Geopolitical Regions

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

Highlights The vaccine promises an eventual return to “normal” life – just as Americans voted to “return to normalcy.” Markets are cheering and hinting at an eventual rotation into value stocks. The contested US election can still cause volatility even though Trump is highly unlikely to change the result. The fiscal stimulus cliff is still a risk to the normalcy rally in the short run. But gridlock is the best political outcome over the coming 12-24 months. Stay strategically long global stocks over bonds. Tactically maintain safe-haven positions, add risk gradually, and stay short China/Taiwan. Feature The news of Pfizer’s success in developing a COVID-19 vaccine galvanized financial markets this week. America’s leading public health official Anthony Fauci also predicted that Moderna’s vaccine candidate would be similarly effective. It will take time to distribute these vaccines but the world can look toward economic recovery next year. Stocks rallied, bonds sold off, and value outperformed growth on the back of the news (Charts 1A and 1B). Chart 1ABiden: Return To Normalcy Biden: Return To Normalcy Biden: Return To Normalcy Chart 1BVaccine: Return To Normalcy Vaccine: Return To Normalcy Vaccine: Return To Normalcy The vaccine announcement super-charged the “return to normalcy” rally that followed the US election. The election’s likeliest policy outcome is that President Elect Joe Biden will not raise sweeping tariffs while Republican senators will not raise taxes next year, the best-case scenario for markets. This is genuinely positive news. The benefits are very clear over the next 12 months. But the risks are also very clear over the next three months: the virus will remain a problem until the vaccine is widely distributed, the US is in the midst of a contested election that could still cause negative surprises, the Republican senators are less likely to agree to fiscal relief, and President Trump will take aggressive actions to cement his legacy during the “lame duck” period of his last 68 days in office. The takeaway is that the US dollar will see a near-term, counter-trend rally and developed markets will outperform emerging markets for a while longer. We are only gradually adding risk to our strategic portfolio as we keep dry powder and maintain tactical safe-haven trades. Is The Election Over Or Not? Yes, most likely the election is over. But our definitive guide to contested US elections will teach any reader to be sensitive to the tail risks. The counting of ballots is not finished and the Electoral College does not vote until December 14. First, it is still possible that President Trump could pull off a victory in Georgia, which will now recount ballots by hand. Biden’s margin of victory of 14,045 votes is not so large there as to make it impossible that Trump would come back with a win (though history suggests recounts only change hundreds, not thousands, of votes). Trump is also narrowing the gap in Arizona, where counting continues, though the latest reports suggest he is still falling short of the roughly 60% share of late ballots that he needs to close the 11,635 vote gap and win the state. Second, there is a 50/50 chance that the Supreme Court will rule that Pennsylvania must stick to the statutory November 3 deadline, i.e. not accept mail-in ballots that arrived in the three days after that date. While the high court would prefer to let Pennsylvania settle its own affairs, this case is of the sort that the court could feel compelled to weigh in. The constitution is crystal clear that legislatures, not courts, decide how a state’s electors are chosen. Such a ruling probably would not reverse Biden’s projected victory in Pennsylvania. Trump is currently trailing Biden by 53,980 votes in this state. State officials say that the ballots that arrived late amount to only 7,800 and would not be able to change the outcome.1 This may be understating the risk but it is probably accurate in the main. Table 1 shows the share of mail-in votes that arrived late in this year’s primary elections. The share was 1.07% in Pennsylvania and up to 3% in other states. Applying the high water mark of 3% to the November 3 general election mail-in ballots, it is possible that 77,187 votes arrived late and would be excluded by a Supreme Court ruling. However, 85% of those ballots would have to have gone to Biden in order for Trump to come out the winner. This is far-fetched. Table 1Share Of Ballots Arriving Late In Primary Election Extrapolated To General Election The "Normalcy" Rally The "Normalcy" Rally It is also unlikely that Republican legislatures will take matters into their own hands and defy the election boards of their state by nominating their own slate of Republican electors – a scenario we entertained in our definitive guide. If Biden leads the statewide vote, then a state legislature would be politically suicidal to appoint the state’s electors to vote for Trump. It would invite a popular backlash. In the case of Pennsylvania, Republican leaders of the lower and upper chambers have explicitly denied any willingness or ability to choose electors other than those entailed by the popular vote. Thus the 1876 “Stolen Election” scenario is extremely unlikely in this critical state. It is just as unlikely in Arizona, Nevada, or Georgia.2 Nevertheless, if President Trump wins in Georgia or gets a favorable Supreme Court verdict, investors will have to increase the probability that the election result will be overturned, which currently stands at 16% (Chart 2). This will cause a bout of volatility even if it changes nothing in the end. If somehow Trump pulls off a Rutherford B. Hayes and overturn the result, markets should sell off. Yes, Trump is an exclusively commercial and reflationary president, but his election on a constitutional technicality would create nearly unprecedented social and political instability in the United States and it would presage major instability globally. Chinese, European, and Canadian assets would be hardest hit (Chart 3). Chart 2Trump’s Tiny Chance Of Reversing Election The "Normalcy" Rally The "Normalcy" Rally Otherwise Trump and the Republicans are trying to do four things with their litigation: (1) probing for weaknesses that can delay or change the Electoral College math (2) conducting due diligence in case fraud really did tip over one of the states (3) saving face for President Trump and his allies, who otherwise would be exposed as failures (4) keeping their base motivated for the showdown in Georgia on January 5, which will determine control of the Senate. Chart 3Trump's Loss Favors Euro, Renminbi, Loonie Trump's Loss Favors Euro, Renminbi, Loonie Trump's Loss Favors Euro, Renminbi, Loonie In Georgia, opinion polls show Republican David Perdue slightly leading Democrat Jon Ossoff, in keeping with his superior showing on November 3. However, Republican Kelly Loeffler is trailing Democrat Raphael Warnock (Charts 4A and 4B). Last week we argued that the odds of Democrats winning both races stood around 20%. If anything this view is generous – given that Perdue already beat Ossoff, and Warnock will continue to suffer attacks for associating with Fidel Castro – but it is in line with online betting markets (Chart 5). Chart 4AVoters Split On Georgia Senate Runoffs The "Normalcy" Rally The "Normalcy" Rally Chart 4BVoters Split On Georgia Senate Runoffs The "Normalcy" Rally The "Normalcy" Rally Chart 5Democrats Have ~20% Chance To Win Senate The "Normalcy" Rally The "Normalcy" Rally Investors should plan on the US government being gridlocked unless something occurs that fundamentally changes the Georgia race. Gridlock is positive, so if Trump’s election disputes keep the Republican political base spirited for the Georgia runoffs, then Trump’s activities have an ironic upside for markets. That is, as long as he doesn’t succeed in overturning the election result and the flames of discontent do not break out into a significant violent incident. Other fears about the transition period are less concerning. Several clients have asked us what should happen if President Elect Biden came down with COVID-19 or were otherwise incapacitated. The answer is that Vice President Elect Kamala Harris would take his place, as she now has popular consent to do exactly that. Prior to the Electoral College voting on December 14, the Democratic National Committee would have to nominate a candidate to replace Biden, almost certainly Harris. After December 14, the regular succession would apply under the twentieth amendment and Harris would automatically fill Biden’s shoes. Harris is only slightly more negative for equities than Biden: her regulatory pen would be more anti-business, but like Biden her main policies depend entirely on control of the senate. Bottom Line: It ain’t over till it’s over. The big picture is positive for risk assets but a surprise from ongoing election disputes or the unusually rocky transition of power would trigger a new bout of volatility. Stay long Japanese yen and health stocks on a tactical time frame. Trump’s Lame Duck Risk An investor in the Wild West has often criticized us for arguing that Trump would become a “war president” as he became a political lame duck at home. This war president view did pay off with Iran in January 2020, but otherwise the criticism is valid (see Trump’s Abraham Accords). Now Trump is almost certainly a lame duck so we will find out what he intends to do when unshackled from election concerns. Stay long Japanese yen and health stocks on a tactical time frame.  Since losing the election, Trump has fired Defense Secretary Mark Esper, several defense officials have resigned, and CIA Director Gina Haspel is rumored to be next on the chopping block. Most of the officials to depart had broken with the president over the course of the election year, so he may just be dishing out punishment now that the campaign is over. But it is possible that Trump is planning a series of final actions to cement his legacy and that these officials were removed because they got in the way. Chart 6Trump's Lame Duck Risk To China And Taiwan Strait Trump's Lame Duck Risk To China And Taiwan Strait Trump's Lame Duck Risk To China And Taiwan Strait First, there is no doubt that Trump is already tightening sanctions on China and Iran. China was the origin of the coronavirus pandemic and Trump has called for reparations, which could mean more tariff hikes. His outstanding legacy in US history will be his insistence that the US confront China. We are fully prepared for this outcome and remain short the renminbi and Taiwanese equities, despite their strong performance year-to-date (Chart 6). Trump could also raise tariffs on Europe. However, investors should be used to tariffs and sanctions by now. The impact would be fleeting and the next administration could reverse it. In the case of the renminbi, or any tariffs that weigh on the euro, investors should buy on the dips. By contrast, there are some conceivable actions – we are speculating – that would be extremely destabilizing and possibly irreversible. These would include: Extending diplomatic recognition to Taiwan, potentially provoking a war with China. Sending aircraft carriers into the Taiwan Strait, like Bill Clinton did during the Third Taiwan Strait Crisis, to shore up US deterrence. Launching surgical strikes against Iran’s ballistic missile and nuclear facilities or critical infrastructure. A prominent official has already denied that Trump intends anything of the sort. Launching surgical strikes against North Korea’s ballistic missile and nuclear facilities. No sign of this, but Kim Jong Un did enhance his capabilities after his meetings with Trump, thus embarrassing the president on a major foreign policy initiative ahead of the election. Providing intelligence and assistance to US allies like Israel who may seek to sabotage or attack Iran now or in future to prevent it from acquiring nuclear weapons. Withdrawing US troops from Germany or South Korea – which is much more consequential than hasty withdrawals from Afghanistan or Syria, which Trump clearly intends. War actions are largely infeasible. The bureaucracy would refuse to implement them. Assuming the Department of Defense would slow-walk any attempts to reduce troops in important regions like Germany or Korea, it would almost certainly avoid instigating a war. Withdrawing troops from Afghanistan or Syria is manageable, and fitting with Trump’s legacy, but it would not be disruptive for financial markets. A diplomatic upgrade or a show of force to demonstrate the American commitment to defend Taiwan is possible and highly disruptive for global financial markets. The critical risk may come from US allies or partners that are threatened by the impending Biden administration and have a window of opportunity to act with full American support while Trump still inhabits the Oval Office. The likeliest candidate would be Israel and Saudi Arabia on the Iranian nuclear program. Trump’s onetime national security advisor, H. R. McMaster, has already warned that Israel could act on the “Begin Doctrine,” which calls for targeted preventive strikes against hostile nuclear capabilities.3 Even here, Israel is unlikely to jeopardize its critical security relationship with the United States, so any actions would be limited, but they could still bring a major increase in regional tensions. Saudi Arabia can do little on its own but President Trump could willingly or unwilling encourage provocative actions. Chart 7Big Tech Is Not Priced For Surprises Big Tech Is Not Priced For Surprises Big Tech Is Not Priced For Surprises Any number of incidents or provocations could occur in this risky interregnum between Trump and Biden. Some suggest Trump will release a treasure trove of documents to discredit Washington and