War/Conflict
Highlights The tech sector faces mounting domestic political and geopolitical risks. We fully expected stimulus hiccups but believe they will give way to large new fiscal support, given that COVID-19 is weighing on consumer confidence. Europe’s relative political stability is a good basis for the euro rally but any comeback in opinion polling by President Trump could give dollar bulls new life. DXY is approaching a critical threshold below which it would break down further. The US could take aggressive actions on Russia and Iran, but China and the Taiwan Strait remain the biggest geopolitical risk. Feature Near-term risks continue to mount against the equity rally, even as governments’ combined monetary and fiscal policies continue to support a cyclical economic rebound. Chart 1Tech Bubble Amid Tech War Testimony by the chief executives of Facebook, Apple, Amazon, and Alphabet to the US House of Representatives highlighted the major political risks facing the market leaders. There are three reasons not to dismiss these risks despite the theatrical nature of the hearings. First, the tech companies’ concentration of wealth would be conspicuous during any economic bust, but this bust has left pandemic-stricken consumers more reliant on their services. Second, acrimony is bipartisan – conservatives are enraged by the tendency of the tech companies to side with the Democratic Party in policing the range of acceptable political discourse, and they increasingly agree with liberals that the companies have excessive corporate power warranting anti-trust probes. Executive action is the immediate risk, but in the coming one-to-two years congressional majorities will also be mustered to tighten regulation. Third, technology is the root of the great power struggle between the US and China – a struggle that will not go away if Biden wins the election. Indeed Biden was part of the administration that launched the US’s “Pivot to Asia” and will have better success in galvanizing US diplomatic allies behind western alternatives to Chinese state-backed and military-linked tech companies. US tech companies struggle to outperform Chinese tech companies except during episodes of US tariffs, given the latter firms’ state-backed turn toward innovation and privileged capture of the Chinese domestic market (Chart 1). The US government cannot afford to break up these companies without weighing the strategic consequences for America’s international competitiveness. The attempt to coordinate a western pressure campaign against Huawei and other leading Chinese firms will continue over the long run as they are accused of stealing technology, circumventing UN sanctions, violating human rights, and compromising the national security of the democracies. China, for its part, will be forced to take counter-measures. US tech companies will be caught in the middle. Like the threat of executive regulation in the domestic sphere, the threat of state action in the international sphere is difficult to time. It could happen immediately, especially given that the US is having some success in galvanizing an alliance even under President Trump (see the UK decision to bar Huawei) and that President Trump’s falling election prospects remove the chief constraint on tough action against China (the administration will likely revoke Huawei’s general license on August 13 or closer to the election). Massive domestic economic stimulus empowers the US to impose a technological cordon and China to retaliate. Combining this headline risk to the tech sector with other indications that the equity rally is extended – the surge in gold prices, the fall in the 30-year/5-year Treasury slope – tells us that investors should be cautious about deploying fresh capital in the near term. Republicans Will Capitulate To New Stimulus Just as President Trump has ignored bad news on the coronavirus, financial markets have ignored bad news on the economy. Dismal Q2 GDP releases were fully expected – Germany shrank by 10.1% while the US shrank by 9.5% on a quarterly basis, 32.9% annualized. But the resurgence of the virus is threatening new government restrictions on economic activity. US initial unemployment claims have edged up over the past three weeks. US consumer confidence regarding future expectations plummeted from 106.1 in June to 91.5 in July, according to the Conference Board’s index. Chart 2Global Instability Will Follow Recession Setbacks in combating the virus will hurt consumers even assuming that governments lack the political will to enforce new lockdowns. The share of countries in recession has surged to levels not seen in 60 years (Chart 2). Financial markets can look past recessions, but the pandemic-driven recession will result in negative surprises and second-order effects that are unforeseen. Yes, fresh fiscal stimulus is coming, but this is more positive for the cyclical outlook than the tactical outlook. Stimulus “hiccups” could precipitate a near-term pullback – such a pullback may be necessary to force politicians to resolve disputes over the size and composition of new stimulus. This risk is immediate in the United States, where House Democrats, Senate Republicans, and the White House have hit an all-too-predictable impasse over the fifth round of stimulus. The bill under negotiation is likely to be President Trump’s last chance to score a legislative victory before the election and the last significant legislative economic relief until early 2021. The Senate Republicans have proposed a $1.1 trillion HEALS Act in response to the House Democrats’ $3.4 trillion HEROES Act, passed in mid-May. As we go to press, the federal unemployment insurance top-up of $600 per week is expiring, with a potential cost of 3% of GDP in fiscal tightening, as well as the moratorium on home evictions. Congress will have to rush through a stop-gap measure to extend these benefits if it cannot resolve the debate on the larger stimulus package. If Democrats and Republicans split the difference then we will get $2.5 trillion in stimulus, likely by August 10. Compromise on the larger package is easy in principle, as Table 1 shows. If the two sides split the difference between their proposals in a commonsense way, as shown in the fourth and fifth columns of Table 1, then the result will be a $2.5 trillion stimulus. This estimate fits with what we have published in the past and likely meets market expectations for the time being. Table 1Outline Of Fifth US COVID Stimulus Package (Estimate) Whether it is enough for the economy depends on how the virus develops and how governments respond once flu season picks up and combines with the coronavirus to pressure the health system this fall. A back-of-the-envelope estimate of the amount of spending necessary to keep the budget deficit from shrinking in the second half of the year comes much closer to the House Democrats’ $3.4 trillion bill (Table 2), which suggests that what appears to be a massive stimulus today could appear insufficient tomorrow. Nevertheless, $2.5 trillion is not exactly small. It would bring the US total to $5 trillion year-to-date, or 24% of GDP! Table 2Reducing The Budget Deficit On A Quarterly Basis Will Slow Economy While a compromise bill should come quickly, the Republican Party is more divided over this round of stimulus than earlier this year. Chart 3US Personal Income Looks Good Compared To 2008-09 First, there is some complacency due to the fact that the economy is recovering, not collapsing as was the case back in March. Our US bond strategist, Ryan Swift, has shown that US personal income is much better off, thus far, than it was in the months following the 2008 financial crisis, even though the initial pre-transfer hit to incomes is larger (Chart 3). Second, the Republican Party is reacting to growing unease within its ranks over the yawning budget deficit, now the largest since World War II (Chart 4). Chart 4If Republicans React To Deficit Concerns They Cook Their Own Goose Chart 5Consumer Confidence Sends Warning Signal To Republicans If Republicans are guided by complacency and fiscal hawks, they will cook their own goose. A failure to provide government support will cause a financial market selloff, will hurt consumer confidence, and will put the final nail in the coffin of their own chance of re-election as well as President Trump’s. Consumer confidence tracks fairly well with presidential approval rating and election outcomes. A further dip could disqualify Trump, whereas a last-minute boost due to stimulus and an economic surge could line him up for a comeback in the last lap (Chart 5). These constraints are obvious so we maintain our high conviction call that a bill will be passed, likely by August 10. But at these levels on the equity market, we simply have no confidence in the market gyrations leading up to or following the passage of the bill. Our conviction level is on the cyclical, 12-month horizon, in which case we expect US and global stimulus to operate and equities to rise. Bottom Line: Political and economic constraints will force Republicans to join Democrats and pass a new stimulus bill of about $2.5 trillion by around August 10. This is cyclically positive, but hiccups in getting it passed, negative surprises, and other risks tied to US politics discourage us from taking an overtly bullish stance over the next three months. Yes, US-China Tensions Are Still Relevant Chart 6Chinese Politburo"s Bark Worse Than Bite On Stimulus Financial markets have shrugged off US-China tensions this year for understandable reasons. The pandemic, recession, and stimulus have overweighed the ongoing US-China conflict. As we have argued, China is undertaking a sweeping fiscal and quasi-fiscal stimulus – despite lingering hawkish rhetoric – and the size is sufficient to assist in global economic recovery as well as domestic Chinese recovery. What the financial market overlooks is that China’s households and firms are still reluctant to spend (Chart 6). China’s Politburo's late July meetings on the economy are frequently important. Initial reports of this year’s meet-up reinforce the stimulus narrative. Hints of hawkishness here and there serve a political purpose in curbing market exuberance, both at home and in the US election context, but China will ultimately remain accommodative because it has already bumped up against its chief constraint of domestic stability. Note that this assessment also leaves space for market jitters in the near-term. The phase one trade deal remains intact as President Trump is counting on it to make the case for re-election while China is looking to avoid antagonizing a loose cannon president who still has a chance of re-election. As long as broad-based tariff rates do not rise, in keeping with Trump’s deal, financial markets can ignore the small fry. We maintain a 40% risk that Trump levels sweeping punitive measures; our base case is that he goes to the election arguing that he gets results through his deal-making while carrying a big stick. At the same time, our view that domestic stimulus removes the economic constraints on conflict, enabling the two countries to escalate tensions, has been vindicated in recent weeks. Chinese political risk continues on a general uptrend, based on market indicators. The market is also starting to price in the immense geopolitical risks embedded in Taiwan’s situation, which we have highlighted consistently since 2016. While North Korea remains on a diplomatic track, refraining from major military provocations, South Korean political risk is still elevated both for domestic and regional reasons (Chart 7). Chart 7China Political Risk Still Trending Upward The market is gradually pricing in a higher risk premium in the renminbi, Taiwanese dollar, and Korean won, and this pricing accords with our longstanding political assessment. The closure of the US and Chinese consulates in Houston and Chengdu is only the latest example of this escalating dynamic. While the US’s initial sanctions on China over Hong Kong were limited in economic impact, the longer term negative consequences continue to build. Hong Kong was the symbol of the Chinese Communist Party’s compatibility with western liberalism; the removal of Hong Kong’s autonomy strikes a permanent blow against this compatibility. China’s decision to go forward with the imposition of a national security law in Hong Kong – and now to bar pro-democratic candidates from the September 6 Legislative Council elections, which will probably be postponed anyway – has accelerated coalition-building among the western democracies. The UK is now clashing with China more openly, especially after blocking Huawei from its 5G system and welcoming Hong Kong political refugees. Australia and China have fought a miniature trade war of their own over China’s lack of transparency regarding COVID-19, and Canada is implicated in the Huawei affair. Even the EU has taken a more “realist” approach to China. Across the Taiwan Strait, political leaders are assisting fleeing Hong Kongers, crying out against Beijing’s expansion of control in its periphery, rallying support from informal allies in the US and West, and doubling down on their “Silicon Shield” (prowess in semiconductor production) as a source of protection. Intel Corporation’s decision to increase its dependency on TSMC for advanced microchips only heightens the centrality of this island and this company in the power struggle between the US and China. China cannot fulfill its global ambitions if the US succeeds in creating a technological cordon. Taiwan is the key to China’s breaking through that cordon. Therefore Taiwan is at heightened risk of economic or even military conflict. The base case is that Beijing will impose economic sanctions first, to undermine Taiwanese leadership. The uncertainty over the US’s willingness to defend Taiwan is still elevated, even if the US is gradually signaling a higher level of commitment. This uncertainty makes strategic miscalculations more likely than otherwise. But Taiwan’s extreme economic dependence on the mainland gives Beijing a lever to pursue its interests and at present that is the most important factor in keeping war risk contained. By the same token, Taiwanese economic and political diversification increases that risk. A “fourth Taiwan Strait crisis” that involves trade war and sanctions is our base case, but war cannot be ruled out, and any war would be a major war. Thus investors can safely ignore Tik-Tok, Hong Kong LegCo elections, and accusations of human rights violations in Xinjiang. But they cannot ignore concrete deterioration in the Taiwan Strait. Or, for that matter, the South and East China Seas, which are not about fishing and offshore drilling but about China’s strategic depth and positioning around Taiwan. Taiwan is at heightened risk of economic or military conflict. The latest developments have seen the CNY-USD exchange rate roll over after a period of appreciation associated with bilateral deal-keeping (Chart 8). Depreciation makes it more likely that President Trump will take punitive actions, but these will still be consistent with maintaining the phase one deal unless his re-election bid completely collapses, rendering him a lame duck and removing his constraints on more economically significant confrontation. We are perilously close to such an outcome, which is why Trump’s approval rating and head-to-head polling against Joe Biden must be monitored closely. If his budding rebound is dashed, then all bets are off with regard to China and Asian power politics. Chart 8A Warning Of Further US-China Escalation Bottom Line: China’s stimulus, like the US stimulus, is a reason for cyclical optimism regarding risk assets. The phase one trade deal with President Trump is less certain – there is a 40% chance it collapses as stimulus and/or Trump’s political woes remove constraints on conflict. Hong Kong is a red herring except with regard to coalition-building between the US and Europe; the Taiwan Strait is the real geopolitical risk. Maritime conflicts relate to Taiwan and are also market-relevant. Europe, Russia, And Oil Risks Europe has proved a geopolitical opportunity rather than a risk, as we have contended. The passage of joint debt issuance in keeping with the seven-year budget reinforces the point. The Dutch, facing an election early next year, held up the negotiations, but ultimately relented as expected. Emmanuel Macron, who convinced German Chancellor Angela Merkel to embrace this major compromise for European solidarity, is seeing his support bounce in opinion polls at home. He is being rewarded for taking a leadership position in favor of European integration as well as for overseeing a domestic economic rebound. His setback in local elections is overstated as a political risk given that the parties that benefited do not pose a risk to European