Domestic Politics

Highlights China-U.S. trade détente goes against our alarmist forecast, prompting us to reassess the view; We do not expect the truce to last long, as China has not given the U.S. what we believe the Trump administration wants; Instead, we see the truce lasting until at least the completion of the North Korea - U.S. summit, at most early 2019; Market is correct to fret about Italy, as the populist agenda will be constrained by the bond market in due course; Stay long DXY, but close our recommendations to short China-exposed S&P 500 companies. Feature Our alarmist view on trade wars appears to be in retreat, or at least "on hold," following the conclusion of the latest trade talks between U.S. and Chinese officials. Global markets breathed a sigh of relief on Monday, after a weekend of extremely positive comments from President Trump's advisers and cabinet members. Particularly bullish were the comments from Trump's top economic adviser, Larry Kudlow, who claimed that China had agreed to reduce its massive trade surplus with the U.S. by $200 billion (Chart 1). Chart 1China, Not NAFTA, Is The Problem The official bilateral statement, subsequently published by the White House, was vague. It claimed that "there was a consensus" regarding a substantive - but unquantifiable - reduction in the U.S. trade deficit.1 The only sectors that were mentioned specifically were "United States agriculture and energy exports." China agreed to "meaningfully" increase the imports of those products, which are low value- added commodity goods. With regard to value-added exports, China merely agreed that it would encourage "expanding trade in manufactured goods and services." The two sides also agreed to "attach paramount importance to intellectual property protections," with China specifically agreeing to "advance relevant amendments to its laws and regulations in this area." Subsequent to the declaratory statement, China lowered tariffs on auto imports from 25% to 15%. It will also cut tariffs on imported car parts, to around 6%, from the current average of about 10%. Is that it? Was the consensus view - that China would merely write a check for some Boeings, beef, and crude oil - essentially right? The key bellwether for trade tensions has been the proposed tariffs on $50-$150 billion worth of goods, set to come in effect as early as May 21. According to Treasury Secretary Steven Mnuchin, this tariff action is now "on hold." Mnuchin was also supposed to announce investment restrictions by this date, another bellwether that is apparently on hold. This is objective evidence that trade tensions have probably peaked for this year.2 On the other hand, there are several reasons to remain cautious: Section 301 Investigation: Robert Lighthizer, the cantankerous U.S. Trade Representative who spearheaded the Section 301 investigation into China's trade practices that justified the abovementioned tariffs and investment restrictions, immediately issued a statement on Sunday dampening enthusiasm: "Real work still needs to be done to achieve changes in a Chinese system that facilitates forced technology transfers in order to do business in China." In the same statement, Lighthizer added that China facilitates "the theft of our companies' intellectual property and business know-how." In other words, Lighthizer does not appear to be excited by the prospect of trading IP and tech protection for additional exports of beef and crude oil. Political Reaction: The reaction from conservative circles was less than enthusiastic, with both congressional officials and various Trump supporters announcing their exasperation with the supposed deal over the weekend.3 The Wall Street Journal claimed that China refused to put a number - such as the aforementioned $200 billion - in the final statement.4 The implication is that Beijing won this round of negotiations. But President Trump will not want to appear weak. If a narrative emerges that he "lost," we would expect President Trump to pivot back to tariffs and confrontation. Support for free trade has recently rebounded among Republican voters but remains dramatically lower among them than among Democrats (Chart 2). As such, it is a salient issue for the president politically. Chart 2Support For Free Trade Recovering, ##br##But Republicans Still Trail Democrats Chart 3China Already ##br##Imports U.S. Commodities... Investment Restrictions: Senator Cornyn's (Texas, Republican) bill to strengthen the Committee on Foreign Investment in the United States (CFIUS) process continues to move through the Senate.5 The Foreign Investment Risk Review Modernization Act Of 2017 (FIRRMA) is currently being considered by the Senate Committee on Banking, Housing, and Urban Affairs and should be submitted to a vote ahead of the November election. Congress is also looking to pass a bipartisan bill that would prevent President Trump from taking it easy on Chinese telecommunication manufacturer ZTE. Chart 4U.S. Commodity Export Growth Is Solid Chart 5... But Impedes Market Access For Higher Value-Added Goods Beef And Oil Is Not Enough: The U.S. already has a growing market share in China's imports of commodities and crude materials, although it could significantly increase its exports in several categories (Chart 3). As the Chinese people develop middle-class consumption habits, the country was always going to import more agricultural products. And as their tastes matured, the U.S. was always going to benefit, given the higher quality and price point of its agricultural exports. In fact, China's imports of U.S. primary commodity exports have been increasing faster than imports of U.S. manufacturing goods (Chart 4). As such, the statement suggests that the U.S. and China have opted for the easiest compromises (commodities) to grant U.S. greater market access; the U.S. may have fallen short on market access for value-added manufacturing (Chart 5). In addition, there was little acknowledgment of the American demands that China cease forced tech transfers, cut subsidies for SOEs, reduce domestic content requirements under the "Made in China 2025" plan, and liberalize trade for U.S. software and high-tech exporters (Chart 6). Given these outstanding and unresolved issues, there are three ways to interpret the about-face in U.S. trade demands: Geopolitical Strategy is wrong: One scenario is that we are wrong, that the Trump administration is not focused on forced tech transfers and IP theft in any serious way.6 On the other hand, if that is true, the U.S. is also not serious about significantly reducing its trade deficit with China, since structurally, IP theft and non-tariff barriers to trade of high-value exports are a major reason why China has a massive surplus. Instead, the U.S. may only be focused on reducing the trade deficit through assurances of greater market access - a key demand as well, but one that could prove temporary or un-strategic, especially if access is only granted for commodities.7 If this is true, it suggests that President Trump's demands on China are transactional, not geopolitical, as we asserted in March.8 Midterms matter: Another scenario is that President Trump does not want to do anything that would hurt the momentum behind the GOP's polling ahead of the November midterms (Chart 7). The administration can always pick up the pressure on China following the election, given that 2019 is not an election year. Trump's political team may believe that Beijing concessions on agriculture, autos, and energy will be sufficient to satisfy the base until then. By mid-2019, the White House can also use twelve months of trade data to assess whether Beijing has actually made any attempt to deliver on its promises of increased imports from the U.S. Chart 6China's High-Tech Protectionism Chart 7Republicans Are Gaining... North Korea matters: Along the same vein as the midterms, there is wisdom in delaying trade action against China given the upcoming June 12 summit between President Trump and North Korean Supreme Leader Kim Jong-un in Singapore. President Trump's approval ratings began their second surge this year following the announced talks (Chart 8), and it is clear that the administration has a lot of political capital invested in the summit's success. Recent North Korean statements, suggesting that they are willing to break off dialogue, may have been the result of the surprise May 8 meeting between Chinese President Xi Jinping and Kim, the second in two months. As such, President Trump may have had to back off on the imposition of tariffs against China in order to ensure that his summit with Kim goes smoothly. At this point, it is difficult to gauge whether the decision to ease the pressure against China was due to strategic or tactical reasons. We expect that the market will price in both, easing geopolitical risk on equity markets. However, if the delay is tactical - and therefore temporary - then the risk premium would remain appropriate. We do not think that we are wrong when it comes to U.S. demands on China. These include greater market access for U.S. value-added exports and services (not just commodities), as well as a radical change in how China awards such access (i.e., ending the demand that technology transfers accompany FDI and market access). In addition, China still massively underpays for U.S. intellectual property (IP) rights and has been promising to do more on that front for decades (Chart 9). Given that China has launched some anti-piracy campaigns, and given its recent success in other top-down campaigns like shuttering excess industrial capacity, it is hard to believe that Beijing could not crack down on IP theft even more significantly. Chart 8...Thanks To Tax Cuts And Kim Jong-un Chart 9What Happened To ~$100 Billion IP Theft? Furthermore, U.S. demands on China are not merely about market access and IP. There is also the issue of aggressive geopolitical footprint in East Asia, particularly the South China Sea. The U.S. defense and intelligence establishment is growing uneasy over China's pace of economic and technological development, given its growing military aggressiveness. In fact, over the past two weeks, China has: Landed the Xian H-6K strategic bombers capable of carrying nuclear weapons on disputed "islands" in the South China Sea; Installed anti-ship cruise missiles, as well as surface-to-air missiles, on three of its outposts in disputed areas. Of course, if we are off the mark on our view of Sino-American tensions, it would mean that the Trump administration is willing to make transactional economic concessions for geopolitical maneuvering room. In other words, more crude oil and LNG exports in exchange for better Chinese positioning in vital sea and air routes in East Asia. We highly doubt that the Trump administration is making such a grand bargain, even if the rhetoric from the White House often suggests that the "America First" agenda would allow for such a strategic shift. Rather, we think the Trump administration, like the Obama administration, put the South China Sea low on the priority list, but will focus greater attention on it when is deemed necessary at some future date. Bottom Line: Trade tensions between China and the U.S. have almost assuredly peaked in a tactical, three-to-six month timeframe. While still not official, it appears that the implementation of tariffs on $50-$150 billion worth of imports from China, set for any time after May 21, is now on hold. As such, a trade war is on hold. We are closing our short China-exposed S&P 500 companies versus U.S. financials and telecoms, a trade that has returned 3.94% and long European / short U.S. industrials, which is down 2% since inception. This greatly reduces investment-relevant geopolitical risk this summer and makes us far less confident that investors should "sell in May and go away." Our tactical bearishness is therefore reduced, although several other geopolitical risks - such as Iran-U.S. tensions, Italian politics, and the U.S. midterm election- remain relevant.9 We do not think that Sino-American tensions have peaked cyclically or structurally (six months and beyond). The Trump Administration continues to lack constraints when it comes to acting tough on China. As such, investors should expect tensions to renew either right after the summit between Trump and Kim in early June or, more likely, following the November midterm elections. Italy: The Divine Comedy Continues Since 2016, we have noted that Italy remains the premier risk to European markets and politics.10 There are two reasons for the view. First, Italy has retained a higher baseline level of Euroskepticism relative to the rest of Europe (Chart 10). While support for the common currency has risen in other member states since 2013, it has remained between 55%-60% in Italy. This is unsurprising given the clearly disappointing economic performance in Italy relative to that of its Mediterranean peers (Chart 11). Chart 10Italy Remains A Relative Euroskeptic Chart 11Lagging Economy Explains Cyclical Euroskepticism Italy's Euroskepticism, however, is not merely a product of economic malaise. Chart 12 shows that a strong majority of Europeans are outright pessimistic about the future of their country outside of the EU. But when Italians are polled in that same survey, the population is increasingly growing optimistic about the option of exit (Chart 13). The only other EU member state whose citizens are as optimistic about a life outside the bloc is the U.K., where population obviously voted for Brexit. Chart 12Europeans Are Pessimists About EU Exit... Chart 13...But Italians Are More Like Brits Furthermore, Italian respondents have begun to self-identify as Italian only, not as "European" also, which breaks with another long-term trend in the rest of the continent (Chart 14) and is also reminiscent of the U.K. The second reason to worry about Italy is its economic performance. Real GDP is still 5.6% below its 2008 peak, while domestic demand continues to linger at 7.9% below its pre-GFC levels (Chart 15). As we posited at the end of 2017, the siren song of FX devaluation would become a powerful political elixir in the 2018 election, as populist policymakers blame Italy's Euro Area membership for the economic performance from Chart 15.11 Chart 14Italians Feel More Italian Chart 15Italian Demand Never Fully Recovered Is the Euro Area to blame for Italy's ills? No. The blame lies squarely at the feet of Italian policymakers, who flubbed efforts to boost collapsing productivity throughout the 1990s and 2000s (Chart 16). There was simply no pressure on politicians to enact reforms amidst the post-Maastricht Treaty convergence in borrowing costs. Italy punted reforms to its educational system, tax collection, and corporate governance. Twenty years of complacency have led to a massive loss in global market share (Chart 17). Chart 16Italy Has A Productivity Problem Chart 17Export Performance Is A Disaster While it is difficult to prove a counterfactual, we are not sure that even outright currency devaluation would have saved Italy from the onslaught of Asian manufacturing in the late 1990s. Euro Area imports from EM Asia have surged from less than 2% of total imports to nearly 10% in the last twenty years. Italy began losing market share to Asia well before the euro was introduced on January 1, 1999, as Chart 18 illustrates. The incoming populist government is unfortunately coming to power with growing global growth headwinds (Chart 19), with negative implications for Italy (Chart 20). These are likely to act as a constraint on plans by the Five Star Movement (M5S) and Lega coalition to blow out the budget deficit in pursuit of massive tax cuts, reversals of pension reforms, minimum wage hikes, and a proposal to increase spending on welfare. Our back-of-the-envelope calculation sees Italy's budget deficit growing to over 7% in 2019 if all the proposed reforms were enacted, well above the 3% limit imposed by the EU on its member states. Chart 18Italy Lost Market Share Amid Globalization Chart 19Tepid Global Growth... Chart 20...Is Bad News For Italy How would the EU Commission react to these proposals, given that Italy would break the rules of the EU Stability and Growth Pact (SGP)? We think the question is irrelevant. The process by which the EU Commission enforces the rules of the SGP is the Excessive Deficit Procedure (EDP), which would take over a year to put into place.12 First, the Commission would have to review the 2019 budget proposed by the new Italian government in September 2018. It would likely tell Rome that its plans would throw it into non-compliance with SGP rules, at which point the EU Commission would recommend the opening of a Significant Deviation Procedure (SDP). If Italy failed to follow the recommendations of the SDP, the Commission would then likely throw Italy into EDP at some point in the first quarter of 2019, or later that year.13 And what happens if Italy does not conform to the rules of the EDP? Italy would be sanctioned by the EU Commission by forcing Rome to make a non-interest-bearing deposit of 0.2% GDP.14 (Because it makes perfect sense to force a country with a large budget deficit to go into an even greater budget deficit.) Even if Rome complied with the sanctions, the punishment would only be feasible at the end of 2019, most likely at the end of Q1 2020. The point is that the above two paragraphs are academic. The Italian bond market would likely react much faster to Rome's budget proposals. The EU Commission operates on an annual and bi-annual timeline, whereas the bond market is on a minute-by-minute timeline. Given the bond market reaction thus far, it is difficult to see how Rome could be given the benefit of the doubt from investors (Chart 21). Investors have been demanding an ever-greater premium on Italian bonds, relative to their credit rating, ever since the election (Chart 22). Chart 21Uh Oh Spaghettio! Chart 22Bond Vigilantes Are Coming As such, the real question for investors is not whether the EU Commission can constrain Rome. It cannot. Rather, it is whether the bond market will. Rising borrowing costs would obviously impact the economy via several transmission channels, including overall business sentiment. But the real risk is Italy's banking sector. Domestic financial institutions hold 45% of Italian treasury bonds (BTPs) (Chart 23), which makes up 9.3% of all their assets, an amount equivalent to 77.8% of their capital and reserves (Chart 24). Foreign investors own 32%, less than they did before the Euro Area crisis, but still a significant amount. Chart 23Foreign Investors Still Hold A Third Of All Italian Debt Chart 24Italian Banks Also Hold Too Many BTPs In 2011, when the Euro Area crisis was raging, Italian 10-year yields hit 7%, or a spread of more than 500 basis points over German bunds. This was equivalent to an implied probability of a euro area breakup of 20% over the subsequent five years (Chart 25).15 What would happen if the populists in Rome followed through with their fiscal plans by September 2018 by including them in the 2019 budget? The bond market would likely begin re-pricing a similar probability of a Euro Area breakup, if not higher. In the process, Italian bonds could lose 20%-to-30% of their value - assuming that German bunds would rally on risk-aversion flows - which would result in a potential 15%-to-25% hit to Italian banks' capital and reserves. With the still large overhang of NPLs, Italian banks would be, for all intents and purposes, insolvent (Chart 26). Chart 25In 2011, Italian Spreads Signal Euro Break-Up Chart 26Italian Banks Still Carry Loads Of Bad Loans The populist government in Rome may not understand this dynamic today, but they will soon enough. This is perhaps why the leadership of both parties has decided to appoint a relatively unknown law professor, Guiseppe Conte, as prime minister. Conte is, according to the Italian press, a moderate and is not a Euroskeptic. It will fall to Conte to try to sell Europe first on as much of the M5S-Lega fiscal stimulus as he can, followed by the Italian public on why the coalition fell far short of its official promises. If the coalition pushes ahead with its promises, and ignores warnings from the bond market, we can see a re-run of the 2015 Greek crisis playing out in Italy. In that unlikely scenario, the ECB would announce publicly that it would no longer support Italian assets if Rome were determined to egregiously depart from the SGP. The populist government in Rome would try to play chicken with the ECB and its Euro Area peers, but the ATM's in the country would stop working, destroying its credibility with voters. In the end, the crisis will cause the populists to mutate into fiscally responsible Europhiles, just as the Euro Area crisis did to Greece's SYRIZA. For investors, this narrative is not a reassuring one. While our conviction level that Italy stays in the Euro Area is high, the scenario we are describing here would still lead to a significant financial crisis centered on the world's seventh-largest bond market. Bottom Line: Over the next several months, we would expect bond market jitters concerning Italy to continue, supporting our bearish view on EUR/USD, which we are currently articulating by being long the DXY (the EUR/USD cross makes up 57.6% of the DXY index). Given global growth headwinds, which are already apparent in the European economic data, and growing Italian risks, the ECB may also turn marginally more dovish for the rest of the year, which would be negative for the euro. Our baseline expectation calls for the new coalition government in Rome to back off from its most populist proposals. We expect that Italy will eventually flirt with overt Euroskepticism, but this would happen after the next recession and quite possibly only after the next election. If we are wrong, and the current populist government does not back off, then we could see a global risk-off due to Italy either later this summer, or in 2019. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see "Joint Statement of the United States and China Regarding Trade Consultations," dated May 19, 2018, available at whitehouse.gov. 2 President Trump later tweeted that the announced deal was substantive and "one of the best things to happen to our farmers in many years!" 3 The most illustrative comment may have come from Dan DiMicco, former steel industry CEO and staunch supporter of President Trump on tariffs, who tweeted "Did president just blink? China and friends appear to be carrying the day." 4 Please see Bob Davis and Lingling Wei, "China Rejects U.S. Target For Narrowing Trade Gap," The Wall Street Journal, dated May 19, 2018, available at wsj.com. 5 Please see "S. 2098 - 115th Congress: Foreign Investment Risk Review Modernization Act Of 2017," dated May 21, 2018, available at www.govtrack.us. 6 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "Are You Ready For 'Maximum Pressure?'" dated May 16, 2018; and "Expect Volatility... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 12 Please see, The Treaty on the Functioning of the European Union, "Excessive deficit procedure (EDP)," available at eur-lex.europa.eu. 13 Have you been missing the European alphabet soup over the past three years? 14 The EU Commission can also suspend financing from the European Structural and Investment Funds (ESIF), but Italy has never participated in a bailout and thus could not be sanctioned that way. 15 Please see BCA European Investment Strategy Weekly Report, "Threats And Opportunities In The Bond Market," dated April 7, 2016, available at eis.bcaresearch.com.

