Protectionism/Competitive devaluation

Highlights China’s July Politburo meeting signaled that policy is unlikely to be overtightened. The Biden administration is likely to pass a bipartisan infrastructure deal – as well as a large spending bill by Christmas. Geopolitical risk in the Middle East will rise as Iran’s new hawkish president stakes out an aggressive position. US-Iran talks just got longer and more complicated. Europe’s relatively low political risk is still a boon for regional assets. However, Russia could still deal negative surprises given its restive domestic politics. Japan will see a rise in political turmoil after the Olympic games but national policy is firmly set on the path that Shinzo Abe blazed. Stay long yen as a tactical hedge. Feature Chart 1Rising Hospitalizations Cause Near-Term Jitters, But UK Rolling Over? Our key view of 2021, that China would verge on overtightening policy but would retreat from such a mistake to preserve its economic recovery, looks to be confirmed after the Politburo’s July meeting opened the way for easier policy in the coming months. Meanwhile the Biden administration is likely to secure a bipartisan infrastructure package and push through a large expansion of the social safety net, further securing the American recovery. Growth and stimulus have peaked in both the US and China but these government actions should keep growth supported at a reasonable level and dispel disinflationary fears. This backdrop should support our pro-cyclical, reflationary trade recommendations in the second half of the year. Jitters continue over COVID-19 variants but new cases have tentatively peaked in the UK, US vaccinations are picking up, and death rates are a lot lower now than they were last year, that is, prior to widescale vaccination (Chart 1). This week we are taking a pause to address some of the very good client questions we have received in recent weeks, ranging from our key views of the year to our outstanding investment recommendations. We hope you find the answers insightful. Will Biden’s Infrastructure Bill Disappoint? Ten Republicans are now slated to join 50 Democrats in the Senate to pass a $1 trillion infrastructure bill that consists of $550 billion in new spending over a ten-year period (Table 1). The deal is not certain to pass and it is ostensibly smaller than Biden’s proposal. But Democrats still have the ability to pass a mammoth spending bill this fall. So the bipartisan bill should not be seen as a disappointment with regard to US fiscal policy or projections. The Republicans appear to have the votes for this bipartisan deal. Traditional infrastructure – including broadband internet – has large popular support, especially when not coupled with tax hikes, as is the case here. Both Biden and Trump ran on a ticket of big infra spending. However, political polarization is still at historic peaks so it is possible the deal could collapse despite the strong signs in the media that it will pass. Going forward, the sense of crisis will dissipate and Republicans will take a more oppositional stance. The Democratic Congress will pass President Joe Biden’s signature reconciliation bill this fall, another dollop of massive spending, without a single Republican vote (Chart 2). After that, fiscal policy will probably be frozen in place through at least 2025. Campaigning will begin for the 2022 midterm elections, which makes major new legislation unlikely in 2022, and congressional gridlock is the likely result of the midterm. Republicans will revert to belt tightening until they gain full control of government or a new global crisis erupts. Table 1Bipartisan Infrastructure Bill Likely To Pass Chart 2Reconciliation Bill Also Likely To Pass Chart 3Biden Cannot Spare A Single Vote In Senate Hence the legislative battle over the reconciliation bill this fall will be the biggest domestic battle of the Biden presidency. The 2021 budget reconciliation bill, based on a $3.5 trillion budget resolution agreed by Democrats in July, will incorporate parts of the American Jobs Plan that did not pass via bipartisan vote (such as $436 billion in green energy subsidies), plus a large expansion of social welfare, the American Families Plan. This bill will likely pass by Christmas but Democrats have only a one-seat margin in the Senate, which means our conviction level must be medium, or subjectively about 65%. The process will be rocky and uncertain (Chart 3). Moderate Democratic senators will ultimately vote with their party because if they do not they will effectively sink the Biden presidency and fan the flames of populist rebellion. US budget deficit projections in Chart 4 show the current status quo, plus scenarios in which we add the bipartisan infra deal, the reconciliation bill, and the reconciliation bill sans tax hikes. The only significant surprise would be if the reconciliation bill passed shorn of tax hikes, which would reduce the fiscal drag by 1% of GDP next year and in coming years. Chart 4APassing Both A Bipartisan Infrastructure Bill And A Reconciliation Bill Cannot Avoid Fiscal Cliff In 2022 … Chart 4B… The Only Major Fiscal Surprise Would Come If Tax Hikes Were Excluded From This Fall’s Reconciliation Bill Chart 5Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing There are two implications. First, government support for the economy has taken a significant step up as a result of the pandemic and election in 2020. There is no fiscal austerity, unlike in 2011-16. Second, a fiscal cliff looms in 2022 regardless of whether Biden’s reconciliation bill passes, although the private economy should continue to recover on the back of vaccines and strong consumer sentiment. This is a temporary problem given the first point. Monetary policy has a better chance of normalizing at some point if fiscal policy delivers as expected. But the Federal Reserve will still be exceedingly careful about resuming rate hikes. President Biden could well announce that he will replace Chairman Powell in the coming months, delivering a marginally dovish surprise (otherwise Biden runs the risk that Powell will be too hawkish in 2022-23). Inflation will abate in the short run but remain a risk over the long run. Essentially the outlook for US equities is still positive for H2 but clouds are forming on the horizon due to peak fiscal stimulus, tax hikes in the reconciliation bill, eventual Fed rate hikes (conceivably 2022, likely 2023), and the fact that US and Chinese growth has peaked while global growth is soon to peak as well. All of these factors point toward a transition phase in global financial markets until economies find stable growth in the post-pandemic, post-stimulus era. Investors will buy the rumor and sell the news of Biden’s multi-trillion reconciliation bill in H2. The bill is largely priced out at the moment due to China’s policy tightening (Chart 5). The next section of this report suggests that China’s policy will ease on the margin over the coming 12 months. Bottom Line: US fiscal policy is delivering, not disappointing. Congress is likely to pass a large reconciliation bill by Christmas, despite no buffer in the Senate, because Democratic Senators know that the Biden presidency hangs in the balance. China’s Khodorkovsky Moment? Many clients have asked whether China’s crackdown on private business, from tech to education, is the country’s “Khodorkovsky moment,” i.e. the point at which Beijing converts into a full, autocratic regime where private enterprise is permanently impaired because it is subject to arbitrary seizure and control of the state. The answer is yes, with caveats. Yes, China’s government is taking a more aggressive, nationalist, and illiberal stance that will permanently impair private business and investor sentiment. But no, this process did not begin overnight and will not proceed in a straight line. There is a cyclical aspect that different investors will have to approach differently. First a reminder of the original Khodorkovsky moment. After the Soviet Union’s collapse, extremely wealthy oligarchs emerged who benefited from the privatization of state assets. When President Putin began to reassert the primacy of the state, he arbitrarily imprisoned Khodorkovsky and dismantled his corporate energy empire, Yukos, giving the spoils to state-owned companies. Russia is a petro state so Putin’s control of the energy sector would be critical for government revenues and strategic resurgence, especially at the dawn of a commodity boom. Both the RUB-USD and Russian equity relative performance performed mostly in line with global crude oil prices, as befits Russia’s economy, even though there was a powerful (geo)political risk premium injected during these two decades due to Russia’s centralization of power and clash with the West (Chart 6). Investors could tactically play the rallies after Khodorkovsky but the general trend depended on the commodity cycle and the secular rise of geopolitical risk. Chart 6Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer President Xi Jinping is a strongman and hardliner, like Putin, but his mission is to prevent Communist China from collapsing like the Soviet Union, rather than to revive it from its ashes. To that end he must reassert the state while trying to sustain the country’s current high level of economic competitiveness. Since China is a complex economy, not a petro state, this requires the state-backed pursuit of science, technology, competitiveness, and productivity to avoid collapse. Therefore Beijing wants to control but not smother the tech companies. Hence there is a cyclical factor to China’s regulatory crackdown. A crackdown on President Xi Jinping’s potential rivals or powerful figures was always very likely to occur ahead of the Communist Party’s five-year personnel reshuffle in 2022, as we argued prior to tech exec Jack Ma’s disappearance. Sackings of high-level figures have happened around every five-year leadership rotation. Similarly a crackdown on the media was expected. True, the pre-party congress crackdowns are different this time around as they are targeted at the private sector, innovative businesses, tech, and social media. Nevertheless, as in the past, a policy easing phase will follow the tightening phase so as to preserve the economy and the mobilization of private capital for strategic purposes. The critical cyclical factor for global investors is China’s monetary and credit impulse. For example, the crackdown on the financial sector ahead of the national party congress in 2017 caused a global manufacturing slowdown because it tightened credit for the entire Chinese economy, reducing imports from abroad. One reason Chinese markets sold off so heavily this spring and summer, was that macroeconomic indicators began decelerating, leaving nothing for investors to sink their teeth into except communism. The latest Politburo meeting suggests that monetary, fiscal, and regulatory policy is likely to get easier, or at least stay just as easy, going forward (Table 2). Once again, the month of July has proved an inflection point in central economic policy. Financial markets can now look forward to a cyclical easing in regulation combined with easing in monetary and fiscal policy over the next 12-24 months. Table 2China’s Politburo Prepares To Ease Policy, Secure Recovery Despite all of the above, for global investors with a lengthy time horizon, the government’s crackdown points to a secular rise of Communist and Big Government interventionism into the economy, with negative ramifications for China’s private sector, economic freedoms, and attractiveness as a destination for foreign investment. The arbitrary and absolutist nature of its advances will be anathema to long-term global capital. Also, social media, unlike other tech firms, pose potential sociopolitical risks and may not boost productivity much, whereas the government wants to promote new manufacturing, materials, energy, electric vehicles, medicine, and other tradable goods. So while Beijing cannot afford to crush the tech sector, it can afford to crush some social media firms. Chart 7China's Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China’s equity market profile looks conspicuously like Russia’s at the time of Khodorkovsky’s arrest (Chart 7). Chinese renminbi has underperformed the dollar on a multi-year basis since Xi Jinping’s rise to power, in line with falling export prices and slowing economic growth, as a result of economic structural change and the administration’s rolling back Deng Xiaoping’s liberal reform era. We expect a cyclical rebound to occur but we do not recommend playing it. Instead we recommend other cyclical plays as China eases policy, particularly in European equities and US-linked emerging markets like Mexico. Bottom Line: The twentieth national party congress in 2022 is a critical political event that is motivating a cyclical crackdown on potential rivals to Communist Party power. Chinese equities will temporarily bounce back, especially with a better prospect for monetary and fiscal easing. But over the long run global investors should stay focused on the secular decline of China’s economic freedoms and hence productivity. What Happened To The US-Iran Deal? Our second key view for 2021 was the US strategic rotation from the Middle East and South Asia to Asia Pacific. This rotation is visible in the Biden administration’s attempt to withdraw from Iraq and Afghanistan while rejoining the 2015 nuclear deal with Iran. However, Biden here faces challenges that will become very high profile in the coming months. The Biden administration failed to rejoin the 2015 deal under the outgoing leadership of the reformist President Hassan Rouhani. This means a new and much more difficult negotiation process will now begin that could last through Biden’s term or beyond. On August 5, President Ebrahim Raisi will take office with an aggressive flourish. The US is already blaming Iran for an act of sabotage in the Persian Gulf that killed one Romanian and one Briton. Raisi will need to establish that he is not a toady, will not cower before the West. The new Israeli government of Prime Minister Naftali Bennett also needs to demonstrate that despite the fall of his hawkish predecessor Benjamin Netanyahu, Jerusalem is willing and able to uphold Israel’s red lines against Iranian nuclear weaponization and regional terrorism. Hence both Iran and its regional rivals, including Saudi Arabia, will rattle sabers and underscore their red lines. The Persian Gulf and Strait of Hormuz will be subject to threats and attacks in the coming months that could escalate dramatically, posing a risk of oil supply disruptions. Given that the Iranians ultimately do want a deal with the Americans, the pressure should be low-to-medium level and persistent, hence inflationary, as opposed to say a lengthy shutdown of the Strait of Hormuz that would cause a giant spike in prices that ultimately kills global demand. Short term, the US attempt to reduce its commitments in Iraq and Afghanistan will invite US enemies to harass or embarrass the Biden administration. The Taliban is likely to retake control of Afghanistan. The US exit will resemble Saigon in 1975. This will be a black eye for the Biden administration. But public opinion and US grand strategy will urge Biden to be rid of the war. So any delays, or a decision to retain low-key sustained troop presence, will not change the big picture of US withdrawal. Long term, Biden needs to pivot to Asia, while President Raisi is ultimately subject to the Supreme Leader Ali Khamenei, who wants to secure Iran’s domestic stability and his own eventual leadership succession. Rejoining the 2015 nuclear deal leads to sanctions relief, without requiring total abandonment of a nuclear program that could someday be weaponized, so Iran will ultimately agree. The problem will then become the regional rise of Iranian power and the balancing act that the US will have to maintain with its allies to keep Iran contained. Bottom Line: The risk to oil prices lies to the upside until a US-Iran deal comes together. The US and Iran still have a shared interest in rejoining the 2015 deal but the time frame is now delayed for months if not years. We still expect a US-Iran deal eventually but previously we had anticipated a rapid deal that would put downward pressure on oil prices in the second half of the year. What Comes After Biden’s White Flag On Nord Stream II? Our third key view for 2021 highlighted Europe’s positive geopolitical and macro backdrop. This view is correct so far, especially given that China’s policymakers are now more likely to ease policy going forward. But Russia could still upset the view. Italy has been the weak link in European integration over the past decade (excluding the UK). So the national unity coalition that has taken shape under Prime Minister Mario Draghi exemplifies the way in which political risks were overrated. Italy is now the government that has benefited the most from the overall COVID crisis in public opinion (Chart 8). The same chart shows that the German government also improved its public standing, although mostly because outgoing Chancellor Angela Merkel is exiting on a high note. Her Christian Democrat-led coalition has not seen a comparable increase in support. The Greens should outperform their opinion polling in the federal election on September 26. But the same polling suggests that the Greens will be constrained within a ruling coalition (Chart 9). The result will be larger spending without the ability to raise taxes substantially. Markets will cheer a fiscally dovish and pro-European ruling coalition. Chart 8European Political Risk Limited, But Rising, Post-COVID The chief risk to this view of low EU political risk comes from Russia. Russia is a state in long-term decline due to the remorseless fall in fertility and productivity. The result has been foreign policy aggression as President Putin attempts to fortify the country’s strategic position and frontiers ahead of an even bleaker future. Chart 9German Election Polls Point To Gridlock? Now domestic political unrest has grown after a decade of policy austerity and the COVID-19 pandemic. Elections for the Duma will be held on September 19 and will serve as the proximate cause for Russia’s next round of unrest and police repression. Foreign aggressiveness may be used to distract the population from the pandemic and poor economy. We have argued that there would not be a diplomatic reset for the US and Russia on par with the reset of 2009-11. We stand by this view but so far it is facing challenges. Putin did not re-invade Ukraine this spring and Biden did not impose tough sanctions canceling the construction of the Nord Stream II gas pipeline to Germany. Russia is tentatively cooperating on the US’s talks with Iran and withdrawal from Afghanistan. The US gave Germany and Russia a free point by condoning the NordStream II. Now the US will expect Germany to take a tough diplomatic line on Russian and Chinese aggression, while expecting Russia to give the US some goodwill in return. They may not deliver. The makeup of the new German coalition will have some impact on its foreign policy trajectory in the coming years. But the last thing that any German government wants is to be thrust into a new cold war that divides the country down the middle. Exports make up 36% of German output, and exports to the Russian and Chinese spheres account for a substantial share of total exports (Chart 10). The US administration prioritizes multilateralism above transactional benefits so the Germans will not suffer any blowback from the Americans for remaining engaged with Russia and China, at least not anytime soon. Russia, on the other hand, may feel a need to seize the moment and make strategic gains in its region, despite Biden’s diplomatic overtures. If the US wraps up its forever wars, Russia’s window of opportunity closes. So Russia may be forced to act sooner rather than later, whether in suppressing domestic dissent, intimidating or attacking its neighbors, or hacking into US digital networks. In the aftermath of the German and Russian elections, we will reassess the risk from Russia. But our strong conviction is that neither Russian nor American strategy have changed and therefore new conflicts are looming. Therefore we prefer developed market European equities and we do not recommend investors take part in the Russian equity rally. Chart 10Germany Opposes New Cold War With Russia Or China Bottom Line: German and European equities should benefit from global vaccination, Biden’s fiscal and foreign policies, and China’s marginal policy easing (Chart 11). Eastern European emerging markets and Russian assets are riskier than they appear because of latent geopolitical tensions that could explode around the time of important elections in September. Chart 11Geopolitical Tailwinds To European Equities What Comes After The Olympics In Japan? Japan is returning to an era of “revolving door” prime ministers. Prime Minister Yoshihide Suga’s sole purpose was to tie up the loose ends of the Shinzo Abe administration, namely by overseeing the Olympics. After the games end, he will struggle to retain leadership of the Liberal Democratic Party. He will be blamed for spread of Delta variant even if the Olympics were not a major factor. If he somehow retains the party’s helm, the October general election will still be an underwhelming performance by the Liberal Democrats, which will sow the seeds of his downfall within a short time (Chart 12). Suga will need to launch a new fiscal spending package, possibly as an election gimmick, and his party has the strength in the Diet to push it through quickly, which will be favorable for the economy. For the elections the problem is not the Liberal Democrats’ popularity, which is still leagues above the nearest competitor, but rather low enthusiasm and backlash over COVID. Abe’s retirement, and the eventual fall of Abe’s hand-picked deputy, does not entail the loss of Abenomics. The Bank of Japan will retain its ultra-dovish cast at least until Haruhiko Kuroda steps down in 2023. The changes that occurred in Japan from 2008-12 exemplified Japan’s existence as an “earthquake society” that undergoes drastic national changes suddenly and rapidly. The paradigm shift will not be reversed. The drivers were the Great Recession, the LDP’s brief stint in the political wilderness, the Tohoku earthquake and Fukushima nuclear crisis, and the rise of China. The BoJ became ultra-dovish and unorthodox, the LDP became more proactive both at home and abroad. The deflationary economic backdrop and Chinese nationalism are still a powerful impetus for these trends to continue – as highlighted by increasingly alarming rhetoric by Japanese officials, including now Shinzo Abe himself, regarding the Chinese military threat to Taiwan. In other words, Suga’s lack of leadership will not stand even if he somehow stays prime minister into 2022. The Liberal Democrats have several potential leaders waiting in the wings and one of these will emerge, whether Yuriko Koike, Shigeru Ishiba, or Shinjiro Koizumi, or someone else. The popular and geopolitical pressures will force the Liberal Democrats and various institutions to continue providing accommodation to the economy and bulking up the nation’s defenses. This will require the BoJ to stay easier for longer and possibly to roll out new unorthodox policies, as with yield curve control in the 2010s. Japan has some of the highest real rates in the G10 as a result of very low inflation expectations and a deeply negative output gap (Chart 13). Abenomics was bearing fruit, prior to COVID-19, so it will be justified to stay the course given that deflation has reemerged as a threat once again. Chart 12Japan: Back To Revolving Door Of Prime Ministers Chart 13Japan To Keep Fighting Deflation Post-Abe Bottom Line: The political and geopolitical backdrop for Japan is clear. The government and BoJ will have to do whatever it takes to stay the course on Abenomics even in the wake of Abe and Suga. Prime ministers will come and go in rapid succession, like in past eras of political turmoil, but the trajectory of national policy is set. We would favor JGBs relative to more high-beta government bonds like American and Canadian. Given deflation, looming Japanese political turmoil, and the secular rise in geopolitical risk, we continue to recommend holding the yen. These views conform with those of BCA’s fixed income and forex strategists. Investment Takeaways China’s policymakers are backing away from the risk of overtightening policy this year. Policy should ease on the margin going forward. Our number one key forecast for 2021 is tentatively confirmed. Base metals are still overextended but global reflation trades should be able to grind higher. The US fiscal spending orgy will continue through the end of the year via Biden’s reconciliation bill, which we expect to pass. Proactive DM fiscal policy will continue to dispel disinflationary fears. Sparks will fly in the Middle East. The US-Iran negotiations will now be long and drawn out with occasional shows of force that highlight the tail risk of war. We expect geopolitics to add a risk premium to oil prices at least until the two countries can rejoin the 2015 nuclear deal. Germany’s Green Party will surprise to the upside in elections, highlighting Europe’s low level of geopolitical risk. China policy easing is positive for European assets. Russia’s outward aggressiveness is the key risk.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