integration, and will ally with him in 2022 against any populist or anti-establishment challenger. We still refrain from reinitiating our long EUR-USD trade, however, given the immediate risks from the US election cycle (Chart 9). We will reevaluate if Trump’s odds of victory fall further. A Biden victory is very favorable for the euro in our view. Chart 9EUR-USD Gets Boost From EU Solidarity We are bullish on pound sterling because even a delay or otherwise sub-optimal outcome to trade talks is mostly priced in at current levels (Charts 10A and 10B). Prime Minister Boris Johnson has the raw ability to walk away without a deal, in the context of strong domestic stimulus, but the long-term economic consequences could condemn him to a single term in office. Compromise is better and in both parties’ interests. Chart 10APound Sterling A Buy Over Long Run Chart 10BPound Sterling A Buy Over Long Run Two other risks are worth a mention in this month’s GeoRisk Update: Chart 11Russia: GeoRisk Indicator Russian Bonds May Face Sanctions Russia: In recent reports we have maintained that Russian geopolitical risk is understated by markets. Domestic unrest is rising, the Trump administration could impose penalties over Nordstream 2 or other issues to head off criticism on the campaign trail, and a Biden administration would be outright confrontational toward Putin’s regime. Moscow may intervene in the US elections or conduct larger cyber attacks. US sanctions could ultimately target trading of local currency Russian government bonds, which so far have been spared (Chart 11). Iran: The jury is still out on whether the recent series of mysterious explosions affecting critical infrastructure in Iran are evidence of a clandestine campaign of sabotage (Table 3). The nature of the incidents leaves some room for accident and coincidence.1 But the inclusion of military and nuclear sites in the list leads us to believe that some degree of “wag the dog” is going on. The prime suspect would be Israel and/or the United States during the window of opportunity afforded by the Trump administration, which looks to be closing over the next six months. Trump likely has a high tolerance for conflict with Iran ahead of the election. Even though Americans are war-weary, they will rally to the president’s defense if Iran is seen as the instigator, as opinion polls showed they did in September 2019 and January of this year. Iran is avoiding goading Trump so far but if it suffers too great of damage from sabotage then it may be forced to react. The dynamic is unstable and hence an oil price spike cannot be ruled out. Table 3Wag The Dog Scenario Playing Out In Iran Chart 12Oil Supply Risks Stem From Iran/Iraq, But COVID Threat To Demand Persists Oil markets have the capacity and the large inventories necessary to absorb supply disruptions caused by a single Iranian incident (Chart 12). Only a chain reaction or major conflict would add to upward pressure. This would also require global demand to stay firm. The threat from COVID-19 suggests that volatility is the only thing one can count on in the near-term. Over the long run we remain bullish crude oil due to the unfettered commitment by world governments to reflation. Bottom Line: The euro rally is fundamentally supported but faces exogenous risks in the short run. We would steer clear of Russian currency and local currency bonds over the US election campaign and aftermath, particularly if Trump’s polling upturn becomes a dead cat bounce. Iran is a “gray swan” geopolitical risk, hiding in plain sight, but its impact on oil markets will be limited unless a major war occurs. Investment Implications The US dollar is at a critical juncture. Our Foreign Exchange Strategist Chester Ntonifor argues that if the DXY index breaks beneath the 93-94 then the greenback has entered a structural bear market. The most recent close was 93.45 and it has hovered below 94 since Monday. Failure to pass US stimulus quickly could result in a dollar bounce along with other safe havens. Over the short run, investors should be prepared for this and other negative surprises relating to the US election and significant geopolitical risks, especially involving China, the tech war, and the Taiwan Strait. Over the long run, investors should position for more fiscal support to combine with ultra-easy monetary policy for as far as the eye can see. The Federal Reserve is not even “thinking about thinking about raising rates.” This combination ultimately entails rising commodity prices, a weakening dollar, and international equity outperformance relative to both US equities and government bonds. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 See Raz Zimmt, "When it comes to Iran, not everything that goes boom in the night is sabotage," Atlantic Council, July 30, 2020. Section II: Appendix : GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Section III: Geopolitical Calendar
Highlights The bull market in US-Iran tensions was never resolved, and now a series of suspicious explosions in Iran raises the possibility that tensions will re-escalate. Iran’s interest lies in waiting out Trump so that a Democratic victory in the US election can restore the US-Iran strategic détente agreed in 2015. However, both the Trump administration and US ally Israel are applying “maximum pressure” on Iran and could go on the offensive at a time when Trump’s odds of re-election are collapsing. Israel cannot engage in a full-fledged war with Iran alone but it would have American backing for pressure tactics through the duration of Trump’s term. A “wag the dog” scenario is not inconceivable because the US and Israel have long-term national security interests at stake while Iran is on the verge of economic collapse. Investors should prepare for near-term global equity volatility and safe-haven demand for a number of reasons but a major escalation in Iran would add to the list. Stay long Brent crude oil. Feature Since May 2018 we have argued that US-Iran tensions will remain market-relevant. We downgraded the odds of US air strikes from 40% in June 2019 to 20% in January of this year after Iran’s lackluster retaliation to the US assassination of its top military commander. Now things are heating up again due to a series of extremely suspicious explosions in Iran that may or may not be linked to Israel and the United States. The COVID-19 pandemic, oil price rout, and global recession have reinforced this bull market in US-Iran tensions by weakening and destabilizing the entire Shia Crescent, from Lebanon to Iran. They have also pushed President Trump dangerously close to “lame duck” status, which reduces the constraints on conflict with Iran for the remainder of his term. In this report we update our Iran view by looking at whether the Trump administration or Israel could attempt to “wag the dog,” i.e. provoke a conflict with Iran to boost Trump’s re-election odds or achieve some long-term strategic objectives while Trump is still in power. We have long held the view that Iran poses a market-relevant geopolitical risk and now the mysterious attacks in Iran suggest it could be materializing. Nothing is confirmed, but it is wise for investors to monitor these developments in case they escalate. Geopolitical incidents often cause buying opportunities but they can create substantial equity drawdowns first. Cyber-Rattling In The Middle East A string of mysterious explosions and fires at military and economic facilities have rocked Iran in recent days (Table 1). Table 1Iran Hit By A String Of Mysterious Attacks The most significant of these incidents is the July 2 explosion at the Natanz nuclear facility – Iran’s main uranium enrichment facility, which houses a new centrifuge assembly center.1 The fire resulted in a significant setback to the development and production of advanced IR-6 and IR-8 centrifuges used to enrich uranium – by up to two years. Iranian officials initially downplayed the incidents as unsuspicious accidents. However the Natanz explosion was too significant to cast off. Iran’s state-run news agency IRNA declared that the Natanz incident may be the work of foreign countries, “especially the Zionist regime [Israel] and the US,” and vowed Iranian retaliation if sabotage is proven to be the case. Similarly, the New York Times reported that an anonymous Middle Eastern intelligence official – rumored to be Mossad chief Yossi Cohen – called the incident the work of Israel.2 Israel’s response to these allegations has been oblique, but the accusation is not far-fetched. Israel has a successful history of halting the advancement of nuclear programs in the region. Mossad’s Operation Opera destroyed Iraq’s only known nuclear facility in 1981, and Operation Outside the Box bombed a suspected nuclear reactor at the Kibar site in Syria in 2007. Israeli intelligence has also previously been accused of targeting Iran’s missile program – with the assassination of four Iranian nuclear scientists between 2010 and 2012. Israel is also believed to be involved, with the US, in Operation Olympic Games, the Stuxnet cyber attacks that stunted Iran’s uranium enrichment program circa 2010. Iran’s ballistic missile program and alleged nuclear weapons ambitions remain Israel’s greatest long-term strategic threat in the region. More recently, Iran and Israel have been locked in a series of cyber-attacks. Israel claims to have foiled an Iranian attack on its water facilities in April which attempted a cyber break on water control systems. A May 9 cyberattack on Iranian shipping hub Shahid Rajaae – through which half of Iran’s maritime trade traverses – is seen as Israeli retaliation. Most recently, Israel’s Mossad revealed that it thwarted Iranian attempts to attack Israeli diplomatic missions in Europe. These attacks come as the US increases pressure on UN Security Council members to support the indefinite extension of the UN arms embargo against Iran, which is scheduled to expire on October 18.3 But other signatories to the 2015 Iranian nuclear agreement – China, Russia, Germany, Britain, and France – argue that since the US withdrew from the Joint Comprehensive Plan of Action (JCPA), its threat to invoke a “snapback” provision of the deal to reimpose former UN sanctions on Iran is not legally valid. The other JCPA signatories remain committed to the deal, arguing for its necessity in order to continue IAEA inspections that prevent Iran from developing nuclear weapons. They are biding their time to see if Trump is re-elected before deciding anything. Iran has moved further from the JCPA’s requirements since announcing, on January 5, 2020, that it will no longer comply with restrictions to its nuclear program (Table 2). The risk is that unless controlled, this will eventually significantly reduce Iran’s “breakout time” – the time required to acquire enough fissile material for one bomb. The nuclear deal aimed to maintain at least a one-year breakout time, and this is generally understood to be the US’s “red line.” Table 2Iran No Longer Complying With 2015 Nuclear Deal Despite some non-compliance, Iran is still permitting IAEA inspectors to monitor and verify its nuclear activities. Yet the IAEA Board of Governors passed a resolution, requesting Iran’s cooperation in the investigation into possible undeclared nuclear materials and sites.4 Chart 1Iran's Sphere Of Influence In Collapse As tensions with US and Israel escalate, Tehran has been keen to highlight its military capabilities. Revolutionary Guard Navy Commander Rear Admiral Alireza revealed the existence of onshore and offshore underground missile sites along the Persian Gulf and Gulf of Oman, holding advanced long-range missiles and new weapons, more capable of launching attacks against enemies. Escalating tensions raise the likelihood of retaliation as Iran reconsiders its “strategic patience” policy.5 Tehran had been playing the waiting game, especially since Trump’s decision to assassinate Quds Force chief Qassem Soleimani in January. Iran has an interest in avoiding confrontation in the months ahead of the US election on November 3. Iran’s attack on Saudi Arabia in September 2019 led to a boost in Trump’s approval rating. A major conflict today would cause a patriotic rally around the president at a time when he is beset with negative opinion over the coronavirus response and poor race relations. Iran has an interest in Joe Biden winning the presidency in November. Biden would likely restore the US-Iran deal, which would remove sanctions and allow Iran to open its economy. However, neither the Trump administration nor the Israeli government share that interest. The latest attacks raise the possibility that the US and/or Israel are going on the offensive. This could force Iran to retaliate. Iranian moderates are already suffering domestically. Iran’s hardline parliamentarians were never on board with the nuclear deal and criticized President Hassan Rouhani when President Trump pulled out of it in May 2018. This past weekend Foreign Minister Javad Zarif, an ally of Rouhani whose reputation also rests on the deal, was heckled as he addressed the parliament. As of February, parliament is mostly comprised of hardliners.6 Iran is also on shaky ground in the Shia Crescent. Lebanon and Iraq – the two countries most entrenched in Iran’s sphere of influence – have been experiencing civil unrest. Protesters in both countries initially took to the streets last fall in demonstration of anger over government corruption, the sectarian based political system, and poor economic conditions. The pandemic and recession have breathed new life into these movements. The Lebanese pound collapsed on the parallel market since October, and some groups have called for the disarmament of Iran-backed Hezbollah (Chart 1). Meanwhile a June cabinet decision in Iraq to cap the amount and number of state salaries and pension payments collected – in attempt to buttress the country’s ailing finances – fueled outrage. Iraq’s Prime Minister Mustafa al-Kadhimi is also in a tussle with Iran-backed paramilitary forces as he attempts to curb their influence and bring them under state control.7 Chart 2Iran Has Little To Lose Thus a timid stance by Iran in face of foreign attacks will not go down well. Instead, with oil production having collapsed, the economy in shambles, and its sphere of influence in turmoil, Tehran has little to lose in protecting what is left of its nuclear program and deterring American or Israeli aggression (Chart 2). With few options left, Iran is likely to move further away from its “strategic patience” in response to the uptick in “maximum pressure.” Bottom Line: Tensions are escalating between Tehran and Washington/Tel Aviv. Cyber attacks are likely to increase in the lead up to the expiration of the arms embargo on October 18 and US elections this fall. Iran may be forced to abandon its policy of “strategic patience” if its foes sabotage its nuclear capabilities. Expect the conflict to spillover to Iran’s proxies in the region – Iraq, Lebanon, and Syria. So What? Massive monetary and fiscal stimulus and continued commitment from OPEC 2.0 on the supply side will keep oil prices moving higher this year. Barring a second COVID-19 wave, our Commodity & Energy Strategists expect oil markets to rebalance beginning in 3Q2020, with Brent prices averaging $40/bbl this year and $65/bbl in 2021 (Chart 3). We remain long Brent which is up 70.55% since initiation in March. The escalation in tensions in the Persian Gulf is an upside risk to this assessment. That said, with major oil producers now operating significantly below capacity in compliance with the OPEC 2.0 production agreement, the net impact on oil prices will likely be muted and short-lived. Production can be increased to fill gaps. As demonstrated by the recent acts of sabotage in Iran and Israel, the increase in geopolitical tensions globally will manifest in cyberattacks, supporting cyber stocks. Our strategically long ISE Cyber Security Index relative to the S&P500 Info Tech sector trade is up 2% since initiation in April (Chart 4). Chart 3Oil Markets On The Way To Recovery Chart 4Buy Cybersecurity Stocks Finally, we should note that Iran is not the only geopolitical risk that could explode amid the US election cycle. China is the greater risk. But President Trump faces fewer financial and economic constraints in a conflict with Iran than he does in a conflict with China. A conflict with Iran could change the game ahead of the election at a time when Trump is beset with the coronavirus and social unrest. His opinion polling would benefit from a rally around the flag, as it did in September 2019. The risk for Trump is that this bump may not last long. Americans are less concerned about Iran than China and Russia and Trump himself has benefited from American weariness of Middle Eastern wars. All we can say for certain is that the US election is of critical strategic importance to several major and minor powers. Trump’s allies and enemies know that the next six months offer their best chance to take actions that either affect the election or exploit the current alignment of US foreign policy relative to a Democratic Party alignment. While China probably prefers Biden, it can deal with either ruling party. Whereas Israel has a unique opportunity to advance its objectives under Trump and Iran has a clear imperative to remove Trump from office. Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The damaged building was constructed in 2013 to be a site for the development of advanced centrifuges. Work there was stopped in 2015 as per requirements of the JCPA, but was restarted when the US withdrew from the deal in 2018. 2 Meanwhile a group of dissidents from within Iran’s military and security forces, calling themselves Homeland Cheetahs, claimed responsibility for the Natanz attack. However, it is possible that the claim was made with the intention to mislead. Please see Jiyar Gol, "Iran blasts: What is behind mysterious fires at key sites?" BBC News, July 6, 2020. 3 The draft US resolution bans Iran from supplying, selling, or transferring weapons after the October 18 expiration of the embargo. It bans UN member states from purchasing Iranian arms or permitting citizens to train or provide financial resources or assistance to Iran without Security Council approval. 4 This resolution, introduced by France, Germany, and the UK, refers to an undeclared uranium metal disc, potential fuel-cycle-related activities such as uranium processing and conversion, and suspected storage of nuclear material. Iran’s parliament responded by issuing a statement signed by 240 out of the 290 members which called the resolution excessive and requested that Iran halt voluntary implementation of additional protocol and change inspections 5 Iran’s state-run news agency IRNA published the following commentary in response to the Natanz explosion: "The Islamic Republic of Iran has so far tried to prevent intensifying crises and the formation of unpredictable conditions and situation … the crossing of red lines of the Islamic Republic of Iran by hostile countries, especially the Zionist regime and the US, means that strategy … should be revised." 6 In addition, 120 out of the 290 parliamentarians signed and delivered a motion to the presiding board of the assembly, requesting that Rouhani be summoned for questioning. The presiding board may not issue the summons and is unlikely to result in Rouhani’s impeachment as Khamenei has requested unity amid high foreign tensions. It nonetheless reflects Rouhani’s weakened position ahead of next year’s elections. 7 Hisham al-Hashemi, an advisor to Prime Minister Mustafa al-Kadhimi who had advised the government on reducing the influence of Iran-backed militias in Iraq, was killed on July 6, days after receiving threatening telephone calls from militias.
Highlights In the short run, extreme policy uncertainty is problematic for risk assets. In the long run, gargantuan fiscal and monetary stimulus continues to support cyclical trades. Equity volatility always increases in the lead-up to US presidential elections. Trump has a 35% chance of reelection. The US-China trade deal is intact for now but the risk of a strategic crisis or tariffs is about 40%. Our Turkish GeoRisk Indicator is lower than it should be based on Turkey’s regional escapades. Feature US equities fell back by 2.6% on June 24 as investors took notice of rising near-term risks to the rally. With gargantuan global monetary and fiscal stimulus, we expect the global stock-to-bond ratio to rise over the long run (Chart 1). However, we still see downside risks prevailing in the near term related to the pandemic, US politics, geopolitics, and the rollout of additional stimulus this summer. Chart 1Risk-On Phase Continues - But Risks Mounting Chart 2Policy Uncertainty Hitting Extremes Global economic policy uncertainty is skyrocketing – particularly due to the epic the November 3 US election showdown. Yet Chinese policy uncertainty remains elevated and will rise higher given that the pandemic epicenter now faces an unprecedented challenge to its economic and political order. China’s economic instability will increase emerging market policy uncertainty (Chart 2). Only Europe is seeing political risk fall, yet Trump’s threats of tariffs against Europe this week highlight that he will resort to protectionism if his approval rating does not benefit from stock market gains, which is currently the case. The COVID-19 outbreak is accelerating in the US in the wake of economic reopening and insufficient public adherence to health precautions and distancing measures. The divergence with Europe is stark (Chart 3). Authorities will struggle to institute sweeping lockdowns again, but some states are tightening restrictions on the margin and this will grow. Chart 3US COVID-19 Outbreak The divergence between daily new infection cases and new deaths in the US, as well as countries as disparate as Sweden and Iran, is not entirely reassuring. The US is effectively following Sweden’s “light touch” model. Ultimately COVID is not much of a risk if deaths are minimized – but tighter social restrictions will frighten the markets regardless (Chart 4). President Trump’s election chances have fallen under the weight of the pandemic – followed by social unrest and controversy over race relations. But net approval on handling the economy is holding up well enough (Chart 5). Chart 4Divergence In New Cases Versus New Deaths Chart 5Trump’s Lifeline Is The Economy Our subjective 35% odds of reelection still seem appropriate for now – but we will upgrade Trump if the financial and economic rebound is sustained while his polling improves. His approval should pick up in the face of a collapse of law and order, not to mention left-wing anarchists removing or vandalizing historical monuments to America’s Founding Fathers and some great public figures who had nothing to do with the Confederacy in the Civil War. Equity volatility will increase ahead of the US election. Chart 6Volatility Always Rises Before US Elections Equity volatility always increases in the lead up to modern American elections (Chart 6) and this year’s extreme polarization, high unemployment, and precarious geopolitical environment suggest that negative surprises could be worse than usual, notwithstanding the tsunami of stimulus. So far this year the S&P 500 is tracing along the lower end of its historical performance during presidential election years. This is consistent with a change of government in November, unless it continues to power upward over the next four months – typically a change of ruling party requires a technical correction on the year. Our US Equity Strategist, Anastasios Avgeriou, also expects the market to begin reacting to political risk – and he precisely timed the market’s peak and trough over the past year (Chart 7). We suspect that the positive correlation between the S&P and the Democratic Party’s odds of a full sweep of government is spurious. The reason the S&P has recovered is because of the economic snapback from the lockdowns and the global stimulus. The reason the odds of a Blue Wave election have surged is because the pandemic and recession decimated Trump and the Republicans. Going forward, the market needs to do more to discount a Democratic sweep. At 35%, this scenario is underrated in Chart 8, which considers all possible presidential and congressional combinations. Standalone bets put the odds of a Blue Wave at slightly above 50%. We have always argued that the party that wins the White House in 2020 is highly likely to take the Senate. Chart 7Market At Risk Of Election Cycle Chart 8Market Will Soon Worry About 'Blue Wave' True, the US is monetizing debt and this will push risk assets higher regardless over the long run. But if former Vice President Joe Biden wins the presidency, he will create a negative regulatory shock for American businesses, and if his party takes the Senate, then corporate taxes, capital gains taxes, federal minimum wages, liability insurance, and the cost of carbon (implicitly or explicitly) will all rise. The market must also reckon with the possibility that Trump is reelected or that he becomes firmly established as a “lame duck” and thus takes desperate measures prior to the election. His threat to impose tariffs on Europe this week underscores our point that if Trump’s approval rating stays low, despite a rising stock market, then the temptation to spend financial capital in pursuit of political capital will rise. This will involve a hard line on immigration and trade. Bottom Line: Tactically, there is more downside. Strategically, we remain pro-cyclical. Stimulus Hiccups This Summer One reason we have urged investors to buy insurance against downside risks this month is because of hurdles in rolling out the next round of fiscal stimulus. The four key drivers of the global growth rebound are liquidity, fiscal easing (Chart 9), an enthusiastic private sector response, and the large cushion of household wealth prior to the crisis. This is according to Mathieu Savary – author of our flagship Bank Credit Analyst report. Mathieu argues that it will be harder for investors to overlook policy uncertainty after the stimulus slows, i.e. the second derivative of liquidity turns negative. Chart 9Gargantuan Fiscal Stimulus The massive increase in budget deficits and the quick recovery in activity amid reopening have reduced politicians’ sense of urgency. We fear that the stock market will have to put more pressure on lawmakers to force them to provide more largesse. Ultimately they will do so – but if they delay, and if delay looks like it is turning into botching the job, then markets will temporarily panic. Why are we confident stimulus will prevail? In the United States, fiscal bills have flown through Congress despite record polarization. Democrats cannot afford to obstruct the stimulus just to hurt the economy and the president’s reelection chances. Instead they have gone hog wild – promoting massive spending across the board to demonstrate their fundamental proposition that government can play a larger and more positive role in Americans’ lives. Their latest proposal is worth $3 trillion, plus an infrastructure bill that nominally amounts to $500 billion over five years. President Trump, for his part, was always fiscally profligate and now wants $2 trillion in stimulus to fuel the economic recovery, thus increasing his chances of reelection as voters grow more optimistic in the second half of the year. He also wants $1 trillion in new infrastructure spending over five years. Yet Republican Senators are dragging their feet and offering only a $1 trillion package. In the end they will adopt Trump’s position because if they do not hang together, they will all hang separately in November. The debate will center on whether the extra $600 in monthly unemployment benefits will be continued (at a cost of $276bn in the previous Coronavirus Aid, Relief, and Economic Security Act). Republicans want to tie benefits to returning to work, since this generous subsidy created perverse incentives and made it more economical for many to stay on the dole. There will also be a debate over whether to issue another round of direct cash checks to citizens ($290bn in the CARES Act). Republicans want to prioritize payroll tax cuts, again focusing on reducing unemployment (Chart 10). Chart 10US Fiscal Stimulus Breakdown Our US bond strategist, Ryan Swift, has shown that the cash handouts present a substantial fiscal “cliff.” Without the original one-time stimulus checks, real personal income would have fallen 5% since February, instead of rising 9% (Chart 11). If Republicans refuse to issue a new round of checks, yet the extra unemployment benefits stay, then over $1 trillion in income will be needed to fill the gap so that overall personal income will end up flat since February. In other words, an ~8% increase in income less transfers from current levels is necessary to prevent overall personal income from falling below its February level. China and the EU will eventually provide more largesse. Republican Senators will capitulate, but the process could be rocky and the market should see volatility this summer. China may also be forced to provide more stimulus in late July at its mid-year Politburo meeting – any lack of dovishness at that meeting will disappoint investors. European talks on the Next Generation recovery fund could also see delays (though they are progressing well so far). Brexit trade deal negotiations pose a near-term risk. There is also a non-negligible chance that the German Constitutional Court will raise further obstructions with the European Central Bank’s quantitative easing programs on August 5. European risks are manageable on the whole, but the market is not discounting much (Chart 12). Chart 11Will Congress Takeaway The Money Tree? Bottom Line: We expect the S&P 500 to trade in a range between 2800 and 3200 points during this period of limbo in which risks over pandemic response and political risks will come to the fore while the market awaits new stimulus measures, which may not be perfectly timely. Chart 12European Risks Are Getting Priced Has The Phase One China Deal Failed Yet? President Trump’s threat this week to slap Europe with tariffs, if it imposes travel restrictions on the US over the coronavirus, points to the dynamic we have highlighted on the more consequential issue of whether Trump hikes broad-based tariffs on China, and/or nullifies the “Phase One” trade deal. Our sense is that if Trump is doing extremely poorly, or extremely well, in terms of opinion polls and the stock market, then the roughly 40% odds of sweeping punitive measures of some kind will go up (Diagram 1). Cumulatively we see the chance of a major tariff hike at 40%. Diagram 1Decision Tree: Risk Of Significant Trump Punitive Measures On China In 2020 White House trade czar Peter Navarro’s comments earlier this week, suggesting that the Phase One trade deal was already over, prompted Trump to tweet that he still fully supports the deal. Negotiations between Secretary of State Mike Pompeo and Chinese Politburo member Yang Jiechi also nominally kept the lid on tensions. However, China may need to depreciate the renminbi to ease deflationary pressures on its economy – and this would provoke Trump to retaliate (Chart 13). Chart 13Chinese Depreciation Would Provoke Trump We have always argued against the durability of the Phase One trade deal. Investors should plan for it to fall apart. Judging by our China GeoRisk Indicator, investors are putting in a higher risk premium into Chinese equities (Chart 14). They are also doing so with Korean equities, which are ultimately connected with US-China tensions. Only Taiwan is pricing zero political risk, which is undeserved and explains why we are short Taiwanese equities. After China’s imposition of a controversial national security law in Hong Kong and America’s decision to prepare retaliatory sanctions, reports emerged that Chinese authorities ordered state-owned agricultural traders to halt imports of soybean and pork – and potentially corn and cotton. These reports were swiftly followed by others that highlighted that state-owned Chinese firms purchased at least three cargoes of US soybeans on June 1, in spite of China’s decision to stop imports.1 Thus this aspect of the deal has not yet collapsed. But we would emphasize that the constraints against a failure of the deal are not prohibitive this year. The $200 billion worth of additional Chinese imports over 2020-2021 promised in the deal included $32 billion worth of additional US farm purchases – with at least $12.5 billion in 2020 and $19.5 billion in 2021 over 2017 imports of $24 billion. However, to date, US agricultural exports to China suggest that China may not even meet 2017 levels (Chart 15). Chart 14GeoRisk Indicators Show Rising Risk Chart 15Trade Deal Durability Still Shaky Soybeans account for roughly 60% of US agricultural exports to China. While Chinese imports are up so far this year relative to 2019, they remain well below pre-trade war levels. Although lower hog herds on the back of the African Swine Flu and disruptions caused by COVID-19 may be blamed, they are not the only cause of subdued purchases. The share of Chinese soybean imports coming from the US is also still below pre-trade war levels (Chart 16). Chart 16China Still Substituting Away From US New Chinese regulation requiring documents assuring food shipments to China are COVID-19 free adds another hurdle – China already banned poultry imports from Tyson Foods Inc. plants. Although the US’s share of China’s pork imports has picked up significantly, it will not go far toward meeting