the Deep State. If that is all that occurs, then investors will be able to give a sigh of relief, as revelations of government intrigue would have to be truly consequential for future events in order to cause a notable market impact. Last-minute executive orders on regulating domestic industries are just as likely to shock markets as any international moves. We speculate that Big Tech is in Trump’s sights for censoring his comments during the election. In the wake of the Supreme Court’s decision in Department of Homeland Security versus Regents of the University of California, the Trump administration is positively incentivized to issue a flurry of executive orders and write them in a way that makes them hard for the Biden administration to rescind them.4 Tech is priced for perfection, despite ruffles due to the vaccine this week, and investors expect Biden-Harris to maintain Obama’s alliance with Silicon Valley, not least because Biden has named executives from Facebook and Apple to his transition team and is considering putting former Google chief Eric Schmidt in charge of a Big Tech task force (Chart 7).5 Ultimately we have no idea what the Trump administration will do in its final two months. A lot of Trump’s attention will be focused on contesting the election. Drastic or reckless decisions will likely be obstructed by the bureaucracy. But the president still retains immense powers and there are executive orders that are legitimate and would benefit the US’s long-term interests even if disruptive for financial markets – and these would be harder for officials to disobey. Trump is an anti-establishment player who intends to shake up Washington, stay involved in politics, and cement his legacy. There is a reason for investors to take political risk seriously rather than to assume that the transition to a more market-friendly administration will be smooth. Bottom Line: Stay long gold on geopolitical risk, despite the potential for a counter-trend rise in the US dollar. We are neutral tech: polarization and fiscal risks are positive for tech shares but reopening and Trump lame duck risks are negative. Biden’s Cabinet Picks This “lame duck Trump” risk explains why we are not overly concerned about Biden’s cabinet picks. Insofar as Biden’s choices affect the market at all, they will confirm the “return to normalcy” theme and hence will be market-friendly. Take for example Biden’s just-announced chief of staff, Ronald Klain, who was chief of staff when Biden served as vice president from 2009- 16. The current transition is obstructed by election disputes, as occurred in November-December of 2000, but the cabinet picks are not likely to bring negative surprises. Already Biden has announced a coronavirus advisory board, a bipartisan transition team, and is pondering other picks, some of which will be known by Thanksgiving. None of the choices are in the least disruptive or radical – and most are acceptable to Wall Street. Biden will pick experts and technocrats who are known from his political career, the Obama administration, the Clinton administration, the Democratic Party, and academia. The market will invariably approve of establishment nominations after four years of anti-establishment picks and spontaneous firings. Since the Senate will remain in Republican hands, the cabinet members will have to be centrist enough to be confirmed. While Biden will inevitably nominate a few progressives, they will either fail in the Senate or take up marginal posts. Stay long gold on Trump “lame duck” geopolitical risks. Biden may have the opportunity to appoint three or even four members to the Federal Reserve’s board of governors. The Trump administration failed to fill two seats, while Fed Chair Jerome Powell’s term will expire in February 2022 (Diagram 1). If Biden appoints Lael Brainard to another post, such as Treasury Secretary, he will have a fourth space to fill. Diagram 1Biden Could Have Three-To-Four Fed Picks The "Normalcy" Rally The "Normalcy" Rally Chart 8Facing Gridlock, Biden Will Re-Regulate The "Normalcy" Rally The "Normalcy" Rally The implication will be a further entrenchment of dovish policy, with greater attention to new concerns that fall outside of traditional monetary policy such as climate change and racial inequality. The Fed has already committed to pursuing “maximum employment,” refraining from rate hikes till the end of 2023, and targeting average inflation – all a major boon to the Biden administration as it attempts to revive the economy. What is negative for markets is that Biden will re-regulate the economy – after Trump’s deregulatory shock – and that this will bring about political risks for small business and key industries like health, financials, and energy (Chart 8). Biden has little other option given that his legislative agenda will be largely stymied. Nevertheless, the sectors most likely to be heavily impacted are attractively valued and stand to benefit from economic normalization if not from Biden’s version of normalcy. Bottom Line: Stay long health and energy. Yes, Gridlock Is Best For Markets Some clients have asked us about our view that gridlocked government is truly the best for financial markets. Wouldn’t Democrats winning control of the Senate in Georgia be better, as it would usher in greater political certainty and larger fiscal spending? We have addressed this issue in previous reports so we will be brief. First, yes, gridlock has higher returns than single-party sweep governments on average over the past 120 years (Chart 9). Clearly the normalcy rally can go higher, but it is equally clear that it will get caught by surprise when the political reality hits home.  Second, however, the stock market’s annual returns are roughly average under single-party sweeps during this period (Chart 10). Chart 9Gridlock Best For Markets The "Normalcy" Rally The "Normalcy" Rally Chart 10Single-Party Sweeps Generate Average Annual Returns The "Normalcy" Rally The "Normalcy" Rally So while investors can cheer gridlock, it is not as if they should sell everything if Democrats do win control of the Senate on January 5. Chart 11Sweeps As Good As Gridlock Over 70 Years The "Normalcy" Rally The "Normalcy" Rally Indeed, looking at the period after World War II, sweep governments have witnessed average annual returns that are the same or slightly better than under gridlock (Chart 11). Whereas limiting the study to the post-Reagan era, gridlocks are clearly favored. If greater fiscal resources are needed then gridlock will quickly become a market risk rather than an opportunity. It is notable that over the past 120 years, there is not an example of a Democratic president presiding over a Republican senate and a Democratic House. There was only one case of the inverse – a Republican President, a Democratic senate, and a Republican House – which occurred in 2001-02 and coincided with a bear market. In fact, this episode should be classified as a Republican sweep, as in Table 2, since a sweep was the result of the 2000 election and the context of the key market-relevant legislation in 2001.6 Table 2Average Annual Equity Returns And Gridlock Government The "Normalcy" Rally The "Normalcy" Rally Chart 12Market Predicted Gridlock In 2020 Market Predicted Gridlock In 2020 Market Predicted Gridlock In 2020 In 2020 the stock market clearly anticipated a gridlocked outcome – the market’s performance matches with the historical profile of divided government (Chart 12). We argued that this was the best case for the market because it meant neither right-wing populism nor left-wing socialism. But we also highlighted that any relief rally on election results (reduced uncertainty) would be cut short by the major near-term implication of gridlock: a delay of fiscal support for the economy in the near term. This was the only deflationary scenario on offer in this election. Hence bad news in winter 2020-21 would precede the good news over the entire 2020-22 period. This is still largely our view, but we admit that the vaccine announcement erodes near-term risk aversion even further. There is little substance to the discussion of whether Americans will take the vaccine or not. Evidence shows that Americans are no less likely to take vaccines than other developed country citizens – assuming they are demonstrated to be safe and effective (Chart 13). Chart 13Yes, Americans Take Vaccines The "Normalcy" Rally The "Normalcy" Rally So gridlock looks even better now than it did previously. Yet we still think the near-term fiscal risks will hit markets sometime soon. Senate Republicans have been emboldened by the fact that their relative hawkishness paid off in the election on November 3. If they would not capitulate to House Speaker Nancy Pelosi prior to the election, they are even less likely to do so after gaining seats in the House, retaining the Senate, and crying foul over the presidential election. McConnell could agree to a $500 billion deal before Christmas – or not. There is no clear basis for optimism. A government shutdown is even possible if the continuing resolution expires on December 12. If the economic data turns sour and/or markets sell off dramatically then the Republicans will be forced to agree to a bigger deal, but as things stand they are not forced to do anything. And that presents a downside risk to the normalcy rally. Investment Takeaways Today’s post-election environment is comparable to the period after 2010, when a new business cycle was beginning and a new President Barack Obama had to face down Republican fiscal hawks in the House of Representatives. Today’s GOP senators may prove somewhat more cooperative with President Elect Biden, but that remains to be seen. Given how tight the election was, Republicans have an incentive to obstruct, slow down the economic recovery, and contest the 2022 midterms and 2024 election on the back of another slow-burn recovery. It worked last time. The debt ceiling crises of 2011 and 2012-13 were different than the fiscal stimulus cliff that Washington faces today but the market implications are similar. At the climax of brinkmanship between the president and the senate, treasuries will rally, the dollar will rally, stocks will fall, and emerging markets will underperform (Charts 14A and 14B). Today there is a greater limit on how far the dollar will rise and how far treasury yields will fall, but a fiscal impasse will still drive flows into these assets. Chart 14AObama’s Debt Ceiling Crises… Obama's Debt Ceiling Crises... Obama's Debt Ceiling Crises... Chart 14B… Presage Biden’s Fiscal Cliffs ... Presage Biden's Fiscal Cliffs ... Presage Biden's Fiscal Cliffs ​​​​​​​This is what we expect over the next three months. The fact that President Trump could bring negative surprises only enhances this expectation. Therefore we are only gradually adding risk to our strategic portfolio and maintaining tactically defensive positions. Clearly the normalcy rally can go higher, but it is equally clear to us that it will get caught by surprise when the political reality hits home. Since this could be anytime over the next two months, we are only gradually adding new risk. We would not deny that the outlook is brighter over the 12-24-month periods due to the vaccine and election results.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Chris Matthews, "Alleging fraud, GOP seeks to overturn election results in Michigan, Pennsylvania," MarketWatch, November 10, 2020, marketwatch.com. 2 See Senator Jake Corman and Representative Kerry Benninghoff, "Pennsylvania lawmakers have no role to play in deciding the presidential election," Centre Daily, October 19, 2020, centredailly.com. As for the 1876 “Stolen Election,” the initial election results suggested that Democrat Samuel Tilden had won 184 electoral votes while Republican Rutherford B. Hayes had won 165. The amount needed for a majority in the Electoral College at the time was 185, so Tilden fell one vote short while Hayes fell 20 votes short. After partisan litigation, actions by state legislatures, an intervention by the US House of Representatives, and a grand political compromise, Hayes won with 185 votes. 3 See Charles Creitz, "McMaster warns Biden on Iran deal: Don't resurrect 'political disaster masquerading as a diplomatic triumph,’" Fox News, November 12, 2020, foxnews.com. 4 In this ruling, which was decided on a 5-4 split with Chief Justice John Roberts siding with liberal justices, the Supreme Court denied the Trump administration’s effort to overturn the Obama administration’s policy known as Deferred Action on Childhood Arrivals (DACA), which stopped the US from deporting illegal immigrants who came to the US as children. The majority opinion argued that the Trump administration had merely asserted, not demonstrated, that the Obama administration’s executive orders were unconstitutional. In doing so, it established a precedent by which the court can determine whether one president’s executive orders should overrule another’s. While future administrations may follow better procedures in attempting to revoke their predecessors’ orders, this decision likely incentivizes the Trump administration to try to issue decrees that will be difficult to revoke. See John Yoo, "How the Supreme Court’s DACA decision harms the Constitution, the presidency, Congress, and the country," American Enterprise Institute, June 22, 2020, aei.org. 5 See Kiran Stacey, “What can Silicon Valley expect from Joe Biden?” Financial Times, November 8, 2020, ft.com. 6 The election produced a Republican sweep, with a 50-50 balance in the Senate, that led to the Bush tax cuts in May 2001. The business cycle was ending, however. In June, Democrats took the senate majority when Republican Senator Jim Jeffords of Vermont became an independent and began caucusing with Democrats. In September terrorists attacked the World Trade Center causing a market collapse.

