Geopolitics

Highlights Three distinct forces are likely to make South Asia’s geopolitical risks increasingly relevant to global investors. First, India’s tensions with China stem from China’s growing foreign policy assertiveness and India’s shift away from traditional neutrality toward aligning with the US and its allies. This creates a security dilemma in South Asia, just as in East Asia. Second, India’s economy is sputtering in the wake of the COVID-19 pandemic, adding fuel to nationalism and populism in advance of a series of important elections. India will stimulate the economy but it could also become more reactive on the international scene. Third, the US is withdrawing from Afghanistan and negotiating a deal with Iran in an effort to reduce the US military presence in the Middle East and South Asia. This will create a scramble for influence across both regions and a power vacuum in Afghanistan that is highly likely to yield negative surprises for India and its neighbors. Traditionally geopolitical risks in South Asia have a limited impact on markets. India’s growth slowdown and forthcoming fiscal stimulus are more relevant for investors. However, a sharp rise in geopolitical risk would undermine India’s structural advantages as the West diversifies away from China. Stay short Indian banks. Feature Geopolitical risks in South Asia are slowly but surely rising. India-Pakistan and China-India are well-known “conflict-dyads” or pairings. Historically, these two sets have been fighting each other over their fuzzy Himalayan border with limited global financial market consequences. But now fundamental changes are afoot that are altering the geopolitical setting in the region. Specifically, the coming together of three distinct forces could trigger a significant geopolitical event in South Asia. The three forces are as follow: Force #1: Sino-Indian Tensions Get Real About a year ago, Indian and Chinese troops clashed in Ladakh, a disputed territory in the Kashmir region. Following these clashes China reduced its military presence in the Pangong Tso area but its presence in some neighboring areas remains meaningful. Besides the troop build-up along India’s eastern border, China is building more air combat infrastructure in its India-facing western theatre. China’s major air bases have historically been concentrated in China’s eastern region, away from the Indian border (Map 1). Consequently, India has historically enjoyed an advantage in airpower. But China appears to be working to mitigate this disadvantage. Map 1Most Of China’s Major Aviation Units Are Located Away From India Owing to China’s increased military focus along the Sino-India border, India’s threat perception of China has undergone a fundamental change in recent years. Notably, India has diverted some of its key army units away from its western Indo-Pak border towards its eastern border with China. India could now have nearly 200,000 troops deployed along its border with China, which would mark a 40% increase from last year.1 Turning attention to the Indo-Pak border, India’s problems with Pakistan appear under control for now. This is owing to the ceasefire agreement that was renewed by the two countries in February 2021. However, this peace cannot possibly be expected to last. This is mainly because core problems between the two countries (like Pakistan’s support of militant proxies and India’s control over Kashmir) remain unaddressed. History too suggests that bouts of peace between the two warring neighbors rarely last long. These bouts usually end abruptly when a terrorist attack takes place in India. With both political turbulence and economic distress in Pakistan rising, the fragile ceasefire between India and Pakistan could be upended over the next six months. In fact, two events over the last week point to the fragility of the ceasefire: Two drones carrying explosives entered an Indian air force station located in Jammu and Kashmir (i.e. a northern territory that India recently reorganized, to Pakistan’s chagrin). Even as no casualties were reported, this attack marks a turning point for terrorist activity in India as this was the first-time terrorists used drones to enter an Indian military base. Hours later, another drone attack struck an Indian base at the Ratnuchak-Kaluchak army station, the site of a major terrorist attack in 2002. Chart 1China, Pakistan And India Cumulatively Added 41 Nuclear Warheads Over 2020 Given that the ceasefire was agreed recently, any further increase in terrorist activity in India over the next six months would suggest that a more substantial breakdown in relations is nigh. Distinct from these recent tensions, China’s troop deployment along India’s eastern arm and Pakistan’s presence along India’s western arm creates a strategic “pincer” that increasingly threatens India. India is naturally concerned. China and Pakistan are allies who have been working closely on projects including the strategic China-Pakistan Economic Corridor (CPEC). The CPEC is a collection of infrastructure projects in Pakistan that includes the development of a port in Gwadar where a future presence of the People's Liberation Army Navy (PLAN) is envisaged. Gwadar has the potential of providing China land-based access to the Indian Ocean. Trust in the South Asian region is clearly running low. Distinct from troop build-ups and drone-attacks, China, Pakistan, and India cumulatively added more than 40 nuclear warheads over the last year (Chart 1). China is reputed to be engaged in an even larger increase in its nuclear arsenal than the data show.2 From a structural perspective, too, geopolitical risks in the South Asian peninsula are bound to keep rising. When it comes to the conflicting Indo-Pak dyad, India’s geopolitical power has been rising relative to that of Pakistan in the 2000s. However, the geopolitical muscle of the Sino-Pak alliance is much greater than that of India on a standalone basis (Chart 2). Chart 2India Has Aligned With The QUAD To Counter The Sino-Pak Alliance China’s active involvement in South Asia is responsible for driving India’s increasing desire to abandon its historical foreign policy stance of non-alignment. India’s membership in the Quadrilateral Security Dialogue (also known as the QUAD, whose other members include the US, Japan, and Australia) bears testimony to India’s active effort to develop closer relations with the US and its allies (Chart 2). India’s alignment with the US is deepening China’s and Pakistan’s distrust of India. Conventional and nuclear military deterrence should prevent full-scale war. But the regional balance is increasingly fluid which means geopolitical risks will slowly but surely rise in South Asia over the coming year and years. Force #2: A Growth Slowdown Alongside India’s Loaded Election Calendar The pandemic has hit the economies of South Asia particularly hard. South Asia historically maintained higher real GDP growth rates relative to Emerging Markets (EMs). But in 2021, this region’s growth rate is set to be lower than that of EM peers (Chart 3). History is replete with examples of a rise in economic distress triggering geopolitical events. South Asia is characterized by unusually low per capita incomes (Chart 4) and the latest slowdown could exacerbate the risk of both social unrest and geopolitical incidents materialising. Chart 3South Asian Economies Have Been Hit Hard By The Pandemic Chart 4South Asia Is Characterized By Very Low Per Capita Incomes To complicate matters a busy state elections calendar is coming up in India. Elections will be due in seven Indian states in 2022. These states account for about 25% of India’s population. State elections due in 2022 will amount to a high-stakes political battle. During state elections in 2021, the ruling Bharatiya Janata Party (BJP) was the incumbent in only one of the five states. In 2022, the BJP is the incumbent party in most of the states that are due for elections, which means it has the advantage but also has a lot to lose, especially in a post-pandemic environment. Elections kick off in the crucial state of Uttar Pradesh next February. Last time this state faced elections Prime Minister Narendra Modi was willing to go to great lengths to boost his popularity ahead of time. Specifically, he upset the nation with a large-scale and unprecedented de-monetization program. Given the busy state election calendar in 2022, we expect the BJP-led central government to focus on policy actions that can improve its support among Indian voters. Two policies in particular are likely to come through: Fiscal Stimulus Measures To Provide Economic Relief: India has refrained from administering a large post-pandemic stimulus thus far. As per budget estimates, the Indian central government’s total expenditure in FY22 is set to increase only by 1% on a year-on-year basis. But the expenditure-side restraint shown by India’s central government could change. With elections and a pandemic (which has now claimed over 400,000 lives in India), the central government could consider a meaningful increase in spending closer to February 2022. Map 2Northern India Views Pakistan Even More Unfavorably Than Rest Of India India’s Finance Minister already announced a fiscal stimulus package of $85 billion (amounting to 2.8% of GDP) earlier this week. Whilst this stimulus entails limited fresh spending (amounting to about 0.6% of India’s GDP), we would not be surprised if the government follows it up with more spending closer to February 2022. Assertive Foreign Policy To Ward-Off Unfriendly Neighbors: India’s northern states are known to harbor unfavorable views of Pakistan (Map 2). The roots of this phenomenon can be traced to geography and the bloody civil strife of 1947 that was triggered by the partition of British-ruled India into the two independent dominions of India and Pakistan. Given the north’s unfavorable views of Pakistan and given looming elections, Indian policy makers may be forced to adopt a far more aggressive foreign policy response, to any terrorist strikes from Pakistan or territorial incursions by China. This kind of response was observed most recently ahead of the Indian General Elections in April-May 2019. An Indian military convoy was attacked by a suicide-bomber in early February 2019 and a Pakistan-based terrorist group claimed responsibility. A fortnight later the Indian air force launched unexpected airstrikes across the Line of Control which were then followed by the Pakistan air force conducting air strikes in Jammu and Kashmir. While the next round of Pakistani and Indian general elections is not due until 2023 and 2024, respectively, it is worth noting that of the seven state elections due in India in 2022, four are in the north (Uttar Pradesh, Punjab, Uttarakhand, and Himachal Pradesh). Force #3: Power Vacuum In Afghanistan The final reason to be wary of the South Asian geopolitical dynamic is the change in US policy: both the Iran nuclear deal expected in August and the impending withdrawal from Afghanistan in September. The US public has now elected three presidents on the demand that foreign wars be reduced. In the wake of Trump and populism the political establishment is now responding. Therefore Biden will ultimately implement both the Iran deal and the Afghan withdrawal regardless of delays or hang-ups. But then he will have to do damage control. In the case of Iran, a last-minute flare-up of conflict in the region is likely this summer, as the US, Israel, Saudi Arabia, and Iran underscore their red lines before the US and Iran settle down to a deal. Indeed it is already happening, with recent US attacks against Iran-backed Shia militias in Syria and Iraq. A major incident would push up oil prices, which is negative for India. But the endgame, an Iranian economic opening, is positive for India, since it imports oil and has had close relations with Iran historically. In the case of Afghanistan, the US exit will activate latent terrorist forces. It will also create a scramble for influence over this landlocked country that could lead to negative surprises across the region. The first principle of the peace agreement between the US and Afghanistan states that the latter will make all efforts to ensure that Afghan soil is not used to further terrorist activity. However, the enforceability of such a guarantee is next to impossible. Notably, the US withdrawal from Afghanistan will revive the Taliban’s influence in the region. This poses major risks for India, which has a long history of being targeted by Afghani terrorist groups. The Taliban played a critical role in the release of terrorists into Pakistan following the hijacking of an Indian Airlines flight in 1999. Furthermore, the Haqqani network, which has pledged allegiance to the Taliban, has attacked Indian assets in the past. Any attack on India deriving from the power vacuum in Afghanistan would upset the precarious regional balance. Whilst there are no immediate triggers for Afghani groups to launch a terrorist attack in India, the US withdrawal will trigger a tectonic shift in the region. Negative surprises emanating from Afghanistan should be expected. Investment Conclusions Chart 5Indian Banks Appear To Have Factored In All Positives We reiterate the need to pare exposure to Indian assets on a tactical basis. India’s growth engine is likely to misfire over the second half of the Indian financial year. Macroeconomic headwinds pose the chief risk for investors, but major geopolitical changes could act as a negative catalyst in the current context. So we urge clients to stay short Indian Banks (Chart 5). Financials account for the lion’s share of India’s benchmark index (26% weight). India could opt for an unexpected expansion in its fiscal deficit soon. Whilst we continue to watch fiscal dynamics closely, we expect the fiscal expansion to materialize closer to February 2022 when India’s most populous state (i.e. Uttar Pradesh) will undergo elections. Over the long run, India’s sense of insecurity will escalate in the context of a more assertive China, stronger Sino-Pakistani ties, and a power vacuum in Afghanistan. For that reason, New Delhi will continue to shed its neutrality and improve relations with the US-led coalition of democratic countries, with an aim to balance China. This process will feed China’s insecurity of being surrounded and contained by a hegemonic American system. This security dilemma is a source of South Asian geopolitical risk that will become more globally relevant over time. China’s conflict with the US and western world should create incentives for India to attract trade and investment. However, its ability to do so will be contingent upon domestic political factors and regional geopolitical factors.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Sudhi Ranjan Sen, ‘India Shifts 50,000 Troops to China Border in Historic Move’, Bloomberg, June 28, 2021, bloomberg.com. 2 Joby Warrick, “China is building more than 100 missile silos in its western desert, analysts say,” Washington Post, June 30, 2021, washingtonpost.com.

