France

Highlights ECB Monetary Policy: Euro Area inflation will likely remain below the European Central Bank (ECB) 2% target for the next few years due to persistent excess capacity in Europe. The ECB will signal this at the December monetary policy meeting, providing the justification to extend their quantitative easing (QE) asset purchase program beyond the current March 2017 expiration date. ECB QE Changes: The constraints imposed on the ECB's bond purchases are self-imposed, and can be easily altered in the event of potential "shortages" of available debt for the QE program. Fears of a potential taper of ECB buying because of those constraints, which have bearish implications for Euro Area bond yields, are overstated. Country Allocation: Move to an above-benchmark stance on core European government debt, which are a low-beta safe haven in the current environment of a cyclical rise in global bond yields. Feature After spending the past couple of months fretting over the next move by the U.S. Federal Reserve or the Bank of Japan, investors' attention shifted to Europe last week. With the current European Central Bank (ECB) government bond quantitative easing (QE) program set to expire in March of next year, the markets were seeking any sort of guidance on whether the ECB will end the program as scheduled, or extend the program beyond March - perhaps with a reduction ("taper") in the size of the bond buying. ECB President Mario Draghi provided no new information at the post-meeting press conference last Thursday, leaving bond investors in limbo until the December meeting when the results of the ECB's assessment of their QE program will be published. Some alterations of the program will likely be announced, but it is too soon for the ECB to consider ending their QE program. With regards to the title of this Weekly Report - the most likely outcome is that the ECB will extend the QE program past March 2017, but will tinker with the rules of QE in an effort to pretend that the central bank is still following a prudent logic for its purchases. Fears of an early taper are overstated, and this makes core European government debt a potential oasis of safety while global bond yields remain in a bear phase. Plenty Of Reasons For The ECB Not To Taper This talk of a tapering of ECB asset purchases following the scheduled end of the current QE program seems premature. After all, neither the ECB's own economic forecasts, nor those of its Survey of Professional Forecasters, are calling for inflation to get close to the 2% target until at least 2018 (Chart of the Week). The ECB staff will prepare a new set of forecasts for the December policy meeting that will include projections for 2019 - perhaps these new estimates will have inflation finally reaching the 2% goal. But in the absence of a credible forecast of inflation returning to target, the ECB will be hard pressed to signal any move to a less-accommodative monetary policy. Headline Euro Area inflation is currently only 0.4%, despite a recent increase in the oil price denominated in Euros, which has been a reliable directional indicator for Euro Area inflation (Chart 2). Chart of the WeekNo Need For An ECB Taper Chart 2European Inflation Is Stubbornly Low The steady decline in the Euro Area unemployment rate over the past three years has coincided with a move higher in overall labor compensation, but this has been purely a "volume" effect resulting from steadily increasing employment growth. With the entire region not yet at full employment, there has been minimal upward pressure on wages or inflation in domestically focused sectors like services (bottom panel). In other words, the lack of Euro Area inflation is a direct function of the excess capacity in Euro Area product and labor markets. According to the IMF, the Euro Area output gap will not close until 2020, which will limit any rise in inflation over the rest of the decade (Chart 3). It will take a more prolonged period of above-trend economic growth to close the output gap, reducing the Euro Area unemployment rate below the full employment NAIRU level, before any recovery in wages or core inflation can take place (bottom panel). This lack of realized inflation is weighing on Euro Area inflation expectations and creating some potential credibility problems for the ECB. As we have discussed in earlier Weekly Reports, inflation expectations in much of the developed economies seem to follow an "adaptive" process, where expectations are formed in lagged response to actual inflation.1 If central banks are fully credible in their ability to use monetary policy to fight inflation (and demand) shortfalls, then those forward-looking expectations should eventually gravitate towards the central bank inflation target. However, if there is a large and persistent shock to realized inflation, then inflation expectations can deviate from the central bank target for an extended period. Using a 5-year moving average of realized headline CPI inflation as a proxy for inflation expectations is a reasonably good (albeit simple) approximation of this adaptive process (Chart 4). The current 60-month moving average for Euro Area headline inflation is 0.6%, not far from the 5-year Euro Area CPI swap rate of 0.9%. However, if the ECB's inflation forecasts for the next two years come to fruition (1.2% in 2017, 1.6% in 2018), then the 5-year moving average will continue to decline, as those higher inflation figures would not offset the sharp fall in inflation witnessed over the past few years. Chart 3Excess Capacity Holding Inflation Down Chart 4Inflation Expectations Will Stay Low Simply put, the ECB's current projections are not consistent with inflation expectations hitting the 2% target by 2018, and likely even beyond that. The ECB will be presenting new projections in December, but it would take a significant upgrade of their growth and inflation forecasts to "move the needle" on longer-term inflation expectations. Perhaps a move away from fiscal austerity across the Euro Area could trigger an upgrade on growth expectations, as that would imply a faster pace of growth and a more rapidly narrowing output gap. However, while the topic of greater fiscal spending has been heating up in the halls of governments in Washington, London and