China & EM Asia

Highlights With a vaccine already rolling out in the UK and soon in the US, investors have reason to be optimistic about next year. Government bond yields are rising, cyclical equities are outperforming defensives, international stocks hinting at outperforming American, and value stocks are starting to beat growth stocks (Chart 1). Feature President Trump’s defeat in the US election also reduces the risk of a global trade war, or a real war with Iran. European, Chinese, and Emirati stocks have rallied since the election, at least partly due to the reduction in these risks (Chart 2). However, geopolitical risk and global policy uncertainty have been rising on a secular, not just cyclical, basis (Chart 3). Geopolitical tensions have escalated with each crisis since the financial meltdown of 2008. Chart 1A New Global Business Cycle A New Global Business Cycle A New Global Business Cycle Chart 2Biden: No Trade War Or War With Iran? Biden: No Trade War Or War With Iran? Biden: No Trade War Or War With Iran? Chart 3Geopolitical Risk And Global Policy Uncertainty Geopolitical Risk And Global Policy Uncertainty Geopolitical Risk And Global Policy Uncertainty Chart 4The Decline Of The Liberal Democracies? The Decline Of The Liberal Democracies? The Decline Of The Liberal Democracies? Trump was a symptom, not a cause, of what ails the world. The cause is the relative decline of the liberal democracies in political, economic, and military strength relative to that of other global players (Chart 4). This relative decline has emboldened Chinese and Russian challenges to the US-led global order, as well as aggressive and unpredictable moves by middle and small powers. Moreover the aftershocks of the pandemic and recession will create social and political instability in various parts of the world, particularly emerging markets (Chart 5). Chart 5EM Troubles Await EM Troubles Await EM Troubles Await Chart 6Global Arms Build-Up Continues Global Arms Build-Up Continues Global Arms Build-Up Continues   We are bullish on risk assets next year, but our view is driven largely from the birth of a new economic cycle, not from geopolitics. Geopolitical risk is rapidly becoming underrated, judging by the steep drop-off in measured risk. There is no going back to a pre-Trump, pre-Xi Jinping, pre-2008, pre-Putin, pre-9/11, pre-historical golden age in which nations were enlightened, benign, and focused exclusively on peace and prosperity. Hard data, such as military spending, show the world moving in the opposite direction (Chart 6). So while stock markets will grind higher next year, investors should not expect that Biden and the vaccine truly portend a “return to normalcy.” Key View #1: China’s Communist Party Turns 100, With Rising Headwinds Investors should ignore the hype about the Chinese Communist Party’s one hundredth birthday in 2021. Since 1997, the Chinese leadership has laid great emphasis on this “first centenary” as an occasion by which China should become a moderately prosperous society. This has been achieved. China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Chart 7China: Less Money, More Problems China: Less Money, More Problems China: Less Money, More Problems The big day, July 1, will be celebrated with a speech by General Secretary Xi Jinping in which he reiterates the development goals of the five-year plan. This plan – which doubles down on import substitution and the aggressive tech acquisition campaign – will be finalized in March, along with Xi’s yet-to-be released vision for 2035, which marks the halfway point to the “second centenary,” 2049, the hundredth birthday of the regime. Xi’s 2035 goals may contain some surprises but the Communist Party’s policy frameworks should be seen as “best laid plans” that are likely to be overturned by economic and geopolitical realities. It was easier for the country to meet its political development targets during the period of rapid industrialization from 1979-2008. Now China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Potential growth is slowing with the graying of society and the country is making a frantic dash, primarily through technology acquisition, to boost productivity and keep from falling into the “middle income trap” (Chart 7). Total debt levels have surged as Beijing attempts to make this transition smoothly, without upsetting social stability. Households and the government are taking on a greater debt load to maintain aggregate demand while the government tries to force the corporate sector to deleverage in fits and starts (Chart 8). The deleveraging process is painful and coincides with a structural transition away from export-led manufacturing. Beijing likely believes it has already led de-industrialization proceed too quickly, given the huge long-term political risks of this process, as witnessed in the US and UK. The fourteenth five-year plan hints that the authorities will give manufacturing a reprieve from structural reform efforts (Chart 9). Chart 8China Struggles To Dismount Debt Bubble China Struggles To Dismount Debt Bubble China Struggles To Dismount Debt Bubble Chart 9China Will Slow De-Industrialization, Stoking Protectionism China Will Slow De-Industrialization, Stoking Protectionism China Will Slow De-Industrialization, Stoking Protectionism Chart 10China Already Reining In Stimulus China Already Reining In Stimulus China Already Reining In Stimulus A premature resumption of deleveraging heightens domestic economic risks. The trade war and then the pandemic forced the Xi administration to abandon its structural reform plans temporarily and drastically ease monetary, fiscal, and credit policy to prevent a recession. Almost immediately the danger of asset bubbles reared its head again. Because the regime is focused on containing systemic financial risk, it has already begun tightening monetary policy as the nation heads into 2021 – even though the rest of the world has not fully recovered from the pandemic (Chart 10). The risk of over-tightening is likely to be contained, since Beijing has no interest in undermining its own recovery. But the risk is understated in financial markets at the moment and, combined with American fiscal risks due to gridlock, this familiar Chinese policy tug-of-war poses a clear risk to the global recovery and emerging market assets next year. Far more important than the first centenary, or even General Secretary Xi’s 2035 vision, is the impending leadership rotation in 2022. Xi was originally supposed to step down at this time – instead he is likely to take on the title of party chairman, like Mao, and aims to stay in power till 2035 or thereabouts. He will consolidate power once again through a range of crackdowns – on political rivals and corruption, on high-flying tech and financial companies, on outdated high-polluting industries, and on ideological dissenters. Beijing must have a stable economy going into its five-year national party congresses, and 2022 is no different. But that goal has largely been achieved through this year’s massive stimulus and the discovery of a global vaccine. In a risk-on environment, the need for economic stability poses a downside risk for financial assets since it implies macro-prudential actions to curb bubbles. The 2017 party congress revealed that Xi sees policy tightening as a key part of his policy agenda and power consolidation. In short, the critical twentieth congress in 2022 offers no promise of plentiful monetary and credit stimulus (Chart 11). All investors can count on is the minimum required for stability. This is positive for emerging markets at the moment, but less so as the lagged effects of this year’s stimulus dissipate. Chart 11No Promise Of Major New Stimulus For Party Congress 2022 No Promise Of Major New Stimulus For Party Congress 2022 No Promise Of Major New Stimulus For Party Congress 2022 Not only will Chinese domestic policy uncertainty remain underestimated, but geopolitical risk will also do so. Superficially, Beijing had a banner year in 2020. It handled the coronavirus better than other countries, especially the US, thus advertising Xi Jinping’s centralized and statist governance model. President Trump lost the election. Regardless of why Trump lost, his trade war precipitated a manufacturing slowdown that hit the Rust Belt in 2019, before the virus, and his loss will warn future presidents against assaulting China’s economy head-on, at least in their first term. All of this is worth gold in Chinese domestic politics. Chart 12China’s Image Suffered In Spite Of Trump 2021 Key Views: No Return To Normalcy 2021 Key Views: No Return To Normalcy Internationally, however, China’s image has collapsed – and this is in spite of Trump’s erratic and belligerent behavior, which alienated most of the world and the US’s allies (Chart 12). Moreover, despite being the origin of COVID-19, China’s is one of the few economies that thrived this year. Its global manufacturing share rose. While delaying and denying transparency regarding the virus, China accused other countries of originating the virus, and unleashed a virulent “wolf warrior” diplomacy, a military standoff with India, and a trade war with Australia. The rest of Asia will be increasingly willing to take calculated risks to counterbalance China’s growing regional clout, and international protectionist headwinds will persist. The United States will play a leading part in this process. Sino-American strategic tensions have grown relentlessly for more than a decade, especially since Xi Jinping rose to power, as is evident from Chinese treasury holdings (Chart 13). The Biden administration will naturally seek a diplomatic “reset” and a new strategic and economic dialogue with China. But Biden has already indicated that he intends to insist on China’s commitments under Trump’s “phase one” trade deal. He says he will keep Trump’s sweeping Section 301 tariffs in place, presumably until China demonstrates improvement on the intellectual property and tech transfer practices that provided the rationale for the tariffs. Biden’s victory in the Rust Belt ensures that he cannot revert to the pre-Trump status quo. Indeed Biden amplifies the US strategic challenge to China’s rise because he is much more likely to assemble a “grand alliance” or “coalition of the willing” focused on constraining China’s illiberal and mercantilist policies. Even the combined economic might of a western coalition is not enough to force China to abandon its statist development model, but it would make negotiations more likely to be successful on the West’s more limited and transactional demands (Chart 14). Chart 13The US-China Divorce Pre-Dates And Post-Dates Trump The US-China Divorce Pre-Dates And Post-Dates Trump The US-China Divorce Pre-Dates And Post-Dates Trump Chart 14Biden's Grand Alliance A Danger To China Biden's Grand Alliance A Danger To China Biden's Grand Alliance A Danger To China The Taiwan Strait is ground zero for US-China geopolitical tensions. The US is reviving its right to arm Taiwan for the sake of its self-defense, but the US commitment is questionable at best – and it is this very uncertainty that makes a miscalculation more likely and hence conflict a major tail risk (Chart 15). True, Beijing has enormous economic leverage over Taiwan, and it is fresh off a triumph of imposing its will over Hong Kong, which vindicates playing the long game rather than taking any preemptive military actions that could prove disastrous. Nevertheless, Xi Jinping’s reassertion of Beijing and communism is driving Taiwanese popular opinion away from the mainland, resulting in a polarizing dynamic that will be extremely difficult to bridge (Chart 16). If China comes to believe that the Biden administration is pursuing a technological blockade just as rapidly and resolutely as the Trump administration, then it could conclude that Taiwan should be brought to heel sooner rather than later. Chart 15US Boosts Arms Sales To Taiwan 2021 Key Views: No Return To Normalcy 2021 Key Views: No Return To Normalcy Chart 16Taiwan Strait Risk Will Explode If Biden Seeks Tech Blockade 2021 Key Views: No Return To Normalcy 2021 Key Views: No Return To Normalcy Bottom Line: On a secular basis, China faces rising domestic economic risks and rising geopolitical risk. Given the rally in Chinese currency and equities in 2021, the downside risk is greater than the upside risk of any fleeting “diplomatic reset” with the United States. Emerging markets will benefit from China’s stimulus this year but will suffer from its policy tightening over time. Key View #2: The US “Pivot To Asia” Is Back On … And Runs Through Iran Most likely President-elect Biden will face gridlock at home. His domestic agenda largely frustrated, he will focus on foreign policy. Given his old age, he may also be a one-term president, which reinforces the need to focus on the achievable. He will aim to restore the Obama administration’s foreign policy, the chief features of which were the 2015 nuclear deal with Iran and the “Pivot to Asia.” The US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. The purpose of the Iranian deal was to limit Iran’s nuclear and regional ambitions, stabilize Iraq, create a semblance of regional balance, and thus enable American military withdrawal. The US could have simply abandoned the region, but Iran’s ensuing supremacy would have destabilized the region and quickly sucked the US back in. The newly energy independent US needed a durable deal. Then it could turn its attention to Asia Pacific, where it needed to rebuild its strategic influence in the face of a challenger that made Iran look like a joke (Chart 17). Chart 17The "Pivot To Asia" In A Nutshell The "Pivot To Asia" In A Nutshell The "Pivot To Asia" In A Nutshell It is possible for Biden to revive the Iranian deal, given that the other five members of the agreement have kept it afloat during the Trump years. Moreover, since it was always an executive deal that lacked Senate approval, Biden can rejoin unilaterally. However, the deal largely expires in 2025 – and the Trump administration accurately criticized the deal’s failure to contain Iran’s missile development and regional ambitions. Therefore Biden is proposing a renegotiation. This could lead to an even greater US-Iran engagement, but it is not clear that a robust new deal is feasible. Iran can also recommit to the old deal, having taken only incremental steps to violate the deal after the US’s departure – manifestly as leverage for future negotiations. Of course, the Iranians are not likely to give up their nuclear program in the long run, as nuclear weapons are the golden ticket to regime survival. Libya gave up its nuclear program and was toppled by NATO; North Korea developed its program into deliverable nuclear weapons and saw an increase in stature. Iran will continue to maintain a nuclear program that someday could be weaponized. Nevertheless, Tehran will be inclined to deal with Biden. President Hassan Rouhani is a lame duck, his legacy in tatters due to Trump, but his final act in office could be to salvage his legacy (and his faction’s hopes) by overseeing a return to the agreement prior to Iran’s presidential election in June. From Supreme Leader Ali Khamenei’s point of view, this would be beneficial. He also needs to secure his legacy, but as he tries to lay the groundwork for his power succession, Iran faces economic collapse, widespread social unrest, and a potentially explosive division between the Iranian Revolutionary Guard Corps and the more pragmatic political faction hoping for economic opening and reform. Iran needs a reprieve from US maximum pressure, so Khamenei will ultimately rejoin a limited nuclear agreement if it enables the regime to live to fight another day. In short, the US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. But this is precisely why conflict could erupt in 2021. First, either in Trump’s final days in office or in the early days of the Biden administration, Israel could take military action – as it has likely done several times this year already – to set back the Iranian nuclear program and try to reinforce its own long-term security. Second, the Biden administration could decide to utilize the immense leverage that President Trump has bequeathed, resulting in a surprisingly confrontational stance that would push Iran to the brink. This is unlikely but it may be necessary due to the following point. Third, China and Russia could refuse to cooperate with the US, eliminating the prospect of a robust renegotiation of the deal, and forcing Biden to choose between accepting the shabby old deal or adopting something similar to Trump’s maximum pressure. China will probably cooperate; Russia is far less certain. Beijing knows that the US intention in Iran is to free up strategic resources to revive the US position in Asia, but it has offered limited cooperation on Iran and North Korea because it does not have an interest in their acquiring nuclear weapons and it needs to mitigate US hostility. Biden has a much stronger political mandate to confront China than he does to confront Iran. Assuming that the Israelis and Saudis can no more prevent Biden’s détente with Iran than they could Obama’s, the next question will be whether Biden effectively shifts from a restored Iranian deal to shoring up these allies and partners. He can possibly build on the Abraham Accords negotiated by the Trump administration smooth Israeli ties with the Arab world. The Middle East could conceivably see a semblance of balance. But not in 2021. The coming year will be the rocky transition phase in which the US-Iran détente succeeds or fails. Chart 18Oil Market Share War Preceded The Last US-Iran Deal Oil Market Share War Preceded The Last US-Iran Deal Oil Market Share War Preceded The Last US-Iran Deal Chart 19Still, Base Case Is For Rising Oil Prices Still, Base Case Is For Rising Oil Prices Still, Base Case Is For Rising Oil Prices Chart 20Biden Needs A Credible Threat Biden Needs A Credible Threat Biden Needs A Credible Threat The lead-up to the 2015 Iranian deal saw a huge collapse in global oil prices due to a market share war with Saudi Arabia, Russia, and the US triggered by US shale production and Iranian sanctions relief (Chart 18). This was despite rising global demand and the emergence of the Islamic State in Iraq. In 2021, global demand will also be reviving and Iraq, though not in the midst of full-scale war, is still unstable. OPEC 2.0 could buckle once again, though Moscow and Riyadh already confirmed this year that they understand the devastating consequences of not cooperating on production discipline. Our Commodity and Energy Strategy projects that the cartel will continue to operate, thus drawing down inventories (Chart 19). The US and/or Israel will have to establish a credible military threat to ensure that Iran is in check, and that will create fireworks and geopolitical risks first before it produces any Middle Eastern balance (Chart 20). Bottom Line: The US and Iran are both driven to revive the 2015 nuclear deal by strategic needs. Whether a better deal can be negotiated is less likely. The return to US-Iran détente is a source of geopolitical risk in 2021 though it should ultimately succeed. The lower risk of full-scale war is negative for global oil prices but OPEC 2.0 cartel behavior will be the key determiner. The cartel flirted with disaster in 2020 and will most likely hang together in 2021 for the sake of its members’ domestic stability. Key View #3: Europe Wins The US Election Chart 21Europe Won The US Election Europe Won The US Election Europe Won The US Election The European Union has not seen as monumental of a challenge from anti-establishment politicians over the past decade as have Britain and America. The establishment has doubled down on integration and solidarity. Now Europe is the big winner of the US election. Brussels and Berlin no longer face a tariff onslaught from Trump, a US-instigated global trade war, or as high of a risk of a major war in the Middle East. Biden’s first order of business will be reviving the trans-Atlantic alliance. Financial markets recognize that Europe is the winner and the euro has finally taken off against the dollar over the past year. European industrials and small caps outperformed during the trade war as well as COVID-19, a bullish signal (Chart 21). Reinforcing this trend is the fact that China is looking to court Europe and reduce momentum for an anti-China coalition. The center of gravity in Europe is Germany and 2021 faces a major transition in German politics. Chancellor Angela Merkel will step down at long last. Her Christian Democratic Union is favored to retain power after receiving a much-needed boost for its handling of this year’s crisis (Chart 22), although the risk of an upset and change of ruling party is much greater than consensus holds. Chart 22German Election Poses Political Risk, Not Investment Risk German Election Poses Political Risk, Not Investment Risk German Election Poses Political Risk, Not Investment Risk However, from an investment point of view, an upset in the German election is not very concerning. A left-wing coalition would take power that would merely reinforce the shift toward more dovish fiscal policy and European solidarity. Either way Germany will affirm what France affirmed in 2017, and what France is on track to reaffirm in 2022: that the European project is intact, despite Brexit, and evolving to address various challenges. The European project is intact, despite Brexit, and evolving to address various challenges. This is not to say that European elections pose no risk. In fact, there will be upsets as a result of this year’s crisis and the troubled aftermath. The countries with upcoming elections – or likely snap elections in the not-too-distant future, like Spain and Italy – show various levels of vulnerability to opposition parties (Chart 23). Chart 23Post-COVID EU Elections Will Not Be A Cakewalk Post-COVID EU Elections Will Not Be A Cakewalk Post-COVID EU Elections Will Not Be A Cakewalk Chart 24Immigration Tailwind For Populism Subsided Immigration Tailwind For Populism Subsided Immigration Tailwind For Populism Subsided The chief risks to Europe stem from fiscal normalization and instability abroad. Regime failures in the Middle East and Africa could send new waves of immigration, and high levels of immigration have fueled anti-establishment politics over the past decade. Yet this is not a problem at the moment (Chart 24). And even more so than the US, the EU has tightened border enforcement and control over immigration (Chart 25). This has enabled the political establishment to save itself from populist discontent. The other danger for Europe is posed by Russian instability. In general, Moscow is focusing on maintaining domestic stability amid the pandemic and ongoing economic austerity, as well as eventual succession concerns. However, Vladimir Putin’s low approval rating has often served as a warning that Russia might take an external action to achieve some limited national objective and instigate opposition from the West, which increases government support at home (Chart 26). Chart 25Europe Tough On Immigration Like US Europe Tough On Immigration Like US Europe Tough On Immigration Like US Chart 26Warning Sign That Russia May Lash Out Warning Sign That Russia May Lash Out Warning Sign That Russia May Lash Out Chart 27Russian Geopolitical Risk Premium Rising Russian Geopolitical Risk Premium Rising Russian Geopolitical Risk Premium Rising The US Democratic Party is also losing faith in engagement with Russia, so while it will need to negotiate on Iran and arms reduction, it will also seek to use sanctions and democracy promotion to undermine Putin’s regime and his leverage over Europe. The Russian geopolitical risk premium will rise, upsetting an otherwise fairly attractive opportunity relative to other emerging markets (Chart 27). Bottom Line: The European democracies have passed a major “stress test” over the past decade. The dollar will fall relative to the euro, in keeping with macro fundamentals, though it will not be supplanted as the leading reserve currency. Europe and the euro will benefit from the change of power in Washington, and a rise in European political risks will still be minor from a global point of view. Russia and the ruble will suffer from a persistent risk premium. Investment Takeaways As the “Year of the Rat” draws to a close, geopolitical risk and global policy uncertainty have come off the boil and safe haven assets have sold off. Yet geopolitical risk will remain elevated in 2021. The secular drivers of the dramatic rise in this risk since 2008 have not been resolved. To play the above themes and views, we are initiating the following strategic investment recommendations: Long developed market equities ex-US – US outperformance over DM has reached extreme levels and the global economic cycle and post-pandemic revival will favor DM-ex-US. Long emerging market equities ex-China – Emerging markets will benefit from a falling dollar and commodity recovery. China has seen the good news but now faces the headwinds outlined above. Long European industrials relative to global – European equities stand to benefit from the change of power in Washington, US-China decoupling, and the global recovery. Long Mexican industrials versus emerging markets – Mexico witnessed the rise of an American protectionist and a landslide election in favor of a populist left-winger. Now it has a new trade deal with the US and the US is diversifying from China, while its ruling party faces a check on its power via midterm elections, and, regardless, has maintained orthodox economic policy. Long Indian equities versus Chinese – Prime Minister Narendra Modi has a single party majority, four years on his political clock, and has recommitted to pro-productivity structural reforms. The nation is taking more concerted action in pursuit of economic development since strategic objectives in South Asia cannot be met without greater dynamism. The US, Japan, Australia, and other countries are looking to develop relations as they diversify from China.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

