Diplomacy/Foreign Relations

Highlights This Special Report was written with our colleagues in BCA Research's Geopolitical Strategy, led by Marko Papic. In it, we explore the evolution of Russia's role in European natural gas markets vis-a-vis the fast-growing U.S. natural gas production and Liquefied Natural Gas (LNG) export capabilities. So what? Rise of U.S. LNG exports to Europe will benefit gas producers and LNG merchants with access to U.S. supplies. Russia will grow ever-more dependent on China, while retaining a market share in Europe. Why? Exports of U.S. LNG to Europe are set to surge over the next decade. Russia will not be completely displaced, as American LNG fills the gap in European natural gas production. But U.S. LNG will lead to the end of oil-indexing of long-term natural gas contracts, hurting Russian state coffers on the margin... ... And forcing Russia further into the arms of China. Also... A tighter Trans-Atlantic partnership - soon to involve a deep energy relationship - and a budding Sino-Russian alliance will further divide the world into two camps, producing a Bifurcated Capitalism that may define this century. Feature Russia's obituaries have been written and re-written many times since the end of the Cold War. And yet, Moscow continues to play an outsized role in global affairs that is belied by quantitative measures of its power (Chart 1). Chart 1From Bipolarity To Multipolarity From Bipolarity To Multipolarity From Bipolarity To Multipolarity How so? The fall of the Soviet Union was precipitated by the country's sclerotic managed economy, its failure to escape the middle income trap, and its disastrous military campaign in Afghanistan. But before it died, the Soviet Union sowed the seeds for its resurrection. The $100-130 billion (in 2018 USD) spent on building a natural gas pipeline infrastructure into Western Europe was the elixir that revived Russian power. Just as Russia emerged from its lost decade in the 1990s, it caught a break. Western Europe's natural gas demand rose. At the same time, China's epic industrialization created a once-in-a-century commodity bull market (Chart 2). With demand for its resources buoyed on both sides of the Eurasian landmass, Russia once again saw revenue fill its coffers (Chart 3). With material wealth came the ability to rebuild its hard power and put up a fight against an expansionary Western alliance encroaching on its sphere of influence. Chart 2Chinese Industrialization... Chinese Industrialization... Chinese Industrialization... Chart 3...Filled Russian Coffers ...Filled Russian Coffers ...Filled Russian Coffers Is there an existential risk to Russia's business model looming in the form of surging U.S. liquefied natural gas (LNG) export capability (Chart 4)? Not yet. Thanks to a massive drop in European domestic production, U.S. LNG exports will fill a growing supply gap, but will not replace Russia's natural gas exports in the medium term. All the same, the once-lucrative European market no longer holds as much promise as it once did with the arrival of the U.S. LNG supplies. Chart 4U.S. LNG Exports Will Surge American Pipes, Russian Gripes? American Pipes, Russian Gripes? In order for Russian natural gas exports to Europe to be permanently displaced, Europe would have to build out new LNG capacity beyond 2020, restart domestic production by incentivizing shale development, or turn to alternative energy sources with large base-load potential, such as nuclear power. None of these are on the horizon. With ~15% of its government revenue sourced from natural gas sales, Russia is as much of a one-trick pony as there is in macroeconomics. While we do not foresee that pony heading off to the glue factory, Russia will face some considerable risks in the future, starting with the shift away from the rigid oil-indexed contracts it favors (which lock the price of natural gas to that of oil). As such, the risk to Russia is not that it loses market share in Europe's energy market, but that this market share yields much smaller income in the future, as gas-on-gas pricing competition increases. The U.S. Shale Revolution Goes Global Our commodity team has presented a compelling case for why investors should expect an increase in U.S. LNG exports beyond the current EIA forecast.1 Increasing volumes of associated natural gas production in the Permian Basin in west Texas, which will have to be transported from the basin so as not to curtail oil production, will drive a large part of the expected growth in LNG exports. Our commodity team expects that a major LNG export center will be developed in south Texas, in Corpus Christi, over the next five years, just as the U.S. surpasses 10 Bcf/d of exports in the middle of the next decade.2 At the same time, global LNG demand is expected to rise at an impressive 1.7% annual rate to 2040 (Chart 5). A few key markets will lead this trend (Chart 6). Based on BCA Commodity & Energy Strategy calculations, world LNG export capacity is expected to go from 48 Bcf/d in 2017 to 61 Bcf/d by 2022 (Chart 7). The majority of the new capacity (53%) will come from the U.S., while 18% will come from Australia and 15% from Russia. Chart 5Global LNG Demand Growth Likely Outpaces Current Expectations American Pipes, Russian Gripes? American Pipes, Russian Gripes? Chart 6Supply - Demand Imbalances Will Fuel LNG Demand Globally American Pipes, Russian Gripes? American Pipes, Russian Gripes? Chart 7LNG Export Capacity Growth American Pipes, Russian Gripes? American Pipes, Russian Gripes? The pickup in Australian export capacity is already impressive. While being a relatively small natural gas producer - the eighth largest, accounting for 3% of world output - it has already become the second largest LNG exporting country in the world with over 7.5 Bcf/d of exports. The bulk of new liquefaction facilities will be operational in 2019. Most of Australia's LNG trade lies with Asia, given its geography. The U.S., whose LNG export terminals will be located in the Gulf of Mexico, only has 3 Bcf/d of liquefaction capacity today. Most of its LNG exports also go to Asia (Table 1), but that may change as the current capacity expansion will see exports rise to just over 9 Bcf/d in 2020.3 Furthermore, American gas will compete with surging Australian LNG exports and a build-up of Russian pipeline export capacity to China, which is set to start delivering gas to the country in 2019. Table 1U.S. LNG Exports By Country American Pipes, Russian Gripes? American Pipes, Russian Gripes? Europe, on the other hand, has massive regasification capacity slack and thus requires only minimal capex to begin importing large volumes of U.S. LNG. Europe has 23 Bcf/d regasification capacity, with a very low utilization rate of just 27%. This means that it has ~ 16 Bcf/d capacity available, more than enough to absorb all of expectant U.S. ~ 6-7 Bcf/d exports in the next couple of years.4 Bottom Line: The U.S. shale revolution is going global, with U.S. LNG exports set to surge over the next 5-10 years. While some of that capacity will find its way to Asia, those markets will also be flooded with Australian LNG and Russian piped natural gas. Europe, on the other hand, is filing just a quarter of its LNG import capacity, making a Trans-Atlantic gas alliance a match made in heaven. From Cold War To Gas War? If half of the currently proposed, pre-FID, LNG export projects were built in the U.S., American capacity would grow to potentially ~26 Bcf/d by 2030. Europe would need only one or two extra LNG import terminals to build over the next two decades to absorb this volume, as its current capacity is able to import nearly every molecule coming out of North America (Chart 8). Chart 8Europe Has Plenty Of Regasification Capacity American Pipes, Russian Gripes? American Pipes, Russian Gripes? Will this new U.S. LNG displace Europe's imports of Russian natural gas? The short answer is no. By 2030, Europe's supply-gap (i.e. domestic supply minus domestic consumption) is estimated to reach 36 Bcf/d. The U.S. could cover a large part of this gap if only half of the proposed pre-FID projects are constructed. However, if Europe's demand remains stable over this period, Europe will still import roughly 20 Bcf/d of Russian natural gas, which in 2017 amounted to 35% of Europe's natural gas consumption. If the U.S. fills 100% of the increase in Europe's supply-gap, it means new Russian natural gas production (the IEA and BP expect Russian production to keep increasing until 2030) will not be sent to Europe. Hence, even if it does not displace old Russian exports, it will limit Russia's ability to export its new natural gas. Europe's demand for natural gas is not likely to be stable. Despite sclerotic growth and generally weak population growth, European governments have tried to incentivize natural gas consumption due to its low emission of CO2 (Table 2). As such, investors should expect further displacement of coal and nuclear power generation in favor of natural gas. Table 2Natgas Emits Less CO2 American Pipes, Russian Gripes? American Pipes, Russian Gripes? Thus, U.S. exports will simply replace Europe's domestic production, which is facing considerable declines. The U.K. North Sea production will decrease 5% annually due to the lack of capex and the large number of fields reaching a mature state. Meanwhile, the Netherlands is phasing-out its Groningen field by 2030. Finally, Norwegian gas production is likely to stagnate after reaching record levels in 2017. The second reason that Europe will not be able to sever its relationship with Russia is that its LNG import terminals are largely located in countries that are not massively dependent on Russian imports (Map 1). The two major LNG terminals serving Central and Eastern Europe are the Swinoujscie terminal in Poland - finished in 2015 - and the Adria project in Croatia, to be completed in 2020. Map 1European Natural Gas Geography American Pipes, Russian Gripes? American Pipes, Russian Gripes? The Polish LNG terminal will do little to alleviate the dependency of countries further East - Belarus, Ukraine, Bulgaria, Hungary, and Slovakia - from Russia as it currently satisfies only one third of Poland's natural gas needs, and is projected to reach 50% by 2022 once the expansion is completed. This could significantly cut Russian exports to Poland, but not completely end them.5 The Croatian LNG terminal will likely make a very small dent in the overall reliance of the Balkans on Russian natural gas, as once it satisfied Croatian demand, little will be left over for the rest of the region. Beyond these two terminals, Europe will have to invest in pipeline infrastructure in order to reverse the flow of pipelines currently taking gas from the East to the West. At some point in the distant future, we could see a scenario where American natural gas flows even through Cold War era, Soviet-built pipelines deep into Central and Eastern Europe. But given the steep declines in West European natural gas production, this day will come after 2030. Bottom Line: Dreams of displacing Russian natural gas in Europe with American are overstated. European imports of U.S. LNG are likely to skyrocket, but that will merely replace the massive decline in West European and North Sea production. What does that mean for geopolitics? It means that Russia will continue to have a role to play in Europe, but its share of European imports will decline. As such, Europe will have options. If it builds more LNG import terminals, it could expand those options beyond American LNG imports. However, Russian geopolitical influence will not be displaced completely. Russian Coffers Will Take A Hit Although Russian natural gas will continue to course through Europe's veins, its state coffers are nonetheless going to take a hit. European governments are actively diversifying away from Russia via U.S. LNG imports, and buyers generally are shortening the tenor of contracts as they seek more flexible pricing.6 The growth in the global LNG market, fueled by surging U.S. production, will ultimately allow Asian and European markets to diversify away from oil-indexed pricing - which tends to be priced higher than gas-on-gas pricing - and expand access to U.S. supplies.7 The EU has co-financed or committed to co-finance LNG infrastructure projects valued at ~ 640mm euros to secure U.S. LNG. Ultimately, as more and more U.S. LNG moves toward Europe, markets will move toward short- and long-term contracts priced in USD/MMBtu (indexed to Henry Hub, LA, prices), much like Brent crude oil priced in USD/bbl. European markets have already seen this shift, as illustrated in Chart 9. Chart 9European Gas-On-Gas Pricing Is Rising American Pipes, Russian Gripes? American Pipes, Russian Gripes? The totality of U.S. export prices is determined by gas-on-gas pricing - i.e., gas priced in USD/MMBtu as a function of gas supply-demand fundamentals. These contracts are without the restrictions found in many oil-indexed contracts. In the U.S., the presence of a deep futures market delivering natural gas to Henry Hub, LA, allows flexible long-term financing and short- and long-term contracting that can be hedged by buyers and sellers. According to Royal Dutch Shell, the spot LNG market doubled from 2010 to 2017, accounting for ~ 25% of all transactions, most of it due to the prodigious increase in U.S. LNG supply. While in Europe the share of LNG spot and short-term deals is small relative to the overall market, it is growing (Chart 10). With U.S. LNG volumes becoming increasingly available in Europe, market participants will be inclined to turn to the LNG spot market to buy or sell outside contracted volumes. This will deepen the development of European natgas markets: in any fully developed market, spot trading is followed by forward contracting, then futures trading using contracts settling against a spot price.8 Chart 10Expect More LNG Spot Trading American Pipes, Russian Gripes? American Pipes, Russian Gripes? Russia is a low-cost gas producer in Europe and will be committed to maintaining its market in Europe. However, with U.S. LNG export capacity potentially reaching ~14 Bcf/d by 2025, from ~3 Bcf/d today, it is entirely likely that Russia will find itself in a price war defending existing market share in Europe at lower prices. Its preferred way of doing business, via oil price indexed contracts, will be challenged overnight by a surge in U.S. LNG imports. Bottom line: The EU and its member states are actively diversifying gas supply sources away from Russia via U.S. LNG purchases. This will lower the marginal price of all gas bought and sold in Europe, all else equal, resulting in lower margins for all sellers of gas and better prices for consumers. Ultimately, the European natural gas market will resemble every other fully developed commodity market, operating on razor-thin margins. This means whatever rents were available in this market will be dissipated as competition increases. Investment And Geopolitical Implications The immediate investment implication of these developments is that gas producers and LNG merchants with access to U.S. shale-gas supplies, processing trading, and risk-management capabilities should be favored in this evolving market. Beyond the short term, however, we expect several ongoing geopolitical developments to be ossified by the flood of American LNG steaming towards European shores: Sino-Russian alliance deepens: As Russian natural gas exports to Europe stagnate, its pipeline infrastructure build-out will increase its exports to China to 3.8 Bcf/d by 2019. China will become the growth market for Russian energy producers, deepening the move between the two former Cold War foes to stabilize their relationship. Although it may seem obvious that Russia would retain leverage in such a relationship - given that it can "turn off the lights" to Beijing at whim - we actually think that Beijing will hold all the cards.9 Europe will have an incentive to keep diversifying its natural gas supplies. Meanwhile, Chinese demand is likely to keep growing. As such, China will become Russia's main option for revenue growth. And as the old adage goes, the customer is always right. Trans-Atlantic alliance deepens: Despite the fears that the "Trump Doctrine" would lead to American isolationism - fears that we shared in 2017 - the growing U.S.-European LNG connection will ensure that the Trans-Atlantic alliance - forged 70 years ago in blood - will be saved via brisk energy trade.10 A growing European energy deficit with the U.S. will also resolve - or at least alleviate - the main source of marital problems in the relationship: Europe's trade surplus. Bifurcation of capitalism: A key theme of BCA's Geopolitical Strategy is that the age of globalization will yield to the world's segmentation into spheres of influence.11 A deepening Trans-Atlantic alliance, when combined with a budding Sino-Russian relationship, will lead to a Bifurcated Capitalism system where the Trans-Atlantic West faces off against the Eurasian East. What would such a Bifurcated Capitalism mean for investors? Time will tell. But it may mean that thirty years of global capitalism (1985 to roughly today) may give way to something more common in human history: a world dissected into spheres of influence where flows of capital, goods, and people within spheres are relatively smooth and unencumbered, yet flows between the spheres are heavily impeded. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Pavel Bilyk, Research Associate Commodity & Energy Strategy pavelb@bcaresearch.com 1 Please see "U.S. Set To Disrupt Global LNG Market," published by BCA Research's Commodity & Energy Strategy October 4, 2018. It is available at ces.bcaresearch.com. 2 Please see "The Price of Permian Gas Pipeline Limits," by Stephen Rassenfoss, in the Journal of Petroleum Technology, published July 19, 2018. 3 Following a two-year pause in project Final Investment Decisions (FIDs) from 2016 to 2017, potential FIDs in 2018 and 2019 could increase the U.S. capacity to ~ 14 Bcf/d by 2025. This will make the U.S. the second-largest exporter of LNG in the world, surpassing Australia. This new wave of investment is yet to be finalized. Therefore, final decisions in 2H18 and 2019 will be crucial to determine the medium-term potential of U.S. LNG. 4 Cheniere Energy, the largest U.S. LNG exporter, expects ~ 50% of its exports to go to Europe, according to S&P Global Platts. Please see "US LNG vs Pipeline Gas: European Market Share War?" published April 2017 by Platts. 5 Additionally, if the Baltic Pipe Project, moving gas from Norway to Poland, reaches FID in 2019, this would help Poland diversify its energy supply from Russia, as the country would cover close to all its domestic demand via its production + LNG and new pipeline imports. 6 Please see "US and Russia step up fight to supply Europe's gas," published by the Financial Times August 3, 2017. See also "Russia's gas still a potent weapon," also published by the FT, re the so-called collateral damage suffered by Europe when Russia cut off gas supplies to Ukraine in January 2009. 7 For the EU, supply diversification is a particularly important goal. On July 25, 2018, the European Commission and the U.S. issued a joint statement, in which the EU agreed to import more LNG from the U.S. "to diversify and render its energy supply more secure. The EU and the U.S. will therefore work to facilitate trade in liquefied natural gas," according to a press release issued August 9, 2018, by the Commission. Re Japan's diversification strategy, please see "Feature: US LNG sources fit with Japan's desire for route diversity: minister," published by S&P Global Platts September 27, 2018. 8 Please see Darrell Duffie, Futures Markets (1988), Prentice-Hall; and Jeffrey C. Williams, The Economic Function of Futures Markets (1986), Cambridge University Press. Longer-term deals already are being signed under flexible Henry Hub futures-based indexing terms in the U.S. This is occurring because the U.S. LNG market is able to tap into futures liquidity that supports hedging by natgas producers and consumers. Please see "Vitol-Cheniere Pact Shows Long-Term LNG Deals Aren't Dead," published by bloomberg.com September 17, 2018. 9 Please see BCA Geopolitical Strategy Special Report, "The Embrace Of The Dragon And The Bear," dated April 11, 2014, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," dated February 1, 2017, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, and Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com.

Highlights The risk of unplanned oil-production outages is rising. One or more such events will severely test OPEC 2.0's spare capacity in a supply-constrained market (Chart of the Week).1 As things now stand, OPEC 2.0 spare capacity - if it is available - and a likely U.S. SPR release of 500k b/d in 1Q19 will not cover expected production losses, if markets are hit with another unplanned outage from Libya or Iraq.2 Demand destruction via higher prices will have to balance markets. Oil markets are tightening (Chart 2). Falling supply and stable demand will produce a 1mm b/d physical deficit into 1H19, forcing continued OECD inventory draws (Chart 3). The dominant scenario in our forecast includes a supply shock arising from lost Iranian and Venezuelan exports, which triggers price-induced demand destruction. We raised the odds of Brent prices hitting $100/bbl by 1Q19, and our 2019 forecast to $95/bbl on the back of these factors. Unplanned outages would lift prices higher. Energy: Overweight. The long April, May and June 2019 Brent calls struck at $85/bbl vs short $90/bbl calls we recommended last week are up an average 33.8%, as of Tuesday's close. Base Metals: Neutral. Our foreign-exchange strategists expect the USD to correct further. This will be bullish for copper, which is up ~ 10% since Sept. 11. Precious Metals: Neutral. The USD correction will support gold in the short term. Technically, gold appears to be forming a pennant, which could be short-term bullish. Ags/Softs: Underweight. Corn prices are benefiting from strong exports, according to USDA data. Accumulated exports for the current crop year are up 27% vs last year in the week ending Sept. 13. Chart of the WeekUnplanned Oil-Production Outage Risks Up, OPEC 2.0's Spare Capacity Down Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect Chart 2Physical Oil Deficit Returns##BR##To Oil Market Next Year Physical Oil Deficit Returns To Oil Market Next Year Physical Oil Deficit Returns To Oil Market Next Year Chart 3Fundamentals Support##BR##Strong Prices Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect Feature Oil markets are approaching a moment of truth. OPEC 2.0's spare capacity likely will be put to the test in 1Q19, as Iranian export volumes continue to fall, and other threats to production - Venezuelan losses, and increasing sectarian tension in Iraq and Libya - come to the fore. As the Chart of the Week demonstrates, spare capacity in the traditional OPEC states is low and falling: The U.S. EIA's most recent estimate of OPEC spare capacity is 1.7mm b/d this year and 1.3mm next year, well below the 2.3mm b/d average of 2008 - 2017. For its part, Russia - the other putative leader of OPEC 2.0 - likely only has ~ 200k b/d of spare capacity to ramp. On a relative basis, OPEC spare capacity is even more stretched: This year, the EIA expects it to average 1.7% of global demand. By next year, it is expected to fall to 1.3%, or ~ 1.3mm b/d. This will be lower than the spare capacity reported for 2008 (1.6%), when OPEC (mostly KSA) found itself struggling to meet surging EM demand, and well below the 2.6% average for 2008 - 2017. Spare capacity is very close to levels last seen in 2016, when low prices resulted in supply destruction. In the wake of the oil-price rout of 2014 - 16, capex collapsed as did maintenance spending needed to keep production steady y/y. This can be seen in the relentless decline in OPEC production ex GCC and the stagnation in other states unable to grow output (Chart 4 and Chart 5). Indeed, as prices hit their nadir in 1Q16, sovereign wealth funds (SWFs) in OPEC and non-OPEC states were being liquidated to cover gaping holes in producers' fiscal accounts. This partly explains the growing incidence of unplanned outages, and our contention OPEC spare-capacity claims are highly suspect (Chart of the Week). Chart 4OPEC 2.0's Core Producers Would Be Taxed to Replace Lost Exports OPEC 2.0's Core Producers Would Be Taxed to Replace Lost Exports OPEC 2.0's Core Producers Would Be Taxed to Replace Lost Exports Chart 5Outside Of A Very Few Regions, Oil Production Has Struggled Outside Of A Very Few Regions, Oil Production Has Struggled Outside Of A Very Few Regions, Oil Production Has Struggled U.S. Remains Adamant On Shutting Down Iran's Exports The Trump administration's goal is to reduce Iranian oil exports to zero via the sanctions it will impose beginning November 4 from ~ 2.5mm b/d back in April, when the U.S. sanctions were announced. However, as the EIA data indicates, achieving this goal would leave markets seriously short oil. Indeed, the Washington-based Center for International Strategic Studies (CSIS) noted in late August, "realistically, there is simply not enough readily available spare oil production capacity in the world to replace the loss of all Iranian barrels (some 2.4 mm b/d), coupled with the potential for further reductions in Venezuela, Libya, Nigeria, and elsewhere."3 Our modeling includes 1.25mm b/d of lost Iranian and Venezuelan exports, continued y/y losses in non-core OPEC (Chart 4), constrained U.S. production growth, and stagnate supply growth outside a handful of states able to lift their output (Chart 5). We do not believe OPEC 2.0 spare capacity is sufficient to cover these losses and one or two additional unplanned outages in Iraq or Libya, or anywhere for that matter. In addition, a 500k b/d release of U.S. SPR after the price goes above $90/bbl in 1Q19 will contain the supply shock we expect slightly, but will not completely reverse it. We have long believed KSA's ability to maintain production above 10.5mm b/d for an extended period is suspect, despite its claims it can ramp to its capacity of 12mm b/d.4 We are carrying KSA's current production at 10.4mm b/d in our balances estimates, roughly the level it self-reported to OPEC last month. To be clear, we are not saying KSA's production cannot be increased - perhaps to 10.7mm b/d - but we are dubious it can get to its claimed 12mm b/d capacity, or that it can sustain 10.7mm b/d indefinitely. It is important to note any short-term increase in OPEC 2.0's production will come out of spare capacity available to meet unplanned outages, or deeper-than-expected Venezuelan losses next year. Lastly, unplanned outages in a market already stretched by tighter supply will accelerate the rate of demand destruction via higher prices. This also would accelerate the arrival of a U.S. recession brought about by an oil-price shock, all else equal.5 Iran's Hand Is Strengthening You'd never know it from the declarations of President Trump and U.S. Treasury Secretary Steve Mnuchin - both of whom are adamant in their professed desire to see Iranian oil exports fall to zero - but the U.S. has been attempting to engage Iran in treaty discussions to limit the country's ballistic-missile capabilities and nuclear-development program.6 Not surprisingly, Iranian officials have shown no interest in such discussions. This is a remarkable turn of events, but not unexpected. At some point, it likely became apparent to the Trump administration the global oil markets are on a trajectory for significantly higher prices, as our analysis and forecasts indicate. It also likely is apparent to administration officials that oil prices - and gasoline prices, in particular, which matter most to U.S. voters - will be surging just as the 2020 presidential campaign gets underway next summer. Along with our colleague Marko Papic, who runs BCA's Geopolitical Strategy, we believe that, from a game-theoretic perspective, the approach from the U.S. actually strengthens Iran's hand. Given its history with the previous round of sanctions, and the economic hardships they imposed, the government in Iran likely believes it can ride out 12 to 18 months of renewed sanctions. It is not unrealistic to entertain the possibility Iranian politicians take the bet that sharply higher gasoline prices in the U.S. by 2H19 will give Democrats in U.S. presidential and congressional races - which kick off next summer - a powerful issue with which to campaign against President Trump and the GOP. Bottom Line: There is a non-trivial chance that OPEC 2.0 spare capacity will prove insufficient to cover the losses in Iranian and Venezuelan exports we foresee in the very near term. Should this prove to be the case, the odds that Brent crude oil prices exceed our $95/bbl forecast for next year are high. We believe Iran's political hand could be strengthened, if it rebuffs overtures by the Trump administration to negotiate a treaty to replace the executive agreement with former U.S. president Obama that limited its nuclear program. We recommended getting long Brent call spreads last week to position for the higher prices we are forecasting for next year. Specifically, we recommended getting long April, May and June 2019 Brent calls struck at $85/bbl vs short $90/bbl calls. As of Tuesday's close, these positions were up 33.8% on average vs their opening levels last Thursday. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see "Upside Risks Dominate BCA's Oil Price Forecast," published by BCA Research's Commodity & Energy Strategy October 26, 2017, and "OPEC 2.0 Scrambles To Reassure Markets," published June 28, 2018. Both are available at ces.bcaresearch.com. 2 OPEC 2.0 is the name we coined for the oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, which was formed in November 2016, following the price collapse brought on by OPEC's market-share war launched in November 2014. Please see last week's Commodity & Energy Strategy lead article, "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl." It is available at ces.bcaresearch.com. In that article we note that, in addition to the highly visible export losses in Iran due to U.S. sanctions and continued deterioration in Venezuelan production, the EIA reduced its estimate of U.S. production growth by 201k b/d in 2019, and the IEA reduced its estimate of Brazilian output this year by 260k b/d. 3 Please see "Whither the Oil Market? Headlines and Tariffs and Bears, Oh My..." published by csis.org August 29, 2018. We are closely following a just-proposed workaround to U.S. sanctions on Iranian oil exports made by the High Representative of the EU, Federica Mogherini, at the UN General Assembly meeting in New York on Tuesday. Ms. Mogherini proposed setting up a special-purpose vehicle that would allow importers in the EU, China and Russia to continue purchasing Iranian oil crude. The SPV would transact in euros, yuan, and roubles, so as to avoid processing transactions through the Society for Worldwide Interbank Financial Telecommunication SWIFT system in Brussels. The SWIFT system is dominated by USD transactions, and the U.S. Treasury has high visibility into transactions made using the system, given USD-denominated transaction like oil purchases and sales must ultimately be cleared through a U.S. bank or intermediary. Iran already takes yuan for its oil, and this mechanism would allow it to purchase goods and services denominated in these currencies. If technical details of the proposed system can be worked out, the SPV could facilitate increased Iranian exports under the U.S. sanctions regime. This would cause us to lower our estimate of lost exports from that country from our baseline assumption of 1.25mm b/d. Please see "Why India Will Struggle to Join Iran's Sanctions Busters," published by bloomberg.com on September 26, 2018. 4 We are not the only ones dubious of KSA's ability to ramp production. Please see "Can Saudi Arabia pump much more oil," published by reuters.com July 1, 2018. 5 In our House view, a recession in the U.S. does not arrive until 2H20. We have argued an oil-supply shock, particularly during a Fed tightening cycle, typically presages a recession in the 6 - 18 months following the shock. Please see Commodity & Energy Strategy lead article, "Odds of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl." It is available at ces.bcaresearch.com. 6 Please see "U.S. seeking to negotiate a treaty with Iran," published September 19, 2018, by reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect Trades Closed in 2018 Summary of Trades Closed in 2017 Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect

Dear Client, Geopolitical analysis is a fundamental part of the investment process. BCA’s Chief Geopolitical Strategist, Marko Papic, will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Highlights The U.S. and China have now acted on their threats and imposed tariffs; A full-blown trade war is expected, as President Trump retaliates to China's retaliation; The Tiananmen Square incident, the third Taiwan Strait Crisis, and the Hainan Island incident are previous U.S.-China clashes worth comparing to today's conflict - they point to more trouble ahead; Trade tensions are already spilling out into strategic tensions in China's near seas. It is too soon to buy Chinese or China-exposed equities. Feature On July 6, President Donald Trump imposed a 25% tariff on $34 billion worth of Chinese imports, to expand to $50 billion on July 20. China responded with tariffs of its own on the same amount (Chart 1). Trump has since threatened to slap a 10% tariff on $200 billion worth of goods, and potentially additional tariffs on another $300 billion. Beijing is refusing to negotiate under duress. Trade tensions have already spilled into the military realm, with scuffles occurring from the coast of Africa to the Taiwan Strait.1 BCA's Geopolitical Strategy has long maintained that U.S.-China relations are in a structural, not merely cyclical, decline.2 One of the most striking illustrations of this thesis has been the divergence of the two economies since the global financial crisis. The Chinese exporter has fallen in importance to China's economy while the U.S. consumer has been taking on less debt (Chart 2). Previously, a close economic dependency - dubbed "Chimerica" by prominent commentators - limited the two countries' underlying strategic distrust. Today, strategic distrust is aggravating economic divisions. Chart 1U.S.-China Trade Hit By Tariffs The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis Chart 2Sino-American Symbiosis Is Over Sino-American Symbiosis Is Over Sino-American Symbiosis Is Over How significant is the current rupture in U.S.-China relations? A brief look at the three major crisis points of the 1980s-2000s reinforces our structural assessment: the current conflict has the potential to become the biggest conflict in U.S.-China relations since the early Cold War. Judging by previous crises, it could last two years or more and involve extensive economic sanctions and military saber-rattling. The disruption to global markets could be much greater than in the past due to China's greater heft on the world stage. Crisis #1: Tiananmen Square, 1989-91 The first major crisis in modern U.S.-China relations was also the worst to date. It is therefore the model against which to compare today's fraying relationship. It centered on the suppression of the Tiananmen Square protests in 1989 by the Communist Party and People's Liberation Army (PLA). Throughout the 1980s, China struggled to manage the rapid economic and social consequences of opening up to the outside world. The release of pent-up demand in an inefficient, command-style supply system resulted in rising bouts of inflation that spurred popular unrest (Chart 3). Meanwhile, student activism and democratic sentiment emerged in the political climate of glasnost across communist regimes. These forces coalesced into the large-scale demonstrations at Tiananmen Square, Beijing, and other cities, in the spring of 1989. In response, the ruling party declared martial law and ordered the PLA to break up the demonstrations on June 3-4. The United States responded with a series of sanctions intended to punish and isolate China's leaders. President George H. W. Bush halted arms exports, other sensitive exports, most civilian and military dialogue, development aid, and support for multilateral bank lending to China.3 The other G7 countries joined with their own restrictions on exports, aid, and loans. China's economy slowed sharply to a 4% growth rate from above 10% for most of the decade. Meanwhile the government expanded the crackdown on domestic dissent. Exports to China clearly suffered from the crisis (Chart 4). Chart 3China's Reform Era Sparked Inflation China's Reform Era Sparked Inflation China's Reform Era Sparked Inflation Chart 4Trade Suffered From Tiananmen Incident Trade Suffered From Tiananmen Incident Trade Suffered From Tiananmen Incident Ultimately, however, the U.S. and its allies proved unwilling to sustain the pressure. While multilateral lending dropped off, direct lending continued (Chart 5). China was also allowed to retain its Most Favored Nation (MFN) trading status. The G7 began removing some of the sanctions as early as the following year. The inflow of FDI recovered sharply (Chart 6). Only a few of the sanctions had a lasting effect.4 Chart 5Multilateral Lending Cut Off After Tiananmen The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis Chart 6FDI Recovered From Tiananmen Quickly The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis The relevance of Tiananmen today is that when faced with domestic instability, China's ruling party took drastic measures to ensure its supremacy. This included weathering the pain of the combined G7 trade sanctions at a time when China's economy was small, weak, and slowing. By comparison, today's trade war also threatens domestic stability - through unemployed manufacturing workers rather than pro-democracy students. Yet it does not involve a united front against China from the West (the Trump administration is simultaneously slapping tariffs on the G7!). Moreover, China's economy is far larger and more influential than in 1989. This gives it a greater ability to retaliate and to deter a conflict that is all the more consequential for global economies and markets (Table 1). As for the market impact, mainland China did not have functional stock markets until 1990-91, but Hong Kong-listed stocks collapsed during the Tiananmen protests and did not fully recover for a year (Chart 7). Today, tariffs are a more direct and lasting threat to corporate earnings than the Tiananmen fallout and it is not clear how far the cycle of retaliation will go. The implication for investors is that Chinese and China-exposed equities are not yet a buy, despite the 10% and 13% selloff in A-shares and H-shares in recent weeks. Table 1China Much Bigger Today Than In Previous U.S.-China Clashes The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis Chart 7Tiananmen Hit Hong Kong Stocks Tiananmen Hit Hong Kong Stocks Tiananmen Hit Hong Kong Stocks Finally, the 1980s-90s marked the heyday of U.S.-China economic engagement and the Bush White House was eager to get on with business (even the Bill Clinton White House proved to be the same). By contrast, the Washington establishment today is united in demanding a tougher stance on China. The two countries are now "peers" locked in a struggle that goes beyond trade to affect long-term national security.5 Rebuilding trust will require painstaking negotiations that may take months; more economic and financial pain may be necessary to force cooperation. Bottom Line: The Tiananmen incident has long provided the basic framework for a rupture in U.S.-China relations, as it involved an official diplomatic cutoff along with a serious blow to Chinese growth rates and foreign trade and investment. Circumstances are even more dangerous today, as China is in a better position to stare down U.S. pressure and the U.S. is more desirous of a drawn-out confrontation. This is a bad combination for risk assets. It is too early to buy into the selloff in Chinese and China-related equities. Crisis #2: The Taiwan Strait, 1995-96 From the end of the Chinese Civil War in 1949 and beginning of the Korean War in 1950, the United States undertook to defend the routed Chinese nationalists on their island refuge of Taiwan. Fighting occasionally broke out over control of the small coastal islands across the strait from Taiwan, most notably in the two "Taiwan Strait Crises" of 1954-55 and 1958. An uneasy equilibrium then developed that lasted until the third Taiwan Strait Crisis in 1995-96. The third crisis arose in the aftermath of Taiwan's democratization. China's economy was booming, it was seeking to modernize its military, and the U.S. was increasing arms sales to Taiwan (Chart 8). In July 1995, Beijing launched a series of missile tests and military exercises, hoping to discourage pro-independence sentiment and dissuade the Taiwanese people from voting for President Lee Teng-hui - who was rightly suspected of favoring independence - ahead of the 1996 elections. The United States responded with a show of force on behalf of its informal ally, eventually deploying two aircraft carriers, USS Nimitz and USS Independence, and various warships to the area. The Nimitz sailed through the strait. Tensions peaked ahead of the Taiwanese election on March 23, 1996 - in which voters went against China's wishes - and simmered for years afterwards. Chart 8Arms Sales Could Reemerge As An Irritant Arms Sales Could Reemerge As An Irritant Arms Sales Could Reemerge As An Irritant Chart 9Taiwan Crisis Hit Mainland And Taiwan, Not U.S. Stocks Taiwan Crisis Hit Mainland And Taiwan, Not U.S. Stocks Taiwan Crisis Hit Mainland And Taiwan, Not U.S. Stocks The military and diplomatic standoff had a pronounced negative impact on financial markets. Both mainland and Taiwanese stock markets sold off and were suppressed for months afterwards (Chart 9). Our measure of the Taiwanese geopolitical risk premium - which utilizes the JPY/USD and USD/KRW exchange rates as proxies - shows that risks reached a peak during this period (Chart 10). As with Tiananmen, however, U.S. stocks were insulated from the crisis. Chart 10Taiwanese Geopolitical Risk Likely To Rise From Here Taiwanese Geopolitical Risk Likely To Rise From Here Taiwanese Geopolitical Risk Likely To Rise From Here Over the long run, China's saber-rattling promoted pro-independence sentiment and Taiwanese identity, factors that are proving to be political risks once again in 2018 (Chart 11). China has held provocative military drills and imposed discrete sanctions as a result of pro-independence election outcomes in 2014-16 (Chart 12). Local elections on November 24 this year could serve as a lightning rod for provocations, especially if pro-independence politicians, which currently hold all branches of government, continue to win.6 Chart 11Beijing's Saber-Rattling Was Counter-Productive The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis Chart 12Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Further, the Trump administration has upgraded Taiwan relations and its trade war with China is already spilling over into Taiwan affairs. The decision to send the destroyers USS Mustin and Benfold through the Taiwan Strait on July 7-8 should be seen in the context of trade tensions. A new aircraft carrier transit is being openly discussed. These are negative signs that warrant caution toward both mainland and Taiwanese equities. Bottom Line: The Third Taiwan Strait Crisis marked the biggest spike in military tensions between the U.S. and China in recent memory and had a markedly negative impact on regional risk assets. It is a worrying sign that the U.S.-China trade war is becoming intermeshed with cross-strait political tensions. We continue to view Taiwan as the potential site of a "Black Swan" event, especially if this November's local election goes against Beijing's wishes.7 Crisis #3: Hainan Island, 2001 Lastly, the "Hainan Island Incident" marks another point of tension in U.S.-China relations. On April 1, 2001 a Chinese jet struck a U.S. EP-3 ARIES II signals reconnaissance plane in the skies over the South China Sea, between Hainan and the contested Paracel Islands. The U.S. plane landed on the southern island, where its crew was detained and interrogated for 10 days while their aircraft was meticulously disassembled. The U.S. issued a half-hearted apology and the crew was released. The Chinese pilot went missing in the crash and was later declared killed in action. The incident fed into already sour feelings between Washington and Beijing. Just two years earlier, the U.S. government had "botched" an attack on a federal Yugoslav target in Belgrade, striking the Chinese embassy and killing three Chinese civilians.8 Thus, at the turn of the century, China was angry about U.S. military interventionism, while the U.S. was wary of China's military modernization. But this period of tensions was ultimately overshadowed by the September 11 terrorist attacks later that year, which prompted the U.S. to turn its attention to the Middle East and the war on terrorism. We highlight the Hainan incident for a simple reason: the South China Sea is a much more fiercely contested space today than it was in 2001. This is not only because global trade traffic has multiplied to around $4.14 trillion in the sea (Diagram 1). It is also because China has attempted to enforce its sovereignty claims over most of the sea by building up military assets there over the past several years.9 The U.S. has begun to push back by conducting "freedom of navigation" exercises that directly challenge China's maritime-territorial claims. Diagram 1South China Sea As Traffic Roundabout The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis In fact, China's entire maritime periphery - from the South China Sea to the Taiwan Strait to the East China Sea - has become a zone of geopolitical risk. The risk stems from China's attempts to establish a sphere of influence - and the American, Japanese, and other Asian nations' attempts to contain China's rise. A Hainan incident today would have a much bigger impact on the market than in 2001, when China's share of global GDP, imports, and military spending was roughly one-third of what it is today (see Table 1 above). And while a diplomatic crisis of this nature could easily cause global stocks to fall, the greater danger to the marketplace is that a military incident occurs. That would jeopardize global trade and growth, and the geopolitical fallout would be more difficult to contain. Bottom Line: U.S.-China strategic tensions came to a head in the South China Sea in 2001, but quickly subsided.. Today both the risk of a miscalculation and the economic stakes are greater than in the past. China's maritime periphery is thus an additional source of geopolitical risk at a time of U.S.-China trade war. Investment Conclusions: Then And Now What the three examples above have in common is that they occurred during the springtime of U.S.-China relations after the rise of Deng Xiaoping and China's "reform and opening up" policy. In each case, thriving trade and corporate profits provided an impetus for Washington and Beijing to move beyond their difficulties. The political elite across the West also believed that economic engagement would nudge China toward fuller liberalization and eventually even democracy. Today, however, the economic logic of a U.S.-China détente has been replaced by strategic rivalry, as the two economic systems are diverging. The U.S. is growing fearful of China's technological prowess, while China fears having its access to technology unplugged.10 As we have highlighted before, President Trump is virtually unconstrained on trade policy as well as on foreign policy and national security. And while he faces congressional resistance to his tariffs on G7 allies, Congress is actually egging him on in the fight against China - as seen with the Senate's vote to re-impose, against Trump's will, sanctions on Chinese telecommunications company ZTE.11 The kerfuffle over Trump's attempted trade deal with China in May was highly illuminating: Trump attempted to sign off on a deal with China to get a "quick win" ahead of the midterms. Secretary of Treasury Steve Mnuchin called it a "truce" and top economic adviser Larry Kudlow promoted it on talk shows. But the deal was rebuffed by Congress, which is demanding resolution to the thornier problems of forced tech transfer and intellectual property theft that Trump's own administration prioritized. Hence this trade war can go farther than even Trump intended. In other words, Trump's protectionist rhetoric on China has been so successful that it now constrains his actions. The U.S. engaged in a similar trade war with Japan in the 1980s and succeeded in reducing Japan's share of the American market and in forcing Japan to invest long-term capital in the U.S. The Trump administration presumably wants to repeat this process and achieve a similar outcome (Chart 13). The intention is not necessarily to destabilize China, but to change the composition of the U.S.'s Asia trade, and hence the distribution of Asian power, and to re-capture Chinese savings via American hard assets. Chart 13The U.S. Hopes To Replicate Japan Trade War The U.S. Hopes To Replicate Japan Trade War The U.S. Hopes To Replicate Japan Trade War Chart 14The U.S. Seeks To Redistribute Asian Trade The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis If China's exports to the U.S. are taxed, both it and other manufacturing nations will have to invest more in other developing Asian economies. The latter can gradually make their manufacturing sectors more efficient, but cannot pose a strategic threat to the United States (Chart 14). However, Japan ultimately capitulated to U.S. tariff pressure because the two countries were Cold War allies with a clear national security hierarchy. By contrast, China and the U.S. are antagonists without a clear hierarchy. Beijing perceives U.S. actions as part of its strategy to contain China's rise. The Southeast Asian countries that stand to benefit from the transformation of international supply chains are also the ones that will eventually become most exposed to U.S.-China conflicts.12 As highlighted above, China is not likely to shrink from the fight that the U.S. is bringing. Given that we expect diplomacy to remain on track in North Korea,13 the result is that Taiwan and the countries around the South China Sea are the likeliest candidates for geopolitical risk events in Asia that disrupt markets this year or next. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 For Taiwan, please see Section II below. For Africa, please see Ryan Browne, "Chinese lasers injure US military pilots in Africa, Pentagon says," CNN, May 4, 2018, available at www.cnn.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, and Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 3 The institutions affected included the multilateral development banks and other U.S. and international development agencies. Please see Dianne E. Rennack, "China: U.S. Economic Sanctions," Congressional Research Service, October 1, 1997, available at congressionalresearch.com 4 Arms and certain high-tech exports remained under restriction for years after the event, both from Europe and the U.S. China is still unable to receive funding from the U.S. Overseas Private Investment Corporation or exports of items on the U.S. Munitions List. 5 Please see BCA Geopolitical Strategy Special Report, "Italy, Spain, Trade Wars... Oh My!" dated May 30, 2018, available at gps.bcaresearch.com. 6 Or if the pro-independence third party or the anti-establishment candidates win. 7 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan," dated March 30, 2018, available at gps.bcaresearch.com. 8 There is an extensive debate over the Belgrade embassy bombing. It can be summarized by saying that although the U.S. apologized for the mistake, the U.S. suspected Chinese collaboration with the Yugoslav government, while China maintains its innocence. 9 We have tracked the South China Sea closely since 2012. Please see BCA Geopolitical Strategy Special Report, "The South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, and "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Pyongyang's Pivot To America," dated June 8, 2018, available at gps.bcaresearch.com. Appendix Returns Following Crises In U.S.-China Relations Returns Following Crises In U.S.-China Relations The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis Open Trades & Positions Open Tactical Recommendations* The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis Open Strategic Recommendations* The U.S. And China: Sizing Up The Crisis The U.S. And China: Sizing Up The Crisis

Highlights BCA's Geopolitical Power Index (GPI) confirms that we live in a multipolar world; Most of President Trump's policies are designed to strike out against this structural reality; Trade war with China is real and presents the premier geopolitical risk in 2018; President Trump's aggression towards G7 allies boils down to greater NAFTA risk; We remain bullish USD, bearish EM, maintain our short U.S. China-exposed equities and closing all our "bullish" NAFTA trades; Remain short GBP/USD, Theresa May's days appear numbered. Feature "We're going to win so much, you're going to be so sick and tired of winning." Candidate Donald Trump, May 26, 2016 In 2013, BCA's Geopolitical Strategy introduced the concept of multipolarity into our financial lexicon.1 Multipolarity is a term in political science that denotes when the number of states powerful enough to pursue an independent and globally relevant foreign policy is greater than one (unipolarity) or two (bipolarity). At the time, the evidence that U.S. global hegemony was in retreat was plentiful, but the idea of a U.S. decline was still far from consensus. By late 2016, however, President Donald Trump was overtly campaigning on it. His campaign slogan, "Make America Great Again," promised to reverse the process by striking out at the perceived causes of the decline: globalization, unchecked illegal immigration, and the ineffective foreign policy of the D.C. establishment. How can we quantitatively prove that the world is multipolar? We recently enhanced the classic National Capability Index (NCI) with our own measure, the Geopolitical Power Index (GPI). The original index, created for the Correlates of War project in 1963, had grown outdated. Its reliance on "military personnel" and "iron and steel production" harkened back to the late nineteenth century and overstated the power of China (Chart 1). Chart 1The National Capability Index Overstates China's Power The National Capability Index Overstates China's Power The National Capability Index Overstates China's Power Our own index avoids these pitfalls, while retaining the parsimony of the NCI, by focusing on six key factors: Population: We adapted the original population measure by penalizing countries with large dependency ratios. Yes, having a vast population matters, but having too many dependents (the elderly and youth) can strain resources otherwise available for global power projection. Global Economic Relevance: The original index failed to capture a country's relevance for the global economy. Designed at the height of the Cold War, the NCI did not foresee today's globalized future. As such, we modified the original index by introducing a measure that captures a country's contribution to global final demand. The more an economy imports, the greater its bargaining power in terms of trade and vis-à-vis its geopolitical rivals. Arms Exports: Having a large army is no longer as relevant now that wars have become a high-tech affair. To capture that reality, we replaced the NCI's focus on the number of soldiers with arms exports as a share of the global defense industry. We retained the original three variables that measure primary energy consumption, GDP, and overall military expenditure. Chart 2 shows the updated data. As expected, the U.S. is in decline, having lost nearly a third of its quantitatively measured geopolitical power since 1998. Over the same period, China has gone from having just 30% of U.S. geopolitical power to over 80%. Other countries, like Russia, India, Turkey, Iran, and Pakistan, have also seen an increase in geopolitical power over the same period, confirming their roles as regional powers (Chart 3). Chart 2BCA's Geopolitical Power Index Illustrates A Multipolar World BCA's Geopolitical Power Index Illustrates A Multipolar World BCA's Geopolitical Power Index Illustrates A Multipolar World Chart 3China Was Not The Only EM To Rise Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? President Trump was elected with the mandate of changing the trajectory of American power and getting the country back on a "winning" path. Investors can perceive nearly all the moves by the administration - from protectionist actions against China and traditional allies, to applying a "Maximum Pressure" doctrine against North Korea and Iran - as a fight against the structural decline of U.S. power. Isn't President Trump "tilting at windmills"? Fighting a vain battle against imaginary adversaries? Yes. The decline of the U.S. is a product of classic imperial overstretch combined with the natural lifecycle of any global hegemon. U.S. policymakers have made decisions that have hastened the decline, but the overarching American geopolitical trajectory would have been negative regardless: Global peace brought prosperity which strengthened Emerging Markets (EM), particularly China, relative to the U.S. That said, Trump is not as crazy as the media often imply. Chaos is not necessarily bad for a domestically driven economy secured by two oceans. The U.S. tends to outperform the rest of the world - economically, financially, and geopolitically - amid turbulence. Our own updated GPI shows that both World Wars were massively favorable for U.S. hegemony (Chart 4), although this time around the chaos is mostly self-inflicted. Chart 4America Profits From Chaos America Profits From Chaos America Profits From Chaos Similarly, Trump's economic populism at home is buoying sentiment and assuaging the negative consequences - real or imagined - of his protectionism. Meanwhile, the threat of tariffs is souring the mood abroad. This policy mix is causing U.S. assets to outperform (Chart 5). Most importantly, the U.S. dollar is now up 2.7% since the beginning of the year, putting pressure on EM assets. When combined with continued counter-cyclical structural reforms in China, we maintain that the overall macro and geopolitical context remains bearish for global risk assets. This is not the first time that an American president has deployed both an aggressive trade policy and an aggressive foreign policy. The difference, this time around, is that the world is multipolar. A defining feature of multipolarity is that it is less predictable and more likely to produce inter-state conflict (Chart 6). As more countries matter - geopolitically, economically, financially - the number of "veto players" rises, making stable equilibria more difficult to produce. As such, bullying as a negotiating tactic worked when used by Presidents Nixon, Reagan, Bush Jr., and Clinton, but may not work today. Investors should therefore prepare for a long period of uncertainty this summer as the world responds to a U.S. administration focused on "winning." Chart 5U.S. Assets Outperform U.S. Assets Outperform U.S. Assets Outperform Chart 6Multipolarity Produces Uncertainty Multipolarity Produces Uncertainty Multipolarity Produces Uncertainty Bottom Line: There is a clear logic behind President Trump's foreign and trade policy. He is trying to reverse a decline in U.S. hegemony. The problem is that his policy decisions are unlikely to address the structural causes of America's decline. What is much more likely is that his policy will cause the rest of the world to react in unpredictable ways. The U.S. may benefit, but that is not a forgone conclusion. Investors should position themselves for a volatile summer. Below we review three key issues, two negative and one positive. The U.S. Vs. China: The Trade War Is Real The Trump administration has announced that it will go ahead with tariffs on $50 billion worth of Chinese imports in retaliation for forced technology transfer and intellectual property theft under Section 301 of the 1974 Trade Act. The tariffs will come in two tranches beginning on July 6. China will respond proportionately, based on both its statements and its response to the steel and aluminum tariffs (Chart 7). If the two sides stop here, then perhaps the trade war can be delayed. But Trump is already saying he will impose tariffs on a further $200 billion worth of goods. At that point, if Beijing re-retaliates, China's proportionate response will cover more goods than the entire range of U.S. imports (Chart 8). Retaliation will have to occur elsewhere. Chart 7Trump's Steel/Aluminum Tariffs Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Chart 8Trump's Tariffs On China Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? We would expect the CNY/USD to weaken as negotiations fail. We would also expect tensions to continue spilling over into the South China Sea and other areas of strategic disagreement.2 The South China Sea or Taiwan could produce market-moving "black swan" geopolitical events this year or next.3 Chart 9Downside Risks Continue Downside Risks Continue Downside Risks Continue It is critical to distinguish between the U.S. trade conflict with China and the one with the G7. In the latter case, the U.S. political establishment will push against the Trump administration, encouraging him to compromise. With China, however, Congress is becoming the aggressor and we certainly do not expect the Defense Department or the intelligence community to play the peacemaker with Beijing. In particular, members of Congress are trying to cancel Trump's ZTE deal while expanding the powers of the Committee on Foreign Investment in the United States (CFIUS) to restrict Chinese investments.4 These congressional factors underscore our theme that U.S.-China tensions are structural and secular.5 Would China stimulate its economy to negate the effects of tariffs? We see nothing yet on the policy side to warrant a change in our fundamental view, which holds that any stimulus will be limited due to the agenda of containing systemic financial risk. Credit growth remains weak and fiscal spending has not yet perked up (Chart 9), portending weak Chinese imports and negative outcomes for EM. The risk to Chinese growth remains to the downside this year (and likely next year) as the government continues with the reforms. Critically, stimulus is not the only possible Chinese response to trade war. A trade war with the United States will provide Xi with a "foreign devil" on whom he can blame the pain of structural reforms. As such, it is entirely possible that Beijing doubles-down on reforms in light of an aggressive U.S. Bottom Line: The U.S.-China trade war is beginning and will cause additional market volatility and, potentially, a "black swan" event, especially ahead of the U.S. midterm elections. We do not expect 2015-style economic stimulus from Beijing. Stay long U.S. small caps relative to large caps; short U.S. China-exposed equities; and remain short EM equities relative to DM. The U.S. Vs. The G6: This Is About NAFTA There was little rhyme or reason to President Trump's smackdown of traditional U.S. allies at the G7 summit in Quebec. As our colleague Peter Berezin recently pointed out, the U.S. is throwing stones while living in a glass house.6 While the overall level of tariff barriers within developed countries is low, the U.S. actually stands at the top end of the spectrum (Chart 10). The decision to launch an investigation into whether automobile imports "threaten to impair the national security" of the U.S. - under Section 232 of the Trade Expansion Act of 1962 - falls into the same rubric of empty threats. The U.S. has had a 25% tariff on imported light trucks since 1964, a decision that likely caused its car companies to become addicted to domestic pickup truck demand to the detriment of global competitiveness. Meanwhile, only 15% of U.S. autos shipped to the EU were subject to the infamous European 10% surcharge on auto imports. This is because U.S. autos containing European parts are exempt from the tariff. Many foreign auto manufacturers have already adjusted to the U.S. market, setting up manufacturing inside the country (Chart 11). Tariffs would hurt luxury brands like BMW, Daimler, Volvo, and Jaguar.7 As such, we doubt the investment-relevance of Trump's threat against autos. Either way, the investigation is unlikely to be completed until the tail-end of Q1 2019. Chart 10Tariffs: Who Is Robbing The U.S.? Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Chart 11Car Imports? What Imports? Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Instead, investors should take Trump's aggressive comments from the G7 in the context of the ongoing NAFTA negotiations and the closing window for a deal. President Trump wants to get a NAFTA deal ahead of the U.S. midterms in November and prior to the new Mexican Congress being inaugurated on September 1.8 This means that a deal has to be concluded by late July, or early August, giving the "old" Mexican Congress enough time to ratify it before the new president - likely Andrés Manuel López Obrador - comes to power on December 1. This would conceivably give the U.S. Congress enough time to ratify a deal by December, assuming Republicans can remove some procedural hurdles before then. The rising probability of no resolution before the U.S. midterm election will increase the risk that Trump will trigger Article 2205 and announce the U.S.'s withdrawal. Trump has always had the option of triggering the six-month withdrawal period as a negotiating tactic to increase the pressure on Canada and Mexico. Withdrawing might fire up the base, while major concessions from Canada or Mexico might be presented as "victories" to voters. Anything short of these binary outcomes is useless to Trump on November 6. Therefore, if Canada and Mexico do not relent in the next month or two, the odds of Trump triggering Article 2205 will shoot up. The key is that Trump faces limited legal or economic constraints in withdrawing: Legal Constraints: Not only can Trump unilaterally withdraw from the agreement, triggering the six-month exit period, but Congress is unlikely to stop him. Announcing withdrawal automatically nullifies much of the 1993 NAFTA Implementation Act.9 Some provisions of NAFTA under this act may continue to be implemented, but the bulk would cease to have effect, and the White House could refuse to enforce the rest. Economic Constraints: The U.S. economy has far less exposure to Canada and Mexico than vice- versa (Chart 12). Certain states and industries would be heavily affected - ironically, the U.S. auto industry would be most severely impacted (Chart 13) - and they would lobby aggressively to save the agreement. But with the American economy hyper-charged with stimulus, the drag from leaving NAFTA is not prohibitive to Trump. Voters will feel any pocketbook consequences about three months late i.e., after the election. Chart 12U.S. Economy:##br## Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA Chart 13NAFTA Has Made U.S. Auto ##br##Manufacturing More Competitive Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? The potential saving grace for Canada is the Canada-U.S. Free Trade Agreement (CUSFTA), which took effect in 1989 and was incorporated into NAFTA. The U.S. and Canada agreed through an exchange of letters to suspend CUSFTA's operation when NAFTA took effect, but the suspension only lasts as long as NAFTA is in effect. However, reinstating CUSFTA is not straightforward. The NAFTA Implementation Act suspends some aspects of the CUSFTA and amends others (for instance, on customs fees), so there will not be an easy transition from NAFTA to a fully operational CUSFTA.10 Trump may well walk away from both CUSFTA and NAFTA in the same proclamation, or he could walk away from NAFTA while leaving CUSFTA in limbo. The latter would mitigate the negative impact on Canada, but it would still see rising tariffs, customs fees, and rising policy uncertainty. Bottom Line: We originally assigned a high probability to the abrogation of NAFTA.11 Subsequently, we lowered the probability due to positive comments from the White House and Trump's negotiating team. This was a mistake. As we initially posited, there are few constraints to abrogating NAFTA, particularly if President Trump intends to renegotiate the deal later, or conclude two separate bilateral deals that effectively maintain the same trade relationship. We are closing our trade favoring an equally-weighted basket of CAD/EUR and MXN/EUR. We are also closing our trade favoring Mexican local government bonds relative to EM. North Korea: A Geopolitical Opportunity, Not A Risk Not every move by the Trump administration is increasing geopolitical volatility. Trump's Maximum Pressure doctrine may have elevated risks on the Korean Peninsula in 2017, but it ultimately worked. The media is missing the big picture on the Singapore Summit. Diplomacy is on track and geopolitical risk - namely the risk of war on the peninsula - is fading. It is false to claim that President Trump got nothing in return for the summit. Since November 28, North Korea has moderated its belligerent threats, ceased conducting missile tests, released three U.S. political prisoners, and largely blocked off access to the Punggye-ri nuclear testing site. Now, North Korean leader Kim Jong-un has held the summit with Trump, reaffirmed his longstanding promise of "complete denuclearization," reaffirmed the peace-seeking April 2018 Panmunjom Declaration with South Korea, and pledged to dismantle a ballistic missile testing site and continue negotiations. In response, President Trump has given security guarantees to the North Korean regime and has pledged to discontinue U.S.-South Korea military drills for the duration of the negotiations. Trump has not yet eased economic sanctions and his administration has ruled out troop withdrawals from South Korea for now. There is much diplomatic work to be done. But the summit was undoubtedly a positive sign, dialogue is continuing at lower levels, and Kim is expected to visit the White House in the near future. Table 1 shows that the Singapore Summit is substantial when compared with major U.S.-North Korea agreements and inter-Korean summits - and it is unprecedented in that it was agreed between American and North Korean leaders. Table 1How The Singapore Summit Stacks Up To Previous Pacts With North Korea Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Because Trump demonstrated a credible military threat, and China enforced sanctions, the foundation is firmer than that of President Barack Obama's April 2012 agreement to provide food aid in payment for a cessation of nuclear and missile activity. It is much more similar to that of President Clinton and the "Agreed Framework" of 1994, which lasted until 2002, despite many serious failures on both the U.S. and North Korean sides. We should also bear in mind that it was originally U.S. Congress, not North Korea, which undermined the 1994 agreement. Aside from removing war risk, Korean diplomacy is of limited global significance. It marginally improves the outlook for South Korean industrials, energy, telecoms, and consumer staples relative to their EM peers (Chart 14). In the long run it should also be positive for the KRW. Chart 14Winners And Losers Of Inter-Korean Engagement Winners And Losers Of Inter-Korean Engagement Winners And Losers Of Inter-Korean Engagement We maintain that a U.S.-China trade war will not be prevented because of a Korean deal. But we do not expect China to spoil the negotiations. Geopolitically, China benefits from reducing the basis for U.S. forces to be stationed in South Korea. Bottom Line: Go long a "peace dividend" basket of South Korean equity sectors (industrials, energy, consumer staples, and telecoms) and short South Korean "loser" sectors (financials, IT, consumer discretionary, and health care), both relative to their EM peers. Stick to our Korean 2-year/10-year sovereign bond curve steepener trade. Brexit Update: A New Election Is Now In Play Prime Minister Theresa May is fending off a revolt within her Conservative Party this week that could set the course for a new election this year. May reneged on a "compromise" with soft-Brexit/Bremain Tory backbenchers on an amendment that would have given the House of Commons a meaningful vote on the final U.K.-EU Brexit deal. According to the press, the compromise was killed by her own Brexit Secretary, David Davis. There is a fundamental problem with Brexit. The current path towards a hard Brexit, pushed on May by hard-Brexit members of her cabinet and articulated in her January 2017 speech, is incompatible with her party's preferences. According to their pre-referendum preferences, a majority of Tory MPs identified with the Bremain campaign ahead of the referendum (Chart 15). That would suggest that a vast majority prefer a soft Brexit today, if not staying in the EU. We would go further. The current trajectory is incompatible with the democratic preferences of the U.K. public. First, polls are showing rising opposition to Brexit (Chart 16). Second, most voters who chose to vote for Brexit in 2016 did so under the assumption that the Conservative Party would pursue a soft Brexit, including continued membership in the Common Market. Boris Johnson, the most prominent supporter of Brexit ahead of the vote and now the foreign minister, famously stated right after the referendum that "there will continue to be free trade and access to the single market."12 Chart 15Westminster MPs Support Bremain! Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Chart 16Bremain On The Rise Bremain On The Rise Bremain On The Rise So what happens now? We expect the government to be defeated on the crucial amendment giving Westminster the right to vote on the final EU-U.K. deal. If that happens, PM May could be replaced by a hard-Brexit prime minister, most likely Davis. Given the lack of support for an actual hard-Brexit outcome - both in Westminster and among the public - we believe that a new election remains likely by March 2019. Bottom Line: Political risk remains elevated in the U.K. A new election could resolve this risk, but the potential for a Jeremy Corbyn-led Labour Party to win the election could add additional political risk to U.K. assets. We remain short GBP/USD. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013; and "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Pyongyang's Pivot To America," dated June 8, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan," dated March 30, 2018, available at gps.bcaresearch.com. 4 The Senate has passed a version of the National Defense Authorization Act with a rider that would boost CFIUS and maintain stringent restrictions on ZTE's business with the U.S. These restrictions have crippled the company but would have been removed under the Trump administration's snap deal in June. The White House claims it will remove the rider when the House and Senate hold a conference to resolve differences between their versions of the defense bill, but it is not clear that the White House will succeed. Congress could test Trump's veto. If Trump does not veto he will break a personal promise to Xi Jinping and escalate the trade war further than perhaps even he intended. 5 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 6 Please see BCA Global Investment Strategy Weekly Report, "Piggy Bank No More? Trump And The Dollar's Reserve Currency Status," dated June 15, 2018, available at gis.bcaresearch.com. 7 We do not include Porsche in this list as we would gladly pay the 25% tariff on top of its current price. 8 Mexican elections for both president and Congress will take place on July 1, but the new Congress will sit on September 1 while the new president will take office on December 1. 9 Please see Lori Wallach, "Presidential Authority to Terminate NAFTA Without Congressional Approval," Public Citizen's Global Trade Watch, November 13, 2017, available at www.citizen.org. 10 The National Customs Brokers and Forwarders Association of America, "Issues Surrounding US Withdrawal From NAFTA," available from GHY International at www.ghy.com. See also Dan Ciuriak, "What if the United States Walks Away From NAFTA?" C. D. Howe Institute Intelligence Memos, dated November 27, 2017, available at www.cdhowe.org. 11 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 12 Please see "U.K. will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. Geopolitical Calendar