Highlights The US is withdrawing from the Middle East and South Asia and making a strategic pivot to Asia Pacific. The third quarter will see risks flare around Iran and the US rejoin the 2015 Iranian nuclear deal. The result is briefly negative for oil prices but the rise of Iran is a new geopolitical trend that will increase Middle Eastern risk over the long run. The geopolitical outlook is dollar bullish, while the macroeconomic outlook is getting less dollar-bearish due to China’s risk of over-tightening policy. Stay neutral USD and be wary of commodities and emerging markets in the third quarter. European political risk is bottoming. The German and French elections are at best minor risks. However, the continent is ripe for negative black swans, especially due to Russian aggression. Go tactically long global large caps and defensives. Feature Chart 1Three Key Views On Track (So Far) We chose “No Return To Normalcy” as the theme of our 2021 outlook. While the COVID-19 vaccine promised economic recovery, we argued that normalization would create complacency regarding fundamental changes that have taken place in the geopolitical environment. A contradiction between an improving macroeconomic backdrop and a foreboding geopolitical backdrop would develop in 2021 and beyond. The “reflation trade” has begun to lose steam as we go to press. However, global recovery will still be the dominant story in the second half of the year as vaccination spreads. The question for the third quarter and the rest of the year is whether reflation will continue. As a matter of forecasting, we think it will. But as a matter of investment strategy, we are taking a more defensive stance until China relaxes economic policy. In our annual outlook we highlighted three key geopolitical views: (1) China’s headwinds, both at home and abroad (2) US détente with Iran and pivot to Asia (3) Europe’s opportunity. All three trends are broadly on track and can be illustrated by looking at equity performance in the relevant regions for the year so far: Chinese stocks sold off, UAE stocks rallied, and European stocks rallied (Chart 1). However, these trends are not exclusively tied to absolute equity performance. The most important question is what happens to global growth and the US dollar as these three key views continue. Stay Neutral On The Dollar It paid off for us to maintain a neutral stance on the dollar. True, the global recovery and exorbitant US trade and budget deficits are bearish for the dollar and bullish for other currencies. But the greenback’s “counter-trend bounce” is proving more formidable than many investors expected. The fundamentals of the American economy and global position remain strong. Since the outbreak of COVID-19, the US has secured its recovery with fiscal policy, maintained rule of law amid a contested election, innovated and distributed vaccines, benefited from more flexible social restrictions, refurbished global alliances, and put pressure on its geopolitical rivals. In essence, the combined effect of President Trump’s and Biden’s policies has been to make America “great again” (Chart 2). From a geopolitical perspective, the dollar is appealing. Chart 2Trump-Biden Make America Great Again? In addition, the first two geopolitical views mentioned above – China’s headwinds and the US-Iran détente – imply a negative environment for China and the renminbi. The reason for the US to do a suboptimal deal with Iran, both in 2015 and 2021, is to reduce the risk of war and buy time to enable a strategic pivot to Asia Pacific. Three US presidents have been elected on the pledge to conclude the “forever wars” in the Middle East and South Asia. Biden is withdrawing US troops from Afghanistan in September. There can be little doubt Biden is committed to an Iran deal, which is supposed to free up the US’s hands (Chart 3). Meanwhile the US public and Congress are unified in their desire to better defend US interests against China’s economic and military rise. There has not yet been a stabilization of US-China policies. Biden is not likely to hold a summit with Chinese President Xi Jinping until late October at earliest – and that is a guess, not a confirmed summit. The Biden administration has completed its review of China policy and is maintaining the Trump administration’s hawkish posture, as predicted. The US and China may resume their strategic and economic dialogue at some point but it is impossible to go back to the status quo ante 2015. That was the year the US adopted a more confrontational stance toward China – a stance later supercharged by Trump’s election and trade tariffs. The hawkish consensus on China is one of the rare unifying factors in a deeply divided America. The Biden administration explicitly says the US-China relationship is now defined by “competition” instead of “engagement.”1 One exception to this neutral view on the dollar has been our decision to go long the Japanese yen and Swiss franc, which has not panned out so far. Our reasoning is that geopolitical risk will boost these currencies but otherwise the reduction of geopolitical risk will weigh on the dollar in the context of global growth recovery. So far geopolitical risk has remained subdued while the US dollar has outperformed. We are still sympathetic to these safe-haven currencies, however, as they are attractively valued as long as one expects geopolitical risks to materialize (Chart 4). Chart 3US Pivot To Asia Runs Through Iran Our third key view, that EU was the real winner of the US election last year, remains on track. This is marginally positive for the euro at the expense of the dollar. Given the above points, we favor an equal-weighted basket of the euro and the dollar relative to the renminbi (Chart 5). Chart 4Safe-Haven Currencies Attractive Chart 5Favor Euro And Dollar Over Renminbi The geopolitical outlook is dollar-bullish. The macroeconomic outlook is dollar-bearish, except that China’s economy looks to slow down. We expect China to ease policy in the second half of the year but it may come late. We remain neutral dollar in the third quarter. Wait For China To Relax Policy July 1 marks the centenary of the Communist Party of China. The main thing investors should know is that the Communist Party predates China’s capitalist phase by sixty years. The party adopted capitalism to improve the economy – it never sacrificed its political or foreign policy goals. This poses a major geopolitical problem today because the Communist Party’s consolidation of power across Greater China, symbolized by Beijing’s revocation of Hong Kong’s special status in 2019, has convinced the western democracies that China is no longer compatible with the liberal world order. China launched a 13.8% of GDP monetary-and-fiscal stimulus over 2018-20 due to the trade war and COVID-19 pandemic. So the economy is stable for the hundredth anniversary celebration. The centenary goals are largely accomplished: GDP is larger, poverty is nearly extinguished, although urban incomes are still lagging (Chart 6). General Secretary Xi Jinping will mark the occasion with a speech. The speech will contribute to his governing philosophy, Xi Jinping Thought, a synthesis of communist Mao Zedong Thought and the pro-capitalist “socialism with Chinese characteristics” pioneered by General Secretary Deng Xiaoping in the 1980s-90s. The effect is to reassert Communist Party and central government primacy after the long period of decentralization that enabled China’s rapid growth phase. It is also to endorse an inward economic turn after the four-decade export-manufacturing boom. The Xi administration’s re-centralization of policy has entailed mini-cycles of tightening and loosening control over the economy. The administration leans against the country’s tendency to gorge itself on debt and grow at any cost – until it must lean the other way for fear of triggering a destabilizing slowdown. For this reason Beijing tightened policy proactively last year, producing a sharp drop in money, credit, and fiscal expansion in 2021 that now threatens to undermine the global recovery. By our measures, any further tightening will result in undershooting the regime’s money and credit targets, i.e. overtightening, and hence threaten to drag on the global recovery (Chart 7). Chart 6China's Communist Party Centenary Goals Chart 7China Verges On Over-Tightening Policy Overtightening would be a policy mistake with potentially disastrous consequences. So the base case should be that the government will relax policy rather than undermine the post-COVID recovery. However, investors cannot be confident about the timing. The 2015 financial turmoil and renminbi devaluation occurred because policymakers reacted too slowly. One reason to believe policy will be eased is that after July 1 the government will turn its attention to the twentieth national party congress in 2022, the once-in-five-years rotation of the Central Committee and Politburo. The party congress begins at the local level at the beginning of next year and culminates in the fall of 2022 with the national rotation of top party leaders. Xi Jinping was originally slated to step down in 2022. So he needs to squash any last-minute push against him by opposing factions of the party. He may have himself named chairman of the Communist Party, like Mao before him. Most importantly he will put his stamp on the “seventh generation” of China’s leaders by promoting his followers into key positions. All of this suggests that the Xi administration cannot risk triggering a recession, even if its preferences remain hawkish on economic policy. Policy easing could come as early as the end of July. As a rule of thumb, we have noticed that the Politburo’s July meeting on economic policy is often an inflection point, as was the case in 2007, 2015, 2018, and 2020 (Table 1). Some observers claim the April Politburo meeting already signaled an easing in policy, although we do not see that. If July clearly signals relaxation, global investors will cheer and emerging market assets and commodities will rise. Table 1China’s Politburo Often Hits Inflection Point On Economic Policy In July Still we maintain a defensive posture going into the third quarter because we do not have a high level of confidence that policymakers will act preemptively. A market riot may precede and motivate the inflection point in policy. Also the negative impact of previous policy tightening will be felt in the third quarter. China plays and industrial metals are extremely vulnerable to further correction (Chart 8). Chart 8China Plays And Metals Vulnerable To Further Correction The earliest occasion for a Biden-Xi summit comes at the end of October, as mentioned. While US-China talks will occur at some level, relations will remain fundamentally unstable. While a Biden-Xi summit may improve the atmosphere and lead to a new round of strategic and economic dialogue, or Phase Two trade talks, the fact is that the US is seeking to contain China’s rise and China is seeking to break out of the strictures of the US-led world order. The global elite and mainstream media will put a lot of emphasis on the post-Trump return to diplomatic “normalcy” and summits. But this is to overemphasize style at the expense of substance. Note that the positive feelings of the Biden-Putin summit on June 16 fizzled in less than a week when Russia allegedly dropped bombs in the path of a British destroyer in the Black Sea. The US and UK were training Ukraine’s military. Britain denies any bombs were dropped but Russia says next time they will hit their target. (More on this below.) This episode is instructive for US-China relations: summitry is overrated. China is building a sphere of influence and the US no longer believes dialogue alone is the answer. Tit-for-tat punitive measures and proxy battles in China’s neighboring areas, from the Korean peninsula to the Taiwan Strait to the South and East China Seas, are the new normal. Bottom Line: Tactically, stay defensive on global risk assets, especially China plays. Strategically, maintain a constructive outlook on the cycle given the global recovery and China’s need eventually to relax monetary and fiscal policy. US-Iran Deal Likely – Then The Real Trouble Starts The US will likely rejoin the 2015 Iranian nuclear deal (Joint Comprehensive Plan of Action) by August and pull out of its longest-ever war in Afghanistan in September. The US is wrapping up its “forever wars” to meet the demands of a war-weary public. Ironically, the long-term consequence is to create power vacuums that invite new geopolitical conflicts in the context of the US’s great power struggle with China and Russia. But for now a deal with Iran – once it is settled – reduces geopolitical risk by reducing the odds of military escalation in the region. The Iran talks are more significant than the Afghanistan pullout. We are confident in a deal because Biden can rejoin the 2015 deal unilaterally – it was never approved by the US Senate as a formal treaty. The Iranians will not support any militant action so aggressive as to scupper a deal that offers them the chance of reviving their economy at a critical time in the regime’s history. Reviving the deal poses a downside risk for oil prices in the third quarter though not over the long run. It is negative in the short run because investors will have to price not only Iran’s current and future production (Chart 9) but also any resulting loss of OPEC 2.0 discipline. Brent crude is trading at $76 per barrel as we go to press, above the $65-$70 per barrel average that our Commodity & Energy Strategy service expects to see over the coming five years (Chart 10). Chart 9Iran's Oil Production Will Return Chart 10Brent Price Faces Short-Term Downside Risk From Iranian Crude The oil price ceiling is enforced by the cartel of oil producers who fear that too high of prices will incentivize US shale oil production as well as the global shift to renewable energy. The Russians have always dragged their feet over oil production cuts and are now pushing for production hikes. The government needs an oil price of around $50-55 per barrel for the budget to break even. The Saudis need higher prices to break even, at $70-75 per barrel. Moscow must coordinate various oil producers, led by the country’s powerful oligarchs and their factions, which is inherently more difficult than the Saudi position of coordinating one producer, Aramco. The Russians and Saudis have maintained cartel discipline so far in 2021, as expected, because the wounds of the market-share war last year are still raw. They retreated from that showdown in less than a month. However, a major escalation in Saudi Arabia’s strategic conflict with Iran could push the Saudis to seek greater market share at Iran’s expense, as occurred before the original Iran deal in 2014-15. Hence our view that the risk to oil prices will shift from the upside to the downside in the second half of the year if the US-Iran deal is reconstituted. Over the long run, the deal is not negative for oil prices. The deal is a tradeoff for lower geopolitical risk today but higher risk in the future. The reason is that Iran’s economic recovery will strengthen its strategic hand and generate a backlash in the region. The global oil supply and demand balance will fluctuate according to circumstances but regional conflict will inject a risk premium over time. Biden’s likely decision to rejoin the 2015 deal should be seen as a delaying tactic. It is impossible to go back to 2015, when the US had mustered a coalition of nations to pressure Iran and when Iran’s “reformist” faction stood to receive a historic boost from the opening of the country’s economy. Now the US lacks a coalition and the reformists are leaving office in disgrace, with the hardliners (“principlists”) taking full power for the foreseeable future. Iran is happy to go back to complying with a deal that consists of sanctions relief in exchange for temporary limits on its nuclear program. The 2015 deal’s restrictions on Iran’s nuclear program begin expiring in 2023 and continue to expire through 2040. Biden has no chance of negotiating a newer and more expansive deal that extends these sunset clauses while also restricting Iran’s ballistic missile program and regional militant activities. He will say that easing sanctions is premised on a broader “follow on” deal to achieve these US goals. But the broader deal is unlikely to materialize anytime soon. The Iranians will commit to future talks but they will have no intention of agreeing to a more expansive deal unless forced. The country’s leaders will never abandon their nuclear program after witnessing the invasions of non-nuclear Libya and Ukraine – in stark contrast with nuclear-armed North Korea. Moreover Biden cannot possibly reassemble the P5+1 coalition with Russia and China anytime soon. The US is directly confronting these states. They could conceivably work with the US when Iran is on the brink of obtaining nuclear weapons but not before then. They did not prevent North Korea. The Supreme Leader Ali Khamenei, the soon-to-be-inaugurated President Ebrahim Raisi, the Iranian Revolutionary Guard Corps, the Ministry of Intelligence, and other pillars of the regime are focused exclusively on strengthening the regime in advance of Khamenei’s impending succession sometime in the coming decade. The succession could easily lead to domestic unrest and a political crisis, which makes the 2020s a critical period for the Islamic Republic. With Tehran focused on