Highlights Globalization is recovering to its pre-pandemic trajectory. But it will fail to live up to potential, as the “hyper-globalization” trends of the 1990s are long gone. China was the biggest winner of hyper-globalization. It now faces unprecedented risks in the context of hypo-globalization. Global investors woke up to China’s domestic political risks this year, which include arbitrary regulatory crackdowns on tech and private business. While Chinese officials will ease policy to soothe markets, the cyclical and structural outlook is still negative for this economy. Growth and stimulus have peaked. Political risk will stay high through the national party congress in fall 2022. US-China relations have not stabilized. India, the clearest EM alternative for global investors, is high-priced relative to China and faces troubles of its own. It is too soon to call a bottom for EM relative to DM. Feature Global investors woke up to China’s domestic political risk over the past week, as Beijing extended its regulatory crackdown to private education companies. Our GeoRisk Indicator shows Chinese political risk reaching late 2017 levels while the broad Chinese stock market continued this year’s slide against emerging market peers (Chart 1). Chart 1China: Domestic Political Risk Takes Investors By Surprise A technical bounce in Chinese tech stocks will very likely occur but we would not recommend playing it. The first of our three key views for 2021 is the confluence of internal and external headwinds for China. True, today’s regulatory blitz will pass over like previous ones and the fast money will snap up Chinese tech firms on the cheap. The Communist Party is making a show of force, not destroying its crown jewels in the tech sector. However, the negative factors weighing on China are both cyclical and structural. Until Chinese President Xi Jinping adjusts his strategy and US-China relations stabilize, investors do not have a solid foundation for putting more capital at risk in China. Globalization is in retreat and this is negative for China, the big winner of the past 40 years. Hypo-Globalization Globalization in the truest sense has expanded over millenia. It will only reverse amid civilizational disasters. But the post-Cold War era of “hyper-globalization” is long gone.1 The 2010s saw the emergence of de-globalization. In the wake of COVID-19, global trade is recovering to its post-2008 trend but it is nowhere near recovering the post-1990 trend (Chart 2). Trade exposure has even fallen within the major free trade blocs, like the EU and USMCA (Chart 3). Chart 2Hypo-Globalization Chart 3Trade Intensity Slows Even Within Trade Blocs Of course, with vaccines and stimulus, global trade will recover in the coming decade. We coined the term “hypo-globalization” to capture this predicament, in which globalization is set to rebound but not to its previous trajectory.2 We now inhabit a world that is under-globalized and under-globalizing, i.e. not as open and free as it could be. A major factor is the US-China economic divorce, which is proceeding apace. China’s latest state actions – in diplomacy, finance, and business – underscore its ongoing disengagement from the US-led global architecture. The US, for its part, is now on its third presidency with protectionist leanings. American and European fiscal stimulus are increasingly protectionist in nature, including rising climate protectionism. Bottom Line: The stimulus-fueled recovery from the global pandemic is not leading to re-globalization so much as hypo-globalization. A cyclical reboot of cross-border trade and investment is occurring but will fall short of global potential due to a darkening geopolitical backdrop. Still No Stabilization In US-China Relations Chart 4Do Nations Prefer Growth? Or Security? A giant window of opportunity is closing for China and Russia – they will look back fondly on the days when the US was bogged down in the Middle East. The US current withdrawal from “forever wars” incentivizes Beijing and Moscow to act aggressively now, whether at home or abroad. Investors tend to overrate the Chinese people’s desire for economic prosperity relative to their fear of insecurity and domination by foreign powers. China today is more desirous of strong national defense than faster economic growth (Chart 4). The rise of Chinese nationalism is pronounced since the Great Recession. President Xi Jinping confirmed this trend in his speech for the Communist Party’s first centenary on July 1, 2021. Xi was notably more concerned with foreign threats than his predecessors in 2001 and 2011 (Chart 5).3 China has arrived as a Great Power on the global stage and will resist being foisted into a subsidiary role by western nations. Chart 5Xi Jinping’s Centenary Speech Signaled Nationalist Turn Meanwhile US-China relations have not stabilized. The latest negotiations did not produce agreed upon terms for managing tensions in the relationship. A bilateral summit between Presidents Biden and Xi Jinping has not been agreed to or scheduled, though it could still come together by the end of October. Foreign Minister Wang Yi produced a set of three major demands: that the US not subvert “socialism with Chinese characteristics,” obstruct China’s development, or infringe on China’s sovereignty and territorial integrity (Table 1). The US’s opposition to China’s state-backed economic model, export controls on advanced technology, and attempts to negotiate a trade deal with the province of Taiwan all violate these demands.4 Table 1China’s Three Demands From The United States (July 2021) The removal of US support for China’s economic, development – recently confirmed by the Biden administration – will take a substantial toll on sentiment within China and among global investors. US President Joe Biden and four executive departments have explicitly warned investors not to invest in Hong Kong or in companies with ties to China’s military-industrial complex and human rights abuses. The US now formally accuses China of genocide in the Xinjiang region.5 Bottom Line: There is no stabilization in US-China relations yet. This will keep the risk premium in Chinese currency and equities elevated. The Sino-American divorce is a major driver of hypo-globalization. China’s Regulatory Crackdown President Xi Jinping’s strategy is consistent. He does not want last year’s stimulus splurge to create destabilizing asset bubbles and he wants to continue converting American antagonism into domestic power consolidation, particularly over the private economy. Now China’s sweeping “anti-trust” regulatory crackdown on tech, education, and other sectors is driving a major rethink among investors, ranging from Ark-founder Cathie Wood to perma-bulls like Stephen Roach. The driver of the latest regulatory crackdown is the administration’s reassertion of central party control. The Chinese economy’s potential growth is slowing, putting pressure on the legitimacy of single-party rule. The Communist Party is responding by trying to improve quality of life while promoting nationalism and “socialism with Chinese characteristics,” i.e. strong central government control and guidance over a market economy. Beijing is also using state power and industrial policy to attempt a great leap forward in science and technology in a bid to secure a place in the sun. Fintech, social media, and other innovative platforms have the potential to create networks of information, wealth, and power beyond the party’s control. Their rise can generate social upheaval at home and increase vulnerability to capital markets abroad. They may even divert resources from core technologies that would do more to increase China’s military-industrial capabilities. Beijing’s goal is to guide economic development, break up the concentration of power outside of the party, prevent systemic risks, and increase popular support in an era of falling income growth. Sociopolitical Risks: Social media has demonstrably exacerbated factionalism and social unrest in the United States, while silencing a sitting president. This extent of corporate power is intolerable for China. Economic And Financial Risks: Innovative fintech companies like Ant Group, via platforms like Alipay, were threatening to disrupt one of the Communist Party’s most important levers of power: the banking and financial system. The People’s Bank of China and other regulators insisted that Ant be treated more like a bank if it were to dabble in lending and wealth management. Hence the PBoC imposed capital adequacy and credit reporting requirements.6 Data Security Risks: Didi Chuxing, the ride-sharing company partly owned by Uber, whose business model it copied and elaborated on, defied authorities by attempting to conduct its initial public offering in the United States in June. The Communist Party cracked down on the company after the IPO to show who was in charge. Even more, Beijing wanted to protect its national data and prevent the US from gaining insights into its future technologies such as electric and autonomous vehicles. Foreign Policy Risks: Beijing is also preempting the American financial authorities, who will likely take action to kick Chinese companies that do not conform to common accounting and transparency standards off US stock exchanges. Better to inflict the first blow (and drive Chinese companies to Hong Kong and Shanghai for IPOs) than to allow free-wheeling capitalism to continue, giving Americans both data and leverage. Thus Beijing is continuing the “self-sufficiency” drive, divorcing itself from the US economy and capital markets, while curbing high-flying tech entrepreneurs and companies. The party’s muscle-flexing will culminate in Xi Jinping’s consolidation of power over the Politburo and Central Committee at the twentieth national party congress in fall 2022, where he is expected to take the title of “Chairman” that only Mao Zedong has held before him. The implication is that the regulatory crackdown can easily last for another six-to-12 more months. True, investors will become desensitized to the tech crackdown. But health care and medical technology are said to be in the Chinese government’s sights. So are various mergers and acquisitions. Both regulatory and political risk premia in different sectors can persist. The current administration has waged several sweeping regulatory campaigns against monopolies, corruption, pollution, overcapacity, leverage, and non-governmental organizations. The time between the initial launch of one of these campaigns and their peak intensity ranges from two to five years (Chart 6). Often, but not always, central policy campaigns have an express, three-year plan associated with them. Chart 6ABeijing Cracked Down On Monopolies, Corruption, Pollution... Chart 6B...NGOs, Overcapacity, And Leverage Chart 7China Tech: Buyer Beware The first and second year mark the peak impact. The negative profile of Chinese tech stocks relative to their global peers suggests that the current crackdown is stretched, although there is little sign of bottom formation yet (Chart 7). The crackdown began with Alibaba founder Jack Ma, and Alibaba stocks have yet to arrest their fall either in absolute terms or relative to the Hang Seng tech index. Bottom Line: A technical bounce is highly likely for Chinese stocks, especially tech, but we would not recommend playing it because of the negative structural factors. For instance, we fully expect the US to delist Chinese companies that do not meet accounting standards. The Chinese Government’s Pain Threshold? The government is not all-powerful – it faces financial and economic constraints, even if political checks and balances are missing. Beijing does not have an interest in destroying its most innovative companies and sectors. Its goal is to maintain the regime’s survival and power. China’s crackdown on private companies goes against its strategic interest of promoting innovation and therefore it cannot continue indefinitely. The hurried meeting of the China Securities Regulatory Commission with top bankers on July 28 suggests policymakers are already feeling the heat.7 In the case of Ant Group, the company ultimately paid a roughly $3 billion fine (which is 18% of its annual revenues) and was forced to restructure. Ant learned that if it wants to behave more like a bank athen it will be regulated more like a bank. Yet investors will still have to wrestle with the long-term implications of China’s arbitrary use of state power to crack down on various companies and IPOs. This is negative for entrepreneurship and innovation, regardless of the government’s intentions. Chart 8China's Pain Threshold = Property Sector Ultimately the property sector is the critical bellwether: it is a prime target of the government’s measures against speculative asset bubbles. It is also an area where authorities hope to ease the cost of living for Chinese households, whose birth rates and fertility rates are collapsing. While there is no risk of China’s entire economy crumbling because of a crackdown on ride-hailing apps or tutoring services, there is a risk of the economy crumbling if over-zealous regulators crush animal spirits in the $52 trillion property sector, as estimated by Goldman Sachs in 2019. Property is the primary store of wealth for Chinese households and businesses and falling property prices could well lead to an unsustainable rise in debt burdens, a nationwide debt-deflation spiral, and a Japanese-style liquidity trap. Judging by residential floor space started, China is rapidly approaching its overall economic pain threshold, meaning that property sector restrictions should ease, while monetary and credit policy should get easier as necessary to preserve the economic recovery (Chart 8). The economy should improve just in time for the party congress in late 2022. Bottom Line: China will be forced to maintain relatively easy monetary and fiscal policy and avoid pricking the property bubble, which should lend some support to the global recovery and emerging markets economies over the cyclical (12-month) time frame. China’s Regulation And Demographic Pressures Is the Chinese government not acting in the public interest by tamping down financial excesses, discouraging anti-competitive corporate practices, and combating social ills? Yes, there is truth to this. But arbitrary administrative controls will not increase the birth rate, corporate productivity, or potential GDP growth. First, it is true that Chinese households cite high prices for education, housing, and medicine as reasons not to have children (Chart 9). However, price caps do not attack the root causes of these problems. The lack of financial security and investment options has long fueled high house prices. The rabid desire to get ahead in life and the exam-oriented education system have long fueled high education prices. Monetary and fiscal authorities are forced to maintain an accommodative environment to maintain minimum levels of economic growth amid high indebtedness – and yet easy money policies fuel asset price inflation. In Japan, fertility rates began falling with economic development, the entrance of women in the work force, and the rise of consumer society. The fertility rate kept falling even when the country slipped into deflation. It perked up when prices started rising again! But it relapsed after the Great Recession and Fukushima nuclear crisis (Chart 10, top panel). Chart 9China: Concerns About Having Children China’s fertility rate bottomed in the 1990s and has gradually recovered despite the historic surge in property prices (Chart 10, second panel), though it is still well below the replacement rate needed to reverse China’s demographic decline in the absence of immigration. A lower cost of living and a higher quality of life will be positive for fertility but will require deeper reforms.8 Chart 10Fertility Fell In Japan Despite Falling Prices At the same time, arbitrary regulatory crackdowns that punish entrepreneurs are not likely to boost productivity. Anti-trust actions could increase competition, which would be positive for productivity, but China’s anti-trust actions are not conducted according to rule of law, or due process, so they increase uncertainty rather than providing a more stable investment environment. China’s tech crackdown is also aimed at limiting vulnerability to foreign (American) authorities. Yet disengagement with the global economy will reduce competition, innovation, and productivity in China. Bottom Line: China’s demographic decline will require larger structural changes. It will not be reversed by an arbitrary game of whack-a-mole against the prices of housing, education, and health. India And South Asia Chart 11China Will Ease Policy... Or India Will Break Out Global investors have turned to Indian equities over the course of the year and they are now reaching a major technical top relative to Chinese stocks (Chart 11). Assuming that China pulls back on its policy tightening, this relationship should revert to mean. India faces tactical geopolitical and macroeconomic headwinds that will hit her sails and slow her down. In other words, there is no great option for emerging markets at the moment. Over the long run, India benefits if China falters. Following the peak of the second COVID-19 wave in May 2021, some high frequency indicators have showed an improvement in India’s economy. However, activity levels appear weaker than of other emerging markets (Chart 12). Given the stringency levels of India’s first lockdown last spring, year-on-year growth will look faster than it really is. As the base effect wanes, underlying weak demand will become evident. Moreover India is still vulnerable to COVID-19. Only 25% of the population has received one or more vaccine shots which is lower than the global level of 28%. The result will be a larger than expected budget deficit. India refrained from administering a large dose of government spending in 2020 (Chart 13). With key state elections due from early 2022 onwards, the government could opt for larger stimulus. This could assume the form of excise duty cuts on petroleum products or an increase in revenue expenditure. These kinds of measures will not enhance India’s productivity but will add to its fiscal deficit. Chart 12Weak Post-COVID Rebound In India – And Losing Steam Chart 13India Likely To Expand Fiscal Spending Soon Such an unexpected increase in India’s fiscal deficit could be viewed adversely by markets. India’s fiscal discipline tends to be poorer than that of peers (see Chart 13 above). Meanwhile India’s north views Pakistan unfavorably and key state elections are due in this region. Consequently, Indian policy makers may be forced to adopt a far more aggressive foreign policy response to any terrorist strikes from Pakistan or territorial incursions by China over August 2021. The US withdrawal from Afghanistan poses risks for India as it has revived the Taliban’s influence. India has a long history of being targeted by Afghani terrorist groups. And its diplomatic footprint in Afghanistan has been diminishing. Earlier in July, India decided temporarily to close its consulate in Kandahar and evacuated about 50 diplomats and security personnel. As August marks the last month of formal US presence in Afghanistan, negative surprises emanating from Afghanistan should be expected. Bottom Line: Pare exposure to Indian assets on a tactical basis. Our Emerging Markets Strategy takes a more optimistic view but geopolitical changes could act as a negative catalyst in the short term. We urge clients to stay short Indian banks. Investment Takeaways US stimulus contrasts with China’s turmoil. The US Biden administration and congressional negotiators of both parties have tentatively agreed on a $1 trillion infrastructure deal over eight years. Even if this bipartisan deal falls through, Democrats alone can and will pass another $1.3-$2.5 trillion in net deficit spending by the end of the year. Stay short the renminbi. Prefer a balance of investments in the dollar and the euro, given the cross-currents of global recovery yet mounting risks to the reflation trade. A technical bounce in Chinese stocks and tech stocks is nigh. China’s policymakers are starting to respond to immediate financial pressures. However, growth has peaked and structural factors are still negative. The geopolitical outlook is still gloomy and China’s domestic political clock is a headwind for at least 12 more months. Prefer developed market equities over emerging markets (Chart 14). Emerging markets failed to outperform in the first half of the year, contrary to our expectation that the global reflation trade would lift them. China/EM will benefit when Beijing eases policy and growth rebounds. Chart 14Emerging Markets: Not Out Of The Woods Yet Stay short Indian banks and strongman EM currencies, including the Turkish lira, the Brazilian real, and the Philippine peso. The biggest driver of EM underperformance this year is the divergence between the US and China. But until China’s policy corrects, the rest of EM faces downside risks.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 Dani Rodrik, The Globalization Paradox: Democracy and the Future of the World Economy (New York: Norton, 2011). 2 See my "Nationalism And Globalization After COVID-19," Investments & Wealth Monitor (Jan/Feb 2021), pp13-21, investmentsandwealth.org. 3 Our study of Xi’s speech is not limited to this quantitative, word-count analysis. A fuller comparison of his speech with that of his predecessors on the same occasion reveals that Xi was fundamentally more favorable toward Marx, less favorable toward Deng Xiaoping and the pro-market Third Plenum, utterly silent on notions of political reform or liberal reform, more harsh in his rhetoric toward the outside world, and hawkish about the mission of reunifying with Taiwan. 4 The Chinese side also insisted that the US stop revoking visas, punishing companies and institutes, treating the press as foreign agents, and detaining executives. It warned that cooperation – which the US seeks on the environment, Iran, North Korea, and other areas – cannot be achieved while the US imposes punitive measures. 5 See US Department of State, "Xinjiang Supply Chain Business Advisory," July 13, 2021, and "Risks and Considerations for Businesses Operating in Hong Kong," July 16, 2021, state.gov. 6 Top business executives are also subject to these displays of state power. For example, Alibaba founder Jack Ma caricatured China’s traditional banks as “pawn shops” and criticized regulators for stifling innovation. He is now lying low and has taken to painting! 