Tokyo, there has been little sign that Euro Area governments are about to open the fiscal spigots anytime soon (and certainly not before elections in Germany and France in 2017). Chart 5European Banks Getting More Cautious? ECB Still Needs To Support Loan Growth The state of Euro Area banks, and what it means for future lending activity, is another factor for the ECB to consider before contemplating any move to a less-accommodative monetary policy. The current growth rates of money and credit are showing no signs of significant deceleration (Chart 5). The latest ECB Euro Area bank lending survey, released last week, did show a modest decline in the net number of banks reporting easier lending standards to businesses, as well as a reduction in the number of banks reporting increasing loan demand from firms. The ongoing hit to European bank profitability from the current negative interest rate environment could be playing a role in the banks moving to a less easy environment for lending. As can be seen in the bottom panel of Chart 5, there is a reliable leading relationship between Euro Area bank equity prices and the growth in bank lending to businesses. The downturn in Euro Area bank stocks in 2016, which has been driven by declining profit expectations, could pose a risk to credit growth in the months ahead. According to a special question asked within the ECB's bank lending survey, a net 82% of respondents reported that the ECB's negative deposit rate has damaged banks' net interest income over the past six months.2 In that same survey, a net 12% of banks reported a boost to loan demand from the ECB's negative interest rate policy, and a net 15% of banks reported that the additional liquidity provided by the ECB bond purchases went towards extending loans to businesses. So while negative interest rates may be hurting bank profit margins, the impact of the ECB's QE is helping offset that to some degree by providing banks with capital gains on their bond portfolios that can be used to finance lending. So without any sign that inflation will soon approach the ECB's target, thus requiring a potential tapering of QE or even a move away from negative interest rates, the prudent course for the ECB to take to support Euro Area credit demand, and economic growth, is to continue with the QE program beyond the March 2017 expiration date. That will require some changes to the ECB's rules of the program, but, in the end, these are only self-imposed constraints. Bottom Line: Euro Area inflation will likely remain below the ECB 2% target over the next few years due to persistent excess capacity in Europe. The ECB will signal this at the December monetary policy meeting, providing the justification to extend their quantitative easing asset purchase program beyond the current March 2017 expiration date. The ECB Has Some Policy Options To Avoid A Taper Tantrum Core European bond yields have been depressed by the ECB's QE program, which have acted to push down both the future expected path of interest rates and the term premium (Chart 6). This has helped anchor real bond yields in negative territory, even with inflation expectations at such low levels. But any signs of potential slowing of the pace of QE buying could quickly unwind this effect, which makes the ECB's next steps so critical for the path of global bond yields. In Chart 7, we show the level and growth rate for the ECB's monetary base, along with five potential future scenarios: The ECB ends their QE program in March 2017, as currently planned; The ECB extends QE for six months to September 2017, at the current pace of €80bn in bond buying per month; The ECB extends QE program for twelve months to March 2018, at a pace of €80bn per month; The ECB extends QE to September 2017, but reduces the pace of purchases to €60bn per month; The ECB extends QE to March 2018, but cuts to €60bn per month. Chart 6ECB QE Still Holding Down Yields Chart 7ECB Needs To Keep The Monetary Base Growing As can be seen in the bottom panel of Chart 7, the growth rate of the ECB's monetary base (and the asset side of their balance sheet) will decelerate sharply in 2017 & 2018 if the ECB does end the QE program as scheduled next March. Extending the program, however, does push out the rapid deceleration phase for monetary base into 2018. This is of critical importance for the Euro Area bond market, as both the outright level and term premium component of German Bund yields have been broadly correlated with the growth rate of the monetary base (Chart 8). In other words, extending the ECB QE program into the future is most important to prevent a "taper tantrum" in European bonds, by signalling to the markets that the ECB wishes to maintain low interest rates for longer. The ECB could even announce a reduction in the pace of purchases, along with an extension, and bond yields should remain well-behaved. This will also help prevent an unwanted appreciation of the Euro, the value of which currently reflects the far easier monetary stance in Europe (Chart 9). Chart 8An ECB Taper Would Be Bad For Bunds Chart 9An Easy-For-Longer ECB Will Weigh On The Euro Given the persistent debates within the ECB (and between the ECB and some Euro Area governments) about the long-run merits of QE, the combination of both an extension and reduction in QE purchases could be the compromise option that satisfies all parties. Alternatively, the ECB could choose to maintain the pace of bond purchases but alter the selection rules governing the program. Given the recent concerns in bond markets that the ECB is "running out of bonds to buy", changing the rules of the QE program is a sensible way for the central bank to free itself from the self-imposed shackles on its bond purchases. There are three options that the ECB can consider: Moving away from strictly allocating the bond purchases according to the ECB "capital key", which essentially weights the bond purchases by the size of each economy; Raising the issuer limits on QE, which limits the ECB to holding no more than 33% of any single issuer or individual bond issue; Reducing the current yield floor on QE, which prevents the ECB from buying any bonds with yields below the ECB deposit rate, which is currently -0.4%; We think option 1 is the least likely to occur, as this