Highlights Iran is second only to China as a target for President Trump during his “lame duck” two months in office. There is plenty of spare capacity to absorb oil supply disruptions, however. President-Elect Biden will rejoin the 2015 Iranian nuclear deal, but the process will be rocky and we are far from a balance of power in the Middle East. The impact on oil supply is positive but the recovery of global demand will push oil prices up over time regardless. Now is not the right time to go long Middle Eastern equities as a reflation trade. We favor the Trans-Pacific Partnership countries. Israeli stocks can continue outperforming Middle East bourses as a whole, but the rotation from growth to value stocks will benefit other bourses. Prefer the UAE to Turkey, where a large political risk premium will persist. Feature Dear Client, With the US election largely complete, this week marks the return to our regular coverage of global market-relevant political risks. Over the past several months we have focused heavily on every aspect of the US election. The effort was worth it: our final forecast of Democratic White House and a Republican Senate came to pass and our trade recommendations generally performed as expected. Nevertheless it is time to refresh and expand our views on other markets and topics. Geopolitical Strategy has always been – necessarily – a global service offering global coverage. Recent events in China, Europe, Russia, Turkey, and the Middle East demand greater attention – and clients have told us as much. Moreover, with promising vaccine candidates on the horizon, major questions are emerging about what the post-pandemic world will bring. To this end we are returning to our roots with weekly offerings on the full range of global affairs. This week we give you a Special Report on the future of the Middle East by one of BCA’s up-and-coming strategists, Roukaya Ibrahim. We know you will find her post-Trump outlook on the region insightful. As always, we look forward to hearing from you about your research needs and what we can do to answer your geopolitical and investment questions in a timely and actionable manner. Sincerely, Matt Gertken Vice President Geopolitical Strategy The Middle East is about to become a major source of geopolitical risk again. First, President Trump remains in office for two months and is rushing to cement his legacy on the way out. Second, President-Elect Joe Biden will likely face gridlock at home and therefore concentrate the first two years of his presidency on foreign policy. Iran is a priority for both presidents. Biden will rejoin the Joint Comprehensive Plan of Action (JCPA), the 2015 nuclear deal with Iran, which Trump pulled out of in 2018. The purpose of the JCPA was to wind down the US war in Iraq and then “pivot” to Asia, where the US has a much greater interest at stake in managing China’s rise (Chart 1). Chart 1Biden To Restore Obama's 'Pivot To Asia' Biden To Restore Obama's 'Pivot To Asia' Biden To Restore Obama's 'Pivot To Asia' Chart 2Squint To See Iran ... US Will Focus On China Squint To See Iran ... US Will Focus On China Squint To See Iran ... US Will Focus On China China poses a major challenge to the US while Iran poses a minor challenge (Chart 2). Biden’s aim will be to restore President Obama’s legacy. Given that the US president has unilateral authority on foreign policy, and that the 2015 deal was an executive deal without Senate approval, Biden has a good chance of success. But conditions are much less propitious than in 2015. He will not improve on the terms of the 2015 deal. Any return to a nuclear agreement and deeper understanding with Iran should ultimately reduce tensions in the Middle East. But the pathway to a new regional power equilibrium is rocky. So geopolitical risk is frontloaded and will be a near-term negative factor for Middle Eastern equities, which otherwise stand to benefit from global economic recovery. Restoring Iranian oil exports will increase global oil supply but geopolitical conflict will occasionally reduce supply. As always Iraq, wedged between Iran and US allies, is the central battleground for the power struggle in the Middle East (Map 1). Over a six-to-twelve month time frame, the global economy should recover and oil prices should trend upward. Map 1The Persian Gulf Is Filled With Black Swan Risks The Middle East After Trump And COVID-19 The Middle East After Trump And COVID-19 Biden Looks To Withdraw Like Obama And Trump Chart 3Biden May Regulate, But US Stays Energy-Independent Biden May Regulate, But US Stays Energy-Independent Biden May Regulate, But US Stays Energy-Independent The US’s ascent toward energy self-sufficiency and its geopolitical decline vis-à-vis China have forced Washington to revise its foreign policy over the past decade, resulting in a strategic divestment from the Middle East (Chart 3). The “Pivot to Asia” is a strategic reality evident in the shift in US military commitments – and Trump has ordered new drawdowns on his way out of office. China’s increasing geopolitical pressure on Australia and rising saber-rattling in the Taiwan Strait highlights the need for the energy-independent US to attend to allies elsewhere. The American public’s view of the Middle East as a strategic quagmire is now producing its third presidency. Obama, Trump, and Biden have all pledged to end the country’s “forever wars” in various ways. The risk to this trend, ironically, was Trump’s aggressive policy on Iran. He revoked Obama’s signature diplomatic achievement and tried to squash Iran’s regional role through “maximum pressure” sanctions and occasional military strikes. He also reinforced US allies Israel and Saudi Arabia, rather than trying to rein them in as Obama had done. Biden’s victory implies that the US will once again favor diplomacy and détente with Iran. Although Iran may make a show of resistance to Biden’s overtures and raise its price so as not to appear to have capitulated to the US, it ultimately has little choice. Its economy is on its last legs, it faces widespread popular unrest, and its sphere of influence is crumbling. Hence constraints on both sides point to a restored nuclear deal. The first obstacle is immediate. President Trump’s “lame duck” period through January 20 is a window of opportunity for Israel or Saudi Arabia to make strategic gains while still enjoying full American support. We highlight the allies because they have much more to fear from Iranian power than the US, and more to lose if the Biden administration appeases Iran. The Trump administration has allegedly reviewed options to launch strikes against Iran since the election, but he has also allegedly ruled against them (as in June 2019). While Trump could still take some kind of action, he would likely face obstruction from the Department of Defense if he tried to do anything that would trigger a full-fledged war in his final two months. It falls to the allies then – or Iran – if conflict is to erupt in the near term. Obama, Trump, and Biden have all pledged to end the country’s "forever wars" in various ways. Cyber-attacks on Iranian nuclear sites this summer are a case in point (Table 1). Suspicious explosions, including at the preeminent Natanz nuclear site, were rumored to be the work of Israel and the United States and raised the specter of a military escalation. However, Iran stuck to its policy of “strategic patience,” hoping for a Biden win. Table 1US And Israel Suspected Of Sabotaging Iran This Year The Middle East After Trump And COVID-19 The Middle East After Trump And COVID-19 It is possible that elements within the Iranian regime, such as the Iranian Revolutionary Guard Corps (IRGC), could launch attacks to deter further sabotage against their infrastructure and capabilities. The IRGC is focused on rigging the 2021 presidential election and ensuring its ascendancy within the Iranian state ahead of the 82 year-old Supreme Leader Ali Khamenei’s succession, so it cannot be assumed to be quiet. The legacy of the outgoing President Rouhani – a relative moderate in Iran’s political scene – hinges on the success of the 2015 agreement, which he pledged would bring economic prosperity to Iran. The deal’s near-collapse has blighted this legacy and triggered a resurgence of hardliners in Iranian politics. This is clear from the February legislative elections in which hardliners won by a landslide (Chart 4). The hardening of the regime will continue, as Khamenei and the IRGC are increasingly focused on solidifying the regime’s security and authority prior to the succession. The next president will almost certainly be a hardliner reminiscent of Mahmoud Ahmadinejad. Oil price volatility should be expected, but over time the vaccine will secure the global economic recovery and oil prices will rise. Still, we assign low odds to Iran instigating a war or pulling out of the JCPA. The past two years have raised the specter of regime collapse. Khamenei is more likely to keep his eye on the prize: a diplomatic agreement with Biden that eases sanctions and thus enables the regime to live to fight another day. This would be his crowning achievement. The change in US leadership offers Tehran an excuse to renegotiate the 2015 deal and blame Trump as an idiosyncratic deviation from an agreement that lay in Iran’s interest. As long as Khamenei retains control of the IRGC this is our base case. Israel is limited in its ability to wage war against Iran alone, but it is not incapable of surgical strikes to set back the clock on the nuclear program, especially if the Trump administration is there to provide assistance in an exigency. The risk is not negligible. Trump’s former National Security Adviser H. R. McMaster has already warned that Israel could act on the “Begin Doctrine” of preemptive strikes against would-be nuclear powers in its neighborhood. While the near-term risk of conflict would remove oil supply, there is a simultaneous risk that cartel behavior would increase supply. Iran’s regional rivals have an interest in preventing a US-Iran deal, but they could not do so in 2015 and ultimately cannot do so today. Therefore they will seek to shore up their political strength in Iraq while undermining the Iranian economy. Saudi Arabia and other oil-producing GCC states benefit from the maximum pressure sanctions that have wiped out Iranian crude exports. The collapse in oil markets is weighing heavily on these economies. An Iranian deal would bring an additional 1mm b/d – 1.5 mm b/d of crude to global markets in short order. Arab petro-states will not cut back on their own production to make room for Iranian crude. They may try to grab greater oil market share ahead of any surge in Iranian exports. In the current oil market environment, Iran has more to lose from the status quo than do its Arab rivals. While ongoing conflict would add to the multiple crises facing Arab oil producers, the risk to oil production is less relevant today than it was at the top of the business cycle. OPEC 2.0 production is ostensibly capped at 36.42 mm b/d but there is plenty of spare capacity to make up for conflict-induced losses (Chart 5). Chart 4Hardliners Roaring Back To Power In Iran The Middle East After Trump And COVID-19 The Middle East After Trump And COVID-19 Chart 5Plenty Of Spare Oil Production Capacity Plenty Of Spare Oil Production Capacity Plenty Of Spare Oil Production Capacity Bottom Line: Biden’s election ensures that he will try to revive the Iranian nuclear deal and pivot to Asia. While this is positive for Middle Eastern stability over the medium term, it comes with near-term risks. A “lame duck” President Trump or Israel could strike out against Iran. The Gulf Arabs will do what they can to undermine Iran as well. Oil price volatility should be expected, but over the long run the main tendency will be for the global economy to recover and hence for oil prices to rise. Iraq: A Persistent Source Of Instability Iraq is the fulcrum of the US-Iran conflict, as witnessed in January with the US assassination of Quds Force commander Qassem Suleimani. Torn between Tehran and Riyadh, Baghdad remains in political crisis and is the chief battleground in the regional power struggle. Prime Minister Mustafa al-Kadhimi is still struggling to bring Iraq’s various militias, many backed by Iran, under the control of the state. The US embassy, military bases, and other interests have been under attack throughout the summer, prompting Secretary of State Mike Pompeo to threaten to withdraw the US embassy from Baghdad (Table 2). As in the past any escalation between Iran and the US will likely occur in Iraq. Table 2Iran Adopting Deterrence Strategy In Iraq The Middle East After Trump And COVID-19 The Middle East After Trump And COVID-19 Beyond Trump’s lame duck period, if Washington looks to normalize relations with Iran, then various Iraqi and Saudi forces will try to make sure that Iraq remains independent. Iraq is the critical strategic buffer zone for Saudi Arabia and it will use its leverage with Sunni forces inside Iraq to oppose Iranian domination and warn the US against giving too much to Iran. The problem for Iraq is that the US is divesting from the region and Biden will focus on the Iranian deal to the neglect of other issues. As a result the Saudis will escalate their influence campaign and Iraq will remain unstable. Bottom Line: Iraq is ground zero for the creation of a new regional power equilibrium. If the US manages to secure its allies, even while reviving the Iranian deal, then Iraq has a prospect of stabilization. But the insecurity of US allies will predominate so Iraq remains at risk of instability, militancy, and oil supply disruptions. A New Dawn? Unification to counter Iran is the chief motive behind the Abraham Peace Accords signed between Israel and the UAE, Bahrain, and Sudan with the Trump administration’s mediation (Table 3). Table 3The Abraham Accords Unify Iran’s Regional Rivals The Middle East After Trump And COVID-19 The Middle East After Trump And COVID-19 Although Israel and the UAE had already been cooperating and sharing intelligence, the deal creates a formal diplomatic partnership against Iran that the countries will need even more as the US pivots to Asia. From Washington’s perspective, the deal enables it to reduce its direct management of the region and delegate authority to its ally and partners. While Saudi Arabia did not sign a deal with Israel, it has signaled a change in strategy. Bahrain is ultimately a Saudi proxy and would not have signed the agreement without Riyadh’s blessing. Moreover, the decision to open Saudi airspace to Israeli airplanes highlights closer cooperation. Additional motives that helped seal the deal: President Trump sought a foreign policy win ahead of the election. The deal reflects his promise to withdraw from the Middle East. Having won 48% of the popular vote, Trump’s approach will loom large over the Republican Party. Israeli Prime Minister Benjamin Netanyahu hoped the deal would secure him a political win amid unpopularity at home. Israel was not even forced to accede to the UAE’s demand to halt the annexation of the West Bank: Netanyahu merely announced that annexation was postponed. And on October 14, only a month after the accords were signed, Israel approved new settler homes in the occupied West Bank. For the UAE, the deal requires little effort but is economically and militarily beneficial. It improves its chances of purchasing long-sought F-35 fighter jets from the US. It is also consequential that the UAE was the first to sign the deal. Abu Dhabi is seeking to raise its stature as a regional power. It has engaged in various Middle Eastern conflicts including in Libya and Yemen and is the only Arab state to have committed troops to Afghanistan for security and humanitarian missions. The UAE has also expanded its influence by being the top source of capex investments in the region (Chart 6). It has emerged as a model Arab state and seeks to replicate that success in its geopolitical status (Chart 7). Chart 6UAE The Top Mideast Investor The Middle East After Trump And COVID-19 The Middle East After Trump And COVID-19 Ultimately the Abraham Accords reflect a shift in Middle Eastern politics to address the US’s withdrawal and changing landscape. The deal’s signatories seek to improve ties not only to face Iran but also to face Turkey, Russia, and even China. Chart 7UAE Leads The Pack The Middle East After Trump And COVID-19 The Middle East After Trump And COVID-19 Opinion polls suggest that young Arabs’ favorable perception of the US are linked to its involvement in the region. Their perception of the US as an ally, or somewhat of an ally, increased post-2018 when President Trump initiated his maximum pressure campaign on Iran (Chart 8). Chart 8US Image Has Bottomed Among Arab Youth The Middle East After Trump And COVID-19 The Middle East After Trump And COVID-19 The Abraham Accords are also significant in that they mark a departure from the Arab Peace Initiative. The Initiative conditions normalization of Arab relations with Israel on Israeli withdrawal from the West Bank, Gaza Strip, Golan Heights, and Lebanon. Until recently, this initiative was a hallmark of regional diplomacy. Palestinians of course have rejected the Abraham Accords and expressed dismay at what they perceive to be disloyalty. Their sidelining could result in an increase in radicalism and militant activity in Israel, though Biden’s election will now blunt that effect and put new demands on Israel. Similarly, Turkey and Qatar oppose the agreement. The rift will widen between the authoritarian states (the GCC and Egypt) and those in favor of political Islam (Turkey and Qatar). Unlike Israel’s previous peace treaties with Egypt and Jordan, which did not result in any economic gains, bilateral economic cooperation is a cornerstone of the Abraham Accords (Table 4). Thus the agreement not only explicitly aligns geopolitical positions in the Middle East, it also weaves Israel into the region’s economies, generating gains for all sides and cementing the partnership. This is a positive example of Trump’s transactional approach to foreign policy. Table 4The Abraham Accords By Sector The Middle East After Trump And COVID-19 The Middle East After Trump And COVID-19 Bottom Line: The Abraham Accords reflect long-developing structural changes in the Middle East. With the US reducing its direct management in the region, Israel and the Arab states are drawing together – particularly in opposition to Iran. If Biden restores the Iranian nuclear deal, there may be a semblance of balance in the region. But its durability will depend on the uncertain willingness of the US to keep the peace. Great Power Struggle Instability stemming from Washington’s shift away from the Middle East is being exacerbated by the competition by great powers and middle powers over filling the power vacuum. Russian and Turkish interference has had mixed results. Both are exerting their influence through greater military engagement in Syria and Libya, in which they have partially stabilized these countries. For instance, Moscow’s 2015 decision to send its air force and some ground troops to Syria reversed President Bashar al-Assad’s fate in Syria, giving him new life. Similarly, Ankara’s increased involvement in the Libyan crisis earlier this year helped the Tripoli-based government drive General Khalifa Haftar’s Libyan National Army back to its eastern enclave. Chart 9AChina Pivots To Middle East China Pivots To Middle East China Pivots To Middle East Yet Russia’s commitment is deliberately limited and likely to become more limited due to increasing domestic political risks. Turkey’s ruling Justice and Development Party has been in power for two decades, is showing economic and political weakness, and is overreaching in international conflicts. Therefore these countries’ interventions do not have a high degree of staying power or predictability. A more durable trend is China’s growing influence in the region. China’s approach emphasizes soft power rather than hard power, but the latter will gradually come into play. China’s main motive is to secure oil supplies. It has emerged as the top oil importer, 46% of which are sourced from the Middle East (Charts 9A and 9B). Chinese interest in the region is evident in its “Comprehensive Strategic Partnerships” (the highest of China’s diplomatic levels) with several key regional actors (Table 5).   Chart 9BChina’s Mideast Dependency Grows The Middle East After Trump And COVID-19 The Middle East After Trump And COVID-19 Rather than interfering in regional politics, China has favored economic cooperation. It has emerged as a top foreign investor in the Arab region (Chart 10 and see Chart 16 below). Table 5China Cultivates Mideast Relations The Middle East After Trump And COVID-19 The Middle East After Trump And COVID-19 Chart 10Awaiting Return Of Chinese Investment The Middle East After Trump And COVID-19 The Middle East After Trump And COVID-19 This approach has been well received by the Arab population, at least the younger generations. The Arab youth see China the most favorably among all the competing foreign actors (Chart 11). Chart 11Arab Youth Have Positive Views Of China The Middle East After Trump And COVID-19 The Middle East After Trump And COVID-19 However, China is also becoming more scrutinizing of its investments in the region. The Belt and Road Initiative is no longer just a blank check. Beijing’s investments are starting to pick up and will continue to revive as its economy recovers in the coming years, but Middle Eastern states will not be able to assume they have China’s unconditional support (Chart 12). Chart 12China's Investment Just Starting To Revive, At Best China's Investment Just Starting To Revive, At Best China's Investment Just Starting To Revive, At Best While China has improved relations with Saudi Arabia and the GCC during the Trump administration’s conflict with Iran, Biden raises the possibility of China reviving its interest in Iran, which is a key linchpin of its Belt and Road Initiative and other strategies of deepening economic relations across Eurasia. Gradually China will take a more obtrusive role. It built its first overseas military base in Djibouti in 2017. Moreover, the strategic pact with Iran it is negotiating, which is likely to be very large even if lower than the official price tag of $400 billion over 25 years, also includes military cooperation. If US-China tensions persist at today’s high levels, China will try to improve its supply security in the Middle East, which will eventually become another front in the new cold war. Bottom Line: The power vacuum left by the US’s reduced commitment to the region has not been filled by any of the major or middle powers. Russian, Chinese, and Turkish actions are unclear and in some cases contradictory. China has the potential to fill in some of the vacuum, but at the moment Chinese strategic involvement is nascent. Détente between the US and Iran clears the way for China to revive relations with Iran, a linchpin of its global, regional, and Eurasian strategy. Economic Progress … Interrupted While these cyclical and structural geopolitical shifts play out, Middle Eastern states also find themselves in a weak economic situation. The double whammy of pandemic and the collapse in oil prices is weighing on household, corporate, and government budgets. It is exposing long-standing vulnerabilities, unwinding recent progress, and introducing new challenges. Arab petro-states face a funding gap in the midst of economic contraction. With oil prices significantly below those needed to balance their budgets, they are re-prioritizing their spending (Chart 13). Chart 13Fiscal Squeeze Hits Arab Petro-States The Middle East After Trump And COVID-19 The Middle East After Trump And COVID-19 While this adjustment has come at the expense of strategic economic plans, in some cases it has also led to an acceleration of fiscal reforms. Oman and Saudi Arabia are cases in point. Oman has been implementing a 5% value-added tax (VAT) since April and plans to impose taxes on high-income earners beginning 2022. Similarly, Saudi Arabia tripled its VAT from 5% to 15%, eliminated a bonus cost-of-living allowance previously granted to public sector employees, and increased custom duties for several imported goods. The immediate aim of these measures is to offset some of the weakness in oil revenues (Chart 14). But over the long run they align with the strategic objective of transitioning from resource-dependent rentier states to economically diverse ones. While the economic shock has weighed on both household and government budgets, the GCC oil producers generally enjoy low debt-to-GDP ratios and comfortable government coffers. They are better positioned than their neighbors to survive the downturn without it morphing into a social, political, or economic crisis. Oil-importing Arab states, on the other hand, face limited fiscal space and have been forced to walk back recent structural reform progress while limiting their fiscal response to the recession (Chart 15). Egypt is highly dependent on tourism and remittances from Arab petro-states. The recession has reversed the improvement in its fiscal situation following austerity measures imposed as part of the three year IMF program. Chart 14Fiscal Reforms Underway The Middle East After Trump And COVID-19 The Middle East After Trump And COVID-19 Chart 15More Stimulus Needed The Middle East After Trump And COVID-19 The Middle East After Trump And COVID-19 That said, as long as nominal GDP outpaces interest on the debt, these countries will avoid a debt crisis. Although Egypt’s 10-year yield is 14.8%, its expected nominal GDP growth of 19.7% this year will ensure debt sustainability. By contrast, Tunisia is more at risk, as the yield on its 10-year government bond is near 10% yet nominal growth lags in the single digits. While policymakers across the region have implemented measures to ease burdens on households through various policies, Gulf Arab states have in some cases limited the benefits to nationals. For instance, the Qatari government announced on June 1 that it would reduce non-Qatari employee wage bills by 30%. While this protects the incomes of GCC nationals, it puts non-nationals at risk of income loss, raising the possibility that weakness among oil-producers will be transferred to non-oil producers. Chart 16Iran Teetering On Edge Iran Teetering On Edge Iran Teetering On Edge This is not to say that GCC nationals are completely immune to income or employment loss. In fact, the unemployment rate among Saudi nationals, which was already higher than the overall unemployment rate, jumped 2.5 pp in the second quarter to 15.5%. The Shia Crescent remains the most vulnerable neighborhood in the Middle East. Syria collapsed over the past decade, Lebanon is in the process of collapse, and Iran and Iraq are teetering (Chart 16). The IMF estimates that Iran needs oil prices at $521.2/bbl to balance its fiscal account! Weakness in Iran has spread across its sphere of influence — i.e. other predominantly Shia states and non-state actors who depend on Tehran for informal funding. Mass protests against poor economic conditions and corruption afflicted Iraq and Lebanon in the fall of 2019, forcing both governments to resign late last year. The political and economic situations have only deteriorated since. The August 4 blast at the Port of Beirut was the final straw for Lebanon which is now facing financial meltdown. Meanwhile, Iraq’s stability continues to be tested. The collapse in oil markets has weighed on government revenues as well as on the current account, which is projected to record a deficit worth 12.6% of GDP this year, following surpluses in the previous years. The good news is that the discovery of a COVID-19 vaccine points to a rebound in global economic activity over the coming 12 months. The bad news is that the virus is breaking out again and the distribution of the vaccine will take time. Eventually the combination of vaccines and additional monetary and fiscal stimulus in the developed world will alleviate some of the Middle East’s deepest strains, but it will be a rocky road. Social and political problems will escalate for some time even after the economy bottoms. Regarding the outlook for oil markets, BCA’s Commodity & Energy Strategists see the confluence of steadily improving demand, a decline in US shale-oil production, and OPEC 2.0 production management pushing oil prices higher. They forecast Brent will average $63 per barrel next year, compared to $44 per barrel at current prices, and they make a good fundamental case for oil to average between $65 - $70 per barrel over the coming five years. The latest readings from global manufacturing PMIs send bullish signals, suggesting that Middle Eastern recovery is gradually underway (Chart 17). It is the near-term that is most treacherous. Chart 17Global Rebound Not A Moment Too Soon Global Rebound Not A Moment Too Soon Global Rebound Not A Moment Too Soon Chart 18New Lockdowns Pose Near-Term Risks The Middle East After Trump And COVID-19 The Middle East After Trump And COVID-19 On the demand-side, COVID-19 cases globally are trending upward with several European countries imposing partial lockdowns (Chart 18). While the lockdowns are unlikely to be as severe as earlier this year, they threaten to delay the recovery in oil markets. In response, the OPEC 2.0 coalition of producers, which was planning to reduce production cuts to 5.7 mm barrel per day in January (leading to higher output) may instead extend the current 7.7 mm barrel per day cuts when it meets again in December 2020. This means petro-states will need to contend with low prices and revenues for longer, while oil importers see shortfalls in remittances. Aside from risks to the oil market, the resurgence in COVID-19 cases adds further uncertainty to the expected recovery in global growth through knock-on effects on activity. Even though not all Middle Eastern countries are experiencing the second wave of the disease, governments have generally tightened stringency measures recently (Chart 19). Chart 19COVID-19 Restrictions Vary By Country The Middle East After Trump And COVID-19 The Middle East After Trump And COVID-19 Bottom Line: Middle Eastern economies have been hit hard by the double whammy of pandemic and oil price collapse. Policy responses have been measured to limit deviation from long-term goals. This is a positive for the long-term outlook. We expect improvements in the global economy and the recovery in oil markets over the coming 12 months to alleviate some of the pressure. However, risks are skewed to the downside and a protracted downturn could put to waste recent structural improvements. Countries that lie in the so-called “Shia Crescent” – Iran, Iraq, and Lebanon – are in dire need of resuscitation. Oil importers face the risk that the cyclical downturn unwinds recent economic improvements and uncovers structural vulnerabilities, weighing on the strategic outlook. Arab petro-states enjoy the most comfortable coffers. But even their economies are at risk, especially in the high-risk scenario in which oil markets do not recover anytime soon. Saudi Arabia and Oman are at a disadvantage versus Qatar in this sense given their outsized dependence on oil and higher fiscal breakeven oil price. Investment Implications Middle Eastern equity market capitalization is growing over time relative to the rest of the world (Chart 20). The region remains a reflation play, with a heavy sectoral focus on materials and financials as well as energy. Thus it stands to benefit over the long run as the global recovery gets underway. Chart 20Investors Gaining Interest In Mideast Over Time Investors Gaining Interest In Mideast Over Time Investors Gaining Interest In Mideast Over Time However, today is not an attractive entry point for the Middle East relative to other emerging markets. The rebalancing of oil markets, the current wave of COVID-19 before the vaccine rollout, and near-term geopolitical risks outlined above imply that the Middle East will face a period of heightened uncertainty and uninspiring equity performance. Protracted economic weakness will weigh on social stability. The oil-rich GCC is least vulnerable to popular unrest as it has the space to be generous to its citizens. But even these countries have had to cut some benefits. The pandemic will erode the social contract currently in place whereby monetary incentives are awarded to make up for the lack of political voice. The Shia Crescent is already in crisis as bouts of mass protests have been occurring in Iran, Iraq, and Lebanon for the past year. And the pandemic has derailed the economic recovery of various states that had only recently gotten back on track after the Arab Spring. Another bout of economic weakness will push people back into the streets, threatening to topple governments again (Chart 21). Chart 21Unrest Will Rise Even After Economic Bottom The Middle East After Trump And COVID-19 The Middle East After Trump And COVID-19 A good entry point into Middle Eastern equities will emerge once the global economy gets onto a better footing as the US and Iran will likely achieve a precarious balance. Geopolitics and the recession are forcing Arab states to adopt greater pragmatism in their economic and foreign policies. Reform policies are creating more diverse economies, as in the case of the UAE (Chart 22), which, unlike Saudi Arabia, is decoupling its equity performance from oil prices. Chart 22UAE About Financials, Saudi About Oil UAE About Financials, Saudi About Oil UAE About Financials, Saudi About Oil The risk to Israel, aside from politics, is that it is a tech-heavy bourse that could start to underperform neighbors like the UAE amid the likely global rotation into value stocks and cyclicals. Chart 23Israel Outperforms, But Beware Rotation To Value Israel Outperforms, But Beware Rotation To Value Israel Outperforms, But Beware Rotation To Value Israel has been outperforming the broad Middle East basket, including the UAE, and that trend looks to continue. But it does not look attractive relative to emerging markets as a whole. The risk to Israel, aside from politics, is that it is a tech-heavy bourse that could start to underperform neighbors like the UAE amid the likely global rotation into value stocks and cyclicals. Israel equity performance relative to Turkey closely tracks global growth versus value stocks (Chart 23). However, we do not recommend playing this specific pair trade. For that we would also need to see an improvement in Turkish governance. Turkey may benefit from global macro developments but its country risk will remain extreme. The recent change of central bank leadership temporarily improved Turkey’s relative performance but does not mark a fundamentally positive turning point in policy, according to BCA’s Emerging Markets Strategist Arthur Budaghyan. President Recep Erdogan is unlikely to adopt orthodox monetary policy and austerity prior to the 2022 elections. The approach of the elections, and several simultaneous foreign adventures, will keep the Turkish political risk premium elevated. Therefore the UAE provides the better long end of a value play on the Middle East.     Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com  

