for its analysis. The world is just too complex and geopolitics operates on long time horizons that are rarely investment-relevant. Geography is not destiny. Rather, geography is the ultimate constraint, an immutable factor that can only be conquered with a massive effort or new technology that comes but once in a generation. To fight geography is folly, even for a hegemon. The Trump Doctrine, as it has taken shape thus far, looks to be just such a folly. In this analysis, we explain why and what the investment relevance may be for the U.S. and the world. We still think the U.S. is likely to regain power in relative terms, but Trump's "charismatic authority" and foreign policy pose a risk to this view. American Geopolitical Imperatives There are two notable "fathers" of geopolitics: Alfred Thayer Mahan and Sir Halford John Mackinder. They both dedicated their life to elucidating great power "Grand Strategy," the implicit but real geopolitical imperatives, rooted in geography, from which a country derives its day-to-day foreign policy. For Mahan, a U.S. Navy Admiral and lecturer at the Naval War College, the imperative of the U.S. was to build a navy to dominate the oceans, the global "commons" that is indispensable to modern trade, economy, and thus "hard power."1 A strong navy is the defining characteristic of a great power. It affords the hegemon military supremacy over vital trade routes and ensures that global commerce operates in its interest. If this sounds like present-day U.S. "Grand Strategy," it is because Mahan had a great influence on American policymakers in the early twentieth century. Theodore Roosevelt supported Mahan's thinking, which included building the Panama Canal. Mahan's The Influence of Sea Power Upon History, and similar work by British strategists, provided a historical and strategic framework for the naval race between the U.K. and Germany that ultimately contributed to the start of World War I.2 Mackinder, a British geographer and academic, focused on the Eurasian landmass, rather than the oceans.3 In his view - perhaps colored by Britain's history of fending off invaders from the continent - Eurasia had sufficient natural resources (Russia), population (China), wealth (Europe), and a geographic buffer from naval powers (the seas surrounding it) to become self-sufficient. Hence any great power that managed to dominate Eurasia, or "the World Island" as Mackinder coined it, would have no need for a navy as it would become a superpower by default (Map 1). Map 1The World According To Mackinder The Trump Doctrine The Trump Doctrine American Grand Strategy is today a combination of both Mahan's and Mackinder's thinking. The U.S. has had two explicit geopolitical imperatives since the end of World War II: Dominate the world's oceans (Mahan); Prevent any one power from dominating Eurasia (Mackinder). To accomplish the first, the U.S. has expended an extraordinary amount of resources to build and operate the world's greatest blue-water navy. To accomplish the second, the U.S. has entered two world wars, the Korean War, the Vietnam War, and spent a good part of the twentieth century containing the Soviet Union. In addition, Washington has fostered a close transatlantic alliance to ensure that Europe, its anchor in Eurasia, remains aligned with the U.S. These were not arbitrary decisions made by a corrupt, Beltway elite looking to enrich itself with the spoils of globalization. These were decisions made by American leaders looking to expand American power, establish global hegemony, and retain it against rivals for centuries to come. Both imperatives are necessary for the U.S. to remain a hegemon. And U.S. hegemony is the foundation of the global monetary and financial system. Not least, it underpins the role of the U.S. dollar as the world's reserve currency. Bottom Line: The U.S. has two geopolitical imperatives: domination of the world's oceans and ensuring the disunity of Eurasia. The Trump Doctrine: America First, Second, And Third Every U.S. president tries to enshrine a foreign policy "doctrine" during their presidency. There is no single document that does the job of elucidating the doctrine; scholars and journalists weave the ideas together from speeches, policy decisions, resource allocation, and rhetoric. This early in the Trump presidency, it is not fair to determine what his foreign policy doctrine will be. Already, with Trump's executive orders on immigration and refugees, it is clear that there is a process of trial and error underway, with the administration reversing its position on green card holders (U.S. permanent residents). We therefore take liberty in projecting the little information we have forward. Chances that we are wrong are high and our conviction level is low. Nevertheless, we have two broad conclusions. If the Trump Doctrine develops as these early clues suggest, then it will either be rejected by Congress and the American policy establishment, or it will initiate the collapse of the geopolitical and economic institutions of our era, ushering in something profoundly different. We see no alternatives. So what are the early outlines of the Trump Doctrine? We see three factors that stand out: Isolationism: Long-term alliances and commitments abroad must have a clear, immediate, and calculable benefit for the U.S. economic "bottom line." Therefore, Japan and South Korea should pay more for the benefits of U.S. alliance, and NATO is a drain on American resources. All alliances and American commitments are negotiable. Mercantilism: The U.S. has no permanent allies, only trade balances that must be positive. Trump has not only threatened China and Mexico with protectionism, but also longstanding allies like Germany and Japan.4 Any country that sports a significant trade surplus with the U.S. is in Washington's crosshairs (Chart 1). Chart 1Trump's Hit List The Trump Doctrine The Trump Doctrine Sovereignty: Trump said in his inaugural address, "it is the right of all nations to put their own interests first" and that America does "not seek to impose our way of life on anyone." This is a stark departure from ideologically-driven foreign policies of both the Bush and Obama White House. However, there is an ideology underpinning Trump's foreign policy: nationalism. Professor Ted Malloch, tipped as the next U.S. Ambassador to the EU, revealed in a BBC interview that the new U.S. President "is very opposed to supranational organizations, he believes in nation states." This statement makes explicit what many of Trump's speeches have implied. Under the tenets of this inchoate Trump Doctrine, NATO and the EU are not just nuisances, but are positively detrimental to U.S. interests. This marks a profound shift in U.S. foreign policy thinking, if it stands. First, both NATO and the EU break the ideological tenet of nationalism. They are international organizations that pool sovereignty for some predetermined common goal. Given that the common goal has nothing to do with the immediate, domestic and economic goals of the U.S., the two organizations are not worth supporting, under this interpretation of the emerging Trump Doctrine. Second, NATO demands a U.S. overseas commitment with little material gain in return. This is not a new argument. President Obama complained about the failure of NATO member states to pay their fair share (2% of GDP on defense) for collective self-defense (Chart 2). However, Obama's intention was to cajole European allies to boost defense spending; NATO's existence was not in question. Trump does not see a point in America paying for Germany's defense, especially when Germany sports a sizeable trade surplus with the U.S. Chart 2NATO States That Need To 'Pay Up' The Trump Doctrine The Trump Doctrine Third, the EU runs a large current account surplus in general and a trade surplus with the U.S. in particular (Chart 3). For the Trump administration, the EU is therefore a rival, perhaps more so even than Russia, which, when viewed through a purely mercantilist lens, is not a foe. Trump's foreign policy is based on an understanding that the world is multipolar and that the U.S. is in relative geopolitical decline. Our data supports President Trump's assertion (Chart 4). In that way, Trump's doctrine is similar to that of the Obama presidency. Both recognize that the U.S. can no longer act unilaterally and that it must retrench from its global responsibilities. But while Obama sought to enhance U.S. power by relying on allies and supranational organizations, Trump seeks to withdraw into Fortress America and geopolitically deleverage. Such a deleveraging, when combined with mercantilism, may cause America's traditional allies to try harder for its approval, like Trump assumes, or it may push America's traditional allies away from Washington's orbit. Chart 3Mercantilism Makes The EU A 'Bad Guy' Mercantilism Makes The EU A 'Bad Guy' Mercantilism Makes The EU A 'Bad Guy' Chart 4American Power In Relative Decline American Power In Relative Decline American Power In Relative Decline Bottom Line: President Trump believes in a "what can you do for me" world.5 This world has no room for twentieth-century alliances, which did not anticipate the disenchantment and polarization of the American public (or the benefit of Trump's wisdom!) in their original design. Transatlantic Drift The most important feature of the Trump Doctrine is that it seeks to replace transatlantic links between the U.S. and Europe with bilateral, ad-hoc alliances. The one such alliance that has received much media attention is the thaw between the U.S. and Russia. To be clear here, we are very much aware that many U.S. presidents have had deep disagreements with Europe and that every president since Reagan has tried to thaw relations with Russia early in his presidency. However, Trump is different in that he is the first U.S. president to: Openly question the very existence of NATO; Openly oppose European integration;6 Openly engage in mercantilist trade policies towards allies while simultaneously undermining geopolitical alliances with them. The problem with this course of action is that other countries will pursue alternative economic and security relationships to hedge against America's perceived lack of commitment, or outright hostility. Japan and South Korea, for example, concerned that they may face tariffs and a drop in U.S. military support, will need to turn more friendly toward China to avoid conflict and access new consumer markets. The same goes for Europe, with Germany and others eager to substitute for the U.S. by selling more to China amid U.S.