would imply buying a greater share of countries with more problematic debt profiles, like Italy or Portugal. There is little chance of such a strategy being well received by the governments in Berlin and Brussels, and the ECB would likely wish to avoid a major political confrontation by allowing larger deviations from the capital key Option 2 is an easier solution to implement. The 33% issuer constraint was always an arbitrary level that was aimed more at bonds with so-called "collective action clauses", where a majority of bondholders can force a decision on all bondholders in the event of a debt restructuring. It is understandable why the ECB would not want to become to decision-making counterparty in the event of a future messy bond restructuring in Europe. However, the ECB's ownership percentages within each Euro Area country are nowhere near the 33% limit at the moment (Chart 10) and, at the current pace and composition of buying, that 33% limit will not even be reached for Germany anytime soon.3 There is room for the ECB to raise the issuer limits, as it has already done for some other parts of its asset purchase programs, like bonds issued by European Union supranationals.4 Chart 10ECB Holdings Are Far From The 33% Issuer Limit Chart 11Lowering The Yield Floor For QE Makes Sense Option 3 is the most binding constraint of all on the ECB purchases, as very large shares of the European government bond market are now trading below the ECB's -0.4% deposit rate (Chart 11). In the case of Germany, nearly 70% of all QE-eligible debt is trading below the ECB's yield floor, which has raised investor concerns that the ECB will soon be unable to buy enough German debt at the current pace of purchases. However, that yield floor constraint is completely arbitrary - there is nothing stopping the ECB from buying bonds trading at a yield below the deposit rate, other than (we suspect) a desire to impose some sort of price discipline on the QE buying to make the ECB appear more credible with its purchases. Chart 12The QE Yield Floor Can Be Changed If the ECB decided to lower the yield floor below the current -0.4% deposit rate, this would open up a greater share of the core European bond markets to QE buying (Chart 12). This would also change the current market narrative that the ECB will soon run out of German bonds to buy. In the end, the most likely path the ECB will take following its December re-assessment of its QE program is a combination of lowering the yield floor on QE bond purchases below -0.4% and raising the issuer limits above 33%. There appears to be plenty of leeway for the ECB to alter their purchases, but without necessarily reducing the monthly pace of buying. Combined with an extension of the end-date of the QE program beyond March, this should alleviate any concerns that the ECB will soon hit a wall with its asset purchases. Bottom Line: The constraints imposed on the ECB's bond purchases are self-imposed, and can be easily altered in the event of potential "shortages" of available debt for the QE program. Fears of a potential taper of ECB buying because of those constraints are overstated. Investment Implications: Move To An Above-Benchmark Stance On Core European Bonds With the ECB having no need to end its QE program early, the case for moving to an overweight stance on core Europe is a strong one. As we noted in our last Weekly Report, favoring bond markets of countries with the lowest inflation rates is a logical investment strategy in the current environment of a modest cyclical upturn in global growth and inflation.5 That justifies our current below-benchmark recommendation on U.S. and U.K. government debt, as both realized inflation and expected inflation are rising in both countries. That leaves the Euro Area and Japan as possible candidates to move to above-benchmark weightings, given their defensive properties as low-beta bond markets. Although with the Bank of Japan now pegging the Japanese government bond (JGB) yield curve with a 10-year yield at 0%, we do not see a compelling investment case for overweighting JGBs as a defensive trade. If an investor wants safety at a 0% yield - with no chance of a capital gain from a decline in yields - than owning T-bills, or even gold, is just as viable as owning JGBs. We recently upgraded Japan to neutral in our recommended portfolio allocation, and we see no reason to move from that. Thus, core European bonds stand out as the candidate to upgrade as a defensive trade during the current bond bear phase, which we expect will continue until at least December when the Fed is expected to deliver another rate hike in the U.S. We see a case for moving to above-benchmark for both Germany and France, but especially so in the latter. The beta of bond returns between France and both the U.S. (Chart 13) & U.S.(Chart 14) is very low, making French bonds a good market to favor at the expense of U.S. Treasuries and U.K. Gilts in currency-hedged bond portfolios. Chart 13French Bonds Are Low Beta To USTs... Chart 14...And To U.K. Gilts Bottom Line: Move to an above-benchmark stance on core European government debt, which are a low-beta safe haven in the current environment of a cyclical rise in global bond yields. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Why Are Global Inflation Expectations Still So Low", dated March 1, 2016, available at gfis.bcaresearch.com. 2 The Q4 2016 ECB Euro Area Bank Lending Survey can be found at https://www.ecb.europa.eu/stats/pdf/blssurvey_201610.pdf. 3 Please note that the denominator in the percentages shown in Chart 10 include only bonds with maturities that are eligible for ECB QE purchases, omitting bonds that will mature in less than 2 year and more than 30 years. 4 For more details on that change to the supranational issuer limits, please see https://www.ecb.europa.eu/mopo/implement/omt/html/pspp-qa.en.html. 5 Please see BCA Global Fixed Income Strategy Weekly Report, "Return Of The Bond Vigilantes", dated October 18, 2016, available at gfis.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

In September, the model outperformed the S&P 500, while it underperformed global equities in both USD and local-currency terms. For October, the model trimmed its allocation to stocks and boosted its weightings in bonds and cash.

