India
Executive Summary Macron Still Favored, But Le Pen Cannot Be Ruled Out Macron is still favored to win the French election but Le Pen’s odds are 45%. Le Pen would halt France’s neoliberal structural reforms, paralyze EU policymaking, and help Russia’s leverage in Ukraine. But she would lack legislative support and would not fatally wound the EU or NATO. European political risk will remain high in Germany, Italy, and Spain. Favor UK equities on a relative basis. Financial markets are complacent about Russian geopolitical risk again. Steer clear of eastern European assets. Do not bottom feed in Chinese stocks. China faces social unrest. North Korean geopolitical risk is back. Australia’s election is an opportunity, not a risk. Stay bullish on Latin America. Prefer Brazil over India. Stay negative on Turkey and Pakistan. Trade Recommendation Inception Date Return TACTICALLY LONG US 10-YEAR TREASURY 2022-04-14 Bottom Line: Go long the US 10-year Treasury on geopolitical risk and near-term peak in inflation. Feature Last year we declared that European political risk had reached a bottom and had nowhere to go but up. Great power rivalry with Russia primarily drove this view but we also argued that our structural theme of populism and nationalism would feed into it. Related Report Geopolitical StrategyThe Geopolitical Consequences Of The Ukraine War In other words, the triumph of the center-left political establishment in the aftermath of Covid-19 would be temporary. The narrow French presidential race highlights this trend. President Emmanuel Macron is still favored but Marine Le Pen, his far-right, anti-establishment opponent, could pull off an upset victory on April 24. The one thing investors can be sure of is that France’s ability to pursue neoliberal structural reforms will be limited even if Macron wins, since he will lack the mandate he received in 2017. Our GeoRisk Indicators this month suggest that global political trends are feeding into today’s stagflationary macroeconomic context. Market Complacent About Russia Again Global financial markets are becoming complacent about European security once again. Markets have begun to price a slightly lower geopolitical risk for Russia after it withdrew military forces from around Kyiv in an open admission that it failed to overthrow the government. However, western sanctions are rising, not falling, and Russia’s retreat from Kyiv means it will need to be more aggressive in the south and east (Chart 1). Chart 1Russia: GeoRisk Indicator Russia has not achieved its core aim of a militarily neutral Ukraine – so it will escalate the military effort to achieve its aim. Any military failure in the east and south would humiliate the Putin regime and make it more unpredictable and dangerous. The West has doubled down on providing Ukraine with arms and hitting Russia with sanctions (e.g. imposing a ban on Russian coal). Germany prevented an overnight ban on Russian oil and natural gas imports but the EU is diversifying away from Russian energy rapidly. Sanctions that eat away at Russia’s export revenues will force it to take a more aggressive posture now, to achieve a favorable ceasefire before funding runs out. Sweden and Finland are reviewing whether to join NATO, with recommendations due by June. Russia will rattle sabers to underscore its red line against NATO enlargement and will continue to threaten “serious military-political repercussions” if these states try to join. We would guess they would remain neutral as a decision to join NATO could lead to a larger war. Bottom Line: Global equities will remain volatile due to a second phase of the war and potential Russian threats against Ukraine’s backers. European equities and currency, especially in emerging Europe, will suffer a persistent risk premium until a ceasefire is concluded. What If Le Pen Wins In France? By contrast with the war in Ukraine, the French election is a short-term source of political risk. A surprise Le Pen victory would shake up the European political establishment but investors should bear in mind that it would not revolutionize the continent or the world, as Le Pen’s powers would be limited. Unlike President Trump in 2017, she would not take office with her party gaining full control of the legislature. Le Pen rallied into the first round of the election on April 10, garnering 23% of the vote, up from 21% in 2017. This is not a huge increase in support but her odds of winning this time are much better than in 2017 because the country has suffered a series of material shocks to its stability. Voters are less enthusiastic about President Macron and his centrist political platform. Macron, the favorite of the political establishment, received 28% of the first-round vote, up from 24% in 2017. Thus he cannot be said to have disappointed expectations, though he is vulnerable. The euro remains weak against the dollar and unlikely to rally until Russian geopolitical risk and French political risk are decided. The market is not fully pricing French risk as things stand (Chart 2). Chart 2France: GeoRisk Indicator The first-round election results show mixed trends. The political establishment suffered but so did the right-wing parties (Table 1). The main explanation is that left-wing, anti-establishment candidate Jean-Luc Mélenchon beat expectations while the center-right Republicans collapsed. Macron is leading Le Pen by only five percentage points in the second-round opinion polling as we go to press (Chart 3). Macron has maintained this gap throughout the race so far and both candidates are very well known to voters. But Le Pen demonstrated significant momentum in the first round and momentum should never be underestimated. Table 1Results Of France’s First-Round Election Chart 3French Election: Macron Maintains Lead Are the polls accurate? Anti-establishment candidates outperformed their polling by 7 percentage points in the first round. Macron, the right-wing candidates, and the pro-establishment candidates all underperformed their March and April polls (Chart 4). Hence investors should expect polls to underrate Le Pen in the second round. Chart 4French Polls Fairly Accurate Versus First-Round Results Given the above points, it is critical to determine which candidate will gather the most support from voters whose first preference got knocked out in the first round. The strength of anti-establishment feeling means that the incumbent is vulnerable while ideological camps may not be as predictable as usual. Mélenchon has asked his voters not to give a single vote to Le Pen but he has not endorsed Macron. About 21% of his supporters say they will vote for Le Pen. Only a little more of them said they would vote for Macron, at 27% (Chart 5). Chart 5To Whom Will Voters Drift? Diagram 1, courtesy of our European Investment Strategy, illustrates that Macron is favored in both scenarios but Le Pen comes within striking distance under certain conservative assumptions about vote switching. Diagram 1Extrapolating France’s First-Round Election To The Second Round Macron’s approval rating has improved since the pandemic. This is unlike the situation in other liberal democracies (Chart 6). Chart 6Macron Handled Pandemic Reasonably Well The pandemic is fading and the economy reviving. Unemployment has fallen from 8.9% to 7.4% over the course of the pandemic. Real wage growth, at 5.8%, is higher than the 3.3% that prevailed when Macron took office in 2017 (Chart 7). Chart 7Real Wages A Boon For Macron But these positives do not rule out a Le Pen surprise. The nation has suffered not one but a series of historic shocks – the pandemic, inflation, and the war in Ukraine. Inflation is rising at 5.1%, pushing the “Misery Index” (inflation plus unemployment) to 12%, higher than when Macron took office, even if lower than the EU average (Chart 8). Chart 8Misery Index The Key Threat To Macron Le Pen has moderated her populist message and rebranded her party in recent years to better align with the median French voter. She claims that she will not pursue a withdrawal from the European Union or the Euro Area currency union. This puts her on the right side of the one issue that disqualified her from the presidency in the past. Yet French trust in the EU is declining markedly, which suggests that Le Pen is in step with the median voter on wanting greater French autonomy (Chart 9). Le Pen’s well-known sympathy toward Vladimir Putin and Russia is a liability in the context of Russian aggression in Ukraine. Only 35% of French people had a positive opinion of Russia back in 2019, whereas 50% had a favorable view of NATO, and the gap has likely grown as a result of the invasion (Chart 10). However, the historic bout of inflation suggests that economic policy could be the most salient issue for voters rather than foreign policy. Chart 9Le Pen Only Electable Because She Accepted Europe Chart 10Le Pen’s NATO Stance Not Disqualifying Le Pen’s economic platform is fiscally liberal and protectionist, which will appeal to voters upset over the rising cost of living and pressures of globalization. She wants to cut the income tax and value-added tax, while reversing Macron’s attempt at raising the retirement age and reforming the pension system. France’s tax rates on income, and on gasoline and diesel, are higher than the OECD average. In other words, Macron is running on painful structural reform while Le Pen is running on fiscal largesse. This is another reason to take seriously the risk of a Le Pen victory. What should investors expect if Le Pen pulls off an upset? France’s attempt at neoliberal structural reforms would grind to a halt. While Le Pen may not be able to pass domestic legislation, she would be able to halt the implementation of Macron’s reforms. Productivity and the fiscal outlook would suffer. Le Pen’s ability to change domestic policy will be limited by the National Assembly, which is due for elections from June 12-19. Her party, the National Rally (formerly the Front National), has never won more than 20% of local elections and performed poorly in the 2017 legislative vote. Investors should wait to see the results of the legislative election before drawing any conclusions about Le Pen’s ability to change domestic policy. France’s foreign policy would diverge from Europe’s. If Le Pen takes the presidency, she will put France at odds with Brussels, Berlin, and Washington, in much the same way that President Trump did. She would paralyze European policymaking. Yet Le Pen alone cannot take France out of the EU. The French public’s negative view of the EU is not the same as a majority desire to leave the bloc – and support for the euro currency stands at 69%. Le Pen does not have the support for “Frexit,” French exit from the EU. Moreover European states face immense pressures to work together in the context of global Great Power Rivalry. Independently they are small compared to the US, Russia, and China. Hence the EU will continue to consolidate as a geopolitical entity over the long run. Russia, however, would benefit from Le Pen’s presidency in the context of Ukraine ceasefire talks. EU sanctions efforts would freeze in place. Le Pen could try to take France out of NATO, though she would face extreme opposition from the military and political establishment. If she succeeded on her own executive authority, the result would be a division among NATO’s ranks in the face of Russia. This cannot be ruled out: if the US and Russia are fighting a new Cold War, then it is not unfathomable that France would revert to its Cold War posture of strategic independence. However, while France withdrew from NATO’s integrated military command from 1966-2009, it never withdrew fully from the alliance and was always still implicated in mutual defense. In today’s context, NATO’s deterrent capability would not be much diminished but Le Pen’s administration would be isolated. Russia would be unable to give any material support to France’s economy or national defense. Bottom Line: Macron is still favored for re-election but investors should upgrade Le Pen’s chances to a subjective 45%. If she wins, the euro will suffer a temporary pullback and French government bond spreads will widen over German bunds. The medium-term view on French equities and bonds will depend on her political capability, which depends on the outcome of the legislative election from June 12-19. She will likely be stymied at home and only capable of tinkering with foreign policy. But if she has legislative support, her agenda is fiscally stimulative and would produce a short-term sugar high for French corporate earnings. However, it would be negative for long-term productivity. UK, Italy, Spain: Who Else Faces Populism? Chart 11Rest Of Europe: GeoRisk Indicators Between Russian geopolitical risk and French political risk, other European countries are likely to see their own geopolitical risk premium rise (Chart 11). But these countries have their own domestic political dynamics that contribute to the reemergence of European political risk. Germany’s domestic political risk is relatively low but it faces continued geopolitical risk in the form of Russia tensions, China’s faltering economy, and potentially French populism (Chart 11, top panel). In Italy, the national unity coalition that took shape under Prime Minister Mario Draghi was an expedient undertaken in the face of the pandemic. As the pandemic fades, a backlash will take shape among the large group of voters who oppose the EU and Italian political establishment. The Italian establishment has distributed the EU recovery funds and secured the Italian presidency as a check on future populist governments. But it may not be able to do more than that before the next general election in June 