a delicate succession, it is not a foregone conclusion that Iran will go on the offensive to expand its sphere of influence immediately after the US deal. But sooner or later a major new geopolitical trend will emerge: the rise of Iran. With sanctions removed, trade and investment increasing, and Chinese and Russian support, Iran will be capable of pursuing its strategic aims in the region more effectively. It will extend its influence across the “Shia Crescent,” including Iraq. The fear that this will inspire in Israel and the Gulf Arab states has already generated a slow-boiling war in the region. This war will intensify as the US will be reluctant to intervene. The purpose of the deal is to enable the war-weary US to reduce its active involvement in the region. The US foreign policy and defense establishment do not entirely see it this way – they emphasize that the US will remain engaged. But US allies in the Middle East will not be convinced. The region already has a taste for the way this works after the US’s precipitous withdrawal from Iraq in 2011, which lead to the rise of the Islamic State terrorist group. Biden will try not to be so precipitous but the writing is on the wall: the US will reduce its focus and commitment. A scramble for power in the region will begin the moment the ink dries on Biden’s signature of the JCPA. Israel and the Arab states are forming a de facto alliance – based on last year’s Abraham Accords – to prepare for Iran’s push to dominate the region. Even if Iran is not overly aggressive (a big if), Israel and the Gulf Arabs will overreact as a result of their fear of abandonment. They will also seek to hedge their bets by improving ties with the Chinese and Russians, making the Middle East the scene of a major new proxy battle in the global great power struggle. As a risk to our view: if the Biden administration changes course this summer and refuses to lift sanctions or rejoin the Iran deal – low but not zero probability – then tensions with Iran will explode almost instantaneously. The Iranians will threaten to close the Strait of Hormuz and a crisis will erupt in the third or fourth quarter. Bottom Line: The US will most likely rejoin the Iranian nuclear deal by August to avoid an immediate crisis or war. The Biden administration will wager that it can lend enough support to regional allies to keep Iran contained. This might work, as the Iranians will focus on fortifying the regime ahead of its leadership succession. However, Iran’s hardline leadership will see an opportunity in America’s withdrawal from its “forever wars.” Iran will increasingly cooperate with Russia and China. Iran’s conflict with Israel and Saudi Arabia will be extremely difficult to manage and will escalate over time, quite possibly creating a revolution or war in Iraq. The Gulf Arabs are already under immense pressure from the green energy revolution. Thus while oil prices might temporarily fall on the return of Iranian exports, they will later see upward pressure from a new wave of Middle Eastern instability. European Political Risk Has (Probably) Bottomed By contrast with all the above we have viewed Europe as a negligible source of (geo)political risk in 2021. European policy uncertainty is falling in Europe relative to these other powers and the rest of the world (Chart 11). Chart 11Europe's Relative Policy Uncertainty Bottoming Chart 12EU Break-Up Risk Hits Floor (Again) The risk of a break-up of the European Union has wilted and remains at historic lows (Chart 12). There is no immediate threat of any European countries emulating the UK and attempting to exit. Even Italian support for the euro has surged. Immigration flows have plummeted. European solidarity is not on the ballot in the upcoming German and French elections. Germany is choosing between the status quo and a “green revolution” that would not really be a revolution due to the constraints of coalition politics. The Greens have lost some momentum relative to their polling earlier this year but underlying trends suggest they will surprise to the upside in the September 26 vote (Charts 13A and 13B). They embrace EU solidarity, robust government spending, weariness with the Merkel regime, and concerns about climate change, Russia, China, and social justice. Chart 13AGerman Greens Will Surprise To Upside Chart 13BGerman Greens Will Surprise To Upside We expect the Greens to surprise to the upside. But as they are forced into a coalition with the ruling Christian Democrats then they will be limited to raising spending rather raising taxes (Table 2). The market will cheer this result. Table 2German Greens’ Ambitious Tax Hike Proposals If the Greens disappoint then a right-leaning government and too early fiscal tightening could become a risk – but it is a minor risk because Merkel’s hand-picked successor, the CDU Chancellor Candidate Armin Laschet, will be pro-Europe and fiscally dovish, just like the mainstream of his party under Merkel. The only limitation on this dovishness is that it would take another global shock for there to be enough votes in the Bundestag to loosen the schuldenbremse or “debt brake.” In France, President Emmanuel Macron is likely to win re-election – the populist candidate Marine Le Pen remains an underdog who is unlikely to make it through France’s two-round electoral system. In Italy, Prime Minister Mario Draghi is overseeing a national unity coalition that will dole out EU recovery funds. An election cannot be held ahead of the presidential election in January, which will be secured by the establishment parties as a major check on any future populist ruling coalition. The risk in these countries, as in Spain and elsewhere, is that neoliberal structural reform and competitiveness are falling by the wayside. Fiscal largesse is positive for securing the recovery but long-term growth potential will remain depressed (Chart 14). Chart 14European And Global Fiscal Stimulus (Updated June 2021) Europe remains stuck in a liquidity trap over the long run. It depends on the rest of the world for growth. This is a problem given that China’s potential growth is slowing and there is no ready substitute that will prop up global growth. Europe is increasingly ripe for negative “black swan” events. The power vacuum in the Middle East described above will lead to instability and regime failures that will threaten European security. Russia will remain aggressive, a reflection of its crumbling structural foundations. The Putin administration has not changed its strategy of building a sphere of influence in the former Soviet Union and pushing back against the West, as signaled by the threat to bomb ships that sail in Crimean waters – a unilateral expansion of Russia’s territorial waters following the Crimean invasion. The Biden administration is not seeking anything comparable to the diplomatic “reset” with Russia from 2009-11, which ended in acrimony. In other words, European political risk may be bottoming as we speak. Investment Takeaways Chart 15Limited Equity Upside From Likely US Infrastructure Bill US Peak Fiscal Stimulus: The Biden administration is highly likely to pass an infrastructure package through Congress, either as a bipartisan deal with Republicans or as part of the American Jobs Plan. The result is another $1-$1.5 trillion fiscal stimulus, albeit over an eight-year period, with infrastructure funding taking until 2024-25 to ramp up. Biden’s other plans probably will not pass before the 2022 midterm election, which will likely bring gridlock. Investors are well aware of these proposals and the policy setting will probably be frozen after this year. Hence there is limited remaining upside for global materials sector and US infrastructure plays (Chart 15). The extravagant US fiscal thrust of 2020-21 will turn into a huge fiscal drag in 2022 (Chart 16). The Federal Reserve, however, will remain ultra-dovish as long as labor market slack persists – regardless of who is at the helm. Chart 16US Fiscal Drag Very Large In 2022 Chart 17Go Long Large Caps And Defensives China’s Headwinds Persist: China may or may not ease policy in time to prevent a market riot. China plays and industrial metals are highly exposed to a correction and we recommend steering clear. US-Iran Deal Weighs On Oil Price: Tactically we are neutral on oil and oil plays. An Iran deal could depress oil prices temporarily – and potentially in a major way if the Saudis agree with the Russians on increasing production. Fundamentals are positive but depend on the OPEC 2.0 cartel. The cartel faces the risk that higher prices will incentivize both alternative oil providers and the green revolution. Europe’s Opportunity: We continue to see the euro and European stocks offering value. Given the troubles with Russia we favor developed Europe plays over emerging Europe. The German election would be a bullish catalyst for European assets but headwinds from China will prevail, which is negative for cyclical European stocks. The Russian Duma election, also in September, creates high potential for Russia to clash with the West between now and then. Tactically, go long global large caps and defensives (Chart 17).   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Independent Vermont Senator Bernie Sanders recently felt it was necessary to warn against a second cold war. Sanders, a democratic socialist, is a reliable indicator of the left wing of the Democratic Party and a dissenter who puts pressure on the center-left Biden administration. His fears underscore the dominance of the new hawkish consensus. Appendix China Russia UK Germany France Italy Canada Spain Taiwan – Province Of China Korea Turkey Brazil Australia

Special Report

Highlights Now that the dust has settled on the hotly contested 2020 election, we introduce our revised and updated quantitative presidential election model. We will periodically update the model as a gauge of President Biden’s political capital as well as the Democratic Party’s evolving odds of keeping the White House in 2024. The model measures the probability of the ruling party’s winning the Electoral College vote for each of the 50 states. As of now, the Democrats only have a 53% chance. Granting that Republicans have a good chance of retaking at least one chamber of Congress in the 2022 midterm election, investors likely face a return to gridlock. Gridlock would mean neither too much nor too little spending and zero tax hikes. The Democratic Party’s success on its current legislative agenda in 2021-22 is highly significant as it will set US fiscal policy for the foreseeable future. Democrats are still highly likely to pass an infrastructure bill by year’s end that will hike corporate taxes and mark peak stimulus for this cycle. Stay long the BCA Infrastructure Basket. Feature The 2020 US Presidential Election has come and gone. Joe Biden defeated Donald Trump with a margin of 74 Electoral College votes to become the 46th president of the United States of America. 57 of these votes came from states where Biden’s margin of victory over Trump hovered around one percentage point or less, highlighting how close the race for the White House was. In this report – for your Independence Day reading pleasure – we introduce the US Political Strategy quantitative presidential election model. Sadly it is never too soon to gear up for the next US presidential election. Our election model is a state-by-state model that uses both economic and political variables to predict the probability of the incumbent party winning the Electoral College votes in each of the 50 states.1 We favor predicting the Electoral College vote over the popular vote since the winner of the presidential election is determined by the Electoral College. There have been five cases in history where the nationwide popular vote did not determine the outcome and two in recent history (George W. Bush in 2000 and Donald Trump in 2016). The college imposes a significant (and deliberate) constraint on majority opinion if it is not shared across America’s geographic regions. The model’s sample size includes ten presidential elections, from 1984-2020, across 50 states, netting 500 observations. The model incorporates the lessons of the narrow 2020 election which took place amid extreme political polarization and an economic recession. The Four Variables Our election model is based off a Probit regression that produces the probability that each state will remain under the control of the incumbent party. The dependent variable (classified as “elected”) is stated as follows: 1 = Incumbent party wins Electoral College votes in state; or, 0 = Incumbent party loses the Electoral College votes in state. This method allows us to measure the probability that a state with certain characteristics will fall into one of these two categories. We can then predict the probability of the incumbent party winning all the Electoral College votes in each of the 50 states. The model has four independent variables, or predictors: State economic health. Specifically, we use the Federal Reserve Bank of Philadelphia State Coincident Index for each of the 50 states. The coincident index combines four of a given state’s economic indicators to summarize current economic conditions in a single statistic. The four indicators are nonfarm payroll employment; average hours worked in manufacturing by production workers; the unemployment rate; and wage and salary disbursements plus proprietors' income deflated by the consumer price index (US city average). In other words, it captures job growth, manufacturing wages, joblessness, and real household income. Margin of victory in previous election. Specifically, we use the incumbent party’s margin of victory in the previous presidential election in each state. A “time for change” variable. This is a categorical variable indicating whether the incumbent party has occupied the White House for one or more terms. Since Biden is serving his first term as president this variable will have no impact on our model’s predictions for the 2024 election. If the Democratic Party were to win the 2024 election and hold the White House for a second term, this variable would then have a negative impact on the party’s odds of winning a third straight term in 2028. Presidential approval rating. Namely, we use the average approval level of the incumbent president in July of an election year. Biden Would Still Win The Election Today Our election model gives us an early look into the 2024 presidential race. We can also look back to see if Biden would win the 2020 presidential election if it were held again today. As it stands, Biden would still win with 308 Electoral College votes (Chart 1), two more than the official account of last year’s election. The two additional votes are a result of the model suggesting Florida (29 votes) would turn Democratic, while Arizona (11 votes) and Georgia (16 votes) would turn Republican, opposite to the 2020 election outcome. Chart 1Quant Model Gives Democrats Only 53% Chance Of Retaining The White House Biden’s overall probability of an election win lies at 53%, in line with early market predictions (Chart 2). These odds reinforce the fact that the 2020 election was closely fought, that the US public remains nearly evenly divided, and that national economic conditions contribute to this division. While it is still early days in the 2024 election cycle, there are some interesting takeaways from our model’s latest prediction. For starters, Florida remains a toss-up state but leans toward the Democrats. Philadelphia and Wisconsin, which were hotly contested in 2020, are only just favored to remain Democratic. Another interesting prediction concerns Arizona and Georgia. Both states were highly contested battlegrounds. For Arizona, it was the first time since the 1996 presidential election that the state turned Democratic; for Georgia it was the first time since 1992. Both states saw larger turnouts for Democrats than in recent elections. However, both states would flip back to Republican control if the election were held today, according to our model, by a more than 10 percentage point change in probability. This is an interesting prediction given that only seven months have passed since the 2020 election. Chart 2Market Has Democrats Ahead Of Republicans The stage was largely set for a Trump loss in 2020. Recessions are catastrophic for presidents running for reelection, especially if they take place during the election year. Coupled with a nationwide health pandemic, Trump was highly likely to lose. In fact his race with Biden proved a lot closer than many commentators expected – in large part due to his unwavering base of support, as reflected in the unprecedentedly small range of his approval rating. This is what prompted us to upgrade his odds from 35% to 45% in a BCA Geopolitical Strategy report on October 26, 2020 (for further discussion see Statistical Appendix). By contrast, Democrats are heavily favored to keep the White House in the 2024 cycle as they will ride the coattails of a recovering US economy, an increasingly vaccinated population, and a (likely) divided Republican opposition. US Still At Peak Polarization Our model produces a novel measure of US political polarization: it shows how many states will be won or lost with extreme certainty (less than 5% or greater than 95%). These are states that are not really competitive because of overwhelming partisan favoritism among their voting populations. Results of in-sample predictions from our model show a slight uptick in the degree of polarization in 2024, which is now above both 2012 and 2020 levels (Chart 3, Top Panel). This change is intuitive coming off the back of one of the most highly contested US elections in history. However, polarization should not rise much higher in the 2024 presidential election cycle. In better economic times, polarization tends to fall, as wider prosperity tends to blanket nationwide social grievances. If Trump wins the Republican nomination in 2024 then one would assume that polarization will remain near peak levels. But if the economy has improved substantially, as we expect, then Trump’s populist platform will have less appeal for voters and the Republican Party will remain divided. This would lead to a higher level of Republican approval of the Democratic candidate, i.e. falling polarization (Chart 3, bottom panel). Chart 3Still At Peak Polarization   Over the next five-to-ten years, we hold the contrarian view that polarization will fall. Generational change in the US will produce more domestic policy consensus, specifically on government spending and taxes, while geopolitical struggle with China will unify the nation against a common enemy for the first time since the Cold War. But our quantitative model pushes against this view at present. Accuracy In Back Tests Our model performs well during in-sample back-testing when comparing it to actual Electoral College vote outcomes for each election since 1984. The model correctly predicts all presidential election outcomes over our sample period (Chart 4), including last year’s narrow result. Chart 4Our Model Predicts All Election Outcomes In Our Sample … The model performs well in out-of-sample back testing too, with prediction accuracy of states at 92%. All election outcomes from 2000-2020 are correctly predicted (Chart 5).  