Are negative yields on $10 trillion of global bonds a sure sign of a bubble? The answer is no... and yes.

In July, the model outperformed both global equities and the S&P 500 in local-currency terms, while underperforming in U.S. dollar terms. For the monthly of August, the model made no changes to overall risk exposure.

We test three channels of contagion from the Brexit shock: political, banking system, and economic.

Special Report

If the U.K. ultimately exits the EU, it will be a major break in the 70 years of European integration. Multipolarity will be reinforced, increasing global geopolitical risk. We expect global risk assets to start taking cues from Europe, not the Fed and China. However, risks of N-Exit - that other EU member states follow suit - may be overstated.

Special Report

Highlight Even alarmists like us have been surprised by the referendum outcome; The referendum is a major break in the 70 years of European integration; It will reinforce multipolarity and increase global geopolitical risk; The U.K., however, is an outlier in terms of Euroskepticism; No other EU country is likely to vote to leave the EU, though tail risks are up; Watch for the "Who is Next" premium to be applied to European assets, and the "reflation trade" is likely over for the time being. Feature "Since they will overload my shoulders," quoth John, "I shall throw down the burden with a squash amongst them, take it up who dares." - John Arbuthnot, complaining about Europe's treatment of Britain, The History of John Bull (1712) Chart 1So Much For Crowd Wisdom British voters have chosen to leave the European Union. The outcome caught most forecasters by surprise, including the "smart money" of the betting markets (Chart 1). We are not as surprised, since we raised the possibility that the conventional view was wrong as early as March and called the referendum "too close to call" in our last missive.1 However, we also thought that the narrow polling would push voters towards the status quo in the last minute. In this analysis, we offer our view on three questions: What is next for the U.K.? Who is next in the EU? Is a risk premium even appropriate? What does this mean for broader global stability? We conclude with investment implications. What Next For The U.K.? In our report last week, "Break Glass To Brexit," we outlined some of the likeliest next steps after Brexit. These have not changed: Cameron's Fate and the Tories: Leaders who stake their credibility on a referendum typically resign if they lose the vote, as with Jacques Parizeau in Quebec or Alex Salmond in Scotland. Cameron has similarly stated that he will resign by October. This introduces greater political risk into British politics. In particular, any economic risks emanating from the referendum will be blamed on the Tories. The Labour Party stands to benefit. Under Jeremy Corbyn it has turned more left-wing than any opposition party since the 1980s. But Labour MPs could also ditch Corbyn in an effort to capitalize on Tory disintegration. British politics will be a rollercoaster for quite some time. The last time the Conservative Party imploded over Europe, a Tony Blair-led Labour waited in the wings. This is not the case today. Article 50 of the Lisbon Treaty: The process of leaving the EU requires the departing member-state to invoke this article, which provides for a two-year period to negotiate an exit that should take account of the state's obligations and future relations with the union. No country has done this before so it is not clear how exactly it will happen. A meeting of the European Council next week provides an opportunity for Cameron to announce the country's intentions. But the government has an incentive to wait before initiating the two-year countdown process until it has formed a negotiation plan, since the EU is likely to take a hard line on the U.K.'s access to the common market. It should be noted that the two-year negotiation timeframe is not firm - the U.K. could withdraw precipitously, or, with approval from all member states, it could negotiate for more than two years. Another Referendum: Yes, it is possible for another referendum to be held. In fact, the likely successor to David Cameron, and "Leave" vote champion, former Mayor of London Boris Johnson, raised the possibility of a second referendum when he announced his support for exit. In other words, even the likely new prime minister and pro-Brexit leader is open to another referendum. Perhaps one could be held after the U.K. ends its negotiations with the EU. The problem is that we doubt the EU will concede much, since that could lead to a chain reaction in Europe. As such, it will depend on the U.K.'s political circumstances whether a new referendum is held. An Act of Parliament: Formal withdrawal will require an act of parliament, since, for instance, the 1972 European Communities Act ensures that the U.K. automatically incorporates EU directives into law and has hitherto been interpreted as establishing the priority of EU law where it contradicts British law. That is a key motivation of the sovereignty argument behind Brexit; the law will have to be replaced if Britain leaves. Notably, the referendum itself does not have any legal consequences. It is a dead letter without a government decision to enact it. That decision should be forthcoming in a mature democracy where the result is clear and uncontested. However, the political aftermath could lead to a parliamentary dissolution, with some groups hoping to delay the country's exit or hold a second referendum. Chart 2Scottish Independence:##br##A Yearning Not Yet Laid To Rest Scottish Referendum: Scots voted 62% to stay in the EU, versus England's 53% to leave, which throws into stark relief the differences in points of view between the two countries. The U.K. vote has reinvigorated calls for independence almost immediately, with the