East Europe & Central Asia

Highlights Bear markets occur in phases, and their narrative can mutate. What began as a selloff caused by the coronavirus outbreak could well mutate into an oil crash-led selloff, and then mutate again into a selloff due to policy omnipotence, or something else. We are reiterating our short positions in the EM equity index and a basket of EM currencies versus the US dollar as well as our defensive positioning in EM domestic bonds and credit markets. We are taking profits on our long gold/short oil and copper trade. Oil prices may stabilize, but risks are still skewed to the downside. We are also booking gains on our long Russian domestic bonds/short oil position. Feature Chart I-1A Record Low Currency VOL Is Followed By Major Market Disturbances A Record Low Currency VOL Is Followed By Major Market Disturbances A Record Low Currency VOL Is Followed By Major Market Disturbances Global financial markets are witnessing the unwinding of the policy put. For the past several years, the consensus in the global investment community was that risk assets could not go down because of policy puts from the Federal Reserve, the US Treasury and President Trump, the European Central Bank and the Chinese authorities. Similarly, crude oil prices had been supported by OPEC 2.0’s put from December 2016 until recently. The latest panic and broad-based liquidation of risk assets has been due not only to fear and uncertainty related to the rapid escalation in COVID-19 cases around the world, but also to investor realization that these policy puts are ineffectual. The Fed’s 50-basis-point intra-meeting rate cut proved incapable of stabilizing global risk assets. Investors have begun to doubt the efficacy of policy puts and have thrown in the proverbial towel. Crucially, the high-speed and intensity of the selloff was due to widespread complacency and overbought conditions in risk assets. In our January 23 report, we quoted Bob Prince, co-CIO of Bridgewater, who stated in Davos that “…we have probably seen the end of the boom-bust cycle.” This comment was consistent with prevalent complacency in global financial markets, reflected in very tight credit spreads worldwide, high US equity multiples and record-low implied volatility in various asset classes. In the same January 23 report, we wrote: “Any time an influential person has made a similar declaration in the past, it marked a major turning point in financial markets. Remarkably, implied volatility for the US dollar has plummeted to a record low, as it has for EM currencies and a wide range of equity markets. Chart I-1 illustrates the implied volatility for EM currencies and the US dollar. Such low levels of implied currency market volatility historically preceded major moves in currency markets and often led to a material selloff in broad EM financial markets.” In that same report , we recommended going long implied EM currency volatility. Since then JP Morgan’s EM currency volatility has risen from 6% to 10%. What began as a selloff caused by the coronavirus outbreak could well mutate into an oil crash-led selloff, and then mutate again into a selloff due to policy omnipotence, or something else. Consistent with this thesis, we reinstated our short EM equity index recommendation in the following week’s report – on January 30. The MSCI EM stock index is down 11% since then. Our target is 800, which is 18% below current levels (Chart I-2, top panel). Chart I-2EM Stocks: A Breakdown In The Making EM Stocks: A Breakdown In The Making EM Stocks: A Breakdown In The Making Market Narratives Mutate Chart I-3VIX Surge In Early 2018 Was A Trigger Not Cause Of Selloff VIX Surge In Early 2018 Was A Trigger Not Cause Of Selloff VIX Surge In Early 2018 Was A Trigger Not Cause Of Selloff Narratives of all large market moves are always expounded in retrospect. Only after a selloff is well-advanced do investors and commentators come up with reasons for it and build a plausible narrative describing it. Critically, bear markets occur in phases, and their narrative can evolve. What began as a selloff caused by the coronavirus outbreak could well mutate into an oil crash-led selloff, and then mutate again into a selloff due to policy omnipotence, or something else. For example, the early 2018 selloff in global equities and industrial commodities was at the time attributed to the spike in US equity volatility (Chart I-3, top and middle panels). In retrospect, January 2018 marked a major top in the global business cycle (Chart I-3, bottom line). Hence, the true reason for the late-January 2018 top in global stocks and industrial commodities was a downturn in global manufacturing and trade and not the surge in the VIX. The key question investors are currently wrestling with is the following: How deep will this selloff be, and how long will it last? Our view is that the selloff in EM and global risk assets is not yet over. As such, we are reiterating our short positions in the EM equity index and a basket of EM currencies versus the US dollar, as well as our defensive positioning in EM domestic bonds and credit markets. Gauging The Downside There is no doubt that global growth will be affected by the spread of COVID-19 and the precautionary measures taken by the authorities, companies and households around the world to contain the outbreak.   Further, growth visibility is extremely low, and that uncertainty is raising the risk premiums that investors demand. The latter is weighing on risk assets in general and global share prices in particular.  Presently, precise forecasts for GDP growth and a potential trajectory of COVID-19 cases are not credible, and hence cannot be relied upon to formulate a sound investment strategy. If the current bloodbath in risk assets persists, a market bottom could be reached well before bad economic data are released or COVID-19 infection cases peak. Given the uncertainty related to both the global growth trajectory and the Covid-19 epidemic, the only way for investors to gauge a market bottom is to continuously examine valuations, technicals and market internals. With respect to valuations and technicals, we have the following observations: The EM equity index seems to breaking below its major support lines. If this breakdowns transpires, there is an air pocket until the index reaches its next technical support, which is 18% below its current level (please refer to the top panel of Chart I-2 on page 3). If the EM MSCI equity index drops to this support range, it would be trading at 11 times its trailing earnings (please refer to the bottom panel of Chart I-2 on page 3). At those levels, the EM equity index would be discounting a lot of bad news, making it immune to dismal economic data and general uncertainty. For the S&P 500, if the current defense line – which held been during 2011, 2015 and 2018 selloffs – is violated, the next long-term technical support is around 2400-2500 (Chart I-4). Inflows to EM fixed-income funds were enormous in 2019. Meanwhile, EM corporate and sovereign spreads have broken out (Chart I-5). Provided this selloff commenced from very overbought and expensive levels, the odds are that liquidation forces will not abate right now and that the selloff in EM fixed income has further to go. Chart I-4S&P 500: Where Technical Support Lies? S&P 500: Where Technical Support Lies? S&P 500: Where Technical Support Lies? Chart I-5EM Sovereign And Corporate Spreads Have Broken Out EM Sovereign And Corporate Spreads Have Broken Out EM Sovereign And Corporate Spreads Have Broken Out   In a nutshell, we suspect that EM local currency bonds and credit markets received a lot of inflows from European investors in recent years because yields were negative across European fixed-income markets. A weak euro was a boon for European investors investing in EM. That, however, is reversing. Since the recent sharp appreciation in the euro and the nosedive in EM currencies, EM financial market returns in euros have collapsed. This will likely prompt an exodus of European investors from EM financial markets. Chart I-6A Major Breakdown In This Cyclical Indicator A Major Breakdown In This Cyclical Indicator A Major Breakdown In This Cyclical Indicator Even though the EM equity index is not expensive or overbought, rising EM USD and local currency bond yields herald lower share prices, as we discussed at length in last week’s report. Our Risk-On/Safe-Haven currency ratio1  has plummeted below its major technical support and the next level is significantly lower. In other words, this indicator is also in an air pocket (Chart I-6). Given it is extremely well-correlated with EM share prices, the latter will not bottom until this indicator stabilizes. Technical configurations of high-beta and cyclical segments of the global equity universe are consistent with failed breakouts. Such a profile is typically not followed by a correction, but by a major drawdown. These include the European aggregate equity index, the Nikkei, global industrials and US high-beta stocks (Chart I-7). Chart I-7AFailed Breakouts Are Often Followed By Large Drawdowns Failed Breakouts Are Often Followed By Large Drawdowns Failed Breakouts Are Often Followed By Large Drawdowns Chart I-7BFailed Breakouts Are Often Followed By Large Drawdowns Failed Breakouts Are Often Followed By Large Drawdowns Failed Breakouts Are Often Followed By Large Drawdowns Chart I-8The Global Stocks-To-Bonds Ratio Is Back To 2011 Levels The Global Stocks-To-Bonds Ratio Is Back To 2011 Levels The Global Stocks-To-Bonds Ratio Is Back To 2011 Levels Finally, the global stock-to-bond ratio has decisively broken below the upward sloping channel that has been in place since 2009 (Chart I-8). Typically, when a market or ratio experiences such a major breakdown, the recovery does not occur quickly and is unlikely to be V-shaped. In short, the structural breakdown in the global stocks-to-bond ratio suggests that global share prices will likely stay under downward pressure for some time. Bottom Line: Odds are that risk assets remain in a liquidation phase and investors should avoid catching a falling knife. The odds are also high that EM share prices in US dollar terms have another 18% downside. We reckon at those levels – where the MSCI EM equity index is around 800 – it would be safe to start accumulating EM equities, even if the global growth outlook remains mired in uncertainty. For now, we recommend playing EM on the short side. What To Do With Oil Plays Despite periodic spikes in crude prices over the past few years, we have held our conviction that oil is in a structural bear market. We doubted the sustainability of the OPEC 2.0 arrangement, arguing that Russia would not cooperate with Saudi Arabia in the long term. Russia did cooperate much longer than we had expected, temporarily supporting oil prices. Ultimately, Russian President Vladimir Putin abandoned the cartel late last week, and the Saudis have hit back with massive price discounts amid large output increases. Consequently, oil prices have crashed and are presently oversold (Chart I-9). Given the uncertainty related to both the global growth trajectory and the Covid-19 epidemic, the only way for investors to gauge a market bottom is to continuously examine valuations, technicals and market internals. However, there will be no rapprochement between the Saudis and the Russians for some time. Given the drop in demand amid sharp increases in supply, crude oil prices may well slide further. Since July 11, 2019, we have been recommending a long gold/short oil and copper trade (Chart I-10). This position has generated a large 40% gain. Today, we are taking profits on this trade. Instead, we are replacing it with a new position: long gold/short copper. Chart I-9A Long-Term Profile Of Oil Prices A Long-Term Profile Of Oil Prices A Long-Term Profile Of Oil Prices Chart I-10Book Profits On Long Gold / Short Oil And Copper Trade Book Profits On Long Gold / Short Oil And Copper Trade Book Profits On Long Gold / Short Oil And Copper Trade   Among oil plays, we have been overweight Mexico and Russia within EM, both in fixed income and equity universes. That said, for absolute return investors, we have not been recommending unhedged long positions in either Mexico or Russia because of our expectation of a drop in oil prices and the ensuing broad-based EM selloff. Regarding Russia, for investors who were looking to gain exposure to local currency bonds, we have been recommending that they hedge this position by shorting oil since November 14, 2019. This recommendation has paid off well, and we are closing this position with a 26% gain. We will be looking to buy Russian local bonds unhedged in the weeks ahead. Chart I-11Relative Performance Of Russian And Mexican Domestic Bonds Is Facing Near-Term Headwinds Relative Performance Of Russian And Mexican Domestic Bonds Is Facing Near-Term Headwinds Relative Performance Of Russian And Mexican Domestic Bonds Is Facing Near-Term Headwinds In Mexico, we have also been reluctant to recommend naked exposure to local currency or US dollar bonds because of our bearish view on oil and the risk of large outflows from EM that would hurt the peso. Indeed, the oil crash and outflows from EM have led to a plunge in the Mexican currency. Instead, in Mexico we have been recommending betting on yield curve steepening. The proposition has been that short rates are anchored by a disinflationary backdrop and tight fiscal policy in Mexico while the long end of the curve could sell off in a scenario of capital outflows from EM. As with Russia, we are monitoring Mexican markets and are looking to recommend buying domestic bonds without hedging the currency risk in the weeks or months ahead. Bottom Line: We are taking profits on our long gold/short oil and copper trade. Oil prices may stabilize, but risks are still skewed to the downside. In the near term, the relative performance of Mexican and Russian stocks and local currency bonds versus their respective EM benchmarks could be undermined by capital outflows from EM in general and these countries in particular (Chart I-11). Nevertheless, both nations’ macro fundamentals remain benign, and their fixed-income and equity markets will outperform their EM peers in the medium term. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes   1     Calculated as ratio of equal-weighted average of total return indices of cad, aud, nzd, brl, idr, mxn, rub, clp & zar relative to average of jpy & chf total returns (including carry); rebased to 100 at January 2000. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Oil prices fell 30% when markets opened Monday morning, following a split between OPEC 2.0’s putative leaders – the Kingdom of Saudi Arabia (KSA) and Russia – over production cuts to balance global oil markets (Chart 1). If KSA and Russia are able to repair the break in what OPEC Secretary General Mohammad Barkindo once called their “Catholic Marriage” the sudden collapse in prices could serve a useful purpose in reminding producers, consumers and investors of the need for full-time management of production and inventories, and restore prices to the $60/bbl neighborhood in 2H20.1 If not, markets could be in for a drawn-out market-share war lasting the better part of this year, with damaging consequences for all involved, with Brent prices remaining closer to $30/bbl (Chart 2). Feature Much as we rely on modeling to guide our expectations, this is purely political at the moment. How Long Will The Oil Price Rout Last? That’s the question that repeatedly is being asked by clients following the breakdown in Vienna last week, and news over the weekend that KSA would engage a market-share war opened by Russian Energy Minister Alexander Novak prior to departing Vienna. Novak gave every impression of renewing a market-share war after Russia rejected the plan put forth by OPEC to remove an additional 1.5mm b/d of production from the market, to combat the demand destruction expected in the wake of COVID-19. The only answer we have to the question: No one knows with certainty. Chart 1Oil Sell-Off Accelerates, As Market-Share War Looms Oil Sell-Off Accelerates, As Market-Share War Looms Oil Sell-Off Accelerates, As Market-Share War Looms Chart 2A Market-Share War Will Keep Oil Prices Depressed A Market-Share War Will Keep Oil Prices Depressed A Market-Share War Will Keep Oil Prices Depressed Neither of the principal actors responsible for the 30% rout in oil prices on Monday morning when markets opened for trading – KSA and Russia – are providing guidance at present. Prices since recovered slightly and were down ~ 20% Monday afternoon. Much as we rely on modeling to guide our expectations, this is purely political at the moment. There are two large personalities involved – Saudi Crown Prince Mohammad bin Salman bin Abdulaziz Al Saud and Russian President Vladimir Putin – who have staked out opposing positions on the level of production cuts needed to balance markets in the short term, as the COVID-19 outbreak spreads beyond China leaving highly uncertain demand losses in its wake.2 If a meeting of OPEC 2.0’s leadership can be arranged before the end of March, a hope expressed by Iran's Oil Minister Bijan Namdar Zanganeh in a Bloomberg interview over the weekend,3 the stage could be set for a rapprochement between KSA and Russia allowing them to repair the rupture in the OPEC 2.0 leadership. Should that occur, the rally in prices could be dramatic – maybe not as dramatic as today's price collapse when markets awoke to the opening rounds of a full-on market-share war between OPEC and Russia. But, over the course of the next few weeks, prices for 2H20 Brent and WTI would begin recovering and moving back toward $60/bbl as markets price in lower inventories on the back of a return to production discipline by OPEC 2.0. If we do not see such a meeting next week, markets will be forced to price in a prolonged price-war that could extend into the end of this year, which will not be easy to arrest. If, as seems to be the case, the Russians' goal is to directly attack shale-oil production in the US with a market-share/price war, the effort most likely will fail. True, there will be an increase in bankruptcies among the shale producers and their services companies. This will set up another round of industry consolidation – i.e., more M&A in the US shales – with the large integrated multinational oil companies that now dominate these provinces adding to their holdings. It is worthwhile remembering that US bankruptcy law recycles assets; it does not retire them permanently. In addition, the acquirers of bankrupt firms’ assets get them at a sharp discount, which greatly helps their cost basis. So, shale assets will change hands, stronger balance sheets will take control of these assets, and a leaner, more efficient group of E+Ps will emerge from the wreckage. What’s Being Priced? It is in neither KSA’s nor Russia’s interest to engage in a prolonged market-share war that keeps Brent prices closer to $30/bbl than to $70/bbl. We estimate oil markets now have to price in the return of ~ 2.8mm b/d of OPEC 2.0 production at the end of this month – i.e., a 10% increase of GCC output, led by KSA’s production getting up to 11mm b/d by year-end; ~ 600k b/d of cuts we were assuming would be approved in last week’s Vienna meetings; and ~ 260k b/d from Russia (Chart 3). This could be understated, as KSA claims 12.5mm b/d of capacity (including its spare capacity). Unchecked supply growth would force inventories to build this year (Chart 4).  In fact, absent a return to production-management by OPEC 2.0, oil markets will extrapolate the higher production and low demand into an expectation for steadily rising inventories, that will – once it becomes apparent the supply of storage globally will be exhausted – force prices toward $20/bbl. Weaker-than-expected demand growth would accelerate this process. Chart 3Higher Production Will Overwhelm Demand In Market-Share War Higher Production Will Overwhelm Demand In Market-Share War Higher Production Will Overwhelm Demand In Market-Share War Chart 4Market-Share War Could Exhaust Storage Forcing Production Out of The Market Market-Share War Could Exhaust Storage Forcing Production Out of The Market Market-Share War Could Exhaust Storage Forcing Production Out of The Market It is in neither KSA’s nor Russia’s interest to engage in a prolonged market-share war that keeps Brent prices closer to $30/bbl than to $70/bbl. The apparent unwillingness of Putin and the Russian oligarchs running the country’s oil companies to make relatively small additional production cuts – vis-à-vis what KSA already has delivered – to support prices has not been well explained by Russian producers. The revenue benefits from small production cuts almost surely exceed the additional revenue that would accrue from a 200-300k b/d increase in  output and keeping prices in the $30-$40/bbl range, a level that is below Russian producers' cost of production onshore and offshore, according to the Moscow Times.  KSA's costs are ~ $17/bbl on the other hand.4 Russia’s economy was wobbly going into the Vienna meetings, which makes sorting this out even more complicated. One thing that can be said for certain is that over the past six months Vladimir Putin has entered into another consolidation phase in attempting to quell public unrest, improve the government’s image, and tighten up control over the country, while preparing for another extension of his time as Russia’s supreme leader. A Battle For Primacy? At one level, it would appear the Russians were pushing back against an apparent demand by OPEC (the old cartel led by KSA) to fall in line. Russia’s rejection of the OPEC proposal could be read as an assertion of their position to show they were, at the very least, KSA’s equal in the coalition. A stronger read of the rejection, given the Russian Energy Minister’s comments following the breakdown in Vienna at the end of last week – "... neither we nor any OPEC or non-OPEC country is required to make (oil) output cuts” – would be Russia was attempting to assert itself as the leader of OPEC 2.0. Giving Russia what amounted to a take-it-or-leave-it ultimatum on production cuts was a high-stakes gamble on KSA’s part. On KSA’s side, it is likely the Saudis grew irritated with the Russian failure to get on board to address a global oil-demand emergency that was spreading beyond China, when they were discussing extending and deepening production cuts in the lead-up to last week’s meetings. Giving Russia what amounted to a take-it-or-leave-it ultimatum on production cuts was a high-stakes gamble on KSA’s part, to say the least. However, as OPEC’s historic kingpin, KSA may have believed its role was to lead the coalition.  Russia’s in a better position now relative to KSA in the short term vis-à-vis foreign reserves ($446 billion), budget surplus (~ $8 billion), and its lower fiscal breakeven price for oil ($50/bbl) vs KSA’s ($84/bbl), as we discussed in our Friday alert (Chart 5). However, with Russian per-capita GDP at ~ half that of KSA’s, it is highly likely – if this market-share war is prolonged – its citizens are going to be hit with the consequences of the oil-price collapse in short order: FX markets are selling ruble heavily today, and, in short order this will feed through into higher consumer prices and inflation. Indeed, we estimate a 1 percentage-point (pp) depreciation in the ruble vs. the USD y/y leads to a 0.14pp increase in Russian inflation (Chart 6). Chart 5Foreign Exchange Reserves Foreign Exchange Reserves Foreign Exchange Reserves Chart 6Russian Ruble Sell-Off Presages Inflation Russian Ruble Sell-Off Presages Inflation Russian Ruble Sell-Off Presages Inflation The Saudi riyal is pegged to the USD, and does not move as much as the ruble. However, KSA’s citizens also will be buffeted once again by a collapse in oil prices, as they were during the 2014-16 market-share war when government revenues came under severe stress. Things To Watch The OPEC 2.0 joint market-monitoring committee could meet again next week in Vienna, but that is not a given. If they do meet, the agenda likely will be dominated by trying to find a face-saving way for both sides to resume production management. Arguably, the presumptive target of the Russian strategy – US shale producers – will be severely damaged by this week’s price collapse, and both could argue the short-term tactic of threatening a price war was a success. The Saudis could also go for a quick solution, if their primary objectives are to sort things out with Russia, stabilize the global economy, and keep President Trump in office, rather than to push down prices in an adventurous attempt to escalate Iran’s internal crisis. We believe Russia badly miscalculated, and was too early in making a play for dominance in OPEC 2.0, if that was its intent. If, on the other hand, these large personalities cannot agree, the price collapse begun today will continue until global oil storage – crude and products – is filled, forcing prices through cash costs of all but the most efficient producers in the world. This level is below $20/bbl. These lower prices could redound to the benefit of China, as fiscal and monetary stimulus provided by policymakers there in the wake of COVID-19 to get the economy back on track for 6% p.a. growth gets super-charged by low oil prices. Bottom Line: We believe Russia badly miscalculated, and was too early in making a play for dominance in OPEC 2.0, if that was its intent. Russian GDP has twice the sensitivity to Brent prices that KSA does, which means such a tactic takes a toll on it as well as the shale producers (Chart 7). Capital markets had the US shale producers on the ropes, so it is difficult to argue there was a need to accelerate the process and shock the world. We again note a full-blown market-share war will set up another round of industry consolidation in the US shales, but, over the medium to longer term, the shale assets of bankrupt companies will only be re-cycled to more efficient operators, as we saw following the last market-share war. This will contribute to a stronger shale sector in the US in the medium term. Chart 7Russian GDP More Sensitive to Brent Prices Russian GDP More Sensitive to Brent Prices Russian GDP More Sensitive to Brent Prices The only other consolation for Russia is a higher likelihood of regime change in the US (more political polarization in the US benefits Russia), and yet the Trump administration has been the most pro-Russian administration in years so this is not at all a clear objective. We will be watching very closely for a meeting of OPEC 2.0’s joint committee next week. If we get it and a face-saving resolution is agreed by KSA and Russia we would expect stronger demand growth in 2H20 to absorb whatever unintended inventory accumulation a still-born price war causes. If not, we will expect a price war into the end of the year, after which the economies of oil producers globally will have been sufficiently battered to naturally force production lower and investment in future production to contract sharply. At that point, oil and oil equities will be an attractive investments for the medium and long term.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1     Please see Russia and Saudi Arabia Hold 'Catholic Marriage' with Poem and Badges, Form Enormous Oil Cartel published by Newsweek July 3, 2019. 2     We will be updating our demand estimates in Thursday’s publication, after we get fresh historical data from the principal providers (EIA, IEA, OPEC). 3     Please see Iran's Oil Minister Wants OPEC+ Output Cut, Hopes for Russia Meeting Soon published by Bloomberg, March 8 2020. 4     Please see Russian Oil Production Among Most Expensive in World published November 12, 2019 by The Moscow Times.  

