Diplomacy/Foreign Relations

Highlights So What? Maintain a cautious stance on Turkish currency and risk assets. Why? Following the AKP’s defeat in Istanbul, Erdogan has doubled down on unorthodox economic policies. Improvements in the current account balance are temporary. Unless investor sentiment is meaningfully repaired, the lira will resume its decline in 2020. In the meantime, tensions with the West – especially the U.S. – will remain elevated. The imposition of secondary sanctions from the U.S. is likely. Feature U.S. President Donald Trump is wavering in the trade war, which is ostensibly positive news for global risk assets that are selling off dramatically amid very gloomy expectations about the near future. The question is whether the delay is too little, too late to halt the slide in financial markets in the near term. The reason to be optimistic is that interest rates have fallen and the global monetary policy “put” is fully in effect. Moreover, it is irrefutable now that President Trump is sensitive to the negative financial effects of the trade war. He is delaying new tariffs on some of the remaining $300 billion worth of imports from China not simply because consumer price inflation has ticked up but more fundamentally because the tightening of financial conditions increases the risk of a recession. A president can survive a small increase in inflation but not a big increase in unemployment. The reason to be pessimistic is that global economic expectations are threatening the crisis levels of 2008 (Chart 1) and Trump’s tariff delay offers cold comfort. His administration has not delayed all the tariffs, and the delay lasts only three months. Rather than renew the license for U.S. companies to do business with Chinese telecom giant Huawei, his Commerce Department has deferred any decision – leaving uncertainty to fester in the all-important tech sector. Chart 1Global Economic Expectations Near Crisis Levels Global Economic Expectations Near Crisis Levels Global Economic Expectations Near Crisis Levels Chart 2More China Stimulus Needed To Prevent EM Breakdown More China Stimulus Needed To Prevent EM Breakdown More China Stimulus Needed To Prevent EM Breakdown Beneath the surface is the fact that China’s money-and-credit growth faltered in July, suggesting that negative sentiment is still suppressing credit demand and preventing policy stimulus from having as big of a bang as in 2015-16. The late-July Politburo meeting signaled a more accommodative turn in policy, as we have expected, and BCA’s China strategist Jing Sima expects more fiscal stimulus to be announced after the October 1 National Day celebration. But high-beta economies and assets will suffer in the meantime – especially emerging market assets (Chart 2). Emerging markets are also seeing geopolitical risks rise across the board – and with the exception of China and Brazil, these risks are underrated by markets: Greater China: Beijing is getting closer to intervening in Hong Kong with police or military force. Such a crackdown will increase the odds of a confrontation with Taiwan and a backlash across the region and world, meaning that East Asian currencies in particular have more room to break down. India: The escalation in Kashmir is not a “red herring.” A single terrorist attack in India blamed on Pakistan could trigger a dangerous military standoff that hurts rather than helps Indian equities, unlike the heavily dramatized standoff ahead of the election earlier this year. Russia: Large-scale protests, overshadowed by Hong Kong, highlight domestic instability amid falling oil prices. These developments bode ill for Russian currency and equities. We will return to these risks in the coming weeks. This week we offer a special report on Turkey, where political risk is becoming extremely underrated as the lira rallies despite a further deterioration in governance (Chart 3). Chart 3Political Risks Are Underrated In Turkey Political Risks Are Underrated In Turkey Political Risks Are Underrated In Turkey Too Early To Write Off Erdogan “Whoever wins Istanbul, wins Turkey … Whoever loses Istanbul, loses Turkey.” President Recep Tayyip Erdogan Turkey’s ruling Justice and Development Party (AKP) has had a tough year. The March 31 local elections – especially the rerun election for mayor of Istanbul – dealt the party its biggest electoral losses since it emerged as the country’s dominant political force in 2002 (Chart 4). The elections came to be seen as a referendum on President Recep Tayyip Erdogan and thus raise the question of whether the party’s strongman leader is in decline – and what that might mean for emerging market investors. Erdogan’s grip on power has long been overrated – it is his vulnerability that has driven him to such extremes of policy over the past decade. The Gezi Park protests of 2013 and the attempted military coup of 2016 revealed significant strains of internal opposition in the aftermath of the Great Recession. Chart 4 With each case of dissent, the AKP responded by stimulating the economy and tightening state control over society (Chart 5). But this strategy faltered last year when monetary policy finally became overextended, the currency collapsed, and the country slid into recession. The opposition finally had its moment. Chart 5 The AKP is less a source of unity. Chart 6 As a consequence, the AKP is less a source of unity among Turkish voters. Both its share of seats in parliament and the overall level of party concentration in the Turkish parliament have declined since 2002 (Chart 6). Were it not for its coalition partner, the Nationalist Movement Party (MHP), the AKP would not have gained a majority in the 2018 parliamentary election. The AKP’s popular base consists of conservative, rural, and religious voters. This bloc is losing influence in parliament relative to centrist and left-wing parties (Chart 7). Moreover, the share of Turks identifying with political Islam, while still the largest grouping, is declining. Those who identify with more secular Turkish nationalism are on the rise (Chart 8). Chart 7 Does this shift entail a major turn in national policy? Will a new party emerge to challenge the AKP at last? Chart 8Secular Nationalism Is On The Rise Secular Nationalism Is On The Rise Secular Nationalism Is On The Rise There has long been speculation that former AKP leaders such as former Turkish president Abdullah Gul, former prime minister Ahmet Davutoglu, and former deputy prime minister Ali Babacan might form a political alternative. The latter resigned from the AKP on July 8, reviving speculation that a rival party could emerge that is capable of combining disillusioned AKP voters with the broader opposition movement at a time when Erdogan’s vulnerability has been made plain. However, the opposition is likely getting ahead of itself. The ruling party still has many tools at its disposal. Its share of seats in parliament is more than double that of the main opposition party, the Republican People’s Party (CHP). It is also viewed favorably in rural areas, and support for Erdogan there will not shift easily. Moreover, despite the negative electoral trend, the AKP has a lot of enthusiasm among its supporters – it is the party with the highest favorability among its own voters (Chart 9). The March election served as a wakeup call for the AKP – a warning not to take its power for granted. Erdogan can still salvage his position. The next election is not due until June 2023, leaving the party with four years to recuperate. While polls for the 2023 parliamentary election paint an ominous sign (Chart 10), they are very early, and the key will be whether Erdogan can divide the opposition and reconnect with his voter base. Above all, this will depend on what changes he makes to economic policy. Chart 9 Chart 10Erdogan Needs To Reconnect With Voter Base Erdogan Needs To Reconnect With Voter Base Erdogan Needs To Reconnect With Voter Base Bottom Line: Erdogan’s and the AKP’s popularity is waning, but it is too soon to write them off. The key question is how Erdogan will handle economic policy now that there are chinks in his armor. Doubling Down On Erdoganomics The fluctuation in the lira “is a U.S.-led operation by the West to corner Turkey … The inflation rate will drop as we lower interest rates.” President Recep Tayyip Erdogan Chart 11 Erdogan needs to see the economy back to recovery in order to secure his success in the next election. A survey conducted early this year reveals that Turks view unemployment, the high cost of living, and the depreciation of the lira as the most significant problems facing Turkey, with 27% of respondents indicating that unemployment is the most important problem facing the country (Chart 11). More importantly, Turks do not have much confidence in the government’s ability to manage this pain – only one-third of respondents viewed economic policies as successful, a 14pp decline from the previous year. This highlights the need for Erdogan to revive confidence in Turkey’s policymaking institutions and to deliver on the economic front.     The key is how Erdogan will handle economic policy. However, it is still too early to call for a sustainable improvement in the Turkish economy as many of the same fundamental imbalances continue to pose risks. While the current account has improved significantly – even registering a surplus in May – the improvement will not endure (Chart 12). On the one hand, the weaker lira has made exports more attractive relative to global competition. However, the improvement in the external balance is in large part due to weaker imports which are now more expensive for Turkey’s residents and have fallen by 19% y/y in 1H2019. Shrinking imports also reflect weak domestic demand which has been weighed down by tight monetary conditions (Chart 13). Chart 12Current Account Improvement Will Not Endure Current Account Improvement Will Not Endure Current Account Improvement Will Not Endure Chart 13Tight Monetary Conditions Weighed On Domestic Demand Tight Monetary Conditions Weighed On Domestic Demand Tight Monetary Conditions Weighed On Domestic Demand What is more, portfolio inflows which in the past were necessary to offset the large current account deficit, have collapsed (Chart 14). Were it not for the improvement in the trade balance, the central bank of the Republic of Turkey (CBRT) would have experienced a pronounced decline in its foreign reserves, and currency pressures would have been significant. A meaningful improvement in investor sentiment – which will remain cautious on the back of economic and geopolitical risks – is a necessary precondition for the return of these inflows. Nevertheless, the current account deficit will likely remain narrow in the second half of the year as the trade balance improves on the back of a weak lira and imports remain depressed due to soft domestic demand. This will keep the lira supported over this period. Although risks from a wide current account deficit have been temporarily put off, years of foreign debt accumulation are a hazard to a sustainable improvement in the lira. Foreign debt obligations (FDO) due over the coming 12 months are extremely elevated at $167 billion (Chart 15). It is not clear that they can be paid off. While the FDO figure is overly pessimistic as some of these debts will be rolled over, net central bank foreign exchange reserves can cover only 2.7% of these obligations. This poses downside risks on the lira at a time when inflows have not yet recovered.1 Moreover, unorthodox economic policies will eventually reverse any improvement in the currency. Chart 14Financial Account Does Not Lend Support Financial Account Does Not Lend Support Financial Account Does Not Lend Support Chart 15FDO Pose A Risk To The Currency FDO Pose A Risk To The Currency FDO Pose A Risk To The Currency While the 4 years between now and the next election could be an opportunity to embark on unpopular structural reforms that will improve the outlook by the time voting season rolls in, Erdogan has instead doubled down on his current strategy. Less than two weeks after the results of the Istanbul election rerun, CBRT governor Murat Cetinkaya was removed by presidential decree. A month later, key CBRT staff were dismissed.2 Chart 16 At his first monetary policy committee meeting as governor on July 25, Murat Uysal slashed the one-week repo rate by 425bps. Given Erdogan’s outspoken distaste for high interest rates, the president’s consolidation of power over economic decision making implies that the outlook for easier monetary policy is now guaranteed. However, the ramifications of this dovish shift will be concerning for voters. The depreciating lira was singled out as the most important economic problem facing Turkey by the largest number of survey respondents (Chart 16). Erdogan’s pursuit of dovish policies despite popular opinion shows that he is doubling down on unorthodox policy despite popular opinion. Monetary easing threatens to unwind the current account improvement and ultimately de-stabilize the lira. Assuming that the banking sector does not hold back the supply of credit to the private sector, lower rates will generate a pickup in demand which will raise imports and widen the current account deficit. Unless there is a marked improvement in investor sentiment – which will remain tainted by the erosion of central bank independence and increased tensions with the West – a return in portfolio inflows to pre-2018 levels is unlikely. As a consequence the lira will begin to soften anew in 2020. The lira will soften anew in 2020. While inflation will subside as the lira stabilizes this year, it will likely remain elevated relative to pre-2018 levels – in the 10% to 15% range. Contrary to Erdoganomics, traditional economic theory postulates that interest rate cuts pose upside pressure on prices. The resurgence in domestic demand will occur against a backdrop of rising wages (Chart 17). Chart 17Price Pressures Will Persist Price Pressures Will Persist Price Pressures Will Persist With foreign currency reserves running low, the CBRT recently adopted several measures to discourage locals from exchanging their liras for foreign currency. These efforts reflect attempts to mitigate the negative impact of monetary easing on the lira, and to ensure FX reserves are supported: A 1-percentage point increase in the reserve requirement ratio for foreign currency deposits and participation funds. A 1-percentage point reduction in the interest rate on dollar-denominated required reserves, reserve options and free reserves held at the bank. An increase in the tax on some foreign exchange sales to 0.1% from zero. These measures make it more expensive for banks to hold foreign currency, incentivizing lira holdings instead. They also raise the CBRT’s foreign reserves highlighting the downside risks on these holdings and the lira. However, given that these measures boost CBRT reserves only superficially – rather than mirroring an improvement in the underlying economic conditions – they highlight that need for policy tightening to defend the lira, even as the CBRT officially pursues an accommodative path. Bottom Line: The Turkish economy will be extremely relevant to Erdogan’s fate in 2023. However with large foreign debt obligations, a rate cutting cycle underway, and foreign investors who remain uneasy, the case for Turkey’s economic recovery – especially amid turbulent global conditions – is weak. In the meantime, Erdogan will continue to blame external factors for the nation’s malaise. Don’t Bet On Trump-Erdogan Friendship “Being Asian and in Asia is as important as being European and in Europe for us.” Turkish Foreign Minister Melvut Cavusoglu For several years Erdogan has attempted to distract the populace from the country’s economic slide by adopting an aggressive foreign policy, particularly toward the West. The immediate cause is Syria, where Turkey has fundamental security interests that clash with those of the U.S. and Europe. But tensions also stem from Erdogan’s economic and political instability. This aggressive foreign policy has not changed in the wake of the AKP’s electoral loss. Erdogan is continuing to test the U.S.’s and EU’s limits and the result is likely to be surprise events, such as U.S.