2023, which means that populism will reemerge and increase the political risk premium in Italian assets going forward (Chart 11, second panel). Spain is still a “divided nation” susceptible to a rise in political risk ahead of the general election due by December 10, 2023. However, the conservative People’s Party, the chief opposition party, has suffered from renewed infighting, which gives temporary relief to the ruling Socialist Worker’s Party of Prime Minister Pedro Sanchez. The Russia-Ukraine issue caused some minor divisions within the government but they are not yet leading to any major political crisis, as nationwide pro-Ukraine sentiment is largely unified. The Andalusia regional election, which is expected this November, will be a check point for the People’s Party’s new leadership and a test run for next year’s general election. Andalusia is the most populous autonomous community in Spain, consisting about 17% of the seats in the congress (the lower house). The risk for Sanchez and the Socialists is that the opposition has a strong popular base and this fact combined with the stagflationary backdrop will keep political polarization high and undermine the government’s staying power (Chart 11, third panel). While Prime Minister Boris Johnson has survived the scandal over attending social events during Covid lockdowns, as we expected, nevertheless the Labour Party is starting to make a comeback that will gain momentum ahead of the 2024 general election. Labour is unlikely to embrace fiscal austerity or attempt to reverse Brexit anytime soon. Hence the UK’s inflationary backdrop will persist (Chart 11, fourth panel). Bottom Line: European political risk has bottomed and will rise in the coming months and years, although the EU and Eurozone will survive. We still favor UK equities over developed market equities (excluding the US) because they are heavily tilted toward consumer staples and energy sectors. Stay long GBP-CZK. Favor European defense stocks over tech. Prefer Spanish stocks over Italian. China: Social Unrest More Likely China’s historic confluence of internal and external risks continues – and hence it is too soon for global investors to try to bottom-feed on Chinese investable equities (Chart 12). A tactical opportunity might emerge for non-US investors in 2023 but now is not the right time to buy. Chart 12China: GeoRisk Indicator In domestic politics, the reversion to autocracy under Xi is exacerbating the economic slowdown. True, Beijing is stimulating the economy by means of its traditional monetary and fiscal tools. The latest data show that the total social financing impulse is reviving, primarily on the back of local government bonds (Chart 13). Yet overall social financing is weaker because private sector sentiment remains downbeat. The government is pursuing excessively stringent social restrictions in the face of the pandemic. Beijing is doubling down on “Covid Zero” policy by locking down massive cities such as Shanghai. The restrictions will fail to prevent the virus from spreading. They are likely to engender social unrest, which we flagged as our top “Black Swan” risk this year and is looking more likely. Lockdowns will also obstruct production and global supply chains, pushing up global goods inflation. Meanwhile the property sector continues to slump on the back of weak domestic demand, large debt levels, excess capacity, regulatory scrutiny, and negative sentiment. Consumer borrowing appetite and general animal spirits are weak in the face of the pandemic and repressive political environment (Chart 14). Chart 13China's Stimulus Has Clearly Arrived Chart 14Yet Chinese Animal Spirits Still Suffering Hence China will be exporting slow growth and inflation – stagflation – to the rest of the world until after the party congress. At that point President Xi will feel politically secure enough to “let 100 flowers bloom” and try to improve economic sentiment at home and abroad. This will be a temporary phenomenon (as were the original 100 flowers under Chairman Mao) but it will be notable for 2023. In foreign politics, Russia’s attack on Ukraine has accelerated the process of Russo-Chinese alliance formation. This partnership will hasten US containment strategy toward China and impose a much faster economic transition on China as it pursues self-sufficiency. The result will be a revival of US-China tensions. The implications are negative for the rest of Asia Pacific: Taiwanese geopolitical risk will continue rising for reasons we have outlined in previous reports. In addition, Taiwanese equities are finally starting to fall off from the pandemic-induced semiconductor rally (Chart 15). The US and others are also pursuing semiconductor supply security, which will reduce Taiwan’s comparative advantage. Chart 15Taiwan: GeoRisk Indicator South Korea faces paralysis and rising tensions with North Korea. The presidential election on May 9 brought the conservatives back into the Blue House. The conservative People Power Party’s candidate, Yoon Suk-yeol, eked out a narrow victory that leaves him without much political capital. His hands are also tied by the National Assembly, at least for the next two years. He will attempt to reorient South Korean foreign policy toward the US alliance and away from China. He will walk away from the “Moonshine” policy of engagement with North Korea, which yielded no fruit over the past five years. North Korea has responded by threatening a nuclear missile test, restarting intercontinental ballistic missile tests for the first time since 2017, and adopting a more aggressive nuclear deterrence policy in which any South Korean attack will ostensibly be punished by a massive nuclear strike. Tensions on the peninsula are set to rise (Chart 16). Three US aircraft carrier groups are around Japan today, despite the war in Europe (where two are placed), suggesting high threat levels. Chart 16South Korea: GeoRisk Indicator Australia’s elections present opportunity rather than risk. Prime Minister Scott Morrison formally scheduled them for May 21. The Australian Labor Party is leading in public opinion and will perform well. The election threatens a change of parties but not a drastic change in national policy – populist parties are weak. No major improvement in China relations should be expected. Any temporary improvement, as with the Biden administration, will be subject to reversal due to China’s long-term challenge to the liberal international order. Cyclically the Australian dollar and equities stand to benefit from the global commodity upcycle as well as relative geopolitical security due to American security guarantees (Chart 17). Chart 17Australia: GeoRisk Indicator Bottom Line: China’s reversion to autocracy will keep global sentiment negative on Chinese equities until 2023 at earliest. Stay short the renminbi and Taiwanese dollar. Favor the Japanese yen over the Korean won. Favor South Korean over Taiwanese equities. Look favorably on the Australian dollar. Turkey, South Africa, And … Canada Turkish geopolitical risk will remain elevated in the context of a rampant Russia, NATO’s revival and tensions with Russia, the threat of commerce destruction and accidents in the Black Sea region, domestic economic mismanagement, foreign military adventures, and the threat posed to the aging Erdogan regime by the political opposition in the wake of the pandemic and the lead-up to the 2023 elections (Chart 18). Chart 18Turkey: GeoRisk Indicator While we are tactically bullish on South African equities and currency, we expect South African political risk to rise steadily into the 2024 general election. Almost a year has passed since the civil unrest episode of 2021. Covid-19 lockdowns have been lifted and the national state of disaster has ended, which has helped quell social tensions. This is evident in the decline of our South Africa GeoRisk indicator from 2021 highs (Chart 19). While fiscal austerity is under way in South Africa, we have argued that fiscal policy will reverse course in time for the 2024 election. In this year’s fiscal budget, the budget deficit is projected to narrow from -6% to -4.2% over the next two years. Government has increased tax revenue collection through structural reforms that are rooting out corruption and wasteful expenditure. But the ANC will have to tap into government spending to shore up lost support come 2024. Thus South Africa benefits tactically from commodity prices but cyclically the currency is vulnerable. Chart 19South Africa: GeoRisk Indicator Canadian political risk will rise but that should not deter investors from favoring Canadian assets that are not exposed to the property bubble. Prime Minister Justin Trudeau has had a net negative approval rating since early 2021 and his government is losing political capital due to inflation, social unrest, and rising difficulties with housing affordability (Chart 20). While he does not face an election until 2025, the Conservative Party is developing more effective messaging. Chart 20Canada: GeoRisk Indicator India Will Stay Neutral But Lean Toward The West Chart 21Sino-Pak Alliance’s Geopolitical Power Is Thrice That Of India US President Joe Biden has openly expressed his administration’s displeasure regarding India’s response to Russia’s invasion of Ukraine. This has led many to question the strength of Indo-US relations and the direction of India’s geopolitical alignments. To complicate matters, China’s overtures towards India have turned positive lately, leading clients to ask if a realignment in Indo-China relations is nigh. To accurately assess India’s long-term geopolitical propensities, it is important to draw a distinction between ‘cyclical’ and ‘structural’ dynamics that are at play today. Such a distinction yields crystal-clear answers about India’s strategic geopolitical leanings. In specific: Indo-US Relations Will Strengthen On A Strategic Horizon: As the US’s and China’s grand strategies collide, minor and major geopolitical earthquakes are bound to take place in South Asia and the Indo-Pacific. Against this backdrop, India will strategically align with the US to strengthen its hand in the region (Chart 21). While the Russo-Ukrainian war is a major global geopolitical event, for India this is a side-show at best. True, India will retain aspects of its historic good relations with Russia. Yet countering China’s encirclement of India is a far more fundamental concern for India. Since Russia has broken with Europe, and China cannot reject Russia’s alliance, India will gradually align with the US and its allies. India And China Will End Up As A Conflicting Dyad: Strategic conflict between the two Asian powers is likely because China’s naval development and its Eurasian strategy threaten India’s national security and geopolitical imperatives, while India’s alliances are adding to China’s distrust of India. Thus any improvement in Sino-Indian diplomatic relations will be short-lived. The US will constantly provide leeway for India in its attempts to court India as a key player in the containment strategy against China. The US and its allies are the premier maritime powers and upholders of the liberal world order – India serves its national interest better by joining them rather than joining China in a risky attempt to confront the US navy and revolutionize the world order. Indo-Russian Relations Are Bound To Fade In The Long Run: India will lean towards the US over the next few years for reasons of security and economics. But India’s movement into America’s sphere of influence will be slow – and that is by design. India is testing waters with America through networks like the Quadrilateral Dialogue. It sees its historic relationship with Russia as a matter of necessity in the short run and a useful diversification strategy in the long run. True, India will maintain a trading relationship with Russia for defense goods and cheap oil. But this trade will be transactional and is not reason enough for India to join Russia and China in opposing US global leadership. While these factors will mean that Indo-Russian relations are amicable over a cyclical horizon, this relationship is bound to fade over a strategic horizon as China and Russia grow closer and the US pursues its grand strategy of countering China and Russia. Bottom Line: India may appear to be neutral about the Russo-Ukrainian war but India will shed its historical stance of neutrality and veer towards America’s sphere of influence on a strategic timeframe. India is fully aware of its strategic importance to both the American camp and the Russo-Chinese camp. It thus has the luxury of making its leanings explicit after extracting most from both sides. Long Brazil / Short India Brazil’s equity markets have been on a tear. MSCI Brazil has outperformed MSCI EM by 49% in 2022 YTD. Brazil’s markets have done well because Brazil is a commodity exporter and the war in Ukraine has little bearing on faraway Latin America. This rally will have legs although Brazil’s political risks will likely pick back up in advance of the election (Chart 22). The reduction in Brazil’s geopolitical risk so far this year has been driven mainly by the fact that the currency has bounced on the surge in commodity prices. In addition, former President Lula da Silva is the current favorite to win the 2022 presidential elections – Lula is a known quantity and not repugnant to global financial institutions (Chart 23). Chart 22Brazil's Markets Have Benefitted From Rising Commodity Prices Chart 23Brazil: Watch Out For Political Impact Of Commodity Prices Whilst there is no denying that the first-round effects of the Ukraine war have been positive for Brazil, there is a need to watch out for the second-round effects of the war as