-China trade conflicts.7 Thus, if we are to take the Trump Doctrine to its conclusion, we end up with an American foreign policy that pushes Eurasia towards the kind of integration - if not exactly alliance - that Mackinder feared. Since greater Eurasian coordination could eventually develop into a dynamic of its own, this process directly contravenes the second tenet of American grand strategy: Prevent any one power from dominating Eurasia. But wait, Trump supporters will cry, Trump is going to throw a wrench in Eurasian coordination by allying with Russia! No, he won't. Russia and America will not be allies. At best, they will be friends with benefits. The two countries have no shared economic interests. Russia sees both Europe and China as its economic partners. The former for supply of badly needed technology and investment (Chart 5), the latter as an energy market and another source of investment (Chart 6).8 Chart 5Russia Needs European Technology ... The Trump Doctrine The Trump Doctrine Chart 6... And Chinese Energy Demand ... And Chinese Energy Demand ... And Chinese Energy Demand Russian policymakers may be cheering Trump for the moment, but that is only because he brings relief from the extremely anti-Kremlin policies of the Obama (and potentially Hillary Clinton) presidency. The Kremlin will take advantage of the change in the White House. Bear in mind, all that Russian policymakers know of the U.S. in recent memory is conflict and realpolitik: It was the U.S. that pushed for NATO to expand into Ukraine and Georgia. Chancellor Angela Merkel, in fact, vetoed those plans at the 2008 NATO Summit; It was the Bush Administration that pushed for Kosovo's independence in 2008; Both the Bush and Obama administrations sought to construct a ballistic missile defense shield on Russia's doorstop in Central and Eastern Europe. If Trump stumbles in the next four years, who is to say that Moscow won't have to deal with an antagonistic Washington by the end of 2020? Trump's olive branches will not alter Russian thinking about the country's long-term interests. Russian President Vladimir Putin is going to do what is good for Russia, no matter how much he may think that Trump is a great guy to party with. And what is good for Russia is deeper economic integration with China and Europe. In fact, with the U.S. becoming an energy producer - and potentially a significant LNG exporter soon - America may become Russia's competitor for Europe's natural gas demand. Trump, his supporters and advisors, may believe that the twentieth century is over and that post-WWII American alliances have atrophied. They have! Russia is not the Soviet Union. It is no surprise that NATO is having an identity crisis when it no longer has a peer enemy to defend against. But geography has not changed. The U.S. is still far from Eurasia and Eurasia is still the "World Island." The Trump Doctrine ignores the entire twentieth century during which the U.S. had to intervene in Europe twice, and Asia three times, at a huge cost of blood and treasure, due to the threat of the continent unifying under a single hegemon. The international organizations that the U.S. set up after the Second World War, including NATO and the EU but also the UN, IMF, and others, were created to ensure that the U.S. did not have to intervene in Europe again. The security alliance and commercial system in Asia Pacific served a similar purpose. Bottom Line: Trans-oceanic alliances and organizations are not vestiges of a past that has changed, but vestiges of a geography that is immutable. The Trump Doctrine, such as it is, threatens to undermine an imperative of American hegemony. If pursued to its professed conclusion, it will therefore end American hegemony. Eurasian Alliance How can Europe, Russia, and China overcome their vast differences and unite in an anti-American alliance? It is not easy, but nor is it impossible. Russian point of view: The U.S. remains Russia's chief strategic threat. Sino-Russian distrust and tensions are overstated, as we discussed in a 2014 Special Report.9 Russia depends on China and Germany for 32% of its imports and 17% of its exports (Chart 7). It is deeply integrated with both economies. The U.S., meanwhile is about as relevant for the Russian economy as Poland in terms of imports and as Belarus in terms of exports. China's point of view: The U.S. is also China's chief strategic threat - and probably the only thing standing between China and regional hegemony over the course of this century. For China, integrating with the denizens of Eurasia makes a lot of sense. First, it would allow China to avoid the folly of competing with the U.S. in direct naval and maritime conflict. Overland transportation routes - which Beijing seeks to develop via its ambitious "The Silk Road Economic Belt" project - will bypass China's contentious and cramped South and East China Seas. Second, Europe has everything China needs from the U.S. (technology, aircraft, IT), and could offer them at discount rates due to a weak euro and general economic malaise (entire continent is for sale, at a discount!). Third, neither Europe nor Russia care what China does with its neighborhood in East Asia. If China wants to take some shoal from the Philippines, Berlin and Moscow will be okay with that. Europe's point of view: The European Union has never spent much time thinking seriously about the U.S. as a threat to its existence. The possibility, at very least, will promote efforts at economic substitution. Europe and Russia must overcome their differences over Ukraine in order to cooperate again. However, as we pointed out above, it was not Europe that sought to integrate Ukraine and Georgia into NATO, it was the United States. Europe needs Russian energy and Russia needs Europe's technology and investment. As long as they delineate where each sphere of influence begins and ends, which they have done before (in 1917 and 1939 if anyone is still counting!) they will be fine. Finally, trade with emerging markets is already more important for the EU than with the U.S. (Chart 8). And China remains a major potential growth market for EU products. Chart 7U.S. No Substitute For Russian Partners U.S. No Substitute For Russian Partners U.S. No Substitute For Russian Partners Chart 8Europe Relies On EM More Than U.S. Europe Relies On EM More Than U.S. Europe Relies On EM More Than U.S. We do not think that a formal EU-Russia-China axis is around the corner, or even likely. However, if the U.S. should pursue a policy of undermining its transatlantic and transpacific alliances, cheerleading the dissolution of the EU, and treating foes and allies equally when it comes to trade protectionism, the probability that it faces a united front from Eurasia increases. We are not sure that the Trump Administration understands this, or even cares. From what we can tell right now, the Trump White House is singularly focused on trade and commercial matters. It is mercantilist, pure and simple. But geopolitics is not a single dimension. It is like a game of three-dimensional chess. Foreign policy and security are on the top chess board, trade and economic matters are in the middle, and domestic politics are played on the bottom board. When the Trump administration threatens the "One China" policy or encourages EU dissolution because the bloc has "overshot its mark," it corners its counterparts on the geopolitical and political chess boards for the sake of trade and commercial interests. This is a mistake. Europe and China will give up chess pieces on the economic board to preserve their position on the geopolitical and political boards. In other words, Trump's strategy of tough-nosed negotiations - which he learned in the global real estate sector - will only strengthen opposition against the U.S. in the real world. We don't think that Trump is playing three-dimensional chess. He is singularly focused on America's economy and commercial interests and his own domestic political coalition. This is unique in post-World War Two American foreign policy. Ronald Reagan, who cajoled Japan and West Germany into the 1985 Plaza Accord, did so because both Berlin and Tokyo understood they owed their security to America. If Reagan threatened to withdraw America's security commitment to either, he would not have gotten the economic deal he wanted. Bottom Line: If pursued to its logical conclusion, the Trump Doctrine will end U.S. hegemony. Trump's foreign policy has raised a specter, however faint at present, which has not been seen since the Molotov-Ribbentrop Pact between Russia and Germany in 1939: a united Eurasian continent marshalling all its human, natural, and technological resources against the U.S. The last time that happened, 549,865 U.S. lives were needed to preserve American hegemony, not to mention the global cost in blood and treasure. Investment Implications In our 2017 Strategic Outlook we posited that investors should get used to the revival of charismatic authority.10 We borrow the concept from German sociologist Max