-imposed sanctions, that hurt Turkey’s economy and financial assets. Erdogan clashes with the West both because of substantive regional disagreements and because it plays well domestically. Turks increasingly see the U.S. and other formal NATO allies as a threat, while looking more favorably upon American rivals like Russia, China, Iran, and Venezuela (Chart 18). The U.S., meanwhile, is expanding the use of “secondary sanctions” to impose costs on states that make undesirable deals with its rivals, and Turkey is now in its sights. The reason is Erdogan’s decision to purchase the S400 missile defense system from Russia. This decision exemplifies the breakdown in the U.S.-Turkish alliance and Turkey’s search for alternative partners and allies. The arms sale is likely – eventually – to trigger secondary sanctions under the U.S. International Emergency Economic Powers Act and especially the Countering America’s Adversaries Through Sanctions Act (CAATSA). Washington has already imposed sanctions on China for buying the same weapons from Russia. Erdogan recently accepted the first delivery of components for the S400s, which are supposed to go live by April 2020. He stuck with this decision in disregard of Washington’s warnings. He has a solid base of popular support across political parties for this act of foreign policy and military independence from the U.S. (Chart 19). But the full consequences have not yet been felt. Chart 18 Chart 19 President Trump’s response is muted thus far. He banned Turkish pilots from the U.S. F-35 program and training but has not yet imposed sanctions due to his special relationship with Erdogan and ongoing negotiations over Syria. Syria is the root of the breakdown in Turkish-American relations since 2014. Washington and Ankara have clashed repeatedly over their preferred means of intervening into the Syrian civil war and fighting the Islamic State. The U.S. relies on the Syrian Democratic Forces, led by the Kurdish People’s Protection Units (YPG), which are affiliated with the Kurdistan Workers’ Party (PKK). The PKK is based in Turkey and both the U.S. and Turkey designate it as a “terrorist organization” due to its militant activities in its long-running struggle for autonomy from Turkey. Chart 20 Turkey has intervened in Syria west of the Euphrates River and has repeatedly threatened to conduct deeper strikes against the Kurds. The latter would put U.S. troops in harm’s way and could result in lost leverage for Western forces seeking to maintain their YPG allies and force an acceptable settlement to the Syrian conflict. There is a basis for a deal between Presidents Trump and Erdogan that could keep sanctions from happening. Trump is attempting to wash its hands of Syria to fulfill a promise of limiting U.S. costs in wars abroad. Meanwhile an aggressive intervention in Syria is not a popular option in Turkey, which is why Erdogan has not acted on threats to seize a larger swath of territory (Chart 20). As a result, the U.S. and Turkey recently formed a joint operation center to coordinate and manage “safe zones” for Syrian refugees. If they can manage the gray area on the Turkish-Syrian border, the Trump administration can continue to prepare for withdrawal while preventing Erdogan from taking too much Kurdish territory. The tradeoff is clear, but similar agreements have fallen apart. First, the U.S. Congress is ready to impose sanctions over the S400s and Trump is under pressure to punish Turkey for undermining NATO and dealing with the Russians. Second, the Trump administration has not found an acceptable solution to the Syrian imbroglio that makes full withdrawal possible. If Trump becomes convinced that the risks of a total and rapid withdrawal from Syria are greater than the rewards (as many of his GOP allies staunchly believe), then he has less incentive to protect Erdogan. Meanwhile Erdogan could still decide he needs to plunge deeper into Syria to counteract the YPG. Or he could retaliate against any sanctions over the S400s and provoke a broader tit-for-tat exchange. He has threatened to cancel orders for Boeing aircraft worth $10 billion. Clearly U.S. sanctions will cause the lira to fall and send Turkey into another bout of financial turmoil. In the meantime Turkey’s relations with Europe also pose risks. While the refugee crisis has abated, in great part due to Turkish cooperation, other disagreements are still problematic: The EU is not upgrading Turkey’s customs union and both sides know that Turkey is not eligible for EU membership anytime soon. In response to what the EU has deemed as illegal drilling for oil and gas off the coast of Cyprus, the EU called off high-level political meetings with Turkey and suspended EUR 145.8 million in pre-accession aid. EU foreign ministers have also put off talks on the Comprehensive Air Transport Agreement between the two parties which would have led to an increase in passengers using Turkish airports as a transit hub. In addition, EU ministers asked the European Investment Bank to review its lending activities in Turkey, which amounted to EUR 358.8 million last year. Erdogan is taking a bolder approach to Cyprus. He has decided to send a fourth ship to drill for natural gas in Cyprus’s Exclusive Economic Zone in the Eastern Mediterranean. The purpose is to rally support for his government by calling on the public’s strong allegiance to Turkish Cypriots (Chart 21). The problem is that a confrontation sought as a domestic distraction could provoke negative policy reactions from the EU (or the U.S., which is reconsidering its arms embargo on the Greek Cypriot side). Relations with the West would get worse. Chart 21 Chart 22... But Turkey Cannot Afford To Flout The EU ... But Turkey Cannot Afford To Flout The EU ... But Turkey Cannot Afford To Flout The EU Turkey cannot afford to flout the U.S. and EU. Its economy is dependent on Europe (Chart 22). And the U.S. still underwrites Turkey’s NATO membership and access to the global financial system. The problem is that Erdogan is an ambitious and unorthodox leader and he has clearly wagered that he can rally domestic support through various confrontations with Western policies. This means that for the immediate future the country is more likely to clash with Western nations than it is to recognize its own limits. Political risks are frontloaded and investors should be cautious before trying to snap up the depressed lira or Turkish government bonds. Bottom Line: Tensions with the West – especially the U.S. – will likely lead to economic sanctions. While there is a basis for Presidents Trump and Erdogan to avoid a falling out, it is not reliable enough to underpin a constructive investment position – especially given Erdogan has not changed course in the wake of this year’s significant electoral loss. Investment Conclusions Chart 23Optimism On Lira Amid Unresolved Risks Optimism On Lira Amid Unresolved Risks Optimism On Lira Amid Unresolved Risks The lira has rallied by 3.6% since the Istanbul election. It has risen 0.3% since the replacement of CBRT Governor Murat Cetinkaya and rallied further despite the sacking of the central bank’s chief economist and other high-level staff (Chart 23). Given that the market knows that the central bank reshuffle entails interest rate cuts, is this a clear signal that the lira has hit a firm bottom and cannot fall further? Turkey is more likely to clash with Western nations.  We doubt it. First, Erdogan’s doubling down on unorthodox policy threatens the recovery in the currency and risk assets and his aggressive foreign policy raises the risk of sanctions and further economic pain. Second, although Turkey is not overly exposed to China, it is heavily exposed to Europe, which is on the brink of a full-fledged recession and depends heavily on the Chinese credit cycle – which had another disappointment in July. German manufacturing PMI has been sinking further below the 50 boom-bust mark since the beginning of the year, and the economy contracted in 2Q2019 (Chart 24). Chart 24Global Backdrop Not Yet Supportive Global Backdrop Not Yet Supportive Global Backdrop Not Yet Supportive Chart 25Improvement In Spread Will Be Fleeting Improvement In Spread Will Be Fleeting Improvement In Spread Will Be Fleeting Given these domestic and global economic risks and geopolitical tensions, we expect any improvement in the sovereign spread to be fleeting (Chart 25). While the lira may experience temporary improvement, pressures will re-emerge in 2020 as the lagged impact of Erdogan’s pursuit of growth at all costs re-emerge. Stay on the sidelines as any improvement in the near term is fraught with risk.     Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy roukayai@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See Emerging Markets Strategy Weekly Report, “Country Insights: Indonesia, Turkey, And The UAE” May 2, 2019, ems.bcaresearch.com. 2 Among those removed are the central bank’s chief economist Hakan Kara as well as the research and monetary policy general manager, markets general manager, and banking and financial institutions general manager.

Highlights Bad news is still looming in the trade war. Public opinion polling in the U.S. gives President Trump more leeway to push the envelope on tariffs and sanctions against China than the consensus recognizes. Trump’s tendency to push the envelope is forcing China into a corner in which structural concessions become too risky. Unrest in Hong Kong reveals the city-state’s political woes as well as the tail-risk of a geopolitical incident in Taiwan. Tariffs on Mexico are still possible. Close long MXN/BRL. Maintain tactical safe-haven plays. Feature Judging by the S&P 500, the Federal Reserve has cut interest rates and the G20 summit between Presidents Donald Trump and Xi Jinping has been a success (Chart 1). Chart 1Trade War? Who Cares! Trade War? Who Cares! Trade War? Who Cares! The problem is that there is not yet a compelling, positive, political catalyst on the trade front. And the Fed has an incentive to wait until after the June 28-29 G20 to make its decision on any cut. At least in the case of the December 1 G20 summit in Buenos Aires there was significant diplomatic preparation ahead of time. That is not yet the case for the summit in Osaka, Japan. And even Buenos Aires ended up being a flop given the subsequent tariff escalation. We are maintaining our tactical safe-haven recommendations – long gold, Swiss bonds, and Japanese yen – until we see a clearer pathway for the risk-on phase to resume amid a summer loaded with fair-probability geopolitical risks: Trump’s aggressive foreign policy, the Democratic primary, China’s domestic policy, the U.S. immigration crisis, and Brexit. Beyond this near-term caution, we agree with BCA’s House View in remaining overweight equities on a cyclical basis (12 months). China’s economic stimulus is likely to pick up further this summer and it still has the capacity to deliver positive surprises. Preparing For The G20 Over the course of this year we have argued for a 50% chance and then 40% chance that the U.S. and China would conclude a trade deal by the G20 summit. However, Commerce Secretary Wilbur Ross and other administration officials, including Chief of Staff Mick Mulvaney, have recently indicated that the best case at the G20 is for the leaders to have dinner and agree to a new timetable that aims to close the negotiations in the coming months. The Trump-Xi summit itself remains unconfirmed as we go to press. This suggests that we were too optimistic about even a barebones trade deal at the G20. We are now extending our time frame to the November 2020 election -- the only deadline that really matters. Diagram 1 presents a cogent and conservative decision tree that results in a 41% chance of a major, Cold War-style escalation in tensions; a 27% chance of a minor escalation that is contained but without a final trade agreement; and a 28% chance of a tenuous or short-term deal. It gives only a 4% chance of a “grand compromise” that initiates a new phase of re-engagement between the two economies. These outcomes clearly represent a large downside risk given where equities are positioned today. Diagram 1Trade War Decision Tree (Updated June 13, 2019) Another Phony G20? And A Word On Hong Kong Another Phony G20? And A Word On Hong Kong Why such gloom when the two sides may be on the brink of a new tariff ceasefire? First, delaying the talks beyond the G20 is disadvantageous for Trump and will make him angry sooner or later. The Trump administration, unlike its predecessors, has made a point of opposing China’s traditional playbook of drawing out negotiations. China benefits in talks over the long run because it gains economic and strategic leverage. This has been the case in every major round of dialogue since the 1980s and it is specifically the case today, as China gradually stimulates its way out of the slowdown that afflicted it at the time of the last G20 (Chart 2). Chart 2China's Bargaining Leverage To Improve On Stimulus China's Bargaining Leverage To Improve On Stimulus China's Bargaining Leverage To Improve On Stimulus Trump would not have called a ceasefire on Dec. 1, 2018 if the stock market had held up amid Fed rate hikes and the Sept. 24 implementation of the 10% tariff on $200 billion. This year the U.S. equity market has bounced back and the Fed has paused, but China’s economy has not yet fully recovered. This gives Trump an advantage that may not last if the talks extend through the rest of the year. And this reasoning explains why Trump raised the tariff rate and blacklisted China’s tech companies in May – to try to clinch a deal by the end of June. He is also threatening to impose tariffs on the remaining $300 billion worth of imports if Xi snubs him in Osaka. If the G20 fails to produce progress, we would bet that Trump will proceed with a sweeping tariff on the remaining $300 billion worth of Chinese imports, whether immediately after the summit or at some later point when he decides that the Chinese are indeed playing for time. How can we be confident of this? After all, Trump’s approval rating has fallen since he escalated the trade war in May and it remains well beneath the average post-World War II presidents at this stage in their first terms, including President Obama’s rating in the summer of 2011 (Chart 3). Recent opinion polls suggest that voters are getting wise to the negative impact of tariffs on their pocketbooks. The financial and political constraints on Trump are not very pressing. Chart 3 We are confident because the financial and political constraints on Trump are not very pressing, at least not at the moment. First, the stock market has risen despite the tariff hikes, so Trump is likely emboldened. Second, Trump is less constrained in the use of tariffs than in other areas. He is bogged down with a Democratic Congress, investigations, and scandals at home. He cannot pursue policy through legislation – he shifted to the threat of tariffs on Mexico because he could not build his border wall. By turbo-charging his trade policy and foreign policy – against China, Iran, Mexico, Russia, most recently Germany … basically everyone except North Korea – he creates the option of turning 2020 into a “foreign policy election” rather than an election about the economy or social policy. A strong economy has not enabled him to break through his ceiling in public opinion thus far and he will lose a social policy election easily (see health care). The risk of his aggressive foreign policy is that it triggers an international crisis. But that would likely benefit him in the polls, given the natural inclination to defend America against foreign enemies. See George W. Bush, 2004 (Chart 4). Third, popular opposition to Trump’s trade war is not clear-cut – voters are ambivalent. In the past we have shown that President Trump’s 2020 run still depends on his ability to increase voter turnout among whites, specifically white males, low-income whites, and whites without college degrees. Recent polls suggest that voters have turned against tariffs and the trade war – namely the Quinnipiac and Monmouth University polls released in late May after the latest tariff hike. But it is essential to dig beneath the surface. These polls reveal that the key voting groups look more favorably than the rest of the country upon Trump’s policies on both trade and China (Chart 5). Chart 4 Chart 5 These voters’ assessment of Trump’s performance overall, across a range of policies, is not disapproving, despite all of the unorthodox and disruptive decisions that Trump has made in his presidency thus far (Chart 6). Chart 6 American voters are neither as enthusiastic about free trade nor as appalled by protectionism as the headline polling suggests. For instance, take the Monmouth University poll, which asked very specific questions about trade, tariffs, and retaliation. If we combine the group of voters who are clearly protectionist with those who are “not sure” or think the answer “depends,” the results do not suggest that Trump is heavily constrained (Table 1). Table 1Americans Are Not As Pro-Free Trade As It Seems Another Phony G20? And A Word On Hong Kong Another Phony G20? And A Word On Hong Kong In swing counties 51% of voters think that free trade is either a bad idea or are undecided. And even 57% percent of voters in counties that voted for Hillary Clinton by more than a 10% margin are in favor of tariffs or unsure. And a majority of voters in the most relevant categories – independents, moderates, non-college graduates, low-income earners – believe that Trump’s tariffs will bring manufacturing back, a highly relevant point for an election that will likely swing on the Rust Belt yet again. This includes Clinton’s most secure districts (Chart 7)! Chart 7 The point is not that Trump lacks political constraints on the trade war – after all, these voters are on the borderline in many cases and concerned about all-out trade war with China. Rather, his aggressive trade tactics enable him to reconnect with and energize his voter base at a time when his other signature policies are tied down. This is critical because his reelection prospects, which we have pegged at 55%, are in great peril, at least judging by his lag in the head-to-head polling against the top Democrats in swing states. Bottom Line: Going forward, Trump has more room to push the envelope than investors realize. A failed G20 summit poses the risk of another selloff in global equities. We are maintaining our tactical safe-haven trades.   