Chart 5… And During Out-Of-Sample Back Testing What Now? We are still a long way from the next presidential election, but the cycle has begun. This means we can begin to form an early view of what is to come over the next three and a half years. The model also gives us a look into what the election backdrop looks like just seven months after the 2020 election. Right now, the Democratic Party holds a decent margin over whoever the Republican competitor may be in 2024. Our model suggests the Democrats would win 308 Electoral College votes if a presidential election were run today, as mentioned. Overall, they have a 53% chance of victory. From a qualitative point of view, our model may be understating the Democrats’ odds in 2024, as things stand today. First, the surest rule of thumb in US politics is that voters will ask themselves whether they are better off than they were four years ago. It is unlikely that voters will be worse off in November 2024 than they were amid the pandemic, recession, and nationwide racial and social unrest of November 2020. Second, the split within the Republican Party over President Trump’s populism, symbolized by marginal Republican votes to convict him of incitement of insurrection over the January 6 riot on Capitol Hill, is likely to produce a closely fought Republican primary election or even a third party candidate, dividing the Republican vote. That’s not to say Republicans have zero chance. Republicans are likely to retake the House of Representatives in 2022, which will give them a base to mount a challenge over the succeeding two years. President Biden will be about to turn 82 years old when the 2024 vote is held – he may choose or be forced to hand the reins to Vice President Kamala Harris, who did not perform well in the 2020 Democratic primary election. Exogenous shocks could take the world by surprise and undermine the “return to normalcy” that the Democrats are trying to project. There are also some interesting toss-up states in 2024, but these will change as we continue to update our model with the latest data. If Biden has to step down, and the Republicans reunify, then the US could see another closely fought election. But Republican reunification is a stretch as things stand today. For now, Biden’s reelection bid will benefit from the recovery and Republican divisions. Investment Takeaways Our quantitative election model gauges the probability that the incumbent political party will retain the White House in the Electoral College vote. The model is based on state-level economic health, the president’s job approval rating, and the strength of his margin of victory in each state, plus an “incumbent advantage” for parties that have only held the White House for one term. The model currently shows that the Democratic Party would win if the 2024 election were held today, albeit with only a 53% probability – an indication of how nearly evenly divided the states remain after the hotly contested election of 2020. However, the model is likely underrating the Democrats as the economy will improve substantially between now and 2024. This will increase the odds of Democrats retaining critical swing states. It will also prolong Republican divisions by depriving them of an economic message around which to rally. But of course anything can happen over three and a half years. The Democrats are favored in 2024 notwithstanding the subjective 75% chance that Republicans retake the House of Representatives in the 2022 midterm elections. A new party in the White House almost always loses seats in Congress at its first midterm. While 2022 could be an exception, we still favor Republicans to regain the House. The takeaway from all of the above is that while 2022 will produce gridlock, nevertheless the 2024 election is unlikely to resolve it. Hence the US will see no drastic domestic legislative changes after 2021-22 period – fiscal policy will be frozen. This provides certainty for investors as it means neither excessive spending, nor austerity, nor tax hikes. Yet midterm elections that produce gridlock exhibit a “buy the rumor, sell the news” profile and are not more bullish for markets than those that produce single-party rule (Chart 6). Monetary policy will probably tighten in 2023 so everything will depend on where the market stands before the election. Incidentally, the model suggests that US political polarization, which hit extreme levels in 2020, will increase further in the 2024 cycle. But this result may not pan out. Over the long run as generational change and geopolitical conflict will force Americans to gather around a new consensus on key policies, namely government spending and foreign and trade policy. Still, we recognize that this reduction in polarization may not occur substantially by 2024 – and on a deeper level that US politics will always be very partisan, as they have been since the presidential election of 1800. Investors should stay constructive on the bull market in the second half of the year as President Biden’s infrastructure bill and/or American Jobs Plan is likely to pass Congress. However, passage in the Senate will mark the top of this cycle’s fiscal stimulus and investors should no longer underweight defensive sectors and growth stocks going forward. Chart 6Gridlock 2022 Will Give Investors Fiscal Certainty   Guy Russell Research Analyst guyr@bcaresearch.com   Statistical Appendix Some clients may be curious as to how our US Political Strategy election model differs from our Geopolitical Strategy model used in the 2020 elections, and where it has made improvements in its efficiency and predictive accuracy. We discuss these improvements herein. Changes To The Geopolitical Strategy Presidential Election Model The last update to the BCA Geopolitical Strategy presidential election model was published at the end of October 2020. We correctly forecast that Biden would win the election in March 2020 and maintained this view throughout the year. By October, however, our quantitative model gave President Trump a 51% chance of winning, predicting that he would gain 279 electoral college votes. We read the model as “too close to call” and stuck with our subjective judgement in favor of Biden for the final prediction, a testament to the need for both quantitative and qualitative analysis. The model missed four states: Arizona, Georgia, Michigan, and New Hampshire. The popular margin of victory in these states was 0.3%, 0.2%, 2.8%, and 8.4% respectively. We knew our model might be over-generous to Trump because we chose to use the range rather than the level of his popular approval rating as a key variable in the model. We did this to counteract the effect of “shy Trump voters,” which distorted traditional public opinion polling.2 Methodology And Variables For the most part, we retain the methodology and suite of economic and political variables used in previous versions of the model. For long-time clients and those who are new to the US Political Strategy and Geopolitical Strategy service, the original version of our model can be found here while the updated 2020 version can be found here.3 The one and only economic variable is now transformed by a six-month change to each state’s coincident index, capturing the improvement or deterioration of the state’s economy. The six-month change results in the best statistical fit for the overall model this time round. In the 2020 model, we transformed the variable by a three-month change. A fast-changing economic environment coupled with a then-higher statistical impact in our model led us to this decision. We still weight the transformation of our economic variable in the same manner as we did in last year’s updated model. We take a weighted average of the six-month change of all the monthly state coincident indices in the presidential term preceding the election. Later months are weighted heavier than earlier months as the most recent context will have a greater impact on voter opinion in the election. In terms of our political variables, the margin of victory is simply measured as the incumbent party’s share of the popular vote minus the non-incumbent party’s vote share. This has not changed from previous versions of our model. For the 2024 model, we have switched back to including the average job approval level instead of range. We use the level as of July of the election year.4 July job approval data shows the highest correlation with the popular and Electoral College vote. October is marginally higher but not enough higher to justify losing three-months of data lead time in our estimation (Chart A1). Obviously whenever we update the model for predictive purposes ahead of November 2024, the latest month’s approval rating serves as a proxy for the final July 2024 reading. Chart A1July Job Approval Highly Correlated With Election Outcome Model Performance Predicted Error The 2024 model has made noteworthy improvements in predictive accuracy across recent elections when compared to the 2020 model. Most noticeable is the large difference in error (Chart A2). The 2020 model failed by a small margin to predict the election outcome. The 2024 model accurately predicts last year’s outcome, although it overpredicts the outcome by 27 Electoral College votes. Chart A2New Model Reduces Predicted Error Over Old Model … The 2024 model also performs well against a different version of the 2020 model, a “bare bones” version that relied exclusively on economic data. This version excluded Trump’s approval data, relying only on an economic explanatory variable to explain the variation in the model’s evolving prediction over time. Our last update to this bare bones model predicted a Trump loss, hence the low prediction error (Chart A3). We published this result alongside our official 2020 model (and other alternatives) for the sake of transparency and to enable clients to choose which of our models better suited their assumptions over ours. We still believe the incumbent president’s job approval data plays a significant role in the presidential election, which is why we included this variable in the GPS and USPS models. But the bare bones model was especially powerful given the economic backdrop in the US last year. Now that the US economy is showing increasing signs of making a full recovery, our 2024 model has learnt from past data and modeling, and still manages to predict 2020’s election outcome despite its inclusion of non-economic (i.e. political) variables. Chart A3… And Performs Well Against “Bare Bones” Economic Model If we create a new bare bones 2024 model and compare it to a comparable 2020 model we arrive at essentially the same outcome (Chart A4). These are two pure economic models, but the new version has a different (smoother) transformation applied to the coincident economic index. That is, changes in economic activity are less volatile. The older version under-predicted the 2020 election outcome by two crucial Electoral College votes, while the new one over-predicted the outcome by 16 votes. Chart A4New “Bare Bones” Economic Model However, for our official 2024 model we will not take this bare bones economic approach but rather will incorporate hard political data (presidential approval, state margin of victory, and a time for change variable). Minimizing predictive error while retaining an explanatory variable that we believe is causal provides us with the most robust model. Classification The 2024 model correctly classifies predicted outcomes at a rate of exactly 90%. That is, when the model makes a prediction of a certain state’s electoral outcome from 1984-2020, it is correct 90% of the time. This level of classification is the highest we have achieved across the several versions we have published since 2016 (Table 1). A close second is the bare bones 2020 model, at 89.11%. Table 1New Model Classifies Outcomes At The Highest Rate … Sensitivity And Specificity – Receiver Operating Characteristic Curve A Receiver Operating Characteristic (ROC) curve is a performance measurement for classification problems of binary modelled outcomes, among others. An ROC curve tells us how much the model is capable of distinguishing between classes. In our case, we have two classes: the dependent variable (classified as “elected”) is stated as 1 = incumbent party wins the Electoral College votes in each state; or 0 = incumbent party does not win the Electoral College votes in each state. The higher the area under the curve (AUC), the better our model is at predicting 0 classes as 0 and 1 classes as 1. An excellent model has AUC near to one. A poor model has an AUC near to zero, which means it has the worst measure of classifying classes correctly, labelling zeros as ones and vice versa. In fact, at a level of zero AUC, the model is reciprocating incorrect classes by predicting zeros as ones and ones as zeros. Statistically, more AUC means that the model is identifying more true positives while minimizing the number/percent of false positives. The ROC curve for our 2024 model has an AUC of 0.9668 (Chart A5), the highest AUC of all models we have developed and tested (Table 2). This means that the true positive rate for classifying outcomes is high and the false positive rate is low, further bolstering the model’s robustness. Chart A5Receiver Operating Characteristic Curve Of New Model Table 2… Has The Best Fit Compared To Older Models … F1 Scores A final grading of the 2024 model is by means of the F1 score. The F1 score is a measurement that considers both precision (specificity in the above ROC curve) and recall (sensitivity in the above ROC curve) to compute the score. The F1 score can be interpreted as a weighted average of the precision and recall values, where an F1 score reaches its best value at 1 and worst value at 0. The 2024 model produces the highest F1 score across our suite of historic models (Table 3). Table 3… And Is The Most Accurate Across All Models After discussing the above statistical metrics and elements of the 2024 model, we are happy to accept it as our new base case presidential election model, premised on its improvement in accuracy at predicting election outcomes in the past, as well as its ability to correctly classify outcomes as they were realized, relative to past published models of this nature. Appendix Tables Table A1USPS Trade Table Table A2Political Risk Matrix Table A3Political Capital Index Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets Footnotes 1     We assume that the District of Columbia will vote for the Democratic candidate due to past voting outcomes overwhelmingly favoring Democrats. 2     Large numbers of people polled in the 2016 and 2020 elections declined to say they were voting for President Trump, who was stigmatized in the mainstream media and society at large, or refused to participate in opinion polling. While some analysts rejected this idea after the 2016 election, the large polling misses in 2020 revived it. As many as one-fifth of Trump voters in 2020 might have kept their support secret. See Gregory Korte, “‘Shy Trump Voters’ Re-Emerge As Explanation For Pollsters’ Miss,” Bloomberg, November 19, 2020, bloomberg.com. See also Ed Kilgore, “What Did We Learn About Political Polling In 2020?” New York Magazine, March 26, 2021, nymag.com. 3    From here on out, the updated 2020 Geopolitical Strategy model will be referred to as the “2020 model”. 4    We we had originally introduced four measures covering this topic back in 2019, two require a longer period of job approval data to be put into estimation, these being the  “October momentum” and the “2-year change” job approval variables. We will revisit additional job approval measures and determine if they should be included in later estimations.  