Highlights A Biden victory with a Republican Senate (28% odds) poses the greatest risk to the global reflation trade. The US is the most susceptible to social unrest of all the developed markets. Europe is stable relative to the US, but political risks are rising as new lockdowns go into effect. Emerging markets are also susceptible to social unrest – even those that look best on paper. Chile and Thailand have more downside due to politics, despite underlying advantages. Turkey and Nigeria are among those at risk of major unrest in a post-COVID world. Book gains on EUR-GBP volatility, Indian pharma, and rare earths. Cut losses. Feature This week saw a long-awaited risk-off move in global financial markets. A new wave of COVID lockdowns plus the US failure to pass a fiscal package finally registered with investors. Over the past two months we have argued that rising COVID cases without stimulus would produce a pre-election selloff that would drive the final nail in President Trump’s re-election bid. That should still be the case (Chart 1).  While we are sticking with our view that Biden will win, we have upgraded Trump’s odds from 35% to 45%. We are focused on Trump’s momentum – not alleged polling errors – in Florida and Pennsylvania, and Biden’s loss of altitude in Arizona, as these trends open a clear Electoral College path to another Trump victory (Chart 2). Nevertheless Biden is tied with Trump among men and leads by 17 percentage points among women. He is also in a statistical tie among the elderly.  Chart 1COVID Rising + Stimulus Falling = Red Ink COVID Rising + Stimulus Falling = Red Ink COVID Rising + Stimulus Falling = Red Ink Chart 2Trump's Momentum In Swing States Trump's Momentum In Swing States Trump's Momentum In Swing States   Even assuming Trump’s comeback proves too little, too late, it could produce a contested election in which Trump has constitutional advantages, or a Republican Senate. Either of these two scenarios would extend the election season volatility for one-to-three months. Our updated US election probabilities are shown in Table 1 alongside the odds from the popular online betting site PredictIt.org. Table 1There Is A 72% Chance The Post-Election Policy Setting Will Favor Reflation Election Trades And Global Social Unrest: A GeoRisk Update Election Trades And Global Social Unrest: A GeoRisk Update A Biden victory with a Republican Senate (28% odds) is the only deflationary scenario in the near term, since fiscal stimulus will be reduced in size and uncertain in timing. However, assuming financial market pressure forces senators to agree, this is actually the best outcome over the full two-year Senate election period, since neither tariffs nor corporate taxes would rise. Notably Treasury yields have risen regardless of election scenario, but there is little doubt that this scenario poses the greatest risk to the global reflation trade (Chart 3). Why does this election matter? Trump’s re-election would prolong US political polarization and “maximum pressure” foreign and trade policy. Trump must win through the constitutional system, not the popular vote, so a win would push polarization up. Polarization at home, including Democratic opposition in the House of Representatives, would drive him abroad. By contrast, a Biden win would include a popular majority and might include a united Democratic Congress, which would result in a clear popular mandate and would concentrate Biden's administration on an ambitious domestic agenda.   A Biden victory with a Republican Senate (28% odds) poses the greatest risk to the global reflation trade. Hence Trump’s election would bolster the USD and US equity outperformance, along with global policy uncertainty relative to the United States (Chart 4). Whereas Biden’s election, if it also brings a Democratic Senate, would bolster global equity outperformance, cyclical equities, and US policy uncertainty relative to global. Chart 3Republican Senate Less Reflationary Republican Senate Less Reflationary Republican Senate Less Reflationary Chart 4Trump Would Boost US Equity Outperformance Trump Would Boost US Equity Outperformance Trump Would Boost US Equity Outperformance   The election will have a geopolitical fallout. First, Trump is still president through January 20 regardless of outcome and could take aggressive actions to seal his legacy and lock the Biden administration into conflict with China or Iran. Second, a contested election would create a power vacuum in which other nations could seek to take advantage of American distraction. Third, a Trump victory spells strategic conflict with Iran and China, and either could try to seize the advantage by acting first. Fourth, a Biden win spells confrontation with Russia and ultimately China, and both countries would test his resolve early in his administration. Diagram 1 summarizes these key market takeaways of the US election scenarios. This week we provide our monthly GeoRisk Update with a special focus on our COVID-19 Social Unrest Index and implications for select developed, emerging, and frontier markets. Diagram 1Scenarios For US Election Outcomes And Market Impacts Election Trades And Global Social Unrest: A GeoRisk Update Election Trades And Global Social Unrest: A GeoRisk Update The United States The market can get hit by negative surprises after the US election just as easily as before.1 The US is a powder keg of social and political angst, ranking the worst among developed markets in our COVID-19 Social Unrest Index (Table 2). The lower a country ranks on the list, the less stable it is and the more susceptible to unrest. Social unrest becomes market-relevant if it weighs on consumer or business sentiment, or if it causes a major change in government or policy. Table 2The US Is The Developed Market Most Susceptible To Social Unrest Election Trades And Global Social Unrest: A GeoRisk Update Election Trades And Global Social Unrest: A GeoRisk Update The first US risk is a contested election. By rallying in the swing states in the final weeks of the election, Trump has increased the likelihood of a disputed outcome. Armies of lawyers will descend upon the swing state election boards. The Supreme Court’s intervention in Florida in 2000 has incentivized political parties to seek a judicial intervention, especially if they think they are losing the popular vote narrowly. Mail-in counts, recounts, and other disputes could push up against the December 14 Electoral College voting date. Worse, if the Electoral College is hung, the House of Representatives would have to decide the outcome in January. Volatility and risk-off sentiment would predominate. Emerging markets are showing the first signs of upheaval in the wake of this year’s crisis. The second risk is resistance to the election results. If Trump wins on a constitutional technicality, the country faces widespread unrest. This would be relevant to investors if it paralyzes major cities, exacerbates the COVID outbreak, or snowballs into something big enough to suppress consumer confidence. If Biden wins on a technicality, the country faces not widespread unrest but isolated pockets of potentially armed resistance or domestic terrorist attacks. The FBI, DHS, and recent news events have confirmed the presence of armed or violent extremist groups of various ideological stripes that pose a rising threat in the current climate of pandemic, unemployment, and polarization.2 They could strike any time after the election.     Europe And Brexit Chart 5European Lockdowns Push Up Political Risk European Lockdowns Push Up Political Risk European Lockdowns Push Up Political Risk Europe and Canada have reinstated lockdowns in response to their rise in COVID-19 cases. The surge in political risk is evident from our GeoRisk Indicators (Chart 5). These lockdowns will not be as draconian as earlier this year as the death rate has been found to be lower than once feared. While most governments have time on the political clock to take a hardline approach today, at the start of what could be a nasty winter season, they do not have so much leeway in 2021. Greece, Spain, Italy, the UK, and France are next in line for social unrest, after the US, in our index, Table 2 above. These countries are also vulnerable because fiscal support is not as robust as elsewhere, as can be seen by our global fiscal stimulus tracker (Chart 6). France is in better shape than the others and marks the dividing line – the 2017 election was a turning point in which the political establishment unified to defeat a right-wing populist challenge. President Emmanuel Macron’s popularity is holding up decently and it will now be buttressed by his tough stance against a spate of radical Islamist terrorist attacks. Extremist incidents will continue to be a problem, given the lockdowns and economic slump. Macron will focus on economic reflation in 2021 leading up to an election for which he is clearly favored in spring of 2022. Anything that derails his political trajectory before that time is of great importance for Europe’s political future, since Macron will be the de facto leader once Angela Merkel steps down in October 2022. Italy and Spain will be ongoing sources of political risk. Italy was the first major European hotspot of the pandemic, and euroskeptic attitudes are quietly ticking back up, but the ruling coalition and especially Prime Minister Giuseppe Conte have received popular backing for their handling of the crisis. Spain, on the other hand, has seen Prime Minister Pedro Sánchez lose support, while conservative parties tick up in popular opinion. These two countries are candidates for early elections when the hens come home to roost for the pandemic and recession (Chart 7). Chart 6More Stimulus Needed In Europe Election Trades And Global Social Unrest: A GeoRisk Update Election Trades And Global Social Unrest: A GeoRisk Update Chart 7Europe’s Leaders Fare Better Than Others Election Trades And Global Social Unrest: A GeoRisk Update Election Trades And Global Social Unrest: A GeoRisk Update   The other major countries with looming elections in 2021-22 are seeing relatively positive outcomes in popular opinion (e.g. the Netherlands, Germany). The exception is the UK, which is on the lower end of the social unrest index and is in the midst of internal disruption due to Brexit. Our assessment remains that Prime Minister Boris Johnson and the Tories will have to accept a trade deal with the EU over the next month (Chart 8). They can afford to leave on paper, but the economy would suffer and Scotland’s nationalists would be empowered to attempt secession. Our European Strategist Dhaval Joshi believes a Biden win in the US will hasten Johnson’s capitulation. We don’t expect much more upside in our GBP-EUR volatility trade after the US election result is known (Chart 9).  Chart 8Go Long Sterling Go Long Sterling Go Long Sterling Chart 9Close EUR-GBP Volatility Trade Close EUR-GBP Volatility Trade Close EUR-GBP Volatility Trade Chart 10Trump Would Weigh On Euro Trump Would Weigh On Euro Trump Would Weigh On Euro Trump’s re-election would be negative for the European Union’s economic and political stability (Chart 10). It would portend a greater trade war, Middle Eastern instability and refugees, Russian aggression, or European populism. By contrast, Biden will not use sweeping tariffs to resolve trade tensions, will seek to restore the 2015 nuclear deal with Iran, will suppress anti-establishment politics, will seek a multilateral approach to China trade tensions, and will only substantially aggravate the Europeans by being too aggressive on Russia. EM: Chile And Thailand Emerging markets are showing the first inevitable signs of upheaval in the wake of this year’s global crisis. What is critical to note about our Social Unrest Index for EM is that even if a country ranks high on the list overall, it could still face significant sociopolitical upheaval. This is manifest in the top-ranked countries of our list – Chile, Malaysia, Thailand, Russia, Indonesia – all of which have already seen some degree of social and/or political unrest in this crisis year (Table 3).  Table 3Even Emerging Markets That Look Good On Paper Are Susceptible To Unrest Election Trades And Global Social Unrest: A GeoRisk Update Election Trades And Global Social Unrest: A GeoRisk Update The best example is Chile, which is top-ranked in the index but ranks ninth in the “Household Grievances” column, which measures inequality, inflation, and unemployment. The latter measure helps explain how Chile erupted last fall and again this fall in mass protests. Chart 11Political Risk Weighs On Chile Political Risk Weighs On Chile Political Risk Weighs On Chile Over the past week Chileans voted overwhelmingly in a referendum to revise their constitution with a constitutional convention that will be elected, i.e. not overdetermined by current members of the National Congress. The constitutional revision process is ultimately a positive way for a country with good governance to assuage its household grievances. But the process will continue through a revision process in April 2021, the November 2021 general election, and a final referendum in 2022, ensuring that political risk persists. Chilean assets have fallen short of their expected performance based on global copper prices, suggesting that they have upside in the near term (Chart 11). Positive news is driven by macro fundamentals, including Chinese stimulus, but political risk will periodically put a cap on rallies by highlighting Chile’s transition to expansive social spending, higher debts, and hence future currency risk. Thailand’s case is different, as it is not household grievances per se but rather the ongoing governance problem that is triggering mass protests. The governance problem stems from regional disparities in wealth and representative government. Modern society and pro-growth populism have repeatedly clashed with the royalist political establishment and its military backers over the past 20 years and that process is set to continue. Chart 12Thailand Not Fully Pricing New Instability Cycle Thailand Not Fully Pricing New Instability Cycle Thailand Not Fully Pricing New Instability Cycle The newest round of the crisis will build for some years and ultimately culminate in some degree of bloodshed before a new political settlement is achieved. Typically, over the past 20 years, Thai political unrest creates a buying opportunity for investors. But the previous major wave of unrest, from 2006-14, occurred during the lead-up to the all-important royal succession. Now the succession is “over” and it is not clear that the new king, Vajiralongkorn, will live up to his father’s legacy as a successful arbiter of society’s conflicts. It is possible that he will overreact to domestic opposition and abuse his powers. Our Emerging Markets Strategy has downgraded Thailand in its portfolio, showing that the economy is suffering from insufficient stimulus as a negative credit impulse offsets public spending during the crisis. Thai equities do not offer relative value within the emerging market space at present (Chart 12). Most likely Thai political troubles will continue to provide a buying opportunity, but at the moment the risks are not sufficiently priced. If Chile, Malaysia, and Thailand are already experiencing significant political risk despite their high rankings on our index, then Brazil, South Africa, Turkey, and the Philippines face even greater challenges going forward. We have written about Brazil recently – we continue to see a rising political risk premium there (Chart 13). We will update our views on South Africa and the Philippines in forthcoming special reports. For now we turn to Turkey. Turkey: One Step Forward, Two Steps Back Turkey scores near the bottom of our Social Unrest Index. The regime of President Recep Tayyip Erdogan has been in power for nearly two decades, is suffering cracks in public support, is continuing to suffer the inflationary consequences of populist monetary and fiscal policy, and is embroiled in a range of international adventures and conflicts, now including Nagorno-Karabakh. After a brief pause of tensions in September, we argued that President Recep Tayyip Erdogan’s retreat would be temporary and that geopolitical tensions would re-escalate. They have done so even sooner than we thought. The lira is collapsing, as registered by our GeoRisk Indicator, which is once again on the rise (Chart 14). Chart 13Brazilian Political Risk Nearing 2018 Levels Brazilian Political Risk Nearing 2018 Levels Brazilian Political Risk Nearing 2018 Levels Chart 14Turkish Political Risk Spikes Anew Turkish Political Risk Spikes Anew Turkish Political Risk Spikes Anew   Relations with Europe have worsened significantly. Aggressive rhetoric between Erdogan and Macron in response to France’s treatment of French Muslims and handling of recent terrorist incidents has led to a diplomatic crisis: Paris recalled its ambassador. The episode highlights both Erdogan’s increased assertiveness vis-à-vis the EU as well as his Neo-Ottoman bid to become the leader of the Muslim world. Erdogan has called for a boycott of French goods (alongside similar popular calls in various Muslim countries). The European Commission warned Turkey could face punitive action at its December summit.   The feud in the eastern Mediterranean is also escalating. Turkey’s Oruc Reis seismic research vessel was once again sent out on an exploratory mission in contested waters on October 12. The mission’s duration was extended multiple times.    The EU may impose sanctions as early as December. Brussels' response to Turkish provocations may include targeted anti-dumping measures, likely on steel and fish. There have also been calls to suspend the customs union, but this would require the conflict to rise above rhetoric as it would harm EU investments in Turkey. Turkey is growing even more assertive in its neighborhood with its support for Azerbaijan in the conflict with Armenia. Tensions with Russia are rising yet again. Erdogan is already overextended in Syria and Libya, and recently threatened to launch a new military operation in northern Syria if Kurdish militants do not relocate from along Turkey’s border. The warning follows a Russian airstrike on Turkey-backed Syrian rebels in Idlib earlier this week – the deadliest strike in Idlib since March. Provoking the United States, Turkey also tested its newly purchased Russian S400 missile defense system on October 16. This was swiftly followed by US warnings that Turkey faces US sanctions under the Countering America’s Adversaries Through Sanctions Act if it operationalizes the system. The risk of punitive action would rise under a Biden presidency as he is more likely to adopt a tougher stance on Erdogan than President Trump. Chart 15More Downside For Turkish Lira More Downside For Turkish Lira More Downside For Turkish Lira These developments all point to a continuation in geopolitical tensions, as Erdogan flouts various risks and constraints. Turkey’s relationship with NATO allies is continuing to deteriorate meaningfully. The lira’s collapse is also in response to economic developments. After a surprise 200 basis points rate hike in September, the CBRT disappointed markets by keeping the benchmark 1 week repo rate on hold at its October 22 meeting. Investors had hoped that the September hike marked a reversal of Erdogan’s unorthodox policies. However, the October decision disconfirms this hope, as the central bank is instead opting for stealth measures to raise the cost of funding (e.g. limiting funding at the benchmark rate and thus forcing banks to borrow at higher costs; widening the interest rate corridor to give itself more room to raise the weighted average cost of funding). These decisions come amid rising inflation, debt monetization, a loss in foreign interest in Turkish equities and bonds, and deteriorating budget and current account balances. All point to further lira weakness (Chart 15). Bottom Line: The TRY faces downside pressure from the deteriorating geopolitical and economic backdrop. Although the EU has so far shown restraint in penalizing Ankara, its stance has not dissuaded Erdogan from adopting a provocative foreign policy stance. Moreover tensions with the US are at risk of escalating due to the possibility of a Biden presidency. Economic factors also point to continued weakness as monetary policy is too loose and the CBRT has not abandoned Erdoganomics. Nigeria: No Political Change Waves of protests have erupted across Nigeria in recent weeks, largely driven by the country’s youth. Protests center on calls to end the special anti-robbery squad (SARS), an arm of the national police service, which has long been accused of extrajudicial killings, torture, extortion, and corruption. Most recently, dozens of soldiers and police officers approached the scene of a major protest site in Lekki, a large district in Lagos, and opened fire, killing 12 people. The violence fueled outrage toward the government and security forces. To quell unrest, the government announced that SARS would be disbanded and promised a host of reforms. Demonstrators are skeptical of government promises without clearly specified timeframes. After all, previous incumbents have suggested police reform would be expedited. This has yet to happen, so we do not expect national policy to meet public demand. Moreover, President Buhari is a former military dictator who has maintained a hard line on security matters. He is in his final term in office and not legally required to step down until 2023. While discontent grows toward the government for social injustices, the Nigerian economy remains vulnerable and imbalanced. The local currency is facing considerable risk of major devaluation stemming from strains on its balance of payments, as BCA’s Emerging Markets Strategy pointed out in a recent report. Low oil prices and weak FDI inflows will foster various imbalances impeding the nation’s structural adjustments and its potential growth rate. The US election will act as a positive catalyst for markets in the short run as long as it produces a clear result and resolves the US fiscal stalemate. Nigeria’s current account excluding oil has been structurally wide, a sign of weak domestic productivity and an uncompetitive currency (Chart 16). Foreign currency reserves stand at $36bn, barely above foreign debt obligations at $28bn. FDI inflows have reached their second lowest point over the past decade, weighing on productivity growth, which is near 0%. A positive for Nigeria’s macro fundamentals is that public debt is low, at 23% of GDP, decreasing the likelihood of a sovereign default in the near term. Government officials refrained from large COVID fiscal relief, keeping spending in check. Coupled with low debt servicing costs, of which the foreign share only represents 2% of government revenues, a currency depreciation to improve competitiveness would not make public debt dynamics a concern. Nominal GDP is above short-term rates (Chart 17). Hence there is room for the currency to fall and government spending to pick up into next year to support the economy.  Chart 16Nigeria Struggles With Economic Rebalance Nigeria Struggles With Economic Rebalance Nigeria Struggles With Economic Rebalance Chart 17Nigeria Has Fiscal Firepower Nigeria Has Fiscal Firepower Nigeria Has Fiscal Firepower   In the post-dictatorship era, oil revenues knit the country’s predominantly Muslim north with its oil-rich and predominantly Christian south. The country has struggled to rebalance the economy in the wake of the 2014 oil shock. Crude production has fallen from over 2 million barrels per day to around 1.6 million bpd since 2010, and Nigeria struggles to meet its modest OPEC quotas. The current global crisis could have a negative long-term impact as rig counts have fallen again. We expect global oil demand to be supported in 2021, as lockdowns will be less stringent the second time and global fiscal stimulus will keep coming. And while Buhari’s age and poor health make him vulnerable, he is not without reserves of political strength. He is seen as someone who has kept up a good fight against the Islamist militant group Boko Haram. Considering that he is a northerner and a Muslim by faith, this strategy has helped ease sectarian tensions across the country, strengthening his grip. The problem is that the size of the global crisis could upset even the most stable of petro-states. Like most of sub-Saharan Africa, the youth population is large – the median age is around 18. If global oil demand relapses amid the second wave of the pandemic and a lack of domestic and global stimulus, the country will suffer yet another wave of unemployment. And if policy remains hawkish, sociopolitical troubles will be amplified.  Nigeria’s impact on global oil prices is limited – it only provides 2% of global oil supply – but it could become a contributor to rising unplanned outages if instability gets out of hand. Bottom Line: The SARS protests are not likely to threaten overall government stability, but mounting economic pressures could exacerbate social unrest, and the negative feedback with security forces. This could deliver a significant blow to the aging Buhari’s government if he does not enact expansionary fiscal policy to smooth out the external shocks. Investment Takeaways Chart 18Biden Good For Global Trade Rebound Biden Good For Global Trade Rebound Biden Good For Global Trade Rebound The US election will act as a positive catalyst for markets in the short run as long as it produces a clear result and resolves the US fiscal stalemate. But a contested election is not unlikely and a deflationary risk arises in the 28% chance that Biden wins while Republicans retain the Senate. Stimulus would still be agreed but its size and timing would be uncertain, prolonging the selloff. Therefore we are updating our portfolio to book some gains and cut some losses. We are booking gains on our EUR-GBP volatility trade for a return of 13%. We are closing our long Indian pharmaceuticals trade for a gain of 12%. We are throwing in the towel on our long defense and aerospace trade for a loss of 21%. And we are closing our rare earths basket trade for a gain of 5%. We are closing two pair trades and re-initiating them as absolute longs: long China Play Index relative to MSCI global stocks (0.1% return) and long ISE Cyber Security Index relative to the NASDAQ (-6.8%). Chinese reflation and global cyber-attacks will remain relevant themes.  The inverse of Trump, Biden is positive for the euro, negative for the dollar, and supportive of global trade. However, a range of higher taxes and levies on corporations suggests that his administration will ultimately weigh on S&P global stocks relative to those at home. And while Biden appears softer on China, we consider this a mispricing, as he has largely coopted Trump’s and Sanders’s trade agenda (Chart 18). Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Guy Russell Research Analyst GuyR@bcaresearch.com Chart 19China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator Chart 20Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Chart 21UK: GeoRisk Indicator UK: GeoRisk Indicator UK: GeoRisk Indicator Chart 22Germany: GeoRisk Indicator Germany: GeoRisk Indicator Germany: GeoRisk Indicator Chart 23France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator Chart 24Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Chart 25Canada: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator Chart 26Spain: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator Chart 27Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Chart 28Korea: GeoRisk Indicator Korea: GeoRisk Indicator Korea: GeoRisk Indicator Chart 29Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Chart 30Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator   Geopolitical Calendar Footnotes 1  There have been strange warnings in recent days – an unidentified aircraft intercepted over a Trump rally in Arizona, a Saudi warning of a potential Houthi attack on Americans, and a Chinese warning of a potential US drone attack against Chinese assets in the South China Sea. None of these have amounted to anything, and the idea of a US drone attack on China is absurd, but investors should be cautious nonetheless, particularly because a range of state and non-state actors will have an incentive to take actions once the US outcome is known. 2  Please see FBI Director Christopher Wray, “Statement Before The House Homeland Security Committee,” Washington DC, September 17, 2020, fbi.gov; Department of Homeland Security, “Homeland Threat Assessment,” October 2020, dhs.gov; Tresa Baldas and Paul Egan, “More details emerge in plot to kidnap Michigan Gov. Whitmer as suspects appear in court,” USA Today, October 13, 2020, usatoday.com.   