Weber, who identified it in his seminal essay, "The Three Types of Legitimate Rule."11 Weber argues that legal-rational authority flows from the institutions and laws that define it, not the individuals holding the office. Today, we are seeing the revival of charismatic authority, which Weber defined as flowing from the extraordinary characteristics of an individual. Such leaders are difficult to predict as they often rise to power precisely because of their opposition to the institutions and laws that define the legal-rational authority. The Trump Doctrine is one example of how charismatic authority can lead to uncertainty. Twentieth century institutions may be flawed, but they have underpinned and continue to underpin American hegemony. The U.S. cannot, at the same time, maintain global hegemony, pursue mercantilist commercial policy, and seek to undermine its global alliances. The Trump White House threatens to push allies and foes, pursuing their own interests, to work in concert to isolate the United States. Perhaps President Trump and his advisors are comforted by the fact that the U.S. has always profited from global chaos. The U.S. benefits from being surrounded by two massive oceans, Canada, and the Sonora-Chihuahuan deserts. Following both the First and Second World Wars, the U.S.'s relative geopolitical power skyrocketed (Chart 9). This is why Trump's election led us to believe that global multipolarity would peak in the coming year and set the stage for an American revival.12 Chart 9The U.S. Benefits From Global Chaos The U.S. Benefits From Global Chaos The U.S. Benefits From Global Chaos However, to maintain primacy while sowing global discord, the U.S. needs more than just Anglo-Saxon allies in the world. It needs an anchor in Eurasia, which is and always will be Europe. Without an anchor, Trump's policies will not sow discord, they will create concord, and unite the "World Island" against America. That is why it is important to see how the Trump Doctrine develops in terms of real policy, as opposed to a year's worth of mostly campaign statements. Already the administration has made some appropriate noises about standing "100% behind NATO" and having an "ironclad commitment" to Japan. But make no mistake, Trump's open doubts have reverberated farther and deeper than these minimal reassurances. It is critical to monitor how the Trump administration approaches NATO, the EU, and bilateral negotiations with key partners. We are already seeing evidence of serious coordination - particularly between Germany and China - that could be a counterweight to U.S. power in the marking. These two outcomes - renewed U.S. hegemony, or U.S. downfall - are essentially binary and it is too soon to know which will prevail. What is the probability of downfall? It is low, but rising. If Trump does not adjust his foreign policy - or, barring that, if the U.S. Congress or American foreign policy, defense, and intelligence establishment do not "correct" Trump's course - then U.S. hegemony will begin to unravel. And with it will go a range of "certainties" underpinning global economic growth and trade, including the U.S. dollar's reserve currency status. If America loses its hegemony, one victim may be the U.S. dollar's role as a safe haven asset. The notion that the greenback is a safe-haven asset even when the chief global risks emanate from the U.S. will be tested. We recommend that long-term investors diversify into other currencies, including the Swiss franc, euro, and, of course, gold. Marko Papic, Senior Vice President marko@bcaresearch.com 1 Alfred Thayer Mahan, The Interest Of America In Sea Power: Present And Future (Boston: Little, Brown and Co., 1918). 2 Mahan, The Influence Of Sea Power Upon History, 1660-1783, 15th ed. (Boston: Little, Brown and Co., 1949). 3 Halford John Mackinder, Democratic Ideals And Reality: A Study In The Politics Of Reconstruction, 15th ed. (Washington, D.C.: National Defense University Press, 1996). 4 Trump has surprised U.S. ally Japan by coupling it with China in some of his statements threatening tariffs. Meanwhile Peter Navarro, chief of the new National Trade Council, has recently accused Germany of currency manipulation and structural trade imbalances. Please see Shawn Donnan, "Trump's top trade adviser accuses Germany of currency exploitation," Financial Times, January 31, 2017 available at www.ft.com. 5 Please see Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 6 Trump has said that the U.K. was "smart" to leave the EU, and has expressed indifference to the existence of the EU and a belief that "others will leave" following the U.K. Please see "Full Transcript of Interview with Donald Trump," The Times of London, January 16, 2017, available at www.thetimes.co.uk. Also, the aforementioned Professor Malloch, potential U.S. Ambassador to the EU, said in his interview with the BBC that "Trump believes that the European Union has in recent decades been tilted strongly and most favorably towards Germany" and that "the EU has overshot its mark." 7 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 8 Please see Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 9 Please see Geopolitical Strategy Special Report, "The Embrace Of The Dragon And The Bear," dated April 11, 2014, available at gps.bcaresearch.com. 10 Please see Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 11 Please see Max Weber, "The Three Types Of legitimate Rule," Berkeley Publications in Society and Institutions 4 (1) (1958): 1-11. Translated by Hans Gerth. Originally published in German in the journal Preussiche Jahrbücher 182, 1-2 (1922). 12 Please see Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com.

Table 1Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update The Reflation Trade Continues It is wrong to think that the recent rally in risk assets is mainly due to the election of President Donald Trump. Yes, since November 8, U.S. equities have risen by 7% and global equities by 3%. But the rally began as long ago as February last year, and since then U.S. and global equities have risen by 25% and 20% respectively. A more useful narrative is that the U.S. went through a "mini-recession" in late 2015/early 2016 (as indicated by the manufacturing ISM and credit spreads, Chart 1). Since then, assets have moved as they typically do in the first year of a cyclical recovery: small caps, cyclicals and value stocks have outperformed, bond yields risen, and equity multiples expanded in anticipation of a recovery in earnings. Expectations of Trump's fiscal stimulus and deregulation merely gave that momentum an extra boost. Our view is that global economic growth is likely to continue to accelerate. With the U.S. now at full employment, wage growth should rise further (Chart 2). Trump's policies are igniting animal spirits among companies, whose capex intentions have jumped sharply (Chart 3). U.S. real GDP growth this year could be 2.5-3%, somewhat above the consensus forecast of 2.3%. Meanwhile, Europe is growing above trend, and China will continue for a while longer to see the effects from last year's massive monetary stimulus (Chart 4). Chart 1One Year On From A Mini Recession One Year On From A Mini Recession One Year On From A Mini Recession Chart 2Wage Growth Is Set To Accelerate Wage Growth Is Set To Accelerate Wage Growth Is Set To Accelerate Chart 3Comapanies' Animal Spirits On The Rise Comapanies' Animal Spirits On The Rise Comapanies' Animal Spirits On The Rise Chart 4China's Reflation Still Coming Through China's Reflation Still Coming Through China's Reflation Still Coming Through In the short term, a correction is possible: the rally looks technically over-extended, and investors have begun to notice that in addition to "good Trump" (tax cuts, deregulation and infrastructure spending), there is also a "bad Trump" (market unfriendly measures such as immigration control, confrontation with China, and arbitrary interference in companies' investment decisions). But, on a 12-month view, our expectations of accelerating growth and only a moderate rise in inflation imply that the "sweet spot" for risk assets will continue, and so we maintain the overweight on equities and underweight on bonds we instituted in late November. What could end the reflation trade? The main risks we see (and the reasons we don't think they are serious enough to derail the rally for now) are: Extreme moves by the new U.S. administration. The biggest risk is a confrontation with China over trade. Our view is that Trump will use the threat of recognizing Taiwan to force concessions out of China. A precedent is the way the U.S. handled its trade deficit with Japan in the 1980s (note that new U.S. Trade Representative Robert Lighthizer was deputy USTR at the time). China is unlikely to accept significant currency appreciation, understanding how this caused a bubble in Japan. But it might agree to voluntary export restrictions, to increasing investment in the U.S., opening the Chinese market more to foreign companies, and to stimulating domestic consumption, as Japan did in the 1980s (Chart 5). This may even chime with how Xi Jinping wants to reform the economy, though missteps by the U.S. could force him into a nationalistic position. Fiscal policy fails. The details of tax cuts are complex: alongside lowering the headline rate of corporate tax to 15% or 20%, for example, Republicans are discussing a border-adjustment tax, one-year depreciation, and an end of the tax offset for interest payments. Infrastructure spending won't happen quickly either, not least since it is disliked by Republican fiscal hawks (who are much less averse to tax cuts). BCA's geopolitical strategists, however, believe that Trump will able to get a program of personal and corporate tax cuts through Congress by August. Economic (and