What About Xi Jinping’s Constraints? Xi is president for life and must be attentive to long-term ramifications. Chart 8Xi Jinping's Immediate Constraint Xi Jinping's Immediate Constraint Xi Jinping's Immediate Constraint If Trump is tempted to continue pushing the envelope, will President Xi back down? While not constrained by the stock market or elections, he does face the prospect of instability in the manufacturing sector and large-scale unemployment (Chart 8), which Beijing has not had to deal with for 20 years. The point is not to claim that laid-off Chinese workers will turn around and protest against their own country in the face of gunboat diplomacy by capitalist imperialists – on the 70th anniversary of the regime, no less. Rather, Xi is president for life and must be attentive to the long-term ramifications of a disruptive transition in the excessively large manufacturing sector. This would cause economic and, yes, ultimately socio-political problems for him down the road. If Trump continues to move toward his 2016 campaign pledge of a 45% tariff on all Chinese imports, as the 2020 election approaches, China’s leaders have far less incentive to put their careers (and lives) on the line to produce structural concessions. A tariff covering all Chinese goods is an absolutist position that China can only address by doubling down on its demand for full tariff rollback. Yet Trump needs to retain some tariffs to enforce the implementation of any agreement. Thus slapping tariffs on all Chinese imports is almost, but not quite, an irreversible step. This is captured in Diagram 1 via the 29% chance that tensions are contained even if a deal falls through. Tensions are even less likely to be contained if the Trump administration follows through on its threats against China’s tech sector. On August 19, the Commerce Department will decide whether to renew the license for U.S. companies to sell key components to Huawei and other blacklisted companies. If the administration denies the license – and moves further ahead with export controls on emerging and foundational technologies – then Beijing faces an outright technological blockade. It will retaliate against U.S. companies – a process already beginning1 – and will likely act on other threats such as a rare earths embargo. In this case strategic tensions will escalate dramatically, including saber-rattling in the air, in cyberspace, or on the high seas. At the moment political frictions in Hong Kong are exacerbating U.S.-China distrust. Bottom Line: Since President Xi’s constraints are longer-term, he has the ability to deny structural concessions to Trump. But Trump’s ability to push the trade war further and further risks forcing China to a point of no return. There is not a clear basis for the geopolitical risk affecting the global trade and growth outlook to fall. Hong Kong: A New Front In The U.S.-China Struggle The large-scale protests that have erupted in Hong Kong – first on April 28 and most recently on June 9 –are important for several reasons: they highlight the immense geopolitical pressure in East Asia emanating from China’s “New Era” under Xi Jinping; they are rapidly becoming entangled in U.S.-China tensions, particularly over technological acquisition; and they foreshadow the political instability on the horizon in Taiwan. Tensions have been rising between Hong Kong and mainland China since the Great Recession and the shock to capitalist financial centers around the world. The tensions are symptomatic of the dramatic change in China over the past decade; the decline of the post-Cold War status quo; and the broader decline of the western world order (e.g. the British Empire). After all, the West is lacking tools to preserve the rights and privileges that Hong Kong was supposed to be guaranteed when the transfer of sovereignty occurred in 1997. More immediately, the current protests are part of a process going back to 2012 in which the disaffected and marginalized parts of Hong Kong society began speaking up against the political establishment. This emerged because of high income inequality (Chart 9), shortcomings in quality of life, excessive property prices (Chart 10), and the mainland’s reassertion of Communist Party rule and encroachments on Hong Kong’s autonomy. Chart 9 Chart 10Another Source Of Hong Kong's Unrest Another Source Of Hong Kong's Unrest Another Source Of Hong Kong's Unrest A simple comparison with Singapore, the other major East Asian city-state, shows that Hong Kong has trailed in GDP per capita and wage gains, while property price inflation has soared ahead (Chart 11). These structural economic factors contributed to the emergence of the “Occupy Central” protests in 2014, which were smaller than today’s protests but signaled the abrupt shift in the political sphere toward disenchantment and activism. Chart 11Why Hong Kong Is Not As Quiet As Singapore Why Hong Kong Is Not As Quiet As Singapore Why Hong Kong Is Not As Quiet As Singapore The 2016 elections for the Legislative Council (LegCo) resulted in a fiasco by which a number of pro-democracy activists, known as “localists,” were squeezed out of the legislature through a combination of juvenile mistakes and heavy-handed intervention by Beijing and the pro-mainland Hong Kong authorities (Chart 12 A&B). Beijing exploited the occasion to extend its legal writ over Hong Kong society and curb some of the city’s freedoms.2 The democratic opposition and dissidents have been sidelined or repressed — and now they face the prospect of being extradited, given that the LegCo is highly likely to pass the “Fugitive Offenders and Mutual Legal Assistance in Criminal Matters” bill that sparked the protests this year. Chart 12 Chart 12 The exclusion of the localists from power runs the risk of radicalizing them and increasing disaffection, making mass protests likely to recur both in the near term and in future. Hong Kongers are losing confidence in the “One Country, Two Systems” arrangement (Chart 13). They are similarly becoming more disillusioned with mainland China, adding fuel to the fire over time (Chart 14). However, in the specific case of the city-state, there is no alternative to Beijing’s ultimate say – and the older generations will continue to support the political establishment. Chart 13 Chart 14 Nevertheless Hong Kong’s discontents will become entangled in the broader Cold War emerging between the U.S. and China. Beijing is accusing the protesters of being lackeys of foreign powers. The U.S. Congress, on both sides of the aisle, is threatening to declare that Hong Kong is no longer sufficiently autonomous from Beijing and therefore no longer eligible for special privileges. Hong Kong faces rising political dependency on China and the potential for special relations with the United States to decline. Chart 15 Part of Washington’s concern lies with Beijing’s aggressive technological acquisition program. Hong Kong has been able to import advanced dual-use technology products from the United States without Beijing’s restrictions. This is not apparent from the proportion of exports but it is important on the technological level (Chart 15). It introduces a backdoor for China to acquire these goods and has prompted a rethink in Washington. Hong Kong is also accused of facilitating the circumventing of sanctions on U.S. enemies. It thus faces rising political dependency on China and the potential for special relations with the United States to decline. These pressures also highlight why we view Taiwan as a potential “Black Swan.” Similar political fissures are emerging as Beijing expands its economic and military dominance over Taiwan. Of course, the political backlash against Beijing has recently been receding in Taiwanese opinion, due to the fact that the nominally pro-independence Democratic Progressive Party has lost most of the momentum it gained after the large-scale “Sunflower” student protests of 2014 (Chart 16). But there are still several reasons that the January 2020 election could become a geopolitical flashpoint: namely the developments in Hong Kong, China’s handling of them, Beijing’s tensions with Washington, and the Trump administration’s temptation to achieve some key goals with the Tsai Ing-wen administration before it leaves office (including arms sales). Even if the Taiwanese political winds shift to become less confrontational toward Beijing after January, the time between now and then is ripe for an “incident” of some kind. Beyond that, the pro-independence opposition will begin activating and marching against the next government if it proves obsequious to the mainland. Chart 16Taiwan: Pro-Mainland Forces Revive Taiwan: Pro-Mainland Forces Revive Taiwan: Pro-Mainland Forces Revive Chart 17 Over the long run, Taiwan is far more autonomous than Hong Kong, harder for Beijing to control, and much more attractive for Beijing’s enemies to defend – namely the U.S. and Japan. Moreover, as the tech conflict with Washington heats up, Taiwan becomes vital for China’s technological self-sufficiency, putting it at higher risk (Chart 17). Beijing will also frown upon the role of Taiwanese companies like FoxConn for taking early steps to diversify the supply chain away from China. This regional strategic reality is not conducive to U.S.-China trade negotiations. And even aside from the U.S., Beijing’s growing power generates resistance from its periphery. This is true of Chinese ally North Korea, which is trying to broaden its options, as well as a historic enemy like Vietnam. Other countries at a bit more of a distance are trying to accommodate both Beijing and Washington, but are increasingly seeing their regimes vacillate based on their orientation toward China – this is true of Thailand in 2014, the Philippines in 2015, South Korea in 2017, and Malaysia in 2018. These changes inject economic policy uncertainty on the country level. Over the long run we see Southeast Asia as a beneficiary of the relocation of supply chains out of China. But at the moment, with the trade war escalating and unresolved and with China taking a heavier hand, we are only recommending holding relatively insulated countries like Thailand. Bottom Line: Our theme of U.S.-China conflict is intertwined with our theme of geopolitical risk rotation to East Asia. States that have domestic-oriented economies, limited exposure to China, or greater U.S. support – including Japan, Thailand, South Korea, Indonesia, and Malaysia – face less geopolitical risk than those heavily exposed to China (Taiwan) or that lack U.S. security guarantees (Hong Kong, Vietnam). Investment Recommendations In addition to our safe-haven tactical trades – long spot gold, long Swiss bonds, and long JPY-USD – we are maintaining our long recommendation for a basket of companies in the MVIS global rare earth and strategic metals index. The basket includes companies not based in mainland China that have seen their stock prices appreciate this year yet have a P/E ratio under 35 (Chart 18). Chart 18Go Long Rare Earth Firms Ex-China Go Long Rare Earth Firms Ex-China Go Long Rare Earth Firms Ex-China We remain short the CNY-USD on the expectation that trade tensions will encourage Beijing to use depreciation as a countervailing tool, despite our expectation of increasing fiscal-and-credit stimulus. Over the long run, we would observe that trade escalation between the U.S. and China bodes poorly for China’s long-term productivity and efficiency. The basis for a reduction in trade tensions is a recommitment to the liberal structural reform agenda that Chinese state economists outlined at the beginning of Xi Jinping’s term in 2012-13. The current trajectory of “the New Long March,” in which Beijing pursues personalized power and uses stimulus to improve self-sufficiency and import-substitution, goes the opposite direction. It is not a pathway for innovation, openness, and technological progress. A simple comparison of China’s long-term equity total return highlights the market’s lack of enthusiasm about the current administration’s approach (Chart 19). The contexts were different, but the earlier outperformance grew from painful structural reforms and a grand compromise with the United States in the late 1990s and early 2000s. Chart 19The Market Wants Reforms And Trade Deal The Market Wants Reforms And Trade Deal The Market Wants Reforms And Trade Deal We are closing our long MXN / short BRL trade for a gain of 4.6%. This trade has bounced back from the U.S.-Mexico deal to avert tariffs. The agreement was not entirely hollow compared to earlier agreements: it calls for Mexico to accelerate the deployment of the National Guard to stem the flow of refugees from Guatemala and central America and expand the Migrant Protection Protocols across the southern border. Trump’s reversal – under Senate pressure, entirely unlike the China dynamic – gave the peso a boost, benefiting our trade. However, one of the fundamental reasons for this trade – the improvement in Mexico’s relative current account balance – has now rolled over (Chart 20) and the tariff threat will reemerge if Mexico proves unable or unwilling to stem the inflow of asylum seekers into the United States (Chart 21). Chart 20Peso Has Outperformed The Real Peso Has Outperformed The Real Peso Has Outperformed The Real Chart 21   As we go to press, the attacks on tankers in Oman highlight our view that oil prices will witness policy-induced volatility and a rising geopolitical risk premium as “fire and fury” shifts to the U.S. and Iran in the near-term. Our expectation of increasing Chinese stimulus helps underpin the constructive view on oil and energy-producing emerging markets.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The American Chamber of Commerce in China and Shanghai released a survey on May 22, 2019 revealing that while 53% of companies have not yet experienced “non-tariff” retaliation by Chinese authorities, 47% had experienced it: 20.1% through increased inspections; 19.7% through slower customs clearance; 14.2% through slow license approvals; another 14.2% through bureaucratic and regulatory complications; and smaller numbers dealing with problems associated with American employees’ visas, increased difficulty closing investment deals, products rejected by customs, and rejections of licenses and applications. 2 We noted at the time, “Mainland forces will bring down the hammer on the pro-independence movement. The election of a new chief executive will appear to reinforce the status quo but in reality Beijing will tighten its legal, political, and security grip. Large protests are likely; political uncertainty will remain high.” See BCA Geopolitical Strategy, “Strategic Outlook 2017: We Are All Geopolitical Strategists Now,” December 14, 2016, available at www.bcaresearch.com.