Highlights Crude oil prices fell ~ 10% Friday after Russia refused to support additional production cuts agreed by OPEC in Vienna (Chart 1). As we go to press, Brent is trading close to $45/bbl and WTI is trading ~ $41/bbl. OPEC producers could implement the go-to strategy they’ve employed in the wake of past demand shocks and cut production on their own, in order to balance the market. That said, there are indications the Saudis will not shoulder the market-balancing role alone. Russian producers have consistently demanded relief from production restraints since 2017, when OPEC 2.0 took over balancing the market. With shale-oil producers on the back foot owing to parsimonious capital markets, Russia could finally be able to deliver the coup de grâce it has been waiting for. This supply shock hits the market as COVID-19 threatens demand globally. Whatever Russia’s intent – be it removing the near-certainty of a production cut, which it always agreed to in the past, or crippling US shale production – two-way risk has returned to these Vienna meetings. Feature Oil markets once again are faced with a possible price collapse – not unlike the swan dive seen when OPEC’s market-share war took Brent from more than $110/bbl in mid-2014 to $26/bbl by early 2016. The proximate aim of that market-share war – led by the Kingdom of Saudi Arabia (KSA) – was to significantly reduce the revenue Iran would receive when it returned to export markets, following its agreement with the US to end its nuclear program in 2015. Tanking oil prices was the most expedient way of accomplishing this. Secondarily, shale-oil producers also may have been targeted, although such a goal was never clearly articulated by KSA’s leadership. Chart 1Russia's Supply Shock Craters Brent, WTI Prices Russia's Supply Shock Craters Brent, WTI Prices Russia's Supply Shock Craters Brent, WTI Prices OPEC’s market-share war did thin the US oil-shale herd, but it did not destroy the industry. If anything, it forced shale-oil producers to focus on their best drilling prospects with their best rigs and crews. This produced a leaner more productive technology-driven cohort of drillers, which posted record production levels on a regular basis. Indeed, by the end of 2019, US production topped 12.9mm b/d – 8.2mm b/d of which was accounted for by shale-oil output – making the US the largest oil and gas producer in the world. The market-share war also brought KSA and Russia together in November 2016 as the putative leaders of OPEC 2.0. The sole mission of this unlikely coalition was to clear the global inventory overhang left in the wake of the market-share war by managing OPEC and non-OPEC production. Russia’s Coup de Grâce Managing global production and inventories with KSA – while US shale-oil producers continued to raise their output to new records regularly – never sat well with Russia’s oil producers.   Managing global production and inventories with KSA – while US shale-oil producers continued to raise their output to new records regularly – never sat well with Russia’s oil producers. Ahead of OPEC 2.0 meetings in Vienna, Russian oligarchs could be counted on to demand higher output levels, and President Vladimir Putin could be counted on to deliver something close to agreed production cuts in time to assuage markets. This semi-annual ritual came to resemble a tightly choreographed set-piece, which may have inured market participants to the oligarchs’ resolve to ultimately increase production levels. Russia certainly was well-prepared when it delivered Friday’s supply shock. Time will tell, but Friday’s breakdown in Vienna could be the coup de grâce Russia’s oligarchs have been waiting to deliver to US shale producers since the formation of OPEC 2.0. Or it could be a well-timed reminder that nothing in oil markets is certain – particularly Russian compliance with production-restraint agreements. The once-certain 11th-hour agreement to adhere to whatever production-cutting agreements OPEC 2.0 came up with is now gone. And with it, the high-probability bet that, regardless of the tensions leading up to the Vienna meetings, a production-management agreement would be delivered, and shale-oil producers would live to fight another day. Chart 2Russia, KSA Foreign Exchange Reserves Russia, KSA Foreign Exchange Reserves Russia, KSA Foreign Exchange Reserves Whatever the case, Russia certainly was well-prepared when it delivered Friday’s supply shock. It has steadily built its foreign-exchange reserves since the price collapse begun in 2014, which now stand at $446 billion, up 45% from their nadir of 2015 (Chart 2). KSA’s foreign-exchange reserves, on the other hand, fell sharply in the wake of the 2014 – 2016 market-share war and have languished at lower levels since. Chart 3Russia, KSA Per-Capita Income Russia's Supply Shock To Oil Markets Russia's Supply Shock To Oil Markets Still, the Kingdom is not without stout resources. It’s gross national income per capita is ~ 2x that of Russia’s (Chart 3), and its days-forward import cover expressed in terms of days of foreign reserves is similarly stout (Chart 4). Chart 4Russia, KSA Import Cover Russia's Supply Shock To Oil Markets Russia's Supply Shock To Oil Markets The economies of both KSA and Russia are exquisitely linked to Brent oil prices (Chart 5). So tempting another market-share or price war is a strategy that could not be sustained by either country for an extended period of time. Chart 5Russia, KSA GDP vs Brent Prices Russia, KSA GDP vs Brent Prices Russia, KSA GDP vs Brent Prices Chart 6Russia, KSA GDP Highly Sensitive To Brent Prices Russia, KSA GDP Highly Sensitive To Brent Prices Russia, KSA GDP Highly Sensitive To Brent Prices The End Of OPEC 2.0? Post-GFC, we estimate Russia’s real GDP elasticity to changes in oil prices is close to twice that of Saudi Arabia. This suggests Russia’s strategy could have dismal consequences for its economy. Oil markets will gnaw on Friday’s breakdown in Vienna, sorting out the signals that were missed in Russian messaging, and figuring out what happens next. Neither Russia nor KSA have the resources to wage an indefinite war of attrition with US shale producers. Both are highly dependent on oil revenues to sustain their economies (Chart 6). Of the two, Russia’s economy is more sensitive to Brent oil prices than KSA’s, as it markets more of its output in trading markets. Post-GFC, we estimate Russia’s real GDP elasticity to changes in oil prices is close to twice that of Saudi Arabia. This suggests Russia’s strategy could have dismal consequences for its economy. Russia’s $50/bbl fiscal breakeven price vs. KSA’s $84/bbl price might give Russia more staying power in the short run, but with per-capita income at roughly half that of Saudi citizens, it will not want to revisit the dire days of 2014-16 when its economy last suffered through an oil-price collapse.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com  

Highlights Supply constraints and unstoppable demand growth – the result of stricter regulations requiring higher loadings in autocatalysts to treat toxic pollution in automobile-engine emissions – will continue to push palladium’s price higher, despite a near-vertical move higher that began in 2H19. South Africa’s power grid is in a state of near-collapse, which will add volatility to mining operations focused on platinum-group metals – chiefly palladium, platinum and rhodium. South Africa accounts for 36% of global palladium production and 73% of platinum production, which makes it difficult to make the case that platinum could be substituted for palladium as its price rises. Palladium stocks are at risk of being further depleted globally as demand from automobile manufacturers in China, the US and Europe remains robust. This will keep palladium forward curves backwardated for the foreseeable future. While pressure to find alternatives for palladium will grow as prices rise, in absolute terms the additional cost resulting from higher prices for the metal – ~ $400 per vehicle – is not yet enough to draw significant investment to this effort. Feature Palladium markets are fundamentally tight and unresponsive to macroeconomic uncertainty. Table 1Top 5 Best Performing Commodities Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues In 2019, for the third year in a row, palladium prices outperformed other major commodities, returning an impressive 54% over the year (Table 1). This is the result of a massive 13% increase in demand for the metal – powered by strong autocatalyst demand for gasoline-powered cars in China and Europe, even as collapsing auto production globally and elevated trade uncertainty continue to dog automobile sales (Chart 1). This apparent contradiction is explained by stricter vehicle emissions regulations in major consuming markets – chiefly the Euro 6d, China 6 and US Tier 3 regimes – and power shortages in South Africa, which are introducing considerable volatility on the supply side in the second-largest producing country for the metal. Chart of the WeekSurging Autocatalyst Palladium Demand Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues  Again this year, palladium markets are fundamentally tight and unresponsive to macroeconomic uncertainty. Palladium prices soared 39% YTD, its fastest 40-day increase since 2010. Unlike other commodity markets, palladium is completely disregarding the COVID-19 outbreak that originated in China late last year. Favorable supply-side fundamentals continue to drive the palladium rally: The metal’s decade-long physical supply deficit intensified in 2019 and we expect it to widen this year (Chart 2, panel 1). On the demand side, Chinese consumption is at risk. China is the world’s largest auto manufacturing market. Hubei Province – COVID-19’s epicenter – is a large car manufacturing hub, accounting for ~ 10% of the country’s annual automobile output. In the wake of COVID-19, the country’s car production is expected to fall 10% in 1Q20. In addition, the virus had infected more than 80,000 people globally, and has spread rapidly outside Hubei into Asia, Europe, the Middle East, Africa, and North America, raising the odds of a pandemic. Interestingly, speculative positioning and ETF investment demand is subdued, and is not inflating prices (Chart 2, panel 2). Chart 2Palladium Deficit To Widen This Year Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Palladium Demand Soars As Auto Production Collapses Strong global automobile catalyst demand drove the rally in palladium prices last year. This occurred as car production fell by 9%, 8%, and 15% in US, China, and India – an unusual divergence in fundamentals. The culprit: Technical changes to autocatalysts from stricter emissions regulations. In China, the latest phase of car emissions regulations – China 6 – was gradually introduced in high-population centers, which also suffer from high levels of pollution. These centers accounted for ~ 60% of annual Chinese car sales in 2019. China 6 represents a major shift in emissions regulations and will make the Chinese auto fleet compliant with Europe’s best practices. As a result, palladium loadings in conforming light-duty gasoline vehicles reportedly increased by ~20% in 2019. This pushed China’s autocatalyst consumption up by 570k oz despite the drop in annual car sales, which created the rare dislocation between the country’s car production and palladium prices (Chart 3). We expect this trend to continue this year: China 6 is on track to be enforced countrywide – i.e., the remaining 40% of car sales – by mid-year, providing an additional ~ 10% boost in loadings of the metal. Chart 3Stricter Regulations Support Prices Amid Falling Car Production Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues In Europe, the introduction of Euro 6c legislation in September 2018 and the extension to all new vehicles of Euro 6d-TEMP regulations in September 2019 – mainly the real driving emissions (RDE) testing procedure adopted in the wake of the Volkswagen “dieselgate” scandal in 2015 – pushed palladium loading in autocatalysts up by ~ 25% from 2017 to 2019.1 The regulations became stricter in January 2020, putting additional stress on manufacturers to comply with the new standards, which will continue to support higher palladium loadings. We expect the COVID-19 outbreak to delay the recovery in global gasoline-powered vehicle production and consumption to 2H20. Lastly, in the US – which remains an important market for autocatalyst palladium demand (Chart 4) – the ongoing implementation of the Tier 3 legislation will continue to gradually increase palladium content in autocatalysts until 2025. For 2020, we do not expect this to significantly boost loadings per vehicle and are factoring in 2% growth. These legislative changes in major automotive markets produced a structural break in our palladium demand model (Chart 5). After adjusting our estimates for greater palladium content in gasoline aftertreatment systems, our model suggests that demand provides strong support to palladium prices, but also suggests other factors – i.e. supply and inventory – are at play. Chart 4North America's Auto Sector Remains A Large Share Of Palladium Demand Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Chart 5Higher Palladium Loadings Largely Explains Last Year's Price Surge Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues In the US and Europe, consumers can absorb higher vehicle sales despite being close to saturated in terms of vehicle ownership. We expect the COVID-19 outbreak to delay the recovery in global gasoline-powered vehicle production and consumption to 2H20. In China, we expect the government will overstimulate its economy to meet its long-term goal of doubling its GDP and per capita income by 2020.2 Automobile ownership and vehicle sales there are low vs. DM economies, suggesting more upside for sales in China (Chart 6). In the US and Europe, consumers can absorb higher vehicle sales despite being close to saturated in terms of vehicle ownership. Car sales move in cycles around long-term demographic trends: The longer the current economic expansion, the further above-trend car sales can rise (Chart 7). Chart 6China: Structural Outlook For Autos Is Bright China Car Consumption Will Rebound In 2H20... Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Chart 7... Likewise For Europe And US Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Bottom Line: The combination of stricter environmental regulations in key gasoline-powered automobile markets and the post-coronavirus rebound in global auto consumption will push the palladium market further in deficit this year as it faces an inelastic supply, critically low inventories and low substitutability over the short-term (more on this below). Palladium Supply In 2020: Weak growth And Low Price-Elasticity Palladium supply is highly constrained. The largest supplies are concentrated in Russia (42%), South Africa (36%) and North America (14%). From 2015 to 2019, supply and capex grew by a very subdued 7% and 15.2% respectively, completely disregarding the 200% rise in prices (Chart 8, panel 1). This illustrates palladium supply’s extremely low price-elasticity.3 Palladium supply growth will remain muted for the foreseeable future, as Eskom begins long-delayed maintenance to refurbish its derelict generation fleet. Primary supplies declined by close to 2% last year on falling shipments from Russia and record electricity load-shedding – i.e. blackouts – in South Africa (Chart 8, panel 2).4 As tight as palladium markets are fundamentally, South Africa’s crippled power grid – long in need of upgrading and repair – has been, and remains, a key driver of short-term platinum-group metals (PGM) prices.5 Following the breakdown of close to 25% of the country’s generating capacity, Eskom – the nation’s utility monopoly responsible for ~ 90% of its electricity generation – has been forced to implement rolling blackouts to balance power supply and demand and prevent permanent damage to the country’s power grid. Palladium supply growth will remain muted for the foreseeable future, as Eskom begins long-delayed maintenance to refurbish its derelict generation fleet. Consequently, Stage 6 load-shedding events likely will become more frequent. These efforts are complicated by massive debt – ~ $30 billion – which has required government bailouts and forced the company to take loans from a Chinese industrial bank. Chart 8Top Palladium Producers' Capex Price-Elasticity Is Low Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues This is playing havoc with PGM supplies. During the unmatched Stage 6 load-shedding in December 2019 – cutting power to 37% of grid users – PGM supplies were reduced by 50%. Stockpiles covered the loss, but persistent blackouts lasting years could push markets into an actual shortage of palladium as inventories would rapidly be depleted. This is a significant risk: Eskom itself warned rolling blackouts will persist for the next 18 months.6 Elevated local currency PGM prices are postponing announced shafts closures, as miners seek to profit from the favorable pricing environment (Chart 9). But insufficient electricity capacity will weigh on mine supply growth over the next few years as companies hold-back on much-needed long-term investments. The final units of Eskom’s Medupi and Kusile projects are expected to be completed over the next two years – adding 4800MW to its installed capacity. This can partially alleviate South Africa’s electricity difficulties, but these units are not enough to support a rebound in economic and mine production growth. South Africa is in profound need of large-scale investments in its power sector. Close to 5000MW of power capacity is scheduled to shut down over the next five years (Chart 10). Chart 9Favorable Domestic Metal Prices For South African Miners Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Chart 10South Africa Needs Additional Power Generation Capacity Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues After years of pressure from mining companies, South Africa’s minister of Mineral Resources and Energy announced it would allow companies to generate unlimited electricity for their own activities. The current political and economic climate is not constructive for meeting this challenge. The World Bank recently slashed South Africa’s 2020 GDP growth forecast to 0.9% from 1.5% previously on the back of electricity and infrastructure constraints impeding domestic growth and weak external demand. Likewise, rating agency Moody's signaled – ahead of its review of South Africa’s Baa3 credit rating in March – it could downgrade the country to speculative grade, citing the detrimental impact of recurring power outages on manufacturing and mining output. After years of pressure from mining companies, South Africa’s minister of Mineral Resources and Energy announced it would allow companies to generate unlimited electricity for their own activities. This will provide much-needed help to the country’s power sector. According to the Minerals Council South Africa, mining companies could bring an additional ~ 1500MW capacity online in the next 9 to 36 months. But doubts remain with regard to the timeline for companies to obtain the necessary licenses and if these can easily be acquired. Johnson Matthey expects supply growth in Russia – the largest producer – will be capped this year as Nornickel’s processing of old mines' copper concentrate – which boosted the company’s palladium supply over the past few years – is finalized. Still, a paltry 1% gain is possible from expected efficiency gains at existing mines, according to Nornickel. The company also announced it will increase production at its Talnakh and South Cluster mines, but this additional supply will only reach markets gradually as processing capacity constraints won’t be resolved until 2023, according to Johnson Matthey. Bottom Line: Growth prospects in the top two palladium-producing countries are weak in 2020. This will not suffice to meet the soaring autocatalyst demand. Higher recycling and inventory releases – both incentivized by higher prices – will be needed to balance the market. Palladium Stockpiles Are Dangerously Low We expect palladium prices will move higher on the expanding deficit, and backwardation in the forward curve will persist to incentivize the release of inventories to market (Chart 11). Yet, global palladium stockpiles have been declining since 2014 and are now at critically low levels, raising the risk of a disrupting shortage of the metal:7 ETF and exchange inventories now stand at a paltry 600k oz (Chart 12). These are the most price-elastic stocks and will get close to zero as prices increase. Chart 10Expect Backwardation To Persist Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Chart 12Price-Sensitive Stockpiles Are Dangerously Low Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Exhaustion of inventory would spike prices until demand destruction or additional supply – both inelastic in the short-run – are able to balance the market. The Russian Ministry of Finance’s reserves – a state secret – are now almost exhausted, according to Russia’s Norilsk Nickel, the largest supplier of physical palladium in the world. Last year, Norilsk Nickel held an estimated 1mm oz of the metal in its Global Palladium Fund, and signaled it is increasingly using its reserves to balance markets and provide needed liquidity. Earlier this year, the company released 3 MT of palladium to the market from stocks. Complete exhaustion of inventory would spike prices until demand destruction or additional supply – both inelastic in the short-run – are able to balance the market. Don’t Count On Substitution, Yet Switching to platinum requires significant capital- and resource-intensive R&D and appears to be beyond the current capabilities of automakers. We expect platinum prices to rise in 2020 supported by improving fundamentals, growing safe-haven demand, and markets pricing in increasing anticipation of substitution from palladium to platinum. Unlike palladium, platinum is also affected by safe-haven demand and gets bid up with gold and silver prices in periods of high uncertainty (Chart 13). With gold prices now above $1,600/oz, platinum will benefit from safe-haven flows due to its relative price advantage (Chart 14). Chart 13Safe-Haven Flows Support Platinum Prices Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Chart 14Platinum Is Cheap Relative To Gold Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues We believe substitution will commence over the coming years, but this is a gradual process. Substitution from expensive palladium to low-priced platinum in industrial applications is the largest risk to our positive view on the palladium-to-platinum (Pd-to-Pt) ratio (Chart 15). This started in smaller and more price-elastic segments (e.g. dental, jewelry and diesel autocatalyst). However, to have a real impact on overall demand and thus the price ratio, substitution needs to take place in gasoline autocatalyst technology. The discount has been at a level consistent with substitution for more than a year, but the urgency to upgrade current designs to meet new environmental legislation and RDE regulations in China, Europe, and the US is the main focus of automakers this year. Switching to platinum requires significant capital- and resource-intensive R&D and appears to be beyond the current capabilities of automakers scrambling to meet the latest anti-pollution regulations globally. Moreover, large-scale substitution will take place only if automakers’ cost-benefit analysis points to significant long-term profits from switching. That said, platinum’s supply security remains a risk in the long-term: South Africa accounts for 73% of global production and our analysis suggests output growth there likely will remain weak over the next few years, especially as Eskom rebuilds its failing power grid. This lack of diversity increases sourcing risks for automakers, who, not without reason, would not want to switch over to platinum only to find that supply is also in doubt down the road. The overall platinum market is 26% smaller than that of palladium. Assuming a one-for-one substitution of Pd to Pt in gasoline catalyzers, a 1.2mm oz reduction in Pd demand – the amount required to reduce palladium’s deficit to zero – would send platinum markets to a 1.4mm oz deficit.8 Without substantial production growth, platinum prices would spike, reducing the profitability of investing in these new catalysts. Thus, substitution will eventually impact the price ratio, but will not be large enough to overturn absolute price level trends. In addition, the amount of PGMs in the typical autocatalyst – ~ 5 grams – adds $400 to the cost of the average automobile (Chart 15, lower panel). We do not believe this cost drives automakers' decisions, which is another reason the substitution of Pt for Pd likely will remain a topic of discussion more than action. Chart 15Palladium's Price Surge Adds ~0 Per Gasoline Car Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Bottom Line: We believe substitution will commence over the coming years, but this is a gradual process and it will not happen on a meaningful scale this year. Thus, we expect the continuation of relative demand and inventory trends will provide a favorable setting for the Pd-to-Pt ratio this year (Chart 16). Chart 16Pd-to-Pt Price Ratio Will Increase Again in 2020 Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues   Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Overweight Brent and WTI crude oil lost 5% and 4% this week, as fears of a global pandemic in the wake of the COVID-19 outbreak gripped markets. Reports of outbreaks in Asia ex-China, the Middle East and Europe fueled these concerns. Against this backdrop, OPEC 2.0 will be meeting in Vienna March 5 and 6 to consider cuts of 600k b/d recommended by its technical committee earlier this month. We continue to expect the full coalition to approve these cuts at the upcoming meetings. Saudi Arabia, Kuwait and the United Arab Emirates reportedly are considering an additional 300k b/d of cuts to offset the global demand hit delivered by COVID-19. The IEA estimates the COVID-19 outbreak will reduce Chinese refining throughput by 1.1mm b/d, and will reduce the call on OPEC crude by 1.7mm b/d in 1Q20. Base Metals: Neutral Iron ore prices weakened, following global equities lower, as the COVID-19 outbreak spread around the world. However, traders continue to report lower stocks of iron ore, which should keep prices supported, according to MB Fastmarkets (Chart 17). We remain long December 2020 high-grade iron ore (65% Fe) vs. short the benchmark 62% Fe contract on the Singapore Commodity Exchange, which we initiated November 7, 2019. This recommendation was up 5.3% as of Tuesday’s close, when we mark to market. Precious Metals: Neutral After retreating slightly from its run toward $1,700/oz earlier this week, gold remains well supported by safe-haven demand (Chart 18).  In addition, actual and expected policy stimulus – e.g., Hong Kong's “helicopter money” drop of USD 1,200 to all permanent residents over the age of 18 – and expectations of additional central bank easing globally to offset the global spread of COVID0-19 will keep gold and precious metals generally supported.  Markets should start pricing in higher inflation expectations as additional stimulus starts to roll in.  Ags/Softs:  Underweight Global grain markets could be set to rally sharply, as unusually wet weather in the Middle East and East Africa spawned by higher-than-usual cyclone activity produces perfect breeding conditions for desert locusts in the region over the next two months.  According to National Geographic, by June the locusts could increase their populations “400-fold compared with today, triggering widespread devastation to crops and pastures in a region that’s already extremely vulnerable to famine.”  This could put more than 13mm people in East Africa at risk of “severe acute food insecurity,” and imperil millions more.  Chart 17China's Iron Ore Stocks Tight Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Chart 18Safe Havens Gold, USD Well Bid Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues   Footnotes 1     Please see New legislation planned in response to dieselgate, published by Autocar June 9, 2016. See also  Johnson Matthey’s February 2020 Pgm Market Report. 2     Our view of strong Chinese fiscal and monetary stimulus was discussed in detail in our February 13, 2020 weekly report titled Iron Ore, Steel Poised For Rally. 3    Historically produced as an inferior byproduct from nickel, gold, and platinum mines, the price incentive from palladium alone isn’t enough to generate the needed investments in new mine production. According to Nornickel, this is slowly changing, palladium is an increasingly large part of mining companies’ revenues, making the metal a valuable co-product. This could improve mines investments’ responsiveness to movement in palladium prices over the medium term. 4    According to Eskom, “Load shedding is aimed at removing load from the power system when there is an imbalance between the electricity available and the demand for electricity. If we did not shed load, then the whole national power system would switch off and no one would have electricity.” The company’s load-shedding program includes 8 stages, where each stage represents the removal of 1000MW of demand – e.g., stage 5 removes 5000MW. This is done by shutting down specific sections of the grid.  5    The PGMs are ruthenium, rhodium, palladium, osmium, iridium, and platinum. 6    Things got worse after the December load-shedding event.  Less than a month later, Reuters noted more than two times the power shed in December went “offline because of plant breakdowns. 7    This can be seen in the close to 12mm oz. decline in UK and Switzerland – home of the largest secured vaults of Palladium and Platinum – net imports. 8    Technological improvement in palladium catalysts has made the metal more efficient in for gasoline-powered engines vs. platinum. It has superior properties in terms of thermal durability and NOx reduction. Thus, the conversion could be greater than 1-to-1 and would imply a smaller share of palladium autocatalyst substitution could be absorbed by existing platinum supplies.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Epic Palladium Rally Likely Continues Epic Palladium Rally Likely Continues