earnings) growth stumble. While corporate and consumer sentiment have picked up recently, hard data has not yet. U.S. 4Q GDP growth of only 1.9%, for example, was disappointing. Earnings growth will need to recover this year to justify elevated multiples. EPS growth for the S&P500 stocks in Q4 2016 looks to have been around 4% YoY according to FactSet. Stocks might fall if earnings do not come in somewhere close to the 12% that the bottom-up consensus forecasts for 2017. Inflation risks rise, triggering the Fed and the European Central Bank to rush to tighten monetary policy. Core U.S. PCE inflation, at 1.7% YoY, is not far below the Fed's 2% target and inflation could accelerate as fiscal policy stimulates an economy where slack has already disappeared. However, it is likely to take some time for inflation expectations to rise, and over the past few months core PCE inflation has, if anything, slowed (Chart 6). We expect the Fed to raise rates three times this year (compared to market expectations of twice) but not to move faster than that. German inflation, at 1.9% YoY, is starting to get uncomfortably high too, but the ECB will probably continue to set policy with more focus on the periphery, especially Italy. Chart 5When U.S. Pushed Japan In The 1980's When U.S. Pushed Japan In The 1980's When U.S. Pushed Japan In The 1980's Chart 6Inflation Has Been Slow To Pick Up Inflation Has Been Slow To Pick Up Inflation Has Been Slow To Pick Up Equities: We prefer U.S. equities over European ones in common currency terms. This is partly because we expect further U.S. dollar appreciation. But we also remained concerned about the structural weakness in the European banking system, and by the higher volatility of eurozone equities. Moreover, European earnings will not be boosted by currency depreciation as much as will Japanese earnings, since the euro has hardly weakened on a trade-weighted basis (Chart 7). We continue to like Japanese equities (with a currency hedge). The Bank of Japan remains committed to an overshoot of its 2% inflation target, which should weaken the yen and boost earnings. We are underweight Emerging Market equities: structural vulnerabilities remain, and the inverse correlation with the U.S. dollar is intact. Chart 7Euro Hasn't Weakened Much Euro Hasn't Weakened Much Euro Hasn't Weakened Much Fixed Income: For now, U.S. 10-year Treasury bonds are at around fair value. But we expect the yield to rise moderately further, as growth and inflation pick up, to about 3% by year-end. Yields on eurozone government bonds will also rise, but not by as much. This means that global sovereigns could produce a YoY negative return for the first time since 1994. In the U.S. we continue to prefer TIPS over nominal bonds: inflation expectations are still 30-40 bps below a normalized level (Chart 8). With risk assets likely to outperform, we recommend exposure to spread product, but find investment grade bonds more attractively valued than high-yield. Currencies: Short term, the dollar has probably overshot and could correct. But growth and interest rate differentials (Chart 9) suggest that the dollar will appreciate further until such time as Europe and Japan can contemplate raising rates. Additionally, if the proposal of a border-adjustment tax looks like becoming reality, the dollar could appreciate sharply: a BAT of 20% would theoretically be offset by a 25% rise in the dollar. The yen is likely to depreciate further (perhaps back to JPY125 against the dollar) as the Bank of Japan successfully maintains its target of a 0% 10-year government bond yield. The euro will fall by less, especially if the market begins to worry about ECB tapering in the face of rising inflation. Chart 8TIPS Have Further to Go Room To Rise TIPS Have Further to Go Room To Rise TIPS Have Further to Go Room To Rise Chart 9Interest Rate Differentials Suggest Stronger Dollar Interest Rate Differentials Suggest Stronger Dollar Interest Rate Differentials Suggest Stronger Dollar Commodities: The supply/demand picture for industrial metals looks roughly balanced for the year, with Chinese demand likely to remain robust, suppliers more disciplined, but the stronger dollar acting as a headwind. In the oil market, Saudi Arabia and Russia seem to be sticking to their commitment to cut supply, but U.S. shale oil producers are filling the gap, with the rig count up 23% in Q4 over the previous quarter. We continue to expect crude oil to average US$55 a barrel for the next two years. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Recommended Asset Allocation Model Portfolio (USD Terms)

Highlights President Trump is as protectionist as Candidate Trump; USD shortage to tighten global financial conditions; Go Long MXN/RMB as a tactical play on U.S.-China trade war; Brexit risks are now overstated; EU will not twist the knife. EUR/GBP is overbought; go short. Feature "We assembled here today are issuing a new decree to be heard in every city, in every foreign capital, and in every hall of power. From this day forward, a new vision will govern our land. From this moment on, it's going to be America First." U.S. President Donald Trump, January 20, 2017, Inaugural Address What are the investment implications of an "America First" world? First, it may be useful to visualize the "America Second" world that President Trump is looking to leave in the rear-view mirror. Chart 1 shows the cost of hegemony. Since the Nixon shock in 1971, the U.S. has seen its trade balance deepen and its military commitments soar, in absolute terms. For President Donald Trump, the return on American investment has been low. Wasteful wars, crumbling infrastructure, decaying factories, stagnant wages, this is what the U.S. has to show for two decades of hegemony. Chart 1United States: The Cost Of Hegemony The "What Can You Do For Me" World? The "What Can You Do For Me" World? On the other hand, the U.S. has enjoyed the exorbitant privilege of its hegemonic position. In at least one major sense, America's allies (and China) are already paying for American hegemony: through their investments in U.S. dollar assets. Chart 2 illustrates this so-called "exorbitant privilege." Despite a deeply negative net international investment position, the U.S. has a positive net investment income.1 Chart 2The "Exorbitant Privilege" The "What Can You Do For Me" World? The "What Can You Do For Me" World? Being the global hegemon effectively lowers U.S. borrowing costs and domestic interest rates, giving U.S. policymakers and consumers an "interest rate they do not deserve." That successive administrations decided to waste this privilege on redrawing the map of the Middle East and giving the wealthiest Americans massive tax cuts, instead of rebuilding Middle America, is hardly the fault of the rest of the world! Foreigners hold U.S. assets because of the size of the economy, the sustainability and deep liquidity of the market, and the perceived stability of its political system. More importantly, they hold U.S. assets because the U.S. acts as both a global defender and a consumer of last resort. If Washington were to raise barriers to its markets and become a doubtful provider of security, states may gradually see less of a payoff in holding U.S. assets and decide to diversify more rapidly. Investors can interpret Trump's "America First" agenda broadly as an effort to dramatically reduce the U.S. current account deficit. Certainly we see his statements on renegotiating NAFTA, facing off against China on trade, and encouraging U.S. exports with tax legislation as parts of a broad effort aimed at improving the U.S. trade balance. If the U.S. were to pursue these protectionist policies aggressively, the end result would be a massive shortage of U.S. dollars globally, a form of global financial tightening. The rest of the world is not blind to the dangers of an America focused on reducing its current account deficit. According to the reporting of Der Spiegel magazine, Chancellor Angela Merkel sent several delegations to meet with the Trump team starting in 2015! No doubt Berlin was nervous hearing candidate Trump's protectionist talk, given that Germany runs one of the largest trade surpluses with the U.S. (Chart 3). In the last such meeting, taking place after the election was decided, Trump's son-in-law and White House advisor, Jared Kushner, asked the Germans a point-blank question, "What can you do for us?"2 In the 1980s, the U.S. asked West Germany and Japan the same question. The result was the 1985 Plaza Accord that engineered the greenback's depreciation versus the deutschmark and the yen (Chart 4). Recent comments from Donald Trump suggest that he would like to follow a similar script, where dollar depreciation does the heavy lifting in adjusting the country's current account deficit.3 Chart 3Trump's Black List Trump's Black List Trump's Black List Chart 4The Impact Of The Plaza Accord The Impact Of The Plaza Accord The Impact Of The Plaza Accord The Trump administration may have dusted off the Reagan playbook from the 1980s, but the world is playing a different game in 2017. First, the Soviet Union no longer exists and certainly no longer has more than 70,000 tanks ready to burst through the "Fulda Gap" towards Frankfurt. President Trump will find China, Germany, and Japan less willing to help the U.S. close its current account deficit, particularly if Trump continues his rhetorical assault on everything from European unity to Japanese security to the One China policy. Second, China, not U.S. allies Germany and Japan, has the largest trade surplus with the U.S. It is very difficult to see Beijing agreeing to a coordinated currency appreciation of the RMB, particularly when it is being threatened with a showdown over Taiwan and the South China Sea. Third, even if China wanted to kowtow to