First Minister Nicola Sturgeon already calling for a new referendum. The failure of the Scottish independence referendum in 2014 has not extinguished the desire to leave (Chart 2), although we suspect the collapse of oil prices may at least raise the economic bar of independence. The Scottish National Party has swept into almost total control of the Scots parliament since the referendum failed. Scotland, by comparison with the U.K., is a disproportionate beneficiary of EU transfers. During the 2014 referendum, the EU pushed against Scots independence, but it may not do so the second time. The loss of Scotland would jeopardize British energy and naval advantages as well as create various internal political risks across the British Isles for the future. Tensions in Ireland: Northern Ireland, like Scotland, benefits from EU funds (like farm subsidies) and voted 56% to remain. It too has groups aggravated by England's vote carrying the day. Any separation of Scotland would motivate forces both in Northern Ireland and in the Republic of Ireland to push for a unified Irish island state. That will aggravate political and sectarian tensions that have only quieted down since 1998 and were even showing a few signs of heating back up before Brexit. Thus Brexit will force Westminster to devote greater attention and resources to re-establishing the U.K.'s compact with its constituent countries. Bottom Line: Political uncertainty will rise across the U.K. due to Brexit. If the decision to leave the EU stays, we believe that the U.K. may cease to exist as a unitary state. However, the referendum may not be the last word on EU membership. The likely next prime minister, Boris Johnson himself, has floated the option of a second referendum and thus the idea that the just-concluded referendum is part of a negotiation strategy. Who Is Next? The immediate question investors are asking is, Who is next to try to leave the EU?" Already, the "Who Is Next Premium" is infecting the Mediterranean European bond markets, with peripheral spreads up across the board (Chart 3). Chart 3The 'Who Is Next?' Premium To simplify the answer to this forecasting challenge, we developed an EU Dependency Index (Chart 4).2 We combine six economic and financial factors to determine which member states have a high bar to clear in order to leave the EU. Chart 4Constraints To Leaving The EU As with all indexes, one should take its conclusions with a grain of salt. But generally speaking, the results are helpful. For instance, Hungary is more constrained in leaving the EU than Sweden. Hungary's trade is almost exclusively with EU member states, its interest payments as a percent of GDP are high (and would become higher post-EU exit), and it benefits the most from structural funds from the EU. Leaving the bloc would be a painful decision for Budapest that would undoubtedly leave the country worse off. One set of factors that our index does not measure is geopolitics. Central and Eastern Europe, as well as Cyprus, are members of the EU for more than just economic benefits. In the case of countries like Romania and Poland, the EU is seen as another layer - on top of NATO membership - of security guarantees vis-à-vis Russia. (For Cyprus, the EU is a form of security arrangement against Turkey.) In the oft-cited 2016 Pew Research poll showing a decline of support for the EU, Poland remains the most supportive with a 72% favorable rate (Chart 5). Hungary is not far behind. Both countries are led by rhetorically Euroskeptic right-of-center parties, but the reality is that they will not contemplate exit. By focusing on the lower end of the dependency index, we can isolate the countries that are the least constrained economically in pursuing a break with the union. We will therefore focus on the Netherlands, Austria, Greece, Spain, Italy, Finland, Germany, Denmark, France, and Sweden. This is not to say that the other countries on the index do not have Euroskeptic movements, but only that we do not take them seriously. How do our selected EU member states stack up against the U.K.? First, as we argued earlier this year, the U.K. stands out for Euroskepticism. In our view, it has the lowest political, economic, financial, and geographic constraints to exiting the bloc. This is born out in data. In particular: Identity: The British have never felt comfortable defining themselves as European (Chart 6). Meanwhile, the sense of "Europeanness" has actually risen in the rest of Europe since 2010. Chart 5Falling Support For The EU Chart 6British Identity Has Always Stood Apart EU Immigration: In our view, the issue of intra-EU immigration carried the day for "Leave" on June 23. Polling data revealed that this issue, perhaps more than any other, was a source of consternation among U.K. voters (Chart 7). The feeling is not mutual across Europe (Chart 8), although France and Italy are similarly split on the issue. Chart 7EU Emigration: A Concern In Britain Chart 8Not Everyone In Europe Is Concerned About EU Emigration Geopolitics: Europeans do not see the EU as a vehicle towards "economic prosperity," but rather a project for "peace" and a "stronger say in the world" (Chart 9). Therefore, for much of the EU, the bloc has a geopolitical component that gives the EU a "geopolitical imperative for integration," as we argued in 2011.3 This is not the case in the U.K., which is the world's fifth largest economy, a nuclear power, a permanent UN Security Council member, and a geographically isolated island. It needs the EU the least in the geopolitical sense. Chart 9The U.K. Does Not Perceive The EU As A Geopolitical Project Confidence: British voters do not see a life outside the EU as a big threat, perhaps revealing why the "Stay" campaign strategy of emphasizing the economic costs of exit was a mistake. When asked whether they thought "their country could better face the future outside the