Highlights Analyses on Asian semis, Argentina and Russia are available on pages 7, 12 and 14, respectively. The most likely trajectory for Chinese growth will be as follows: the initial plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that quick rebound will probably be followed by weaker growth. Financial markets will soon focus on growth beyond the temporary rebound. In our opinion, it will be weaker than markets are currently pricing. Thus, risks for EM risk assets and currencies are skewed to the downside. A major and lasting selloff in EM stocks will only occur if EM corporate bond yields rise. In this week’s report we discuss what it will take for EM corporate credit spreads to widen. Feature The downside risks to EM risk assets and currencies are growing. We continue to recommend underweighting EM equities, credit and currencies versus their DM counterparts. Today we are initiating a short position in EM stocks in absolute terms. Chart I-1 illustrates that the total return index (including carry) of EM ex-China currencies versus the US dollar has failed to break above its 2019 highs, and has rolled over decisively.  In contrast, the trade-weighted US dollar has exhibited a bullish technical configuration by rebounding from its 200-day moving average (Chart I-2). Odds are the dollar will make new highs. An upleg in the greenback will foreshadow a relapse in EM financial markets. Chart I-1EM Ex-China Currencies Have Been Struggling Despite Low US Rates EM Ex-China Currencies Have Been Struggling Despite Low US Rates EM Ex-China Currencies Have Been Struggling Despite Low US Rates Chart I-2The US Dollar Remains In A Bull Market The US Dollar Remains In A Bull Market The US Dollar Remains In A Bull Market   Growth Trajectory After The Dust Settles The evolution of the coronavirus remains highly uncertain and unpredictable. As with any pandemic or virus outbreak, its evolution will be complex with non-trivial odds of a second wave. Even under the assumption that the epidemic will be fully contained by the end of March, its economic impact on the Chinese and Asian economies will likely be greater than global financial markets are currently pricing. As investors come to the realization that this initial pick-up in economic activity after the virus outbreak will be followed by weaker growth, the odds of a selloff in equities and credit markets will rise. In our January 30 report titled Coronavirus Versus SARS: Mind The Economic Differences, we argued that using the framework from the SARS outbreak to analyze the current epidemic is inappropriate. First, only a small portion of the Chinese economy was shut down in 2003, and for a brief period of time. The current closures and limited operations are much more widespread and likely more prolonged. Table I-1China’s Importance Now And In 2003 EM: Growing Risk Of A Breakdown EM: Growing Risk Of A Breakdown Second, China accounts for a substantially larger share of the global economy today than it did in 2003 (Table I-1). Hence, the global business cycle is presently much more sensitive to demand and production in the mainland than it was during the SARS outbreak. Global financial markets have rebounded following the initial selloff in late January on expectations that the Chinese and global economies will experience a V-shaped recovery. In last week’s report, we discussed why the odds favor a tepid recovery for the Chinese business cycle and global trade. The main point of last week’s report was as follows: with the median company and household in China being overleveraged, any reduction in cash flow or income will undermine their ability to service their debt and will dent their confidence for some time. Hence, consumption, investment and hiring over the next several months will be negatively affected, even after the outbreak is contained. This in turn will diminish the multiplier effect of policy stimulus in China. Chart I-3Our Expectations Of China’s Business Cycle EM: Growing Risk Of A Breakdown EM: Growing Risk Of A Breakdown The most likely pattern for Chinese growth will likely resemble the trajectory demonstrated in Chart I-3. It assumes the plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that snap-back will likely be followed by weaker growth, for reasons discussed in last week’s report. Equity and credit markets in Asia and worldwide have been sanguine because they have so far focused exclusively on expectations of a sharp rebound. As investors come to the realization that this initial pick-up in economic activity will be followed by weaker growth, the odds of a selloff in equities and credit markets will rise. Bottom Line: The most likely trajectory for Chinese and Asian growth will be as follows: the initial plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that quick rebound will probably be followed by weaker growth. Financial markets are not pricing in this scenario. Thus, risks are skewed to the downside for EM risk assets and currencies. The Missing Ingredient For An Equity Selloff The missing ingredient for a selloff in EM equities is rising EM corporate bond yields. Chart I-4 illustrates that bear markets in EM stocks typically occur when EM US dollar corporate bond yields are rising. Hence, what matters for the direction of EM share prices is not risk-free rates/yields but EM corporate borrowing costs. Chart I-4The Destiny Of EM Equities Is DependEnt On EM Corporate Bond Yields The Destiny Of EM Equities is DependEnt On EM Corporate Bond Yields The Destiny Of EM Equities is DependEnt On EM Corporate Bond Yields EM (and US) corporate bond yields can rise under the following circumstances: (1) when US Treasury yields are ascending more than corporate credit spreads are tightening; (2) when credit spreads are widening more than Treasury yields are falling; or (3) when both government bond yields and corporate credit spreads are increasing simultaneously. Provided the backdrop of weaker growth is bullish for government bonds, presently corporate bond yields can only rise if credit spreads widen by more than the drop in Treasury yields. In short, the destiny of EM equities currently relies on corporate spreads. A major and lasting selloff in EM stocks will only occur if their respective corporate bond yields rise. From a historical perspective, EM and US corporate credit spreads are currently extremely tight (Chart I-5). A China-related growth scare could trigger a widening in EM corporate credit spreads. As this occurs, corporate bond yields will climb, causing share prices to plummet. EM corporate spreads have historically been correlated with EM exchange rates, the global/Chinese business cycle, and commodities prices (Chart I-6). The Chinese property market plays an especially pivotal role for the outlook of EM corporate spreads. Chart I-5EM And US Corporate Spread Remain Tame EM And US Corporate Spread Remain Tame EM And US Corporate Spread Remain Tame Chart I-6EM Corporate Spreads Inversely Correlate With EM Currencies And Commodities Prices EM Corporate Spreads Inversely Correlate With EM Currencies And Commodities Prices EM Corporate Spreads Inversely Correlate With EM Currencies And Commodities Prices   First, offshore bonds issued by mainland property developers account for a large share of the EM corporate bond index. Chart I-7China Property Market Will Continue Disappointing China Property Market Will Continue Disappointing China Property Market Will Continue Disappointing Second, swings in China’s property markets often drive the mainland’s business cycle and its demand for resources, chemicals and industrial machinery. In turn, Chinese imports of commodities affect both economic growth and exchange rates of EM ex-China. Finally, the latter two determine the direction of EM ex-China corporate spreads. China’s construction activity and property developers were struggling before the coronavirus outbreak (Chart I-7). Given their high debt burden, the ongoing plunge in new property sales and their cash flow will not only weigh on their debt sustainability but also force them to curtail construction activity. The latter will continue suppressing commodities prices. The sensitivity of EM corporate spreads to these variables have in recent years diminished because of the unrelenting search for yield by global investors. As QE policies by DM central banks have removed some $9 trillion of high-quality securities from circulation, the volume of securities available in the markets has shrunk. This has distorted historical correlations of EM corporate spreads with their fundamental drivers – namely, China’s construction activity, commodities prices, EM exchange rates and the global trade cycle. Nonetheless, EM corporate credit spreads’ sensitivity to these variables has diminished, but has not vanished outright. If EM currencies depreciate meaningfully, commodities prices plunge and China’s growth and the global trade cycle disappoint, odds are that EM corporate spreads will widen. Given that credit markets are already in overbought territory, any selloff could trigger a cascading effect, resulting in meaningful credit-spread widening. Bottom Line: A major and lasting selloff in EM stocks will only occur if their respective corporate bond yields rise. The timing is uncertain, but the odds of EM corporate credit spreads widening are mounting as Chinese growth underwhelms, commodities prices drop and EM currencies depreciate. If these trends persist, they will push EM shares prices over the cliff. As to today’s recommendation to short the EM stock index, we anticipate at least a 10% selloff in EM stocks in US-dollar terms. For currency investors, we are maintaining our shorts in a basket of EM currencies versus the dollar. This basket includes the BRL, CLP, COP, ZAR, KRW, IDR and PHP. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Are Semiconductor Stocks Facing An Air Pocket? Global semiconductor share prices have continued to hit new highs, even though there has not been any recovery (positive growth) in global semiconductor sales or in their corporate earnings (EPS). The coronavirus outbreak and the resulting delay in 5G phone sales in China in the first half of 2020 will trigger a pullback in semiconductor equities. Global semiconductor sales bottomed on a rate-of-change basis in June, but their annual growth rate was still negative in December. In the meantime, global semi share prices have been rallying since January 2019. This divergence between stock prices and revenue of global semiconductor stocks is unprecedented (Chart II-1). Chart II-1Over-Hyped Global Semi Share Prices Global Semiconductor Market: Sales & Share Prices Over-Hyped Global Semi Share Prices Global Semiconductor Market: Sales & Share Prices Over-Hyped Global Semi Share Prices Odds are that global semi stocks in general, and Asian ones in particular, will experience a pullback in the coming weeks. The coronavirus outbreak will likely dampen expectations related to the speed of 5G adoption and penetration in China. Critically, China accounted for 35% of global semiconductor sales in 2019, versus 19% for the US and 10% for the whole of Europe. In brief, semiconductor demand from China is now greater than the US and European demand combined. Furthermore, the latest news that the US administration is considering changing its regulations to prevent shipments of semiconductor chips to China’s Huawei Technologies from global companies - including Taiwan's TSMC - could hurt chip stocks further. Since Huawei Technologies is the global leader in 5G networks and smartphones, the ban, if implemented, will instigate a sizable setback to 5G adoption in China and elsewhere. Table II-1Industry Forecasts Of The 2020 Global 5G- Smartphone Shipments EM: Growing Risk Of A Breakdown EM: Growing Risk Of A Breakdown Our updated estimate of global 5G smartphone shipments is between 160 million and 180 million units in 2020, which is below the median of industry expectations of 210 million units (Table II-1). The key reasons why the industry’s expectations are unreasonably high, in our opinion, are as follows: Chinese demand for new smartphones will likely stay weak (Chart II-2). The mainland smartphone market has become extremely saturated, with 1.3 billion units having been sold in just the past three years – nearly equaling the entire Chinese population. Chinese official data show that each Chinese household owned 2.5 phones on average in 2018, and that the average household size was about three persons (Chart II-3). This suggests that going forward nearly all potential phone demand in China is for replacement phones, and that there is no urgent need for households to buy new phones. Chart II-2Chinese Smartphone Demand: Further Decline In 2020 Chinese Smartphone Demand: Further Decline In 2020 Chinese Smartphone Demand: Further Decline In 2020 Chart II-3Chinese Households: No Urgent Need For A New Phone Chinese Households: No Urgent Need For A New Phone Chinese Households: No Urgent Need For A New Phone   The Chinese government’s boost to 5G infrastructure investment will likely increase annual installed 5G base stations from 130,000 units last year to about 600,000 to 800,000 this year. However, the total number of 5G base stations will still only account for about 7-9% of total base stations in China in 2020. Hence, geographical coverage will not be sufficiently wide enough to warrant a very high rate of 5G smartphone adoption and penetration. From Chinese consumers’ perspectives, a 5G phone in 2020 will be a ‘nice-to-have,’ but not a ‘must-have.’ Given increasing economic uncertainty and many concerns related to the use of 5G phones, mainland consumers may delay their purchases into 2021 when 5G phone networks will have more geographic coverage.  The number of 5G phone models on the market is expanding, but not that quickly. Consumers may take their time to wait for more models to hit the market before making a 5G phone purchase. For example, Apple will release four 5G phone models, but only in September 2020. Moreover, the price competition between 5G and 4G phones is getting increasingly intense. Smartphone producers have already started to cut prices of their 4G phones aggressively. For example, the price of Apple’s iPhone XS, released in September 2018, has already dropped by about 50% in China. Outside of China, 5G infrastructure development will be much slower. The majority of developed countries will likely give in to pressure from the US and limit their use of Huawei 5G equipment. This will delay infrastructure installation and adoption of 5G throughout the rest of the world because Huawei has the leading and cheapest 5G technology. In 2019, China accounted for about 70% of worldwide 5G smartphone shipments. We reckon that in 2020 Chinese 5G smartphone shipments will be between 120 million and 130 million units. Assuming this accounts for about 70-75% of the world shipment of 5G phones this year, we arrive at our estimate of global 5G smartphone shipments of between 160 million and 180 million units. We agree that 5G technology is revolutionary. Nevertheless, we still believe global semi share prices are presently overhyped by unreasonably optimistic 2020 projections. Overall, investors are pricing global semi stocks using the pace and trajectory of 4G smartphones adoption. However, in 2020 the number and speed of 5G phone penetration will continue lagging that of 4G ones when the latter were introduced in December 2013 (Chart II-4). We agree that 5G technology is revolutionary, and its adoption and penetration will surge in the coming years. Nevertheless, we still believe global semi share prices are presently overhyped by unreasonably optimistic 2020 projections (Chart II-5).  Chart II-4China 5G-Adoption Pace: Slower Than The Case With 4G China 5G-Adoption Pace: Slower Than The Case With 4G China 5G-Adoption Pace: Slower Than The Case With 4G Chart II-5Net Earnings Of Global Semi Sector: Too Optimistic? Net Earnings Of Global Semi Sector: Too Optimistic? Net Earnings Of Global Semi Sector: Too Optimistic?   Investment Implications Global semi stocks’ valuations are very elevated, as shown in Chart II-6 and Chart II-7. Besides, semi stocks are overbought, suggesting they could correct meaningfully if lofty growth expectations currently baked into their prices do not materialize in the first half of this year. Chart II-6Global Semi Stocks Valuations: Very Elevated Global Semi Stocks Valuations: Very Elevated Global Semi Stocks Valuations: Very Elevated Chart II-7Global Semi Stocks’ Valuations: Very Elevated Global Semi Stocks Valuations: Very Elevated Global Semi Stocks Valuations: Very Elevated   The coronavirus outbreak and the resulting delay in 5G phone sales in China in the first half of 2020, along with US pressure on global semi producers not to sell to Huawei, will likely trigger a pullback in semiconductor equities. We recommend patiently waiting for a better entry point for absolute return investors. Within the EM equity universe, we have not been underweight Asian semi stocks because of our negative outlook for the overall EM equity benchmark. The Argentine government will drag out foreign debt negotiations with the IMF and foreign private creditors to secure a more favorable settlement. We remain neutral on Taiwan and overweight Korea. The reason is that DRAM makers such as Samsung and Hynix have rallied much less than TSMC. Besides, geopolitical risks in relation to Taiwan in general and TSMC in particular are rising, warranting a more defensive stance on Taiwanese stocks relative to Korean equities. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Argentina’s Eternal Tango With Foreign Creditors Chart III-1Downside Risks To Bond Prices Downside Risks to Bond Prices Downside Risks to Bond Prices Our view remains that debt negotiations will be drawn-out because the Argentine government is both unwilling and lacks the financial capacity to service public foreign debt. The administration’s recent attitude toward foreign creditors and the IMF have startled markets: sovereign Eurobond bond prices have tanked (Chart III-1). The reasons why the Fernandez administration will play tough ball with creditors and the IMF are as follows: The country’s foreign funding and the public sector debt situations are precarious. Hence, the lower the recovery rate they negotiate with creditors, the more funds will be available to expand social programs and secure domestic political support. Given Fernandez’s and Peronist’s voter base, the government is inclined to please the population at expense of foreign creditors. Moreover, Alberto Fernandez is facing increasing scrutiny from radical Peronists, who want to dissolve the debt altogether. Vice-president Fernandez de Kirchner stated that Argentina should not pay international agents until the economy escapes a recession. To further add to creditors’ frustration, the government has yet to announce a comprehensive economic plan to revive the economy and service outstanding debt. The public foreign currency debt burden is unsustainable – its level stands at $250 billion, about 4 times larger than exports. The country is still in a recession, and economic indicators do not show much improvement. Committing to fiscal austerity to service foreign debt would entail further economic suffering for Argentine businesses and households, something Fernandez rejected throughout his campaign. The authorities are singularly focused on reviving the economy: government expenditures have grown by over 50% annually under the current administration (Chart III-2). Crucially, Argentina has already achieved a large trade surplus and its current account balance is approaching zero (Chart III-3). Assuming exports stay flat, the economy can afford to maintain its current level of imports. This makes the authorities less willing to compromise and more inclined to adopt a tough stance in debt negotiations. Chart III-2Peronist Government Has Again Boosted Fiscal Spending Peronist Government Has Again Boosted Fiscal Spending Peronist Government Has Again Boosted Fiscal Spending Chart III-3Argentina: Current Account Is Almost Balanced Argentina: Current Account Is Almost Balanced Argentina: Current Account Is Almost Balanced   The risk of this negotiation strategy is that the nation will not be able to raise foreign funding for a while. Nevertheless, the country is currently de facto not receiving any external financing. Hence, this risk is less pressing. Moreover, the administration has already delayed all US$ bond payments until August. This allows them to extend negotiations with creditors over the next six months, thereby increasing uncertainty and further pushing down bond prices. A lower market price on Argentine bonds is beneficial for the government’s negotiation strategy as it implies lower expectations for foreign creditors. Thus, the Fernandez administration’s strategy will be to play hardball and draw-out negotiations as long as possible. We expect Argentina to reach a settlement with creditors no earlier than in the third quarter of this year and at recovery rates below current prices of the nation’s Eurobonds. Russian financial assets will be supported due to improving public sector governance, accelerating domestic demand growth and healthy macro fundamentals. Bottom Line: The government will drag out foreign debt negotiations with the IMF and foreign private creditors to secure a more favorable settlement. Continue to underweight Argentine financial assets over the next several months. Juan Egaña Research Associate juane@bcaresearch.com Russia: Harvesting The Benefits Of Macro Orthodoxy Russian financial markets have shown resilience in face of falling oil prices. This has been the upshot of the nation’s prudent macro policies in recent years. We have been positive on Russia and overweight Russian markets over the past two years and this stance remains intact. Going forward, Russian financial assets will be supported due to improving public sector governance, accelerating domestic demand growth and healthy macro fundamentals: Fiscal policy will be relaxed substantially – both infrastructure and social spending will rise. Specifically, the Kremlin is eager to ramp up the national projects program. This is bullish for domestic demand. Russia’s public finances are currently in a very healthy state. Public debt (14% of GDP) is minimal and foreign public debt (4% of GDP) is tiny. The overall fiscal balance is in large surplus (2.7% of GDP). The current account is also in surplus. Hence, a major boost in fiscal spending will not undermine Russia’s macro stability for some time. As a major sign of policy change, President Putin has sidelined or reduced the authority of policymakers who have been advocating tight fiscal policy. This policy change has been overdue as fiscal policy has been unreasonably tight for longer than required (Chart IV-1). Chart IV-1Russia: Government Spending Has Been Extremely Weak Russia: Government Spending Has Been Extremely Weak Russia: Government Spending Has Been Extremely Weak Importantly, the recent changes at the highest levels of government are also positive for governance and productivity. The new Prime Minister Mishustin has earned this appointment for his achievements as the head of the federal tax authority. He has restructured and reorganized the tax department in a way that has boosted its efficiency/productivity substantially and increased tax collection. By promoting him to the head of government, Putin has boosted Mishustin’s authority to reform the entire federal governance system. Given his record of accomplishment, odds are that the new prime minister will succeed in implementing some reforms and restructuring. Thereby, productivity growth that has been stagnant in Russia for a decade could revive modestly. Also, Putin was reluctant to boost infrastructure spending as he was afraid of money being misappropriated without a proper monitoring system. Putin now hopes Mishustin can introduce an efficient governance system of fiscal spending to assure infrastructure projects can be realized with reasonably minimal losses. As to monetary policy, real interest rates are still very high. The prime lending rate is 10%, the policy rate is 6% and nominal GDP growth is 3.3% (Chart IV-2). Weak growth (Chart IV-3) and low inflation will encourage the central bank to continue cutting interest rates. Chart IV-2Russia: Interest Rates Remain Excessively High Russia: Interest Rates Remain Excessively High Russia: Interest Rates Remain Excessively High Chart IV-3Russia's Growth Is Very Sluggish Russia's Growth Is Very Sluggish Russia's Growth Is Very Sluggish   Finally, the economy does not have any structural excesses and imbalances. The central bank has done a good job in cleansing the banking system and the latter is in healthy shape. Bottom Line: The ruble will be supported by improving productivity, cyclical growth acceleration and a healthy fiscal position. We continue recommending overweighting Russian stocks, local currency bonds and sovereign credit relative to their respective EM benchmarks. Last week, we also recommended a new trade: Short Turkish bank stocks / long Russian bank stocks. The main risk to the absolute performance of Russian markets is another plunge in oil prices and a broad selloff in EM. On November 14, 2019 we recommended absolute return investors to go long Russian local currency bonds and short oil. This strategy remains intact. Finally, we have been recommending the long ruble / short Colombian peso trade since May 31, 2018. This position has generated large gains and we are reiterating it. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Geopolitical sparks in the Mediterranean point to the revival of realism or realpolitik in places where it has long been dormant. Europe is wary of Russia but will keep buying more of its natural gas. This will be a source of tension with the United States. Turkey is wary of Russia but will continue choosing pragmatic deals with Moscow that fly in the face of Europe and the United States. Turkey’s intervention in Libya is small but symbolic. Increases in foreign policy aggressiveness are negative signs for Turkey as they stem from domestic economic and political instability. Short Turkish currency, equities, and local government bonds. The recent increase in immigration into Europe will fuel another bout of populism if it goes unchecked. Feature “Multipolarity,” or competition among multiple powerful nations, is our overarching geopolitical theme at BCA Research. The collapse of the Soviet Union did not lead to the United States establishing a global empire, which might in theory have provided a stable and predictable trade and investment regime. The United States lashed out when attacked but otherwise became consumed by internal struggles: financial crisis and political polarization. Under two administrations the American public has demanded a reduced commitment to international affairs. Europe is even less likely to project power abroad – particularly after being thrown on the defensive by the Syrian and Libyan revolutions and ineffectual EU responses. Turkey’s aggressive foreign policy is a symptom of global multipolarity – which makes the world less predictable for investors. Emerging markets have risen in economic and military power relative to their developed counterparts. They demand a redistribution of global political power to set aright historical grievances and address immediate concerns, such as supply line insecurities, which increase alongside a rapidly growing economy. Multipolarity is apparent in Russia’s resurgence: pushing back on its borders with Europe and NATO, seeking a greater role in the Middle East and North Africa, interfering in US politics, and cementing its partnership with China. Multipolarity is equally evident when medium-sized powers – especially those that used to take orders from the US and Europe – seek to establish an independent foreign policy and throw off the shackles of the past. Turkey is just such a middle power. Strongman President Recep Tayyip Erdogan initially sought to lead Turkey into a new era of regional ascendancy. The Great Recession and Arab Spring intervened. Domestic economic vulnerabilities and regional instability have driven him to pursue increasingly populist and unorthodox policies that threaten the credit of the nation and security of the currency. A coup attempt in 2016 and domestic political losses in 2019 drove Erdogan further down this path, which includes aggressive foreign policy as well as domestic economic stimulus. The Anatolian peninsula has always stood at the crossroads of Europe and Asia, as well as Russia and Africa. Turkey’s efforts to change the regional status quo to its favor, increase leverage over its neighbors in Europe and the Middle East, and deal with Russia’s Vladimir Putin from a position of strength, are causing the geopolitics of the Mediterranean to heat up. It has now intervened in the Libyan civil war. In this special report, we focus on this trend and ask what it means for global investors. Unfinished Business In Libya Chart 1Haftar Is Weaponizing Libya’s Oil The Geopolitics Of The Mediterranean The Geopolitics Of The Mediterranean As the Libyan conflict enters its sixth year this spring, the battle for control of the western bastion of Tripoli rages. Multiple efforts to mediate the conflict between Field Marshal Khalifa Haftar of the Libyan National Army (LNA) and Prime Minister Fayez al-Sarraj of the UN-recognized Government of National Accord (GNA) have failed. Ceasefire talks in Moscow, Rome, and Berlin have fizzled. Instead, fighting has finally hit oil production, with the state-run National Oil Corp (NOC) declaring force majeure on supplies on January 18. Tribal leaders who support Haftar have blockaded eastern ports (Chart 1). Previously the mutual dependence of the rival factions on oil revenues ensured production and exports went mostly undisturbed. LNA forces control nearly all key oil pipelines, fields, ports, and terminals in Libya. The exceptions are the Zawiyya and Mellitah terminals and offshore fields (Map 1). However the National Oil Company (NOC), headquartered in the GNA-controlled Tripoli, is the sole entity controlling operations and the sole marketer of Libyan oil. Map 1Libya’s Oil And Natural Gas Infrastructure: Monopolized By Haftar The Geopolitics Of The Mediterranean The Geopolitics Of The Mediterranean General Haftar’s blockade – which has ground oil production to a halt – displays his ability to weaponize oil to obtain concessions from the Tripoli-based government. Tribal leaders behind the blockade are calling for a larger share of oil revenues, for which they are at the mercy of the LNA and NOC. With little progress in Haftar’s push to gain control of Tripoli, and Libya more generally, the conflict has reached a stalemate. Not one to back down, Haftar’s decision to cut off oil sales from the Tripoli government, which also cuts off revenues to his own parallel administration, is a brute attempt to force a settlement. Haftar’s gambit follows Turkey’s decision to intervene in Libya on behalf of Sarraj and the GNA. Turkey has deployed roughly 2,000 Syrian fighters, as well as 35 Turkish soldiers in an advisory capacity. Turkey apparently feared that Haftar, who has substantial backing from Egypt and the Gulf Arabs as well as Russia and France, was about to triumph, or at least force a settlement detrimental to Turkish interests. Bottom Line: Turkey’s decision to intervene in the Libyan civil war – while limited in magnitude thus far – raises the stakes of the conflict, which involves the EU, Russia, and the Arab states. It is a clear signal of the geopolitical multipolarity in the region – and a political risk that is flying under the radar amid higher profile risks in other parts of the world. Political Interests: Islamist Democracy Versus Arab Dictatorship The Libyan civil war is a proxy war between foreign nations motivated by conflicting economic and strategic interests in North Africa and the Mediterranean. But there is an ideological and political structure to the conflict that explains the alignment of the nations: Turkey is exporting democracy while the Arab states try to preserve their dictatorships. Haftar’s primary supporters include Egypt, the United Arab Emirates (UAE), and Saudi Arabia. These states see monarchy as the way to maintain stability in a region constantly on the edge of chaos. Islamist democracy movements, such as Egypt’s Muslim Brotherhood, pose a threat to their long-term authority and security. They try to suppress these movements and contain regimes that promote them or their militant allies. They are willing to achieve one-man rule by force and thus support military strongmen like Egypt’s Abdel Fattah el-Sisi and Libya’s General Haftar. On the other side of the conflict stand the backers of the GNA – Turkey and Qatar – which support political Islam and party politics (Chart 2). Turkey’s Erdogan and his Justice and Development Party (AKP) are sympathetic to Hamas in the Palestinian territories and Egypt’s Muslim Brotherhood. They want to ensure a lasting role for Islamic parties in the region, which strengthens their legitimacy. They do not want Libya’s Islamists to suffer the same fate as their affiliates in the Muslim Brotherhood – removal via a military coup. Chart 2Turkey Sees A Place For Political Islam Turkey Sees A Place For Political Islam Turkey Sees A Place For Political Islam Chart 3Turkey Steps In Amid Qatar Embargo The Geopolitics Of The Mediterranean The Geopolitics Of The Mediterranean The political conflict is mirrored in the Persian Gulf in the form of the air, land, and sea embargo imposed on Qatar in 2017 at the hands of the Saudis, Egyptians, and Emiratis. The Qatar crisis followed a 2014 diplomatic rift and the 2011 Arab Spring, when Qatar supported protesters and democracy movements against neighboring regimes. The embargo strengthened Turkey-Qatar relations, as Turkey stepped in to ensure that Qataris – who are heavily dependent on imports – would continue to receive essentials (Chart 3). Bottom Line: The alliances forged in the Libyan conflict reflect differing responses to powerful forces of change in the region. Established monarchies and dictatorships are struggling to maintain control of large youth populations and rapidly modernizing economies. Their response is to fortify the existing regime, suppress dissent, and launch gradual reforms through the central government. Their fear of Islamist movements makes them suspicious of Tripoli and the various Islamist groups allied with the GNA, and aligns them with Khalifa Haftar’s attempt to impose a new secular dictatorship in Libya. Meanwhile Turkey, with an active Islamist democracy, is seeking to export its political model, and Muslim Brotherhood-esque political participation, to gain influence across the region, including in Libya and North Africa. Economic Interests: The Scramble For Energy Sources Chart 4Europe Addicted To Russian Gas The Geopolitics Of The Mediterranean The Geopolitics Of The Mediterranean The Libyan proxy war is also about natural resources, for all the powers involved. Turkey’s intervention reflects its supply insecurity and desire to carve a larger role for itself in the east Mediterranean economy. Turkey needs to secure cheap energy supplies, and also wants to make itself central to any emerging east Mediterranean natural gas hub that aims to serve Europe. Europe’s increasing dependency on natural gas imports to meet its energy demand, and Russia’s outsized role – supplying the EU with 40% of its needs – have encouraged a search for alternative suppliers (Chart 4). Israel is attempting to fill that role with resources discovered offshore in the eastern Mediterranean. Given its strategic location, Turkey hopes to become an energy hub. First, it is cooperating with the Russians. Presidents Putin and Erdogan inaugurated the Turkish Stream pipeline (TurkStream) at a ceremony in Istanbul on January 8. The pipeline will transport 15.75 billion cubic meters (Bcm) of Russian natural gas to Europe via Turkey. This is part of Russia’s attempt, along with the Nord Stream 2 pipeline, to bypass Ukraine and increase export capacity, strengthening its dominance over Europe’s natural gas market (Map 2). Map 2Russia’s Latest Pipelines Bypass Ukraine The Geopolitics Of The Mediterranean The Geopolitics Of The Mediterranean Europe and its allies are wary of Russian influence, but the EU is not really willing to halt business with Russia, which is a low-cost and long-term provider free from the turmoil of the Middle East. Despite the significant growth in US natural gas supplies, the relatively higher cost makes Russian supplies comparatively more attractive (Chart 5). Chart 5Russian Gas Is Competitive In European Markets … The Geopolitics Of The Mediterranean The Geopolitics Of The Mediterranean Chart 6… As US Attempts To Gain Market Share The Geopolitics Of The Mediterranean The Geopolitics Of The Mediterranean The result will be tensions with the United States, which expects the Europeans to honor the security relationship by buying American