the trade deal requirements. China’s pork purchases from the US were valued at $0.3 billion in 2017, while soybean imports came in at $14 billion. Bottom Line: Trump’s only lifeline at the moment is the economy which pushes against canceling the US-China deal. But if he becomes a lame duck – or if exogenous factors humiliate him – then all bets are off. The passage of massive stimulus in the US and China removes economic constraints to conflict. Will Erdogan Overstep In Libya? We have long been bearish on Turkey relative to other emerging markets due to President Tayyip Erdogan’s populist policies, which erode monetary and fiscal responsibility and governance. Turkey’s intervention in Libya has marked a turning point in the Libyan civil war. The offensive to seize Tripoli on the part of General Khalifa Haftar of the Tobruk-based Libyan National Army (LNA) has been met with defeat (Map 1). Map 1Libya’s Battlefront Is Closing In On The Oil Crescent Foreign backing has enabled the conflict. Egypt, the UAE, Saudi Arabia, and Russia are the Libyan National Army’s main supporters, while Turkey and Qatar support Prime Minister Fayez al-Sarraj of the UN recognized Government of National Accord (GNA). The GNA’s successes this year can be credited to Turkey, which ramped up its intervention in Libya, even as oil prices collapsed, hurting Haftar and his supporters. Now the battlefront has shifted to Sirte and the al-Jufra airbase – the largest in Libya – and is closing in on the eastern oil-producing crescent, which contains over 60% of Libya’s oil. The victor in Sirte will also have control over the oil ports of Sidra, Ras Lanuf, Marsa al-Brega, and Zuwetina. With all parties eying the prize, the conflict is intensifying. Tripoli faces greater resistance as its forces move east. Egyptian President Abdel Fattah al-Sisi’s June 6 ceasefire proposal, dubbed the Cairo Initiative, was rejected by al-Sarraj and Turkey. Instead, the Tripoli-based government wants to capture Sirte and al-Jufra before coming to the table. The recapturing of oil infrastructure would bring back some of Libya's lost output (Chart 17). Nevertheless, OPEC 2.0 is committed to keeping oil markets on track to rebalance, reducing the net effect of a Libyan production increase on global supplies. However, the GNA’s swift successes in the West may not be replicable as it moves further East, where support for Haftar is deeper and where the stakes are higher for both sides. This is demonstrated by the GNA’s failed attempt to capture Sirte on June 6. The battlefront is now at Egypt’s red line – GNA control of al-Jufra would pose a direct threat to Egypt and is thus considered a border in Egypt’s national security strategy. A push eastward risks escalating the conflict further by drawing in Egypt militarily. In a televised speech on June 20, al-Sisi threatened to deploy Egypt’s military if the red line is crossed. The statement was interpreted by Ankara as a declaration of war, raising the possibility that Egypt will go to war with Turkey in Libya. On paper, Egypt’s military is up to the task. Its recent upgrades have pulled up its ranking to ninth globally according to the Global Fire Power Index, surpassing Turkey’s strength in land and naval forces (Chart 18). However, while Turkey’s military has been active in other foreign conflicts such as in Syria, Egypt’s army is untested on foreign soil. Its most recent military encounter was the 1973 Yom Kippur War. Even after years of fighting, it has yet to declare victory against terrorist cells in the Sinai Peninsula. Thus Egypt’s rusty forces could face a protracted conflict in Libya rather than a swift victory. Chart 17GNA/Turkish Success Would Revive Libyan Oil Production Chart 18Egypt Is Militarily Capable … On Paper Other constraints may also deter al-Sisi from following through on his threat: Other Arab backers of the Libyan National Army – the UAE and Saudi Arabia – are unlikely to provide much support as their economies have been hammered by low oil prices. Egypt’s own economy is in poor shape to withstand a protracted war, with public debt on an unsustainable path. Not coincidentally, Egypt faces another potential military escalation to its south where it has been clashing with Ethiopia over the construction of the Grand Ethiopian Renaissance Dam on the Blue Nile. The dam will control Egypt’s water supply. The latest round of negotiations failed last week. While Cairo is hoping to obtain a bilateral agreement over the schedule for filling the dam, Addis Ababa has indicated that it will begin filling the dam in July regardless of whether an agreement is reached. Al-Sisi’s response to the deadlocked situation has been to request an intervention by the UN Security Council. However, as the July filling date nears, the Egypt-Ethiopia standoff risks escalating into war. For Egypt, there is an urgency to secure its future water supplies now before Ethiopia begins filling the dam. And while resolving the Libyan conflict is also a matter of national security – Egypt sees the Libyan National Army as a buffer between its porous western border and the extremist elements of the GNA – the risks are not as pressing. Thus a military intervention in Libya would distract Egypt from the Ethiopian conflict and risk drawing it into a war on two fronts. Moreover, Egypt generally, and al-Sisi in particular, risk losing credibility in case of a defeat. That said, Egypt has high stakes in Libya. A GNA defeat could annul the recent Libya-Turkey maritime demarcation agreement – a positive for Egypt’s gas ambitions – and eliminate the presence of unfriendly militias on its Western border. Thus, if the GNA or GNA-allied forces kill Egyptian citizens, or look as if they are capable of utterly defeating Haftar on his own turf, then it would be a prompt for intervention. Meanwhile Turkey’s regional influence and foreign policy assertiveness is growing – and at risk of over-extension. Erdogan’s interests in Libya stem from both economic and strategic objectives. In addition to benefitting from oil and gas rights and rebuilding contracts, Ankara’s strategy is in line with its pursuit of greater regional influence as set out in the Mavi Vatan, its current strategic doctrine.2 There are already rumors of Turkish plans to establish bases in the recently captured al-Watiya air base and Misrata naval base. This would be in addition to Ankara’s bases in Somalia and in norther Iraq. Erdogan is partly driven into these foreign policy adventures to distract from his domestic challenges and keep his support level elevated ahead of the 2023 general election (Chart 19). However, his growing assertiveness threatens to alienate European neighbors and NATO allies, which have so far played a minimal role in the Libyan conflict yet have important interests there. For now, the western powers seem focused on countering Russian intervention in Libya and the broader Mediterranean. Prime Minister al-Sarraj and General Stephen Townsend, head of US Africa Command (AFRICOM), met earlier this week and reiterated the need to return to the negotiating table and respect Libyan sovereignty and the UN arms embargo, with a focus on stemming Russian interference. However, Turkish relations with the West may take a turn for the worse if Erdogan oversteps. Turkey continues to threaten Europe with floods of refugees and immigrants if its demands are not met. This pressure will grow due to the COVID-19 crisis, which will ripple across the Middle East, Africa, and South Asia. Ankara also continues to press territorial claims in the Mediterranean Sea, ostensibly for energy development.3 Turkey has recently clashed with Greece and France on the seas. In sum, the Libyan conflict is intensifying as it moves into the oil crescent. The Turkey-backed GNA will face greater resistance in Sirte and al-Jufra, even assuming that Egypt does not follow through on its threat of intervening militarily. Erdogan’s foreign adventurism will provoke greater opposition in Libya and elsewhere among key western powers, Russia, and the Gulf Arab states. Bottom Line: The implication is that a deterioration in Turkey’s relationship with the West, military overextension, and continued domestic economic mismanagement will push up our Turkey GeoRisk Indicator, which is a way of saying that it will weigh on the currency (Chart 20). Chart 19Erdogan’s Fear Of Opposition Drives Bold Policy Chart 20Foreign And Domestic Factors Will Push Up Turkish Risk Stay short our “Strongman Basket” of emerging market currencies, including the Turkish lira. Investment Takeaways We entered the year by going strategically long EUR-USD, but closed the trade upon the COVID-19 lockdowns. We have resisted reinitiating it despite the 5% rally over the past three months due to extreme political risks this year, namely the US election and trade risks. Trump’s threat of tariffs on Europe this week highlights our concern. We will wait until the election outcome before reinstituting this trade, which should benefit over time as global and Chinese growth recover and the US dollar drops on yawning twin deficits. Throughout this year’s crisis we have periodically added cyclical and value plays to our strategic portfolio. We favor stocks over bonds and recommend going long global equities relative to the US 30-year treasuries. We are particularly interested in commodities that will benefit from ultra-reflationary policy and supply constraints due to insufficient capital spending. This month we recommend investors go long our BCA Rare Earth Basket, which features producers of rare earth elements and metals that can substitute for Chinese production (Chart 21). This trade reflects our macro outlook as well as our sense that the secular US-China strategic conflict will heat up before it cools down. Chart 21Position For An Escalation In The US-China Conflict Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 Please see Karl Plume et al, "China buys U.S. soybeans after halt to U.S. purchases ordered: sources," Reuters, June 1, 2020. 2 The Mavi Vatan or “Blue Homeland Doctrine” was announced by Turkish Admiral Cem Gurdeniz in 2006 and sets targets to Turkish control in two main regions. The first region is the three seas surrounding it – the Mediterranean Sea, Aegean Sea, and Black Sea with the goal of securing energy supplies and supporting Turkey’s economic growth. The second region encompasses the Red Sea, Caspian Sea and Arabian Sea where Ankara has strategic objectives. 3 Ankara’s gas drilling activities off Cyprus have been a form of frequent provocation for Greece and Cyprus. Ankara has also stated that it may begin oil exploration under a controversial maritime deal with Libya as early as August. Section II: Appendix : GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Section III: Geopolitical Calendar
Highlights The cyclical rally in stocks is not over, but the S&P 500 will churn between 2800 and 3200 this summer. Supportive policy, robust household balance sheets and budding economic growth have put a floor under global bourses. Political risk, demanding valuations and COVID-related headlines are creating potent headwinds in the near term that must be resolved. During the ongoing flat but volatile performance of equities, investors should build short positions against government bonds and the dollar. Deep cyclicals, banks and Japanese equities offer opportunities to generate alpha. In the long term, structurally rising inflation will ensure that stocks outperform bonds, but commodities will beat them both. Feature Institutional investors still despise the equity market rebound that began on March 23. Relative to history, professional investors are heavily overweight cash, bonds and defensive sectors but they are underweight equities as an asset class and cyclical sectors specifically. Furthermore, the beta of global macro hedge funds to the stock market is in the bottom of its distribution, which indicates the funds’ low net exposure to equities. The attitude of market participants is understandable given that the economy is in tatters. According to the New York Fed Weekly Economic Index, Q2 GDP in the US will contract by 8.4% compared with last year. Industrial production is still 15.9% below its pre-pandemic high and the US unemployment rate stands at either 13.3% or 16.4%, depending how the BLS accounts for furloughed employees. Moreover, deflationary forces are building, which hurts profits. Despite these discouraging economic reports, the S&P 500 is trading only 7.9% below its February 19 all-time high and is displaying a demanding forward P/E ratio of 21.4. Stocks will continue to churn over the summer with little direction. Financial markets are forward looking and the collapse of risk asset prices in March forewarned of an economic calamity. Stimulus, liquidity conditions and an eventual recovery are creating strong tailwinds for stocks. However, demanding valuations, rising political risks and overbought short-term technicals argue for a correction. These forces will probably balance out each other in the coming months. Investors must be nimble. Buying beta is not enough; finding cheap assets levered to the nascent recovery will be a source of excess returns. Bonds are vulnerable to the recovery and purchasing deep cyclicals at the expense of defensives makes increasing sense. Japanese stocks offer another attractive opportunity. Five Pillars Behind Stocks… Our BCA Equity Scorecard remains in bullish territory despite the conflict between the sorry state of the global economy and the violence of the equity rally since late March (Chart I-1). Five forces support share prices. Chart I-1The Rally Is Underpinned The first pillar is extraordinarily accommodative liquidity conditions created by global central banks, which have aggressively slashed policy rates and allowed real interest rates to collapse. Additionally, forward guidance indicates that policy will remain easy for the foreseeable future. For example, the Federal Reserve does not anticipate tightening policy through 2022 and the Bank of Japan expects to stand pat until at least 2023. In response, the yield curve in advanced economies has started to steepen, which indicates that the policy easing is having a positive impact on the world’s economic outlook (Chart I-2). Various liquidity measures demonstrate the gush of high-powered money in the financial and economic system in the wake of monetary policy easing. Our US Financial Liquidity Index and dollar-based liquidity measure have skyrocketed. Historically, these two indicators forecast the direction of growth and the stock market (Chart I-3). Chart I-2The Yield Curve Likes What It Sees Chart I-3Exploding Liquidity Conditions The second pillar is the greatest fiscal easing since World War II. The US government has increased spending by $2.9 trillion since March. House Democrats have passed an additional $3 trillion plan. Senate Republicans will not ratify the entire proposal, but our Geopolitical Strategy service expects them to concede to $2 trillion.1 Meanwhile, the White House is offering a further $1 trillion infrastructure program over five years. Details of the infrastructure plan are murky, but its existence confirms that fiscal profligacy is the new mantra in Washington and the federal deficit could reach 23% of GDP this year. Chart I-4Loosest Fiscal Policy Since WWII The list of new fiscal measures worldwide is long; the key point is that governments are injecting funds to lessen the COVID-19 recession pain on their respective populations and small businesses (Chart I-4). Excluding loans guarantees, even tight-fisted Germany has rolled out EUR 0.44 trillion in relief programs, amounting to 12.9% of GDP. Japan has announced JPY 63.5 trillion of “fresh water” stimulus so far, representing 11.4% of GDP. Loan guarantees administered by various governments along with the Fed’s Primary and Secondary Market Credit Facilities also limit how high business bankruptcies will climb. As we discussed last month, it is unlikely that countries will return to the level of spending and budget deficits that prevailed prior to COVID-19, even if the intensity of fiscal support declines from its current extreme.2 Voters in the West and emerging markets are fed up with the Washington Consensus of limited state intervention. Consequently, the median voter has pivoted to the left on economic matters, especially in Anglo-Saxon nations (Chart I-5).3 The fiscal laxity consistent with economic populism and dirigisme will boost aggregate demand for many years. The third supporting pillar is the private sector’s response to monetary and fiscal easing unleashed by global policymakers. Unlike in 2008, the amount of loans and commercial papers issued by US businesses is climbing, which indicates stronger market access than during the Great Financial Crisis (GFC). A consequence of the large uptick