Highlights Our constraints-based methodology does not rely on human intelligence or the "rumor mill" to analyze political risks; Yet insights from our travels across the U.S., including inside the Beltway, offer interesting background information and a sense of the general pulse; Anecdotal information suggests that Trump is not "normalizing" in office; that U.S.-China relations will get worse before they get better; and that Trump will walk away from the 2015 Iranian nuclear deal. Stick to our current trades: energy over industrial metals; South Korean bull steepener; long DXY; long DM equities versus EM; long JPY/EUR; short Chinese tech stocks and U.S. S&P500 China-exposed stocks. Feature With the third inter-Korean summit demonstrating our view that "diplomacy is on track,"1 we remind investors of the key geopolitical risks we have been emphasizing - souring U.S.-China relations and rising geopolitical risks over Iran's role in the Middle East.2 We at BCA's Geopolitical Strategy do not base our analysis on information from human "intelligence" sources. No private enterprise can obtain the volume of intelligence that would make the sample statistically significant. Private political analysts relying on such intelligence are at best using flawed reasoning devoid of an analytical framework, and at worst are hucksters. Government intelligence agencies obviously collect a wide swath of not only human but also electronic and signals intelligence. Their sample can be statistically significant. However, the cost of such an effort is prohibitive to the private sector. Nonetheless, we may use human intelligence for background information, insight into how to improve our framework, and to take the subjective pulse of any particular situation. The latter is sometimes the most useful. It is not what a policymaker says that matters so much as how they say it, or the fact that they mention the subject at all. Given that we live in an era of political paradigm shifts, and that "charismatic leadership" is rising in influence relative to more predictable, established institutions and systems,3 we have decided to do something we have not done in the past: share some insights from our recent trips to Washington, DC and elsewhere in the U.S. Caveat emptor: the rumor mill is often wildly misleading, which is why we do not base our research on it. Exhibit A: Donald Trump's tax cuts, which our constraints-based methodology enabled us to predict in spite of the prognostications of in-the-know people throughout the year.4 Trump Is Not Normalizing U.S. domestic politics is the top concern of investors, policymakers, and policy wonks almost everywhere we go. It routinely ranks above concerns about Russia, China, the Middle East, or emerging markets (EM). We frequently heard that the U.S. is entering a period of political turmoil worse than anything since President Richard Nixon and the Watergate scandal. Some old Washington hands even claim that the Trump era will cause even greater uncertainty than the Nixon era did because Congress is allegedly less willing to keep the president in check. Economic policy uncertainty, based on newspaper word count, is at least comparable today to the tumultuous 1973-74 period, which culminated with Nixon's resignation in August 1974, and is trending upward (Chart 1). Chart 1Trump Uncertainty Approaching Nixon Levels? Of course, there is a big difference between Trump's and Nixon's context: today the economy is not going through a recession but rip-roaring ahead, charged with Trump's tax cuts and a bipartisan spending splurge. And the nation is not in the midst of a large-scale and deeply divisive war (not yet, anyway). There is little chance of major new legislation this year, yet deregulation, particularly financial deregulation, will continue to pad corporate earnings and grease the wheels of the economy. The booming economy is lifting Trump's approval ratings, which are trying to converge to the average of previous presidents at this stage in their terms (Chart 2). This development poses the single biggest risk to the unanimous opinion in DC that Republicans face a "Blue Wave" (Democratic Party sweep) in the midterm elections on November 6. However, a key support of the "Blue Wave" theory is that Republicans are split among themselves - and no one in the Washington swamp will deny it. Pro-business, establishment Republicans have never trusted Trump. They are retiring in droves rather than face up to either populist challengers in the Republican primary elections this summer or enthusiastic "anti-Trump" Democrats and independents in the general election (Chart 3).5 Chart 2Is Trump's Stimulus Bump Over? Chart 3GOP Retirements Are Unprecedented Trump is expected to ignite a constitutional crisis by firing Special Counsel Robert Mueller, the man leading the investigation into the Trump campaign's alleged collusion with Russia. Republicans are widely against firing Mueller, but they are not united in legislating against it, leaving Trump unconstrained. Senate Majority Leader Mitch McConnell (R, KY) says he will not allow consideration on the Senate floor of a bill approved by the Senate Judiciary Committee that would protect Mueller from firing.6 If Trump fires Mueller, Democrats expect a political earthquake. Some think that mass protests, and mass counter-protests encouraged by Trump himself, will culminate in violence. (We would expect protests to be mostly limited to activists, but obviously violent incidents are probable at mass rallies with opposing sides.) The Democrats are widely expected to take the House of Representatives; most observers are on the fence about the Senate. The House is enough to impeach Trump, which is widely expected to occur, by hook or by crook. But the impact on the country's political polarization will be much worse if there is impeachment without "smoking gun" evidence against Trump's person. Nixon, recall, refused to hand over evidence (the Watergate tapes) under a court order. When he handed some tapes over, they emitted a suspicious buzzing sound at critical points in the recording. Public opinion turned against him, prompting his party to abandon ship. He resigned because the loss of party support made him unlikely to survive impeachment. By contrast, there is not yet any comparable missing or doctored evidence in Trump's case, nor any sinkhole in Republican opinion that would presage a 67-vote conviction in the Senate (Chart 4). Chart 4Trump Not Yet In Nixon's Shoes Still, clouds are on the horizon. When people raise concerns about geopolitical issues - the U.S.-Russia confrontation, or the potential for a trade war with China - their starting point is uncertainty about President Donald Trump and his administration's policies. The United States is seen as the chief source of political risk in the world. Bottom Line: People in the Beltway who were once willing to believe that Trump would learn on the job and become "normalized" in office now seem to be shifting to the view that he is truly an unorthodox, and potentially reckless, president. The New (Aggressive) Consensus On China China is in the air like never before in D.C. In policy circles, the striking thing is the near unanimity of the disenchantment with China. Republicans are angry with China over trade and national security. Democrats are not to be outdone, having long been angry with China over trade, and also labor issues and human rights violations. It seems that everyone in the government and bureaucracy, liberal or conservative, is either demanding a tougher policy on China or resigned to its inevitability. American officials flatly reject the view that the Trump administration is instigating a conflict with China that destabilizes the world economy. Rather they insist that China has already instigated the conflict and caused destabilizing global imbalances through its mercantilist policies. They firmly believe that the U.S. can and should disrupt the status quo in order to change China's behavior, but that no one wants a trade war. They believe that the U.S. can be aggressive without causing things to spiral out of control. This could be a problem, as we detect a similar hardening of sentiment in China. On our travels there, the attitude was one of defiance toward Trump and Washington. We have received assurances that Beijing will not simply fold, no matter how much pain is incurred from trade measures. Of course, it is in China's interest to bluster in order to deter the U.S. from tariffs. But Chinese policymakers may be ready to sustain greater damage than Washington or the investment community expects. Tech companies are particularly out of the loop with Washington. They are said to have been unprepared for the president's actions upon receiving the Section 301 investigation results. They may also be underestimating the product list that the U.S. Trade Representative has drawn up pursuant to Section 301.7 Even products on that list that are not imported directly from China could have their trade disrupted. While China is demanding that the U.S. ease restrictions on high-tech exports, to reduce the trade imbalance (Chart 5), the U.S. believes that export controls allow for plenty of waivers and exceptions. They do not see export controls as a major risk. Chart 5U.S. Deficit Due To Security Concerns Rather, they see rising U.S. restrictions on Chinese investment in the U.S. as the real risk. The U.S. wants reciprocity in investment as well as trade. The emphasis lies on fair and equal access, which will require massive compromises from China, given its practice of walling off "strategic" sectors (including aviation, energy, electricity, shipping, and communications) from foreign interests. China's recent pledges to allow foreigners majority stakes in financial companies may not be enough to pacify the U.S. negotiators, especially if the promises hinge on long-term implementation. Treasury Secretary Steve Mnuchin will cause a stir when he releases his guidelines for investment restrictions, as expected by May 21 under the president's declaration on the Section 301 probe (Table 1).8 Both the House of Representatives and Senate are expected, within a couple of months, to pass the Foreign Investment Risk Review Modernization Act, proposed by Senator John Cornyn (R, TX) and Representative Robert Pittenger (R, NC). This bill would grant greater powers to the secretive Committee on Foreign Investment in the United States (CFIUS) in conducting investigations into foreign investment deals with national security ramifications. Under the new law CFIUS will be able to review proposed investment deals on grounds that go beyond a strict reading of national security. They will now include economic security, and potential sectoral impacts as well as individual corporate impacts, and previously neglected issues like intellectual property.9 Trump is unlikely to veto the bill, as previous presidents have done when laws cracking down on China have passed Congress, given his desire to shake up the China relationship. Table 1Protectionism: Upcoming Dates To Watch Will CFIUS enforcement truly intensify? Treasury's actions may preempt the bill, and CFIUS has already been subjecting China to greater scrutiny for years (Chart 6). Moreover, American presidents have always canceled investment deals if CFIUS advised against them.10 Presumably broadening CFIUS's powers will result in a wider range of deals struck down. The government already stopped Broadcom, a Singaporean company, from taking over the U.S. firm Qualcomm, in March, for reasons that have more to do with R&D and competitiveness (economic security) than with any military applications of its technologies (national security). Separately, U.S. policy elites are starting to turn their sights toward China's global propaganda and psychological operations. The scandal over the Communist Party's subversive institutional and political influence in Australia has heightened concerns in other Western, especially Anglo-Saxon, countries.11 This is a new trend that will have bigger implications going forward in Western civil society and the business community, with state efforts to create firewalls against Chinese state intrusion exacerbating political and trade tensions. Australians have the most favorable view of China in the West, and on the whole they continue to see China in a positive light. However, this view will likely sour this year. The recent attempt by Prime Minister Malcolm Turnbull to pass legislation guarding against Communist Party interference in Australian politics has already led to a series of diplomatic incidents, including tensions over the South China Sea and Pacific Islands. These can get worse in the near future. Consistently, over 40% of Australians view China as "likely" to become a military threat over the next 20 years (Chart 7), and this number will worsen if attempts to safeguard democratic institutions from state-backed influence operations cause China to retaliate with punitive measures toward Australia. China is offering some concessions to counteract the new, aggressive consensus in Washington. Enforcing UN sanctions against North Korea was the big turn. But it is also allowing the RMB to appreciate against the USD (Chart 8), which is an issue close to Trump's heart. The change in temperature in Washington can be measured by the fact that these concessions seem to be taken for granted while the discussion moves onto other demands like trade and investment reciprocity. Chart 6U.S. To Restrict Chinese Investment Chart 7Australian Fears About China To Rise Chart 8Is This Enough To Stay Trump's Hand On Tariffs? Simultaneously, China is courting Europe. European policymakers say that they share U.S. concerns about China's trade practices but wish to resolve disputes through the World Trade Organization and reject unilateral American actions or aggressive punitive measures that could harm global stability. Meanwhile China hopes that American policy toward Iran and the Middle East will alienate the Europeans while distracting Washington from formulating a coherent pivot to Asia. Bottom Line: Investors are underestimating the potential for a full-blown trade war. Policymakers - in China as well as the U.S. - have greater appetite for confrontation. Iran: Reversing Obama's Legacy The financial news media continue to underrate the importance of geopolitical risk tied to Iran this year (Chart 9). Our sense is that the Trump administration, when in doubt, is still biased towards reversing Obama-era policy on any given issue. Iranian nuclear deal of 2015 appears to be no exception. Chart 9Iranian Geopolitical Risk About to Shoot Up Signs have emerged for months that Trump is likely to refuse to waive Iranian sanctions (Table 2) when the renewal comes due on May 12. He has fired his national security adviser and secretary of state, as well as lesser officials, in preference for Iran hawks.12 French President Emmanuel Macron, having tried to convince Trump to retain the deal on his recent state visit to Washington, is apparently convinced Trump will scrap it.13 Table 2U.S. Sanctions Have Global Reach Moreover, discussions of Iran mark the one exception to the hardening consensus on China. A number of people we spoke with were not convinced that the Trump administration will truly devote the main thrust of its foreign policy to countering China. Some believed U.S. voters did not have the stomach for a trade fight that would affect their pocketbooks. Others believed that the Trump administration would simply revert to a more traditional Republican foreign policy, accepting a "quick win" on China trade while pursuing a confrontational military posture in the Persian Gulf. Still others believed that Trump has unique reasons, such as political weakness at home and the desire to be respected abroad, for wanting to be in lock-step with Israeli Prime Minister Benjamin Netanyahu and Crown Prince Mohammad bin Salman against Iran. All agreed that while a shift to China makes strategic sense, it may not overrule Republican policy preferences or inertia. The stakes are high. Allowing sanctions to snap back into place would affect a substantial portion of the one million barrels per day of oil that Iran has brought onto global markets since sanctions were eased in January 2016 (Chart 10). Chart 10Re-Imposing Iranian Sanctions Threatens Oil Supply And Middle East Stability As BCA's Commodity & Energy Strategy notes, global oil supply is tight and the critical driver - emerging market demand - remains strong. Meanwhile the "OPEC 2.0" cartel plans to extend production cuts throughout 2018 and likely into 2019, further draining global inventories. Inventories are now on track to fall beneath their 2010-14 average level by next year. In this context, the geopolitical risk premium will add to upside oil price risks this year. Our commodity strategists still expect oil prices to average $70-$74 per barrel this year (WTI and Brent respectively), but they can see it shooting above $80 per barrel on occasion, and warn that even small supply disruptions (whether from Iran, Venezuela, Libya, or elsewhere) could send prices even higher (Chart 11).14 Chart 11Oil Prices Can Make Runs Into /Barrel Range If the U.S. re-imposes sanctions on Iran, we doubt that the full one million barrels per day of post-sanctions Iranian production will be taken offline. Global compliance with sanctions will be ineffective this time around. The Trump administration's sanctions will not have the legitimacy or buy-in that the Obama administration's sanctions did. Trump may even intend to impose the sanctions for domestic political consumption while giving Europe, Japan, and others a free pass. Still, the geopolitical and production impact will be significant. As for oil, price overshoots are even more likely when one considers Venezuela, where our oil analysts estimate that state collapse will remove around 500,000 barrel per day from last year's average by the end of this year.15 Bottom Line: We continue to expect energy commodities to outperform metals in an environment where energy prices benefit from a rising geopolitical risk premium, while metals could suffer from ongoing risks to Chinese growth. Investment Conclusions Independently of the above anecdotes, Geopolitical Strategy has laid out a case urging clients to sell in May and go away.16 Last year we were confident recommending that clients forget this old adage because we had clarity on the geopolitical risks and their constraints. This year, with both China and Iran, we lack that clarity. The U.S.'s European allies could perhaps convince Trump to maintain the 2015 Iranian nuclear agreement, and Trump could perhaps accept China's concessions (such as they are) to get a "quick win" on the trade front before the midterm elections. But we have no basis for assessing that he will do either with any degree of conviction. How long will it take to resolve the raft of outstanding U.S.-Iran and U.S.-China tensions? Our uncertainty here gives us a high conviction view that this summer will be turbulent. Geopolitical tensions will likely get worse before they get better. We would reiterate our recommendation that clients be long DXY and hold a "geopolitical protector portfolio" of Swiss bonds and gold. We remain long developed market equities relative to emerging markets and long JPY/EUR. We are also maintaining our shorts on Chinese tech stocks and U.S. stocks exposed to China. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 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. 4 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 6 Please see Jordain Carney, "McConnell: Senate won't take up Mueller protection bill," April 17, 2018, available at thehill.com. 7 Please see U.S. Trade Representative, "Under Section 301 Action, USTR Releases Proposed Tariff List on Chinese Products," and "USTR Robert Lighthizer Statement on the President's Additional Section 301 Action," dated April 3 and April 5, 2018, available at ustr.gov. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 9 Please see Senator Jon Cornyn, "S.2098 - Foreign Investment Risk Review Modernization Act of 2017," dated Nov. 8, 2017, available at www.congress.gov. For the argument behind the bill, see Cornyn and Dianne Feinstein, "FIRRMA Act will give Committee on Foreign Investment a needed update," The Hill, dated March 21, 2018, available at thehill.com. 10 Please see Wilson Sonsini Goodrich & Rosati, "CFIUS In 2017: A Momentous Year," 2018, available at www.wsgr.com. 11 Australian Senator Sam Dastyari (Labor Party) resigned on December 11, 2017 after it was exposed that he accepted cash donations from a Chinese property developer that he used to repay his own debts. He had also supported China's position in the South China Sea. The scandal prompted revelations of a range of Chinese state-linked political donations. Prime Minister Malcolm Turnbull has introduced legislation banning foreign political donations and forcing lobbyists for foreign countries to register. 12 Mike Pompeo replaced Rex Tillerson as Secretary of State, John Bolton replaced H.R. McMaster as National Security Adviser, and Chief of Staff John Kelly has been sidelined; Bolton has appointed Mira Ricardel as his deputy, who has been said to clash with Secretary of Defense James Mattis in trying to staff the Pentagon with Trump loyalists. Please see Niall Stanage, "The Memo: Nationalists gain upper hand in Trump's White House," The Hill, April 25, 2018, available at thehill.com. 13 Macron has presented a framework that German Chancellor Angela Merkel and U.K. Prime Minister Theresa May have accepted that would call for improvements to outstanding issues with Iran while keeping the 2015 deal intact. Macron has also spoken with Iranian President Hassan Rouhani about retaining the deal while addressing the Trump administration's grievances. 14 Please see BCA Commodity & Energy Strategy Weekly Report, "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," dated April 19, 2018, available at ces.bcaresearch.com. 15 Please see footnote 14, and BCA Geopolitical Strategy and Energy Sector Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. Geopolitical Calendar

Special Report