Highlights Biden’s chances of winning the US election are rising, but it is still unsettled and could bring negative surprises to financial markets. The fiscal cliff will not subside immediately as the Senate Republicans have been vindicated for their fiscally hawkish approach. We doubt Democrats will win both Senate seats in Georgia to restore the lost “Democratic Sweep” scenario that offered maximum policy reflation. President Trump’s lame duck period, if he loses, lasts for three months and could bring negative surprises on China, the Taiwan Strait, Big Tech, Iran, or North Korea. The US remains at “peak polarization,” though we expect a growing national consensus over the long haul. Go long a basket of Trans-Pacific Partnership countries on a strategic time horizon to capitalize on what we believe will be Biden’s pro-trade-ex-China policy. Feature Chart 1Market Response To US Election Market Response To US Election Market Response To US Election The US presidential election remains undecided despite former Vice President Joe Biden’s increasing likelihood of victory. Votes will be recounted in several states while one potential tipping-point state, Pennsylvania, could easily swing on a Supreme Court decision. The Senate is likely to remain in Republican hands, though there is still a ~20% chance that it will flip if Democrats win both of the likely Georgia runoff elections on January 5. Thus our base case is the same as in our final forecast: Biden plus a Republican Senate. Financial markets first rallied and have now paused (Chart 1). The pause makes sense to us. Ultimately the best-case scenario of this election was always Biden plus a Republican Senate – neither tariffs nor taxes would increase. But this same scenario also always posed the highest risk of near-term fiscal tightening that would undermine the US recovery and global reflation trade. GOP Senators will insist on a smaller fiscal relief bill and may wait too long to enact it. Below we discuss these dynamics and why we maintain a tactically defensive position amid this contested election. We will not go full risk-on until the critical short-run risks subside: the contested election, the fiscal impasse, Trump’s “lame duck” executive orders, and the international response. Biden Not Yet President-Elect Biden is leading the vote tally in Arizona, Georgia, Michigan, Nevada, Pennsylvania, and Wisconsin as we go to press. To all appearances he has reclaimed the “Blue Wall” (MI, PA, WI) and made inroads in the Sun Belt (AZ, GA). We will not go full risk-on until the critical short-run risks subside. Map 1 shows tentative election results. Unsettled states are colored lightly while settled states are solid red or blue. This map points to a Biden victory even if Georgia and Pennsylvania slip back to Trump. The President would need to reclaim the latter two and one other state to reach 270 Electoral College votes. Map 1US 2020 Election Results (Tentative) Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Chart 2 shows the final prediction of our quantitative model. While our model predicted a Trump victory at 51% odds, we subjectively capped Trump’s odds at 45% because we disagreed that Trump would win Michigan.1 We did not do the same for our Senate model as the results matched with our subjective judgment that Republicans would keep control. Chart 2Our Presidential Quant Model Versus Actual Results Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Investors cannot yet conclude that the contested election risks have abated. If Biden wins only AZ, NV, MI, and WI, then he will end up with 270 Electoral College votes. This is the minimal vote needed for a victory. It is legitimate, but it means that a net of one faithless elector, or a disqualified elector, could throw the nation into a historic and nearly unprecedented crisis. If the Electoral College becomes indecisive for any reason, the House of Representatives will decide the election. Each state will get one vote. The results of the election suggest Republicans have four-to-ten seat majority of state delegations in the House (Table 1). Trump would win. Polarization and unrest would explode. Not for nothing did we brand this election cycle “Civil War Lite.” Table 1State Delegations In US House Of Representatives Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization The greater the margin of victory in the Electoral College, the less vulnerable the nation is to indecision in the college, or to a result decided in the courts. The Republicans have a strong case in Pennsylvania that votes that arrived after November 3 should not be counted. It is not clear if the Supreme Court will revisit the case, having left it unresolved prior to the election. If Pennsylvania’s 20 electoral votes become the fulcrum of the election, and the Supreme Court rules to exclude votes received after November 3, and if Trump thereby wins the count, a national crisis will erupt. This is not high probability at the moment because Biden can afford to lose Pennsylvania if he wins Nevada or Georgia. But the history of contested elections teaches that investors should not rush to conclusions. Senate Gridlock Will Survive Georgia Runoffs The most likely balance of power is a Democratic president with a Republican Senate and Democratic House, i.e. gridlock. Chart 3 shows the likely balance of power in Congress. Democrats would need to win both runoff elections in Georgia to win 50 seats, which would give them a de facto majority if Biden wins, since Vice President Kamala Harris would become President of the Senate and break any tie votes there. They are unlikely to do so. Chart 3AGridlock In US Government Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Chart 3BGridlock In US Government Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Why do we doubt that Democrats will win both Georgia seats, given that Trump is now falling short in the statewide presidential vote? First, Republicans tend to do well in runoffs as Georgia is a conservative-leaning state (Chart 4). Second, the Republican vote was greater than the Democratic vote in both Senate elections, though falling short of 50%. Third, exit polls show that voters leaned Republican in the suburbs and were mostly concerned about the economy, not the coronavirus. Fourth, also clear from exit polls, Republican voters will be more motivated to retain control of the Senate with Trump out, while Democratic voters will be less motivated with Biden in (Chart 5). Voter turnout will drop in the special election as usual. Neither Trump nor the presidency will be on the ballot on January 5. Still, it is possible for Democrats to win both seats and hence de facto control of the Senate. We would say the odds are roughly 20% (0.5 x 0.4 = 0.2). Chart 4GOP Does Well In Georgia Runoffs Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Chart 5Georgia 2020 Election Results (So Far) Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization If Democrats pulled off two victories in Georgia, the “Blue Sweep” scenario would be reaffirmed and several legislative proposals that had a 0% chance of passage in a Republican Senate would become at least possible. Certainly taxes would go up – the Democrats would be able to use the reconciliation process to push through reforms to the health care system paid for by partially repealing the Trump Tax Cut and Jobs Act. They would also be able to pass legislation that is popular with moderate Democrats who would then hold the balance in the Senate. The Green New Deal would become possible, if highly improbable. There would be a small chance of removing the filibuster in an exigency, but a vanishingly small chance of other radical structural changes, like creating new seats on the Supreme Court or granting statehood to Washington DC and Puerto Rico. A 50-50 count in the Senate, with Harris breaking the tie, would produce a larger increase in the budget deficit than otherwise. Stocks would have to discount the tax hike but they would recover quickly on the prospect of combined monetary and fiscal ultra-dovishness. Fiscal Impasse Prolonged Biden plus a Republican Senate is positive for the US corporate earnings outlook over the 24 months between now and the 2022 midterm election. It is also positive for the global earnings outlook over the four-year period due to the drastically reduced odds of a global trade war. But it is negative in the near term because it will result in a smaller and delayed fiscal relief package – and sooner than later the market will need a signal that the government will not pull the rug out from under the recovery. Biden plus a GOP Senate is negative in the near term due to fiscal risks but positive beyond that. True, the US economy continues to bounce back rapidly, which is why the Republicans performed so well in this election despite a recession, a pandemic, and a failure to pass another round of stimulus beforehand. In October the unemployment rate fell to 6.9%. Yet previous rounds of fiscal support are drying up. The job market is showing some signs of underlying weakness and these will worsen as long as benefits run out and COVID-19 cases discourage economic activity (Chart 6). Personal income has dropped off from its peak when the first round of stimulus was passed in March. Without the dole it will relapse (Chart 7). Chart 6US Job Market Weakening Sans Stimulus US Job Market Weakening Sans Stimulus US Job Market Weakening Sans Stimulus Chart 7US Personal Income Will Drop Sans Stimulus US Personal Income Will Drop Sans Stimulus US Personal Income Will Drop Sans Stimulus Will Senate Republicans agree to a fiscal deal in the “lame duck” session before the new Congress sits on January 3? We have no basis for a high-conviction view. They might agree to a deal in the range of $500 billion to $1 trillion, but only if the Democrats come down to these levels in the talks. Senate Majority Leader Mitch McConnell is one of the big winners of the election. He held his seat and likely maintained Republican control of the Senate without capitulating to House Speaker Nancy Pelosi’s demands of a $3 trillion-plus relief bill. He wagered that Republicans would do better with voters if they concentrated on reopening the economy (and confirming Amy Coney Barrett to the Supreme Court) while limiting any fiscal bill to targeted COVID response measures. He drew a hawkish line against broad-based social spending and bailouts for state and local governments. The gambit appears to have worked. House Democrats, far from gaining seats, lost five. We would not be surprised if Pelosi were replaced as speaker in 2021. Her plan backfired so badly that if Trump had stayed on message in his campaign, he might even have won. The implication is that unless Pelosi comes down to McConnell’s number, the fiscal impasse will extend into January and February. The American public approves of fiscal relief, but that did not force McConnell’s hand earlier, as the economy was recovering regardless (Table 2). Unless the economy slumps or financial markets selloff drastically, he will likely insist on a skinny deal that includes liability protections for businesses while minimizing bailouts for indebted blue states. Table 2Americans Support Fiscal Stimulus Package Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Hence investors are likely to get bad news before good news on the US fiscal front. And if other bad news arises, the absence of fiscal support will be sorely felt. This motivates our tactically defensive posture until the fiscal impasse is resolved. Peak Polarization Polarization is at peak levels in the US and the election result suggests it will remain elevated. Whichever party wins will win with a narrow margin. There is simply no commanding mandate for either party, as has been the case this century, so the struggle will continue (Chart 8). Chart 8Polarization Will Continue With Narrow Margins Of Victory Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Of course, polarization may subside temporarily, assuming Trump loses. At least under Biden the Electoral College vote will coincide with the popular vote, improving popular consent. Biden will have a lower disapproval rating, probably throughout his term. High disapproval tends to coincide with crises in modern US history, but in 2021, after the dust clears from this election, the country may catch its breath (Chart 9). Chart 9Presidential Disapproval Will Fall Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Much will depend on whether the presumed Biden administration is willing to sideline the left-wing of the Democratic Party to court the median voter. Exit polling in the swing states strongly suggests that the Biden