Highlights North Korea is a geopolitical opportunity more than a risk to markets - the key regional risk comes from U.S.-China tensions; China's geopolitical rise, and the fear of a U.S. attack on North Korea, is driving the two Koreas together; The U.S. can accept something less than complete denuclearization - such as inspections and a missile freeze; The path of peace and eventual unification removes the risk of disruption to the global economy and is positive for South Korea's currency and certain assets. Feature We at BCA's Geopolitical Strategy have been optimists about the diplomatic tack in North Korea since September 2017.1 Our optimism stands in stark contrast to our pessimism about U.S.-China relations. U.S.-China trade tensions will create an ongoing headwind for assets linked to the status quo of Sino-American engagement (Chart 1). U.S. President Donald Trump's threat to move forward with tariffs on $50 billion worth of Chinese goods - and his decision to impose steel and aluminum tariffs on China and others - lends credence to our long-held view that globalization has peaked.2 The seal on protectionism has been broken by the country known as the guarantor of free trade (Chart 2). Chart 1Trade Tensions Far From Resolved Trade Tensions Far From Resolved Trade Tensions Far From Resolved Chart 2The U.S. Has Broken The Seal On Protectionism The U.S. Has Broken The Seal On Protectionism The U.S. Has Broken The Seal On Protectionism Trade tensions are also spilling out into strategic areas of disagreement, as we expected.3 This week, Defense Secretary James Mattis warned China that the U.S. will maintain a "steady drumbeat" of freedom of navigation operations in the South China Sea (Diagram 1). The goal is to reject China's claims of sovereignty over the sea and the rocks and reefs within it.4 The potential for a geopolitical incident or "Black Swan" event to occur in the South China Sea - or even the Taiwan Strait - is high. Diagram 1The U.S. Is Pushing Back Against China's Maritime-Territorial Claims Pyongyang's Pivot To America Pyongyang's Pivot To America For investors, the secular decline in U.S.-China ties and the "apex of globalization" are much more relevant than what happens on the Korean peninsula - as long as the peninsula does not become the central battleground between the two great powers in a replay of the devastating 1950-53 war. In this report we argue that it will not. The current round of diplomacy between the U.S. and North Korea is likely to bear fruit in a diplomatic settlement of some kind, even a peace treaty, by 2020.5 Investors should see North Korea as a geopolitical opportunity rather than a geopolitical risk. While North Korea can still contribute to volatility, we recommend investors monitor U.S.-China trade tensions, the East and South China Seas, and Taiwan as the chief sources of market-relevant geopolitical risk in this region going forward. Elsewhere, U.S.-Iran tensions are the key understated geopolitical risk to markets. China: Hiding In Plain Sight The current diplomatic effort in the Koreas has a powerful tailwind behind it: the rise of China. China's re-emergence simply cannot be overstated. It is on track to reclaim its historic role as the world's largest economy (Chart 3A) and is developing naval, air, space and cyber-space capabilities that are rapidly eroding the U.S.'s military supremacy (Chart 3B). The rise of China vis-à-vis the U.S. is the single biggest difference between today's attempts to resolve the Korean issue and previous attempts in the 1990s and 2000s. China is reaching a critical mass that is changing the behavior of the states around it (Chart 4). Chart 3AChina's Economic Revival: ##br##The Long View Pyongyang's Pivot To America Pyongyang's Pivot To America Chart 3BChina's Comprehensive ##br##Geopolitical Power Rising China's Comprehensive Geopolitical Power Rising China's Comprehensive Geopolitical Power Rising Chart 4EM Economic ##br##Reliance On China EM Economic Reliance On China EM Economic Reliance On China As a result, a number of anomalies are occurring throughout the region: The United States is trying to revive its Pacific presence, yet cannot decide how: From 2010-16, the U.S. sought a historic deal with Iran that would enable it to wash its hands of the Middle East and "pivot to Asia." The Trans-Pacific Partnership (TPP) was envisioned as an advanced trade deal - excluding China - that would integrate the Pacific Rim economies under a new trade framework; China would have to reform its economy in order to join. Under President Trump, however, the U.S. canceled the TPP and revoked the Iranian deal,6 while maintaining the pivot to Asia through "hard power" tactics. The Washington establishment is unified in its desire to toughen policy on China, but it is divided about how to do so - a sign of the enormity of the challenge. Japan is taking drastic, 1930s-style measures to reflate its economy, which is necessary to revive its overall strategic capability. Military spending is on the rise (Chart 5). Symbolically, the pacifist Article Nine in the post-WWII constitution may be revised next year.7 Taiwan is distancing itself from China, with Beijing-skeptic candidates dominating every level of government since the 2014 and 2016 elections. The Taiwanese increasingly see themselves as exclusively Taiwanese, not also Chinese (Chart 6) - making Taiwan a potential source of "Black Swan" events.8 Chart 5Japan's 'Re-Militarization' Japan's 'Re-Militarization' Japan's 'Re-Militarization' Chart 6Majority Of Taiwanese Are Exclusively Taiwanese Pyongyang's Pivot To America Pyongyang's Pivot To America Southeast Asian states are vacillating. Filipinos and South Koreans recently voted against confrontation with China while Malaysians have voted against excessive Chinese influence; Thailand's junta has warmed up to Beijing while Myanmar's junta has sought some distance. The common thread is the desire to do something about China.9 India, long known for its independent foreign policy and "non-aligned" status in the Cold War, has begun courting deeper relationships with the U.S., Japan, and Australia, for fear of China. Even Russia, one of Beijing's closest partners, is engaged in talks with Japan that could result in a peace treaty, allowing these two to bury the hatchet and create economic and strategic options outside of China's control.10 Australia - the country with the most favorable view of China in the West (Chart 7) - is in the midst of an internal crisis over China that has recently broken out into a direct diplomatic spat resulting in Beijing imposing discrete economic sanctions. It goes without saying that China's rise is being felt with extreme sensitivity on the Korean peninsula. Korean kingdoms have historically struggled either to maintain their independence from China or to avoid becoming the battleground in China's conflicts with outside powers. North Korea has taken this dependency to the extreme. Trade data shows that its links to China have grown substantially since the Global Financial Crisis. China's stimulus-fueled economic boom increased commodity imports, while international sanctions cut off Pyongyang's access to most other foreign capital. The strategic vulnerability is revealed both before and after China's enforcement of sanctions in 2017 (Chart 8).11 Chart 7Australia And Russia Are China's Best Friends Pyongyang's Pivot To America Pyongyang's Pivot To America Chart 8North Korea's Over-Reliance On China North Korea's Over-Reliance On China North Korea's Over-Reliance On China Chinese President Xi Jinping's ascendancy - marked by his strict personal control of the ruling party and scrapping of term limits - has reinforced the North's vulnerability. Like his predecessor Jiang Zemin (1992-2004), Xi represents a faction in the Communist Party of China that sees Pyongyang as more of a liability than an asset. North Korea's anxiety can be marked by Kim Jong Un's attempts to reduce the "pro-China" faction within the North Korean state. For instance, he has ordered the execution of his uncle, Jang Song Taek, who was close to Beijing, and his half-brother, Kim Jong Nam, who lived in Macao and was China's "alternative" to Kim.12 In effect, the next few years offer what is probably North Korea's last chance to create some new strategic options with South Korea and the rest of the world if it is to avoid being a mere vassal state for the coming centuries. Pyongyang's chief security threat is the United States and it has pursued a nuclear deterrent for decades in order to be able to negotiate with the U.S. for regime survival. The deterrent gives the North some independence, but normalizing ties with South Korea and the U.S. would enable the North to diversify its economy and reduce its dependence on China. South Korea is also fearful that the coming decades will bring a Chinese empire that effectively swallows North Korea and surrounds Seoul. Eventually the North must liberalize and industrialize its economy: will South Korea have a part in this process, or will China take it all? South Korean President Moon Jae-in wishes to reduce the risk of war prompted by North Korea's conflict with the United States, but he also wishes to gain leverage over the North so that China does not absorb its economy. In short, the historic re-emergence of China is encouraging Korean integration, as the two Korean states begin to reconsider their relationship and national needs in the face of global "multipolarity" and great power competition.13 The strategic logic is thus pushing toward Korean unification, even if unification is in practice a long way away. A unified Korean peninsula would rise toward the level of Japan in comprehensive geopolitical power (see Chart 3B above). With a population of 75 million, South Korean technological prowess, and at least nuclear potential (if not outright capability), the Koreas would be better prepared to defend their interests against China and other neighbors than they are separately. In a multipolar world, strength in numbers has an appealing strategic logic. Unification, however, will be extremely costly for the ruling elites of both North and South Korea, possibly prohibitive. It is not within our five-year forecast horizon. Instead, economic engagement will be the main focus, a necessary but not sufficient step toward unification. Bottom Line: China's rise, as it pertains to Korea, is underestimated by investors. It is putting pressure on the two Koreas to cooperate, create some solidarity, and expand their economic and strategic options over the long run. It is also putting pressure on the U.S. to encourage this process and try to remove or reduce the nuclear threat through economic engagement rather than war. How Is "Moonshine" Different From "Sunshine"? South Korean President Moon Jae-in won a sweeping victory in the election of May 2017 on a promise to renew South Korea's engagement with the North. His agenda has been nicknamed "Moonshine policy."14 Will Moonshine actually work? In addition to China's rise, several of today's political trends are supportive of a diplomatic settlement: North Korean leadership change: Power succession and consolidation: Kim is not the rash and inexperienced youth that many feared upon his coming to power in 2011. Instead he has consolidated power within the regime and waged high-stakes international negotiations with the U.S. and China. He is also overseeing a generational change in the upper ranks of the party and state. Such a change is necessary if North Korea is ever to revamp its relations with the world.15 Economic reform: In March 2013, not long after coming to power, Kim signaled a shift in national policy. The North Korean governing philosophy under his father was called juche, or "self-reliance," and had a heavy emphasis on putting the military first. But Kim has promised to develop the economy alongside nuclear weapons, creating a governing philosophy known as byungjin, or "parallel development."16 There is substantial evidence of marketization in North Korea, which was formally allowed in 2003 but has been growing faster since the Global Financial Crisis and the country's failed currency reforms at that time. Official statistics, such as they are, do not capture this organic and informal market process (Chart 9). Farmers have been allowed to keep some of their profits; official and unofficial marketplaces have cropped up; informal banking is developing; mobile phones and televisions are more prevalent.17 Foreign policy and strategic deterrence: Kim has demonstrated to the world that his country's nuclear and missile capabilities are more advanced than previously thought (Diagram 2). The American defense and intelligence establishment have been forced, during Kim's rapid phase of tests in 2016-17, to revise upward their expectations of the North's ability to strike the U.S. homeland with a nuclear weapon. This creates a new environment in which the U.S. can no longer ignore North Korea. Yet Kim has also proven himself to be a rational actor by discontinuing missile tests when tensions approached a boil in late 2017 and offering an olive branch to the South Koreans and Americans in early 2018.18 Chart 9North Korea: Rising From A Very Low Level North Korea: Rising From A Very Low Level North Korea: Rising From A Very Low Level Diagram 2North Korea's Proven Missile Reach Pyongyang's Pivot To America Pyongyang's Pivot To America American leadership change: Pivot to Asia: The United States has attempted to "rebalance" its strategic posture by reducing its commitment to the Middle East and "pivoting" to East Asia. This is to confront the China challenge. President Trump's North Korea and China policies are aggressive, despite the fact that Trump is also ramping up pressure on Iran.19 International sanctions tightened: The U.S. has responded to North Korea's nuclear and missile advances by redoubling the international sanctions regime (Chart 10). A credible military threat: The Trump administration has also established a "credible threat" through its use of military drills, aircraft carrier deployments in the region, and Trump's hawkish speeches to the United Nations General Assembly and South Korean National Assembly. The demonstration that the military option is "on the table" is reminiscent of the Iranian nuclear negotiations from 2011-15 (and those to come) (Chart 11).20 Trump's maneuvering room: Few people doubt the current U.S. president's willingness to do something unpredictable, "out of the box," or even "crazy," such as preemptively attacking North Korea, or, on the other hand, withdrawing U.S. troops from South Korea (Trump has often expressed dissatisfaction with the cost of U.S. troop commitments). For better or worse, the U.S. has much greater room for maneuver than it used to in making a deal with North Korea. Chart 10U.S.-Led Sanctions Tightened The Noose U.S.-Led Sanctions Tightened The Noose U.S.-Led Sanctions Tightened The Noose Chart 11U.S. Demonstration Of Credible Military Threat Causes Market Jitters U.S. Demonstration Of Credible Military Threat Causes Market Jitters U.S. Demonstration Of Credible Military Threat Causes Market Jitters Chinese leadership change: Xi's irritation with Kim: President Xi Jinping wants to create a Chinese sphere of influence in the region, which includes depriving the U.S. of a reason to bulk up its Asia Pacific presence. However, North Korea's threats and provocations give the U.S. good reason to build up its military assets, including missile defense.21 Pyongyang as an obstacle to Chinese power projection: Xi also wants to focus China's military and strategic development toward new dimensions of defense (sea, air, space, cyber) and improve China's ability to project power globally. But the potential for a crisis in North Korea - whether regime collapse or American invasion - ties China down to a 1950s-style military posture with a heavy focus on its army in the northeast. China enforces sanctions on the North: The above factors, combined with President Trump's sanctions on Chinese companies for dealing with the North, have prompted China to change its policy toward North Korea. China has been enforcing stringent sanctions since mid-2017 (Chart 12). China benefits from North Korean economic opening: China also has an interest in North Korea's economic opening - it has pioneered this process and has also clearly benefited from the recent opening of formerly closed neighboring states like Myanmar and Cambodia (Chart 13). China wants to remain the biggest player in the North's economy as it opens further. China seeks leverage over South Korea: Direct trade and infrastructure links to South Korea will also increase China's leverage over the South. Already President Moon has given China assurances of stopping U.S. missile defense deployments in exchange for the removal of economic sanctions against South Korean companies.22 Xi Jinping is not going anywhere: Xi has consolidated power and removed limits on his term in office, so China's policy shift toward the Koreas cannot be assumed to be easily reversible. Chart 12Even China Enforces Sanctions This Time Even China Enforces Sanctions This Time Even China Enforces Sanctions This Time Chart 13China Gains When Neighbors Open Up China Gains When Neighbors Open Up China Gains When Neighbors Open Up South Korean leadership change: The fall of the right-wing: The right-of-center parties and politicians in South Korea have suffered a cyclical drop in support. First, their hawkish policies since 2008 failed to prevent North Korea's belligerence. Second, former President Park Geun-hye was impeached and removed from office in early 2017 due to scandals that marred the right wing's popular standing. The legislative elections of 2016 and the post-impeachment presidential election of 2017 show that the major center-left party (the Minjoo Party) has made a big comeback. Local elections to be held on June 13, 2018 - the day after the planned Trump-Kim summit in Singapore - are likely to reinforce this trend (Chart 14 A&B). Thus the Moon administration is benefiting from a popular tailwind that will support its dovish approach to the North and could last for several years (Chart 15). The next election, for the legislature, is not until April 15, 2020, giving Moon time to implement his policies. Fear of abandonment: President Trump's policies threaten South Korea with the risk of preemptive war or American abandonment, making engagement with the North all the more necessary. Chart 14ASouth Korea's Right-Wing Faltered In 2016... Pyongyang's Pivot To America Pyongyang's Pivot To America Chart 14B... And Left-Wing Will Likely Win In 2018 Pyongyang's Pivot To America Pyongyang's Pivot To America Chart 15Ruling Minjoo Party Has Plenty Of Momentum Pyongyang's Pivot To America Pyongyang's Pivot To America The only other significant players are Russia and Japan, neither of which is willing or able to derail a diplomatic process pursued by both Koreas and the U.S. and China.23 Critically, this peace process is being driven by constraints, not preferences. True, Xi Jinping may be irritated by Kim Jong Un and Donald Trump may yearn for a Nobel peace prize. But the underlying factors are the following constraints on these policymakers: North Korea's regime cannot allow foreign domination, whether through war or economics; The U.S. regime cannot allow its homeland to be attacked by North Korea or its regional presence to be eliminated; China's regime cannot allow a Syria-style influx of North Korean refugees into China's Rust-Belt northeast or an American occupation of North Korea; South Korea's regime cannot allow anyone to trigger a war in which Seoul will be the first to be decimated. In each case, these states are bumping up against their constraints, such that the "Moonshine" diplomatic initiative is supported from all angles. Not only are the current U.S. and North Korean leaders planning to meet for the first time in the history, to build on the Moon-Kim summits, but they have already overcome a moment of cold feet that nearly quashed the June 12 summit.24 If the summit falls through, another summit will be scheduled; such is the underlying pressure of the above constraints. South Korean opinion polls demonstrate the pent-up demand for diplomacy that brought Moon and the Minjoo Party to power. The number of South Koreans who "trust" North Korea to denuclearize and pursue peace has shot up from 15% to 65% in recent polls (Chart 16A). Chart 16ASouth Koreans More Trusting Toward North... Pyongyang's Pivot To America Pyongyang's Pivot To America Chart 16B... Yet Doubt Full Denuclearization Will Occur Pyongyang's Pivot To America Pyongyang's Pivot To America Chart 17South Koreans Want Unification... Eventually Pyongyang's Pivot To America Pyongyang's Pivot To America Of course, "denuclearization" is a slippery term - about 64% of South Koreans doubt that the North will really give up its nuclear program. And yet even that number has fallen from 90% at the beginning of this year (Chart 16B). These numbers are volatile but reveal a deeply held public preference for some kind of deal that removes the threat of armed conflict. Indeed, 78% of South Koreans say they ultimately want not only peace but unification with the North (Chart 17). Subjectively, we think the probability of some kind of diplomatic settlement is 95% and the probability of war 5%. The next question is what kind of a settlement will it be? Bottom Line: The current diplomatic track on the Korean peninsula has greater potential than the previous two diplomatic pushes in 2000 and 2007. The different powers remain constrained by the lack of palatable or tolerable options other than diplomacy, yet China's rise and North Korea's missile capabilities have made the status quo unacceptable. Therefore we expect some kind of settlement that reduces tensions and allows for economic engagement. The U.S. Can Accept Less Than Full Denuclearization What about the critical issue of North Korea's strategic standoff with the United States? Will North Korea give up its nuclear program? Can the U.S. accept a deal that does not include complete and verifiable denuclearization? Subjectively, we would put full denuclearization at a 15% probability. It is three times more likely than a war (5% chance), but five times less likely than a lesser settlement (80% chance). The question boils down to whether the United States is capable of a preemptive military strike on North Korea that denies it the ability to inflict devastating casualties on South Korea. Such a strike would require the U.S. to use numerous tactical nuclear weapons on North Korean nuclear and chemical sites as well as artillery units deeply embedded in the hills overlooking Seoul.25 If the U.S. is believed capable of such an attack, then the North will need to retain some of its nuclear deterrent so that it can deter the U.S. from such an attack directly, by threatening U.S. cities. If the U.S. is not believed capable, then the North can afford to trade away its nuclear program and rely on its conventional deterrent of decimating Seoul as its chief security guarantee. Our assessment is that the U.S. is broadly capable of executing such an attack, however little it intends to do so. The U.S. would need to be politically willing to accept the devastation of Seoul, nuclear fallout over Japan, and potentially a second war with China (which might intervene more readily this time than in 1950). This is extremely unlikely to say the least. But given President Trump's hawkishness and the drastic vacillations of today's polarized U.S. public opinion and foreign policy, North Korea cannot gamble that the U.S. would under no circumstances, ever, adopt such a course of action. In other words, North Korea has developed a nuclear deterrent not to trade it away for concessions but to maintain it at some level. National Security Adviser John Bolton said it all in one word: Libya. Libyan President Mohammar Qaddafi unilaterally abandoned his country's nuclear program in 2003, in the wake of the 9/11 attacks, to improve relations with the West. This worked until the Arab Spring, when Qaddafi was brutalized and executed after his regime collapsed under pressure of popular rebellion and a NATO bombing campaign. NATO struck his personal convoy, leaving him exposed to rebel militias. In other words, North Korea could be fully compliant and yet the U.S. could betray it. Regime change would be more likely for the U.S. to pursue if the North did not have a nuclear deterrent. In the negotiations, even an offer of total U.S. troop withdrawal from South Korea for denuclearization - which is extremely unlikely - probably cannot convince Kim Jong Un of his personal safety and his regime's security in an era of Iraq 2003, Libya 2011, Syria 2011, Ukraine 2014, and "Zero Dark Thirty."26 Finally, if it is true that North Korea also fears Chinese domination over the long run, then maintaining a nuclear deterrent is all the more important to secure the regime's independence, as it also constrains China. Thus we highly doubt that Pyongyang will fully, verifiably, and irreversibly denuclearize. We reserve a 15% chance simply because its ability to strike Seoul with artillery does give it greater leverage than Libya or other states that faced U.S.-imposed regime change. This fact combined with the possibility of an irresistible package of economic and political benefits from the Americans could conceivably cause the North to change course dramatically. But this is not our baseline case. More likely, Pyongyang can offer, and Washington can accept, mothballing reactors, holding nuclear inspections, freezing the ballistic missile program, and committing to a non-belligerent foreign policy, along with gradual normalization of diplomatic and economic relations. Washington can accept a sub-optimal deal because such a deal preserves the raison d'être for U.S. forces in Korea, yet reduces the threat to the homeland and helps dilute China's influence on the peninsula. As for the 5% chance of war, even if Pyongyang eschews any and all denuclearization, the U.S. may still opt for containment rather than war.27 Bottom Line: The U.S. can settle for "containment" against North Korea, whereas North Korea probably cannot give up its rudimentary nuclear deterrent given its twin fears of American invasion or Chinese domination. The U.S. gains from normalizing relations with the North, given that it enables North Korea to diversify its foreign policy away from China and yet Washington retains its overwhelming nuclear preemptive strike capability in the event that an attack is deemed imminent. North Korea Is The Most Promising Pariah State It is useful to remember how badly communism has served North Koreans relative to their capitalist neighbors. Chart 18 explains the unsustainability of the North's system and the impetus to change. At the same time, South Korea's development path suggests that North Korea has economic potential. There is considerable room to increase basic capital stock - roads, buildings, and basic equipment, etc. - even assuming that North Korea's pace of liberalization prevents the same kind of economic boom that fully capitalist South Korea witnessed in the second half of the twentieth century (Chart 19). Won't liberalizing the economy fatally undermine Kim's totalitarian regime? History teaches otherwise. The reform of communist East Asian regimes like China (1978) and Vietnam (1986) shows that partial liberalization can be pursued without fatally undermining the regime, as long as the regime is willing to do whatever it takes to stay in power, i.e. use domestic security and intelligence forces to suppress opposition and dissent. Communist states in other parts of the world - such as Cuba - also attest to this fact. This is not to say that liberalization poses no threat to Pyongyang. First, liberalization itself can lead to economic consequences, like inflation, that trigger instability, as China experienced in the 1980s. Second, successful liberalization increases household wealth, which can result in growing demand for civil rights and political participation, as occurred under South Korea's right-wing military dictatorship in the 1970s-80s, and as will eventually occur even in China.28 Still, North Korea today is faced with the same predicament that Iran, Myanmar, Cambodia, Cuba, and Zimbabwe face. All of them are trying gingerly to open up their economies, as their sclerotic regimes face a greater threat of social instability from economic opportunity costs than from popular political opposition. They are changing not a moment too soon. Global labor force, trade, and productivity have all slowed in recent decades, marking a contrast to the exuberant external environment that the emerging and frontier markets faced when opening their economies in the late twentieth century (Chart 20). They may still have a cheap labor advantage but they will struggle to develop as rapidly with global potential growth falling. Chart 18A Reason To Reform And Open Up A Reason To Reform And Open Up A Reason To Reform And Open Up Chart 19North Korea Could Follow This Path Pyongyang's Pivot To America Pyongyang's Pivot To America Chart 20North Korea Joins Global Market As Potential Growth Slows North Korea Joins Global Market As Potential Growth Slows North Korea Joins Global Market As Potential Growth Slows North Korea is better situated than any of these late-bloomers. Its immediate neighbors, South Korea, China, and Japan, each sport current account surpluses and positive international investment positions (Chart 21), giving the North a ready pool of capital to tap as it opens its doors. The global search for yield persists more or less (Chart 22), motivating investors to explore the riskiest and worst-governed countries, and yet North Korea sits in a prosperous corner of the world. South Korean investors can envision high returns from basic productivity-enhancing investments in the North, while accepting that unification and its immense fiscal costs are still a long way away. Chart 21Ample Sources Of Investment For North Korea Pyongyang's Pivot To America Pyongyang's Pivot To America Chart 22North Korea: Don't Miss The Search For Yield North Korea: Don't Miss The Search For Yield North Korea: Don't Miss The Search For Yield This means that North Korea - if it calms its quarrels with the West - will have alternatives to China's outward investment push (Chart 23), albeit with China remaining the biggest player. North Korea is not a large enough economy to have a major global impact when it opens up, but it is big enough to affect South Korea. It will make available a pool of cheap labor for a country that is otherwise suffering from the worst of low fertility and a shrinking workforce (Chart 24). The North's reserves of thermal coal, which are comparable to Indonesia's (Chart 25), and other commodities, are also likely to be exploited given that South Korea and its neighbors are already scouring the globe for resource plays. Chart 23China's Belt And Road Initiative China's Belt And Road Initiative China's Belt And Road Initiative Chart 24Reunification Would Increase Labor Force Pyongyang's Pivot To America Pyongyang's Pivot To America Chart 25North Korea Has Sizable Coal Reserves Pyongyang's Pivot To America Pyongyang's Pivot To America In reality, of course, it is the North's overexposure to commodities that is putting pressure on the regime to reform (in addition to international sanctions). China's economy is transitioning to a less resource-intensive model, putting the North's coal and metals exports in long-term jeopardy. The North lacks capital to industrialize and develop a manufacturing sector, and it risks missing out on the new wave of industrialization that is rewarding neighbors like Vietnam, Cambodia, and Myanmar. The slowdown in global trade and globalization threatens to close the window of opportunity for the North. Bottom Line: Oppressive communist regimes have proved capable of selectively opening up to outside trade and investment while maintaining the regime. North Korea is attempting to create a favorable foreign policy environment to take its nascent economic reforms further. The global search for yield, especially by Northeast Asian states, may still offer an opportunity to attract capital. China's economic transition adds a sense of urgency, given North Korea's need to diversify. Investment Conclusions North Korea is small, but independent, and it is pivoting to South Korea and the United States to increase its strategic and economic options. China has an interest in letting this happen, but will try to remain the dominant power. Almost every peace treaty or major diplomatic settlement in human history has involved a series of dramatic ups and downs in the lead-up to the agreement. Diplomatic volatility should increase the closer the different parties get to an agreement, due to the fears and hesitations of losing out in the final compromise. Investors should stay focused on the structural factors. North Korea is more of a geopolitical opportunity than a geopolitical risk for markets today. War is especially unlikely over 2018-19. Hence the North Korean issue is unlikely to disrupt the global economy or threaten a bullish global equity view over this time period. That would be up to other factors. Only if the new round of diplomacy completely and utterly collapses will the tail-risk of war reemerge. U.S.