Latin America’s largest economy heads towards elections. Surging prices will affect two key constituencies in Brazil: consumers and farmers. Consumer price inflation in Brazil has been ascendant and adding to Brazil’s median voter’s economic miseries. Rising inflation will thus undermine President Jair Bolsonaro’s re-election prospects further. The fact that energy prices are a potent polling issue is evinced by the fact that Bolsonaro recently sacked the chief executive of Petrobras (i.e. Brazil’s largest listed company) over rising fuel costs. Furthermore, Brazil is a leading exporter of farm produce and hence also a large importer of fertilizers. Fertilizer prices have surged since the war broke out. This is problematic for Brazil since Russia and Belarus account for a lion’s share of Brazil’s fertilizer imports. Much like inflation in general, the surge in fertilizer prices will affect the elections because some of the regions that support Bolsonaro also happen to be regions whose reliance on agriculture is meaningful (Map 1). They will suffer from higher input prices. Map 1States That Supported Bolso, Could Be Affected By Fertilizer Price Surge Chart 24Long Brazil Financials / Short India Given that Bolsonaro continues to lag Lula on popularity ratings – and given the adverse effect that higher commodity prices will have on Brazil’s voters – we expect Bolsonaro to resort to fiscal populism or attacks on Brazil’s institutions in a last-ditch effort to cling to power. He could even be emboldened by the fact that Sérgio Moro, the former judge and corruption fighter, decided to pull out of the presidential race. This could provide a fillip to Bolso’s popularity. Bottom Line: Brazil currently offers a buying opportunity owing to attractive valuations and high commodity prices. But investors should stay wary of latent political risks in Brazil, which could manifest themselves as presidential elections draw closer. We urge investors to take-on only selective tactical exposure in Brazil for now. Equities appear cheap but political and macro risks abound. To play the rally yet stave off political risk, we suggest a tactical pair trade: Long Brazil Financials / Short India (Chart 24). Whilst we remain constructive on India on a strategic horizon, for the next 12 months we worry about near-term macro and geopolitical headwinds as well as India’s rich valuations. Don’t Buy Into Pakistan’s Government Change Chart 25Pakistan’s Military Is Unusually Influential The newest phase in Pakistan’s endless cycle of political instability has begun. Prime Minister Imran Khan has been ousted. A new coalition government and a new prime minister, Shehbaz Sharif, have assumed power. Prime Minister Sharif’s appointment may make it appear like risks imposed by Pakistan have abated. After all, Sharif is seen as a good administrator and has signaled an interest in mending ties with India. But despite the appearance of a regime change, geopolitical risks imposed by Pakistan remain intact for three sets of reasons: Military Is Still In Charge: Pakistan’s military has been and remains the primary power center in the country (Chart 25). Former Prime Minister Khan’s rise to power was possible owing to the military’s support and he fell for the same reason. Since the military influences the civil administration as well as foreign policy, a lasting improvement in Indo-Pak relations is highly unlikely. Risk Of “Rally Round The Flag” Diversion: General elections are due in Pakistan by October 2023. Sharif is acutely aware of the stiff competition he will face at these elections. His competitors exist outside as well as inside his government. One such contender is Bilawal Bhutto-Zardari of the Pakistan People’s Party (PPP), which is a key coalition partner of the new government that assumed power. Imran Khan himself is still popular and will plot to return to power. Against such a backdrop the newly elected PM is highly unlikely to pursue an improvement in Indo-Pak relations. Such a strategy will adversely affect his popularity and may also upset the military. Hence we highlight the risk of the February 2021 Indo-Pak ceasefire being violated in the run up to Pakistan’s general elections. India’s government has no reason to prevent tensions, given its own political calculations and the benefits of nationalism. Internal Social Instability Poor: Pakistan is young but the country can be likened to a social tinderbox. Many poor youths, a weak economy, and inadequate political valves to release social tensions make for an explosive combination. Pakistan remains a source of geopolitical risk for the South Asian region. Some clients have inquired as to whether the change of government in Pakistan implies closer relations with the United States. The US has less need for Pakistan now that it has withdrawn from Afghanistan. It is focused on countering Russia and China. As such the US has great need of courting India and less need of courting Pakistan. Pakistan will remain China’s ally and will struggle to retain significant US assistance. Bottom Line: We remain strategic sellers of Pakistani equities. Pakistan must contend with high internal social instability, a weak democracy, a weak economy and an unusually influential military. As long as the military remains excessively influential in Pakistan, its foreign policy stance towards India will stay hostile. Yet the military will remain influential because Pakistan exists in a permanent geopolitical competition with India. And until Pakistan’s economy improves structurally and endemically, its alliance with China will stay strong. Investment Takeaways Cyclically go long US 10-year Treasuries. Geopolitical risks are historically high and rising but complacency is returning to markets. Meanwhile inflation is nearing a cyclical peak. Favor US stocks over global. It is too soon to go long euro or European assets, especially emerging Europe. Favor UK equities over developed markets (excluding the US). Stay long GBP-CZK. Favor European defense stocks over European tech. Stay short the Chinese renminbi and Taiwanese dollar. Favor the Japanese yen over the Korean won. Favor South Korean over Taiwanese equities. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Yushu Ma Research Analyst yushu.ma@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com Alice Brocheux Research Associate alice.brocheux@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Section III: Geopolitical Calendar
Since last October, Indian stocks have been in a trading range relative to their EM counterparts. Similarly, they have not fallen much so far in absolute terms – even though foreign investors have exited this market en masse over the past several months. The…
Executive Summary Profit Margins Are Headed Lower; So Are Equity Multiples The post pandemic profit recovery in India was driven by a one-off revival of demand from very depressed levels, which led to a spike in profit margins as companies’ sales outpaced their costs (hiring costs and financing cost). The glacial pace of job creation since the pandemic and the muted wage growth is to blame for weak household income, which in turn is hurting consumption. Indian growth is wobbling as household consumption is losing steam, and capital investments are decelerating. The Ukraine crisis and the resulting oil / commodity price surge will hurt Indian firms’ margins and profits even more in the months to come. Indian stocks are still expensive, and future profit expectations are elevated – especially relative to their EM and emerging Asian counterparts. This has set the stage for profit disappointment. Bottom Line: Indian growth is decelerating amid high stock valuations. Higher for longer commodity prices will hurt as well. Equity investors should downgrade Indian stocks tactically from neutral to underweight in EM and emerging Asian portfolios. Domestic bond investors should book profits on their Indian exposure, and downgrade to neutral in EM and emerging Asian baskets. Feature Chart 1Indian Stocks Are Headed For A Turbulent Time Long COVID is a condition that manifests itself after a person recovers from the acute phase of the disease. The Indian economy is showing similar signs: after an initial post-COVID recovery, household consumption and investment have begun to disappoint. This is happening at a time when Indian equity valuations and investors’ profit expectations are much higher than those of the rest of the EM. As such, Indian share prices are set for a turbulent time ahead. Equity investors should tactically downgrade this bourse to underweight in EM and emerging Asian portfolios (Chart 1). Domestic bond investors should book profits on their Indian exposure, and downgrade it to neutral in EM and emerging Asian baskets. Consumer Spending During and in the immediate aftermath of the pandemic, the Indian government did not supplement lost household income caused by the lockdowns and the layoffs by any good measure. Tangible fiscal stimulus (i.e., excluding government guarantees etc.) amounted to less than 2% of GDP. Post-pandemic, jobs have been growing at a glacial pace. In fact, India’s total employment is estimated to be still 8% lower as of the end of 2021 compared to the first quarter of 2020, as per Oxford Economics data. Consistently, wage growth has been very poor as well – in both urban and rural areas (Chart 2). Wages in real terms (deflated by CPI) have been contracting. Household income has therefore remained severely impaired. The consequences of meagre household incomes can now be seen in persistently weak consumer durable sales. Chart 3 shows that passenger cars and 2-wheeler sales are languishing at much lower levels than they were in the pre-pandemic period. Chart 2Subdued Employment And Poor Wage Growth Sapped Household Income … Chart 3… Leading To Impaired Household Consumption Chart 4Signs Of Softening Business Activity The overall growth in India was seen to be softening even before the Ukraine crisis. The economy grew at a 5.4% YoY rate in the last quarter of 2021, down from 8.5% in the previous quarter. The trend appears to be continuing into this year. Corroborating evidence comes in the form of the number of E-way bills1 issued – which is a barometer of business activity. The number peaked in October last year and has been struggling since (Chart 4). Persistently weak consumer demand is a crucial reason why manufacturing production is also struggling to get back to the pre-pandemic trend – which would be a good 10% higher than the current level (Chart 4, bottom panel). Industrial production will face difficulty gaining traction should weakness in consumer demand linger. On the whole, the post-pandemic economic recovery in India was a rapid one initially; but is now gradually losing steam as joblessness remains high and wages remain low. Looming Energy Tax Ominously, odds have risen that core (non-oil) consumer demand could be even weaker in the months ahead. The sharp rise in crude prices will soon mean that Indian consumers and businesses will have to shell out more for their energy-related purchases. Chart 5 shows that retail gasoline and diesel prices in India did not keep pace with the global crude prices in recent months. Hence, if some or all of the rise is passed on to the consumers, domestic fuel prices could go up by about 10 - 20%. If so, that would be a major tax on the economy. Higher expenses on fuel and transportation – which make up about 15% of consumer spending – will force households to curtail their non-oil spending elsewhere. That means non-energy firms would see lower sales. Those firms would also see their own operating and raw material costs going up given the higher oil and other commodity prices. Together, these will have a pronounced negative impact on these firms’ profit margins. Lower margins are a harbinger of lower stock multiples (Chart 6). Chart 5Retail Gasoline And Diesel Prices Could Rise Materially Chart 6Profit Margins Are Headed Lower; So Are Equity Multiples Notably, Indian corporate profit margins had surged to decade high levels last year thanks mainly to cost cutting. Wage bills had gone down as businesses slashed employees; and were slow to re-hire them. Interest expenses had also gone down – both relative to sales and profits – as the central bank cut interest rates aggressively. When sales revived after the lockdowns, the higher/rising margins led to surging profits. But now, both sales and margins are in jeopardy as weak consumer demand is hurting the former, while rising raw materials cost will hurt the latter. Profits are set to disappoint as a result. Related Report Emerging Markets StrategyEquity Capitulation, A Commodity Shock And Geopolitics What’s more, faltering profits could also lead to a premature slowdown in India’s capital investments. Firms’ capex plans are highly contingent on profit growth; and therefore, the former may see a dip in the coming months with dwindling profits (Chart 7). This potential development could be a major negative for India’s sustainable growth story, and its ill-effects may linger. What makes this episode of oil/commodity shock particularly negative for India is that it is taking place when consumer demand is already sluggish. Previous oil shocks in 2007-08 and 2011-12 took place when the underlying growth was quite robust. Stronger underlying growth allows for the absorption of negative exogenous shocks like higher oil & energy prices. Overall, rising oil prices have historically been bearish for Indian stocks’ relative performance. That correlation had broken down since the onset of the pandemic two years ago (Chart 8). However, now with the crude price hovering around $100 a barrel, India’s relative equity outperformance versus the EM