EU," British respondents have consistently answered in the affirmative (Chart 10). This is not the case for any other country in Europe. It is an important point because holding a negative view of the EU is not the same as wanting to leave it. Greece is a good example. While 38% of Greeks see the EU in a negative light, 56% do not think the country would do better outside of it (Chart 11). Denmark, Sweden, Finland, and the Netherlands - all frequently cited as "Euroskeptic" candidates for a future EU-exit - also score surprisingly low on confidence that they would be successful outside of the EU. However, Italian confidence in a future sans Europe appears to be growing, and Austrian confidence has always been high. Chart 10AThe U.K. Is Confident About ##br##Life Outside The EU Chart 10BThe U.K. Is Confident About ##br##Life Outside The EU Chart 11Not Everyone Who Is Angry##br## Wants A Divorce Currency: The U.K. is not a member of the euro area and therefore does not have to deal with the redenomination risk of exit. For countries in the Mediterranean, such a risk would see household wealth redenominated into pesetas, lira, and francs. For Germany, it would mean a 20-30% deutschmark appreciation and a devastating blow to its export-driven economy. Support for membership in the euro area remains surprisingly high in the countries that are members of the currency union (Chart 12). In fact, support for the euro is at or near its highest levels ever in Finland, France, Germany, the Netherlands, Spain, and even Greece! Again, Italy stands as a dangerous outlier. Chart 12ASupport For The Euro Remains Strong Chart 12BSupport For The Euro Remains Strong From the polling data we can conclude that the U.K. stands alone in consistently lying on the Euroskeptic side of each political category. However, we can also make five general observations: Italy has clearly seen a significant rise in Euroskepticism over the past decade; Austria has always lacked enthusiasm for the EU, although its support of the euro remains high; Concerns over the Nordic countries are overstated, there is no evidence that they are Euroskeptics; France is mixed, scoring high on Euroskepticism when it comes to immigration, but low on other issues. Germany is committed to European institutions. So, who is next? With great respect to the history made on June 23 and to the growing anti-establishment sentiment around the world, we suspect that nobody will follow in the U.K.'s footsteps and actually vote to leave. In fact, European policymakers are likely to push against the June 23 vote with a new treaty that takes into account many of the grievances of Euroskeptics around the continent. But the point is that the economic, financial, political, and geopolitical costs of exit are much higher for every other EU member state. Nevertheless, given the success of the U.K.'s referendum, the probability that another vote on EU membership will be held has increased. That alone will be enough for the markets to apply a "Who is Next" premium to European assets, which explains the European asset sell-off the day after the referendum. We are in particular focused on five countries: Chart 13Italian Politics: A Rising Risk Italy: Unlike its Mediterranean peer Spain, Italy has not seen any improvement in competitiveness and remains embroiled in sub-par growth. The constitutional referendum in October - on streamlining governance, a necessary step before embarking on painful structural reforms - could fail, leading to an early election late this year or early next. At the moment, the anti-establishment Five Star Movement (5SM) is closing in on the ruling Democratic Party in the polls (Chart 13). Its leader, Beppe Grillo, has called for an EU referendum, but its rising political star - and new mayor of Rome - Virginia Raggi has rejected Euroskepticism. If an early election this or next year produces a 5SM government, a political crisis will ensue. The Netherlands: According to the survey data we reviewed in this analysis, the Netherlands would not vote to leave the EU. That is our high conviction view. However, the Euroskeptic Party for Freedom is leading in the polls for the upcoming Dutch general election, set to be held no later than March 15, 2017. Its leader Geert Wilders has said that he would call for an EU membership referendum if he were to win the election. Austria: According to the data reviewed in this analysis, Austrian Euroskepticism is on the rise. The next general election is set for the end of 2018 and will likely see the Euroskeptic Freedom Party win the largest share of the vote. This leaves the possibility of an EU membership referendum open for 2019. France: Presidential elections in France are set for April and May 2017 (two rounds). Marine Le Pen appears to have peaked in popularity in 2013 and thus has very little chance of winning (Chart 14). However, her likely progress into the second round could put French Euroskepticism in the spotlight. Investors should remember that French Euroskepticism is not at all a novel concept, so greater changes would need to be forthcoming (Chart 15). Chart 14Has Marine Le Pen Peaked? Chart 15France Has A Tradition of Euroskepticism Germany: No, we do not think there is any chance of a referendum on the EU or euro membership in Germany. If there was one, it would fail to produce an exit on both accounts. However, Germany is the key country to watch because the future of the EU depends on it. Without a shift from Berlin on the bloc's adherence to strict budget discipline, the EU may not survive. Germans have crossed their "red lines" numerous times in order to preserve the euro area, suggesting that they are quite flexible (Table 1). However, it has always taken a major crisis for them to move. Table 1Europe: The Hurdle To Heterodoxy Is Low Another important notice here is that the European migration crisis likely had an influence on the U.K. referendum result. But the numbers show that the crisis has not only abated, but that it has effectively ended. The overall figures show that migration flows peaked at 220,000 in October 2015, whereas they were only 9,354 in June (Chart 16). Breaking down the flows by destination (Greece vs. Italy) does not reveal any new information (Chart 17). The migration flows have therefore not shifted from the Balkan route to the Italian one. Chart 16The Migration Crisis Is Over!