Economy

Highlights Trump is now clearly retreating from policies that harm the economy and reduce his reelection chances. Geopolitical risks are abating for the first time since May – a boon for financial markets amid global policy stimulus. The U.S. and China are containing tensions in the short term – though we remain skeptical about a final trade agreement. The U.S. election cycle is a rising source of political risk even as global risks fall – but Warren is not a reason to turn cyclically bearish. Book gains on our long spot gold trade. Feature President Trump is staging a tactical retreat from his “maximum pressure” foreign and trade policies. As a late-cycle president with an election looming, his decision to escalate conflicts with China and Iran in May revealed a voracious risk appetite. This “war president” mentality – the idea that Trump would reconnect with his political base ahead of 2020 at the risk of undermining his own economy – led us to recommend a defensive position over the course of the summer, even though we remained cyclically bullish. Now with Trump’s backpedaling this tactical narrative is starting to turn. The shift adds policy support to the recent up-tick in critical risk-on indicators (Chart 1). While U.S.-China fears have played a much greater role than Brexit in the political tailwind behind global government bond yields (Chart 2), the collapse of Boris Johnson’s no-deal gambit is also helping geopolitical risk to abate. Chart 1Risk-On Indicators Flash Green Chart 2China Political Risk To Ease (Brexit Is Nice Too) Unfortunately, it is too soon to sound the all-clear: The U.S. election cycle still warrants caution. As we highlighted in July, the rise of the progressive wing of the Democratic Party, particularly firebrand Senator Elizabeth Warren of Massachusetts, is causing jitters in the marketplace. Warren is on the cusp of displacing Vermont Senator Bernie Sanders as the second-place candidate behind former Vice President Joe Biden. Biden remains the frontrunner – which helps to support a constructive cyclical view – but the progressives have a tailwind and his status could change. Moreover, the entire primary process and U.S. election cycle will engender policy uncertainty and “black swan” risks. Trump’s pivot could come too late to save the bull market. There are still significant risks to our House View that equities will be higher in a year’s time. If a bear market and recession become a foregone conclusion, then Trump will have to return to a war footing. This means escalating the conflict with China or confronting Iran in a desperate bid to get voters to rally around the flag. This is a substantial political risk given that the odds of a recession are elevated and rising. Despite these risks, it is significant for the global macro view that President Trump is making a last ditch effort to save the business cycle while it can still be saved. This supports BCA’s House View that investors should maintain a cyclical risk-on orientation. How Do We Know Trump Is In Retreat? Here are the critical signs that Trump is downgrading his administration’s level of aggression after another summer of “fire and fury”: The U.S. and China are now officially easing tensions. Trump has delayed the October 1 tariff hike (from 25% to 30% on $250 billion worth of goods), while China has issued waivers for tariffs and promised to increase purchases of U.S. farm goods in advance of talks. Talks are resuming with the principal negotiators set to meet face-to-face after China’s National Day celebration on October 1. Critically, the two sides are reportedly picking up the nearly completed draft text of a trade agreement that was abandoned in May when divisions over compliance and tariffs resulted in a breakdown. Trump and Xi Jinping have an occasion to meet in Santiago, Chile in November, which is the best time for a signing if the talks progress well. Trump fired his hawkish National Security Adviser, John Bolton. Bolton was a supporter of the president’s “maximum pressure” foreign policy toward rivals, including China as well as Iran and North Korea. Oil prices dropped on the expectation that U.S. relations with Iran could improve, easing oil sanctions and increasing supply (Chart 3). But ultimately the signal is bullish for oil. The real significance is not Bolton himself but rather that Trump is changing tack to reduce geopolitical risks to economic growth. Whoever replaces Bolton is far less likely to be an uber-hawk (Bolton had cornered that market). A trade deal with Japan has been agreed in principle and may be signed in late September. U.S. relations with Europe are marginally improving. Trump even sent Secretary of State Mike Pompeo on a trip to discuss a diplomatic “reset” with the EU’s new crop of leaders set to take power in November and December. These improvements are tentative. Trump still explicitly rejects the idea that he should court Europe to apply unified pressure on