benchmark will give up some of its gains of the past two years. Chart 7Dwindling Profits Could Lead To A Slowdown In Caital Expenditure Chart 8India’s Relative Equity Outperformance Cannot Continue With $100 Oil How About Inflation? Chart 9Global Commodity Prices Dictate Indian PPI, But Not So Much CPI India’s producer price inflation (PPI) is highly geared to global commodity prices. As such, one can expect PPI to re-accelerate in the months ahead. That said, commodity prices are not a major driver of India’s consumer price inflation (CPI). The latter will therefore likely remain more well behaved than PPI would (Chart 9). Historically, the two primary drivers of India’s CPI have been the economy’s productivity growth rate and broad money (M3) growth rate. Since productivity trends do not change much in the near term, it’s money supply that determines the short-term trajectory of CPI (Chart 10). Chart 10Money Supply Determines India’s CPI Over Cyclical Horizon Chart 11Drivers Of India’s Money Supply Will See Only A Mediocre Growth Money growth has been quite mediocre recently; and will likely stay that way. This is because neither of the two main drivers of money supply, bank credit and fiscal expenditure, are set to rise very strongly. In the proposed fiscal budget for April 2022 – March 2023, the government is planning to raise current expenditure2 by just 1% in nominal terms; and the total expenditure by 5%. Meanwhile, non-interest government spending growth has already come back to normal levels following the one-off surge during the pandemic (Chart 11, top panel). Bank credit has also slowed on the margin this year. That it has barely grown in real terms in the past couple of years is also dampening inflationary pressures (Chart 11, bottom panel). All this means that any rise in consumer price inflation will be limited. Notably, a marginal rise in consumer price inflation is unlikely to lead to policy tightening by the central bank. This is because the source of inflation would be supply driven, rather than demand driven. The central bank would recognize that higher commodity prices will exacerbate the already weak consumer demand; and therefore, any further policy tightening could decimate growth. On the whole, very sluggish wage growth and contained core CPI support the fact that there are no genuine demand-driven inflationary pressures in the country (Chart 12). A rise in global food prices should also not impact India much as the country is not a big importer of food grains and most of its food is domestically grown. All in all, the RBI is likely to ignore the slight pickup in CPI, and will refrain from raising rates. How Much Downside In Stocks? Indian stocks have been in a trading range relative to their EM counterparts since we downgraded them to neutral in October last year. In absolute terms also they have not fallen much so far – even though foreign investors have exited this market en masse over the past several months. The missing piece of the puzzle for this apparent dichotomy is the massive purchases by domestic mutual funds in recent months. This local demand is what prevented this bourse from tanking (Chart 13). Chart 12India’s Consumer Inflation Will Not Rise By Too Much Chart 13The Massive Purchases Of Mutual Funds Will Wane With Profit Disappointment Chart 14Indian Stock Multiples Are Still Very High Relative To Their Counterparts Going forward, however, those domestic purchases are likely to wane as growth and profits slow, and local investors become wary of their equity exposures. That would lead to a sell-off in stock prices. Notably, Indian stocks are still quite pricey when compared to both their EM and emerging Asian counterparts based on the cyclically adjusted P/E ratio (Chart 14). As explained above, Indian stock multiples are set to fall materially as firms’ profit margins are squeezed in the months to come. Investors have paid high equity multiples as they have extrapolated the strong profit recovery post-pandemic into the future. However, the profit recovery post-pandemic was driven by a one-off revival of demand from very depressed levels and a one-off spike in profit margins as companies’ sales outpaced their costs (hiring costs and financing cost). As and when investors realize that a sustainable profit growth rate is much lower than the initial post-pandemic trajectory, multiples will shrink somewhat. At the same time, firms’ topline will also wobble as non-oil consumer spending sees forced retrenchment. Weakish topline, multiplied by lower margins, entails weak earnings growth. That would be another drag (besides shrinking multiples) on Indian share prices. Notably, a sell-off in Indian stocks usually comes with a depreciating rupee – thereby compounding woes for foreign investors in Indian stocks. All in all, this bourse could witness a major down leg in absolute USD terms in the months to come. Relative to other EM and emerging Asian markets also they will trade on the weaker side. Book Profits On Domestic Bonds We have been overweight India in EM local currency bond portfolios given Indian bonds’ rather high yields, and the country’s prudent fiscal policy, benign inflation outlook, and a cheap currency. The call has worked out well (Chart 15, top panel). However, following the sharp rise in EM bond yields, Indian bond yields are no longer attractive in relative terms (Chart 15, bottom panel). A less sanguine rupee outlook over the short term is another cause for concern. Besides, rising US bond yields would make Indian bonds look less attractive. Considering all, we recommend EM local currency bond investors take profits on their overweight India exposure and reduce the allocation to neutral in EM and emerging Asian baskets. Investment Recommendations Equities: Indian firms’ profit outlook has deteriorated significantly given odds of disappointing margins and still high equity valuations. Investors should tactically downgrade this market from neutral to underweight in EM and emerging Asian equity portfolios. Absolute return investors should avoid this market outright. Currency and Bonds: The Indian rupee is at a risk of mild depreciation along with a sell-off in the Indian stock markets. However, given that the currency is cheap, its relapse will not be large (Chart 16). Chart 15Indian Domestic Bonds Are Not As Attractive Any More; Book Profits Chart 16Indian Rupee Is Cheap, And Hence Has Only A Limited Downside Indian government bonds have outperformed their EM counterparts over the past four years; but are no longer as attractive as the yield advantage has disappeared and the rupee has a weaker near-term outlook. Investors should book profits on their overweight allocations, and downgrade them to neutral relative to EM and emerging Asian baskets. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1 E-way bills are issued as part of Goods & Services Tax (GST) collection mechanism. 2 The rest is capital expenditure – which the government is planning to raise by 24%, albeit from a much smaller base (2.6% of GDP) compared to current expenditure (13.6% of GDP).
HighlightsUpgrade odds of Russia invading Ukraine from 50% to 75%. The US and allies are transferring arms to Ukraine while seeking alternate energy supply for Europe.Of the 75% war risk, we give 10% odds to Russia conquering all of Ukraine, as discussed in our “Five Black Swans For 2022.” Russia’s limited war aims worked in 2014 and President Putin tends to take calculated military risks. Full-scale invasion would force the West to unify.The remaining 25% goes to diplomatic resolution. It appears that the US is not offering Russia sufficient security guarantees. Ukrainian leaders do not have a domestic mandate to surrender and have not done so for eight years. Russia cannot accept the status quo now that it has made armed demands for big change.Our third key view for 2022 – that oil producing states have geopolitical leverage – is vividly on display.Tactically stay defensive. But cyclically stay invested. Book 10% gain on long DM Europe / short EM Europe. Book a 8.6% gain on long CAD-RUB.FeatureUkraine’s economy is small but investors rightly worry that an expansion of the still simmering 2014 war there will cause Europe’s energy supply to tighten, pushing up prices and dragging on European demand. Russia would cut off natural gas to Ukraine, which would cut off 6.6% of Europe’s natural gas imports, 18% of Germany’s, 77% of Hungary’s, and 38% of Italy’s (Chart 1). Chart 1Ukraine Hinges On Germany If Europe retaliates against Russia with crippling sanctions, Russia and Belarus could conceivably cut off another 20% of Europe’s imports and 60% of Germany’s imports. The Czech Republic, Finland, and Hungary get almost 100% of their natural gas from Ukraine and Russia, while Finland, Poland, and Hungary get more than half of their oil from Russia. In other words, Europe will try to avoid war and try to limit sanctions so that Russia does not further reduce supply.Yet Russia, if waging war, will prefer to receive revenues from Europe, as long as Europe is still buying. Thus Russia will keep its military aims limited so that Germany and other countries have a basis for watering down sanctions to keep the energy flowing and avoid a recession. The US has already committed to sweeping sanctions against Russia and is much more likely to follow through (though President Biden also wants to avoid an energy shock ahead of midterm elections).Energy consumption amounts to only 2% of European GDP, though it could rise to 5% in the event of a shock, as our European Investment Strategist Mathieu Savary has shown. This number would not be far from the 7% reached in 2008, which coincided with financial crisis and recession. All of Europe will suffer from high prices, not only those that import via Ukraine, and Europe’s supply squeeze would push up global prices as well. So the risk of a recession in Europe will rise if the energy squeeze worsens, even if a recession is ultimately avoided.Whatever Russia ends up doing with its military, it may start off with shock and awe. Europe might see its first major war since World War II. Global investors will react very negatively, at least until they can be assured that the conflict will remain contained in Ukraine. According to our market-based quantitative indicators of Russian geopolitical risk, there is still complacency – the ruble has not fallen as far as one would expect based on key macro variables (Chart 2). Chart 2Russia Geopolitical Risk: Two Quantitative Indicators Chart 3Russian Market Reaction Amid Ukraine Crisis Investors will sell European – especially eastern European – equities and currencies even more rapidly if a war breaks out (Chart 3). It is too soon to buy the dip. What is needed is a Russian decision and then clarity on the scope of the western reaction. Even then, developed Europe and non-European emerging markets will be more attractive.Looking at global equities: How did the market respond to previous Russian invasions?Few conclusions can be drawn from Russia’s invasion of Georgia in 2008, given Georgia’s lack of systemic importance and the simultaneous global financial crisis (Chart 4). Stocks underperformed bonds and cyclicals underperformed defensives, but value caught a bid relative to growth.Russia’s initial invasion of Ukraine in 2014 occurred in a different macroeconomic context but saw stocks flat relative to bonds, cyclicals fall relative to defensives (except energy stocks), and small caps roll over relative to large caps (Chart 5). Value stocks, however, outperformed growth stocks. Chart 4Market Reaction To Russian Invasion Of Georgia Chart 5Market Reaction To Russian Invasion Of Crimea Chart 6Ukraine Crisis And Energy: 2022 Versus 2014 However, in today’s context, these cyclical trends are looking stretched, so a temporary pullback from these trends should be expected. Value stocks, especially energy stocks, have skyrocketed relative to growth and defensives and are likely to pull back in a global risk-off move (Chart 6). Tactically we recommend American over European assets, defensives over cyclicals, large caps over small caps, and safe-haven assets like gold and the Japanese yen.Washington Offers “No Change” To MoscowWhy is a diplomatic solution less likely than before?The US offered no concessions to Russia in its formal written response to Russia’s demands on January 26. “No change, and there will be no change” in longstanding policies, according to Secretary of State Antony Blinken.1 The relevant policies are not about NATO membership – Ukraine is never going to join NATO – but rather about the US and NATO making Ukraine a de facto member by providing arms and defense cooperation. Russia obviously sees a US-armed Ukraine as a threat to its national security.One of the few realistic demands of Russia’s – that the US and NATO stop providing arms – has been flung back in Russia’s face. Blinken pointed out in his press conference that the US has given more defense aid to Ukraine in the past year than in any previous year. He said the US will continue to provide arms while pursuing diplomacy, including five MI-17 helicopters on the way. He also noted that the US has authorized allies to transfer American-origin arms to Ukraine.2The importance of the defense cooperation is not the quality of the arms being transferred (so far) but the long-term potential for the US to turn Ukraine into Russia’s Taiwan, i.e. a foreign-backed military enemy on its doorstep. The costs of inaction today could be checkmate from Russia’s long-term strategic point of view. Russia has warned for 14 years that it saw Ukraine as a red line and yet the US and NATO have increased defense cooperation. It is a moot point whether the US provides arms