administration won the election (if indeed it did) by improving Democratic support among the majority white population, non-college educated voters, and senior citizens, all groups that delivered Trump the victory in 2016. The Democrats had mixed results among ethnic minorities and suburban voters. Their biggest liability was their focus on issues other than the economy (Chart 10). Chart 10Exit Polls Say Focus On Bread And Butter Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Over the coming decade we think the combination of (1) cold war with China and (2) generational change on fiscal policy will produce a new national consensus. But we are not there yet. The contested election is not guaranteed to end amicably. If Trump wins on a technicality, the country will erupt into mass protests; if he loses and keeps crying stolen election, isolated domestic terrorist incidents are entirely possible. Moreover the battle over the 2020 census and redistricting process will be fierce. Democrats will be hungry to take the Senate in 2022, failing Georgia in January, to achieve major legislative objectives while Biden is in office. And the 2024 election will be vulnerable to the fact that Biden may have to bow out due to old age, depriving the Democrats of an incumbent advantage. The bottom line is that Republicans outperformed and will not be inclined to help the Biden administration start off on strong footing. The implication is the fiscal battle will extend into the New Year unless a stock market selloff forces Republicans to compromise. Fiscal cliffs will be a recurring theme until at least the 2022 election. A deflationary tail risk will persist. Obama’s Legacy Secured? The sole significance of a gridlocked Biden presidency will lie in regulatory affairs, foreign policy, and trade policy. These are the policy areas where presidents have unilateral authority and Biden can act without the Senate’s approval. In this context, Biden’s sole focus will be to consolidate the legacy of the Barack Obama administration, in which he served. 1. Obamacare (ACA): Republicans failed to repeal and replace this bill despite a red sweep in 2016. Biden’s election ensures that Obamacare will be implemented, if not expanded, as he will have the power to enforce the law at the executive level. The risk is that the conservative-leaning Supreme Court could strike it down. Based on past experience, the health care sector will benefit from the drop in uncertainty once the court’s decision is known (Chart 11). For investors the lesson of the past four election cycles is that Obamacare is here to stay, but Americans will not adopt a single-payer system until 2025 at the earliest conceivable date. We are long health equipment and see this outcome as beneficial to the health sector in general, particularly health insurance companies. Big Pharma, however, will suffer from bipartisan populist pressures to cap prices. 2. Iran Nuclear Deal (JCPA): Biden will seek to restore Obama’s signature foreign policy accomplishment, the Joint Comprehensive Plan of Action, i.e. the Iran nuclear deal of 2015. The purpose of the deal was to establish a modus vivendi in the Middle East so that the US could “pivot to Asia” and focus its energy on the existential strategic challenge posed by China. Biden will stick with this plan. The Iranians also want to restore the deal but will play hard to get at first. Israel and Saudi Arabia could act to thwart Iran and tie Biden’s hands in the final three months of Trump’s presidency while they have unmitigated American backing. Chart 11Obamacare Preserved Obamacare Preserved Obamacare Preserved The implication is that Iranian oil production will return to oil markets (Chart 12), but that conflict could cause production outages, and Saudi Arabia could increase production to seize market share. Hence price volatility is the outcome, which makes sense amid fiscal risks and COVID risks to demand as well. 3. The Trans-Pacific Partnership (CPTPP): Biden claims he will “renegotiate” the Trans-Pacific Partnership, which was the Obama administration’s key trade initiative. The idea was to group like-minded Pacific Rim countries into an advanced trade deal that addressed services, the digital economy, labor and environmental standards, and pointedly excluded China. Trump withdrew from the deal out of pique despite the fact that it served the purpose of diversifying the American supply chain away from China. The impact of rejoining is miniscule from an economic point of view (Chart 13), but it will be a boon for small emerging markets like Mexico, Chile, Vietnam, and Malaysia. Chart 12Restoring The Iran Nuclear Deal Restoring The Iran Nuclear Deal Restoring The Iran Nuclear Deal Chart 13Rejoining The Trans-Pacific Partnership Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization The bigger takeaway is that Biden will continue the US grand strategic shift toward confronting China, which will be a headwind toward Chinese manufacturing and a tailwind for India, Latin America, Southeast Asia. The US will cultivate relations with the Association of Southeast Asian Nations (ASEAN) as a more coherent economic bloc and a manufacturing counterweight to China (Chart 14). A lame duck Trump will  attempt to cement his legacy by targeting China/Taiwan, Iran, North Korea, or Big Tech. When it comes to on-shoring, Biden’s focus will be reducing dependency on China and improving the US’s supply security in sensitive areas like health and defense. Trade and strategic tensions with China will persist, but a global trade war is not in the cards. Manufacturing economies ex-China stand to benefit. 4. The Paris Climate Accord: Biden will not be able to pass his own version of the Green New Deal without the Senate, so investor excitement over a government-backed surge in green investment will subside for the time being (Chart 15). He will also moderate his stance on the energy sector after his pledge to phase out oil and gas nearly cost him the election. He was never likely to ban fracking comprehensively anyway. Chart 14ASEAN's Moment ASEAN's Moment ASEAN's Moment Biden will be able to rejoin the international Paris Agreement and reverse President Trump’s deregulation of the energy sector. He will re-regulate the economy to lift clean air, water, environment, and sustainability standards. This is a headwind for the energy sector, but stocks are already heavily discounted and congressional gridlock is a positive surprise. Chart 15Returning To The Paris Climate Accord Returning To The Paris Climate Accord Returning To The Paris Climate Accord There may be some room for compromise with Senate Republicans when it comes to renewables in a likely infrastructure package next year. Post-Trump Republicans may also be interested in Biden’s idea of a “carbon adjustment fee” on imports, which is another way of saying tariffs on Chinese-made goods. Like the health care sector, the election is tentatively positive for US energy stocks – especially once fiscal risks are surmounted. Investment Takeaways Chart 16Lame Duck Trump Risk: Taiwan Strait Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Three near-term risks prevent us from taking a tactically risk-on investment stance. First, the contested election, which could still throw up surprises. Second, the fiscal stimulus impasse, which could persist into January or February and will reduce the market’s margin of safety in the event of other negative surprises. Third, a lame duck Trump will attempt to cement his legacy via executive orders. He could target China/Taiwan, Iran, North Korea, or even Big Tech. On China, Trump is already tightening export controls on China and selling a large arms package to Taiwan (Chart 16). The lame duck period of any presidency is a useful time for the US to advance strategic objectives. Trump will also blame China and the coronavirus for his defeat. He could seek reparations for the virus, restrictions on Chinese manufacturing and immigration to the US, export controls or sanctions on tech companies, secondary sanctions over Iran or North Korea, delisting of Chinese companies listed in the US, sanctions over human rights violations in China’s autonomous regions, or travel bans on Communist Party members. During these three months, Big Tech will face crosswinds – risks from Trump, but opportunities from gridlock. Polarization has helped support US equity and tech outperformance over the past decade. Frequent hold-ups over the budget in Congress weigh on growth and inflation expectations, thus favoring growth stocks and tech. Internal divisions have prompted the US to lash out abroad, increasing risks to international stocks and driving safe-haven demand into the dollar and tech. More broadly the second wave of the pandemic is a boon for tech earnings and Biden will restore the Obama administration’s alliance with Silicon Valley. But tech is already priced for perfection and this favorable trend will be cut short when COVID restrictions ease and Biden works out a compromise with the Senate GOP over stimulus and the budget (Chart 17). Beyond these near-term risks, we have a constructive outlook for risk assets over the next 12 months. Chart 17Biden, Peak Polarization, And Big Tech Biden, Peak Polarization, And Big Tech Biden, Peak Polarization, And Big Tech Chart 18Global Stocks, Cyclicals Benefit When US Fiscal Impasse Resolved Global Stocks, Cyclicals Benefit When US Fiscal Impasse Resolved Global Stocks, Cyclicals Benefit When US Fiscal Impasse Resolved Insofar as Biden seeks to restore US commitment to global free trade, and more stable and cooperative relations with allies and partners ex-China, global policy uncertainty should fall relative to the United States. Once near-term fiscal hurdles are cleared, the dollar’s strength can subside and global stocks and global cyclicals can start to outperform (Chart 18). Chart 19Trump An Exclusively Commercial President Trump An Exclusively Commercial President Trump An Exclusively Commercial President We also favor stocks over bonds on a strategic horizon. Trump was an exclusively commercial president whose approval rating had a tight correlation with the stock-to-bond ratio (Chart 19). A surge in stocks would help power Trump’s approval. This relationship is not standard across presidents. But it does make sense during periods of policy change that affect earnings. Trump’s tax cuts are the best example. Equities outpaced bonds in anticipation of tax cuts in 2017. Trump’s approval rating recovered once the bill was passed. President Obama’s approval rating also correlated somewhat with the stock-to-bond ratio during the critical fiscal cliff negotiations under gridlock from 2010-12. Once Biden works out a compromise with GOP Senators, bond yields will rise and stocks will power upward. The takeaway from these points is that volatility can remain elevated over the next 0-3 months (Chart 20). We would not expect it to go as high as in 2000, when the dotcom bubble burst, but Trump’s lame duck maneuvers against China could generate a massive selloff. But this cannot be ruled out. Indeed, Trump’s constraints have almost entirely fallen away regardless of whether he loses or wins. Investors should take a phased and conservative approach to adding risk in the near term. The outlook will brighten up when the president is known, a fiscal deal is reached, and President Trump’s legacy as the Man Who Confronted China is complete. Chart 20Volatility Will Stay Elevated In Short Run Volatility Will Stay Elevated In Short Run Volatility Will Stay Elevated In Short Run Chart 21Go Long Trans-Pacific Partnership Go Long Trans-Pacific Partnership Go Long Trans-Pacific Partnership Given our view that Biden will be hawkish on China, especially amid gridlock at home, we are maintaining our short CNY-USD trade. We also recommend buying a basket of Trans-Pacific Partnership bourses, weighted by global stock market capitalization, on a strategic time-frame to capture what we expect will be Biden’s pro-trade-ex-China policy (Chart 21). Finally, to capture the views expressed above regarding Biden’s likely market impacts, over the short and long run, we will go long US health care relative to the broad market on a tactical basis and long US energy on a strategic basis.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 As things stand, the model overrated the Republicans in Arizona and Georgia as well, though really Georgia looks to be the only state Democrats won that the model gave high odds of staying Republican. If we had used the level rather than the range of Trump’s approval rating – or if we had neglected opinion polling altogether – the model would have called a Biden win.