7 See Emily Tan and Evelyn Cheng, "China will still allow IPOs in the United States, securities regulator tells brokerages," CNBC, July 28, 2021, cnbc.com. Officials are sensitive to the market blowback but the fact remains that IPOs in the US have been discouraged and arbitrary regulatory crackdowns are possible at any time. 8 Increasing social spending also requires local governments to raise more revenue but the central government had been cracking down on the major source of revenues for local government: land sales and local government financing vehicles. With the threat of punishment for local excesses and lack of revenue source, local governments have no choice but to cut social services, pushing affluent residents towards private services, while leaving the less fortunate with fewer services. As with financial regulations, the central government may backpedal from too tough regulation of local governments, but more economic and financial pain will be required to make it happen. The Geopolitics Of The Olympics The 2020 Summer Olympics are currently underway in Tokyo, even though it is 2021. The arenas are mostly empty given the global pandemic and economic slowdown. Every four years the Summer Olympics create a golden opportunity for the host nation to showcase its achievements, infrastructure, culture, and beauty. But the Olympics also have a long history of geopolitical significance: terrorist acts, war protests, social demonstrations, and boycotts. In 1906 an Irish athlete climbed a flag pole to wave the Irish flag in protest of his selection to the British team instead of the Irish one. In 1968 two African American athletes raised their fists as an act of protest against racial discrimination in the US after the assassination of Martin Luther King Jr. In 1972, the Palestinian terrorist group Black September massacred eleven Israeli Olympians in Munich, Germany. In 1980 the US led the western bloc to boycott the Moscow Olympics while the Soviet Union and its allies retaliated by boycotting the 1984 Los Angeles Olympics. In 2008, Russia used the Olympics as a convenient distraction from its invasion of Georgia, a major step in its geopolitical resurgence. So far, thankfully, the Tokyo Olympics have gone without incident. However, looking forward, geopolitics is already looming over the upcoming 2022 Winter Olympics in Beijing. How the world has changed. The 2008 Summer Olympics marked China’s global coming-of-age celebration. The breathtaking opening ceremony featured 15,000 performers and cost $100 million. The $350 million Bird’s Nest Stadium showcased to the world China’s long history, economic prowess, and various other triumphs. All of this took place while the western democratic capitalist economies grappled with what would become the worst financial and economic crisis since the Great Depression. In 2008, global elites spoke of China as a “responsible stakeholder” that was conducting a “peaceful rise” in international affairs. The world welcomed its roughly $600 billion stimulus. Now elites speak of China as primarily a threat and a competitor, a “revisionist” state challenging the liberal world order. China is blamed for a lack of transparency (if not virological malfeasance) in handling the COVID-19 pandemic. It is blamed for breaking governance promises and violating human rights in Hong Kong, for alleged genocide in Xinjiang, and for a list of other wrongdoings, including tough “Wolf Warrior” diplomacy, cyber-crime and cyber-sabotage, and revanchist maritime-territorial claims. Even aside from these accusations it is clear that China is suffering greater financial volatility as a result of its conflicting economic goals. Talk of a diplomatic or even full boycott of Beijing’s winter games is already brewing. Sponsors are also second-guessing their involvement. More than half of Canadians support boycotting the winter games. Germany is another bellwether to watch. In 2014, Germany’s president (not chancellor) boycotted the Sochi Olympics; in 2021, the EU and China are witnessing a major deterioration of relations. Parliamentarians in the UK, Italy, Sweden, Switzerland, and Norway have asked their governments to outline their official stance on the winter games. In the age of “woke capitalism,” a sponsorship boycott of the games is a possibility. This is especially true given the recent Chinese backlash against European multinational corporations for violating China’s own rules of political correctness. A boycott which includes any members of the US, Norway, Canada, Sweden, Germany, or the Netherlands would be substantial as these are the top performers in the Winter Olympics. Even if there is no boycott, there is bound to be some political protests and social demonstrations, and China will not be able to censor anything said by Western broadcasters televising the events. Athletes usually suffer backlash at home if they make critical statements about their country, but they run very little risk of a backlash for criticizing China. If anything, protests against China’s handling of human rights will be tacitly encouraged. Beijing, for its part, will likely overreact, as these days it not only controls the message at home but also attempts more actively to export censorship. This is precisely what the western governments are now trying to counteract, for their own political purposes. The bottom line is that the 2008 Beijing Olympics reflected China’s strengths in stark contrast with the failures of democratic capitalism, while the 2022 Olympics are likely to highlight the opposite: China’s weaknesses, even as the liberal democracies attempt a revival of their global leadership.   Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Section II: GeoRisk Indicator China Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia Section III: Geopolitical Calendar

Special Report

Highlights Investors should view social media as a technological innovation with negative productivity growth. Social media has contributed to policy mistakes – such as fiscal austerity and protectionism – that have acted as shocks to aggregate demand over the past 15 years. The cyclical component of productivity was long lasting in nature during the last economic expansion. Forces that negatively impact economic growth but do not change the factors of production necessarily reduce measured productivity, and repeated policy mistakes strongly contributed to the slow growth profile of the last economic cycle. Political polarization in a rapidly changing world is the root cause of these policy shocks, but social media likely facilitated and magnified them. The risks of additional mistakes from populism remain present, even before considering other risks to society from social media: a reduction in mental health among young social media users, and the role that social media has played in spreading misinformation. A potential revival in protectionist sentiment is a risk to a constructive cyclical view that we will be closely monitoring over the coming 12-24 months. Investors with concentrated positions in social media stocks should be aware of the potential idiosyncratic risks facing these companies from the public’s impression of the impact of social media on society – especially if social media companies come to be widely associated with political gridlock, the polarization of society, and failed economic policies (as already appears to be the case). Feature Investors should view social media as a technological innovation with negative productivity growth. Social media has contributed to policy mistakes – such as fiscal austerity and protectionism – that have acted as shocks to aggregate demand over the past 15 years. Political polarization in a rapidly changing world is the root cause of these policy shocks, but social media likely facilitated and magnified them. While the risk of premature fiscal consolidation appears low today compared to the 2010-14 period, the pandemic and its aftermath could force the Biden administration or Congressional Democrats toward protectionist or otherwise populist actions over the coming year in the lead up to the 2022 mid-term elections. The midterms, for their part, are expected to bring gridlock back into US politics, which could remove fiscal options should the economy backslide. Frequent shocks during the last economic expansion reinforced the narrative of secular stagnation. In the coming years, any additional policy shocks following a return to economic normality will again be seen by both investors and the Fed as strong justification for low interest rates – despite the case for cyclically and structurally higher bond yields. In addition, investors with concentrated positions in social media companies should take seriously the long-term idiosyncratic risks facing these stocks. These risks stem from the public’s impression of the impact of social media on society, particularly if social media comes to be widely associated with political gridlock, the polarization of society, and failed economic policies. A Brief History Of Social Media The earliest social networking websites date back to the late 1990s, but the most influential social media platforms, such as Facebook and Twitter, originated in the mid-2000s. Prior to the advent of modern-day smartphones, user access to platforms such as Facebook and Twitter was limited to the websites of these platforms (desktop access). Following the release of the first iPhone in June 2007, however, mobile social media applications became available, allowing users much more convenient access to these platforms. Charts II-1 and II-2 highlight the impact that smartphones have had on the spread of social media, especially since the release of the iPhone 3G in 2008. In 2006, Facebook had roughly 12 million monthly active users; by 2009, this number had climbed to 360 million, growing to over 600 million the year after. Twitter, by contrast, grew somewhat later, reaching 100 million monthly active users in Q3 2011. Chart II-1Facebook: Monthly Active Users Chart II-2Twitter: Monthly Active Users Worldwide   Social media usage is more common among those who are younger, but Chart II-3 highlights that usage has risen over time for all age groups. As of Q1 2021, 81% of Americans aged 30-49 reported using at least one social media website, compared to 73% of those aged 50-64 and 45% of those aged 65 and over. Chart II-4 highlights that the usage of Twitter skews in particular toward the young, and that, by contrast, Facebook and YouTube are the social media platforms of choice among older Americans. Chart II-3A Sizeable Majority Of US Adults Regularly Use Social Media Chart II-4Older Americans Use Facebook Far More Than Twitter Chart II-5Social Media Has Changed The Way People Consume News As a final point documenting the development and significance of social media, Chart II-5 highlights that more Americans now report consuming news often (roughly once per day) from a smartphone, computer, or tablet other than from television. Radio and print have been completely eclipsed as sources of frequent news. The major news publications themselves are often promoted through social media, but the rise of the Internet has weighed heavily on the journalism industry. Social media has, for better and for worse, enabled the rapid proliferation of alternative news, citizen journalism, rumor, conspiracy theories, and foreign disinformation. The Link Between Social Media And Post-GFC Austerity Following the 2008-2009 global financial crisis (GFC), there have been at least five deeply impactful non-monetary shocks to the US and global economies that have contributed to the disconnection between growth and interest rates: A prolonged period of US household deleveraging from 2008-2014 The Euro Area sovereign debt crisis Fiscal austerity in the US, UK, and Euro Area from 2010 – 2012/2014 The US dollar / oil price shock of 2014 The rise of populist economic policies, such as the UK decision to leave the European Union, and the US-initiated trade war of 2018-2019. Among these shocks to growth, social media has had a clear impact on two of them. In the case of austerity in the aftermath of the Great Recession, a sharp rise in fiscal conservatism in 2009 and 2010, emblematized by the rise of the US Tea Party, profoundly affected the 2010 US midterm elections. It is not surprising that there was a fiscally conservative backlash following the crisis: the US budget deficit and debt-to-GDP ratio soared after the economy collapsed and the government enacted fiscal stimulus to bail out the banking system. And midterm elections in the US often lead to significant gains for the opposition party However, Tea Party supporters rapidly took up a new means of communicating to mobilize politically, and there is evidence that this contributed to their electoral success. Chart II-6 illustrates that the number of tweets with the Tea Party hashtag rose significantly in 2010 in the lead-up to the election, which saw the Republican Party take control of the House of Representatives as well as the victory of several Tea Party-endorsed politicians. Table II-1 highlights that Tea Party candidates, who rode the wave of fiscal conservatism, significantly outperformed Democrats and non-Tea Party Republicans in the use of Twitter during the 2010 campaign, underscoring that social media use was a factor aiding outreach to voters. Chart II-6Tea Party Supporters Rapidly Adopted Social Media To Mobilize Politically Table II-1Tea Party Candidates Significantly Outperformed In Their Use Of Social Media   And while it is more difficult to analyze the use and impact of Facebook by Tea Party candidates and supporters owing to inherent differences in the structure of the Facebook platform, interviews with core organizers of both the Tea Party and Occupy Wall Street movements have noted that activists in these ideologically opposed groups viewed Facebook as the most important social networking service for their political activities.1 Under normal circumstances, we agree that fiscal policy should be symmetric, with reduced fiscal support during economic expansions following fiscal easing during recessions. But in the context of multi-year household deleveraging, the fiscal drag that occurred in following the 2010 midterm elections was clearly a policy mistake. This mistake occurred partially under full Democratic control of government and especially under a gridlocked Congress after 2010. Chart II-7 highlights that the contribution to growth from government spending turned sharpy negative in 2010 and continued to subtract from growth for some time thereafter. In addition, panel of Chart II-7 highlights that the US economic policy uncertainty index rose in 2010 after falling during the first year of the recovery, reaching a new high in 2011 during the Tea Party-inspired debt ceiling crisis. Chart II-7The Fiscal Drag That Followed The 2010 Midterm Elections Was A Clear Policy Mistake Chart II-8Policy Mistakes Significantly Contributed To Last Cycle's Subpar Growth Profile In addition to the negative impact of government spending on economic growth, this extreme uncertainty very likely damaged confidence in the economic recovery, contributing to the subpar pace of growth in the first half of the last economic expansion. Chart II-8 highlights the weak evolution in real per capita GDP from 2009-2019 compared with previous economic cycles, which was caused by a prolonged household balance sheet recovery process that was made worse by policy mistakes. To be sure, the UK and the EU did not have a Tea Party, and yet political elites imposed fiscal austerity. It is also the case that President Obama was the first president to embrace social media as a political and public relations tool. So it cannot be said that either social media or the Republican Party are uniquely to blame for the policy mistakes of that era. But US fiscal policy would have been considerably looser in the 2010s if not for the Tea Party backlash, which was partly enabled by social media. Too tight of fiscal policy in turn fed populism and produced additional policy mistakes down the road. From Fiscal Drag To Populism While social media is clearly not the root cause of the recent rise of populist policies, it has had a hand in bringing them about – in both a direct and indirect manner. The indirect link between social media use and the rise in populist policies has mainly occurred through the highly successful use of social media by international terrorist organizations (chiefly ISIL) and its impact on sentiment toward immigration in several developed market economies. Chart II-9Terrorism And Immigration Likely Contributed To Brexit Chart II-9 highlights that public concerns about immigration and race in the UK began to rise sharply in 2012, in lockstep with both the rise in UK immigrants from EU accession countries and a series of events: the Syrian refugee crisis, the establishment and reign of the Islamic State, and three major terrorist attacks in European countries for which ISIL claimed responsibility. Given that the main argument for “Brexit” was for the UK to regain control over its immigration policies, these events almost certainly increased UK public support for withdrawing from the EU. In other words, it is not clear that Brexit would have occurred (at least at that moment in time) without these events given the narrow margin of victory for the “leave” campaign. The absence of social media would not have prevented the rise of ISIL, as that occurred in response to the US’s precipitous withdrawal from Iraq. The inevitable rise of ISIL would still have generated a backlash against immigration. Moreover, fiscal austerity in the UK and EU also fed other grievances that supported the Brexit movement. But social media accelerated and amplified the entire process.  Chart II-10Brexit Weakened UK Economic Performance Prior To The Pandemic Chart II-10 presents fairly strong evidence that Brexit weakened UK economic performance relative to the Euro Area prior to the pandemic, with the exception of the 2018-2019 period. In this period Euro Area manufacturing underperformed during the Trump administration’s trade war as a result of its comparatively higher exposure to automobile production and its stronger ties to China. Panel 2 highlights that GBP-EUR fell sharply in advance of the referendum, and remains comparatively weak today. Turning to the US, Donald Trump’s election as US President in 2016 was aided by both the direct and indirect effects of social media. In terms of indirect effects, Trump benefited from similar concerns over immigration and terrorism that caused the UK to leave the EU: Chart II-11 highlights that terrorism and foreign policy were second and third on the list of concerns of registered voters in mid-2016, and Chart II-12 highlights that voters regarded Trump as the better candidate to defend the US against future terrorist attacks. Chart II-11Terrorism Ranked Highly As An Issue In The 2016 US Election Chart II-12Voters Regarded Trump As Better Equipped To Defend Against Terrorism Trump’s election; and the enactment of populist policies under his administration, were directly aided by Trump’s active use of social media (mainly Twitter) to boost his candidacy. Chart II-13 highlights that there were an average of 15-20 tweets per day from Trump’s Twitter account from 2013-2015, and 80% of those tweets occurred before he announced his candidacy for president in June 2015. This strongly underscores that Trump mainly used Twitter to lay the groundwork for his candidacy as an unconventional political outsider rather than as a campaign tool itself, which distinguishes his use of social media from that of other politicians. In other words, new technology disrupted the “good old boys’ club” of traditional media and elite politics. Some policies of the Trump administration were positive for financial markets, and it is fair to say that Trump fired up animal spirits to some extent: Chart II-14 highlights that the Tax Cuts and Jobs Act caused a significant rise in stock market earnings per share. But the Trump tax cuts were a conventional policy pushed mostly by the Congressional leadership of the Republican Party, and they did not meaningfully boost economic growth. Chart II-15 highlights that, while the US ISM manufacturing index rose sharply in the first year of Trump’s administration, an uptrend was already underway prior to the election as a result of a significant improvement in Chinese credit growth and a recovery in oil prices after the devastating collapse that took place in 2014-2015. Chart II-13Trump Used Twitter To Lay The Groundwork For His Candidacy Chart II-14The Trump Tax Cuts A Huge Rise In Corporate Earnings   Chart II-15But The Tax Cuts Did Not Do Much To Boost Growth Similarly, Chart II-15 highlights that the Trump trade war does not bear the full responsibility of the significant slowdown in growth in 2019, as China’s credit impulse decelerated significantly between the passage of the Tax Cuts and Jobs Act and the onset of the trade war because Chinese policymakers turned to address domestic concerns. Chart II-16The Trade War Caused An Explosion In Global Trade Uncertainty But Chart II-16 highlights that the aggressive imposition of tariffs, especially between the US and China, caused an explosion in trade uncertainty even when measured on an equally-weighted basis (i.e., when overweighting trade uncertainty, in countries other than the US and China), which undoubtedly weighed on the global economy and contributed to a very significant slowdown in US jobs growth in 2019 (panel 2). Moreover, Chinese policymakers responded to the trade onslaught by deleveraging, which weighed on the global economy; and consolidating their grip on power at home. In essence, Trump was a political outsider who utilized social media to bypass the traditional media and make his case to the American people. Other factors contributed to his surprising victory, not the least of which was the austerity-induced, slow-growth recovery in key swing states. While US policy was already shifting to be more confrontational toward China, the Trump administration was more belligerent in its use of tariffs than previous administrations. The trade war thus qualifies as another policy shock that was facilitated by the existence of social media. Viewing Social Media As A Negative Productivity-Innovation A rise in fiscal conservatism leading to misguided austerity, the UK’s decision to leave the European Union, and the Trump administration’s trade war have represented significant non-monetary shocks to both the US and global economies over the past 12 years. These shocks strongly contributed to the subpar growth profile of the last economic expansion, as demonstrated above. Chart II-17Policy Mistakes, Partially Enabled By Social Media, Reduced Productivity During The Last Expansion Given the above, it is reasonable for investors to view social media as a technological innovation with negative productivity growth, given that it has facilitated policy mistakes during the last economic expansion. Chart II-17 underscores this point, by highlighting that multi-factor productivity growth has been extremely weak in the post-GFC environment. While productivity is usually driven by supply-side factors over the longer term, it has a cyclical component to it – and in the case of the last economic expansion, the cyclical component was long lasting in nature. Any forces negatively impacting economic growth that do not change the factors of production necessarily reduce measured productivity; it is for this reason that measured productivity declines during recessions; and policy mistakes negatively impact productivity growth. The Risk Of Aggressive Austerity Seems Low Today… Chart II-18State & Local Government Finances Are In Much Better Shape Today Fiscal austerity in the early phase of the last economic cycle was the first social media-linked shock that we identified, but the risk of aggressive austerity appears low today. Much of the fiscal drag that occurred in the aftermath of the global financial crisis happened because of insufficient financial support to state and local governments – and the subsequent refusal by Congress to authorize more aid. But Chart II-18 highlights that state and local government finances have already meaningfully recovered, on the back of bipartisan stimulus in 2020, while the American Rescue Plan provides significant additional funding. While it is true that US fiscal policy is set to detract from growth over the coming 6-12 months, this will merely reflect the unwinding of fiscal aid that had aimed to support household income temporarily lost, as a result of a drastic reduction in services spending. As we noted in last month’s report,2 goods spending will likely slow as fiscal thrust turns to fiscal drag, but services spending will improve meaningfully – aided not just by a post-pandemic normalization in economic activity, but also by the deployment of some of the sizable excess savings that US households have accumulated over the past year. Fiscal drag will also occur outside of the US next year. For example, the IMF is forecasting a two percentage point increase in the Euro Area’s cyclically-adjusted primary budget balance, which would represent the largest annual increase over the past two decades. But here too the reduction in government spending will reflect the end of pandemic-related income support, and is likely to occur alongside a positive private-sector services impulse. During the worst of the Euro Area sovereign debt crisis, the impact of austerity was especially acute because it was persistent, and it occurred while the output gap was still large in several Euro Area economies. Chart II-19 highlights that Euro Area fiscal consolidation from 2010-2013 was negatively correlated with economic activity during that period, and Chart II-20 highlights that, with the potential exception of Spain, this austerity does not appear to have led to subsequently stronger rates of growth. Chart II-19Euro Area Austerity Lowered Growth During The Consolidation Phase… Chart II-20…And Did Not Seem To Subsequently Raise Growth   This experiment in austerity led the IMF to conclude that fiscal multipliers are indeed large during periods of substantial economic slack, constrained monetary policy, and synchronized fiscal adjustment across numerous economies.3 Similarly, attitudes about austerity have shifted among policymakers globally in the wake of the populist backlash. Given this, despite the significant increase in government debt levels that has occurred as a result of the pandemic, we