##br## (Did Anyone Tell The Voters?) Chart 17Migrants Are Not ##br##Coming Via Libya As such, it is possible that by the time an Austrian, Dutch, or Italian referendum on EU membership is called, the issue of migration may no longer be front-and-center on voters' minds. In fact, EU efforts to intercept refugee flows at the bloc's external borders could be seen as successful by that point. Bottom Line: A "Who is Next" premium will undoubtedly be applied to European assets now that the U.K. has voted to leave the EU. However, it will likely overstate the risks of other countries following suit. The U.K. has the least political, economic, financial, and geopolitical constraints to exiting the bloc. Broad Political And Geopolitical Implications The decision by the U.K. electorate to leave the EU is going to increase both political and geopolitical volatility. It strikes at the stability of the European Union, which is one of the core post-World War Two institutions that have kept peace in the Western world for the past seventy years. As such, its implications - if London goes ahead with Brexit - will be profound. The U.K. referendum will have implications for multipolarity, a major theme of BCA's Geopolitical Strategy. The world lacks global leadership as the U.S. wanes in relative geopolitical power. From an investor's perspective, this is a negative process as multipolarity is empirically and theoretically proven to be a harbinger of inter-state conflict. Today, this process has largely been assuaged by the existence of Cold War-era institutions that allow the U.S. to amplify its power. The EU, NATO, and financial institutions such as the IMF and the World Bank are such entities. By leaving the EU, the U.K. does not necessarily undermine this global order, but it does show that a 43 year-old geopolitical relationship can end. It will weaken the EU as a global player, given the U.K.'s obvious hard power, and aid Europe's geopolitical rivals. And if it further leads to disintegration of the EU, which is not our base case, it will massively increase global geopolitical risk. We suspect our clients will have to brush up on obscure geographical references - such as Alsace-Lorraine, Silesia, and South Tyrol - by the time this process is over, if it ever begins. This is a profoundly negative outcome, if it were to occur. Generations that thought they would never see another armed conflict on the European Peninsula may be in for a surprise. On the domestic political front, the rise of the anti-establishment - particularly in the U.S. and U.K. - has been one of the most talked-about themes in the financial community in 2016. However, it is unclear how to price the risk, if any, of non-centrists coming to power. In part, the reason is that investors have had widespread disbelief that populism could win any major election in any major economy. That has now changed with the U.K. choosing to exit the EU. Chart 18Debt Replaced Income We suspect that the focus over the next several months - in terms of assigning risk premia - will remain on Europe. However, the reality is that middle class malaise may be the most advanced in the laissez-faire economies of the U.S. and the U.K., especially now that the debt supercycle is no longer available to assuage the pain of decade-long stagnant wages (Chart 18). In a way, anti-globalization policies are merely the politically right-of-center approach to redistributing income. The last three decades of free trade and laissez-faire policies have led to growing income inequality as winners of globalization captured most of the gains and losers were left to face the consequences, and the painful adjustment, without much redistribution. Take the vote on EU membership, which saw all of England vote to leave except for the financial capital of the world, London. For Bernie Sanders and Jeremy Corbyn - as well as Podemos in Spain and SYRIZA in Greece - the answer is to dial up the redistribution. For Donald Trump, UKIP, and Marine Le Pen in France, the answer is to wall off their economies and hope to stave off redistribution by shifting the blame for tepid growth to the outside world. Both policies will be equally bad for equity markets and risk assets, as they will erode profit margins one way or another. The 1990s consensus on deregulation, privatization, low taxes, budgetary discipline, and free trade is over. The median voter is shifting to the left-of-center and demanding economic policies that are in contravention of the 1990s "Third Way" consensus (Diagram 1). According to the median voter theory, policymakers will shift with the median voter to a new center and will not shift back to the old center once they capture power.4 Thus, even if the establishment wins in the U.S. this year and France and Germany next year, it will have moved away from the laissez-faire and globalization consensus. Diagram 1Median Voter Theorem This is bad news for emerging markets. It is also bad news for the shares of global companies who have benefited tremendously from the steady dismantling of barriers to the free flow of goods, capital, and labor. In the long run, the decline of globalization will also usher in higher inflation. Globalization has effectively produced the largest supply-side shock in the history of mankind. As such, it is a major deflationary force. But if policymakers respond to populism with protectionism and fiscal expenditure, then