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

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

Highlights Latin America faces a deep economic contraction and a new surge of social unrest and political unrest. However, the risks are increasingly priced into financial markets – especially if global monetary and fiscal stimulus continue. A looming global cyclical upturn, massive US and Chinese stimulus, a weaker dollar, and rising commodity prices will lift Latin American currencies and assets. Mexico faces lower trade risk and lower political risk. Colombia’s fundamentals are sound and political risk is contained. Chile’s political risk is significant but will benefit from the macro backdrop. Brazil will remain volatile. We are bearish on Argentina. Venezuela’s regime will be replaced before long. Our tactical positioning is defensive on COVID-19 and US political risk, but we see Latin America as an opportunity over the long run. Feature Cracks in the edifice of this year’s global stock market recovery are emerging with COVID-19 cases rebounding and US political risks rising. Emerging markets that rallied earlier this year have fallen back. This includes Latin America, where the pandemic’s per capita death toll is comparable only to Europe and the United States (Chart 1). Latin America is a risky region for investors because the past decade was a lost decade, particularly after the commodity bust in 2014. Poor macro fundamentals, deep household grievances, heavy dependency on commodity prices, and preexisting political polarization and social unrest have weighed on the region’s currencies and government bonds. Latin American equities have underperformed emerging markets over the period (Chart 2). Chart 1Pandemic Adds To Latin America’s Many Woes Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long Chart 2Global Reflation Needed For LATAM To Outperform Global Reflation Needed For LATAM To Outperform Global Reflation Needed For LATAM To Outperform Looking beyond near-term risks, however, global economic recovery and gargantuan monetary and fiscal stimulus hold out the prospect of a sustained recovery in growth and trade, a weakening US dollar, and a boost to commodity prices (Chart 3). This outlook is favorable for Latin American economies and companies. Chart 3Global Stimulus Keeps Up Commodity Prices Global Stimulus Keeps Up Commodity Prices Global Stimulus Keeps Up Commodity Prices In this report, we analyze the coronavirus outbreak and its likely political impact in six Latin American markets: Argentina, Brazil, Colombia, Chile, and Mexico. The crisis is exacerbating the region’s longstanding problems and freezing attempts at supply-side reforms. However, a lot of political risk is already priced, particularly in Mexico and Colombia. Bullish Mexico: Trade War And Leftism Already Peaked As it stands, Mexico has over 740,000 confirmed cases and over 77,000 deaths, with new cases increasing daily (Chart 4). Testing occurs at a rate of 15,300 tests per 1 million people, one of the lowest rates of any major country. Hence the true number of cases is likely well higher than the official count. The health care system is overwhelmed. Chart 4Mexico Not Too Bad On Virus Death Toll Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long The crisis has been a rude awakening for President Andrés Manuel López Obrador (AMLO), but we see Mexico as an investment opportunity rather than a risk. Chart 5Mexico: Left-Wing Unlikely To Outdo 2018 Win Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long AMLO and his National Regeneration Movement (MORENA) swept to power in 2018 as champions of the poor fed up with the country’s corrupt political establishment. Two tailwinds fueled MORENA’s rise: First, the failure of Mexico’s ruling elites. The 2008 financial crisis knocked one of the dominant parties out of power, while the brief comeback of the traditional ruling party (the Institutional Revolutionary Party or PRI) faltered amid the slow-burn recovery of the 2010s. Second, AMLO’s victory was an answer to the populist and protectionist turn in the United States under President Trump, who had vowed to build a wall and make Mexico pay for it as well as to renegotiate NAFTA to be more favorable to the United States. Mexicans voted to fight fire with fire. Neo-liberalism and supply-side structural reform seemed discredited in a blaze of Yankee imperialism and AMLO and his movement offered the only viable alternative. AMLO became Mexico’s first left-wing populist president in recent memory, while MORENA won an outright majority in the Senate and, with its coalition partners, a three-fifths majority in the Chamber of Deputies (Chart 5). From this back story it is clear that investors interested in Mexican assets faced two primary structural risks: (1) a left-wing “revolution,” given AMLO’s lack of legislative roadblocks (2) American protectionism. About 29% of Mexico’s GDP consists of exports to the US (Chart 6). Chart 6Mexico Will Benefit From US Mega-Stimulus Mexico Will Benefit From US Mega-Stimulus Mexico Will Benefit From US Mega-Stimulus Investors took these risks seriously, judging by the relative performance of Mexican energy and industrial equities (Chart 7). Trade war threatened exporters while AMLO aimed to revitalize the moribund state-owned energy company at the expense of foreign investors admitted by his predecessor’s structural reforms Chart 7Investors DisappointedAfter AMLO Election Rally Investors DisappointedAfter AMLO Election Rally Investors DisappointedAfter AMLO Election Rally However, the left-wing revolution threat was always overstated: Mexico has become the largest fiscal hawk in the region under AMLO. Moreover, monetary policy had remained overly tight before the pandemic. Indeed, AMLO’s track record as mayor of Mexico City in the early 2000s showed his penchant for fiscal frugality. His left-wing policies have been focused on reviving the state-owned oil company PEMEX and increasing signature social programs, which have been funded by slashing other government expenditures, even during the COVID-19 outbreak. Going forward, Mexico’s orthodox economic policy is a major positive relative to emerging markets with out-of-control debt dynamics, often exacerbated by populist leaders, such as Brazil (Chart 8). MORENA will face greater constraints going forward. AMLO’s approval rating has normalized at around 60%, roughly the average for Mexican presidents (Chart 9). MORENA’s support rate has fallen from 45% to below 20%. With midterm elections looming in July 2021, MORENA is unlikely to outperform its 2018 landslide. So while AMLO will win his proposed 2021 presidential “referendum,” he will do so with a smaller share of the vote and a weakened parliament. Reality has set in for Mexico’s new ruling party. Chart 8Mexico’s Low Debts A Boon Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long Chart 9AMLO’s Approval Rating Solid, But Normalizing Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long AMLO and MORENA are likely to be chastened but not to fall from power, which means there is unlikely to be a wholesale reversal in national policy. The crisis has killed AMLO’s honeymoon but not his presidency. He still has 60% approval and his term in office lasts until 2024. The main opposition parties are still floundering (Chart 10). The creation of six new parties since 2018 will help MORENA either by adding to its coalition or taking votes away from the opposition. US fiscal stimulus and shift away from China benefit Mexico over the long run. Second, we now know that the US protectionist threat was also overstated: President Trump’s first term demonstrates that even if the US elects a populist and protectionist president who pledges to take an aggressive approach toward Mexico, the ties that bind the two countries will not be easily broken. One of the few times Senate Republicans openly defied President Trump was their refusal in June 2019 to allow sweeping 5%-25% unilateral tariff rates on Mexican imports. Hence even if Trump wins and the GOP retains the Senate, Mexico has some safeguards here. Trump would also be constrained by House Democrats on the issue of building a border wall and reforming the US immigration system. AMLO visited Trump in Washington to sign the USMCA ahead of the election. The trade deal is part of Trump’s legacy so Trump is more likely to attack other trade surplus countries than Mexico. Former Vice President Joe Biden and the Democratic Party are more likely to win the US election. In that case, US policy toward Mexico will turn more dovish. House Democrats helped negotiate the USMCA deal and voted to pass it. Biden is unlikely to impose large tariffs on Mexico. It is still possible that US-Mexico tensions will reignite later, if immigration swells under Biden, but the latter is not guaranteed. Two additional macro and geopolitical factors also play to Mexico’s favor over the long run: First, the US’s profligate fiscal policy will benefit its neighbor and trading partner. Massive American monetary and fiscal stimulus – about to receive another dollop of around $2-$2.5 trillion in new spending – will total upwards of 20% of US GDP in 2020 (Chart 11). This is especially likely in the event of a Democratic clean sweep. Yet Democrats are likely to retain the House, preventing Republicans from slashing spending too much even if they convince Trump to adopt their fiscal hawkishness in any second term. Chart 10MORENA’s Approval Comes Down To Earth Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long Chart 11Mexican Exports Will Benefit From US Stimulus Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long Chart 12US Leaving China Will Boost Mexico Industrialization US Leaving China Will Boost Mexico Industrialization US Leaving China Will Boost Mexico Industrialization Second, the US is leading a global movement to diversify supply chains away from China. This shift is rooted in US grand strategy and began under the Obama administration, and it is highly likely to continue whether Trump or Biden wins. A Biden victory will result in a more multilateral approach that is more beneficial for global trade, but still penalizes China – which is good for Mexico. No country has suffered a greater opportunity cost from China’s industrialization than Mexico (Chart 12). Both Biden and Trump are advertising a policy of on-shoring that will, in effect, benefit US trading partners ex-China. US current account deficits stem from its domestic savings-investment balance and therefore will persist even if China is cut out, driving production elsewhere. Bottom Line: We are optimistic about Mexico. Trade risk from the US is unlikely to rise higher than during 2017-19, while legislative hurdles facing AMLO and MORENA cannot get much lower than they are today. The currency is fairly valued and equities are not too pricey. Gargantuan US stimulus and a shift away from China dependency will boost growth and investment in Mexico. We will look for opportunities to go long the Mexican peso and assets. Volatile Brazil: Fiscal Restraint Is Gone While much of the world is focused on a second wave of Covid-19, Brazil has struggled to hurdle its first. The country has over 4.8 million confirmed cases (23 000 cases per 1 million people), and 143,000 deaths, second only to the United States. Coronavirus testing in Brazil stands at 73,900 tests per 1 million people, i.e. higher than Mexico’s but not enough to paint a complete picture of the virus’ course (Chart 13). The Brazilian government’s response has been chaotic. With a nearly universal health care system, albeit one that is under-funded, Brazil was not as poorly prepared as some countries. However, like his populist counterparts in Mexico and the United States, Bolsonaro chose to prioritize the economy over the virus response. Brazil was one of the few major countries in the world not to impose a national lockdown. The Ministry of Health, consumed with political turmoil, failed to develop a nationwide plan of action.1 Bolsonaro quarreled with governors who imposed state lockdown measures. With conflicting state and federal messages, Brazilians were unsure about the benefits of social isolation, hand washing, and face coverings, leading to a widespread lack of compliance and a major outbreak of the disease. Bolsonaro’s approach has led to some benefits, however, and the government implemented the largest fiscal response in the region at a whopping 16% of GDP. The economy is recovering faster than that of neighboring countries (Chart 14). Bolsonaro’s approval rating has also improved. The polling looks like a short-term “crisis bounce,” but Bolsonaro is now ahead of his likeliest rivals in 2022, including former President Lula Da Silva and former Justice Minister Sergio Moro. The crisis has catapulted Bolsonaro back into the approval range of other Brazilian presidents, at least for the moment (Chart 15). Chart 13Bolsonaro And Trump Prioritize Recession Over Pandemic Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long Chart 14Bolsonaro's Economy Roaring Back Bolsonaro's Economy Roaring Back Bolsonaro's Economy Roaring Back All eyes will next turn to the municipal elections slated for November 15, 2020. The first elections since Bolsonaro came to power will be a test of whether the left-wing opposition can recover. One of the key pillars of Bolsonaro’s political capital was the collapse of the Worker’s Party after the economic crisis and Car Wash corruption scandal of the 2010s. The local government election will also reflect public views of the pandemic. Local governments are important when it comes to combating COVID-19. On April 15, Brazil’s Supreme Federal Court gave them the power to set quarantine restrictions and rules with regard to public transit, transport, and highway use. They are in charge of utilizing numerous rounds of aid from the federal government to mitigate the health and economic effects of the virus. Many have rejected Bolsonaro’s cavalier attitude, imposed stricter health measures, and