Geopolitics

The Fed delivered a "hawkish hold." Remain tactically short U.S. equities and position for a stronger dollar. Meanwhile, the Bank of Japan laid out a radical overhaul: The new framework is consistent with price-level targeting and debt monetization. Long-term investors should position for a weaker yen and higher Japanese equity prices. Also, stay structurally underweight Japanese bonds: Zero is a resting point, rather than a final destination, for 10-year JGB yields.

Without saying it, the BoJ introduced a price level target. While the announcement underwhelms in the details, its key implication is that the BoJ wrote a blank check to the government. Increased talk of cooperation between the government and the BoJ suggests more fiscal easing will materialize, which will ultimately hurt the yen. In the short term, markets will test the BoJ and the government's resolve.

It is becoming increasingly likely that the U.K. will, after all, exit the EU. Feature The initial post-Brexit economic data have surprised to the upside as a result of the Bank of England's quick reflexes, the fall of the pound, and decline in real interest rates. Yet this does not reflect the real impact of Brexit - which, of course, has not happened yet and likely will not for the next 48 months. Despite the sanguine outcome thus far, we expect the economy to deteriorate going forward: The country's credit impulse, which leads GDP growth by about six months, suggests that a recession looms (Chart 1). Chart 1U.K. Economy Post Brexit Vote: Don't Get Complacent U.K. Economy Post Brexit Vote: Don't Get Complacent U.K. Economy Post Brexit Vote: Don't Get Complacent Leading indicators for housing prices in London and Britain are also diving. Business and consumer confidence have collapsed (Chart 2). The recent stall in global equities only makes matters worse, given the U.K.'s high exposure to financial markets (Chart 3). Chart 2First Feel For Brexit First Feel For Brexit First Feel For Brexit Chart 3Global Worries For Britain bca.gps_sr_2016_09_16_c3 bca.gps_sr_2016_09_16_c3 Most ominously, the decline in the GBP implies that net FDI has also already nosedived (we are still waiting for Q2 data), which would mean that the U.K. has become structurally less appealing to long-term investors (Chart 4). Will the costs of Brexit be enough for "Bregret" to set in? Given that the recession is expected to be mild, probably not. Generally, there are three signposts suggesting that Brexit is here to stay: Public opinion: Britons are not yet having second thoughts regarding the June 23 referendum. First, opinion polling shows Britons are not suffering "Bregret" but in fact support the referendum outcome by 46% to 42-3%, roughly the same as the Brexit camp's margin of victory on Britain's "independence day." Meanwhile, the Conservative Party's approval ratings have remained resilient at 37% (Chart 5). Prime Minister Theresa May is polling at a 50% support rate, signaling that an outright majority thinks she is cut out for the unenviable job of negotiating exit with the European Union and stabilizing the economy (Chart 6). Chart 4Will FDI Turn Away? Will FDI Turn Away? Will FDI Turn Away? Chart 5No Brexit Cost For The Tories bca.gps_sr_2016_09_16_c5 bca.gps_sr_2016_09_16_c5 Labour Pains: The Labour Party has suffered the brunt of the post-referendum backlash. In stark contrast with May's popularity, Labour leader Jeremy Corbyn is wallowing in unpopularity. He is fending off a leadership challenge by Owen Smith, whom the parliamentary side of the party prefers (as opposed to the grassroots, who still defend Corbyn). The leadership challenge should be determined at the Labour Party conference September 24-8. Corbyn is most likely to prevail since, according to polls of the party's internal electorate, 62% support him over Smith (Chart 7). A Corbyn win is bullish for Brexit given his unpopularity nationally, wavering support of EU membership, and general lack of support amongst fellow Labour MPs. Chart 6May-Corbyn Gap Suggests No Bregret BREXIT Update: Brexit Means Brexit, Until Brexit BREXIT Update: Brexit Means Brexit, Until Brexit Chart 7Under Corbyn, Labour May Split BREXIT Update: Brexit Means Brexit, Until Brexit BREXIT Update: Brexit Means Brexit, Until Brexit No U.K. Breakup: The Scottish quest for independence - a likely derivative of Brexit, at least eventually - has been waylaid by short-term concerns over economic and political stability. There will be no quick Scottish reaction to shock British voters about the consequences of the Brexit vote and give reason for pause (Chart 8). Chart 8Scotland Is Becoming Cautious bca.gps_sr_2016_09_16_c8 bca.gps_sr_2016_09_16_c8 The conclusion is inescapable: "Brexit means Brexit," as Prime Minister May has repeatedly maintained. While there is still a fair chance for an eventual second referendum on the terms of the EU-U.K. negotiations - or a 2020 general election that is, in effect, the same thing - the economic fallout will have to create a tangible shift in public opinion before a reversal of the referendum can be contemplated again. "Bregret" may yet happen, but it most likely will require a formal exit from the EU! At that point, it will be too late for policymakers to act on it and adjust the course. So what