Highlights China’s 14th Five Year Plan and broader national strategy will continue to provoke opposition from the US and the West, regardless of the US election. China’s economic blueprint will focus on self-sufficiency, “dual circulation” (import substitution), state subsidies, and high-tech advancement – all factors that will continue to provoke western ire. US political polarization creates geopolitical risks, particularly for China, which will support the dollar and US equity outperformance, depending on the election result. If Trump wins, polarization will persist, he will face gridlock at home, and he will thus continue his aggressive foreign and trade policies, with China facing disruptive consequences. The CNY, EUR, and especially TWD would suffer. If Biden wins, he could face either gridlock or full Democratic control. The former case presents a greater risk of a focus on trade and foreign policy. The latter would result in a domestically focused Washington, which gives China breathing space. The CNY and EUR would benefit, but the TWD would face limited upside. Either way, investors are likely to become over-exuberant about assets that are exposed to the US-China relationship in the event of a Biden victory. Over the long run, this is a bull trap.  Feature In the years after the 2008 financial crisis, the global news media proclaimed the rise of China and the demise of the United States as a global leader. The US’s free-wheeling democracy and capitalism led to economic collapse, partisan gridlock, and nearly a self-inflicted default on sovereign debt. Meanwhile China’s state-controlled system stimulated its economy, cracked down on the first inklings of unrest in the spring of 2011, and expanded its regional and global influence.  The conclusion is similar today in the wake of the COVID-19 crisis. The US has squandered its response to the pandemic, while partisan gridlock threatens the economic recovery. China has suppressed the virus that started within its borders and its economy is rapidly on the mend. The orgy of social unrest and political dysfunction in the US has weighed on its international image and leadership. What the past decade showed, however, is that the first narrative to take hold after a global crisis is not likely to be the final narrative. In fact, the past decade was the most difficult for China since the 1980s. The next decade will be even more challenging. The COVID-19 pandemic brought to an official conclusion the unprecedented economic boom of the past four decades (Chart 1). Though Chinese policy makers have navigated relatively well, the social and political system faces greater challenges in a new economic and international environment. Chinese potential GDP growth has now fallen to 3%, as the labor force contracts and productivity remains flat. Chart 1China Already Plucked The Long-Hanging Fruit China Already Plucked The Long-Hanging Fruit China Already Plucked The Long-Hanging Fruit China is well-situated in the short run to benefit from domestic and global economic stimulus, but over the long run its challenges are significantly underrated. China Faces Headwinds From Abroad Chinese leaders are prepared for any of the possible outcomes in the US election. With regard to US foreign and trade policy, the election is about tactics, not strategy. US grand strategy clearly dictates that Washington focus on curbing China, which is the only country that can challenge the US for global supremacy over the long run. But the US is not alone – other countries are also taking a more skeptical stance toward China’s geopolitical prominence. The result is that China will continue to emphasize self-sufficiency, a centrally guided economic model, and state-supported technological advancement in its fourteenth Five Year Plan for 2021-25 (see Appendix). This policy trajectory, combined with the key policy developments of the past decade, suggests that China’s self-sufficiency drive will continue to attract geopolitical opposition from the US and the West: Capital Controls: China tightened its capital controls aggressively during the financial turmoil of 2015-16. This emergency decision undercut the liberal reform agenda and alienated the western world on one of its critical structural demands. With China having grown its money supply from 175% to 197% of GDP since 2009, and capital flowing out again amid this year’s crisis (Chart 2), Beijing will not be able to fully liberalize its capital account anytime soon. Chart 2China's Capital Controls China's Capital Controls China's Capital Controls Chart 3China's State-Owned Enterprises Revived China's State-Owned Enterprises Revived China's State-Owned Enterprises Revived State-Owned Enterprises: The current administration has struggled with slowing trend growth and deflationary pressures. This is not an environment opportune for restructuring or liquidating inefficient state-owned enterprises (SOEs). It is the opposite of the 1990s, when SOEs were last culled. The regime has instead promised to make SOEs bigger and stronger (Chart 3). While it has pursued reforms to allow more private ownership of state assets, it has also encouraged public ownership of private assets, thus producing “mixed ownership” and a fusion of state and corporate power. The US and western countries resent this reassertion of state-backed economic power, notwithstanding the fact that all countries are increasing state support amid the collapse in global demand. Notably, China will likely resist cutting manufacturing capacity any faster than it will already be cut due to the global recession and foreign protectionism, meaning that stimulus-fueled overcapacity will continue to be a problem for foreign competitors. Chart 4The Tech Race Continues The Tech Race Continues The Tech Race Continues The Tech Race: Beijing is continuing a frantic dash to upgrade its science and technology capabilities in order to lift total factor productivity, which is essential to maintaining growth in the coming decades in the post-export-industrial phase. Expenditures on research and development are skyrocketing, now rivaling the United States. True, R&D spending is flattening out as a percentage of GDP, but this is likely temporary — even faster R&D spending will probably become an official target for the next five years (Chart 4). The full weight of the political system is being thrown behind the goal of creating a “Great Leap Forward” in advanced and emerging technologies. Western countries are increasingly sensitive to China’s advances in semiconductor manufacturing, artificial intelligence, new vehicles, new energy, new materials, and computing. The new strategy of “dual circulation” will consist of import substitution, especially for critical tech goods, and will incorporate programs like “Made in China 2025” as well as “new infrastructure” that are high tech and have become targets of the West. The US and others are openly adopting export controls and reducing supply chain dependency on China. Beijing will struggle to maintain its rapid innovation drive without inviting more punitive measures from the West. Chart 5US Fears China’s Military Rise Is China Afraid Of Big Bad Biden? Is China Afraid Of Big Bad Biden? Military Spending: China adopted a more assertive foreign policy in the mid-2000s and intensified this approach after 2012. Military spending has risen along with economic heft and western experts have long believed that China spends considerably more than it lets on. If we assume that China began to spend 3.75% of GDP per year after its strategic break with the US – a reasonable number in keeping with Russia’s long-term average – then China is narrowing the defense spending gap with the US more rapidly than is widely believed (Chart 5). Given the US’s giant defense spending, this is a continual source of distrust. Bear in mind that China’s defense and security aims are more limited than those of the US, at least in the short run. While the US must maintain the ability to project power globally, China need only grow its regional sphere of influence. Regionalism: While the Xi administration consolidates power within the Communist Party and central government in Beijing, it is also consolidating Beijing’s authority within Greater China. This includes efforts to bring to heel wayward provinces and regions such as Xinjiang, Tibet, Hong Kong, and Taiwan. Much of this is a fait accompli that western governments can do little about. Even in Hong Kong, public opinion is showing signs of resignation to the new legislative powers that Beijing has asserted. However, Taiwan is the clear outlier. Public opinion has shifted sharply against mainland China. Given that Taiwan is the epicenter of the new cold war with the US, both for reasons of political legitimacy as well as technological capability, a fourth Taiwan Strait crisis is looming (Chart 6). China has economic leverage to use first, but if this fails then a military confrontation cannot be ruled out. The above points do not hinge on the US election outcome or other cyclical factors, and highlight that geopolitical tensions will persist, particularly with the United States. The US’s adoption of a confrontational rather than cooperative posture toward China is a paradigm shift in international relations. Unlike Washington’s crackdown on Japanese trade in the 1980s, the US and China do not have an underlying trust or sense of shared security interests. Beijing’s willingness to increase US imports or appreciate its currency arbitrarily, to suit the shifting demands of US administrations, have substantial limits. Economic decoupling will continue in an environment of strategic insecurity (Chart 7). Chart 6Struggles In Greater China Is China Afraid Of Big Bad Biden? Is China Afraid Of Big Bad Biden? Chart 7US Redistributes Trade Deficit US Redistributes Trade Deficit US Redistributes Trade Deficit   President Trump’s biggest mistake in pursuing his trade war with China lies in his failure to build a grand alliance, or coalition of the willing, among likeminded liberal democracies. This would have amplified his leverage over China in making demands for structural reform and opening up. But this point can be overstated. China’s international image has collapsed, in Europe and Asia as well as in North America, despite the Trump administration’s diplomatic failures. Much of this effect stems from COVID-19, but that does not mean it is less grave. If the US courts allies in the trade conflict with China, it will find governments willing to cooperate (Chart 8). Chart 8China’s Image Suffers Under Trump Is China Afraid Of Big Bad Biden? Is China Afraid Of Big Bad Biden? Map 1Proxy Battles In Asia Pacific Is China Afraid Of Big Bad Biden? Is China Afraid Of Big Bad Biden? Chart 9US Arms Sales To Taiwan US Arms Sales To Taiwan US Arms Sales To Taiwan China’s perennial geopolitical challenge is shown in Map 1. It is geographically encircled by nations that have grown increasingly wary of its regional ambitions and will reach out to the US and West. These countries wish to continue benefiting from China’s economic rise but seek security guarantees to offset China’s rising strategic clout. The result will be “proxy battles,” in some cases political, in others military (Chart 9). Taiwan, South Korea, the Philippines, and Vietnam each face substantial geopolitical risk. In the case of South Korea and the Philippines, this risk is partially priced by financial markets. But in the case of Taiwan and Vietnam, it is almost entirely underrated. Taiwan has only an ambiguous defense commitment from the US, while Vietnam is a Chinese rival that entirely lacks a security guarantee from the United States. Bottom Line: Geopolitical risk will remain elevated in Asia Pacific regardless of what occurs in the US election. The growth of Chinese power, and its state-led economic model, will ensure that trade tensions persist. These will culminate in strategic conflicts in certain neighboring countries. China Will Re-Consolidate Power When Trump was inaugurated in January 2017, we argued that the looming US-China trade war would not be determined solely by relative economic size and export exposure. Instead, political unity would be a critical factor. While the US ostensibly had the economic advantage, China had the political advantage. The nineteenth National Party Congress would see Xi Jinping consolidate power domestically, while President Trump would struggle with domestic opposition and divisions within the US and the West over his protectionism. Having secured an economic rebound this year, China is likely to consolidate domestic power even further in 2021-22. This period culminates in the critical twentieth National Party Congress. Originally Xi Jinping was expected to step down at this time and hand the reins to the leader of the opposing faction. Now the opposing faction has been laid low, and Xi is likely to promote his faction and entrench his rule. The period will likely be marked with at least one major crackdown on the regime’s political rivals. Ultimately, social and political control will be tightened, particularly beginning in late 2021. These events provide good reasons for anticipating that Chinese monetary, fiscal, and regulatory policy will not tighten drastically, but rather will merely normalize by mid-2021, assuming that the recovery stays on track (Chart 10). Yet this logic only goes so far – it is more bullish for the macro view today and in 2021, than it is in 2022. Obviously the regime wants to avoid a slump in 2021, the hundredth anniversary of the Communist Party, and investors should keep this in mind. But the 2017 party congress was attended by a deleveraging campaign that surprised the world in its intensity. The point is that stability, not rapid growth, is the imperative in 2022. If speculative bubbles have become a greater threat by that time, then the monetary and fiscal policy backdrop will lean hawkish rather than dovish. Tightening central control over the economy helps the Xi administration consolidate power. Chart 10China Still Consolidating Domestic Power, 2021-22 China Still Consolidating Domestic Power, 2021-22 China Still Consolidating Domestic Power, 2021-22 US Polarization A Risk For China If China continues to consolidate, the key question is what will happen in the United States. The answer will be known in short order, but what is critical to observe is that US political polarization is a geopolitical risk, and therefore if it continues to escalate it will be positive for the US dollar and negative for Chinese and other emerging market assets. The past several years have been marked by an increase in US social and political instability. Indeed, according to Worldwide Governance Indicators, the US’s governance has declined while China’s has improved, notably on the issue of political stability and the absence of violence (Chart 11). While these rankings are partial, nevertheless they point to the reality of US political division. The decade’s giant increase in political polarization has coincided with a bull market in US equities and the greenback, best exemplified by the outperformance of the US technology sector (Chart 12). Chart 11US Instability A Source Of Global Risk Is China Afraid Of Big Bad Biden? Is China Afraid Of Big Bad Biden? If President Trump prevails, this trend will continue. Trump cannot win the popular vote, but his regional support could grant him a victory in the Electoral College. Or he could prevail through a contested election adjudicated by the Supreme Court or the House of Representatives. If this should occur, polarization will intensify, as the government’s legitimacy will suffer due to lack of popularity in a democracy. Facing gridlock at home, Trump would pursue trade war – not only with China, but also conceivably with the European Union. The consequence is that a surprise Trump victory (45% odds) would be negative for the euro, the renminbi, and especially the Taiwanese dollar (Chart 13). Chart 12US Polarization Reinforces Safe-Haven Status US Polarization Reinforces Safe-Haven Status US Polarization Reinforces Safe-Haven Status Chart 13Trump Second Term Would Weigh On CNY, EUR, TWD Trump Second Term Would Weigh On CNY, EUR, TWD Trump Second Term Would Weigh On CNY, EUR, TWD However, if former Vice President Biden prevails, he could win in two possible ways: one with gridlock in Congress, the other with a Democratic sweep of the House and Senate. In the former case, US polarization will persist. Biden will be incapable of executing his domestic agenda, as he will be obstructed by a Republican Senate. This will drive him into foreign policy, where he will ultimately prove to be tough on China – and certainly tougher than the Obama administration. In the latter case, a Democratic sweep of legislative and executive branches, Biden will not face domestic constraints and will be primarily focused on an ambitious agenda for rebuilding and rebalancing the US economy, with elements of the New Deal and the Green New Deal. He will be less focused on international affairs, at least initially. Trade risks will decline, along with US fiscal risks, thus producing a higher-growth macro policy environment. In both cases, while we expect a President Biden to seek a diplomatic “reset” with China, he is unlikely to repeal President Trump’s tariffs. Instead he will seek to utilize the leverage that Trump has built up, while pursuing a new strategic and economic dialogue with China. Ultimately this dialogue will be undermined by China’s state-backed economic policies and foreign policy assertiveness (see previous section), as well as Biden’s simultaneous courting of Europe and other liberal democracies. But clearly there is more room for Chinese assets to outperform under a Biden victory, especially a Democratic sweep. Investment Takeaways If Biden wins, the stock market is likely to become overly exuberant about a Biden administration’s positive implications for China-exposed companies (Chart 14). The same can be said for Chinese tech companies that are highly export-oriented (Chart 15). In a Democratic sweep, this rally can be prolonged, as US equities will face greater political risk than international equities. But any rally in assets exposed to the US-China relationship will ultimately be a bull trap, as US grand strategy calls for containing China, while Chinese grand strategy calls for breaking through containment. The US and Chinese tech sectors and Taiwanese assets are by far the most vulnerable to this dynamic, given their lofty valuations. Chart 14Market Over-Optimistic On Biden Boost To China Plays Market Over-Optimistic On Biden Boost To China Plays Market Over-Optimistic On Biden Boost To China Plays Chart 15Chinese Tech Faces Trade Tensions Chinese Tech Faces Trade Tensions Chinese Tech Faces Trade Tensions If we are correct that geopolitical risk will persist for China regardless of US political party, then the primary beneficiaries of Chinese stimulus and US decoupling will be domestic-oriented Chinese equities as well as “China plays” – external markets that export machinery and resources to China, such as Australia, Brazil, and Sweden. China will still invest heavily in traditional infrastructure, property, and manufacturing to shore up demand whenever it sags amid the difficulties of the economic transition. Our China Play Index, designed by Mathieu Savary of our flagship The Bank Credit Analyst, neatly captures the potential for this index to outperform on the back of Chinese stimulus, which will be even more necessary if US policy continues to be punitive (Chart 16). The near term could involve substantial US fiscal risks as well as geopolitical risks with China, which can occur under a gridlocked Biden administration or a second term Trump administration. Over the next year, the looming Chinese and global recovery, combined with ultra-dovish US monetary policy, spells continued downside for the US dollar and upside for Chinese and emerging market currencies and risk assets (Chart 17). But while the dollar may face challenges to its reserve currency dominance, China’s geopolitical risks, at home and abroad, will prevent the renminbi from making more than incremental gains on the dollar. The euro is a much likelier alternative for the foreseeable future. Chart 16China Plays Will Benefit From Reflation China Plays Will Benefit From Reflation China Plays Will Benefit From Reflation Chart 17King Dollar Persists … But Cyclical Downside Looms King Dollar Persists ... But Cyclical Downside Looms King Dollar Persists ... But Cyclical Downside Looms   Appendix Table 1China’s 14th Five Year Plan Goals Is China Afraid Of Big Bad Biden? Is China Afraid Of Big Bad Biden?   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

Highlights US-China relations in 2020 consist of a gentleman’s agreement to keep the Phase One trade deal in place and aggressive maneuvering in every other policy area. Stimulus is unlikely to be curtailed in the US or China yet, which means brinkmanship will eventually lead to a negative surprise for markets. But it is just as unlikely to come after the election as before. Joe Biden would only initially benefit Chinese equities – trade and tech conflict is a secular trend. North Korea is not a red herring, but South Korea is still a geopolitical investment opportunity more than a risk, especially relative to Taiwan. Feature Chart 1US Power Struggle Raises Risk To Rally US Power Struggle Raises Risk To Rally US Power Struggle Raises Risk To Rally The “everything is awesome” rally continues, with US tech stocks unfazed by rising domestic and international risks. However, according to The Lego Movie 2, everything is not that awesome. The Treasury market smells trouble and long-dated yields remain subdued, despite a substantial new dose of monetary policy dovishness (Chart 1, top panel). In the near term we agree with the bears and remain tactically long 10-year Treasuries. Global policy uncertainty remains extremely elevated despite dropping off a bit from the heights of the pandemic lockdowns. US uncertainty, which is now rising relative to global, will climb through November and possibly all the way through Inauguration Day on January 20 (Chart 1, bottom panels). A contested election is not a low-probability event now that President Trump is making a comeback in the election race. President Trump’s comeback could generate a counter-trend bounce in the US dollar (Chart 2A). His comeback is not based in online betting odds but in battleground opinion polls (Chart 2B). Former Vice President Joe Biden is currently polling the same against Trump as Hillary Clinton did in 2016. Chart 2ATrump Staging A Comeback, But US Consumers Flagging Trump Staging A Comeback, But US Consumers Flagging Trump Staging A Comeback, But US Consumers Flagging Chart 2BTrump Staging A Comeback, But US Consumers Flagging The Trump-Xi Gentleman’s Agreement - GeoRisk Update The Trump-Xi Gentleman’s Agreement - GeoRisk Update Why should Trump be less negative for the greenback than Biden? First, Trump is a protectionist who would turn to aggressive foreign and trade policy when it became clear that most of his other legislative priorities would not make it past the Democratic House of Representatives. Unilateral, sweeping tariffs against China, and possibly the EU and various other nations, would weigh on global trade and economic recovery and hence support the dollar. Second, Trump’s populism means he would pursue growth at all costs, which means that US growth would increase relative to that of the rest of the world. Democrats, by contrast, would raise taxes and regulations that would have to be offset by new spending, weighing on growth at least at first. Thus Trump would inject animal spirits into the US economy while dampening those spirits abroad; Biden would do the opposite. The dollar may not rally sustainably, but it would be flat or fall less rapidly than if Biden and the Democrats reduced trade risks abroad while deterring domestic private investment. It is not yet clear that Trump’s comeback will have legs. The nation is still in thrall to the pandemic, recession, and social unrest, which undermine a sitting president. US consumer confidence has fallen, as anticipated (Chart 2, bottom panel). Trump should still be seen as an underdog despite his incumbent status. A Trump comeback could precipitate a counter-trend bounce in the US dollar. Nevertheless, our quantitative election model gives Trump a 45% chance of victory, up from 42% last month. Florida has shifted back into the Republican column – albeit as a “toss up” state with a roughly even chance of going either way (Chart 3). The shift reflects improvement in state leading economic indexes as a result of the V-shaped recovery in the economy thus far. Chart 3Trump Nearly Regains Florida In Our Quantitative Election Model, Odds Of Victory 45% The Trump-Xi Gentleman’s Agreement - GeoRisk Update The Trump-Xi Gentleman’s Agreement - GeoRisk Update Assuming Trump signs a new relief bill in September, which is working its way through Congress as we speak, we will upgrade our subjective odds from 35% to something closer to our quantitative model (and the market consensus). While Trump is less negative for the dollar than Biden, the dollar may fall anyway, at least beyond any near-term bounce. First, monetary policy is ultra-dovish. As we go to press, Fed Chairman Jerome Powell has given a sneak preview of the Fed’s strategic review of monetary policy at the Kansas City Fed’s annual Jackson Hole summit (this time hosted in cyberspace instead of Wyoming). Powell met expectations that the Fed will adopt average inflation targeting. Inflation will be allowed to overshoot the 2% inflation target to compensate for periods of undershooting. Maximum employment will be the goal rather than an attempt to prevent excessive deviation from the Fed’s estimates of neutral unemployment. This means US growth and inflation will push real rates lower and weaken the dollar. Moreover, as mentioned, Trump’s big spending would eventually drive investors away from the dollar, especially in the context of global economic recovery. Trump, like Biden, would refuse to impose fiscal austerity amid high unemployment. The one area where he would be able to compromise with House Democrats would be spending bills, as in his first term. The US budget deficit and trade deficit would remain very large, showering the world with dollar liquidity. Risk-on currencies will attract buyers in a new global business cycle. Republicans and Democrats have released their policy platforms following their national conventions. We will revisit these platforms in detail in a future report. The Democratic platform is the one that matters most because the Democrats are more likely to win full control of Congress and thus be capable of enacting their preferred policies. Their platform is reflationary, but in seeking to rebalance the economy to reduce financial and social disparities through more progressive tax policy it would offset some of the fiscal spending. Biden would also moderate foreign policy and trade policy, launching a new dialogue with China to manage tensions. The dollar would fall faster in this environment. Bottom Line: President Trump is staging a comeback in the election campaign. If the comeback receives a boost from fiscal stimulus, Trump could pull off a Harry Truman-style surprise victory. This would precipitate a bounce in the US dollar in the near term. Over the medium term, the dollar should continue falling due to US debt monetization and global recovery. The Trump-Xi Gentleman’s Agreement Has Two Months Left Financial markets have largely ignored US-China strategic tensions this year because the two countries are puffing themselves up with monetary and fiscal stimulus. Going forward, either the stimulus will falter, or the US-China conflict will escalate to the point of triggering a negative surprise for markets. Chart 4US-China: Embracing While Struggling US-China: Embracing While Struggling US-China: Embracing While Struggling China is unlikely to pull back on stimulus measures. It cannot do so when unemployment has spiked and the economy is experiencing the weakest growth in over 40 years. Authorities said as much during the annual July Politburo meeting on the economy (a meeting that has often marked turning points in policy), when they pledged to maintain accommodative policy and to speed up local government issuance of special bonds. Money supply is growing briskly. The market is validating the signal from China’s easy monetary policies and robust credit expansion. Our China Play Index – which consists of the Australian dollar, iron ore prices, Brazilian equities, and Swedish equities – continues to rally smartly, breaking above its 2019 peaks (Chart 4, top panel). The risk to this view is that the People’s Bank of China may not provide additional monetary easing in the near term, as the Politburo signaled that monetary policy would be more flexible and targeted in the second half of the year. The three-month Shanghai interbank rate has been rising since April. Politically, Chinese authorities would benefit from releasing negative news or statements that would undermine President Trump’s reelection campaign. However, Beijing would not make consequential moves merely to spite Trump. Its primary interest lies in its own stability. Credit growth will continue growing at its current clip through most of the rest of the year and fiscal spending will expand, particularly to support infrastructure projects. The US Congress is also likely to add more stimulus before the election, as noted above. Thus with both countries stimulating, the risk is that they escalate their strategic confrontation to the point that it causes a negative surprise in financial markets. Will this occur? The US-China relationship in 2020 has been characterized by (1) a gentleman’s agreement to adhere to the Phase One trade deal, which was reaffirmed by top negotiators this week; (2) an aggressive pursuit of national interest in every other policy