Highlights The Philippines is seeing a genuine inflation outbreak. The Duterte administration's policies favor "growth at all costs." "Charter change," or constitutional revision, will stoke political polarization, erode governance, and feed inflation. We are neutral on Philippine stocks and bonds within EM benchmarks for now but are placing the country on downgrade watch. Feature Chart 1Markets Sold On Duterte Election It has been nearly two years since Rodrigo "Roddy" Duterte - the Philippines' populist and anti-establishment president - was elected. On May 11, 2016, two days after the vote, BCA's Geopolitical Strategy and Emerging Markets Strategy published a joint report arguing that Duterte would "take the shine off" the economic structural reforms that had taken place under the outgoing administration of President Benigno Aquino.1 We downgraded the bourse from overweight to neutral within the EM universe. Financial markets have largely vindicated this view. Philippine stocks peaked against EM stocks three days before Duterte's inauguration and have continued to underperform since then. The Philippine peso has also suffered, both in real effective terms and relative to the weakening U.S. dollar (Chart 1). Is it time to buy then? No. Duterte's policies will continue to erode the country's governance and macro fundamentals, overheating the economy and subtracting from investment returns. Of course, the country is well insulated from any China or commodity shock, and this is an important advantage over other EMs in the medium term. Also, equity and currency valuations have improved relative to other EMs. Hence we recommend clients remain neutral Philippine stocks, currency, and credit versus the EM benchmark for now, and use any meaningful outperformance to downgrade the country to underweight within aggregate EM portfolios. An Inflation Outbreak One of the most reliable definitions of a populist leader is one who pursues nominal, as opposed to real, GDP growth. While policymakers can stimulate nominal growth through various policies, real growth over the long run depends on productivity and labor force growth, which are much harder to control. The only way policymakers can affect real growth is by undertaking structural reforms - which are often painful and unpopular in the short run. By contrast, faster nominal growth as a result of higher inflation can create the "money illusion" among the populace and bring political rewards, at least for a time.2 Higher nominal growth might initially please the public, but when inflation escalates it will reduce living standards. Moreover, an inflation outbreak will eventually necessitate major policy tightening and a growth downturn to reverse inflation. A comparison of a range of populist political leaders with orthodox (non-populist) leaders across Latin America, Central Europe, and Central Asia demonstrates that populists really do tend to achieve higher nominal growth relative to non-populists in the first two years of their rule (Chart 2). This finding has served BCA's Geopolitical Strategy well in predicting that U.S. President Donald Trump would blow out the federal budget through tax cuts and government spending in pursuit of faster growth.3 With stimulus taking effect while the output gap is closed, inflationary pressures are likely to rise higher than they otherwise would have done over the next 12-to-24 months.4 Chart 2Populists Pursue Nominal GDP Growth President Duterte of the Philippines also appears to fit this rubric. Like Donald Trump, he combines foul-mouthed eccentricity and personal risk-taking with a policy agenda of tax cuts, fiscal spending, and deregulation (Table 1).5 Yet unlike Trump, his infrastructure program - which is desperately needed in the Philippines, a laggard in this respect - is up and running, producing a large increase in capital expenditures and imports. The gap between nominal and real GDP growth - i.e. the inflation rate - looks likely to rise further. Table 1Duterte's Agenda Consists Of Drug War, Tax Cuts, And Big Spending Signs of an inflation outbreak are already evident. Chart 3 shows that both core and headline inflation measures are now rising sharply and have crossed the Bangko Sentral ng Pilipinas's (BSP) 3% inflation target by a wide margin, even rising above the 2%-4% target band. Further, local currency yields are rapidly ascending while the currency has been plunging against the weak U.S. dollar. These indicators suggest that the inflation outbreak that BCA's Emerging Markets Strategy warned investors about in October has now come to pass.6 The official explanation for the inflation spike this year is Duterte's tax reform bill, which took effect January 1 (and is the first of several such bills). The bill cuts taxes for households and raises excise taxes on a range of goods - from electricity, petroleum products, coal, and mining to sugary drinks and tobacco.7 The central bank has cited this law and its ramifications (including transportation costs and wage demands) as reasons for the inflation overshoot to be temporary. Yet Duterte's growth agenda and the BSP's simulative policies have created an environment ripe for inflationary pressures to build, namely by encouraging banks to expand their balance sheets and money supply (Chart 4). This has led to excessive strength in domestic demand. Chart 3An Inflation Outbreak Chart 4Stimulative Policies Further signs of a genuine inflation outbreak include: Twin deficits: both the current account and fiscal balances are negative in the Philippines, a significant development over the past two years (Chart 5). Further, the trade balance now stands at a nearly two-decade low of 9.5% of GDP (Chart 6). Worryingly, the current account has fallen into deficit despite the fact that remittances from Filipinos living abroad, which account for 9% of GDP, have been robust (Chart 6, bottom panel). Oil prices are surprising to the upside as global inventories drain and the geopolitical risk premium rises. This puts additional pressure on the current account balance and adds to inflationary pressures. Chart 5The Philippines Now Has Twin Deficits Chart 6Trade Deficit Worsens; Remittances The Saving Grace The Philippines' import bill is growing briskly, especially that of consumer goods (Chart 7, top panel). Meanwhile, overall export volumes and revenues of non-electronic/manufacturing exports are contracting (Chart 7, second panel). This is a sign that the Philippine economy is losing competiveness. Indeed, the third panel of Chart 7 shows that the country's global export market share is deteriorating. Wages are rising across many sectors (Chart 8). The imposition of excise taxes on electricity and fuel has prompted a wave of demands for higher wages from labor groups and provincial wage boards. Duterte is also said to be preparing a nationwide minimum wage law (to increase regional wages vis-à-vis the capital Manila) and an end to temporary employment contracts, which cover about 25% of the nation's workers and pay wages that are 33% lower on average. As wage growth outpaces productivity gains, unit labor costs are rising, eating into listed non-financial companies' profit margins (Chart 9). Chart 7Domestic Demand Surges While Competitiveness Falls Chart 8Wage Growth Is Strong On the fiscal front, the Duterte administration is pushing badly needed spending increases in infrastructure, health, and education. The investments amount to $42 billion over six years, or roughly 2% of GDP per year in new fiscal spending.8 While these investments will be beneficial in the long run as they augment both the hard and soft infrastructure of the nation, their size and timing needs to be modulated in real time to prevent them from creating excessive inflationary pressures in the short and medium run. This is difficult and the administration is likely to err on the side of higher spending that feeds inflation. Further, the administration's tax reform plan is unlikely to raise enough revenue to cover all the new spending. The first tax reform bill to pass through Congress cuts household tax rates for most brackets (with rates to fall further in 2023) and raises the threshold to qualify for income tax, thereby narrowing the tax base to 17% of the population. The value added tax (VAT) will also have its threshold increased. Corporate taxes will be cut next. Revenue shortfalls will add to the budget deficit. Loosening fiscal policy will foster higher inflation and will continue weighing on the currency. Despite the upside inflation surprise, the central bank has kept the policy rate at the record low level of 3% where it has been since 2014. It also cut reserve requirements in March, injecting liquidity into the system. Deputy Governor Diwa Guinigundo says that an inflation reading within the target band at the May 10 monetary policy meeting will increase the likelihood that no rate hikes will occur this year.9 The central bank explicitly views this year's high inflation as a passing phenomenon tied to the excise taxes. It may also have stayed its hand due to signs of waning momentum in certain segments of the economy such as autos and property construction, which are weakening (Chart 10). Chart 9Higher Labor Costs Eat Firm Margins Chart 10Central Bank Not Worried About Overheating But in light of the fiscal and credit trends outlined above, and given that the Philippine economy is domestically driven and insulated from the slowdown in global growth, we do not expect domestic growth to fall very far. Overall, the central bank has maintained accommodative monetary policy for too long and tolerated an inflation outbreak. At this stage, central bank independence thus becomes a critical question. The current governor, Nestor Espenilla, is a tough enforcer against financial crimes who may be willing to do what it takes to rein in inflation: his comments have been a mixture of hawkish and dovish. But he is also a Duterte appointee, and thus perhaps unwilling to counter a popular, and forceful, president. It is too soon to say that the BSP will fail in its duties, but it does have a reputation for dovishness that it has reinforced this year.10 This analysis points to a policy of "growth at all costs." Odds are that growth will remain fast, that the inflation outbreak will continue, and that the BSP has fallen behind the curve. Bottom Line: The Philippines is witnessing an inflation outbreak that is likely to continue. Credit growth is booming, fiscal policy is loose, and the central bank is behind the curve. This policy setup is negative for the currency and for stock prices and local bonds in the absolute. Cha-Cha: What Does It Mean? In the long run, Duterte's authoritarian leanings will weigh on the country's performance. Governance has declined since he took office, primarily because of his rampant war against drugs. The Drug War has officially led to the deaths of 6,542 people since July 1, 2016, according to the Philippine Drug Enforcement Agency.11 Human rights groups believe the actual tally is twice as high. Yet even if we exclude "political stability and absence of violence" from the Philippines' governance indicators, the country's score has declined under Duterte and is worse than that of its neighbors (Chart 11). And this score does not yet account for the fact that Duterte has imposed martial law on the southern island of Mindanao and is using his popularity (56% net approval, Chart 12) and supermajority in Congress (89% of seats in the House and 74% in the Senate) to push a constitutional rewrite that would give him even more extensive powers.12 Chart 11Even Excluding The Drug War, Philippine Governance Is Bad And Getting Worse Chart 12Duterte Is Popular (But Not That Popular) Like previous administrations, the Duterte administration wants to revise the 1987 Philippine constitution. There are three current proposals, each of which would change the government from a "unitary" to a "federal" system.13 Manila would remain the capital but the provinces would be incorporated into states or regions that would have their own governments and greater autonomy. The proposals differ in detail, but if and when congressmen and senators reconstitute themselves into a Constituent Assembly to rewrite the charter, they will have complete freedom, i.e. will not be limited to the specifics of these proposals. A popular referendum will be necessary to approve the results and could occur as early as May 13, 2019, when Senate elections will be held, or the summer afterwards.14 "Charter change" or Cha-cha is a perennial preoccupation in the country with three main drivers (Table 2). First, successive Philippine presidents try to revise the constitution so that they can stay in power longer than the single, six-year term limit. Second, provincial political forces seek to change the constitution to decentralize power. Third, economic reformers and business interests seek to remove protectionist articles embedded in the constitution, particularly limitations on private and foreign investment. Table 2History Of Cha-Cha In The Philippines In general, Manila is seen as a distant and unresponsive capital ruling over an extremely diverse and disparate archipelago. The centralized system is prone to corruption due to the pyramid-like patronage structure descending from a handful of elite, Manila-based, families at the top. Meanwhile the provinces lack autonomy and economic development. While the capital region only contains 13% of the population, it accounts for 38% of GDP. The central government has trouble raising resources - as indicated by a low tax revenue share of GDP compared to neighbors (Chart 13). It is at times incapable of providing essential services like security and infrastructure, particularly in far-flung provinces like Mindanao or parts of the Visayas where poverty, under-development, natural disasters, and militancy reign. The chief goal of those who want a federal system is to decentralize power in order to strengthen the provinces. They argue that reversing the role of central and regional fiscal powers will improve government effectiveness overall by bringing the government closer to the people it governs. Today, the central government controls about 93.7% of the revenues and 82.7% of the spending while local governments control about 6.3% and 17.3% respectively (Chart 14). Chart 13The Philippine Government Is Underfunded And Weak Chart 14The Philippine Government Is Heavily Centralized Under a federal system these roles would reverse. Local governments would gain greater powers to tax and spend within their jurisdictions, while also improving tax collection. This would enable them to improve public services while still providing the federal government with resources to pursue national goals. Better funded and more autonomous local governments would presumably be more responsive to public demands within their jurisdictions. This is especially the case given the country's population and geography, with 101 million people spread out over more than 7,000 islands. The result - say the proponents - would be better governance all around, including greater economic development across the regions. From this point of view, over the long run, Cha-cha appears to be a pro-market outcome. In particular, the proposed changes will probably include greater openness to foreign direct investment (FDI), easing restrictions on land ownership, utilization, and resource exploitation that have long been difficult to remove because of their constitutional status (a vestige of anti-colonial sentiment). The Philippines falls markedly behind its peers in attracting FDI (Chart 15). This change would likely have a positive impact on FDI and productivity, as the Philippines has long suffered from its closed, protectionist, and heavily regulated model.15 Chart 15The Problem With Constitutional Restrictions On Foreign Investment However, Cha-cha's opponents argue that the net effect will be negative for the business community and financial markets because of the drastic shift in the status quo. They argue that the 1987 constitution provides ample authority for decentralization but that Congress has refused to pass implementing legislation due to vested interests. As opposed to reforming the Local Government Code and other laws on the books, a total change of the government system would be controversial, expensive, and prone to expanding bureaucracy (as it would replicate the current national government institutions for each state/region in the new federal system). It would also be self-interested. Cha-cha would give Duterte additional powers to oversee the chaotic transition, and likely give him new powers in the aftermath as a result of the provisions themselves.16 Weighing both sides, we expect that charter change will require a massive political struggle and a long transition period in which economic uncertainty will spike. It will also give Duterte more arbitrary power and weaken central institutions and legal frameworks designed to keep him in check. While he insists that he will step down in 2022 according to existing term limits, Cha-cha could remove the constitutional limit on his time in office or allow him to resume as prime minister indefinitely. He would also have extensive powers of appointment and dismissal affecting the judiciary and other checks and balances. Is creeping authoritarianism market-negative? Not necessarily. Authoritarian governments in some cases have greater ability to make difficult, unpopular decisions that benefit national interests in the long run - including on macroeconomic policy. Singapore, Taiwan, and China are famous regional examples. Nevertheless, the Philippines is not Singapore or China - it is not a weak or non-existent democracy with a strong central government, but rather a strong democracy with a weak central government. It will not be easy for Duterte to seize ever-greater control if he should attempt to. He will eventually meet resistance from "people power" - mass protests from civil society such as those that overthrew dictator Ferdinand Marcos in 1986 and President Joseph Estrada in 2001. Such a movement may not develop in the short run, given his popularity, but the distance from here to there will involve political instability and a deterioration of monetary and fiscal management. To illustrate this process, consider the Philippines' record in the "Polity IV" dataset, which is a political science tool that provides a standardized measure of the quality of democracy in different regimes across the world.17 A time series of the Philippines' Polity scores illustrates the drastic collapse of governance under Marcos (Chart 16), who imposed martial law from 1972-81 and plunged the country into a morass of oppression, dysfunction, and corruption. This ended with the first People Power Revolution in 1986 and the promulgation of the 1987 constitution. Since then, Polity scores have improved markedly. Today the Philippines scores an eight, within the range of western democracies. The democratic era has been a boon for investors who have seen the Philippines improve its macroeconomic and business environment over this period. But Duterte is a Marcos-like figure who could reverse this process even if he does not drag the country all the way down into the worst conditions of the 1970s-80s. Could Duterte succeed in charter change where his post-Marcos predecessors have failed? Yes. He has a lot of political capital and is well situated to push for dramatic change. He is an anti-establishment political outsider - the first Philippine president from the deep south - elected amidst a wave of disenchantment over persistent, endemic problems like poverty, corruption, lawlessness, and lack of development. He has high public approval ratings and a supermajority in Congress (Chart 17). It is too early in the game to give firm probabilities on whether the constitutional changes will pass the necessary popular referendum in spring or summer 2019, but it is perfectly possible for Duterte to succeed judging by his standing today. Chart 16The Marcos Dictatorship Was Inflationary Chart 17Duterte's Legislative Supermajority What will be the economic effects? Aside from policy uncertainty, decentralization will be good for growth and inflation. Local leaders will have more tax money to spend and less central discipline. Pent-up demand for development in the provinces will be unleashed, with local political leaders likely to encourage credit expansion. In the context outlined above this change means higher inflation. Inflation rates in the provinces should start to climb toward those of the capital region, while those of the capital region would have no reason to fall amid the flurry of new activity. Hence investors interested in the Philippines must monitor the long and rocky road of charter change. They should look to see if the Congress and Senate do indeed merge into a Constituent Assembly (the quickest yet most controversial way of revising the constitution because it is the least constrained); what proposals look to be codified in the drafting of the constitution and assembly debates; if Duterte retains his popularity throughout the constitutional process; and whether the public is supportive of the proposals.18 Our rule of thumb is that a constitutional process focused on decentralization and removal of protectionist provisions would be market-positive in principle. However, if authoritarian provisions creep into the final text, they may reveal the market-negative priorities and a lack of constraints on policymakers in Manila. Bottom Line: Philippine governance will continue to decay under the Duterte administration. Revisions to the constitution will have pro-market aspects, and net FDI will probably continue to rise. But these positive aspects will be overweighed by the politically polarizing and destabilizing process of charter change itself. Moreover, decentralization will feed into the current credit boom and inflationary backdrop and could produce excesses. The U.S.-China Crossfire The Philippines is a strategically located island chain that frames the South China Sea (Diagram 1). It has been caught in great power struggles for centuries. The rising U.S. colonial power displaced the remnants of the established Spanish colonial power there in 1898; the rising Japanese empire displaced the established U.S. in 1941, only to be defeated by the U.S. and its allies in 1944. Diagram 1The South China Sea: Still A Risk Now China is the rising power in Asia and is applying pressure on America's visiting forces. The Philippines is again caught in the middle. It relies on the U.S. more than China economically and strategically, but China is rapidly catching up, as is clear in trade data (Chart 18). And China's newfound naval assertiveness must be taken seriously. Indeed, Duterte claims that Chinese President Xi Jinping threatened him with war if his country crossed China's red line in the South China Sea.19 Chart 18China Rivals U.S. In The Philippines Geopolitical risk has fallen since Duterte's election as a result of his pledge to improve relations with China and distance his country from the United States. This was a sharp reversal of Philippine policy. From 2010-16, the Aquino administration engaged in aggressive strategic balancing against China. The country was threatened by China's militarization of the Spratly Islands in the South China Sea and encroachment into Philippine maritime space and territory. The pro-American direction of Aquino's policy culminated in the signing of the Enhanced Defense Cooperation Agreement (EDCA), which granted the American military the right, for ten years, to rotate back into Philippine bases. In July 2016, the Permanent Court of Arbitration ruled in favor of the Philippines, against China, in a landmark case of international law. It held that the South China Sea "islands" were not islands at all and that China could not base territorial or maritime claims off them.20 This strategic balancing brought tensions with China to a near boiling point. However, the pot was taken off the fire when the Philippine public elected the outspokenly anti-American, pro-Chinese, and communist-sympathizing Duterte. Duterte immediately set about courting Chinese investment, calling for bilateral China-Philippine solutions in the South China Sea (such as joint energy development), and denouncing President Barack Obama, the West, and various international legal bodies.21 As a result, China has largely dropped its pressure tactics against the Philippines. It has been investing more in the country over time (Chart 19) and has recently proposed a range of new projects worth a headline value of $26 billion. In the short run, Duterte's policy is positive because it enables the country to extract economic and security benefits from both the U.S. and China. China has reduced its coercive tactics, while the U.S. under President Trump has taken an easy-going attitude both toward Duterte's human rights violations and his pro-China (and pro-Russia) leanings. Duterte, for his part, has not tried to nullify the 2014 military pact with the U.S., but rather reversed his claim that he would sever ties with the U.S. by asking for American counter-insurgency support during the 2017 Siege of Marawi. Eventually, however, the emerging U.S.-China "Cold War" could force Duterte to make unpopular choices that violate economic relations with China or security protections from the U.S. The Philippine public is largely pro-American and suspicious of China.22 Thus, if Duterte pushes his foreign policy too far, he will provoke a backlash. This could take the form of a revolt against Chinese investments in the economy - as Chinese companies will be eager to take advantage of greater FDI access, especially under constitutional reform. Or it could take the form of a revolt against Chinese encroachments in the South China Sea, which are bound to recur.23 Alternatively, if the Philippines takes China's side, the U.S. could threaten to cut off market access, remittances, or (less likely) military support. A rupture in U.S. or China relations could spark or feed into domestic opposition to Duterte over political or constitutional issues or trigger a tense U.S.-China diplomatic standoff with economic ramifications. This is something to monitor in case a conflict emerges such as that which occurred in 2012-14 at the height of Philippine-China tensions, or in South Korea in 2015-16. In both cases, China imposed discrete economic sanctions against American allies as a result of foreign policy moves they took in stride with the United States (Chart 20). Chart 19Chinese Investment Will Rise Under Duterte Chart 20China Imposes Sanctions In Geopolitical Spats Bottom Line: Geopolitical risks have abated over the past two years and should remain contained for the next few years, as China wishes to reward Duterte and his foreign policy. However, relations between the U.S. and China are getting worse, which puts the Philippines in the middle of the crossfire. The South China Sea remains a fundamental, not superficial, source of tension. Investment Conclusions Chart 21Stocks And Bonds Will Underperform This scenario is negative for financial markets and will cause stocks to fall and local bonds yields to rise in absolute terms (Chart 21). Philippine equities remain very expensive. At this point only policy tightening by the BSP can control inflation, but that, even if it were to occur (unlikely in our opinion), will be negative for growth and financial markets in the short-to-medium term. Relative to other EMs, Philippine financial markets have underperformed considerably for the past few years, and thus might experience a relative rebound. If so, it will not be due to Philippine fundamentals but to the fact that in other EMs, fundamentals are deteriorating and financial markets selling off. These markets have had a good run in the past two years and are vulnerable to the downside. In this context, it matters that the Philippines is not a major commodity exporter and not highly vulnerable to a Chinese growth slowdown. Oversold conditions relative to EM peers and lower commodity prices could allow the Philippine bourse and currency to outperform those peers for a time. We thus maintain neutral allocation on Philippine stocks and bonds within EM benchmarks for now but are placing it on downgrade watch. On the political side, President Duterte is making investments in the country that will improve the supply side, but his policies will feed inflation in the short term and erode governance in the long term. His push to reshape the political and governmental system will increase political risk at a rare moment when geopolitical risks have somewhat abated. The latter are significant, but latent, and could flare up significantly in the long run due to U.S.