in credit growth has been an explosion in banking deposits. Given the surge in private-sector liquidity – not just base money – broad money creation has eclipsed that of the GFC (Chart I-6). Part of this money will seek higher returns than the -0.97% real short rate available to investors in the US (or -0.9% in Europe), a process that will bid up risk assets. Chart I-5The US Population's Shift To The Left Chart I-6The Private Sector's Liquidity Is Improving The financial health of the US household sector is the fourth pillar buttressing stocks. Households entered the recession with debt equal to 99.4% of disposable income, the lowest share in 19 years. Moreover, debt servicing only represents 9.7% of disposable income, the lowest percentage of the past four decades. Along with generous support from the US government, the resilience created by strong balance sheets explains why delinquency rates remain muted despite a surge in unemployment (Table I-1).4 Moreover, the decline in household net worth pales in comparison with the GFC (Chart I-7). Hence, the wealth effect will not have the same deleterious impact on consumption as it did after 2008. In the wake of large fiscal transfers, the savings rate explosion to an all-time high of 32.9% is a blessing. The surge in savings is applying a powerful brake on 67.7% of the US economy, but its eventual decline will fuel a quick consumption recovery, a positive trend absent after the GFC. Table I-1Consumer Borrowers Are Hanging In There Chart I-7Smaller Hit To Net Worth Than The GFC The final pillar is the path of the global business cycle. Important predictors of the US economy have improved. The June Philly Fed and Empire State surveys are gaining ground, thanks to their rebounding new orders and employment components. The Conference Board’s LEI is also climbing, even when its financial constituents are excluded. Residential activity, which also leads the US business cycle, is sending positive signals. According to the June NAHB Housing market index, homebuilder confidence is quickly recouping lost ground and building permits are bottoming. These two series suggest that the contribution of housing to GDP growth will only expand. Household spending is showing promising growth as the economy re-opens. In May, US auto sales jumped 44.1% higher and retail sales (excluding autos) soared by 12.4%. Additionally, the retail sales control group5 has already recovered to its pre-pandemic levels. The healing labor market and the bounce in consumer confidence have fueled this record performance because they will prompt a normalization in the savings rate. Progress is also evident outside the US. The expectations component of the German IFO survey is rebounding vigorously, a good omen for European industrial production (Chart I-8). Similarly, the continued climb in China’s credit and fiscal impulse suggests that global industrial production will move higher. Finally, EM carry trades are recovering, which indicates that liquidity is seeping into corners of the global economy that contribute the most to capex (Chart I-9). Chart I-8European Hopes Chart I-9Positive Signals For Global Manufacturers Against this backdrop, there is an increasing probability that analysts will upgrade their 2020 EPS estimates. The odds of upward revisions to 2021 and 2022 estimates (especially outside of the tech and healthcare sectors) are much more significant, especially because the historical pattern of deep recessions followed by sharp rebounds should repeat itself (Chart I-10). A strong recovery will ultimately foster risk-taking. Mechanically, higher expected cash flows and lower risk premia will remain tailwinds behind stocks. Chart I-10The Deeper The Fall, The Faster The Rebound … And Three Reasons To Worry The five pillars shoring up stocks face three powerful factors working at cross purposes against share prices. The first hurdle against stocks is that in aggregate, the S&P 500 is already discounting the coming economic recovery. In the US, the 12-month forward P/E ratio bounced from a low of 13.4 on March 23 to the current 21.4. Bidding up multiples to such heights in a short timeframe opens up the potential for investor disappointments with economic activity or earnings. Equally concerning, the global expectations component of the German ZEW survey has returned to near-record highs. The ZEW is a survey of financial professionals largely influenced by the performance of equities. In order for stocks to continue to rise, they will need an even greater global economic rebound than implied by the ZEW (Chart I-11). Chart I-11Stocks Already Know That IP Will Jump Back Political risk poses a second hurdle against stocks. As intense as it is today, policy uncertainty will not likely abate this summer, which will put upward pressure on the equity risk premium. According to BCA Research’s Geopolitical strategy service, the combination of elevated share prices and President Trump’s low approval rating will increase the prospect of erratic moves by the White House. A pitfall particularly under-appreciated by risk assets is a new round of tariffs in the Sino-US trade war.6 Another hazard is an escalation of tensions with the European Union. US domestic politics are also problematic. Fiscal stimulus has been a pillar for the market. However, as the economy recovers, politicians could let down their guard and resist passing new measures on the docket. This danger is self-limiting. If legislators delay voting on proposed laws, then the resulting drop in the market will put greater pressure on policymakers to continue to support the economy. Either way, this tug-of-war could easily cause some painful bouts of market volatility. Chart I-12How Long Will Stocks Ignore Politics? In recent months, the equity risk premium could ignore rising political risk as long as financial liquidity was expanding at an accelerating pace (Chart I-12). However, the bulk of monetary easing is over because the Fed, the ECB and the global central banks have already expended most of their ammunition. Moreover, the ECB, the Bank of England, the Bank of Japan and the Swiss National Bank have agreed to slow the pace at which they tap the Fed’s dollar swap line from daily to three times a week. This indicates that the private sector’s extreme appetite for liquidity has been satiated by the increase in base money since March 19. Thus, the expansion of liquidity will decelerate, even if its level remains plentiful. Overlooking political uncertainty will become harder after the second derivative of liquidity turns negative. The third hurdle against the stock market is the evolution of COVID-19. A second wave of infection has started in many countries and it will only continue to escalate as economies re-open, loosen social distancing rules and test more potential cases. Investors will be rattled by headlines such as the resumption of lockdowns in Beijing and mounting new cases in the southern US. Chart I-13A Different Wave BCA’s base case is that a second wave of infections will not result in large-scale lockdowns that paralyzed the global economy in Q1 and Q2. Importantly, the number of new deaths is lagging the spread of recorded new infections (Chart 1-13). This dichotomy highlights better testing, our improved understanding of the disease and our greater capacity to protect vulnerable individuals. A Summer Of Discontent The S&P 500 and global equities will face a summer of directionless gyrations with elevated volatility. Before we can escape this pattern, the technical froth that has engulfed the market must dissipate. Our Tactical Strength Indicator is massively overbought and is consistent with a period of consolidation. (Chart I-14). The same is true of short-term breadth. The proportion of NYSE stocks trading above their 10-week moving average is close to its highest level in the past 20 years, which indicates that meaningful equity gains are doubtful in the coming months. (Chart I-14, bottom panel). A correction should not morph into a renewed bear market because the pillars behind stocks are too strong. Nonetheless, the S&P 500 may retest the 2800-2900 zone during the summer. On the upside, it will be capped near 3200 during that same period. A resolution of the political risks surrounding the market is needed to settle the churning pattern. Another factor will be the progressive normalization of our tactical indicators after an extended period of sideways trading. Finally, continued progress on the treatment of COVID-19 (not necessarily a vaccine) and the formulation of a coherent health policy for the fall will create the impetus for higher share prices later this year. How To Profit When Stocks Churn A strategy most likely to generate the highest reward-to-risk ratio will be to focus on assets and sectors that have not yet fully priced in the upcoming global economic recovery, unlike the broad stock market. The bond market fits within this strategy. G-7 and US yields remain extremely expensive (Chart I-15). Additionally, according to our Composite Technical Indicator, Treasuries are losing momentum (see Section III, page 41). This valuation and technical backdrop renders government bonds vulnerable to both a strong economy and an upward reassessment of the outlook for inflation. Chart I-14A Needed Digestive Break Chart I-15Bonds Are Pricey... Cyclical dynamics also paint a poor outlook for bonds. Globally, the supply of government securities is swelling by approximately $6 trillion, which will slowly lift depressed term premia. Moreover, there has been a sharp incline in excess liquidity as approximated by the gap between our US Financial Liquidity Index and the rate of change of the US LEI. Such a development has led yields higher since the GFC (Chart I-16). Finally, the diffusion index of fifteen Swedish economic variables has started to recover, an indicator that often signals higher yields (Chart I-17). Sweden is an excellent bellwether for the global business cycle because it is a small, open economy where shipments of industrial and intermediate goods account for 55% of exports. Chart I-16...And Vulnerable To Excess Liquidity Chart I-17Sweden's Message The FX market also offers reasonably priced vehicles to bet on the burgeoning global cyclical upswing. Balance-of-payments dynamics are increasingly bearish for the US dollar. A fall in the household savings rate will widen the current account deficit because the fiscal balance remains deeply negative. Meanwhile, US real interest rate differentials are narrowing, thus the capital account surplus will likely recede. The resulting balance-of-payment deficit will accentuate selling pressures on the USD created by a pick-up in global industrial activity (Chart I-18). AUD/CHF offers another attractive opportunity. The AUD trades near a record low relative to the CHF, yet this cross will benefit from a rebound in global nominal GDP growth (Chart I-19). Moreover, Australia managed the COVID-19 crisis very well and it can proceed quickly with its re-opening. Meanwhile, the expensiveness of the CHF versus the EUR will continue to foster deflationary pressures in Switzerland. This contrast ensures that the Swiss National Bank remains more dovish than the Reserve Bank of Australia. Chart I-18Bearish Dollar Backdrop Chart I-19AUD/CHF As A Bet On The Recovery Within equities, deep cyclical stocks remain attractive relative to defensive ones. The same acceleration in our excess liquidity proxy that warned of a fall in bond prices indicates that the cyclicals-to-defensives ratio should appreciate. This ratio also benefits meaningfully when the dollar depreciates. A weaker dollar is synonymous with stronger global industrial production. It also eases deflationary pressures and boosts the price of commodities, which increases pricing power for industrial, material and energy stocks. Finally, the cyclical-to-defensives ratio rises when the silver-to-gold ratio turns up. An outperformance of silver has been an important signal that reflation is starting to improve the global economic outlook (Chart I-20).7 Chart I-20Cyclicals Have Not Priced In The Recovery Banks also offer attractive opportunities. Investors have clobbered banks because they expect prodigious non-performing loans (NPL) due to the threats to private-sector balance sheets from the deepest recession in nine decades. However, NPLs are not expanding by as much as anticipated thanks to the ample support by global monetary and fiscal authorities. Moreover, banks were conservative and built loss reserves ahead of the crisis. In this context, the extreme valuation discount embedded in banks relative to the S&P 500 seems exaggerated (Chart I-21). Additionally, the gap between the expected growth rate of banks’ long-term earnings and that of the broad market is wider than at any other point in the past 15 years. Investors have also bid up the price of protection against bank shares (Chart I-22). Therefore, despite near-term risks induced by the Fed’s Stress Test, banks are a cheap contrarian bet on a global recovery. Chart I-21Banks Are Cheap Chart I-22Banks As A Contrarian Bet Investors should continue to favor foreign versus US equities, which is consistent with our positive outlook on banks and deep cyclical stocks, as well as our negative disposition toward the dollar. Foreign stocks outperform US ones when the dollar depreciates because the former overweight cyclical equities and financials (Chart I-23). Moreover, foreign stocks trade at discounts to US equities and embed significantly lower expected cash flow growth, which suggests that they would offer investors upside from the impending global economic recovery. Chart I-23Favor Foreign Stocks EM stocks fit within this context. Both EM FX and equities trade at a valuation discount consistent with an upcoming rally (Chart I-24). Moreover, cheap valuations increase the likelihood that a depreciating US dollar will boost EM currencies by easing global financial conditions. Moreover, the momentum of EM equities relative to global ones is forming a positive divergence with the price ratio, which is consistent with liquidity making its way into these markets (Chart I-25). Our Emerging Markets Strategy team is more worried about EM stocks than we are because EM bourses would be unlikely to participate as much as US ones in a mania driven by retail investors.8 Chart I-24Attractive EM Valuations Chart I-25EM: A Coiled-Spring Bet On A Weaker Dollar? Chart I-26Japanese Stocks As A Trade Finally, an opportunity to overweight Japanese equities has emerged. The Nikkei has collapsed in conjunction with a meltdown in Japanese industrial production. However, Japanese earnings should recover faster than in the rest of the world. Japan has efficiently handled its COVID-19 outbreak with fewer lockdowns. Moreover, Japan’s earnings per share (EPS) are highly levered to both the global business cycle and China’s economic fluctuations. Consequently, if we expect global activity to recover and China’s credit and fiscal impulse to continue to improve, then we also anticipate that Japan’s EPS will outperform the MSCI All-Country World Index (Chart I-26). Additionally, on a price-to-cash flow basis, Japanese equities trade at a deep-enough discount to global stocks to foreshadow an upcoming period of outperformance. Bottom Line: Equities will be tossed about for the coming quarter or two, buffeted between five tailwinds and three headwinds. While the S&P is expected to gyrate between 2800 and 3200 this summer, investors can seek alpha by selling bonds, selling the dollar and buying AUD/CHF, and favoring deep cyclical stocks as well as banks at the expense of defensives. As a corollary, foreign equities, especially Japanese ones, have a window to outperform the US. EM stocks could also generate excess returns, but they are a more uncertain bet. Exploring Long-Term Risks We explore some investment implications linked to our theme of structurally rising inflation, which will cause lower real long-term portfolio returns than in the previous four decades. Populism and the ossification of the supply-side of the economy will push inflation up this cycle toward an average of 3% to 5%.9 Chart I-27S&P 500 Long-Term Perspective Adjusted for inflation, the 10-year cumulative average return for stocks stands at 12.4%, which is an elevated reading. The strength of the past performance increases the probability that a period of mean reversion is near (Chart I-27). The end of the debt supercycle raises the likelihood that an era of low real returns will materialize. Non-financial debt accounts for 258.7% of GDP, a level only topped at the depth of the Great Depression when nominal GDP collapsed by 46% from its 1929 peak. Meanwhile, yields are at record lows (Chart I-28). Such a combination suggests that there is little way forward to boost debt by enough to enhance growth, especially