Highlights So What? Markets remain complacent about U.S.-China trade. Why? The U.S. has escalated the trade war by threatening sanctions on key Chinese tech firms. Chinese President Xi Jinping is preparing his domestic audience for protracted struggle. U.S. domestic politics do not prohibit, and likely encourage, a tough stance on China. Farmers are not a constraint on Trump — economic growth is. Go long spot gold and JPY-USD. Feature Markets remain complacent. Chart 1 suggests that while the combination of unilateral trade tariffs and spiking U.S. 10-year Treasury yields was enough to sink the S&P 500 in 2018, the former alone cannot do so today. Chart 1Tariffs Alone Not Enough To Sink Equities? Wrong. Tariffs Alone Not Enough To Sink Equities? Wrong. Tariffs Alone Not Enough To Sink Equities? Wrong. Specifically, the increase in the Section 301 tariff rate from 10% to 25% on $200 billion worth of Chinese imports and the threat of a new 25% tariff on the remaining $300 billion worth of Chinese imports in just a month’s time has only led to a 3% pullback in equities since May 3. That was the last trading day prior to President Donald Trump’s infamous tweet about hiking the tariff. Unlike the trade war escalation in October through November of last year, the Federal Reserve is no longer hiking rates, China’s economic indicators have bottomed, and U.S. equity investors have now fully imbibed the “Art of the Deal.” The consensus holds that the escalation of trade tensions with China is contained within the context of Trump’s well-known routine of inflicting pain and then compromising. We would wager that the bond market is right and equities are wrong. Equities will converge to the downside, unless the market receives a concrete positive catalyst that improves the near-term outlook for U.S.-China relations and hence global trade. The problem is that for equities such a catalyst could happen at any time in the form of additional Chinese stimulus. Therefore, higher volatility is the only guaranteed outcome. The sudden onslaught of U.S. pressure makes it harder for Chinese President Xi Jinping to offer structural concessions to his American counterpart without looking weak. It was easier to do so when the threat of tariffs was under wraps, as was the case between December 1 and May 5. This new obstacle informed our decision to close out our long China equities and long copper trades and downgrade our end-June trade deal probability from 50% to 40%. But the escalation of tensions makes stimulus more likely to surprise to the upside, which will at least partially offset the negative hit to global sentiment and the trade outlook. Waiting For A Positive Political Intervention Three negative geopolitical catalysts loom in plain sight, while investors are still waiting on a positive catalyst. The negatives: China has not yet announced retaliation to the U.S. Commerce Department’s blacklisting of Huawei and a handful of other Chinese tech firms; the U.S. could implement the blacklist within three months, increasing the risk of a broader “tech blockade” against China; and the U.S. authorities are prepared to extend tariffs to all Chinese goods in one month. Meanwhile there are no high-level talks currently scheduled between the principal Chinese and American negotiators as we go to press. This could change quickly. But if negotiating teams do not hold substantive meetings with positive reports afterwards, then investors cannot be sure that Presidents Donald Trump and Xi Jinping will speak to each other, let alone finalize a substantive trade deal, at the G20 in Japan on June 28-29. The macro backdrop is hardly encouraging: global export volumes are contracting and the dollar’s fall may be arrested amid a huge spike in global policy uncertainty. Any rebound in the greenback will pile additional pressure onto trade flows, at least until the market sees a substantial increase in Chinese stimulus (Chart 2). Furthermore, it is concerning that President Trump, a businessman president and champion of American manufacturing, is raising tariffs at a time when lending and factory activity are already slowing in the politically vital Midwestern states (Chart 3). The implication is that he is unfazed by economic risks and therefore less predictable. He is pursuing long-term national foreign policy objectives at the expense of everything else. This may be patriotic but it will be painful for global equity investors. Chart 2Trump Unfazed By Deteriorating Global Economy Trump Unfazed By Deteriorating Global Economy Trump Unfazed By Deteriorating Global Economy Chart 3Economic Activity Is Already Slowing Economic Activity Is Already Slowing Economic Activity Is Already Slowing Chart 4Markets Blasé About Looming Risks Markets Blasé About Looming Risks Markets Blasé About Looming Risks It is not only the S&P 500 that is failing to register the dangerous combination of weak global trade and escalating U.S.-China strategic conflict. Our colleague Anastasios Avgeriou of the BCA U.S. Equity Strategy points out that the “Ted spread,” the premium charged on interbank lending over the risk-free rate, is as docile as the safe-haven Japanese yen (Chart 4). President Xi Jinping, however, is not so blasé. He took a trip to Jiangxi province on May 20 to declare that China is embarking on a “new Long March.” This is a reference to the legendary strategic withdrawal executed by the early Chinese Communist Party in its civil war against the nationalists in 1934-35. It was an 8,000-mile slog across the rugged terrain of western and central China, peppered with battles against warlords and nationalists, in which nearly nine-tenths of the communist troops never made it. It is a historical event of immense propagandistic power used to celebrate the CPC’s resilience and ultimate triumph over corrupt and capitalist forces backed by imperialist Western powers. Most importantly, the Long March culminated in Mao Zedong’s consolidation of power over the party and ultimately the nation. In short, President Xi just told President Trump to “bring it on,” as he apparently believes that a conflict with the U.S. will strengthen his rule. The S&P 500 and the “Ted spread” are failing to register the dangerous combination of weak global trade and escalating U.S.-China strategic conflict. Trump, meanwhile, operates on a much shorter time horizon. He is coming closer to impeachment, as House Speaker Nancy Pelosi sharpens her rhetoric and negotiations over a bipartisan infrastructure bill collapse. Impeachment will fail and in the process will most likely help Trump’s reelection chances. But gridlock at home means that one of our top five “Black Swan” risks for 2019 is now being activated: Trump is at risk of becoming a lame duck and is therefore looking for conflicts abroad as a way of stirring up support at home. Bottom Line: The bad news in the trade war is all-too-apparent while good news is elusive. Yet key “risk off” indicators have hardly responded. We recommend going long JPY-USD on a cyclical basis on the expectation that the market will continue to have indigestion until a positive catalyst emerges in the trade talks. Trump’s Trade War Calculus Chart 5 The trade war is focused on China more so than other states – and Trump likely has the public backing for such a conflict. President Trump delayed any Section 232 tariffs on auto and auto parts imports this month as the China trade war escalated (Chart 5). This confirms our reasoning that the nearly 50/50 risk of tariffs on car imports from Europe and Japan (recently upgraded from 35%) is contingent on first wrapping up a China deal. Another signal that Trump is conscientious not to saddle the equity market with too many trade wars is the decision finally to exempt Canada and Mexico from Section 232 aluminum and steel tariffs (Chart 6). It is now possible for Canada to ratify the deal before parliament dissolves in late June and for the U.S. and Mexico to follow. American ratification will involve twists and turns as the Democrats raise challenges but their obstructionism is ultimately fruitless as it will not hurt Trump’s approval ratings and labor unions largely support the new deal. Meanwhile a major hurdle relating to Mexican labor standards has already been met. These are positive developments for these markets and yet they call attention to a critical point about the Trump administration’s trade strategy: Trump has not shown much willingness to compromise his trade demands with allies in order to secure their cooperation in pressuring China. The threat of car tariffs is still looming over Europe (and even Japan and South Korea). In fact, a united front among these players would have made it much harder for China to resist structural changes (Chart 7). Chart 6Canada And Mexico Are Off The Hook Canada And Mexico Are Off The Hook Canada And Mexico Are Off The Hook Chart 7A 'Coalition Of The Willing' Would Be More Effective A 'Coalition Of The Willing' Would Be More Effective A 'Coalition Of The Willing' Would Be More Effective Nevertheless, we have long held that China, not NAFTA or Europe, would be the focus of Trump’s ire because there is much greater consensus within the U.S. political establishment on the need for a more muscular approach to China grievances, and hence fewer constraints on Trump. This view has now come full circle, at least for the time being. Bear in mind that while Republicans and even Democrats have a favorable view of international trade, in keeping with an improving economy (Chart 8), the U.S. as a whole is more skeptical of free trade than most other countries (Chart 9). The economy is insulated and globalization has operated unchecked for several decades, generating resentment. Chart 8 Chart 9 Chart 10 This is especially relevant with China. Americans have an unfavorable view of China’s trade practices and China in general (Charts 10 and 11). This perception is getting worse as the great power competition heats up. Even a majority or near-majority of Democrats view China’s cyber-attacks, ownership of U.S. debt, environmental policies, and economic competition as causes of real concern (Chart 12). This means Trump is closer to the median voter when he is tough on China. Chart 11 Chart 12 The result is a lower chance of a “weak deal,” i.e. a short-term deal to reduce the trade deficit primarily through Chinese purchases of commodities, since this will be a political liability for Trump. He may be forced into such a deal if the market revolts (say 35% odds). But otherwise he will hold out for something better, which Xi Jinping may be unwilling to give. China, not NAFTA or Europe, is the focus of Trump’s ire. This is why we rank “no deal” at 50%, more likely than any kind of deal (40%), though there is some chance of an extension of talks beyond the June G20 (10%). Bottom Line: The delay of auto tariffs and progress in replacing NAFTA suggest that the Trump administration is cognizant of the negative market impact of its trade wars and the need to focus on China. However, the risks to Europe and Japan are not yet removed. And any Chinese concessions will be weaker than might otherwise have been possible had Trump created a “coalition of the willing” to prosecute China’s violations of global trading norms. A weak deal makes it more likely that strategic conflict is the result. Trump Beats Bernie Beats Biden? Or Vice Versa? U.S. domestic politics are also pushing Trump in the direction of conflict with China. The American voter’s distrust of China explains why former Vice President Joe Biden, and leading contender for the Democratic Party nomination in 2020, recently caught flak from both sides of the aisle for being soft on China. At a campaign stop in Iowa on May 1, Biden said, “China is going to eat our lunch? Come on, man … They’re not competition for us.” He has made similarly dovish comments in the recent past. It makes sense, then, that Trump is trying to link “Sleepy Joe” (as he calls Biden) with weakness on China and trade. Biden, who is still enjoying a very sizable bump to his polling a month after formally announcing his candidacy (Chart 13), is a direct threat to Trump’s electoral strategy of maximizing white blue-collar turnout and support, particularly in the Midwestern swing states. Biden was on the ticket when President Barack Obama won these states in 2008 and 2012. He is a native son of Pennsylvania. And he appeals to the same voters as a plain-talking everyman. Chart 13 Both Biden and Democratic Socialist Bernie Sanders of Vermont are beating Trump in the very early head-to-head polling for the 2020 presidential race. In fact, Sanders has a bigger lead over Trump than Biden in many of these polls (Chart 14). Chart 14 Yet Sanders has a narrower path to victory in the general election – he is heavily dependent on the Rustbelt, where he could either win based on repeating the 2016 results in a new demographic context (the “Status Quo” scenario in Chart 15), or by winning back the blue-collar voters who abandoned the Democrats for Trump in 2016 (the “Blue Collar Democrats” scenario). Sanders performed well in these states in the Democratic primary in 2016, whereas he struggled in the South. Chart 15 Chart 16Democrats Swung Too Far Left For Many Independents Democrats Swung Too Far Left For Many Independents Democrats Swung Too Far Left For Many Independents Biden, on the other hand, is capable of winning not only in these two scenarios, but also by rebuilding the Obama coalition. He has a better bid to win over the black community due to his close association with Obama and his command of Democratic Party machinery, plus potentially his choice of running mate (the “Obama vs. Trump” scenario). By this means Biden, unlike Sanders, can compete against Trump in the Sun Belt and South in addition to the Midwest. Therefore, it is all the more imperative for Trump to try to corner Biden and frame the debate about Biden early. Trump may also be betting that despite the head-to-head polling, Sanders is too far left for the median voter. While the Democratic Party swings sharply to the left, the median voter remains more centrist, judging by the fact that independent voters (who make up half the electorate now) only slightly favor Democrats over Republicans, a trend that is only slightly rising (Chart 16). Biden’s polling is strong enough that he holds out the prospect of winning the Democratic nomination relatively smoothly, without deepening the ideological split in the party too much. Whereas Trump would benefit in the general election if Democrats suffered an internal split over a bloody primary season in which Bernie Sanders clawed his way to the nomination. The hit to American farmers is probably not a significant political constraint on President Trump waging his trade war. The upshot is that Trump is vulnerable in U.S. politics and will attempt to take action to strengthen his position. Meanwhile if Biden’s position on trade changes then we will know that he reads the Midwestern voter the same way Trump does – as a protectionist. Bottom Line: Trump’s eagerness to attack Biden reveals the specific threat that Biden poses to Trump’s electoral strategy as well as Trump’s calculus that a belligerent position on China is a vote-getter in the key Midwestern swing states. We expect Biden to become more hawkish on China, which will emphasize the long-term nature of the U.S.-China struggle and confirm the median voter’s appetite for hawkish policy. American Farmers Unlikely To Alter The 2020 Playing Field Chart 17 Chart 18 Yet can Trump’s political base withstand the trade war? And can he possibly win the swing states if the trade war is escalating and damaging pocketbooks? There are many stories about farmers in the Midwest and other purple states who are deeply alarmed at Trump’s trade policies, prompting questions about whether he could be unseated there. American farmers have been among the hardest hit in the trade war. China was a major market for U.S. agricultural exports prior to the conflict (Chart 17). Since then U.S. agriculture has struggled, as exports to China have declined by more than 50% y/y in 2018 (Chart 18). Agricultural commodity prices are down ~10% since a year ago, with soybeans – the poster child of the conflict – trading at 10 year lows. Net farm incomes – a broad measure of profits – were on a downward trend prior to the trade war (Chart 19). While the USDA estimates that overall U.S. farm income will increase by 8.1% y/y this year, this follows a nearly 18% y/y decline in 2018 to reach the lowest level since 2002 (Chart 20). The recent escalation of the trade war will weigh on these incomes. Chart 19 Chart 20 A common narrative in the financial media is that this hit to American farmers is a significant political constraint on President Trump in waging his trade war. He could be forced to accept a watered-down deal with China to preserve this voting bloc’s support ahead of November 2020, the thinking goes. Possibly, but probably not because of farmers abandoning the Republican Party en masse. First of all, rural counties and small towns continued supporting the Republican Party in the 2018 midterms, at a time when the initial negative impact of the trade war was front-page news (Chart 21). Second, some of the key farm states are unlikely to be key swing states in the election. Take soybeans, for example. Prior to the trade war, nearly 60% of U.S. soybean exports, and more than a third of U.S. soybeans, ended up in China. Illinois is the top producer, followed by Iowa and Minnesota. Last year soybean production in these three states accounted for 15%, 13%, and 8% of total U.S. production, respectively. As such, agriculture and livestock products exports to China in 1Q2019 are down 76% y/y in Illinois and 97% y/y in Minnesota. However, Trump won Iowa by nearly 150 thousand votes, a 9.4% margin, and there are not enough farmers in the state to overturn that margin. The negative impact on soybeans could prevent Trump from picking up Minnesota, where he lost by only 1.5% of the vote. But Minnesota is unlikely to cost him the White House in 2020. The picture is different in the key swing states of Michigan, Pennsylvania, and Wisconsin. Farming accounts for only ~1% of jobs in Michigan, Ohio, and Pennsylvania – and 2.3% of jobs in Wisconsin – and thus farmers represent a small share of the voting bloc in these states (Chart 22). But Trump won Michigan by a mere 0.23% of the vote, Pennsylvania by 0.72%, and Wisconsin by 0.77%. If one-fifth of farmers in these states switched their vote, Trump’s 2016 margin of victory would vanish. Chart 21 Chart 22 Of course, manufacturers are a much larger voting bloc (Chart 23). And rural voters are unlikely to shift to the Democrats on such a large scale. Moreover, ag exports from these states have generally held up (Chart 24), the majority of their exports are destined for North America rather than China. The benefit from the recent thaw in North American trade relations will outweigh the loss of China as a market (Chart 25). Chart 23 Chart 24 The Trump administration is also producing an aid package worth at least $15 billion to shield farmers at least partially from the trade war impact.1 This compares to an estimated $12 billion loss in net farm income in 2018. Chart 25 Chart 26 Ultimately, Trump is much more threatened by other voting groups in these states. Young voters, women, minorities, suburbanites, and college-educated white voters all pose a threat to his thin margins if they turn out to vote and/or increase their support for the Democratic Party in 2020. A surge in Millennials, for instance, played the chief role in unseating Republican Governor Scott Walker in Wisconsin in 2018 (Chart 26). While midterm elections differ fundamentally from presidential elections, the Republicans lost 10 out of 12 significant elections in the Midwest during the midterms (Table 1). Table 1Republicans Lost Almost All Significant Midwest Elections In The Midterm Is Trump Ready For The New Long March? Is Trump Ready For The New Long March? It is true that the winning Democratic candidates in the six major statewide races in Michigan, Pennsylvania, and Wisconsin all had voters who believed Trump’s trade policies were more likely to “hurt” the local economy than help it, according to exit polls (Chart 27). At the same time, a majority of voters believed that the trade policies either “helped” the local economy or “had no impact,” as opposed to hurting it. And Democrats are somewhat divided on this issue. Health care, not the economy, was the primary concern of voters. Moreover, health care, not the economy, was the primary concern of voters, especially Democratic voters (Chart 28). Republicans cared more about the economy and tended to support Trump’s trade policies. Chart 27 Chart 28 In sum, unless the trade war causes a general economic slowdown that changes voter priorities, Trump’s chief threat in 2020 comes from urban and suburban voters angry over his attempt to dismantle the Affordable Care Act, rather than from farmers suffering from the trade war. The large bloc of manufacturing workers in the Midwestern battleground states helps to explain why Trump is willing to wage a trade war at such a critical time: loyal rural counties bear the brunt of the economic pain yet a tough-on-China policy could bring out swing voters from the manufacturing sector in suburbs and cities. Bottom Line: Trump could very well lose agriculture-heavy swing states in 2020, but it would not be because of losing his base among rural voters. Rather, it would be a result of a broader economic slowdown – or a superior showing of key demographic groups in favor of Democrats for other reasons like health care. The large bloc of manufacturing voters relative to Trump’s margins of victory helps to explain his aggressive posture on the trade war. Investment Conclusions Go long JPY-USD on a cyclical, 12-month horizon in the context of escalating trade war, complacent markets, and yet the prospect of additional Chinese stimulus improving global growth. This trade should be reinforced by the specific hurdles facing Japan over the next three to 18 months. While we would not be surprised if a trade agreement with the U.S. is concluded quickly, even ahead of any U.S.-China deal, nevertheless Japan faces upper house elections, a potential consumption tax hike, and preparations for a contentious constitutional revision and popular referendum on the cyclical horizon. On the expectation of greater Chinese stimulus, we are maintaining our long China Play Index call, which is up 2.2%. As a hedge against both geopolitical risk and the impact of Chinese stimulus over the cyclical horizon, go long spot gold.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 While the plan is yet to be finalized, payments of ~$2/bushel to soybean farmers, $0.63/bushel to wheat farmers, and $0.04/bushel to corn farmers are under consideration. Unlike last year when the payments were distributed according to farmers’ current production, a potential modification to this year’s plan is that the payments will be distributed based on this years’ planted acreage and past yields.