-China conflicts. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Ayman Kawtharani, Associate Editor Emerging Markets Strategy ayman@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 2The "money illusion" is a concept in macroeconomics coined by economist Irving Fisher, who wrote a book of the same title in 1928, to describe the failure of economic actors to perceive fluctuations in the value of any unit of money. In other words, people tend to pay more attention to nominal than to real changes in money or prices. The concept is valid today, albeit subject to academic debate over its precise workings. 3 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, and Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Perched On An Icy Cliff," dated March 29, 2018, and "Two Tectonic Macro Shifts," dated January 31, 2018, available at ems.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 6 Please see "The Philippines: An Overheating Economy Requires Policy Tightening" in BCA Emerging Markets Strategy Weekly Report, "Is The Dollar Expensive, And Are EM Currencies Cheap?" dated October 11, 2017, available at ems.bcaresearch.com. 7 Please see Office of the Presidential Spokesperson, "A Guide To T.R.A.I.N. Tax Reform for Acceleration and Inclusion (Republic Act No. 10963," dated January 2018, available at www.pcoo.gov.ph, and Department of Finance, "The Tax Reform For Acceleration And Inclusion (TRAIN) Act," dated December 27, 2017, available at www.dof.gov.ph. 8 Please see the Philippine Department of Finance, "The Comprehensive Tax Reform Program: Package One: Tax Reform For Acceleration And Inclusion (TRAIN)," January 2018, available at www.dof.gov.ph. 9 At its March policy meeting the BSP decided to keep interest rates on hold despite a March inflation reading of 4.3%, above the top of the target range of 4%. For Guinigundo's comments about the May 10 meeting, please see "Philippines c. bank says monetary policy still data-driven, may hold rates," April 20, 2018, available at www.reuters.com. 10 The BSP has reportedly only surprised markets four times out of 84 scheduled monetary policy meetings over the past ten years. Please see Siegfrid Alegado, "Life Is Getting Harder For Philippine Central Bank Watchers," dated March 21, 2018, available at www.bloomberg.com. 11 Please see Rambo Talabong, "Duterte gov't tally: At least 4,000 suspects killed in drug war," dated April 5, 2018, available at www.rappler.com. 12 Duterte's personal popularity is overstated. He was elected in a landslide, but only received 39% of the popular vote. The Pulse Asia quarterly polls suggest his popularity and "trust" ratings have ranged from 78%-86% since his inauguration (currently 80%), but this falls to 60% if undecided voters and disapproving voters are netted out. The Social Weather Station polls, which we cite, show a 56% net approval rating, which is mostly in line with Duterte's predecessor President Aquino at this stage in his term. 13 There are currently three draft proposals. The first is Senate Resolution No. 10, filed by Senator Nene Pimentel; the second is House Resolution No. 08, filed by Representatives Aurelio Gonzales and Eugene Michael de Vera; the third is the ruling PDP Laban Party's proposal, from Jonathan E. Malaya at the party's Federalism Institute. 14 The funding to hold a referendum in 2018 does not exist nor are legislators ready. A "special budget" will coincide with the plebiscite, no doubt strictly to pay for the polling and not to grease the wheels of the "yes" vote! Please see Bea Cupin, "Charter Change timetable: Plebiscite in 2018 or May 2019, says Pimentel," I, February 2, 2018, available at www.rappler.com. 15 Please see Gary B. Olivar, "Update On Constitutional Reforms Towards Economic Liberalization And Federalism," American Chamber of Commerce Legislative Committee, dated September 27, 2017, available at www.investphilippines.info. 16 Please see Neri Javier Colmenares, "Legal Memorandum on Charter Change under the Duterte Administration: Resolution of Both Houses No. 8 Proposed Federal Constitution," December 4, 2017, available at www.cbcplaiko.org. 17 Please see the Center for Systemic Peace and Monty G. Marshall, Ted Robert Gurr, and Keith Jaggers, "Polity IV Project: Political Regime Characteristics and Transitions, 1800-2016," July 25, 2017, available at www.systemicpeace.org. 18 Local elections in May 2018 may also provide some indications of popular support, as well as the Senate elections in May 2019 (if the referendum is not simultaneous). 19 Please see Richard Javad Heydarian, "Did China threaten war against the Philippines?" Asia Times, dated May 23, 2017, available at www.atimes.com. 20 Please see BCA Geopolitical Strategy Special Report, "South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 21 He has since said the Philippines will leave the International Criminal Court, which it joined in 2014, and arrest any prosecutor of the court who comes to the Philippines to investigate the government and police handling of the drug war. Please see Rosalie O. Abatayo, "Arresting ICC prosecutor could get Duterte in more legal trouble, says lawyer," The Philippine Daily Inquirer, April 22, 2018, available at globalnation.inquirer.net. 22 Please see Jacob Poushter and Caldwell Bishop, "People In The Philippines Still Favor U.S. Over China, But Gap Is Narrowing," Pew Research Center, September 21, 2017, available at www.pewglobal.org. 23 At present the Association of Southeast Asian Nations is negotiating a long-awaited, albeit non-binding, "code of conduct" with China in the South China Sea that could be concluded as early as this or next year. However, South China Sea tensions could heat up again at any point due to Chinese encroachments, U.S. pushback, or other regional actions. Also, with oil prices set to increase rapidly, non-U.S./OPEC/Russia international offshore oil rigs could begin to increase again, renewing an additional source of tension in the sea.

Highlights Midterm election is yet another geopolitical headwind to the markets this summer; A "lame duck" Trump could seek relevance abroad, with aggressive foreign and trade policy; Investors would be right to fret about a hard turn to the left by the Democratic Party; Democrats have 60% probability of taking the House and 45% probability of taking the Senate; On a cyclical horizon, midterm election will not undermine pro-business policies of the Trump administration, but may signal a paradigm shift over a more structural time horizon. Feature Geopolitical winds have turned from tailwinds to headwinds. This is as we expected last April, when we correctly forecast that geopolitical risks were overstated in 2017 but understated for 2018.1 This January we focused on several key risks for 2018: trade protectionism, Iran-U.S. geopolitical tensions, and a potential black swan risk in Taiwan.2 In our 2018 Strategic Outlook, we also pointed out that if Donald Trump becomes an early "lame duck" president, he will seek relevance abroad.3 It is therefore time to turn to the question of the upcoming midterm election, set to take place on November 6. For most of our clients, the midterm election is another volatile political event to add to an already long list (Table 1). True, the midterm election could produce a gridlocked Congress - which we recently showed quantitatively is marginally negative for the markets - and a potential push to impeach President Trump.4 However, this is not the worst of it. As November approaches, through a tumultuous summer full of headline risks, President Trump may double-down on his doctrine of "maximum pressure" - which objectively succeeded in the case of North Korea. This could produce more aggressive rhetoric and policy in the ongoing trade skirmish with China, further sanctions against Iran, and tensions with Russia. Table 1Protectionism: Upcoming Dates To Watch President Trump would not be the first U.S. president to seek relevance abroad, although he may be the earliest, and potentially the lamest, lame duck president in recent U.S. history.5 As such, the real risk is not the Democrats taking over the House, but rather how the Trump administration reacts to a sudden loss of legislative initiative. While a Democratic House would dramatically increase domestic political constraints on President Trump, there are few constitutional constraints on U.S. presidents when it comes to foreign policy. As such, the midterm election is market relevant, but not because Democratic Party control will be able to impact domestic policy. Investors should remember why markets cheered President Trump in the first place: Chart 1Trump: A Boon For Main Street And Wall Street Chart 2Easy Fiscal + Tight Money = Buy SPX Deregulation: Business confidence soared even before Donald Trump was inaugurated as president, especially among small businesses, while regulatory worries melted away (Chart 1).6 The executive branch controls the regulatory process, which means that the Democratic takeover of the House of Representatives, or even the Senate, will have little impact. Tax cuts: Fears that the Democrats will be able to reverse the tax cuts are overstated. Without a veto-proof majority in both chambers of Congress - two-thirds of the seats - the Democrats cannot regain legislative initiative or reverse President Trump's accomplishments. Table 2ADXY Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Table 2BSPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Fiscal policy: Markets are currently pricing in a rare mix of tightening monetary policy and stimulative fiscal policy, a bullish combination (Chart 2) that tends to boost both equities and the dollar (Table 2). While there is no need for fiscal profligacy at the current point in the cycle (Chart 3), we would think that investors would recoil at any sign of fiscal conservativism. But looking for austerity within the current Democratic Party - whose official party platform calls for universal health coverage, for example - is a mistake. Chart 3An Odd Time For Fiscal Profligacy As such, the Democratic Party's control of the House - or even the Senate, given that a filibuster-proof majority is out of reach in 2018 - is unlikely to reverse the policy and regulatory backdrop that has been so beneficial for equities over the past 18 months. Instead, the risks are twofold. First, that President Trump reacts to the coming electoral bloodbath well ahead of November with aggressive foreign and trade policy that plays to his base. Second, that markets begin pricing in impeachment risk. Although we do not think that impeachment would have a major or direct impact on earnings and the real economy, it could add to volatility and could imply higher odds of a Democratic win in 2020 (think Gerald Ford). This would present a scenario in which the Democrats would be more likely to reverse Trump's policies in 2020, thus increasing uncertainty. As such impeachment could start being priced in well ahead of the November election. We would therefore expect midterm-related volatility to rise before the election. The election itself could likely be a time to buy risk assets, provided that fundamentals, the macro backdrop, and geopolitical risks all combine into a bullish signal, as long as President Trump makes an effort to move to the middle and work with either a split Congress, or even a potentially Democratic-led legislature. These are all sources of uncertainty and therefore provide plenty of reasons for the markets to fret ahead of the election. Who Will Win The Midterm Election? It is too early to have a high conviction view on the midterm election, which is still over six months away. Betting markets give Democrats roughly 70% probability of winning the House and just 40% of winning the Senate (Chart 4). We roughly agree with those odds, but would give the Democrats a lower chance of winning the House and a slightly higher chance of winning the Senate. There are broadly five reasons why the Democratic Party has a very good chance of winning the House of Representatives in November: Chart 4GOP Odds Have Fallen, But Stabilized Chart 5GOP Trails In Polls, But Still Close Polling: The generic congressional ballot (Chart 5) has the Democrats up 6.7% on the Republicans. The generic ballot has a decent predictive track record. Basically, the party that is up tends to perform well in the election. Meanwhile, Trump's approval rating, despite its recent recovery in support, remains at the lower end of presidential approval ratings ahead of midterm elections, predicting a 35-seat loss for Republicans in the House (Chart 6). On the whole, the Democrats' polling advantage is modest-to-strong. True, it could unravel over the summer. But at current levels, it is still a respectable advantage. Chart 6Republican Presidents And Midterm Results Retirements: Republicans in the House and the Senate are retiring at an alarming pace, one never seen in the modern political context (Chart 7). We cannot overstate how important this is, especially given that there has been a 20% swing against non-incumbent Republicans in deeply conservative districts that have held special elections thus far (Table 3). Most worrying for the GOP is that, of the 42 Republicans who have announced retirement, 18 sit in seats that are not "solidly" held by the GOP.7 These are seats that only elected the Republican candidate by an average of at most 5% more than the overall Republican vote in the 2012 and 2016 election. Chart 7GOP Retirements Are Unprecedented Table 32017 Special Elections Are Ominous For The GOP History: Of the 18 midterm elections since World War II, the sitting president's party only retained congressional control four times (Chart 8). The only president to win congressional control during the midterm election was Bush Jr., an election that was held a year after the September 11 terrorist attack (i.e., an exception). Americans like checks and balances and abhor hubris. Redistricting: Gerrymandering - politically motivated redrawing of district electoral maps - has mainly favored Republicans over the past decade.8 It has also significantly reduced the number of competitive districts available to electoral swings (Chart 9). Recently, however, the Pennsylvania state Supreme Court invoked the state constitution and struck down the congressional map that favored the GOP. The Supreme Court of the U.S. then refused an emergency request from Pennsylvania Republicans to block the new, non-partisan map drawn by the state court. This decision followed several decisions in 2016-17 that saw congressional maps in North Carolina, Virginia, Texas, Wisconsin, and Alabama either thrown out or questioned. The changes will help the Democrats at the margin, potentially making the difference between a majority and a minority position in the House. Chart 8Trump Is ##br##Fighting History Chart 9Gerrymandering Reduces##br## Competitive House Seats Momentum: Shouldn't a strong economy and sub-4% unemployment rate help the Republicans in November? The simple answer is not much. Just as a strong economy and a 4.7% unemployment rate did not help the incumbent party and its candidate Secretary Hillary Clinton fend off the inexperienced challenger, Donald Trump, in 2016. Simply put, economics is relative and partisan. While Republican voters suddenly became very happy about the economy after Trump's election - having been miserable merely days before- it is now the Democrats who believe that the economy is in a downward spiral (Chart 10). It is therefore difficult to see how the current economic performance makes enough of a difference to swing voters away from the trends we describe above. Further supporting this view is the fact that economic issues, broadly defined, are declining in terms of relevance in the upcoming election (Chart 11).9 Chart 10Politics Trumps Data! Chart 11It's Not Necessarily The Economy The trend is clear: Republicans are in trouble when it comes to the House of Representatives (Chart 12). Democrats need to win only 25 seats in November and there are now 29 Republicans representing seats that The Cook Political Report, the expert political analysis shop when it comes to predicting individual House races, classifies as "toss-up or worse." Our call, at this point, is that the Democrats have a 60% probability of winning the House of Representatives. We hesitate to set our odds at the higher end, near where the betting markets are pricing it, as there is still a long time until the election. In addition, the Democrats' lead in the generic congressional ballot has halved from 13% since December. What about the Senate? We modeled the individual Senate races by combining the state and national economic and political variables with the latest available opinion polling.10 We only focused on the races that we believe are currently competitive and we may change the mix as new information becomes available. Our model is a work in progress and we will update our clients as it develops. The results of our "beta" model, expressed as a margin of victory by the GOP candidate (GOP total vote minus Democrat total vote), show that the Democrats have a surprisingly decent chance of picking up the Senate (Chart 13).11 This is astonishing given that the Democrats are defending nine seats in "red states," whereas Republicans are only defending one seat in a "blue state" (Nevada). Basically, our model predicts that Republicans would lose Nevada and Tennessee. Meanwhile, of the five Senate races that are ranked as "toss ups" and that are currently held by Democrats, our model predicts that Republicans will only win Indiana. Given that current polling is highly unreliable, we would take all predictions of our model with a healthy dose of skepticism. Nonetheless, the results are surprisingly bullish for the Democrats. Chart 12The Number Of "At-Risk" GOP Seats Has Doubled Chart 13BCA Senate Model Says: Election Is Too Close To Call Our call, at this point, is that the Democrats have a 45% probability of winning the Senate; essentially the election is too close to call. This is higher than where the betting markets are pricing the election and an astonishing turnaround from 12 months ago, when most forecasts ignored Democrat chances in the Senate given how unfavorable the math was for their odds of winning. What does it all mean for the markets? Chart 14Midterm Elections Are A Boon For The S&P 500... Chart 15...But Really, It's All About The Fed Generally speaking, the market has performed very well following midterm elections during a Republican presidency (Chart 14). At closer inspection, however, it appears that this may have been because monetary policy has almost always been easy during these periods (Chart 15). As fate would have it, Republican presidents have been generally blessed with easy monetary policy. As such, we do not think that investors should take anything from this data. Table 4Democratic Primaries To Watch Rather than rely on uncertain empirical results, we would simply point out that the run-up to the midterm election, this coming summer, looks packed with geopolitical risks and uncertainty. President Trump is facing a potential defeat in Congress and will want to ensure that his base turns out for the election. This could mean doubling down on those parts of his policy agenda where the constitutional constraints are the weakest: foreign and trade policy. This is a recipe for more volatility. The midterm election is therefore a catalyst, if not the source, of near-term volatility. Furthermore, investors should carefully observe the results of key Democratic primary races (Table 4). Any sign that the Democratic Party is fielding left-wing candidates, as opposed to centrists, would have two implications. On one hand, it would lower our odds of the Democrats winning the House and definitely the Senate. On the other hand, it would increase the odds that the U.S. will have a political paradigm shift over the next electoral cycle. If the Democrats swing hard to the left and win the midterm election, the implications for investors would be hard to overstate. As a point of reference, investors should remember that Republicans swung hard to the right in 2010-14, presaging the rise of Trump. Yet these Republican victories took place in the face of long-term demographic and social headwinds, whereas comparable Democratic victories today would take place in the face of long-term demographic and social tailwinds. American policy can shift harder to the left over the coming decade than it did to the right over the past eight years.12 As Charts 16 and 17 show, the U.S. is at "peak inequality." As the example of France illustrates, income inequality does not necessarily go up. In the early 1960s, France had a larger share of the national income apportioned to the wealthy than the U.S. does today. Since then, it has fallen. In other words, societal decisions on wealth redistribution vary over time. The concern for investors would be if any Democratic party move to the far left is rewarded at the polls in November. If this were to happen, it would be appropriate to begin pricing in a significant decline in the share of national income that goes to corporate profits, if not yet a decline in social unrest. As Chart 17 illustrates, a significant decline in wealth concentration in France occurred right around the late 1960s. The May 1968 revolution was one of the most paradigm-shifting moments in France's post-World War II history. If the markets begin pricing in anything close to this degree of change in the U.S., the S&P 500 could enter a bear market. Chart 16GOP Tax Cuts: Same Old Story Chart 17Beware May 1968 Bottom Line: Our odds of the Democrats winning the House are 60%, below market expectations. Our odds of the Democrats winning the Senate are 45%, above market expectations. While we do not think that Democratic control of Congress, or just the House, will be negative for earnings on a cyclical time horizon, we do understand why investors would price in higher volatility. First, President Trump may respond to a loss of congressional control by seeking relevance abroad through hawkish foreign and trade policy. Second, investors may sense a paradigm shift occurring in the U.S. if left-wing Democrats start winning primary races and then go on to win the House. Is Impeachment A Risk? In a report titled Break Glass In Case Of Impeachment, we argued that investors should fade impeachment-related volatility.13 Equity markets are driven by earnings. As such, there has to be a direct relationship between political volatility and company earnings. Impeachment has rarely produced such a link. Chart 18 looks at market performance during the Teapot Dome Scandal (April 1922 to October 1927), Watergate (February 1973 to August 1974), and President Clinton's Lewinsky Affair (January 1998 to February 1999). Of the three, the Teapot Dome scandal did not result in impeachment proceedings, but only because President Harding died in office in 1923 - and neither his death nor the unfolding scandal prevented the stock market from "roaring" through the mid-1920s.14 Chart 18AVolatility Amid Three U.S. Scandals Chart 18BEquities Amid Three U.S. Scandals The market reaction to the Lewinsky Affair was also highly muted. Like the Teapot Dome incident, it occurred amidst one of the greatest bull markets in U.S. history. Of course, U.S. equities did fall 19% mid-way through the Clinton impeachment process, but this was more due to global risk factors than domestic politics. Watergate appears to have affected both equity markets and volatility. The S&P 500 fell 39% from February 7, 1973 - when the Senate established a select committee to investigate Watergate - until Nixon's resignation on August 9, 1974. That said, the scandal alone did not cause the correction; rather, it was a combination of factors, including the second devaluation of the dollar, rapid increases in price inflation, and a massive insurance fraud scandal. Writing in the summer of 1973, BCA remarked that while a speculative, "Watergate-inspired," attack on the dollar further contributed to some short-term capital outflow, but that the macro-fundamentals of the economy would ultimately persevere. Would today play out more like Teapot and Clinton, or Nixon? It will depend on the fundamentals. In the 1920s and the 1990s, fundamentals were solid and thus politics could not dent the ongoing bull market. In the early 1970s, macro fundamentals were terrible and thus politics accentuated the decline in the bear market. One thing that impeachment would not change, however, is policy. The U.S. is not Brazil. Impeachment will not lead to a 180 degree change in policy outcomes. Vice President Mike Pence is a Republican and is as pro-business as Trump. Given that the aggressive trade policy towards China has both public and establishment support, we would not expect any relief on the protectionism front. However, there would be a lot