established local teams comprised of medical professionals, public officials, and private donors to monitor the outbreak. If the Worker’s Party fails to recover from the shellacking it suffered in Brazil’s local elections in 2016, then Bolsonaro’s polling bounce would be reinforced and his administration would get a new lease on life. The opposite is also true: a strong recovery will undercut his political capital, especially because it is still possible that Da Silva will be cleared of corruption charges and capable of running for office in 2022. Bolsonaro also faces a test on another pillar of his political capital: the fight against corruption. A criminal investigation of the administration emerged after the resignation of popular justice Minister, Sergio Moro, who accuses the president of wrongdoing. There is an additional pending investigation for his team’s use of “fake news” during the 2018 campaign, which many deem illegal. So far, however, talk of impeachment has not hurt the president. Only about 46% of Brazilians support impeachment (Chart 16), which is not enough to get him removed from office. Any future impeachment push will depend on the following factors: Chart 15Bolsonaro Enjoys Popularity Boost Amid Pandemic Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long Chart 16Nowhere Near Enough Support For Bolso Impeachment Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long First, the president has allied with an alliance of center-right parties, called the Centrao, that controls 40% of seats in the Chamber of Deputies and has played a historic role in the rise and fall of Brazilian presidents (Chart 17). The Centrao can shield Bolsonaro from impeachment just as its opposition ultimately led to former President Dilma Rousseff’s removal in August 2016. By the same token, if these allies turn on him, removal will become the likely outcome. Second, powerful politicians like House Speaker Rodrigo Maia are reluctant to impeach because it would add “more wood in the fire,” i.e. worsen political instability. It would be bad politics for the impeachment directors as well. But this could change. The other two pillars of Bolsonaro’s political capital are law and order and structural economic reform. Bolsonaro has maintained his law-and-order image through cozy relations with the military, as well as through a slight decline in homicides (Chart 18). Chart 17Brazil: Presidential Parties Small, Need Support From ‘Centrists’ Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long Chart 18Bolsonaro's "Law And Order" Message Works So Far Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long Structural reform is the critical factor for investors, but the crisis has slowed the reform agenda, particularly on the fiscal front. The main way for Brazil to reform is to reduce the size of government. The government takes up a large share of national output, comparable to Argentina, and public debt is soaring. The country was already hurtling toward a sovereign debt crisis prior to COVID-19 (Chart 19). Bolsonaro’s signature legislative achievement, pension reform, has done little to arrest this trajectory, as it was watered down to gain passage and then the pandemic wiped out the fiscal gains. Ironically, Bolsonaro’s improved popularity is negative for fiscal consolidation, since it will encourage him to play the populist ahead of the 2022 election. Pension reform was never popular and passing it did nothing to boost Bolsonaro’s approval rating. On the contrary, his approval began to rise when the pandemic struck and he loosened fiscal policy. Going forward he will need to maintain fiscal spending to rebuild the economy. He is already jeopardizing Brazil’s key fiscal rules. As for the election, Brazil always increases government spending in the year before and year of a presidential election, as all parties hope to buy votes (Chart 20). Chart 19Brazil's Fiscal Crisis Accelerates Brazil's Fiscal Crisis Accelerates Brazil's Fiscal Crisis Accelerates Chart 20Brazil Cranks Up Spending Ahead Of Elections Brazil Cranks Up Spending Ahead Of Elections Brazil Cranks Up Spending Ahead Of Elections The implication is that any fiscal hawkishness will have to wait until Bolsonaro’s second term. Of course, if Bolsonaro loses the vote, left-wing parties may return to power and fiscal profligacy will be the order of the day. So investors do not have a good prospect for fiscal consolidation anytime soon, barring a successful candidacy by the aforementioned Moro on a reformist and anti-corruption ticket. Fiscal expansion and loose monetary policy are positive for domestic demand initially but negative for the out-of-control debt profile and hence ultimately the currency and government bond prices over the long term. Outside Brazil, geopolitical conditions are reasonably favorable. If Trump wins, Bolsonaro’s right-wing populism will gain some legitimacy and he may be able to negotiate good trade relations with the United States. If Trump loses, Bolsonaro will become politically isolated, but Brazil will benefit economically, as Joe Biden is friendlier to global trade than Trump. Brazil’s trade openness has grown rapidly, one area of reform that will continue. China is also interested in closer relations with Brazil as it faces trade conflict with the US and Australia. If Trump wins, Bolsonaro benefits from further Chinese substitution away from the United States. If Trump loses, Beijing will not return to former dependencies on the United States. Also, while China cannot substitute Brazil for Australia entirely, it is likely to increase imports from Brazil on the margin (Chart 21). Chart 21Brazil Benefits If China Diversifies From US And Oz Brazil Benefits If China Diversifies From US And Oz Brazil Benefits If China Diversifies From US And Oz Chart 22Brazilian Political Risk Down From 2015-16 Peak Brazilian Political Risk Down From 2015-16 Peak Brazilian Political Risk Down From 2015-16 Peak Ultimately Brazil is a country filled with political risk due to extreme inequality and indebtedness. But as long as the global economy and commodity prices recover, Bolsonaro will be able to ride the wave and short-term political risks will continue to subside from the extremely elevated levels of 2016 (Chart 22).   Bottom Line: Bolsonaro’s popularity bounced in the face of the national crisis. Local elections in November are an important barometer of whether his administration and its neoliberal structural reform agenda can survive beyond 2022. Either way, fiscal consolidation is on hold prior to the 2022 election. We are long Brazilian equities as a China play, but the outlook is ultimately negative for the currency. Bearish Argentina: Peronism Restored Argentina has 751,000 cases of coronavirus (16,800 cases per 1 million people) and about 16,900 deaths. Testing stands at 41,700 test per 1 million people. After the federal government eased quarantine restrictions and began reopening most of the country on June 7, total cases followed the general trend of the region (Chart 23). Chart 23Argentina’s COVID-19 Suppression Losing Steam Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long Despite early measures to flatten the curve, Argentina lacks hospital beds, doctors, and medical supplies, especially in the capital of Buenos Aires where 88% of the country’s confirmed cases are found. The coronavirus has exposed stark differences between the rich and poor in terms of access and quality of health care, with about a third of the population uninsured. Politically secure, Fernandez has prioritized the medical crisis over the economy, imposing some of the world’s strictest lockdown measures in mid-March and declaring a one-year national health emergency – the first country in Latin America to do so. However, Argentina’s multi-decade economic mismanagement and recent policy vacillations mean that the crisis came at a bad time. Argentina has been in a deep recession for over two years, with skyrocketing inflation and peso devaluation, excessive budget deficits and external debts, and a 10% poverty rate in 2018 (Chart 24). Former President Mauricio Macri’s badly needed but ultimately failed attempt at supply-side reforms resulted in an economic collapse that saw the left-wing Peronist/Kirchnerista faction regain power in 2019. Argentina’s fiscal problems will continue on the back of populist economic unorthodoxy. Sovereign risk has temporarily fallen. Argentina received a $300 million emergency loan from the World Bank and another $4 billion loan from the Inter-American Development Bank. The country has defaulted on sovereign debt nine times, but the Fernandez government reached a deal with its largest creditors to restructure $65 billion in early August. The government agreed to bring some debt payments forward, thus buying itself immediate debt relief. It now has a little more than five years until the debt pile’s biggest wave of maturities comes due (Chart 25). Chart 24Poverty Rates Spike Amid Crisis, Including In Argentina Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long Chart 25Argentina's Sovereign Risk Will Rise From Here Argentina's Sovereign Risk Will Rise From Here Argentina's Sovereign Risk Will Rise From Here This deal will give President Fernandez a significant boost. He took office in December 2019 so he has time to ride out the crisis before facing voters again in 2023. However, his reliance on populist economic unorthodoxy ensures that Argentina’s fiscal problems will continue. Consider the following: Before Covid-19, in an attempt to regain credibility among international lenders, Fernandez appointed Martin Guzman, as Minister of Economy. Guzman is an academic and a disciple of American Nobel-prize winner Joseph Stiglitz, but has little policy-making experience. Fernandez pushed an Economic Emergency Law through Congress, giving him emergency powers to renegotiate debt terms and intervene in the economy. He re-imposed import-substitution policies, such as large tax increases on agricultural exports, currency controls, and utility price freezes. In Fernandez’s inauguration speech, he justified a return to leftist policies by saying, “until we eliminate hunger we will ask for greater solidarity from those who have more capacity to give it.” This is a traditional trap for Argentina which results in worse economic outcomes over the long run. Chart 26Argentina’s Government Scores Well In Opinion Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long Fernandez’s government has increased fiscal spending on food aid and other safety nets for the unemployed and furloughed. It has required banks to give out loans at reduced interest rates. Initially it pledged 2% of GDP to social and welfare relief programs, but that number has risen since the onset of the pandemic. For now, Fernandez has considerable political capital. The crisis will wipe out the memory of the Kirchneristas’ previous failings. Social spending is now flowing to Fernandez’s political base and the informal sector of the economy, which accounts for almost half of all Argentine workers. Public support for Fernandez has remained strong through the economic woes and pandemic, with his approval rating at around 67%. Over 80% of people polled have confidence in the government’s handling of the virus (Chart 26), according to opinion polls. Profligate spending will likely continue beyond the cyclical demands of the current crisis, adding to Argentina’s unsustainable debt profile. When the pandemic subsides, international lenders will be less willing to extend credit to Argentina and invest, given their record of default and high tax rates. International companies and even small caps have fled the country due to its draconian currency controls. Bottom Line: Argentina has witnessed a fall in uncertainty but going forward political risk will revive. Populist Kirchnerista policies do not create productivity improvements or reduce debt, and the country’s macro fundamentals will underperform in the long run. RIP Venezuela: The Final (Final) Nail In The Coffin For years, Venezuela has suffered an economic crisis with high levels of unemployment, hyperinflation, and mass shortages of food, medical supplies, and even gasoline. Many citizens claim they’re more likely to die from starvation than the coronavirus. Out of the country’s 47 hospitals that are supposedly dedicated to COVID-19, only 57% have a regular water supply, while 43% have a shortage of PPE kits for medical staff and practitioners. Nicolas Maduro – the hapless successor to Hugo Chavez – declared a state of emergency and implemented a nationwide and long-lasting lockdown, enforced by police. The government issued a unique “7 + 7” plan, where strict lockdowns are imposed for seven days, relaxed for another seven days, re-imposed, and so on. Nevertheless, cases have been increasing. Over time the crisis in Venezuela has forced around five million Venezuelans, including skilled workers and medical doctors, to leave the country (Chart 27). Spillover effects are straining neighboring Colombia, which has taken in 1.5 million of the refugees, and Brazil. Although thousands of Venezuelans have returned home during the pandemic, the massive movements will only make the virus more prevalent. In early June, Maduro reopened borders with Colombia after closing them in February when opposition leader (and rival claimant to the presidency) Juan Guaidó tried to import foreign aid. Maduro denied that Venezuela is in humanitarian crisis and warned against a coup d'état by the United States. The political opposition is stymied for now. In January 2019, Guaidó declared himself president of Venezuela over Maduro, whose government has circumvented the constitutional system since losing the parliamentary election of 2015. Guaido receives broad support from the international community, including Europe and the United States, while Maduro is backed by China, Russia, and Iran. Over 18 months later, Guaidó wields nearly no power at home and Maduro remains in place with the army’s top generals still backing