Highlights So What? Odds of a total breakdown in U.S.-China relations are highly underrated. Why? The key market-relevant geopolitical event is Trump’s large risk appetite. Inflationary pressures resulting from the trade tariffs are not prohibitive for Trump’s trade war. Chinese stimulus will surprise to the upside, but a massive stimulus package will depend on talks collapsing and maximum tariffs. Markets will sell before they recover. We will maintain our current portfolio hedge of Swiss bonds and gold. Feature Chart 1Equities Sell, Safe Havens Rally Equities Sell, Safe Havens Rally Equities Sell, Safe Havens Rally Global equities have sold off and safe-haven assets caught a bid since the near-breakdown in U.S.-China trade negotiations on May 5 (Chart 1). Yet financial markets are still complacent, as the 2.8% drawdown to date on global equities and the S&P 500 does not yet reflect the depth of the geopolitical risk to sentiment and corporate earnings. To understand this risk we need to step away from the ups and downs of the trade negotiations and ask, What have we learned about U.S. policy over the past month and what does it mean for global markets on a cyclical and structural horizon? We have learned that in the lead-up to the 2020 election, President Trump is not seeking to protect his greatest asset – namely, a strong American economy – but rather to solidify his support through new ventures. By imposing the full brunt of sanctions on Iran and hiking the tariff rate on Chinese imports, Trump has made two highly significant decisions that could jeopardize the American voter’s pocketbook, with a full 18 months to go before November 3, 2020. Why has he done this? Because he believes the American economy can take the pain and he will achieve resounding foreign policy successes. These, he hopes, will make his reelection more likely. President Trump’s aggressive posture is a direct threat to the global equity bull market due to (1) higher odds of a negative shock to global trade when global growth is already weak, and (2) higher odds of an oil price shock due to a potential vicious spiral of Middle East conflict. Wreaking Havoc Historically, the United States thrives when the rest of the world is in chaos. This was obviously the case during World War I and II (Chart 2). But it also proved true in the chaotic aftermaths of the Soviet Union’s collapse and the global financial crisis, though the U.S. did suffer along with everyone else during the 2008-09 downturn. American equities have generally outperformed during periods of global chaos (Chart 3). Chart 2America Thrives Amid Global Chaos America Thrives Amid Global Chaos America Thrives Amid Global Chaos Chart 3U.S. Equities Outperform During Global Crises U.S. Equities Outperform During Global Crises U.S. Equities Outperform During Global Crises The reasons for U.S. immunity are well known: the U.S. has a large, insulated, consumer-driven economy; it has immense economic advantages enhanced by its dominance of North America; it has vast and liquid financial markets; and it is the world’s preponderant technological and military power. This position enables Washington to act more aggressively than other capitals in pursuit of the national interest – and to recover more quickly from mistakes. Chart 4U.S. Preponderance Declining U.S. Preponderance Declining U.S. Preponderance Declining It follows that there is an influential idea or myth that the country can or should exploit this advantage, when necessary or desirable, by “wreaking havoc” abroad. The prime example is the preemptive invasion of Iraq. In this way Washington can turn the tables on its opponents and keep them off balance. The Trump administration, regardless of Trump’s intentions, could soon become the epitome of this school of thought. First, it is true that, structurally, American preponderance has been decreasing: despite various crises, there has been sufficient peace and prosperity in the twenty-first century to see the rest of the world’s wealth, trade, and arms grow relative to the United States (Chart 4). With the rise of China and resurgence of Russia, U.S. global leadership is at risk and the Trump administration has adopted unorthodox policies to confront its rivals and try to reverse this process. Second, cyclically, President Trump is stymied at home after his Republican Party lost the House of Representatives in the 2018 midterm election. Scandals and investigations plague his inner circle. Unable to secure funding for his signature campaign promise – the southern border wall – Trump faces the risk of irrelevance. Foreign policy, especially trade policy, thus becomes the clearest avenue for him to try to notch up victories. Trump faces the risk of irrelevance. Foreign policy thus becomes the clearest avenue for him to try to notch up victories. Bottom Line: The key market-relevant event over the past month has been the Trump administration’s demonstration of voracious risk appetite. This is fundamentally a cyclical not tactical risk to the bull market due to tit-for-tat tariffs, sanctions, and provocations with rivals like China and Iran. Pocketbooks Versus Patriotism Trump’s vulnerability becomes clear by looking at our electoral Map 1, which highlights his excruciatingly thin margins of victory in the critical “swing states” in the 2016 election. We emphasize the margin of victory among white voters – which are slightly higher than the margins overall – because the Trump campaign courted the white working class specifically in a calculated strategy to swing the Midwest “Rustbelt” states and win the election. Chart The problem for Trump is that while whites remain the majority of the eligible voting population, it is a declining majority due to demographic change. Demographics is not near-term destiny, but the vanishingly thin margins ensure that Trump cannot assume that he will win reelection without generating even more turnout and support among blue-collar whites in the key states. Chart 5 Job creation and rising incomes are the chief hope. The problem is that Trump’s tax cuts and the red-hot economy in 2018 did not prevent Republicans from getting hit hard in the midterm elections, especially in the Midwest. Moreover today’s resilient economy is not preventing the top two Democratic candidates, former Vice President Joe Biden and independent Vermont Senator Bernie Sanders, from beating Trump in head-to-head polling in the key swing states (Chart 5). Trump’s national approval rating, at about 44%, is nearly as good as it gets, but the indications from the Midwest are worrisome, especially because the economy has slowed. If the economy is not winning the argument on the campaign trail in 2020, Trump will need to have another leg to stand on. In addition to hammering home his attempts to build a wall on the border, Trump will highlight his economic nationalism. Protectionism has won the Rustbelt over the past three elections. As we have since 2016 argued, this now boils down to pressure on China. If Trump’s policies provoke China (or Iran) to take aggressive actions, he will have a pretext to exercise American power in a way that will likely create a rally-around-the-flag effect, at least in the short term. Elections do not normally hinge on foreign policy, but they certainly can. While President Trump may not actually want a war with Iran, he knows that George W. Bush cruised to victory amid the Afghan and Iraqi wars. Or he may have in mind 1964, when Lyndon B. Johnson crushed Barry Goldwater, an offbeat, ideological “movement candidate” (can anyone say Bernie Sanders?) in the face of a hulking communist menace, the Soviet Union. A conflict with China (or Iran) could serve similar purposes in 2020, either distracting the populace from a weakening economy or adding to an election bid centered on a reaccelerating economy. The problem is that a patriotic conflict with China or Iran is an insurance policy that threatens to undermine the health and safety of the very thing being insured: the U.S. economy. Indeed, U.S. stocks did not outperform after the September 11th attacks or during the Bush administration’s wars abroad. In essence, Trump is a gambler and is now going for broke. This constitutes a huge risk to the global economy and financial markets – a risk that was subdued just a month ago due to oil sanction waivers and tariff-free trade talks. Bottom Line: President Trump is courting international chaos because his policy priorities are tied down with gridlock and scandal at home. Aggressive foreign policy is a strategy to rack up policy victories and potentially expand his voter base, but it comes at the risk of higher policy uncertainty and negative economic impacts that could derail this year’s fledgling economic rebound and the long-running bull market. “No Deal” Is More Likely Than A Weak Deal It wasn’t just a tweet that sent volatility higher over the past two weeks. Most likely, President Trump decided to raise tariffs on China at the advice of his trade negotiators, who had become convinced that China was not offering deep enough concessions (“structural changes”) and was playing for time. This was always the greatest risk in the trade talks. China is indeed playing for time, as it has no security guarantee from the United States and therefore cannot embrace structural changes in the way that Japan did during the U.S.-Japanese trade war in the 1980s. Originally, the talks were set to last 90 days with the tariff hike by March 1. Trump was apparently determined not to lose credibility on this threat as China drew out the negotiations. Hence, he piled on the pressure to try to force a conclusion by the June 28-29 G20 summit in Japan, which has been the target date for our trade war probabilities over the past several months (Table 1). We have now adjusted those probabilities to upgrade the risk that talks collapse (50%) and downgrade the odds of a deal to 40% by that date. Table 1U.S.-China Trade War: Probabilities Of A Deal By End Of June 2019 How Trump Became A War President How Trump Became A War President The underlying calculation from the Trump administration is that a cosmetic, short-term deal – along the lines of the NAFTA renegotiation – will be difficult to defend on the campaign trail and hence politically risky. We upgraded the risk that talks collapse (50%) and downgraded the odds of a deal to 40% by end of June. If China agreed arbitrarily to increase imports from the U.S. by 10% by 2020, it would only increase the level of imports above the pre-trade war 2015-18 trend by $23 billion dollars in 2029 (Chart 6, panel 1). It would also have a minimal impact on the trade deficit. The deficit has increased so much in recent years that the impact of a 10% increase in exports by 2020 would merely offset the high point we reached during the trade war, leaving Trump with a mere $800 million per year by 2029 (Chart 6, panel 2). Chart 6 For commodities in particular – where China offered the largest purchases – the negative impact of the trade war has been so great that a 10% increase by 2020 over the status quo would fail to offset the recent damages over a ten-year period. China would have to increase imports by at least 17% to offset the trade war-induced decreases. If commodity imports were 30% higher in 2020 than otherwise, the impact 10 years down the line would amount to a mere $11 billion per year. These gains are smaller, as Chinese negotiators have long argued, than what could be made if the U.S. increased exports of advanced technology products to China. If the U.S. exported as many of these products to China as it does to the EU, as a share of EU GDP, it would amount to a $48 billion increase in exports. For Japan, the equivalent would be an $85 billion increase. Increasing the growth of these exports to China to match the recent trend of such exports globally would nearly double the amount sent to China by 2029, earning the U.S. an additional $60 billion that year (Chart 6, panel 3). The problem, of course, is that the confrontation with China is specifically focused on the latter’s technological acquisition and competition with the United States – it is precisely not about making reductions to the trade deficit at the expense of technological superiority. The tech war is more likely to derail the trade talks than the trade talks are likely to resolve the tech war. It is hugely significant that, at the moment of decision, President Trump sided with U.S. Trade Representative Robert Lighthizer and did not accept a deal focused on marginal improvements to the trade deficit. There was always a strong possibility – we previously put it at a 50% chance – that Trump would accept a short-term deal in order to get a “quick win” and minimize tariff pains ahead of the election, while punting the longer-term structural grievances until his second term when he would be less constrained by the economy. But this possibility has clearly fallen. We now put it at 35%, as shown in Table 1 above. Trump sees a shallow deal as a political liability. The most important takeaway from Table 1, however, is that the odds of a “Grand Compromise” have dropped to a mere 5%. Trump still may settle for a deal to reduce economic risks ahead of the election, but a grand compromise is very hard to get. Bottom Line: Our adjusted trade war probabilities suggest that global equities can fall further on a tactical horizon and that downside risks are grave, given a 50% chance that talks utterly collapse by the end of June. This would include a 30% chance of igniting an intense period of saber-rattling, sanctions, and Cold War-esque tensions that would cause a global flight to quality. Won’t The Trade War Turn Voters Against Trump? No. Chart 7 While geopolitical and political constraints push against a weak deal, the economic constraints of a failure to conclude a deal are not prohibitive. The latest tariff hike doubles the dollar magnitude of the tariffs, and an additional 25% tariff on the remaining $300 billion of imports would more than quadruple the magnitude of the tariffs from the April 2019 level (Chart 7). With all U.S. imports from China affected, price rises will percolate upward through all tradable industries and consumer goods. A few points are worth noting: The domestic value-add of Chinese exports to the U.S. is not as low as consensus holds. China’s manufacturing sector is highly competitive, comparable to the EU and Germany in the degree to which its exports to the U.S. incorporate foreign value (Chart 8). This means that Americans cannot substitute other goods for Chinese goods as easily as one might think. Chart 8 There remains a massive gulf between the nominal output of China’s manufacturing sector and the rest of Asia (Chart 9). Strategically it makes sense for the U.S. to want to decrease China’s share of American imports from Asia and reduce China’s centrality to the production process. But Asia cannot yet substitute for China. In practical terms this requires spreading China’s concentrated production system across the Indonesian archipelago. It is inefficient and will raise costs and import prices. Even in areas where China is lacking – such as technology, institutions, and governance – it still has a productivity advantage over the rest of Asia, pointing yet again to the cost-push inflationary consequences of an abrupt transition forced by tariffs (Chart 10). Chart 9Asia Cannot Replace China ... Yet Asia Cannot Replace China ... Yet Asia Cannot Replace China ... Yet Chart 10China's Productivity Beats Rest Of Asia China's Productivity Beats Rest Of Asia China's Productivity Beats Rest Of Asia Nevertheless, these cost factors are not so great as to force Trump into a weak deal. While the new and proposed tariff expansions will impact consumer goods more than the earlier batches that attempted to spare the consumer, the truth is that Chinese imports do not comprise a large share of the U.S. consumer basket (Chart 11). Chart 11American Shoppers Not Too Exposed To China American Shoppers Not Too Exposed To China American Shoppers Not Too Exposed To China Chart 12Goods Price Inflation Not An Immediate Risk Goods Price Inflation Not An Immediate Risk Goods Price Inflation Not An Immediate Risk Goods prices have been flat in the U.S., albeit in great part because of China, and they have fallen while the consumer price index and the real wage component of the CPI have risen by more than 20% since 2001 (Chart 12). Moreover, it is precisely in consumer goods where the American shopper does have considerable ability to substitute away from China – as opposed to the American corporation, which will have a harder time replacing Chinese-made capital goods quickly (Table 2). Thus, the risk impacts Wall Street differently than Main Street. Table 2Capital Goods Harder To Substitute How Trump Became A War President How Trump Became A War President Further, the median American household’s real income growth is still elevated (Chart 13). This comes on top of the fact that net household worth and the saving rate are both in good shape. President Trump has some leeway in waging