China. But his administration has agreed to a beef export deal with the EU and, as long as China talks are ongoing, he is unlikely to slap tariffs on European cars. This decision will likely be postponed beyond November 14. All of the above confirms that Trump is focused on reelection. But how can we be sure this less-hawkish policy turn will last longer than five minutes? Rising unemployment is the most deadly leading indicator of a president’s approval rating. Economic data is alarming for a sitting president. Following a drop in business sentiment and investment, consumer sentiment is now suffering (Chart 4). Manufacturing – the sector Trump was ostensibly elected to defend – has slipped into outright contraction and loans and leases are shrinking in the electorally vital Midwestern states (Chart 5). Chart 3Bolton Bolting Is Bullish For Brent Chart 4A Reason For Trump To De-Escalate Fortunately for Trump, the job market is showing signs of resilience, with initial unemployment claims dropping hard (Chart 6). Chart 5Another Reason For Trump To De-Escalate Chart 6Good News For Trump Chart 7U.S. Consumer Should Prevent Recession BCA does not expect a recession within the next 12 months. The American consumer remains buoyant and median family incomes are strong (Chart 7). Nevertheless, Trump cannot assume anything. The proliferation of the “R” word has a negative psychological effect on businesses and consumers that could create a negative feedback loop. It also raises the risk of an equity selloff that tightens financial conditions and exacerbates the slowdown (Chart 8). Trump’s Democratic opponents and much of the news media will amplify negative economic news. Chart 8Trump Needs To Change The Topic While Trump cares about the stock market, his election ultimately rests on voters, not investors. Even if recession is avoided, a rising unemployment rate would be the most deadly leading indicator of a sitting president’s approval rating (Charts 9A & 9B). It is a far more telling variable than income growth or gasoline prices, for example. Chart 9APresidential Approval... Chart 9B...Follows Unemployment As Charts 9A & 9B demonstrate, unemployment and presidential approval are not always tightly correlated. Rather, for all recent presidents, the direction of unemployment ultimately prevailed over the approval rating by the time of the election – it pulled approval up or down in the final lap of the term in office. Moreover Trump, a bull-market president, is one of the cases where the approval rating is indeed tightly correlated with unemployment, as with Bill Clinton. And he is particularly vulnerable because his approval is historically weak and the unemployment rate can hardly fall much further from today. Granting that Trump is now going to adopt a more pro-market foreign and trade policy orientation, the next question is: what will that entail? Bottom Line: Trump’s tactical policy retreat is materializing which means that geopolitical risk stemming from U.S. foreign and trade policy is declining on the margin. While Trump is unpredictable, his sensitivity to the drop in his polling and weakening economy shows he wants to be reelected. Hence policy will have to moderate. Bolton Bolts – Geopolitical Risks Abate Trump’s ousting of his National Security Adviser Bolton is an important sign of the less-hawkish shift in administration policy. The ouster itself is not surprising in the least. Trump ran for office on a relatively isolationist foreign policy of non-intervention, withdrawal from long-running wars, and eschewing regime change and foreign quagmires to focus on America’s commercial interests. By contrast Bolton is perhaps the Republican Party’s most outspoken war hawk – a neo-conservative of the Bush era who advocated regime change in North Korea and Iran. This position was always at odds with Trump’s eagerness to negotiate and strike deals with the world’s dictators in the name of trade and riches rather than war and expenses.1 Chart 10Will Xi Sell Pyongyang For Washington? The immediate implication is that the U.S. and Iran will reduce tensions. We will address this topic at length next week, but the gist is that Trump is much more likely to relax sanctions and hold a summit with Iranian President Hassan Rouhani now than before. This is in keeping with our view that the China trade war is a far greater geopolitical risk than the U.S.-Iran tensions post-withdrawal from the 2015 nuclear pact. However, Bolton’s firing is bullish for oil prices. Iran may still stage low-level provocations that threaten supply, but Saudi Arabia has also appointed a new energy minister in preparation for an OPEC 2.0 strategy that aims to bolster prices in the advance of the initial public offering of Aramco.2 At the same time, Trump’s softening foreign policy stance portends an improvement to the global economy. Nowhere is this clearer than with North Korea and China. Kim Jong Un has explicitly demanded Bolton’s replacement to get talks back on track – Trump has now met this demand. North Korea has also been an integral component of the U.S.