LNG (Chart 6) and will always abhor anything resembling a Russo-European alliance. American legislation signed on December 20 would impose sanctions on firms that lay pipes for Nord Stream 2 and TurkStream. Second, Turkey wants to become central to eastern Mediterranean energy development. A series of offshore discoveries in recent decades has sparked talk of cooperation among potential suppliers (Table 1). There is a huge constraint on developing the fields quickly, as there is no export route currently available for the volumes that will be produced. While the reserves are not significant on a global scale, their location so close to Europe, and growing needs in the Middle East, has generated some interest. Table 1Recent East Mediterranean Discoveries Are Relatively Small, But Geopolitically Attractive The Geopolitics Of The Mediterranean The Geopolitics Of The Mediterranean However, Europe and Israel – the status quo powers – threaten to marginalize Turkey in this process: A meeting of the energy ministers of Egypt, Cyprus, Greece, Israel, Italy, the Palestinian territories, and Jordan in Cairo last July resulted in the creation of the Eastern Mediterranean Gas Forum to promote regional energy cooperation. Turkey – along with Lebanon and Syria – was excluded. Turkey seeks access to natural resources – and to prevent Israel, Egypt, and Europe from excluding it. The EastMed Pipeline deal – signed by Greece, Cyprus, and Israel on January 2 – envisages a nearly 2,000 km subsea pipeline transporting gas from Israeli and Cypriot offshore fields to Cyprus, Crete and Greece, supplying Europe with 9-12 Bcm per year (Map 3). The project enjoys the support of the European Commission and the US as an attempt to diversify Europe’s gas supplies and boost its energy security.1 But it would also be an alternative to an overland pipeline on Turkish territory. Map 3The Proposed EastMed Pipeline Would Marginalize Turkey The Geopolitics Of The Mediterranean The Geopolitics Of The Mediterranean Egypt has two underutilized liquefied natural gas plants – in Idku and Damietta – and has benefited from the 2015 discovery of the Zohr gas field. Egypt has recently become a net exporter of natural gas (Chart 7). It signed a deal with Israel to purchase 85.3 Bcm – $19.5 billion – of gas from Leviathan and Tamar fields over 15 years. Egypt sees itself as an energy hub if it can re-export Israeli supplies economically. Note that Russia and Turkey have some overlapping interests here. Russia does not want Europe to diversify, while Turkey does not want to allow alternatives to Russia that exclude Turkey. Thus maintaining the current trajectory of natural gas projects is not only useful for Russia’s economy (Chart 8) but also for Turkey’s strategic ambitions. Chart 7Egypt Also Aims To Become East Mediterranean Gas Hub The Geopolitics Of The Mediterranean The Geopolitics Of The Mediterranean Of course, while Russian pipes are actually getting built, the EastMed pipeline is not – for economic as well as geopolitical reasons. Europe is currently well supplied and energy prices are low. At an estimated $7 billion, the cost of constructing the EastMed pipeline is exorbitant. Chart 8Maintaining Energy Dominance Advances Russia’s Strategic Ambitions Too The Geopolitics Of The Mediterranean The Geopolitics Of The Mediterranean Still, Turkey must make its influence known now, as energy development and pipelines are necessarily long-term projects. The chaos in Libya presents an opportunity. Seizing on the Libyan GNA’s weakness, Turkey signed an agreement to provide for offshore maritime boundaries and energy cooperation as well as military aid. The EastMed pipeline, of course, would need to cross through Turkish and Libyan economic zones (see Map 3 above).2 Turkey is incapable of asserting its will militarily in the Mediterranean against powerful western naval forces. But short of war, it is capable of expanding its claims and leverage over regional energy and forcing the Israelis and Europeans to deal with it pragmatically and realistically rather than exclude it from their plans. Part of Turkey’s goal is to cement an alliance with Libya – at least a partitioned western Libyan government in any ceasefire brokered with Haftar and the Russians. Bottom Line: While Turkey and Russia support opposing sides in the Libyan conflict, both benefit from dealing directly with each other – bypassing the western powers, which are frustrated and ineffectual in Libya. Both would gain some direct energy leverage over Europe and both would gain some influence over any future eastern Mediterranean routes to Europe. In Libya, if either side triumphs and unites the country, it will grant its allies oil and gas contracts almost exclusively. But if the different foreign actors can build up leverage on opposing sides, they can hope to secure at least some of their interests in a final settlement. Turkey Needs Foreign Distractions The foregoing would imply that Turkey is playing the game well, except that its foreign adventures are in great part driven by domestic economic and political instability. After all, Turkey’s maritime claims are useless if they cannot be enforced, and offshore development and pipeline-building are at a low level given weak energy prices and slowing global demand. Economically, in true populist fashion, Erdogan has repeatedly employed money creation and fiscal spending to juice nominal GDP growth. The result is a wage-price spiral, currency depreciation, and current account deficits that exacerbate the problem. The poor economy has mobilized political opposition. Over the past year, for the first time since Erdogan rose to power in 2002, his Justice and Development Party is fracturing. Former Turkish deputy prime minister Ali Babacan, a founding member of the AKP, as well as former prime minister Ahmet Davutoglu, have both announced breakaway political parties that threaten to erode support for the AKP. Local elections in 2019 resulted in a popular rebuke in Istanbul. Thus Erdogan is distracting the public with hawkish or nationalist stances abroad that are popular at home. Turkey has taken a strident stance against the US and Europe, symbolized by its threats to loose Syrian refugees into Europe and its purchase of S400 missile defense from Russia despite being a NATO member. Military incursions in Syria aim to relocate refugees back to Syria (Chart 9). Chart 9Erdogan Is Distracting Turks With Popular Foreign Stances The Geopolitics Of The Mediterranean The Geopolitics Of The Mediterranean Chart 10No Love Lost Toward The West The Geopolitics Of The Mediterranean The Geopolitics Of The Mediterranean Turkish public opinion encourages close cooperation with Russia and a more aggressive stance against the West (Chart 10). This is a basis for Russia and Turkey to continue cutting transactional deals despite falling on opposite sides of conflicts in Syria, Libya, Iran, and elsewhere. Erdogan’s pretensions of reviving Ottoman grandeur in the Mediterranean fall in this context. Elections are not until 2023, but we expect Erdogan to continue using foreign policy as a distraction. The opposition is trying to unite behind a single candidate, which could jeopardize Erdogan’s grip on power. The insistence on stimulus at all costs means that Erdogan is not allowing the economic reckoning to occur now, three years before the election. He is trying to delay it indefinitely, which may fail. Libya may not get resolved, however. Allies of Haftar’s LNA – specifically Egypt, Saudi Arabia, and the UAE – will be motivated to intensify their support of him for fear that a loss would revive domestic interest in political Islam. Egypt especially fears militant proxies being unleashed from any base of operations there. The LNA currently serves as a buffer between Egypt and the militant actors in Libya. If Haftar is defeated, Egypt’s porous western border would provoke a harsh reaction from Cairo. The threat of a revival of Islamic State in Libya has united the Egyptian people – a critical variable in the administration’s vision of a stable country. That has provided Egypt’s Sisi an excuse to flex his muscles through military exercises. Neither Russia nor NATO will be moved to bring a decisive finish to the conflict, as neither wishes to invest too heavily in it. Bottom Line: Erdogan has doubled down on populism at home and abroad. His assertive foreign policy in Syria and now Libya may end up exacerbating economic and political pressures on the ruling party. What Is The Endgame In Libya? There are three possible scenarios to end the current stalemate between the Haftar’s forces and the internationally recognized GNA: Military: An outright military victory by either Haftar or Sarraj is highly unlikely. While Haftar’s forces enjoy military and financial support from the UAE, he lacks popular support in Tripoli – which has proved to be challenging to takeover. Similarly, Sarraj’s army is not strong enough to confront the eastern forces and reunify the country. The merely limited involvement of foreign actors – including Turkey – makes a military solution all the more elusive. The most likely path to a quick military victory comes if foreign actors disengage. This will only occur if they are punished for their involvement, and thus it requires a major neutral power, perhaps the United States, to change the calculus of countries involved. But the US is eschewing involvement and the Europeans have shown no appetite for a heavy commitment. Diplomatic: A negotiated settlement is eventually likely, given the loss of oil revenues. A ceasefire would assign some autonomy to each side of the country. Given Haftar’s ambitions of conquering the capital and becoming a strongman for the country as a whole, the diplomatic route will be challenging unless his Gulf backers grow tired of subsidizing him. Financial: Haftar could win by breaking the NOC’s monopoly on oil. In the past, the LNA failed at selling the oil extracted from infrastructure under its control. If Haftar manages to market the oil without the aid of the NOC then he will be able to guarantee a stream of revenue for his forces and at the same time starve the Tripoli government of financing. This would pose an existential risk for the GNA. The key challenge in this scenario is to obtain international backing for LNA sales of Libyan crude supplies. Libya’s partition into two de facto states is the likeliest outcome. Bottom Line: Unless one of the constraints on a military, diplomatic, or financial end to the conflict is broken, the current stalemate in the Libyan conflict will endure. A partition of Libya will be the practical consequence. Turkey hopes to boost its regional influence through Tripoli, and thus increase its leverage over Europe, but a heavy investment could result in fiscal losses or spiral into a broader regional confrontation. Investment Implications While it is not clear how long the current blockade on Libyan ports will last – or the associated over 1 million barrels per day loss of production – oil supplies will remain at risk so long as the conflict endures. However, unlike supplies in the Gulf or in Venezuela, Libyan crude is of the light sweet grade. There is enough global spare capacity – from US shales – to make up for the Libyan loss, at least over the short term. The fall in Libyan supplies is occurring against the backdrop of oil markets that have been beaten down by the decline in demand on the back of the coronavirus impact (Chart 11). The OPEC 2.0 technical panel recommended additional output cuts of 600 thousand barrels per day last week, and is waiting on a final decision by Russia. We expect the cartel to tighten supplies to shore up prices. The instability in Libya could also affect Europe through immigration. The conflict re-routes migrants through the western route and thus could result in an increased flow to Spain and Portugal, rather than Italy which was previously their landing pad (Chart 12). A meaningful pick up would have a negative impact on European domestic political stability, especially with Germany in the midst of a succession crisis and incapable of taking a lead role. Chart 11Libyan Blockade Comes Amid Demand Shock Libyan Blockade Comes Amid Demand Shock Libyan Blockade Comes Amid Demand Shock Chart 12Refugees Will Favor Western Route Across The Mediterranean Refugees Will Favor Western Route Across The Mediterranean Refugees Will Favor Western Route Across The Mediterranean Erdogan’s foreign adventurism, and aggression against the West, poses a risk for Turkish markets. We remain underweight Turkish currency and risk assets. Our Emerging Markets strategists expect foreign capital outflows from EM to weigh on Turkey’s currency, local fixed-income and sovereign credit relative to EM benchmarks. Go short the Turkish lira relative to the US dollar. Bottom Line: Historically, the Mediterranean was the world’s most important waterway. It was the “life line” of the British empire. The US succeeded the British as the guarantor of Suez and corralled both Turkey and Greece into a single alliance under the Truman Doctrine. This status quo held until the twenty-first century. Since 2000, Russia has revived, US foreign policy in the Middle East has become erratic, and the Europeans have lost clout. Turkey is seeking to carve a space for itself and challenge the settlements of the past, all the way back to the 1923 Treaty of Lausanne. Yet in the wake of the Great Recession its economy is unstable and its populist leaders are taking greater risks abroad. The result will be greater friction with Europe, or the Arab states, or both. Given Turkey’s mismanagement at home, and limited gains to be made in Syria or Libya, Turkish assets will be the first to suffer from negative surprises.   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 The Eastern Mediterranean Security and Energy Partnership Act of 2019 is an American bi-partisan bill the lends full support for the East Med pipelines and greater security cooperation with Israel, Cyprus, and Greece. The US Senate also passed an amendment to the National Defense Authorization Act last June which ended the arms embargo on Cyprus. 2 Turkey has also been engaging in drilling activities in disputed waters near Cyprus – which Ankara argues it is undertaking in order to protect Turkish-Cypriot claims – motivating EU economic sanctions in the form of travel bans and asset freezes on two Turkish nationals.

Highlights An analysis on Turkey is available on page 10. In the short term, EM share prices will likely continue searching for a direction as visibility is extremely low. Beyond the near term, an appropriate strategy for EM equity investors is buying breakouts and selling breakdowns. The forthcoming stimulus from China is not a surefire guarantee of an immediate cyclical recovery. Low and falling willingness to spend among Chinese consumers and enterprises could overwhelm the positive boost from the stimulus. Forecasting changes in willingness to spend is not straightforward. Elsewhere, we are recommending a new trade: Short Turkish banks / long Russian banks. Feature Chart I-1EM Vs DM Equities: The Path Of Least Resistance Is Down EM Vs DM Equities: The Path Of Least Resistance Is Down EM Vs DM Equities: The Path Of Least Resistance Is Down EM risk assets and currencies as well as China-related financial markets are facing higher than usual uncertainty. Not only are the magnitude and duration of the coronavirus shock to the mainland’s economy unknown, but also both the scale of China’s forthcoming stimulus and its multiplier are highly uncertain. How should investors navigate through such uncertainty? For EM equity investors, an appropriate strategy is buying breakouts and selling breakdowns. Presently, we maintain a neutral stance on the absolute performance of EM stocks. We initiated a long position on December 19 and closed it on January 30 to manage risks amid the coronavirus outbreak. For asset allocators, we continue to recommend underweighting EM within global equity and credit portfolios (Chart I-1). As to exchange rates, investors should stay short a basket of EM currencies versus the US dollar. The EM equity index and EM currencies have been in a trading range in the past 12 months (Chart I-2). In the short term, markets will likely continue searching for a direction as visibility is extremely low. Beyond the near term, however, EM share prices and currencies are unlikely to remain in a narrow trading range. They will either break out or break down. Which way the market swings is contingent on corporate profits and the business cycle. A Framework To Assess Shocks What framework should investors use to gauge economic and financial market outcomes? We recommend the following: When a system – in this case the Chinese economy – is hit by an external shock, its most likely trajectory depends on the duration and magnitude of the shock as well as the initial health of the system. If the system is balanced and robust, a moderate shock can certainly shake it, but will not knock it over. A V-shaped recovery is most likely in this case. By contrast, if the system is unbalanced and precarious, a measured tremor could produce an outsized negative impact. As a result, this economy is more likely to experience a U-shaped recovery. No one can gauge with any precision the impact of the coronavirus outbreak on China’s economy. The only thing we can assess is the health of the mainland economy prior to this exogenous shock. Beyond the near term, EM share prices and currencies are unlikely to remain in a narrow trading range. Which way the market swings is contingent on corporate profits and the business cycle. In this regard, we present the following analysis on both the economy’s cyclical condition and structural vitality: 1. Cyclically, China’s growth was ostensibly bottoming when the coronavirus outbreak occurred. The top panel of Chart I-3 illustrates that – at that time – the Chinese broad money impulse foreshadowed a revival in nominal industrial output from late 2019 until mid-2020. In the second half of this year, however, the same indicator projected renewed growth deterioration. Chart I-2EM Stocks And Currencies Are In A Trading Range: How Long Will It Last? EM Stocks And Currencies Are In A Trading Range: How Long Will It Last? EM Stocks And Currencies Are In A Trading Range: How Long Will It Last? Chart I-3Without The Coronavirus Outbreak, Chinese Recovery Would Have Been Muted And Short-Lived Without The Coronavirus Outbreak, Chinese Recovery Would Have Been Muted And Short-Lived Without The Coronavirus Outbreak, Chinese Recovery Would Have Been Muted And Short-Lived   Notably, the broad money impulse has often led the credit and fiscal spending impulse, and it currently signals a rollover in the latter sometime in the first half of 2020 (Chart I-3, bottom panel). Chart I-4EM Corporate Profits: Modest And Temporary Improvement EM Corporate Profits: Modest And Temporary Improvement EM Corporate Profits: Modest And Temporary Improvement Consistently, China’s narrow money growth had been projecting a muted and only temporary rebound in EM corporate profits – which are often driven by the Middle Kingdom’s business cycle – from late 2019 until the middle of 2020 (Chart I-4). Thereafter, EM profit growth was set to relapse anew. In short, even prior to the coronavirus outbreak, our indicators were signaling that any economic improvement on the back of the Chinese government’s 2018-19 stimulus would have been muted and short-lived from late 2019 until mid-2020. Hence, the negative shock from the public health emergency could end up nullifying the pending recovery. 2. Structurally, as we have written extensively, China has enormous credit and money excesses. The economy has become addicted to rampant money and credit creation. This, along with the misallocation of capital and the resulting growth in the number of zombie companies, makes the system vulnerable, even to moderate shocks. It is reasonable to assume that there are some companies that enjoy great financial health, some zombies that are unable to service their debt at all, and a certain number of enterprises that generate just enough cash flow to service their debt. While the coronavirus-induced downtrend in the economy will not materially change the financial status of healthy or zombie businesses, it will likely alter the financial standings of debtors that were on the proverbial edge. Assuming the unavoidable drop in cash flows due to the country’s sudden shutdowns, these debtors will struggle to service their debt. This will likely alter their short-to-midterm decision making. For example, if they were planning to expand their operations and hire more employees, these plans are likely to be shelved for now. Low and falling willingness among households to consume and among enterprises to invest and hire could overwhelm the positive boost from the stimulus. In short, the coronavirus-induced shutdowns are cutting into cash flows, but they do not in any way reduce debt burdens. Chart I-5 illustrates that debt servicing costs as a share of income for companies and households in China are among the highest in the world. Chart I-5China Has A High Debt Service-To-Income Ratio China Has A High Debt Service-To-Income Ratio China Has A High Debt Service-To-Income Ratio Notably, this measure for China is relative to nominal GDP while for other countries it is relative to disposable income. Disposable income is smaller than GDP as it takes into account taxes paid. Therefore, on a comparable basis, this ratio for China will be meaningfully higher than the one shown on Chart I-5. Bottom Line: Provided the Chinese economy is highly leveraged, it is reasonable to conjecture that the recovery following the adverse shock from the coronavirus will be U- rather than V-shaped. Stimulus: Yes. Multiplier: Unknown. It is a given that the Chinese authorities will inject more fiscal and monetary stimulus into the system. Nevertheless, the ultimate size of stimulus is unknown. So far, the following has been announced: On the monetary and credit side: A RMB300 billion re-lending quota to supply special low-cost funds to assist national commercial banks and local banks to provide preferential interest rate loans to key enterprises for epidemic prevention and control; On February 3, open market operation rates were cut by 10 basis points, and the key 7-day repo rate fell by 45 basis points; The People’s Bank of China injected liquidity1 via open market operations; The People’s Bank of China encouraged banks to lower lending costs for small and medium enterprises by 10% in some provinces. Critically, the banking regulatory authority has indicated it will allow an extension of the transition period for the implementation of the New Asset Management Regulation beyond 2020. Chart I-6Marginal Propensity To Spend Varies From Cycle To Cycle Marginal Propensity To Spend Varies From Cycle To Cycle Marginal Propensity To Spend Varies From Cycle To Cycle On the fiscal side: Additional local government debt quotas of RMB848 billion have been approved, on top of the previously authorized quota of RMB1 trillion in November 2019; the front-loaded debt quota will offer local governments more flexibility with their budgets and support growth via public investment; Cumulatively about RMB66 billion in supplementary funds has been deployed to support local governments and businesses, according to the Ministry of Finance; The authorities have delayed or partially waived taxes, social security fees, and government-owned rents for affected businesses; The government has instituted refunds of unemployment insurance premiums to enterprises who retain most employees in some cities; The central government will provide temporary interest rate relief (equivalent to 50% of the re-lending policy rate) on loans to key enterprises involved in the fight against the epidemic. However, stimulus in and of itself is not a sufficient condition on which to bet on a V-shaped recovery. Stimulus (or in the opposite scenario, tightening) does not always immediately entail an economic recovery (or on the flip side, a downturn). For one, policy stimuli always work with a time lag. In addition, the size of stimulus is still unknown. What’s more, the multiplier of the stimulus varies from cycle to cycle. Chart I-7Chinese Households Are Indebted Chinese Households Are Indebted Chinese Households Are Indebted We gauge the magnitude of any stimulus in China by observing money, credit and fiscal spending impulses. The multiplier is in turn contingent on economic agents’ (households and enterprises) propensity to spend. The impact of a large amount of stimulus can be offset by a low/falling marginal willingness to spend (a lower multiplier). Before the coronavirus outbreak, the marginal propensity to spend in China had improved slightly for households and had barely stabilized in the case of companies (Chart I-6). It is plausible to assume that a negative shock to confidence will likely dent both households’ and companies’ marginal propensity to consume. This is especially true since both economic agents are highly leveraged, as discussed above (Chart I-7). Finally, the leads and lags between the measures of stimulus like money impulses or credit and fiscal spending impulses and EM stocks in general and Chinese share prices in particular are not constant, as illustrated in Chart I-8 and Chart I-9. Chart I-8China: Share Prices And Money Impulse China: Share Prices And Money Impulse China: Share Prices And Money Impulse Chart I-9EM Stock Prices And China Credit And Fiscal Impulse EM Stock Prices And China Credit And Fiscal Impulse EM Stock Prices And China Credit And Fiscal Impulse   Bottom Line: Forthcoming stimulus is not a surefire guarantee of an immediate cyclical rally – neither for EM risk assets and currencies, nor for other China-related plays. This does not mean that a rally will not occur. Rather, gauging the timing and potential drawdown that precede it are almost impossible. The basis is that low and falling willingness among households to consume and among enterprises to invest and hire could overwhelm the positive boost from the stimulus. Unfortunately, forecasting changes in willingness to spend is not straightforward. Investment Strategy Chart I-10An Inconclusive Message From This Reliable Indicator An Inconclusive Message From This Reliable Indicator An Inconclusive Message From This Reliable Indicator We are currently neutral on EM stocks in absolute terms. We will be watching for market-based indicators to signal a breakout or breakdown and will adjust our strategy accordingly. One of our favorite indicators – the Risk-On /Safe-Haven currency ratio – is presently inconclusive (Chart I-10). Relative to DM, EM share prices broke to new lows last week as illustrated in Chart I-1 on page 1. We continue recommending an underweight position in EM within a global equity portfolio. Consistently, we are reiterating our long-standing short EM / long S&P 500 strategy. The US dollar’s technical profile is bullish (Chart I-11), which entails that its bull market is not yet over. We continue shorting an equally-weighted basket of BRL, CLP, COP, ZAR, KRW, IDR and PHP against the US dollar. We are also short the CNY versus the greenback on a structural basis. Within the EM currency space, we favor the MXN, RUB, CZK, THB and TWD. Finally, EM exchange rates hold the key to the performance of both EM local currency and US dollar bonds. Given our negative view on the currency, we are reluctant to chase the decline in domestic bond yields and narrowing spreads in the sovereign credit space (Chart I-12). Chart I-11The US Dollar Rally Is Intact The US Dollar Rally Is Intact The US Dollar Rally Is Intact Chart I-12EM: Local Bond Yields And Sovereign Spreads Are Too Low EM: Local Bond Yields And Sovereign Spreads Are Too Low EM: Local Bond Yields And Sovereign Spreads Are Too Low   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Turkey: Doubling Down On Unsound Policies Despite the steep drop in oil prices, Turkish stocks have failed to outperform the EM equity benchmark (Chart II-1). When a market fails to outperform amid a historically bullish backdrop, it is often a sign of trouble ahead. The basis for the decoupling between Turkey’s relative performance and oil prices is President Erdogan’s doubling down on populist and unorthodox macro policies. He is eager to boost growth at any cost. As a litmus test of aggressive expansionist policies, local currency broad money growth has already surged to 24% (Chart II-2). In brief, these overly expansionary policies will undermine the currency, lift inflation and lead to a further exodus of investors from the country’s financial markets. Chart II-1A Bearish Sign For Turkish Equities A Bearish Sign For Turkish Equities A Bearish Sign For Turkish Equities Chart II-2Turkey: Rampant Money Creation Turkey: Rampant Money Creation Turkey: Rampant Money Creation   Chart II-3Turkey: Booming Fiscal Spending Turkey: Booming Fiscal Spending Turkey: Booming Fiscal Spending First, the central bank has cut interest rates to below inflation. The outcome is negative policy rates in real terms. Moreover, the central bank has resumed plentiful liquidity provisioning to banks to prevent interbank rates from rising. Second, government expenditures are surging (Chart II-3). Ballooning government borrowing is largely being financed by commercial banks – i.e., the latter are involved in outright monetization of public debt (Chart II-4, top panel). Chart II-4Public Debt Monetization By Commercial Banks Public Debt Monetization By Commercial Banks Public Debt Monetization By Commercial Banks In the past two years, banks have purchased some TRY 250 billion of government bonds. This has boosted their share of holdings of government local currency bonds from 45% to 58% (Chart II-4, bottom panel). This has not only capped local bond yields, but also enormously expanded money supply. When a commercial bank purchases a bond from a non-bank entity, it creates a new deposit (broad money supply), as we discussed in November 29, 2018 report. The authorities have also announced tax cuts on various consumer goods in order to boost consumption. This is leading to a resurgence in consumer goods imports. In short, the trade balance is bound to widen again as domestic consumption resumes. Third, the government is forcing both state-owned and private banks to substantially boost credit flows to the economy. Last week, the AKP proposed a new banking bill that could force banks to fund large-scale projects. Further, the banking regulator is penalizing banks that fail to meet a “credit volume criteria’ by lowering the interest rate banks receive on their required reserves at the central bank. Crucially, the authorities are forcing banks to cut lending rates. Banks’ net interest rate margins have declined to all-time lows (Chart II-5). It will narrow further as they continue to cut lending rates, while holding deposit rates high to avoid flight from local currency deposits into US dollars. Banks, especially public ones, have dramatically accelerated their credit origination. This will lead to capital misallocation and potentially to non-performing loans (NPLs). On banks’ balance sheets, NPLs have been, and will remain, artificially suppressed. Neither banks nor regulators are incentivized to provision for potential loan losses.  Insolvent banks can operate indefinitely so long as their shareholders and regulators allow it, and the central bank provides sufficient liquidity. This will most certainly be the case in Turkey in the years to come. Constraints in such a scenario are surging inflation and currency devaluation. Turkish authorities have whole-heartedly opted for these lax fiscal, monetary and bank regulatory policies. This entails that inflation and currency devaluation are unavoidable. Overly expansionary policies will undermine the currency, lift inflation and lead to a further exodus of foreign investors from the country’s financial markets. Lastly, surging wages and unit labor costs corroborate that inflationary pressures are genuine and rampant (Chart II-6). The minimum wage is set to increase by another 15% this year. Chart II-5Banks' Net Interest Margins At All Time Lows Banks' Net Interest Margins At All Time Lows Banks' Net Interest Margins At All Time Lows Chart II-6Turkey: Wages Are Surging Turkey: Wages Are Surging Turkey: Wages Are Surging   The government has been trying to regulate prices in the consumer sector by putting administrative price caps in place. Yet inflation remains persistently high in both goods and services sectors. Investment Recommendation Chart II-7Excessive Stimulus Is Bearish For The Lira Excessive Stimulus Is Bearish For The Lira Excessive Stimulus Is Bearish For The Lira The Turkish lira is again on a precipice. Only government intervention can temporarily prevent a major down leg. We are reiterating our underweight call on Turkish stocks within an EM equity portfolio. As a new trade, we are recommending a short Turkish banks / long Russian banks position. In contrast to Turkey, Russia’s macro policies have been, and remain, extremely orthodox. The new Russian government is poised to boost fiscal stimulus and the economy will accelerate with low inflation. We will discuss Russia in next week’s report. Finally, a surging fiscal and credit impulse in Turkey often leads to higher inflation and downward pressure on the currency (Chart II-7). As such, local currency government yields offer little protection at these levels against a depreciating currency. Therefore, investors should underweight the Turkish currency, local fixed-income and sovereign credit relative to their respective EM benchmarks. Andrija Vesic Research Analyst andrijav@bcaresearch.com   Footnotes 1     We published A Primer On Liquidity on January 16, 2020 illustrating that the linkages from liquidity provisions by central banks and both increased spending in the real economy and higher asset prices are ambiguous. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Our top five geopolitical “Black Swans” are risks that the market is seriously underpricing. With the “phase one” trade deal signed, Chinese policy could become less accommodative, resulting in a negative economic surprise. The trade deal may fall victim to domestic politics, raising the risk of a US-China military skirmish. A Biden victory at the Democratic National Convention or a Democratic takeover of the White House could trigger social unrest and violence in the US. A pickup in the flow of migrants to Europe would fundamentally undermine political stability there. Russia’s weak economy will add fuel to domestic unrest, risking an escalation beyond the point of containment. Over the past four years, BCA’s Geopolitical Strategy service has started off each year with their top five geopolitical “Black Swans.” These are low-probability events whose market impact would be significant enough to matter for global investors. Unlike the great Byron Wien’s perennial list of market surprises, we do not assign these events a “better than 50% likelihood of happening.” We offer risks that the market is seriously underpricing by assigning them only single-digit probabilities when we think the reality is closer to 10%-15%, a level at which a risk premium ought to be assigned. Some of our risks below are so obscure that it is not clear how exactly to price them. We exclude issues that are fairly probable, such as flare-ups in Indo-Pakistani conflict. The two major risks of the year – discussed in our Geopolitical Strategy’s annual outlook – are that either US President Donald Trump or Chinese President Xi Jinping overreaches in a major way. But what would truly surprise the market would be a policy-induced relapse in Chinese growth or a direct military clash between the two great powers. That is how we begin. Other risks stem from domestic affairs in the US, Europe, and Russia. Black Swan 1: China’s Financial Crisis Begins Chart II-1A Crackdown On Financial Risk Could Cause China's Economy To Derail A Crackdown On Financial Risk Could Cause China's Economy To Derail A Crackdown On Financial Risk Could Cause China's Economy To Derail The risk of Xi Jinping’s concentration of power in his own person is that individuals can easily make mistakes, especially if unchecked by advisors or institutions. Lower officials will fear correcting or admonishing an all-powerful leader. Inconvenient information may not be relayed up the hierarchy. Such behavior was rampant in Chairman Mao Zedong’s time, leading to famine among other ills. Insofar as President Xi’s cult of personality successfully imitates Mao’s, it will be subject to similar errors. If President Xi overreaches and makes a policy mistake this year, it could occur in economic policy or other policies. We begin with economic policy, as we have charted the risks of Xi’s crackdown on the financial system since early 2017 (Chart II-1). This year is supposed to be the third and final year of Xi Jinping’s “three battles” against systemic risk, pollution, and poverty. The first battle actually focuses on financial risk, i.e. China’s money and credit bubble. The regime has compromised on this goal since mid-2018, allowing monetary easing to stabilize the economy amid the trade war. But with a “phase one” trade deal having been signed, there is an underrated risk that economic policy will return to its prior setting, i.e. become less accommodative (Chart II-2). When Xi launched the “deleveraging campaign” in 2017, we posited that the authorities would be willing to tolerate an annual GDP growth rate below 6%. This would not only cull excesses in the economy but also demonstrate that the administration means business when it says that China must prioritize quality rather than quantity of growth. While Chinese authorities are most likely targeting “around 6%” in 2020, it is entirely possible that the authorities will allow an undershoot in the 5.5%-5.9% range. They will argue that the GDP target for 2020 has already been met on a compound growth rate basis (Chart II-3), as astute clients have pointed out. They may see less need for stimulus than the market expects. Chart II-2Easing Of Trade Tensions May Re-Incentivize Tighter Policy Easing Of Trade Tensions May Re-Incentivize Tighter Policy Easing Of Trade Tensions May Re-Incentivize Tighter Policy Chart II-3Chinese Authorities Might Tolerate A Growth Undershoot In 2020 Chinese Authorities Might Tolerate A Growth Undershoot In 2020 Chinese Authorities Might Tolerate A Growth Undershoot In 2020   Similarly, while urban disposable income is ostensibly lagging its target of doubling 2010 levels by 2020, China’s 13th Five Year Plan, which concludes in 2020, conspicuously avoided treating urban and rural income targets separately. If the authorities focus only on general disposable income, then they are on track to meet their target (Chart II-4). This would reduce the impetus for greater economic support. The Xi administration may aim only for stability, not acceleration, in the economy. There are already tentative signs that Chinese authorities are “satisfied” with the amount of stimulus they have injected: some indicators of money and credit have already peaked (Chart II-5). The crackdown on shadow banking has eased, but informal lending is still contracting. The regime is still pushing reforms that shake up state-owned enterprises. Chart II-4Lower Impetus For Economic Support Due To Improvements In National Income? Lower Impetus For Economic Support Due To Improvements In National Income? Lower Impetus For Economic Support Due To Improvements In National Income? Chart II-5Has China's Stimulus Peaked? chart 5 Has China's Stimulus Peaked? Has China's Stimulus Peaked?   An added headwind for the Chinese economy stems from the currency. The currency should track interest rate differentials. Beijing’s incremental monetary stimulus, in the form of cuts to bank reserve requirement ratios (RRRs), should also push the renminbi down over time (Chart II-6). However, an essential aspect of any trade deal with the Trump administration is the need to demonstrate that China is not competitively devaluing. Hence the CNY-USD could overshoot in the first half of the year. This is positive for global exports to China, but it tightens Chinese financial conditions at home. A stronger than otherwise justified renminbi would add to any negative economic surprises from less accommodative monetary and fiscal policy. Conventional wisdom says China will stimulate the economy ahead of two major political events: the centenary of the Communist Party in 2021 and the twentieth National Party Congress in 2022. The former is a highly symbolic anniversary, as Xi has reasserted the supremacy of the party in all things, while the latter is more significant for policy, as it is a leadership reshuffle that will usher in the sixth generation of China’s political elite. But conventional wisdom may be wrong – the Xi administration may aim only for stability, not acceleration, in the economy. It would make sense to save dry powder for the next US or global recession. The obvious implication is that China’s economic rebound may lose steam as early as H2 – but the black swan risk is that negative surprises could cause a vicious spiral inside of China. This is a country with massive financial and economic imbalances, a declining potential growth profile, and persistent political obstacles to growth both at home and abroad. Corporate defaults have spiked sharply. While the default rate is lower than elsewhere, the market may be sniffing out a bigger problem as it charges a much higher premium for onshore Chinese bonds (Chart II-7). Chart II-6CNY/USD Overshoot Would Tighten Chinese Financial Conditions CNY-USD Overshoot Would Tighten Chinese Financial Conditions CNY-USD Overshoot Would Tighten Chinese Financial Conditions Chart II-7Is China's Bond Market Sniffing Out A Problem? Is China's Bond Market Sniffing Out A Problem? Is China's Bond Market Sniffing Out A Problem?   Bottom Line: Our view is that China’s authorities will remain accommodative in 2020 in order to ensure that growth bottoms and the labor market continues to improve. But Beijing has compromised its domestic economic discipline since 2018 in order to fight trade war. The risk now, with a “phase one” deal in hand, is that Xi Jinping returns to his three-year battle plan and underestimates the downward pressures on the economy. The result would be a huge negative surprise for the Chinese and global economy in 2020. Black Swan 2: The US And China Go To War In 2013, we predicted that US-China conflict was “more likely than you think.” This was not just an argument for trade conflict or general enmity that raises the temperature in the Asia-Pacific region – we included military conflict. At the time, the notion that a Sino-American armed conflict was the world’s greatest geopolitical threat seemed ludicrous to many of our clients. We published this analysis in October of that year, months after the Islamic State “Soldier’s Harvest” offensive into Iraq. Trying to direct investors to the budding rivalry between American and Chinese naval forces in the South China Sea amidst the Islamic State hysteria was challenging, to say the least. Chart II-8Americans’ Attitudes Toward China Plunged… February 2020 February 2020 The suggestion that an accidental skirmish between the US and China could descend into a full-blown conflict involved a stretch of the imagination because China was not yet perceived by the American public as a major threat. In 2014, only 19%of the US public saw China as the “greatest threat to the US in the future.” This came between Russia, at 23%, and Iran, at 16%. Today, China and Russia share the top spot with 24%. Furthermore, the share of Americans with an unfavorable view of China has increased from 52% to 60% in the six intervening years (Chart II-8). The level of enmity expressed by the US public toward China is still lower than that toward the Soviet Union at the onset of the Cold War in the 1950s (Chart II-9). However, the trajectory of distrust is clearly mounting. We expect this trend to continue: anti-China sentiment is one of the few sources of bipartisan agreement remaining in Washington, DC (Chart II-10). Chinese sentiment toward the United States has also darkened dramatically. The geopolitical rivalry is deepening for structural reasons: as China advances in size and sophistication, it seeks to alter the regional status quo in its favor, while the US grows fearful and seeks to contain China. Chart II-9…But Not Yet To War-Inducing Levels February 2020 February 2020 Chart II-10Distrust Of China Is Bipartisan February 2020 February 2020 Chart II-11Newfound American Concern For China’s Repression February 2020 February 2020 One example of rising enmity is the US public’s newfound concern for China’s domestic policies and human rights, specifically Beijing’s treatment of its Uyghur minority in Xinjiang. A Google Trends analysis of the term “Uyghur” or “Uyghur camps” shows a dramatic rise in mentions since Q2 of 2018, around the same time the trade war ramped up in a major way (Chart II-11). While startling revelations of re-education camps in Xinjiang emerged in recent years, the reality is that Beijing has used heavy-handed tactics against both militant groups and the wider Uyghur minority since at least 2008 – and much earlier than that. As such, the surge of interest by the general American public and legislators – culminating in the Uyghur Human Rights Policy Act of 2019 – is a product of the renewed strategic tension between the two countries. The same can be said for Hong Kong: the US did not pass a Hong Kong Human Rights and Democracy Act in 2014, during the first round of mass protests, which prompted Beijing to take heavy-handed legal, legislative, and censorship actions. It passed the bill in 2019, after the climate in Washington had changed. Why does this matter for investors? There are two general risks that come with a greater public engagement in foreign policy. First, the “phase one” trade deal between China and the US could fall victim to domestic politics. This deal envisions a large step up in Sino-American economic cooperation. But if China is to import around $200 billion of additional US goods and services over the next two years – an almost inconceivable figure – the US and China will have to tamp down on public vitriol. This is notably the case if the Democratic Party takes over the White House, given its likely greater focus on liberal concerns such as human rights. And yet the latest bills became law under President Trump and a Republican Senate, and we fully expect a second Trump term to involve a re-escalation of trade tensions to ensure compliance with phase one and to try to gain greater structural concessions in phase two. Second, mounting nationalist sentiment will make it more difficult for US and Chinese policymakers to reduce tensions following a potential future military skirmish, accidental or otherwise. While our scenario of a military conflict in 2013 was cogent, the public backlash in the United States was probably manageable.1 Today we can no longer guarantee that this is the case. The “phase one” trade deal risks falling victim to domestic politics due to greater public engagement in foreign policy. China has greater control over the domestic narrative and public discourse, but the rise of the middle class and the government’s efforts to rebuild support for the single-party regime have combined to create an increase in nationalism. Thus it is also more difficult for Chinese policymakers to contain the popular backlash if conflict erupts. In short, the probability of a quick tamping down of public enmity is actively being reduced as American public vilification of China is closing the gap with China’s burgeoning nationalism at an alarming pace. Another of our black swan risks – Taiwan island – is inextricably bound up in this dangerous US-China dynamic. To be clear, Washington will tread carefully, as a conflict over Taiwan could become a major war. Nevertheless Taiwan’s election, as we expected, has injected new vitality into this already underrated geopolitical risk. It is not only that a high-turnout election (Chart II-12) gave President Tsai Ing-wen a greater mandate (Chart II-13), or that her Democratic Progressive Party retained its legislative majority (Chart II-14). It is not only that the trigger for this resounding victory was the revolt in Hong Kong and the Taiwanese people’s rejection of the “one country, two systems” formula for Taiwan. It is also that Tsai followed up with a repudiation of the mainland by declaring, “We don’t have a need to declare ourselves an independent state. We are an independent country already and we call ourselves the Republic of China, Taiwan.” Chart II-12Tsai Ing-Wen Enjoys A Greater Mandate On Higher Turnout… February 2020 February 2020 Chart II-13…Popular Support… February 2020 February 2020 Chart II-14…And A Legislative Majority February 2020 February 2020 This statement is not a minor rhetorical flourish but will be received as a major provocation in Beijing: the crystallization of a long-brewing clash between Beijing and Taipei. Additional punitive economic measures against Taiwan are now guaranteed. Saber-rattling could easily ignite in the coming year and beyond. Taiwan is the epicenter of the US-China strategic conflict. First, Beijing cannot compromise on its security or its political legitimacy and considers the “one China principle” to be inviolable. Second, the US maintains defense relations with Taiwan (and is in the process of delivering on a relatively large new package of arms). Third, the US’s true willingness to fight a war on Taiwan’s behalf is in doubt, which means that deterrence has eroded and there is greater room for miscalculation. Bottom Line: A US-China military skirmish has been our biggest black swan risk since we began writing the BCA Geopolitical Strategy. The difference between then and now, however, is that the American public is actually paying attention. Political ideology – the question of democracy and human rights – is clearly merging with trade, security, and other differences to provoke Americans of all stripes. This makes any skirmish more than just a temporary risk-off event, as it could lead to a string of incidents or even protracted military conflict. Black Swan 3: Social Unrest Erupts In America There are numerous lessons that one can learn from the ongoing unrest in Hong Kong, but perhaps the most cogent one is that Millennials and Generation Z are not as docile and feckless as their elders think. Images of university students and even teenagers throwing flying kicks and Molotov cocktails while clad in black body armor have shocked the world. Perhaps all those violent video games did have a lasting impact on the youth! What is surprising is that so few commentators have made the cognitive leap from the ultra-first world streets of Hong Kong to other developed economies. Perhaps what is clouding analysts’ minds is the idiosyncratic nature of the dispute in Hong Kong, the “one China” angle. However, Hong Kong youth are confronted with similar socio-economic challenges that their peers in other advanced economies face: overpriced real estate and a bifurcated service-sector labor market with few mid-tier jobs that pay a decent wage. There is a risk of rebellion from Trump’s most ardent supporters if he loses the White House. In the US, Millennials and Gen Z are also facing challenges unique to the US. First, their debt burden is much more toxic than that of the older cohorts, given that it is made up of student loans and credit card debt (Chart II-15). Second, they find themselves at odds – demographically and ideologically – with the older cohorts (Chart II-16). Chart II-15Younger American Cohorts Plagued By Toxic Debt February 2020 February 2020 Chart II-16Younger And Older Cohorts At Odds Demographically February 2020 February 2020 Chart II-17Massive Turnout To The 2016 Referendum On Trump February 2020 February 2020 The adage that the youth are apolitical and do not turn out to vote may have ended thanks to President Trump. The 2018 midterm election, which the Democratic Party successfully turned into a referendum on the president, saw the youth (18-29) turnout nearly double from 20% to 36% (the 30-44 year-old cohort also saw a jump in turnout from 35.6% to 48.8%). The election saw one of the highest turnouts in recent memory, with a 53.4% figure, just two points off the 2016 general election figure (Chart II-17). Despite the high turnout in 2018, the-most-definitely-not-Millennial Vice President Joe Biden continues to lead the Democratic Party in the polls. His probability of winning the nomination is not overwhelming, but it is the highest of any contender. In recent polls, Biden comes third place in Millennial/Gen-Z vote preferences (Chart II-18). Yet he is hardly out of contention, especially for the 30-44 year-old cohort. The view that “Uncle Joe” does not fit the Democratic Party zeitgeist has become so entrenched in the Democratic Party narrative that it became conventional wisdom last year, pulling oddsmakers and betting markets away from the clear frontrunner (Chart II-19). Chart II-18Biden Unpopular Among Young American Voters February 2020 February 2020 Chart II-19Bookies Pulled Down 'Uncle Joe’s' Odds, Capturing Democratic Party Zeitgeist February 2020 February 2020     As such, a Biden victory at the Democratic National Convention in Milwaukee, Wisconsin on July 13-16 may come as an affront to the left-wing activists who will surely descend on the convention. This will particularly be the case if Biden wins despite the progressive candidates amassing a majority of overall delegates, which is possible judging by the combined progressive vote share in current polling (Chart II-20). He would arrive in Milwaukee without clearing the 1990 delegate count required to win on the first ballot. On the second ballot, his presidency would then receive a boost from “superdelegates” and those progressives who are unwilling to “rock the boat,” i.e. unify against an establishment candidate with the largest share of votes. This is also how Mayor Michael Bloomberg could pull off a surprise win. Chart II-20Progressives Come Closest To Victory February 2020 February 2020 Such a “brokered” – or contested – convention has not occurred since 1952. However, several Democratic Party conventions came close, including 1968, 1972, and 1984. The 1968 one in Chicago was notable for considerable violence and unrest. Even if the Milwaukee Democratic Party convention does not produce unrest, it could sow the seeds for unrest later in the year. First, a breakout Biden performance in the primaries is unlikely. As such, he will likely need to pledge a shift to the left at the convention, including by accepting a progressive vice-presidential candidate. Second, an actual progressive may win the primary. Chart II-21Zealots In Both Parties Perceive Each Other As A National Threat February 2020 February 2020 It is likely that either of the two options would be seen as an existential threat to many of Trump’s loyal supporters across the United States. President Trump’s rhetoric often paints the scenario of a Democratic takeover of the White House in apocalyptic terms. And data suggests that the zealots in both parties perceive each other as a “threat to the nation’s wellbeing” (Chart II-21). The American Civil War in the nineteenth century began with the election of a president. This is not just because Abraham Lincoln was a particularly reviled figure in the South, but because the states that ultimately formed the Confederacy saw in his election the demographic writing-on-the-wall. The election was an expression of a general will that, from that point onwards, was irreversible. Given demographic trends in the US today, it is possible that many would see in Trump’s loss a similar fait accompli. If one perceives progressive Democrats as an existential threat to the US constitution, rebellion is the obvious and rational response. Bottom Line: Year 2020 may be a particularly violent one for the US. First, left wing activists may be shocked and angered to learn that Joe Biden (or Bloomberg) is the nominee of the Democratic Party come July. With so much hype behind the progressive candidates throughout the campaign, Biden’s nomination could be seen as an affront to what was supposed to be “the big year” for left-wing candidates. Second, investors have to start thinking about what happens if Biden – or a progressive candidate – goes on to defeat President Trump in the general election. While liberal America took Trump’s election badly, it has demographics – and thus time – on its side. Trump’s most ardent supporters may conclude that his defeat means the end of America as they know it. Black Swan 4: Europe’s Migration Crisis Restarts It is a testament to Europe’s resilience that we do not have a Black Swan scenario based on an election or a political crisis set on the continent in 2020. Support for the common currency and the EU as a whole has rebounded to its highest since 2013. Even early elections in Germany and Italy are unlikely to produce geopolitical risk. The populists in the former are in no danger of outperforming whereas the populists in the latter barely deserve the designation. But what if one of the reasons for the surge in populism – unchecked illegal immigration – were to return in 2020? Chart II-22Decline In Illegal Immigration Dampened European Populism February 2020 February 2020 The data suggests that the risk of migrant flows has massively subsided. From its peak of over a million arrivals in 2015, the data shows that only 125,472 migrants crossed into Europe via land and sea routes in the Mediterranean last year (Chart II-22). Why? There are five reasons that we believe have checked the flow of migrants: Supply: The civil wars in Syria, Iraq, and Libya have largely subsided. Heterogenous regions, cities, and neighborhoods have been ethnically cleansed and internal boundaries have largely ossified. It is unlikely that any future conflict will produce massive outflows of refugees as the displacement has already taken place. These countries are now largely divided into armed, ethnically homogenous, camps. Enforcement: The EU has stepped up border enforcement since 2015, pouring resources into the land border with Turkey and naval patrols across the Mediterranean. Individual member states – particularly Italy and Hungary – have also stepped up border enforcement policy. While most EU member states have publicly chided both for “draconian” policies, there is no impetus to force Rome and Budapest to change policy. Libyan Imbroglio: Conflict in Libya has flared up in 2019 with military warlord Khalifa Haftar looking to wrest control from the UN-backed Government of National Accord led by Fayez al-Serraj. The Islamic State has regrouped in the country as well. Ironically, the conflict is helping stem the flow of migrants as African migrants from sub-Saharan countries dare not cross into Libya as they did in 2015 when there was a brief lull in fighting. Turkish benevolence: Ankara is quick to point out that it is the only thing standing between Europe and a massive deluge of migrants. Turkey is said to host somewhere between two and four million refugees from various conflicts in the Middle East. Fear of the crossing: If crossing the Mediterranean was easy, Europe would have experienced a massive influx of migrants throughout the twentieth century. Not only is it not easy, it is costly and quite deadly, with thousands lost each year. Furthermore, most migrants are not welcomed when they arrive to Europe, many are held in terrible conditions in holding camps in Italy and Greece. Over time, migrants who made it into Europe have reported these dangers and conditions, reducing the overall demand for illegal migration. We do not foresee these five factors changing, at least not all at once. However, there are several reasons to worry about the flow of migrants in 2020. US-Iran tensions have sparked outright military action, while unrest is flaring up across Iran’s sphere of influence. Going forward, Iran could destabilize Iraq or fuel Shia unrest against US-backed regimes. Second, Afghanistan has been the source of most migrants to Europe via sea and land Mediterranean routes – 19.2%. The conflict in the country continues and may flare up with President Trump’s decision to formally withdraw most US troops from the country in 2020. Third, a break in fighting in Libya may encourage sub-Saharan migrants to revisit routes to Europe. Migrants from Guinea, Cote d’Ivoire, and the Democratic Republic of Congo make up over 10% of migrants to Europe. Finally, Turkish relationship with the West could break up further in 2020, causing Ankara to ship migrants northward. We highly doubt that President Erdogan will risk such a break, given that 50% of Turkish exports go to Europe. A European embargo on Turkish exports – which would be a highly likely response to such an act – would crush the already decimated Turkish economy. Bottom Line: While we do not see a return to the 2015 level of migration in 2020, we flag this risk because it would fundamentally undermine political stability in Europe. Black Swan 5: Russia Faces A “Peasant Revolt” Our fifth and final black swan risk for the year stems from Russia. This risk may seem obvious, since the US election creates a dynamic that revives the inherent conflict in US-Russian relations. Russia could seek to accomplish foreign policy objectives – interfering in US elections, punishing regional adversaries. The Trump administration may be friendly toward Russia but Trump is unlikely to veto any sanctions passed by the House and Senate in an election year, should an occasion for new sanctions arise. Conversely Russia could anticipate greater US pressure if the Democrats win in November. Yet it is Russia’s domestic affairs that represent the real underrated risk. Putin’s fourth term as president has been characterized by increased focus on domestic political control and stability as opposed to foreign adventurism. The creation of a special National Guard in 2016, reporting directly to Putin and responsible for quelling domestic unrest, symbolizes the shift in focus. So too does Russia’s adherence to the OPEC 2.0 regime of production control to keep oil prices above their budget breakeven level. Meanwhile Putin’s courting of Europe for the Nordstream II pipeline, and his slight peacemaking efforts with Ukraine, has suggested a slightly more restrained international posture. Strategically it makes little sense for Russia to court negative attention at a time when the US and Europe are at odds over trade and the Middle East, the US is preoccupied with China and Iran, and Russia itself faces mounting domestic problems. The domestic problems are long in coming. The central bank has maintained a stringent monetary policy for the better part of the decade. Despite cutting interest rates recently, monetary and credit conditions are still tight, hurting domestic demand. Moscow has also imposed fiscal austerity, namely by cutting back on state pensions and hiking the value added tax. Real wage growth is weak (Chart II-23), retail sales are falling, and domestic demand looks to weaken further, as Andrija Vesic of BCA Emerging Markets Strategy observes in a recent Special Report. The effect of Russia’s policy austerity has been a drop in public approval of the administration (Chart II-24). Protests erupted in 2019 but were largely drowned out by the larger and more globally significant protests in Hong Kong. These were met by police suppression that has not removed their underlying cause. Putin’s first major decision of the new year was to reshuffle the government, entailing Prime Minister Dmitri Medvedev’s transfer to a new post and the appointment of a new cabinet. This move reveals the need to show some accountability to reduce popular pressure. While Moscow now has room to cut interest rates and ease fiscal policy, it is behind the curve and the weak economy will add fuel to domestic unrest. Chart II-23Sluggish Wage Growth Threatens Russian Stability Sluggish Wage Growth Threatens Russian Stability Sluggish Wage Growth Threatens Russian Stability Chart II-24Austerity Weighed On The Administration's Popularity In Russia Austerity Weighed On The Administration's Popularity In Russia Austerity Weighed On The Administration's Popularity In Russia   Meanwhile Putin’s efforts to alter the Russian constitution so he can stay in power beyond current term limits, effectively becoming emperor for life, like Xi Jinping, should not be dismissed merely because they are expected. They reflect a need to take advantage of Putin’s popular standing to consolidate domestic political power at a time when the ruling United Russia party and the federal government face discontent. They also ensure that strategic conflict with the United States will take on an ideological dimension. Russia's recent cabinet shakeup is positive from the point of view of economic reform. And the country's monetary and fiscal room provide a basis for remaining overweight equities within EM, as our Emerging Markets Strategy recommends. However, Russian equities have rallied hard and the political risk is understated. Chart II-25Russian Political Risk Is Unsustainably Low Russian Political Risk Is Unsustainably Low Russian Political Risk Is Unsustainably Low Bottom Line: It is never easy predicting Putin’s next international move. Our market-based indicators of Russian political risk have hit multi-year lows, but both the domestic and international context suggest that these lows will not be sustained (Chart II-25). A new bout of risk can emanate from Putin, or from changes in Washington, or from the Russian people themselves. What would take the world by surprise would be domestic unrest on a larger scale than Russia can easily suppress through the police force. Housekeeping We are closing our long European Union / short Chinese equities strategic trade with a 1.61% loss since inception on May 10, 2019. Dhaval Joshi of BCA’s European Investment Strategy downgraded the Eurostoxx 50 to underweight versus the S&P 500 and the Nikkei 225 this week. He makes the point that the Euro Area bond yield 6-month impulse hit 100 bps – a critical technical level – and will be a strong headwind to growth. We will look to reopen this trade at a later date when the euphoria over the “phase one” trade deal subsides, as we still favor European equities and DM bourses over EM. We will reinstitute our long Brent crude H2 2020 versus H2 2021 tactical position, which was stopped out on January 9, 2020. We remain bullish on oil fundamentals and expect Middle East instability to add a political risk premium. China's stimulus and the oil view also give reason for us to reinitiate our long Malaysian equities relative to EM as a tactical position. The Malaysian ringgit will benefit as oil prices move higher, helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power. Higher oil prices also correlate with higher equity prices, while China's stimulus and the US trade ceasefire will push the US dollar lower and help trade revive in the region. Marko Papic Chief Strategist, Clocktower Group Matt Gertken Geopolitical Strategist Footnotes 1 Observe how little attention the public paid to US-China saber-rattling around China’s announcement of an Air Defense Identification Zone in the East China Sea that year.