when each additional dollar of debt generates a diminishing amount of output. Chart I-28The End Of The Debt Super Cycle Chart I-29Little Room To Cut Taxes Populist governments will remain profligate and play an expanding role in the economy instead of accepting the necessary increase in savings required to reduce debt and create a more robust economy. However, effective personal and corporate tax rates are already very low in the US (Chart I-29). Therefore, the only way to offer fiscal support would be to increase government spending. Growth will become less vigorous as the government’s share of GDP increases (Chart I-30). Moreover, monetary policy will likely remain lax, which boosts the chance of stagflation developing. Chart I-30The Bigger The Government, The Lower The Growth Elevated stock multiples are a problem for long-term investors. The S&P 500’s Shiller P/E ratio stands at 29.1, and its price-to-sales ratio is at 2.2. If bond yields remain minimal, then low discount rates can rationalize those extreme multiples. However, if inflation moves above 4%, especially when real output is not expanding robustly, then multiples will mean-revert and equities will generate subpar real returns. Chart I-31Profit Margins: From Tailwind To Headwind? Profit margins pose an additional problem for stocks. The decline in unit labor costs relative to selling prices has allowed abnormally wide domestic EBITDA margins to persist (Chart I-31). However, inflation, populism, greater government involvement in the economy and lower efficiency of supply chains will conspire to undo this extraordinary level of profitability. In other words, while the share of national income taken up by wages will expand, profits will account for a progressively smaller slice of output. (Chart I-31, bottom panel). Lower profit margins will push down RoE and accentuate the decline in multiples while also hurting projected long-term cash flows. Chart I-32Elevated Household Exposure To Stocks Finally, from a structural perspective, households are already aggressively overweighting equities. Stocks comprise 54% of US households’ discretionary portfolios. US households held more shares only in 1968 and 2000, two years that marked the beginning of painful drops in real stock prices (Chart I-32). US stocks are most vulnerable to the increase of inflation. Not only are they much more expensive than their global counterparts, but as the Section II special report written by Matt Gertken highlights, the growing nationalism spreading around the world hurts the global order built by and around the US during the past 70 years. With this system of influence diminished, US firms will not be able to command their current valuation premium. Despite low expected real rates of return, equities will still outperform bonds in the coming decade (Table I-2). Even though stocks are more volatile than bonds, stocks have not significantly outperformed bonds during the past 35 years. This was possible because inflation fell from its peak in the early 1980s. However, bonds are unlikely to once again generate higher risk-adjusted returns than equities if inflation bottoms. Moreover, bonds are more expensive than stocks (Chart I-33). A structural bear market in bonds would hurt risk-parity strategies and end the incredible strength in growth stocks. Table I-2Rising Inflation Flatters Stocks Over Bonds The outperformance of stocks over bonds will be of little solace to investors if equities generate poor real returns. Instead, investors should explore commodities, an asset class that benefits from rising inflation, especially given the combination of strong government spending and too-accommodative monetary policy. Moreover, after a decade of weak capex in natural resource extraction, the supply of commodities will expand slowly. Hence, our base case this cycle is for a weakening in the stock-to-gold ratio (Chart I-34). The stock-to-industrial commodities ratio will also fall from its heady levels. As a result, the energy, materials and industrial sectors are attractive on a long-term basis beyond the next six to 12 months. Chart I-33Bonds Look Worse Than Stocks... Chart I-34...But Gold Looks The Best Mathieu Savary Vice President The Bank Credit Analyst June 25, 2020 Next Report: July 30, 2020 II. Nationalism And Globalization After COVID-19 Economic shocks in recent decades have led to surges in nationalism and the COVID-19 crisis is unlikely to be different. Nationalism adds to the structural challenges facing globalization, which is already in retreat. Investors face at least a 35% chance that President Trump will be reelected and energize a nationalist and protectionist agenda that is globally disruptive. China is also indulging in nationalism as trend growth slows, raising the probability of a clash with the US even if Trump does not win. US-China economic decoupling will present opportunities as well as risks – primarily for India and Southeast Asia. Since the Great Recession, investors have watched the US dollar and US equities outperform their peers in the face of a destabilizing world order (Chart II-1). Chart II-1US Outperformance Amid Global Disorder Global and American economic policy uncertainty has surged to the highest levels on record. Investors face political and geopolitical power struggles, trade wars, a global pandemic and recession, and social unrest. How will these risks shape up in the wake of COVID-19? First, massive monetary and fiscal stimulus ensure a global recovery but they also remove some of the economic limitations on countries that are witnessing a surge in nationalism. Second, nationalism creates a precarious environment for globalization – namely the wave of “hyper-globalization” since 2000. Nationalism and de-globalization do not depend on the United States alone but rather have shifted to the East, which means that geopolitical risks will remain elevated even if the US presidential election sees a restoration of the more dovish Democratic Party. Economic Shocks Fuel Nationalism’s Revival Nationalism is the idea that the political state should be made up of a single ethnic or cultural community. While many disasters have resulted from this idea, it is responsible for the modern nation-state and it has enabled democracies to take shape across Europe, the Americas, and beyond. Industrialization is also more feasible under nationalism because cultural conformity helps labor competitiveness.10 At the end of the Cold War, transnational communist ideology collapsed and democratic liberalism grew complacent. Each successive economic shock or major crisis has led to a surge in nationalism to fill the ideological gaps that were exposed. Chart II-2The Resurgence Of Russian Nationalism Chart II-3USA: From Nationalism To Anti-Nationalism For instance, various nationalists and populists emerged from the financial crises of the late 1990s. Russian President Vladimir Putin sought to restore Russia to greatness in its own and other peoples’ eyes (Chart II-2). Not every Russian adventure has mattered for investors, but taken together they have undermined the stability of the global system and raised barriers to exchange. The invasion of Crimea in 2014 and the interference in the US election in 2016 helped to fuel the rise in policy uncertainty, risk premiums in Russian assets, and safe havens over the past decade. The September 11, 2001 terrorist attacks in the United States created a surge in American nationalism (Chart II-3). This surge has since collapsed, but while it lasted the US destabilized the Middle East and provided Russia and China with the opportunity to pursue a nationalist path of their own. Investors who went long oil and short the US dollar at this time could have done worse. The 2008 crisis spawned new waves of nationalist feeling in countries such as China, Japan, the UK, and India (Chart II-4). Conservatives of the majority cultural group rose to power, including in China, where provincial grassroots members of the elite reasserted the Communist Party’s centrality. Japan and India became excellent equity investment opportunities in their respective spheres, while the UK and China saw their currencies weaken. The rising number of wars and conflicts across the world since 2008 reflects the shift toward nationalism, whether among minority groups seeking autonomy or nation-states seeking living space (Chart II-5). Chart II-4Nationalist Trends Since The Great Recession Chart II-5World Conflicts Rise After Major Crises COVID-19 is the latest economic shock that will feed a new round of nationalism. At least 750 million people are extremely vulnerable across the world, mostly concentrated in the shatter belt from Libya to Turkey, Iran, Pakistan, and India.11 Instability will generate emigration and conflict. Once again the global oil supply will be at risk from Middle Eastern instability and the dollar will eventually fall due to gargantuan budget and trade deficits. Today’s shock will differ, however, in the way it knocks against globalization, a process that has already begun to slow. Specifically, this crisis threatens to generate instability in East Asia – the workshop of the world – due to the strategic conflict between the US and China. This conflict will play out in the form of “proxy battles” in Greater China and the East Asian periphery. The dollar’s recent weakness is a telling sign of the future to come. In the short run, however, political and geopolitical risks are acute and will support safe havens. Globalization In Retreat Nationalism is not necessarily at odds with globalization. Historically there are many cases in which nationalism undergirds a foreign policy that favors trade and eschews military intervention. This is the default setting of maritime powers such as the British and Dutch. Prior to WWII it was the American setting, and after WWII it was the Japanese. Over the past thirty years, however, the rise of nationalism has generally worked against global trade, peace, and order. That’s because after WWII most of the world accepted internationalist ideals and institutions promoted by the United States that encouraged free markets and free trade. Serious challenges to that US-led system are necessarily challenges to global trade. This is true even if they originate in the United States. Globalization has occurred in waves continuously since the sixteenth century. It is not a light matter to suggest that it is experiencing a reversal. Yet the best historical evidence suggests that global imports, as a share of global output, have hit a major top (Chart II-6).12 The line in this chart will fall further in 2020. American household deleveraging, China’s secular slowdown, and the 2014 drop in oil and commodities have had a pervasive impact on the export contribution to global growth. Chart II-6Globalization Hits A Major Top Chart II-7Both Goods And Services Face Headwinds The next upswing of the business cycle will prompt an increase in trade in 2021. Global fiscal stimulus this year amounts to 8% of GDP and counting. But will the import-to-GDP ratio surpass previous highs? Probably not anytime soon. It is impossible to recreate America’s consumption boom and China’s production boom of the 1980s-2000s with public debt alone. Global trend growth is slowing. Isn’t globalization proceeding in services, if not goods? The world is more interconnected than ever, with nearly half of the population using the Internet – almost 30% in Sub-Saharan Africa. One in every two people uses a smartphone. Eventually the pandemic will be mitigated and global travel will resume. Nevertheless, the global services trade is also facing headwinds. And it requires even more political will to break down barriers for services than it does for goods (Chart II-7). The desire of nations to control and patrol cyberspace has resulted in separate Internets for authoritarian states like Russia and China. Even democracies are turning to censorship and content controls to protect their ideologies. Political demands to protect workers and industries are gaining ground. Policymakers in China and Russia have already shifted back toward import substitution; now the US and EU are joining them, at least when it comes to strategic sectors (health, defense). Nationalists and populists across the emerging world will follow their lead. Regional and wealth inequalities are driving populations to be more skeptical of globalization. GDP per capita has not grown as fast as GDP itself, a simple indication of how globalization does not benefit everyone equally even though it increases growth overall (Chart II-8). Inequality is a factor not only because of relatively well-off workers in the developed world who resent losing their job or earning less than their neighbors. Inequality is also rife in the developing world where opportunities to work, earn higher wages, borrow, enter markets, and innovate are lacking. Over the past decade, emerging countries like Brazil, Indonesia, Mexico, and South Africa have seen growing skepticism about whether foreign openness creates jobs or lifts wages.13 Immigration is probably the clearest indication of the break from globalization. The United States and especially the European Union have faced an influx of refugees and immigrants across their southern borders and have resorted to hard-nosed tactics to put a stop to it (Chart II-9). Chart II-8Global Inequality Fuels Protectionism Chart II-9US And EU Crack Down On Immigration There is zero chance that these tough tactics will come to an end anytime soon in Europe, where the political establishment has discovered a winning combination with voters by promoting European integration yet tightening control of borders. This combination has kept populists at bay in France, Italy, the Netherlands, Spain, and Germany. A degree of nationalism has been co-opted by the transnational European project. In the US, extreme polarization could cause a major change in immigration policy, depending on the election later this year. But note that the Obama administration was relatively hawkish on the border and the next president will face sky-high unemployment, which discourages flinging open the gates. Reduced immigration will weigh on potential GDP growth and drive up the wage bill for domestic corporations. If nationalism continues to rise and to hinder the movement of people, goods, capital, and ideas, then it will reduce the market’s expectations of future earnings. American Nationalism Still A Risk The United States is experiencing a “Civil War Lite” that may take anywhere from one-to-five years to resolve. The November 3 presidential election will have a major impact on the direction of nationalism and globalization over the coming presidential term. If President Trump is reelected – which we peg at 35% odds – then American nationalism and protectionism will gain a new lease on life. Other nations will follow the US’s lead. If Trump fails, then nationalism will likely be driven by external forces, but protectionism will persist in some form. Chart II-10Trump Is Not Yet Down For The Count Investors should not write Trump off. If the election were held today, Trump would lose, but the election is still four months away. His national approval rating has troughed at a higher level than previous troughs. His disapproval rating has spiked but has not yet cleared its early 2019 peak (Chart II-10).14 This is despite an unprecedented deluge of bad news: universal condemnation from Democrats and the media, high-profile defections from fellow Republicans and cabinet members, stunning defeats at the Supreme Court, and scathing rebukes from top US army officers. If Trump’s odds are 35% then this translates to a 35% chance that the United States will continue pursuing globally disruptive “America First” foreign and trade policies in the 2020-24 period. First Trump will attempt to pass a Reciprocal Trade Act to equalize tariffs with all trading partners. Assuming Democrats block it in the House of Representatives, he will still have sweeping executive authority to levy tariffs. He will launch the next round in the trade war with China to secure a “Phase Two” trade deal, which will be tougher because it will be focused on structural reforms. He could also open new fronts against the European Union, Mexico, and other trade surplus countries. By contrast, these risks will melt away if Biden is elected. Biden would restore the Obama administration’s approach of trade favoritism toward strategic allies and partners, such as Europe and the members of the Trans-Pacific Partnership, but only occasional use of tariffs. Biden would work with international organizations like the World Trade Organization. His foreign policy would also open up trade with pariah states like Iran, reducing the tail-risk of a war to almost zero. Biden would be tougher on China than Presidents Obama or Bill