-China negotiations throughout Trump’s administration. If Trump’s diplomacy succeeds with North Korea, markets will rightly conclude that U.S.-China tensions are falling. China has an interest in denuclearizing the peninsula, which ultimately entails getting rid of U.S. troops, so it has shown it can comply with U.S. sanctions (Chart 10). A third Trump-Kim summit that results in a nuclear deal of any kind would be a concrete policy win for Trump and a strategic win for China.   The North Korean threat itself is not market-relevant – war risk peaked in 2017 (Chart 11). But an official agreement would provide an “off-ramp” for U.S.-China trade tensions. It would boost trade talks enough to improve global sentiment, and it could even increase the chances that the two countries conclude a deal involving tariff rollback. A Trump-Kim agreement would provide an “off-ramp” for U.S.-China trade tensions. Bolton’s ouster could also smooth U.S.-China tensions over Taiwan – he was an outspoken hawk on this front as well. His presence encouraged fears in Beijing that the Trump administration was planning a significant upgrade in Taiwan relations. These apprehensions were already high from the moment Trump accepted President Tsai Ing-wen’s congratulations on his election in 2016. It remains to be seen whether Trump will delay an $8 billion arms sale that will be the biggest since 1992 (Chart 12) – China has threatened to sanction U.S. defense firms if it goes ahead. But postponement is more likely now than before. This would help along the trade talks. Chart 11North Korea: 'Off-Ramp' For US-China Tensions Chart 12Will Trump Sell Taipei For Beijing? The direction of Taiwan in the near term partly depends on the direction of Hong Kong. Bolton likely advised a hard line in defense of the mass pro-democracy protests, which Trump was inclined to neglect for the sake of the trade talks with Beijing. Unless a mainland intervention and bloody security crackdown occurs – which is still a risk, and would make it politically impossible to conclude a trade deal with China – Trump will probably continue to sideline this Special Administrative Region. The jury is still out on whether protests will escalate after China’s National Day celebration, but Bolton’s absence and Hong Kong’s concessions to the protesters (which are backed by Beijing) are both positive signs. All of these factors suggest that the odds of a U.S.-China trade deal by November 2020 should rise. But is that really the case? For now we are maintaining our view that the odds are 40% by November 2020, though the risks are to the upside. Chart 13Trump Can Partially Offset China Tariffs While Trump and Xi can certainly make an executive decision to agree to a deal – any deal – we maintain our high-conviction view that it will lack durability due to uncertainties regarding compliance on China’s side and faithfulness on Trump’s side. And a shallow deal may be politically untenable if markets and the economy rebound. Crucially, neither China’s economic data nor U.S. financial conditions are forcing either side to capitulate entirely. Trump’s policy retreat entails the removal of trade risks from Canada, Mexico, and Japan first and foremost, and likely the European Union. This will offer some consolation to markets even though the small increase in U.S. exports in the near-term will not offset the sharp drop in exports to China (Chart 13). Combined with a de-escalation and containment of tensions with China, and worldwide monetary and fiscal stimulus, markets will face a substantial policy improvement. This will actually reduce the incentive for a final trade deal. If financial and economic pressure intensify and the U.S. heads toward a technical correction or bear market, Trump will need to capitulate. This will require significant tariff rollback. At that point, Xi Jinping will have the opportunity to agree to a short-term deal based on China’s current concessions and nothing more (Table 1). This would demonstrate to the whole world that it does not pay to coerce China: China operates on mutual respect and win-win agreements. This would be acceptable to Xi Jinping since it would at least buy some time until the inevitable second round of the strategic conflict in 2021. But we are not at full capitulation yet. Table 1China’s Offers Thus Far In The Trade War Bottom Line: Trump’s policy retreat includes the ouster of Bolton, which deescalates geopolitical risk on several fronts. Nevertheless, none of these risks – Iran, China, North Korea, Hong Kong, Taiwan – is fundamentally resolved. A U.S.