less tweeting, insults, and erratic foreign policy rhetoric aimed at both allies and rivals. The "maximum pressure" doctrine would likely be replaced by a more traditional policy of carrots and sticks. Most notably, we think this would minimize the risk of a proxy war with Iran in the Middle East. How likely is impeachment once Democrats take over the House? It depends. If President Trump fires Department of Justice Special Counsel Robert Mueller, the Democrats in the House of Representatives may get enough votes to impeach President Trump even without a House takeover! The question is whether impeachment would matter. As we outlined in our special report, impeachment is a political, not a legal, process. As such, the House of Representatives has a low bar for impeachment. It can essentially impeach the U.S. president for anything, including a debatable claim that he obstructed justice. The real question is whether the Senate would convict. To do so, the Senate must hold a trial and vote on whether to remove the president from office by a two-thirds majority (67 votes). Even if Democrats win the Senate, they would need over 15 Republican Senators to join them in removing a sitting U.S. president from office, which has never been done in American history. This could happen, but it would require the American public, particularly Republicans, to lose faith in President Trump. In particular, we have been advising clients to focus on Republican voters' support for Trump. If it dips well below 70%, we suspect that Senators could start switching sides. We are currently nowhere near these levels (Chart 19). What could change these levels of support? The Mueller special investigation is a big risk to President Trump even if one thinks that the charge of collusion with Russia is unfounded. President Bill Clinton was similarly investigated by an independent special investigator, Kenneth Starr. Starr initially focused on the suicide of deputy White House counsel Vince Foster and the Whitewater real estate investments by Bill Clinton. But the trail led elsewhere. Ultimately, the "Starr Report" alleged that Clinton lied under oath regarding his extramarital affair with Monica Lewinsky, an issue completely unrelated to the original investigation. In other words, once independent investigators start digging, there is no telling what skeletons they will exhume. We do not intend to "prosecute" claims against President Trump in this or any future report. But we can also envision a scenario where the Mueller investigation reveals enough evidence of malfeasance to shake GOP voter confidence in President Trump, leading to a potential scenario where he is removed from power. Would the market care at this point? We think the answer is yes. While removal of a U.S. president has no impact on earnings, it could have an impact on social stability. Political polarization is at its highest levels in the U.S. (Chart 20), and roughly 40% of both Democrats and Republicans believe that their political competitors pose a "threat to the nation's well-being" (Chart 21). Chart 19Impeachment: Not A Risk (Yet) Chart 20Polarization, As Inequality, Remains At Record Highs Chart 21"A Threat To The Nation's Well-Being?" Really?! We would fade any risk of a widespread, Red State rebellion. Since a change in Republican opinion is required for Senators to convict Trump, most of Trump's supporters will have already lost faith in him by the time he is removed from office. As we outlined in our Strategic Outlook, we doubt that many Trump voters would risk social unrest to defend their champion.15 Many conservative voters simply wanted change and were willing to give an outsider a chance (much as their liberal counterparts did in 2008!). But convincing the markets may take time, and any sign of even minimal right-wing terrorism could create volatility and drawdowns. Bottom Line: Impeachment remains a headline risk to the markets. We continue to believe that impeachment will merely accentuate the impact of fundamentals on risk assets. However, fundamentals themselves are starting to look vulnerable, at least on a tactical horizon. As such, we are entering a six-month period where geopolitical, trade, and domestic political risks could pose headwinds to U.S. risk assets. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com David Boucher, Associate Vice President Quantitative Strategist davidb@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017; "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 5 President Clinton launched the largest NATO military operation at the time against Yugoslavia amidst impeachment proceedings against him while President George H. W. Bush ordered U.S. troops into Somalia a month after losing the 1992 election. Ironically, President George H. W. Bush intervened in Somalia in order to lock in the supposedly isolationist Bill Clinton, who had defeated him three weeks earlier, into an internationalist foreign policy. Less dramatic, but still notable examples, are President George W. Bush ordering the "surge" of troops into Iraq in 2007 after losing both houses of Congress in 2006, and President Barack Obama negotiating the Iranian nuclear deal after losing the Senate (and hence the entire Congress) to the Republicans in 2014. 6 Please see BCA Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much For Populism!" dated November 8, 2017, available at gps.bcaresearch.com. 7 We use The Cook Political Report methodology for reporting the characteristic of House seats. Seats are split into "toss-up or worse," "likely/lean," and "solid" based on their Partisan Voter Index (PVI) score. The Cook PVI measures how each district performs at the presidential level compared to the nation as a whole. A district with a D+2 PVI voted an average of two points more Democratic than the nation did as a whole in the last two presidential elections (2012 and 2016 for current PVI rating). The Cook Political Report defines a "swing seat" as one that falls between D+5 and R+5. A "solid Republican" seat would therefore be any seat with a PVI of R+5 or higher. A "solid Democrat" seat would therefore be any seat with a PVI of D+5 or greater. 8 This is not to say that Democrats have not redistricted for partisan reasons. California was famously redistricted in the 1980s. Most recently, former Maryland Governor Martin O'Malley admitted, during a court deposition, that he redrew the state's district borders specifically to increase the Democratic congressional majority in the state. Please see Amber Phillips, "Maryland's redistricting case reminds us: Both parties gerrymander. A lot." The Washington Post, dated March 28, 2018, available at washingtonpost.com. 9 Please see BCA U.S. Investment Strategy Weekly Report, "As Good As It Gets?" dated January 29, 2018, available at usis.bcaresearch.com. 10 The state variables include the annual percent change in personal income, the annual change in the Philadelphia Fed Coincidence index, and incumbency. The national variables include presidential approval ratings, a variable indicating whether the last presidential election was close, and the annual percent change in real GDP, CPI, industrial production, and the DXY. We add to this mix of national and state data the latest opinion polling by state race and the generic congressional ballot. 11 The U.S. Vice President, Republican Mike Pence, would cast the deciding vote in case of a 50-50 tie and therefore the Democrats require a pickup of two seats. 12 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 14 "Teapot Dome" was for decades the largest corruption scandal in U.S. history. It involved President Warren G. Harding, his Secretary of the Interior, other officials, and a number of oil companies that were given extremely favorable leases to drill oil in federal land in Wyoming. Investigations and prosecutions lasted through 1927. 15 Please see BCA Geopolitical Strategy Strategic Outlook, "BCA Geopolitical Strategy 2017 Report Card," dated December 13, 2017, available at gps.bcaresearch.com.

Highlights After the March FOMC Meeting, market pricing for short-term rates is largely consistent with the Fed's forecasts. For investors and the Fed, the health of the economy and earnings matter more than Trump's political woes. However, the U.S. / China trade disputes will now take center stage. How can investors prepare for the trough in Citigroup Economic Surprise Index? Investors remain skeptical that the unemployment rate can fall to 3.5% and wonder what pace of monthly payroll growth would be required to get it there. Feature The S&P 500 fell more than 2% last Thursday after President Trump announced a new round of tariffs aimed at China. Treasury yields drifted modestly lower, and the trade weighted dollar fell 1%. Credit spreads widened. The trade tensions and the softer dollar drove gold up by nearly 3%. Meanwhile, another drawdown in oil inventories drove WTI oil nearly 5% higher. The VIX climbed last week, and has more than doubled since the start of the year. The market largely ignored last week's FOMC meeting. Fed Chair Powell stuck to the script at his first post-meeting press conference, but noted that trade was a topic of discussion. The "...For Inflation" section of this week's report provides more detail on Fed's view of the economy and rates. U.S. risk assets also sold off last week as market participants reacted negatively to Trump's political woes and trade policies. BCA's view is that investors should fade the former and focus on the later. We discuss Trump's political situation, as well as the trade tensions in the second section of this week's report ("...For the Next Tweet"). Nearly all the data in last week's sparse economic calendar exceeded expectations. At 1.8%, the Atlanta Fed GDPNow estimate for Q1 finished the week where it started. An unusual run of harsh winter weather in the Northeastern U.S. in March will keep downward pressure on the Citigroup Economic Surprise Index for the next month or so. We provide more detail on the Citigroup Economic Surprise Index and the performance of risk assets as the index rises and falls in the "...For The Washout" section of this week's report. Moreover, in the final section of the report ("...For The Labor Market"), we discuss how the unemployment rate can get to BCA's target of 3.5% in the next 12 months. ... For Inflation As widely expected, the FOMC last week delivered its sixth rate hike of the cycle and Fed members were more optimistic on the economic outlook. However, U.S. trade policy is a cloud over the outlook. The Fed downgraded its assessment of current economic conditions, but upgraded the outlook. The current pace of economic activity was described as "moderate" and opposed to "solid" in the previous FOMC statement. This reflects some disappointing data releases, which is also apparent in the Atlanta Fed's GDPNow model forecasting just 1.8% growth in Q1. But the Fed does not expect the softness to persist and noted that "the economic outlook has strengthened" (details below in "...For the Washout"). This was reflected in the updated economic projections. GDP growth forecasts were revised to 2.7% and 2.4% for 2018 and 2019, respectively (Chart 1). That's up from 2.5% and 2.1%, and comfortably above the Fed's 1.8% estimate for potential growth. As a consequence, the Fed expects the unemployment rate to drop to 3.6% in 2019, which would be well below the Fed's revised 4.5% estimate of full employment (details below in "...For the Labor Market"). Despite growth being above-trend and the jobless rate falling far below NAIRU, FOMC participants are not forecasting a major acceleration in inflation. From 1.9% in 2018, core PCE inflation is seen fairly steady at 2.1% in 2019 and 2020. To some degree, the upward pressure on inflation will be mitigated by a higher path for the Fed funds rate. Although the median projection remains for three rate hikes this year, the Fed expects slightly faster rate hikes in 2019 and 2020 (Chart 2). The Fed funds rate is now expected to end 2020 at 3.375%, up from 3.125% expected in December. This will put monetary policy on the tighter side of the Fed's 2.875% estimate of the neutral rate. Chart 1The FOMC'S Latest Forecasts Chart 2Market And The Fed In Agreement On Rates Of course, the path of the Fed funds rate will depend on the degree of slack in the economy and the resulting inflationary pressures. The Fed could be underestimating the inflationary pressures associated with a jobless rate that will be nearly 1% below NAIRU. Alternatively, a rising participation rate could slow the decline in the unemployment rate, or the Fed's estimate of NAIRU could get revised much lower. Finally, while the fiscal stimulus is behind the Fed's more optimistic outlook, U.S. trade policy is a growing downside risk (details below in "...For the Next Tweet"). During his press conference, Fed Chair Powell said that FOMC members were aware of the risk, but it was not incorporated into their forecasts. President Trump announced tariffs on China last week. China may then retaliate with its own tariffs. As we've said before, nobody wins from trade wars. Economic activity will be weaker and prices will be higher. A full blown trade war could jeopardize the Fed's rosy forecasts. Bottom Line: Market pricing for short-term rates is largely consistent with the Fed's forecasts. Therefore, the outcome of last week's FOMC meeting is not very market relevant. Investors are more focused on trade policy for now. ... For The Next Tweet BCA is looking beyond any market volatility induced by President Trump's political scandals.1 The decision to impeach President Trump is a purely political decision that rests with the House of Representatives. Under GOP control, Trump will not likely be impeached if he continues to fire his White House aides or members of his cabinet. That is his purview as President. However, relieving Special Counsel Mueller of his duties would probably be a red line for House Republicans and lead to impeachment. That said, it is very difficult to see the impeachment in the House lead to Trump's removal by the Senate, given his elevated approval ratings among GOP voters (Chart 3). Trump's support with GOP voters, our Geopolitical Strategy service's critical measure of whether Trump can stay in power, is back at 2016 election levels with GOP voters (Chart 3). Furthermore, conviction in the Senate (and removal from office), requires 67 votes. If the Democrats take the House, they are likely to impeach Trump in 2019. But even if the Democrats retake the Senate this fall, they would fall far short of that 67-vote threshold for conviction. For investors and the Fed, the health of the economy and earnings matter more than Trump's political woes. Equity markets performed well when the economy and earnings backdrop was favorable during presidential scandals in the 1920s and the 1990s. In the early 1970s, amid soaring inflation and the worst recession since the Great Depression, there was a bear market in equities (Chart 4A). Likewise, surges in equity market volatility amid political scandals were related more to economic and financial events than politics (Chart 4B). Chart 4AFor Markets,##BR##Economy Matters More Than Politics Chart 4BMarket Volatility During##BR##U.S. Political Scandals Today's environment - while not as robust as in the 1920s or late 1990s - provides support for higher stock prices, above-trend economic growth, escalating inflation, three more Fed rate hikes this year, and higher Treasury bond yields. Moreover, none of the issues that investors care about (tax cuts, deregulation, lifting of the spending caps, etc.) can be reversed by Trump's impeachment. Even a Democratic wave in this fall's mid-term Congressional elections will not deliver the opposition party a veto-proof majority (Chart 5). Thus, in the current economic cycle, we expect pro-market forces at the legislative and executive branches of government to persist. Chart 5Democrats's Lead in Generic Congressional##BR##Ballot Has Moved Lower This Year However, Trump's political scandals may cost the GOP the House in this fall's mid-term elections. Table 1 and Chart 6 show that political gridlock is not positive for stock prices after controlling for important macro factors.2 The average monthly return on the S&P 500 is considerably higher when the executive and legislative branches are unified. The worst outcome for equity markets, by far, is when the President faces a split legislature. BCA's Geopolitical Strategy service noted that while the market has cheered the limited scope of tariffs imposed earlier this month, investors may be underestimating the political shifts that underpinned Trump's move. There is little reason to think that protectionism will fade when Trump leaves office. The Administration's decision late last week to introduce sanctions aimed at China represents another escalation of the trade spat initiated in early March. Increased trade tensions with China represent a near-term risk to the markets.3 However, BCA's Geopolitical Strategy team notes that the latest round of tariffs suggests that Trump has made a bid to increase negotiation leverage with China rather than launch a protectionist broadside. This is good news in the short term, relative to the worst fears given Trump's lack of legal/constitutional constraints. But in the long term, Trump's latest move on trade policy support's our view that geopolitical risk is moving to East Asia and the U.S. / China conflict is a high-risk scenario that markets are now going to have to start pricing in.4 Table 1Divided Government Is, In Fact, Bad For Stocks Chart 6A Unified Congress Is A Boon For Stocks Bottom Line: Investors should dismiss the risk of domestic political scandals interrupting the market-friendly policy back drop. However, U.S. / China trade disputes will take center stage. China is motivated to prevent a trade war through significant compromises that Trump can advertise as wins to his audience this November. If Trump accepts these concessions, then the risk of a trade war with China will likely be removed until the next race for President in 2020. ... For The Washout The U.S. economic data have disappointed so far this year, as illustrated by Citigroup Economic Surprise Index (Chart 7). The Index peaked at 84.5 in December 2017 and subsequently has moved lower for 64 days. Since early 2011, there were six other episodes when the Surprise Index behaved similarly. These phases lasted an average of 86 days; the median number of days from peak to trough was 66 days. The implication is that the trough in the Citigroup Economic Surprise reading may be a month or two away. However, the relatively low economic expectations at end-2017 suggest that the disappointment may be truncated. On the other hand, the Tax Cut and Jobs Act of 2017, along with the lifting of budgetary spending caps in early 2018, have likely raised economists' near-term projections. Chart 7U.S. Financial Markets As Economic Surprise Index Declines The performance of key financial markets and commodities since the Economic Surprise Index crested in December 2017 matches the historical record, with a few notable exceptions (Table 2 and Charts 7 and 8). As the Index rolled over in late 2017, stocks beat bonds, credit outperformed Treasuries and the dollar fell, matching previous episodes. However, counter to the historical trend, gold and oil prices have increased and small caps have underperformed in the past three months. Table 2Financial Market Performance As The Economic Surprise Index Falls Chart 8Economic Surprise Approaching A Turning Point Based on BCA's research,5 tactical investors should add to their risk positions as the Citigroup Economic Surprise Index bottoms and begins to climb. As the Economic Surprise Index rises, stocks beat bonds by an average of 8700 bps and in six of the seven episodes since 2011 (Table 3). Furthermore, the performance of stock-to-bond ratio is better when the Economic Surprise Index is accelerating. Table 3 again shows that all asset classes also perform better when the Index climbs. After briefly moving above zero in early 2017 - indicating that inflation data was stronger than analysts projected - the Citigroup Inflation Surprise index rolled over again (Chart 9, top panel) through year end 2017. Reports on the CPI, PPI and average hourly earnings continued to fall short of consensus forecasts despite tightening of the labor and product markets. The disappointment on price data relative to consensus forecasts is not new. Although there were brief periods when prices exceeded forecasts in 2010 and 2011, the last time that inflation exceeded market consensus in this business cycle was in late 2009 and early 2010. In the last few years of the 2001-2007 economic expansion through early 2009, the price data eclipsed forecasts more than half of the time. During this interval, economists underestimated the impact of surging energy prices on inflation readings. Table 3Financial Market Performance As The Economic Surprise Index Rises Chart 9The Fed Cycle And Inflation Surprise Moreover, the Citigroup Inflation Surprise index escalated during previous tightening regimes when the economy was at full employment and the Fed funds rate was in accommodative territory (Chart 9). The last time those conditions were in place, which was in 2005, the Fed was wrapping up a rate increase campaign that began in mid-2004. An increase in the Citigroup Inflation Surprise Index also accompanied most of the Fed's rate hikes from mid-1999 through mid-2000. In late 2015, as the current set of rate hikes commenced, the inflation surprise index was on the upswing, the economy was close to full employment and the Fed funds rate was accommodative. Bottom Line: The disappointing run of economic data will not end for another few months. The unusually harsh winter weather in March in the Northeastern exacerbates the situation. However, the weakness in the economic data is not a sign that a recession is at hand. We expect that the inflation surprise index will continue to grind higher, as unemployment dips further into 'excess demand' territory (details below in "...For The Labor Market"). After the Citigroup Economic Surprise Index forms a bottom and starts to rise, history suggests that stocks will beat bonds, investment-grade and high-yield corporate bonds will outpace Treasuries, and gold and oil will climb. Stay overweight stocks versus bonds, long credit and underweight duration. ... For The Labor Market BCA expects the unemployment rate to hit 3.5% by late 2018 or early next year, the first time since December 1969. Our base case assumes that the economy will generate 200,000 nonfarm payroll jobs per month and that the labor force participation rate will remain at 63%. The unemployment rate was 4.1% in February 2018 and bottomed at 4.4% in 2006 and 2007; the rate reached a 30-year low at 3.8% in 2000. As noted in the first section of this week's report, at the conclusion of last week's meeting, the FOMC nudged down its view of this year's unemployment rate to 3.8%. The FOMC also slightly adjusted its long-term forecast of the unemployment rate to 4.5%. The implication is that BCA and the FOMC expect the U.S. economy to continue to run below full employment this year. Nonetheless, investors remain skeptical that the unemployment rate can fall to 3.5% and wonder what pace of monthly payroll growth would be required to get it there. In Table 4 we look at various scenarios (monthly increases in payrolls, annual percentage change in participation rate) to show when the unemployment rate will dip below 3.5%. In the past three months, total nonfarm payroll employment increased by 242,000 per month, and in the past year, the average monthly increase was 190,000. The participation rate was 63% in February, little changed from a year ago as an improved labor market offset demographic factors that continue to drive down this rate. Our calculations assume that the labor force will expand by 0.9% per year, matching the growth rate in the past 12 months. Chart 10 shows the history of the unemployment rate and several scenarios in the next two years that assume the participation rate stays at 63%. Table 4Dates When 3.5% Unemployment Rate Threshold Is Reached Chart 10The Unemployment Rate Under Various Monthly Job Count Scenarios Bottom Line: BCA's view is that the FOMC's forecast for the unemployment rate at the end of 2018 (3.8%) is too high and only marginally lower than the current 4.1% rate. This is inconsistent with real GDP growth well in excess of its supply-side potential. The macro backdrop will likely justify the FOMC hiking more quickly than the March 2018 dots forecast. The risks are skewed to the upside. BCA expects the 2/10 Treasury yield curve to steepen through mid-year and then flatten by year-end, spending most of 2018 between 0 and 50 bps. Stay underweight duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Policies Are Stimulative Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report "The South China Sea: Smooth Sailing?," dated March 28, 2017, available at gps.bcaresearch.com. 5 Please see BCA U.S. Investment Strategy Weekly Reports, "Solid Start," dated January 8, 2018 and "The Revenge Of Animal Spirits," dated October 30, 2017. Both available at usis.bcaresearch.com.