does this mean for the U.K.? Britain faces long-term opportunity costs from leaving the EU. As we have argued, departing the EU will not be devastating, but is clearly a suboptimal outcome. Freedom isn't free. Three long-term risks stand out: Financial sector: The conventional wisdom regarding the costs to the U.K. financial sector is probably correct. The Brexit referendum gave policymakers a mandate to negotiate access to the free market and limit the flow of EU migrants. It is highly unlikely that voters who favored Brexit care much about the wellbeing of the London financial elite. The U.K. political elites may want to abandon their base and make a deal that favors the financial industry, but we doubt that the EU member states have any intentions of being reasonable and compliant. As such, the EU will set up barriers to British services exports in general and financial system in particular. For example, now that the U.K. has decided to leave, the EU will have even less incentive to implement the 2006 EU's Services Directive, which has been a source of contention between London and Brussels for a decade. In addition, London will no longer have recourse to the EU judiciary in order to stymie protectionism emanating from the continent. In 2015, the U.K. took the ECB to court over its decision to require financial transactions in euros to be conducted in the euro area, i.e. out of the City, and won. This avenue will no longer be available for the U.K., allowing EU member states to slowly introduce rules and regulations that force the financial industry - at least that dedicated to transactions in euros - out of London. FDI: As the Bremain camp warned, the U.K. will likely cease to be a platform for global companies to access the EU, triggering a long-term decline in foreign direct investment. Post-Brexit FDI statistics are not available, but the trend had already declined after the Great Recession and yet again after 2014 (see Chart 4). Chart 9Intra-EU Migration##br##Boosts Labor Force Growth BREXIT Update: Brexit Means Brexit, Until Brexit BREXIT Update: Brexit Means Brexit, Until Brexit Growth: If the U.K. successfully reduces the inflow of EU migrants, a key demand of the Brexiteers, then potential GDP growth will fall by about 25% (Chart 9). Despite the high cost, we do not see how Westminster can pull a bait-and-switch on the populace over this issue, one of the key demands of the Brexit voters. Ultimately the EU will not prevent the U.K. from blocking immigration. Dominant EU countries like Germany gain nothing from the flow of relatively productive and well-educated Eastern European migrants into the British labor force. On the contrary, they benefit from taking more of these migrants themselves. Therefore the EU can ultimately compromise on this critical issue - though it will exact a price. By demanding both market access and restricted flows of people, the U.K. will exhaust most of its capital in the exit negotiations. The EU will dictate the rest of the terms. The U.K. will likely emerge in a tolerable situation, but it will have to adopt, without shaping, all EU regulations, thus negating almost entirely the argument that Brexit would restore sovereignty (Diagram 1). The result will be little alleviation of burdensome regulation, but higher EU protectionism toward U.K. service exports. Diagram 1Brexit And Sovereignty: It's Complicated BREXIT Update: Brexit Means Brexit, Until Brexit BREXIT Update: Brexit Means Brexit, Until Brexit Bottom Line: It is becoming increasingly clear that Brexit will mean Brexit. However, the initial positive economic surprises are not telling the entire story. The U.K. will have no trouble surviving outside the EU but will face economic headwinds as the long-term detriment becomes palpable. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Managing Editor marko@bcaresearch.com

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

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

The Fed is sending signals that another rate hike is coming, despite sluggish U.S. growth and modest inflation, while both the ECB and BoJ are facing questions about the ability to maintain the pace of bond purchase programs. Amidst all this uncertainty, bond risk premiums can rise further in the near term.

Cuba will become a notable frontier market now that the Communist regime has no foreign geopolitical partner to prop it up. A poor demographic profile does not prevent the country from capitalizing on American tourism. It also stands to benefit from access to U.S. consumers and rising Chinese consumerism.

Hong Kong's growing political awareness and rising sensitivity to public policy underscores brewing social tensions brought about by decades of <i>Laissez-Faire</i> capitalism. Social policies will likely become progressively more redistributive, with potentially a longer-term negative impact on asset prices.

The post-Brexit rebound has pushed stocks into overbought territory. U.S. equities, in particular, look increasingly priced for perfection. Higher U.S. rate expectations will push up the dollar, further curbing S&P 500 profit growth. Share buyback activity and dividend growth are slowing, while U.S. election risks are likely to rise. Go short the NASDAQ 100 futures as a tactical hedge.