strongly doubt that advanced economies will attempt to engage in additional austerity prematurely, i.e., before unemployment rates have returned close-to steady-state levels. …But The Risk Of Protectionism And Other Populist Measures Looms Large The role that social media has played at magnifying populist policies should be concerning for investors, especially given that there has been a rising trend towards populism over the past 20 years. In a recent paper, Funke, Schularick, and Trebesch have compiled a cross-country database on populism dating back to 1900, defining populist leaders as those who employ a political strategy focusing on the conflict between “the people” and “the elites.” Chart II-21 highlights that the number of populist governments worldwide has risen significantly since the 1980s and 1990s, and Chart II-22 highlights that the economic performance of countries with populist leaders is clearly negative. Chart II-21Populism Has Been On The Rise For The Past 30 Years The authors found that countries’ real GDP growth underperformed by approximately one percentage point per year after a populist leader comes to power, relative to both the country’s own long-term growth rate and relative to the prevailing level of global growth. To control for the potential causal link between economic growth and the rise of populist leaders, Chart II-23 highlights the results of a synthetic control method employed by the authors that generates a similar conclusion to the unconditional averages shown in Chart II-22: populist economic policies are significantly negative for real economic growth. Chart II-22Populist Leaders Are Clearly Growth Killers Even After… Chart II-23… Controlling For The Odds That Weak Growth Leads To Populism Chart II-24Inequality: The Most Important Structural Cause Of Populism And Polarization This is especially concerning given that wealth and income inequality, perhaps the single most important structural cause of rising populism and political polarization, is nearly as elevated as it was in the 1920s and 1930s (Chart II-24). This trend, at least in the US, has been exacerbated by a decline in public trust of mainstream media among independents and Republicans that began in the early 2000s and helped to fuel the public’s adoption of alternative news and social media. The decline in trust clearly accelerated as a result of erroneous reporting on what turned out to be nonexistent weapons of mass destruction in Iraq and other controversies of the Bush administration. Chart II-21 showed that the rise in populism has also yet to abate, suggesting that social media has the potential to continue to amplify policy mistakes for the foreseeable future. It is not yet clear what economic mistakes will occur under the Biden administration, but investors should not rule out the possibility of policies that are harmful for growth. The likely passage of a bipartisan infrastructure bill or a partisan reconciliation bill in the second half of this year will most likely be the final word on fiscal policy until at least 2025,4 underscoring that active fiscal austerity is not likely a major risk to investors. Spending levels will probably freeze after 2022: Republicans will not be able to slash spending, and Democrats will not be able to hike spending or taxes, if Republicans win at least one chamber of Congress in the midterms (as is likely). Biden has preserved the most significant of Trump’s protectionist policies by maintaining US import tariffs against China, and the lesson from the Tea Party’s surge following the global financial crisis is that major political shifts, magnified by social media, can manifest themselves as policy with the potential to impact economic activity within a two-year window. Attitudes toward China have shifted negatively around the world because of deindustrialization and now the pandemic.5 White collar workers in DM countries have clearly fared better during lockdowns than those of lower-income households. This has created extremely fertile ground for a revival in populist sentiment, which could force the Biden administration or Congressional Democrats toward protectionist or otherwise populist actions over the coming year, in the lead up to the 2022 mid-term elections. Investment Conclusions In this report, we have documented the historical link between social media, populism, and policy mistakes during the last economic expansion. It is clear that neither social media nor even populism is solely responsible for all mistakes – the UK’s and EU’s ill-judged foray into austerity was driven by elites. Furthermore, we have not addressed in this report the impact of populism on actions of emerging markets, such as China and Russia, whose own behavior has dealt disinflationary blows to the global economy. Nevertheless, populism is a potent force that clearly has the power to harness new technology and deliver shocks to the global economy and financial markets. The risks of additional mistakes from populism are still present, and that is even before considering other risks to society from social media: a reduction in mental health among young social media users, and the role that social media has played in spreading misinformation – contributing to the vaccine hesitancy in some DM countries that we discussed in Section 1 of our report. Two investment conclusions emerge from our analysis. First, we noted in our April report that there is a chance that investor expectations for the natural rate of interest (“R-star”) will rise once the economy normalizes post-pandemic, but that this will likely not occur as long as investors continue to believe in the narrative of secular stagnation. Despite the fact that the past decade’s shocks occurred against the backdrop of persistent household deleveraging (which has ended in the US), these shocks reinforced that narrative, and any additional policy shocks following a return to economic normality will again be seen by both investors and the Fed as strong justification for low interest rates. Thus, while the rapid closure of output gaps in advanced economies over the coming year argues for both cyclically and structurally higher bond yields, a revival in protectionist sentiment is a risk to this view that we will be closely monitoring over the coming 12-24 months. Chart II-25The Underperformance Of Social Media Would Not Excessively Weigh On The Broad Market Second, for tech investors, the bipartisan shift in public sentiment to become more critical of social media companies is gradually becoming a real risk, potentially affecting user growth. Based solely on Facebook, Twitter, Pinterest, and Snapchat, social media companies do not account for a very significant share of the overall equity market (Chart II-25), suggesting that the impact of a negative shift in sentiment toward social media companies would not be an overly significant event for equity investors in general. Chart II-25 highlights that the share of social media companies as a percent of the broad tech sector rises if Google is included; YouTube accounts for less than 15% of Google’s total advertising revenue, however, suggesting modest additional exposure beyond the solid line in Chart II-25. Still, investors with concentrated positions in social media stocks should be aware of the potential idiosyncratic risks facing social media companies as a result of the public’s impression of the impact of social media on society. If social media companies come to be widely associated with political gridlock, the polarization of society, and failed economic policies (as already appears to be the case), then the fundamental performance of these stocks is likely to be quite poor regardless of whether or not tech companies ultimately enjoy a relatively friendly regulatory environment under the Biden administration. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Grassroots Organizing in the Digital Age: Considering Values and Technology in Tea Party and Occupy Wall Street by Agarwal, Barthel, Rost, Borning, Bennett, and Johnson, Information, Communication & Society, 2014. 2 Please see The Bank Credit Analyst “July 2021,” dated June 24, 2021, available at bca.bcaresearch.com 3 “Are We Underestimating Short-Term Fiscal Multipliers?” IMF World Economic Outlook, October 2012 4 Please see US Political Strategy Outlook "Third Quarter Outlook 2021: Game Time," dated June 30, 2021, available at usps.bcaresearch.com 5 “Unfavorable Views of China Reach Historic Highs in Many Countries,” PEW Research Center, October 2020.

Highlights President Biden has called for the US intelligence community to investigate the origins of COVID-19 and one of Biden’s top diplomats has stated the obvious: the era of “engagement” with China is over. This clinches our long-held view that any Democratic president would be a hawk like President Trump. The US-China conflict – and global geopolitical risk – will revive and undermine global risk appetite. China faces a confluence of geopolitical and macroeconomic challenges, suggesting that its equity underperformance will continue. Domestic Chinese investors should stay long government bonds. Foreign investors should sell into the bond rally to reduce exposure to any future sanctions. The impending agreement of a global minimum corporate tax rate has limited concrete implications that are not already known but it symbolizes the return of Big Government in the western world. Our updated GeoRisk Indicators are available in the Appendix, as well as our monthly geopolitical calendar. Feature In our quarterly webcast, “Geopolitics And Bull Markets,” we argued that geopolitical themes matter to investors when they have a demonstrable relationship with the macroeconomic backdrop. When geopolitics and macro are synchronized, a simple yet powerful investment thesis can be discerned. The US war on terror, Russia’s resurgence, the EU debt crisis, and Brexit each provided cases in which a geopolitically informed macro view was both accessible and actionable at an early stage. Investors generally did well if they sold the relevant country’s currency and disfavored its equities on a relative basis. Chart 1China's Decade Of Troubles Of course, the market takeaway is not always so clear. When geopolitics and macroeconomics are desynchronized, the trick is to determine which framework will prevail over the financial markets and for how long. Sometimes the market moves to its own rhythm. The goal is not to trade on geopolitics but rather to invest with geopolitics. One of our key views for this year – headwinds for China – is an example of synchronization. Two weeks ago we discussed China’s macroeconomic challenge. In this report we discuss China’s foreign policy challenge: geopolitical pressure from the US and its allies. In particular we address President Biden’s call for a deeper intelligence dive into the origins of COVID-19. The takeaway is negative for China’s currency and risk assets. The Great Recession dealt a painful blow to the Chinese version of the East Asian economic miracle. By 2015, China’s financial turmoil and currency devaluation should have convinced even bullish investors to keep their distance from Chinese stocks and the renminbi. If investors stuck with this bearish view despite the post-2016 rally, on fear of trade war, they were rewarded in 2018-19. Only with China’s containment of COVID-19 and large economic stimulus in 2020 has CNY-USD threatened to break out (Chart 1). We expect the renminbi to weaken anew, especially once the Fed begins to taper asset purchases. Our cyclical view is still bullish but US-China relations are unstable so we remain tactically defensive. Forget Biden’s China Review, He’s A Hawk Chinese financial markets face a host of challenges this year, despite the positive factors for China’s manufacturing sector amid the global recovery. At home these challenges consist of a structural economic slowdown, a withdrawal of policy stimulus, bearish sentiment among households, and an ongoing government crackdown on systemic risk. Abroad the Democratic Party’s return to power in Washington means that the US will bring more allies to bear in its attempt to curb China’s rise. This combination of factors presents a headwind for Chinese equities and a tailwind for government bonds (Chart 2). This is true at least until the government should hit its pain threshold and re-stimulate. Chart 2Global Investors Still Wary New stimulus may not occur in 2022. The Communist Party’s leadership rotation merely requires economic stability, not rapid growth. While the central government has a record of stimulating when its pain threshold is hit, even under the economically hawkish President Xi Jinping, a financial market riot is usually part of this threshold. This implies near-term downside, particularly for global commodities and metals, which are also facing a Chinese regulatory backlash to deter speculation. In this context, President Biden’s call for a deeper US intelligence investigation into the origin of COVID-19 is an important confirming signal of the US’s hawkish turn toward China. Biden gave 90 days for the intelligence community to report back to him. We will not enter into the debate about COVID-19’s origins. From a geopolitical point of view it is a moot point. The facts of the virus origin may never be established. According to Biden’s statement, at least one US intelligence agency believes the “lab leak theory” is the most likely source of the virus (while two other agencies decided in favor of animal-to-human transmission). Meanwhile Chinese government spokespeople continue to push the theory that the virus originated at the US’s Fort Detrick in Maryland or at a US-affiliated global research center. What is certain is that the first major outbreak of a highly contagious disease occurred in Wuhan. Both sides are demanding greater transparency and will reject each other’s claims based on a lack of transparency. If the US intelligence report concludes that COVID originated from the Wuhan Institute of Virology, the Chinese government and media will reject the report. If the report exonerates the Wuhan laboratory, at least half of the US public will disbelieve it and it will not deter Biden from drawing a hard line on more macro-relevant policy disputes with China. The US’s hawkish bipartisan consensus on China took shape before COVID. Biden’s decision to order the fresh report introduces skepticism regarding the World Health Organization’s narrative, which was until now the mainstream media’s narrative. Previously this skepticism was ghettoized in US public discourse: indeed, until Biden’s announcement on May 26, the social media company Facebook suppressed claims that the virus came from a lab accident or human failure. Thus Biden’s action will ensure that a large swathe of the American public will always tend to support this theory regardless of the next report’s findings. At the same time Biden discontinued a State Department effort to prove the lab leak theory, which shows that it is not a foregone conclusion what his administration will decide. The good news is that even if the report concluded in favor of the lab leak, the Biden administration would remain highly unlikely to demand that China pay “reparations,” like the Trump administration demanded in 2020. This demand, if actualized, would be explosive. The bad news is that a future nationalist administration could conceivably use the investigation as a basis to demand reparations. Nationalism is a force to be reckoned with in both countries and the dispute over COVID’s origin will exacerbate it. Traditionally the presidents of both countries would tamp down nationalism or attempt to keep it harnessed. But in the post-Xi, post-Trump era it is harder to control. The death toll of COVID-19 will be a permanent source of popular grievance around the world and a wedge between the US and China (Chart 3). China’s international image suffered dramatically in 2020. So far in 2021 China has not regained any diplomatic ground. Chart 3Death Toll Of COVID-19 The US is repairing its image via a return to multilateralism while the Europeans have put their Comprehensive Agreement on Investment with China on hold due to a spat over sanctions arising from western accusations of genocide (a subject on which China pointedly answered that it did not need to be lectured by Europeans). Notably Biden’s Department of State also endorsed its predecessor’s accusation of genocide in Xinjiang. Any authoritative US intelligence review that solidifies doubts about the WHO’s initial investigation – even if it should not affirm the lab leak theory – would give Biden more ammunition in global opinion to form a democratic alliance to pressure China (for example, in Europe). An important factor that enables the US to remain hawkish on China is fiscal stimulus. While stimulus helps bring about economic recovery, it also lowers the bar to political confrontation (Chart 4). Countries with supercharged domestic demand do not have as much to fear from punitive trade measures. The Biden administration has not taken new punitive measures against China but it is clearly not worried about Chinese retaliation. Chart 4Large Fiscal Stimulus Lowers The Bar To Geopolitical Conflict China’s stimulus is underrated in this chart (which excludes non-fiscal measures) but it is still true that China’s policy has been somewhat restrained and it will need to stimulate its economy again in response to any new punitive measures or any global loss of confidence. At least China is limited in its ability to tighten policy due to the threat of US pressure and western trade protectionism. Simultaneous with Biden’s announcement on COVID-19, his administration’s coordinator for Indo-Pacific affairs, Kurt Campbell, proclaimed in a speech that the era of “engagement” with China is officially over and the new paradigm is one of “competition.” By now Campbell is stating the obvious. But this tone is a change both from his tone while serving in President Obama’s Department of State and from his article in Foreign Affairs last year (when he was basically auditioning for his current role in the Biden administration).1 Campbell even said in his latest remarks that the Trump administration was right about the “direction” of China policy (though not the “execution”), which is candid. Campbell was speaking at Stanford University but his comments were obviously aimed for broader consumption. Investors no longer need to wait for the outcome of the Biden administration’s comprehensive review of policy toward China. The answer is known: the Biden administration’s hawkishness is confirmed. The Department of Defense report on China policy, due in June, is very unlikely to strike a more dovish posture than the president’s health policy. Now investors must worry about how rapidly tensions will escalate and put a drag on global sentiment. Bottom Line: US-China relations are unstable and pose an immediate threat to global risk appetite. The fundamental geopolitical assessment of US-China relations has been confirmed yet again. The US is seeking to constrain China’s rise because China is the only country capable of rivaling the US for supremacy in Asia and the world. Meanwhile China is rejecting liberalization in favor of economic self-sufficiency and maintaining an offensive foreign policy as it is wary of US containment and interference. Presidents Biden and Xi Jinping are still capable of stabilizing relations in the medium term but they are unlikely to substantially de-escalate tensions. And at the moment tensions are escalating. China’s Reaction: The Example Of Australia How will China respond to Biden’s new inquiry into COVID’s origins? Obviously Beijing will react negatively but we would not expect anything concrete to occur until the result of the inquiry is released in 90 days. China will be more constrained in its response to the US than it has been with Australia, which called for an international inquiry early last year, as the US is a superior power. Australia was the first to ban Chinese telecom company Huawei from its 5G network (back in 2018) and it was the first to call for a COVID probe. Relations between China and Australia have deteriorated steadily since then, but macro trends have clearly driven the Aussie dollar. The AUD-JPY exchange rate is a good measure for global risk appetite and it is wavering in recent weeks (Chart 5). Chart 5Australian Dollar Follows Macro Trends, Rallies Amid China Trade Spat Tensions have also escalated due to China’s dependency on Australian commodity exports at a time of spiking commodity prices. This is a recurring theme going back to the Stern Hu affair. The COVID spat led China to impose a series of sanctions against Australian beef, barley, wine, and coal. But because China cannot replace Australian resources (at least, not in the short term), its punitive measures are limited. It faces rising producer prices as a result of its trade restrictions (Chart 6). This dependency is a bigger problem for China today than it was in previous cycles so China will try to diversify. Chart 6Constraints On China's Tarrifs On Australia By contrast, China is not likely to impose sanctions on the US in response to Biden’s investigation, unless Biden attacks first. China’s imports from the US are booming and its currency is appreciating sharply. Despite Beijing’s efforts to keep the Phase One trade deal from collapsing, Biden is maintaining Trump’s tariffs and the US-China trade divorce is proceeding (Chart 7). Bilateral tariff rates are still 16-17 percentage points higher than they were in 2018, with US tariffs on China at 19% (versus 3% on the rest of the world) while Chinese tariffs on the US stand at 21% (versus 6% on the rest of the world). The Biden administration timed this week’s hawkish statements to coincide with the first meeting of US trade negotiators with China, which was a more civil affair. Both countries acknowledged that the relationship is important and trade needs to be continued. However, US Trade Representative Katherine Tai’s comments were not overly optimistic (she told Reuters that the relationship is “very, very challenging”). She has also been explicit about maintaining policy continuity with the Trump administration. We highly doubt that China’s share of US imports will ever surpass its pre-Trump peaks. The Biden administration has also refrained so far from loosening export controls on high-tech trade with China. This has caused a bull market in Taiwan while causing problems for Chinese semiconductor stocks’ relative performance (Chart 8). If Biden’s policy review does not lead to any relaxation of export controls on commercial items then it will mark a further escalation in tensions. Chart 7US Tarrifs Reduce China In Trade Deficit Bottom Line: Until Presidents Biden and Xi stabilize relations at the top, the trade negotiations over implementing the Phase One trade deal – and any new Phase Two talks – cannot bring major positive surprises for financial markets. Chart 8US Export Controls Amid Chip Shortage Congress Is More Hawkish Than Biden Biden’s ability to reduce frictions with China, should he seek to, will also be limited by Congress and public opinion. With the US deeply politically divided, and polarization at historically high levels, China has emerged as one of the few areas of agreement. The hawkish consensus is symbolized by new legislation such as the Strategic Competition Act, which is making its way through the Senate rapidly. Congress is also trying to boost US competitiveness through bills such as the Endless Frontier Act. These bills would subject China to scrutiny and potential punitive measures over a broad range of issues but most of all they would ignite US industrial policy , STEM education, and R&D, and diversify the US’s supply chains. We would highlight three key points with regard to the global impact of this legislation: Global supply chains are shifting regardless: This trend is fairly well established in tech, defense, and pharmaceuticals. It will continue unless we see a major policy reversal from China to try to court western powers and reduce frictions. The EU and India are less enthusiastic than the US and Australia about removing China from supply chains but they are not opposed. The EU Commission has recommended new defensive economic measures that cover supply chains in batteries, cloud services, hydrogen energy, pharmaceuticals, materials, and semiconductors. As mentioned, the EU is also hesitating to ratify the Comprehensive Agreement on Investment with China. Hence the EU is moving in the US’s direction independently of proposed US laws. After all, China’s rise up the tech value chain (and its decision to stop cutting back the size of its manufacturing sector) ultimately threatens the EU’s comparative advantage. The EU is also aligned with the US on democratic values and network security. India has taken a harder stance on China than