his trade war. The risk, of course, is that this income growth is decelerating and Trump has given the tariffs 18 months to cause negative impacts for consumers prior to the election. He is also simultaneously wagering that the U.S.’s newfound energy independence – and his own ability to tap the strategic petroleum reserve – will prevent gasoline prices from spiking (Chart 14). This would occur as a result of any Iranian-backed attacks on oil production and export facilities across the Middle East. Chart 13American Household Still In Good Shape American Household Still In Good Shape American Household Still In Good Shape Chart 14Fuel Prices Already Rising Fuel Prices Already Rising Fuel Prices Already Rising Bottom Line: Inflationary pressures will result from trade tariffs (and Iranian sanctions) but they are not prohibitive for Trump thus far. This is not a recipe for cost-push inflation significant enough to trigger a recession or derail Trump’s reelection odds at present, but it is a risk that will need to be monitored. How Will China Respond? More Stimulus! The immediate ramification of a heightened trade war is deteriorating global trade and sentiment and hence slower global growth that pushes down prices. Indeed, the escalation of the trade war brings sharply into focus two long-running Geopolitical Strategy themes: Sino-American Conflict: U.S. and Chinese exports to each other have already sharply fallen off (Chart 15). Trade is interconnected so this will further depress global and Asia-ex-China exports. Chart 15Trade War Hurts Bilateral Trade ... And All Trade Trade War Hurts Bilateral Trade ... And All Trade Trade War Hurts Bilateral Trade ... And All Trade Chart 16Global Trade Already Rolling Over Global Trade Already Rolling Over Global Trade Already Rolling Over Apex of Globalization: Global trade as a whole is contracting as a result of the global slowdown, which the trade war has exacerbated (Chart 16). The negative impact on China is acute and threatens something akin to the global manufacturing recession of 2015 (Chart 17). Given that the trade war is now piling onto a merely fledgling rebound in Chinese and global growth this year, it is possible that the manufacturing slowdown could even get worse than 2015 and culminate in a global recession in our worst case scenario of a major strategic escalation. Preventing this outcome, China will increase fiscal-and-credit stimulus, which we have argued is likely to overshoot expectations this year due to trade war and the country’s desire to meet 2020 urban income goals (Chart 18). The magnitude should be comparable to the 2015-16 stimulus, unless a global recession is immediately in view, in which case it will be larger. Chart 17A Relapse Would Point Toward 2015-Sized Crisis A Relapse Would Point Toward 2015-Sized Crisis A Relapse Would Point Toward 2015-Sized Crisis It was the Xi administration that undertook the huge 2015-16 expansion of credit, so this magnitude is not out of the question. While Xi has attempted to contain leverage and reduce systemic financial risk, he is ultimately like his predecessors, most notably Jiang Zemin, in the sense that he will aim for social stability above all. Chart 18China Will Keep Stimulating China Will Keep Stimulating China Will Keep Stimulating The pain threshold of today’s policymakers has already been discovered, seeing how President Xi and the Politburo began easing policy in July 2018 after the U.S. implemented the initial Section 301 tariffs. The Chinese leaders were willing to tighten credit controls until this external risk materialized. The fact that the trade war is the proximate cause of heightened stimulus was confirmed in the wake of the Buenos Aires summit, where Xi chose to stimulate the economy further – resulting in a surge of credit in Q1 – as a way of improving China’s leverage vis-à-vis the United States in the 90-day talks. China will increase fiscal-and-credit stimulus … The magnitude should be comparable to the 2015-16 stimulus. In short, Xi and his government will stimulate first and ask questions later. Both fiscal and credit stimulus will be utilized, including traditional fiscal infrastructure spending and permissiveness toward shadow banking. A dramatic renminbi depreciation could occur but would be evidence that talks will fail (Chart 19). Chart 19Currency Agreement: Far From A Plaza Accord Currency Agreement: Far From A Plaza Accord Currency Agreement: Far From A Plaza Accord Stimulus will continue to be tactical, rolled out in piecemeal announcements, at least as long as the trade talks continue and there is a prospect of China’s economy rebounding without drastic measures. Only a total breakdown in negotiations – and collapse into outright Cold War – will prompt a massive stimulus package. Bottom Line: Chinese stimulus will surprise to the upside while talks are going, and it will increase dramatically if talks collapse. This will ultimately support global growth but it will not prevent market riots between a negative policy shock and the point at which markets are totally reassured about the magnitude of stimulus. How Will The Negotiations Proceed? Precariously. The risk of a strategic conflict is much higher than the markets are currently pricing. This is highlighted in Table 1 above, but there are additional reasons to have a high conviction on this point. We can demonstrate this by constructing a simple decision tree that outlines the step-by-step process by which the U.S. and China will proceed in their negotiations after the May 10 tariff rate hike (Diagram 1). To these we attach subjective probabilities that we believe are fair and slightly conservative. The result shows that it is not difficult to conclude that the conditional probability of a long-term, durable trade agreement is a mere 4%, whereas the conditional probability of an uncontained escalation in strategic tensions is as high as 59%! This is a much worse outcome than our actual view as expressed in Table 1. Diagram 1A Simple Decision Tree Says Geopolitical Risks Are Huge How Trump Became A War President How Trump Became A War President A similar exercise – an analysis of competing hypotheses conducted according to analytical techniques used by the U.S. intelligence community – reinforces the point that the most likely scenario is a major escalation in tensions, while the least likely is a “grand compromise” (Appendix). While our final trade war probabilities in Table 1 are not as pessimistic as these exercises suggest, the latter reinforce the point that the market is too sanguine. An increase in tariffs after five months of negotiations, with a threat to impose even more sweeping tariffs with a one-month deadline, is not conducive to Chinese concessions and therefore increases the odds of talks failing and an escalation in strategic conflict unprecedented in U.S.-China relations since the rupture from 1989-91. And this rupture would be considerably worse for the global economy. The Trump administration’s political logic is willing to accept such a conflict on the basis that a foreign policy confrontation can produce a rally-around-the-flag effect whereas a short-term deal that does not address significant technological and national security concerns is a political liability on the campaign trail. Yes, it is important that Presidents Trump and Xi are making verifiable preparations to attend the G20 summit in Japan. But they could cancel their attendance or snub each other at the event. In our view investors should wait for something more substantial to become more optimistic about political risk – such as public commitments to structural changes by China and a complementary tariff rollback schedule by the United States. Bottom Line: The odds of a total breakdown in U.S.-China relations and a Cold War-style escalation of strategic conflict are highly underrated. Markets will sell before they recover. Investment Implications Chart 20China's Nuclear Option Might Fizzle China's Nuclear Option Might Fizzle China's Nuclear Option Might Fizzle Equity markets are exposed to further downside in the short run. Even a minor escalation is not fully priced according to our Global Investment Strategy’s equity market forecasts based on our own geopolitical scenario probabilities (see Table 1 above). Our Chief Global Strategist Peter Berezin would recommend increasing exposure to risk if the S&P 500 falls 5% from current levels, other factors being equal. Cyclically, any trade agreement will fail to bring substantial benefits to the U.S.-China trade and investment outlook over a horizon beyond 12-24 months. The tech industries of the two countries will not benefit greatly from the deal. While multinational corporations exposed to the Asian manufacturing supply chain could suffer earnings downgrades from trade war, China’s stimulus will be a countervailing factor, particularly for commodities and commodity-oriented EMs. Therefore, we will keep our China Play Index and long Indonesia trades in place despite near-term risks. Ironically, U.S. treasuries can rally even when China is reducing its holdings, as global demand rises amid crisis (Chart 20). However, given that bonds have already rallied and we expect Chinese stimulus to come sooner rather than later, we will maintain our current portfolio hedge of Swiss bonds and gold, which is up 2%. We are closing our long small caps trade for a loss of 11.9%.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Image

Highlights Even if higher tariffs are imposed tonight, there is a good chance that China and the U.S. will reach a temporary trade truce over the coming weeks. Contrary to President Trump’s assertion, U.S. companies and consumers have borne all of the costs of the tariffs. With the next U.S. presidential campaign less than one year away, the self-described “master negotiator” will actually need to prove that he can negotiate a trade deal. If trade talks do collapse, the Chinese will ramp up credit/fiscal stimulus “MMT style,” thus providing a cushion under global growth and risk assets. In fact, there is a very high probability that the Chinese will overreact to the risks to growth, much like they did in 2009 and 2016. Investors should remain overweight global equities for the next 12 months, while positioning for a modestly weaker U.S. dollar and somewhat higher global bond yields. Feature Tariff Man Strikes Again Hopes for a quick end to the trade war were dashed last Sunday. President Trump threatened to hike tariffs on $200 billion of Chinese goods and begin proceedings to tax the remaining $325 billion of imports currently not subject to tariffs. Although details remain sketchy, U.S. Trade Representative Robert Lighthizer apparently informed the president that the Chinese were backtracking on prior commitments to change laws dealing with issues such as market access, forced technology transfers, and IP theft.1 This infuriated Trump. Trump’s announcement came just as Vice Premier Liu He and a 100-person Chinese trade delegation were set to depart for Washington. As BCA’s Chief Geopolitical Strategist Matt Gertken has noted, the relationship between the two sides was deteriorating even before Trump fired his latest salvo.2 The Chinese government was incensed by the U.S. request that Canada detain and extradite a senior official at Huawei, a top Chinese telecom firm. For its part, the Trump Administration was irked by China’s questionable enforcement of Iranian oil imports, the escalation of Chinese military drills around Taiwan, and the perception that China had not done enough to keep North Korea in check following the failed summit with Kim Jong-Un in Hanoi. It would be naïve to expect these ongoing geopolitical issues to fade anytime soon. The world is shifting from a unipolar to a multipolar one (Chart 1). In an environment where there are overlapping spheres of influence, geopolitical tensions will rise. Chart 1The Era Of Unipolarity Is Over The Era Of Unipolarity Is Over The Era Of Unipolarity Is Over That said, stocks still managed to advance during the first four decades of the post-war era even though the U.S. and the Soviet Union were at each other’s throats. What investors need today is some reassurance that the current trade spat will not degenerate into a full-out trade war that undermines global commerce. Ultimately, we think they will get this reassurance for the same reason that the Soviets and Americans never ended up lobbing missiles at each other: It would have been a lose-lose proposition to do so. Yet, the path from here to there will be a bumpy one. Investors should expect heightened volatility over the coming weeks. As It Turns Out, Trade Wars Are Neither Good Nor Easy To Win There was never any doubt that Wall Street would suffer from a trade war. What was less clear at the outset was the impact that higher tariffs would have on Main Street. Despite President Trump’s claim that the tariffs paid to the U.S. Treasury were “mostly borne by China,” the evidence suggests that close to 100% of the tariffs were, in fact, borne by U.S. companies and consumers. What investors need today is some reassurance that the current trade spat will not degenerate into a full-out trade war that undermines global commerce. A recent NBER paper compared the prices of Chinese imports that were subject to tariffs and similar goods that were not.3 Had Chinese producers been forced to bear the cost of the tariffs, one would have expected pre-tariff import prices to decline. In fact, they didn’t. The tariffs were simply absorbed by U.S. importers in the form of lower profit margins and by U.S. consumers in the form of higher selling prices. This does not mean that Chinese producers escaped unscathed. The paper showed that imports of tariffed goods dropped sharply as U.S. demand shifted away from China and towards domestically-produced goods and imports from other countries. Chart 2Support For Protectionism Rises When Unemployment Is High Support For Protectionism Rises When Unemployment Is High Support For Protectionism Rises When Unemployment Is High One might think that the decision to divert spending from Chinese goods to, say, Korean goods would be irrelevant for U.S. welfare. However, a simple thought experiment reveals that this is not the case. Suppose that a 10% tariff raises the price of an imported good from $100 to $110. If the consumer buys this good from China, the consumer will lose $10 while the U.S. government will gain $10, implying no loss in welfare. However, suppose the consumer buys the same good, tariff-free, from Korea for $105. Then the consumer loses $5 while the government gets no additional revenue, implying a net loss in national welfare of $5. Things get trickier when we consider the case where the consumer buys an identical domestically-produced good for say, $107, in order to avoid the tariff. If the economy is suffering from high unemployment, the additional demand will boost GDP by $107. The consumer who bought the domestically-produced good will be worse off by $7, but wages and profits will rise by $107, leaving a net gain of $100 for the economy. When unemployment is high, beggar-thy-neighbor policies make more sense. This is a key reason why support for protectionism tends to rise when unemployment increases (Chart 2). Today, however, the U.S. unemployment rate is at a 49-year low. To the extent that tariffs shift demand towards locally sourced goods, this is likely to require that workers and capital be diverted from other uses. When this occurs, there is no change in overall GDP. Within the context of the example above, all that would happen is that consumers would lose $7, reducing national welfare by the same amount. In fact, it is even worse than that. The example above does not include the impact on welfare from any resources that would need to be squandered from having to shift workers and capital equipment from sectors of the economy that lose from higher tariffs to those that gain from them. Nor does the example include the adverse impact on national welfare from any retaliatory policies. Ironically, while the evidence suggests that U.S. tariffs did not have much effect on Chinese import prices, it does appear that Chinese tariffs had an effect on U.S. export prices. Agricultural prices are highly sensitive to market conditions. Chart 3 shows that grain and soybean prices fell noticeably in 2018 on days when trade tensions intensified. This pattern has continued into the present. It is not surprising that Senators Chuck Grassley and Joni Ernst, along with other senior Iowa politicians, penned a letter to President Trump imploring him to reach a trade deal in order to help the state’s farming communities.4 Chart 3 China’s Secret Weapon: MMT To be fair, the arguments above do not account for the strategic possibility that the threat of punitive tariffs forces the Chinese to open their markets and refrain from corporate espionage and IP theft. If Trump is able to wrangle these concessions from the Chinese, then he could remove the tariffs, creating an environment more favorable to American corporate