the Trump administration, it is not clear that RMB appreciation can be engineered. The country's capital outflows have swelled to a record level of $205 billion (Chart 5) and the PBoC has continued to inject RMB into the banking system via outright lending to banks and open-market operations (Chart 6). Unlike Japan in 1985, China is at the peak of its leveraging cycle and thus unwilling to see its currency - and domestic interest rates - appreciate. At best, Beijing can continue to fight capital outflows and close its capital account. But even this creates a paradox, since the U.S. administration can accuse it of currency manipulation even if such manipulation is preventing, not enabling, currency depreciation!4 Chart 5China: Unrecorded Capital Outflows China: Unrecorded Capital Outflows China: Unrecorded Capital Outflows Chart 6PBoC Injects Massive Liquidity PBoC Injects Massive Liquidity PBoC Injects Massive Liquidity To conclude, the world is (re)entering a mercantilist era and sits at the Apex of Globalization.5 The new White House is almost singularly focused on bringing the U.S. current account deficit down. It intends to do this by means of three primary tools: Protectionism: The Republicans in the House of Representatives have proposed a "destination-based border adjustment tax," which would effectively subsidize exports and tax imports. (It would levy the corporate tax on the difference between domestic revenues and domestic costs, thus giving a rebate to exporters who make revenues abroad while incurring costs domestically.)6 While the proponents of the new tax system argue it is equivalent to the VAT systems in G7 economies, the change would nonetheless undermine America's role as "the global consumer of last resort." In our view, it would be the opening salvo of a global trade war. Dirigisme: President Trump has not shied away from directly intervening to keep corporate production inside the U.S. He has also insisted on a vague proposal to impose a 35% "border tax" on U.S. corporates that manufacture abroad for domestic consumption. (Details are scant: His Treasury Secretary Steven Mnuchin has denied an across-the-board tax of this nature, but has confirmed that one would apply to specific companies.) Structural Demands: Trump's approach suggests that he wishes to force structural changes on trade surplus economies in order to correct structural imbalances in the American economy - and in this process he is not adverse to lobbing strategic threats. While he holds out the possibility of charging China with currency manipulation, in fact he can draw from a whole sheet of American trade grievances not limited to the currency to demand major changes to their trade relationship. The fundamental problem for the global economy is that in order to reduce the U.S. current account deficit, the world must experience severe global tightening. Dollars held by U.S. multinationals abroad, which finance global credit markets, will come back to the U.S. and tighten liquidity abroad. And emerging market corporate borrowers who have overextended themselves borrowing in U.S. dollars will struggle to repay debts in appreciating dollars. These structural trends are set to exacerbate an already ongoing cyclical process. As BCA's Emerging Markets Strategy has recently pointed out, global demand for U.S. dollars is rising faster than the supply of U.S. dollars.7 Our EM team's first measure of U.S. dollar liquidity is "the sum of the U.S. monetary base and U.S. Treasury securities held in custody for official and international accounts." The second measure "is the sum of the U.S. monetary base and U.S. Treasury securities held by all foreign residents." As Chart 7 and Chart 8 illustrate, both calculations indicate that dollar liquidity is in a precipitous decline already. Meanwhile, foreign official holdings of U.S. Treasury securities is contracting, while the amount of U.S. Treasury securities held by all foreigners has stalled (Chart 9). Chart 7Dollar Liquidity Declining... Dollar Liquidity Declining... Dollar Liquidity Declining... Chart 8... Any Way You Look At It ... Any Way You Look At It ... Any Way You Look At It Chart 9Components Of U.S. Dollar Liquidity Components Of U.S. Dollar Liquidity Components Of U.S. Dollar Liquidity Chart 10It Hurts To Borrow In USD It Hurts To Borrow In USD It Hurts To Borrow In USD Concurrently, U.S. dollar borrowing costs continue to rise (Chart 10). Our EM team expects EM debtors with U.S. dollar liabilities to either repay U.S. dollar debt or hedge it. This will ultimately increase the demand for U.S. dollars in the months ahead. Near-term U.S. dollar appreciation will only reinforce and accelerate the mercantilist push in the White House and Congress. President Trump and the GOP in the House will find common ground on the border-adjustment tax, which Trump recently admitted he did not understand or look favorably upon. The passage of the law, or some such equivalent, has a much greater chance than investors expect. So does a U.S.-China trade war, as we argued last week.8 How should investors position themselves for the confluence of geopolitical, political, and financial factors we have described above? The world is facing both the cyclical liquidity crunch that BCA's Emerging Markets Team has elucidated and the potential for a secular tightening as the Trump administration focuses its efforts on closing the U.S. current account deficit. Five investment implications are top of our mind: Chart 11Market Response To Trump Win On High End Market Response To Trump Win On High End Market Response To Trump Win On High End Chart 12Market Is Priced For 'Magnificent' Events Market Is Priced For 'Magnificent' Events Market Is Priced For 'Magnificent' Events Buy VIX. The S&P 500 has continued to power on since the election, buoyed by positive economic surprises, strong global earnings, and the hope of a pro-business shift in the White House. The equity market performance puts the Trump presidency in the upper range of post-election market outcomes (Chart 11). However, with 10-year Treasuries back above fair value, the VIX near 12, and EM equities near their pre-November high, the market is pricing none of the political and geopolitical risks of an impending trade war between the U.S. and China, nor is it pricing the general mercantilist shift in Washington D.C. (Chart 12). As a result, we recommend that clients put on a "mercantilist hedge," like deep out-of-the-money S&P 500 puts, or VIX calls. For instance, a long VIX 20/25 call spread for March expiry. Long DM / Short EM. Mercantilism and the U.S. dollar bull market are the worst combination possible for EM risk assets. We therefore reiterate our long-held strategic recommendation of being long developed markets / short emerging markets. Overweight Euro Area Equities. Investors should overweight euro area equities relative to the U.S. As we have discussed in the 2017 Strategic Outlook, political risks in Europe this year are a red herring.9 We will expand on the upcoming French elections in next week's report. Meanwhile, investors appear complacent about protectionism and what it may mean for the S&P 500, which sources 44% of its earnings abroad. European companies, on the other hand, could stand to profit from a China-U.S. trade war. Chart 13Peso Is A Buy Versus Trump's Enemy #1 Peso Is A Buy Versus Trump's Enemy #1 Peso Is A Buy Versus Trump's Enemy #1 Chart 14Peso As Cheap As During Tequila Crisis Peso As Cheap As During Tequila Crisis Peso As Cheap As During Tequila Crisis Long MXN/RMB. As a tactical play on the U.S.-China trade war, we recommend clients go long MXN/RMB (Chart 13). The peso is now as cheap as it was in early 1995, at the heights of the Tequila Crisis, as per the BCA's Foreign Exchange Strategy model (Chart 14). While Mexico remains squarely in Trump's crosshairs on immigration and security, the damage to the currency appears to be done and has ironically made the country's exports more competitive. In addition, Trump's pick for Commerce Secretary, Wilbur Ross, has informed his NAFTA counterparts that "rules of origin" will be central to NAFTA re-negotiation. This can be interpreted as the U.S. using every tool at its disposal to impose punitive measures on China, including forcing NAFTA partners to close off the "rules of origin" loophole.10 But the reality is that the U.S. trade deficit with its NAFTA partners is far less daunting than that with China (Chart 15). Meanwhile, we remain negative on the RMB for fundamental reasons that we have stressed in our research. Small Is Beautiful. We continue to recommend that clients find protection from rising protectionism in small caps. Small caps are traditionally domestically geared irrespective of their domicile. Anastasios Avgeriou, Chief Strategist of BCA's Global Alpha Sector Strategy, also points out that small caps in the U.S. will benefit as the new administration follows through with promised corporate tax cuts, which will benefit small caps disproportionally to large caps given that the effective tax rate of multinationals is already low. Moreover, small companies will benefit most from any cuts in regulations, most of which have been written by multinationals in order to create barriers to entry (Chart 16). Of course, we could just be paranoid! After all, much of Trump's proposed policies - massive tax cuts, infrastructure spending, major rearmament, the border wall - would increase domestic spending and thus widen the current account deficit, not shrink it. And all the protectionism and de-globalization could just be posturing by the Trump administration, both to get a better deal from China and Europe and to give voters in the Midwest some political red meat. Chart 15China, Not NAFTA, In Trump's Crosshairs China, Not NAFTA, In Trump's Crosshairs China, Not