usual, which marks an important break with the past. India’s decision to exclude Huawei from its 5G network is not final but it is likely to be at least partially implemented. A working group of democracies is forming regardless. The Strategic Competition Act calls for the creation of a working group of democracies but the truth is that this is already happening through more effective forums like the G7 and bilateral summits. Just as the implementation of the act would will ultimately depend on President Biden, so the willingness of other countries to adopt the recommendations of the working group would depend on their own executives. Allies have leeway as Biden will not use punitive measures against them: Any policy change from the EU, UK, India, and Australia will be independent of the US Congress passing the Strategic Competition Act. These countries will be self-directed. The US would have to devote diplomatic energy to maintaining a sustained effort by these states to counter China in the face of economic costs. This will be limited by the fact that the Biden administration will be very reluctant to impose punitive measures on allies to insist on their cooperation. The allies will set the pace of pressure on China rather than the United States. This gives the EU an important position, particularly Germany. And yet the trends in Germany suggest that the government will be more hawkish on China after the federal elections in September. Bottom Line: The Biden administration is unlikely to use punitive measures against allies so new US laws are less important than overall US diplomacy with each of the allies. Some allies will be less compliant with US policies given their need for trade with China. But so far there appears to be a common position taking shape even with the EU that is prejudicial to China’s involvement in key sectors of emerging technologies. If China does not respond by reducing its foreign policy assertiveness, then China’s economic growth will suffer. That drag would have to be offset by new supply chain construction in Southeast Asia and other countries. Investment Takeaways The foregoing highlights the international risks facing China even at a time when its trend growth is slowing (Chart 9) and its ongoing struggle with domestic financial imbalances is intensifying. China’s debt-service costs have risen sharply and Beijing is putting pressure on corporations and local governments to straighten out their finances (Chart 10), resulting in a wave of defaults. This backdrop is worrisome for investors until policymakers reassure them that government support will continue. Chart 9China's Growth Potential Slowing Chart 10China's Leaders Struggle With Debt China’s domestic stability is a key indicator of whether geopolitical risks could spiral out of control. In particular we think aggressive action in the Taiwan Strait is likely to be delayed as long as the Chinese economy and regime are stable. China has rattled sabers over the strait this year in a warning to the United States not to cross its red line (Chart 11). It is not yet clear how Biden’s policy continuity with the Trump administration will affect cross-strait stability. We see no basis yet for changing our view that there is a 60% chance of a market-negative geopolitical incident in 2021-22 and a 5% chance of full-scale war in the short run. Chart 11China PLA Flights Over Taiwan Strait Putting all of the above together, we see substantial support for two key market-relevant geopolitical risks: Chinese domestic politics (including policy tightening) and persistent US-China tensions (including but not limited to the Taiwan Strait). We remain tactically defensive, a stance supported by several recent turns in global markets: The global stock-to-bond ratio has rolled over. China is a negative factor for global risk appetite (Chart 12). Global cyclical equities are no longer outperforming defensives. There is a stark divergence between Chinese cyclicals and global cyclicals stemming from the painful transition in China’s bloated industrial economy (Chart 13). Global large caps are catching a bid relative to small caps (Chart 14). Chart 12Global Stock-To-Bond Ratio Rolled Over Chart 13Global Cyclicals-To-Defensives Pause Chart 14Global Large Caps Catch A Bid Versus Small Caps Cyclically the global economic recovery should continue as the pandemic wanes. China will eventually relax policy to prevent too abrupt of a slowdown. Therefore our strategic portfolio reflects our high-conviction view that the current global economic expansion will continue even as it faces hurdles from the secular rise in geopolitical risk, especially US-China cold war. Measurable geopolitical risk and policy uncertainty are likely to rebound sooner rather than later, with a negative impact on high-beta risk assets. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Coda: Global Minimum Tax Symbolizes Return Of Big Government On Thursday, the US Treasury Department released a proposal to set the global minimum corporate tax rate at 15%. The plan is to stop what Treasury Secretary Janet Yellen has referred to as a global “race to the bottom” and create the basis for a rehabilitation of government budgets damaged by pandemic-era stimulus. Although the newly proposed 15% rate is significantly below President Biden’s bid to raise the US Global Intangible Low-Taxed Income (GILTI) rate to 21% from 10.5%, it is the same rate as his proposed minimum tax on corporate book income. Biden is also raising the headline corporate tax rate from 21% to around 25% (or at highest 28%). Negotiators at the OECD were initially discussing a 12.5% global minimum rate. The finance ministers of both France and Germany – where the corporate income tax rates are 32.0% and 29.9%, respectively – both responded positively to the announcement. However, Ireland, which uses low corporate taxes as an economic development strategy, is obviously more comfortable with a minimum closer to its own 12.5% rate. Discussions are likely to occur when G7 finance ministers meet on June 4-5. Countries are hoping to establish a broad outline for the proposal by the G20 meeting in early July. It is highly likely that the OECD will come to an agreement. However, it is not a truly “global” minimum as there will still be tax havens. Compliance and enforcement will vary across countries. A close look at the domestic political capital of the relevant countries shows that while many countries have the raw parliamentary majorities necessary to raise taxes, most countries have substantial conservative contingents capable of preventing stiff corporate tax hikes (Table 1, in the Appendix). Our Geopolitical strategists highlight that the Biden administration’s compromise on the minimum rate reflects its pragmatism as well as emphasis on multilateralism. Any global deal will be non-binding but the two most important low-tax players are already committed to raising corporate rates well above this level: Biden’s plan is noted above, while the UK’s budget for March includes a jump in the business rate to 25% in April 2023 from the current 19%. Ireland and Hungary are the only outliers but they may eventually be forced to yield to such a large coalition of bigger economies (Chart 15). Chart 15Global Minimum Corporate Tax Impact Is Symbolic Rather Than Concrete Thus a nominal minimum corporate tax rate is likely to be forged but it will not be truly global and it will not change the corporate rate for most countries. The reality of what companies pay will also depend on loopholes, tax havens, and the effective tax rate. Bottom Line: On a structural horizon, the global minimum corporate tax is significant for showing a paradigm shift in global macro policy: western governments are starting to raise taxes and revenue after decades of cutting taxes. The experiment with limited government has ended and Big Government is making a comeback. On a cyclical horizon, the US concession on global minimum tax is that the Biden administration aims to be pragmatic and “get things done.” Biden is also working with Republicans to pass bills covering some bipartisan aspects of his domestic agenda, such as trade, manufacturing, and China. The takeaway from a global point of view is that Biden may prove to be a compromiser rather than an ideologue, unlike his predecessors.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Roukaya Ibrahim Vice President Daily Insights RoukayaI@bcaresearch.com Footnotes 1 Kurt M. Campbell and Jake Sullivan, "Competition Without Catastrophe," Foreign Affairs, September/October 2019, foreignaffairs.com. Section II: Appendix Table 1OECD: Which Countries Are Willing And Able To Raise Corporate Tax Rates? GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan – Province Of China Korea Turkey Brazil Australia Section III: Geopolitical Calendar

Highlights Global stocks are very vulnerable to a correction. But cyclically the Fed is committed to an inflation overshoot and the global economy is recovering. China’s fiscal-and-credit impulse fell sharply, which leaves global cyclical stocks and commodities exposed to a pullback. Beyond the near term, China’s need for political stability should prevent excessive policy tightening. The risk is frontloaded. China’s population census underscores one of our mega-themes: China’s domestic politics are unstable and can bring negative surprises. India’s state elections, held amid a massive COVID-19 wave, suggest that the ruling party is still favored in 2024. This implies policy continuity. Stick with a bullish cyclical bias but be prepared to shift if China commits a policy mistake. Feature Chart 1Inflation Rears Its Head Global markets shuddered this week in the face of a strong core inflation print in the US as well as broader fears as inflation rears its head after a long slumber (Chart 1). Cyclically we still expect investors to rotate away from US stocks into international stocks and for the US dollar to fall as the global economy recovers (Chart 2). However, this view also entails that emerging market stocks should start outperforming their developed market peers, which has not panned out so far this year. Emerging markets are not only technology-heavy and vulnerable to rising US bond yields but also further challenged now by China’s stimulus having peaked. Chart 2Equity Market Trembles Chart 3Global Economy And Sentiment Recovering Chart 4Global Cyclicals Versus Defensives Wavering The one thing we can rely on is that the COVID-19 vaccine rollout will continue to enable a global growth recovery (Chart 3). The US dollar is signaling as much. The greenback bounced in the first quarter on US relative growth outperformance but it has since fallen back. A falling dollar is positive for cyclical stocks relative to defensives, although cyclicals are flagging that the reflation trade is overdone in the near term (Chart 4). China’s growth now becomes the critical focal point. A policy mistake in China would upset the bullish cyclical view. China’s tightening of monetary and fiscal policy is a major global policy risk that we have highlighted this year and it is now materializing. However, we have also highlighted the constraints to tightening. At present China is standing right on the threshold of overtightening according to our benchmarks. If China tightens further, we will take a fundamentally more defensive view. Also in this report we will review the results of China’s population census and the implications of India’s recent state elections in the face of the latest big wave of COVID-19 infections. We are not making any changes to our bullish view on India yet but we are putting it on watch. China: The Overtightening Risk China’s troubles stem from the ongoing change of its economic model from reliance on foreign trade to reliance on domestic demand. This was a strategic decision that the Communist Party made prior to the rise of President Xi Jinping. Xi also has come to embody it and reinforce it through his strategic vision and confrontation with the United States. Beijing’s goal was to manage a smooth and stable transition. The financial turmoil of 2015 and the trade war of 2018-19 jeopardized that goal but policymakers ultimately prevailed. Then COVID-19 broke out and caused the first real economic contraction since the 1970s. While China contained the virus and bounced back with another massive round of stimulus (13.8% of GDP from the onset of the trade war to the 2021 peak), it now faces an even more difficult transition. Chart 5China's Rising Propensity To Save The need to improve quality of life is more urgent given that potential GDP has slowed. The need to contain systemic financial risk is more urgent given the big new increase in debt. And the need to diversify the economy is more urgent given that the US is now creating a coalition of democracies to confront China over a range of policies. The spike in the “marginal propensity to save” among Chinese people and corporations – as measured by the ratio of long-term cash deposits to short-term deposits – is an indication that the country is beset by troubles and animal spirits are depressed (Chart 5). China’s fiscal-and-credit impulse is turning down after the large expansion in 2018-21. Policymakers have signaled since last year that they would withdraw emergency stimulus and now the impact is apparent in the hard data. China’s money, credit, and combined credit-and-fiscal impulses all correlate with economic growth after a six-to-nine-month lag. This is true regardless of which indicators one uses for China’s money and credit cycles and economic activity (Charts 6A and 6B). China’s economic momentum is peaking and will become a headwind for the global economy later this year and in 2022, even though the world is otherwise enjoying the tailwinds of vaccination and economic reopening. Chart 6AChina’s Fiscal-And-Credit Impulse Falls Sharply … Chart 6B… As Do Money-And-Credit Impulses The downshift in the fiscal-and-credit impulse portends a slowdown in demand for commodities, materials, and other goods that China imports, especially for domestic consumption. (Chinese imports of parts and inputs that go into its manufacturing exports to the rest of the world look healthier as the rest of the world recovers.) This shift will make it hard for high-flying metals prices and other China plays, such as Swedish stocks, to continue rising without a correction (Chart 7). Speculative positioning is heavily in favor of commodities at the moment. The divergence between China and the metals markets that it dominates looks untenable in the short run (Chart 8). Chart 7China Reflation Trades Near Peaks Chart 8Money Cycle And Commodity Prices Clash The global shift to green or renewable energy systems (i.e. de-carbonization) is bullish for metals, especially copper, but will not be able to make up for the fall in Chinese demand in the short run, as our Emerging Markets Strategy has shown. China’s domestic uses of copper for construction and industry make up about 56.5% of global copper demand while the green energy race – namely the production of solar panels, windmills, electric cars – makes up only about 3.5% of global demand. This number somewhat understates the green program since re-gearing and retrofitting existing systems and structures is also projected, such as with electricity grids. But the point is that a drop in China’s copper consumption will work against the big increase in American and European consumption – especially given that the US infrastructure program will not kick in until 2022 at the earliest. Hence global copper demand will slow over the next 12 months in response to China even though the rest of the world’s demand is rising. Chinese policymakers have not yet signaled that they are worried about overtightening policy or that they will ease policy anew. The Politburo meeting at the end of April did not contain a major policy change from the Central Economic Work Conference in December or the Government Work Report in March (Table 1). But if there was a significant difference, it lay in reducing last year’s sense of emergency further while projecting some kind of scheme to hold local government officials accountable for hidden debt. The implication is continued tight policy – and hence the risk of overtightening remains substantial. Table 1China’s Recent Macroeconomic Policy Statements: Removing Stimulus Chart 9Benchmarks For China's Policy Tightening True, the tea leaves of the April meeting can be read in various ways. The April statement left out phrases about “maintaining necessary policy support” from the overarching macroeconomic policy guidance, which would imply less support for the economy. But it also left out the goal of keeping money supply (M2) and credit growth (total social financing) in line with nominal GDP growth, which could be seen as enabling a new uptick in credit growth. However, the People’s Bank of China did maintain this credit goal in its first quarter monetary policy report, so one cannot be sure. Notice that according to this rubric, China is right on the threshold of “overtightening” policy that we have utilized to measure the risk (Chart 9). Based on Chinese policymaking over the past two decades, we would expect any major inflection point to be announced at the July Politburo meeting, not the April one. We do not consider April a major change from the preceding meetings – nor does our China Investment Strategy. Therefore excessive policy tightening remains a genuine risk for the Chinese and global economy over the next 12 months. Our checklist for excessive tightening underscores this point (Table 2). Table 2Checklist For Chinese Policy Tightening China’s fiscal-and-credit downshift is occurring in advance of the twentieth national party congress, which will take place throughout 2022 and culminate with the rotation of the top leadership (the Politburo Standing Committee) in the autumn. The economy is sufficiently stimulated for the Communist Party’s hundredth birthday on July 1 of this year, so policymakers are focused on preventing excesses. Financial risk prevention, anti-monopoly regulation, and tamping down on the property bubble are the orders of the day. The increase in corporate and government bond defaults and bankruptcies underscore the leadership’s willingness to push forward with economic restructuring and reform, which is well-attested in recent years (Chart 10). Chart 10Creative Destruction In China Investors cannot assume that the party congress in 2022 is a reason for the leadership to ease policy. The contrary occurred in the lead-up to the 2017 party congress. However, investors also cannot assume that China will overtighten and sink its own economy ahead of such an important event. Stability will be the goal – as was the case in 2017 and previous party congresses – and this means that policy easing will occur at some point if the current round of tightening becomes too painful financially and economically. China-linked assets are vulnerable in the short run until policymakers reach their inflection point. Incidentally, the approach of the twentieth national party congress will be a magnet for political intrigue and shocking events. The top leader normally sacks a prominent rival ahead of a party congress as a show of force in the process of promoting his faction. The government also tightens media controls and cracks down on dissidents, who may speak up or protest around the event. But in 2022 the stakes are higher. President Xi was originally expected to step down in 2022 but now he will not, which will arouse at least some opposition. Moreover, under Xi, China has undertaken three historic policy revolutions: it is adopting a strongman leadership model, to the detriment of the collective leadership model under the two previous presidents; it is emphasizing economic self-sufficiency, at the expense of liberalization and openness; and it is emphasizing great power status, at the expense of cooperation with the United States and its allies. Bottom Line: Global equities, commodities, and “China plays” stand at risk of a substantial correction as a result of China’s policy tightening. Our base case is that China will avoid overtightening but the latest money and credit numbers run up against our threshold for changing that view. Another sharp drop in these indicators will necessitate a change. China’s Disappearing Workforce Ultimately one of the constraints on overtightening policy is the decline in China’s potential GDP growth as a result of its shrinking working-age population. China’s seventh population census came out this week and underscored the deep structural changes affecting the country and its economy. Population growth over the past ten years slowed to 5.4%, the lowest rate since the first census in 1953. The fertility rate fell to 1.3 in 2020, lower than the 2.1 replacement rate and the 1.8 target set when Chinese authorities relaxed the one-child policy in 2016. The fertility rate is also lower than the World Bank’s estimates (1.7 in 2019) and even Japan’s rate. The birthrate (births per 1,000 people) also fell, with the number of newborns in 2020 at the lowest point since 1961, the year of the Great Famine. The birth rate has converged to that of high-income countries, implying that economic development is having the same effect of discouraging childbearing in China, although China is less developed than these countries. Chart 11China’s Working Population Falling Faster Than Japan’s In 1990s The youngest cohort rose from 16.6% to 17.95% of the population, the oldest cohort rose 8.9% in 2010 to 13.5% today, while the working-age cohort fell from 75.3% to 68.6%. The working-age population peaked in 2010 and fell by 6.79 percentage points over the past ten years. By contrast, Japan’s working-age population peaked in 1992 and fell 2.18 percentage points in the subsequent decade (Chart 11). In other words China is experiencing the demographic transition that hit Japan in the early 1990s – but China’s working-age population might fall even faster. The country is experiencing this tectonic socioeconomic shift at a lower level of per capita wealth than Japan had attained. The demographic challenge will put pressure on China’s socioeconomic and political system. The China miracle, like other Asian miracles, was premised on the use of export-manufacturing to generate large piles of savings that could be repurposed for national development. The decline in China’s working-age population coincides with economic development and a likely decline in the saving rate over the long run. This is shown in Chart 12, which shows two different pictures of China’s working population alongside the gross national saving rate. As China’s dependency ratio rises the saving rate will fall and fewer funds will be available for repurposing. The cost of capital will rise and economic restructuring will accelerate. In the case of Japan, the demographic shift coincided with the 1990 financial crisis and then a nationwide shift in economic behavior. The saving rate fell as the economy evolved but the savings that were generated still exceeded investment due to the shortfall in private demand and the pressure of large debt burdens. Companies focused on paying down debt rather than expanding investment and production (Chart 13). All of this occurred when the external environment was benign, whereas China faces a similar demographic challenge in the context of rising economic pressure due to geopolitical tensions. Chart 12Chinese Workers Getting Scarcer Chart 13High Savings Enable Debt Splurge Until Debt Overwhelms China has so far avoided a debilitating financial crisis and collapse in real estate prices that would saddle the country with a traumatizing liquidity trap. The Chinese authorities are painfully aware of the danger of the property bubble and are therefore eager to prevent financial excesses and curb bubble-like activity. This is what makes the risk of overtightening significant. But a mistake in either direction can lead to a slide into deflation. The Xi administration has stimulated the economy whenever activity slowed too much or financial instability threatened to get out of hand, as noted above, but this is a difficult balancing act, which is why we monitor the risk of excessive tightening so closely. A few other notable takeaways from China’s population census include: The two-child policy is not succeeding so far. COVID-19 might have had a negative effect on fertility but it could not have affected births very much due to the timing. So the trends cannot be distorted too much by the pandemic. Rapid urbanization continues, with the rate hitting 64% of the population, up 14 percentage points from 2010. Policy discussions are emphasizing lifting the retirement age; providing financial incentives for having babies; a range of price controls to make it more affordable to have babies, most notably by suppressing the property bubble; and