Highlights The liquidity-driven rally will soon be followed by an acceleration in global growth. The economic recovery will bump up expectations of long-term profit growth. The dollar has downside, but the euro will not benefit much. Overweight stocks relative to bonds and bet on traditional cyclical sectors and commodities. The potential for outperformance of value relative to growth favors European equities. The probability of a tech mania is escalating: how should investors factor an expanding bubble into their portfolios? Feature Chart I-1A Bull Market In Stocks And Volatility? A Bull Market In Stocks And Volatility? A Bull Market In Stocks And Volatility? Despite all odds, the nCoV-2019 outbreak is barely denting the S&P 500’s frenetic rally. Plentiful liquidity, thawing Sino-US trade relations and improving economic activity in Asia, all have created ideal conditions for risk assets to appreciate on a cyclical basis. Stocks may look increasingly expensive and are primed to correct, but the bubble will expand further. After lifting asset valuations, monetary policy easing will soon boost worldwide economic activity. Consequently, earnings in the US and Europe will improve. As long as central bankers remain unconcerned about inflation, investors will bid up stocks. Investors should remember we are in the final innings of a bull market. Stocks can deliver outsized returns during this period, but often at the cost of elevated volatility, and the options market is not pricing in this uncertainty (Chart I-1). Moreover, timing the ultimate end of the bubble is extremely difficult. Hence, we prefer to look for assets that can still benefit from easy monetary conditions and rebounding growth, but are not as expensive as equities. Industrial commodities fit that description, especially after their recent selloff. The dollar remains a crucial asset to gauge the path of least resistance for assets. If it refuses to swoon, then it will indicate that global growth is in a weaker state than we foresaw. The good news is that the broad trade-weighted dollar seems to have peaked. Accommodative Monetary Conditions Are Here To Stay Easy liquidity has been the lifeblood of the S&P 500’s rally. The surge in the index coincided with the lagged impact of the rise in our US Financial Liquidity Index (Chart I-2). Low rates have allowed stocks to climb higher, yet earnings expectations remain muted. For example, since November 26, 2018, the forward P/E ratio for the S&P 500 has increased from 15.2 to 18.7, while 10-year Treasury yields have collapsed from 3.1% to 1.6%. Meanwhile, expectations for long-term earnings annual growth extracted from equity multiples using a discounted cash flow model have dropped from 2.4% to 1.2%. Historically, easier monetary policy pushes asset prices higher before it lifts economic activity. Historically, easier monetary policy pushes asset prices higher before it lifts economic activity. Yet, stocks and risk assets normally continue to climb when the economy recovers. Even without any additional monetary easing, as long as policy remains accommodative, risk assets will generate positive returns. Expectations for stronger cash flow growth become the force driving asset prices higher. Policy will likely remain accommodative around the world. Within this framework, peak monetary easing is probably behind us, even though liquidity conditions remain extremely accommodative. Nominal interest rates remain very low, and real bond yields are still falling. Unlike in 2018 and 2019, dropping TIPs yields reflect rising inflation expectations (Chart I-3). Those factors together indicate that policy is reflationary, which is confirmed by the gold rally. Chart I-2A Liquidity Driven Rally A Liquidity Driven Rally A Liquidity Driven Rally Chart I-3Today, Lower TIPS Yields Are Reflationary Today, Lower TIPS Yields Are Reflationary Today, Lower TIPS Yields Are Reflationary   Chart I-4Economic Activity To Respond To Liquidity Economic Activity To Respond To Liquidity Economic Activity To Respond To Liquidity Based on the historical lags between monetary easing and manufacturing activity, the global industrial sector is set to mend (Chart I-4). Moreover, the liquidity-driven surge in stock prices, combined with low yields and compressed credit spreads, has eased financial conditions, which creates the catalyst for an industrial recovery. Where will the growth come from? First, worldwide inventory levels have collapsed after making negative contributions to growth since mid-2018 (Chart I-5). Thus, there is room for an inventory restocking. Secondly, auto sales in Europe and China have rebounded to 18.5% from -23% and to -0.1% from -16.4%, respectively. Thirdly, China’s credit and fiscal impulse has improved. The uptick in Chinese iron ore imports indicates that the pass-through from domestic reflation to global economic activity will materialize soon (Chart I-6). Finally, following the Phase One Sino-US trade deal, global business confidence is bottoming, as exemplified by Belgium’s business confidence, Switzerland KOF LEI, Korea's manufacturing business survey, or US CFO and CEO confidence measures. The increase in EM earnings revisions shows that US capex intentions should soon re-accelerate, which bodes well for investment both in the US and globally (Chart I-7). Chart I-5Room For Inventory Restocking Room For Inventory Restocking Room For Inventory Restocking Chart I-6China Points To Stronger Global Growth China Points To Stronger Global Growth China Points To Stronger Global Growth   Construction activity, a gauge of the monetary stance, is looking up across the advanced economies. In the US, housing starts – a leading indicator of domestic demand – have hit a 13-year high. A pullback in this volatile data series is likely, but it should be limited. Vacancies remain at a paltry 1.4%, household formation is solid and affordability is not demanding (Chart I-8). In Europe, construction activity has been relatively stable through the economic slowdown. Even in Canada and Australia, housing transactions have gathered steam quickly following declines in mortgage rates (Chart I-9). Chart I-7Capex Is Set To Recover Capex Is Set To Recover Capex Is Set To Recover Chart I-8US Housing Is Robust US Housing Is Robust US Housing Is Robust Chart I-9Even The Canadian And Australian Housing Markets Are Stabilizing Even The Canadian And Australian Housing Markets Are Stabilizing Even The Canadian And Australian Housing Markets Are Stabilizing Consumers will remain a source of strength for the global economy. The dichotomy between weak manufacturing PMIs and the stable service sector reflects a healthy consumer spending. December retail sales in Europe and the US corroborate this assessment. The stabilization in US business confidence suggests that household incomes are not in as much jeopardy as three months ago. As household net worth and credit growth improve further, a stable outlook for household income will underwrite greater gains in consumption. Policy will likely remain accommodative around the world. For the time being, US inflationary pressures are muted. The New York Fed’s Underlying Inflation Gauge has rolled over, hourly earnings growth has moved back below 3%, our pipeline inflation indicator derived from the ISM is weak, and core producer prices are flagging (Chart I-10). This trend is not US-specific. In the OECD, core consumer price inflation is set to decelerate due to the lagged impact of the manufacturing slowdown. Central banks are also constrained to remain dovish by their own rhetoric. The Fed's statement this week was a testament to this reality. Central banks are increasingly looking to set symmetrical inflation targets. After a decade of missing their targets, a symmetric target would imply keeping policy easier for longer, even if realized inflation moves back above 2%. A rebound in global growth and weak inflation should create a poisonous environment for the US dollar. Finally, fiscal policy will make a small positive contribution to growth in most major advanced economies in 2020, particularly in Germany and the UK (Table I-1). Chart I-10Limited Inflation Will Allow The Fed To Remain Easy Limited Inflation Will Allow The Fed To Remain Easy Limited Inflation Will Allow The Fed To Remain Easy Table I-1Modest Fiscal Easing In 2020 February 2020 February 2020   The Dollar And The Sino-US Phase One Deal At first glance, a rebound in global growth and weak inflation should create a poisonous environment for the US dollar (Chart I-11). As we have often argued, the dollar’s defining characteristic is its pronounced counter-cyclicality. Chart I-11A Painful Backdrop For The Greenback February 2020 February 2020 Deteriorating dollar fundamentals make this risk particularly relevant. US interest rates are well above those in the rest of the G10, but the gap in short rates has significantly narrowed. Historically, the direction of rates differentials and not their levels has determined the trend in the USD (Chart I-12). Moreover, real differentials at the long end of the curve support the notion that the maximum tailwinds for the dollar are behind us (Chart I-12, bottom panel). Furthermore, now that the US Treasury has replenished its accounts at the Federal Reserve, the Fed’s addition of excess reserves in the system will likely become increasingly negative for the dollar, especially against EM currencies. Likewise, relative money supply trends between the US, Europe, Japan and China already predict a decline in the dollar (Chart I-13). Chart I-12Interest Rate Differentials Do Not Favor The Dollar... Interest Rate Differentials Do Not Favor The Dollar... Interest Rate Differentials Do Not Favor The Dollar... Chart I-13...Neither Do Money Supply Trends ...Neither Do Money Supply Trends ...Neither Do Money Supply Trends   Chart I-14The Phase One Deal Is Ambitious February 2020 February 2020 The recent Sino-US trade agreement obscures what appears to be a straightforward picture. According to the Phase One deal signed mid-January, China will increase its US imports by $200 billion in the next two years vis-à-vis the high-water mark of $186 billion reached in 2017. This is an extremely ambitious goal (Chart I-14). Politically, it is positive that China has committed to buy manufactured goods and services in addition to commodities. However, the scale of the increase in imports of US manufactured goods is large, at $77 billion. China cannot fulfill this obligation if domestic growth merely stabilizes or picks up just a little, especially now that the domestic economy is in the midst of a spreading illness. It will have to substitute some of its European and Japanese imports with US goods. A consequence of this trade deal is that the euro’s gains will probably lag those recorded in normal business cycle upswings. Historically, European growth outperforms the US when China’s monetary conditions are easing and its marginal propensity to consume is rising (Chart I-15). However, given the potential for China to substitute European goods in favor of US ones, China’s economic reacceleration probably will not benefit Europe as much as it normally does. China may not ultimately follow through with as big of US purchases as it has promised, but it is likely, at least initially, to show good faith in the agreement. The euro’s gains will probably lag those recorded in normal business cycle upswings. While the trade agreement is a headwind for the euro, it is a positive for the Chinese yuan. The US output gap stands at 0.1% of potential GDP and the US labor market is near full employment. The US industrial sector does not possess the required spare capacity to fulfill additional Chinese demand. To equilibrate the market for US goods, prices will have to adjust to become more favorable for Chinese purchasers. The simplest mechanism to achieve this outcome is for the RMB to appreciate. Meanwhile, the euro is trading 16% below its equilibrium, which will allow European producers to fulfill US domestic demand. A widening US trade deficit with Europe would undo improvements in the trade balance with China. The probability that US equities correct further in the short-term is elevated. The implication for the dollar is that the broad trade-weighted USD will likely outperform the Dollar Index (DXY). The euro represents 18.9% of the broad trade-weighted dollar versus 57.6% of the DXY. Asian currencies, EM currencies at large, the AUD and the NZD, all should benefit from their close correlation with the RMB (Chart I-16). Chart I-15Europe Normally Wins When China Recovers Europe Normally Wins When China Recovers Europe Normally Wins When China Recovers Chart I-16EM, Asian, And Antipodean Exchange Rates Love A Strong RMB EM, Asian, And Antipodean Exchange Rates Love A Strong RMB EM, Asian, And Antipodean Exchange Rates Love A Strong RMB   Obviously, before the RMB and the assets linked to it can appreciate further, the panic surrounding the coronavirus will have to dissipate. However, the economic damage created by SARS was short lived. This respiratory syndrome resulted in a 2.4% contraction Hong-Kong’s GDP in the second quarter of 2003. The economy of Hong Kong recovered that loss quickly afterward. Investment Forecasts BCA continues to forecast upside in safe-haven yields. Global interest rates remain well below equilibrium and a global economic recovery bodes poorly for bond prices (Chart I-17). However, inflation expectations and not real yields will drive nominal yield changes. The dovish slant of global central banks and the growing likelihood that symmetric inflation targets will become the norm is creating long-term upside risks for inflation. Moreover, if symmetric inflation targets imply lower real short rates in the future, then they also imply lower real long rates today. Investors should begin switching their risk assets into industrial commodity plays, especially after their recent selloff. Easy monetary conditions, decreased real rates and an improvement in economic activity are also consistent with an outperformance of assets with higher yields. High-yield bonds, which offer attractive breakeven spreads, will benefit from this backdrop (Chart I-18). Furthermore, carry trades will likely continue to perform well. In addition to low interest rates across most of the G10, the low currency volatility caused by an extended period of easy policy will continue to encourage carry-seeking strategies. Chart I-17Bonds Are Still Expensive Bonds Are Still Expensive Bonds Are Still Expensive Chart I-18Where Is The Value In Credit? Where Is The Value In Credit? Where Is The Value In Credit?   An environment in which growth is accelerating and monetary policy is accommodative argues in favor of stocks. Our profit growth model for the S&P 500 has finally moved back into positive territory. As earnings improve, investors will likely re-rate depressed long-term growth expectations for cash flows (Chart I-19). The flip side is that equity risk premia are elevated, especially outside the US (Chart I-19). Hence, as long as accelerating growth (but not tighter policy) drives up yields, equities should withstand rising borrowing costs. The use of passive investing and the prevalence of “closet indexers” accentuates the risk that a tech mania could blossom. The 400 point surge in the S&P 500 since early October complicates the picture. The probability that US equities correct further in the short-term is elevated, based on their short-term momentum and sentiment measures, such as the put/call ratio (Chart I-20). Foreign equities will continue to correct along US ones, even if they are cheaper. Chart I-19Elevated Stock Multiples Reflect Low Yields, Not Growth Exuberance Elevated Stock Multiples Reflect Low Yields, Not Growth Exuberance Elevated Stock Multiples Reflect Low Yields, Not Growth Exuberance Chart I-20Tactical Risks For Stocks Tactical Risks For Stocks Tactical Risks For Stocks   Chart I-21Buy Commodities/Sell Stocks? Buy Commodities / Sell Stocks? Buy Commodities / Sell Stocks? The coronavirus panic seems to be the catalyst for such a correction. When a market is overextended, any shock can cause a pullback in prices. Moreover, as of writing, medical professionals still have to ascertain the virus’s severity and potential mutations. Therefore, risk assets must embed a significant risk premium for such uncertainty, even if ultimately the infection turns out to be mild. However, that risk premium will likely prove to be short lived. During the SARS crisis in 2003, stocks bottomed when the number of reported new cases peaked. The tech sector has plentiful downside if the correction gathers strength. As indicated in BCA’s US Equity Sector Strategy, Apple, Microsoft, Google, Amazon and Facebook account for 18% of the US market capitalization, which is the highest market concentration since the late 1990s tech bubble. Investors should begin switching their risk assets into industrial commodity plays, especially after their recent selloff. Commodity prices are trading at a large discount to US equities. Moreover, the momentum of natural resource prices relative to stocks has begun to form a positive divergence with the price ratio of these two assets (Chart I-21). Technical divergences such as the one visible in the ratio of commodities to equities are often positive signals. Low real rates, an ample liquidity backdrop, a global economic recovery, a weak broad trade-weighted dollar and a strong RMB, all benefit commodities over equities. Tech stocks underperform commodities when the dollar weakens and growth strengthens. Moreover, our positive stance on the RMB justifies stronger prices for copper, oil and EM equities (Chart I-22). Chart I-22The Winners From A CNY Rebound February 2020 February 2020 Our US Equity Strategy Service has also reiterated its preference for industrials and energy stocks, and it recently upgraded materials stocks to neutral.1 All three sectors trade at significant valuation discounts to the broad market and to tech stocks in particular. They are also oversold in relative terms. Finally, their operating metrics are improving, a trend which will be magnified if global growth re-accelerates. Do not make these bets aggressively. A weakening broad trade-weighted dollar would allow for a rotation into foreign equities and an outperformance of value relative to growth stocks. The share of US equities in the MSCI All-Country World Index is a direct function of the broad trade-weighted dollar (Chart I-23). Moreover, since 1971, the dollar and the relative performance of growth stocks versus value stocks have exhibited a positive correlation (Chart I-24). Thus, the dollar’s recent strength has been a key component behind the run enjoyed by tech stocks. Chart I-23Global Stocks Love A Soft Dollar Global Stocks Love A Soft Dollar Global Stocks Love A Soft Dollar Chart I-24Value Stocks Needs A Weaker Dollar To Outperform Growth Stocks Value Stocks Needs A Weaker Dollar To Outperform Growth Stocks Value Stocks Needs A Weaker Dollar To Outperform Growth Stocks Despite the risks to the euro discussed in the previous section, European equities could still outperform US equities. Such a move would be consistent with value stocks beating growth equities (Chart I-24, bottom panel). This correlation exists because the euro area has a combined 17.7% weighting to tech and healthcare stocks compared with a 37.1% allocation in US benchmarks. Moreover, a cheap euro should allow European industrials and materials to outperform their US counterparts. Finally, the recent uptick in the European credit impulse indicates that an acceleration in European profit growth is imminent, a view that is in line with our preference for European financials (Chart I-25).2 Chart I-25Euro Area Profits Should Improve Euro Area Profits Should Improve Euro Area Profits Should Improve Bottom Line: The current environment remains favorable for risk assets on a 12-month investment horizon. As such, we expect stocks and bond yields to continue to rise in 2020. Moreover, a pick-up in global growth, along with a fall in the broad trade-weighted dollar, should weigh on tech and growth stocks, and boost the attractiveness of commodity plays, industrial, energy and materials stocks, as well as European and EM equities. Forecast Meets Strategy Liquidity-driven rallies, such as the current one, can carry on regardless of the fundamentals. As Keynes noted 90 years ago: “Markets can remain irrational longer than you can stay solvent.” The gap between forecast and strategy can be great. The use of passive investing and the prevalence of “closet indexers” accentuates the risk that a tech mania could blossom. We assign a substantial 30% probability to the risk of another tech mania. Outflows from equity ETFs and mutual funds have been large. Investors will be tempted to move back into those vehicles if stocks continue to rally on the back of plentiful liquidity and improving global growth (Chart I-26). In the process, the new inflows will prop up the over-represented, over-valued, and over-extended tech behemoths. Chart I-26Depressed Equity Flows Should Pick Up Depressed Equity Flows Should Pick Up Depressed Equity Flows Should Pick Up The current tech bubble can easily run a lot further. Based on current valuations, the NASDAQ trades at a P/E ratio of 31 compared with 68 in March 2000 (Chart I-27). Moreover, momentum is becoming increasingly favorable for the NASDAQ and other high-flying tech stocks. The NASDAQ is outperforming high-dividend stocks and after a period of consolidation, its relative performance is breaking out. Momentum often performs very well in liquidity-driven rallies. Chart I-27Where Is The Bubble? Where Is The Bubble? Where Is The Bubble? Chart I-28Debt Loads Are Already High Everywhere Debt Loads Are Already High Everywhere Debt Loads Are Already High Everywhere A full-fledged tech mania would make our overweight equities / underweight bonds a profitable call, but it would invalidate our sector and regional recommendations. Moreover, with a few exceptions in China and Taiwan, the major tech bellwethers are listed in the US. A tech bubble would most likely push our bearish dollar stance to the offside. Bubbles are dangerous: participating on the upside is easy, but cashing out is not. Moreover, financial bubbles tend to exacerbate the economic pain that follows the bust. During manic phases, capital is poorly invested and the economy becomes geared to the sectors that benefit from the financial excesses. These assets lose their value when the bubble deflates. Moreover, bubbles often result in growing private-sector indebtedness. Writing off or paying back this debt saps the economy’s vitality. Making matters worse, today overall indebtedness is unprecedented and central banks have little room to reflate the global economy once the bubble bursts (Chart I-28). Finally, US/Iran tensions will create additional risk in the years ahead. Matt Gertken, BCA’s Geopolitical Strategist, warns that the ratcheting down of tensions following Iran’s retaliation to General Soleimani’s assassination is temporary.3 As a result, the oil market remains a source of left-handed tail-risk. Section II discusses other potential black swans lurking in the geopolitical sphere. We continue to recommend that investors overweight industrials and energy, upgrade materials to neutral, Europe to overweight, and curtail their USD exposure as long as US inflation remains well behaved and the US inflation breakeven rate stays below the 2.3% to 2.5% range. However, do not make these bets aggressively. Moreover, some downside protection is merited. Due to our very negative view on bonds, we prefer garnering these hedges via a 15% allocation to gold and the yen. The yen is especially attractive because it is one of the few cheap, safe-haven plays (Chart I-29). Chart I-29The Yen Offers Cheap Portfolio Protection The Yen Offers Cheap Portfolio Protection The Yen Offers Cheap Portfolio Protection Mathieu Savary Vice President The Bank Credit Analyst January 30, 2020 Next Report: February 27, 2020   II. Five Black Swans In 2020 Our top five geopolitical “Black Swans” are risks that the market is seriously underpricing. With the “phase one” trade deal signed, Chinese policy could become less accommodative, resulting in a negative economic surprise. The trade deal may fall victim to domestic politics, raising the risk of a US-China military skirmish. A Biden victory at the Democratic National Convention or a Democratic takeover of the White House could trigger social unrest and violence in the US. A pickup in the flow of migrants to Europe would fundamentally undermine political stability there. Russia’s weak economy will add fuel to domestic unrest, risking an escalation beyond the point of containment. Over the past four years, BCA’s Geopolitical Strategy service has started off each year with their top five geopolitical “Black Swans.” These are low-probability events whose market impact would be significant enough to matter for global investors. Unlike the great Byron Wien’s perennial list of market surprises, we do not assign these events a “better than 50% likelihood of happening.” We offer risks that the market is seriously underpricing by assigning them only single-digit probabilities when we think the reality is closer to 10%-15%, a level at which a risk premium ought to be assigned. Some of our risks below are so obscure that it is not clear how exactly to price them. We exclude issues that are fairly probable, such as flare-ups in Indo-Pakistani conflict. The two major risks of the year – discussed in our Geopolitical Strategy’s annual outlook – are that either US President Donald Trump or Chinese President Xi Jinping overreaches in a major way. But what would truly surprise the market would be a policy-induced relapse in Chinese growth or a direct military clash between the two great powers. That is how we begin. Other risks stem from domestic affairs in the US, Europe, and Russia. Black Swan 1: China’s Financial Crisis Begins Chart II-1A Crackdown On Financial Risk Could Cause China's Economy To Derail A Crackdown On Financial Risk Could Cause China's Economy To Derail A Crackdown On Financial Risk Could Cause China's Economy To Derail The risk of Xi Jinping’s concentration of power in his own person is that individuals can easily make mistakes, especially if unchecked by advisors or institutions. Lower officials will fear correcting or admonishing an all-powerful leader. Inconvenient information may not be relayed up the hierarchy. Such behavior was rampant in Chairman Mao Zedong’s time, leading to famine among other ills. Insofar as President Xi’s cult of personality successfully imitates Mao’s, it will be subject to similar errors. If President Xi overreaches and makes a policy mistake this year, it could occur in economic policy or other policies. We begin with economic policy, as we have charted the risks of Xi’s crackdown on the financial system since early 2017 (Chart II-1). This year is supposed to be the third and final year of Xi Jinping’s “three battles” against systemic risk, pollution, and poverty. The first battle actually focuses on financial risk, i.e. China’s money and credit bubble. The regime has compromised on this goal since mid-2018, allowing monetary easing to stabilize the economy amid the trade war. But with a “phase one” trade deal having been signed, there is an underrated risk that economic policy will return to its prior setting, i.e. become less accommodative (Chart II-2). When Xi launched the “deleveraging campaign” in 2017, we posited that the authorities would be willing to tolerate an annual GDP growth rate below 6%. This would not only cull excesses in the economy but also demonstrate that the administration means business when it says that China must prioritize quality rather than quantity of growth. While Chinese authorities are most likely targeting “around 6%” in 2020, it is entirely possible that the authorities will allow an undershoot in the 5.5%-5.9% range. They will argue that the GDP target for 2020 has already been met on a compound growth rate basis (Chart II-3), as astute clients have pointed out. They may see less need for stimulus than the market expects. Chart II-2Easing Of Trade Tensions May Re-Incentivize Tighter Policy Easing Of Trade Tensions May Re-Incentivize Tighter Policy Easing Of Trade Tensions May Re-Incentivize Tighter Policy Chart II-3Chinese Authorities Might Tolerate A Growth Undershoot In 2020 Chinese Authorities Might Tolerate A Growth Undershoot In 2020 Chinese Authorities Might Tolerate A Growth Undershoot In 2020   Similarly, while urban disposable income is ostensibly lagging its target of doubling 2010 levels by 2020, China’s 13th Five Year Plan, which concludes in 2020, conspicuously avoided treating urban and rural income targets separately. If the authorities focus only on general disposable income, then they are on track to meet their target (Chart II-4). This would reduce the impetus for greater economic support. The Xi administration may aim only for stability, not acceleration, in the economy. There are already tentative signs that Chinese authorities are “satisfied” with the amount of stimulus they have injected: some indicators of money and credit have already peaked (Chart II-5). The crackdown on shadow banking has eased, but informal lending is still contracting. The regime is still pushing reforms that shake up state-owned enterprises. Chart II-4Lower Impetus For Economic Support Due To Improvements In National Income? Lower Impetus For Economic Support Due To Improvements In National Income? Lower Impetus For Economic Support Due To Improvements In National Income? Chart II-5Has China's Stimulus Peaked? chart 5 Has China's Stimulus Peaked? Has China's Stimulus Peaked?   