NAFTA, In Trump's Crosshairs Chart 16Small Is Beautiful Small Is Beautiful Small Is Beautiful But Geopolitical Strategy analysts get paid to be paranoid! And we worry that much of Trump's promises that would widen U.S. deficits are being watered down or pushed to the background. Yes, we have held a high conviction view that infrastructure spending would come through, but now it appears that it will be complemented with significant spending cuts. The next 100 days will tell us which prerogatives the Trump Administration favors: rebuilding America directly, or doing so indirectly via protectionism. If the former, then the current market rally is justified. If the intention is to reduce the current account deficit, look out. Marko Papic, Senior Vice President marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Brexit: A Brave New World Miranda: O brave new world! Prospero: 'Tis new to thee. — Shakespeare, The Tempest The U.K. Supreme Court ruled on January 24 that parliament must have a say in triggering Article 50 of the Lisbon Treaty, which enables the U.K. to "exit" the European Union. This decision, as well as Theresa May's January 17 "Brexit means exit" speech, caught us in London while visiting clients. Reactions were mixed. The pound continues to rally. January 16 remains the low point in the GBP/USD cross since the vote to leave on June 23 last year (Chart 17). Chart 17Has Brexit Uncertainty Bottomed? Has Brexit Uncertainty Bottomed? Has Brexit Uncertainty Bottomed? Should investors expect more downside to the pound or do the recent events mark a bottom in political uncertainty? The market consensus suggests that further volatility in the pound is warranted for three reasons: Europeans will seek to punish the U.K. for Brexit, to set an example to their own Euroskeptics; Prime Minister May's assertion that the U.K. would seek to exit the common market is negative for the country's economy; Legal uncertainties about Brexit remain. We disagree with this assessment, at least in the short and medium term. Therefore, the pound rally on the day of May's speech was warranted, although we agree that exiting the EU Common Market will ultimately be suboptimal for the country's economy. First, by setting out a clean break from the EU, including the common market, Prime Minister May has removed a considerable amount of political uncertainty. As we pointed out in our original net assessment of Brexit, leaving the EU while remaining in its common market is illogical.11 Paradoxically, the U.K. stood to lose rather than regain sovereignty if it left the EU yet remained in the common market (Diagram 1). Diagram 1The Quite Un-British Lack Of Common Sense Behind Soft Brexit The "What Can You Do For Me" World? The "What Can You Do For Me" World? Why? Because membership in the common market entails a financial burden, full adoption of the acquis communautaire (the EU body of law), and acceptance of the "Four Freedoms," including the freedom of movement of workers. Given that the Brexit vote was largely motivated by concerns of sovereignty and immigration (Chart 18), it did not make sense to vote to leave the EU and then seek to retain membership in the common market. Apparently May and her cabinet agree. Chart 18It's Sovereignty, Stupid! The "What Can You Do For Me" World? The "What Can You Do For Me" World? Second, now that the U.K. has chosen to depart from the common market, the EU no longer needs to take as hostile of a negotiating position as before. The EU member states were not going to let the U.K. dictate its own terms of membership. That would have set a precedent for future Euroskeptic governments looking for an alternative relationship with the bloc, i.e. the so-called "Europe, à la carte" that European policymakers dread. But now that the U.K. is asking for a clean exit, with a free trade agreement to be negotiated in lieu of common market membership, the EU has less reason to punish London. An FTA arrangement will be beneficial to EU exporters, who want access to the U.K. market, and it will send a message to Euroskeptics on the continent that there is no alternative to full membership. Leaving the EU means leaving the market and falling back - at best - to an FTA-level relationship that the EU shares with Mexico and (most recently) Canada. Third, leaving the EU and the common market are political, not legal, decisions, and the lingering legal battles are neither avoidable nor likely to be substantive. Theresa May had already stolen thunder when she said that the final deal with the EU would be put to a vote in parliament. The Supreme Court ruling - as well as other legal hangups - could conceivably give rise to complications that bind the government's hands, but most likely parliament will pass a simple bill or motion granting permission for the government to invoke Article 50. That is because the referendum, and public opinion since then, speak loud and clear (Chart 19). The Conservative Party remains in a comfortable lead over the Labour Party (Chart 20), which itself is not opposing the referendum outcome. In addition, the House of Commons has already approved the government's Brexit timetable by a margin of 372 seats in a 650-seat body - with 461 ayes. That is a stark contrast with a few months ago when around 494 MPs were said to be against Brexit. Chart 19No 'Bremorse' Or 'Bregret' The "What Can You Do For Me" World? The "What Can You Do For Me" World? Chart 20Tories Still Triumphant Tories Still Triumphant Tories Still Triumphant The bigger question comes down to the parliamentary vote on the deal that is to be negotiated over the next two years. Could the Parliament vote down the final agreement with the EU? Absolutely. However, it is unlikely. The economic calamity predicted by many commentators has not happened, as we discuss below. Bottom Line: The combination of the Supreme Court decision and Prime Minister May's speech has reduced political uncertainty regarding Brexit. The EU will negotiate hard with the U.K., but the main cause of consternation - the U.K. asking for special treatment with respect to the common market - is now off the table. Yes, the EU does hold all the cards when it comes to negotiating an FTA agreement, and the process could entail some alarming twists and turns (given the last-minute crisis in the EU-Canada FTA). But we do not expect EU-U.K. negotiations to imperil the pound dramatically beyond what we've already seen. Will Leaving The Common Market Hurt Britain? Does this mean that Brexit is "much ado about nothing?" In the short and medium term, we think the answer is yes. In the long-term, leaving the EU Common Market is a suboptimal outcome for three reasons: Trade - Net exports rarely contribute positively to U.K. growth (Chart 21) and the trade deficit with the EU is particularly deep. As such, proponents of Brexit claim that putting up modest trade barriers against the EU could be beneficial. However, the U.K. has a services trade surplus with the EU (Chart 22). While it is not as large as the trade deficit, there was hope that the eventual implementation of the 2006 EU's Services Directive would have opened up new markets for U.K.'s highly competitive services industry and thus reduced the trade deficit over time. As the bottom panel of Chart 22 shows, the U.K.'s service exports to the rest of the world have outpaced those to the EU, suggesting that there is much room for improvement. This hope is now dashed and the EU may go back to putting up non-tariff barriers to services that reverse Britain's modest surplus with the bloc. Free Trade Agreements rarely adequately cover services, which means that the U.K.'s hope of expanding service exports to a new high is probably gone. Chart 21U.K. Is Consumer-Driven U.K. Is Consumer-Driven U.K. Is Consumer-Driven Chart 22Service Exports At Risk After Brexit Service Exports At Risk After Brexit Service Exports At Risk After Brexit Foreign Investment - FDI is declining, whether for cyclical reasons or because foreign companies fear losing access to Europe via the U.K. It remains to be seen how FDI will respond to the U.K.'s renunciation of the common market, but it is unlikely to be positive (Chart 23). The U.K.'s financial sector will also be negatively impacted since leaving the common market will mean that London will no longer have recourse to the EU judiciary in order to stymie European protectionism.12 This is unlikely to destroy London's status as the global financial center, but it will impact FDI on the margin. Labor Growth - The loss of labor inflow will be the biggest cost of Brexit. A decrease of immigration from the EU could reduce the U.K.'s labor force growth by a maximum of two-thirds, translating to a 25% loss in the potential GDP growth rate (Chart 24). While the U.K. is not, in fact, closing off all immigration, labor-force growth will decline, and potential GDP with it. Chart 23FDI To Suffer From Brexit? FDI To Suffer From Brexit? FDI To Suffer From Brexit? Chart 24Labor Growth Suffers Most From Brexit The "What Can You Do For Me" World? The "What Can You Do For Me" World? In addition, the EU Common Market forces companies to compete for market share in the developed world's largest consumer market. This competition is supposed to accelerate creative destruction and thus productivity, while giving the winners of the competition the spoils, i.e. a better ability to establish "economies of scale." In a 2011 report, the Bank of International Settlements (BIS) published an econometric study that compared four scenarios: the U.K. remains in the common market as the EU fully liberalizes trade; the U.K. remains in the EU's single market, but does not fully liberalize trade with the rest of the EU; the U.K. leaves the common market; the U.K. enters NAFTA.13 Of the four scenarios, only the first leads