-China tensions, North Korea's nuclear program, and Trump's re-election bid could conceivably lead to a breakdown of diplomacy by 2020. The Trump administration would then return to its "maximum pressure" campaign and the probability of military strikes would rise. However, we put a low probability on such a breakdown occurring and would argue that the grave implications should be seen as a strong constraint driving the different parties to cut a deal. Assuming diplomacy succeeds, it should provide a small tailwind for South Korea's currency and risk assets, which at the moment face a negative environment due to slowing global growth, Chinese reforms, and a strengthening U.S. dollar. First, the end-game itself - Korean unification - is implicitly a positive for removing the risk and uncertainty of conflict and increasing Korea's potential GDP. Germany's unification remains the best analogy, for better or worse. German unification led to a brief decline in total factor productivity, but also a multi-year rally in equities, the deutschmark, and a bullish curve-steepening relative to world markets (Chart 26A). Chart 26AGermany Benefited From Reunification... Germany Benefited From Reunification... Germany Benefited From Reunification... Chart 26B...South Korea Is Not There Yet ...South Korea Is Not There Yet ...South Korea Is Not There Yet South Korea is not yet at the cusp of unification, so the analogy with German assets is premature, but it is not a foregone conclusion that South Korea will suffer as it embarks on the path toward unification. Of course, this year's diplomatic progress has coincided with renewed EM financial turmoil that has clouded any benefits from improved North-South relations (Chart 26 B). Moreover, the burden of unification will be immense given that North Korea is much larger and poorer relative to the South than East Germany was to West Germany, and markets will have to price in this burden by expecting larger South Korean budget deficits in future. Still, we would expect KRW/USD to benefit on the margin, especially given Korea's simultaneous promise to the Trump administration not to engage in competitive devaluation. Second, certain Korean sectors are poised to benefit from integration with the North. Looking at how the different sectors have performed before and after the April 27 inter-Korean summit, relative to their EM counterparts, reveals that industrials, energy, consumer staples, and telecoms are the relative winners (Chart 27).29 Chart 27Winners And Losers Of Inter-Korean Engagement Winners And Losers Of Inter-Korean Engagement Winners And Losers Of Inter-Korean Engagement Chart 28AReal Estate Near The DMZ... Real Estate Near The DMZ... Real Estate Near The DMZ... Chart 28B...Is Optimistic Once Again ...Is Optimistic Once Again ...Is Optimistic Once Again Third, the signal from real estate along the DMZ is loud and clear. Paju is known as the best proxy for improved Korean relations and transaction volumes have spiked since Moon and Kim met on April 27 and declared an end to the Korean War. The move is particularly notable when contrasted with the rest of Gyeonggi province, which is not inherently a "unification" play (Chart 28A & 28B). Similar moves happened in Paju real estate around the time of the first and second inter-Korean summits in 2000 and 2007, but as this report has shown, there is more reason to be optimistic today. This example speaks to the many opportunities for specialized funds to generate returns as development projects get underway. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Special Report, "The South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 4 Mattis criticized China's militarization of the South China Sea rocks at the annual Shangri-La Dialogue, accusing Chinese President Xi Jinping of violating his word on this matter. He also criticized China's Belt and Road Initiative. The same week, Marine Corps Lt. Gen. Kenneth McKenzie told a reporter that "the United States military has had a lot of experience in the Western Pacific, taking down small islands," in a thinly veiled hint to China's South China Sea activity. Finally, a report surfaced suggesting that the U.S. is considering sending a warship through the Taiwan Strait. Please see Ben Westcott, "US plans 'steady drumbeat' of exercises in South China Sea: Mattis," CNN, May 31, 2018, available at www.cnn.com; Laignee Barron, "Pentagon Official Says U.S. Can 'Take Down' Man-Made Islands Like Those in the South China Sea," Time, June 1, 2018, available at time.com; "Exclusive: At delicate moment, U.S. weighs warship passage through Taiwan Strait," Reuters, June 4, 2018, available at www.reuters.com. 5 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan," dated March 30, 2018, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Vladimir Putin, Act IV," dated March 7, 2018, available at gps.bcaresearch.com. 11 Satellite imagery reveals that international sanctions have hindered manufacturing development and increased reliance on trade with China. Please see Yong Suk Lee, "International Isolation and Regional Inequality: Evidence from Sanctions on North Korea," Stanford University, Center on Global Poverty and Development, Working Paper 575 (October 2016), available at globalpoverty.stanford.edu. 12 North Korea's disagreements with China have given rise to a host of academic articles and studies in recent years. For an overview please see Philip Wen and Christian Shepherd, " 'Lips and teeth' no more as China's ties with North Korea fray," Reuters, September 8, 2017, available at www.reuters.com. See also Sebastian Harnisch, "The life and near-death of an alliance: China, North Korea and autocratic military cooperation," Heidelberg University, WISC Conference, Taipei, April 2017; and Weiqi Zhang, "Neither friend nor big brother: China's role in North Korean foreign policy strategy," Palgrave Communications 4:16 (2018), available at www.nature.com. 13 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 14 The term is a pun on the original "Sunshine" engagement policy of Moon's predecessors Kim Dae-jung and Roh Moo-hyun. President Kim's engagement attempt culminated in the first Inter-Korean summit in 2000, but was ultimately derailed by a hawkish turn in U.S. and North Korean policies and the inclusion of North Korea among the "Axis of Evil" following the 9/11 attacks. "Sunshine policy" revived again under President Roh Moo-hyun, leading to the second Inter-Korean summit in 2007. Roh's protégé, Moon, is now reviving the policy. Unfortunately, "moonshine" is saddled with the connotation of fraud and/or poison! 15 The major challenge to his rule came in late 2013 but he nipped it in the bud by executing his uncle Jang Song Taek and purging Jang's faction. He had his half-brother Kim Jong Nam assassinated in Malaysia in 2017. He promoted his sister, Kim Yeo-jong, to deputy chief of the Propaganda Department in the Korean Worker's Party. Kim has taken steps to empower the State Affairs Commission (cabinet), the Korean Worker's Party, and the legislature, the Supreme People's Assembly, vis-à-vis the long-dominant military. He has also reshuffled the military extensively, prior to a significant reshuffle this week that signaled a willingness to compromise with the Americans. See Thomas Fingar et al, "Analyzing The Structure And Performance Of Kim Jong-un's Regime," Shorenstein Asia-Pacific Research Center, Stanford University, June 2017, available at fsi.stanford.edu; and Hyonhee Shin, "North Korea's Three New Military Leaders Are Loyal To Kim, Not Policies," Reuters, June 4, 2018, available at reuters.com. 16 William Brown, "Is 'Byungjin' Working? A Look at North Korea's Money," The Peninsula, Korea Economic Institute of America, September 7, 2016, available at keia.org. 17 Please see Andrei Lankov, "The Resurgence of a Market Economy in North Korea," Carnegie Endowment for International Peace, January 2016, available at carnegieendowment.org; Sunchul Choi and Mark A. Myers, "Marketization in North Korea," United States Department of Agriculture, Global Agricultural Information Network Report KS1545, December 9, 2015, available at www.fas.usda.gov. 18 This diplomacy also reinforces Kim's reformist bent. In April 2017 he appointed Ri Su-yong, a close ally, to oversee foreign relations, and resurrected the Foreign Relations Committee within the country's legislature, the Supreme People's Assembly. See Fingar in footnote 15. 19 Please see footnote 6 above. 20 Please see BCA Geopolitical Strategy Special Report, "Trump Re-Establishes America's 'Credible Threat'," dated April 7, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 22 Presidents Moon and Xi agreed to improve bilateral relations, with China removing economic sanctions, on the basis of South Korea promising the "Three No's" - no additional THAAD deployments, no expansion of U.S. missile defense, and no trilateral military alliance with Japan and the U.S. Please see Park Byong-su, "South Korea's "three no's" announcement key to restoring relations with China," Hankyoreh, dated November 2, 2017, available at english.hani.co.kr. 23 Indeed, Russia shares China's desire to prevent North Korea from provoking the U.S. into a greater Pacific military presence, while Japan shares the American desire to reduce the North Korean nuclear and military threat to its homeland. 24 North Korea publicly aired misgivings about the upcoming Trump-Kim summit after the new National Security Adviser, John Bolton, implied that the administration would seek "the Libya model" (unilateral and total nuclear disarmament and dismantlement by North Korea) in its negotiations. North Korea criticized Bolton, a war-hawk who has a negative history with North Korea going back to the George W. Bush administration, putting the summit in jeopardy. The North was also angry about the U.S. and South Korean decision to proceed with annual military exercises ahead of the summit. Further, Chinese President Xi Jinping may have urged Kim Jong Un to tread more carefully, or cancel the summit, during a second meeting between these two presidents in early May. The White House rebuked Bolton's comments, saying the negotiations would follow "the Trump model." 25 Please see Christopher Woolf, "The only effective arms against North Korea's missile bunkers are nuclear weapons, says a top war planner," Public Radio International, August 10, 2017, available at www.pri.org; and Uri Friedman, "North Korea: The Military Options," The Atlantic, dated May 17, 2017, available at www.theatlantic.om. 26 Iraq set a precedent for U.S. preemptive invasion; Syria was a fellow nuclear aspirant and member of the Axis of Evil that suffered both Israeli strikes against its nuclear facilities and economic and political collapse due to mismanagement and international isolation; Ukraine gave up its Soviet nuclear weapons in 1994 with the Budapest Memorandum as a guarantee of its security only to suffer Russian invasion in 2014; and "Zero Dark Thirty" refers to the U.S. Seal Team Six covert raid into the heart of Pakistan to capture or kill Osama Bin Laden. 27 Our own analysis of the "bloody nose" military strike option, which is more likely than a full-blown war but very difficult to prevent from escalating, can be found in BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "A Long View Of China," dated December 28, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Special Report, "South Korea: A Comeback For Consumer Stocks?" June 28, 2017, available at gps.bcaresearch.com.

Highlights Investors are underestimating the risks of U.S.-Iran tensions; The Obama administration's 2015 deal resulted in Iran curbing aggressive regional behavior that threatened global oil supply; The U.S. negotiating position vis-à-vis Iran has not improved; Unlike North Korea, Iran can retaliate against the Trump administration's "Maximum Pressure" doctrine - particularly in Iraq; U.S.-Iran conflicts will negatively affect global oil supply, critical geographies, and sectarian tensions - hence a geopolitical risk premium is warranted. Our Commodity & Energy Strategy (CES) desk is using a new ensemble forecast, which takes its 2H18 Brent forecast to $76/bbl from an average $78/bbl, and WTI to $70/bbl from $72/bbl. For next year, CES's Brent forecast goes to $73/bbl from $80/bbl, and WTI goes to $67/bbl from $72/bbl. CES expects higher volatility, as well. Feature Following the roll-out of our oil-price ensemble model last week, we are publishing a Special Report written by our colleague Marko Papic, who runs BCA's Geopolitical Strategy (GPS) service. This report explores the more nuanced aspects of the U.S. - Iran sanctions conflict, and why the contest for Iraq is important for investors. We also summarize our latest forecast. We trust you will find this analysis informative, Robert P. Ryan, Chief Commodity Strategist Commodity & Energy Strategy Tensions between the U.S. and Iran snuck up on the markets (Chart 1), even though President Trump's policy agenda was well telegraphed via rhetoric, action, and White House personnel moves.1 Still, investors doubt the market relevance of the U.S. withdrawal from the Joint Comprehensive Plan of Action (JCPOA), the international agreement between Iran and the P5+1.2 Chart 1Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Several reasons to fade the risks - and hence to fade any implications for global oil supply - have become conventional wisdom. These include the alleged ability of OPEC and Russia to boost production and Washington's supposed ineffectiveness without an internationally binding sanction regime. Chart 2BCA's Updated Ensemble Forecast:##BR##Brent Averages /bbl in 2H18 BCA's Updated Ensemble Forecast: Brent Averages $76/bbl in 2H18 BCA's Updated Ensemble Forecast: Brent Averages $76/bbl in 2H18 Our view is that investors and markets are underestimating the geopolitical, economic, and financial relevance of the U.S.-Iran tensions. First, the ideological rhetoric surrounding the original U.S.-Iran détente tends to be devoid of strategic analysis. Second, Iran's hard power capabilities are underestimated. Third, OPEC 2.0's ability to tap into its spare capacity is overestimated.3 CES's updated ensemble forecast takes its 2H18 Brent forecast to $76/bbl from an average $78/bbl previously, and its WTI forecast to $70/bbl from $72/bbl (Chart 2). For next year, CES's Brent forecast goes to $73/bbl from $80/bbl, and its WTI expectation goes to $67/bbl from $72/bbl. CES expects higher volatility, as well, as markets continue to process sometimes-conflicting news flows. This means spike to and through $80/bbl for Brent are more likely than markets currently anticipate. Why Did The U.S.-Iran Détente Emerge In 2015? Both detractors and defenders of the 2015 nuclear deal often misunderstand the logic of the deal. First, the defenders are wrong when they claim that the deal creates a robust mechanism that ensures that Iran will never produce a nuclear device. Given that the most critical components of the deal expire in 10 or 15 years, it is simply false to assert that the deal is a permanent solution. More importantly, Iran already reached "breakout capacity" in mid-2013, which means that it had already achieved the necessary know-how to become a nuclear power.4 We know because we wrote about it at the time, using the data of Iran's cumulative production of enriched uranium provided to the International Atomic Energy Agency (IAEA).5 In August 2013, Iran's stockpile of 20% enriched uranium, produced at the impregnable Fordow facility, reached 200kg (Chart 3). Chart 3Iran's Negotiating Leverage Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict At that point, Israeli threats of attacking Iran became vacuous, as the Israeli air force lacked the necessary bunker-busting technology to penetrate Fordow.6 As we wrote in 2013, this critical moment gave Tehran the confidence to give up "some material/physical components of its nuclear program as it has developed the human capital necessary to achieve nuclear status."7 The JCPOA forced Iran to stop enriching uranium at the Fordow facility altogether and to give up its stockpile of uranium enriched at 20%. However, Iran only agreed to the deal because it had reached a level of technological know-how that has not been eliminated by mothballing centrifuges and "converting" facilities to civilian nuclear research. Iran is a nuclear power in all but name. Second, the detractors of the JCPOA are incorrect when they claim that Iran did not give up any regional hegemony when it signed the deal. This criticism focuses on Iran's expanded role in the Syrian Civil War since 2011, as well as its traditional patronage networks with the Lebanese Shia militants Hezbollah and with Yemen's Houthis. However, critics ignore several other, far more critical, fronts of Iranian influence: Strait of Hormuz: In 2012, Iran's nearly daily threats to close the Strait of Hormuz were very much a clear and present danger for global investors (Map 1). Although we argued in 2012 that Iran's capability was limited to a 10-day closure, followed by another month during which they could threaten the safe passage of vessels through the Strait, even such a short crisis would add a considerable risk premium to oil markets given that it would remove about 17-18 million bbl/day from global oil supply (Chart 4).8 Since 2012, Iran's capabilities to threaten the Strait have grown, while the West's anti-mine capabilities have largely stayed the same.9 Map 1Saudi Arabia's Eastern Province Is A Crucial Piece Of Real Estate Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict Chart 4Geopolitical Crises And Global Peak Supply Losses Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq: The key geographic buffer between Saudi Arabia and Iran is Iraq (Map 2). Iran filled the power vacuum created by the U.S. invasion almost immediately after Saddam Hussein's overthrow. It deployed members of the infamous Quds Force of the Iranian Revolutionary Guard Corps (IRGC) into Iraq to support the initial anti-American insurgency. Iran's support for Prime Minister Nouri al-Maliki was critical following the American withdrawal in 2011, particularly as his government became increasingly focused on anti-Sunni insurgency. Map 2Iraq: A Buffer Between Saudi Arabia And Iran Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict Bahrain: Home of the U.S. Fifth Fleet, Bahrain experienced social unrest in 2011. The majority of Bahrain's population are Shia, while the country is ruled by the Saudi-aligned, Sunni, Al Khalifa monarchy. The majority of Shia protests were at least rhetorically, and some reports suggest materially, supported by Iran. To quell the protests, and preempt any potential Iranian interference, Saudi Arabia intervened militarily with a Gulf Cooperation Council (GCC) Peninsula Shield Force. Eastern Province: Similar to the unrest in Bahrain, Shia protests engulfed Saudi Arabia's Eastern Province in 2011. The province is highly strategic, as it is where nearly all of Saudi oil production, processing, and transportation facilities are located (Map 1). Like Bahrain, it has a large Shia population. Saudi security forces cracked down on the uprising and have continued to do so, with paramilitary operations lasting into 2017. While Iranian involvement in the protests is unproven, it has been suspected. Anti-Israel Rhetoric: Under President Mahmoud Ahmadinejad, Iran threatened Israel with destruction on a regular basis. While these were mostly rhetorical attacks, the implication of the threat was that any attack against Iran and its nuclear facilities would result in retaliation against U.S. interests in the Persian Gulf and Iraq and direct military action against Israel. Both defenders and detractors of the JCPOA are therefore mistaken. The JCPOA does not impact Iran's ability to achieve "breakout capacity" given that it already reached it in mid-2013. And Iran's regional influence has not expanded since the deal was signed in 2015. In fact, since the détente in 2015, and in some cases since negotiations between the Obama administration and Tehran began in 2013, Iran has been a factor of stability in the Middle East. Specifically, Iran has willingly: Stopped threatening the Strait of Hormuz (the last overt threats to close the Strait of Hormuz were made in 2012); Acquiesced to Nouri al-Maliki's ousting as Prime Minister of Iraq in 2014 and his replacement by the far more moderate and less sectarian Haider al-Abadi; Stopped meddling in Bahraini and Saudi internal affairs; Stopped threatening Israel's existence (although its material support for Hezbollah clearly continues and presents a threat to Israel's security); Participated in joint military operations with the U.S. military against the Islamic State, cooperation without which Baghdad would have most likely fallen to the Sunni radicals in late 2014. The final point is worth expanding on. After the fall of Mosul - Iraq's second largest city - to the Islamic State in May 2014, Iranian troops and military advisors on the ground in Iraq cooperated with the U.S. air force to arrest and ultimately reverse the gains by the radical Sunni terrorist group. Without direct Iranian military cooperation - and without Tehran's material and logistical support for the Iraqi Shia militias - the Islamic State could not have been eradicated from Iraq (Map 3). Map 3The Collapse Of A Would-Be Caliphate Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict How did such a dramatic change in Tehran's foreign policy emerge between 2012 and 2015? Iranian leadership realized in 2012 that the U.S. military and economic threats against it were real. Internationally coordinated sanctions had a damaging effect on the economy, threatening to destabilize a regime that had experienced social upheaval in the 2009 Green Revolution (Chart 5). It therefore began negotiations almost immediately after the imposition of stringent economic sanctions in early and mid-2012.10 Chart 5Iran's Sanctions Had A Hard Bite Iran's Sanctions Had A Hard Bite Iran's Sanctions Had A Hard Bite To facilitate the negotiations, the Guardian Council of Iran disqualified President Ahmadinejad's preferred candidate for the 2013 Iranian presidential elections, while allowing Hassan Rouhani's candidacy.11 Rouhani, a moderate, won the June 2013 election in a landslide win, giving him a strong political mandate to continue the negotiations and, relatedly, to pursue economic development. Many commentators forget, however, that Supreme Leader Ayatollah Sayyid Ali Hosseini Khamenei allowed Rouhani to run in the first place, knowing full well that he would likely win. In other words, Rouhani's victory revealed the preferences of the Iranian regime to negotiate and adjust its foreign policy. Bottom Line: The 2015 U.S.-Iran détente traded American acquiescence in Iranian nuclear development - frozen at the point of "breakout capacity" - in exchange for Iran's cooperation on a number of strategically vital regional issues. As such, focusing on just the JCPOA, without considering the totality of Iranian behavior before and since the deal, is a mistake. Iran curbed its influence in several regional hot spots - almost all of which are critical to global oil supply. The Obama administration essentially agreed to Iran becoming a de facto nuclear power in exchange for Iran backing away from aggressive regional behavior. This included Iran's jeopardizing the safe passage of oil through the Strait of Hormuz either by directly threatening to close the channel or through covert actions in Bahrain and the Eastern Province. The U.S. also drove Iran to accept a far less sectarian Iraq, by forcing out the ardently pro-Tehran al-Maliki and replacing him with a prime minister far more acceptable to Saudi Arabia and Iraqi Sunnis. Why Did The U.S. Chose Diplomacy In 2011? The alternative to the above deal was some sort of military action against Iranian nuclear facilities. The U.S. contemplated such action in late 2011. Two options existed, either striking Iran's facilities with its own military or allowing Israel to do it themselves. One reason to choose diplomacy and economic sanctions over war was the limited capability of Israel to attack Iran alone.13 Israel does not possess strategic bombing capability. As such, it would have required a massive air flotilla of bomber-fighters to get to the Iranian nuclear facilities. While the Israeli air force has the capability to reach Iranian facilities and bomb them, their effectiveness is dubious and the ability to counter Iranian retaliatory capacity with follow-up strikes is non-existent. Chart 6Great Power Competition Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict The second was the fact that a U.S. strike against Iran would be exceedingly complex. Compared to previous Israeli strikes against nuclear facilities in Iraq (Operation Opera 1981) and Syria (Operation Outside The Box 2007), Iran presented a much more challenging target. Its superior surface-to-air missile capability would necessitate a prolonged, and dangerous, suppression of enemy air defense (SEAD) mission. In parallel, the U.S. would have to preemptively strike Iran's ballistic missile launching pads as well as its entire navy, so as to obviate Iran's ability to retaliate against international shipping or the U.S. and its allies in the region. The U.S. also had a strategic reason to avoid entangling itself in yet another military campaign in the Middle East. The public was war-weary and the Obama administration gauged that in a world where global adversaries like China and Russia were growing in geopolitical power, avoiding another major military confrontation in a region of decreasing value to U.S. interests (thanks partly to growing U.S. shale oil production) was of paramount importance (Chart 6). Notable in 2011 was growing Chinese assertiveness throughout East Asia (please see the Appendix on page 24). Particularly alarming was the willingness of Beijing to assert dubious claims to atolls and isles in the South China Sea, a globally vital piece of real estate (Diagram 1). There was a belief - which has at best only partially materialized - that if the United States divested itself of the Middle East, then it could focus more intently on countering China's challenge to traditional U.S. dominance in East Asia and the Pacific. Diagram 1South China Sea As Traffic Roundabout Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict Bottom Line: The Obama administration therefore chose a policy of military posturing toward Iran to establish a credible threat. The military option was signaled in order to get the international community - both allies and adversaries - on board with tough economic sanctions. The ultimate deal, the JCPOA, did not give the U.S. and its allies everything they wanted precisely because they did not enter the negotiations from a position of preponderance of power. Critics of the JCPOA ignore this reality and assume that going back to the status quo ante bellum will somehow improve the U.S. negotiating position. It won't. What Happens If The U.S.-Iran Détente Ends? The Trump administration is serious about applying its Maximum Pressure tactics on Iran. Buoyed by the successful application of this strategy in North Korea, the White House believes that it can get a better deal with Tehran. We do not necessarily disagree. It is indeed true that the U.S. is a far more powerful country than Iran, with a far more powerful military. On a long enough timeline, with enough pressure, it ought to be able to force Tehran to concede, assuming that credible threats are used.14 Unlike the Obama administration, the Trump administration will presumably rely on Israel far less, and on its own military capability a lot more, to deliver those threats, which should be more effective. The problem is that the timeline on which such a strategy would work is likely to be a lot longer with Iran than with North Korea. This is because Iran's retaliatory capabilities are far greater than the one-trick-pony Pyongyang, which could effectively only launch ballistic missiles and threaten all-out war with U.S. and its regional allies.15 While those threats are indeed worrisome, they are also vacuous as they would lead to a total war in which the North Korean regime would meet its demise. Iran has a far more effective array of potential retaliation that can serve a strategic purpose without leading to total war. As we listed above, it could rhetorically threaten the Strait of Hormuz or attempt to incite further unrest in Bahrain and Saudi Arabia's Eastern Province. The key retaliation could be to take the war to Iraq. The just-concluded election in Iraq appears to have favored Shia political forces not allied to Iran, including the Alliance Towards Reform (Saairun) led by the infamous cleric, Muqtada al-Sadr (Chart 7). Surrounding this election, various Iranian policymakers and military leaders have said that they would not allow Iraq to drift outside of Iran's sphere of influence, a warning to the nationalist Sadr who has fought against both the American and Iranian military presence in his country. Iraq is not only a strategic buffer between Saudi Arabia and Iran, the two regional rivals, but also a critical source of global oil supply, having brought online about half as much new supply as U.S. shale since 2011 (Chart 8). If Iranian-allied Shia factions engage in an armed confrontation with nationalist Shias allied with Muqtada al-Sadr, such a conflict will not play out in irrelevant desert governorates, as the fight against the Islamic State did. Chart 7Iraqi Elections Favored Shiites But Not Iran Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict Chart 8Iraq Critical To Global Oil Supply Iraq Critical To Global Oil Supply Iraq Critical To Global Oil Supply Instead, a Shia-on-Shia conflict would play out precisely in regions with oil production and transportation facilities. In 2008, for example, Iranian-allied Prime Minister Nouri al-Maliki fought a brief civil war against Sadr's Mahdi Army in what came to be known as the "Battle of Basra." While Iran had originally supported Sadr in his insurgency against the U.S., it came to Maliki's support in that brief but deadly six-day conflict. Basra is Iraq's chief port through which much of the country's oil exports flow. Iraq may therefore become a critical battleground as Iran retaliates against U.S. Maximum Pressure. From Iran's perspective, holding onto influence in Iraq is critical. It is the transit route through which Iran has established an over-land connection with its allies in Syria and Lebanon (Map 4). Threatening Iraqi oil exports, or even causing some of the supply to come off-line, would also be a convenient way to reduce the financial costs of the sanctions. A 500,000 b/d loss of exports - at an average price of $70 per barrel (as Brent has averaged in 2018) - could roughly be compensated by an increase in oil prices by $10 per barrel, given Iran's total exports. As such, Iran, faced with lost supply due to sanctions, will have an incentive to make sure that prices go up (i.e., that rivals do not simply replace Iranian supply, keeping prices more or less level). The easiest way to accomplish this, to add a geopolitical risk premium to oil prices, is through the meddling in Iraqi affairs. Map 4Iran Needs Iraq To Project Power Through The Levant Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict It is too early to forecast with a high degree of confidence precisely how the U.S.-Iran confrontation will develop. However, Diagram 2 offers our take on the path towards retaliation. Diagram 2Iran-U.S. Tensions Decision Tree Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict The critical U.S. sanctions against Iran will become effective on November 4 (Box 1). We believe that the Trump administration is serious and that it will force European allies, as well as South Korea and Japan, to cease imports of oil from Iran. China will be much harder to cajole. Box 1: Iranian Sanction Timeline President Trump issued a National Security Presidential Memorandum to re-impose all U.S. sanctions lifted or waived in connection with the JCPOA. The Office of Foreign Assets Control expects all sanctions lifted under the JCPOA to be re-imposed and in full effect after November 4, 2018. However, there are two schedules by which sanctions will be re-imposed, a 90-day and 180-day wind-down periods.1 Sanctions Re-Imposed After August 6, 2018 The first batch of sanctions that will be re-imposed will come into effect 90 days after the announced withdrawal from the JCPOA. These include: Sanctions on direct or indirect sale, supply, or transfer to or from Iran of several commodities (including gold), semi-finished metals, and industrial process software; Sanctions on the purchase or acquisition of U.S. dollar banknotes by the government of Iran; Sanctions on trade in Iranian currency and facilitation of the issuance of Iranian sovereign debt; Sanctions on Iran's automotive sector; Sanctions on export or re-export to Iran of commercial passenger aircraft and related parts. Sanctions Re-Imposed After November 4, 2018 The second batch of sanctions will come into effect 180 days after the announced Trump administration JCPOA withdrawal decision. These include: Sanctions on Iranian port operators, shipping, and shipbuilding activities; Sanctions against petroleum-related transactions with the National Iranian Oil Company (NIOC), Naftiran Intertrade Company (NICO), and National Iranian Tanker Company (NITC); Sanctions against the purchase of petroleum, petroleum products, or petrochemical products from Iran; Sanctions on transactions and provision of financial messaging services by foreign financial institutions with the Central Bank of Iran; Sanctions on Iran's energy sector; Sanctions on the provision of insurance, reinsurance, and underwriting services. 1a Please see the U.S. Treasury Department, "Frequently Asked Questions Regarding the Re-Imposition of Sanctions Pursuant to the May 8, 2018, National Security Presidential Memorandum Relating to the Joint Comprehensive Plan of Action (JCPOA)," dated May 8, 2018, available at www.treasury.gov. By Q1 2019, the impact on Iranian oil exports will be clear. We suspect that Iran will, at that point, have the choice of either relenting to Trump's Maximum Pressure, or escalating tensions through retaliation. We give the latter a much higher degree of confidence and suspect that a cycle of retaliation and Maximum Pressure would lead to a conditional probability of war between Iran and the U.S. of around 20%. This is a significant number, and it is critical if President Trump wants to apply credible threats of war to Iran. Bottom Line: Unlike North Korea, Iran has several levers it can use to retaliate against U.S. Maximum Pressure. Iran agreed to set these levers aside as negotiations with the Obama administration progressed, and it has kept them aside since the conclusion of the JCPOA. It is therefore easy for Tehran to resurrect them against the Trump administration. Critical among these levers is meddling in Iraq's internal affairs. Not only is Iraq critical to Iran's regional influence; it is also key to global oil supply. We suspect that a cycle of Iranian retaliation and American Maximum Pressure raises the probability of U.S.