because it does not empathize with Russia’s security interests or because it believes Russia will attack Ukraine regardless.A diplomatic solution could still come from the US, if more information comes to light, or from Ukraine itself, under French and German pressure. Ukraine could make promises to respect Russia’s national security interests and implement the Minsk Protocols it was forced into after Russia seized Crimea in 2014.3If Ukraine surrenders, Russia can claim victory and reduce the threat of war, at least temporarily. But it would not eliminate the long-term risk of war since Ukraine’s government may not be willing or able to implement any such agreement. Ukraine views the Minsk agreement as a Russian imposition and it has rejected key parts of it (such as federalization and granting rights and privileges to Russian separatists in Donbass) for eight years already.4The joint statement from Russia, Ukraine, France, and Germany on January 26 reaffirms the ceasefire in the Donbass.5 It is unlikely that Russia can walk away with this ceasefire alone, having made fundamental demands regarding Russia’s long-term security and the European order. It is more likely that any Ukrainian violation of the ceasefire will now offer a pretext for Russia to respond with military force.Russia’s military advantage is immediate whereas diplomatic attempts by Ukraine to buy time could help it stage a more formidable defense against Russia in future, given ongoing US and NATO defense cooperation. This is why the continuation of arms transfers is the signal. Russia is incentivized to take action sooner rather than later now that the western willingness and urgency to provide arms has increased.Putin has succeeded with his “small war” and “hybrid war” strategy thus far. Russian forex and gold reserves at $630 billion (38% of GDP), gradual diversification away from the dollar (16% of forex reserves), low short-term external debt (5% of GDP), an alternative bank communication system, a special economic relationship with China, a Eurasian Economic Union that can help circumvent sanctions, all provide Russia with some buffer against US sanctions.GeoRisk Indicators: Europe Chart 7European GeoRisk Indicator Amid Ukraine Crisis In our Q3 2021 outlook, we argued that European political risk had bottomed due to Russia. Our geopolitical risk indicators show that financial markets tend to price European political risks in line with the USD-EUR exchange rate. The dollar rallied in 2021 and has since fallen back but a war and energy squeeze in Europe should help the dollar stay resilient, as should Federal Reserve rate hikes (Chart 7).If Russia attacks, the Ukrainians will fall back and then mount an insurgency. This will make the war more difficult than its planners initially believe. It will also raise the risk that war will spill over. Neighbors that provide economic aid – not to mention military aid – will eventually make themselves vulnerable to Russian attack, either to destroy commerce or cut insurgency supply lines.NATO will fortify its borders with troops but then tensions will grow on those borders, reducing security and raising uncertainty in the Baltics, Poland, Slovakia, and the Czech Republic. Ukraine could become a war zone like Libya or Syria except that this time the US and Russia would truly be fighting a proxy war against each other.Other European Risks Pale In ComparisonWe will monitor the French election in case the Ukraine conflict causes dynamics to shift against President Emmanuel Macron. Most likely Macron’s diplomatic flourishes, combined with France’s insulation from Russia and Ukraine, will benefit him at the ballot box.In the UK, Prime Minister Boris Johnson faces a leadership challenge. He will probably survive but the Conservative Party faces a serious challenge over the coming years. Labour’s comeback will build ahead of the next election, given that the pandemic has dealt a powerful blow against the Tories, who have been in power since 2010 and are therefore becoming stale. Labour has gotten over the Jeremy Corbyn problem.What matters is whether the UK rejoins the EU, whether Scotland leaves the UK, and whether the next government has a strong majority with which to lead. So far there have not been major changes on these issues:The Tories still have a 75-seat majority through 2024.Support for Scottish independence is stuck at 45% where it has been since 2014.Polling is still evenly divided on Brexit. Labour taking power is a prerequisite to any reunion with the EU, Labour does not want to campaign on re-opening the Brexit issue. While Labour will want to run against inflation, and win back the middle class, rather than for the EU.Thus political risk will be flat, not returning to Brexit highs anytime soon, which is marginally good news for pound sterling over a cyclical horizon (Chart 8). Chart 8UK GeoRisk Indicator And Boris Johnson's Troubles India Enters Populist Phase Of Election Cycle2022 will mark the beginning of India’s election season in full earnest, even though general elections are not due until 2024. This is because within the five-year election cycle spanning from 2019-2024, this year will see elections in some of India’s largest states (Chart 9).More importantly 2022 will see elections take place in most of India’s northern region (Chart 10), which is a key constituency for the ruling Bhartiya Janata Party (BJP). Chart 9India: Major State Elections This Year Chart 10North India In Focus With State Elections Of all the state elections due this year, the most critical will be those in Uttar Pradesh, where voting will begin on February 10, 2022. Final results will be declared a month later on March 10, 2022.Uttar Pradesh Will Disappoint BJPAt the last state elections held in Uttar Pradesh in 2017, BJP stormed into power with one of the strongest mandates ever seen in this sprawling and heterogenous state. The BJP boosted its seat share to an extraordinary 77%, leaving competitors far behind (Chart 11). Chart 11Bhartiya Janata Party (BJP) Stormed Into Power In Uttar Pradesh (UP) In 2017 Cut to 2022, the BJP appears likely to cross the 50% majority threshold but will cede seat share to a regional party called the Samajwadi Party (SP).What will drive this reduction in seats? The reduction will be driven by a degree of anti-incumbency sentiment and some adverse socio-political arithmetic. In a state where voting is still driven to a large extent by identity politics, it is worth recalling that the BJP was able to win the 2017 elections by pulling votes from three distinct communities:BJP’s core constituency of upper caste Hindus.A subset of Other Backward Classes (OBCs).A subset of a community belonging historically to one of the lowest social levels in India called Dalits.This winning formula of 2017 may not work in 2022 as the BJP faces resentment from parts of each of these three communities as well as from farmers (who were against farm law reforms that the BJP tried to pass).There is a chance that these groups may flock to the regional Samajwadi Party in 2022. The latter is in a position of strength as it is expected to retain support from its core constituency of Muslims and upper-caste OBCs too.Yet the risk is to the downside for the ruling party. Modi and the BJP have suffered a hit to their popular support from the global pandemic and recession, like other world leaders.Reading The Tea Leaves For 2024The pro-Modi wave that began in 2014, and gained steam in Uttar Pradesh in 2017, became a tsunami by 2019, causing the BJP to win a decisive 56% of seats in the national assembly. So, if the BJP loses seats in Uttar Pradesh this year, what will be the implications for the general elections of 2024?In a base case scenario, the Modi-led BJP appears set to emerge as the single largest party in the 2024 elections (albeit with a lower seat share than the 62 of 80 seats that the BJP managed in 2019). As the BJP administration ages, it is expected to lose a degree of seat share in its core constituency of north India. But these losses should be partially offset by gains in regions like east India where the BJP continues to make inroads. Also, national parties tend to attract higher vote share at general elections as compared to state elections, and this is true for the BJP. Most likely the pandemic will have fallen away by 2024 and the economy will be expanding.However, a lot can change in two years, and a major disappointment at Uttar Pradesh would sound alarm bells. By 2024, the BJP will have been in power for ten years. So it is not a foregone conclusion that the BJP will win a single-party majority for a third time, even if it does remain the biggest party.Regional parties like the Samajwadi Party (from Uttar Pradesh), Trinamool Congress (from West Bengal), Shiv Sena (from Maharashtra) and Aam Aadmi Party (from New Delhi) are small but rising and may incrementally eat into the BJP’s national seat share.Policy Implications For 2022 Chart 12India’s Fiscal Report Card May Worsen With Populism India’s central government will unveil its budget for FY23 on Feb 1, 2022 in the Indian parliament. We expect the government to announce a fiscal deficit of 6.6% of GDP which will be marginally lower than the FY22 target of 6.8% of GDP. However, with key elections around the corner, we allocate a high probability to the government announcing a big-bang pro-farmer or pro-poor scheme from this pulpit. This high focus on populism and inadequate focus on capital expenditure could lead markets to question India’s fiscal well-being at a time when its debt levels are high (Chart 12).Distinct from policy risks in the short run, geopolitical risks confronting India are elevated too. India’s relationship with China continues to fester. Sino-Indian frictions could easily take a turn for the worst in 2022 as India enters the business end of its five-year election cycle on one hand and China’s all-important 20th National Congress of the Chinese Communist Party (NCCCP) is due in the fall of 2022. China could take advantage of US distraction in Ukraine to flex its muscles in Asia. A geopolitical showdown with China would likely only cause a temporary drop in Indian equities, but taken with other factors, now is not the time to buy.Bottom Line: We remain positive on India on a strategic horizon. However, in view of India approaching the business-end of its five-year election cycle, when policy risks tend to become elevated, we reiterate our tactical sell on India.GeoRisk Indicators: Rest Of WorldNeutral China: China’s performance relative to emerging markets may be starting to bottom but we do not recommend buying it. Domestic political risk is still rising according to our indicator and we expect it to keep rising (Chart 13). Negative political surprises will occur in the lead up to the twentieth national party congress and the March 2023 implementation of the “Common Prosperity” plan. Any Russian conflict will distract the US and enable General Secretary Xi Jinping to cement his second ten-year term in office – and China’s reversion to autocracy – with minimal foreign opposition. The US’s conflict with China is one reason Russia believes it has a window of opportunity. Chart 13CHINA GEORISK INDICATOR Short Taiwan: Taiwan’s geopolitical risk has paused far short of previous peaks as the country’s currency and stock market benefit from the ongoing semiconductor shortage. But a peak may be starting to form in relative equity performance (Chart 14). We doubt that China will see any Russian attack on Ukraine in 2022 as an opportunity to invade Taiwan, although economic sanctions and cyber-attacks are an option that we fully anticipate. Invading Taiwan is far more difficult militarily than invading Ukraine and China is less ready than Russia for such an operation. However, China might be able to exploit a Russian attack as soon as 2024. Chart 14TAIWAN TERRITORY GEORISK INDICATOR Long South Korea: South Korea’s presidential election is approaching on March 9 and this event combined with North Korea’s new cycle of missile provocations will keep political risk elevated (Chart 15). The conservative People Power party has pulled ahead in opinion polling and the incumbent Democratic Party has been weakened by the pandemic. But the race is still fairly tight and a viable third party candidate could make a comeback. China’s policy easing should eventually benefit South Korea. Chart 15SOUTH KOREA GEORISK INDICATOR Long Australia: Australia’s federal election must be held by May 21 and anti-incumbency feeling has taken hold, with the Liberal-National coalition collapsing in opinion polls relative to the Australian Labor Party. Australia still faces shockwaves from the pandemic and China’s secular slowdown, reversion to autocracy, and conflict with the US, especially if the US gets distracted in Europe. Political risk is high and rising (Chart 16). However, Australia benefits from rising commodity prices and we favor developed markets outside the United States. Chart 16AUSTRALIA GEORISK INDICATOR Long Canada: Canada’s recapitalized its political system with last year’s general election and political risk is subsiding (Chart 17). Canada benefits from rising oil and commodity prices and close proximity to the hyper-stimulated US economy. Chart 17CANADA GEORISK INDICATOR Neutral Turkey: Turkey is one of our perennial candidates for a “black swan” event as the country’s political stability continues to suffer under strongman rule, unorthodox monetary and fiscal policy, military adventures in North Africa and Syria, and now a Russian bid to dominate the Black Sea. Elections looming in 2023 will provoke turmoil as the Erdogan administration is extremely vulnerable and yet has many ways to try to cling to power (Chart 18). Chart 18TURKEY GEORISK INDICATOR Neutral Brazil: Brazilian political risk is subsiding as the market expects former President Lula da Silva to return to power in this October’s presidential election and replace current populist President Jair Bolsonaro. Relative equity performance always appears as if it has bottomed only to inch lower in the next selloff. China’s policy easing is a boon for Brazil but China is not providing massive stimulus, the election will be tumultuous, and even a Lula victory will need to see a market riot to ensure that structural reforms are pursued (Chart 19). Chart 19BRAZIL GEORISK INDICATOR Long South Africa: South Africa still faces elevated political risk despite the conclusion of the 2021 municipal elections. However, the ruling African National Congress, which is pursuing an anti-corruption drive, is likely to stay in power, lending policy continuity. Equities have bottomed and are rebounding relative to emerging markets (Chart 20). The danger is that structural reforms will slip ahead of the spring 2024 election. Chart 20SOUTH AFRICA GEORISK INDICATOR Investment TakeawaysTactically stay long gold, defensives over cyclicals, large caps over small caps, Japanese industrials versus German, GBP-CZK, and JPY-KRW.Book a 10% gain on long DM Europe / short EM Europe. Book a 8.6% gain on long CAD-RUB. Matt Gertken Vice PresidentGeopolitical Strategymattg@bcaresearch.com Ritika Mankar, CFAEditor/Strategistritika.mankar@bcaresearch.comFootnotes1 For Blinken’s press conference on the US formal response to Russia, see US Department of State, "Secretary Antony J. Blinken at a Press Availability," January 26, 2022, state.gov.2 For Ukraine’s criticism that Germany should offer pillows in addition to helmets, see Humeyra Pamuk and Dmitry Antonov, "U.S. responds to Russia security demands as Ukraine tensions mount," Reuters, January 26, 2022, reuters.com. For the US’s $2.5 billion in defense aid to Ukraine since 2014, see Elias Yousif, "U.S. Military Assistance to Ukraine," January 26, 2022, stimson.org. For purpose and significance, see Samuel Charap and Scott Boston, "U.S. Military Aid to Ukraine: A Silver Bullet?" Rand Blog, rand.org.3 Michael Kofman, "Putin’s Wager in Russia’s Standoff with the West," War on the Rocks, January 24, 2022, warontherocks.com.4 In 2021 the US apparently moved to embrace the Minsk Protocols for the first time, but since then it has not joined the talks. See National Security Adviser Jack Sullivan, "White House Daily Briefing," December 7, 2021, c-span.org. 5 Élysée, "Declaration of the advisors to the N4 Heads of States and Governments," January 26, 2022, elysee.fr. See also "Russia, Ukraine agree to uphold cease-fire in Normandy talks," DW, January 26, 2022, dw.com.Geopolitical CalendarStrategic ThemesOpen Tactical Positions (0-6 Months)Open Cyclical Recommendations (6-18 Months)
BCA Research’s Emerging Markets Strategy service expects profits to be the main driver of Indian stocks next year. Indian stocks need more time to digest and consolidate the significant gains from earlier this year. However, the country’s medium…
Highlights Indian stocks need more time to digest and consolidate the significant gains from earlier this year. However, the country’s medium and long-term growth outlook remains positive. Indian firms’ profit margins will likely settle at a higher level than usual. That will also put a floor on its equity multiples. With an imminent topline recovery, the main driver of Indian stocks next year will be profits, in contrast with multiple expansions during the last year and a half. India is beginning a cyclical expansion with a cheap rupee. Stay neutral Indian stocks in an EM equity basket for now. Investors should overweight India in an EM domestic bond portfolio. Feature Chart 1Indian Stocks Are Overbought We tactically downgraded Indian stocks from overweight to neutral in EM and emerging Asian equity portfolios in early October this year. This call has worked out well so far as India’s absolute and relative share prices seem to have peaked. The primary reason for our tactical “neutral” call on Indian equities was this market’s vertical rise earlier this year, both in absolute and relative terms. Similar spikes – in terms of magnitude and duration back in 2007 and in 2014 – were followed by a period of underperformance (Chart 1). Yet, we recommended downgrading to only a neutral allocation. The reason is that the country’s cyclical outlook remains constructive, and the profit expansion cycle has further to run. That forbade us from turning too bearish on this bourse. A neutral stance on India also makes sense for the next several months as this bourse digests and consolidates its previous gains. In this report, we detail the various nuances of our analysis. Meanwhile, the Indian currency is cheap versus the greenback and will likely be one of the best performing currencies in the EM world over the next year. A positive currency outlook also makes Indian government bonds attractive for foreign investors, as Indian bonds also offer a high yield amid a benign domestic inflation backdrop. Dedicated EM domestic bond portfolios should stay overweight India. Equity Multiple Compression Ahead? Chart 2India's Profit Margin Expansion Has Led To Its Equity Re-Rating An upshot to the steep equity rally earlier this year has been India’s stretched valuations. That made many investors question the sustainability of the outperformance. A pertinent question, therefore, is how overvalued have Indian stocks become? And how much multiple compression can investors expect in this bourse? Before we answer this question, it’s useful to understand what drove the cyclical re-rating of Indian markets in the first place. The solid black line in Chart 2 shows the gross profit margins of all Indian listed non-financial firms. They have risen substantially since spring 2020 to reach decade-high levels. Margin expansions of this magnitude are indicative of material efficiency gains; and are usually rewarded with an equity re-rating. This is indeed what happened since spring 2020: stock multiples rose following the expanding margins. The same can be said if we only consider the major non-financial corporations’ EBITDA margins (Chart 2, bottom panel). If one looks at the cyclically adjusted P/E ratio (CAPE) instead, we see a very similar thing: the CAPE ratio has also risen in line with rising profit margins (Chart 3). Chart 3Profit Margins Have A Bearing On Equity Valuations Charts 2 and 3 show that the positive correlations between profit margins and stock multiples held steady over past several cycles. Hence, it will be reasonable to expect that should Indian firms hold on to wide margins, they will not suffer a significant de-rating going forward. Can Margins Stay Wide? Chart 4Indian Firms' Borrowing Costs Will Likely Stay Low Before we delve into the question of whether margins can stay wide, we need to understand what caused such a margin expansion in the first place. That cause is cost cutting: wage bills have gone down as businesses slashed employees. Data from Oxford economics show that there had been 9% fewer workers in India as of September 2021 compared to March 2020, just before the pandemic. Interest expense has also gone down – both relative to sales and profits (Chart 4) – as interest rates were cut aggressively. In our view, the latest rollover in profit margins will likely be temporary and limited. It is probably due to hiring back of some employees. Beyond a near-term limited drop in margins, the more relevant question to ask is, can Indian corporations maintain high margins? Our bias is that, to a large extent, they can. The main reason is that firms’ costs are slated to stay under control: Chart 5Indian Companies Do Not Face Any Wage Pressures Wage expectations are low. Going forward, as millions of new job seekers and workers temporarily discouraged by the pandemic enter the job market, wages have little chance of much of an increase. The top panel of Chart 5 shows salary expectations from an industrial survey by RBI. Both the assessment for the current quarter and expectations for the next quarter have been a net negative for a while. Rural wages are also similarly timid (Chart 5, bottom panel). Notably, companies’ hiring back of employees is slow. It seems they prefer to substitute labor by capital by investing in new machines and equipment. This will boost productivity and cap wages. Overall, high productivity growth will keep companies’ profit margins wide and excess labor will suppress wages. Higher margins and low inflation are bullish for the stock market. Critically, headline inflation is within the central bank target bands, and our model shows that it will likely remain as such (Chart 6, top panel). Core inflation is also likely to stay flattish (Chart 6, bottom panel). This means the odds are that the central bank will not raise rates anytime soon. Flattish inflation and policy rates mean firms’ borrowing costs, in both nominal and real terms, are slated to stay approximately as low as they are now. Low real borrowing costs are usually a tailwind for stocks (Chart 7). Chart 7Low Borrowing Costs Are Bullish For Stocks All put together, Indian companies will likely see their costs largely under control. That, in turn, should keep profit margins wider than usual. Wide profit margins should limit multiple compression. Can The Topline Rise Further? Wider margins will boost total profits if and once the topline (revenues) recovers. So, the next question is, how much topline recovery is in the cards? Chart 8Indian Economy Is In A Rapid Expansion Mode There are already signs that sales will likely accelerate in the months to come: PMI indexes for both the manufacturing and services sectors have recovered strongly since the Delta variant-induced lockdowns in spring. They are now hovering around a very high level of close to 60. This indicates that the economy is in a rapid expansion mode (Chart 8). The Industrial Outlook survey (conducted by the RBI) shows that the order books for the September quarter was already at a decade-high level. The expectation for the next few quarters is even more elevated – indicating strong momentum (Chart 9, top panel). In other surveys, such as the PMI and Business Expectation survey (from Dun & Bradstreet), we see similar strong order books (Chart 9, bottom panel). While orders are strong, inventory of finished goods is low. Not surprisingly, businesses are expecting very high-capacity utilization in the next few quarters (Chart 10, top two panels). Chart 9Firms' Order Books Are Quite Robust Chart 10Low Inventories Mean Stronger Economic Activity Ahead They are expecting to hire more people. Companies also believe consumer demand will revive which will enable wider profit margins. In sum, firms are optimistic about accelerating economic activity (Chart 10, bottom two panels). Chart 11A Positive Bank Credit Impulse Is Bullish For Industrial Activity This, in turn, is encouraging them to make capital investments. Finally, the commercial banks’ credit impulse has also turned positive. Rising bank credit impulses usually signal stronger industrial production (Chart 11). To summarize, chances are that firms’ top lines are set to rise materially. Coupled with high margins, this will translate into strong profit acceleration in the next several quarters. Put differently, over the past year and a half, Indian firms witnessed rising margins. Going forward, they will likely see rising profits. Higher profits, in turn, will propel Indian share prices cyclically beyond any short-term consolidation. A Sustainable Expansion? In a notable departure from most developed countries, India’s recovery from the pandemic-induced recession has been more capex-led, rather than consumption-led (Chart 12). One reason for that is the Indian government did not supplement the lost household incomes during the lockdowns nearly as much as developed countries did. That, in turn, kept household demand low. And it also contributed to keeping inflation in check – even though India’s supply side was also paralyzed due to strict lockdown measures. On the other hand, firms’ profits soared owing to rigorous cost-cutting. Higher profits in turn have encouraged firms to expand their production capacity. Companies are ramping up capital spending as they expect sales to accelerate in the future (Chart 13). Chart 12A Capex-Led Recovery Will Prolong The Economic Expansion Chart 13Strong Profits Are Encouraging Firms To Ramp Up Capital Spending Notably, the combination of curtailed household demand and robust capital expenditure has set India’s inflation dynamics apart from many other countries in Latin America and EMEA. While India’s inflation remains largely contained, countries in those regions are witnessing accelerating inflation. Also, over a cyclical horizon, a capex-led expansion is very crucial for India as this will determine the duration and magnitude of the cycle. Strong investment expenditures do not only boost firms’ competitiveness and profitability, but they also help keep inflationary pressures at bay. Lower inflation for a longer period means the central bank need not raise rates as soon and/or as much as otherwise would be the case. That in turn allows the economic and profit expansion to continue for longer. An extended period of expansion is also positive for multiples as investors extrapolate profit growth over many years ahead. India’s current dynamics are a case in point. Given the country is facing no imminent interest rate hikes, stock multiples can stay higher for longer. This is because multiple de-rating commences only after meaningful rate hikes have already been accorded (Chart 14). Since that is quite far off, valuations are not facing any immediate and considerable headwinds. Finally, India is beginning the new cycle with a rather inexpensive currency. Chart 15 shows that the rupee is currently cheaper by about 10% than what would be its “fair value” vis-à-vis the US dollar. The fair value has been derived from a regression analysis of the exchange rate on the relative manufacturing producer prices of India and the US. Chart 14It Takes Several Rate Hikes Before It Hurts Stock Multiples Chart 15India's Cyclical Expansion Has A Tailwind From Cheap Currency Investment Conclusions Equities: Given the vertical rise earlier this year, Indian stocks would likely need a few more months to digest previous gains and consolidate. Hence, even though the country’s cyclical outlook remains constructive, we recommend that dedicated EM and Asian equity portfolios stay neutral on this market for now. Absolute return investors should stay on the sidelines and wait for a better entry point. Currency and Bonds: The rupee is cheap and could be one of the best performers within the EM world over a cyclical horizon. Indian government bonds also offer a good value with a rather high yield (6.4% for 10-year securities) amid a benign inflation outlook. A positive rupee outlook also makes Indian bonds more appealing for foreign investors. Investors should stay overweight India in an EM local currency bond portfolio. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes
The rally in Indian equities appears to be losing some steam. The MSCI India index is down nearly 4% over the past two weeks. This follows a spectacular 26% rally since Q2. The recent slump comes amid concerns that valuations are getting stretched and news…
Highlights Short-term inflation risk will escalate further if politics causes new supply disruptions. Long-term inflation risk is significant as well. There is a distinct risk of a geopolitical crisis in the Middle East that would push up energy prices: the US’s unfinished business with Iran. The primary disinflationary risk is China’s property sector distress. However, Beijing will strive to maintain stability prior to the twentieth national party congress in fall 2022. South Asian geopolitical risks are rising. The Indo-Pakistani ceasefire is likely to break down, while Afghani terrorism will rebound. Book gains on our emerging market currency short targeting “strongman” regimes. Feature Investors are underrating the risk of a global oil shock. This was our geopolitical takeaway from the BCA Conference this year. Investors are focused on the risk of inflation and stagflation, always with reference to the 1970s. The sharp increase in energy prices due to the Arab Oil Embargo of 1973 and the Iranian Revolution of 1979 are universally cited as aggravating factors of stagflation at that time. But these events are also given as critical differences between the situation in the 1970s and today. Unfortunately, there could be similarities. From a strictly geopolitical perspective, the risk of a conflict in the Middle East is significant both in the near term and over the coming year or so. The risk stems from the US’s unfinished business with Iran. More broadly, any supply disruption would have an outsized impact as global energy inventories decline. OPEC’s spare capacity at present can cover a 5 million barrel shock (Chart 1). In this week’s report we also provide tactical updates on China, Russia, and India. Geopolitics And The 1970s Inflation Chart 2Wage-Price Spiral, Stagflation In 1970s Fundamentally the stagflation of the 1970s occurred because global policymakers engendered a spiral of higher wages and higher prices. The wage-price spiral was exacerbated by a falling dollar, after President Nixon abandoned the gold standard, and a commodity price surge (Chart 2). Monetary policy clearly played a role. It was too easy for too long, with broad money supply consistently rising relative to nominal GDP (Chart 3). Central banks including the Federal Reserve were focused exclusively on employment. Policymakers saw the primary risk to the institution’s credibility as recession and unemployment, not inflation. Fear of the Great Depression lurked under the surface. Fiscal policy also played a role. The size of the US budget deficit at this time is often exaggerated but there is no question that they were growing and contributed to the bout of inflation and spike in bond yields (Chart 4). The reason was not only President Johnson’s large social spending program, known as the “Great Society.” It was also Johnson’s war – the Vietnam war. Chart 3Central Banks Focused On Employment, Not Prices, In 1970s On top of this heady mix of inflationary variables came geopolitics. The Yom Kippur war in 1973 prompted Arab states to impose an embargo on Israel’s supporters in the West. The Arab embargo cut off 8% of global oil demand at the time. Oil prices skyrocketed, precipitating a deep recession (Chart 5). Chart 4Johnson's 'Great Society' And Vietnam War Spending The embargo came to a halt in spring of 1974 after Israeli forces withdrew to the east of the Suez Canal. The oil shock exacerbated the underlying inflationary wave that continued throughout the decade. The Iranian revolution triggered another oil shock in 1979, bringing the rise in general prices to their peak in the early 1980s, at which point policymakers intervened decisively. Chart 5Arab Oil Embargo And Iranian Revolution There is an analogy with today’s global policy mix. Fear of the Great Recession and deflation rules within policymaking circles, albeit less so among the general public. The Fed and the European Central Bank have adjusted their strategies to pursue an average inflation target and “maximum employment.” Chart 6Wage-Price Spiral Today? The Biden administration is reviving big government with a framework agreement of around $1.2 trillion in new deficit spending on infrastructure, green energy, and social programs likely to pass Congress before year’s end. In short, the macro and policy backdrop are changing in a way that is reminiscent of the 1970s despite various structural differences between the two periods. It is too early to declare that a wage-price spiral has developed but core inflation is rising and investors are right to be concerned about the direction and potential for inflation surprises down the road (Chart 6). These trends would not be nearly as concerning if they were not occurring in the context of a shift in public opinion in favor of government versus markets, labor versus capital, onshoring versus offshoring, and protectionism versus free trade. Investors should note that the last policy sea change (in the opposite direction) lasted roughly 30-40 years. The global savings glut – shown here as the combined current account balances of the world’s major economies – has begun to decline, implying that a major deflationary force might be subsiding. Asian exporters apparently have substantial pricing power, as witnessed by rising export prices, although they have yet to break above the secular downtrend of the post-2008 period (Chart 7). Chart 7Hypo-Globalization Is Inflationary A commodity price surge is also underway, of course, though it is so far manageable. The US and EU economies are less energy-intensive than in the 1970s and there is considerable buffer between today’s high prices and an economic recession (Chart 8). Chart 8Wage-Price Spiral Today? The problem is that there is a diminishing margin of safety. Furthermore, a crisis in the Middle East is not far-fetched, as there is a concrete and distinct reason for worrying about one: the US’s unresolved collision course with Iran. A crisis in the Persian Gulf would greatly exacerbate today’s energy shortages. Iran: The Risk Of An Oil Shock Iran now says it will rejoin diplomatic talks over its nuclear program in late November. This development was expected, and is important, but it masks the urgent and dangerous trajectory of events that could blow up any day now. It is emphatically not an “all clear” sign for geopolitical risk in the Persian Gulf. The US is hinting, merely hinting, that it is willing to use military force to prevent Iran from going nuclear. The Iranians doubt US appetite for war and have every reason to think that nuclear status will guarantee them regime survival. Thus the Iranians are incentivized to use diplomacy as a screen while pursuing nuclear weaponization – unless the US and Israel make a convincing display of military strength to force Iran back to genuine diplomacy. A convincing display is hard to do. A secret war is taking place, of sabotage and cyber-attacks. On October 26 a cyber-attack disrupted Iranian gas stations. But even attacks on nuclear scientists and facilities have not dissuaded the Iranians from making progress on their nuclear program yet. Iran does not want to be attacked but it knows that a ground invasion is virtually impossible and air strikes alone have a poor record of winning wars. The Iranians have achieved 60% highly enriched uranium and are expected to achieve nuclear breakout capacity – the ability to make a nuclear device – sometime between now and December (Table 1). The IAEA no longer has any visibility in Iran. The regime’s verified production of uranium metal can only be used for the construction of a warhead. Recent technical progress may be irreversible, according to the Institute for Science and International Security.1 If that is true then the upcoming round of diplomatic negotiations is already doomed. Table 1Iran’s Compliance With Nuclear Deal And Time Until Breakout (Oct 2021) American policymakers seem overconfident in the face of this clear nuclear proliferation risk. This is strange given that North Korea successfully manipulated them over the past three decades and now has an arsenal of 40-50 nuclear weapons. The consensus goes as follows: Regime instability: Americans emphasize that the Iranian regime is unstable, lacks genuine support, and faces a large and restive youth population. This is all true. Indeed Iran is one of the most likely candidates for major regime instability in the wake of the COVID-19 shock. Chart 9AIran's Economy Sees Inflation Spike ... Chart 9B... Yet Some Green Shoots Are Rising However, popular protest has not had any effect on the regime over the past 12 years. Today the economy is improving and illicit oil revenues are rising (Chart 9). A new nationalist government is in charge that has far greater support than the discredited reformist faction that failed on both the economic and foreign policy fronts (Chart 10). The sophisticated idea that achieving nuclear breakout will somehow weaken the regime is wishful thinking. If it provokes US and/or Israeli air strikes, it will most likely see the people rally around the flag and convince the next generation to adopt the revolutionary cause.2 If it does not provoke a war, then the regime’s strategic wisdom will be confirmed. American military and economic superiority: Americans tend to think that Iran will back down in the face of the US’s and Israel’s overwhelming military and economic superiority. It is true that a massive show of force – combined with the sale of specialized weaponry to Israel to enable a successful strike against extremely hardened nuclear facilities – could force Iran to pause its nuclear quest and go back to negotiations. Yet the US’s awesome display of military power in both Iraq and Afghanistan ended in ignominy and have not deterred Iran, just next door, after 20 years. Nor have American economic sanctions, including “maximum pressure” sanctions since 2019. The US is starkly divided, very few people view Iran as a major threat, and there is an aversion to wars in the Middle East (Chart 11). The Iranians could be forgiven for doubting that the US has the appetite to enforce its demands. In short the US is attempting to turn its strategic focus to China and Asia Pacific, which creates a power vacuum in the Middle East that Iran may attempt to fill. Meanwhile global supply and demand balances for energy are tight, with shortages popping up around the world, giving Iran greater leverage. From an investment point of view, a crisis is likely in the near term regardless of what happens afterwards. A crisis is necessary to force the US and Iran to return to a durable nuclear deal like in 2015. Otherwise Iran will reach nuclear breakout and an even bigger crisis will erupt, potentially forcing the US and Israel (or Israel alone) to take military action. Diplomatic efforts will need to have some quick and substantial victories in the coming months to convince us that the countries have moved off their collision course. A conflict with Iran will not necessarily go to the extreme of Iran shutting down the Strait of Hormuz and cutting off 21% of the world’s oil and 26% of liquefied natural gas (Chart 12). If that happens a global recession is unavoidable. It would more likely involve lesser conflicts, at least initially, such as “Tanker War 2.0” in the Persian Gulf.3 Or it could involve a flare-up of the ongoing proxy war by missile and drone strikes, such as with the Abqaiq attack in 2019 that knocked 5.7 million barrels per day offline overnight. The impact on oil markets will depend on the nature and magnitude of the event. What are the odds of a military conflict? In past reports we have demonstrated that there is a 40% chance of conflict with Iran. The country’s nuclear program is at a critical juncture. The longer the world goes without a diplomatic track to defuse tensions, the more investors should brace for negative surprises. Bottom Line: There is a clear and present danger of a geopolitical oil shock. The implication is that oil and LNG prices could spike in the coming zero-to-12 