Clinton, as the consensus in Washington is now hawkish and Biden would need to keep the blue-collar voters he won back from Trump. He may keep Trump’s tariffs in place as negotiating leverage. But he is less likely to expand these tariffs – and there is zero chance he will use them against Europe. At the same time, it will take a year or more to court the allies and put together a “coalition of the willing” to pressure China on structural reforms and liberalization. China would get a reprieve – and so would financial markets. Thus investors have a roughly 65% chance of seeing US policy “normalize” into an internationalist (not nationalist) approach that reduces the US contribution to trade policy uncertainty and geopolitical risk over the next few years at minimum. But there are still four months to go before the election; these odds can change, and equity market volatility will come first. Moreover a mellower US would still need to react to nationalism in Asia. European Nationalism Not A Risk (Yet) Chart II-11English Versus Scottish Nationalism European nationalism has reemerged in recent years but has greatly disappointed the prophets of doom who expected it to lead to the breakup of the European Union. The southern European states suffered the most from COVID-19 but many of them have made their decision regarding nationalism and the supra-national EU. Greece underwent a depression yet remained in the union. Italians could easily elect the right-wing anti-establishment League to head a government in the not-too-distant future. But there is no appetite for an Italian exit. Brexit is the grand exception. If Trump wins, then the UK and British Prime Minister Boris Johnson will be seen as the vanguard of the revival of nationalism in the West. If Trump loses, English nationalism will appear an isolated case that is constrained by its own logic given the response of Scottish nationalism (Chart II-11). The trend in the British Isles would become increasingly remote from the trends in continental Europe and the United States. The majority of Europeans identify both as Europeans and as their home nationality, including majorities in countries like Greece, Italy, France, and Austria where visions of life outside the union are the most robust (Chart II-12). Even the Catalonians are focused on options other than independence, which has fallen to 36% support. Eastern European nationalists play a careful balancing game of posturing against Brussels yet never drifting so far as to let Russia devour them. Chart II-12European Nationalism Is Limited (For Now) Europeans have embraced the EU as a multi-ethnic confederation that requires dual allegiances and prioritizes the European project. COVID-19 has so far reinforced this trend, showing solidarity as the predominant force, and much more promptly than during the 2011 crisis. It will take a different kind of crisis to reverse this trend of deeper integration. European nationalists would benefit from another economic crash, a new refugee wave from the Middle East, or conflict with Turkish nationalism. The latter is already burning brightly and will eventually flame out, but not before causing a regional crisis of some kind. European policymakers are containing nationalism by co-opting some of its demands. The EU is taking steps to guard against globalization, particularly on immigration and Chinese mercantilism. The lack of nationalist uprisings in Europe do not overthrow the contention that globalization is slowing down. Europe can become more integrated at home while maintaining the higher barriers against globalization that it has always maintained relative to the UK and United States. Chinese Nationalism The Biggest Risk The nationalist risk to globalization is most significant in East Asia and the Pacific, where Chinese nationalism continues the ascent that began with the Great Recession. China’s slowdown in growth rates has weakened the Communist Party’s confidence in the long-term viability of single-party rule. The result has been a shift in the party line to promote ideology and quality of life improvements to compensate for slower income gains. Xi Jinping’s governing philosophy consists of nationalist territorial gains, promoting “the China Dream” for the middle class, and projecting ambitious goals of global influence by 2035 and 2049. The result has been a clash between mainland Chinese and peripheral Chinese territories – especially Hong Kong and Taiwan (Chart II-13). The turn away from Chinese identity in these areas runs up against their economic interest. It is largely a reaction to the surge in mainland nationalist sentiment, which cannot be observed directly due to the absence of reliable opinion polling. Chart II-13AChinese Nationalism On The Mainland, Anti-Nationalism In Periphery Chart II-13BChinese Nationalism On The Mainland, Anti-Nationalism In Periphery The conflict over identity in Greater China is perhaps the world’s greatest geopolitical risk. While Hong Kong has no conceivable alternative to Beijing’s supremacy, Taiwan does. The US is interested in reviving its technological and defense relationship with Taiwan now that it seeks to counterbalance China. Chart II-14Taiwan: Epicenter Of US-China Cold War Beijing may be faced with a technology cordon imposed by the United States, and yet have the option of circumventing this cordon via Taiwan’s advanced semiconductor manufacturing. Taiwan’s “Silicon Shield” used to be its security guarantee. Now that the US is tightening export controls and sanctions on China, Beijing has a greater need to confiscate that shield. This makes Taiwan the epicenter of the US-China struggle, as we have highlighted since 2016. The risk of a fourth Taiwan Strait crisis is as pertinent in the short run as it is over the long run, given that the US and China have already intensified their saber-rattling in the Strait (Chart II-14), including in the wake of COVID-19 specifically. China’s secular slowdown is prompting it to encroach on the borders of all of its neighbors simultaneously, creating a nascent balance-of-power alliance ranging from India to Australia to Japan. If China fails to curb its nationalism, then eventually US political polarization will decline as the country unites in the face of a peer competitor. If American divisions persist, they could drive the US to instigate conflict with China. Thus a failure of either side to restrain itself is a major geopolitical risk. The US and China ultimately face mutually assured destruction in the event of conflict, but they can have a clash in the near term before they learn their limits. The Cold War provides many occasions of such a learning process – from the Berlin airlift to the Cuban missile crisis. Such crises typically present buying opportunities for financial markets, but the consequences could be more far reaching if the Asian manufacturing supply chain is permanently damaged or if the shifting of supply chains out of China is too rapid. Globalization will also suffer as a result of currency wars. The US has not been successful in driving the dollar down, a key demand of the US-China trade war. It is much harder to force China to reform its labor and wage policies than it is to force it to appreciate its currency. But unlike Japan in 1985, China will not commit to unilateral appreciation for fear of American economic sabotage. Punitive measures will remain an American tool. Contrary to popular belief, the US is not attempting to eliminate its trade deficit. It is attempting to reduce overreliance on China. Status quo globalization is intolerable for US strategy. But autarky is intolerable for US corporations. The compromise is globalization-ex-China, i.e., economic decoupling. Investment Implications Chart II-15Favor International Stocks As Growth Revives US stock market’s capitalization now makes up 58% of global capitalization (Chart II-15), reflecting the strength and innovation of American companies as well as a worldwide flight to safety during a decade of rising policy uncertainty and geopolitical risk. The revival of global growth amid this year’s gargantuan stimulus will prompt a major rotation out of US equities and into international and emerging market equities over the long run. As mentioned, the US greenback would also trend downward. However, there will be little clarity on the pace of nationalism and the fate of globalization until the US election is decided. Moreover the fate of globalization does not depend entirely on the United States. It mostly depends on countries in the east – Russia, China, and India, all of which are increasingly nationalistic. A miscalculation over Taiwan, North Korea, the East China Sea, the South China Sea, trade, or technology could ignite into tariffs, sanctions, boycotts, embargoes, saber-rattling, proxy battles, and potentially even direct conflict. These risks are elevated in the short run but will persist in the long run. As the US decouples from China it will have to deepen relations with other trading partners. The trade deficit will not go away but will be redistributed to Asian allies. Southeast Asian nations and India – whose own nationalism has created a shift in favor of economic development – will be the long-run beneficiaries. Matt Gertken Vice President Geopolitical Strategist III. Indicators And Reference Charts We continue to favor stocks at the expense of bonds, a view held since our April issue. Global fiscal and monetary conditions remain highly accommodative. Now that the global economy is starting to recover as lockdowns ease, another tailwind for stocks has emerged. Nonetheless, last month we warned that the S&P 500 was entering a consolidation phase and that a pattern of volatile ups and downs would ensue. The combination of tactically overbought markets, elevated geopolitical risk, and a looming second wave of infections continues to sustain this short-term view. Hence, the S&P 500 is likely to churn between 2088 and 3200 over the coming months. On a cyclical basis, the same factors that made us willing buyers of stocks since late March remain broadly in place. Stocks are becoming increasingly expensive, but monetary conditions are extremely accommodative. Our Speculation Indicator continues to send a benign signal, which indicates that from a cyclical perspective, the market is not especially vulnerable. Finally, our Revealed Preference Indicator is flashing a strong buy signal. Tactically, equities must still digest the heady gains made since March 23. We have had five 5% or more corrections since March 23. More of them are in the cards. Both our Tactical Strength Indicator and the share of NYSE stocks trading above their 10-week moving averages point to a pullback of 5% to 10%. Moreover, while it remains extremely stimulative, our Monetary Indicator is not rising anymore, which increases the probability that traders start to pay more attention to geopolitical risks. According to our Bond Valuation Index, Treasurys are significantly more overvalued than equities. Additionally, our Composite Technical Indicator is losing momentum. This backdrop is dangerous for bonds, especially when sentiment towards this asset class is as high as it is today and economic growth is turning the corner. Finally, we expect the yield curve to steepen, especially for very long maturities where the Fed is less active. In a similar vein, inflation breakeven rates are a clean vehicle to bet on higher yields. Since we last published, the dollar has broken down. The greenback is expensive and its counter-cyclicality is a major handicap during a global economic recovery. Additionally, the US twin deficits are increasingly problematic. The fiscal deficit remains exceptionally wide and the re-opening of the US economy will pull down the household savings rate. The current account deficit is therefore bound to widen. The continued low level of real interest rates will complicate financing this deficit and to equilibrate the funding of US liabilities, the dollar will depreciate. The widening in the current account deficit also means that the large increase in money supply by the Fed will leak out of the US economy. This process will accentuate the dollar’s negative impulse. Technically, the accelerating downward momentum in our Dollar Composite Technical Indicator also warns of additional downside for the USD. Commodities continue to gain traction. The rapid move up in the Baltic Dry index suggests that more gains are in store for natural resource prices, especially as our momentum indicator is gaining strength. Moreover, the commodity advance/decline line remains in an uptrend. A global economic recovery, a weakening dollar, and falling real interest rates (driven by easy policy) indicate that fundamental factors – not just technical ones – are also increasingly commodity bullish. Tactically, if stocks churn, as we expect, commodities will likely do so as well. However, this move should also be seen as a consolidation of previous gains. Finally, gold remains strong, lifted by accommodative monetary conditions and a weak dollar. However, the yellow metal is now trading at a significant premium to its short-term fundamentals. Gold too is likely to trade in a volatile sideways pattern, especially if bond yields rise. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1 Please see Geopolitical Strategy "Social Unrest Can Still Cause Volatility," dated June 5, 2020, available at gps.bcaresearch.com 2 Please see The Bank Credit Analyst "June 2020," dated May 28, 2020, available at bca.bcaresearch.com 3 Please see Geopolitical Strategy "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com 4 Please see US Investment Strategy "So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC)," dated June 8, 2020, available at usis.bcaresearch.com 5 The control group excludes auto and gas stations, and building materials. 6 Please see Geopolitical Strategy "Geopolitics Is The Next Shoe To Drop," dated April 10, 2020, available at gps.bcaresearch.com 7 Gold and silver are precious metals that benefit from lower interest rates and a weak dollar. However, a much larger proportion of the demand for silver comes from industrial processes. Thus, silver outperforms gold when an economic recovery is imminent. 8 Please see Emerging Markets Strategy "A FOMO-Driven Mania?," dated June 4, 2020, and Emerging Markets Strategy "EM: Follow The Momentum," dated June 18, 2020, available at ems.bcaresearch.com 9 Please see The Bank Credit Analyst "June 2020," dated May 28, 2020, available at bca.bcaresearch.com 10 Ernest Gellner, Nations and Nationalism (Ithaca, NY: Cornell University Press, 1983). 11 Neli Esipova, Julie Ray, and Ying Han, “750 Million Struggling To Meet Basic Needs With No Safety Net,” Gallup News, June 16, 2020. 12 Christopher Chase-Dunn et al, “The Development of World-Systems,” Sociology of Development 1 (2015), pp. 149-172; and Chase-Dunn, Yukio Kawano, Benjamin Brewer, “Trade globalization since 1795: waves of integration in the world-system,” American Sociological Review 65 (2000), pp. 77-95. 13 Bruce Stokes, “Americans, Like Many In Other Advanced Economies, Not Convinced Of Trade’s Benefits,” September 26, 2018. 14 In other words, the mishandling of COVID-19 and the historic George Floyd protests of June 2020 have not taken as great of a toll on Trump’s national approval, thus far, as the Ukraine scandal last October, the government shutdown in January-February 2019, the near-failure to pass tax cuts in December 2017, or the Charlottesville incident in August 2017. This is surprising and points once more to Trump’s very solid political base, which could serve as a springboard for a comeback over the next four months.