-Iran military confrontation to 20%. We will be looking at several key factors in assessing whether the U.S. and Iran are heading towards a confrontation. To that end, we have compiled a U.S.-Iran confrontation checklist (Table 1). Table 1Will The U.S. Attack Iran? Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict Investment Implications Over the past several years, there have been many geopolitical crises in the Middle East. We have tended to fade most of them, from a perspective of a geopolitical risk premium applied to oil prices. This is because we always seek the second derivative of any geopolitical event. In the context of the Middle East, by "second derivative" we mean that we are interested in whether the market impact of a new piece of information - of a new geopolitical event - will amount to more than just a random perturbation with ephemeral, decaying, market implications. To determine the potential of new information to catalyze a persistent market risk premium or discount, we investigate whether it changes the way things change in a given region or context. In 2015, we identified three factors that we believe are critical for a geopolitical event in the Middle East to have such second derivative implications, and thus global market implications.16 These are: Oil supply: The event should impact current global oil supply either directly or through a clear channel of contagion. Renewed sanctions against Iran do so directly. So would Iranian retaliation in Iraq or the Persian Gulf. Geography: The event should occur in a geography that is of existential significance to one of the regional or global players. Re-imposed sanctions obviously directly impact Iran as they could increase domestic political crisis. A potential Iranian proxy-war in Iraq would be highly relevant to Saudi Arabia, which considers Iraq as a vital buffer with Iran. Sectarian contagion: The event should exacerbate sectarian conflict - Sunni vs. Shia - which is more likely to lead contagion than tribal conflict such as the Libyan Civil War. A renewed U.S.-Iran tensions check all of our factors. The risk is therefore real and should be priced by the market through a geopolitical risk premium. In addition, Iranian sanctions could tighten up the outlook for oil markets in 2019 by 400,000-600,000 b/d, reversing most of the production gains that Iran has made since 2016 (Chart 9). This is a problem given that the enormous oversupply of crude oil and oil products held in inventories has already been significantly cut. BCA's Commodity & Energy Strategy and Energy Sector Strategy teams believe that global petroleum inventories will be further reduced in 2019 (Chart 10). Chart 9Current And Future Iran##BR##Production Is At Risk Current And Future Iran Production Is At Risk Current And Future Iran Production Is At Risk Chart 10Tighter Markets And Lower Inventories,##BR##Keep Forward Curves Backwardated Tighter Markets And Lower Inventories, Keep Forward Curves Backwardated Tighter Markets And Lower Inventories, Keep Forward Curves Backwardated What about the hints from the OPEC 2.0 alliance that they would surge production in light of supply loss from Iran? Oil prices fell on the belief OPEC 2.0 could easily restore 1.8 MMb/d of production that they agreed to hold off the market since early 2017. Our commodity strategists have always considered the full number to be an illusion that consists of 1.2 MMb/d of voluntary cuts and around 500,000 b/d of natural production declines that were counted as "cuts" so that the cartel could project an image of greater collaboration than it actually achieved (Chart 11). In fact, some of the lesser "contributors" to the OPEC cut pledged to lower 2017 production by ~400,000 b/d, but are facing 2018 production levels that are projected to be ~700,000 b/d below their 2016 reference levels, and 2019 production levels are estimated to decline by another 200,000 b/d (Chart 12). Furthermore, renewed Iran-U.S. tensions may only be the second-most investment-relevant geopolitical risk for oil markets. Our commodity team expects Venezuelan production to fall to 1.2 MMb/d by the end of 2018 and to 1 MMb/d by the end of 2019, but these production levels could turn out to be optimistic (Chart 13). Chart 11Primary OPEC 2.0 Members Are Producing##BR##1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Chart 12Secondary##BR##OPEC 2.0 Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Chart 13Venezuela Is##BR##A Bigger Risk Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk 2H18, 2019 Oil Forecasts BCA's Commodity & Energy Strategy updated its forecast last week, after the leaders of OPEC 2.0 indicated member states would be considering putting as much as 1mm b/d back on the market, following the price run-up accurately called from the beginning of this year. KSA and Russian are not being explicit about what they intend to do. In the background are the U.S.'s renewed Iran sanctions discussed above, which could remove ~ 500k b/d from the export markets by the end of 1H19, and the increasingly likely collapse of Venezuela's exports, which could remove ~ 1mm b/d. Against this, we have production in the U.S. shales increasing this year and next by ~ 1.3 - 1.4mm b/d to offset these potential losses, but even there we're seeing problems getting the shale oil out of the U.S.17 That's why CES went to an ensemble forecast, and will keep it in place as the market continues to process these conflicting signals (Chart 14). While some production will be restored to the market this year, it will be a drawn-out process, given CES's view OPEC 2.0 does not want to undo the hard work it took to drain OECD oil inventories (Chart 15). CES's Brent forecast was lowered $2/bbl in 2H18 and $7/bbl in 2019 to $76/bbl and to $73/bbl, respectively. CES's WTI forecast for 2H18 also was lowered $2/bbl to $70/bbl, while our 2019 forecast is now at $67/bbl, down $5/bbl vs. our previous forecast. Chart 14Factors In BCA's Ensemble Forecast Factors In BCA's Ensemble Forecast Factors In BCA's Ensemble Forecast Chart 15Balances Will Loosen If Supply Increases Balances Will Loosen If Supply Increases Balances Will Loosen If Supply Increases CES continues to expect continued strength on the demand side, with global oil consumption growing 1.7mm b/d. This will be driven by steady income growth in EM economies. One of the principal gauges CES uses to assess EM demand - import volumes - continues to move higher on a year-on-year basis, signaling incomes continue to expand (Chart 16). EM growth accounts for 1.3 of the 1.7mm b/d of growth we're expecting in 2018 and 2019. In forthcoming research, CES will be looking more deeply into the evolution of demand and the threat - if any - higher prices pose for EM growth. As was noted in last week's CES publication,17 consumers in many states no longer are shielded from high oil prices, as they were in the past: Governments around the world used the collapse in prices beginning in 2014 to remove/reduce fuel subsidies. This changes the dynamics of EM oil demand considerably, even if governments feel compelled to step into markets and order suppliers to not pass through the entire price increase. OPEC 2.0's leaders - KSA and Russia - appear united in their view of what is required to keep oil markets balanced over the long haul, so as not to disincentivize consumers from purchasing cars and trucks and the motor fuel required to run them. But over the short term, their goals differ. KSA is looking to IPO Saudi Aramco - next year, according to the latest reports - and this sale would most definitely benefit from higher prices. Indeed, KSA's oil minister Khalid al-Falih appeared to be comfortable with prices pushing toward $80/bbl recently. Russia's energy minister, Alexander Novak, has said in the past he favors an oil price somewhere between $50 and $60/bbl. CES continues to believe the dominant price risks remain on the upside - at 28.31% and 12.12%, markets continue to underestimate the probability Brent prices will trade above $80 and $90/bbl this year and next (Chart 17). Chart 16Strong EM Commodity Demand Expected,##BR##As Incomes And Imports Continue To Grow Strong EM Commodity Demand Expected, As Incomes And Imports Continue To Grow Strong EM Commodity Demand Expected, As Incomes And Imports Continue To Grow Chart 17Oil Markets Continue To Underestimate##BR##Upside Price Risks In 2H18 And 2019 Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict Bottom Line: A renewal of U.S. - Iran tensions throws up real risks that are not being fully priced by the oil markets at present. They raise the probability global oil supplies out of the Middle East will be directly threatened, and that tensions in Iran and Iraq will flare into proxy wars. Such an outcome would be highly relevant to Saudi Arabia, which considers Iraq as a vital buffer with Iran. Lastly, rising tensions could exacerbate sectarian conflict in the Middle East as a whole, particularly along the Sunni - Shia divide, which is more likely to lead contagion than tribal conflict such as the Libyan Civil War. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 2 The JCPOA was concluded in Vienna on July 14, 2015 between Iran and the five permanent members of the United Nations Security Council (China, France, Russia, the United Kingdom, and the United States), plus Germany (the "+1" of the P5+1). 3 BCA's Senior Commodity & Energy Strategist Robert P. Ryan has given the name "OPEC 2.0" to the Saudi-Russian alliance that is focused on regaining a modicum of control over the rate at which U.S. shale-oil resources are developed. Please see BCA Commodity & Energy Strategy Weekly Report, "KSA's, Russia's End Game: Contain U.S. Shale Oil," dated March 30, 2017; and "The Game's Afoot In Oil, But Which One?" dated April 6, 2017, available at ces.bcaresearch.com. 4 "Breakout" nuclear capacity is defined here as having enough uranium enriched at lower levels, such as at 20%, to produce sufficient quantities of highly-enriched uranium (HEU) required for a nuclear device. The often-reported amount of 20% enriched uranium required for breakout capacity is 200kg. However, the actual amount of uranium required depends on the number of centrifuges being employed and their efficiency. In our 2013 report, we gauged that Iran could produce enough HEU within 4-5 weeks at the Fordow facility to develop a weapon, which means that it had effectively reached "breakout capacity." 5 Please see International Atomic Energy Agency, "Implementation Of The NPT Safeguards Agreement And Relevant Provisions Of Security Council Resolutions In The Islamic Republic Of Iran," IAEA Board Report, dated August 28, 2013, available at www.iaea.org. 6 Although, in a move designed to increase pressure on Iran and its main trade partners, the Obama administration sold Israel the GBU-28 bunker-busting ordinance. That specific ordinance is very powerful, but still not capable enough to penetrate Fordow. 7 Please see BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift," dated November 13, 2013, available at gps.bcaresearch.com. 8 Please see BCA Special Report, "Crisis In The Persian Gulf: Investment Implications," dated March 1, 2012, available at gps.bcaresearch.com. 9 There are four U.S. Navy Avenger-class minesweepers based in Bahrain as part of the joint U.S.-U.K. TF-52. This number has been the same since 2012, when they were deployed to the region. 10 Particularly crippling for Iran's economy was the EU oil embargo imposed in January 2012, effective from July of that year, and the banning of Iranian financial institutions from participating in the SWIFT system in March 2012. 11 The Guardian Council of the Constitution is a 12-member, unelected body wielding considerable power in Iran. It has consistently disqualified reformist candidates from running in elections, which makes its approval of Rouhani's candidacy all the more significant. 12 Please see BCA Geopolitical Strategy Special Report, "Reality Check: Israel Will Not Bomb Iran (Ever)," dated August 14, 2013, available at gps.bcaresearch.com. 13 The NATO war with Yugoslavia in 1999 reveals how challenging SEAD missions can be if the adversary refuses to engage its air defense systems. The U.S. and its NATO allies bombed Serbia and its forces for nearly three months with limited effectiveness against the country's surface-to-air capabilities. The Serbian military simply refused to turn on its radar installations, making U.S. AGM-88 HARM air-to-surface anti-radiation missiles, designed to home in on electronic transmissions coming from radar systems, ineffective. 14 Please see BCA Geopolitical Strategy Special Report, "Trump Re-Establishes America's 'Credible Threats,'" dated April 7, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "Middle East: A Tale Of Red Herrings And Black Swans," dated October 14, 2015, available at gps.bcaresearch.com. 17 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Guiding To Higher Output; Volatility Set To Rise ... Again," published May 31, 2018.It is available at ces.bcaresearch.com. Appendix Notable Clashes In The South China Sea (2010-18) Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict Trades Closed in 2018 Summary of Trades Closed in 2017 Iraq Is The Prize In U.S. - Iran Sanctions Conflict Iraq Is The Prize In U.S. - Iran Sanctions Conflict

Highlights Investors are underestimating the risks of U.S.-Iran tensions; The Obama administration's 2015 deal resulted in Iran curbing aggressive regional behavior that threatened global oil supply; The U.S. negotiating position vis-à-vis Iran has not improved; Unlike North Korea, Iran can retaliate against the Trump administration's "Maximum Pressure" doctrine - particularly in Iraq; U.S.-Iran conflicts will negatively affect global oil supply, critical geographies, and sectarian tensions - hence a geopolitical risk premium is warranted. Average Brent and WTI oil prices should rise to $80/bbl and $72/bbl in 2019 even without adding the full range of events that will drive up the geopolitical risk premium. Risks lie to the upside. Feature Tensions between the U.S. and Iran snuck up on the markets (Chart 1), even though President Trump's policy agenda was well telegraphed via rhetoric, action, and White House personnel moves.1 Still, investors doubt the market relevance of the U.S. withdrawal from the Joint Comprehensive Plan of Action (JCPOA), the international agreement between Iran and the P5+1.2 Chart 1Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Several reasons to fade the risks - and hence to fade any implications for global oil supply - have become conventional wisdom. These include the alleged ability of OPEC and Russia to boost production and Washington's supposed ineffectiveness without an internationally binding sanction regime. Our view is that investors and markets are underestimating the geopolitical, economic, and financial relevance of the U.S.-Iran tensions. First, the ideological rhetoric surrounding the original U.S.-Iran détente tends to be devoid of strategic analysis. Second, Iran's hard power capabilities are underestimated. Third, OPEC 2.0's ability to tap into its spare capacity is overestimated.3 To put some numbers on the difference between our view and the market's view, we rely on the implied option volatilities for crude oil futures.4 As Chart 2 illustrates, the oil markets are currently pricing in just under 30% probability that oil prices will exceed $80/bbl by year-end, and merely 14% that they will touch $90/bbl in the same timeframe. We believe these odds are too low and will take the other side of that bet. Chart 2The Market Continues To Underestimate High Oil Prices Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Did The U.S.-Iran Détente Emerge In 2015? Both detractors and defenders of the 2015 nuclear deal often misunderstand the logic of the deal. First, the defenders are wrong when they claim that the deal creates a robust mechanism that ensures that Iran will never produce a nuclear device. Given that the most critical components of the deal expire in 10 or 15 years, it is simply false to assert that the deal is a permanent solution. More importantly, Iran already reached "breakout capacity" in mid-2013, which means that it had already achieved the necessary know-how to become a nuclear power.5 We know because we wrote about it at the time, using the data of Iran's cumulative production of enriched uranium provided to the International Atomic Energy Agency (IAEA).6 In August 2013, Iran's stockpile of 20% enriched uranium, produced at the impregnable Fordow facility, reached 200kg (Chart 3). Chart 3Iran's Negotiating Leverage Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize At that point, Israeli threats of attacking Iran became vacuous, as the Israeli air force lacked the necessary bunker-busting technology to penetrate Fordow.7 As we wrote in 2013, this critical moment gave Tehran the confidence to give up "some material/physical components of its nuclear program as it has developed the human capital necessary to achieve nuclear status."8 The JCPOA forced Iran to stop enriching uranium at the Fordow facility altogether and to give up its stockpile of uranium enriched at 20%. However, Iran only agreed to the deal because it had reached a level of technological know-how that has not been eliminated by mothballing centrifuges and "converting" facilities to civilian nuclear research. Iran is a nuclear power in all but name. Second, the detractors of the JCPOA are incorrect when they claim that Iran did not give up any regional hegemony when it signed the deal. This criticism focuses on Iran's expanded role in the Syrian Civil War since 2011, as well as its traditional patronage networks with the Lebanese Shia militants Hezbollah and with Yemen's Houthis. However, critics ignore several other, far more critical, fronts of Iranian influence: Strait of Hormuz: In 2012, Iran's nearly daily threats to close the Strait of Hormuz were very much a clear and present danger for global investors (Map 1). Although we argued in 2012 that Iran's capability was limited to a 10-day closure, followed by another month during which they could threaten the safe passage of vessels through the Strait, even such a short crisis would add a considerable risk premium to oil markets given that it would remove about 17-18 million bbl/day from global oil supply (Chart 4).9 Since 2012, Iran's capabilities to threaten the Strait have grown, while the West's anti-mine capabilities have largely stayed the same.10 Map 1Saudi Arabia's Eastern Province Is A Crucial Piece Of Real Estate Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Chart 4Geopolitical Crises And Global Peak Supply Losses Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Iraq: The key geographic buffer between Saudi Arabia and Iran is Iraq (Map 2). Iran filled the power vacuum created by the U.S. invasion almost immediately after Saddam Hussein's overthrow. It deployed members of the infamous Quds Force of the Iranian Revolutionary Guard Corps (IRGC) into Iraq to support the initial anti-American insurgency. Iran's support for Prime Minister Nouri al-Maliki was critical following the American withdrawal in 2011, particularly as his government became increasingly focused on anti-Sunni insurgency. Map 2Iraq: A Buffer Between Saudi Arabia And Iran Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Bahrain: Home of the U.S. Fifth Fleet, Bahrain experienced social unrest in 2011. The majority of Bahrain's population are Shia, while the country is ruled by the Saudi-aligned, Sunni, Al Khalifa monarchy. The majority of Shia protests were at least rhetorically, and some reports suggest materially, supported by Iran. To quell the protests, and preempt any potential Iranian interference, Saudi Arabia intervened militarily with a Gulf Cooperation Council (GCC) Peninsula Shield Force. Eastern Province: Similar to the unrest in Bahrain, Shia protests engulfed Saudi Arabia's Eastern Province in 2011. The province is highly strategic, as it is where nearly all of Saudi oil production, processing, and transportation facilities are located (Map 1). Like Bahrain, it has a large Shia population. Saudi security forces cracked down on the uprising and have continued to do so, with paramilitary operations lasting into 2017. While Iranian involvement in the protests is unproven, it has been suspected. Anti-Israel Rhetoric: Under President Mahmoud Ahmadinejad, Iran threatened Israel with destruction on a regular basis. While these were mostly rhetorical attacks, the implication of the threat was that any attack against Iran and its nuclear facilities would result in retaliation against U.S. interests in the Persian Gulf and Iraq and direct military action against Israel. Both defenders and detractors of the JCPOA are therefore mistaken. The JCPOA does not impact Iran's ability to achieve "breakout capacity" given that it already reached it in mid-2013. And Iran's regional influence has not expanded since the deal was signed in 2015. In fact, since the détente in 2015, and in some cases since negotiations between the Obama administration and Tehran began in 2013, Iran has been a factor of stability in the Middle East. Specifically, Iran has willingly: Stopped threatening the Strait of Hormuz (the last overt threats to close the Strait of Hormuz were made in 2012); Acquiesced to Nouri al-Maliki's ousting as Prime Minister of Iraq in 2014 and his replacement by the far more moderate and less sectarian Haider al-Abadi; Stopped meddling in Bahraini and Saudi internal affairs; Stopped threatening Israel's existence (although its material support for Hezbollah clearly continues and presents a threat to Israel's security); Participated in joint military operations with the U.S. military against the Islamic State, cooperation without which Baghdad would have most likely fallen to the Sunni radicals in late 2014. The final point is worth expanding on. After the fall of Mosul - Iraq's second largest city - to the Islamic State in May 2014, Iranian troops and military advisors on the ground in Iraq cooperated with the U.S. air force to arrest and ultimately reverse the gains by the radical Sunni terrorist group. Without direct Iranian military cooperation - and without Tehran's material and logistical support for the Iraqi Shia militias - the Islamic State could not have been eradicated from Iraq (Map 3). How did such a dramatic change in Tehran's foreign policy emerge between 2012 and 2015? Iranian leadership realized in 2012 that the U.S. military and economic threats against it were real. Internationally coordinated sanctions had a damaging effect on the economy, threatening to destabilize a regime that had experienced social upheaval in the 2009 Green Revolution (Chart 5). It therefore began negotiations almost immediately after the imposition of stringent economic sanctions in early and mid-2012.11 Map 3The Collapse Of A Would-Be Caliphate Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Chart 5Iran's Sanctions Had A Hard Bite Iran's Sanctions Had A Hard Bite Iran's Sanctions Had A Hard Bite To facilitate the negotiations, the Guardian Council of Iran disqualified President Ahmadinejad's preferred candidate for the 2013 Iranian presidential elections, while allowing Hassan Rouhani's candidacy.12 Rouhani, a moderate, won the June 2013 election in a landslide win, giving him a strong political mandate to continue the negotiations and, relatedly, to pursue economic development. Many commentators forget, however, that Supreme Leader Ayatollah Sayyid Ali Hosseini Khamenei allowed Rouhani to run in the first place, knowing full well that he would likely win. In other words, Rouhani's victory revealed the preferences of the Iranian regime to negotiate and adjust its foreign policy. Bottom Line: The 2015 U.S.-Iran détente traded American acquiescence in Iranian nuclear development - frozen at the point of "breakout capacity" - in exchange for Iran's cooperation on a number of strategically vital regional issues. As such, focusing on just the JCPOA, without considering the totality of Iranian behavior before and since the deal, is a mistake. Iran curbed its influence in several regional hot spots - almost all of which are critical to global oil supply. The Obama administration essentially agreed to Iran becoming a de facto nuclear power in exchange for Iran backing away from aggressive regional behavior. This included Iran's jeopardizing the safe passage of oil through the Strait of Hormuz either by directly threatening to close the channel or through covert actions in Bahrain and the Eastern Province. The U.S. also drove Iran to accept a far less sectarian Iraq, by forcing out the ardently pro-Tehran al-Maliki and replacing him with a prime minister far more acceptable to Saudi Arabia and Iraqi Sunnis. Why Did The U.S. Chose Diplomacy In 2011? The alternative to the above deal was some sort of military action against Iranian nuclear facilities. The U.S. contemplated such action in late 2011. Two options existed, either striking Iran's facilities with its own military or allowing Israel to do it themselves. One reason to choose diplomacy and economic sanctions over war was the limited capability of Israel to attack Iran alone.13 Israel does not possess strategic bombing capability. As such, it would have required a massive air flotilla of bomber-fighters to get to the Iranian nuclear facilities. While the Israeli air force has the capability to reach Iranian facilities and bomb them, their effectiveness is dubious and the ability to counter Iranian retaliatory capacity with follow-up strikes is non-existent. The second was the fact that a U.S. strike against Iran would be exceedingly complex. Compared to previous Israeli strikes against nuclear facilities in Iraq (Operation Opera 1981) and Syria (Operation Outside The Box 2007), Iran presented a much more challenging target. Its superior surface-to-air missile capability would necessitate a prolonged, and dangerous, suppression of enemy air defense (SEAD) mission.14 In parallel, the U.S. would have to preemptively strike Iran's ballistic missile launching pads as well as its entire navy, so as to obviate Iran's ability to retaliate against international shipping or the U.S. and its allies in the region. The U.S. also had a strategic reason to avoid entangling itself in yet another military campaign in the Middle East. The public was war-weary and the Obama administration gauged that in a world where global adversaries like China and Russia were growing in geopolitical power, avoiding another major military confrontation in a region of decreasing value to U.S. interests (thanks partly to growing U.S. shale oil production) was of paramount importance (Chart 6). Notable in 2011 was growing Chinese assertiveness throughout East Asia (please see the Appendix). Particularly alarming was the willingness of Beijing to assert dubious claims to atolls and isles in the South China Sea, a globally vital piece of real estate (Diagram 1). There was a belief - which has at best only partially materialized - that if the United States divested itself of the Middle East, then it could focus more intently on countering China's challenge to traditional U.S. dominance in East Asia and the Pacific. Chart 6Great Power Competition Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Diagram 1South China Sea As Traffic Roundabout Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Bottom Line: The Obama administration therefore chose a policy of military posturing toward Iran to establish a credible threat. The military option was signaled in order to get the international community - both allies and adversaries - on board with tough economic sanctions. The ultimate deal, the JCPOA, did not give the U.S. and its allies everything they wanted precisely because they did not enter the negotiations from a position of preponderance of power. Critics of the JCPOA ignore this reality and assume that going back to the status quo ante bellum will somehow improve the U.S. negotiating position. It won't. What Happens If The U.S.-Iran Détente Ends? The Trump administration is serious about applying its Maximum Pressure tactics on Iran. Buoyed by the successful application of this strategy in North Korea, the White House believes that it can get a better deal with Tehran. We do not necessarily disagree. It is indeed true that the U.S. is a far more powerful country than Iran, with a far more powerful military. On a long enough timeline, with enough pressure, it ought to be able to force Tehran to concede, assuming that credible threats are used.15 Unlike the Obama administration, the Trump administration will presumably rely on Israel far less, and on its own military capability a lot more, to deliver those threats, which should be more effective. The problem is that the timeline on which such a strategy would work is likely to be a lot longer with Iran than with North Korea. This is because Iran's retaliatory capabilities are far greater than the one-trick-pony Pyongyang, which could effectively only launch ballistic missiles and threaten all-out war with U.S. and its regional allies.16 While those threats are indeed worrisome, they are also vacuous as they would lead to a total war in which the North Korean regime would meet its demise. Iran has a far more effective array of potential retaliation that can serve a strategic purpose without leading to total war. As we listed above, it could rhetorically threaten the Strait of Hormuz or attempt to incite further unrest in Bahrain and Saudi Arabia's Eastern Province. The key retaliation could be to take the war to Iraq. The just-concluded election in Iraq appears to have favored Shia political forces not allied to Iran, including the Alliance Towards Reform (Saairun) led by the infamous cleric, Muqtada al-Sadr (Chart 7). Surrounding this election, various Iranian policymakers and military leaders have said that they would not allow Iraq to drift outside of Iran's sphere of influence, a warning to the nationalist Sadr who has fought against both the American and Iranian military presence in his country. Iraq is not only a strategic buffer between Saudi Arabia and Iran, the two regional rivals, but also a critical source of global oil supply, having brought online about half as much new supply as U.S. shale since 2011 (Chart 8). If Iranian-allied Shia factions engage in an armed confrontation with nationalist Shias allied with Muqtada al-Sadr, such a conflict will not play out in irrelevant desert governorates, as the fight against the Islamic State did. Chart 7Iraqi Elections Favored Shiites But Not Iran Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Chart 8Iraq Critical To Global Oil Supply Iraq Critical To Global Oil Supply Iraq Critical To Global Oil Supply Instead, a Shia-on-Shia conflict would play out precisely in regions with oil production and transportation facilities. In 2008, for example, Iranian-allied Prime Minister Nouri al-Maliki fought a brief civil war against Sadr's Mahdi Army in what came to be known as the "Battle of Basra." While Iran had originally supported Sadr in his insurgency against the U.S., it came to Maliki's support in that brief but deadly six-day conflict. Basra is Iraq's chief port through which much of the country's oil exports flow. Iraq may therefore become a critical battleground as Iran retaliates against U.S. Maximum Pressure. From Iran's perspective, holding onto influence in Iraq is critical. It is the transit route through which Iran has established an over-land connection with its allies in Syria and Lebanon (Map 4). Threatening Iraqi oil exports, or even causing some of the supply to come off-line, would also be a convenient way to reduce the financial costs of the sanctions. A 500,000 b/d loss of exports - at an average price of $70 per barrel (as Brent has averaged in 2018) - could roughly be compensated by an increase in oil prices by $10 per barrel, given Iran's total exports. As such, Iran, faced with lost supply due to sanctions, will have an incentive to make sure that prices go up (i.e., that rivals do not simply replace Iranian supply, keeping prices more or less level). The easiest way to accomplish this, to add a geopolitical risk premium to oil prices, is through the meddling in Iraqi affairs. Map 4Iran Needs Iraq To Project Power Through The Levant Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize It is too early to forecast with a high degree of confidence precisely how the U.S.-Iran confrontation will develop. However, Diagram 2 offers our take on the path towards retaliation. Diagram 2Iran-U.S. Tensions Decision Tree Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize The critical U.S. sanctions against Iran will become effective on November 4 (Box 1). We believe that the Trump administration is serious and that it will force European allies, as well as South Korea and Japan, to cease imports of oil from Iran. China will be much harder to cajole. BOX 1 Iranian Sanction Timeline President Trump issued a National Security Presidential Memorandum to re-impose all U.S. sanctions lifted or waived in connection with the JCPOA. The Office of Foreign Assets Control expects all sanctions lifted under the JCPOA to be re-imposed and in full effect after November 4, 2018. However, there are two schedules by which sanctions will be re-imposed, a 90-day and 180-day wind-down periods.1 Sanctions Re-Imposed After August 6, 2018 The first batch of sanctions that will be re-imposed will come into effect 90 days after the announced withdrawal from the JCPOA. These include: Sanctions on direct or indirect sale, supply, or transfer to or from Iran of several commodities (including gold), semi-finished metals, and industrial process software; Sanctions on the purchase or acquisition of U.S. dollar banknotes by the government of Iran; Sanctions on trade in Iranian currency and facilitation of the issuance of Iranian sovereign debt; Sanctions on Iran's automotive sector; Sanctions on export or re-export to Iran of commercial passenger aircraft and related parts. Sanctions Re-Imposed After November 4, 2018 The second batch of sanctions will come into effect 180 days after the announced Trump administration JCPOA withdrawal decision. These include: Sanctions on Iranian port operators, shipping, and shipbuilding activities; Sanctions against petroleum-related transactions with the National Iranian Oil Company (NIOC), Naftiran Intertrade Company (NICO), and National Iranian Tanker Company (NITC); Sanctions against the purchase of petroleum, petroleum products, or petrochemical products from Iran; Sanctions on transactions and provision of financial messaging services by foreign financial institutions with the Central Bank of Iran; Sanctions on Iran's energy sector; Sanctions on the provision of insurance, reinsurance, and underwriting services. 1 Please see the U.S. Treasury Department, "Frequently Asked Questions Regarding the Re-Imposition of Sanctions Pursuant to the May 8, 2018, National Security Presidential Memorandum Relating to the Joint Comprehensive Plan of Action (JCPOA)," dated May 8, 2018, available at www.treasury.gov. By Q1 2019, the impact on Iranian oil exports will be clear. We suspect that Iran will, at that point, have the choice of either relenting to Trump's Maximum Pressure, or escalating tensions through retaliation. We give the latter a much higher degree of confidence and suspect that a cycle of retaliation and Maximum Pressure would lead to a conditional probability of war between Iran and the U.S. of around 20%. This is a significant number, and it is critical if President Trump wants to apply credible threats of war to Iran. Bottom Line: Unlike North Korea, Iran has several levers it can use to retaliate against U.S. Maximum Pressure. Iran agreed to set these levers aside as negotiations with the Obama administration progressed, and it has kept them aside since the conclusion of the JCPOA. It is therefore easy for Tehran to resurrect them against the Trump administration. Critical among these levers is meddling in Iraq's internal affairs. Not only is Iraq critical to Iran's regional influence; it is also key to global oil supply. We suspect that a cycle of Iranian retaliation and American Maximum Pressure raises the probability of U.S.