him. However, the Trump administration has expanded sanctions throughout its term. Maduro is unable to access international financing from the IMF, after requesting an emergency $5 billion loan to combat COVID-19, partly due to US opposition. Food prices in Venezuela have risen 259% since January. Low worldwide demand for oil – representing 32% of Venezuelan GDP – means the last leg of the economy has weakened. The government has little room to maneuver fiscally or otherwise combat the virus. Maduro has used the crisis to strengthen his domestic security grip. The military, police, and revolutionary militias are enforcing lockdowns to thwart demonstrations. The opposition is divided, with Guaidó now quarreling with former opposition leader Henrique Capriles over whether to contend the parliamentary elections on December 6. The elections will inevitably be rigged; but to boycott them is to allow Maduro officially to retake the key constitutional body that he lost (and then sidelined) back in 2016. Nevertheless, the material foundations of the country have long collapsed (Chart 28). The pandemic and recession will ultimately prove the final (final, final) nail in the coffin. The military is ruling from behind the scenes but will not want to jeopardize its own status when the Bolivarian revolution is finally abandoned. The timing of this denouement is, as always, anybody’s guess. Chart 27Venezuela’s Refugees Show State Collapse Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long Chart 28Venezuela's Regime Cannot Survive Venezuela's Regime Cannot Survive Venezuela's Regime Cannot Survive   Bottom Line: President Trump will maintain maximum on Maduro and Venezuela as long as he is in office. The regime will struggle to survive long enough to enjoy the benefits of the commodity price upswing next year. Whenever Maduro falls, the prospect of an eventual resuscitation of oil production will open up. Bullish Colombia: Political Risk Contained (For Now) Chart 29Colombia Flattened The Curve Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long The Colombian government responded swiftly to COVID-19. President Ivan Duque shut seven border crossings with Venezuela, declared a state of emergency, and imposed lockdown measures in mid-March. The measures have been stringent and extended. The effect on the spread of the disease is discernible compared to Colombia’s neighbors (Chart 29). The city of Medellin, with 2.5 million residents and only 2,399 coronavirus deaths, became the best-case scenario for combating the virus. Through the use of an online app, the city government connected people with money and food, while obtaining important data to track cases. Despite the lockdowns, fiscal policy has been tight. True, the government provided payroll subsidies for formal and informal workers unable to work during lockdowns.2 But government spending as a whole is limited (Chart 30). This is positive for the country’s currency and government bonds but will exacerbate political tensions later. Chart 30Colombia's Fiscal Hawkishness Good For Currency, But Will Spur Opposition Colombia's Fiscal Hawkishness Good For Currency, But Will Spur Opposition Colombia's Fiscal Hawkishness Good For Currency, But Will Spur Opposition Duque’s approval ratings were low back in February (23%) but nearly doubled when the crisis struck (Chart 31). However, they have since fallen back to around 40% and high unemployment and fiscal restraint will challenge his government in coming years. Chart 31Colombia’s President Struggling, But Has Time To Recover Pre-Election Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long Colombia is relatively politically stable but tensions are building beneath the surface that will challenge the country’s recent improvements in governance and the 2016 peace deal. On August 4, former President Alvaro Uribe was put under house arrest by a section of the Colombian Supreme Court amid an investigation on witness tampering. He was the first ex-president to be detained in Colombia’s history. Subsequently he resigned from the Senate to obtain better treatment at the hands of the more friendly Attorney General’s office. Uribe is powerful. He created Centro Democratico, which is the largest party in the Senate and the second largest in Congress. He also hand-picked President Duque. His case will continue to be a source of political polarization. Right-leaning factions have not yet convinced moderates to oppose the country’s UN-backed 2016 peace deal, which ended decades of fighting between government forces and the Revolutionary Armed Forces of Colombia (FARC), the leading rebel group. If that changes, then domestic security will decline and investor sentiment will decline at least marginally. Colombia’s political polarization will be contained by Venezuela’s collapse – as long as the economy recovers. In the wake of the oil bust in 2014, Colombia saw the left-wing factions unite around a single candidate – Gustavo Petro, an ex-guerilla – who challenged the conservative establishment in the 2018 election, pledging to tackle inequality. Petro was soundly defeated, giving markets reason to cheer. Now, however, inequality is combining with a deep recession, austerity, and the potential for a failed peace process to challenge the conservatives in 2022. Table 1Latin America Is Vulnerable To Social Unrest Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long Chart 32MXN, COL, And CLP Outperform While BRL Lags MXN, COL, And CLP Outperform While BRL Lags MXN, COL, And CLP Outperform While BRL Lags The saving grace for the conservatives will likely be the global cyclical upswing, combined with Venezuela’s collapse continuing to unite the right and divide the left. However, the Uribe faction’s dominance is getting long in the tooth and Colombia is vulnerable to social unrest based on our COVID-19 Unrest Index (Table 1). The election is not all that soon. The Colombian peso is still relatively cheap and yet has outperformed other emerging market currencies due to the strong COVID-19 response and the oil rally (Chart 32). Bottom Line: Tight fiscal policy combined with a strong pandemic response – and the recovery in oil prices – will benefit the Colombian peso. Equities are attractively valued. Political risk will build as the 2022 election draws closer, however. Volatile Chile: Tactical Buys Hinge On Politics, China Chile has been a hotspot for the coronavirus. Its lackluster response to the pandemic is fanning the embers of the social unrest that erupted last year. Unrest is tied to a larger political crisis unfolding over the constitutional order, which evolved from the 1980 constitution of dictator Augusto Pinochet. Chile is transitioning from a neoliberal economic model to a welfare state, as Arthur Budaghyan and Juan Egaña of BCA’s Emerging Markets Strategy showed in an excellent special report last year. This transition raises headwinds for an currency, equities, and government bonds. The Chilean government, led by President Sebastián Piñera, declared a state of emergency in March and boosted health care spending throughout the country. The government also passed numerous emergency relief packages to small businesses, workers of the informal economy, and local governments. However, high levels of poverty and overcrowding, especially in the capital of Santiago, have hindered efforts to contain the coronavirus (Chart 33). The government imposed strict lockdowns, including a nationwide increase in police and up to five-year prison penalties for violating quarantines. The political opposition argues that Piñera’s extension of the “state of catastrophe” has allowed him to use emergency powers to restrict citizens’ rights in the name of curbing the pandemic. His approval rating has fallen beneath 22% while popular disapproval has surged above 68% (Chart 34). Chart 33Chile’s Handling Of COVID-19 Largely Successful Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long Chart 34Chile’s Govt Embattled Amid Constitutional Rewrite Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long Chart 35Chile: Inequality Falling, But High Level Still Sparks Unrest Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long Chile was already a tinderbox before the pandemic. Beginning with a small hike to subway fares in Santiago in October 2019, pent-up social grievances erupted against the country’s elite. Protests have continued even during lockdowns and morphed into demands for broader social reform (Chart 35). Chile's top rank on our COVID-19 Social Unrest Index belies the fact that it has high wealth inequality, a threadbare social safety net, high debt levels, and now higher unemployment (Table 1). Table 1Latin America Is Vulnerable To Social Unrest Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long In a concession to protesters, the Piñera administration agreed to revise the constitution. A popular referendum will be held on October 25, though it has already been delayed once. The referendum will determine whether to hold a direct constitutional assembly, whose members are drawn from the population as a whole, or a mixed constitutional assembly, in which congress takes up half of the seats. The latter is the more conservative option; the former is more progressive and will deepen political polarization as the political establishment will resist it (Chart 36). The process to revise the constitution is supposed to last until the end of 2022 but it could drag on longer. Moreover it will be complicated by presidential and legislative elections slated for November 2021. The timing of these events ensures that short-term partisan factors will have a major impact on constitutional revision, which bodes ill for resolving structural political problems. The Piñera administration’s goal is to pacify the protesters with some reforms, thus winning his party re-election, while preserving key elements of the current political establishment. But the pandemic has made it harder to do this, requiring either greater government concessions or a new round of unrest. The implication is that political risk will remain elevated over the next few years. Political risk will thus undermine good news on the macro front, including the peso’s strong performance this year so far (Chart 32 above). Of course, there are positive macro factors countervailing this political risk. One of which is China’s recovery. Beijing accounts for 51% of global copper demand, and Chile provides 28% of mine supply, and China is stimulating aggressively. Chilean exports track even more closely with China’s credit impulse than those of other Latin American economies (Chart 37). Chart 36COVID-19 Unrest Index: If Chile Faces Unrest, Then All Latin America Faces Unrest Latin America: Get Ready To Go Long Latin America: Get Ready To Go Long However, the market has partly priced China’s boost whereas Chile’s political risk will erupt again soon. With regard to the US election, Chile stands to benefit from a Democratic victory that improves the outlook for China’s economy and global trade. Like Peru, Chile is a member of the CPTPP and stands to benefit if Biden is elected and eventually rejoins this pact. Chart 37Chile Constitutional Battle Will Increase Political Risk Chile Constitutional Battle Will Increase Political Risk Chile Constitutional Battle Will Increase Political Risk   Bottom Line: A secular rise in domestic political risk as the country is pressured to expand the social safety net is a negative factor for the peso and stock market that will weigh on its otherwise positive macro backdrop. Investment Takeaways The above review reveals some common threads. First, the last decade has not led to lasting neoliberal reforms or major strides in promoting productivity. Attempts at supply-side structural reform have been modest or have failed entirely in Argentina, Brazil, Chile, and Mexico. Colombia’s attempt at a peace deal may falter. Venezuela is a failed state. Second, populism, whether left-wing or right-wing, entails that most governments will pursue economic growth at any cost. Fiscal hawkishness has been put on pause, with the exception of Mexico and Colombia, where it will benefit the currencies. Near-term risks abound in Q4 2020 but the long term is favorable for Latin American financial assets due to global reflation. China is stimulating its economy aggressively. US sanctions will weigh on China, but it will need to stimulate more in response to maintain internal stability. This will boost commodity prices. The dollar will eventually weaken as global growth recovers, the Fed avoids raising rates, and the US maintains large twin deficits. This is ultimately true even if Trump is re-elected. A weaker dollar helps commodities and Latin American countries with US dollar debts. All things considered, Mexico and Colombia will come out looking the best, but we will also look for opportunities when discounts on Chilean assets become excessive. The US’s secular confrontation with China over trade tensions holds out the prospect of Latin American markets reversing their long equity underperformance relative to Asian manufacturers (Chart 38). Latin American manufacturers like Mexico will benefit from American trade diversification. If the US joins the CPTPP, then Chile and Peru will also benefit. Metals producers like Chile will benefit most from China’s stimulus. Chart 38China's Stimulus A Boon For Latin America China's Stimulus A Boon For Latin America China's Stimulus A Boon For Latin America   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Daniel Kohen Consulting Editor Footnotes 1 The Ministry of Health exemplifies growing fractures across the administration. In mid-May, the Health Minister (Nelson Teich) resigned just four weeks into the job, after Bolsonaro fired the previous one (Luiz Henrique Mandetta) for defending lockdown measures imposed by some mayors and governors. 2 There are about 1.8 million Venezuelan refugees in Colombia. They rely on the informal work, with many falling back into poverty as a result of the mandatory quarantines.