area. Beijing accelerated its power grab in Hong Kong; the US accelerated up its ban on Chinese tech. Chinese imports of US commodities are naturally much weaker than projected due to economic reality but neither side has an interest in exiting the deal. The renminbi continues to appreciate against the dollar on the back of Chinese and global recovery (Chart 4, second and third panels). Nevertheless a new burst of stimulus will lower the hurdle to President Trump taking additional punitive measures against China. The administration could have paused after its major decision to finalize its ban on business with Huawei and other tech firms, which ostensibly even extends to foreign firms that use US-designed parts in sales to China. It did not. Trump is maintaining the pressure with new sanctions over China’s militarization of the South China Sea. Washington is also likely to kick Chinese companies off US stock exchanges if they fail to meet transparency and accounting standards. Trump is not only burnishing his “tough on China” credentials against Democratic candidate Joe Biden – the US’s recent measures are unlikely to be repealed under either president in the coming years. Chart 5China Faces Internal And External Political Pressures China Faces Internal And External Political Pressures China Faces Internal And External Political Pressures Therefore stimulus will enable US actions and Chinese reactions that will eventually trigger a pullback in financial markets. Chinese tech equities are reflecting this headwind. Equities ex-tech are likely to outperform (Chart 5, top panel). A Biden victory does not prevent Trump from taking punitive measures against China on his way out of office, to solidify his legacy as the Man Who Confronted China, so Chinese tech will remain at risk. Biden would be more favorable for emerging market equities because his administration would speed the dollar’s decline. A change of government in the US would temporarily disrupt the US’s overall policy assault against China. Biden’s foreign and trade policies would be more predictable and orthodox than Trump’s. Over a twelve month period, after a shot across the bow to warn that he is not a lightweight, Biden would probably attempt a diplomatic reset with China – a new round of engagement and dialogue that would support the Chinese equity rally. Eventually this reset would fail, however, and Biden would all the while be working up a coalition of democracies to pressure China to change its behavior – not only on trade but also on unions, carbon emissions, and human rights. Externally focused Chinese companies will remain exposed to the harmful secular trend of US-China power struggle regardless of the US election outcome. Coming out of the secretive leaders’ conclave at the Beidaihe resort in August, it is clear once again that Chinese domestic politics is not conducive to smooth US-China relations. Chinese political risk remains underrated. Our GeoRisk indicator is gradually picking up on this trend, and so are other quantitative political risk indicators such as that provided by GeoQuant (Chart 5, second panel). President Xi Jinping has been dubbed the “Chairman of Everything” due to his tendency to promote a neo-Maoist personality cult and thus shift Chinese governance from consensus-rule to personal rule. He is once again reportedly considering taking on the title of “Chairman” of the Communist Party, a position that only Mao Zedong has held.1 More importantly he is re-energizing his domestic anti-corruption campaign, i.e. political purge, this time against law enforcement. Xi had already seized control of China’s domestic security forces but controlling the police is even more critical in a period of high unemployment, slow growth, and social unrest (Chart 5, third panel). Xi’s attempt to re-consolidate power ahead of the Communist Party centennial in 2021 and especially the twentieth national party congress in 2022 is already under way. China’s domestic and international political environment is a risk for the renminbi, which we noted is rallying forcefully on the global rebound. We will not join this rally until the US election is decided at minimum. With the US posing a long-term threat, Beijing is speeding up its attempts to diversify away from the US dollar, both in trade settlements and foreign exchange reserves. Reliance on the dollar leaves Chinese banks and companies vulnerable to US financial sanctions, which have harmed US rivals like Russia and Iran. Over the long run there is a lot of upside for the yuan given its very low level of global penetration (about 2% of both SWIFT transactions and global foreign exchange reserves) and yet China’s very high share of global trade (about 15%). Cross-border settlements in RMB are recovering gradually after the steep drop-off following 2016. Beijing is also allowing foreign investors greater access to onshore financial markets where they will hold more and more RMB-denominated assets. However, the yuan will not become a reserve currency anytime soon given China’s state-controlled economy and closed capital account. We favor the euro, yen, and other G7 currencies as alternatives to the dollar. Hong Kong equities have suffered from the combination of Xi Jinping’s centralization of power and the US-China strategic conflict. The above analysis suggests that while they may get a temporary reprieve, the secular outlook is uninspiring. However, the Hong Kong monetary authorities are capable of managing the dollar peg. They have been able to manage dollar strength over the past decade, including the COVID-19 dollar run-up, and foreign exchange reserves are more than ample. By contrast, a sharp drop in the dollar can be handled even more easily by printing additional HKD. Eventually shifting to a trade basket, or a renminbi peg, is to be expected. The US election may support the Chinese equity rally if Biden wins, but tech equities should continue to underperform the rest of the bourse due to US grand strategy. Bottom Line: We prefer to play China’s growth recovery via outside countries that export into China, such as Sweden, Australia, and Brazil. The US election may support the Chinese equity rally if Biden wins, but tech equities should continue to underperform the rest of the bourse due to US grand strategy which will remain focused on constraining China’s tech ambitions. North Korea Is Not A Red Herring – But Taiwan Is Entirely Underrated The Taiwan Strait remains the chief geopolitical risk. Xi Jinping’s reassertion of Beijing’s supremacy within China’s sphere of influence has led to a backlash in Taiwanese politics and a confrontational posture across the Strait that is being expressed in saber-rattling and low-level economic sanctions that could easily escalate. Chart 6Taiwan Remains #1 Geopolitical Risk Taiwan Remains #1 Geopolitical Risk Taiwan Remains #1 Geopolitical Risk Military exercises and jingoistic rhetoric are also heating up, not only directly relating to Taiwan but also in the neighboring South China Sea, which is critical to national security for all geopolitical actors in Northeast Asia. On August 26 Beijing testing two anti-ship ballistic missiles known as “aircraft carrier killers” in the South China Sea (the DF-21D and the DF-26B). We have long argued that the lack of clarity over whether the US would uphold its defense obligations to Taiwan makes the situation ripe for misunderstandings. The US Naval Institute has recently confirmed the validity of fears about a full-scale conflict in the near term.2 Neither Beijing nor Taipei nor Washington has crossed a red line. But China’s imposition of legislative dependency on Hong Kong highlights the incompatibility of the Communist Party’s governing model with western liberalism. The “one country, two systems” formulation has become unacceptable to the Taiwanese people, who want to preserve their autonomy indefinitely. The US ban on doing business with Huawei extends to foreign companies that use US parts or designs, squeezing Taiwanese companies (Chart 6, top panel). War is possible, but our base case still holds that the mainland will first use economic means. In particular it will impose economic sanctions, either precipitating or in response to a Fourth Taiwan Strait Crisis. The market continues to underrate the enormous risk to the Taiwanese dollar, as captured by the low level of our risk indicators (Chart 6, second panel). We continue to recommend shorting Taiwan relative to emerging markets. Taiwan is a short relative to South Korea, in particular, which stands to benefit from any negative turn of events in cross-strait relations. Korean equities are finally perking up, though the US tech war with China is weighing on the South Korean tech sector (Chart 7, top panel). We see this as a geopolitical opportunity given that both China and the US will need South Korean companies as they divorce each other. Korean political risk, however, may also be shifting from adequately priced to underrated. The risk premium has trended upward since President Trump’s diplomatic overture to leader Kim Jong Un stopped making progress (Chart 7, second and third panels). We have largely dismissed concerns about North Korea since the reduction of tensions in late 2017 due to our assessment that diplomacy would remain on track throughout Trump’s first term. This has proved to be the case, but it is still possible that North Korea could prove globally relevant before the US election. Chart 7North Korea A Non-Negligible Risk North Korea A Non-Negligible Risk North Korea A Non-Negligible Risk The reason stems from rumors of Kim Jong Un’s health problems earlier this year. We noted at the time that it was suspicious that preparations for Kim’s sister, Kim Yo Jong, to take on greater responsibilities within the Politburo of the Worker’s Party seemed to predate reports of Kim Jong Un’s illness. For the North Korean state to continue to promote her implies that something may indeed be amiss. In fact, she has missed two Politburo meetings after her aggressive public relations campaign against South Korea was called off this summer. It is possible she got too much attention as the Number Two person in the regime. The South Korean National Intelligence Service is debating her status with the Defense Ministry and Unification Ministry. What is clear is that Kim Jong Un is preparing a new five-year economic plan, to be launched in January 2021, and that he is eager to share any blame for disastrous internal conditions in the country amid the global pandemic and recession. The market is typically correct not to hyperventilate over North Korean risks, but after 2016 North Korea is no longer a “red herring.” First, any domestic power struggle would occur at an immensely inconvenient time given the breakdown in US-China trust. Second, as the North manages any internal problems through its opaque and untested political process, it could be pressed into making a show of force that would either embarrass and antagonize President Trump, or provoke a forceful response from a future President Biden, given that North Korea in theory has the raw capability to deliver a crude nuclear weapon to the continental United States. If any US president makes a show of force, it will antagonize China and could lead to a major standoff. This would upset the markets at least temporarily. We are long Korean equities and would also look favorably on Korean tech. A geopolitical risk premium could temporarily undercut these stocks if North Korean diplomacy fails around the US election. But the risk is globally relevant only if Pyongyang somehow sparks a standoff between the US and China. Otherwise a major Korean peninsula crisis is far less of a concern than that of a crisis in the Taiwan Strait.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1Financial Times. 2 See Admiral James A. Winnefeld and Michael J. Morell, "The War That Never Was?" US Naval Institute Proceedings 146: 8 (August 2020), usni.org. Section II: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights The stock market can apparently ignore the intensifying US-China conflict as long as massive monetary and fiscal stimulus continues. Hence the ongoing “stimulus hiccup” is a big problem. Ultimately a stimulus bill will pass, but risks are rising that it will come too late or fall short in size. The longer the negotiations drag on, the more likely that the absence of fiscal support, the spiraling US-China conflict, US political instability, and other risks will take center stage and upset the equity rally. Assuming a new stimulus package will ultimately pass, it will fuel Trump’s tentative comeback in opinion polls, increasing the risk that the revolution in the global trading system gets a new lease on life. Thus volatility is likely to rise from here until the US succession is settled. Stay long JPY-USD and health stocks in the near term and bullion in the long term. Feature Two of the key views we have hammered since May are coming to fruition: Stimulus Hiccup: The White House and Congress are struggling to get a new relief bill passed. We have argued that the next round of fiscal stimulus would face execution risks that would cause equity volatility to rise again, which is now occurring (Chart 1). Ultimately we expect the Republican Senate to capitulate to a major new stimulus bill. But the very near term is murky and the negotiations pose a clear and present danger to an equity market that has now surpassed its pre-COVID-19 highs (Chart 2). Chart 1Volatility Is Bottoming, Will Rise Ahead Of US Election Volatility Is Bottoming, Will Rise Ahead Of US Election Volatility Is Bottoming, Will Rise Ahead Of US Election Chart 2Markets Recovered, Near-Term Risk To Downside Markets Recovered, Near-Term Risk To Downside Markets Recovered, Near-Term Risk To Downside US-China Conflict: The White House has revoked Chinese tech giant Huawei’s general license, leaving the company in thrall to periodic Commerce Department allowances that will impede business. It has also expanded punitive measures to a slew of subsidiaries and Chinese software companies like TikTok (ByteDance) and WeChat (Tencent). We have argued that President Trump’s electoral vulnerability and economic stimulus in both countries lowered the bar to conflict and decoupling. Both countries have an interest in reducing their interdependency and the COVID-19 crisis has given them an opportunity to make structural changes that were previously more difficult. Neither the US tech sector, nor China-exposed US stocks, nor Taiwanese equities are pricing this monumental geopolitical risk at present (Chart 3). Combining these two views results in a dangerous outlook for global risk assets in the near term. The reason we argued that US-China tensions would escalate to the point of disrupting markets this year was that we viewed domestic stimulus as lowering the economic and financial bar that prevented conflict. Hence US and Chinese confrontational steps could go farther than the market expected and eventually something would snap (Chart 4). Chart 3Market Ignores US-China Escalation Market Ignores US-China Escalation Market Ignores US-China Escalation Chart 4US And Global Stimulus Enable US-China Fight Trade War Sans Stimulus Is Unsustainable Trade War Sans Stimulus Is Unsustainable Yet today tensions are escalating despite the failure to arrange a new jolt of domestic stimulus. This is true on both sides, as China is also seeing a deceleration in stimulus provision, mainly on the monetary side, that we also expect to be temporary but nevertheless has negative implications in the near term. The longer fresh stimulus is delayed, the more likely that markets will respond to the historic breakdown in US-China relations, US political instability, and other risks to corporate earnings and the economic recovery. Constraints On Politicians Support Cyclical Recovery To be sure, there is evidence that politicians are aware of their limits and already heading back to the negotiating table. Even with talks ongoing, the risks of delayed stimulus or Chinese retaliation are substantial. First, the White House, House Democrats, and Senate Republicans are continuing to negotiate despite being on recess while hosting national party conventions this week and next. House members are rushing back to Washington to vote on measures to boost the US postal service amid a controversy over how to handle mail-in voting for the election amid the pandemic. This has opened a pathway for stimulus talks to get back on track. It could result in a “skinny” stimulus bill quickly, or otherwise new developments could lead to the roughly $2.5 trillion blowout that we expect based on the two sides splitting the difference on most issues (Table 1). Table 1Stimulus Bill Will Hit $2.5 Trillion If Democrats And Republicans Split The Difference Trade War Sans Stimulus Is Unsustainable Trade War Sans Stimulus Is Unsustainable Chart 5Trump’s Reelection Bid Stands On The Economy Trade War Sans Stimulus Is Unsustainable Trade War Sans Stimulus Is Unsustainable Second, the US and China are arranging to keep talking. Ostensibly they are checking up on the status of the Phase One trade deal. The Trump administration cannot easily walk away from this deal– unless Trump irredeemably becomes a lame duck making a desperate bid to turn the tables on the Democrats. To do so would hurt Trump’s credibility on renegotiating US trade deals and likely trigger a selloff in the stock market that could set back the economic recovery and remove the last leg that his reelection bid stands on (Chart 5). The Chinese, for their part, have stuck with the deal despite US punitive measures because they do not want to provoke Trump, lest he attempt to inflict maximum damage on their economy in his final months or in a second presidential term. The renminbi is not depreciating relative to the dollar, suggesting that the tenuous truce is intact for now (Chart 6). Chart 6Renminbi Signals Phase One Trade Deal Intact ... For Now Renminbi Signals Phase One Trade Deal Intact ... For Now Renminbi Signals Phase One Trade Deal Intact ... For Now Yet The Market May Sell Before Politicians Soften Their Line Nevertheless in the very near term investors have very low visibility on what happens next. Congress could still fumble and cause greater doubts. It could easily fail to reach a new stimulus deal until after September 8 when the Senate returns or September 14 when the House returns. President Trump’s executive orders, and negotiating gestures from Republicans, are a tenuous bridge for markets as they fall far short of even the Republicans’ $1 trillion asking price. The stock market will plunge if the talks collapse, but it will also drop if the stimulus falls short. The market may have to sell off to force politicians to provide stimulus and temper strategic competition. Trump’s complicated attempt to extend relief via executive orders, and/or a skinny deal that does not include direct rebates to households and funding for state and local governments, would be inadequate for the needs of the economy (Chart 7). It is imperative for Senate Republicans to capitulate and come closer to the Democrats $2.4 trillion standing offer (down from $3.4 trillion) – but it is possible they could miscalculate and fail to compromise. Democrats will not cave because they ultimately benefit at the ballot box if stimulus flops and financial turmoil returns. Chart 7US Economy Needs Extended Period Of Fiscal Support US Economy Needs Extended Period Of Fiscal Support US Economy Needs Extended Period Of Fiscal Support On the China front, it is not guaranteed that China will refrain from retaliation against tech companies like Apple that depend on China for their operations. The market is betting that a rally entirely based on the tech sector can be sustained even in the face of an expanding tech war between the world’s biggest economies (Chart 8). Yet China suffers an economic and strategic blow from the US imposition of a technological cordon and Xi Jinping could decide to retaliate immediately. He could come to believe that the risk of not retaliating – which would entail continuing economic recovery and possibly Trump’s reelection on an anti-China platform – is greater than the risk of retaliation and financial turmoil. He has the ability to stimulate the domestic economy and benefits if he sets a precedent that American presidents lose if they attack China. China may not turn to Taiwan immediately, but since 2016 we have highlighted that Taiwan, not Hong Kong, is the major geopolitical risk stemming from the US-China crisis. Saber-rattling, cyber-rattling, and punitive economic measures are picking up in the Taiwan Strait and could lead to a global geopolitical crisis at any time. Here, too, the base case is that China will remain in a holding pattern until after the US election. It also should use economic sanctions long before it resorts to the final military option (Chart 9). But there is a large risk of miscalculation as the US seeks to cut off Taiwan semiconductor trade with China while Taiwan reduces its economic dependency on the mainland and tightens its defense relations with the United States. The Trump administration presents a window of opportunity so the risks are elevated in the lead up to and aftermath of the US election. Chart 8Tech Bubble Amid Tech War An Obvious Danger Tech Bubble Amid Tech War An Obvious Danger Tech Bubble Amid Tech War An Obvious Danger Chart 9China's Economic Card May Be Only Thing Preventing War China's Economic Card May Be Only Thing Preventing War China's Economic Card May Be Only Thing Preventing War We do not view Chinese economic sanctions on Taiwan as a tail risk but rather as our base case. Of course, we eschew conspiracy theories and usually seek to curb enthusiasm over war risks, as with Sino-Indian saber-rattling. But Taiwan is the epicenter of the political, military, and technological struggle between Washington and Beijing. War is a tail-risk, but even minor clashes would have a major impact on global financial markets. Other Risks Come To Forefront Amid Stimulus Hiccup Chart 10Trump’s Comeback Substantial If Stimulus Passes, Pandemic Subsides Trade War Sans Stimulus Is Unsustainable Trade War Sans Stimulus Is Unsustainable The longer stimulus is delayed, the more likely that other risks will rise to the forefront and trouble the equity market. The US election does not offer much upside for markets at this point. Other risks stem from Iran and Russia. In the US election, President Trump is beginning to make a comeback in the opinion polling (Chart 10). Trump’s approval rating benefits from signing off on deals, so a final stimulus bill from Congress is essential. But a stimulus bill, a continued rollover in new cases of COVID-19, and a revival of support among his base would improve his odds of winning. Former Vice President Joe Biden is not polling much better against Trump than former Secretary of State Hillary Clinton did back in 2016 (Chart 11). Biden’s momentum in national opinion polling has been arrested, especially in battleground states, and the lower end of the “band of uncertainty” around the polling also suggests that Trump is within striking distance (Chart 12). Chart 11Biden Polling About Same As Hillary Versus Trump Trade War Sans Stimulus Is Unsustainable Trade War Sans Stimulus Is Unsustainable   Chart 12Trump Still Within Striking Distance Of Biden Trade War Sans Stimulus Is Unsustainable Trade War Sans Stimulus Is Unsustainable Our election model suggests that Trump has a 42% chance of winning, which is higher than our subjective 35% (Chart 13). We will upgrade if a stimulus bill is agreed. A Trump comeback may be received well by US equity markets – as it prevents tax hikes, re-regulation, higher minimum wages, and a federal push to revive labor unions, all promoted by Biden and the Democrats. But then again, Biden’s agenda is more reflationary, whereas Trump faces obstacles in a still-Democratic House, leaving global trade as the path of least resistance – which is market-negative. The dollar may bounce on the prospect of a Trump second term (Chart 14). Tech stocks, Chinese currency, and other cyclicals, such as the euro and European stocks, will suffer a setback if Trump is reelected. Chart 13We Give Trump 35% Odds, Quant Model Shows Upside At 42% Trade War Sans Stimulus Is Unsustainable Trade War Sans Stimulus Is Unsustainable Lesser risks, still notable, include Iran and Russia. Chart 14Trump Could Trigger Near-Term Dollar Bounce Trump Could Trigger Near-Term Dollar Bounce Trump Could Trigger Near-Term Dollar Bounce We have maintained that the US and Iran are in a bull market of geopolitical tensions and that this could result in crisis around the election. The US’s decision on August 20 unilaterally to maintain the expiring international conventional arms embargo on Iran is a clear trigger for a military incident. The macro and market implications are different and less dire than with a US-China crisis. But oil price volatility would rise due to regional instability, President Trump’s reelection bid could benefit, and that would carry the implication of expanding trade war with China. Meanwhile our expectation of sharply rising Russian geopolitical risk is materializing both within Russia and in relations with Europe, which is preparing sanctions over the suppression of dissent within both Russia and its satellite state Belarus. Russia is capable of interfering in the US election while a Democratic victory would likely lead to a US policy offensive against Russia. Investors must look beyond the short term. If stimulus is passed, the stock market will go up, but the US and China will be further enabled and ultimately their strategic showdown will cap the gains by harming the tech sector. Meanwhile, if the stimulus fails, then the market will plunge. Investment Takeaways At present the stock market seems prepared for Trump to remain in the White House – or for Republicans to retain the Senate. The market’s YTD profile matches that of past elections that result in gridlock, as opposed to the Democratic “clean sweep” scenario that we have flagged as the likeliest outcome (Chart 15). However, this profile will change, the market will correct, if Trump does not sign a new relief act. Assuming stimulus ultimately passes, markets will cheer and Trump’s comeback in the polls will get a boost. He could still lose the election, given fundamental political and economic weaknesses captured in our state-by-state quantitative model above. But the election itself would be more closely fought – with a contested outcome more likely to occur and roil markets. Finally a Trump victory would give a new mandate to the US-China breakdown and the revolution in the global trading system, which is ultimately negative for risk assets and the cyclical recovery. Hence our confidence that the next few months will be marked by volatility. Ultimately geopolitical and macro fundamentals are negative for the dollar even if Trump provides the occasion for a last gasp in the past decade’s dollar bull market. The US is monetizing its debt and flooding the world with dollar liquidity. Meanwhile China and other powers are diversifying away from the dollar and into gold, the euro, the yen, and other reserve currencies over the long run (Chart 16). Chart 15Dollar Outlook Bearish In Medium Term Dollar Outlook Bearish In Medium Term Dollar Outlook Bearish In Medium Term Chart 16Stock Market Preparing For Trump Win And More Gridlock? Stock Market Preparing For Trump Win And More Gridlock? Stock Market Preparing For Trump Win And More Gridlock? The great US fiscal debate is over, regardless of Trump or Biden, as populism has made austerity impracticable and massive twin deficits will ensue. Thus we remain long gold and the Japanese yen. We have refrained from re-initiating our long EUR-USD trade given our expectation of stimulus hiccups and US-China tensions, but will reconsider if and when these hurdles are cleared. Our strategic portfolio continues to expect a global recovery over the next twelve months and beyond but tactically we are positioned against downside risks.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