-Iran military confrontation to 20%. We will be looking at several key factors in assessing whether the U.S. and Iran are heading towards a confrontation. To that end, we have compiled a U.S.-Iran confrontation checklist (Table 1). Table 1Will The U.S. Attack Iran? Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Investment Implications Over the past several years, there have been many geopolitical crises in the Middle East. We have tended to fade most of them, from a perspective of a geopolitical risk premium applied to oil prices. This is because we always seek the second derivative of any geopolitical event. In the context of the Middle East, by "second derivative" we mean that we are interested in whether the market impact of a new piece of information - of a new geopolitical event - will amount to more than just a random perturbation with ephemeral, decaying, market implications. To determine the potential of new information to catalyze a persistent market risk premium or discount, we investigate whether it changes the way things change in a given region or context. In 2015, we identified three factors that we believe are critical for a geopolitical event in the Middle East to have such second derivative implications, and thus global market implications.17 These are: Oil supply: The event should impact current global oil supply either directly or through a clear channel of contagion. Renewed sanctions against Iran do so directly. So would Iranian retaliation in Iraq or the Persian Gulf. Geography: The event should occur in a geography that is of existential significance to one of the regional or global players. Re-imposed sanctions obviously directly impact Iran as they could increase domestic political crisis. A potential Iranian proxy-war in Iraq would be highly relevant to Saudi Arabia, which considers Iraq as a vital buffer with Iran. Sectarian contagion: The event should exacerbate sectarian conflict - Sunni vs. Shia - which is more likely to lead contagion than tribal conflict such as the Libyan Civil War. A renewed U.S.-Iran tensions check all of our factors. The risk is therefore real and should be priced by the market through a geopolitical risk premium. In addition, Iranian sanctions could tighten up the outlook for oil markets in 2019 by 400,000-600,000 b/d, reversing most of the production gains that Iran has made since 2016 (Chart 9). This is a problem given that the enormous oversupply of crude oil and oil products held in inventories has already been significantly cut. BCA's Commodity & Energy Strategy and Energy Sector Strategy teams believe that global petroleum inventories will be further reduced in 2019 (Chart 10). Chart 9Current And Future Iran##br## Production Is At Risk Current And Future Iran Production Is At Risk Current And Future Iran Production Is At Risk Chart 10Tighter Markets And Lower Inventories,##br## Keep Forward Curves Backwardated Tighter Markets And Lower Inventories, Keep Forward Curves Backwardated Tighter Markets And Lower Inventories, Keep Forward Curves Backwardated What about the hints from the OPEC 2.0 alliance that they would surge production in light of supply loss from Iran? Oil prices fell on the belief OPEC 2.0 could easily restore 1.8 MMb/d of production that they agreed to hold off the market since early 2017. Our commodity strategists have always considered the full number to be an illusion that consists of 1.2 MMb/d of voluntary cuts and around 500,000 b/d of natural production declines that were counted as "cuts" so that the cartel could project an image of greater collaboration than it actually achieved (Chart 11). In fact, some of the lesser "contributors" to the OPEC cut pledged to lower 2017 production by ~400,000 b/d, but are facing 2018 production levels that are projected to be ~700,000 b/d below their 2016 reference levels, and 2019 production levels are estimated to decline by another 200,000 b/d (Chart 12). Chart 11Primary OPEC 2.0 Members Are Producing##br## 1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Chart 12Secondary OPEC 2.0 "Contributors" ##br##Can't Even Reach Their Quotas Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Furthermore, renewed Iran-U.S. tensions may only be the second-most investment-relevant geopolitical risk for oil markets. Our commodity team expects Venezuelan production to fall to 1.2 MMb/d by the end of 2018 and to 1 MMb/d by the end of 2019, but these production levels could turn out to be optimistic (Chart 13). BCA's Commodity & Energy Strategy therefore projects that the combination of stable global demand, steady declines in Venezuela's crude oil output, and the loss of Iranian exports to U.S. sanctions in 2019 will lift the average Brent and WTI prices to $80 and $72/bbl respectively (Chart 14).18 This forecast, however, represents our baseline based on fundamentals of global oil supply and demand (Chart 15) and does not include our potential scenarios outlined in Diagram 2, which would obviously add additional geopolitical risk premium. Chart 13Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk Chart 14Brent Will Average $80/bbl In 2019 Brent Will Average $80/bbl In 2019 Brent Will Average $80/bbl In 2019 Chart 15Balances Tighter As Supply Falls Balances Tighter As Supply Falls Balances Tighter As Supply Falls For investors looking for equity-market exposure in this scenario, BCA's Energy Sector Strategy recommends overweighing U.S. shale producers and shale-focused service companies for investors looking for equity-market exposure to oil prices. Our colleague Matt Conlan, of the BCA Energy Sector Strategy, has broken down this recommendation into specific equity calls, which we encourage our clients to peruse.19 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 2 The JCPOA was concluded in Vienna on July 14, 2015 between Iran and the five permanent members of the United Nations Security Council (China, France, Russia, the United Kingdom, and the United States), plus Germany (the "+1" of the P5+1). 3 BCA's Senior Commodity & Energy Strategist Robert P. Ryan has given the name "OPEC 2.0" to the Saudi-Russian alliance that is focused on regaining a modicum of control over the rate at which U.S. shale-oil resources are developed. Please see BCA Commodity & Energy Strategy Weekly Report, "KSA's, Russia's End Game: Contain U.S. Shale Oil," dated March 30, 2017; and "The Game's Afoot In Oil, But Which One?" dated April 6, 2017, available at ces.bcaresearch.com. 4 We use Brent implied volatility - of at-the-money options of the selected futures contract - as an input to construct the cumulative normal density of future prices. Thus, the probability obtained is one where the terminal futures price, at the selected months, exceeds the strike price quoted. In order to derive this probability, we need the current market price of the selected future contract, the number of days to expiration, the strike price, and a measure of the volatility of this contract. 5 "Breakout" nuclear capacity is defined here as having enough uranium enriched at lower levels, such as at 20%, to produce sufficient quantities of highly-enriched uranium (HEU) required for a nuclear device. The often-reported amount of 20% enriched uranium required for breakout capacity is 200kg. However, the actual amount of uranium required depends on the number of centrifuges being employed and their efficiency. In our 2013 report, we gauged that Iran could produce enough HEU within 4-5 weeks at the Fordow facility to develop a weapon, which means that it had effectively reached "breakout capacity." 6 Please see International Atomic Energy Agency, "Implementation Of The NPT Safeguards Agreement And Relevant Provisions Of Security Council Resolutions In The Islamic Republic Of Iran," IAEA Board Report, dated August 28, 2013, available at www.iaea.org. 7 Although, in a move designed to increase pressure on Iran and its main trade partners, the Obama administration sold Israel the GBU-28 bunker-busting ordinance. That specific ordinance is very powerful, but still not capable enough to penetrate Fordow. 8 Please see BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift," dated November 13, 2013, available at gps.bcaresearch.com. 9 Please see BCA Special Report, "Crisis In The Persian Gulf: Investment Implications," dated March 1, 2012, available at gps.bcaresearch.com. 10 There are four U.S. Navy Avenger-class minesweepers based in Bahrain as part of the joint U.S.-U.K. TF-52. This number has been the same since 2012, when they were deployed to the region. 11 Particularly crippling for Iran's economy was the EU oil embargo imposed in January 2012, effective from July of that year, and the banning of Iranian financial institutions from participating in the SWIFT system in March 2012. 12 The Guardian Council of the Constitution is a 12-member, unelected body wielding considerable power in Iran. It has consistently disqualified reformist candidates from running in elections, which makes its approval of Rouhani's candidacy all the more significant. 13 Please see BCA Geopolitical Strategy Special Report, "Reality Check: Israel Will Not Bomb Iran (Ever)," dated August 14, 2013, available at gps.bcaresearch.com. 14 The NATO war with Yugoslavia in 1999 reveals how challenging SEAD missions can be if the adversary refuses to engage its air defense systems. The U.S. and its NATO allies bombed Serbia and its forces for nearly three months with limited effectiveness against the country's surface-to-air capabilities. The Serbian military simply refused to turn on its radar installations, making U.S. AGM-88 HARM air-to-surface anti-radiation missiles, designed to home in on electronic transmissions coming from radar systems, ineffective. 15 Please see BCA Geopolitical Strategy Special Report, "Trump Re-Establishes America's 'Credible Threats,'" dated April 7, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Middle East: A Tale Of Red Herrings And Black Swans," dated October 14, 2015, available at gps.bcaresearch.com. 18 Please see BCA Commodity & Energy Strategy Weekly Report, "Brent, WTI Average $80, $72 Next Year; Upside Risk Dominates, $100/bbl Possible In 2019," dated May 24, 2018, available at ces.bcaresearch.com. 19 Please see BCA Energy Sector Strategy Weekly Report, "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," dated May 9, 2018, available at nrg.bcaresearch.com. Appendix Notable Clashes In The South China Sea (2010-18) Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Notable Clashes In The South China Sea (2010-18) (Continued) Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Notable Clashes In The South China Sea (2010-18) (Continued) Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize

Highlights China-U.S. trade détente goes against our alarmist forecast, prompting us to reassess the view; We do not expect the truce to last long, as China has not given the U.S. what we believe the Trump administration wants; Instead, we see the truce lasting until at least the completion of the North Korea - U.S. summit, at most early 2019; Market is correct to fret about Italy, as the populist agenda will be constrained by the bond market in due course; Stay long DXY, but close our recommendations to short China-exposed S&P 500 companies. Feature Our alarmist view on trade wars appears to be in retreat, or at least "on hold," following the conclusion of the latest trade talks between U.S. and Chinese officials. Global markets breathed a sigh of relief on Monday, after a weekend of extremely positive comments from President Trump's advisers and cabinet members. Particularly bullish were the comments from Trump's top economic adviser, Larry Kudlow, who claimed that China had agreed to reduce its massive trade surplus with the U.S. by $200 billion (Chart 1). Chart 1China, Not NAFTA, Is The Problem China, Not NAFTA, Is The Problem China, Not NAFTA, Is The Problem The official bilateral statement, subsequently published by the White House, was vague. It claimed that "there was a consensus" regarding a substantive - but unquantifiable - reduction in the U.S. trade deficit.1 The only sectors that were mentioned specifically were "United States agriculture and energy exports." China agreed to "meaningfully" increase the imports of those products, which are low value- added commodity goods. With regard to value-added exports, China merely agreed that it would encourage "expanding trade in manufactured goods and services." The two sides also agreed to "attach paramount importance to intellectual property protections," with China specifically agreeing to "advance relevant amendments to its laws and regulations in this area." Subsequent to the declaratory statement, China lowered tariffs on auto imports from 25% to 15%. It will also cut tariffs on imported car parts, to around 6%, from the current average of about 10%. Is that it? Was the consensus view - that China would merely write a check for some Boeings, beef, and crude oil - essentially right? The key bellwether for trade tensions has been the proposed tariffs on $50-$150 billion worth of goods, set to come in effect as early as May 21. According to Treasury Secretary Steven Mnuchin, this tariff action is now "on hold." Mnuchin was also supposed to announce investment restrictions by this date, another bellwether that is apparently on hold. This is objective evidence that trade tensions have probably peaked for this year.2 On the other hand, there are several reasons to remain cautious: Section 301 Investigation: Robert Lighthizer, the cantankerous U.S. Trade Representative who spearheaded the Section 301 investigation into China's trade practices that justified the abovementioned tariffs and investment restrictions, immediately issued a statement on Sunday dampening enthusiasm: "Real work still needs to be done to achieve changes in a Chinese system that facilitates forced technology transfers in order to do business in China." In the same statement, Lighthizer added that China facilitates "the theft of our companies' intellectual property and business know-how." In other words, Lighthizer does not appear to be excited by the prospect of trading IP and tech protection for additional exports of beef and crude oil. Political Reaction: The reaction from conservative circles was less than enthusiastic, with both congressional officials and various Trump supporters announcing their exasperation with the supposed deal over the weekend.3 The Wall Street Journal claimed that China refused to put a number - such as the aforementioned $200 billion - in the final statement.4 The implication is that Beijing won this round of negotiations. But President Trump will not want to appear weak. If a narrative emerges that he "lost," we would expect President Trump to pivot back to tariffs and confrontation. Support for free trade has recently rebounded among Republican voters but remains dramatically lower among them than among Democrats (Chart 2). As such, it is a salient issue for the president politically. Chart 2Support For Free Trade Recovering, ##br##But Republicans Still Trail Democrats Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 3China Already ##br##Imports U.S. Commodities... Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Investment Restrictions: Senator Cornyn's (Texas, Republican) bill to strengthen the Committee on Foreign Investment in the United States (CFIUS) process continues to move through the Senate.5 The Foreign Investment Risk Review Modernization Act Of 2017 (FIRRMA) is currently being considered by the Senate Committee on Banking, Housing, and Urban Affairs and should be submitted to a vote ahead of the November election. Congress is also looking to pass a bipartisan bill that would prevent President Trump from taking it easy on Chinese telecommunication manufacturer ZTE. Chart 4U.S. Commodity Export Growth Is Solid Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 5... But Impedes Market Access For Higher Value-Added Goods Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Beef And Oil Is Not Enough: The U.S. already has a growing market share in China's imports of commodities and crude materials, although it could significantly increase its exports in several categories (Chart 3). As the Chinese people develop middle-class consumption habits, the country was always going to import more agricultural products. And as their tastes matured, the U.S. was always going to benefit, given the higher quality and price point of its agricultural exports. In fact, China's imports of U.S. primary commodity exports have been increasing faster than imports of U.S. manufacturing goods (Chart 4). As such, the statement suggests that the U.S. and China have opted for the easiest compromises (commodities) to grant U.S. greater market access; the U.S. may have fallen short on market access for value-added manufacturing (Chart 5). In addition, there was little acknowledgment of the American demands that China cease forced tech transfers, cut subsidies for SOEs, reduce domestic content requirements under the "Made in China 2025" plan, and liberalize trade for U.S. software and high-tech exporters (Chart 6). Given these outstanding and unresolved issues, there are three ways to interpret the about-face in U.S. trade demands: Geopolitical Strategy is wrong: One scenario is that we are wrong, that the Trump administration is not focused on forced tech transfers and IP theft in any serious way.6 On the other hand, if that is true, the U.S. is also not serious about significantly reducing its trade deficit with China, since structurally, IP theft and non-tariff barriers to trade of high-value exports are a major reason why China has a massive surplus. Instead, the U.S. may only be focused on reducing the trade deficit through assurances of greater market access - a key demand as well, but one that could prove temporary or un-strategic, especially if access is only granted for commodities.7 If this is true, it suggests that President Trump's demands on China are transactional, not geopolitical, as we asserted in March.8 Midterms matter: Another scenario is that President Trump does not want to do anything that would hurt the momentum behind the GOP's polling ahead of the November midterms (Chart 7). The administration can always pick up the pressure on China following the election, given that 2019 is not an election year. Trump's political team may believe that Beijing concessions on agriculture, autos, and energy will be sufficient to satisfy the base until then. By mid-2019, the White House can also use twelve months of trade data to assess whether Beijing has actually made any attempt to deliver on its promises of increased imports from the U.S. Chart 6China's High-Tech Protectionism Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 7Republicans Are Gaining... Republicans Are Gaining... Republicans Are Gaining... North Korea matters: Along the same vein as the midterms, there is wisdom in delaying trade action against China given the upcoming June 12 summit between President Trump and North Korean Supreme Leader Kim Jong-un in Singapore. President Trump's approval ratings began their second surge this year following the announced talks (Chart 8), and it is clear that the administration has a lot of political capital invested in the summit's success. Recent North Korean statements, suggesting that they are willing to break off dialogue, may have been the result of the surprise May 8 meeting between Chinese President Xi Jinping and Kim, the second in two months. As such, President Trump may have had to back off on the imposition of tariffs against China in order to ensure that his summit with Kim goes smoothly. At this point, it is difficult to gauge whether the decision to ease the pressure against China was due to strategic or tactical reasons. We expect that the market will price in both, easing geopolitical risk on equity markets. However, if the delay is tactical - and therefore temporary - then the risk premium would remain appropriate. We do not think that we are wrong when it comes to U.S. demands on China. These include greater market access for U.S. value-added exports and services (not just commodities), as well as a radical change in how China awards such access (i.e., ending the demand that technology transfers accompany FDI and market access). In addition, China still massively underpays for U.S. intellectual property (IP) rights and has been promising to do more on that front for decades (Chart 9). Given that China has launched some anti-piracy campaigns, and given its recent success in other top-down campaigns like shuttering excess industrial capacity, it is hard to believe that Beijing could not crack down on IP theft even more significantly. Chart 8...Thanks To Tax Cuts And Kim Jong-un ...Thanks To Tax Cuts And Kim Jong-un ...Thanks To Tax Cuts And Kim Jong-un Chart 9What Happened To ~$100 Billion IP Theft? Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Furthermore, U.S. demands on China are not merely about market access and IP. There is also the issue of aggressive geopolitical footprint in East Asia, particularly the South China Sea. The U.S. defense and intelligence establishment is growing uneasy over China's pace of economic and technological development, given its growing military aggressiveness. In fact, over the past two weeks, China has: Landed the Xian H-6K strategic bombers capable of carrying nuclear weapons on disputed "islands" in the South China Sea; Installed anti-ship cruise missiles, as well as surface-to-air missiles, on three of its outposts in disputed areas. Of course, if we are off the mark on our view of Sino-American tensions, it would mean that the Trump administration is willing to make transactional economic concessions for geopolitical maneuvering room. In other words, more crude oil and LNG exports in exchange for better Chinese positioning in vital sea and air routes in East Asia. We highly doubt that the Trump administration is making such a grand bargain, even if the rhetoric from the White House often suggests that the "America First" agenda would allow for such a strategic shift. Rather, we think the Trump administration, like the Obama administration, put the South China Sea low on the priority list, but will focus greater attention on it when is deemed necessary at some future date. Bottom Line: Trade tensions between China and the U.S. have almost assuredly peaked in a tactical, three-to-six month timeframe. While still not official, it appears that the implementation of tariffs on $50-$150 billion worth of imports from China, set for any time after May 21, is now on hold. As such, a trade war is on hold. We are closing our short China-exposed S&P 500 companies versus U.S. financials and telecoms, a trade that has returned 3.94% and long European / short U.S. industrials, which is down 2% since inception. This greatly reduces investment-relevant geopolitical risk this summer and makes us far less confident that investors should "sell in May and go away." Our tactical bearishness is therefore reduced, although several other geopolitical risks - such as Iran-U.S. tensions, Italian politics, and the U.S. midterm election- remain relevant.9 We do not think that Sino-American tensions have peaked cyclically or structurally (six months and beyond). The Trump Administration continues to lack constraints when it comes to acting tough on China. As such, investors should expect tensions to renew either right after the summit between Trump and Kim in early June or, more likely, following the November midterm elections. Italy: The Divine Comedy Continues Since 2016, we have noted that Italy remains the premier risk to European markets and politics.10 There are two reasons for the view. First, Italy has retained a higher baseline level of Euroskepticism relative to the rest of Europe (Chart 10). While support for the common currency has risen in other member states since 2013, it has remained between 55%-60% in Italy. This is unsurprising given the clearly disappointing economic performance in Italy relative to that of its Mediterranean peers (Chart 11). Chart 10Italy Remains A Relative Euroskeptic Italy Remains A Relative Euroskeptic Italy Remains A Relative Euroskeptic Chart 11Lagging Economy Explains Cyclical Euroskepticism Lagging Economy Explains Cyclical Euroskepticism Lagging Economy Explains Cyclical Euroskepticism Italy's Euroskepticism, however, is not merely a product of economic malaise. Chart 12 shows that a strong majority of Europeans are outright pessimistic about the future of their country outside of the EU. But when Italians are polled in that same survey, the population is increasingly growing optimistic about the option of exit (Chart 13). The only other EU member state whose citizens are as optimistic about a life outside the bloc is the U.K., where population obviously voted for Brexit. Chart 12Europeans Are Pessimists About EU Exit... Europeans Are Pessimists About EU Exit... Europeans Are Pessimists About EU Exit... Chart 13...But Italians Are More Like Brits ...But Italians Are More Like Brits ...But Italians Are More Like Brits Furthermore, Italian respondents have begun to self-identify as Italian only, not as "European" also, which breaks with another long-term trend in the rest of the continent (Chart 14) and is also reminiscent of the U.K. The second reason to worry about Italy is its economic performance. Real GDP is still 5.6% below its 2008 peak, while domestic demand continues to linger at 7.9% below its pre-GFC levels (Chart 15). As we posited at the end of 2017, the siren song of FX devaluation would become a powerful political elixir in the 2018 election, as populist policymakers blame Italy's Euro Area membership for the economic performance from Chart 15.11 Chart 14Italians Feel More Italian Italians Feel More Italian Italians Feel More Italian Chart 15Italian Demand Never Fully Recovered Italian Demand Never Fully Recovered Italian Demand Never Fully Recovered Is the Euro Area to blame for Italy's ills? No. The blame lies squarely at the feet of Italian policymakers, who flubbed efforts to boost collapsing productivity throughout the 1990s and 2000s (Chart 16). There was simply no pressure on politicians to enact reforms amidst the post-Maastricht Treaty convergence in borrowing costs. Italy punted reforms to its educational system, tax collection, and corporate governance. Twenty years of complacency have led to a massive loss in global market share (Chart 17). Chart 16Italy Has A Productivity Problem Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 17Export Performance Is A Disaster Export Performance Is A Disaster Export Performance Is A Disaster While it is difficult to prove a counterfactual, we are not sure that even outright currency devaluation would have saved Italy from the onslaught of Asian manufacturing in the late 1990s. Euro Area imports from EM Asia have surged from less than 2% of total imports to nearly 10% in the last twenty years. Italy began losing market share to Asia well before the euro was introduced on January 1, 1999, as Chart 18 illustrates. The incoming populist government is unfortunately coming to power with growing global growth headwinds (Chart 19), with negative implications for Italy (Chart 20). These are likely to act as a constraint on plans by the Five Star Movement (M5S) and Lega coalition to blow out the budget deficit in pursuit of massive tax cuts, reversals of pension reforms, minimum wage hikes, and a proposal to increase spending on welfare. Our back-of-the-envelope calculation sees Italy's budget deficit growing to over 7% in 2019 if all the proposed reforms were enacted, well above the 3% limit imposed by the EU on its member states. Chart 18Italy Lost Market Share Amid Globalization Italy Lost Market Share Amid Globalization Italy Lost Market Share Amid Globalization Chart 19Tepid Global Growth... Tepid Global Growth... Tepid Global Growth... Chart 20...Is Bad News For Italy ...Is Bad News For Italy ...Is Bad News For Italy How would the EU Commission react to these proposals, given that Italy would break the rules of the EU Stability and Growth Pact (SGP)? We think the question is irrelevant. The process by which the EU Commission enforces the rules of the SGP is the Excessive Deficit Procedure (EDP), which would take over a year to put into place.12 First, the Commission would have to review the 2019 budget proposed by the new Italian government in September 2018. It would likely tell Rome that its plans would throw it into non-compliance with SGP rules, at which point the EU Commission would recommend the opening of a Significant Deviation Procedure (SDP). If Italy failed to follow the recommendations of the SDP, the Commission would then likely throw Italy into EDP at some point in the first quarter of 2019, or later that year.13 And what happens if Italy does not conform to the rules of the EDP? Italy would be sanctioned by the EU Commission by forcing Rome to make a non-interest-bearing deposit of 0.2% GDP.14 (Because it makes perfect sense to force a country with a large budget deficit to go into an even greater budget deficit.) Even if Rome complied with the sanctions, the punishment would only be feasible at the end of 2019, most likely at the end of Q1 2020. The point is that the above two paragraphs are academic. The Italian bond market would likely react much faster to Rome's budget proposals. The EU Commission operates on an annual and bi-annual timeline, whereas the bond market is on a minute-by-minute timeline. Given the bond market reaction thus far, it is difficult to see how Rome could be given the benefit of the doubt from investors (Chart 21). Investors have been demanding an ever-greater premium on Italian bonds, relative to their credit rating, ever since the election (Chart 22). Chart 21Uh Oh Spaghettio! Uh Oh Spaghettio! Uh Oh Spaghettio! Chart 22Bond Vigilantes Are Coming Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) As such, the real question for investors is not whether the EU Commission can constrain Rome. It cannot. Rather, it is whether the bond market will. Rising borrowing costs would obviously impact the economy via several transmission channels, including overall business sentiment. But the real risk is Italy's banking sector. Domestic financial institutions hold 45% of Italian treasury bonds (BTPs) (Chart 23), which makes up 9.3% of all their assets, an amount equivalent to 77.8% of their capital and reserves (Chart 24). Foreign investors own 32%, less than they did before the Euro Area crisis, but still a significant amount. Chart 23Foreign Investors Still Hold A Third Of All Italian Debt Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 24Italian Banks Also Hold Too Many BTPs Italian Banks Also Hold Too Many BTPs Italian Banks Also Hold Too Many BTPs In 2011, when the Euro Area crisis was raging, Italian 10-year yields hit 7%, or a spread of more than 500 basis points over German bunds. This was equivalent to an implied probability of a euro area breakup of 20% over the subsequent five years (Chart 25).15 What would happen if the populists in Rome followed through with their fiscal plans by September 2018 by including them in the 2019 budget? The bond market would likely begin re-pricing a similar probability of a Euro Area breakup, if not higher. In the process, Italian bonds could lose 20%-to-30% of their value - assuming that German bunds would rally on risk-aversion flows - which would result in a potential 15%-to-25% hit to Italian banks' capital and reserves. With the still large overhang of NPLs, Italian banks would be, for all intents and purposes, insolvent (Chart 26). Chart 25In 2011, Italian Spreads Signal Euro Break-Up In 2011, Italian Spreads Signal Euro Break-Up In 2011, Italian Spreads Signal Euro Break-Up Chart 26Italian Banks Still Carry Loads Of Bad Loans Italian Banks Still Carry Loads Of Bad Loans Italian Banks Still Carry Loads Of Bad Loans The populist government in Rome may not understand this dynamic today, but they will soon enough. This is perhaps why the leadership of both parties has decided to appoint a relatively unknown law professor, Guiseppe Conte, as prime minister. Conte is, according to the Italian press, a moderate and is not a Euroskeptic. It will fall to Conte to try to sell Europe first on as much of the M5S-Lega fiscal stimulus as he can, followed by the Italian public on why the coalition fell far short of its official promises. If the coalition pushes ahead with its promises, and ignores warnings from the bond market, we can see a re-run of the 2015 Greek crisis playing out in Italy. In that unlikely scenario, the ECB would announce publicly that it would no longer support Italian assets if Rome were determined to egregiously depart from the SGP. The populist government in Rome would try to play chicken with the ECB and its Euro Area peers, but the ATM's in the country would stop working, destroying its credibility with voters. In the end, the crisis will cause the populists to mutate into fiscally responsible Europhiles, just as the Euro Area crisis did to Greece's SYRIZA. For investors, this narrative is not a reassuring one. While our conviction level that Italy stays in the Euro Area is high, the scenario we are describing here would still lead to a significant financial crisis centered on the world's seventh-largest bond market. Bottom Line: Over the next several months, we would expect bond market jitters concerning Italy to continue, supporting our bearish view on EUR/USD, which we are currently articulating by being long the DXY (the EUR/USD cross makes up 57.6% of the DXY index). Given global growth headwinds, which are already apparent in the European economic data, and growing Italian risks, the ECB may also turn marginally more dovish for the rest of the year, which would be negative for the euro. Our baseline expectation calls for the new coalition government in Rome to back off from its most populist proposals. We expect that Italy will eventually flirt with overt Euroskepticism, but this would happen after the next recession and quite possibly only after the next election. If we are wrong, and the current populist government does not back off, then we could see a global risk-off due to Italy either later this summer, or in 2019. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see "Joint Statement of the United States and China Regarding Trade Consultations," dated May 19, 2018, available at whitehouse.gov. 2 President Trump later tweeted that the announced deal was substantive and "one of the best things to happen to our farmers in many years!" 3 The most illustrative comment may have come from Dan DiMicco, former steel industry CEO and staunch supporter of President Trump on tariffs, who tweeted "Did president just blink? China and friends appear to be carrying the day." 4 Please see Bob Davis and Lingling Wei, "China Rejects U.S. Target For Narrowing Trade Gap," The Wall Street Journal, dated May 19, 2018, available at wsj.com. 5 Please see "S. 2098 - 115th Congress: Foreign Investment Risk Review Modernization Act Of 2017," dated May 21, 2018, available at www.govtrack.us. 6 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "Are You Ready For 'Maximum Pressure?'" dated May 16, 2018; and "Expect Volatility... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 12 Please see, The Treaty on the Functioning of the European Union, "Excessive deficit procedure (EDP)," available at eur-lex.europa.eu. 13 Have you been missing the European alphabet soup over the past three years? 14 The EU Commission can also suspend financing from the European Structural and Investment Funds (ESIF), but Italy has never participated in a bailout and thus could not be sanctioned that way. 15 Please see BCA European Investment Strategy Weekly Report, "Threats And Opportunities In The Bond Market," dated April 7, 2016, available at eis.bcaresearch.com.