Special Report

Dear Clients, This week we are re-publishing an excellent Special Report written by our geopolitical team that appeared in the January 2018 Bank Credit Analyst. The recent removal of term limits on the Chinese presidency, a move that was foreshadowed in the report, has refocused global investor attention on the country's secular outlook. The report explains why the long-run outlook for China hinges on Xi Jinping's willingness to use his immense personal authority and concentration of power for the purposes of good governance and market-oriented economic reform. Without concrete progress, investors will have to decide whether they want to invest in a China that is becoming less economically vibrant as well as more authoritarian. I trust you will find this report insightful. Best regards, Jonathan LaBerge, CFA, Vice President Special Report Highlights 2018 is a pivotal year for China, as it will set the trajectory for President Xi Jinping's second term ... and he may not step down in 2022. Poverty, inequality, and middle-class angst are structural and persistent threats to China's political stability. The new wave of the anti-corruption campaign is part of Xi's attempt to improve governance and mitigate political risks. Yet without institutional checks and balances, Xi's governance agenda will fail. Without pro-market reforms, investors will face a China that is both more authoritarian and less productive. Feature Hearts rectified, persons were cultivated; persons cultivated, families were regulated; families regulated, states were rightly governed; states rightly governed, the whole world was made tranquil and happy. - Confucius, The Great Learning Comparisons of modern Chinese politics with Confucian notions of political order have become cliché. Nevertheless, there is a distinctly Confucian element to Chinese President Xi Jinping's strategy. Xi's sweeping anti-corruption campaign, which will enter "phase two" in 2018, is essentially an attempt to rectify the hearts and regulate the families of Communist Party officials and civil servants. The same could be said for his use of censorship and strict ideological controls to ensure that the general public remains in line with the regime. Yet Xi is also using positive measures - like pollution curbs, social welfare, and other reforms - to win over hearts and minds. His purpose is ultimately the preservation of the Chinese state - namely, the prevention of a Soviet-style collapse. Only if the regime is stable at home can Xi hope to enhance the state's international security and erode American hegemony in East Asia. This would, from Beijing's vantage, make the whole world more tranquil and happy. Chart 1The New Normal Thus, for investors seeking a better understanding of China in the long run, it is necessary to look at what is happening to its governance as well as to its macroeconomic fundamentals and foreign relations.1 China's greatest vulnerability over the long run is its political system. Because Xi Jinping's willingness to relinquish power is now uncertain, his governance and reform agenda in his second term will have an outsized impact on China's long-run investment outlook. The Danger From Within From 1978-2008, the Communist Party's legitimacy rested on its ability to deliver rising incomes. Since the Great Recession, however, China has entered a "New Normal" of declining potential GDP growth as the society ages and productivity growth converges toward the emerging market average (Chart 1). In this context, Chinese policymakers are deathly afraid of getting caught in the "middle income trap," a loose concept used to explain why some middle-income economies get bogged down in slower growth rates that prevent them from reaching high-income status (Chart 2).2 Such a negative economic outcome would likely prompt a wave of popular discontent, which, in turn, could eventually jeopardize Communist Party rule. The quid pro quo between the Chinese government and its population is that the former delivers rising incomes in exchange for the latter's compliance with authoritarian rule. The party is not blind to the fate of other authoritarian states whose growth trajectory stalled. Chart 2Will China Get Caught In The Middle-Income Trap? The threat of popular unrest in China may seem remote today. The Communist Party is rallying around its leader, Xi Jinping; the economy rebounded from the turmoil of 2015 and its cyclical slowdown in recent months is so far benign; consumer sentiment is extremely buoyant; and the global economic backdrop is bright (Chart 3). Yet these positive political and economic developments are cyclical, whereas the underlying political risks are structural and persistent. China has made massive gains in lifting its population out of poverty, but it is still home to 559 million people, around 40% of the population, living on less than $6 per day, the living standard of Uzbekistan. It will be harder to continue improving these workers' quality of life as trend growth slows and the prospects for export-oriented manufacturing dry up. This is why the Xi administration has recently renewed its attention to poverty alleviation. The government is on target in lifting rural incomes, but behind target in lifting urban incomes, and urban-dwellers are now the majority of the nation (Chart 4). The plight of China's 200-250 million urban migrants, in particular, poses the risk of social discontent. Moreover, while China knows how to alleviate poverty, it has less experiencing coping with the greatest threat to the regime: the rapid growth of the middle class, with its high expectations, demands for meritocracy and social mobility, and potential for unrest if those expectations are spoiled (Chart 5). Chart 3China's Slowdown So Far Benign Chart 4Urban Income Targets At Risk Chart 5The Communist Party's Greatest Challenge Democracy is not necessarily a condition for reaching high-income status, but all of Asia's high-income countries are democracies. A higher level of wealth encourages household autonomy vis-à-vis the state. Today, China has reached the $8,000 GDP per capita range that often accompanies the overthrow of authoritarian regimes.3 The Chinese are above the level of income at which the Taiwanese replaced their military dictatorship in 1987; China's poorest provinces are now above South Korea's level in that same year, when it too cast off the yoke of authoritarianism (Chart 6). Chart 6China's Development Beyond Point At Which##br## Taiwan And Korea Overthrew Dictatorship This is not an argument for democracy in China. We are agnostic about whether China will become democratic in our lifetime. We are making a far more humble point: that political risk will mount as wealth is accumulated by the country's growing middle class. Several emerging markets - including Thailand, Malaysia, Turkey and Brazil - have witnessed substantial political tumult after their middle class reached half of the population and stalled (Chart 7). China is approaching this point and will eventually face similar challenges. Chart 7Middle Class Growth Troubles Other EMs The comparison reveals that an inflection point exists for a society where the country's political establishment faces difficulties in negotiating the growing demands of a wealthier population. As political scientists have shown empirically, the very norms of society evolve as wealth erodes the pull of Malthusian and traditional cultural variables.4 Political transformation can follow this process, often quite unexpectedly and radically.5 Clearly the Chinese public shows no sign of large-scale, revolutionary sentiment at the moment. And political opposition does not necessarily result in regime change. Nevertheless, it is empirically false that the Chinese people are naturally opposed to democracy or representative government. After all, Sun Yat Sen founded a Republic of China in 1912, well before many western democratic transformations! And more to the point, the best survey evidence shows that the Chinese are culturally most similar to their East Asian neighbors (as well as, surprisingly, the Baltic and eastern European states): this is not a neighborhood that inherently eschews democracy. Remarkably, recent surveys suggest that China's millennial generation, while not wildly enthusiastic about democracy, is nevertheless more enthusiastic than its peers in the western world's liberal democracies (Chart 8)! Chart 8Chinese People Not Less Fond Of Democracy Than Others China is also home to one of the most reliable predictors of political change: inequality. China's economic boom is coincident with the rise of extreme inequalities in income, wealth, region, and social status. True, judging by average household wealth, everyone appears to be a winner; but the average is misleading because it is pulled upward by very high net worth individuals - and China has created 528 billionaires in the past decade alone. Chart 9Inequality: A Severe Problem In China A better measure is the mean-to-median wealth ratio, as it demonstrates the gap that opens up between the average and the typical household. As Chart 9 demonstrates, China is witnessing a sharp increase in inequality relative to its neighbors and peers. More standard measures of inequality, such as the Gini coefficient, also show very high readings in China. And this trend has combined with social immobility: China has a very high degree of generational earnings elasticity, which is a measure of the responsiveness of one's income to one's parent's income. If elasticity is high, then social outcomes are largely predetermined by family and social mobility is low. On this measure, China is an extreme outlier - comparable to the U.S. and the U.K., which, while very different economies, have suffered recent political shocks as a result of this very predicament (Chart 10). "China does not have voters" unlike the U.S. and U.K., is the instant reply. Yet that statement entails that China has no pressure valve for releasing pent-up frustrations. Any political shock may be more, not less, destabilizing. In the U.S. and the U.K., voters could release their frustrations by electing an anti-establishment president or abrogating a trade relationship with Europe. In China, the only option may be to demand an "exit" from the political system altogether. Chart 10China An Outlier In Inequality And Social Immobility Note that there is already substantial evidence of social unrest in China over the past decade. From 2003 to 2007, China faced a worrisome increase in "mass incidents," at which point the National Bureau of Statistics stopped keeping track. The longer data on "public incidents" suggests that the level of unrest remains elevated, despite improvements under the Xi administration (Chart 11). Broader measures tell a similar story of a country facing severe tensions under the surface. For instance, China's public security spending outstrips its national defense spending (Chart 12). Chart 11Chinese Social Unrest Is Real Chart 12China Spends More On ##br##Domestic Security Than Defense In essence, Chinese political risk is understated. This conclusion may seem counterintuitive, given Xi's remarkable consolidation of power. But is ultimately structural factors, not individual leaders, that will carry the day. The Communist Party is in a good position now, but its leaders are all-too-aware of the volcanic frustrations that could be unleashed should they fail to deliver the "China Dream." This is why so much depends upon Xi's policy agenda in the second half of his term. To that question we will now turn. Bottom Line: The Communist Party is at a cyclical high point of above-trend economic growth and political consolidation under a strongman leader. However, political risk is understated: poverty, inequality, and middle-class angst are structural and persistent and the long-term potential growth rate is slowing. If we assume that China is not unique in its historical trajectory, then we can conclude that it is approaching one of the most politically volatile periods in its development. The Governance And Reform Agenda Since coming to office in 2012-13, President Xi has spearheaded an extraordinary anti-corruption campaign and purge of the Communist Party (Chart 13). The campaign has understandably drawn comparisons to Chairman Mao Zedong's Cultural Revolution (1966-76). Yet these are not entirely fair, as Xi has tried to improve governance as well as eradicate his enemies. As Xi prepares for his "re-election" in March 2018, he has declared that he will expand the anti-corruption campaign further in his second term in office: details are scant, but the gist is that the campaign will branch out from the ruling party to the entire state bureaucracy, on a permanent basis, in the form of a new National Supervision Commission.6 There are three ways in which this agenda could prove positive for China's long-term outlook. First, the regime clearly hopes to convince the public that it is addressing the most burning social grievances. Corruption persistently ranks at the top of the list, insofar as public opinion can be known (Chart 14). Public opinion is hard to measure, but it is clear that consumer sentiment is soaring in the wake of the October party congress (see Chart 3 above). It is also worth noting that the Chinese public's optimism perked up in Xi's first year in office, when the policy agenda on offer was substantially the same and the economy had just experienced a sharp drop in growth rates (Chart 15). Reassuring the public over corruption will improve trust in the regime. Chart 13Xi's Anti-Corruption Campaign Chart 14Chinese Public Grievances Second, the anti-corruption campaign feeds into Xi's broader economic reform agenda. Productivity growth is harder to generate as a country's industrialization process matures. With the bulk of the big increases in labor, capital, and land supply now complete in China, the need to improve total factor productivity becomes more pressing (Chart 16). Unlike the early stages of growth, this requires reaching the hard-to-get economic conditions, such as property rights, human capital, financial deepening, entrepreneurship, innovation, education, technology, and social welfare. Chart 15Anti-Corruption Is Popular Chart 16Productivity Requires Institutional Change On this count, the Xi administration's anti-corruption campaign has been a net positive. The most widely accepted corruption indicators suggest that it has made a notable improvement to the country's governance. Yet the country remains far below its competitors in the absolute rankings, notably its most similar neighbor Taiwan (Chart 17 A&B). The institutionalization of the campaign could thus further improve the institutional framework and business environment. Chart 17AAnti-Corruption Campaign Is A Plus ... Chart 17B... But There's A Long Way To Go Third, the anti-corruption campaign can serve as a central government tool in enforcing other economic reforms. Pro-productivity reforms are harder to execute in the context of slowing growth because political resistance increases among established actors fighting to preserve their existing advantages. If the ruling party is to break through these vested interests, it needs a powerful set of tools. Recently, the central government in Beijing has been able to implement policy more effectively on the local level by paving the way through corruption probes that remove personnel and sharpen compliance. Case in point: the use of anti-corruption officials this year gave teeth to environmental inspection teams tasked with trimming overcapacity in the industrial sector (Chart 18). And there are already clear signs that this method will be replicated as financial regulators tackle the shadow banking sector.7 Chart 18Reforms Cut Steel Capacity, ##br##Reduced Need For Scrap These last examples - financial and environmental regulatory tightening - are policy priorities in 2018. The coercive aspect of the corruption probes should ensure that they are more effective than they would otherwise be. And reining in asset bubbles and reducing pollution are clear long-term positives for the regime. Ideally, then, Xi's anti-corruption campaign will deliver three substantial improvements to China's long-term outlook: greater public trust in the government, higher total factor productivity, and reduced systemic risks. The administration hopes that it can mitigate its governance deficit while improving economic sustainability. In this way it can buy both public support and precious time to continue adjusting to the new normal. The danger is that these policies will combine to increase downside risks to growth in the short term.8 Bottom Line: Xi's anti-corruption campaign is being expanded and institutionalized to cover the entire Chinese administrative state. This is a consequential campaign that will take up a large part of Xi's second term. It is the administration's major attempt to mitigate the socio-political challenges that await China as it rises up the income ladder. Absolute Power Corrupts Absolutely? The problem, however, is that Xi may merely use the anti-corruption campaign to accrue more power into his hands. As is clear from the above, Xi's governance agenda is far from impartial and professional. The anti-corruption campaign is being used not only to punish corrupt officials but also to achieve various other goals. Xi has even publicly linked the campaign to the downfall of his political rivals.9 In essence, the campaign highlights the core contradiction of the Xi administration: can Xi genuinely improve China's governance by means of the centralization and personalization of power? Over the long haul, the fundamental problem is the absence of checks and balances, i.e. accountability, from Xi's agenda. For instance, the National Supervision Commission will be granted immense powers to investigate and punish malefactors within the state - but who will inspect the inspectors? Xi's other governance reforms suffer the same problem. His attempt to create "rule of law" is lacking the critical ingredients of judicial independence and oversight. The courts are not likely to be able to bring cases against the party, central government, or powerful state-owned firms, and they will not be able to repeal government decisions. Thus, as many commentators have noted, Xi's notion of rule of law is more accurately described as "rule by law": the reformed legal system will in all probability remain an instrument in the hands of the Communist Party. Chart 19China's Governance Still Falls Far Behind Likewise, Xi's attempt to grant the People's Bank of China greater powers of oversight in order to combat systemic financial risk suffers from the fact that the central bank is not independent, and will remain subordinate to the State Council, and hence to the Politburo Standing Committee. This is not even to mention the lamentable fact that Xi's campaign for better governance has so far coincided with extensive repression of civil society, which does not mesh well with the desire to improve human capital and innovation.10 Thus it is of immense importance whether Xi sets up relatively durable anti-corruption, legal, and financial institutions that will maintain their legitimate functions beyond his term and political purposes. Otherwise, his actions will simply illustrate why China's governance indicators lag so far behind its peers in absolute terms. Corruption perceptions may improve further, but there will be virtually no progress in areas like "voice and accountability," "political stability and absence of violence," "rule of law," and "regulatory quality," each of which touches on the Communist Party's weak spots in various ways (Chart 19). Analysis of the Communist Party's shifting leadership characteristics reinforces a pessimistic view of the long run if Xi misses his current opportunity.11 The party's top leadership increasingly consists of career politicians from the poor, heavily populated interior provinces - i.e. the home base of the party. Their educational backgrounds are less scientific, i.e. more susceptible to party ideology. (Indeed, Xi Jinping's top young protégé, Chen Miner, is a propaganda chief.) And their work experience largely consists of ruling China's provinces, where they earned their spurs by crushing rebellions and redistributing funds to placate various interest groups (Chart 20). While one should be careful in drawing conclusions from such general statistics, the contrast with the leadership that oversaw China's boldest reforms in the 1990s is plain. Bottom Line: Xi's reform agenda is contradictory in its attempt to create better governance through centralizing and personalizing power. Unless he creates checks and balances in his reform of China's institutions, he is likely to fall short of long-lasting improvements. The character profiles of China's political elite do not suggest that the party will become more likely to pursue pro-market reforms in Xi's wake. Chart 20China's Leaders Becoming More 'Communist' Over Time Xi Jinping's Choice Xi is the pivotal player because of his rare consolidation of power, and 2018 is the pivotal year. It is pivotal because it will establish the policy trajectory of Xi's second term - which may or may not extend into additional terms after 2022. So far, the world has gained a few key takeaways from Xi's policy blueprint, which he delivered at the nineteenth National Party Congress on October 18: Xi has consolidated power: He and his faction reign supreme both within the Communist Party and the broader Chinese state; Xi's policy agenda is broadly continuous: Xi's speech built on his administration's stated aims in the first five years as well as the inherited long-term aims of previous administrations; China is coming out of its shell: In the international realm, Xi sees China "moving closer to center stage and making greater contributions to mankind"; The 2022 succession is in doubt: Xi refrained from promoting a successor to the Politburo Standing Committee, the unwritten norm since 1992. Chart 21Market Not Too Worried About##br## Party Congress Outcomes Markets have not reacted overly negatively to these developments (Chart 21), as the latter do not pose an immediate threat to the global rally in risk assets. The reasons are several: Maoism is overrated: While the Communist Party constitution now treats Xi Jinping as the sole peer of the disastrous ruler Mao Zedong, the market does not buy the Maoist rhetoric. Instead, it sees policy continuity, yet with more effective central leadership, which is a plus. Reforms are making gradual progress: Xi is treading carefully, but is still publicly committed to a reform agenda of rebalancing China's economic model toward consumption and services, improving governance and productivity, and maintaining trade openness. Whatever the shortcomings of the first five years, this agenda is at least reformist in intention. China's tactic of "seeking progress while maintaining stability" is certainly more reassuring than "progress at any cost" or "no progress at all"! Trump and Xi are getting along so far: Xi's promises to move China toward center stage threaten to increase geopolitical tensions with the United States in the long run, yet markets are not overly alarmed. China is imposing sanctions on North Korea to help resolve the nuclear missile standoff, negotiating a "Code of Conduct" in the South China Sea, and promoting the Belt and Road Initiative (BRI), which will marginally add to global development and growth. Trump is hurling threatening words rather than concrete tariffs. 