Highlights The tech sector faces mounting domestic political and geopolitical risks. We fully expected stimulus hiccups but believe they will give way to large new fiscal support, given that COVID-19 is weighing on consumer confidence. Europe’s relative political stability is a good basis for the euro rally but any comeback in opinion polling by President Trump could give dollar bulls new life. DXY is approaching a critical threshold below which it would break down further. The US could take aggressive actions on Russia and Iran, but China and the Taiwan Strait remain the biggest geopolitical risk. Feature Near-term risks continue to mount against the equity rally, even as governments’ combined monetary and fiscal policies continue to support a cyclical economic rebound. Chart 1Tech Bubble Amid Tech War Tech Bubble Amid Tech War Tech Bubble Amid Tech War Testimony by the chief executives of Facebook, Apple, Amazon, and Alphabet to the US House of Representatives highlighted the major political risks facing the market leaders. There are three reasons not to dismiss these risks despite the theatrical nature of the hearings. First, the tech companies’ concentration of wealth would be conspicuous during any economic bust, but this bust has left pandemic-stricken consumers more reliant on their services. Second, acrimony is bipartisan – conservatives are enraged by the tendency of the tech companies to side with the Democratic Party in policing the range of acceptable political discourse, and they increasingly agree with liberals that the companies have excessive corporate power warranting anti-trust probes. Executive action is the immediate risk, but in the coming one-to-two years congressional majorities will also be mustered to tighten regulation. Third, technology is the root of the great power struggle between the US and China – a struggle that will not go away if Biden wins the election. Indeed Biden was part of the administration that launched the US’s “Pivot to Asia” and will have better success in galvanizing US diplomatic allies behind western alternatives to Chinese state-backed and military-linked tech companies. US tech companies struggle to outperform Chinese tech companies except during episodes of US tariffs, given the latter firms’ state-backed turn toward innovation and privileged capture of the Chinese domestic market (Chart 1). The US government cannot afford to break up these companies without weighing the strategic consequences for America’s international competitiveness. The attempt to coordinate a western pressure campaign against Huawei and other leading Chinese firms will continue over the long run as they are accused of stealing technology, circumventing UN sanctions, violating human rights, and compromising the national security of the democracies. China, for its part, will be forced to take counter-measures. US tech companies will be caught in the middle. Like the threat of executive regulation in the domestic sphere, the threat of state action in the international sphere is difficult to time. It could happen immediately, especially given that the US is having some success in galvanizing an alliance even under President Trump (see the UK decision to bar Huawei) and that President Trump’s falling election prospects remove the chief constraint on tough action against China (the administration will likely revoke Huawei’s general license on August 13 or closer to the election). Massive domestic economic stimulus empowers the US to impose a technological cordon and China to retaliate. Combining this headline risk to the tech sector with other indications that the equity rally is extended – the surge in gold prices, the fall in the 30-year/5-year Treasury slope – tells us that investors should be cautious about deploying fresh capital in the near term. Republicans Will Capitulate To New Stimulus Just as President Trump has ignored bad news on the coronavirus, financial markets have ignored bad news on the economy. Dismal Q2 GDP releases were fully expected – Germany shrank by 10.1% while the US shrank by 9.5% on a quarterly basis, 32.9% annualized. But the resurgence of the virus is threatening new government restrictions on economic activity. US initial unemployment claims have edged up over the past three weeks. US consumer confidence regarding future expectations plummeted from 106.1 in June to 91.5 in July, according to the Conference Board’s index. Chart 2Global Instability Will Follow Recession A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) Setbacks in combating the virus will hurt consumers even assuming that governments lack the political will to enforce new lockdowns. The share of countries in recession has surged to levels not seen in 60 years (Chart 2). Financial markets can look past recessions, but the pandemic-driven recession will result in negative surprises and second-order effects that are unforeseen. Yes, fresh fiscal stimulus is coming, but this is more positive for the cyclical outlook than the tactical outlook. Stimulus “hiccups” could precipitate a near-term pullback – such a pullback may be necessary to force politicians to resolve disputes over the size and composition of new stimulus. This risk is immediate in the United States, where House Democrats, Senate Republicans, and the White House have hit an all-too-predictable impasse over the fifth round of stimulus. The bill under negotiation is likely to be President Trump’s last chance to score a legislative victory before the election and the last significant legislative economic relief until early 2021. The Senate Republicans have proposed a $1.1 trillion HEALS Act in response to the House Democrats’ $3.4 trillion HEROES Act, passed in mid-May. As we go to press, the federal unemployment insurance top-up of $600 per week is expiring, with a potential cost of 3% of GDP in fiscal tightening, as well as the moratorium on home evictions. Congress will have to rush through a stop-gap measure to extend these benefits if it cannot resolve the debate on the larger stimulus package. If Democrats and Republicans split the difference then we will get $2.5 trillion in stimulus, likely by August 10. Compromise on the larger package is easy in principle, as Table 1 shows. If the two sides split the difference between their proposals in a commonsense way, as shown in the fourth and fifth columns of Table 1, then the result will be a $2.5 trillion stimulus. This estimate fits with what we have published in the past and likely meets market expectations for the time being. Table 1Outline Of Fifth US COVID Stimulus Package (Estimate) A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) Whether it is enough for the economy depends on how the virus develops and how governments respond once flu season picks up and combines with the coronavirus to pressure the health system this fall. A back-of-the-envelope estimate of the amount of spending necessary to keep the budget deficit from shrinking in the second half of the year comes much closer to the House Democrats’ $3.4 trillion bill (Table 2), which suggests that what appears to be a massive stimulus today could appear insufficient tomorrow. Nevertheless, $2.5 trillion is not exactly small. It would bring the US total to $5 trillion year-to-date, or 24% of GDP! Table 2Reducing The Budget Deficit On A Quarterly Basis Will Slow Economy A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) While a compromise bill should come quickly, the Republican Party is more divided over this round of stimulus than earlier this year. Chart 3US Personal Income Looks Good Compared To 2008-09 US Personal Income Looks Good Compared To 2008-09 US Personal Income Looks Good Compared To 2008-09 First, there is some complacency due to the fact that the economy is recovering, not collapsing as was the case back in March. Our US bond strategist, Ryan Swift, has shown that US personal income is much better off, thus far, than it was in the months following the 2008 financial crisis, even though the initial pre-transfer hit to incomes is larger (Chart 3). Second, the Republican Party is reacting to growing unease within its ranks over the yawning budget deficit, now the largest since World War II (Chart 4). Chart 4If Republicans React To Deficit Concerns They Cook Their Own Goose If Republicans React To Deficit Concerns They Cook Their Own Goose If Republicans React To Deficit Concerns They Cook Their Own Goose Chart 5Consumer Confidence Sends Warning Signal To Republicans A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) If Republicans are guided by complacency and fiscal hawks, they will cook their own goose. A failure to provide government support will cause a financial market selloff, will hurt consumer confidence, and will put the final nail in the coffin of their own chance of re-election as well as President Trump’s. Consumer confidence tracks fairly well with presidential approval rating and election outcomes. A further dip could disqualify Trump, whereas a last-minute boost due to stimulus and an economic surge could line him up for a comeback in the last lap (Chart 5). These constraints are obvious so we maintain our high conviction call that a bill will be passed, likely by August 10. But at these levels on the equity market, we simply have no confidence in the market gyrations leading up to or following the passage of the bill. Our conviction level is on the cyclical, 12-month horizon, in which case we expect US and global stimulus to operate and equities to rise. Bottom Line: Political and economic constraints will force Republicans to join Democrats and pass a new stimulus bill of about $2.5 trillion by around August 10. This is cyclically positive, but hiccups in getting it passed, negative surprises, and other risks tied to US politics discourage us from taking an overtly bullish stance over the next three months. Yes, US-China Tensions Are Still Relevant Chart 6Chinese Politburo"s Bark Worse Than Bite On Stimulus Chinese Politburo"s Bark Worse Than Bite On Stimulus Chinese Politburo"s Bark Worse Than Bite On Stimulus Financial markets have shrugged off US-China tensions this year for understandable reasons. The pandemic, recession, and stimulus have overweighed the ongoing US-China conflict. As we have argued, China is undertaking a sweeping fiscal and quasi-fiscal stimulus – despite lingering hawkish rhetoric – and the size is sufficient to assist in global economic recovery as well as domestic Chinese recovery. What the financial market overlooks is that China’s households and firms are still reluctant to spend (Chart 6). China’s Politburo's late July meetings on the economy are frequently important. Initial reports of this year’s meet-up reinforce the stimulus narrative. Hints of hawkishness here and there serve a political purpose in curbing market exuberance, both at home and in the US election context, but China will ultimately remain accommodative because it has already bumped up against its chief constraint of domestic stability. Note that this assessment also leaves space for market jitters in the near-term. The phase one trade deal remains intact as President Trump is counting on it to make the case for re-election while China is looking to avoid antagonizing a loose cannon president who still has a chance of re-election. As long as broad-based tariff rates do not rise, in keeping with Trump’s deal, financial markets can ignore the small fry. We maintain a 40% risk that Trump levels sweeping punitive measures; our base case is that he goes to the election arguing that he gets results through his deal-making while carrying a big stick. At the same time, our view that domestic stimulus removes the economic constraints on conflict, enabling the two countries to escalate tensions, has been vindicated in recent weeks. Chinese political risk continues on a general uptrend, based on market indicators. The market is also starting to price in the immense geopolitical risks embedded in Taiwan’s situation, which we have highlighted consistently since 2016. While North Korea remains on a diplomatic track, refraining from major military provocations, South Korean political risk is still elevated both for domestic and regional reasons (Chart 7). Chart 7China Political Risk Still Trending Upward China Political Risk Still Trending Upward China Political Risk Still Trending Upward The market is gradually pricing in a higher risk premium in the renminbi, Taiwanese dollar, and Korean won, and this pricing accords with our longstanding political assessment. The closure of the US and Chinese consulates in Houston and Chengdu is only the latest example of this escalating dynamic. While the US’s initial sanctions on China over Hong Kong were limited in economic impact, the longer term negative consequences continue to build. Hong Kong was the symbol of the Chinese Communist Party’s compatibility with western liberalism; the removal of Hong Kong’s autonomy strikes a permanent blow against this compatibility. China’s decision to go forward with the imposition of a national security law in Hong Kong – and now to bar pro-democratic candidates from the September 6 Legislative Council elections, which will probably be postponed anyway – has accelerated coalition-building among the western democracies. The UK is now clashing with China more openly, especially after blocking Huawei from its 5G system and welcoming Hong Kong political refugees. Australia and China have fought a miniature trade war of their own over China’s lack of transparency regarding COVID-19, and Canada is implicated in the Huawei affair. Even the EU has taken a more “realist” approach to China. Across the Taiwan Strait, political leaders are assisting fleeing Hong Kongers, crying out against Beijing’s expansion of control in its periphery, rallying support from informal allies in the US and West, and doubling down on their “Silicon Shield” (prowess in semiconductor production) as a source of protection. Intel Corporation’s decision to increase its dependency on TSMC for advanced microchips only heightens the centrality of this island and this company in the power struggle between the US and China. China cannot fulfill its global ambitions if the US succeeds in creating a technological cordon. Taiwan is the key to China’s breaking through that cordon. Therefore Taiwan is at heightened risk of economic or even military conflict. The base case is that Beijing will impose economic sanctions first, to undermine Taiwanese leadership. The uncertainty over the US’s willingness to defend Taiwan is still elevated, even if the US is gradually signaling a higher level of commitment. This uncertainty makes strategic miscalculations more likely than otherwise. But Taiwan’s extreme economic dependence on the mainland gives Beijing a lever to pursue its interests and at present that is the most important factor in keeping war risk contained. By the same token, Taiwanese economic and political diversification increases that risk. A “fourth Taiwan Strait crisis” that involves trade war and sanctions is our base case, but war cannot be ruled out, and any war would be a major war. Thus investors can safely ignore Tik-Tok, Hong Kong LegCo elections, and accusations of human rights violations in Xinjiang. But they cannot ignore concrete deterioration in the Taiwan Strait. Or, for that matter, the South and East China Seas, which are not about fishing and offshore drilling but about China’s strategic depth and positioning around Taiwan. Taiwan is at heightened risk of economic or military conflict. The latest developments have seen the CNY-USD exchange rate roll over after a period of appreciation associated with bilateral deal-keeping (Chart 8). Depreciation makes it more likely that President Trump will take punitive actions, but these will still be consistent with maintaining the phase one deal unless his re-election bid completely collapses, rendering him a lame duck and removing his constraints on more economically significant confrontation. We are perilously close to such an outcome, which is why Trump’s approval rating and head-to-head polling against Joe Biden must be monitored closely. If his budding rebound is dashed, then all bets are off with regard to China and Asian power politics. Chart 8A Warning Of Further US-China Escalation A Warning Of Further US-China Escalation A Warning Of Further US-China Escalation Bottom Line: China’s stimulus, like the US stimulus, is a reason for cyclical optimism regarding risk assets. The phase one trade deal with President Trump is less certain – there is a 40% chance it collapses as stimulus and/or Trump’s political woes remove constraints on conflict. Hong Kong is a red herring except with regard to coalition-building between the US and Europe; the Taiwan Strait is the real geopolitical risk. Maritime conflicts relate to Taiwan and are also market-relevant. Europe, Russia, And Oil Risks Europe has proved a geopolitical opportunity rather than a risk, as we have contended. The passage of joint debt issuance in keeping with the seven-year budget reinforces the point. The Dutch, facing an election early next year, held up the negotiations, but ultimately relented as expected. Emmanuel Macron, who convinced German Chancellor Angela Merkel to embrace this major compromise for European solidarity, is seeing his support bounce in opinion polls at home. He is being rewarded for taking a leadership position in favor of European integration as well as for overseeing a domestic economic rebound. His setback in local elections is overstated as a political risk given that the parties that benefited do not pose a risk to European integration, and will ally with him in 2022 against any populist or anti-establishment challenger. We still refrain from reinitiating our long EUR-USD trade, however, given the immediate risks from the US election cycle (Chart 9). We will reevaluate if Trump’s odds of victory fall further. A Biden victory is very favorable for the euro in our view. Chart 9EUR-USD Gets Boost From EU Solidarity EUR-USD Gets Boost From EU Solidarity EUR-USD Gets Boost From EU Solidarity We are bullish on pound sterling because even a delay or otherwise sub-optimal outcome to trade talks is mostly priced in at current levels (Charts 10A and 10B). Prime Minister Boris Johnson has the raw ability to walk away without a deal, in the context of strong domestic stimulus, but the long-term economic consequences could condemn him to a single term in office. Compromise is better and in both parties’ interests. Chart 10APound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Chart 10BPound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Two other risks are worth a mention in this month’s GeoRisk Update: Chart 11Russia: GeoRisk Indicator Russian Bonds May Face Sanctions Russia: GeoRisk Indicator Russian Bonds May Face Sanctions Russia: GeoRisk Indicator Russian Bonds May Face Sanctions Russia: In recent reports we have maintained that Russian geopolitical risk is understated by markets. Domestic unrest is rising, the Trump administration could impose penalties over Nordstream 2 or other issues to head off criticism on the campaign trail, and a Biden administration would be outright confrontational toward Putin’s regime. Moscow may intervene in the US elections or conduct larger cyber attacks. US sanctions could ultimately target trading of local currency Russian government bonds, which so far have been spared (Chart 11). Iran: The jury is still out on whether the recent series of mysterious explosions affecting critical infrastructure in Iran are evidence of a clandestine campaign of sabotage (Table 3). The nature of the incidents leaves some room for accident and coincidence.1 But the inclusion of military and nuclear sites in the list leads us to believe that some degree of “wag the dog” is going on. The prime suspect would be Israel and/or the United States during the window of opportunity afforded by the Trump administration, which looks to be closing over the next six months. Trump likely has a high tolerance for conflict with Iran ahead of the election. Even though Americans are war-weary, they will rally to the president’s defense if Iran is seen as the instigator, as opinion polls showed they did in September 2019 and January of this year. Iran is avoiding goading Trump so far but if it suffers too great of damage from sabotage then it may be forced to react. The dynamic is unstable and hence an oil price spike cannot be ruled out. Table 3Wag The Dog Scenario Playing Out In Iran A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) Chart 12Oil Supply Risks Stem From Iran/Iraq, But COVID Threat To Demand Persists Oil Supply Risks Stem From Iran/Iraq, But COVID Threat To Demand Persists Oil Supply Risks Stem From Iran/Iraq, But COVID Threat To Demand Persists Oil markets have the capacity and the large inventories necessary to absorb supply disruptions caused by a single Iranian incident (Chart 12). Only a chain reaction or major conflict would add to upward pressure. This would also require global demand to stay firm. The threat from COVID-19 suggests that volatility is the only thing one can count on in the near-term. Over the long run we remain bullish crude oil due to the unfettered commitment by world governments to reflation. Bottom Line: The euro rally is fundamentally supported but faces exogenous risks in the short run. We would steer clear of Russian currency and local currency bonds over the US election campaign and aftermath, particularly if Trump’s polling upturn becomes a dead cat bounce. Iran is a “gray swan” geopolitical risk, hiding in plain sight, but its impact on oil markets will be limited unless a major war occurs. Investment Implications The US dollar is at a critical juncture. Our Foreign Exchange Strategist Chester Ntonifor argues that if the DXY index breaks beneath the 93-94 then the greenback has entered a structural bear market. The most recent close was 93.45 and it has hovered below 94 since Monday. Failure to pass US stimulus quickly could result in a dollar bounce along with other safe havens. Over the short run, investors should be prepared for this and other negative surprises relating to the US election and significant geopolitical risks, especially involving China, the tech war, and the Taiwan Strait. Over the long run, investors should position for more fiscal support to combine with ultra-easy monetary policy for as far as the eye can see. The Federal Reserve is not even “thinking about thinking about raising rates.” This combination ultimately entails rising commodity prices, a weakening dollar, and international equity outperformance relative to both US equities and government bonds.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Raz Zimmt, "When it comes to Iran, not everything that goes boom in the night is sabotage," Atlantic Council, July 30, 2020. Section II: Appendix : GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights Economic shocks in recent decades have led to surges in nationalism and the COVID-19 crisis is unlikely to be different. Nationalism adds to the structural challenges facing globalization, which is already in retreat. Investors face at least a 35% chance that President Trump will be reelected and energize a nationalist and protectionist agenda that is globally disruptive. China is also indulging in nationalism as trend growth slows, raising the probability of a clash with the US even if Trump does not win. US-China economic decoupling will present opportunities as well as risks – primarily for India and Southeast Asia. Feature Since the Great Recession, investors have watched the US dollar and US equities outperform their peers in the face of a destabilizing world order (Chart 1). Chart 1US Outperformance Amid Global Disorder US Outperformance Amid Global Disorder US Outperformance Amid Global Disorder Global and American economic policy uncertainty has surged to the highest levels on record. Investors face political and geopolitical power struggles, trade wars, a global pandemic and recession, and social unrest.  How will these risks shape up in the wake of COVID-19? First, massive monetary and fiscal stimulus ensure a global recovery but they also remove some of the economic limitations on countries that are witnessing a surge in nationalism.  Second, nationalism creates a precarious environment for globalization – namely the wave of “hyper-globalization” since 2000. Nationalism and de-globalization do not depend on the United States alone but rather have shifted to the East, which means that geopolitical risks will remain elevated even if the US presidential election sees a restoration of the more dovish Democratic Party.  Economic Shocks Fuel Nationalism’s Revival Nationalism is the idea that the political state should be made up of a single ethnic or cultural community. While many disasters have resulted from this idea, it is responsible for the modern nation-state and it has enabled democracies to take shape across Europe, the Americas, and beyond. Industrialization is also more feasible under nationalism because cultural conformity helps labor competitiveness.1  At the end of the Cold War, transnational communist ideology collapsed and democratic liberalism grew complacent. Each successive economic shock or major crisis has led to a surge in nationalism to fill the ideological gaps that were exposed. For instance, various nationalists and populists emerged from the financial crises of the late 1990s. Russian President Vladimir Putin sought to restore Russia to greatness in its own and other peoples’ eyes (Chart 2). Not every Russian adventure has mattered for investors, but taken together they have undermined the stability of the global system and raised barriers to exchange. The invasion of Crimea in 2014 and the interference in the US election in 2016 helped to fuel the rise in policy uncertainty, risk premiums in Russian assets, and safe havens over the past decade. The September 11, 2001 terrorist attacks in the United States created a surge in American nationalism (Chart 3). This surge has since collapsed, but while it lasted the US destabilized the Middle East and provided Russia and China with the opportunity to pursue a nationalist path of their own. Investors who went long oil and short the US dollar at this time could have done worse. Chart 2The Resurgence Of Russian Nationalism Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Chart 3USA: From Nationalism To Anti-Nationalism Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 The 2008 crisis spawned new waves of nationalist feeling in countries such as China, Japan, the UK, and India (Chart 4). Conservatives of the majority cultural group rose to power, including in China, where provincial grassroots members of the elite reasserted the Communist Party’s centrality. Japan and India became excellent equity investment opportunities in their respective spheres, while the UK and China saw their currencies weaken.  The rising number of wars and conflicts across the world since 2008 reflects the shift toward nationalism, whether among minority groups seeking autonomy or nation-states seeking living space (Chart 5). Chart 4Nationalist Trends Since The Great Recession Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Chart 5World Conflicts Rise After Major Crises Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 COVID-19 is the latest economic shock that will feed a new round of nationalism. At least 750 million people are extremely vulnerable across the world, mostly concentrated in the shatter belt from Libya to Turkey, Iran, Pakistan, and India.2 Instability will generate emigration and conflict. Once again the global oil supply will be at risk from Middle Eastern instability and the dollar will eventually fall due to gargantuan budget and trade deficits. Today’s shock will differ, however, in the way it knocks against globalization, a process that has already begun to slow. Specifically, this crisis threatens to generate instability in East Asia – the workshop of the world – due to the strategic conflict between the US and China. This conflict will play out in the form of “proxy battles” in Greater China and the East Asian periphery. The dollar’s recent weakness is a telling sign of the future to come. In the short run, however, political and geopolitical risks are acute and will support safe havens. Globalization In Retreat Nationalism is not necessarily at odds with globalization. Historically there are many cases in which nationalism undergirds a foreign policy that favors trade and eschews military intervention. This is the default setting of maritime powers such as the British and Dutch. Prior to WWII it was the American setting, and after WWII it was the Japanese. Over the past thirty years, however, the rise of nationalism has generally worked against global trade, peace, and order. That’s because after WWII most of the world accepted internationalist ideals and institutions promoted by the United States that encouraged free markets and free trade. Serious challenges to that US-led system are necessarily challenges to global trade. This is true even if they originate in the United States. Globalization has occurred in waves continuously since the sixteenth century. It is not a light matter to suggest that it is experiencing a reversal. Yet the best historical evidence suggests that global imports, as a share of global output, have hit a major top (Chart 6).3 The line in this chart will fall further in 2020. American household deleveraging, China’s secular slowdown, and the 2014 drop in oil and commodities have had a pervasive impact on the export contribution to global growth.   Chart 6Globalization Hits A Major Top Globalization Hits A Major Top Globalization Hits A Major Top The next upswing of the business cycle will prompt an increase in trade in 2021. Global fiscal stimulus this year amounts to 8% of GDP and counting. But will the import-to-GDP  ratio surpass previous highs? Probably not anytime soon. It is impossible to recreate America’s consumption boom and China’s production boom of the 1980s-2000s with public debt alone. Global trend growth is slowing. Isn’t globalization proceeding in services, if not goods? The world is more interconnected than ever, with nearly half of the population using the Internet – almost 30% in Sub-Saharan Africa. One in every two people uses a smartphone. Eventually the pandemic will be mitigated and global travel will resume. Nevertheless, the global services trade is also facing headwinds. And it requires even more political will to break down barriers for services than it does for goods (Chart 7). The desire of nations to control and patrol cyber space has resulted in separate Internets for authoritarian states like Russia and China. Even democracies are turning to censorship and content controls to protect their ideologies.  