measures to ensure that property prices do not fall too rapidly in smaller cities as migration from the country continues. China’s ethnic minority population, which consists of 9% of the total population, grew much faster (10% rate) over the past decade than the Han majority, which makes up 91% of the population (growing at a 5% rate). Minorities are exempt from the one-child (and two-child) policy. Yet ethnic tensions have arisen, particularly in autonomous regions like Xinjiang, prompting greater international scrutiny of China’s policies toward minorities. China’s demographic challenge is widely known but the latest census reinforces the magnitude of the challenge. China’s potential growth is falling while the rising dependency ratio underscores social changes that will make greater demands of government. Greater fiscal and social spending needs will require difficult economic tradeoffs and unpopular political decisions. Economic change and the movement of people will also deepen regional and wealth disparities. All of these points underscore one of our consistent Geopolitical Strategy mega-themes: China’s domestic political risks are underrated. Bottom Line: China’s 2020 census reinforces the demographic decline that lies at the root of China’s rising socioeconomic and political challenges. While China has a strong central government with power consolidated under a single ruling party, and a track record of managing its various challenges successfully in recent decades, nevertheless the magnitude of the changes happening are overwhelming and will bring negative economic and political surprises. India: State Elections Not A Turning Point Against Modi At the height of the second COVID-19 wave in India, elections were held in five Indian states. Results for the state of West Bengal were most important. West Bengal is a large state, accounting for nearly a-tenth of legislators at India’s national assembly, and the ruling Bharatiya Janata Party (BJP) of Prime Minister Narendra Modi had declared that it would win nearly 70% of the 294 seats there. In the event West Bengal delivered a landslide victory for the All India Trinamool Congress (AITMC), a regional party. Despite the fact that the AITMC was facing a two term anti-incumbency, the AITMC seat count hit an all-time high. Few had seen this coming as evinced by the fact that AITMC’s performance exceeded forecasts made by most pollsters. What should investors make of the BJP’s loss in this key state? Was it a backlash against Modi’s handling of the pandemic? Does it portend a change of government and national policy in the general elections in 2024? Not really. Here we highlight three key takeaways: Takeaway #1: The BJP’s performance was noteworthy Chart 14India: BJP Gets Foot In Door In West Bengal Whilst the BJP fell short of its goals in West Bengal, the state is not a BJP stronghold. The BJP is known to have natural traction in Hindi-speaking regions of India and West Bengal is a non-Hindi speaking state where the BJP was traditionally seen as an outsider. Also, this state is known to be unusually unwilling to accept change. For instance, before AITMC, the Left was in power for a record spell of 34 years in this state. In such a setting, the BJP’s performance in 2021 in West Bengal is noteworthy: the party increased its seat count to 77 seats, compared to only 3 seats in 2016 (Chart 14). This performance now catapults the BJP into becoming the key opposition party in West Bengal. It also indicates that the BJP may take time but has what it takes to build traction in states that are not traditional strongholds. Given that it achieved this feat in a state where it has little historic strength, its performance is noteworthy as a sign that the BJP remains a force to be reckoned with. Takeaway #2: The BJP’s popularity slipped but it is still favored to retain power in 2024 Whilst discontent against the BJP is rising on account of its poor handling of COVID-19 and the accompanying economic distress, there remains no viable alternative to the BJP at the national level. The recent state elections, not only in West Bengal, confirm that the opposition Indian National Congress (INC) is yet to get its act in order. The Congress party collapsed from 44 seats in Bengal to 0 seats. More importantly, the Congress is yet to resolve two critical issues, i.e. the need to appoint or elect an internal leader with mass appeal, and the need to develop an identifiable policy agenda. The weakness of the Congress means that while the BJP’s seat count could diminish as against its 2019 peak performance, nevertheless our base-case scenario for 2024 remains that of a BJP-led government maintaining power in India. Policy continuity and the chance of some structural reform are still the base case. Takeaway #3: The rise and rise of India’s regional parties The rise of the BJP over the last decade has coincided with losses in seats by both the Congress party and India’s regional parties. However, the most recent round of state elections signals that the BJP cannot compress regional parties’ seat share drastically. For instance, in West Bengal, it managed to win 77 seats by itself but this was not at the expense of the AITMC, which is the dominant player in this state. In another large state where elections were held earlier this month, i.e. Tamil Nadu, control continues to fluctuate between two well-entrenched regional parties. Chart 15India: BJP Peaked In 2019 But Still Favored 2024 The 2019 general elections saw the share of regional parties (defined as all parties excluding the BJP and Congress) fall to 35% from the near 40% levels seen at the general elections of 2014 (Chart 15). The 2024 elections could in fact see regional parties’ seat share move up a notch as the BJP’s peak seat count could diminish from the highs of 2019. The coming rise of India’s regional parties is a trend rooted in a simple dynamic. With the BJP as a two-term incumbent in the 2024 elections, voters could choose to gratify regional parties at the margin, in the absence of any alternative to the BJP at the national level. The BJP remains in a position to be the single largest party in India in 2024 with a seat count in excess of the half-way mark. But could a situation arise where the ruling party pulls in a regional party to stay ahead of the half-way mark with a large buffer? Absolutely. But of course 2024 is a long way away. Managing COVID-19 and its economic fallout will make it harder than otherwise for the BJP to beat its 2019 performance. The next bout of key state elections in India are due in February 2022 and India’s largest state, Uttar Pradesh, will see elections. With the BJP currently in power in this Hindi-speaking state, the February 2022 elections will shed more light on BJP’s ability to mitigate the anti-incumbency effect of the pandemic and economic shock. Bottom-Line: BJP’s popularity in India has been shaken but not dramatically so. The BJP remains firmly in a position to be the single largest party in India with a seat count that should cross the half-way mark in 2024. So government stability is not a concern in this emerging market for now. In light of China’s domestic political risks, and India’s political continuity, we will maintain our India trades for the time being (Charts 16A and 16B). However, we are undertaking a review of India as a whole and will update clients with our conclusions in a forthcoming special report. Chart 16AStay Long Indian Bonds Versus EM Chart 16BStick To Long India / Short China Investment Takeaways Maintain near-term safe-haven trades. Close long natural gas futures for a 19.8% gain. Maintain cyclical (12-month) bullish positioning with a preference for value over growth stocks. Maintain long positions in commodities, including rare earth metals, and emerging markets. But be prepared to cut these trades if China overtightens policy according to our benchmarks. For now, continue to overweight Indian local currency bonds relative to emerging market peers and Indian stocks relative to Chinese stocks. But we are reviewing our bullish stance on India. Chart 17Cyber Security Stocks Perk Up Amid Tech Rout Stay long cyber security stocks – though continue to prefer aerospace and defense over cyber security as a geopolitical “back to work” trade. Cyber security stocks perked up relative to the tech sector during the general tech selloff over the past week. The large-scale Colonial Pipeline ransomware cyber attack in the US temporarily shuttered a major network that supplies about 45% of the East Coast’s fuel (Chart 17). Nevertheless the attack on critical infrastructure highlights that cyber security is a secular theme and investors should maintain exposure. Cyber stocks have outperformed tech in general since the vaccine discovery (Chart 18). Chart 18Cyber Security Is A Secular Theme Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Yushu Ma Research Associate yushu.ma@bcaresearch.com Ritika Mankar, CFA Editor/Strategist Ritika.Mankar@bcaresearch.com

Highlights Biden’s policy on China is hawkish so far, as expected, but temporary improvement is possible. We are cyclically bearish on the dollar but are taking a neutral tactical stance as the greenback’s bounce could go higher than expected if US-China relations take another downward dive. US-Iran tensions are on track to escalate in the second quarter as the pressure builds toward what we think will be a third quarter restoration of the 2015 nuclear deal. Oil price volatility is the takeaway. The anticipated US-Russia conflict has emerged and will bring negative surprises, especially for Russian and emerging European markets. Europe still enjoys relative political stability. A German election upset would bring upside risk to the euro and bund yields, while Scottish independence risk is contained for now. In this report we are launching the first in a new series of regular quarterly outlook reports that will supplement our annual Geopolitical Strategy strategic outlook. Feature The decline in global policy uncertainty and geopolitical risk that attended the US election and COVID-19 vaccine discovery has largely played out. Global investors have witnessed successful vaccine rollouts in the US and UK and can look forward to other countries, namely the EU-27, catching up. They have witnessed a splurge of US fiscal spending – $2.8 trillion since December – unprecedented in peacetime. And they have seen the Chinese government offer assurances that monetary tightening will not undermine the economic recovery. The risk of the US doubling down on belligerent trade protectionism has fallen by the wayside along with the Trump presidency. Going forward, there are signs that policy uncertainty and geopolitical risk will revive. First, as the global semiconductor shortage and Suez Canal blockage highlight, the world economy will sputter and strain at the sudden eruption of economic activity as the pandemic subsides and vast government spending takes effect. Financial instability is a likely consequence of the sudden, simultaneous adoption of debt monetization across a range of economies combined with a global high-tech race and energy overhaul. Second, the defeat of the Trump presidency does not reverse the secular increase in geopolitical tensions arising from America’s internal divisions and weakening hand relative to China, Russia, and others. On the contrary, large monetary and fiscal stimulus lowers the economic costs of conflict and encourages autarkic, self-sufficiency policies that make governments more likely to struggle with each other to secure their supply chains. Chart 1AThe Return Of Geopolitical Risk Chart 1BThe Return Of Geopolitical Risk If we look at simple, crude measures of geopolitical risk we can see the market awakening to the new wall of worry for this business cycle – Great Power struggle, the persistence of “America First” with a different figurehead, China policy tightening, and a vacuum of European leadership. The US dollar is rising, developed market equities are outperforming emerging markets, safe-haven currencies are ticking up against commodity currencies, and gold is perking back up (Charts 1A & 1B). The cyclical upswing should reverse most of these trends over the medium term but investors should be cautious in the short term. US Stimulus, Chinese Tightening, And The Greenback The US remains the world’s preponderant power despite its political dysfunction and economic decline relative to emerging markets. The US has struggled to formulate a coherent way to deal with declining influence, as shown by dramatic policy reversals toward Iraq, Iran, China, and Russia. The pattern of unpredictability will continue. The Biden administration’s longevity is unknown so foreign states will be cautious of making firm commitments, implementing deals, or taking irrevocable actions. This does not mean the Biden administration will have a small impact – far from it. Biden’s national policy seeks to fire up the American economy, refurbish alliances, export liberal democratic ideology, and compete with China and Russia. The firing up is largely already accomplished – the American Rescue Plan Act (ARPA) and Biden’s forthcoming “Build Back Better” proposals will ultimately rank with Johnson’s Great Society. The Fed estimates that US GDP growth will hit 6.5% this year, higher than the consensus of economic forecasts estimates 5.5%, driven by giant government pump-priming (Chart 2). The US, which is already an insulated economy, is virtually inured to foreign shocks for the time being. Chart 2US Injects Steroids Next comes the courting of allies to form a united democratic front against the world’s ambitious dictatorships. This process will be very difficult as the allies are averse to taking risks, especially on behalf of an erratic America. Chart 3US Stimulus Briefly Halts Decline In Global Economic Share The Obama administration spent six full years creating a coalition to pressure an economically miniscule Iran into signing the 2015 nuclear deal. Imagine how long it will take Biden to convince the EU-27 and small Asian states to stick their necks out against Xi Jinping’s China. Especially if they suspect that the US’s purpose is to force China to open its doors primarily for the Americans. If the US grows at the rate of consensus forecasts then its share of global GDP will be 17.6% by 2025 (Chart 3). However, the US’s decline should not be exaggerated. Consider the lesson of the past year, in which the US seemed to flounder in the face of the pandemic. The US’s death count, on a population basis, was in line with other developed markets and yet its citizens exercised a greater degree of individual freedom. It maintained the rule of law despite extreme polarization, social unrest, and a controversial election. Its development of mRNA vaccines highlighted its ongoing innovation edge. And it has rolled out the vaccines rapidly. Internal divisions are still extreme and likely to produce social instability (we are still in the zone of “peak polarization”). But the US economic foundation is now fundamentally supported – political collapse is improbable. Chart 4US Vs China: The Stimulus Impulse In short, the US saw the “Civil War Lite” and has moved onto “Reconstruction Lite,” with a big expansion of the social safety net and infrastructure as well as taxes already being drafted. Meanwhile General Secretary Xi has managed to steer China into a good position for the much-ballyhooed 100th anniversary of the Communist Party on July 1. His administration is tightening monetary and fiscal policy marginally to resume the fight against systemic financial risk. China faces vast socioeconomic imbalances that, if left unattended, could eventually overturn the Communist Party’s rule. So far the tightening of policy is modest but the risk of a policy mistake is non-negligible and something global financial markets will have to grapple with in the second quarter. Comparing the US and China reveals an impending divergence in relative monetary and fiscal stimulus (Chart 4). China’s money and credit impulse is peaking – some signs of economic deceleration are popping up – even as the US lets loose a deluge of liquidity and pump-priming. The result is that the world is likely to experience waning Chinese demand and waxing US demand in the second half of the year. It is almost the mirror image of 2009-10, when China’s economy skyrocketed on a stimulus splurge while the US recovered more slowly with less policy support. The medium-to-long-run implication is that the US will have a bumpy downhill ride over the coming decade whereas China will recover more smoothly. Yet the analogy only goes so far. The structural transition facing China’s society and economy is severe and US-led international pressure on its economy will make it more severe. The short-run implication – for Q2 2021 – is that the US dollar’s bounce could run longer than consensus expects. Commodity prices, commodity currencies, and emerging market assets face a correction from very toppy levels. The global cyclical upswing will continue as long as China avoids a policy mistake of overtightening as we expect but the near-term is fraught with downside risk. Bottom Line: We are neutral on the dollar from a tactical point of view. While our bias is to expect the dollar to relapse, in line with the BCA House View and our Foreign Exchange Strategy, we are loathe to bet against the greenback given US stimulus and Chinese tightening. This is not to mention geopolitical tensions highlighted below that would reinforce the dollar. Biden’s China Policy And The Semiconductor Shortage Any spike in US-China strategic tensions in Q2 would exacerbate the above reasoning on the dollar. It would also lead to a deeper selloff in Chinese and EM Asian currencies and risk assets. A spike in tensions is not guaranteed but investors should plan for the worst. One of our core views for many years has been that any Democratic administration taking office in 2020 would remain hawkish on China, albeit less so than the Trump administration. So far this view is holding up. It may not have been the cause of the drop in Chinese and emerging Asian equities but it has not helped. However, the jury is still out on Biden’s China policy and the second quarter will likely see major actions that crystallize the relative hawkish or dovish change in policy. The acrimonious US-China meeting in Alaska meeting does not necessarily mean anything. The Biden administration has a full China policy review underway that will not be completed until around early June. The first bilateral summit between Biden and Xi could occur on Earth Day, April 22, or sometime thereafter, as the countries are looking to restart strategic dialogue and engage on nuclear non-proliferation and carbon emission reductions. Specifically China wants to swap its help on North Korea – which restarted ballistic missile launches as we go to press – for easier US policies on trade and tech. Only if and when a new attempt at engagement breaks down will the Biden administration conclude that it has a basis for pursuing a more offensive policy toward China. The problem is that new engagement probably will break down, sooner or later, for reasons we outlined last week: the areas of cooperation are limited – obviously so on health and cybersecurity, but even on climate change. Engagement on Iran and North Korea may have more success but the bigger conflicts over tech and Taiwan will persist. Ultimately China is fixated on strategic self-sufficiency and rapid tech acquisition in the national interest, leaving little room for US market access or removal of high-tech export controls. The threat that Biden will ultimately adopt and expand on Trump’s punitive measures will hang over Beijing’s head. The risk of a Republican victory in 2024 will also discourage China from implementing any deep structural concessions. The crux of the conflict remains the tech sector and specifically semiconductors.1 China is rapidly gaining market share but the US is using its immense leverage over chip design and equipment to cut off China’s access to chips and industry development. The ongoing threat of an American chip blockade is now being exacerbated by a global shortage of semiconductors as the economy recovers (Chart 5), exposing China’s long-term economic vulnerability. Chart 5Global Semiconductor Shortage There is room for some de-escalation but not much – and it is not to be counted on. The Biden administration, like the Obama administration, subscribes to the view that the US should prioritize maintaining its lead in tech innovation rather than trying to compete with China’s high-subsidy model, which is gobbling up the lower end of the computer chip market. Biden’s policy will at first be defensive rather than offensive – focused on improving US supply chain security rather than curtailing Chinese supply. Biden’s proposal for domestic infrastructure program will include funds for the semiconductor industry and research. While the Biden administration likely prizes leadership and innovation over the on-shoring of US chip production, the US government must also look to supply security, specifically for the military, so some on-shoring of production is inevitable.2 Ultimately the Biden administration can continue using export controls to slow China’s semiconductor development or it can pare these controls back. If it does nothing then China’s state-backed tech program will lead to a rapid increase in Chinese capabilities and market share as has occurred in other industries. If it maintains restrictions then it will delay China’s development, especially on the highest end of chips, but not prevent China from gaining the technology through circumventing export controls, subsidizing its domestic industry, and poaching from Taiwan and South Korea. Given that technological supremacy will lead to military supremacy the US is likely to maintain restrictions. But a full chip blockade on China would require expanding controls and enforcing them on third parties, and massively increases strategic tensions, should Biden ever decide to go this ultra-hawkish route. The Biden administration can adjust the pace and intensity of export controls but cannot give China free rein. Biden will want to block China’s access to the US market, or funds, or parts when these feed its military-industrial complex but relax pressure on China’s commercial trade. This is only a temporary fix. The commercial/military distinction is hard to draw when Beijing continually pursues “civil-military fusion” to maximize its industrial and strategic capabilities. Therefore US-China strategic tensions over tech will worsen over the long run even if Biden pursues engagement in the short run. Bottom Line: Biden’s China policy has started out hawkish as expected but the real policy remains unknown. The second quarter will reveal key details. Biden could pursue engagement, leading to a reduction in tensions. Investors should wait and see rather than bet on de-escalation, given that tensions will escalate anew over the medium and long term and therefore may never really decline. Iran And Oil Price Volatility Biden’s other foreign policy challenges in the second quarter hinge on Iran and Russia. The Biden administration aims to restore the 2015 Iranian nuclear deal and is likely to move quickly. This is not merely a matter of intention but of national capability since US grand strategy is pushing the US to shift focus to Asia Pacific, and an Iranian nuclear crisis divides US attention and resources. Biden has the ability to return to the 2015 deal with a flick of his wrist. The Iranians also have that ability, at least until lame duck President Hassan Rouhani leaves office in August – beyond that, a much longer negotiation would be necessary. US-Iran talks will lead to demonstrations of credible military threats, which means that geopolitical attacks and tensions in the Middle East will likely go higher before they fall on any deal. The past several years have already seen a series of displays of military force by the Iranians and the US and its allies and this process may escalate all summer (Map 1). Map 1Military Incidents In Persian Gulf Since Abqaiq Refinery Attack, 2019 It is too soon to draw conclusions regarding the Israeli election on March 23 but it is possible that Prime Minister Benjamin Netanyahu will remain in power (Chart 6). If this is the case then Israel will oppose the American effort to rejoin the Iranian nuclear deal, culminating in a crisis sometime in the summer (or fall) in which the Israelis make a major show of force against Iran. Even if Netanyahu falls from power, the new Israeli government will still have to show Iran that it cannot be pushed around. Fundamentally, however, a change in leadership in Israel would bring the US and Israel into alignment and thus smooth the process for a deal that seeks to contain Iran’s nuclear program at least through 