2022 is a long way away: Markets are unconcerned with Xi's decision not to put a clear successor on the Politburo Standing Committee, even though it implies that Xi will not step down at the end of his term in five years. Investors are implicitly approving Xi's strongman behavior while blissfully ignoring the implication that the peaceful transition of power in China could become less secure. Are investors right to be so sanguine? Cyclically, BCA's China Investment Strategy is overweight Chinese investible equities relative to EM and global stocks.12 Geopolitical Strategy also recommends that clients follow this view and overweight China relative to EM. Beyond this 6-12 month period, it depends on how Xi uses his political capital. If Xi is serious about governance and economic reform, then long-term investors should tolerate the other political risks, and the volatility of reforms, and overweight China within their EM portfolio. After all, China's two greatest pro-market reformers, Deng Xiaoping and Jiang Zemin, were also heavy-handed authoritarians who crushed domestic dissent, clashed with the United States from time to time, and hesitated to relinquish control to their successors. However, if Xi is not serious, then investors with a long time horizon should downgrade China/EM assets - as not only China but the world will have a serious problem on its hands. For Deng Xiaoping and Jiang Zemin always reaffirmed China's pro-market orientation and desire to integrate into the global economic order. If Xi turns his back on this orientation, while imprisoning his rivals for corruption, concentrating power exclusively in his own person, and contesting U.S. leadership in the Asia Pacific, then the long-run outlook for China and the region should darken rather quickly. Domestic institutions will decay and trade and foreign investment will suffer. How and when will investors know the difference? As mentioned, we think 2018 is critical. Xi is flush with political capital and has a positive global economic backdrop. If he does not frontload serious efforts this year then it will become harder to gain traction as time goes by.13 If he demurs, the Chinese political system will not afford another opportunity like this for years to come. The country will approach the 2020s with additional layers of bureaucracy loyal to Xi, but no significant macro adjustments to its governance or productivity. It is not clear how long China's growth rate is sustainable without pro-productivity reforms. It is also not clear that the world will wait five years before responding to a China that, without a new reform push, will appear unabashedly mercantilist, neo-communist, and revisionist. Bottom Line: The long-run investment outlook for China hinges on Xi Jinping's willingness to use his immense personal authority and concentration of power for the purposes of good governance and market-oriented economic reform. Without concrete progress, investors will have to decide whether they want to invest in a China that is becoming less economically vibrant as well as more authoritarian. We think this would be a bad bet. Matt Gertken Associate Vice President Geopolitical Strategy Marko Papic Senior Vice President Chief Geopolitical Strategist Geopolitical Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms", dated May 13, 2015, available at gps.bcaresearch.com. 2 Chinese policymakers are expressly concerned about the middle-income trap. Please see the World Bank and China's Development Research Center of the State Council, "China 2030: Building A Modern, Harmonious, And Creative Society," 2013, available at www.worldbank.org. Liu He, who is perhaps Xi Jinping's top economic adviser, had a hand in drafting this report and is now a member of the Politburo and shortlisted to take charge of the newly established Financial Stability and Development Commission at the People's Bank of China. 3 Please see Indermit S. Gill and Homi Kharas, "The Middle-Income Trap Turns Ten," World Bank, Policy Research Working Paper 7403 (August, 2015), available at www.worldbank.org 4 Please see Ronald Inglehart and Christian Welzel, Modernization, Cultural Change and Democracy: the Human Development Sequence (Cambridge: CUP, 2005). 5 For example, the collaps of the Soviet Union and the Arab Spring, as well as the downfall of communist regimes writ large, were completely unanticipated. 6 Specifically, Xi is creating a National Supervision Commission that will group a range of existing anti-graft watchdogs under its roof at the local, provincial, and central levels of administration, while coordinating with the Communist Party's top anti-graft watchdog. More details are likely to be revealed at the March legislative session, but what matters is that the initiative is a significant attempt to institutionalize the anti-corruption campaign. Please see BCA Geopolitical Strategy Special Report, "China's Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 7 China has recently drafted top anti-graft officials, such as Zhou Liang, from the powerful Central Discipline and Inspection Commission and placed them in the China Banking Regulatory Commission, which is in charge of overseeing banks. Authorities have already imposed fines in nearly 3,000 cases in 2017 affecting various kinds of banks, including state-owned banks. On the broader use of anti-corruption teams for economic policy, please see Barry Naughton, "The General Secretary's Extended Reach: Xi Jinping Combines Economics And Politics," China Leadership Monitor 54 (Fall 2017), available at www.hoover.org. 8 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 9 Please see Gao Shan et al, "China's President Xi Jinping Hits Out at 'Political Conspiracies' in Keynote Speech," Radio Free Asia, January 3, 2017, available at www.rfa.org 10 Xi has cranked up the state's propaganda organs, censorship of the media, public surveillance, and broader ideological and security controls (including an aggressive push for "cyber-sovereignty") to warn the public that there is no alternative to Communist Party rule. This tendency has raised alarms among civil rights defenders, lawyers, NGOs, and the western world to the effect that China's governance is actually regressing despite nominal improvement in standard indicators. This is the opposite of Confucius's bottom-up notion of order. 11 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress", dated July 19, 2017, available at gps.bcaresearch.com. 12 Investors should note that, since the publication of this report, BCA's China Investment Strategy service has closed its long MSCI China / short MSCI EM trade. We are now primarily expressing our cyclically positive stance towards Chinese stocks by being long MSCI China ex-technology versus MSCI All Country World (ACW) ex-tech. For more information please see China Investment Strategy Weekly Report "After The Selloff: A View From China", dated February 15, 2018, available at cis.bcaresearch.com. 13 Xi faces politically sensitive deadlines in the 2020-22 period: the economic targets in the thirteenth Five Year Plan; the hundredth anniversary of the Communist Party in 2021; and Xi's possible retirement at the twentieth National Party Congress in 2022. At that point he will need to focus on demonstrating the Communist Party's all-around excellence and make careful preparations either to step down or cling to power. Cyclical Investment Stance Equity Sector Recommendations

Highlights The political path of least resistance leads to fiscal profligacy - in the U.S. and beyond. The response to populism is underway. The U.S. midterm election is market-relevant. Gridlock between the White House and Congress does, in fact, weigh on equity returns, after controlling for macro variables. The Democratic Party's chances of taking over Congress have fallen, but remain 50% in the House of Representatives. A divided House and Senate is the worst combination for equities, but macro factors matter most. China is clearly rebooting its "reform" agenda as Xi Jinping becomes an irresistible force. We remain long H-shares relative to EM, for now. Emerging markets - including an improved South Africa - will suffer as politics become a tailwind for U.S. growth and a headwind for Chinese growth. Feature The bond market has been shocked into action this month by the twin realizations that the Republican-held Congress is not as incompetent as believed and that the Republican Party is not as fiscally conservative as professed. When combined with steady U.S. wage growth and rising inflation expectations (Chart 1), our core 2018 theme - that U.S. politics would act as an accelerant to growth - has been priced in by the bond market with impressive urgency.1 The tax cuts alone were not enough to wake the bond market. First, the realization that a tax cut would pass Congress struck markets in late October, when it became increasingly clear that the $1.5 trillion Tax Cuts And Jobs Act would indeed pass the Senate. Second, the bill's passage along strict party lines - including the slimmest of margins in the Senate thanks to reconciliation rules - convinced investors that there would be no further compromises down the pipeline. The real game changer was the realization that the political path of least resistance leads towards profligacy. This happened with the signing into law of the February 9 two-year budget compromise (the Bipartisan Budget Act of 2018) that will see fiscal spending raised by around $380 billion.2 The deal failed to gain the support of a majority of Republicans in the House, despite House Speaker Paul Ryan's support, but 73 Democrats crossed the aisle to ensure its passage. They did so despite a lack of formal assurances that the House would consider an immigration bill. The three-day shutdown in late January has forced Democrats, who largely took the blame, to assess whether they care more about preserving their liberal credentials on fiscal policy or immigration policy. The two-year budget agreement is a testament to their concern for the former. The deal will see the budget deficit most likely rise to about 5.5% of GDP in FY2019, up from 3.3% in last year's CBO baseline forecast (Chart 2). Chart 1Rising U.S. Inflation Expectations Chart 2Fiscal Policy Gets Expansive Adding to the newly authorized fiscal spending could be a congressional rule-change that reintroduces earmarks - leading to a potential $20 billion additional spending per year. There is also a 10-year infrastructure plan that could see spending increase by another ~$200 billion over the next decade. The new budget compromise, combined with last year's tax cuts, will massively increase U.S. fiscal thrust beyond the IMF's baseline (Chart 3). The IMF's forecast, done before the tax cuts were passed, suggested that fiscal thrust would contract by about 0.5% of GDP this year, and would only slightly expand in 2019. Now we estimate that fiscal thrust will be a positive 0.8% of GDP in 2018 and 1.3% in 2019. These figures are tentative because it is not clear exactly how much of the spending will take place this year versus 2019 and 2020. Our colleague Mark McClellan, author of BCA's flagship The Bank Credit Analyst, has stressed that the impact on GDP growth will be less than these figures suggest because the economic multipliers related to tax cuts are less than those for spending.3 Our theme that the political path of least resistance will lead to profligacy is not exclusive to the U.S. After all, populism is not exclusive to the U.S, with non-centrist parties consistently capturing around 16% of the electoral vote in Europe (Chart 4). Chart 3The Budget Deal And Tax Cuts##br## Will Expand U.S. Fiscal Thrust Chart 4Populism Will Fuel Fiscal##br##Spending Beyond The U.S. Policymakers are not price-setters in the political marketplace, but price-takers. The price-setter is the median voter, who we believe has swung to the left when it comes to economic policy in developed markets after a multi-year, low-growth, economic recovery.4 Broadly speaking, investors should prepare for higher fiscal spending globally on the back of this dynamic. Aside from the U.S., the populist dynamic is evident in the world's third (Japan), fourth (Germany), and sixth (the U.K.) largest economies. Japan may have started it all, as a political paradigm shift in 2011-12 spurred a historic reflationary effort.5 Geopolitical pressure from China and domestic political pressures on the back of an extraordinary rise in income inequality, and natural and national disasters, combined to create the political context that made Abenomics possible. While the fiscal arrow has somewhat disappointed - particularly when PM Shinzo Abe authorized the 2014 increase in the consumption tax - Japan has still surprised to the upside on fiscal thrust (Chart 5). On average, the IMF has underestimated Japan's fiscal impulse by 0.84% since the beginning of 2012. Investors often understate the ability of centrist, establishment policymakers to rebrand anti-establishment policies - whether on fiscal spending or immigration - as their own. In January 2015, we asked whether "Abenomics Is The Future?"6 We concluded that rising populism in Europe would require a policy response not unlike the policy mix favored by Tokyo. Today, the details of the latest German coalition deal between the formally fiscally conservative Christian Democratic Union (CDU) and the center-left Social Democratic Party (SDP) means that even Germany has now succumbed to the political pressure to reflate. The CDU has agreed to fork over the influential ministry of finance to the profligate SPD and apparently spend an additional 46 billion euros, over the duration of the Grand Coalition, on public investment and tax cuts. Finally, in the U.K., the end of austerity came quickly on the heels of the Brexit referendum, the ultimate populist shot-across-the-bow. The new Chancellor of the Exchequer, Philip Hammond, announced a shift away from austerity almost immediately, scrapping targets for balancing the budget by the end of the decade. The change in rhetoric has carried over to the new government, especially after the Labour Party pummeled the Tories on austerity in the lead up to the June 2017 election. The bond market action over the past several weeks suggests that investors have not fully appreciated the political shifts underway over the past several years. Bond yields had to "catch up" to the political reality essentially over the course of February. However, the structural upward trajectory is now in place. The end of stimulative monetary policy will accelerate the rise in bond yields. Quantitative easing programs have soaked up more than the net government issuance of the major economies. Chart 6 shows that the flow of the major economies' government bonds available for the private sector to purchase was negative from 2015-2017. This flow will now swing to the positive side as fiscal spending necessitates greater issuance and as central banks withdraw demand. Real interest rates may therefore be higher to the extent that government bonds will have to compete with private-sector issuance for available savings. Chart 5Japan's Abenomics Leads The Way To More Spending Chart 6Lots Of Bonds Hitting The Private Market Bottom Line: The U.S. electorate chose the populist, anti-establishment Donald Trump as president with unemployment at a multi-decade low of 4.6%. The message from the U.S. election, and the rise of anti-establishment parties in Europe, is that the electorate is restless, even with the post-Great Financial Crisis recovery now in its ninth year. Policymakers have heard the message, loud and clear, and are adjusting fiscal policy accordingly. Over the course of the next quarter, BCA's Global Investment Strategy expects the rapid rise in bond yields to peter out, but investors should use any bond rallies as an opportunity to reduce duration risk. BCA's House View calls for the 10-year Treasury yield to finish the year at about 3.25%.7 Our U.S. bond strategists expect the end-of-cycle level of the nominal 10-year Treasury yield to be between 3.3% and 3.5%.8 Does The U.S. Midterm Election Matter? The three-day government shutdown that ended on January 22 has hurt the chances of the Democratic Party in the upcoming midterm election. The Democrats' lead in the generic congressional ballot has gone from a high of 13% at the end of 2017 to just 9% today (Chart 7). As Chart 8 illustrates, this generic ballot has some predictive quality. However, it also suggests that for Democrats, the lead needs to be considerably larger than for Republicans to generate the type of seat-swing needed to win a majority in the House of Representatives in 2018. Chart 7Democrats Have Lost Some Steam Chart 8Democrats Need Big Polling Lead To Win Majority There are three reasons for this built-in advantage for the Republican Party in recent midterm elections. First, the Republicans dominate the rural vote, which tends to be overrepresented in any electoral system that draws electoral districts geographically. Second, redistricting - or gerrymandering - has tended to favor the Republican Party in the past several elections. While the Supreme Court has recently struck down some of the most egregiously drawn electoral districts, the overall impact of gerrymandering since 2010 overwhelmingly favors the GOP. Third, midterm elections tend to have a lot lower voter turnout than general elections, which hurts the Democrats who rely on the youth and minority vote. Both constituencies tend to shy away from participation in the midterm election. Does the market care who wins the House and Senate? On the margin, yes. If the current GOP control of the White House, House of Representatives, and Senate were to be broken, markets might react negatively. It is often stated that gridlock has a positive effect on stock prices, as it reduces the probability of harmful government involvement in the economy and financial markets. However, research by our colleague Jonathan LaBerge, which we have recently updated, suggests otherwise. After controlling for the macro environment, gridlock between the White House and Congress is actually associated with modestly lower equity market returns.9 This conclusion is based on the past century of data. For most of that period, polarization has steadily risen to today's record-setting levels (Chart 9). As such, the negative impact of gridlock could be higher today. Table 1 illustrates the impact of four factors on monthly S&P 500 price returns. The first two columns demonstrate the effect on returns of recessions and tightening monetary policy, respectively, whereas the last two columns measure the effects of executive/legislative disunity and reduced uncertainty in the 12-months following presidential and midterm elections.10 The table presents the beta of a simple regression based on dummy variables for each of the four components (t-statistics are shown in parentheses). Chart 9U.S. Polarization Has Risen For 60 Years Table 1Divided Government Is, In Fact, Bad For Stocks As expected, the macro context has a much larger impact on stock returns than politically driven effects. The impact of political gridlock is shown to be negative regardless of timeframe. The takeaway for equity investors is that, contrary to popular belief, political gridlock is not positive for stock prices after controlling for important macro factors. Absolute results are similarly negative, with the average monthly S&P 500 returns considerably larger during periods of unified executive and legislative branches (Chart 10). Intriguingly, the less negative constellation of forces is when the president faces a unified Congress ruled by the opposing party. We would reason that such periods force the president to compromise with the legislature, which constitutionally has a lot of authority over domestic policy. The worst outcome for equity markets, by far, is when the president faces a split legislature. In these cases, we suspect that uncertainty rises as neither party has to take responsibility for negative policy outcomes, making them more likely. Chart 10A Unified Congress Is A Boon For Stocks In the current context, gridlock could lead to greater political volatility. For example, a Democratic House of Representatives would begin several investigations into the Trump White House and could potentially initiate impeachment proceedings against the president. But as we pointed out last year, impeachment alone is no reason to sell stocks.11 The Democrats would not have the ability to alter President Trump's deregulatory trajectory - which remains under the purview of the executive - nor would they be likely to gain enough seats to repeal the tax cut legislation. Yet given President Trump's populist bias, center-left Democrats could find much in common with the president on spending. This would only reinforce our adage that the political path of least resistance will tend towards profligacy. The only thing that President Trump and the Democrats in Congress will find in common, in other words, will be to blow out the U.S. budget deficit. Bottom Line: The chances of a Democratic takeover following the midterm elections have