Chart 7Both Goods And Services Face Headwinds Both Goods And Services Face Headwinds Both Goods And Services Face Headwinds Political demands to protect workers and industries are gaining ground. Policymakers in China and Russia have already shifted back toward import substitution; now the US and EU are joining them, at least when it comes to strategic sectors (health, defense). Nationalists and populists across the emerging world will follow their lead. Regional and wealth inequalities are driving populations to be more skeptical of globalization. GDP per capita has not grown as fast as GDP itself, a simple indication of how globalization does not benefit everyone equally even though it increases growth overall (Chart 8). Inequality is a factor not only because of relatively well-off workers in the developed world who resent losing their job or earning less than their neighbors. Inequality is also rife in the developing world where opportunities to work, earn higher wages, borrow, enter markets, and innovate are lacking. Over the past decade, emerging countries like Brazil, Indonesia, Mexico, and South Africa have seen growing skepticism about whether foreign openness creates jobs or lifts wages.4  Immigration is probably the clearest indication of the break from globalization. The United States and especially the European Union have faced an influx of refugees and immigrants across their southern borders and have resorted to hard-nosed tactics to put a stop to it (Chart 9). Chart 8Global Inequality Fuels Protectionism Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Chart 9US And EU Crack Down On Immigration Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 There is zero chance that these tough tactics will come to an end anytime soon in Europe, where the political establishment has discovered a winning combination with voters by promoting European integration yet tightening control of borders. This combination has kept populists at bay in France, Italy, the Netherlands, Spain, and Germany. A degree of nationalism has been co-opted by the transnational European project. In the US, extreme polarization could cause a major change in immigration policy, depending on the election later this year. But note that the Obama administration was relatively hawkish on the border and the next president will face sky-high unemployment, which discourages flinging open the gates.  Reduced immigration will weigh on potential GDP growth and drive up the wage bill for domestic corporations. If nationalism continues to rise and to hinder the movement of people, goods, capital, and ideas, then it will reduce the market’s expectations of future earnings. American Nationalism Still A Risk  The United States is experiencing a “Civil War Lite” that may take anywhere from one-to-five years to resolve. The November 3 presidential election will have a major impact on the direction of nationalism and globalization over the coming presidential term. If President Trump is reelected – which we peg at 35% odds – then American nationalism and protectionism will gain a new lease on life. Other nations will follow the US’s lead. If Trump fails, then nationalism will likely be driven by external forces, but protectionism will persist in some form. Chart 10Trump Is Not Yet Down For The Count Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Investors should not write Trump off. If the election were held today, Trump would lose, but the election is still four months away. His national approval rating has troughed at a higher level than previous troughs. His disapproval rating has spiked but has not yet cleared its early 2019 peak (Chart 10).5 This is despite an unprecedented deluge of bad news: universal condemnation from Democrats and the media, high-profile defections from fellow Republicans and cabinet members, stunning defeats at the Supreme Court, and scathing rebukes from top US army officers. If Trump’s odds are 35% then this translates to a 35% chance that the United States will continue pursuing globally disruptive “America First” foreign and trade policies in the 2020-24 period.    First Trump will attempt to pass a Reciprocal Trade Act to equalize tariffs with all trading partners. Assuming Democrats block it in the House of Representatives, he will still have sweeping executive authority to levy tariffs. He will launch the next round in the trade war with China to secure a “Phase Two” trade deal, which will be tougher because it will be focused on structural reforms. He could also open new fronts against the European Union, Mexico, and other trade surplus countries. By contrast, these risks will melt away if Biden is elected. Biden would restore the Obama administration’s approach of trade favoritism toward strategic allies and partners, such as Europe and the members of the Trans-Pacific Partnership, but only occasional use of tariffs. Biden would work with international organizations like the World Trade Organization. His foreign policy would also open up trade with pariah states like Iran, reducing the tail-risk of a war to almost zero.  Biden would be tougher on China than Presidents Obama or Bill Clinton, as the consensus in Washington is now hawkish and Biden would need to keep the blue-collar voters he won back from Trump. He may keep Trump’s tariffs in place as negotiating leverage. But he is less likely to expand these tariffs – and there is zero chance he will use them against Europe. At the same time, it will take a year or more to court the allies and put together a "coalition of the willing" to pressure China on structural reforms and liberalization. China would get a reprieve – and so would financial markets. Thus investors have a roughly 65% chance of seeing US policy “normalize” into an internationalist (not nationalist) approach that reduces the US contribution to trade policy uncertainty and geopolitical risk over the next few years at minimum. But there are still four months to go before the election; these odds can change, and equity market volatility will come first. Moreover a mellower US would still need to react to nationalism in Asia. European Nationalism Not A Risk (Yet) European nationalism has reemerged in recent years but has greatly disappointed the prophets of doom who expected it to lead to the breakup of the European Union. The southern European states suffered the most from COVID-19 but many of them have made their decision regarding nationalism and the supra-national EU. Greece underwent a depression yet remained in the union. Italians could easily elect the right-wing anti-establishment League to head a government in the not-too-distant future. But there is no appetite for an Italian exit. Brexit is the grand exception. If Trump wins, then the UK and British Prime Minister Boris Johnson will be seen as the vanguard of the revival of nationalism in the West. If Trump loses, English nationalism will appear an isolated case that is constrained by its own logic given the response of Scottish nationalism (Chart 11). The trend in the British Isles would become increasingly remote from the trends in continental Europe and the United States. The majority of Europeans identify both as Europeans and as their home nationality, including majorities in countries like Greece, Italy, France, and Austria where visions of life outside the union are the most robust (Chart 12). Even the Catalonians are focused on options other than independence, which has fallen to 36% support. Eastern European nationalists play a careful balancing game of posturing against Brussels yet never drifting so far as to let Russia devour them. Chart 11English Versus Scottish Nationalism English Versus Scottish Nationalism English Versus Scottish Nationalism Chart 12European Nationalism Is Limited (For Now) European Nationalism Is Limited (For Now) European Nationalism Is Limited (For Now) Europeans have embraced the EU as a multi-ethnic confederation that requires dual allegiances and prioritizes the European project. COVID-19 has so far reinforced this trend, showing solidarity as the predominant force, and much more promptly than during the 2011 crisis. It will take a different kind of crisis to reverse this trend of deeper integration. European nationalists would benefit from another economic crash, a new refugee wave from the Middle East, or conflict with Turkish nationalism. The latter is already burning brightly and will eventually flame out, but not before causing a regional crisis of some kind. European policymakers are containing nationalism by co-opting some of its demands. The EU is taking steps to guard against globalization, particularly on immigration and Chinese mercantilism. The lack of nationalist uprisings in Europe do not overthrow the contention that globalization is slowing down. Europe can become more integrated at home while maintaining the higher barriers against globalization that it has always maintained relative to the UK and United States. Chinese Nationalism The Biggest Risk The nationalist risk to globalization is most significant in East Asia and the Pacific, where Chinese nationalism continues the ascent that began with the Great Recession. China’s slowdown in growth rates has weakened the Communist Party’s confidence in the long-term viability of single-party rule. The result has been a shift in the party line to promote ideology and quality of life improvements to compensate for slower income gains. Xi Jinping’s governing philosophy consists of nationalist territorial gains, promoting “the China Dream” for the middle class, and projecting ambitious goals of global influence by 2035 and 2049. The result has been a clash between mainland Chinese and peripheral Chinese territories – especially Hong Kong and Taiwan (Chart 13). The turn away from Chinese identity in these areas runs up against their economic interest. It is largely a reaction to the surge in mainland nationalist sentiment, which cannot be observed directly due to the absence of reliable opinion polling. Chart 13Chinese Nationalism On The Mainland, Anti-Nationalism In Periphery Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 The conflict over identity in Greater China is perhaps the world’s greatest geopolitical risk. While Hong Kong has no conceivable alternative to Beijing’s supremacy, Taiwan does. The US is interested in reviving its technological and defense relationship with Taiwan now that it seeks to counterbalance China. Chart 14Taiwan: Epicenter Of US-China Cold War Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Beijing may be faced with a technology cordon imposed by the United States, and yet have the option of circumventing this cordon via Taiwan’s advanced semiconductor manufacturing. Taiwan’s “Silicon Shield” used to be its security guarantee. Now that the US is tightening export controls and sanctions on China, Beijing has a greater need to confiscate that shield. This makes Taiwan the epicenter of the US-China struggle, as we have highlighted since 2016. The risk of a fourth Taiwan Strait crisis is as pertinent in the short run as it is over the long run, given that the US and China have already intensified their saber-rattling in the Strait (Chart 14), including in the wake of COVID-19 specifically. China’s secular slowdown is prompting it to encroach on the borders of all of its neighbors simultaneously, creating a nascent balance-of-power alliance ranging from India to Australia to Japan. If China fails to curb its nationalism, then eventually US political polarization will decline as the country unites in the face of a peer competitor. If American divisions persist, they could drive the US to instigate conflict with China. Thus a failure of either side to restrain itself is a major geopolitical risk. The US and China ultimately face mutually assured destruction in the event of conflict, but they can have a clash in the near term before they learn their limits. The Cold War provides many occasions of such a learning process – from the Berlin airlift to the Cuban missile crisis. Such crises typically present buying opportunities for financial markets, but the consequences could be more far reaching if the Asian manufacturing supply chain is permanently damaged or if the shifting of supply chains out of China is too rapid. Globalization will also suffer as a result of currency wars. The US has not been successful in driving the dollar down, a key demand of the US-China trade war. It is much harder to force China to reform its labor and wage policies than it is to force it to appreciate its currency. But unlike Japan in 1985, China will not commit to unilateral appreciation for fear of American economic sabotage.   Punitive measures will remain an American tool. Contrary to popular belief, the US is not attempting to eliminate its trade deficit. It is attempting to reduce overreliance on China. Status quo globalization is intolerable for US strategy. But autarky is intolerable for US corporations. The compromise is globalization-ex-China, i.e., economic decoupling. Investment Implications Chart 15Favor International Stocks As Growth Revives Favor International Stocks As Growth Revives Favor International Stocks As Growth Revives US stock market capitalization now makes up 58% of global capitalization (Chart 15), reflecting the strength and innovation of American companies as well as a worldwide flight to safety during a decade of rising policy uncertainty and geopolitical risk. The revival of global growth amid this year’s gargantuan stimulus will prompt a major rotation out of US equities and into international and emerging market equities over the long run. As mentioned, the US greenback would also trend downward. However, there will be little clarity on the pace of nationalism and the fate of globalization until the US election is decided. Moreover the fate of globalization does not depend entirely on the United States. It mostly depends on countries in the east – Russia, China, and India, all of which are increasingly nationalistic.  A miscalculation over Taiwan, North Korea, the East China Sea, the South China Sea, trade, or technology could ignite into tariffs, sanctions, boycotts, embargoes, saber-rattling, proxy battles, and potentially even direct conflict. These risks are elevated in the short run but will persist in the long run. As the US decouples from China it will have to deepen relations with other trading partners. The trade deficit will not go away but will be redistributed to Asian allies. Southeast Asian nations and India – whose own nationalism has created a shift in favor of economic development – will be the long-run beneficiaries.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1  Ernest Gellner, Nations and Nationalism (Ithaca, NY: Cornell University Press, 1983). 2  Neli Esipova, Julie Ray, and Ying Han, “750 Million Struggling To Meet Basic Needs With No Safety Net,” Gallup News, June 16, 2020. 3 Christopher Chase-Dunn et al, “The Development of World-Systems,” Sociology of Development 1 (2015), pp. 149-172; and Chase-Dunn, Yukio Kawano, Benjamin Brewer, “Trade globalization since 1795: waves of integration in the world-system,” American Sociological Review 65 (2000), pp. 77-95. 4 Bruce Stokes, “Americans, Like Many In Other Advanced Economies, Not Convinced Of Trade’s Benefits,” September 26, 2018. 5 In other words, the mishandling of COVID-19 and the historic George Floyd protests of June 2020 have not taken as great of a toll on Trump’s national approval, thus far, as the Ukraine scandal last October, the government shutdown in January-February 2019, the near-failure to pass tax cuts in December 2017, or the Charlottesville incident in August 2017. This is surprising and points once more to Trump’s very solid political base, which could serve as a springboard for a comeback over the next four months.

  Highlights In the short run, extreme policy uncertainty is problematic for risk assets. In the long run, gargantuan fiscal and monetary stimulus continues to support cyclical trades. Equity volatility always increases in the lead-up to US presidential elections. Trump has a 35% chance of reelection. The US-China trade deal is intact for now but the risk of a strategic crisis or tariffs is about 40%. Our Turkish GeoRisk Indicator is lower than it should be based on Turkey’s regional escapades. Feature US equities fell back by 2.6% on June 24 as investors took notice of rising near-term risks to the rally. With gargantuan global monetary and fiscal stimulus, we expect the global stock-to-bond ratio to rise over the long run (Chart 1). However, we still see downside risks prevailing in the near term related to the pandemic, US politics, geopolitics, and the rollout of additional stimulus this summer. Chart 1Risk-On Phase Continues - But Risks Mounting Risk-On Phase Continues - But Risks Mounting Risk-On Phase Continues - But Risks Mounting Chart 2Policy Uncertainty Hitting Extremes Policy Uncertainty Hitting Extremes Policy Uncertainty Hitting Extremes Global economic policy uncertainty is skyrocketing – particularly due to the epic the November 3 US election showdown. Yet Chinese policy uncertainty remains elevated and will rise higher given that the pandemic epicenter now faces an unprecedented challenge to its economic and political order. China’s economic instability will increase emerging market policy uncertainty (Chart 2). Only Europe is seeing political risk fall, yet Trump’s threats of tariffs against Europe this week highlight that he will resort to protectionism if his approval rating does not benefit from stock market gains, which is currently the case. The COVID-19 outbreak is accelerating in the US in the wake of economic reopening and insufficient public adherence to health precautions and distancing measures. The divergence with Europe is stark (Chart 3). Authorities will struggle to institute sweeping lockdowns again, but some states are tightening restrictions on the margin and this will grow. Chart 3US COVID-19 Outbreak Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) The divergence between daily new infection cases and new deaths in the US, as well as countries as disparate as Sweden and Iran, is not entirely reassuring. The US is effectively following Sweden’s “light touch” model. Ultimately COVID is not much of a risk if deaths are minimized – but tighter social restrictions will frighten the markets regardless (Chart 4). President Trump’s election chances have fallen under the weight of the pandemic – followed by social unrest and controversy over race relations. But net approval on handling the economy is holding up well enough (Chart 5). Chart 4Divergence In New Cases Versus New Deaths Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Chart 5Trump’s Lifeline Is The Economy Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Our subjective 35% odds of reelection still seem appropriate for now – but we will upgrade Trump if the financial and economic rebound is sustained while his polling improves. His approval should pick up in the face of a collapse of law and order, not to mention left-wing anarchists removing or vandalizing historical monuments to America’s Founding Fathers and some great public figures who had nothing to do with the Confederacy in the Civil War. Equity volatility will increase ahead of the US election. Chart 6Volatility Always Rises Before US Elections Volatility Always Rises Before US Elections Volatility Always Rises Before US Elections Equity volatility always increases in the lead up to modern American elections (Chart 6) and this year’s extreme polarization, high unemployment, and precarious geopolitical environment suggest that negative surprises could be worse than usual, notwithstanding the tsunami of stimulus. So far this year the S&P 500 is tracing along the lower end of its historical performance during presidential election years. This is consistent with a change of government in November, unless it continues to power upward over the next four months – typically a change of ruling party requires a technical correction on the year. Our US Equity Strategist, Anastasios Avgeriou, also expects the market to begin reacting to political risk – and he precisely timed the market’s peak and trough over the past year (Chart 7). We suspect that the positive correlation between the S&P and the Democratic Party’s odds of a full sweep of government is spurious. The reason the S&P has recovered is because of the economic snapback from the lockdowns and the global stimulus. The reason the odds of a Blue Wave election have surged is because the pandemic and recession decimated Trump and the Republicans. Going forward, the market needs to do more to discount a Democratic sweep. At 35%, this scenario is underrated in Chart 8, which considers all possible presidential and congressional combinations. Standalone bets put the odds of a Blue Wave at slightly above 50%. We have always argued that the party that wins the White House in 2020 is highly likely to take the Senate. Chart 7Market At Risk Of Election Cycle Market At Risk Of Election Cycle Market At Risk Of Election Cycle Chart 8Market Will Soon Worry About 'Blue Wave' Market Will Soon Worry About 'Blue Wave' Market Will Soon Worry About 'Blue Wave' True, the US is monetizing debt and this will push risk assets higher regardless over the long run. But if former Vice President Joe Biden wins the presidency, he will create a negative regulatory shock for American businesses, and if his party takes the Senate, then corporate taxes, capital gains taxes, federal minimum wages, liability insurance, and the cost of carbon (implicitly or explicitly) will all rise. The market must also reckon with the possibility that Trump is reelected or that he becomes firmly established as a “lame duck” and thus takes desperate measures prior to the election. His threat to impose tariffs on Europe this week underscores our point that if Trump’s approval rating stays low, despite a rising stock market, then the temptation to spend financial capital in pursuit of political capital will rise. This will involve a hard line on immigration and trade. Bottom Line: Tactically, there is more downside. Strategically, we remain pro-cyclical. Stimulus Hiccups This Summer One reason we have urged investors to buy insurance against downside risks this month is because of hurdles in rolling out the next round of fiscal stimulus. The four key drivers of the global growth rebound are liquidity, fiscal easing (Chart 9), an enthusiastic private sector response, and the large cushion of household wealth prior to the crisis. This is according to Mathieu Savary – author of our flagship Bank Credit Analyst report. Mathieu argues that it will be harder for investors to overlook policy uncertainty after the stimulus slows, i.e. the second derivative of liquidity turns negative. Chart 9Gargantuan Fiscal Stimulus Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) The massive increase in budget deficits and the quick recovery in activity amid reopening have reduced politicians’ sense of urgency. We fear that the stock market will have to put more pressure on lawmakers to force them to provide more largesse. Ultimately they will do so – but if they delay, and if delay looks like it is turning into botching the job, then markets will temporarily panic. Why are we confident stimulus will prevail? In the United States, fiscal bills have flown through Congress despite record polarization. Democrats cannot afford to obstruct the stimulus just to hurt the economy and the president’s reelection chances. Instead they have gone hog wild – promoting massive spending across the board to demonstrate their fundamental proposition that government can play a larger and more positive role in Americans’ lives. Their latest proposal is worth $3 trillion, plus an infrastructure bill that nominally amounts to $500 billion over five years. President Trump, for his part, was always fiscally profligate and now wants $2 trillion in stimulus to fuel the economic recovery, thus increasing his chances of reelection as voters grow more optimistic in the second half of the year. He also wants $1 trillion in new infrastructure spending over five years. Yet Republican Senators are dragging their feet and offering only a $1 trillion package. In the end they will adopt Trump’s position because if they do not hang together, they will all hang separately in November. The debate will center on whether the extra $600 in monthly unemployment benefits will be continued (at a cost of $276bn in the previous Coronavirus Aid, Relief, and Economic Security Act). Republicans want to tie benefits to returning to work, since this generous subsidy created perverse incentives and made it more economical for many to stay on the dole. There will also be a debate over whether to issue another round of direct cash checks to citizens ($290bn in the CARES Act). Republicans want to prioritize payroll tax cuts, again focusing on reducing unemployment (Chart 10). Chart 10US Fiscal Stimulus Breakdown Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Our US bond strategist, Ryan Swift, has shown that the cash handouts present a substantial fiscal “cliff.” Without the original one-time stimulus checks, real personal income would have fallen 5% since February, instead of rising 9% (Chart 11). If Republicans refuse to issue a new round of checks, yet the extra unemployment benefits stay, then over $1 trillion in income will be needed to fill the gap so that overall personal income will end up flat since February. In other words, an ~8% increase in income less transfers from current levels is necessary to prevent overall personal income from falling below its February level. China and the EU will eventually provide more largesse. Republican Senators will capitulate, but the process could be rocky and the market should see volatility this summer. China may also be forced to provide more stimulus in late July at its mid-year Politburo meeting – any lack of dovishness at that meeting will disappoint investors. European talks on the Next Generation recovery fund could also see delays (though they are progressing well so far). Brexit trade deal negotiations pose a near-term risk. There is also a non-negligible chance that the German Constitutional Court will raise further obstructions with the European Central Bank’s quantitative easing programs on August 5. European risks are manageable on the whole, but the market is not discounting much (Chart 12). Chart 11Will Congress Takeaway The Money Tree? Will Congress Takeaway The Money Tree? Will Congress Takeaway The Money Tree? Bottom Line: We expect the S&P 500 to trade in a range between 2800 and 3200 points during this period of limbo in which risks over pandemic response and political risks will come to the fore while the market awaits new stimulus measures, which may not be perfectly timely. Chart 12European Risks Are Getting Priced European Risks Are Getting Priced European Risks Are Getting Priced Has The Phase One China Deal Failed Yet? President Trump’s threat this week to slap Europe with tariffs, if it imposes travel restrictions on the US over the coronavirus, points to the dynamic we have highlighted on the more consequential issue of whether Trump hikes broad-based tariffs on China, and/or nullifies the “Phase One” trade deal. Our sense is that if Trump is doing extremely poorly, or extremely well, in terms of opinion polls and the stock market, then the roughly 40% odds of sweeping punitive measures of some kind will go up (Diagram 1). Cumulatively we see the chance of a major tariff hike at 40%. Diagram 1Decision Tree: Risk Of Significant Trump Punitive Measures On China In 2020 Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) White House trade czar Peter Navarro’s comments earlier this week, suggesting that the Phase One trade deal was already over, prompted Trump to tweet that he still fully supports the deal. Negotiations between Secretary of State Mike Pompeo and Chinese Politburo member Yang Jiechi also nominally kept the lid on tensions. However, China may need to depreciate the renminbi to ease deflationary pressures on its economy – and this would provoke Trump to retaliate (Chart 13). Chart 13Chinese Depreciation Would Provoke Trump Chinese Depreciation Would Provoke Trump Chinese Depreciation Would Provoke Trump We have always argued against the durability of the Phase One trade deal. Investors should plan for it to fall apart. Judging by our China GeoRisk Indicator, investors are putting in a higher risk premium into Chinese equities (Chart 14). They are also doing so with Korean equities, which are ultimately connected with US-China tensions. Only Taiwan is pricing zero political risk, which is undeserved and explains why we are short Taiwanese equities. After China’s imposition of a controversial national security law in Hong Kong and America’s decision to prepare retaliatory sanctions, reports emerged that Chinese authorities ordered state-owned agricultural traders to halt imports of soybean and pork – and potentially corn and cotton. These reports were swiftly followed by others that highlighted that state-owned Chinese firms purchased at least three cargoes of US soybeans on June 1, in spite of China’s decision to stop imports.1 Thus this aspect of the deal has not yet collapsed. But we would emphasize that the constraints against a failure of the deal are not prohibitive this year. The $200 billion worth of additional Chinese imports over 2020-2021 promised in the deal included $32 billion worth of additional US farm purchases – with at least $12.5 billion in 2020 and $19.5 billion in 2021 over 2017 imports of $24 billion. However, to date, US agricultural exports to China suggest that China may not even meet 2017 levels (Chart 15). Chart 14GeoRisk Indicators Show Rising Risk GeoRisk Indicators Show Rising Risk GeoRisk Indicators Show Rising Risk Chart 15Trade Deal Durability Still Shaky Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Soybeans account for roughly 60% of US agricultural exports to China. While Chinese imports are up so far this year relative to 2019, they remain well below pre-trade war levels. Although lower hog herds on the back of the African Swine Flu and disruptions caused by COVID-19 may be blamed, they are not the only cause of subdued purchases. The share of Chinese soybean imports coming from the US is also still below pre-trade war levels (Chart 16). Chart 16China Still Substituting Away From US Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) New Chinese regulation requiring documents assuring food shipments to China are COVID-19 free adds another hurdle – China already banned poultry imports from Tyson Foods Inc. plants. Although the US’s share of China’s pork imports has picked up significantly, it will not go far toward meeting the trade deal requirements. China’s pork purchases from the US were valued at $0.3 billion in 2017, while soybean imports came in at $14 billion. Bottom Line: Trump’s only lifeline at the moment is the economy which pushes against canceling the US-China deal. But if he becomes a lame duck – or if exogenous factors humiliate him – then all bets are off. The