interests. The problem is that China will resist conceding so much ground. True, a trade war would hurt Chinese exporters much more than it would hurt U.S. firms. However, China is no longer as dependent on trade as it once was. Chinese exports to the U.S. account for only 3.6% of GDP, down from 7.3% of GDP in 2006 (Chart 4). China also has plenty of tools to support the economy in the event of a trade war. Chief among these is credit/fiscal stimulus. As we discussed three weeks ago, investors are underestimating China’s ability to ramp up credit growth in order to support spending throughout the economy.5 High levels of household savings have kept interest rates below the growth rate of the economy (Chart 5). When GDP growth exceeds the interest rate at which the government can borrow, even a persistently large budget deficit will produce a stable debt-to-GDP ratio in the long run. Chart 4China Is No Longer As Dependent On Trade With The U.S. As It Once Was China Is No Longer As Dependent On Trade With The U.S. As It Once Was China Is No Longer As Dependent On Trade With The U.S. As It Once Was Chart 5China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy   The standard counterargument is that governments cannot control the interest rate at which they borrow. This means that they run the risk of experiencing a vicious circle where high debt levels cause bond yields to rise, making it more difficult for the government to service its debt. This could lead to even higher bond yields and, eventually, default. However, this argument applies only to countries that do not issue their own currencies. Since a sovereign government can always print cash to pay for the goods and services, it can never run out of money. Chinese exports to the U.S. account for only 3.6% of GDP, down from 7.3% of GDP in 2006. The main reason a sovereign central bank would wish to raise rates is to prevent the economy from overheating. If a rising fiscal deficit is the consequence of a decline in private-sector spending (which is something that would likely happen during a trade war), there is no risk of overheating, and hence, there is no need to raise interest rates. We are not big fans of Modern Monetary Theory, but at least on this point, the MMT crowd is right while most analysts are wrong. Investment Conclusions It is impossible to say with any confidence what the next few days will bring on the trade front. If the Trump Administration’s allegation that the Chinese backtracked on prior commitments turns out to be true, it is possible that some of them will be reinstated, thus allowing the negotiations to resume. This could prompt Trump to offer a “grace period” to the Chinese of one or two weeks later tonight before scheduled tariff hikes are set to occur. If tariffs do go up, what should investors do? The answer depends on how much stocks fall in response to the news. If global equities were to decline by more than five percent, our inclination would be to get more bullish. There are two reasons for this. First, the failure to reach a deal this week does not mean that the talks will irrevocably break down. The point of Trump’s tariffs was never to raise revenue. It was to force the Chinese into a trade agreement that served America’s interests. With less than a year to go before the presidential campaign kicks into high gear, the self-described “master negotiator” needs to prove to the American public that he can actually negotiate a trade deal. This means some sort of an agreement is more likely than not. Second, as noted above, China will respond aggressively with fresh stimulus if the U.S. slaps tariffs on its exports. This will help cushion global growth and risk assets. Infrastructure spending tends to be more commodity intensive than manufacturing production. Thus, even if the Chinese government exactly offsets the loss of manufacturing exports with additional infrastructure spending, the net effect on global growth will probably be positive. China will respond aggressively with fresh stimulus if the U.S. slaps tariffs on its exports. In reality, there is a very high probability that the Chinese will do more than that. As the 2009 and 2016 episodes illustrate, when faced with a clear downside shock to growth, the government calibrates the policy response based on the worst-case scenario. Not only would a bout of hyperstimulus provide downside protection to the Chinese economy against a growth shock, it would also give the government more negotiating leverage with Trump. After all, it is much easier to brush away threats of punitive tariffs if you have an economy that is humming along. Investors should remain overweight global equities for the next 12 months, while positioning for a modestly weaker U.S. dollar and somewhat higher global bond yields. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      David Lawder, Jeff Mason, and Michael Martina, “Exclusive: China backtracked on almost all aspects of U.S. trade deal – sources,” Reuters, May 8, 2019. 2      Please see Geopolitical Strategy Special Alert, “U.S. And China Get Cold Feet,” dated May 6, 2019. 3      Mary Amiti, Stephen J. Redding, and David E. Weinstein, “The Impact of the 2018 Trade War on U.S. Prices and Welfare,” NBER Working Paper No. 25672, (March 2019). 4      “Young, Ernst Lead Iowa Delegation in Letter Urging President Not to Impose Tariffs,” Joni Ernst United States Senator For Iowa, March 7, 2018. 5      Please see Global Investment Strategy Weekly Report, “Chinese Debt: A Contrarian View,” dated April 19, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 6 Tactical Trades Strategic Recommendations Closed Trades

Highlights So What? The Trump administration’s decision to apply maximum pressure to Iran fundamentally changes the investment landscape in 2019-20. Why? The impact of the Iran sanctions on a stand-alone basis can easily be handled given OPEC 2.0’s current spare capacity. However, not only Iranian and Venezuelan oil but also Iraqi oil could be pulled off the market in a full-fledged conflict. Policy-induced volatility and the oil risk premium will rise. Geopolitical tail risks have gotten fatter and the odds of a recession have also increased. Feature What are the Trump administration’s foreign policy objectives? First, to confront the U.S.’s greatest long-term competitor, China, by demanding economic reforms and greater market access. Second, to force a decision-point upon rogue regimes with significant ballistic missile programs and nuclear-weapon aspirations: North Korea and Iran. Third, to maintain credible deterrence in Russia’s periphery. Fourth, to reassert the Monroe Doctrine through regime change in Venezuela. The common thread, even with Russia, is confrontation. It is not necessary for President Trump to pursue all of these objectives at once. So his decision last November to issue waivers for eight importers of Iranian oil suggested to us that he was prioritizing – and becoming more risk averse ahead of the 2020 election. Full enforcement of the oil sanctions at that time threatened to push oil prices up at the same time as the Fed was raising rates, a pernicious combination late in the cycle (Chart 1). Thus, after walking away from the 2015 nuclear accord with Iran, it made sense for Trump to delay any confrontation with Iran until his hoped-for second term in office. He could focus on building the border wall, resolving trade tensions with China, and making peace with North Korea instead. Chart 1Full Sanctions Enforcement Was Too Risky Last November Full Sanctions Enforcement Was Too Risky Last November Full Sanctions Enforcement Was Too Risky Last November Chart 2Sanctions Will Raise Risk Sanctions Will Raise Risk Sanctions Will Raise Risk   This view has now been proved wrong. The oil waivers apparently represented only a temporary delay in the administration’s hawkish Iran policy. Now that financial conditions have eased and growth has stabilized, Trump has declared the Iranian Revolutionary Guard Corps a foreign terrorist organization and announced that he will discontinue the waivers, demanding full compliance on energy sanctions from all states by the end of May. Volatility will move higher (Chart 2). Trump is emboldened by America’s newfound energy independence (Chart 3). While the shale boom can be used to reduce U.S. strategic commitments in the Middle East, it can also encourage Washington to believe it is invulnerable to traditional Middle Eastern risks. Trump’s advisers, Secretary of State Mike Pompeo and National Security Adviser John Bolton, apparently have won the Iran policy debate on this basis. Since Trump’s reelection is far from guaranteed, it would appear his advisers view re-imposing sanctions against Iran as a rare opportunity to achieve long-term strategic objectives. They may not have the chance in 2021. Chart 3The U.S. Is Energy Independent The U.S. Is Energy Independent The U.S. Is Energy Independent Chart 4Trump's Reelection At Risk If Oil Spikes Trump's Reelection At Risk If Oil Spikes Trump's Reelection At Risk If Oil Spikes All the same, the problem for Trump is that, while the U.S. will survive any chaos ensuing from an Iran confrontation, his presidency may not. Full enforcement of the sanctions could spiral out of control and, through the oil price channel, come back to hurt Trump’s economy – and hence his re-election odds (Chart 4). The implication is that Trump has either been misled about the risks of his Iran policy, or he does not care as much about his re-election odds as we believed. Either way, the result is aggressive policy, which increases the geopolitical risk premium in oil prices. We can see this in our simulations (below), which are based entirely on spare capacity and compliance by consumers to the sanctions. We did not include an Iran-retaliation scenario in this modeling. Therefore, any threat to Iraqi supplies, or talks of disrupting the Strait of Hormuz will add to our prices forecasts. U.S. Administration Sailing Close To The Wind From their public comments, it would appear the U.S. administration has convinced itself the global oil market can absorb a disruption from the loss of production in Iran and Venezuela. For the Trump administration, this view is supported by growing U.S. shale-oil supplies, and the administration’s belief the Kingdom of Saudi Arabia (KSA) and its Gulf allies stand ready to increase production to cover any losses arising from the re-imposition of Iranian oil-export sanctions by the U.S. This belief supports the administration’s end-game, which appears to be regime change in Iran, a position long favored by Trump’s national security advisor John Bolton. Frank Fannon, U.S. Assistant Secretary of State for Energy Resources, succinctly captured the administration’s view when he declared, “We are doing this ... in a favorable market condition with full commitment from producing countries.” He further stated, “We think this is the right time.”1 We believe the Trump administration is sailing close to the wind here. The U.S. administration has convinced itself the global oil market can absorb a disruption from the loss of oil production in Iran and Venezuela. While increasing U.S. shale output does provide something of a cushion to global oil markets, it is not a substitute for the heavy-sour crude produced by Iran and Venezuela (and others), which is favored by refiners with complex units. The loss of Iranian exports hits these refiners harder than those able to process lighter, sweeter crude of the sort exported by the U.S. (Chart 5).2 As Iranian and Venezuelan barrels are lost to the market, these heavier crudes are getting more scarce relative to the crude produced in U.S. shales – typically classified as West Texas Intermediate (WTI) crude oil. This can be seen in tighter light-versus-heavy crude oil spreads, and the wider Brent-WTI spreads, which indicate WTI is relatively more plentiful (Charts 6A & 6B). Chart 5 Chart 6AWTI Relatively More Plentiful… WTI Relatively More Plentiful... WTI Relatively More Plentiful... Chart 6B…As Heavier Crudes Become More Scarce ...As Heavier Crudes Become More Scarce ...As Heavier Crudes Become More Scarce It is true U.S. production continues to grow, which is causing crude oil inventories to increase as sanctions on Iran are being re-imposed. We expect U.S. shale-oil output to grow 1.2mm b/d this year – taking it to a record 8.4mm b/d on average – and 800k b/d next year. Caution is required regarding inventories, however: U.S. refiners are in the thick of their plant maintenance – known as turn-around season – and have loaded a lot of the maintenance they would normally have done in the Fall into Spring. As a result, U.S. refiners are running at reduced rates preparing for the Northern Hemisphere’s summer driving season and the January 1, 2020, implementation of the U.N. IMO 2020 regulations, which will require shippers to use lower-sulfur fuel to power their vessels worldwide.3 OPEC 2.0 Gains Control Of Brent Forward Curve Growing U.S. production and inventories might give the Trump administration comfort the market can absorb the loss of Iran’s exports – some 1.3mm b/d at present. However, our base case holds that Iran’s exports will stabilize at ~ 600k b/d after sanctions fully kick in. In most of the scenarios we run (Table 1), the impact of Iran sanctions on a stand-alone basis can easily be handled given OPEC 2.0’s current spare capacity (Chart 7).4 Indeed, many of the low-probability scenarios we run – including the “maximum pressure” scenario, in which the Trump administration succeeds in removing all of Iran’s exports – can be accommodated by current supply and spare capacity without sending Brent prices through $100/bbl (Chart 8). OPEC 2.0 holds ~ 1.5mm b/d of what we would describe as readily available spare capacity – mostly in KSA – that can be brought to market fairly quickly, as the ramp-up last year ahead of the first round of sanctions in November amply demonstrated. Another 1.5mm b/d or so is held by the Kingdom and its GCC allies, but it would take longer to bring on line. Table 1BCA Oil Market Scenarios U.S.-Iran: This Means War? U.S.-Iran: This Means War? Chart 7OPEC 2.0 Can Handle Iranian Losses OPEC 2.0 Can Handle Iranian Losses OPEC 2.0 Can Handle Iranian Losses Chart 8Brent Unlikely To Surpass $100 Brent Unlikely To Surpass $100 Brent Unlikely To Surpass $100 In reality, once refiners are up and running at max capacity in the U.S. in a few weeks, U.S. inventories will begin to draw hard. This will support what we believe to be OPEC 2.0’s goal of backwardating the Brent curve – perhaps sharply. This will allow it some breathing space to gradually add barrels to the market in 2H19 as needed, as our balances and forecasts assume. It is important to remember OPEC 2.0 was formed to drain the massive storage overhang that resulted from the 2014-16 market-share war launched by KSA. The Kingdom’s energy minister, Khalid al-Falih, is in no hurry to reverse OPEC 2.0’s strategy now. Throughout the ramp to renewed sanctions, he has steadfastly maintained the Kingdom will provide oil as Aramco’s customers need it, following the blind-side hit KSA took from the Trump administration in November when it granted Iran’s largest customers waivers on its export sanctions. U.S. Pressure On OPEC To Raise Output Will Grow We expect the Trump administration to continue to pressure OPEC – the old cartel, not OPEC 2.0 – to boost production post-sanctions. However, it is not entirely clear that this time OPEC’s – particularly KSA’s – interests are 100% aligned with President Trump’s. KSA and other producers were shocked by the administration’s decision to grant waivers after lifting supply sharply in response to Trump’s demands. This time around, we believe OPEC – KSA in particular – will be more cautious lifting output, even as the U.S. Navy very publicly displays its ability to project and sustain force in the Mediterranean and Persian Gulf regions (Map 1). With good reason: The U.S. holds ~ 650mm barrels of oil in its Strategic Petroleum Reserve (SPR), which can be released at a rate of 1mm to 1.3mm b/d for a year or so. Realistically, it is probably more like six to nine months, since, by the time much of the oil has been released to the market the reserves that are left likely will have higher concentrations of contaminants (e.g., metals and solids that migrated to the bottom of the storage while it was sitting idle), making buyers way more leery of using it. Chart After the shock of the waivers, KSA likely will minimize its exposure to another surprise from the U.S. as sanctions take hold. The risk to OPEC – KSA in particular – is that Trump again will pull a fast one as the U.S. general election approaches. Given Trump’s demonstrated sensitivity to U.S. gasoline prices approaching elections, it is not unlikely that he would hold on to the SPR barrels until mid to late summer 2020, then release them in time to reduce prices further. If, in the run-up to U.S. elections, OPEC has steadily increased production to build precautionary inventories then it runs a non-trivial risk the crude oil price would