to an increase in wealth for the U.K., with 7.1% additional GDP over ten years. U.K. exports would increase by 47%, against 38.1% for its imports. Wages of both skilled and unskilled workers would increase as well. Meanwhile, the report finds that closer integration with NAFTA would not compensate for looser U.K. ties with the EU. In fact, the U.K. national income would be 7.4% smaller if the U.K. tied up with NAFTA instead of taking part in further trade liberalization on the continent. Why rely on a 2011 report for the assessment of benefits of the common market? Because it was written by a competent, relatively unbiased international body and predates the highly politicized environment surrounding Brexit that has since infected almost all think-tank research. And yet the more recent research echoes the 2011 report in terms of the negative consequences of leaving the common market.14 In addition, the BIS study actually attempts to forecast the benefit of further removing trade barriers in the single market, which is at least the intention of the EU Commission. That said, our concerns regarding the U.K. economy are long-term. It may take years before the full economic impact of leaving the common market can be assessed. In addition, much of our analysis hinges on the Europeans fully liberalizing the common market and removing the last remaining non-tariff barriers to trade, particularly of services. At the present-day level of liberalization, the U.K. may benefit by leaving. In addition, we do not expect a balance-of-payments crisis in the U.K. any time soon. The U.K. current account is deeply negative, unsurprisingly so given the deep trade imbalance with the EU and world. However, our colleague Mathieu Savary, Vice-President of BCA's Foreign Exchange Strategy, has pointed out that the elasticity of imports to the pound is in fact negative, a very surprising result. This reflects an extremely elevated import content of British exports. A lower pound is therefore unlikely to be the most crucial means of improving the current-account position. Certainly leaving the common market will not improve the competitiveness of British exports in the EU. Chart 25The U.K.'s Basic Balance Is Healthy The U.K.'s Basic Balance Is Healthy The U.K.'s Basic Balance Is Healthy But this raises a bigger question: why does the U.K. have to improve its current account deficit? As our FX team points out in Chart 25, despite having a current-account deficit of nearly 6% of GDP, the U.K. runs a basic balance-of-payments surplus of 12%, even after the recent fall in FDI inflows. The reason for the massive balance-of-payments surplus is the financial account surplus of 6.17% of GDP, a feature of the U.K. being a destination for foreign capital, which flows from its status as a global financial center and prime real estate destination. In other words, leaving the common market will not change the fundamentals of the U.K. balance of payments much. The country will remain a global financial center and will still run a capital account surplus, which will suppress the country's interest rates, buoy the GBP, and give tailwinds to imports of foreign goods. Meanwhile, exports will not benefit as they will face marginally higher tariffs as the country exits the EU Common Market. At best, new tariffs will be offset by a cheaper GBP. As such, leaving the common market is not going to be a disaster for the U.K. Nor will it be a panacea for the country's deep current account deficit. And that is okay. The U.K. will not face a crisis in funding its current account deficit. What is clear is that for the time being, the U.K. economy is holding up. Our forex strategists recently argued that U.K.'s growth has surprised to the upside and that the improvement is sustainable: Monetary and fiscal policy are both accommodative (Chart 26); Inflation is limited; Tight labor market drives up wages and puts cash in consumers' pockets (Chart 27); Credit growth remains robust (Chart 28). Chart 26Easy Money Smooths The Way To Brexit Easy Money Smooths The Way To Brexit Easy Money Smooths The Way To Brexit Chart 27British Labor Market Tightening British Labor Market Tightening British Labor Market Tightening Chart 28U.K. Credit Growth Looking Good U.K. Credit Growth Looking Good U.K. Credit Growth Looking Good This means that the political trajectory is set for the time being. "Bremorse" and "Bregret" will remain phantoms for the time being. Bottom Line: Leaving the common market is a suboptimal but not apocalyptic outcome for the U.K. The combination of decent economic performance and lowered political uncertainty in the near term will support the pound. Given the pound's 20% correction since the June referendum, we believe that the market has already priced in the new, marginally negative, post-Brexit paradigm. The Big Picture It is impossible to say whether the long-term negative economic effects of Brexit will affect voters drastically enough and quickly enough for Scotland, or parliament, to act in 2018 or 2019 and modify the government's decision to pursue a "Hard Brexit." It seems conceivable if something changes in the fundamental dynamics outlined above, but we wouldn't bet on it. At the moment even a new Scottish referendum appears unlikely (Chart 29). Scottish voters have soured on independence, perhaps due to a combination of continued political uncertainty in the EU (Scotland's political alternative to the U.K.) and a collapse in oil prices (arguably Scotland's economic alternative to the U.K.). The issue is not resolved but on ice for the time being. Chart 29Brexit Not Driving Scots To Independence (Yet) Brexit Not Driving Scots To Independence (Yet) Brexit Not Driving Scots To Independence (Yet) More likely, the government will get its way on Brexit and the 2020 elections will mark a significant popular test of the Conservative leadership and the final deal with the EU. Then the aftermath will be an entirely new ballgame for the U.K. and all four of its constituent nations. If Britain's new beginning is founded on protectionism and dirigisme - as the government suggests - then the public is likely to be disappointed. The "brave new world" of Brexit may prove to be rather mundane, disappointing, and eerily reminiscent of the ghastly 1970s.15 Hence the Shakespeare quote at the top of this report. The political circumstances of Brexit resemble the U.K. landscape before it joined the European Economic Community in 1973: greater government role in the economy, trade protectionism, tight labor market, higher wages, and inflation. Yet this was a period when the U.K. economy underperformed Europe's. The U.K.'s eventual era of outperformance was contingent on the structural reforms of the Thatcher era and expanded access to the European market (Chart 30). It remains to be seen what happens when the U.K. leaves the market and rolls back Thatcherite reforms. The weak pound and proactive fiscal policy will fail to create a manufacturing revolution. That is because most manufacturing has hollowed out because of automation, not foreign workers stealing Britons' jobs. Moreover, as for the pound, it is important to remember that currency effects are temporary and any boost to exports that the weak pound is generating will be short-lived, as with the case of China in the 1990s and the EU in the past two years (Chart 31). Chart 30U.K. Growth To Lag Europe's Once Again? U.K. Growth To Lag Europe's Once Again? U.K. Growth To Lag Europe's Once Again? Chart 31Export Boost From Devaluation Is Fleeting Export Boost From Devaluation Is Fleeting Export Boost From Devaluation Is Fleeting In addition, we would argue that, in an environment of de-globalization - in which tariffs are rising, albeit slowly for the time being (Chart 32) - the EU Common Market provides Europe with a mechanism by which to protect its vast consumer market. The U.K. may have chosen the precisely wrong time in which to abandon the protection of continental European protectionism. It could suffer by finding itself on the outside of the common market as global tariffs begin to rise significantly. Chart 32Protectionism On The March The "What Can You Do For Me" World? The "What Can You Do For Me" World? What about the restoration of the "Special Relationship" between the U.K. and the U.S.? Could moving to the "front of the queue" on negotiating an FTA with the world's largest economy make a difference for the U.K.? Perhaps, but as the BIS study above indicates, an FTA with North America or the U.S. alone is unlikely to replace the benefits of the common market. In addition, it is difficult to imagine how a protectionist U.S. administration that is looking to massively decrease its current account deficit will help the U.K. expand trade with the U.S. By contrast, Trump's election in the United States poses massive risks to globalization, both through his protectionism and the strong USD implications of his core policies. This will reverberate negatively across the commodities and EM space. In such an environment, the U.K. may not be able to make much headway in its "Global Britain" initiatives to conclude fast trade deals with EM economies that stand to lose the most in the de-globalization era. Bottom Line: As a trading nation, the U.K. is likely to lose out in a prolonged period of de-globalization. Membership in the EU could have served as a bulwark against this global trend. Investment Implications We diverge from our colleagues in the Foreign Exchange Strategy and European Investment Strategy when it comes to the assessment of political risk looming over Brexit.16 The decision to leave the common market will alleviate the pressure on Europeans to seek vindictive punishment. Earlier, the U.K. was forcing them to choose between making an exception to the rules and demonstrating the negative consequences of leaving the bloc. Now the U.K. is self-evidently taking on its own punishment - the economic burden of leaving the common market - and the EU will probably deem that sufficient. Will the EU play tough? Yes, especially since the EU retains considerable economic leverage over Britain (Chart 33). But the stakes are far smaller now. Furthermore, investors should remember that core European states - especially France and Germany - remain major military allies of the U.K. and will continue to be deeply intertwined economically. As such, we believe that the pound has already priced in the new economic paradigm and that the expectations of political uncertainty ahead of the U.K.