passage of massive stimulus in the US and China removes economic constraints to conflict. Will Erdogan Overstep In Libya? We have long been bearish on Turkey relative to other emerging markets due to President Tayyip Erdogan’s populist policies, which erode monetary and fiscal responsibility and governance. Turkey’s intervention in Libya has marked a turning point in the Libyan civil war. The offensive to seize Tripoli on the part of General Khalifa Haftar of the Tobruk-based Libyan National Army (LNA) has been met with defeat (Map 1). Map 1Libya’s Battlefront Is Closing In On The Oil Crescent Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Foreign backing has enabled the conflict. Egypt, the UAE, Saudi Arabia, and Russia are the Libyan National Army’s main supporters, while Turkey and Qatar support Prime Minister Fayez al-Sarraj of the UN recognized Government of National Accord (GNA). The GNA’s successes this year can be credited to Turkey, which ramped up its intervention in Libya, even as oil prices collapsed, hurting Haftar and his supporters. Now the battlefront has shifted to Sirte and the al-Jufra airbase – the largest in Libya – and is closing in on the eastern oil-producing crescent, which contains over 60% of Libya’s oil. The victor in Sirte will also have control over the oil ports of Sidra, Ras Lanuf, Marsa al-Brega, and Zuwetina. With all parties eying the prize, the conflict is intensifying. Tripoli faces greater resistance as its forces move east. Egyptian President Abdel Fattah al-Sisi’s June 6 ceasefire proposal, dubbed the Cairo Initiative, was rejected by al-Sarraj and Turkey. Instead, the Tripoli-based government wants to capture Sirte and al-Jufra before coming to the table. The recapturing of oil infrastructure would bring back some of Libya's lost output (Chart 17). Nevertheless, OPEC 2.0 is committed to keeping oil markets on track to rebalance, reducing the net effect of a Libyan production increase on global supplies. However, the GNA’s swift successes in the West may not be replicable as it moves further East, where support for Haftar is deeper and where the stakes are higher for both sides. This is demonstrated by the GNA’s failed attempt to capture Sirte on June 6. The battlefront is now at Egypt’s red line – GNA control of al-Jufra would pose a direct threat to Egypt and is thus considered a border in Egypt’s national security strategy. A push eastward risks escalating the conflict further by drawing in Egypt militarily. In a televised speech on June 20, al-Sisi threatened to deploy Egypt’s military if the red line is crossed. The statement was interpreted by Ankara as a declaration of war, raising the possibility that Egypt will go to war with Turkey in Libya. On paper, Egypt’s military is up to the task. Its recent upgrades have pulled up its ranking to ninth globally according to the Global Fire Power Index, surpassing Turkey’s strength in land and naval forces (Chart 18). However, while Turkey’s military has been active in other foreign conflicts such as in Syria, Egypt’s army is untested on foreign soil. Its most recent military encounter was the 1973 Yom Kippur War. Even after years of fighting, it has yet to declare victory against terrorist cells in the Sinai Peninsula. Thus Egypt’s rusty forces could face a protracted conflict in Libya rather than a swift victory. Chart 17GNA/Turkish Success Would Revive Libyan Oil Production Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Chart 18Egypt Is Militarily Capable … On Paper Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Other constraints may also deter al-Sisi from following through on his threat: Other Arab backers of the Libyan National Army – the UAE and Saudi Arabia – are unlikely to provide much support as their economies have been hammered by low oil prices. Egypt’s own economy is in poor shape to withstand a protracted war, with public debt on an unsustainable path. Not coincidentally, Egypt faces another potential military escalation to its south where it has been clashing with Ethiopia over the construction of the Grand Ethiopian Renaissance Dam on the Blue Nile. The dam will control Egypt’s water supply. The latest round of negotiations failed last week. While Cairo is hoping to obtain a bilateral agreement over the schedule for filling the dam, Addis Ababa has indicated that it will begin filling the dam in July regardless of whether an agreement is reached. Al-Sisi’s response to the deadlocked situation has been to request an intervention by the UN Security Council. However, as the July filling date nears, the Egypt-Ethiopia standoff risks escalating into war. For Egypt, there is an urgency to secure its future water supplies now before Ethiopia begins filling the dam. And while resolving the Libyan conflict is also a matter of national security – Egypt sees the Libyan National Army as a buffer between its porous western border and the extremist elements of the GNA – the risks are not as pressing. Thus a military intervention in Libya would distract Egypt from the Ethiopian conflict and risk drawing it into a war on two fronts. Moreover, Egypt generally, and al-Sisi in particular, risk losing credibility in case of a defeat. That said, Egypt has high stakes in Libya. A GNA defeat could annul the recent Libya-Turkey maritime demarcation agreement – a positive for Egypt’s gas ambitions – and eliminate the presence of unfriendly militias on its Western border. Thus, if the GNA or GNA-allied forces kill Egyptian citizens, or look as if they are capable of utterly defeating Haftar on his own turf, then it would be a prompt for intervention. Meanwhile Turkey’s regional influence and foreign policy assertiveness is growing – and at risk of over-extension. Erdogan’s interests in Libya stem from both economic and strategic objectives. In addition to benefitting from oil and gas rights and rebuilding contracts, Ankara’s strategy is in line with its pursuit of greater regional influence as set out in the Mavi Vatan, its current strategic doctrine.2 There are already rumors of Turkish plans to establish bases in the recently captured al-Watiya air base and Misrata naval base. This would be in addition to Ankara’s bases in Somalia and in norther Iraq. Erdogan is partly driven into these foreign policy adventures to distract from his domestic challenges and keep his support level elevated ahead of the 2023 general election (Chart 19). However, his growing assertiveness threatens to alienate European neighbors and NATO allies, which have so far played a minimal role in the Libyan conflict yet have important interests there. For now, the western powers seem focused on countering Russian intervention in Libya and the broader Mediterranean. Prime Minister al-Sarraj and General Stephen Townsend, head of US Africa Command (AFRICOM), met earlier this week and reiterated the need to return to the negotiating table and respect Libyan sovereignty and the UN arms embargo, with a focus on stemming Russian interference. However, Turkish relations with the West may take a turn for the worse if Erdogan oversteps. Turkey continues to threaten Europe with floods of refugees and immigrants if its demands are not met. This pressure will grow due to the COVID-19 crisis, which will ripple across the Middle East, Africa, and South Asia. Ankara also continues to press territorial claims in the Mediterranean Sea, ostensibly for energy development.3 Turkey has recently clashed with Greece and France on the seas. In sum, the Libyan conflict is intensifying as it moves into the oil crescent. The Turkey-backed GNA will face greater resistance in Sirte and al-Jufra, even assuming that Egypt does not follow through on its threat of intervening militarily. Erdogan’s foreign adventurism will provoke greater opposition in Libya and elsewhere among key western powers, Russia, and the Gulf Arab states. Bottom Line: The implication is that a deterioration in Turkey’s relationship with the West, military overextension, and continued domestic economic mismanagement will push up our Turkey GeoRisk Indicator, which is a way of saying that it will weigh on the currency (Chart 20). Chart 19Erdogan’s Fear Of Opposition Drives Bold Policy Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Chart 20Foreign And Domestic Factors Will Push Up Turkish Risk Foreign And Domestic Factors Will Push Up Turkish Risk Foreign And Domestic Factors Will Push Up Turkish Risk Stay short our “Strongman Basket” of emerging market currencies, including the Turkish lira. Investment Takeaways We entered the year by going strategically long EUR-USD, but closed the trade upon the COVID-19 lockdowns. We have resisted reinitiating it despite the 5% rally over the past three months due to extreme political risks this year, namely the US election and trade risks. Trump’s threat of tariffs on Europe this week highlights our concern. We will wait until the election outcome before reinstituting this trade, which should benefit over time as global and Chinese growth recover and the US dollar drops on yawning twin deficits. Throughout this year’s crisis we have periodically added cyclical and value plays to our strategic portfolio. We favor stocks over bonds and recommend going long global equities relative to the US 30-year treasuries. We are particularly interested in commodities that will benefit from ultra-reflationary policy and supply constraints due to insufficient capital spending. This month we recommend investors go long our BCA Rare Earth Basket, which features producers of rare earth elements and metals that can substitute for Chinese production (Chart 21). This trade reflects our macro outlook as well as our sense that the secular US-China strategic conflict will heat up before it cools down. Chart 21Position For An Escalation In The US-China Conflict Position For An Escalation In The US-China Conflict Position For An Escalation In The US-China Conflict   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 Please see Karl Plume et al, "China buys U.S. soybeans after halt to U.S. purchases ordered: sources," Reuters, June 1, 2020. 2 The Mavi Vatan or “Blue Homeland Doctrine” was announced by Turkish Admiral Cem Gurdeniz in 2006 and sets targets to Turkish control in two main regions. The first region is the three seas surrounding it – the Mediterranean Sea, Aegean Sea, and Black Sea with the goal of securing energy supplies and supporting Turkey’s economic growth. The second region encompasses the Red Sea, Caspian Sea and Arabian Sea where Ankara has strategic objectives. 3 Ankara’s gas drilling activities off Cyprus have been a form of frequent provocation for Greece and Cyprus. Ankara has also stated that it may begin oil exploration under a controversial maritime deal with Libya as early as August. Section II: Appendix : GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights China and India periodically fight each other on their fuzzy Himalayan border with zero market consequences. A major conflict is possible in the current environment – but it would present a buying opportunity. Chinese escalation with India would not have a negative impact on global trade and economy, unlike escalation with the US or its East Asian allies. If China gets into a major conflict with India, it is less likely to stage major military actions in the South China Sea or Taiwan Strait. It would reduce much more significant geopolitical risks. Go strategically long Indian pharmaceuticals. Feature India and China have engaged in their first deadly military clash since 1967. An Indian colonel and at least 20 troops died in fighting on June 15 in the Galwan Valley, Ladakh, where territorial disputes have heated up over the past month.At least 50 Chinese troops are estimated dead.1 Chart 1Regional Equities May Not Shrug Off War In Himalayas ... At First Regional Equities May Not Shrug Off War In Himalayas ... At First Regional Equities May Not Shrug Off War In Himalayas ... At First It was a minor incident. No shots were fired. Combatants used stones and knives and threw each other off cliffs. However, the occasion of the battle was a negotiation to de-escalate tensions, and talks have gone on since June 3. So that bodes ill. Prime Minister Narendra Modi’s government has not responded but China’s foreign ministry is making conciliatory remarks. Normally India-China border clashes occur during the summer, when weather permits, and do not last long and do not impact the rest of the world, either politically or financially. However, the structural and cyclical drivers of the conflict suggest it could escalate over the summer. A major escalation between nuclear powers is unlikely but could conceivably cause volatility in global financial markets. Global equity investors are focused on other things (COVID-19, global stimulus), but recent volatility suggests that Chinese, Indian, and Pakistani bourses could be vulnerable to any major military escalation (Chart 1). However, a Himalayan-inspired selloff would be short-lived and would present a buying opportunity. India-China tensions are far less relevant to global financial markets than China’s disputes with the United States in East Asia. If the US uses India as a pretext for tougher actions on China, then that is a different story. But it is unlikely for reasons explained below. Our base case strategic assessment of India remains the same: Chinese expansionism will pressure India to speed up economic development to gain greater influence in South Asia. India will also pursue better trade and defense relations with the United States and its allies in East Asia and the Pacific. We are tactically cautious on global equities, but strategically we expect equities to beat bonds and cyclicals to beat defensives. Selloffs stemming from Himalayan conflict will create buying opportunities for emerging market equities, especially India. The Drivers Of The Ladakh Skirmish India and China have a 2,170-mile border in the Himalayan mountains that is disputed in India’s northwest (Aksai Chin) and northeast (Sikkim; Arunachal Pradesh). These border disputes have simmered for decades and occasionally flare into violent incidents, usually meaningless. An India-China border war could occur, but is unlikely. Today’s clashes are mostly taking place in eastern Ladakh, as with disputes in 2013-14. Minor incidents have also occurred in India’s northeast (Naku La, Sikkim). These may be unrelated, but they may also suggest a broad India-China border conflict is in the works (Map 1). Map 1India And China Often Fight Over Undefined Himalayan Border When Ice Melts The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness There is always a local spark for clashes along the Line of Actual Control. These tend to be triggered by infrastructure construction or military patrols that cross the countries’ various border claims. Typically China triggers the incident as it is always pouring more money and concrete into new structures to solidify its territorial claims, whereas India’s resources are more limited. However, in recent years India has grown more capable. Both sides may also be surging infrastructure spending amid the recession (Chart 2). Chart 2China No Longer Alone In Nation-Building In Himalayas China No Longer Alone In Nation-Building In Himalayas China No Longer Alone In Nation-Building In Himalayas Chart 3China's Slower Growth Jeopardizes Communist Party Legitimacy China's Slower Growth Jeopardizes Communist Party Legitimacy China's Slower Growth Jeopardizes Communist Party Legitimacy In the current dispute both sides claim the other broke the peace. Indian builders supposedly violated China’s space while working on the Darbuk-Shayok-DBO road which connects to an airfield near Galwan Valley, the site of the clash. But the Indian side argues that Chinese military forces have ventured several miles from their usual outposts and amassed major forces on their side suggesting they are preparing for a bigger effort to expand their control of territory. 2 We may never know who “started” it. There is no clear border and even the Line of Actual Control is hard to define.3 Investors should not confuse the proximate cause of this conflict for the underlying cause. There are structural and cyclical factors at work on both sides: 1. China’s declining domestic stability and rising international assertiveness. The crises of 2008, 2015, 2018-19, and 2020 have caused a hard break in China’s economic model. Slower trend growth jeopardizes the Communist Party’s long-term monopoly on power (Chart 3). The Xi Jinping administration has responded to each crisis by tightening the party’s grip and reasserting central Beijing control. This is true at home, in peripheral territories like Xinjiang and Hong Kong, and abroad, as in the South China Sea and the Belt and Road Initiative. Territorial disputes have flared up across China’s borders. India is no exception, with incidents in 2013, 2014, 2017, and now 2020 marking the change (Table 1). Table 1China’s Territorial Assertiveness Triggers Clashes With India The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness The China-Pakistan Economic Corridor strengthens the alliance between these two countries and deepens India’s insecurities. India perceives China’s Belt and Road Initiative as a threat of economic and eventually military encirclement. In 2017, the Doklam dispute between China, Bhutan, and India – which lasted over two months – served to distract the Chinese populace from a major increase in US pressure on China’s periphery. That was President Trump’s “fire and fury” campaign to intimidate North Korea into entering nuclear negotiations (Chart 4). In 2020, China faces its first recessionary environment since the mid-1970s as well as rocky relations with the United States over trade, technology, Hong Kong, North Korea again, and possibly even the Taiwan Strait. It is a convenient time to turn the public’s attention to the Himalayas. Chart 4China's Last Dispute With India Occurred During US-North Korea Tensions China's Last Dispute With India Occurred During US-North Korea Tensions China's Last Dispute With India Occurred During US-North Korea Tensions 2. India’s emerging national consensus and international coming-of-age. India’s rise as a global power has accelerated since the Great Recession, especially after oil prices fell in 2014. Prime Minister Modi has won two smashing general elections with single-party majorities, in 2014 and 2019. His movement also maintains the upper hand in state legislatures, which is important given that India’s weak federal government cannot simply force structural reforms onto the country (Map 2). Modi’s electoral success reflects a deeper national consensus on the need for stronger central leadership, faster economic development, deeper international trade and investment ties, and pro-efficiency reforms such as the creation of a single market. The policy retreat from globalization benefits insular and service-oriented economies like India at the expense of mercantilist trading powers such as China. America’s pivot to Asia and “Indo-Pacific” strategy create a chance for India to attract investment as multinational corporations diversify away from China (Chart 5). Map 2Modi’s Political Capital At State-Level The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness Chart 5India Attracts Investment As Supply Chains Diversify From China The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness Chart 6US And India Fiscal Stimulus Enable Supply Chain Shift Out Of China The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness In August 2019, after Modi’s big election victory, he launched an ambitious agenda of state-building. He converted the autonomous region of Jammu and Kashmir into two union territories under New Delhi: Jammu and Kashmir, and Ladakh. This change of status quo angered China and Pakistan, which felt their own territory threatened. Chinese territorial pressure could be retribution for these administrative reforms. China and Pakistan will also want to undermine Modi’s party in upcoming elections for the state assembly of Jammu and Kashmir. China’s territorial encroachments reflect its desire to gain control of the entire Aksai Chin plateau. India does not want China to gain such a strategic advantage at the head of the Indus River and valley. The global pandemic and recession reinforced these structural and cyclical trends by pushing both India and China to use nationalist devices to divert their populations from domestic ills. The use of fiscal stimulus across the world enables leaders to pursue risky strategic policies (Chart 6). There is also a tactical issue: India took over the chairmanship of the World Health Assembly in May, while the US is lobbying on behalf of Taiwan’s long desire to be represented in the World Health Organization in the wake of COVID-19. China is resisting this call and could be using Ladakh as a pressure tactic.4 How Far Will Sino-Indian Conflict Escalate? Reports suggest that India and China have reinforced troops in and near Ladakh and have brought more firepower and airpower into range.5 Some of this activity, on both sides, consists of seasonal military drills. So it is not certain that a build-up is occurring. China is less constrained and more capable of escalation than India. If China continues pressing its territorial advance, or if India tries to reclaim territory or take other territory in compensation, then the fight will expand. The conflict is taking place in rocky recesses at a far remove from the rest of the world, so there is a temptation to believe that any escalation can be controlled.6 This may be false and lead to tit-for-tat escalation. Table 2Military Balance: India Versus China In Himalayas The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness Which side faces greater constraints? China is least constrained and most capable of escalation. Over the short run, China can utilize improved military command and capabilities in the area and can control the media and political response at home. Besting India would demonstrate that all Asian territorial claimants should defer to China. However, over the long run, aggression would cement the balance-of-power alliance between the US and India. India is more constrained than China, less capable of escalation: Modi has considerable political capital, but his conventional military advantage in this area is eroding and China has the higher ground from which to stage attacks (Table 2). India’s loss in the 1962 Himalayan war with China was a national humiliation. A repeat of such an event could destroy much of Modi’s mystique as a strongman leader and national savior. In the worst-case scenario, China would demonstrate superior military capability while the US and its allies would remain utterly aloof, leaving India looking both weak and isolated. Therefore India will engage in tit-for-tat military response while seeking diplomatic de-escalation. The US lacks interest in the dispute: Trump has already offered to mediate, presumably to demonstrate his deal-making skills again before the election. But the US does not have a compelling interest in this dispute and India does not want US mediation. If Trump takes punitive measures against China it will be for other reasons. Serious punitive measures require the stock market and economy to relapse, since at the moment Trump’s average approval rating is 43% and he hopes financial and economic gains will help him recover (Diagram 1). Diagram 1Odds President Trump Will Hike Tariffs On China Before US Election The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness The above points suggest that China can afford to escalate if it wants to show India and the rest of Asia that the US is toothless and that China’s territorial claims in Asia should not be opposed. Since COVID-19, China has been aggressive in the South China Sea and Taiwan Strait, despite the fact that these areas bring economic risks. The Himalayas do not. The implication is that China’s risk appetite is large, particularly in territorial disputes, and driven by social and economic pressure at home. Investment Takeaways Because India and China (and Pakistan) have nuclear arms, and because the US could get involved, it is possible that a major escalation could occur and cause volatility in global financial markets. But it would not last long and no parties will use nuclear arms over Himalayan territorial disputes. A major conflict that results in a Chinese victory would subtract from Prime Minister Modi’s political capital and hence weigh on Indian equities, which have broken down badly since COVID-19 (Chart 7). The reason is that strong political support for Modi would enable India to continue making structural economic reforms that increase productivity. Chart 7Indian Equities Underperforming Since COVID-19 Indian Equities Underperforming Since COVID-19 Indian Equities Underperforming Since COVID-19 Chart 8India’s Path To Regional Primacy Lies Through Economic Opening And Reform The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness In the long run, a major conflict, especially a humiliating defeat, would accelerate India’s attempts to improve national economic prowess for the sake of strategic security. Since India cannot achieve its strategic objective of primacy in South Asia merely through military power, it will need to do so through a stronger economic pull (Chart 8). This is an impetus for structural economic reform even beyond Modi. Hence our secularly bullish outlook on India. Indian pharmaceutical equities offer an investment opportunity (Chart 9). In an attempt to address land acquisition, which is one of the biggest constraints faced by companies looking to invest in India, New Delhi has announced that it is developing an area the size of Luxembourg to attract businesses moving out of China. The government reached out to over 1,000 US companies in April with incentives for them to move their facilities to India, with a focus on industries in which India has a comparative advantage, such as medical equipment suppliers, food processing units, textiles, leather, and auto part makers. Chart 9US And Indian Stimulus Policies Will Boost Investment In Indian Pharma US And Indian Stimulus Policies Will Boost Investment In Indian Pharma US And Indian Stimulus Policies Will Boost Investment In Indian Pharma While India is not as economically competitive as China, it could be attractive for non-strategic industries that would not want to relocate to the US but are looking to reduce uncertainty from US-China tensions. The next round of US fiscal stimulus is also likely to contain significant provisions that will incentivize companies to relocate from China, particularly in the medical and health care sector. For global investors, while a major Sino-Indian escalation could lead to short-term volatility, it would ultimately be a positive development if Beijing vented its nationalism on a strip of earth that is not globally relevant, rather than on the seas, which are highly relevant. Conflict between the US and China in East Asia is a far greater risk than Sino-Indian conflict. Indeed Chinese and American actions over the Taiwan Strait, North Korea, or the South and East China Seas are still far more likely than Sino-Indian tensions to affect global trade and stability and financial markets this year. The US could impose sanctions on Chinese tech and trade, a military incident could occur in the Taiwan Strait, North Korea could provoke US President Donald Trump into a new round of “fire and fury” that triggers a showdown with China, or the US and China could fight a naval skirmish in the South or East China Sea. None of these options is low probability, especially surrounding the US election. Over the short run, global investors should prepare for greater equity volatility, primarily because of hiccups in delivering new stimulus in the US, EU, and China, plus US domestic political risks and US-China-Asia strategic tensions. Stay long JPY-USD. Over the long run, a global growth rebound driven by massive global fiscal and monetary stimulus will drive the US dollar to weaken, global equities to outperform bonds, and cyclicals to outperform defensives. We remain long China-sensitive plays as well as infrastructure, cyber-security, and defense stocks. Strategically, go long Indian pharmaceuticals relative to the emerging market benchmark.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The Guardian, "Soldiers fell to their deaths as India and China’s troops fought with rocks," June 17, 2020. 2 See Ashley J. Tellis, "Hustling in the Himalayas: The Sino-Indian Border Confrontation," Carnegie Endowment for International Peace, June 4, 2020. See also Mohan Guruswamy, "India-China Border Dispute: Is A Give And Take Possible Now?" South Asia Monitor, June 3, 2020. 3 The Treaty of Tingmosgang (1684) only specifies one checkpost, at the Lhari Stream near Demchok, leaving everything else to disputed Indian and Chinese claims. See Alexander Davis and Ruth Gamble, "The local cost of rising India-China tensions," June 1, 2020. 4 See Nayanima Basu, "India Isn’t Worried About Tension With China, Unlikely To Give In To US Pressure On Taiwan," May 13, 2020. 5 See Ren Feng and He Penglei, "PLA Xizang Military Command holds coordinated exercise in plateau region," China Military Online, June 15, 2020. See also "空降兵某旅积极探索远程兵力投送新模式 空地同步 奔赴高原". 6 The reason escalation is normally limited is because of the extreme difficulty of operating extended military operations and resupply at 13,000-feet altitude. Both sides have the ability to surge reinforcements and equalize the contest. The cost and difficulty of retaking lost territory is often prohibitive. And while India’s conventional military power may overbalance China in this region, China has the uphill advantage and has made leaps and bounds in operational capabilities in recent decades. In short, escalation is normally controllable. See Aidan Milliff, "Tension High, Altitude Higher: Logistical And Physiological Constraints On The Indo-Chinese Border," War On The Rocks, June 8, 2020.