the deflationary forces of globalization will reverse. Perhaps sooner than the market expects. Bottom Line: The Goldilocks era for investors - in terms of the economic policy consensus - is over. When combined with the hegemonic instability of a multipolar order, Brexit means that politics and geopolitics will become an ever more relevant analytical lens for investors. The apex of globalization has come and gone.5 Investment Implications At BCA, we have long maintained that at times such as this, it makes sense to take a cold shower and resist making any rushed investment decision. Brexit, if it were to go ahead as currently planned, has the potential to change the world, but it is not clear precisely how. The current market sell-off offers a buying opportunity, at least in the short term. Policymakers are already responding with renewed stimulus. The G7 communique issued on the heels of the referendum has essentially given a green light to Japan and Europe to intervene in the currency markets. The Fed funds rate futures are now pricing in a 15% probability of a U.S. rate cut by the end of the year, whereas the probability was zero just one day ago. Nevertheless, the damage has been done. Peter Berezin, Chief Strategist of BCA's Global Investment Strategy, fears that the "reflation trade" that began in February may be over. Certainly the data out of China is becoming more difficult to square, with declining credit growth and leading indicators (like excavator sales) taking a plunge. Reflation by policymakers may eventually combine with the pervasive "search for yield" to buoy risk assets. At the moment, however, all eyes will be turned to Europe and the "Who is Next" premium likely to creep into assets. We suspect that global assets will take cues not from the Fed or China in the short term, but Europe and the usual bellwether of the continent's future: Mediterranean economies. In terms of U.K. assets, several immediate investment strategies exist: Currency: BCA's Foreign Exchange Strategy recommends buying the GBP/USD at 1.32. Short FTSE 250/FTSE 100: The FTSE 250 has outperformed the FTSE 100 since 2000 (Chart 19), closely reflecting the performance of the U.K. economy relative to the euro area. Uncertainty caused by a vote in favor of Brexit will weigh on consumer and business confidence in the U.K., hurting the FTSE 250's performance, while a weaker GBP/USD should give a boost to the globally-oriented FTSE 100. Long FTSE 100 "exporters" / FTSE 100 "financials": While negative for the pound, Brexit should represent a boon to export-oriented industries. British real net exports increased during the period of sterling weakness following "Black Wednesday" - the pound's exit from the European Exchange Rate Mechanism (ERM) in September 1992 - reaching a level that they have been unable to regain since (Chart 20). Meanwhile, the greatest uncertainty would surround the financial sector, which would face both the potential loss of market access in the euro area and negative political consequences. Chart 19Go Long U.K. Exporters Chart 20Weak Pound Is Good For Exports Buy inflation protection: We favor getting long 10-year U.K. CPI swaps / short 10-year U.S. CPI swaps (Chart 21). BCA's Global Fixed Income Strategy team argues that inflation could surprise to the upside in the U.K. First, the labor market is tightening and firms are having increasing difficulty recruiting (Chart 22). A weaker pound will also lead to higher inflation through higher import prices. To counter the negative economic effects, the Bank of England will now likely cut interest rates, and perhaps even engage in renewed quantitative easing, which means that monetary policy will not curb but feed the inflationary impulses of Brexit. Chart 21Buy Inflation Protection Chart 22U.K. Labor Market Is Tightening Play the corporate bond market: The U.K. corporate bond market has not priced in Brexit (Chart 23). Investors should underweight U.K. financials versus euro area financials and/or underweight U.K. financials versus U.K. industrials. Ahead of the referendum, U.K. financial spreads had only widened mildly versus peers in the U.S. and the euro area. They were not even showing signs of stress against U.K. industrials. The Brexit vote will likely push these spreads wider. Play the yield curve: If Brexit happens, the yield curve will most likely steepen. As more interest rate cuts are priced in the short end of the curve, inflationary pressures will bubble up and push the longer part of the curve higher. The belly of the curve will profit from these conditions (Chart 24). Chart 23Corporate Bond Market ##br##Has Not Priced In Brexit Chart 24Long Bullet Vs. ##br##The Wings Marko Papic, Managing Editor marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com 1 Please see BCA Special Report, "Break Glass To Brexit: A Fact Sheet," dated June 17, 2016, and BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 2 The six factors are trade balance with the EU, exports as percent of GDP, debt interest payments, gross government debt, foreign direct investment, and net transfers to the EU. 3 Please see BCA's The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated October 19, 2011, 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, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com.

The latest conclusions from the sector-based (right) way to pick stock markets. Plus some important conclusions for credit markets.

The model has downgraded France to underweight due to deteriorating liquidity and technical conditions. U.S. weight is boosted by 4 points at the expenses of European countries.

No significant change was made except that the weight of France was increased to 7% from 1.7%, largely driven by improvement in relative liquidity conditions. It's mainly financed by a reduction in the U.S. weight which remains the largest overweight in the model.