months. The implication would be a dramatic “up then down” movement in global energy prices. Inflation expectations should benefit from simmering tensions but a full-blown war would cause an extreme price spike and global recession. China: The Return Of The Authoritative Person Another reason that today’s inflation risk could last longer than expected is that China’s government is likely to backpedal from overtightening monetary, fiscal, and regulatory policy. If this is true then China will secure its economic recovery, the global recovery will continue, commodity prices will stay elevated, and the inflation expectations and bond yields will recover. If it is not true then investors will start talking about disinflation and deflation again soon. We are not bullish on Chinese assets – far from it. We see China entering a property-induced debt-deflation crisis over the long run. But over the 2021-22 period we have argued that China would pull back from the brink of overtightening. Our GeoRisk Indicator for China highlights how policy risk remains elevated (see Appendix). So far our assessment appears largely accurate. The government has quietly intervened to prevent the troubled developer Evergrande from suffering a Lehman-style collapse. The long-delayed imposition of a nationwide property tax is once again being diluted into a few regional trial balloons. Alibaba founder Jack Ma, whom the government disappeared last year, has reappeared in public view, which implies that Beijing recognizes that its crackdown on Big Tech could cause long-term damage to innovation. At this critical juncture, a mysterious “authoritative” commentator has returned to the scene after five years of silence. Widely believed to be Vice Premier Liu He, a Politburo member and Xi Jinping confidante on economic affairs, the authoritative person argues in a recent editorial that China will stick with its current economic policies.4 However, the message was not entirely hawkish. Table 2 highlights the key arguments – China is not oblivious to the risk of a policy mistake. Table 2Messages From China’s ‘Authoritative Person’ On Economic Policy (2021) Readers will recall that a similar “authoritative Person” first appeared in the People’s Daily in May 2016. At that time, the Chinese government had just relented in the face of economic instability and stimulated the economy. It saw a 3.5% of GDP increase in fiscal spending and a 10.0% of GDP increase in the credit impulse from the trough in 2015 to the peak in 2016. The authoritative person was explaining that the intention to reform would persist despite the relapse into debt-fueled growth. So one must wonder today whether the authoritative person is emerging because Beijing is sticking to its guns (consensus view) or rather because it is gradually being forced to relax policy by the manifest risk of financial instability. To be fair, a recent announcement on government special purpose bonds does not indicate major fiscal easing. If local governments accelerate their issuance of new special purpose bonds to meet their quota for the year then they are still not dramatically increasing the fiscal support for the economy. But this announcement could protect against downside growth risks. The first quarter of 2022 will be the true test of whether China will remain hawkish. Going forward there are two significant dangers as we see it. The first is that policymakers prove ideological rather than pragmatic. An autocratic government could get so wrapped up in its populist campaign to restrain high housing costs that it refuses to slacken policies enough and causes a crash. The second danger is that inflation stays higher for longer, preventing authorities from easing policy even when they know they need to do so to stabilize growth. The second danger is the bigger of the two risks. As for the first risk, ideology will take a backseat to necessity. Xi Jinping needs to secure key promotions for his faction in the top positions of the Communist Party at the twentieth national party congress in 2022. He cannot be sure to succeed if the economy is in free fall. A self-induced crash would be a very peculiar way of trying to solidify one’s stature as leader for life at the critical hour. Similarly China cannot maintain a long-term great power competition with the United States if it deliberately triggers property deflation and financial turmoil. It can and will continue modernizing and upgrading its military, e.g. developing hypersonic missiles, even if it faces financial turmoil. But it will have a much greater chance of neutralizing US regional allies and creating a regional buffer space if its economic growth is stable. Ultimately China cannot prevent financial instability, economic distress, and political risk from rising in the coming years. There will be a reckoning for its vast imbalances, as with all countries. It could be that this reckoning will upset the Xi administration’s best-laid plans for 2022. But before that happens we expect policy to ease. A policy mistake today would mean that very negative economic outcomes will arrive precisely in time to affect sociopolitical stability ahead of the party congress next fall. We will keep betting against that. Bottom Line: China’s “authoritative” media commentator shows that policymakers are not as hawkish as the consensus holds. The main takeaway is that policymakers will adjust the intensity of their reform efforts to maintain stability. This is standard Chinese policymaking and it is more important than usual ahead of the political rotation in 2022. Otherwise global inflation risk will quickly give way to deflation risk as defaults among China’s property developers spread and morph into broader financial and economic instability. Indo-Pakistani Ceasefire: A Breakdown Is Nigh India and Pakistan agreed to a ceasefire along the line of control in February 2021. While the agreement has held up so far, a breakdown is probably around the corner. It was never likely to last for long. Over the short run, the ceasefire made sense for both countries: COVID-19 Risks: The first wave of the pandemic had abated but COVID-19-related risks loomed large. India had administered less than 15 million vaccine doses back then and Pakistan only 100,000. Dangerous Transitions Were Underway: With America’s withdrawal from Afghanistan in the works, Pakistan was fully focused on its western border. India was pre-occupied with its eastern front, where skirmishes with Chinese troops forced it to redirect some of its military focus. As we now head towards the end of 2021, these constraints are no longer binding. COVID-19 Risks Under Control: The vaccination campaign in India and Pakistan has gathered pace. More than 50% of India’s population and 30% of Pakistan’s have been given at least one dose. Pakistan’s Ducks Are Lined-up In Afghanistan: America’s withdrawal from Afghanistan has been completed. Afghanistan is under Taliban’s control and Pakistan has a better hold over the affairs of its western neighbor. One constraint remains: India and China remain embroiled in border disputes. Conciliatory talks between their military commanders broke down a fortnight ago. Winter makes it nearly impossible to undertake significant operations in the Himalayas but a failure of coordination today could set up a conflict either immediately or in the spring. While India may see greater value in maintaining the ceasefire than Pakistan, India has elections due in key northern states in 2022. India’s northern states harbor even less favorable views of Pakistan than the rest of India. Hence any small event could trigger a disproportionate response from India. Bottom Line: While it is impossible to predict the timing, a breakdown in the Indo-Pakistani ceasefire may materialize in 2022 or sooner. Depending on the exact nature of any conflict, a geopolitically induced selloff in Indian equities could create a much-needed consolidation of this year’s rally and ultimately a buying opportunity. Russia, Global Terrorism, And Great Power Relations Part of Putin’s strategy of rebuilding the Russian empire involves ensuring that Russia has a seat at the table for every major negotiation in Eurasia. Now that the US has withdrawn forces from Afghanistan, Russia is pursuing a greater role there. Most recently Russia hosted delegations from China, Pakistan, India, and the Taliban. India too is planning to host a national security advisor-level conference next month to discuss the Afghanistan situation. Do these conferences matter for global investors? Not directly. But regional developments can give insight into the strategies of the great powers in a world that is witnessing a secular rise in geopolitical risk. China, Russia, and India have skin in the game when it comes to Afghanistan’s future. This is because all three powers have much to lose if Afghanistan becomes a large-scale incubator for terrorists who can infiltrate Russia through Central Asia, China through Xinjiang, or India through Pakistan. Hence all three regional powers will be constrained to stay involved in the affairs of Afghanistan. Terrorism-related risks in South Asia have been capped over the last decade due to the American war (Chart 13). The US withdrawal will lead to the activation of latent terrorist activity. This poses risks specifically for India, which has a history of being targeted by Afghani terrorist groups. And yet, while China and Russia saw the Afghan vacuum coming and have been engaging with Taliban from the get-go, India only recently began engaging with Taliban. The evolution of Afghanistan under the Taliban will also influence the risk of terrorism for the rest of the world. In the wake of the global pandemic and recession, social misery and regime failures in areas with large youth populations will continue to combine with modern communications technology to create a revival of terrorist threats (Chart 14). American officials recently warned of the potential for transnational attacks based in Afghanistan to strike the homeland within six months. That risk may be exaggerated today but it is real over the long run, especially as US intelligence turns its strategic focus toward states and away from non-state actors. India, Europe, and other targets are probably even more vulnerable than the United States. If Russia and China succeed in shaping the new Afghanistan’s leadership then the focus of militant proxies will be directed elsewhere. Beyond terrorism, if Russia and China coordinate closely over Afghanistan then India may be left in the cold. This would reinforce recent trends in which a tightening Russo-Chinese partnership hastens India’s shift away from neutrality and toward favoring the US and the West in strategic matters. If these trends continue to the point of alliance formation, then they increase the risk that any conflicts between two powers will implicate others. Bottom Line: Afghanistan is now a regional barometer of multilateral cooperation on counterterrorism, the exclusivity of Russo-Chinese cooperation, and India’s strategic isolation or alignment with the West. Investment Takeaways It is too soon to play down inflation risks. We share the BCA House View that they will subside next year as pandemic effects wane. But we also see clear near-term risks to this view. In the short run (zero to 12 months), a distinct risk of a Middle Eastern geopolitical crisis looms. A gradual escalation of tensions is inflationary whereas a sharp spike in conflict would push energy prices into punitive territory and kill global demand. Over the next 12 months, China’s economic and financial instability will also elicit policy easing or fiscal stimulus as necessary to preserve stability, as highlighted by the regime’s mouthpiece. Obviously stimulus will not be utilized if the economic recovery is stable, given elevated producer prices. In a future report we will show that Russia is willing and able to manipulate natural gas prices to increase its bargaining leverage over Europe. This dynamic, combined with the risk of cold winter weather exacerbating shortages, suggests that the worst is not yet over. Geopolitical conflict with Russia will resume over the long run. Stay long gold as a hedge against both inflation and geopolitical crises involving Iran, Taiwan/China, and Russia. Maintain “value” plays as a cheap hedge against inflation. Book a profit of 2.5% on our short trade for currencies of emerging market “strongmen,” Turkey, Brazil, and the Philippines. Our view is still negative on these economies. Stay long cyber-security stocks. Over the long run, inflation risk must be monitored. We expect significant inflation risk to persist as a result of a generational change in global policy in favor of government and labor over business and capital. But the US is maintaining easy immigration policy and boosting productivity-enhancing investments. Meanwhile China’s secular slowdown is disinflationary. The dollar may remain resilient in the face of persistently high geopolitical risk. The jury is still out. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 David Albright and Sarah Burkhard, "Iran’s Recent, Irreversible Nuclear Advances," Institute for Science and International Security, September 22, 2021, isis-online.org. 2 Ray Takeyh, "The Bomb Will Backfire On Iran," Foreign Affairs, October 18, 2021, foreignaffairs.com. 3 See Aaron Stein and Afshon Ostovar, "Tanker War 2.0: Iranian Strategy In The Gulf," Foreign Policy Research Institute, August 10, 2021, fpri.org. 4 "Ten Questions About China’s Economy," Xinhua, October 24, 2021, news.cn. Section II: Appendix: GeoRisk Indicator China Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia South Africa Section III: Geopolitical Calendar