-EU negotiations may be overdone. We therefore recommend that investors short EUR/GBP outright. Our aforementioned forex strategist Mathieu Savary argues that, on an intermediate-term basis, the outlook for this cross is driven by interest rate differentials and policy considerations. Due to the balance-sheet operations conducted by the BoE and ECB, interest rates in the U.K. and the euro area do not fully reflect domestic policy stances. Instead, Mathieu uses the shadow rates. Currently, shadow rates unequivocally point toward a lower EUR/GBP (Chart 34). In fact, balance-sheet dynamics point toward shorting EUR/GBP. Chart 33EU Holds The Cards In FTA Negotiation EU Holds The Cards In FTA Negotiation EU Holds The Cards In FTA Negotiation Chart 34Shadow Rates Point To Stronger GBP Shadow Rates Point To Stronger GBP Shadow Rates Point To Stronger GBP For full disclosure, Mathieu cautions clients to wait on executing a short EUR/GBP until after Article 50 is enacted. By contrast, we think that political uncertainty regarding Brexit likely peaked on January 16. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President marko@bcaresearch.com 1 While the U.S. runs a massively negative net international investment position, its net international income remains positive. In other words, foreigners receive a much lower return on U.S. assets while the U.S. benefits from risk premia in foreign markets. 2 Please see Spiegel Online, "Donald Trump and the New World Order," dated January 20, 2017, available at Spiegel.de. 3 In a widely-quoted interview with The Wall Street Journal, Donald Trump said that the U.S. dollar is "too strong." He continued that, "Our companies can't compete with [China] now because our currency is too strong. And it's killing us." Please see The Wall Street Journal, "Donald Trump Warns on House Republican Tax Plan," dated January 16, 2017, available at wsj.com. 4 We would note that the Trump administration and its Treasury Department have considerable leeway over how they choose to interpret China's foreign exchange practices. In 1992, when the U.S. government last accused China of currency manipulation, it issued a warning in its spring report before leveling the accusation in the winter report. The RMB did not depreciate in the meantime but remained stable, and Treasury noted this approvingly; however, Treasury chose 1989 as the base level for its assessment, and found manipulation. The Trump administration could use much more aggressive interpretive methods than this to achieve its ends. 5 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, and Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 14, 2014, available at gps.bcaresearch.com. 6 Please see BCA Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Weekly Report, "The U.S. Dollar's Uptrend And China's Options," dated January 11, 2017, available at ems.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 10 Critics, including Trump supporters, claim that NAFTA sets too low of a threshold for the domestic content of a good deemed to have originated within the NAFTA countries. Goods that are nearly 40% foreign-made can thus be treated as NAFTA-made. This is one of many contentious points in the trade deal. 11 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. 12 In 2015, the U.K. took the ECB to court over its decision to require financial transactions denominated in euros to be conducted in the euro area, i.e. out of the City, and won. This avenue of legal redress will no longer be available for the U.K., allowing EU member states to slowly introduce rules and regulations that corral the financial industry - or at least to the parts focused on transactions in euros - out of London. 13 Please see Bank of International Settlements, "The economic consequences for the U.K. and the EU of completing the Single Market," BIS Economics Paper No. 11, dated February 2011, available at www.gov.uk. 14 Please see Her Majesty's Government, "H.M. Treasury Analysis: The Long-Term Economic Impact Of EU Membership And The Alternatives," Cmnd. 9250, April 2016, available at www.gov.uk. and Jagjit S. Chadha, "The Referendum Blues: Shocking The System," National Institute Economic Review 237 (August 2016), available at www.niesr.ac.uk. 15 We were going to use "grey" to describe Britain in the 1970s. However, our colleague Martin Barnes, BCA's Chief Economist, insisted that "grey" did not do the "ghastly" 1970s justice. When it comes to the U.K. in the 1970s, we are going to defer to Martin. 16 Please see BCA Research European Investment Strategy Weekly Report, “May’s Brexit Speech: No Substance,” dated January 19, 2017, available at eis.bcaresearch.com. Geopolitical Calendar

Highlights Our immediate reaction to Theresa May's vision of Brexit boils down to three points: You can wish all you want... but what you wish isn't what you get. Do you understand the legal framework? Where does this leave Scotland? Feature You Can Wish All You Want... But What You Wish Isn't What You Get Theresa May essentially set out her wish-list for what Brexit should look like. But it was a vision seen through rose-tinted spectacles. The speech listed all the benefits to the U.K. but conveniently ignored most of the costs. It was a speech to rouse the Conservative Party, rather than to present a thoughtful and sober analysis. Hence, the speech was riddled with intellectual inconsistencies and impossibilities. For example, she wants "Britain to negotiate its own trade agreements" which would entail departing the Customs Union. But contradicting this, she also wants "cross-border trade to be as frictionless as possible" which would entail retaining some sort of Customs Union. More importantly, there are two sides to every negotiation and so far, we are only hearing one side - May's vision of a future in sunlit uplands. Spokesmen for the EU27 are probably chomping at the bit to reply. But smartly, they have entered a vow of silence until after Article 50. Just like a poker player who has to wait just a little longer to reveal that he carries all the aces... Do You Understand The Legal Framework? Events since the referendum on June 23 show that the U.K. Government was completely unprepared for the No vote. Hence, the government's strategy - in as much as one exists - has been made on the hoof, and quite often with the minimum of research or analysis. Most notably, the government did not understand the legal framework to leave the EU - specifically that the invoking of Article 50 of the Lisbon Treaty might require an Act of Parliament, a precondition on which the Supreme Court will soon opine. Now, Prime Minister May claims that "we will no longer be members of the Single Market", but this may not be simple to deliver. Leaving the EU might not automatically mean leaving the Single Market. This is because the Single Market is not defined by the EU but by the European Economic Area (EEA), consisting of the 28 countries of the EU plus Norway, Iceland and Liechtenstein. Crucially, membership of the EEA is governed by its own Treaty. Therefore, leaving the Single Market will require a careful legal interpretation of Article 126, Article 127 and Article 128 of the EEA Treaty. We will cover this in more detail in a future report. Prime Minister May also promised Parliament a vote on the final deal struck with the EU27. But it was unclear whether losing that vote would mean staying in the EU (as the pound seemed to interpret) or leaving with no deal (more likely). Where Does This Leave Scotland? A clean Brexit would be a pyrrhic victory if it meant the breakup of the United Kingdom - indeed it would effectively become an 'Engexit', rather than a Brexit. But that is the risk, because Nicola Sturgeon has said that leaving the Single Market is a red line that Scotland is unwilling to cross. Thereby, Theresa May's speech has increased the probability of a new referendum on Scottish Independence. In summary, the speech did not reduce the uncertainties around Brexit. It increased them. The U.K. is not out of the woods, it is just about to enter the woods. Hence, the knee-jerk spike in the pound was unwarranted. We anticipate further volatility in the pound and maintain our strategy of 'owning the tails': for example, short pound/euro but with call options at €1.30. As for the FTSE100 relative performance, investment reductionism shows that it is just an inverse play on the pound. As the pound weakens, the FTSE100 outperforms, and vice-versa (Chart of the Week). Chart of the WeekFTSE100 Relative Performance Is Just An Inverse Play On The Pound FTSE100 Relative Performance Is Just An Inverse Play On The Pound FTSE100 Relative Performance Is Just An Inverse Play On The Pound Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* Pleasingly, our long gold position has hit its profit target in a classic liquidity-triggered trend reversal. There are no new trades this week. 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-2 Long Gold Long Gold * 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 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. 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