Highlights China and India periodically fight each other on their fuzzy Himalayan border with zero market consequences. A major conflict is possible in the current environment – but it would present a buying opportunity. Chinese escalation with India would not have a negative impact on global trade and economy, unlike escalation with the US or its East Asian allies. If China gets into a major conflict with India, it is less likely to stage major military actions in the South China Sea or Taiwan Strait. It would reduce much more significant geopolitical risks. Go strategically long Indian pharmaceuticals. Feature India and China have engaged in their first deadly military clash since 1967. An Indian colonel and at least 20 troops died in fighting on June 15 in the Galwan Valley, Ladakh, where territorial disputes have heated up over the past month.At least 50 Chinese troops are estimated dead.1 Chart 1Regional Equities May Not Shrug Off War In Himalayas ... At First It was a minor incident. No shots were fired. Combatants used stones and knives and threw each other off cliffs. However, the occasion of the battle was a negotiation to de-escalate tensions, and talks have gone on since June 3. So that bodes ill. Prime Minister Narendra Modi’s government has not responded but China’s foreign ministry is making conciliatory remarks. Normally India-China border clashes occur during the summer, when weather permits, and do not last long and do not impact the rest of the world, either politically or financially. However, the structural and cyclical drivers of the conflict suggest it could escalate over the summer. A major escalation between nuclear powers is unlikely but could conceivably cause volatility in global financial markets. Global equity investors are focused on other things (COVID-19, global stimulus), but recent volatility suggests that Chinese, Indian, and Pakistani bourses could be vulnerable to any major military escalation (Chart 1). However, a Himalayan-inspired selloff would be short-lived and would present a buying opportunity. India-China tensions are far less relevant to global financial markets than China’s disputes with the United States in East Asia. If the US uses India as a pretext for tougher actions on China, then that is a different story. But it is unlikely for reasons explained below. Our base case strategic assessment of India remains the same: Chinese expansionism will pressure India to speed up economic development to gain greater influence in South Asia. India will also pursue better trade and defense relations with the United States and its allies in East Asia and the Pacific. We are tactically cautious on global equities, but strategically we expect equities to beat bonds and cyclicals to beat defensives. Selloffs stemming from Himalayan conflict will create buying opportunities for emerging market equities, especially India. The Drivers Of The Ladakh Skirmish India and China have a 2,170-mile border in the Himalayan mountains that is disputed in India’s northwest (Aksai Chin) and northeast (Sikkim; Arunachal Pradesh). These border disputes have simmered for decades and occasionally flare into violent incidents, usually meaningless. An India-China border war could occur, but is unlikely. Today’s clashes are mostly taking place in eastern Ladakh, as with disputes in 2013-14. Minor incidents have also occurred in India’s northeast (Naku La, Sikkim). These may be unrelated, but they may also suggest a broad India-China border conflict is in the works (Map 1). Map 1India And China Often Fight Over Undefined Himalayan Border When Ice Melts There is always a local spark for clashes along the Line of Actual Control. These tend to be triggered by infrastructure construction or military patrols that cross the countries’ various border claims. Typically China triggers the incident as it is always pouring more money and concrete into new structures to solidify its territorial claims, whereas India’s resources are more limited. However, in recent years India has grown more capable. Both sides may also be surging infrastructure spending amid the recession (Chart 2). Chart 2China No Longer Alone In Nation-Building In Himalayas Chart 3China's Slower Growth Jeopardizes Communist Party Legitimacy In the current dispute both sides claim the other broke the peace. Indian builders supposedly violated China’s space while working on the Darbuk-Shayok-DBO road which connects to an airfield near Galwan Valley, the site of the clash. But the Indian side argues that Chinese military forces have ventured several miles from their usual outposts and amassed major forces on their side suggesting they are preparing for a bigger effort to expand their control of territory. 2 We may never know who “started” it. There is no clear border and even the Line of Actual Control is hard to define.3 Investors should not confuse the proximate cause of this conflict for the underlying cause. There are structural and cyclical factors at work on both sides: 1. China’s declining domestic stability and rising international assertiveness. The crises of 2008, 2015, 2018-19, and 2020 have caused a hard break in China’s economic model. Slower trend growth jeopardizes the Communist Party’s long-term monopoly on power (Chart 3). The Xi Jinping administration has responded to each crisis by tightening the party’s grip and reasserting central Beijing control. This is true at home, in peripheral territories like Xinjiang and Hong Kong, and abroad, as in the South China Sea and the Belt and Road Initiative. Territorial disputes have flared up across China’s borders. India is no exception, with incidents in 2013, 2014, 2017, and now 2020 marking the change (Table 1). Table 1China’s Territorial Assertiveness Triggers Clashes With India The China-Pakistan Economic Corridor strengthens the alliance between these two countries and deepens India’s insecurities. India perceives China’s Belt and Road Initiative as a threat of economic and eventually military encirclement. In 2017, the Doklam dispute between China, Bhutan, and India – which lasted over two months – served to distract the Chinese populace from a major increase in US pressure on China’s periphery. That was President Trump’s “fire and fury” campaign to intimidate North Korea into entering nuclear negotiations (Chart 4). In 2020, China faces its first recessionary environment since the mid-1970s as well as rocky relations with the United States over trade, technology, Hong Kong, North Korea again, and possibly even the Taiwan Strait. It is a convenient time to turn the public’s attention to the Himalayas. Chart 4China's Last Dispute With India Occurred During US-North Korea Tensions 2. India’s emerging national consensus and international coming-of-age. India’s rise as a global power has accelerated since the Great Recession, especially after oil prices fell in 2014. Prime Minister Modi has won two smashing general elections with single-party majorities, in 2014 and 2019. His movement also maintains the upper hand in state legislatures, which is important given that India’s weak federal government cannot simply force structural reforms onto the country (Map 2). Modi’s electoral success reflects a deeper national consensus on the need for stronger central leadership, faster economic development, deeper international trade and investment ties, and pro-efficiency reforms such as the creation of a single market. The policy retreat from globalization benefits insular and service-oriented economies like India at the expense of mercantilist trading powers such as China. America’s pivot to Asia and “Indo-Pacific” strategy create a chance for India to attract investment as multinational corporations diversify away from China (Chart 5). Map 2Modi’s Political Capital At State-Level Chart 5India Attracts Investment As Supply Chains Diversify From China Chart 6US And India Fiscal Stimulus Enable Supply Chain Shift Out Of China In August 2019, after Modi’s big election victory, he launched an ambitious agenda of state-building. He converted the autonomous region of Jammu and Kashmir into two union territories under New Delhi: Jammu and Kashmir, and Ladakh. This change of status quo angered China and Pakistan, which felt their own territory threatened. Chinese territorial pressure could be retribution for these administrative reforms. China and Pakistan will also want to undermine Modi’s party in upcoming elections for the state assembly of Jammu and Kashmir. China’s territorial encroachments reflect its desire to gain control of the entire Aksai Chin plateau. India does not want China to gain such a strategic advantage at the head of the Indus River and valley. The global pandemic and recession reinforced these structural and cyclical trends by pushing both India and China to use nationalist devices to divert their populations from domestic ills. The use of fiscal stimulus across the world enables leaders to pursue risky strategic policies (Chart 6). There is also a tactical issue: India took over the chairmanship of the World Health Assembly in May, while the US is lobbying on behalf of Taiwan’s long desire to be represented in the World Health Organization in the wake of COVID-19. China is resisting this call and could be using Ladakh as a pressure tactic.4 How Far Will Sino-Indian Conflict Escalate? Reports suggest that India and China have reinforced troops in and near Ladakh and have brought more firepower and airpower into range.5 Some of this activity, on both sides, consists of seasonal military drills. So it is not certain that a build-up is occurring. China is less constrained and more capable of escalation than India. If China continues pressing its territorial advance, or if India tries to reclaim territory or take other territory in compensation, then the fight will expand. The conflict is taking place in rocky recesses at a far remove from the rest of the world, so there is a temptation to believe that any escalation can be controlled.6 This may be false and lead to tit-for-tat escalation. Table 2Military Balance: India Versus China In Himalayas Which side faces greater constraints? China is least constrained and most capable of escalation. Over the short run, China can utilize improved military command and capabilities in the area and can control the media and political response at home. Besting India would demonstrate that all Asian territorial claimants should defer to China. However, over the long run, aggression would cement the balance-of-power alliance between the US and India. India is more constrained than China, less capable of escalation: Modi has considerable political capital, but his conventional military advantage in this area is eroding and China has the higher ground from which to stage attacks (Table 2). India’s loss in the 1962 Himalayan war with China was a national humiliation. A repeat of such an event could destroy much of Modi’s mystique as a strongman leader and national savior. In the worst-case scenario, China would demonstrate superior military capability while the US and its allies would remain utterly aloof, leaving India looking both weak and isolated. Therefore India will engage in tit-for-tat military response while seeking diplomatic de-escalation. The US lacks interest in the dispute: Trump has already offered to mediate, presumably to demonstrate his deal-making skills again before the election. But the US does not have a compelling interest in this dispute and India does not want US mediation. If Trump takes punitive measures against China it will be for other reasons. Serious punitive measures require the stock market and economy to relapse, since at the moment Trump’s average approval rating is 43% and he hopes financial and economic gains will help him recover (Diagram 1). Diagram 1Odds President Trump Will Hike Tariffs On China Before US Election The above points suggest that China can afford to escalate if it wants to show India and the rest of Asia that the US is toothless and that China’s territorial claims in Asia should not be opposed. Since COVID-19, China has been aggressive in the South China Sea and Taiwan Strait, despite the fact that these areas bring economic risks. The Himalayas do not. The implication is that China’s risk appetite is large, particularly in territorial disputes, and driven by social and economic pressure at home. Investment Takeaways Because India and China (and Pakistan) have nuclear arms, and because the US could get involved, it is possible that a major escalation could occur and cause volatility in global financial markets. But it would not last long and no parties will use nuclear arms over Himalayan territorial disputes. A major conflict that results in a Chinese victory would subtract from Prime Minister Modi’s political capital and hence weigh on Indian equities, which have broken down badly since COVID-19 (Chart 7). The reason is that strong political support for Modi would enable India to continue making structural economic reforms that increase productivity. Chart 7Indian Equities Underperforming Since COVID-19 Chart 8India’s Path To Regional Primacy Lies Through Economic Opening And Reform In the long run, a major conflict, especially a humiliating defeat, would accelerate India’s attempts to improve national economic prowess for the sake of strategic security. Since India cannot achieve its strategic objective of primacy in South Asia merely through military power, it will need to do so through a stronger economic pull (Chart 8). This is an impetus for structural economic reform even beyond Modi. Hence our secularly bullish outlook on India. Indian pharmaceutical equities offer an investment opportunity (Chart 9). In an attempt to address land acquisition, which is one of the biggest constraints faced by companies looking to invest in India, New Delhi has announced that it is developing an area the size of Luxembourg to attract businesses moving out of China. The government reached out to over 1,000 US companies in April with incentives for them to move their facilities to India, with a focus on industries in which India has a comparative advantage, such as medical equipment suppliers, food processing units, textiles, leather, and auto part makers. Chart 9US And Indian Stimulus Policies Will Boost Investment In Indian Pharma While India is not as economically competitive as China, it could be attractive for non-strategic industries that would not want to relocate to the US but are looking to reduce uncertainty from US-China tensions. The next round of US fiscal stimulus is also likely to contain significant provisions that will incentivize companies to relocate from China, particularly in the medical and health care sector. For global investors, while a major Sino-Indian escalation could lead to short-term volatility, it would ultimately be a positive development if Beijing vented its nationalism on a strip of earth that is not globally relevant, rather than on the seas, which are highly relevant. Conflict between the US and China in East Asia is a far greater risk than Sino-Indian conflict. Indeed Chinese and American actions over the Taiwan Strait, North Korea, or the South and East China Seas are still far more likely than Sino-Indian tensions to affect global trade and stability and financial markets this year. The US could impose sanctions on Chinese tech and trade, a military incident could occur in the Taiwan Strait, North Korea could provoke US President Donald Trump into a new round of “fire and fury” that triggers a showdown with China, or the US and China could fight a naval skirmish in the South or East China Sea. None of these options is low probability, especially surrounding the US election. Over the short run, global investors should prepare for greater equity volatility, primarily because of hiccups in delivering new stimulus in the US, EU, and China, plus US domestic political risks and US-China-Asia strategic tensions. Stay long JPY-USD. Over the long run, a global growth rebound driven by massive global fiscal and monetary stimulus will drive the US dollar to weaken, global equities to outperform bonds, and cyclicals to outperform defensives. We remain long China-sensitive plays as well as infrastructure, cyber-security, and defense stocks. Strategically, go long Indian pharmaceuticals relative to the emerging market benchmark. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The Guardian, "Soldiers fell to their deaths as India and China’s troops fought with rocks," June 17, 2020. 2 See Ashley J. Tellis, "Hustling in the Himalayas: The Sino-Indian Border Confrontation," Carnegie Endowment for International Peace, June 4, 2020. See also Mohan Guruswamy, "India-China Border Dispute: Is A Give And Take Possible Now?" South Asia Monitor, June 3, 2020. 3 The Treaty of Tingmosgang (1684) only specifies one checkpost, at the Lhari Stream near Demchok, leaving everything else to disputed Indian and Chinese claims. See Alexander Davis and Ruth Gamble, "The local cost of rising India-China tensions," June 1, 2020. 4 See Nayanima Basu, "India Isn’t Worried About Tension With China, Unlikely To Give In To US Pressure On Taiwan," May 13, 2020. 5 See Ren Feng and He Penglei, "PLA Xizang Military Command holds coordinated exercise in plateau region," China Military Online, June 15, 2020. See also "空降兵某旅积极探索远程兵力投送新模式 空地同步 奔赴高原". 6 The reason escalation is normally limited is because of the extreme difficulty of operating extended military operations and resupply at 13,000-feet altitude. Both sides have the ability to surge reinforcements and equalize the contest. The cost and difficulty of retaking lost territory is often prohibitive. And while India’s conventional military power may overbalance China in this region, China has the uphill advantage and has made leaps and bounds in operational capabilities in recent decades. In short, escalation is normally controllable. See Aidan Milliff, "Tension High, Altitude Higher: Logistical And Physiological Constraints On The Indo-Chinese Border," War On The Rocks, June 8, 2020.