once again crash as SPR barrels are released. The Kingdom of Saudi Arabia’s energy minister, Khalid al-Falih, is in no hurry to reverse OPEC 2.0’s strategy now. In this iteration of Iranian export sanctions, we expect KSA to adopt a just-in-time inventory management strategy, so that it is not caught out once again over-supplying the market ahead of a U.S. surprise. U.S. Shales Will Figure Into OPEC 2.0’s Calculus Chart 9U.S. Export Capacity Is Constrained U.S. Export Capacity Is Constrained U.S. Export Capacity Is Constrained The other big fundamental OPEC 2.0 will be considering is the rate at which U.S. shale oil can be exported. Export capacity still is constrained by the shortage of deep-water harbor facilities in the U.S. Gulf. This is being addressed, but it has been slowed by additional requests for environmental impact statements from the federal and state governments. If prices start moving higher because KSA and OPEC 2.0 are responding to tightening markets with caution (and slowly), we’d likely see WTI production increase – it’ll have 2mm b/d of new pipe in the Permian to fill by end-2019 – but that crude could start backing up as storage in the U.S. Gulf fills. This would again widen the Brent vs. WTI - Houston spread, which will benefit refiners in the U.S. Gulf, but will lower prices received by U.S. shale producers (again) (Chart 9). Bottom Line: Trump’s decision not to extend the Iranian oil waivers suggests that he has plenty of risk appetite ahead of the 2020 election. His Iran policy is now the biggest geopolitical risk to the late-cycle bull market. It also risks tightening the oil market considerably as the election approaches. Can Iran’s Regime Withstand The Sanctions? Iran’s economic weakness was an added inducement for the Trump administration to take an aggressive turn. The sanctions against Iran’s crude oil exports have not yet been implemented in full force, but the economy is already showing signs of distress. For one, inflation is back near 40% – levels only reached during the previous round of sanctions (Chart 10). Given that food, beverages, and transportation are among the sectors experiencing the fastest growing prices, lower income groups – which the World Bank estimates spend almost half their income on food alone – will suffer disproportionately. Economic dissatisfaction has catalyzed protests in Iran in the past, and the squeeze from the U.S. sanctions could propel further unrest. Chart 10Iran's Economy Already Showing Signs Of Distress Iran's Economy Already Showing Signs Of Distress Iran's Economy Already Showing Signs Of Distress Chart 11 Moreover, soaring prices are coinciding with a slowdown in activity and consumption. On the surface Iran appears relatively well protected given that its economy is not as directly correlated with oil exports as some of its peers (Chart 11). However, Iran’s oil and non-oil sectors are actually closely intertwined. This is evident from weakness in the non-oil sector during the previous round of sanctions (Chart 12). The IMF expects the economy to contract by 6% this year – faster than its 3.9% estimate for last year – leaving Iranians to face a period of deepening stagflation. Chart 12 The jump in consumer prices is a reflection of the ongoing collapse of the currency. Despite the government’s best efforts to stabilize the foreign exchange market, heightened demand for foreign currencies caused a nearly 30% depreciation in the unofficial exchange rate vis-à-vis the U.S. dollar since the beginning of the year (Chart 13). Chart 13Unofficial Exchange Rate Continues To Weaken Unofficial Exchange Rate Continues To Weaken Unofficial Exchange Rate Continues To Weaken Chart 14Debt Burden Is Manageable Debt Burden Is Manageable Debt Burden Is Manageable To soften the impact of the weaker currency and the potential shortage of essential goods, authorities have introduced a three-tier exchange rate system, and banned the export of several products including grains and seeds, powdered milk, butter, and tea. Since the level of external debt remains manageable (Chart 14) the weak currency will pressure the economy through its impact on prices (highlighted above), with imported inflation eroding purchasing power. Furthermore, Iran will not benefit from any additional export competitiveness due to currency depreciation. The current account surplus is expected to deteriorate and eventually flip to a deficit amidst weak exports, and despite declining imports (Chart 15). The fact that Iran runs a non-energy trade deficit does not help. Chart 15Trade Surplus At Risk Trade Surplus At Risk Trade Surplus At Risk Chart 16Rising Budget Deficit Is A Constraint Rising Budget Deficit Is A Constraint Rising Budget Deficit Is A Constraint In terms of the fiscal purse, under normal circumstances, a weaker rial would raise government revenue from oil exports. However, given the restrictions on oil exports, the fiscal budget will not benefit from this relationship. Instead, the dominant impact will be greater government spending. Historically, expenditures tend to be countercyclical, aiming to mitigate the impact of the deteriorating economic environment on Iranian households (Chart 16). In the past, the Iranian government’s healthy fiscal balance allowed policymakers to implement social protection schemes to combat poverty and revitalize the economy. Now, however, the fiscal coffers are no longer so well-cushioned and the deficit will constrain this option. Stimulative fiscal policy in this environment would only raise inflation further. Furthermore, given that the lion’s share of Iran’s imports are capital and intermediate goods, the currency depreciation will spill over into the domestic industry and weaken demand, even for domestically produced goods. Investments have been lacking in many of the most essential services. The electricity sector is a prime example: while demand is rising, spare capacity is dwindling and causing recurring outages. Similarly, foreign direct investment will likely fall in this uncertain political environment. With the economy on the brink, Iran is not in a position to confront the United States directly. It must take total sanctions enforcement as a very grave risk and seek delaying actions and negotiations. However, this vulnerability will turn into desperation if the Trump administration proceeds with a full embargo without any “off ramp” for negotiations. Bottom Line: Full enforcement of sanctions threatens to destabilize Iran’s already vulnerable economy. Inflation is soaring, the currency is plunging, and the economy will likely be plagued by a twin deficit going forward. The implication is that Iran will eschew direct confrontation unless forced. Will Iran Retaliate In Iraq? Iran is also at risk of losing one of its great sources of leverage: Iraqi stability. Given its gloomy economic outlook, Iran is looking to expand ties with its neighbors in an attempt to soften the blow from the sanctions. Earlier this year president Hassan Rouhani and Iraqi prime minister Adel Abdul Mahdi signed several preliminary trade deals, with the ultimate aim to boost bilateral trade to $20 billion from its current ~$12 billion. However, natural gas exports to Iraq – a major traded good – are covered by the sanctions, so this target is probably unattainable. Although Iran is currently the only foreign supplier of natural gas and electricity to Iraq, the temporary halt in electricity supplies last summer coincided with violent protests in Southern Iraq.5 Growing anger over Iran’s inability to satisfy its commitments to Iraq highlights the tensions in the Iraq-Iran relationship. What’s more, the U.S. is pressuring Iraq to turn to other neighbors such as Saudi Arabia, Jordan, and Kuwait for its electricity needs.6 In March, it renewed a three-month waiver allowing Iraq to import Iranian gas. Then Saudi Arabia promised to connect Iraq to the Saudi electricity grid during a visit by its economic delegation to Baghdad on April 4.7 At that meeting, the Saudi delegation also agreed to provide Iraq with $1 billion in loans, $500 million to boost exports, and a sporting complex as a gift. Additionally, the Saudi consulate in Baghdad – which had been closed for almost 3 decades – reopened last month. Saudi Arabia and Iraq are starting to cooperate. Iraq’s new government is clearly taking a pragmatic approach to its regional relationships. This is also largely in line with growing domestic opposition to Iranian interference within Iraq. Influential Shia leaders such as Muqtada al-Sadr and Ayatollah Ali al-Sistani have been voicing concerns about Iran’s influence in Iraqi politics. As such, the new Iraqi government is attempting to walk a tight rope between placating Iran and taking advantage of new opportunities with its Arab neighbors to rebuild its economy. This trend raises the risk that Iran will strike rapidly in Iraq if it believes Trump’s maximum pressure strategy is succeeding in bringing oil exports to zero. Iraq is the logical target as Iran has great political and sectarian influence there, it is the geographic buffer with Saudi Arabia, and it is the necessary launchpad for Iran’s strategic opponents to undermine or attack the Iranian regime (Map 2). Chart Thus, not only Iranian and Venezuelan oil but also Iraqi oil could be pulled off the market in a fullfledged conflict. Chart 17 Thus, not only Iranian and Venezuelan oil but also Iraqi oil could be pulled off the market in a full-fledged conflict. About 85% of Iraq’s crude exports flow through the southern port city of Basra (Chart 17). It is already home to recurrent protests and any disruptions there threaten around 3.5mm bbl shipping to international markets daily. Bottom Line: Iraq is caught in the strategic tug-of-war between Iran and Saudi Arabia, with the latter gaining influence at present. Sanctions could compel Iran to retaliate in Iraq, jeopardizing up to 3.5mm b/d of supply. What Comes Next? The latest data suggest that Japan is in full compliance with the U.S. sanctions against Iran as of April and that China has been front-running the sanctions and is now reducing imports, as it was at the time the waivers were first introduced. China may not go to zero, but it is apparently complying. This is important given that the Trump administration has essentially introduced a bold new demand – cut off all energy imports from Iran – at the eleventh hour of the U.S.-China trade negotiations. Our projections of spare capacity suggest that the Trump administration will believe it has room to enforce the sanctions fully (Chart 18). This is a risky approach, as a fairly standard unplanned outage anywhere else in the world could bring spare capacity much lower, but the data suggest that Trump’s team will not see it as a hard constraint. If necessary, the administration can later choose to soft-pedal enforcement on black market activity so as to calibrate the global impact. Chart 18 The Iranians, for their part, are unlikely to leap to the most aggressive forms of retaliation immediately – such as fomenting unrest in Iraq – because of their economic vulnerability. Small acts of sabotage or subversion are a way to send the U.S. a warning signal, but generally Iran will want to signal defiance while shifting the emphasis to negotiations. Hence it will primarily retaliate through diplomatic actions and calculated displays of force. A limited response enables Iran to appear innocent, divide the U.S. and EU, and thus isolate the U.S. over its belligerent policies. Previously, Trump has sought to negotiate with Iranian President Hassan Rouhani. The Iranians have so far rebuffed him, but Foreign Minister Mohammad Zarif’s initial response to the waiver announcement was to blame Trump’s advisers, instead of Trump himself, and offer an exchange of prisoners (And release of detained Americans happen to be one of the Trump administration’s key demands – see Table 2.) Negotiations could begin through back channels and an uneasy period of tensions could thus ensue without a full-blown war. Table 2Trump Administration’s 12 Demands On Iran U.S.-Iran: This Means War? U.S.-Iran: This Means War? The problem is that negotiations cannot work if Trump fully and immediately enforces the sanctions without offering Iran an “off ramp.” If the administration backs Iran into a corner it will have no option but to strike out forcefully. Negotiations also cannot work if Iran joins the U.S. in withdrawing from the 2015 deal and reactivating its nuclear program, specifically the suspected military dimensions of that program. This would force Trump to respond (Diagram 1). Diagram 1Iran-U.S. Tensions Decision Tree U.S.-Iran: This Means War? U.S.-Iran: This Means War? In short, a period of “fire and fury” is about to ensue between Trump and Rouhani. It will be even more uncertain and disruptive than the summer 2017 showdown between Trump and Kim Jong Un of North Korea (Chart 19), which drove a 35 bps decline in the 10-year Treasury yield. Chart 19Upcoming "Fire And Fury" Will Be More Disruptive Than 2017 Trump-Kim Showdown Upcoming "Fire And Fury" Will Be More Disruptive Than 2017 Trump-Jong Un Showdown Upcoming "Fire And Fury" Will Be More Disruptive Than 2017 Trump-Jong Un Showdown There is a pathway for Trump’s pressure tactics to succeed: Iran is vulnerable and the United States and its allies are in a position of relative strength in terms of global oil supply. Therefore, it is possible that Trump could fully enforce the sanctions and yet avoid any uncontrollable crisis or oil shock. However, this pathway, at a subjective 26% probability, is less likely than the combined 48% probability of the alternatives: either escalation short of war, or ultimatums leading to Middle Eastern instability and much higher odds of war. Bottom Line: The geopolitical risk of U.S.-Iran confrontation is not contained. But we do not expect Iran to overreact unless Trump plows forward with full and immediate sanctions enforcement and offers no realistic “off ramp” for negotiations. At that point Iranian retaliation will be concrete and escalation could spiral out of control. Investors should keep in mind that Iran is not North Korea. Unlike the hermit kingdom, Iran has the ability to retaliate with a number of different levers. Indeed, it has threatened to shut the Strait of Hormuz in the past, and could, at the limit, be backed into that corner. While the risk of this is extremely low, should it occur the consequences would be huge – close to 20% of the world’s daily oil supply passes through the Strait daily. Indeed, just this week Iran’s Oil Minister Bijan Zanganeh again threatened to take action against any OPEC member working against its interests. Following a meeting with the Cartel’s president, he is reported to have said, “Iran is a member of OPEC because of its interests, and if other members of OPEC seek to threaten Iran or endanger its interests, Iran will not remain silent.”8 Investment Conclusions The Trump administration’s decision to apply maximum pressure to Iran is a significant and unexpected injection of geopolitical risk that we believe fundamentally changes the investment landscape in 2019-20. While our base case is that the U.S. will enforce the oil sanctions gradually and in such a way as to avoid causing an oil shock, policy-induced volatility and the oil risk premium will rise. Geopolitical tail risks have gotten fatter and the odds of a recession have also increased. Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com   Footnotes 1 Please see Humeyra Pamuk and Timothy Gardner, “How Trump’s hawkish advisors won debate on Iran oil sanctions,” Reuters, May 1, 2019, available at reuters.com. 2 Heavy-sour crudes are those with low API gravity (a measure of how easily a crude flows) and higher sulfur content. Light-sweet crudes have higher API gravity and lower sulfur content. 3 Please see BCA Commodity & Energy Strategy Weekly Report, “IMO 2020: The Greening Of The Ship-Fuel Market,” February 28, 2019, available at ces.bcaresearch.com. 4 OPEC 2.0 is the name we coined for the producer coalition led by KSA and Russia, which was formed in 2016 to manage global crude oil output. Its goal is to drain the massive storage overhang caused by the market-share war launched by KSA in 2014. 5 Iran cited dissatisfaction with Iraq over the accumulation of unpaid bills as the cause of the halt in electricity exports to Iraq. This prompted Iraqi authorities – under pressure from domestic unrest – to send a delegation to Saudi Arabia in attempt to negotiate an electricity agreement. 6 Please see Edward Wong, “Trump Pushes Iraq to Stop Buying Energy From Iran,” The New York Times, February 11, 2019, available at nytimes.com. 7 Please see Geneive Abdo and Firas Maksad, “Iraq’s Place in the Saudi Arabian-Iranian Rivalry,” The National Interest, April 15, 2019, available at nationalinterest.org. 8 Please see Babk Dehghanpisheh, “Iran will respond if OPEC members threaten its interests: oil minister,” Reuters, May 2, 2019, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Image Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Image