fallen, but remain at 50% for the House of Representatives. A gridlocked Congress is mildly negative for equity markets, taking into consideration that macro variables still dominate. Nonetheless, investors should ignore the likely higher political volatility and focus on the fact that President Trump and the Democrats are not that far apart when it comes to spending. China: The Reform Reboot Is Here And It Is Still Winter He told us not to believe the people who say it's spring in China again. It's still winter. - Anonymous Chinese government official referring to Liu He, the top economic adviser.12 The one risk to the BCA House View of a structural bond bear market - at least in the near term - is a peaking of global growth and a slowdown in emerging markets. The EM economies, which normally magnify booms in advanced economies, particularly in latter stages of the economic cycle, are currently experiencing a relative contraction in their PMIs (Chart 11). BCA Foreign Exchange Strategy's "carry canary" indicator - which shows that EM/JPY carry trades tend to lead global industrial activity - is similarly flashing warning signs (Chart 12).13 Chart 11EM Economies Underperforming Chart 12Yen Carry Trades Signal Distress At the heart of the divergence in growth between EM and DM is China. Beijing has been tightening monetary conditions as part of overall structural reform efforts, causing a sharp deceleration in the Li Keqiang index (Chart 13). In addition, the orders-to-inventories ratio has begun to contract, import volumes are weak, and export price growth is slowing sharply (Chart 14). Chart 13Li Keqiang Index Surprises Downward Chart 14China's Economy Weakens... The Chinese slowdown is fundamentally driven by politics. Last April we introduced a checklist for determining whether Chinese President Xi Jinping would "reboot" his reform agenda during his second term in office. We define "reform" as policies that accelerate the transition of China's growth model away from investment-driven, resource-intensive growth. Since then, political and economic events have supported our thesis. Most recently, interbank lending rates have spiked due to China's new macro-prudential regulations and monetary policy (Chart 15), and January's total credit growth clocked in at an uninspiring 11.2% (Chart 16). Tight credit control in the first calendar month typically implies that credit expansion will be limited for the rest of the year (Chart 17). A strong grip on money and credit growth is entirely in keeping with the three-year "battle" that Xi Jinping has declared against systemic financial risk.14 Chart 15...While Policy Drives Up Interbank Rates Chart 16January Credit Growth Disappoints... Chart 17... And January Credit Is The Biggest In short, we have just crossed the 50% threshold on our checklist, confirming that China is indeed rebooting its reform agenda (Table 2). Going forward, what matters is the intensity and duration of the reform push. Three events at the start of the Chinese New Year suggest that the market will be surprised by both. Table 2How Do We Know China Is Reforming? First, the National People's Congress (NPC), which convenes March 5, is reportedly planning to remove term limits for the president and vice-president, thus enabling Xi Jinping to remain as president well beyond March 2023. Xi was already set up to be the most powerful man in China's politics through the 2020s,15 so we do not consider this a material change in circumstances: the material change occurred last October when "Xi Thought" received the status of "Mao Zedong Thought" in the Communist Party's constitution and reshaped the Politburo to his liking. The point is that Xi's position is irresistible which means that his policies will have greater, not lesser, effectiveness as party and state bureaucrats scramble to enact them faithfully.16 Chart 18Crackdown On Shadow Lending Has Teeth Second, the Communist Party is reportedly convening its "Third Plenum" half a year early this year - that is, in late February and early March, just before the annual legislative meeting that begins March 5. This is a symbolic move. The third plenum is known as the "reform plenum," and this year is the fortieth anniversary of the 1978 third plenum that launched China's market reform and opening up to the global economy under Deng Xiaoping. However, the last time China convened a third plenum - in 2013 when Xi first announced his agenda - the excitement fizzled as implementation proved to be slow.17 As we have repeatedly warned clients, China's political environment has changed dramatically since 2013: the constraints to painful structural reforms have fallen.18 If the third plenum is indeed held early, some key decisions on reform initiatives will be made as we go to press, and any that require legislative approval will receive it instantly when the National People's Congress convenes on March 5.19 This will be a "double punch" that will supercharge the reform agenda this year. It is precisely the kind of ambition that we have been expecting. Third, one of the most important administrative vehicles of this new reform push, the Financial Stability and Development Commission (FSDC), has just made its first serious move.20 On February 23, China's top insurance regulator announced that it is taking control of Anbang Insurance Group for one year, possibly two, in order to restructure it amid insolvency and systemic risks. Anbang's troubles are idiosyncratic and have received ample media attention since June 2017.21 Nevertheless, China's government has just seized a company with assets over $300bn. Clearly the crackdown on the shadow financial sector has teeth (Chart 18). Anbang's case will reverberate beyond the handful of private companies involved in shadow banking and highly leveraged foreign acquisitions abroad. Beijing's focus is systemic risk, not merely innovative insurance products. The central government is scrutinizing state-owned enterprises (SOEs) and local governments as well as a range of financial companies and products. We provide a list of reform initiatives in Table 3. Table 3China Is Rebooting Economic Reforms What is the cumulative effect of these three developments? Basically, they raise the stakes for Xi's policies dramatically this year. If Xi makes himself president for life, and yet this year's third plenum is as over-hyped and under-delivered as in 2013, then we would expect China's economic future to darken rapidly. China will lose any pretext of reform just as the United States goes on the offensive against Beijing's mercantilism. It would be time to short China on a long-term time line. However, it would also spell doom for our positive U.S. dollar outlook and bearish EM view. If, on the other hand, Xi Jinping couples his power grab with renewed efforts to restructure China's economy and improve market access for foreigners, then he has a chance of deleveraging, improving China's productivity, and managing tensions with the U.S. This is the best outcome for investors, although it would still be negative for Chinese growth and imports, and hence EM assets, this year. The next political indicator to watch is the March 5 NPC session. This legislative meeting will be critical in determining what precise reforms the Xi administration will prioritize this year. The NPC occurs annually but is more important this year than usual because it installs a new government for the 2018-23 period and will kick off the new agenda. In terms of personnel, there is much speculation (Table 4).22 Investors should stay focused on the big picture: four months ago, the news media focused on Xi Jinping's Maoist thirst for power and declared that all reform efforts were dead in the water. Now the press is filled with speculation about which key reformer will get which key economic/financial position. The big picture is that Xi is using his Mao-like authority in the Communist Party to rein in the country's economic and financial imbalances. His new economic team will have to establish their credibility this year by remaining firm when the market and vested interests push back, which means more policy-induced volatility should be expected. Table 4China's New Government Takes Shape At National People's Congress The risk is that Beijing overcorrects, not that reforms languish like they did in 2015-16. Our subjective probability of a policy mistake remains at 30%, but we expect that the market will start to price in this higher probability of risk as the March political events unfold. As Liu He declared at Davos, China's reforms this year will "exceed the international community's expectations."23 The anti-corruption campaign is another important factor to monitor. In addition to any major economic legislation, the most important law that the NPC may pass is one that would create a new nationwide National Supervisory Commission, which will expand the Communist Party's anti-corruption campaign into every level of the state bureaucracy. In other words, an anti-corruption component is sharpening the policy effectiveness of the economic and financial agenda. In the aforementioned Anbang case, for instance, corporate chief Wu Xiaohui was stung by a corruption probe in June 2017 and is being tried for "economic crimes" - now his company and its counterparty risks are being restructured. The combination of anti-corruption campaign and regulatory crackdown has the potential to cause significant risk aversion among financial institutions, SOEs, and local governments. Add in the ongoing pollution curbs, and any significant SOE restructuring, and Chinese policy becomes a clear source of volatility and economic policy uncertainty this year that the market is not, as yet, pricing (Chart 19). On cue, perhaps in anticipation of rising domestic volatility, China has stopped updating its home-grown version of the VIX (Chart 20). Chart 19Market Expects No Political Volatility Yet Chart 20Has China Halted Its Version Of The VIX? We would not expect anything more than a whiff, at best, of policy easing at the NPC this March. For instance, poverty alleviation efforts will require some fiscal spending. But even then, the point of fiscal spending will be to offset credit tightness, not to stimulate the economy in any remarkable way. Monetary policy may not get much tighter from here, as inflation is rolling over amid the slowdown (Chart 21),24 but anything suggesting a substantial shift back to easy policy would be contrary to our view. More accommodative policy at this point in time would suggest that Xi has no real intention of fighting systemic risk and - further - that global growth faces no significant impediment from China this year. In such a scenario, the dollar could fall further and EM would outperform. We expect the contrary. We are long DXY and short EUR/JPY. We remain overweight Chinese H-shares within emerging markets, but we will close this trade if we suspect either that reform is a fig leaf or that authorities have moved into overcorrection territory. Otherwise, reform is a good thing for Chinese firms relative to EM counterparts that have come to rely on China's longstanding commodity- and capital-intensive growth model (Chart 22). Chart 21Monetary Policy May Not Tighten From Here Chart 22Tighter-Fisted China Will Hit EM Bottom Line: Xi Jinping has rebooted China's economic reforms. The new government being assembled is likely to intensify the crackdown on systemic financial risk. Reforms will surprise to the upside, which means that Chinese growth is likely to surprise to the downside amidst the current slowdown, thus weighing on global growth at a time when populism provides a tailwind to U.S. growth. What It All Means For South Africa And Emerging Markets We spent a full week in South Africa last June and came back with these thoughts about the country's economy and the markets:25 The main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart 23). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart 23Weak Inflation And Dollar Drove EM Assets Chart 24Market Likes Ramaphosa, Unlike Zuma In the near term, South African politics obviously do matter. Markets have cheered the election of Cyril Ramaphosa to the presidency of the African National Congress (ANC), a stark contrast to the market reaction following his predecessor's ascendancy to the same position (Chart 24). However, the now President Ramaphosa's defeat of ex-President Jacob Zuma's former cabinet minister and ex-wife, Nkosazana Dlamini-Zuma was narrow and has split the ANC down the middle. On one side is Ramaphosa's pragmatic wing, on the other is Dlamini-Zuma's side, focused on racial inequality and social justice. Chart 25Chronic Youth Unemployment Chart 26Few Gains In Middle Class Population For now, the ANC bureaucracy has served as an important circuit-breaker that will limit electoral choices in the 2019 election to the pro-market Ramaphosa, centrist Democratic Alliance, and radical Economic Freedom Fighters. From investors' perspective, this is a good thing. After all, it is clear that if the South African median voter had her way, she would probably not vote for Ramaphosa, given that the country is facing chronic unemployment (Chart 25), endemic corruption, poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. South Africa stands alone amongst its EM peers when it comes to its tepid rise in the middle class as a percent of the population (Chart 26) and persistently high income inequality (Chart 27). We see no evidence that the electorate will welcome pro-market structural reforms. Chart 27Inequality Remains Very High Nonetheless, Ramaphosa's presidency is a positive given the recent deterioration of South Africa's governance, which should improve as the new regime focuses on fighting corruption and restructuring SOEs. Whether Ramaphosa will similarly have the maneuvering room to correct the country's endemically low productivity (Chart 28) and still large twin deficits (Chart 29) is another question altogether. Chart 28A Distant Laggard In Productivity Chart 29Twin Deficits A Structural Weakness Will investors have time to find out the answer to those latter questions? Not if our core thesis for this year - that politics is a tailwind to U.S. growth and a headwind to Chinese growth - is right. In an environment where the U.S. 10-year Treasury yield is rising, DXY stabilizes, and Chinese economy slows down, commodities and thus South African assets will come under pressure. As our colleague Arthur Budaghyan, BCA's chief EM strategist, recently put it: positive political developments are magnified amid a benign external backdrop. Conversely, in a negative external environment, positive political transformations can have limited impact on the direction of financial markets. Bottom Line: Markets are cheering Ramaphosa's ascendancy to the South African presidency. We agree that the development is, all other things being equal, bullish for South Africa's economy and assets. However, the structural challenges are vast and we do not see enough political unity in the ANC to resolve them. Furthermore, we are not sure that the global macro environment will remain sanguine for long enough to give policymakers the time for preemptive structural reforms. To reflect the potential for a positive political change and forthcoming orthodox macro policies, we are closing our recommendation to bet on yield curve steepening in South Africa, which has been flat since initiation on June 28, 2017. However, we will maintain our recommendation to buy South African 5-year CDS protection and sell Russian, even though it has returned a loss of 17.08 bps thus far. We expect that Russia will prove to be a low-beta EM play in the next downturn, whereas South Africa will not be so lucky. On a different note, we are booking gains of 2525bps on our short Venezeulan vs. EM 10-yr sovereign bonds, as our commodity team upgrades its oil-price forecast for this year. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 2 Please see the Congressional Budget Office, "Bipartisan Budget Act of 2018," February 8, 2018, available at www.cbo.gov. 3 Please see BCA The Bank Credit Analyst Monthly Report, "March 2018," dated February 22, 2018, available at bca.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Japan's Political Paradigm Shift: Investment Implications," dated December 21, 2012, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Monthly Report, "Is Abenomics The Future?" dated February 11, 2015, available at gps.bcaresearch.com. 7 Please see BCA Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018, available at gis.bcaresearch.com. 8 Please see BCA U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds," dated February 20, 2018, available at usbs.bcaresearch.com. 9 Please see BCA U.S. Investment Strategy Weekly Report, "A Party On The QE2," dated November 8, 2010, available at usis.bcaresearch.com. 10 We include the last factor in the regression because it could be that the market responds positively in the post-election period, irrespective of the election outcome, simply because political uncertainty is diminished. 11 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 12 Please see Tom Mitchell, "Xi's China: The Rise Of Party Politics," Financial Times, July 25, 2016, available at ft.com. See also BCA Geopolitical Strategy and China Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at www.bcaresearch.com. 13 "Carry Canary" indicator tracks the performance of EM/JPY carry trades. These trades short the Japanese Yen and long an emerging market currency with a high interest rate (Brazilian real, Russian ruble, or South African rand), and as such they are highly geared to a positive global growth back-drop. Please see BCA Foreign Exchange Strategy Weekly Report, "The Yen's Mighty Rise Continues ... For Now," dated February 16, 2018, available at fes.bcaresearch.com. 14 The other two battles are against pollution and poverty. 15 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 19 Consider that the standard political calendar would have called for Xi to make personnel adjustments at the second plenum (which was held in January), then to formalize those personnel changes at the legislature in March, and then to announce reform initiatives at the third plenum in the fall, leaving implementation until late in the year or even March 2019. Instead, all of this will be done by March of this year, leaving the rest of the year for implementation. 20 The Financial Stability and Development Commission was created last July at an important financial gathering that occurs once every five years. We dubbed it a "Preemptive Dodd Frank" at the time because of China's avowed intention to use it to tackle systemic financial risk. Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. The FSDC's purpose is to coordinate the People's Bank of China with the chief financial regulators - the banking, insurance, and securities regulatory commissions (CBRC, CIRC, and CSRC) and the State Administration of Foreign Exchange (SAFE). There is even a possibility under discussion (we think very low probability of happening) that the FSDC will preside above the central bank - though the precise organizational structure will remain unclear until it is formalized, probably during the March legislative session. 21 Anbang is part of a group of companies, including Foresea, Fosun, HNA, Ping An, and Dalian Wanda, that have been targeted over the past year for shady financial doings, corruption, excessive debt, and capital flight. In particular, Anbang was integral to the development of universal life products, which have been highly restricted since last year. These were not standard insurance products but risky short-term, high-yield shadow investment products. Investors could redeem them easily so there was a risk that purchasers could swamp insurance companies with demands for paybacks if investment returns fell short. This would leave insurance companies squeezed for cash, which in turn could shake other financial institutions. The systemic risk not only threatened legitimate insurance customers but also threatened to leave insurance companies unable to make debt payments on huge leveraged buyouts that they had done abroad. Anbang and others had used these and other shadow products to lever up and then go on a global acquisition spree, buying assets like insurance subsidiaries, hotels, and media/entertainment companies. The targeted firms are also in trouble with the central government for trying to divest themselves of China's currency at the height of the RMB depreciation and capital flight of 2015. They were using China's shadow leverage to springboard into Western assets that would be safe from RMB devaluation and Chinese political risk. The government wants outward investment to go into China's strategic goals (such as the Belt and Road Initiative) instead of into high-profile, marquee Western assets and brands. 22 Particularly over whether Xi Jinping's right-hand man, Liu He, will be appointed as the new central bank governor, to replace long-serving Governor Zhou Xiaochuan, and/or whether he will replace Vice Premier Ma Kai as chairman of the FSDC. It is important whether Liu He takes the place of central banker or chief reformer because those roles are so different. Making him PBoC chief would keep a reformer at the helm of a key institution at an important point in its evolution, but will raise questions about who, if anyone, will take charge of structural reform. Giving him the broader and more ad hoc role of Reformer-in-Chief would be reminiscent of Zhu Rongji at the historic NPC session in March 1998, i.e. very optimistic for reforms. Of course, Liu He is not the only person to watch. It is also important to see what role former anti-corruption czar Wang Qishan gets (for instance, leading U.S. negotiations) and whether rising stars like bank regulator Guo Shuqing are given more authority (he is a hawkish reformer). 23 Please see Xie Yu and Frank Tang, "Xi picks team of problem solvers to head China's economic portfolios," South China Morning Post, dated February 21, 2018, available at www.scmp.com. 24 Please see BCA China Investment Strategy Weekly Report, "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com. 25 Please see BCA Geopolitical Strategy Special Report, "South Africa: Crisis Of Expectations," dated June 28, 2017, available at gps.bcaresearch.com.