Special Report

Highlights China’s Communist Party has overcome a range of challenges over the past 100 years, performed especially well over the past 42 years, but the macro and geopolitical outlook is darkening. The “East Asian miracle” phase of Chinese growth has ended. Potential GDP growth is slowing and it will be harder for Beijing to maintain financial and sociopolitical stability. The Communist Party has shifted the basis of its legitimacy from rapid growth to quality of life and nationalist foreign policy. The latter, however, will undermine the former by stirring up foreign protectionism. In the near term, global investors should favor developed market equities over China/EM equities. But they should favor China and Hong Kong stocks over Taiwanese stocks given significant geopolitical risk over the Taiwan Strait. Structurally, favor the US dollar and euro over the renminbi. Feature Ten years ago, in the lead up to the Communist Party’s 90th anniversary, I wrote a report called “China and the End of the Deng Dynasty,” referring to Deng Xiaoping, the Chinese Communist Party’s great pro-market reformer.1 The argument rested on three points: the end of the export-manufacturing economic model, an increasingly assertive foreign policy, and the revival of Maoist nationalism. After ten years the report holds up reasonably well but it did not venture to forecast what precisely would come next. In reality it is the rule of the Communist Party, and not the leader of any one man, that fits into China’s history of dynastic cycles. As the party celebrates a hundred years since its founding on July 23, 1921, it is necessary to pause and reflect on what the party has achieved over the past century and what the current Xi Jinping era implies for the country’s next 100 years. Single-Party Rule Can Bring Economic Success. Communism Cannot. Regime type does not preclude wealth. Countries can prosper regardless of whether they are ruled by one person, one party, or many parties. The richest countries in the world grew rich over centuries in which their governments evolved from monarchy to democracy and sometimes back again. Even today several of the world’s wealthy democracies are better described as republics or oligarchies. Chart 1China Outperformed Communism But Not Liberal Democracy The rule of one person, or autocracy, is not necessarily bad for economic growth. For every Kim Il Sung of North Korea there is a Lee Kuan Yew of Singapore. But authority based on a single person often expires with that person and rarely survives his grandchild. In China, Chairman Mao Zedong’s death occasioned a power struggle. Deng Xiaoping’s attempts to step down led to popular unrest that threatened the Communist Party’s rule on two separate occasions in the 1980s. The rule of a single party is thought to be more sustainable. Japan and Singapore are effectively single-party states and the wealthiest countries in Asia. They are democracies with leadership rotation and a popular voice in national affairs. And yet South Korea’s boom times occurred under single-party military rule. The same goes for the renegade province of Taiwan. Only around the time these two reached about $11,000-$14,000 GDP per capita did they evolve into multi-party democracies – though their wealth grew rapidly in the wake of that transition. China and soon Vietnam will test whether non-democratic, single-party rule can persist beyond the middle-income economic status that brought about democratic transition in Taiwan (Chart 1). Vietnam and Taiwan are the closest communist and non-communist governing systems, respectively, to mainland China. Insofar as China and Vietnam succeed at catching up with Taiwan it will be for reasons other than Marxist-Leninist ideology. Most communist systems have failed. At the height of international communism in the twentieth century there were 44 states ruled by communist parties; today there are five. China and Vietnam are the rare examples of communist states that not only survived the Soviet Union’s fall but also unleashed market forces and prospered (Chart 2). North Korea survived in squalor; Cuba’s experience is mixed. States that close off their economies do not have a good record of generating wealth. Closed economies lack competition and investment, struggle with stagflation, and often succumb to corruption and political strife. Openness seems to be a more diagnostic variable than government type or ideology, given the prosperity of democratic Japan and non-democratic China. Has the CPC performed better than other communist regimes? Arguably. It performs better than Vietnam but worse than Cuba on critical measures like infant mortality rates and life expectancy. Has it performed better than comparable non-communist regimes? Not really, though it is fast approaching Taiwan in all of these measures (Chart 3). Chart 2Communist States Get Rich By Compromising Their Communism Chart 3China Catching Up To Cuba On Basic Wellbeing What can be said for certain is that, since China’s 1979 reform and opening up, the CPC has avoided many errors and catastrophes. It survived the 1980s, 1990s, and 2000s without succumbing to international isolation, internal divisions, or economic crisis. It has drastically increased its share of global power (Table 1). Contrast this global ascent with the litany of mistakes and crises in the US since the year 2000. The CPC also managed the past decade relatively well despite the Chinese financial turmoil of 2015-16, the US trade war of 2018-19, and the COVID-19 pandemic. However, these events hint at greater challenges to come. China’s transition to a consumer-oriented economy has hardly begun. The struggle to manage systemic financial risk is intensifying today at risk to growth and stability (Chart 4). The trade war is simmering despite the Phase One trade deal and the change of party in the White House. And it is too soon to draw conclusions about the impact of the global pandemic, though China suppressed the virus more rapidly than other countries and led the world into recovery. Table 1China’s Global Rise After ‘Reform And Opening Up’ Chart 4China To Keep Struggling With Financial Instability Judging by the points above, there are two significant risks on the horizon. First, the CPC’s revival of neo-Maoist ideology, particularly the new economic mantra of self-reliance and “dual circulation” (import substitution), poses the risk of closing the economy and undermining productivity.2 Second, China’s sliding back into the rule of a single person – after the “consensus rule” that prevailed after Deng Xiaoping – increases the risk of unpredictable decision-making and a succession crisis whenever General Secretary Xi Jinping steps down. The party’s internal logic holds that China’s economic and geopolitical challenges are so enormous as to require a strongman leader at the helm of a single-party and centralized state. But because of the traditional problems with one-man rule, there is no guarantee that the country will remain as stable as it has been over the past 42 years. Slowing Growth Drives Clash With Foreign Powers Every major East Asian economy has enjoyed a “miracle” phase of growth – and every one of them has seen this phase come to an end. Now it is China’s turn. The country’s potential GDP growth is slowing as the population peaks, the labor force shrinks, wages rise, and companies outsource production to cheaper neighbors (Charts 5A & 5B). The Communist Party is attempting to reverse the collapse in the fertility rate by shifting from its historic “one Child policy,” which sharply reduced births. It shifted to a two-child policy in 2016 and a three-child policy in 2021 but the results have not been encouraging over the past five years. Chart 5AChina’s Demographic Decline Accelerating Chart 5BChina’s Demographic Decline Accelerating In the best case China’s growth will follow the trajectory of Taiwan and South Korea, which implies at most a 6% yearly growth rate over the next decade (Chart 6). This is not too slow but it will induce financial instability as well as hardship for overly indebted households, firms, and local governments. Chart 6China's Growth Rates Will Converge With Taiwan, South Korea The Communist Party’s legitimacy was not originally based on rapid economic growth but it came to be seen that way over the roaring decades of the 1980s through the 2000s. Thus when the Great Recession struck the party had to shift the party’s base of legitimacy. The new focus became quality of life, as marked by the Xi administration’s ongoing initiatives to cut back on corruption, pollution, poverty, credit excesses, and industrial overcapacity while increasing spending on health, education, and society (Chart 7). Chart 7China’s Fiscal Burdens Will Rise On Social Welfare Needs The party’s efforts to improve standards of living and consumer safety also coincided with an increase in propaganda, censorship, and repression to foreclose political dissent. The country falls far short in global governance indicators (Chart 8). Chart 8China Lags In Governance, Rule Of Law A second major new source of party legitimacy is nationalist foreign policy. China adopted a “more assertive” foreign and trade policy in the mid-2000s as its import dependencies ballooned. It helped that the US was distracted with wars of choice and financial crises. After the Great Recession the CPC’s foreign policy nationalism became a tool of generating domestic popular support amid slower economic growth. This was apparent in the clashes with Japan and other countries in the East and South China Seas in the early 2010s, in territorial disputes with India throughout the past decade, in political spats with Norway and most recently Australia, and in military showdowns over the Korean peninsula (2015-16) and today the Taiwan Strait (Chart 9). Chart 9Proxy Wars A Real Risk In China’s Periphery If China were primarily focused on foreign policy and global strategy then it would not provoke multiple neighbors on opposite sides of its territory at the same time. This is a good way to motivate the formation of a global balance-of-power coalition that can constrain China in the coming years. But China’s outward assertiveness is not driven primarily by foreign policy considerations. It is driven by the secular economic slowdown at home and the need to use nationalism to drum up domestic support. This is why China seems indifferent to offending multiple countries at once (like India and Australia) as well as more distant trade partners whom it “should be” courting rather than offending (like Europe). Such assertive foreign policy threatens to undermine quality of life, namely by provoking international protectionism and sanctions on trade and investment. The US is galvanizing a coalition of democracies to put pressure on China over its trade practices and human rights. The Asian allies are mostly in step with the US because they fear China’s growing clout. The European states do not have as much to fear from China’s military but they do fear China’s state-backed industry and technological rise. Europe’s elites also worry about anti-establishment political movements just like American elites and therefore are trying to win back the hearts and minds of the working class through a more proactive use of fiscal and industrial policy. This entails a more assertive trade policy. China has so far not adapted to the potential for a unified front among the democracies, other than through rhetoric. Thus the international horizon is darkening even as China’s growth rates shift downward. China’s Geopolitical Outlook Is Dimming China’s government has overcome a range of challenges and crises. The country takes an ever larger role in global trade despite its falling share of global population because of its productivity and competitiveness. The drop in China’s outward direct investment is tied to the global pandemic and may not mark a top, given that the country will still run substantial current account surpluses for the foreseeable future and will need to recycle these into natural resources and foreign production (Chart 10). However, the limited adoption of the renminbi as a reserve currency in the face of this formidable commercial power reveals the world’s reservations about Beijing’s ability to maintain macroeconomic stability, good governance, and peaceful foreign relations. Chart 10China's Rise Continues Chart 11China's Policy Uncertainty: A Structural Uptrend China is not in a position to alter the course of national policy dramatically prior to the Communist Party’s twentieth national congress in 2022. The Xi administration is focused on normalizing monetary and fiscal policy and heading off any sociopolitical disturbances prior to that critical event, in which General Secretary Xi Jinping, who was originally slated to step down at this time according to the old rules, may be anointed the overarching “chairman” position that Mao Zedong once held. The seventh generation of Chinese leaders will be promoted at this five-year rotation of the Central Committee and will further consolidate the Xi administration’s grip. It will also cement the party’s rotation back to leaders who have ideological educations, as opposed to the norm in the 1990s and early 2000s of promoting leaders with technocratic skills and scientific educations.3 This does not mean that President Xi will refuse to hold a summit with US President Biden in the coming months nor does it mean that US-China strategic and economic dialogue will remain defunct. But it does mean that Beijing is unlikely to make any major course correction until after the 2022 reshuffle – and even then a course correction is unlikely. China has taken its current path because the Communist Party fears the sociopolitical consequences of relinquishing economic control just as potential growth slows. The new ruling philosophy holds that the Soviet Union fell because of Mikhail Gorbachev’s glasnost and perestroika, not because openness and restructuring came too late. Moreover it is far from clear that the US, Europe, and other democratic allies will apply such significant and sustained pressure as to force China to change its overall strategy. America is still internally divided and its foreign policy incoherent; the EU remains reactive and risk-averse. China has a well-established set of strategic goals for 2035 and 2049, the 100th anniversary of the People’s Republic, and the broad outlines will not be abandoned. The implication is that tensions with the US and China’s Asian neighbors will persist. Rising policy uncertainty is a secular trend that will pick back up sooner rather than later (Chart 11), to the detriment of a stable and predictable investment environment. Chart 12Chinese Government’s Net Worth High But Hidden Liabilities Pose Risks Monetary and fiscal dovishness and a continued debt buildup are the obvious and necessary solutions to China’s combination of falling growth potential, rising social liabilities, the need to maintain the rapid military buildup in the face of geopolitical challenges. Sovereign countries can amass vast debts if they own their own debt and keep nominal growth above average bond yields. China’s government has a very favorable balance sheet when national assets are taken into consideration as well as liabilities, according to the IMF (Chart 12). On the other hand, China’s government is having to assume a lot of hidden liabilities from inefficient state-owned companies and local governments. In the short run there are major systemic financial risks even though in the long run Beijing will be able to increase its borrowing and bail out failing entities in order to maintain stability, just like Japan, the US, and Europe have had to do. The question for China is whether the social and political system will be able to handle major crises as well as the US and Europe have done, which is not that well. Investment Takeaways The rule of a single party is not a bar to economic success – but the rule of a single person is a liability due to the problem of succession. Marxism-Leninism is terrible for productivity unless it is compromised to allow for markets to operate, as in China and Vietnam. States that close their economies to the outside world usually atrophy. There is no compelling evidence that China’s Communist Party has performed better than a non-communist alternative would have done, given the province of Taiwan’s superior performance on most economic indicators. Since 1979, the Communist Party has avoided catastrophic errors. It has capitalized on domestic economic potential and a favorable international environment. Now, in the 2020s, both of these factors are changing for the worse. China’s “miracle” phase of growth has expired, as it did for other East Asian states before it. The maturation of the economy and slowdown of potential GDP have forced the Communist Party to shift the base of its political legitimacy to something other than rapid income growth: namely, quality of life and nationalist foreign policy. An aggressive foreign policy works against quality of life by provoking protectionism from foreign powers, particularly the United States, which is capable of leading a coalition of states to pressure China. The Communist Party’s policy trajectory is unlikely to change much through the twentieth national party congress in 2022. After that, a major course correction to improve relations with the West is conceivable, though we would not bet on it. Between 2021 and China’s 2035 and 2049 milestones, the Communist Party must navigate between rising socioeconomic pressures at home and rising geopolitical pressures abroad. An economic or political breakdown at home, or a total breakdown in relations with the US, could lead to proxy wars in China’s periphery, including but not limited to the Taiwan Strait. For now, global investors should favor the euro and US dollar over the renminbi (Chart 13). Chart 13Prefer The Dollar And Euro To The Renminbi Mainland investors should favor government bonds relative to stocks. Chinese stocks hit a major peak earlier this year and the government’s seizure of control over the tech sector is taking a toll. Investors should prefer developed market equities relative to Chinese equities until China’s current phase of policy tightening ends and there is at least a temporary improvement in relations with the United States. But investors should also prefer Chinese and Hong Kong stocks relative to Taiwanese due to the high risk of a diplomatic crisis and the tail risk of a war. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 The report concluded, “the emerging trends suggest a likely break from Deng's position toward heavier state intervention in the economy, more contentious relationships with neighbors, and a Party that rules primarily through ideology and social control.” Co-written with Jennifer Richmond, "China and the End of the Deng Dynasty," Stratfor, April 19, 2011, worldview.stratfor.com. 2 The Xi administration’s new concept of “dual circulation” entails that state policy will encourage the domestic economy whereas the international economy will play a secondary role. This is a reversal of the outward and trade-oriented economic model under Deng Xiaoping. See “Xi: China’s economy has potential to maintain long-term stable development,” November 4, 2020, news.cgtn.com. 3 See Willy Wo-Lap Lam, "China’s Seventh-Generation Leadership Emerges onto the Stage," Jamestown Foundation, China Brief 19:7, April 9, 2019, Jamestown.org.