-China trade agreement is not even necessary if the two political leaders are sufficiently supported by positive global macro developments. We continue to believe North Korea will lead to Trump diplomatic successes. De-escalation could lead to a breakthrough in trade talks pointing toward a deal, but it could also simply create an “off ramp” for the U.S. and China to contain tensions without having to capitulate on the trade front. Warren Still Warrants Caution While geopolitical risk has some room to abate, domestic political risk in the U.S. will pick up the slack. The entire American election cycle will trouble the markets over the coming 12 months – particularly due to the high chances of significant social unrest. Yet the greatest risks are frontloaded in the form of the Democratic Primary contest. This is because Warren will continue to do well in the early primary debates and therefore could soon morph into the biggest market risk of the entire election cycle. To be clear, her position as the frontrunner in the online betting markets is not validated by the national or state-level opinion polling. Biden remains dominant (Chart 14). If he stays firm above a 30% support rate, with double-digit leads over his nearest competitors in a range of important states, his chances of winning will rise over time and market uncertainty will fall. Chart 14Biden Still The Frontrunner In Democratic Primary While Biden’s election would be market-negative on the margin due to the outlook for tax hikes and re-regulation, Trump’s reelection is not as market-positive as some may believe since he will be unbridled in his second term and more capable of pursuing his aggressive protectionism. Ultimately, the choice between Trump and Biden is a choice between two candidates whose policies and flaws are well known and relatively digestible by markets. If Warren or Sanders come close to the Oval Office, the equity market will go through a re-rating. On the contrary, if Warren surpasses Sanders and takes the lead, uncertainty will skyrocket regardless of Trump’s advantages in the general election. This is not unlikely, as the leftward lurch within the party continues to propel the progressive candidates upward in the contest (Chart 15). If Warren or Sanders are seen as coming within one step from the Oval Office, the equity market will have to go through a re-rating. These progressive populists are proposing an onslaught of laws and regulations against banks, health insurers, oil and gas drillers, and the tech oligopoly. The agenda is inherently negative for corporate earnings in these sectors, as Peter Berezin of BCA’s Global Investment Strategy shows in a recent report.3 Chart 15Progressive Consolidation Would Increase Market Angst Chart 16Stocks Will Start To Trade On Polls Health stocks are clearly reacting to Warren’s surge in the online betting markets (Chart 16), so any convergence of the polling of real voters to these probabilities will cause a reckoning in this sector as well as in other sectors she has targeted, like financials, technology, and energy. The saving grace for now – a reason we remain cyclically bullish – is that Biden has not yet broken down in the polling. He is the least market-negative of the top three candidates, yet the most electable from the point of view of the swing state polling and electoral-college calculus. Warren is the most market-negative yet least electable of the top three. She must decisively surpass Sanders in order to create lasting volatility. Yet this will be hard to do because his electoral-college path to the presidency is clearer than Warren’s, judging by head-to-head polls with Trump, and he has the machinery and motivation to slog through the primary race for a long time – which undercuts both him and Warren versus Biden. Warren and Sanders are also less likely to lead the Democrats to victory in the senate even if they take the White House due to their lack of appeal in key senate races like Arizona and Georgia. Without a majority in the senate, their radical policy agenda will have to be left at the door. Investment Implications We are booking gains on our long spot gold trade at 16% since initiation. The thesis remains sound and we will reinitiate when appropriate.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Bolton’s tenure with Trump began with an incredible faux pas in which he advocated “the Libyan model” for the administration’s North Korean policy – prompting Trump to overrule him and reject that model. No comment could have been more inappropriate for a president trying to build trust with Kim Jong Un to sign a denuclearization deal. Libyan dictator Muammar Gaddafi was killed by enemy militias in Libya after NATO warplanes bombed his convoy – NATO’s intervention occurred despite Gaddafi’s having abandoned his nuclear weapon program in the wake of the September 1, 2001 attacks to avoid conflict with the U.S. and its allies. 2 See BCA Commodity & Energy Strategy Weekly Report, “Ignore The KSA-Russia Production Pact, Focus Instead On Their Need For Cash,” September 8, 016, ces.bcaresearch.com. 3 See BCA Global Investment Strategy Weekly Report, “Elizabeth Warren And The Markets,” September 1, 2019, gis.bcaresearch.com.