An added headwind for the Chinese economy stems from the currency. The currency should track interest rate differentials. Beijing’s incremental monetary stimulus, in the form of cuts to bank reserve requirement ratios (RRRs), should also push the renminbi down over time (Chart II-6). However, an essential aspect of any trade deal with the Trump administration is the need to demonstrate that China is not competitively devaluing. Hence the CNY-USD could overshoot in the first half of the year. This is positive for global exports to China, but it tightens Chinese financial conditions at home. A stronger than otherwise justified renminbi would add to any negative economic surprises from less accommodative monetary and fiscal policy. Conventional wisdom says China will stimulate the economy ahead of two major political events: the centenary of the Communist Party in 2021 and the twentieth National Party Congress in 2022. The former is a highly symbolic anniversary, as Xi has reasserted the supremacy of the party in all things, while the latter is more significant for policy, as it is a leadership reshuffle that will usher in the sixth generation of China’s political elite. But conventional wisdom may be wrong – the Xi administration may aim only for stability, not acceleration, in the economy. It would make sense to save dry powder for the next US or global recession. The obvious implication is that China’s economic rebound may lose steam as early as H2 – but the black swan risk is that negative surprises could cause a vicious spiral inside of China. This is a country with massive financial and economic imbalances, a declining potential growth profile, and persistent political obstacles to growth both at home and abroad. Corporate defaults have spiked sharply. While the default rate is lower than elsewhere, the market may be sniffing out a bigger problem as it charges a much higher premium for onshore Chinese bonds (Chart II-7). Chart II-6CNY/USD Overshoot Would Tighten Chinese Financial Conditions CNY-USD Overshoot Would Tighten Chinese Financial Conditions CNY-USD Overshoot Would Tighten Chinese Financial Conditions Chart II-7Is China's Bond Market Sniffing Out A Problem? Is China's Bond Market Sniffing Out A Problem? Is China's Bond Market Sniffing Out A Problem?   Bottom Line: Our view is that China’s authorities will remain accommodative in 2020 in order to ensure that growth bottoms and the labor market continues to improve. But Beijing has compromised its domestic economic discipline since 2018 in order to fight trade war. The risk now, with a “phase one” deal in hand, is that Xi Jinping returns to his three-year battle plan and underestimates the downward pressures on the economy. The result would be a huge negative surprise for the Chinese and global economy in 2020. Black Swan 2: The US And China Go To War In 2013, we predicted that US-China conflict was “more likely than you think.” This was not just an argument for trade conflict or general enmity that raises the temperature in the Asia-Pacific region – we included military conflict. At the time, the notion that a Sino-American armed conflict was the world’s greatest geopolitical threat seemed ludicrous to many of our clients. We published this analysis in October of that year, months after the Islamic State “Soldier’s Harvest” offensive into Iraq. Trying to direct investors to the budding rivalry between American and Chinese naval forces in the South China Sea amidst the Islamic State hysteria was challenging, to say the least. Chart II-8Americans’ Attitudes Toward China Plunged… February 2020 February 2020 The suggestion that an accidental skirmish between the US and China could descend into a full-blown conflict involved a stretch of the imagination because China was not yet perceived by the American public as a major threat. In 2014, only 19%of the US public saw China as the “greatest threat to the US in the future.” This came between Russia, at 23%, and Iran, at 16%. Today, China and Russia share the top spot with 24%. Furthermore, the share of Americans with an unfavorable view of China has increased from 52% to 60% in the six intervening years (Chart II-8). The level of enmity expressed by the US public toward China is still lower than that toward the Soviet Union at the onset of the Cold War in the 1950s (Chart II-9). However, the trajectory of distrust is clearly mounting. We expect this trend to continue: anti-China sentiment is one of the few sources of bipartisan agreement remaining in Washington, DC (Chart II-10). Chinese sentiment toward the United States has also darkened dramatically. The geopolitical rivalry is deepening for structural reasons: as China advances in size and sophistication, it seeks to alter the regional status quo in its favor, while the US grows fearful and seeks to contain China. Chart II-9…But Not Yet To War-Inducing Levels February 2020 February 2020 Chart II-10Distrust Of China Is Bipartisan February 2020 February 2020   Chart II-11Newfound American Concern For China’s Repression February 2020 February 2020 One example of rising enmity is the US public’s newfound concern for China’s domestic policies and human rights, specifically Beijing’s treatment of its Uyghur minority in Xinjiang. A Google Trends analysis of the term “Uyghur” or “Uyghur camps” shows a dramatic rise in mentions since Q2 of 2018, around the same time the trade war ramped up in a major way (Chart II-11). While startling revelations of re-education camps in Xinjiang emerged in recent years, the reality is that Beijing has used heavy-handed tactics against both militant groups and the wider Uyghur minority since at least 2008 – and much earlier than that. As such, the surge of interest by the general American public and legislators – culminating in the Uyghur Human Rights Policy Act of 2019 – is a product of the renewed strategic tension between the two countries. The same can be said for Hong Kong: the US did not pass a Hong Kong Human Rights and Democracy Act in 2014, during the first round of mass protests, which prompted Beijing to take heavy-handed legal, legislative, and censorship actions. It passed the bill in 2019, after the climate in Washington had changed. Why does this matter for investors? There are two general risks that come with a greater public engagement in foreign policy. First, the “phase one” trade deal between China and the US could fall victim to domestic politics. This deal envisions a large step up in Sino-American economic cooperation. But if China is to import around $200 billion of additional US goods and services over the next two years – an almost inconceivable figure – the US and China will have to tamp down on public vitriol. This is notably the case if the Democratic Party takes over the White House, given its likely greater focus on liberal concerns such as human rights. And yet the latest bills became law under President Trump and a Republican Senate, and we fully expect a second Trump term to involve a re-escalation of trade tensions to ensure compliance with phase one and to try to gain greater structural concessions in phase two. Second, mounting nationalist sentiment will make it more difficult for US and Chinese policymakers to reduce tensions following a potential future military skirmish, accidental or otherwise. While our scenario of a military conflict in 2013 was cogent, the public backlash in the United States was probably manageable.3 Today we can no longer guarantee that this is the case. The “phase one” trade deal risks falling victim to domestic politics due to greater public engagement in foreign policy. China has greater control over the domestic narrative and public discourse, but the rise of the middle class and the government’s efforts to rebuild support for the single-party regime have combined to create an increase in nationalism. Thus it is also more difficult for Chinese policymakers to contain the popular backlash if conflict erupts. In short, the probability of a quick tamping down of public enmity is actively being reduced as American public vilification of China is closing the gap with China’s burgeoning nationalism at an alarming pace. Another of our black swan risks – Taiwan island – is inextricably bound up in this dangerous US-China dynamic. To be clear, Washington will tread carefully, as a conflict over Taiwan could become a major war. Nevertheless Taiwan’s election, as we expected, has injected new vitality into this already underrated geopolitical risk. It is not only that a high-turnout election (Chart II-12) gave President Tsai Ing-wen a greater mandate (Chart II-13), or that her Democratic Progressive Party retained its legislative majority (Chart II-14). It is not only that the trigger for this resounding victory was the revolt in Hong Kong and the Taiwanese people’s rejection of the “one country, two systems” formula for Taiwan. It is also that Tsai followed up with a repudiation of the mainland by declaring, “We don’t have a need to declare ourselves an independent state. We are an independent country already and we call ourselves the Republic of China, Taiwan.” Chart II-12Tsai Ing-Wen Enjoys A Greater Mandate On Higher Turnout… February 2020 February 2020 Chart II-13…Popular Support… February 2020 February 2020 Chart II-14…And A Legislative Majority February 2020 February 2020 This statement is not a minor rhetorical flourish but will be received as a major provocation in Beijing: the crystallization of a long-brewing clash between Beijing and Taipei. Additional punitive economic measures against Taiwan are now guaranteed. Saber-rattling could easily ignite in the coming year and beyond. Taiwan is the epicenter of the US-China strategic conflict. First, Beijing cannot compromise on its security or its political legitimacy and considers the “one China principle” to be inviolable. Second, the US maintains defense relations with Taiwan (and is in the process of delivering on a relatively large new package of arms). Third, the US’s true willingness to fight a war on Taiwan’s behalf is in doubt, which means that deterrence has eroded and there is greater room for miscalculation. Bottom Line: A US-China military skirmish has been our biggest black swan risk since we began writing the BCA Geopolitical Strategy. The difference between then and now, however, is that the American public is actually paying attention. Political ideology – the question of democracy and human rights – is clearly merging with trade, security, and other differences to provoke Americans of all stripes. This makes any skirmish more than just a temporary risk-off event, as it could lead to a string of incidents or even protracted military conflict. Black Swan 3: Social Unrest Erupts In America There are numerous lessons that one can learn from the ongoing unrest in Hong Kong, but perhaps the most cogent one is that Millennials and Generation Z are not as docile and feckless as their elders think. Images of university students and even teenagers throwing flying kicks and Molotov cocktails while clad in black body armor have shocked the world. Perhaps all those violent video games did have a lasting impact on the youth! What is surprising is that so few commentators have made the cognitive leap from the ultra-first world streets of Hong Kong to other developed economies. Perhaps what is clouding analysts’ minds is the idiosyncratic nature of the dispute in Hong Kong, the “one China” angle. However, Hong Kong youth are confronted with similar socio-economic challenges that their peers in other advanced economies face: overpriced real estate and a bifurcated service-sector labor market with few mid-tier jobs that pay a decent wage. There is a risk of rebellion from Trump’s most ardent supporters if he loses the White House. In the US, Millennials and Gen Z are also facing challenges unique to the US. First, their debt burden is much more toxic than that of the older cohorts, given that it is made up of student loans and credit card debt (Chart II-15). Second, they find themselves at odds – demographically and ideologically – with the older cohorts (Chart II-16). Chart II-15Younger American Cohorts Plagued By Toxic Debt February 2020 February 2020 Chart II-16Younger And Older Cohorts At Odds Demographically February 2020 February 2020   Chart II-17Massive Turnout To The 2016 Referendum On Trump February 2020 February 2020 The adage that the youth are apolitical and do not turn out to vote may have ended thanks to President Trump. The 2018 midterm election, which the Democratic Party successfully turned into a referendum on the president, saw the youth (18-29) turnout nearly double from 20% to 36% (the 30-44 year-old cohort also saw a jump in turnout from 35.6% to 48.8%). The election saw one of the highest turnouts in recent memory, with a 53.4% figure, just two points off the 2016 general election figure (Chart II-17). Despite the high turnout in 2018, the-most-definitely-not-Millennial Vice President Joe Biden continues to lead the Democratic Party in the polls. His probability of winning the nomination is not overwhelming, but it is the highest of any contender. In recent polls, Biden comes third place in Millennial/Gen-Z vote preferences (Chart II-18). Yet he is hardly out of contention, especially for the 30-44 year-old cohort. The view that “Uncle Joe” does not fit the Democratic Party zeitgeist has become so entrenched in the Democratic Party narrative that it became conventional wisdom last year, pulling oddsmakers and betting markets away from the clear frontrunner (Chart II-19). Chart II-18Biden Unpopular Among Young American Voters February 2020 February 2020 Chart II-19Bookies Pulled Down 'Uncle Joe’s' Odds, Capturing Democratic Party Zeitgeist February 2020 February 2020     As such, a Biden victory at the Democratic National Convention in Milwaukee, Wisconsin on July 13-16 may come as an affront to the left-wing activists who will surely descend on the convention. This will particularly be the case if Biden wins despite the progressive candidates amassing a majority of overall delegates, which is possible judging by the combined progressive vote share in current polling (Chart II-20). He would arrive in Milwaukee without clearing the 1990 delegate count required to win on the first ballot. On the second ballot, his presidency would then receive a boost from “superdelegates” and those progressives who are unwilling to “rock the boat,” i.e. unify against an establishment candidate with the largest share of votes. This is also how Mayor Michael Bloomberg could pull off a surprise win. Chart II-20Progressives Come Closest To Victory February 2020 February 2020 Such a “brokered” – or contested – convention has not occurred since 1952. However, several Democratic Party conventions came close, including 1968, 1972, and 1984. The 1968 one in Chicago was notable for considerable violence and unrest. Even if the Milwaukee Democratic Party convention does not produce unrest, it could sow the seeds for unrest later in the year. First, a breakout Biden performance in the primaries is unlikely. As such, he will likely need to pledge a shift to the left at the convention, including by accepting a progressive vice-presidential candidate. Second, an actual progressive may win the primary. Chart II-21Zealots In Both Parties Perceive Each Other As A National Threat February 2020 February 2020 It is likely that either of the two options would be seen as an existential threat to many of Trump’s loyal supporters across the United States. President Trump’s rhetoric often paints the scenario of a Democratic takeover of the White House in apocalyptic terms. And data suggests that the zealots in both parties perceive each other as a “threat to the nation’s wellbeing” (Chart II-21). The American Civil War in the nineteenth century began with the election of a president. This is not just because Abraham Lincoln was a particularly reviled figure in the South, but because the states that ultimately formed the Confederacy saw in his election the demographic writing-on-the-wall. The election was an expression of a general will that, from that point onwards, was irreversible. Given demographic trends in the US today, it is possible that many would see in Trump’s loss a similar fait accompli. If one perceives progressive Democrats as an existential threat to the US constitution, rebellion is the obvious and rational response. Bottom Line: Year 2020 may be a particularly violent one for the US. First, left wing activists may be shocked and angered to learn that Joe Biden (or Bloomberg) is the nominee of the Democratic Party come July. With so much hype behind the progressive candidates throughout the campaign, Biden’s nomination could be seen as an affront to what was supposed to be “the big year” for left-wing candidates. Second, investors have to start thinking about what happens if Biden – or a progressive candidate – goes on to defeat President Trump in the general election. While liberal America took Trump’s election badly, it has demographics – and thus time – on its side. Trump’s most ardent supporters may conclude that his defeat means the end of America as they know it. Black Swan 4: Europe’s Migration Crisis Restarts It is a testament to Europe’s resilience that we do not have a Black Swan scenario based on an election or a political crisis set on the continent in 2020. Support for the common currency and the EU as a whole has rebounded to its highest since 2013. Even early elections in Germany and Italy are unlikely to produce geopolitical risk. The populists in the former are in no danger of outperforming whereas the populists in the latter barely deserve the designation. But what if one of the reasons for the surge in populism – unchecked illegal immigration – were to return in 2020? Chart II-22Decline In Illegal Immigration Dampened European Populism February 2020 February 2020 The data suggests that the risk of migrant flows has massively subsided. From its peak of over a million arrivals in 2015, the data shows that only 125,472 migrants crossed into Europe via land and sea routes in the Mediterranean last year (Chart II-22). Why? There are five reasons that we believe have checked the flow of migrants: Supply: The civil wars in Syria, Iraq, and Libya have largely subsided. Heterogenous regions, cities, and neighborhoods have been ethnically cleansed and internal boundaries have largely ossified. It is unlikely that any future conflict will produce massive outflows of refugees as the displacement has already taken place. These countries are now largely divided into armed, ethnically homogenous, camps. Enforcement: The EU has stepped up border enforcement since 2015, pouring resources into the land border with Turkey and naval patrols across the Mediterranean. Individual member states – particularly Italy and Hungary – have also stepped up border enforcement policy. While most EU member states have publicly chided both for “draconian” policies, there is no impetus to force Rome and Budapest to change policy. Libyan Imbroglio: Conflict in Libya has flared up in 2019 with military warlord Khalifa Haftar looking to wrest control from the UN-backed Government of National Accord led by Fayez al-Serraj. The Islamic State has regrouped in the country as well. Ironically, the conflict is helping stem the flow of migrants as African migrants from sub-Saharan countries dare not cross into Libya as they did in 2015 when there was a brief lull in fighting. Turkish benevolence: Ankara is quick to point out that it is the only thing standing between Europe and a massive deluge of migrants. Turkey is said to host somewhere between two and four million refugees from various conflicts in the Middle East. Fear of the crossing: If crossing the Mediterranean was easy, Europe would have experienced a massive influx of migrants throughout the twentieth century. Not only is it not easy, it is costly and quite deadly, with thousands lost each year. Furthermore, most migrants are not welcomed when they arrive to Europe, many are held in terrible conditions in holding camps in Italy and Greece. Over time, migrants who made it into Europe have reported these dangers and conditions, reducing the overall demand for illegal migration. We do not foresee these five factors changing, at least not all at once. However, there are several reasons to worry about the flow of migrants in 2020. US-Iran tensions have sparked outright military action, while unrest is flaring up across Iran’s sphere of influence. Going forward, Iran could destabilize Iraq or fuel Shia unrest against US-backed regimes. Second, Afghanistan has been the source of most migrants to Europe via sea and land Mediterranean routes – 19.2%. The conflict in the country continues and may flare up with President Trump’s decision to formally withdraw most US troops from the country in 2020. Third, a break in fighting in Libya may encourage sub-Saharan migrants to revisit routes to Europe. Migrants from Guinea, Cote d’Ivoire, and the Democratic Republic of Congo make up over 10% of migrants to Europe. Finally, Turkish relationship with the West could break up further in 2020, causing Ankara to ship migrants northward. We highly doubt that President Erdogan will risk such a break, given that 50% of Turkish exports go to Europe. A European embargo on Turkish exports – which would be a highly likely response to such an act – would crush the already decimated Turkish economy. Bottom Line: While we do not see a return to the 2015 level of migration in 2020, we flag this risk because it would fundamentally undermine political stability in Europe. Black Swan 5: Russia Faces A “Peasant Revolt” Our fifth and final black swan risk for the year stems from Russia. This risk may seem obvious, since the US election creates a dynamic that revives the inherent conflict in US-Russian relations. Russia could seek to accomplish foreign policy objectives – interfering in US elections, punishing regional adversaries. The Trump administration may be friendly toward Russia but Trump is unlikely to veto any sanctions passed by the House and Senate in an election year, should an occasion for new sanctions arise. Conversely Russia could anticipate greater US pressure if the Democrats win in November. Yet it is Russia’s domestic affairs that represent the real underrated risk. Putin’s fourth term as president has been characterized by increased focus on domestic political control and stability as opposed to foreign adventurism. The creation of a special National Guard in 2016, reporting directly to Putin and responsible for quelling domestic unrest, symbolizes the shift in focus. So too does Russia’s adherence to the OPEC 2.0 regime of production control to keep oil prices above their budget breakeven level. Meanwhile Putin’s courting of Europe for the Nordstream II pipeline, and his slight peacemaking efforts with Ukraine, has suggested a slightly more restrained international posture. Strategically it makes little sense for Russia to court negative attention at a time when the US and Europe are at odds over trade and the Middle East, the US is preoccupied with China and Iran, and Russia itself faces mounting domestic problems. The domestic problems are long in coming. The central bank has maintained a stringent monetary policy for the better part of the decade. Despite cutting interest rates recently, monetary and credit conditions are still tight, hurting domestic demand. Moscow has also imposed fiscal austerity, namely by cutting back on state pensions and hiking the value added tax. Real wage growth is weak (Chart II-23), retail sales are falling, and domestic demand looks to weaken further, as Andrija Vesic of BCA Emerging Markets Strategy observes in a recent Special Report. The effect of Russia’s policy austerity has been a drop in public approval of the administration (Chart II-24). Protests erupted in 2019 but were largely drowned out by the larger and more globally significant protests in Hong Kong. These were met by police suppression that has not removed their underlying cause. Putin’s first major decision of the new year was to reshuffle the government, entailing Prime Minister Dmitri Medvedev’s transfer to a new post and the appointment of a new cabinet. This move reveals the need to show some accountability to reduce popular pressure. While Moscow now has room to cut interest rates and ease fiscal policy, it is behind the curve and the weak economy will add fuel to domestic unrest. Chart II-23Sluggish Wage Growth Threatens Russian Stability Sluggish Wage Growth Threatens Russian Stability Sluggish Wage Growth Threatens Russian Stability Chart II-24Austerity Weighed On The Administration's Popularity In Russia Austerity Weighed On The Administration's Popularity In Russia Austerity Weighed On The Administration's Popularity In Russia   Meanwhile Putin’s efforts to alter the Russian constitution so he can stay in power beyond current term limits, effectively becoming emperor for life, like Xi Jinping, should not be dismissed merely because they are expected. They reflect a need to take advantage of Putin’s popular standing to consolidate domestic political power at a time when the ruling United Russia party and the federal government face discontent. They also ensure that strategic conflict with the United States will take on an ideological dimension. Russia's recent cabinet shakeup is positive from the point of view of economic reform. And the country's monetary and fiscal room provide a basis for remaining overweight equities within EM, as our Emerging Markets Strategy recommends. However, Russian equities have rallied hard and the political risk is understated. Chart II-25Russian Political Risk Is Unsustainably Low Russian Political Risk Is Unsustainably Low Russian Political Risk Is Unsustainably Low Bottom Line: It is never easy predicting Putin’s next international move. Our market-based indicators of Russian political risk have hit multi-year lows, but both the domestic and international context suggest that these lows will not be sustained (Chart II-25). A new bout of risk can emanate from Putin, or from changes in Washington, or from the Russian people themselves. What would take the world by surprise would be domestic unrest on a larger scale than Russia can easily suppress through the police force. Housekeeping We are closing our long European Union / short Chinese equities strategic trade with a 1.61% loss since inception on May 10, 2019. Dhaval Joshi of BCA’s European Investment Strategy downgraded the Eurostoxx 50 to underweight versus the S&P 500 and the Nikkei 225 this week. He makes the point that the Euro Area bond yield 6-month impulse hit 100 bps – a critical technical level – and will be a strong headwind to growth. We will look to reopen this trade at a later date when the euphoria over the “phase one” trade deal subsides, as we still favor European equities and DM bourses over EM. We will reinstitute our long Brent crude H2 2020 versus H2 2021 tactical position, which was stopped out on January 9, 2020. We remain bullish on oil fundamentals and expect Middle East instability to add a political risk premium. China's stimulus and the oil view also give reason for us to reinitiate our long Malaysian equities relative to EM as a tactical position. The Malaysian ringgit will benefit as oil prices move higher, helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power. Higher oil prices also correlate with higher equity prices, while China's stimulus and the US trade ceasefire will push the US dollar lower and help trade revive in the region. Marko Papic Chief Strategist, Clocktower Group Matt Gertken Geopolitical Strategist   III. Indicators And Reference Charts The S&P 500 rally looks increasingly vulnerable from a tactical perspective. The US benchmark is overbought, and the percentage of NYSE stocks above their 30-week and 10-week moving averages is rolling over at elevated levels. Additionally, the number of NYSE new highs minus new lows has moved in a parabolic fashion and has hit levels that in previous years have warned of an imminent correction. The spread of nCoV-2019 is likely to be the catalyst to a pullback that could cause the S&P 500 to retest its October 2019 breakout. An improving outlook for global growth, limited inflationary pressures and global central banks who maintain an accommodative monetary stance bode well for stocks. Therefore, the anticipated equity correction will not morph into a bear market. For now, our Monetary Indicator remains at extremely elevated levels. Furthermore, our Composite Technical Indicator has strengthened. Additionally, our BCA Composite Valuation index suggests that stocks are expensive, but not so much as to cancel out the supportive monetary and technical backdrop. Finally, our Speculation Indicator is elevated, but is not so high as to warn of an imminent market top. This somewhat muted level of speculation is congruent with the expectation of low long-term growth rates for profits embedded in equity prices. In contrast to our Revealed Preference Indicator, our Willingness-to-Pay (WTP) is moving in accordance with our constructive cyclical stance for stocks. Indeed, the WTP for the US, Japan and Europe continues to improve. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. This broad-based improvement therefore bodes well for equities. Meanwhile, net earnings revisions appear to be forming a trough. 10-year Treasury yields remain extremely expensive. Moreover, according to our Composite Technical Indicator, T-Note prices are losing momentum. The fear surrounding the spread of the new coronavirus has cause bonds to rally again, but this is likely to be the last hurrah for the Treasury markets before a major reversal takes hold. The rising risk premia linked to the coronavirus is also helping the dollar right now, but signs that global growth is bottoming, such as the stabilization in the global PMIs, the pick-up in the German ZEW and Belgium’s Business Confidence surveys, or the improvement in Asia’s export growth, point to a worsening outlook for the counter-cyclical US dollar. Moreover, the dollar trades at a large premium of 24.5% relative to its purchasing-power parity equilibrium. Additionally, the negative divergence between the dollar and our Composite Momentum Indicator suggests that the dollar is technically vulnerable. In fact, the very modest pick-up in the dollar in response to the severe fears created by the spreading illness in China argues that dollar buying might have become exhausted. Finally, commodity prices have corrected meaningfully in response to the stronger dollar and the growth fears created by the spread of the coronavirus. However, they have not pulled back below the levels where they traded when they broke out in late 2019. Moreover, the advance/decline line of the Continuous Commodity Index remains at an elevated level, indicating underlying strength in the commodity complex. Natural resources prices will likely become the key beneficiaries of both the eventual pullback in virus-related fears and the weaker dollar.   EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see US Equity Strategy Weekly Report "Three EPS Scenarios," dated January 13, 2020, available at uses.bcaresearch.com; US Equity Strategy Insight Report "Bombed Out Energy," dated January 8, 2020, available at uses.bcaresearch.com; US Equity Strategy Special Report "Industrials: Start Your Engines," dated January 21, 2020, available at uses.bcaresearch.com 2  Please see The Bank Credit Analyst Monthly Report "January 2020," dated December 20, 2019 available at bca.bcaresearch.com; The Bank Credit Analyst Monthly Report "OUTLOOK 2020: Heading Into The End Game," dated November 22, 2019 available at bca.bcaresearch.com 3 Please see Geopolitical Strategy "A Reprieve Amid The Bull Market In Iran Tensions," dated January 8, 2020, available at gps.bcaresearch.com 4 Observe how little attention the public paid to US-China saber-rattling around China’s announcement of an Air Defense Identification Zone in the East China Sea that year.