2025. Any better deal would require an entirely new diplomatic effort. Chart 6Israeli Ruling Coalition Share Of Knesset Shares In Recent Elections The Russians or Saudi Arabians might reduce their oil production discipline once a deal becomes inevitable, so as not to lose market share to Iranian oil that will come back onto global markets. Thus oil markets could face unexpected oil supply outages due to conflict followed by OPEC or Iranian supply increases, implying that prices will be volatile. Our Commodity & Energy Strategy expects prices to average $65/barrel in 2021, $70/barrel in 2022, and $60-$80/barrel through 2025. Bottom Line: Oil prices will be volatile in the second quarter as they may be affected by the twists and turns of US-Iran negotiations, which may not reach a new equilibrium until July or August at earliest. Otherwise a multi-year diplomatic process will be required, which will suck away the Biden administration’s foreign policy capital, resulting either in precipitous reduction in Middle East focus or a neglect of greater long-term challenges from China and Russia. Russian Risks, Germany Elections, And Scottish Independence European politics are more stable than elsewhere in the world – marked by Italy’s sudden formation of a technocratic unity government under Prime Minister Mario Draghi. Draghi is focused on using EU recovery funds to boost Italian productivity and growth. Europe’s economic growth has underperformed that of the US so far this year. The EU is not witnessing the same degree of fiscal stimulus as the US (Chart 7). The core member states all face a fiscal drag in the coming two years and meanwhile the bloc has struggled to roll out COVID-19 vaccines efficiently. However, the vaccines are proven to be effective and will eventually be rolled out, so investors should buy into the discount in the euro and European stocks as a result of the various mishaps. Global and European industrial production and economic sentiment are bouncing back and German yields are rising albeit not as rapidly as American (Chart 8). Chart 7EU Stimulus Lags But Targets Productivity Chart 8Global And Euro Area Production To Accelerate Chart 9German Conservatives Waver in Polls The main exceptions to Europe’s relative political stability come from Germany and Scotland. German Chancellor Angela Merkel is a lame duck and her party is falling in opinion polls with only six months to go before the general election on September 26 (Chart 9). Merkel even faced the threat of a no-confidence motion in the Bundestag this week due to her attempt to extend COVID lockdowns over Easter and sudden retreat in the face of a public backlash. Merkel apologized but her party is looking extremely shaky after recent election losses on the state level. The rise of a new left-wing German governing coalition is much more likely than the market expects. The second quarter will see the selection of a chancellor-candidate for her Christian Democratic Union and its Bavarian sister party the Christian Social Union. Table 1 highlights the likeliest chancellor-candidates of all the parties and their policy stances, from the point of view of whether they have a “hawkish,” hard-line policy stance or “dovish,” easy policy stance on the major issues. What stands out is that the entire German political spectrum is now effectively centrist or dovish on monetary and fiscal policy following the lessons of the 13 years since the global financial crisis. Table 1German Chancellor Candidates, 2021 In other words, while Germany’s conservatives will seek an earlier normalization of policy in the wake of the crisis, none of them are as hawkish as in the past, and an election upset would bring even more dovish leaders into power. Thus the German election is a political risk but not a global market risk. It should not fundamentally alter the trajectory of German equities or bond yields – which is up amid global and European recovery – and if anything it would boost the euro. The potential German chancellor candidates show more variation when it comes to immigration, the environment, and foreign policy. Germany has been leading the charge for renewable energy and will continue on that trajectory (Chart 10). However it has simultaneously pursued the NordStream II natural gas pipeline with Russia, which would bring 55 billion cubic meters of natural gas straight into Germany, bypassing eastern Europe and its fraught geopolitics. This pipeline, which could be completed as early as August, would improve Germany’s energy security and Russia’s economic security, which remain closely intertwined despite animosity in other areas (Chart 11). But the pipeline would come at the expense of eastern Europe’s leverage – and American interests – and therefore opposition is rising, including among the ascendant German Green Party. Chart 10Germany’s Switch To Renewables Chart 11Germany Puts Multilateralism To The Test Chart 12UK-EU Trade Deal Dampens Scots Nationalism While Merkel and the Christian Democrats are dead-set on completing the pipeline, global investors are underrating the possibility of a major incident in which the US uses diplomacy and sanctions to halt the project. This is not intuitive because Biden is focused on restoring the US alliance with Europe, particularly Germany. But he is doing so in order to counter Russian and Chinese authoritarianism. Therefore the pipeline could mark the first real test of Biden’s – and Germany’s – understanding of multilateralism. Importantly the US is not pursuing a diplomatic “reset” with Russia at the outset of Biden’s term. This has now been confirmed with Biden’s accusation that Russian President Vladimir Putin is a “killer” and the ensuing, highly symbolic Russian withdrawal of its ambassador to the United States, unseen even in the Cold War. The Americans are imposing sanctions in retaliation for Russia’s alleged interference in the 2016 and 2020 elections. Russia is largely inured to US sanctions at this point but if the US wanted to make a difference it would insist on a stop to NordStream by cutting off access to the US market to the various European engineering and insurance companies critical to construction.3 Yet German leaders would have to be cajoled and it may be more realistic for the US to demand other concessions from Germany, particularly on countering China. The US-German arrangement will go a long way toward defining Germany’s and the EU’s risk appetite in the context of Biden’s proposal to build a more robust democratic alliance to counter revisionist authoritarian states. The Russians say they want to avoid a permanent deterioration in relations with the US, which they warn is on the verge of occurring. There is some space for engagement, such as on restoring the Iran deal, which Russia ostensibly supports. Biden may want to keep Russia pacified until he has an Iranian deal in hand. Ultimately, however, US-Russian relations are headed to new lows as the Biden administration brings counter-pressure on the Russians in retribution for the past decade of actions to undermine the United States. Germany’s place in this conflict will determine its own level of geopolitical risk. Clearly we would favor German assets over those of emerging Europe or Russian in this environment. One final risk from Europe is worth mentioning for the second quarter: the UK and Scotland. Scottish elections on May 6 could enable the Scottish National Party to push for a second independence referendum. So far our assessment is correct that Scottish independence will lose momentum after Prime Minister Boris Johnson’s post-Brexit trade deal with the European Union. Scottish nationalists are falling (Chart 12) and support for independence has dropped back toward the 45% level where the 2014 referendum ended up. Nevertheless elections can bring surprises and this narrative bears vigilance as a threat to the pound’s sharp rebound. Bottom Line: Europe’s relative political stability is challenged by US-Russia geopolitical tensions, the higher-than-expected risk of a German election upset, and the tail risk of Scottish independence. Of these only a US-Russia blowup, over NordStream or other issues, poses a major downside risk to global investors. We continue to underweight EM Europe and Russian currency and financial assets. Investment Takeaways Our three key views for 2021, in addition to coordinated monetary and fiscal stimulus, are largely on track for the year so far: China’s Headwinds: China’s renminbi and stock market are indeed suffering due to policy tightening and US geopolitical pressure. Risk to our view: if Biden and Xi make major compromises to reengage, and Xi eases monetary and fiscal policy anew, then the global reflation trade and Chinese equities will receive another boost. US-Iran Triggered Oil Volatility: The US and Iran are still in stalemate and the window of opportunity for a quick restoration of the 2015 deal is rapidly narrowing. Tensions are indeed escalating prior to any resolution, which would come in the third quarter, thus producing first upside then downside pressures for oil prices. Risk to our view: the Biden administration has no need for a new Iran deal and tensions escalate in a major way that causes a major risk premium in oil prices and forces the US to downgrade its pressure campaign against China. Europe’s Outperformance: So far this year the dollar has rallied and the EU has botched its vaccine rollout, challenging our optimistic assessment of Europe. But as highlighted in this report, we anticipated the main risks – government change in Germany, a Scots referendum – and the former is positive for the euro while the downside risk to the pound is contained. The major geopolitical problem is Russia, where we always expected substantial market-negative risks to materialize after Biden’s election. Risk to our view: A US-Russian reset that lowers geopolitical tensions across eastern Europe or a German status quo election followed by a tightening of fiscal policy sooner than the market expects.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 For an excellent recent review of the issues see Danny Crichton, Chris Miller, and Jordan Schneider, "Labs Over Fabs: How The U.S. Should Invest In The Future Of Semiconductors," Foreign Policy Research Institute, March 2021, issuu.com. 2 Alex Fang, "US Congress pushes $100bn research blitz to outcompete China," Nikkei Asia, March 23, 2021, asia.nikkei.com. In anticipation of the Biden administration’s dual attempt to promote, on one hand, innovation, and on the other hand, semiconductor supply security, the US semiconductor giant Intel has announced that it will build a $20 billion chip fabrication plant in Arizona. This is in addition to TSMC’s plans to build a plant in Arizona manufacturing chips that are necessary for the US Air Force’s F-35 jets. See Kif Leswing, "Intel is spending $20 billion to build two new chip plants in Arizona," CNBC, March 23, 2021, cnbc.com. 3 See Margarita Assenova, "Clouds Darkening Over Nord Stream Two Pipeline," Eurasia Daily Monitor 18:17 (2021), Jamestown Foundation, February 1, 2021, Jamestown.org.   Appendix: GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Section III: Geopolitical Calendar

Special Report

Highlights Our recalibrated model suggests that, if President Trump places a 25% tariff on all Chinese goods exports to the US, then the RMB should fall by 4% against the dollar from its current value. The RMB has been trending below its “fair value” in the past two years, but as US-China tensions escalate, the PBoC will likely allow the market forces to push the RMB lower. We continue to hold a long position in the USD-CNH, but recommend investors keep the position on a short leash. The key risk to this view is a broad-based dollar weakness. So far, the yuan has been resilient against a dramatic drop in the DXY. The more that the RMB deviates from its fair value, the more rapidly and strongly it could appreciate in the absence of further tariff hikes. Feature The strong probability of a re-ignited US-China trade war this year will place the RMB under downward pressure against the USD.1 Unlike in 2019 when China was trying to reconcile with the US to reach a trade deal, this year President Trump will encounter a much less compromising President Xi Jinping. Therefore, it is more likely that Beijing will use depreciation as a countervailing tool on, and even ahead of any additional tariffs on Chinese goods exports to the US.   The RMB would likely fall by 4% if the US was to boost import tariffs to 25% on all Chinese goods. We recalibrated our Equilibrium Exchange Rate Model to project the tactical (0-3 months) fluctuations in the RMB against the dollar, in different scenarios of tariff hikes. If President Trump is to raise the tariff rate to 25% on all US imports of Chinese goods, the RMB should fall by 4% against the dollar from its current value. On a cyclical time horizon (the next 12 months), however, the RMB will likely rebound. The RMB has been trending below its fair value against the dollar since the onset of the trade war in mid-2018, but the economic fundamentals that supported the dollar’s strength in the last two years have diminished. Even if a second wave of the Covid-19 pandemic materializes, but does not result in severe lockdown measures, the dollar as a countercyclical currency will be pushed lower as global growth continues to recover. The combination of a stronger global economy and weaker dollar should help strengthen pro-cyclical currencies, such as the RMB. A Recalibrated Model Based On The Economics Of Tariffs If the US were to impose further tariffs on Chinese exports, how much will the RMB fall against the dollar? According to our recalibrated Equilibrium Exchange Rate Model, if the US was to boost import tariffs to 25% on all Chinese goods tomorrow, then the RMB would likely fall by 4% to around 7.35 against the dollar2 (Chart 1A and 1B). That said, currency markets tend to undershoot, and market forces will likely push the RMB lower on the prospect of further escalation. More importantly, the PBoC will be less likely to lean against this weakness, since the lower in the exchange rate will buffet exports. Chart 1AUSDCNY Under Tariff Rate Hike Scenarios Chart 1BA Tariff Timeline The Evolution Of The US-China Trade War Tariff hikes typically catalyze an adjustment between two countries: either in the exchange rate to realign price competitiveness, in the quantity of tradeable goods, or a combination of the two.  Chinese goods exports to the US have only modestly decreased in the past two years from the pre-trade war year of 2017. Given that global trade has been mostly slowing since then, it signifies that the adjustment has largely occurred through the exchange rate (Chart 2). For a perfectly open economy, standard economic theory suggests that the exchange rate should move by the same percentage as the tariff increase to allow markets to clear. However, both the US and China do not have perfectly open economies. This suggests that the currency adjustment needed should be smaller.3 For example, as of 2019 only 16.7% of Chinese exports go to the US. A 25% tariff on all of these exports will lift overall export prices by only 4.2% (16.7*25%). This does not even take into consideration export substitution, and/or other factors that will influence tradeable prices. Chart 2Chinese Exports To The US Did Not Drop Much... Chart 3...Mainly Because China "Paid For" The Tariffs By Depreciating Its Currency Therefore, we recalibrated our model to reflect the assumed increases in both Chinese export prices and US import prices, rather than the pure increase in the US tariff rates. We also assumed that China will bear the brunt of the costs from the tariff hikes, which appears to have been the case in the past two years (Chart 3). The projections for where the USD/CNY rate is likely to settle in the next 0-3 months have closely tracked movements in the currency since July 2018. A Cyclical View On The RMB The RMB has depreciated by about 12% versus the dollar from its peak in April 2018, a non-trivial move for a currency that has been tightly managed. Rapid depreciations in the past two years have changed the valuation perspective of the RMB. Compared with our fair value estimates, the RMB has been undervalued in both real effective exchange rate terms and against the dollar. Chart 4The RMB Is Undervalued In Real Effective Terms... Our revamped Equilibrium Exchange Rate Model concludes that existing tariff rates should have the USD-CNY settle at around 6.98.  Currently, USDCNY is close to 7.1, suggesting that the market has been pricing in the risk of the US raising tariffs on China.  This means in the absence of further tariff hikes, the RMB will rebound and revert towards its fair value. Moreover, the RMB in real effective exchange rate terms has been undervalued compared with our fair value estimate, which is based on China's relative productivity trends and real bond yield differentials (Chart 4). With a 10-year bond in China yielding 2.8%, versus 0.7% in the US, interest rate differentials are likely to continue to structurally favor the RMB. Against the dollar, the RMB is also undervalued based on our relative purchasing power parity (PPP) models (Chart 5). Our PPP models make two crucial adjustments for an apples-to-apples comparison. First, the CPI baskets are broken into five subcomponents including food, shelter, health, transportation and household goods. Second, we run two regressions, one using the relative price ratios of the five subgroups (regression 1), and another using an aggregated price index weighted symmetrically across both the US and China (regression 2).4 Chart 5...And Against The Dollar Chart 6The PBoC Is Taking A More "Laissez-Faire" Approach Towards The RMB Depreciation It is true that valuation rarely matters in the near term and the market almost always over- or under-shoots from its "fair value" levels. The strength in the USD since early 2018 has also played a dominant role in the RMB’s depreciation. However, the RMB’s spot exchange rate has deviated from its fundamental equilibrium in the past two years. In contrast with the previous cycle, the PBoC does not appear to have intervened heavily in the offshore market to prevent excessive currency weakness. For example, in 2015/2016, the PBoC heavily clamped down on outflows. Offshore HIBOR rates also spiked, which is widely viewed as the PBoC's attempt to maintain exchange rate stability and to punish speculators by dramatically squeezing RMB liquidity in the offshore market. This time around, the PBoC is taking a more “laissez-faire” approach even though the RMB is weaker than back then (Chart 6). The key message is that longer-term investors should use RMB weakness to accumulate long positions, as any tariff-related weakness will cheapen an already attractive currency. Investment Conclusions In the near-term, a flare-up in the US-China trade war could trigger investors’ risk-off sentiment and economic fundamentals could be temporarily put aside. We continue to recommend a long position in the USD-CNH. Nevertheless, the more that the RMB deviates from its fair value, the more rapidly and strongly it will reverse to its fundamental equilibrium when tensions ease between the nations. The sharp reversal in the USD-CNY spot rate in the past three weeks illustrates this view (Chart 7). Thus, we recommend investors keep the long USD-CNH position on a short leash. Chart 7CNY/USD Below Its Long-Term Trend Chart 8US Money Supply Growth Way Outpaces China The economic fundamentals that have supported the dollar over the past two years are evaporating. The large overhang of China’s local currency money supply may exert structural downward pressure on the RMB exchange rate.5 However, money supply in the US has grown exponentially since the onset of the pandemic and has outpaced that of China (Chart 8). Interest rate differentials between the US and China will likely widen as well. Last week’s FOMC meeting made it clear that the Fed does not intend to raise rates through 2022. In contrast, the PBoC has a track record of normalizing monetary conditions about nine months after a trough in China’s nominal GDP growth (Chart 9). Chart 9The 'Old Faithful' PBoC Policy Normalization Pattern There is mounting evidence that the dollar is entering a new down cycle. Aside from the Fed’s dovish stance, there is mounting evidence that the dollar is entering a new down cycle. Typically, the dollar tends to run in long cycles, of about 10-years, with bear markets defined by rising twin deficits in the US. The reason is that as the Treasury issues more and more debt to finance spending, investors usually require a cheaper exchange rate to keep funding these deficits (Chart 10). Chart 10The Dollar And Cycles Chart 11USD A Counter-Cyclical Currency As such, in the next 12 months, barring a second wave of the pandemic that triggers severe lockdown measures, the dollar as a countercyclical currency will be pushed lower as global growth rebounds. This should help strengthen the RMB, given the USD/CNY rate tends to move with the dollar over cyclical periods (Chart 11).   Jing Sima China Strategist jings@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com     Footnotes 1We assign a 40% probability that the US will revert to tariffs on China within the year. Please see China Investment Strategy Special Report "Watch Out For A Second Wave (Of US-China Frictions)," dated June 10, 2020, available at cis.bcaresearch.com 2As of June 15, 2020, USDCNY exchange rate is at 7.09. 3Please see Foreign Exchange Strategy Weekly Report "USD/CNY And Market Turbulence," dated August 9, 2019, available at fes.bcaresearch.com 4Please see Foreign Exchange Strategy Special Report "A Fresh Look At Purchasing Power Parity," dated August 23, 2019, available at fes.bcaresearch.com 5At around $3 trillion, China’s central bank foreign exchange reserves are equivalent to only 14% of all yuan deposits, and 11% of broad money supply Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights The economic and health crises since Q1 2020 have accelerated the breakdown in the US-China relationship. Although the US is in a much weaker economic position this year than in 2019, President Trump may have fewer political constraints to an escalation in the trade war. President Xi Jinping is fueling provocations with the US, adding instability and unpredictability to the geopolitical equation. The Phase One trade deal may be collapsing. We recommend a defensive stance on Chinese risk assets and the RMB during the summer. Feature The outbreak of COVID-19 this year has sparked the worst economic contraction in China and the US in decades. Economic calamities and social unrest should have tied the hands of leaders in both countries. However, as our Geopolitical Strategist Matt Gertken reminds us, this is an atypical election year in the US and some constraints that previously deterred both sides from taking aggressive actions may be diminishing.1 We agree that the economic and health crises have likely accelerated the possibility of a breakdown in the relationship between the US and China. The risk will likely reach a new height in the summer, when pressure on Trump’s election campaign intensifies leading up to the vote in November. While there is a growing bipartisan hawkish view on China in Washington, China is also playing a part in fanning the flames. The USD/CNY exchange rate will be extremely volatile during this episode of heightened geopolitical turbulence. We continue to hold a long USD-CNH position, with the expectation that the RMB will likely weaken further in the summer. Trump Facing Fewer Constraints Whether Trump’s chances of reelection increase through a strong recovery in the US stock market and economy, or decrease through an economic recession and/or weak public support, either scenario could remove constraints preventing Trump from confronting China.     Trump’s current priority may be to secure a recovery in the equity market and improve his polling, which will require economic improvement. Ironically, the US stock market has been on fire despite the battered real economy. The S&P 500 Index has gone up by 44% since its trough on March 23, nearly erasing its losses for the year. The higher the market rises, the more Trump may believe that the market can sustain a shock even if he resorts to imposing tariffs on Chinese export goods - particularly if his approval rating does not rise along with the market. The market’s reaction in 2018 and 2019 provides a good example of how the US financial markets shrugged off any negative impact from a trade war between the US and China (Chart 1). If the pandemic prevents the US economy from fully reopening and/or recovering in the summer, then an equity market correction could send a negative signal about Trump’s reelection prospects. In this case, Trump may not be as enslaved by financial constraints as he would have been if the economy was in an expansionary state.  