Highlights The US Innovation and Competition Act shows that the US is rediscovering industrial policy amid domestic populism and foreign geopolitical risk.  Fiscal accommodation is a basis for the economy to improve, political polarization to moderate, and Congress’s approval rating to continue to normalize.  Biden’s infrastructure bill still has a subjective 80% chance of passage, despite bipartisan talks faltering and his own caucus growing restive. The price tag is still around $1-$1.5 trillion. Senate passage will mark peak US stimulus for this cycle. Close long consumer staples for a gain of 6%. Cut losses on long materials/tech. Close our fiscal advantage trade relative to the NASDAQ. Feature Bipartisanship is not dead in the 117th Congress, though a bipartisan deal on infrastructure may not come together. Investors should still expect Congress to pass the president’s signature legislative proposal, the American Jobs Plan. Our subjective odds remain 80% with high conviction. The bill’s price tag is still ranging from $1-to-$1.5 trillion in deficit spending this year, or 4.4%-6.7% of GDP – i.e. not a number that financial markets can ignore. A budget resolution is being drafted with a rough headline value of $1.5 trillion. Financial markets are experiencing an inevitable period of doubts over whether the bill will actually pass. In the short run investors should stay invested in infrastructure plays, cyclical equity sectors, and value stocks. However, market dynamics are shifting and there is a basis for upgrading the tech and health sectors. The Senate’s passage of Biden’s infrastructure bill, in whatever form, will mark the peak of US fiscal stimulus for this cycle. Meanwhile our theme of bipartisan structural reform is apparent in the Senate’s passage of the Innovation and Competition Act on June 8 (Chart 1). This bill marks a rare bipartisan achievement in Congress and a sea change in American policymaking. The sea change is the US’s need to revive industrial policy in order to compete with adversaries abroad – a mission that the political establishment supports after being snapped out of its slumber by President Trump’s populist rebellion. In this report we take a look at the domestic consequences of this bill. We leave the international consequences to our sister Geopolitical Strategy service. Chart 1Newsflash: Bipartisan Bill Passes Senate Via Regular Order! We also look at the surprising recovery in Congress’s popular approval rating. While the US remains at “peak polarization” from a historic point of view, there is a cyclical drop in polarization after the quadruple crisis of 2020 (pandemic, recession, social unrest, contested election) (Chart 2). This cyclical drop may well become a secular decline over the coming decade, as fiscal accommodation at home and geopolitical risk abroad will generate domestic policy consensus on the topics of trade, manufacturing, industry, and technology. This trend will support Congress’s approval rating. Chart 2Polarization Subsides From Crisis Peaks While Congress will never be loved, it will not be as hated in the coming decade as the past decade. The reason is that Congress is taking a more active role in the economy. This is positive for markets in the short run but adds policy uncertainty over the long run. The Return Of Industrial Policy The US Innovation and Competition Act (USICA) is the outcome of a crisis in the American political system two decades in the making. The hyper-globalization of the Bill Clinton presidency, combined with the profligate economic and foreign policies of the George W. Bush presidency, led to the Great Recession. While the US was distracted with foreign wars and financial crisis, China emerged as a challenger to the US’s strategic dominance (Russia also revived and undermined US stability). The Obama administration began taking tougher action on China in 2015 but by then it was too late to accomplish much. The sluggish recovery and loss of national status triggered a populist rebellion in the form of the Trump administration, which provoked an even greater backlash from the political establishment in 2020. The Republicans imposed fiscal austerity, took power, then abandoned austerity and declared a trade war on China. The Democrats took back power, abandoned austerity, and are continuing the trade war. Now the two parties agree on the need to increase government support for the economy (infrastructure, industrial policy, protectionism) and to redirect foreign policy to confront major powers like China and Russia (as opposed to wasteful forever wars in the Middle East and South Asia). Public opinion has been coalescing around these twin goals since 2008 and the Biden administration so far can be said to represent a kind of synthesis of the Obama and Trump administrations. Even more powerful is the formation of a new consensus in Congress, which is the “first branch” of the US government and represents popular attitudes. Congress has always been more nationalist and more protectionist in its leanings than the executive and judicial branches, which represent policy elites and technocrats.1 While Congress is fickle when it comes to passing fancies of the day, it can be incredibly stubborn when it comes to a nationwide, once-in-a-generation popular consensus. Moreover China does not present a fleeting challenge like Iraq or Al Qaeda. It is more like the Soviet Union and will motivate a congressional consensus and policy consensus for decades. Great power competition will work against US political polarization. A Productivity Mini-Boom The USICA consists of about $115 billion in federal research and development funding, $52 billion in funding for the US semiconductor industry, and $10 billion for regional tech hubs. Funding will flow to the National Science Foundation, NASA, the Department of Energy, and the Defense Advanced Research Projects Agency (DARPA), among others. There are also specific measures to counter China (including intellectual property protections) as well as a regulatory overhaul to codify “Buy America” provisions and require that materials used in federally funded projects are produced in the United States (Table 1). Table 1US Senate Passes Bipartisan ‘Innovation And Competition Act’ To Counter China In research and development, the USICA formalizes the key technologies that the federal government should focus on and fund. These include: AI, machine learning, and autonomy High performance computing Quantum science and technology Natural and anthropogenic disaster prevention and mitigation Advanced communication technology Biotech, medical tech, genomics, and synthetic biology Data storage and cybersecurity Advanced energy, industrial efficiency, batteries, nuclear energy Advanced material science The $81 billion allocated to the National Science Foundation, covering fiscal 2022-26, will be allocated as shown in Table 2. The Department of Energy will focus on energy-related supply chain issues within the key technological areas of focus. Table 2NSF Gets Additional Dole Private research and development amount to more than twice the R&D spending of the federal government (Chart 3). Higher spending will augment private R&D, rather than substitute for it. It will likely boost US productivity, which has been in the doldrums over the past few years. Chart 3A Boost To R&D Spending While it is speculative to say whether the revival of industrial policy will cause productivity to break out of its long-term structural decline, a mini-boom seems warranted, especially when considering that foreign competition will remain a constant impetus (Chart 4). There is ample pork-barrel spending and plenty of potential for boondoggles, as will always be the case with fiscal spending splurges. But a rise in productivity will have a greater macro impact. Chart 4US Productivity Boom, Or At Least Mini-Boom Another aspect of the bill consists of funding for regional technology hubs. The office of Economic Development Administration will oversee three tech hubs in each region covered by the EDA’s regional office. These must be areas that are not already tech centers. No less than one third of the funding will go to small and rural communities and at least one consortium must be headquartered in a low-population state. The info-tech revolution and de-industrialization have created a problem of regional inequality, which these measures attempt to address. The USICA also funds the incentives for the domestic semiconductor industry first outlined in the national defense appropriations last year. The CHIPS Act, for example, helps incentivize investment in facilities and equipment for computer chip fabrication, assembly, testing, advanced packaging, and R&D. This funding was subject to the availability of appropriations but is now authorized under the USICA to the tune of $52 billion. Substantial breakthroughs in the 1980s-90s, in software and other areas, followed on much smaller public investments in education and research.2 The semiconductor industry is capital-intensive. For every one dollar in sales, 15 cents of capital expenditures are needed, compared to just seven cents in the tech sector as a whole and six cents across companies in the S&P 500 index. The capex requirement for the energy sector grew from six cents in 2004 to 17 cents in 2015, almost tripling in a decade due to the capital intensity of the shale boom (Chart 5). Thus lowering the cost of investment for the semiconductor companies will have a major positive impact. Quarterly capex for the chip makers stands at around $25 billion. An infusion of $52 billion in government incentives over five years amounts to $2.6 billion per quarter or roughly 10% of current capex. Chart 5A Boon For US Semi Capex Finally, the USICA consists of notable “Buy America” or protectionist measures. The bill holds that public works must be produced by American workers and funding should not be used to reward companies that “offshore” their operations, especially to countries that do not share US regulatory standards on workers, workplace safety, and the environment. The USICA gives a big sop to US manufacturing: all manufactured goods purchased with the bill’s funding must be made in the USA or have at least 55% of their total components sourced in the country. All iron and steel manufacturing processes, from melting through coatings, must occur in the United States. Buy America provisions will stir up some quarrels with US allies and trading partners but ultimately the US will need to increase imports as a result of the USICA. Private non-residential investment in the US moves closely with import growth, whereas US government investment has less of a relationship with imports (Chart 6). Chart 6Supply Constraints Amid US Fiscal Stimulus The Buy American provision will put new pressures on a supply chain that is already strained by the pandemic and the Trump administration’s tariffs. Industrial production is at an all-time high and so are producer prices, which means that producers have high pricing power. This is beneficial for the industrial and materials sectors over the medium term, even if the short-term inflation scare proves overdone (Chart 7). Buy American provisions will even improve the pricing power of the machinery sub-sector, as contractors will be forced to buy American-made machinery. The bottom line is that the Biden administration has coopted the Trump administration’s agenda on China, trade, and manufacturing, which itself was an attempt to steal thunder from the Obama administration. However, Biden and the Democrats bring a defensive and domestic-oriented approach rather than an offensive and foreign-oriented approach. Tariffs and investment restrictions will stay on China but they are not being increased or tightened (at least not yet). Instead the emphasis falls on fiscal largesse for US industry and manufacturing as well as research and development, promotion of STEM education (science, technology, education, and mathematics), and semiconductor subsidies. Chart 7Sustained Proactive Fiscal Policy Is Inflationary The goal is to increase the pace of US innovation, notwithstanding the fact that countries will continue to borrow, spy, and steal from each other. The international context of competition – and the widespread resort to debt monetization – will have a positive impact on productivity over the long run. But the protectionist regulations will combine with US supply constraints to put upward pressure on material and industrial prices over the short and medium run. Will Americans Hate Congress Less? A bipartisan industrial agenda in Congress raises the question of whether a bipartisan infrastructure deal can also be achieved. We remain optimistic, though the talks are currently wobbling. Biden’s approval among Democrats is falling as the Democratic caucus abandons his attempt to forge a bipartisan infrastructure deal and presses for a Democrat-only reconciliation bill. However, his overall approval rating is not likely to settle at a lower level than that of Presidents Obama and Trump. His approval rating on handling the economy has probably already hit its floor (Chart 8). He still has the ability to pass a signature piece of legislation, according to our Political Capital Index (Appendix). Chart 8Biden Struggles With Democratic Party Chart 9US Public Approving Of Congress?!? The sharp increase in public approval for Congress is another signal of Biden’s political capital (Chart 9). About 36% of Americans now say they approve of the job Congress is doing while 61% disapprove. This is not very good in absolute terms but relative to Congress’s history it is notable. The sharp uptick is due in large part to the expanded unemployment benefits, stimulus checks, and other social subsidies doled out during the pandemic. A fleeting spike in approval also occurred around the GFC-era stimulus, only to give way to new lows. Yet there is a deeper source. Approval of Congress has risen continually since the bruising debt ceiling standoffs and government shutdowns of 2010-14, when the Obama administration squared off against a Republican Congress in the context of a sluggish economy (Chart 10). With Gallup polling data going back to the 1970s, the big picture is that Americans lost faith in Congress during the stagflationary 1970s, the first Gulf War and recession of the early 1990s, and especially the Iraq/Afghanistan wars and Great Recession. It is now slowly recovering to normally low (rather than abnormally low) levels. Chart 10A Longer View Of Public Attitudes Toward Congress Aside from fleeting rallies around the flag, such as after the September 11, 2001 terrorist attacks, public approval of Congress rarely rises above 50%. The reasons are obvious: Congress is an institution in which power-hungry politicians engage in endless and petty quarrels over the minutiae of public policy in full view of the world. Its job is inherently unpopular.3 But as partisanship and polarization have increased dramatically since the 1980s, Congress has lost effectiveness at its primary function of forging compromises and passing laws. The public differs on what laws should be passed but it generally disapproves of the lack of compromise (Chart 11). A clear uptrend in congressional approval has emerged since the near-recession of 2015. The one overriding change in national policy since that time has been the activation of the fiscal lever. Trump unleashed a bipartisan spending binge as well as tax cuts. COVID-19 encouraged a Trump-Biden spending binge. Now Biden’s measures are adding to this anti-austerity blowout. While voters rewarded Congress for balancing the budget in the 1990s, the Great Recession marked a secular change. Disapproval rose with the process of fiscal tightening from 2010-14 (budget sequestration) and fell as the fiscal deficit has widened since then (Chart 12). Chart 11Public Approves Of Lawmakers Who … Make Laws Chart 12Public Approves Of Spendthrift Congress? Voters do not approve of Congress based on wonky policy views. Their approval, like their approval of the president, tracks with the state of the nation. There is a fairly close correlation between the two approval ratings. A major deviation emerged in 2010-14 when President Obama partially restored public faith in the presidency (albeit with historically low approval ratings) while Congress sank to even lower lows than it witnessed during the Iraq war on the back of Republican obstructionism and Obama’s second-term legislative failures (Chart 13). The current trend is for presidential approval to remain flat at its post-2010 levels while Congress regains some support. Chart 13Approval Of Congress Tracks Approval Of President Congressional infighting will resume after Biden passes the American Jobs Plan. His American Families Plan is much less likely to pass. Opposition Republicans have a subjective 75% chance of retaking the House of Representatives in 2022, which would result in gridlock. However, congressional approval is normalizing from the depths of the disinflationary 2010s to around the 30%-40% range. It will probably continue tracking presidential approval. And history shows that presidential approval ultimately hinges on peace and prosperity as opposed to war, recession, and scandal (Chart 14). This will dictate the direction under the Biden administration and beyond. Chart 14Approval Of President Tracks ‘Peace And Prosperity’ A critical factor is whether polarization will continue to subside. High polarization makes it so that voters identify the passage or failure of government policy exclusively with the ruling party; this incentivizes the opposition to obstruct.4 Lower polarization enables bipartisan deals and thus forces the two parties to share the praise and the blame of new policies. Compromise and lawmaking increase congressional approval; higher congressional approval increases the odds of compromise. The current legislative agenda reveals several areas of emerging consensus, not only on industrial policy and manufacturing but also on anti-trust law and infrastructure (Table 3). Table 3Pending Legislation In Congress Under Biden The Biden administration may only get one or two more major bipartisan legislative accomplishments. Polarization is still at historically elevated levels. In the next two-to-five years polarization could easily re-escalate, given the ongoing power struggle between the two dominant parties and the grievances over the 2020 election. However, over the next five-to-ten years, polarization should settle at levels beneath the record highs witnessed in 2020 due to foreign competition and fiscal accommodation. The USICA shows how this trend could take shape. Investment Takeaways The macro implications of Biden’s political capital and Congress’s rising approval rating consist of trends and themes that we have emphasized before: the return of Big Government; populist monetary and fiscal policy; protectionist industrial policy; nation building at home; and geopolitical struggle abroad. There is no direct market impact of a less unpopular Congress – the implication can be positive or negative depending on the policies, assets, and time frames in question. For example, the congressional effect, in which markets rally while Congress is at recess, is debatable.5 Congress is least active in January, July, August, and December and yet this recess schedule manifestly has no consistent impact on well-known equity market calendar effects (Chart 15). Chart 15Calendar Effects But No Congressional Calendar Effect Markets under congressional gridlock often outperform markets under single-party sweeps but the difference is small and debatable (Chart 16). Markets dislike both effective congresses that pursue market-unfriendly policies and ineffective congresses that would be pursuing market-friendly policies. The pandemic and recession required an effective congress, bipartisan stimulus resulted, and approval has gone up. Sustaining this approval will require avoiding both deflationary and stagflationary environments in the coming years, as well as gratuitous wars and massive scandals. That will be difficult. Chart 16Sweeps Don’t Always Underperform Gridlock Still, a floor in congressional approval has probably been established over the past decade as the US political establishment has rediscovered proactive fiscal policy at home and nationalism abroad. These two key trends create cross-currents for the dollar. The macroeconomic backdrop for the dollar is bearish but the political and geopolitical backdrop is bullish. At present the dollar stands at a critical juncture. Any increase in global policy uncertainty and geopolitical risk abroad should push the dollar up (Chart 17). Given the dollar-bearish BCA House View, we are therefore neutral and will revisit the issue in our upcoming third quarter outlook report. We are adjusting our equity sector risk matrix. Our new US Equity Strategist, Irene Tunkel, argues convincingly that investors should continue favoring cyclicals but also take a more optimistic outlook on the tech and health sectors. We agree on health in particular since the Biden administration’s policy risks have largely been passed up. We are closing our long materials / short tech trade for a loss of 8.2% and our long fiscal advantage / NASDAQ trade for a loss of 1.3%. We will also close our long consumer staples trade for a gain of 6.5%. Chart 17Relative Policy Uncertainty Rising, Greenback On Edge   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com   Appendix Table A1USPS Trade Table Table A2Political Risk Matrix Table A3Political Capital Index Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets Footnotes 1     See David R. Mayhew, “Is Congress ‘The Broken Branch?,’” Boston University Law Review 89 (2009), 357-69, bu.edu. 2     See Danny Crichton, Chris Miller, and Jordan Schneider, “Labs Over Fabs: How The U.S. Should Invest In The Future Of Semiconductors,” Foreign Policy Research Institute, March 2021, www.fpri.org. 3    See John R. Hibbing and Christopher W. Larimer, “The American Public’s View Of Congress,” Faculty Publications: Political Science 27 (2008), digitalcommons.unl.edu/poliscifacpub/27.  4    See David R. Jones, “Partisan Polarization and the Effect of Congressional Performance Evaluations on Party Brands and American Elections,” Political Research Quarterly 68:4 (2015), 785-801, jstor.org. See also Jones, “Declining Trust In Congress: Effects of Polarization and Consequences for Democracy,” The Forum 13:3 (2015), degruyter.com. 5    Some market participants and researchers have uncovered a “Congressional effect” in which stock market returns are higher on average on days when Congress is on recess than on days when it is in session.   