Highlights Our top five geopolitical “Black Swans” are risks that the market is seriously underpricing. With the “phase one” trade deal signed, Chinese policy could become less accommodative, resulting in a negative economic surprise. The trade deal may fall victim to domestic politics, raising the risk of a US-China military skirmish. A Biden victory at the Democratic National Convention or a Democratic takeover of the White House could trigger social unrest and violence in the US. A pickup in the flow of migrants to Europe would fundamentally undermine political stability there. Russia’s weak economy will add fuel to domestic unrest, risking an escalation beyond the point of containment. Feature Over the past four years, we have started off the year with our top five geopolitical “Black Swans.” These are low-probability events whose market impact would be significant enough to matter for global investors. Unlike the great Byron Wien’s perennial list of market surprises, we do not assign these events a “better than 50% likelihood of happening.” We offer risks that the market is seriously underpricing by assigning them only single-digit probabilities when we think the reality is closer to 10%-15%, a level at which a risk premium ought to be assigned. Some of our risks below are so obscure that it is not clear how exactly to price them. We exclude issues that are fairly probable, such as flare-ups in Indo-Pakistani conflict. The two major risks of the year – discussed in our annual outlook – are that either US President Donald Trump or Chinese President Xi Jinping overreaches in a major way. But what would truly surprise the market would be a policy-induced relapse in Chinese growth or a direct military clash between the two great powers. That is how we begin. Other risks stem from domestic affairs in the US, Europe, and Russia. Black Swan 1: China’s Financial Crisis Begins The risk of Xi Jinping’s concentration of power in his own person is that individuals can easily make mistakes, especially if unchecked by advisors or institutions. Lower officials will fear correcting or admonishing an all-powerful leader. Inconvenient information may not be relayed up the hierarchy. Such behavior was rampant in Chairman Mao Zedong’s time, leading to famine among other ills. Insofar as President Xi’s cult of personality successfully imitates Mao’s, it will be subject to similar errors. If President Xi overreaches and makes a policy mistake this year, it could occur in economic policy or other policies. We begin with economic policy, as we have charted the risks of Xi’s crackdown on the financial system since early 2017 (Chart 1). Chart 1A Crackdown On Financial Risk Could Cause China's Economy To Derail A Crackdown On Financial Risk Could Cause China's Economy To Derail A Crackdown On Financial Risk Could Cause China's Economy To Derail Chart 2Easing Of Trade Tensions May Re-Incentivize Tighter Policy Easing Of Trade Tensions May Re-Incentivize Tighter Policy Easing Of Trade Tensions May Re-Incentivize Tighter Policy This year is supposed to be the third and final year of Xi Jinping’s “three battles” against systemic risk, pollution, and poverty. The first battle actually focuses on financial risk, i.e. China’s money and credit bubble. The regime has compromised on this goal since mid-2018, allowing monetary easing to stabilize the economy amid the trade war. But with a “phase one” trade deal having been signed, there is an underrated risk that economic policy will return to its prior setting, i.e. become less accommodative (Chart 2). When Xi launched the “deleveraging campaign” in 2017, we posited that the authorities would be willing to tolerate an annual GDP growth rate below 6%. This would not only cull excesses in the economy but also demonstrate that the administration means business when it says that China must prioritize quality rather than quantity of growth. While Chinese authorities are most likely targeting “around 6%” in 2020, it is entirely possible that the authorities will allow an undershoot in the 5.5%-5.9% range. They will argue that the GDP target for 2020 has already been met on a compound growth rate basis (Chart 3), as astute clients have pointed out. They may see less need for stimulus than the market expects. Chart 3Chinese Authorities Might Tolerate A Growth Undershoot In 2020 Chinese Authorities Might Tolerate A Growth Undershoot In 2020 Chinese Authorities Might Tolerate A Growth Undershoot In 2020 Similarly, while urban disposable income is ostensibly lagging its target of doubling 2010 levels by 2020, China’s 13th Five Year Plan, which concludes in 2020, conspicuously avoided treating urban and rural income targets separately. Chart 4Lower Impetus For Economic Support Due To Improvements In National Income? Lower Impetus For Economic Support Due To Improvements In National Income? Lower Impetus For Economic Support Due To Improvements In National Income? Chart 5Has China's Stimulus Peaked? Has China's Stimulus Peaked? Has China's Stimulus Peaked? If the authorities focus only on general disposable income, then they are on track to meet their target (Chart 4). This would reduce the impetus for greater economic support. There are already tentative signs that Chinese authorities are “satisfied” with the amount of stimulus they have injected: some indicators of money and credit have already peaked (Chart 5). The crackdown on shadow banking has eased, but informal lending is still contracting. The regime is still pushing reforms that shake up state-owned enterprises. The Xi administration may aim only for stability, not acceleration, in the economy. An added headwind for the Chinese economy stems from the currency. The currency should track interest rate differentials. Beijing’s incremental monetary stimulus, in the form of cuts to bank reserve requirement ratios (RRRs), should also push the renminbi down over time (Chart 6). However, an essential aspect of any trade deal with the Trump administration is the need to demonstrate that China is not competitively devaluing. Hence the CNY-USD could overshoot in the first half of the year. This is positive for global exports to China, but it tightens Chinese financial conditions at home. A stronger than otherwise justified renminbi would add to any negative economic surprises from less accommodative monetary and fiscal policy. Conventional wisdom says China will stimulate the economy ahead of two major political events: the centenary of the Communist Party in 2021 and the twentieth National Party Congress in 2022. The former is a highly symbolic anniversary, as Xi has reasserted the supremacy of the party in all things, while the latter is more significant for policy, as it is a leadership reshuffle that will usher in the sixth generation of China’s political elite. But conventional wisdom may be wrong – the Xi administration may aim only for stability, not acceleration, in the economy. It would make sense to save dry powder for the next US or global recession. The obvious implication is that China’s economic rebound may lose steam as early as H2 – but the black swan risk is that negative surprises could cause a vicious spiral inside of China. This is a country with massive financial and economic imbalances, a declining potential growth profile, and persistent political obstacles to growth both at home and abroad. Corporate defaults have spiked sharply. While the default rate is lower than elsewhere, the market may be sniffing out a bigger problem as it charges a much higher premium for onshore Chinese bonds (Chart 7). Chart 6CNY-USD Overshoot Would Tighten Chinese Financial Conditions CNY-USD Overshoot Would Tighten Chinese Financial Conditions CNY-USD Overshoot Would Tighten Chinese Financial Conditions Chart 7Is China's Bond Market Sniffing Out A Problem? Is China's Bond Market Sniffing Out A Problem? Is China's Bond Market Sniffing Out A Problem? Bottom Line: Our view is that China’s authorities will remain accommodative in 2020 in order to ensure that growth bottoms and the labor market continues to improve. But Beijing has compromised its domestic economic discipline since 2018 in order to fight trade war. The risk now, with a “phase one” deal in hand, is that Xi Jinping returns to his three-year battle plan and underestimates the downward pressures on the economy. The result would be a huge negative surprise for the Chinese and global economy in 2020. Black Swan 2: The US And China Go To War In 2013, we predicted that US-China conflict was “more likely than you think.” This was not just an argument for trade conflict or general enmity that raises the temperature in the Asia-Pacific region – we included military conflict. Chart 8Americans' Attitudes Toward China Plunged … Five Black Swans In 2020 Five Black Swans In 2020 At the time, the notion that a Sino-American armed conflict was the world’s greatest geopolitical threat seemed ludicrous to many of our clients. We published this analysis in October of that year, months after the Islamic State “Soldier’s Harvest” offensive into Iraq. Trying to direct investors to the budding rivalry between American and Chinese naval forces in the South China Sea amidst the Islamic State hysteria was challenging, to say the least. The suggestion that an accidental skirmish between the US and China could descend into a full-blown conflict involved a stretch of the imagination because China was not yet perceived by the American public as a major threat. In 2014, only 19%of the US public saw China as the “greatest threat to the US in the future.” This came between Russia, at 23%, and Iran, at 16%. Today, China and Russia share the top spot with 24%. Furthermore, the share of Americans with an unfavorable view of China has increased from 52% to 60% in the six intervening years (Chart 8). The level of enmity expressed by the US public toward China is still lower than that toward the Soviet Union at the onset of the Cold War in the 1950s (Chart 9). However, the trajectory of distrust is clearly mounting. We expect this trend to continue: anti-China sentiment is one of the few sources of bipartisan agreement remaining in Washington, DC (Chart 10). Chinese sentiment toward the United States has also darkened dramatically. The geopolitical rivalry is deepening for structural reasons: as China advances in size and sophistication, it seeks to alter the regional status quo in its favor, while the US grows fearful and seeks to contain China. Chart 9… But Not Yet To War-Inducing Levels Five Black Swans In 2020 Five Black Swans In 2020 Chart 10Distrust Of China Is Bipartisan Five Black Swans In 2020 Five Black Swans In 2020 Chart 11Newfound American Concern For China’s Repression Five Black Swans In 2020 Five Black Swans In 2020 One example of rising enmity is the US public’s newfound concern for China’s domestic policies and human rights, specifically Beijing’s treatment of its Uyghur minority in Xinjiang. A Google Trends analysis of the term “Uyghur” or “Uyghur camps” shows a dramatic rise in mentions since Q2 of 2018, around the same time the trade war ramped up in a major way (Chart 11). While startling revelations of re-education camps in Xinjiang emerged in recent years, the reality is that Beijing has used heavy-handed tactics against both militant groups and the wider Uyghur minority since at least 2008 – and much earlier than that. As such, the surge of interest by the general American public and legislators – culminating in the Uyghur Human Rights Policy Act of 2019 – is a product of the renewed strategic tension between the two countries. The “phase one” trade deal risks falling victim to domestic politics due to greater public engagement in foreign policy. The same can be said for Hong Kong: the US did not pass a Hong Kong Human Rights and Democracy Act in 2014, during the first round of mass protests, which prompted Beijing to take heavy-handed legal, legislative, and censorship actions. It passed the bill in 2019, after the climate in Washington had changed. Why does this matter for investors? There are two general risks that come with a greater public engagement in foreign policy. First, the “phase one” trade deal between China and the US could fall victim to domestic politics. This deal envisions a large step up in Sino-American economic cooperation. But if China is to import around $200 billion of additional US goods and services over the next two years – an almost inconceivable figure – the US and China will have to tamp down on public vitriol. This is notably the case if the Democratic Party takes over the White House, given its likely greater focus on liberal concerns such as human rights. And yet the latest bills became law under President Trump and a Republican Senate, and we fully expect a second Trump term to involve a re-escalation of trade tensions to ensure compliance with phase one and to try to gain greater structural concessions in phase two. Second, mounting nationalist sentiment will make it more difficult for US and Chinese policymakers to reduce tensions following a potential future military skirmish, accidental or otherwise. While our scenario of a military conflict in 2013 was cogent, the public backlash in the United States was probably manageable.1 Today we can no longer guarantee that this is the case. China has greater control over the domestic narrative and public discourse, but the rise of the middle class and the government’s efforts to rebuild support for the single-party regime have combined to create an increase in nationalism. Thus it is also more difficult for Chinese policymakers to contain the popular backlash if conflict erupts. In short, the probability of a quick tamping down of public enmity is actively being reduced as American public vilification of China is closing the gap with China’s burgeoning nationalism at an alarming pace. Chart 12Tsai Ing-Wen Enjoys A Greater Mandate On Higher Turnout … Five Black Swans In 2020 Five Black Swans In 2020 Another of our black swan risks – Taiwan island – is inextricably bound up in this dangerous US-China dynamic. To be clear, Washington will tread carefully, as a conflict over Taiwan could become a major war. Nevertheless Taiwan’s election, as we expected, has injected new vitality into this already underrated geopolitical risk. It is not only that a high-turnout election (Chart 12) gave President Tsai Ing-wen a greater mandate (Chart 13), or that her Democratic Progressive Party retained its legislative majority (Chart 14). It is not only that the trigger for this resounding victory was the revolt in Hong Kong and the Taiwanese people’s rejection of the “one country, two systems” formula for Taiwan. It is also that Tsai followed up with a repudiation of the mainland by declaring, “We don’t have a need to declare ourselves an independent state. We are an independent country already and we call ourselves the Republic of China, Taiwan.” Chart 13… Popular Support … Five Black Swans In 2020 Five Black Swans In 2020 Chart 14… And A Legislative Majority Five Black Swans In 2020 Five Black Swans In 2020 This statement is not a minor rhetorical flourish but will be received as a major provocation in Beijing: the crystallization of a long-brewing clash between Beijing and Taipei. Additional punitive economic measures against Taiwan are now guaranteed. Saber-rattling could easily ignite in the coming year and beyond. Taiwan is the epicenter of the US-China strategic conflict. First, Beijing cannot compromise on its security or its political legitimacy and considers the “one China principle” to be inviolable. Second, the US maintains defense relations with Taiwan (and is in the process of delivering on a relatively large new package of arms). Third, the US’s true willingness to fight a war on Taiwan’s behalf is in doubt, which means that deterrence has eroded and there is greater room for miscalculation. Bottom Line: A US-China military skirmish has been our biggest black swan risk since we began writing the BCA Geopolitical Strategy. The difference between then and now, however, is that the American public is actually paying attention. Political ideology – the question of democracy and human rights – is clearly merging with trade, security, and other differences to provoke Americans of all stripes. This makes any skirmish more than just a temporary risk-off event, as it could lead to a string of incidents or even protracted military conflict. Black Swan 3: Social Unrest Erupts In America There are numerous lessons that one can learn from the ongoing unrest in Hong Kong, but perhaps the most cogent one is that Millennials and Generation Z are not as docile and feckless as their elders think. Images of university students and even teenagers throwing flying kicks and Molotov cocktails while clad in black body armor have shocked the world. Perhaps all those violent video games did have a lasting impact on the youth! What is surprising is that so few commentators have made the cognitive leap from the ultra-first world streets of Hong Kong to other developed economies. Perhaps what is clouding analysts’ minds is the idiosyncratic nature of the dispute in Hong Kong, the “one China” angle. However, Hong Kong youth are confronted with similar socio-economic challenges that their peers in other advanced economies face: overpriced real estate and a bifurcated service-sector labor market with few mid-tier jobs that pay a decent wage. In the US, Millennials and Gen Z are also facing challenges unique to the US. First, their debt burden is much more toxic than that of the older cohorts, given that it is made up of student loans and credit card debt (Chart 15). Second, they find themselves at odds – demographically and ideologically – with the older cohorts (Chart 16). Chart 15Younger American Cohorts Plagued By Toxic Debt Five Black Swans In 2020 Five Black Swans In 2020 Chart 16Younger And Older Cohorts At Odds Demographically Five Black Swans In 2020 Five Black Swans In 2020 The adage that the youth are apolitical and do not turn out to vote may have ended thanks to President Trump. The 2018 midterm election, which the Democratic Party successfully turned into a referendum on the president, saw the youth (18-29) turnout nearly double from 20% to 36% (the 30-44 year-old cohort also saw a jump in turnout from 35.6% to 48.8%). The election saw one of the highest turnouts in recent memory, with a 53.4% figure, just two points off the 2016 general election figure (Chart 17). Chart 17Massive Turnout To The 2016 Referendum On Trump Five Black Swans In 2020 Five Black Swans In 2020 Despite the high turnout in 2018, the-most-definitely-not-Millennial Vice President Joe Biden continues to lead the Democratic Party in the polls. Chart 18Biden Unpopular Among Young American Voters Five Black Swans In 2020 Five Black Swans In 2020 Chart 19Bookies Pulled Down "Uncle Joe's" Odds, Capturing Democratic Party Zeitgeist Five Black Swans In 2020 Five Black Swans In 2020 His probability of winning the nomination is not overwhelming, but it is the highest of any contender. In recent polls, Biden comes third place in Millennial/Gen-Z vote preferences (Chart 18). Yet he is hardly out of contention, especially for the 30-44 year-old cohort. The view that “Uncle Joe” does not fit the Democratic Party zeitgeist has become so entrenched in the Democratic Party narrative that it became conventional wisdom last year, pulling oddsmakers and betting markets away from the clear frontrunner (Chart 19). As such, a Biden victory at the Democratic National Convention in Milwaukee, Wisconsin on July 13-16 may come as an affront to the left-wing activists who will surely descend on the convention. This will particularly be the case if Biden wins despite the progressive candidates amassing a majority of overall delegates, which is possible judging by the combined progressive vote share in current polling (Chart 20). He would arrive in Milwaukee without clearing the 1990 delegate count required to win on the first ballot. On the second ballot, his presidency would then receive a boost from “superdelegates” and those progressives who are unwilling to “rock the boat,” i.e. unify against an establishment candidate with the largest share of votes. This is also how Mayor Michael Bloomberg could pull off a surprise win. Chart 20Progressives Come Closest To Victory Five Black Swans In 2020 Five Black Swans In 2020 Such a “brokered” – or contested – convention has not occurred since 1952. However, several Democratic Party conventions came close, including 1968, 1972, and 1984. The 1968 one in Chicago was notable for considerable violence and unrest. Even if the Milwaukee Democratic Party convention does not produce unrest, it could sow the seeds for unrest later in the year. First, a breakout Biden performance in the primaries is unlikely. As such, he will likely need to pledge a shift to the left at the convention, including by accepting a progressive vice-presidential candidate. Second, an actual progressive may win the primary. Chart 21Zealots In Both Parties Perceive Each Other As A National Threat Five Black Swans In 2020 Five Black Swans In 2020 It is likely that either of the two options would be seen as an existential threat to many of Trump’s loyal supporters across the United States. President Trump’s rhetoric often paints the scenario of a Democratic takeover of the White House in apocalyptic terms. And data suggests that the zealots in both parties perceive each other as a “threat to the nation’s wellbeing” (Chart 21). The American Civil War in the nineteenth century began with the election of a president. This is not just because Abraham Lincoln was a particularly reviled figure in the South, but because the states that ultimately formed the Confederacy saw in his election the demographic writing-on-the-wall. The election was an expression of a general will that, from that point onwards, was irreversible. Given demographic trends in the US today, it is possible that many would see in Trump’s loss a similar fait accompli. If one perceives progressive Democrats as an existential threat to the US constitution, rebellion is the obvious and rational response. There is a risk of rebellion from Trump’s most ardent supporters if he loses the White House. Bottom Line: Year 2020 may be a particularly violent one for the US. First, left wing activists may be shocked and angered to learn that Joe Biden (or Bloomberg) is the nominee of the Democratic Party come July. With so much hype behind the progressive candidates throughout the campaign, Biden’s nomination could be seen as an affront to what was supposed to be “the big year” for left-wing candidates. Second, investors have to start thinking about what happens if Biden – or a progressive candidate – goes on to defeat President Trump in the general election. While liberal America took Trump’s election badly, it has demographics – and thus time – on its side. Trump’s most ardent supporters may conclude that his defeat means the end of America as they know it. Black Swan 4: Europe’s Migration Crisis Restarts Chart 22Decline In Illegal Immigration Dampened European Populism Five Black Swans In 2020 Five Black Swans In 2020 It is a testament to Europe’s resilience that we do not have a Black Swan scenario based on an election or a political crisis set on the continent in 2020. Support for the common currency and the EU as a whole has rebounded to its highest since 2013. Even early elections in Germany and Italy are unlikely to produce geopolitical risk. The populists in the former are in no danger of outperforming whereas the populists in the latter barely deserve the designation. But what if one of the reasons for the surge in populism – unchecked illegal immigration – were to return in 2020? The data suggests that the risk of migrant flows has massively subsided. From its peak of over a million arrivals in 2015, the data shows that only 125,472 migrants crossed into Europe via land and sea routes in the Mediterranean last year (Chart 22). Why? There are five reasons that we believe have checked the flow of migrants: Supply: The civil wars in Syria, Iraq, and Libya have largely subsided. Heterogenous regions, cities, and neighborhoods have been ethnically cleansed and internal boundaries have largely ossified. It is unlikely that any future conflict will produce massive outflows of refugees as the displacement has already taken place. These countries are now largely divided into armed, ethnically homogenous, camps. Enforcement: The EU has stepped up border enforcement since 2015, pouring resources into the land border with Turkey and naval patrols across the Mediterranean. Individual member states – particularly Italy and Hungary – have also stepped up border enforcement policy. While most EU member states have publicly chided both for “draconian” policies, there is no impetus to force Rome and Budapest to change policy. Libyan Imbroglio: Conflict in Libya has flared up in 2019 with military warlord Khalifa Haftar looking to wrest control from the UN-backed Government of National Accord led by Fayez al-Serraj. The Islamic State has regrouped in the country as well. Ironically, the conflict is helping stem the flow of migrants as African migrants from sub-Saharan countries dare not cross into Libya as they did in 2015 when there was a brief lull in fighting. Turkish benevolence: Ankara is quick to point out that it is the only thing standing between Europe and a massive deluge of migrants. Turkey is said to host somewhere between two and four million refugees from various conflicts in the Middle East. Fear of the crossing: If crossing the Mediterranean was easy, Europe would have experienced a massive influx of migrants throughout the twentieth century. Not only is it not easy, it is costly and quite deadly, with thousands lost each year. Furthermore, most migrants are not welcomed when they arrive to Europe, many are held in terrible conditions in holding camps in Italy and Greece. Over time, migrants who made it into Europe have reported these dangers and conditions, reducing the overall demand for illegal migration. We do not foresee these five factors changing, at least not all at once. However, there are several reasons to worry about the flow of migrants in 2020. US-Iran tensions have sparked outright military action, while unrest is flaring up across Iran’s sphere of influence. Going forward, Iran could destabilize Iraq or fuel Shia unrest against US-backed regimes. Second, Afghanistan has been the source of most migrants to Europe via sea and land Mediterranean routes – 19.2%. The conflict in the country continues and may flare up with President Trump’s decision to formally withdraw most US troops from the country in 2020. Third, a break in fighting in Libya may encourage sub-Saharan migrants to revisit routes to Europe. Migrants from Guinea, Cote d’Ivoire, and the Democratic Republic of Congo make up over 10% of migrants to Europe. Finally, Turkish relationship with the West could break up further in 2020, causing Ankara to ship migrants northward. We highly doubt that President Erdogan will risk such a break, given that 50% of Turkish exports go to Europe. A European embargo on Turkish exports – which would be a highly likely response to such an act – would crush the already decimated Turkish economy. Bottom Line: While we do not see a return to the 2015 level of migration in 2020, we flag this risk because it would fundamentally undermine political stability in Europe. Black Swan 5: Russia Faces A “Peasant Revolt” Our fifth and final black swan risk for the year stems from Russia. This risk may seem obvious, since the US election creates a dynamic that revives the inherent conflict in US-Russian relations. Russia could seek to accomplish foreign policy objectives – interfering in US elections, punishing regional adversaries. The Trump administration may be friendly toward Russia but Trump is unlikely to veto any sanctions passed by the House and Senate in an election year, should an occasion for new sanctions arise. Conversely Russia could anticipate greater US pressure if the Democrats win in November. Yet it is Russia’s domestic affairs that represent the real underrated risk. Putin’s fourth term as president has been characterized by increased focus on domestic political control and stability as opposed to foreign adventurism. The creation of a special National Guard in 2016, reporting directly to Putin and responsible for quelling domestic unrest, symbolizes the shift in focus. So too does Russia’s adherence to the OPEC 2.0 regime of production control to keep oil prices above their budget breakeven level. Meanwhile Putin’s courting of Europe for the Nordstream II pipeline, and his slight peacemaking efforts with Ukraine, has suggested a slightly more restrained international posture. Chart 23Sluggish Wage Growth Threatens Russian Stability Sluggish Wage Growth Threatens Russian Stability Sluggish Wage Growth Threatens Russian Stability Strategically it makes little sense for Russia to court negative attention at a time when the US and Europe are at odds over trade and the Middle East, the US is preoccupied with China and Iran, and Russia itself faces mounting domestic problems. The domestic problems are long in coming. The central bank has maintained a stringent monetary policy for the better part of the decade. Despite cutting interest rates recently, monetary and credit conditions are still tight, hurting domestic demand. Moscow has also imposed fiscal austerity, namely by cutting back on state pensions and hiking the value added tax. Real wage growth is weak (Chart 23), retail sales are falling, and domestic demand looks to weaken further, as Andrija Vesic of BCA Emerging Markets Strategy observes in a recent Special Report. The effect of Russia’s policy austerity has been a drop in public approval of the administration (Chart 24). Protests erupted in 2019 but were largely drowned out by the larger and more globally significant protests in Hong Kong. These were met by police suppression that has not removed their underlying cause. Putin’s first major decision of the new year was to reshuffle the government, entailing Prime Minister Dmitri Medvedev’s transfer to a new post and the appointment of a new cabinet. This move reveals the need to show some accountability to reduce popular pressure. While Moscow now has room to cut interest rates and ease fiscal policy, it is behind the curve and the weak economy will add fuel to domestic unrest. Meanwhile Putin’s efforts to alter the Russian constitution so he can stay in power beyond current term limits, effectively becoming emperor for life, like Xi Jinping, should not be dismissed merely because they are expected. They reflect a need to take advantage of Putin’s popular standing to consolidate domestic political power at a time when the ruling United Russia party and the federal government face discontent. They also ensure that strategic conflict with the United States will take on an ideological dimension. Chart 24Austerity Weighed On The Administration's Popularity In Russia Austerity Weighed On The Administration's Popularity In Russia Austerity Weighed On The Administration's Popularity In Russia Chart 25Russian Political Risk Is Unsustainably Low Russian Political Risk Is Unsustainably Low Russian Political Risk Is Unsustainably Low Russia's recent cabinet shakeup is positive from the point of view of economic reform. And the country's monetary and fiscal room provide a basis for remaining overweight equities within EM, as our Emerging Markets Strategy recommends. However, Russian equities have rallied hard and the political risk is understated. Bottom Line: It is never easy predicting Putin’s next international move. Our market-based indicators of Russian political risk have hit multi-year lows, but both the domestic and international context suggest that these lows will not be sustained (Chart 25). A new bout of risk can emanate from Putin, or from changes in Washington, or from the Russian people themselves. What would take the world by surprise would be domestic unrest on a larger scale than Russia can easily suppress through the police force. Housekeeping We are closing our long European Union / short Chinese equities strategic trade with a 1.61% loss since inception on May 10, 2019. Dhaval Joshi of BCA’s European Investment Strategy downgraded the Eurostoxx 50 to underweight versus the S&P 500 and the Nikkei 225 this week. He makes the point that the Euro Area bond yield 6-month impulse hit 100 bps – a critical technical level – and will be a strong headwind to growth. We will look to reopen this trade at a later date when the euphoria over the “phase one” trade deal subsides, as we still favor European equities and DM bourses over EM. We will reinstitute our long Brent crude H2 2020 versus H2 2021 tactical position, which was stopped out on January 9, 2020. We remain bullish on oil fundamentals and expect Middle East instability to add a political risk premium. China's stimulus and the oil view also give reason for us to reinitiate our long Malaysian equities relative to EM as a tactical position. The Malaysian ringgit will benefit as oil prices move higher, helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power. Higher oil prices also correlate with higher equity prices, while China's stimulus and the US trade ceasefire will push the US dollar lower and help trade revive in the region. Marko Papic Consulting Editor marko@bcaresearch.com Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 Observe how little attention the public paid to US-China saber-rattling around China’s announcement of an Air Defense Identification Zone in the East China Sea that year.