Highlights Divergence between U.S. and global economic outcomes is bullish for the U.S. dollar and bad for EM assets; Maximum Pressure worked with North Korea, but it may not with Iran, putting upside pressure on oil; An election is the only way to resolve split over Brexit and the new anti-establishment coalition in Italy is not market positive; Historic election outcome in Malaysia and the prospect of a weakened Erdogan favors Malaysian over Turkish assets; Reinitiate long Russian vs EM equities in light of higher oil price and reopen French versus German industrials as reforms continue unimpeded in France. Feature "Speak softly and carry a big stick; you will go far." - Theodore Roosevelt, in a letter to Henry L. Sprague, January 26, 1900. May started with a geopolitical bang. On May 4, a high-profile U.S. trade delegation to Beijing returned home after two days of failed negotiations. Instead of bridging the gap between the two superpowers, the delegation doubled it.1 On May 8, President Trump put his Maximum Pressure doctrine - honed against Pyongyang - into action against Iran, announcing that the U.S. would withdraw from the Obama administration's Iran nuclear deal - also referred to as the Joint Comprehensive Plan of Action (JCPOA). These geopolitical headlines were good for the U.S. dollar, bad for Treasuries, and generally miserable for emerging market (EM) assets (Chart 1).2 We have expected these very market moves since the beginning of the year, recommending that clients go long the DXY on January 31 and go short EM equities vs. DM on March 6.3 Chart 1EM Breakdown? EM Breakdown? EM Breakdown? Chart 2U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows Geopolitical risks, however, are merely the accelerant of an ongoing process of global growth redistribution. A key theme for BCA's Geopolitical Strategy this year has been the divergent ramifications of populist stimulus in the U.S. and structural reforms in China. This political divergence in economic outcomes has reduced growth in the latter and accelerated it in the former, a bullish environment for the U.S. dollar (Chart 2).4 Data is starting to support this narrative: Chart 3Global Growth On A Knife Edge Global Growth On A Knife Edge Global Growth On A Knife Edge Chart 4German Data... German Data... German Data... The BCA OECD LEI has stalled, but the diffusion index shows a clear deterioration (Chart 3); German trade is showing signs of weakness, as is industrial production and IFO business confidence (Chart 4); Another bellwether of global trade, South Korea, is showing a rapid deterioration in exports (Chart 5); Global economic surprise index is now in negative territory (Chart 6). Chart 5...And South Korean, Foreshadows Risks ...And South Korean, Foreshadows Risks ...And South Korean, Foreshadows Risks Chart 6Unexpected Slowdown In Global Growth Unexpected Slowdown In Global Growth Unexpected Slowdown In Global Growth Meanwhile, on the U.S. side of the ledger, wage pressures are rising as the number of unemployed workers and job openings converge (Chart 7). Given the additional tailwinds of fiscal stimulus, which we see no real chance of being reversed either before or after the midterm election, the U.S. economy is likely to continue to surprise to the upside relative to the rest of the world, a bullish outcome for the U.S. dollar (Chart 8). In this environment of U.S. outperformance and global growth underperformance, EM assets are likely to suffer. Chart 7U.S. Labor Market Is Tightening U.S. Labor Market Is Tightening U.S. Labor Market Is Tightening Chart 8U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD Additionally, it does not help that geopolitical risks will weigh on confidence and will buoy demand for safe haven assets, such as the U.S. dollar. First, U.S.-China trade relations will continue to dominate the news flow this summer. President Trump's positive tweets on the smartphone giant ZTE aside, the U.S. and China have not reached a substantive agreement and upcoming deadlines on trade-related matters remain a risk (Table 1). Table 1Protectionism: Upcoming Dates To Watch Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" Second, President Trump's application of Maximum Pressure on Iran will cause further volatility and upside pressure on the oil markets. The media was caught by surprise by the president's announcement that he is withdrawing the U.S. from the JCPOA, which is puzzling given that the May 12 expiration of the sanctions waiver was well-telegraphed (Chart 9). It is also surprising given that President Trump signaled his pivot towards an aggressive foreign policy by appointing John Bolton and Mike Pompeo - two adherents of a hawkish foreign policy - to replace more middle-of-the-road policymakers. It was these personnel changes, combined with the U.S. president's lack of constraints on foreign policy, that inspired us to include Iran as the premier geopolitical risk for 2018.5 Chart 9Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Iran-U.S. Tensions: Maximum Pressure Is Real Last year, BCA's Geopolitical Strategy correctly forecast that President Trump's Maximum Pressure doctrine would work against North Korea. First, we noted that President Trump reestablished America's "credible threat," a crucial factor in any negotiation.6 Without credible threats, it is impossible to cajole one's rival into shifting away from the status quo. The trick with North Korea, for each administration that preceded President Trump, was that it was difficult to establish such a credible threat given Pyongyang's ability to retaliate through conventional artillery against South Korean population centers. President Trump swept this concern aside by appearing unconcerned with what were to befall South Korean civilians or the Korean-U.S. alliance. Second, we noted in a detailed military analysis that North Korean retaliation - apart from the aforementioned conventional capacity - was paltry.7 President Trump called Kim Jong-un's bluff about targeting Guam with ballistic missiles and kept up Maximum Pressure throughout a summer full of rhetorical bluster. As tensions rose, China blinked first, enforcing President Trump's demand for tighter sanctions. China did not want the U.S. to attack North Korea or to use the North Korean threat as a reason to build up its military assets in the region. The collapse of North Korean exports to China ultimately starved the regime of hard cash and, in conjunction with U.S. military and rhetorical pressure, forced Kim Jong-un to back off (Chart 10). In essence, President Trump's doctrine is a modification of President Theodore Roosevelt's maxim. Instead of "talking softly," President Trump recommends "tweeting aggressively".8 It is important to recount the North Korean experience for several reasons: Maximum Pressure worked with North Korea: It is an objective fact that President Trump was correct in using Maximum Pressure on North Korea. Our analysis last year carefully detailed why it would be a success. However, we also specifically outlined why it would work with North Korea. Particularly relevant was Pyongyang's inability to counter American economic pressure and rhetoric with material leverage. Kim Jong-un's only objective capability is to launch a massive artillery attack against civilians in Seoul. Given his preference not to engage in a full-out war against South Korea and the U.S., he balked and folded. Trump is tripling-down on what works: President Trump, as all presidents before him, is learning on the job. The North Korean experience has convinced him that his Maximum Pressure tactic works. In particular, it works because it forces third parties to enforce economic sanctions on the target nation. If China were to abandon its traditional ally North Korea and enforced painful sanctions, the logic goes, then Europeans would ditch Iran much faster. Iran is not North Korea: The danger with applying a Maximum Pressure tactic against Iran is that Tehran has multiple levers around the Middle East that it could deploy to counter U.S. pressure. President Obama did not sign the JCPOA merely because he was a dove.9 He did so because the deal resolved several regional security challenges and allowed the U.S. to pivot to Asia (Chart 11). Chart 10Maximum Pressure Worked On Pyongyang Maximum Pressure Worked On Pyongyang Maximum Pressure Worked On Pyongyang Chart 11Iran Nuclear Deal Had A Strategic Imperative Iran Nuclear Deal Had A Strategic Imperative Iran Nuclear Deal Had A Strategic Imperative To understand why Iran is not North Korea, and how the application of Maximum Pressure could induce greater uncertainty in this case, investors first have to comprehend why the U.S.-Iran nuclear deal was concluded in the first place. Maximum Pressure Applied To Iran The 2015 U.S.-Iran deal resolved a crucial security dilemma in the Middle East: what to do about Iran's growing power in the region. Ever since the U.S. toppling of Saddam Hussein's regime in 2003, the fulcrum of the region's disequilibrium has been the status of Iraq. Iraq is a natural geographic buffer between Iran and Saudi Arabia, the two regional rivals. Hussein, a Sunni, ruled Iraq - 65% of which is Shia - either as an overt client of the U.S. and Saudi Arabia (1980-1988), or as a free agent largely opposed to everyone in the region (from 1990s onwards). Both options were largely acceptable to Saudi Arabia, although the former was preferable. Iran quickly seized the initiative in Iraq following the U.S. overthrow of Hussein, which created a vast vacuum of power in the country. Elite members of the country's Revolutionary Guards (IRGC), the so-called Quds Force, infiltrated Iraq and supplied various Shia militias with weapons and training that fueled the anti-U.S. insurgency. An overt Iranian ally, Nouri al-Maliki, assumed power in 2006. Soon the anti-U.S. insurgency evolved into sectarian violence as the Sunni population revolted and various Sunni militias, supported by Saudi Arabia, rose up against Shia-dominated Baghdad. The U.S. troops stationed in Iraq quickly became either incapable of controlling the sectarian violence or direct targets of the violence themselves. This rebellion eventually mutated into the Islamic State, which spread from Iraq to Syria in 2012 and then back to Iraq two years later. The Obama administration quickly realized that a U.S. military presence in Iraq would have to be permanent if Iranian influence in the country was to be curbed in the long term. This position was untenable, however, given U.S. military casualties in Iraq, American public opinion about the war, and lack of clarity on U.S. long-term interests in Iraq in the first place. President Obama therefore simultaneously withdrew American troops from Iraq in 2011 and began pressuring Iran on its nuclear program between 2011 and 2015.10 In addition, the U.S. demanded that Iran curb its influence in Iraq, that its anti-American/Israel rhetoric cease, and that it help defend Iraq against the attacks by the Islamic State in 2014. Tehran obliged on all three fronts, joining forces with the U.S. Air Force and Special Forces in the defense of Baghdad in the fall 2014.11 In 2014, Iran acquiesced in seeing its ally al-Maliki replaced by the far less sectarian Haider al-Abadi. These moves helped ease tensions between the U.S. and Iran and led to the signing of the JCPOA in 2015. From Tehran's perspective, it has abided by all the demands made by Washington during the 2012-2015 negotiations, both those covered by the JCPOA overtly and those never explicitly put down on paper. Yes, Iran's influence in the Middle East has expanded well beyond Iraq and into Syria, where Iranian troops are overtly supporting President Bashar al-Assad. But from Iran's perspective, the U.S. abandoned Syria in 2012 - when President Obama failed to enforce his "red line" on chemical weapons use. In fact, without Iranian and Russian intervention, it is likely that the Islamic State would have gained a greater foothold in Syria. The point that its critics miss is that the 2015 nuclear deal always envisioned giving Iran a sphere of influence in the Middle East. Otherwise, Tehran would not have agreed to curb its nuclear program! To force Iran to negotiate, President Obama did threaten Tehran with military force. As we have detailed in the past, President Obama established a credible threat by outsourcing it to Israel in 2011. It was this threat of a unilateral Israeli attack, which Obama did little to limit or prevent, that ultimately forced Europeans to accept the hawkish American position and impose crippling economic sanctions against Iran in early 2012. As such, it is highly unlikely that a rerun of the same strategy by the U.S., this time with Trump in charge and with potentially less global cooperation on sanctions, will produce a different, or better, deal. The recent history is important to recount because the Trump administration is convinced that it can get a better deal from Iran than the Obama administration did. This may be true, but it will require considerable amounts of pressure on Iran to achieve it. At some point, we expect that this pressure will look very much like a preparation for war against Iran, either by U.S. allies Israel and Saudi Arabia, or by the U.S. itself. First, President Trump will have to create a credible threat of force, as President Obama and Israeli Prime Minister Benjamin Netanyahu did in 2011-2012. Second, President Trump will have to be willing to sanction companies in Europe and Asia for doing business with Iran in order to curb Iran's oil exports. According to National Security Advisor John Bolton, European companies will have by the end of 2018 to curb their activities with Iran or face sanctions. The one difference this time around is Iraqi politics. Elections held on May 13 appear to have resulted in a surge of support for anti-Iranian Shia candidates, starting with the ardently anti-American and anti-Iranian Shia Ayatollah Muqtada al-Sadr. Sadr is a Shia, but also an Iraqi nationalist who campaigned on an anti-Tehran, anti-poverty, anti-corruption line. If the election signals a clear shift in Baghdad against Iran, then Iran may have one less important lever to play against the U.S. and its allies. However, we are only cautiously optimistic about Iraq. Pro-Iranian Shia forces, while in a clear minority, still maintain the support of roughly half of Iraqi Shias. And al-Sadr may not be able to govern effectively, given that his track record thus far mainly consists of waging insurgent warfare (against Americans) and whipping up populist fervor (against Iran). Any move in Baghdad, with U.S. and Saudi backing, to limit Iranian-allied Shia groups from government could lead to renewed sectarian conflict. Therein lies the key difference between North Korea and Iran. Iran has military, intelligence, and operational capabilities that North Korea does not. This is precisely why the U.S. concluded the 2015 deal in the first place, so that Iran would curb those capabilities regionally and limit its operations to the Iranian "sphere of influence." In addition, Iran is constrained against reopening negotiations with the U.S. domestically by the ongoing political contest between the moderates - such as President Hassan Rouhani - and the hawks - represented by the military and intelligence nexus. Supreme Leader Khamenei sits somewhere in the middle, but will side with the hawks if it looks like Rouhani's promise of economic benefits from the détente with the West will fall short of reality. The combination of domestic pressure and capabilities therefore makes it likely that Iran retaliates against American pressure at some point. While such retaliation could be largely investment-irrelevant - say by supporting Hezbollah rocket attacks into Israel or ramping up military operations in Syria - it could also affect oil prices if it includes activities in and around the Persian Gulf. Bottom Line: We caution clients not to believe the narrative that "Trump is all talk." As the example in North Korea suggests, Trump's rhetoric drove China to enforce sanctions in order to avert war on the Korean Peninsula. We therefore expect the U.S. administration to continue to threaten European and Asian partners and allies with sanctions, causing an eventual drop in Iranian oil exports. In addition, we expect Iran to play hardball, using its various proxies in the region to remind the Trump administration why Obama signed the 2015 deal in the first place. Could Trump ultimately be right on Iran as he was on North Korea? Absolutely. It is simply naïve to assume that Iran will negotiate without Maximum Pressure, which by definition will be market-relevant. Impact On Energy Markets BCA Energy Sector Strategy believes that the re-imposition of sanctions could result in a loss of 300,000-500,000 b/d of production by early 2019.12 This would take 2019 production back down to 3.3-3.5 MMB/d instead of growing to nearly 4.0 MMb/d as our commodity strategists have modeled in their supply-demand forecasts. In total, Iranian sanctions could tighten up the outlook for 2019 oil markets by 400,000-600,000 b/d, reversing the production that Iran has brought online since 2016 (Chart 12). Is the global energy market able to withstand this type of loss of production? First, Chart 13 shows that the enormous oversupply of crude oil and oil products held in inventories has already been cut from 450 million barrels at its peak to less than 100 million barrels today. Surplus inventories are destined to shrink to nothing by the end of the year even without geopolitical risks. In short, there is no excess inventory cushion. Chart 12Current And Future Iran Production Is At Risk Current And Future Iran Production Is At Risk Current And Future Iran Production Is At Risk Chart 13Excess Petroleum Inventories Are All But Gone Excess Petroleum Inventories Are All But Gone Excess Petroleum Inventories Are All But Gone Second, spare capacity within the OPEC 2.0 alliance - Saudi Arabia and Russia - is controversial. Many clients believe that OPEC 2.0 could easily restore the 1.8 MMb/d of production that they agreed to hold off the market since early 2017. However, our commodity team has always considered the full number to be an illusion that consists of 1.2 MMb/d of voluntary cuts and around 500,000 b/d of natural production declines that were counted as "cuts" so that the cartel could project an image of greater collaboration than it actually has achieved (Chart 14). In fact, some of the lesser "contributors" to the OPEC cut pledged to lower 2017 production by ~400,000 b/d, but are facing 2018 production levels that are projected to be ~700,000 b/d below their 2016 reference levels, and 2019 production levels are estimated to decline by another 200,000 b/d (Chart 15). Chart 14Primary OPEC 2.0 Members Are ##br##Producing 1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Chart 15Secondary OPEC 2.0 "Contributors"##br## Can't Even Reach Their Quotas Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Third, renewed Iran-U.S. tensions may only be the second-most investment-relevant geopolitical risk for oil markets. Our commodity team expects Venezuelan production to fall to 1.23 MMb/d by the end of 2018 and to 1 MMb/d by the end of 2019, but these production levels could turn out to be optimistic (Chart 16). Venezuelan production declined by 450,000 b/d over the course of 21 months (December 2015 to September 2017), followed by another 450,000 b/d plunge over the past six months (September 2017 to March 2018), as the country's failing economy goes through the death spiral of its 20-year socialist experiment. The oil production supply chain is now suffering from shortages of everything, including capital. It is difficult to predict what broken link in the supply chain is most likely to impact production next, when it will happen, and what the size of the production impact will be. The combination of President Trump's Maximum Pressure doctrine applied to Iran, continued deterioration in Venezuelan production, and the inability of OPEC 2.0 to surge production as fast as the market thinks is unambiguously bullish for oil prices. Oil markets are currently pricing in a just under 35% probability that oil prices will exceed $80/bbl by year-end (Chart 17).13 We believe these odds are too low and will take the other side of that bet. Indeed, we think that the odds of Brent prices ending above $90/bbl this year are much higher than the 16% chance being priced in the markets presently, even though this is up from just under 4% at the beginning of the year. Chart 16Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk Chart 17Market Continues To Underestimate High Oil Prices Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" Bottom Line: Our colleague Bob Ryan, Chief Commodity & Energy Strategist, also expects higher volatility, as news flows become noisier. The recommendation by BCA's Commodity & Energy Strategy is to go long Feb/19 $80/bbl Brent calls expiring in Dec/18 vs. short Feb/19 $85/bbl calls, given our assessment that the odds of ending the year above $90/bbl are higher than the market's expectations. A key variable to watch in the ongoing saga will be President Trump's willingness to impose secondary sanctions against European and Asian companies doing business with Iran. We do not think that the White House is bluffing. The mounting probability of sanctions will create "stroke of pen" risk and raise compliance costs to doing business with Iran, leading to lower Iranian exports by the end of the year. Europe Update: Political Risks Returning Risks in Europe are rising on multiple fronts. First, we continue to believe that the domestic political situation in the U.K. regarding Brexit is untenable. Second, the coalition of populists in Italy - combining the anti-establishment Five Star Movement (M5S) and the Euroskeptic Lega - appears poised to become a reality. Brexit: Start Pricing In Prime Minister Corbyn Since our Brexit update in February, the pound has taken a wild ride, but our view has remained the same.14 PM May has an untenable negotiating position. The soft-Brexit majority in Westminster is growing confident while the hard-Brexit majority in her own Tory party is growing louder. We do not know who will win, but odds of an unclear outcome are growing. The first problem is the status of Northern Ireland. The 1998 Good Friday agreement, which ended decades of paramilitary conflict on the island, established an invisible border between the Republic of Ireland and Northern Ireland. Membership in the EU by both made the removal of a physical border a simple affair. But if the U.K. exits the bloc, and takes Northern Ireland with it, presumably a physical barrier would have to be reestablished, either in Ireland or between Northern Ireland and the rest of the U.K. The former would jeopardize the Good Friday agreement, the latter would jeopardize the U.K.'s integrity as a state. The EU, led on by Dublin's interests, has proposed that Northern Ireland maintain some elements of the EU acquis communautaire - the accumulated body of EU's laws and obligations - in order to facilitate the effectiveness of the 1998 Good Friday agreement. For many Tories in the U.K., particularly those who consider themselves "Unionists," the arrangement smacks of a Trojan Horse by the EU to slowly but surely untie the strings that bind the U.K. together. If Northern Ireland gets an exception, then pro-EU Scotland is sure to ask for one too. The second problem is that the Tories are divided on whether to remain part of the EU customs union. PM May is in favor of a "customs partnership" with the EU, which would see unified tariffs and duties on goods and services across the EU bloc and the U.K. However, her own cabinet voted against her on the issue, mainly because a customs union with the EU would eliminate the main supposed benefit of Brexit: negotiating free trade deals independent of the EU. It is unclear how PM May intends to resolve the multiple disagreements on these issues within her party. Thus far, her strategy was to simply put the eventual deal with the EU up for a vote in Westminster. She agreed to hold such a vote, but with the caveat that a vote against the deal would break off negotiations with the EU and lead to a total Brexit. The threat of such a hard Brexit would force soft Brexiters among the Tories to accept whatever compromise she got from Brussels. Unfortunately for May's tactic, the House of Lords voted on April 30 to amend the flagship EU Withdrawal Bill to empower Westminster to send the government back to the negotiating table in case of a rejection of the final deal with the EU. The amendment will be accepted if the House of Commons agrees to it, which it may, given that a number of soft Brexit Tories are receptive. A defeat of the final negotiated settlement could prolong negotiations with the EU. Brussels is on record stating that it would prolong the transition period and give the U.K. a different Brexit date, moving the current date of March 2019. However, it is unclear why May would continue negotiating at that point, given that her own parliament would send her back to Brussels, hat in hand. The fundamental problem for May is the same that has plagued the last three Tory Prime Ministers: the U.K. Conservative Party is intractably split with itself on Brexit. The only way to resolve the split may be for PM May to call an election and give herself a mandate to negotiate with the EU once she is politically recapitalized. This realization, that the probability of a new election is non-negligible, will likely weigh on the pound going forward. Investors would likely balk at the possibility that Jeremy Corbyn will become the prime minister, although polling data suggests that his surge in popularity is over (Chart 18). Local elections in early May also ended inconclusively for Labour's chances, with no big outpouring for left-leaning candidates. Even if Labour is forced to form a coalition with the Scottish National Party (SNP), it is unlikely that the left-leaning SNP would be much of a check on Corbyn's Labour. Chart 18Corbyn's Popularity Is In Decline Corbyn's Popularity Is In Decline Corbyn's Popularity Is In Decline Bottom Line: Theresa May will either have to call a new election between now and March of next year or she will use the threat of a new election to get hard-Brexit Tories in line. Either way, markets will have to reprice the probability of a Labour-led government between now and a resolution to the Brexit crisis. Italy: Start Pricing In A Populist Government Leaders of Italy's populist parties - M5S and Lega - have come to an agreement on a coalition that will put the two anti-establishment parties in charge of the EU's third-largest economy. Markets are taking the news in stride because M5S has taken a 180-degree turn on Euroskepticism. Although Lega remains overtly Euroskeptic, its leader Matteo Salvini has said that he does not want a chaotic exit from the currency bloc. Is the market right to ignore the risks? On one hand, it is a positive development that the anti-establishment forces take over the reins in Italy. Establishment parties have failed to reform the country, while time spent in government will de-radicalize both anti-establishment parties. Furthermore, the one item on the political agenda that both parties agree on is to radically curb illegal migration into Italy, a process that is already underway (Chart 19). On the other hand, the economic pact signed by both parties is completely and utterly incompatible with reality. It combines a flat tax and a guaranteed basic income with a lowering of the retirement age. This would blow a hole in Italy's budget, barring a miraculous positive impact on GDP growth. The market is likely ignoring the coalition's economic policies as it assumes they cannot be put into action. This is not because Rome is afraid to flout Brussels' rules, but because the bond market is not going to finance Italian expenditures. Long-dated Italian bonds are already cheap relative to the country's credit rating (Chart 20), evidence that the market is asking for a premium to finance Italian expenditures. This is despite the ongoing ECB bond buying efforts. Once the ECB ends the program later this year, or in early 2019, the pressure on Rome from the bond market will grow. Chart 19European Migration Crisis Is Over European Migration Crisis Is Over European Migration Crisis Is Over Chart 20Italian Bonds Still Require A Risk Premium Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" We suspect that both M5S and Lega are aware of their constraints. After all, neither M5S leader Luigi Di Maio nor Lega's Salvini are going to take the prime minister spot. This is extraordinary! We cannot remember the last time a leader of the winning party refused to take the top political spot following an election. Both Di Maio and Salvini are trying to pass the buck for the failure of the coalition. In one way, this is market-positive, as it suggests that the anti-establishment coalition will do nothing of note during its mandate. But it also suggests that markets will have to deal with a new Italian election relatively quickly. As such, we would warn investors to steer clear of Italian assets. Their performance in 2017, and early 2018, suggests that the market has already priced in the most market-positive outcome. Yes, Italy will not leave the Euro Area. But no, there is no "Macron of Italy" to resolve its long-term growth problems. Bottom Line: The Italian government formation is not market-positive. Italian bonds are cheap for a reason. While it is unlikely that the populist coalition will have the room to maneuver its profligate coalition deal into action, the bond market may have to discipline Italian policymakers from time to time. In the long term, none of the structural problems that Italy faces - many of which we have identified in a number of reports - will be tackled by the incoming coalition.15 This will expose Italy to an eventual resurgence in Euroskepticism at the first sight of the next recession. Emerging Markets: Elections In Malaysia And Turkey Offer Divergent Outcomes As we pointed out at the beginning of this report, an environment of rising U.S. yields, a surging dollar, and moderating global growth is negative for emerging markets. In this context, politics is unlikely to make much of a difference. The recently announced early election in Turkey is a case in point. Markets briefly cheered the announced election (Chart 21), before investors realized that there is unlikely to be a consolidation of power behind President Erdogan (Chart 22). Even if Erdogan were to somehow massively outperform expectations and consolidate political capital, it is not clear why investors would cheer such an outcome given his track record, particularly on the economy, over the past decade. Chart 21Investors Briefly Cheered Ankara's Snap Election Investors Briefly Cheered Ankara's Snap Election Investors Briefly Cheered Ankara's Snap Election Chart 22Is Erdogan In Trouble? Is Erdogan In Trouble? Is Erdogan In Trouble? Malaysia, on the other hand, could be the one EM economy that defies the negative macro context due to political events. Our most bullish long-term scenario for Malaysia - a historic victory for the opposition Pakatan Harapan coalition - came to pass with the election on May 9 (Chart 23).16 Significantly, outgoing Prime Minister Najib Razak accepted the election results as the will of the people. He did not incite violence or refuse to cede power. Rather, he congratulated incoming Prime Minister Mahathir Mohamad and promised to help ensure a smooth transition. This marks the first transfer of power since Malaysian independence in 1957. It was democratic and peaceful, which establishes a hugely consequential and market-friendly precedent. How did the opposition pull off this historic upset? Ethnic-majority Malays swung to the opposition; Mahathir's "charismatic authority" had an outsized effect; Barisan Nasional "safety deposits" in Sabah and Sarawak failed; Voters rejected fundamentalist Islamism. What are the implications? Better Governance - Governance has been deteriorating, especially under Najib's rule, but now voters have demanded improvements that could include term-limits for prime ministers and legislative protections for officials investigating wrongdoing by top leaders (Chart 24). Economic Stimulus - Pakatan Harapan campaigned against some of the painful pro-market structural reforms that Najib put in place. They have promised to repeal the new Goods and Services Tax (GST) and reinstate fuel subsidies. They have also proposed raising the minimum wage and harmonizing it across the country. While these pledges will be watered down,17 they are positive for nominal growth in the short term but negative for fiscal sustainability in the long term. Chart 23Comfortable Majority For Pakatan Harapan Coalition Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" Chart 24Voters Want Governance Improvements Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" The one understated risk comes from China. Najib's weakness had led him to court China and rely increasingly on Chinese investment as an economic strategy. Mahathir and Pakatan Harapan will seek to revise all Chinese investment (including under the Belt and Road Initiative). This review is not necessarily to cancel projects but to haggle about prices and ensure that domestic labor is employed. Mahathir will also try to assert Malaysian rights in the South China Sea. None of this means that a crisis is impending, but China has increasingly used economic sanctions to punish and reward its neighbors according to whether their electoral outcomes are favorable to China,18 and we expect tensions to increase. Investment Conclusion On the one hand, in the short run, the picture for Malaysia is mixed. Pakatan Harapan will likely pursue some stimulative economic policies, but these come amidst fundamental macro weaknesses that we have highlighted in the past - and may even exacerbate them. On the other hand, a key external factor is working in the new government's favor: oil. With oil prices likely to move higher, the Malaysian ringgit is likely to benefit (Chart 25), helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power, a key election grievance. Higher oil prices are also correlated with higher equity prices. Over the long run, we have a high-conviction view that this election is bullish for Malaysia. It sends a historic signal that the populace wants better governance. BCA's Emerging Markets Strategy has found that improvements in governance are crucial for long-term productivity, growth, and asset performance.19 Hence, BCA's Geopolitical Strategy recommends clients go long Malaysian equities relative to EM. Now is a good entry point despite short-term volatility (Chart 26). We also think that going long MYR/TRY will articulate both our bullish oil story as well as our divergent views on political risks in Malaysia and Turkey (Chart 27). Chart 25Oil Outlook Favors Malaysian Assets Oil Outlook Favors Malaysian Assets Oil Outlook Favors Malaysian Assets Chart 26Long Malaysian Equities Versus EM Long Malaysian Equities Versus EM Long Malaysian Equities Versus EM Chart 27Higher Oil Prices Favor MYR Than TRY Higher Oil Prices Favor MYR Than TRY Higher Oil Prices Favor MYR Than TRY We are re-initiating two trades this week. First, the recently stopped out long Russian / short EM equities recommendation. We still believe that the view is on strong fundamentals, at least in the tactical and cyclical sense.20 Russian President Vladimir Putin has won another mandate and appears to be focusing on domestic economy and the constraints to Russian geopolitical adventurism have grown. The Trump administration has apparently also grown wary of further sanctions against Russia. However, our initial timing was massively off, as tensions between Russia and West did not peak in early March as we thought. We are giving this high-risk, high-reward trade another go, particularly in light of our oil price outlook. Second, we booked 10.26% gains on our recommendation to go long French industrials versus their German counterparts. We are reopening this view again as structural reforms continue in France unimpeded. Meanwhile, risk of global trade wars and a global growth slowdown should impact the high-beta German industrials more than the French. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Senior Analyst jesse.kuri@bcaresearch.com 1 Washington's demand that China cut its annual trade surplus has grown from $100 billion, announced previously by President Trump, to at least $200 billion. 2 Please see BCA Emerging Markets Strategy Weekly Report, "EM: A Correction Or Bear Market?" dated May 10, 2018, available at ems.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "'America Is Roaring Back!' (But Why Is King Dollar Whispering?),"dated January 31, 2018, and Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat,'" dated April 7, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, and "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 8 Instead of a "big stick," President Trump would likely also recommend a "big nuclear button." 9 This is an important though obvious point. We find that many liberally-oriented clients are unwilling to give President Trump credit for correctly handling the North Korean negotiations. Similarly, conservative-oriented clients refuse to accept that President Obama's dealings with Iran had a strategic logic, even though they clearly did. President Obama would not have been able to conclude the JCPOA without the full support of U.S. intelligence and military establishment. 10 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 11 While there was no confirmed collaboration between Iranian ground forces in Iraq and the U.S. Air Force, we assume that it happened in 2014 in the defense of Baghdad. The U.S. A-10 Warthog was extensively used against Islamic State ground forces in that battle. The plane is most effective when it has communication from ground forces engaging enemy units. Given that Iranian troops and Iranian backed Shia militias did the majority of the fighting in the defense of Baghdad, we assume that there was tactical communication between U.S. and the Iranian military in 2014, a whole year before the U.S.-Iran nuclear détente was concluded. 12 Please see BCA Energy Sector Strategy Weekly Report, "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," dated May 9, 2018, available at nrg.bcaresearch.com. 13 Please see BCA Commodity & Energy Strategy Weekly Report, "Feedback Loop: Spec Positioning & Oil Price Volatility," dated May 10, 2018, available at ces.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "Bear Hunting And A Brexit Update," dated February 14, 2018, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, and "Europe's Divine Comedy Party II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "How To Play Malaysia's Elections (And Thailand's Lack Thereof)," dated March 21, 2018, available at gps.bcaresearch.com. 17 For instance, the proposed Sales and Services Tax (SST) is more like a rebranding of the GST than a true abolition. And while fuel subsidies will be reinstated - weighing on the fiscal deficit - they will have a quota and only certain vehicles will be eligible. It will not be a return to the old pricing regime where subsidies were unlimited and were for everyone. 18 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Special Report, "Ranking EM Countries Based on Structural Variables," dated August 2, 2017, available at ems.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Special Report, "Vladimir Putin, Act IV," dated March 7, 2018, available at gps.bcaresearch.com.