Highlights Geopolitical risk is trickling back into financial markets. China’s fiscal-and-credit impulse collapsed again. The Global Economic Policy Uncertainty Index is ticking back up after the sharp drop from 2020. All of our proprietary GeoRisk Indicators are elevated or rising. Geopolitical risk often rises during bull markets – the Geopolitical Risk Index can even spike without triggering a bear market or recession. Nevertheless a rise in geopolitical risk is positive for the US dollar, which happens to stand at a critical technical point. The macroeconomic backdrop for the dollar is becoming less bearish given China’s impending slowdown. President Biden’s trip to Europe and summit with Russian President Vladimir Putin will underscore a foreign policy of forming a democratic alliance to confront Russia and China, confirming the secular trend of rising geopolitical risk. Shift to a defensive tactical position. Feature Back in March 2017 we wrote a report, “Donald Trump Is Who We Thought He Was,” in which we reaffirmed our 2016 view that President Trump would succeed in steering the US in the direction of fiscal largesse and trade protectionism. Now it is time for us to do the same with President Biden. Our forecast for Biden rested on the same points: the US would pursue fiscal profligacy and mercantilist trade policy. The recognition of a consistent national policy despite extreme partisan divisions is a testament to the usefulness of macro analysis and the geopolitical method. Trump stole the Democrats’ thunder with his anti-austerity and anti-free trade message. Biden stole it back. It was the median voter in the Rust Belt who was calling the shots all along (after all, Biden would still have won the election without Arizona and Georgia). We did make some qualifications, of course. Biden would maintain a hawkish line on China and Russia but he would reject Trump’s aggressive foreign and trade policy when it came to US allies.1 Biden would restore President Obama’s policy on Iran and immigration but not Russia, where there would be no “diplomatic reset.” And Biden’s fiscal profligacy, unlike Trump’s, would come with tax hikes on corporations and the wealthy … even though they would fall far short of offsetting the new spending. This is what brings us to this week’s report: New developments are confirming this view of the Biden administration. Geopolitical Risk And Bull Markets Chart 1Global Geopolitical Risk And The Dollar In recent weeks Biden has adopted a hawkish policy on China, lowered tensions with Europe, and sought to restore President Obama’s policy of détente with Iran. The jury is still out on relations with Russia – Biden will meet with Putin on June 16 – but we do not expect a 2009-style “reset” that increases engagement. Still, it is too soon to declare a “Biden doctrine” of foreign policy because Biden has not yet faced a major foreign crisis. A major test is coming soon. Biden’s decision to double down on hawkish policy toward China will bring ramifications. His possible deal with Iran faces a range of enemies, including within Iran. His reduction in tensions with Russia is not settled yet. While the specific source and timing of his first major foreign policy crisis is impossible predict, structural tensions are rebuilding. An aggregate of our 13 market-based GeoRisk indicators suggests that global political risk is skyrocketing once again. A sharp spike in the indicator, which is happening now, usually correlates with a dollar rally (Chart 1). This indicator is mean-reverting since it measures the deviation of emerging market currencies, or developed market equity markets, from underlying macroeconomic fundamentals. The implication is positive for the dollar, although the correlation is not always positive. Looking at both the DXY’s level and its rate of change shows periods when the global risk indicator fell yet the dollar stayed strong – and vice versa. The big increase in the indicator over the past week stems mostly from Germany, South Korea, Brazil, and Australia, though all 13 of the indicators are now either elevated or rising, including the China/Taiwan indicators. Some of the increase is due to base effects. As global exports recover, currencies and equities that we monitor are staying weaker than one would expect. This causes the relevant BCA GeoRisk indicator to rise. Base effects from the weak economy in June 2020 will fall out in coming weeks. But the aggregate shows that all of the indicators are either high or rising and, on a country by country level, they are now in established uptrends even aside from base effects. Chart 2Global Policy Uncertainty Revives Meanwhile the global Economic Policy Uncertainty Index is recovering across the world after the drop in uncertainty following the COVID-19 crisis (Chart 2). Policy uncertainty is also linked to the dollar and this indicator shows that it is rising on a secular basis. The Geopolitical Risk Index, maintained by Matteo Iacoviello and a group of academics affiliated with the Policy Uncertainty Index, is also in a secular uptrend, although cyclically it has not recovered from the post-COVID drop-off. It is sensitive to traditional, war-linked geopolitical risk as reported in newspapers. By contrast our proprietary indicators are sensitive to market perceptions of any kind of risk, not just political, both domestic and international. A comparison of the Geopolitical Risk Index with the S&P 500 over the past century shows that a geopolitical crisis may occur at the beginning of a business cycle but it may not be linked with a recession or bear market. Risk can rise, even extravagantly, during economic expansions without causing major pullbacks. But a crisis event certainly can trigger a recession or bear market, particularly if it is tied to the global oil supply, as in the early 1970s, 1980s, and 1990s (Chart 3). Chart 3Secular Rise In Geopolitical Risk Soon To Reassert Itself While geopolitical risk is normally positive for the dollar, the macroeconomic backdrop is negative. The dollar’s attempt to recover earlier this year faltered. This underlying cyclical bearish dollar trend is due to global economic recovery – which will continue – and extravagant American monetary expansion and budget deficits. This is why we have preferred gold – it is a hedge against both geopolitical risk and inflation expectations. Tactically this year we have refrained from betting against the dollar except when building up some safe-haven positions like Japanese yen. Over the medium and long term we expect geopolitical risk to put a floor under the greenback. The bottom line is that the US dollar is at a critical technical crossroads where it could break out or break down. Macro factors suggest a breakdown but the recovery of global policy uncertainty and geopolitical risk suggests the opposite. We remain neutral. A final quantitative indicator of the recovery of geopolitical risk is the performance of global aerospace and defense stocks (Chart 4). Defense shares are rising in absolute and relative terms. Chart 4Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Can The WWII Peace Be Prolonged? Qualitative assessments of geopolitical risk are necessary to explain why risk is on a secular upswing – why drops in the quantitative indicators are temporary and the troughs keep getting higher. Great nations are returning to aggressive competition after a period of relative peace and prosperity. Over the past two decades Russia and China took advantage of America’s preoccupations with the Middle East, the financial crisis, and domestic partisanship in order to build up their global influence. The result is a world in which authority is contested. The current crisis is not merely about the end of the post-Cold War international order. It is much scarier than that. It is about the decay of the post-WWII international order and the return of the centuries-long struggle for global supremacy among Great Powers. The US and European political establishments fear the collapse of the WWII settlement in the face of eroding legitimacy at home and rising challenges from abroad. The 1945 peace settlement gave rise to both a Cold War and a diplomatic system, including the United Nations Security Council, for resolving differences among the great powers. It also gave rise to European integration and various institutions of American “liberal hegemony.” It is this system of managing great power struggle, and not the post-Cold War system of American domination, that lies in danger of unraveling. This is evident from the following points: American preeminence only lasted fifteen years, or at best until the 2008 Georgia war and global financial crisis. The US has been an incoherent wild card for at least 13 years now, almost as long as it was said to be the global empire. Russian antagonism with the West never really ended. In retrospect the 1990s were a hiatus rather than a conclusion of this conflict. China’s geopolitical rise has thawed the frozen conflicts in Asia from the 1940s-50s – i.e. the Chinese civil war, the Hong Kong and Taiwan Strait predicaments, the Korean conflict, Japanese pacifism, and regional battles for political influence and territory. Europe’s inward focus and difficulty projecting power have been a constant, as has its tendency to act as a constraint on America. Only now is Europe getting closer to full independence (which helped trigger Brexit). Geopolitical pressures will remain historically elevated for the foreseeable future because the underlying problem is whether great power struggle can be contained and major wars can be prevented. Specifically the question is whether the US can accommodate China’s rise – and whether China can continue to channel its domestic ambitions into productive uses (i.e. not attempts to create a Greater Chinese and then East Asian empire). The Great Recession killed off the “East Asia miracle” phase of China’s growth. Potential GDP is declining, which undermines social stability and threatens the Communist Party’s legitimacy. The renminbi is on a downtrend that began with the Xi Jinping era. The sharp rally during the COVID crisis is over, as both domestic and international pressures are rising again (Chart 5). Chart 5Biden Administration Review Of China Policy: More China Bashing While the data for China’s domestic labor protests is limited in extent, we can use it as a proxy for domestic instability in lieu of official statistics that were tellingly discontinued back in 2005. The slowdown in credit growth and the cyclical sectors of the economy suggest that domestic political risk is underrated in the lead up to the 2022 leadership rotation (Chart 6). Chart 6China's Domestic Political Risk Will Rise Chart 7Steer Clear Of Taiwan Strait The increasing focus on China’s access to key industrial and technological inputs, the tensions over the Taiwan Strait, and the formation of a Russo-Chinese bloc that is excluded from the West all suggest that the risk to global stability is grave and historic. It is reminiscent of the global power struggles of the seventeenth through early twentieth centuries. The outperformance of Taiwanese equities from 2019-20 reflects strong global demand for advanced semiconductors but the global response to this geopolitical bottleneck is to boost production at home and replace Taiwan. Therefore Taiwan’s comparative advantage will erode even as geopolitical risk rises (Chart 7). The drop in geopolitical tensions during COVID-19 is over, as highlighted above. With the US, EU, and other countries launching probes into whether the virus emerged from a laboratory leak in China – contrary to what their publics were told last year – it is likely that a period of national recriminations has begun. There is a substantial risk of nationalism, xenophobia, and jingoism emerging along with new sources of instability. An Alliance Of Democracies The Biden administration’s attempt to restore liberal hegemony across the world requires a period of alliance refurbishment with the Europeans. That is the purpose of his current trip to the UK, Belgium, and Switzerland. But diplomacy only goes so far. The structural factor that has changed is the willingness of the West to utilize government in the economic sphere, i.e. fiscal proactivity. Infrastructure spending and industrial policy, at the service of national security as well as demand-side stimulus, are the order of the day. This revolution in economic policy – a return to Big Government in the West – poses a threat to the authoritarian powers, which have benefited in recent decades by using central strategic planning to take advantage of the West’s democratic and laissez-faire governance. If the West restores a degree of central government – and central coordination via NATO and other institutions – then Beijing and Moscow will face greater pressure on their economies and fewer strategic options. About 16 American allies fall short of the 2% of GDP target for annual defense spending – ranging from Italy to Canada to Germany to Japan. However, recent trends show that defense spending did indeed increase during the Trump administration (Chart 8). Chart 8NATO Boosts Defense Spending The European Union as a whole has added $50 billion to the annual total over the past five years. A discernible rise in defense spending is taking place even in Germany (Chart 9). The same point could be made for Japan, which is significantly boosting defense spending (as a share of output) after decades of saying it would do so without following through. A major reason for the American political establishment’s rejection of President Trump was the risk he posed to the trans-Atlantic alliance. A decline in NATO and US-EU ties would dramatically undermine European security and ultimately American security. Hence Biden is adopting the Trump administration’s hawkish approach to trade with China but winding down the trade war with Europe (Chart 10). Chart 9Europe Spending More On Guns Chart 10US Ends Trade War With Europe? A multilateral deal aimed at setting a floor in global corporate taxes rates is intended to prevent the US and Europe from undercutting each other – and to ensure governments have sufficient funding to maintain social spending and reduce income inequality (Chart 11). Inequality is seen as having vitiated sociopolitical stability and trust in government in the democracies. Chart 11‘Global’ Corporate Tax Deal Shows Return Of Big Government, Attempt To Reduce Inequality In The West Risks To Biden’s Diplomacy It is possible that Biden’s attempt to restore US alliances will go nowhere over the course of his four-year term in office. The Europeans may well remain risk averse despite their initial signals of willingness to work with Biden to tackle China’s and Russia’s challenges to the western system. The Germans flatly rejected both Biden and Trump on the Nord Stream II natural gas pipeline linkage with Russia, which is virtually complete and which strengthens the foundation of Russo-German engagement (more on this below). The US’s lack of international reliability – given the potential of another partisan reversal in four years – makes it very hard for countries to make any sacrifices on behalf of US initiatives. The US’s profound domestic divisions have only slightly abated since the crises of 2020 and could easily flare up again. A major outbreak of domestic instability could distract Biden from the foreign policy game.2 However, American incapacity is a risk, not our base case, over the coming years. We expect the US economic stimulus to stabilize the country enough that the internal political crisis will be contained and the US will continue to play a global role. The “Civil War Lite” has mostly concluded, excepting one or two aftershocks, and the US is