A falling approval rating, coupled with domestic social unrest, would make Trump a “lame duck” President (Chart 2).  Therefore, he may try to divert attention away from the economy and adopt an aggressive foreign and trade policy. China is already perceived negatively by a majority of American voters and certain political communities, thus there could be a political upside for Trump to escalate his confrontation with China. Chart 1US Stocks Kept Reaching New Highs In 2019 Despite An Ongoing Trade War Chart 2Trump’s Polling Drops Below Average All bets are off if Trump’s approval rating continues to trend downwards, regardless of whether the US equity market continues to rally and/or if the US economy is mired in recession. Our Geopolitical Strategy illustrates the scenarios as follows (Diagram 1). If Trump’s approval rating is high and the market is up, then Trump is “winning” and the only risk of a tariff hike would come from overconfidence or Chinese provocation. If his approval is up but the market falls, then he may become more inclined to use tariffs. If his approval rating is low but the market is up, then he has ammunition to get tougher on China. If his approval and the market are collapsing, then he is a “lame duck president” and all bets are off. Combined, these scenarios imply there is a 59% probability that Trump refrains from large tariffs, and a 41% chance that he reverts to large tariffs. Diagram 1Odds President Trump Will Hike Tariffs On China Before US Election Bottom Line: All bets are off if Trump’s approval rating continues to trend downwards, regardless of whether the US equity market continues to rally and/or if the US economy is mired in recession. Both scenarios would remove financial and economic constraints that Trump faced in 2019. If Trump's polling is weak, he may spend financial ammunition to shore up his “America First” credentials.      Adding China To The Geopolitical Instability Equation China itself may be an independent source of geopolitical instability and unpredictability. While President Xi Jinping does not have any electoral constraints, he needs to restore the confidence of Chinese people in the wake of the worst public health crisis and economic performance in decades. Like Trump, the pandemic gives President Xi an incentive to distract his populace from domestic crises by adopting hawkish foreign policies.  This hawkish approach was demonstrated when a new Hong Kong SAR national security law was proposed and approved at this year’s National People’s Congress (NPC). The new law would give Beijing greater direct control over Hong Kong, in contravention of its promise of 50 years of substantial autonomy enshrined in the Sino-British Joint Declaration of 1984.  China’s foreign policy tone recently shifted to a more combative one. This “wolf warrior diplomacy" has gained popularity among Chinese diplomats.2 During a news conference at this year’s NPC, China’s Foreign Minister Wang Yi defended the “wolf warrior diplomacy” by stating that the country will stand firm in defending its national interest and combating “smears.”  Chart 3Chinese Imports Of American Goods Are Falling Far Short Of The Target Set By The Trade Deal The response from the Trump administration has been lukewarm. While Secretary of State Mike Pompeo will strip Hong Kong of its autonomous status, President Trump is taking limited sanctions on mainland China and eschewing more drastic punitive measures. China may see the timid response as a sign that Trump is reluctant to take action on China and tip the bilateral relationship into an outright confrontation. This perception is, in itself, a risk that may lead to more provocation on both sides. Lastly, the Phase One trade deal is tenuous. US Trade Representative Robert Lighthizer last week stated that "China has done a pretty good job" at meeting its trade-deal quotas,3 but we have long argued China was never going to honor the commitment to its full extent.4 The latest data shows that Chinese purchases of American exports in the first four months of 2020, from manufacturing goods to agricultural produce and energy, have fallen far short of the huge expansion agreed in the deal (Chart 3). The recent depreciation in the RMB may be another sign that China is abandoning the Phase One trade deal.5 Weakness in economic fundamentals and renewed tensions between the US and China may have contributed to the RMB’s recent depreciation. However, the decline was reinforced by the PBoC’s move to set the CNY/USD fixing rate to its lowest point since 2008 (Chart 4). Given that the RMB has become an anchor for emerging market currencies, a rapid drop in the RMB would lead to selloffs in emerging Asian and Latin American currencies and, in turn, would strengthen the USD (Chart 5). The Trump administration may see a swift RMB depreciation as China is deliberately violating the Phase One trade deal, which will prompt Trump to seek retaliatory actions against China. Chinese purchases of American goods in the first four months of 2020 have fallen far short of the Phase One trade agreement. Chart 4Is The PBoC Sending A Warning Signal To Trump? Chart 5The RMB Has Been The Anchor Currency In EM Bottom Line: While China is prioritizing its own economic recovery, its foreign policy stance has decisively swung to a more combative one. Additionally, the Phase One trade deal is on the verge of collapsing.  Investment Conclusions The USD/CNY exchange rate will likely be extremely volatile in the next quarter amid heightened geopolitical turbulence, with more downside risks to the RMB. As such, we continue to recommend that investors hedge their RMB exposure in Chinese stocks by holding a long USD-CNH position. We remain neutral on Chinese stocks in relative terms in view of the non-trivial, near-term vulnerability of risk assets. As in 2019, investable stocks are particularly exposed to an escalation in the US-China conflict (Chart 6). Chart 6Large Divergence In Onshore Versus Offshore Stock Performance During The Trade War Chart 7Stocks In Some Domestic Demand-Oriented Sectors Are Still Relatively Safe Bets Price corrections in both China’s onshore and offshore aggregate equity markets are likely to occur during the summer. Nevertheless, cyclical plays that closely track Chinese stimulus are relatively safe bets, especially for China’s domestic investors and in absolute terms (Chart 7).   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1Please see Geopolitical Strategy Weekly Report "Spheres Of Influence (GeoRisk Update)," dated May 29, 2020, available at gps.bcaresearch.com 2South China Morning Post, “Chinese Foreign Minister Wang Yi defends ‘wolf warrior’ diplomats for standing up to ‘smears’”, May 24, 2020 3Bloomberg, “Lighthizer Says He Feels ‘Very Good’ About Phase One China Deal”, June 4, 2020 4Please see China Investment Strategy Weekly Report "Managing Expectations," dated January 22, 2020, available at cis.bcaresearch.com 5The Phase One trade deal prohibits both the US and China from manipulating exchange rates to devalue their currencies for competitive purposes. Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights Egypt’s balance of payments have deteriorated materially due to both the crash in oil prices and the global pandemic. The country’s foreign funding requirements in 2020 are high and the currency is under depreciation pressures. Unless domestic interest rates are brought considerably lower, the nation’s public debt is on an unsustainable trajectory. Hence, Egypt needs to reduce local interest rates substantially and rapidly. And in so doing, the central bank cannot control or defend the exchange rate. The latter is set to depreciate. Investors should buy Egyptian local currency bonds while hedging their currency exposure. Feature The Central Bank of Egypt (CBE) is depleting its foreign exchange (FX) reserves to defend the currency (Chart I-1). As the CBE’s foreign exchange reserves diminish, so will its ability to support the currency. As such, the Egyptian pound will likely depreciate in the next 6-9 months. Interestingly, despite being a net importer of energy, many of Egypt’s critical macro parameters are positively correlated with oil prices (Chart I-2). Egypt is in fact deeply integrated in the Gulf oil-economy network via trade and capital flows. In other words, Egypt is a veiled play on oil. Chart I-1The CBE Has Been Defending The Currency Chart I-2Egypt: A Veiled Play On Oil   Although oil prices have rallied sharply recently, the Emerging Markets Strategy team believes upside is limited and that oil prices will average about $40 over the next three years.1  In addition, local interest rates that are persistently above 10% are disastrous for both Egypt’s domestic demand and public debt sustainability. Egypt’s current account balance strongly correlates with oil prices because of the strong interlinkages that exist between Egypt and the oil-exporting Gulf countries. To preclude a vicious cycle in both the economy and public debt, the CBE should reduce interest rates materially and rapidly. Therefore, higher interest rates cannot be used to defend the exchange rate. Balance Of Payments Strains Egypt’s balance of payments (BoP) dynamics have deteriorated and the probability of a currency devaluation has risen: Current Account: The current account deficit – which stood at $9 billion and 3% of the GDP as of December 2019 – is widening significantly due to the plunge in oil prices this year (Chart I-2, top panel). Egypt’s current account balance strongly correlates with oil prices because of the strong interlinkages that exist between Egypt and the oil-exporting Gulf countries. The latter have been hard hit by the twin shocks of the coronavirus pandemic and the oil crash. First, Egypt’s $27 billion in annual remittances are drying up (Chart I-2, bottom panel). The majority of these transmittals come from Egyptian workers working in Gulf countries. Second, Egypt’s tourism industry – which brings in $13 billion in annual revenues or 4% of GDP – has collapsed due to the pandemic. Tourist arrivals from Middle Eastern countries – which makeup 20% of total tourist arrivals into Egypt – will diminish substantially due to both the pandemic and the negative income shock that the Gulf economies have experienced (Chart I-3). Third, Egyptian exports are in freefall (Chart I-4, top panel). Not only is this due to the freeze in global trade, but also because the country’s exports to the oil-leveraged Arab economies have taken a massive hit. The latter make up 25% of Egypt’s total goods shipments. Chart I-3Egypt: Tourism Is Linked To Oil Prices Chart I-4Exports Revenues Swing With Oil Prices   Furthermore, since 2019 Egypt has been increasingly exporting natural gas. The collapse in gas prices has probably already wiped out a large of chunk its natural gas export revenues (Chart I-5). Chart 6 exhibits the structure of Egypt’s exports of goods and services. Energy, tourism and transportation constituted 67% of total exports in 2019. Chart I-5Gas Export Revenues Are At Risk Chart I-6Egypt: Structure Of Goods & Services Exports Chart I-7Exports Are Shrinking Amid Resilient Imports Finally, while export revenues have plunged, imports remain resilient (Chart I-7). Critically, 26% of Egypt’s imports are composed of essential and basic items such as consumer non-durable goods, wheat and maize. Consumption of these staples and goods are less sensitive to business cycle oscillations. Therefore, the nation’s current account deficit has ballooned. A wider current account deficit needs to be funded by foreign inflows. With foreign investors reluctant to provide funds, the CBE has lately been financing BoP by depleting its foreign exchange reserves (Chart I-1, on page 1). Foreign Funding Requirements: Not only is Egypt facing a massively deteriorating current account deficit, but the country also carries large foreign funding debt obligations (FDO). FDOs are the sum of debt expiring in the next 12 months, and interest as well as amortization payments over the next 12 months. FDOs due in 2020 were $24 billion.2 In turn, Egypt’s total foreign funding requirements (FFR) – which is the sum of FDOs and the country’s current account deficit – has risen to $33 billion.3 Importantly, this FFR amount is based on the current account for 2019 and, thereby, does not take Egypt’s deteriorating current account deficit into consideration – as discussed above. Meanwhile, the central bank has net FX reserves of only $8 billion.4 If the monetary authorities continue to fund FFR of $33 billion in 2020 to prevent the pound from depreciating, the CBE will soon run out of its net FX reserves. Overall, Chart I-8 compares Egypt to the rest of the EM universe: with respect to (1) exports-to-FDO on the x-axis and (2) foreign exchange reserves-to-FFR on the y-axis. Based on these two measurements, Egypt is among the most vulnerable EM countries in terms of the balance of payments as it has the lowest FX reserves-to-FFR ratio and a low export-to-FDO ratio as well. Chart I-8Egypt Is One Of The Most Exposed EM Countries To Currency Depreciation Chart I-9FDI Inflows Are Set To Diminish Foreign Funding of Private Sector: Egypt will struggle to attract private-sector foreign inflows to meet its large FFR amid this adverse regional economic environment and the likely renewed relapse in oil prices in the months ahead. FDI inflows are set to drop (Chart I-9). The oil & gas sector has been the largest recipient of FDI inflows recently (around 55% in 2019 according to the central bank). The crash in both crude oil and natural gas prices will therefore ensure that FDIs into this sector will dry up. Besides, overall FDI inflows emanating from Gulf countries are poised to shrink substantially.5 Chart I-10The Egyptian Pound Is Once Again Expensive Foreign Funding of Government: With FDI inflows diminishing, the Egyptian government has once again been forced to approach the IMF for assistance. The country managed to secure $8 billion in assistance from the IMF ($2.8 billion in May and $5.2 in June). This has ameliorated international investor confidence in Egypt. Indeed, the country raised $5 billion by issuing US dollar-denominated sovereign bonds in May. Egypt is now seeking another $4 billion from other international lenders. Crucially, assuming Egypt manages to get the $4 billion loan, which would allow it to raise a total of $17 billion, Egypt would still be short on foreign funding to finance its $33 billion in FFR. Therefore, the currency will come under pressure of devaluation. As we argue below, the nation’s public debt sustainability is in jeopardy unless local currency interest rates are brought down substantially. This can only happen if the currency is allowed to depreciate. Consistently, foreign investors might be unwilling to lend to Egypt until interest rates are pushed lower and the country’s public debt trajectory is placed back on a sustainable path. Finally, the Egyptian pound has once again become expensive according to the real effective exchange rate (REER) which is based on both consumer and producer prices (Chart I-10). Bottom Line: Egypt is facing sharply slowing foreign inflows due to both the crash in oil prices and the global pandemic. This is occurring amid increased FFRs. Meanwhile, the CBE’s net FX reserves are insufficient to defend the exchange rate. Public Debt Sustainability The BoP strains discussed above are forcing the CBE to keep interest rates high to prevent the currency from depreciating. Yet the country’s public debt is on a dangerous path due to elevated interest rates. In turn, without currency devaluation that ultimately allows local interest rates to drop dramatically, the sustainability of Egypt’s public debt will worsen considerably. The BoP strains discussed above are forcing the CBE to keep interest rates high to prevent the currency from depreciating. Yet the country’s public debt is on a dangerous path due to elevated interest rates. To start, Egypt’s public debt stands at 97% of GDP – local currency and foreign currency debt account for 79% and 18% of GDP respectively (Chart I-11, top panel). Chart I-12 illustrates that interest payments on public debt is already using up 60% of government revenue and stands at 10% of GDP. Chart I-11Egypt: Public Debt Profile Chart I-12The Government's Interest Payments Are Unsustainable   Therefore, if the CBE keeps interest rates at the current level, then the government will continue to pay high interest on its debt. Generally, two conditions need to be met to ensure public debt sustainability in any country (i.e., to ensure that the public debt-to-GDP ratio does not to surge). Nominal GDP growth needs to be higher than government borrowing costs. The government needs to run persistently large primary fiscal surpluses. Chart I-13Egypt: Nominal GDP Growth And Government Borrowing Costs Regarding the first condition, nominal GDP growth was already dangerously close to the level of Egypt’s government borrowing costs even before the pandemic hit Egypt (Chart I-13). With the pandemic, both domestic demand and exports have plunged. Consequently, nominal GDP is likely close to zero while local currency borrowing costs are above 10%. So long as nominal GDP growth remains below borrowing costs, the public debt sustainability will continue to deteriorate. As to the second condition, Egypt only started running primary fiscal surpluses in 2018 as it implemented extremely tight fiscal policy by cutting non-interest expenditures (Chart I-14). However, that was only possible because economic growth was then strong. As growth has slumped, government revenue is most likely shrinking. Chart I-14Egypt Only Recently Started Running A Primary Fiscal Surplus Tightening fiscal policy amid the economic downturn will be ruinous. Cutting non-interest expenditures further will depress the already weak economy, drying up both nominal GDP and government revenues even more. This will bring about a vicious economic cycle. Needless to say, the latter option is politically unviable. The most feasible option to ensure sustainability of public debt dynamics is to bring down domestic interest rates considerably. Lower local interest rates will reduce interest expenditures on its domestic debt and will either narrow overall fiscal deficit or free up space for the government to spend elsewhere, boosting much needed economic growth. Meanwhile lower interest rates will boost demand for credit and revive private-sector domestic demand. Provided Egypt’s public debt has a short maturity profile, lower interest rates will reasonably quickly feed into lower interest payments for the government. This means that lower interest rates could reasonably quickly feed to lower interest payments for the government. Importantly, there is a trade-off between the exchange rates and interest rates. Lowering interest rates entail currency depreciation. According to the impossible trinity theory, a central bank facing an open capital needs to choose between controlling interest rates or the exchange rate, it cannot control both simultaneously. As such, if the Central Bank of Egypt opts to bring down local interest rates, while keeping the capital account reasonably open, it needs to tolerate a weaker currency amid its ongoing BoP strains. Bottom Line: Public debt dynamics are treading on a dangerous path. Egypt needs to bring down local interest rates down substantially and rapidly. And in so doing, the CBE cannot control and defend the exchange rate. Devaluation Is Needed All in all, the Egyptian authorities are facing a tight tradeoff: (1) either they continue to defend the currency at the expense of depressing the economy and worsening public debt dynamic, or (2) they tolerate a one-off currency devaluation which would allow the monetary authorities reduce interest rates aggressively. The latter will help stimulate economic growth and make public debt sustainable. Specifically, if the Central Bank of Egypt opts for defending the currency from depreciation, it will need to tolerate much higher interest rates for a long period of time. The CBE would essentially need to deplete whatever little net FX reserves it currently has to fund BoP deficits. This would simultaneously shrink local banking system liquidity, pushing domestic interbank rates higher.  All in all, the Egyptian authorities are facing a tight tradeoff: (1) either they continue to defend the currency at the expense of depressing the economy and worsening public debt dynamic, or (2) they tolerate a one-off currency devaluation which would allow the monetary authorities reduce interest rates aggressively. Worryingly, not only would high interest rates devastate the already shaky Egyptian economy, but higher domestic interest rates carry major ramifications for Egypt’s public debt sustainability as discussed earlier. A one-off currency devaluation is painful and carries some political risks yet, it is still the least worst choice for Egypt from a longer-term perspective. Although inflation will spike due to pass-through from currency devaluation, it will be a transitory one-off increase (Chart I-15). Besides, the pertinent risk to the Egyptian economy currently is low inflation and high real interest rates (Chart I-16). Chart I-15Egypt: Currency-Induced Inflation Is A One-Off Chart I-16Egypt: Real Interest Rates Are High     In turn, currency depreciation will ultimately provide the CBE with scope to reduce its policy rate which will help stimulate the ailing economy as well as make public debt trajectory more sustainable. Finally, odds are high that Egyptian authorities might choose to devalue the currency sooner rather than later. The basis for this is that the government’s foreign public debt is still relatively small at 18% of the GDP and 19% of the total government debt (Chart I-11, on page 8). Further, the majority (70%) of Egypt’s foreign public debt remains linked to international and bilateral government loans making it easier to renegotiate their terms than in the case of publicly traded sovereign US dollar bonds (Chart I-11, bottom panel). This means that currency depreciation will not materially deteriorate the government’s debt servicing ability. Furthermore, Egypt has experience managing and tolerating currency depreciation. The currency depreciated against the US dollar by 50% in 2016 and before that by 12% in 2013. Bottom Line: The Central Bank of Egypt will not hike interest rates or sell its foreign currency reserves for too long to defend the pound. Odds are high that it will allow the currency to depreciate and will cut interest rates materially. Investment Recommendations Chart I-17Egyptian Pound In The Forward Market Investors should buy Egyptian 3-year local currency bonds while hedging their currency exposure. The basis is that low inflation and a depressed economy in Egypt will lead the CBE to cut rates by several hundred basis points over the next 12 months while allowing currency to depreciate. Forward markets are pricing 5% depreciation in the EGP in the next 6 months and 10% in the next 12 months (Chart I-17). We would assign a higher probability of depreciation.   For now, EM credit portfolios should have a neutral allocation on Egyptian sovereign credit. While another potential drop in oil prices and the currency devaluation could push sovereign spreads wider (Chart I-18), eventually large rate cuts by the CBE will make public debt dynamics more sustainable. Absolute return investors should wait for devaluation to go long on Egypt’s US dollar sovereign bonds. Chart I-18Remain Neutral On Egypt's Sovereign Credit Chart I-19Remain Neutral On Egyptian Equities   Equity investors should keep a neutral allocation on Egyptian stocks with an EM equity portfolio (Chart I-19). Lower interest rates ahead will eventually boost this stock market. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com      1 This is the view of BCA’s Emerging Markets Strategy service and it differs from the view of BCA’s Commodities and Energy Strategy service. 2 We exclude the Central Bank’s foreign liabilities due in 2020 as they are mostly deposits at the Central Bank of Egypt owed to Gulf countries. It is highly likely that Gulf lenders will agree to extend these deposits given the difficulties Egypt is experiencing. 3 Excluding the Central Bank’s foreign liabilities due in the next 12 months. Please refer to above footnote. 4 The amount of net foreign exchange reserves currently at the Central Bank – i.e. excluding the Bank’s foreign liabilities– are now low at $8 billion. 5 Gulf Co-operation Countries (GCC) are in no position to provide much financial assistance due to the pandemic and oil crash as they are under severe financial strain themselves. Also, GCC countries run strict currency pegs and need to preserve their dwindling foreign exchange reserves to defend their currency pegs to the US dollar.