Highlights The grand U.S.-China strategic negotiation is focused on Korea and trade - only Korea is seeing good news; The trade war is expanding to include investment - and Chinese capital account liberalization is the silver bullet; Capital account openness has mixed benefits for EMs, yet the risks are dire. China's policymakers will move only gradually; If Trump demands faster liberalization, a full-blown trade war is more likely; Favor DM equities over EM. Feature The American and Chinese economies have diverged for years (Chart 1), threatening to remove the constraint on broader strategic disagreements. Amidst the uncertainty, a grand U.S.-China negotiation is taking place, focused on two primary dimensions: Korea and trade. Chart 1Economic Constraint To Conflict Erodes Economic Constraint To Conflict Erodes Economic Constraint To Conflict Erodes On the Korea front, the news is mostly positive.1 The leaders of North and South Korea have held their third summit, promising an end to hostilities and a new beginning for economic engagement and possibly denuclearization. They are laying the groundwork for U.S. President Donald Trump to meet North Korean leader Kim Jong Un sometime this month, or in June. From China's point of view, the North Korean developments are mostly positive. A belligerent North Korea provides the U.S. and its allies with a reason to build up their military assets in the region, which can also serve to contain China. A calmer North Korea removes this reason and, over the long run, holds out the potential for the reduction of U.S. troops in South Korea. On net, China has benefited from the opening up of the formerly reclusive Vietnamese and Myanmar economies and stands to do the same if North Korea follows suit. On U.S.-China trade, however, the news is not so good.2 The two countries have just seen another high-level embassy conclude without progress, all but ensuring that relations will get worse before they get better. Investors should prepare for the U.S. to take additional punitive measures and for China to retaliate in kind. The U.S. Treasury Department is on the verge of imposing landmark new restrictions on Chinese investment by May 21 or sooner. Congress, separate from the Trump administration and in a notable sign of bipartisan unity, is considering legislation that would do the same. This is independent from Trump's impending tariffs on $50-$150 billion worth of Chinese goods, which could also come as early as May 21. In other words, the U.S.-China economic conflict is rotating from trade to investment. Hence, in this report, we take a look at the "Holy Grail" of American demands on China: capital account liberalization. So far the Trump administration has not pushed its demands this far. That is a good thing, because China is not willing to move quickly on this front. Rapid and complete opening to global capital flows is a "red line" for China, so it is an important indicator of whether the two great powers are heading toward a full-blown trade war. The Uncertainties Of Capital Account Liberalization A country's capital account covers foreign direct investment (FDI), portfolio investment, cross-border banking transactions, and other miscellaneous international capital flows. Since the 1960s, especially since 1989, developed market economies in the West have encouraged the free flow of capital across national borders (Chart 2). As with the free flow of goods, services, and labor, the flow of capital promised integrated markets and more efficient uses of resources. Just as freer trade would lower prices, spur competition, and improve efficiency and innovation, so would the unfettered movement of capital. Trading partners could use savings to invest in each other's areas of productive potential that lacked funds. In this sense, capital flows were nothing but future trade flows: today's cross-border investment would be tomorrow's production of freely tradable goods.3 The laissez-faire, Anglo-Saxon economies promoted capital account liberalization for several reasons. First, economic theory and practice supported free trade as a means of increasing wealth, and free trade requires some degree of capital liberalization. Furthermore, liberalization played to the advantage of London and New York City, as international financial hubs, and both the U.S. and the U.K. sought to expand their role as providers of global reserve currencies.4 The European Community also sought freer capital flows due to the fact that the creation of the common market, at minimum, required it for trade financing. In the 1980s, France's bad experience with capital controls led it to adopt a more laissez-faire approach, prompting a convergence across Europe to the Anglo-Saxon model. Capital account liberalization joined free trade, fiscal conservatism, and deregulation as part of the "Washington Consensus" orthodoxy. Major economies were encouraged to liberalize their capital accounts if they wanted to join the OECD, like Japan, or if they sought economic and financial assistance from the IMF (Table 1).5 And yet the empirical evidence of the benefits of capital account liberalization is surprisingly mixed. There is not a clear causal connection between free movement of capital and improved macroeconomic variables like higher rates of growth, investment, or productivity. Relative to other kinds of international liberalization - of labor markets, for example - capital account liberalization is likely to bring small gains to growth rates (Table 2). Chart 2Global Capital Flows Expand China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Table 1Capital Account Liberalization: A Timeline China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Table 2Economic Benefits Of Open Borders China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks We can illustrate this point simply by showing that emerging market economies with more open capital accounts, whether defined by the IMF's Capital Account Openness Index or by the ratio of direct and portfolio capital flows to GDP, do not necessarily have higher potential GDP growth or productivity (Chart 3 A&B). A change in openness also does not correlate with a change in growth potential or productivity. Chart 3AEM Capital Openness Not Obviously Correlated With Potential Growth (1) China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Chart 3BEM Capital Openness Not Obviously Correlated With Potential Growth (2) China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks This conclusion can be reinforced by looking at portfolio investment. Portfolio investment is usually one of the last types of investment to be deregulated. Hence a large ratio of portfolio investment to GDP is a proxy for capital liberalization. However, emerging markets that rank high in this regard do not record higher potential growth, productivity, or capital productivity contributions to GDP growth (Chart 4). Chart 4EM: Larger Foreign Stock Inflows Not Correlated With Capital Productivity China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks While the benefits of capital account liberalization are debatable, the risks are dire. It has contributed to, if not caused, a number of financial crises in recent decades. Latin America saw a series of such crises from 1982-89. Mexico's peso crisis of 1994 also owed much of its severity to destabilizing capital flows. Japan opened its capital account in 1979 and over the succeeding decade experienced a rollercoaster of massive capital influx, culminating in the property bubble and financial crash of 1990. Thailand, South Korea, and other Asian countries suffered the Asian Financial Crisis of 1997-98 as a result of premature and poorly sequenced liberalization. All of these countries faced different financial and economic circumstances, and the crises had different causes, but what they shared in common was a relatively recent openness to large inflows and outflows of global capital that triggered or exacerbated currency moves and liquidity shortages.6 This is not to say that there are not benefits to capital account liberalization, or that the benefits never outweigh the costs. The major multilateral global institutions continue to believe that capital account liberalization is optimal policy, if only because the richest, freest, best governed, and most advanced economies have all liberalized. Capital account openness is positively correlated with "rule of law" governance indicators. And back-of-the-envelope exercises such as those shown above suggest that developed market economies do see higher potential growth and capital productivity as a result of capital account liberalization, at least up to a point (Charts 5A & 5B). Chart 5ADM: Capital Openness Is Correlated With Potential Growth (1) China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Chart 5BDM: Capital Openness Is Correlated With Potential Growth (2) China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks While a number of countries have experienced financial and economic crises after opening their capital accounts, studies have shown that the causal connection is not always clear (the crisis did not necessarily stem from capital account liberalization).7 The removal of barriers to entry or exit of capital does not have a unidirectional effect but can exacerbate capital flows when times are good or bad. Moreover, some research shows that countries are more likely to suffer financial crises from capital controls than from the removal of them.8 And it is very difficult for countries with open current accounts (free trade) to enforce rigid capital controls anyway, since the distinction between capital flows covering trade transactions and other capital flows is difficult in practice to enforce, resulting in leakage. Because of the link between trade and capital, no country has ever fully and permanently reversed liberalization.9 The academic debate rages on, but from a political point of view, two things are clear. First, the best practices of the most advanced countries suggest that capital account liberalization is optimal policy. Second, policymakers in less open economies are faced with uncertainty and a range of views from economic advisers, orthodox and unorthodox. In the wake of crises in recent decades, this uncertainty has made them less inclined over the years to trust to economic orthodoxy or the "Washington Consensus" when making critical decisions about capital flows. Rather, opening is likely when economic problems call for a change in tack, while capital controls are likely when flows are considered excessive or destabilizing. Bottom Line: Capital account liberalization is the best practice among advanced economies but the risk-reward ratio for policymakers in EMs and partly closed economies is likely skewed to the downside. China's Stalled Capital Account Liberalization Chart 6China's Fear Of Capital Flight China's Fear Of Capital Flight China's Fear Of Capital Flight In recent years China's policymakers have struggled with the problem of capital account liberalization. In the aftermath of the global financial crisis they announced that they would speed up the process. In 2015 they pledged to complete it by 2020, only to re-impose capital controls when financial turmoil that year prompted large capital outflows (Chart 6). In 2017 President Xi Jinping claimed that the country remains committed to gradual liberalization. We have argued that his administration would ease these controls later rather than sooner, in order to pursue tricky domestic financial reforms first.10 As we have seen (Chart 3 above), China lies on the low end of the IMF's "Capital Account Openness" index, which ranks countries across the world based on six economic indicators and 12 asset classes. By this measure, China is slightly more open than India - a notoriously hermetic economy - and less open than the Philippines. China's closed capital account is also clear from its international investment position. China has fewer international assets and liabilities, as a share of output, than the U.S., Japan, Europe, or South Korea (Charts 7A & 7B). China's international assets are largely the result of its government's $3.1 trillion in foreign exchange reserves, as well as outward FDI. As for its liabilities, China has opened up to FDI more so than portfolio investment or other capital flows. This is because FDI is long-term capital that tends to be more closely tied to real production; it is difficult to unwind it in times of crisis. China allows inward and outward FDI to gain knowhow, technology, and natural resources. It is more closed, however, to short-term capital flows, such as dollar-denominated bank debt, currency speculation, and portfolio investment. Typically it is these short-term flows that are most destabilizing, especially when countries are newly open to them. Chart 7AChina Has Fewer Foreign Assets, Mostly Official Forex Reserves China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Chart 7BChina Has Fewer Foreign Liabilities, Mostly FDI China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Western economies, however, stand to benefit if China opens up to these shorter-term capital flows. They have a comparative advantage in financial services and thus can rebalance their relationships with China if it gives its households and corporations more freedom to manage their wealth in foreign currencies and assets. It is logical that China's FDI and portfolio investment in western countries would rise if Chinese investors were allowed to go abroad, simply because the latter would wish to diversify their portfolios for the first time. China's neighbors and trade partners would receive a windfall of new investments. Meanwhile they would gain new investment opportunities, as private capital would be able to venture into China, and flee out of it, more easily.11 Western countries are also increasingly agitating for China to loosen its inward capital restrictions. Despite China's openness to FDI relative to other capital flows, it is still one of the world's most restrictive countries in which to invest long-term capital (Chart 8). China's heavy restrictions have granted monopolies to Chinese companies, depriving foreigners of the fruits of China's growth. This is especially important as China moves into consumer- and services-oriented growth. Western countries have a comparative advantage in high-end consumer goods and services relative to low-end goods and manufacturing in general, where they have largely lost out to Chinese competition in recent decades. Chart 8China Is Highly Restrictive Toward Foreign Direct Investment China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks China, too, stands to benefit from freer capital flows, and policymakers believe there is a self-interest in liberalizing. But Beijing has repeatedly demonstrated that it wants to move very gradually because of the skewed risk-reward assessment. China's harrowing experience with capital flight in 2014-16 has vindicated this policy.12 It is not necessarily capital account opening per se that causes destabilizing capital outflows - it is also the macro and financial environment. And China has all the hallmarks of an economy that could suffer a crisis from premature liberalization, including: Large macro imbalances (Chart 9); An immature and shallow financial system (Chart 10); Lack of information transparency; Weak rule of law. Chart 9China Has Macro Imbalances China Has Macro Imbalances China Has Macro Imbalances Chart 10China's Financial System Is Shallow China's Financial System Is Shallow China's Financial System Is Shallow Bottom Line: It is guaranteed that China will not pursue capital account liberalization rapidly. It will continue to take small steps, and ultimately "two steps forward and one step back" if necessary to maintain overall stability. Will China Liberalize? By the same logic, why should China liberalize at all? The 2014-16 crisis not only revealed the dangers of too-rapid opening but also the dangers of an inflexible currency and draconian capital controls. When Chinese authorities devalued the yuan in August 2015, they made the capital flight (and global panic) worse. Since then, by imposing strict capital controls, China's leaders have signaled to domestic and foreign investors (1) that they are unwilling to allow global capital flows to discipline their fiscal or monetary policies (a negative sign for China's macro fundamentals), and (2) that they may deny investors the rights of their property or even confiscate it.13 This is why China has made important policy changes since the 2014-16 crisis. First, it has maintained a more flexible "managed float" of the RMB, allowing it to trade more freely along with a basket of currencies that belong to major trading partners and abandoning the dollar peg. Various measures of the exchange rate - offshore deliverable forwards, spot rates, and the exchange rate at interest rate parity - have converged, revealing an exchange rate that is more market-oriented, i.e. less heavily managed by the People's Bank of China (Chart 11).14 This process is being pursued with the long-term interest of rebalancing the economy - making it more flexible and less fixed to an export-led manufacturing model. It is also necessary in order to internationalize the yuan, which is a long and rocky road but, it is hoped, will eventually reduce foreign exchange risk to China's economy (Chart 12). One of the main reasons that governments, including China, have maintained closed capital accounts is to control exchange rates. As currencies float more freely, the economy becomes better able to withstand large or volatile capital flows. At the same time, the yuan will never be a global reserve currency if China never opens the capital account. Chart 11The RMB Is Floating A Bit More Freely The RMB Is Floating A Bit More Freely The RMB Is Floating A Bit More Freely Chart 12The RMB Is Going Global ... Slowly The RMB Is Going Global ... Slowly The RMB Is Going Global ... Slowly Second, while tight capital controls remain in place, Beijing is pursuing long-delayed reforms to the financial sector and fiscal and legal systems to allow for better financial regulation, supervision, and transparency. For instance, the new central bank Governor Yi Gang's reported desire to genuinely liberalize domestic deposit interest rates will prepare China's banks for greater competition with each other, and hence ultimately to greater competition from abroad. This in turn will improve allocation of capital across the economy. Another example is the expansion of the domestic and offshore bond markets - and gradual formalization of the local government debt market - in order to deepen the financial sector.15 These reforms are desirable in themselves but also necessary for eventual capital account liberalization, as countries with deep domestic financial markets have less vulnerability to new surges of foreign inflows or outflows. Naturally, the reform process is taking place on China's timeline. Since Beijing stresses overall stability above all else, it is gradual. But we would expect the Xi administration to continue with piecemeal opening measures through the coming years, so that by 2021, the capital account is materially more open than it is today. As for full liberalization, it is beyond our forecasting horizon. Xi's goal of turning China into a "modern socialist country" by 2035 is not too late of a timeframe to consider, given the potential for serious setbacks. But such delayed progress raises the prospect of a clash with the U.S. A risk to this view is that China backslides yet again on the internal reforms, making it impossible to move to the subsequent stage of opening up to international flows. Vested financial and non-financial corporate interests often oppose capital account liberalization. State-controlled companies, for instance, will gradually have to compete more intensely for capital that comes from better disciplined domestic banks, all while watching small and medium-sized rivals gain market share due to the newfound access to foreign capital, which makes them more competitive.16 Backsliding will, again, antagonize the West. Bottom Line: China is preparing to open its capital account further, as we are in the "two steps forward" phase following Xi Jinping's political recapitalization in 2017. A New Front In The U.S.-China Trade War The U.S. has long argued that China maintains excessive capital controls that violate the conditions of China's accession to the World Trade Organization in 2001.17 The following statement, from one of the U.S. government's annual reports on China's compliance with the WTO, was written before the Trump administration took office and is typical of such reports and of the overall U.S. position: Although China continues to consider reforms to its investment regime ... many aspects of China's investment regime, including lack of a substantially liberalized market, maintenance of administrative approvals and the potential for a new and overly broad national security review system, continue to cause foreign investors great concern ... China has added a variety of restrictions on investment that appear designed to shield inefficient or monopolistic Chinese enterprises from foreign competition.18 The Trump administration's own reports on China's WTO compliance have amplified such criticisms.19 Remember that it was partly China's lack of WTO compliance that the Trump administration highlighted as justification for the sanctions announced in March under Section 301 of the 1974 Trade Act. In particular, the administration argues that U.S.-China investment relations are not fair or reciprocal, i.e. that the U.S. does not have as great of investment access in China as vice versa (Chart 13). Even in FDI, where China is relatively open and the bilateral sums are fairly reciprocal, the U.S. share is smaller than that of comparable developed economies, such as Japan and Europe (Chart 14). While it is not a foregone conclusion that this is the result of discriminatory policies, the U.S. argues that it suffers from unfair practices. What is clear is that China designates a number of sectors "strategic," excluding them from foreign investment, and places caps on foreign ownership. The two countries tried but failed to conclude a bilateral investment treaty under the Obama administration, which was meant to resolve this problem and stimulate private capital flows. China also has not implemented a nationwide foreign investment "negative list," which it has promised since 2013.20 A negative list would explicitly designate sectors that are off-limits to foreign investment and thus implicitly liberalize investment in all others. Chart 13The U.S. Wants Investment Reciprocity China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Chart 14The U.S. Wants More Investment Access China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks The U.S. is also demanding greater reciprocity for its banks to lend to Chinese borrowers. China is well-known for heavily restricting foreign bank access, with foreign loans accounting for only 2.75% of total. The U.S. grants much larger market access to Chinese lenders than vice versa (Chart 15). While there are perfectly good reasons for U.S. banks to hold a smaller share of China's total cross-border bank loans than European banks and comparable Asian banks (U.S. banks focus on their large domestic market while European and Japanese banks are bigger international lenders), nevertheless the Americans will see their smaller market share as evidence that American market access can go up (Chart 16). Chart 15The U.S. Wants Banking Reciprocity China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Chart 16The U.S. Wants More Banking Access China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Thus the silver bullet for the Trump administration would be to demand accelerated, full capital account liberalization from Beijing. This would address the above problems of investment access while also constituting a larger demand for China to hasten structural reforms that would favor American interests. This is why American officials have urged China to liberalize during high-level bilateral dialogues in the past - while knowing that the reform itself was of such significance that China would only move gradually.21 Chart 17Is The RMB Undervalued? Is The RMB Undervalued? Is The RMB Undervalued? So far the Trump administration has not demanded that China accelerate capital account liberalization, perhaps knowing that it would be a non-starter for China.22 One reason may be the expectation that the RMB could depreciate. True, the yuan is roughly at fair value in real effective terms, after a 7.4% appreciation since Trump's inauguration. However, China's 2014-16 capital flight episode suggests that, under the circumstances of a rapid opening of the capital account, outflow pressure could resume and the currency could fall. This would, at least for a time, drive down CNY/USD, contrary to Trump's oft-repeated desire that the currency appreciate. Trump adheres to a view that the RMB is structurally undervalued, as illustrated here by the IMF's purchasing power parity model, which suggests that it should rise by 45% against the greenback (Chart 17). Given Trump's rhetoric, it may not be far-fetched to suggest that Trump is disinclined to push for capital account liberalization and would rather see China maintain its current "managed" system in order to manage the CNY/USD even further upward. The broader point, however, is that previous U.S. administrations have pushed for faster capital account liberalization, and the Trump administration could eventually follow suit. This would mark a major escalation in the standoff, since China possibly cannot, and certainly will not, deliver such a momentous structural change on a timeline imposed by a foreign power. Bottom Line: Rapid capital account liberalization represents China's "red line" in the trade talks. If Trump pushes his demands this far, then he will be seen as threatening China's stability and will be rebuffed. This is a pathway to a full-blown trade war. Investment Conclusions Capital account liberalization is by no means the only indicator for gauging whether the U.S. and China are heading toward a full-blown trade war. As things stand, Trump will soon impose Section 301 tariffs, China will retaliate, and Trump will retaliate to the retaliation. This is our definition of a trade war. Not only is Trump threatening tariffs on $50-$150 billion worth of imports. He is now demanding that China reduce the U.S.'s trade deficit by $200 billion, or 53% of the total, twice as much as earlier. To give an indication of how significant such a change would be for China over the long haul, Table 3 provides a very simple scenario analysis of what would happen to China's trade surplus, current account surplus, and GDP growth rate if the U.S. reduced its bilateral trade deficit by 10%, 33%, or 50%. It shows that if the deficit fell by 33%, Trump's initial goal, then China's current account balance would fall to less than one percent of GDP, and GDP growth would slow down to 6.24% for the year. Table 3Scenario Analysis: Trump Slashes U.S. Trade Deficit With China China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks Table 4 takes the worst-case scenario for China, in which the U.S. cuts the deficit by 50%, while oil prices average $90/bbl due to oil price shocks from unplanned production outages in Iran (where Trump is re-imposing sanctions), or Venezuela or others, amid a very tight global oil market.23 China's current account surplus would go negative, while GDP growth would fall to 5.32%! Table 4Scenario Analysis: Trump Slashes Deficit, Oil Prices Soar China's "Red Line" In The Trade Talks China's "Red Line" In The Trade Talks These scenarios are significant because they are not very far-fetched. Instead, they show how easily China could undergo a symbolic transition into a "twin deficit" country - a country with an estimated 13% budget deficit and a negative current account balance. Such a development would not necessarily have immediate concrete ramifications. But it would, if it became a trend, mark a turning point in which China begins exporting rather than importing global wealth. It would cause global investors to scrutinize the country in different ways than before and to question the status and long-term trajectory of China's traditional buffers against financial and economic challenges: the country's large national savings and foreign exchange reserves. These scenarios are merely suggestive and meant to show the gravity of Trump's threats and the seriousness with which Xi will take them. In the current U.S.-China trade conflict, if China allows the CNY/USD to weaken - the logical way of alleviating tariff impacts - then it will be depreciating the currency in Trump's face: conflict will intensify. It is not clear how long the conflict will last or how bad it will get, so investors would be wise to hedge their exposure to stocks along the U.S.-China value chain, favoring small caps and domestic plays in both countries. BCA's Geopolitical Strategy recommends staying long DM equities relative to EM equities. We are short Chinese technology stocks outright, and short China-exposed S&P 500 stocks. By contrast, BCA's China Investment Strategy service continues to recommend that investors stay overweight Chinese stocks excluding the technology sector (versus global ex-tech stocks) over the coming 6-12 months with a short leash. As highlighted in this report, the near-term risks to China from the external sector are clearly to the downside, which supports the decision of the China Investment Strategy team to place Chinese stocks on downgrade watch for Q2.24 This watch remains in effect for the coming two months, a period during which we hope fuller clarity on the U.S.-China trade dispute and the pace of decline in China's industrial sector will emerge. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 3 Please see Barry Eichengreen, "Capital Account Liberalization: What Do Cross-Country Studies Tell Us?" World Bank Economic Review 15:3 (2001), 341-65. Available at documents.worldbank.org. 4 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "Is King Dollar Facing Regicide?" dated April 27, 2018, available at gps.bcaresearch.com. 5 Please see Jeff Chelsky, "Capital Account Liberalization: Does Advanced Economy Experience Provide Lessons for China?" World Bank Economic Premise 74 (2012), available at openknowledge.worldbank.org. 6 Please see Donald J. Mathieson and Liliana Rojas-Suarez, "Liberalization of the Capital Account: Experiences and Issues," International Monetary Fund, March 15, 1993, available at www.imf.org; Ricardo Gottschalk, "Sequencing Trade and Capital Account Liberalization: The Experience of Brazil in the 1990s," United Nations Conference on Trade and Development and United Nations Development Programme Occasional Paper (2004), available at unctad.org; see also Sarah M. Brooks, "Explaining Capital Account Liberalization In Latin America: A Transitional Cost Approach," World Politics 56:3 (2004), 389-430. 7 Please see Peter Blair Henry, "Capital Account Liberalization: Theory, Evidence, and Speculation," Federal Reserve Bank of San Francisco Working Paper 2007-32 (2006); see also Eichengreen in footnote 1 above. 8 Please see Reuven Glick, Xueyan Guo, and Michael Hutchison, "Currency Crises, Capital-Account Liberalization, and Selection Bias," The Review of Economics and Statistics 88:4 (2006), 698-714, available at www.mitpressjournals.org. 9 Please see M. Ayhan Kose and Eswar Prasad, "Capital Accounts: Liberalize Or Not?" International Monetary Fund, Finance and Development, dated July 29, 2017, available at www.imf.org. 10 Please see BCA Geopolitical Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 11 This western interest in Chinese capital account liberalization exists entirely aside from any of the aforementioned capital flight pressures from Chinese investors, which could reignite again. Foreign countries would welcome such inflows to some extent but not to the point that they become destabilizing at home or abroad. 12 The earliest rumored deadline for capital account liberalization was the seventeenth National Party Congress of the Communist Party in 2007. Please see Derek Scissors, "Liberalization In Reverse," The Heritage Foundation, May 4, 2009, available at www.heritage.org. 13 Eichengreen highlighted these points with regard to the literature and observations on capital account liberalization across a range of countries. They are highly relevant to China today. 14 Please see BCA China Investment Strategy Weekly Report, "Has The RMB Gone Too Far?" dated February 1, 2018, available at cis.bcaresearch.com. 15 Please see BCA China Investment Strategy Weekly Report, "Embracing Chinese Bonds," dated July 6, 2017, available at cis.bcaresearch.com. 16 Raghuram G. Rajan and Luigi Zingales, "The Great Reversals: The Politics of Financial Development in the Twentieth Century," Journal of Financial Economics 69 (2003), 5-50, available at faculty.chicagobooth.edu. 17 China did not commit to fully liberalizing the capital account as part of its WTO accession agreements, but rather the U.S. cites China's use of capital controls as a means of violating other WTO commitments regarding market access, subsidization, etc. At the time China joined the WTO, it was widely believed that its commitments would include gradual liberalization. For instance, the State Administration of Foreign Exchange lifted capital controls imposed during the Asian Financial Crisis in September 2001. Please see Lin Guijun and Ronald M. Schramm, "China's Foreign Exchange Policies Since 1979: A Review of Developments and an Assessment," China Economic Review 14:3 (2003), 246-280, available at www.sciencedirect.com. 18 U.S. Trade Representative, "2015 Report To Congress On China's WTO Compliance," December 2015, available at ustr.gov. 19 U.S. Trade Representative, "2017 Report To Congress On China's WTO Compliance," January 2018, available at ustr.gov. 20 Please see U.S. Department of State, "2012 U.S. Model Bilateral Investment Treaty," available at www.state.gov. See also U.S. Department of the Treasury, "Joint U.S.-China Economic Track Fact Sheet of the Fifth Meeting of the U.S.-China Strategic and Economic Dialogue," July 12, 2013, available at www.treasury.gov. 21 See, for instance, U.S. Department of the Treasury, "2015 U.S.-China Strategic and Economic Dialogue Joint U.S.-China Fact Sheet - Economic Track," June 6, 2015, available at www.treasury.gov. 22 However, Michael Pillsbury, director of the Center for Chinese Strategy at the Hudson Institute and an adviser on Trump's transition team, has argued that the Trump administration's endgame is to implement the well-known World Bank and China State Council Development Research Center report, China 2030, which full-throatedly endorses capital account liberalization. Please see Robert Delaney, "Donald Trump's trade endgame said to be the opening of China's economy," South China Morning Post, April 3, 2018, available at www.scmp.com. For the report, see "China 2030: Building a Modern, Harmonious, and Creative Society," 2013, available at www.worldbank.org. 23 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. 24 Please see BCA China Investment Strategy Weekly Report, "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight," dated March 28, 2018, available at cis.bcaresearch.com.