entering into a “Reconstruction Lite” era. The implication is negative for China and Russia, as they will now have to confront an America that, if not wholly unified, is at least recovering. Congress’s impending passage of the Innovation and Competition Act – notably through regular legislative order and bipartisan compromise – is case in point. The Senate has already passed this approximately $250 billion smorgasbord of industrial policy, supply chain resilience, and alliance refurbishment. It will allot around $50 billion to the domestic semiconductor industry almost immediately as well as $17 billion to DARPA, $81 billion for federal research and development through the National Science Foundation, which includes $29 billion for education in science, technology, engineering, and mathematics, and other initiatives (Table 1). Table 1Peak Polarization: US Congress Passes Bipartisan ‘Innovation And Competition Act’ To Counter China With the combination of foreign competition, the political establishment’s need to distract from domestic divisions, and the benefit of debt monetization courtesy of the Federal Reserve, the US is likely to achieve some notable successes in pushing back against China and Russia. On the diplomatic front, the US will meet with some success because the European and Asian allies do not wish to see the US embrace nationalism and isolationism. They have their own interests in deterring Russia and China. Lack Of Engagement With Russia Russian leadership has dealt with the country’s structural weaknesses by adopting aggressive foreign policy. At some point either the weaknesses or the foreign policy will create a crisis that will undermine the current regime – after all, Russia has greatly lagged the West in economic development and quality of life (Chart 12). But President Putin has been successful at improving the country’s wealth and status from its miserably low base in the 1990s and this has preserved sociopolitical stability so far. Chart 12Russia's Domestic Political Risk It is debatable whether US policy toward Russia ever really changed under President Trump, but there has certainly not been a change in strategy from Russia. Thus investors should expect US-Russia antagonism to continue after Biden’s summit with Putin even if there is an ostensible improvement. The fundamental purpose of Putin’s strategy has been to salvage the Russian empire after the Soviet collapse, ensure that all world powers recognize Russia’s veto power over major global policies and initiatives, and establish a strong strategic position for the coming decades as Russia’s demographic decline takes its toll. A key component of the strategy has been to increase economic self-sufficiency and reduce exposure to US sanctions. Since the invasion of Ukraine in 2014, Putin has rapidly increased Russia’s foreign exchange reserves so as to buffer against shocks (Chart 13). Chart 13Russia Fortified Against US Sanctions Putin has also reduced Russia’s reliance on the US dollar to about 22% (Chart 14), primarily by substituting the euro and gold. Russia will not be willing or able to purge US dollars from its system entirely but it has been able to limit America’s ability to hurt Russia by constricting access to dollars and the dollar-based global financial architecture. Russian Finance Minister Anton Siluanov highlighted this process ahead of the Biden-Putin summit by declaring that the National Wealth Fund will divest of its remaining $40 billion of its US dollar holdings. Chart 14Russia Diversifies From USD In general this year, Russia is highlighting its various advantages: its resilience against US sanctions, its ability to re-invade Ukraine, its ability to escalate its military presence in Belarus and the Black Sea, and its ability to conduct or condone cyberattacks on vital American food and fuel supplies (Chart 15). Meanwhile the US is suffering from deep political divisions at home and strategic incoherence abroad and these are only starting to be mended by domestic economic stimulus and alliance refurbishment. Chart 15Cyber Security Stocks Recover Europe’s risk-aversion when it comes to strategic confrontation with Russia, and the lack of stability in US-Russia relations, means that investors should not chase Russian currency or financial assets amid the cyclical commodity rally. Investors should also expect risk premiums to remain high in developing European economies relative to their developed counterparts. This is true despite the fact that developed market Europe’s outperformance relative to emerging Europe recently peaked and rolled over. From a technical perspective this outperformance looks to subside but geopolitical tensions can easily escalate in the near term, particularly in advance of the Russian and German elections in September (Chart 16). Chart 16Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Europe trades in line with EUR-RUB and these pair trades all correspond closely to geopolitical tensions with Russia (Chart 17). A notable exception is the UK, whose stock market looks attractive relative to eastern Europe and is much more secure from any geopolitical crisis in this region (Chart 17, bottom panel). The pound is particularly attractive against the Czech koruna, as Russo-Czech tensions have heated up in advance of October’s legislative election there (Chart 18). Chart 17Long UK Versus Eastern Europe Chart 18Long GBP Versus CZK Meanwhile Russia and China have grown closer together out of strategic necessity. Germany’s Election And Stance Toward Russia Germany’s position on Russia is now critical. The decision to complete the Nord Stream II pipeline against American wishes either means that the Biden administration can be safely ignored – since it prizes multilateralism and alliances above all things and is therefore toothless when opposed – or it means that German will aim to compensate the Americans in some other area of strategic concern. Washington is clearly attempting to rally the Germans to its side with regard to putting pressure on China over its trade practices and human rights. This could be the avenue for the US and Germany to tighten their bond despite the new milestone in German-Russia relations. The US may call on Germany to stand up for eastern Europe against Russian aggression but on that front Berlin will continue to disappoint. It has no desire to be drawn into a new Cold War given that the last one resulted in the partition of Germany. The implication is negative for China on one hand and eastern Europe on the other. Germany’s federal election on September 26 will be important because it will determine who will succeed Chancellor Angela Merkel, both in Germany and on the European and global stage. The ruling Christian Democratic Union (CDU) is hoping to ride Merkel’s coattails to another term in charge of the government. But they are likely to rule alongside the Greens, who have surged in opinion polls in recent years. The state election in Saxony-Anhalt over the weekend saw the CDU win 37% of the popular vote, better than any recent result, while Germany’s second major party, the Social Democrats, continued their decline (Table 2). The far-right Alternative for Germany won 21% of the vote, a downshift from 2016, while the Greens won 6% of the vote, a slight improvement from 2016. All parties underperformed opinion polling except the CDU (Chart 19). Table 2Saxony-Anhalt Election Results Chart 19Germany: Conservatives Outperform In Final State Election Before Federal Vote, But Face Challenges Chart 20Germany: Greens Will Outperform in 2021 Vote The implication is still not excellent for the CDU. Saxony-Anhalt is a middling German state, a CDU stronghold, and a state with a popular CDU leader. So it is not representative of the national campaign ahead of September. The latest nationwide opinion polling puts the CDU at around 25% support. They are neck-and-neck with the Greens. The country’s left- and right-leaning ideological blocs are also evenly balanced in opinion polls (Chart 20). A potential concern for the CDU is that the Free Democratic Party is ticking up in national polls, which gives them the potential to steal conservative votes. Betting markets are manifestly underrating the chance that Annalena Baerbock and the Greens take over the chancellorship (Charts 21A and 21B). We still give a subjective 35% chance that the Greens will lead the next German government without the CDU, a 30% that the Greens will lead with the CDU, and a 25% chance that the CDU retains power but forms a coalition with the Greens. A coalition government would moderate the Greens’ ambitious agenda of raising taxes on carbon emissions, wealth, the financial sector, and Big Tech. The CDU has already shifted in a pro-environmental, fiscally proactive direction. Chart 21AGerman Greens Will Recover Chart 21BGerman Greens Still Underrated No matter what the German election will support fiscal spending and European solidarity, which is positive for the euro and regional equities over the next 12 to 24 months. However, the Greens would pursue a more confrontational stance toward Russia, a petro-state whose special relations with the German establishment have impeded the transition to carbon neutrality. Latin America’s Troubles A final aspect of Biden’s agenda deserves some attention: immigration and the Mexican border. Obviously this one of the areas where Biden starkly differs from Trump, unlike on Europe and China, as mentioned above. Vice President Kamala Harris recently came back from a trip to Guatemala and Mexico that received negative media attention. Harris has been put in charge of managing the border crisis, the surge in immigrant arrivals over 2020-21, both to give her some foreign policy experience and to manage the public outcry. Despite telling immigrants explicitly “Do not come,” Harris has no power to deter the influx at a time when the US economy is fired up on historic economic stimulus and the Democratic Party has cut back on all manner of border and immigration enforcement. From a macro perspective the real story is the collapse of political and geopolitical risk in Mexico. From 2016-20 Mexico faced a protectionist onslaught from the Trump administration and then a left-wing supermajority in Congress. But these structural risks have dissipated with the USMCA trade deal and the inability of President Andrés Manuel López Obrador to follow through with anti-market reforms, as we highlighted in reports in October and April. The midterm election deprived the ruling MORENA party of its single-party majority in the Chamber of Deputies, the lower house of the legislature (Chart 22). AMLO is now politically constrained – he will not be able to revive state control over the energy and power sectors. Chart 22Mexican Midterm Election Constrained Left-Wing Populism, Political Risk Chart 23Buy Mexico (And Canada) On US Stimulus American monetary and fiscal stimulus, and the supply-chain shift away from China, also provide tailwinds for Mexico. In short, the Mexican election adds the final piece to one of our key themes stemming from the Biden administration, US populism, and US-China tensions: favor Mexico and Canada (Chart 23). A further implication is that Mexico should outperform Brazil in the equity space. Brazil is closely linked to China’s credit cycle and metals prices, which are slated to turn down as a result of Chinese policy tightening. Mexico is linked to the US economy and oil prices (Chart 24). While our trade stopped out at -5% last week we still favor the underlying view. Brazilian political risk and unsustainable debt dynamics will continue to weigh on the currency and equities until political change is cemented in the 2022 election and the new government is then forced by financial market riots into undertaking structural reforms. Chart 24Brazil's Troubles Not Truly Over - Mexico Will Outperform Elsewhere in Latin America, the rise of a militant left-wing populist to the presidency in a contested election in Peru, and the ongoing social unrest in Colombia and Chile, are less significant than the abrupt slowdown in China’s credit growth (Charts 25A and 25B). According to our COVID-19 Social Stability Index, investors should favor Mexico. Turkey, the Philippines, South Africa, Colombia, and Brazil are the most likely to see substantial social instability according to this ranking system (Table 3). Chart 25AMexico To Outperform Latin America Chart 25BChina’s Slowdown Will Hit South America Table 3Post-COVID Emerging Market Social Unrest Only Just Beginning Investment Takeaways Close long emerging markets relative to developed markets for a loss of 6.8% – this is a strategic trade that we will revisit but it faces challenges in the near term due to China’s slowdown (Chart 26). Go long Mexican equities relative to emerging markets on a strategic time frame. Our long Mexico / short Brazil trade hit the stop loss at 5% but the technical profile and investment thesis are still sound over the short and medium term. Chart 26China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets Chart 27Relative Uncertainty And Safe Havens China’s sharp fiscal-and-credit slowdown suggests that investors should reduce risk exposure, take a defensive tactical positioning, and wait for China’s policy tightening to be priced before buying risky assets. Our geopolitical method suggests the dollar will rise, while macro fundamentals are becoming less dollar-bearish due to China. We are neutral for now and will reassess for our third quarter forecast later this month. If US policy uncertainty falls relative to global uncertainty then the EUR-USD will also fall and safe-haven assets like Swiss bonds will gain a bid (Chart 27). Gold is an excellent haven amid medium-term geopolitical and inflation risks but we recommend closing our long silver trade for a gain of 4.5%. Disfavor emerging Europe relative to developed Europe, where heavy discounts can persist due to geopolitical risk premiums. We will reassess after the Russian Duma election in September. Go long GBP-CZK. Close the Euro “laggards” trade. Go long an equal-weighted basket of euros and US dollars relative to the Chinese renminbi. Short the TWD-USD on a strategic basis. Prefer South Korea to Taiwan – while the semiconductor splurge favors Taiwan, investors should diversify away from the island that lies at the epicenter of global geopolitical risk. Close long defense relative to cyber stocks for a gain of 9.8%. This was a geopolitical “back to work” trade but the cyber rebound is now significant enough to warrant closing this trade.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Trump’s policy toward Russia is an excellent example of geopolitical constraints. Despite any personal preferences in favor of closer ties with Russia, Trump and his administration ultimately reaffirmed Article 5 of NATO, authorized the sale of lethal weapons to Ukraine, and deployed US troops to Poland and the Czech Republic. 2 As just one example, given the controversial and contested US election of 2020, it is possible that a major terrorist attack could occur. Neither wing of America’s ideological fringes has a monopoly on fanaticism and violence. Meanwhile foreign powers stand to benefit from US civil strife. A truly disruptive sequence of events in the US in the coming years could lead to greater political instability in the US and a period in which global powers would be able to do what they want without having to deal with Biden’s attempt to regroup with Europe and restore some semblance of a global police force. The US would fall behind in foreign affairs, leaving power vacuums in various regions that would see new sources of political and geopolitical risk crop up. Then the US would struggle to catch up, with another set of destabilizing consequences.