Highlights Senate Republicans would be suicidal not to agree to a fiscal relief bill before the election. Democrats are still offering a $2.2 trillion package. Grassroots Republican voters will forgive Republicans for blowing out the budget deficit but they will never forgive them for throwing away control of the White House and Senate. Nevertheless financial markets face more downside until a deal is reached. We are booking gains on several of our tactical risk-off trades but will hold our strategic risk-on trades, as we are still constructive over a 12-month period. Turkey is stepping back from its foreign adventurism in the face of constraints. Our GeoRisk Indicator for Turkey has rolled over. Feature Financial markets continue to sell off in the face of a range of risks, including new threats of COVID-19 restrictions in Europe, an increase in daily new cases of the disease in the United States (Chart 1), and the US Congress’s problems passing a new round of fiscal relief. Chart 1Increase In COVID-19 Cases Among Factors Weighing On Markets Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 2Congress Will Pass Stimulus ~$2-$2.5 Trillion Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Since May, when the Democrats passed the $3.4 trillion HEROES Act, we have maintained that “stimulus hiccups” would roil the market. However, we also argued that Congress would eventually pass a new package – probably in the range of $2-$2.5 trillion (Chart 2).1 The latter part of this view remains to be seen and has come under pressure from investors who fear that Congress could fail to produce a bill entirely. We are sticking with our guns. GOP senators will recognize that they face sweeping election losses; House Democrats will not be able to reverse course and deprive households of badly needed assistance. However, stock investors might sell more between now and the final deal, which must be done by around October 9 so that lawmakers can go back to their home states to campaign for the November 3 election. Moreover the fiscal deal might not come in time to save the Republicans’ re-election bid in the White House and Senate, which raises further downside risk due to the Democratic agenda of re-regulation and tax hikes. And the election’s aftershocks could also be market-negative. For example, President Trump could also escalate the conflict with China, whether as the “comeback kid” or as a lame duck. Therefore this week we are booking some gains. We will not recommend a tactical risk-on position until our fiscal view is confirmed and we can reassess. US Fiscal Stimulus Is Coming Chart 3Republicans Highly Unlikely To Win House Of Representatives Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Why would Democrats agree to a stimulus bill given that it could help President Trump and the Republicans get re-elected? Democrats are afraid to deprive households of relief amid a crisis merely to spite the president and score election points. Around 28-43 of Democrats in the House of Representatives face re-election in districts that are competitive or could become competitive. Republicans need a net gain of 20 seats to retake the House (Chart 3). If Democrats offer to cooperate yet Republican senators balk, then the latter will take the blame for any failed deal and ensuing financial turmoil. The experience of other fiscal cliffs bears this out. The debt ceiling crises of 2011 and 2013 and the government shutdowns of 2013 and 2018-19 all suggest that net presidential and congressional approval ratings suffer when partisanship prevents compromise on major fiscal issues (Charts 4A and 4B). This is a risk for the ruling GOP. All Democrats have to do is remain open to compromise. Net presidential and congressional approval ratings suffer when partisanship prevents compromise on major fiscal issues – a risk for the ruling GOP. Chart 4AFiscal Failures Pose A Risk To Ruling GOP Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 4BFiscal Failures Pose A Risk To Ruling GOP Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Confirming this reasoning, Democrats joined with Republicans this week to pass a continuing resolution to maintain government spending levels through December 11, thus avoiding a government shutdown. Clearly the two parties can still cooperate despite record levels of partisanship. House Speaker Nancy Pelosi ruled out using government shutdown as a weapon to hurt the Republicans, fearing it would backfire. And just last week vulnerable House members pressured Pelosi into stating that the House will remain in session in October until a fiscal relief bill is passed. Democrats remain committed to their current plan – solidifying their grip on the House and demonstrating that they can govern, and that government can do more for households, by passing bills. This is still the strategy even if the risk is that these bills give Trump a marginal benefit. The Democratic demand is for a very large fiscal package – House Speaker Nancy Pelosi is today offering $2.2 trillion, a compromise from the initial $3.4 trillion bill (Table 1). A smaller bill is harder to negotiate because it would cut the House Democrats’ spending priorities for their constituents, including around $1 trillion in state and local government aid, while still giving Trump a bounce in opinion polls for boosting pandemic relief. This is unacceptable – and this is how a policy mistake could happen. Table 1What A Fiscal Compromise Will Look Like Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 5Senate Republicans Face A Hotly Contested Election Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 6Republican Senators' Hung Up On Future Deficit Concerns Republican Senators' Hung Up On Future Deficit Concerns Republican Senators' Hung Up On Future Deficit Concerns Senate Republicans face a hotly contested election – with 23 of them up for re-election versus only 12 Democrats. However, 30 of them are not up for re-election this year (Chart 5). These senators fear the eventual return of deficit concerns among the Republican base so they are bargaining to limit emergency spending (Chart 6). Until they can be cajoled by their fellow senators and the White House, they pose a risk to the passage of new stimulus. But this risk is overrated. Ultimately Senate Majority Leader Mitch McConnell and the Senate Republicans will capitulate. It is political suicide if they do not. The GOP will lose control of the Senate and the White House if premature fiscal tightening sparks a bloody September-October selloff just ahead of the election (Charts 7Aand 7B). Chart 7AStocks Sell, Bonds Rally … When Congress Goes Off Fiscal Cliff Stocks Sell, Bonds Rally... When Congress Goes Off Fiscal Cliff Stocks Sell, Bonds Rally... When Congress Goes Off Fiscal Cliff Chart 7BStocks Sell, Bonds Rally … When Congress Goes Off Fiscal Cliff Stocks Sell, Bonds Rally... When Congress Goes Off Fiscal Cliff Stocks Sell, Bonds Rally... When Congress Goes Off Fiscal Cliff Chart 8Trump Compares Poorly To Other Presidents Re-Elected Amid Recession Trump Compares Poorly To Other Presidents Re-Elected Amid Recession Trump Compares Poorly To Other Presidents Re-Elected Amid Recession Only three out of six presidents in modern times have been re-elected when a recession struck during the election year yet ended prior to the fall campaign. These were William McKinley in 1900, Teddy Roosevelt in 1904, and Calvin Coolidge in 1924.2 Trump faces the same scenario, but financial markets are signaling that Trump is not faring as well as these three predecessors (Chart 8). The Senate races are all on a knife’s edge (Chart 9). American politics are highly nationalized – partisan identification overrides regional concerns. President Trump has also personalized his political party, making the election a referendum on himself (Chart 10). These trends suggest the Senate will fall to the party that wins the White House. Chart 9The Senate Races Are All On A Knife’s Edge Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Consumer confidence is weak and bodes ill for the incumbent president and party (Chart 11). Chart 10Trump Has Personalized Partisan Politics Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 11Consumer Confidence Bodes Ill For Trump And GOP Consumer Confidence Bodes Ill For Trump And GOP Consumer Confidence Bodes Ill For Trump And GOP A failure to provide stimulus will ensure that sentiment worsens for the rest of the campaign and overshadows some underlying material improvements that are the Republicans’ only saving grace. Wage growth is recovering in line with the V-shape recovery in blue and purple states, including purple states that voted for Trump (Chart 12). The manufacturing rebound – and a surge in loans – is creating the conditions for the “Blue Wall” of Pennsylvania, Michigan, and Wisconsin to re-elect President Trump (Chart 13). A fiscal failure will blot out this positive news. Chart 12Fiscal Failure Would Blot Out Economic Improvements Fiscal Failure Would Blot Out Economic Improvements Fiscal Failure Would Blot Out Economic Improvements Chart 13Blue Wall' Could Re-Elect Trump On Economic Improvement Blue Wall' Could Re-Elect Trump On Economic Improvement Blue Wall' Could Re-Elect Trump On Economic Improvement Republicans’ standing offer is for a $1.3 trillion bill. The bipartisan “Problem Solver’s Caucus” has separately proposed a $1.5 trillion package that could be converted. McConnell has shown he can muster his troops by producing 52 Republican votes on a skinny relief bill on September 10. The Senate will go on recess on Friday, October 9 and the House is committed to staying until a bill is done. Negotiations cannot drag on much longer than that, however, because lawmakers need to go back to their home states and districts to campaign for the election. The equity selloff suggests policymakers will need to respond sooner anyway. Is there a way for Trump to bypass Congress and provide stimulus unilaterally? Chart 14Gridlock In 2020-22 Is Possible Under Trump Or Biden Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Trump is only too happy to run against a “do-nothing Congress,” which is how Harry Truman pulled off his surprise victory in 1948. He could use executive orders to redirect federal funds that have already been appropriated. However, he has already provided stimulus by decree – delaying payroll tax collections and calling on states to provide unemployment insurance – and yet the market has sold off anyway. That is because these measures are half-baked – they lack the size and the force of an act of Congress. They require coordination with states and firms, which face uncertainty over the legality of the measures and have little incentive to make sacrifices for an administration that may not last more than a few months. In short, if Trump tries to stimulate by decree, it is an election gimmick that will not satisfy market participants who need to look beyond the next 39 days to the critical question of whether US fiscal authorities understand the needs of the economy and can coordinate effectively. Congressional failure will cast a pall over the outlook given that there is still a fair chance the election could produce gridlock for the 2020-22 period, under Trump or Biden (Chart 14). Bottom Line: Financial markets face more downside until Senate Republicans capitulate to Pelosi’s demand of a bill around $2-$2.5 trillion. We think they will, but that is not an argument for getting long now – Republicans could capitulate too late to save the market from a deeper selloff. Investors should book profits now and buy when the deal is clinched. What About The Supreme Court? The Supreme Court battle over the death of Justice Ruth Bader Ginsburg may increase the risk of miscalculation in the stimulus negotiations, but not by much. Subjectively we would upgrade that risk from 25% to 33%. Republicans will fill the vacant seat before the election. So far they have the votes – even if Senator Mitt Romney changes his mind, there is still a one-seat buffer. However, a win on the high court has a mixed impact on financial markets. It may increase the odds of a Democratic Party sweep, which is initially a net negative for equities. But House Democrats will become less inclined to compromise on the size of the fiscal bill that we expect. They will say “take it or leave it” on the $2.2 trillion offer. The lowest we can see Democrats passing is $1.9 trillion. If the GOP fails to budge, the equity selloff will be aggravated by the implication that Democrats will win a clean sweep and thus gain the power to raise corporate and capital gains taxes next year. We have put 55%-60% odds on a clean sweep, but the market stands at 49%, so there is room for the market to adjust (Chart 15). As for the Supreme Court itself, a Republican nomination is legitimate regardless of the election timing, though the decision to go forward this close to the election reveals extreme levels of polarization. The Republican pick could energize the Democrats in the election, as occurred with the nomination of Justice Brett Kavanaugh just ahead of the 2018 midterms. A Democratic overreaction could mobilize conservatives, but this will be moot if the stock market collapses. If the presidential election is contested or disputed, Trump’s court nominee pick could cast the decisive vote, although, once nominated, a justice may not rule in accordance with his or her nominator’s wishes. The Supreme Court battle raises the risk of stimulus miscalculation to 33%. In a period of “peak polarization,” one should expect the Supreme Court battle to escalate further from here (Chart 16). Democrats are likely to remove the filibuster if they win the Senate. This would theoretically enable them to create four new seats on the court, which they could then fill with liberal judges. Franklin Roosevelt attempted to pack the court in 1937 when it got in the way of the New Deal and his plan only narrowly failed due to the unexpected death of a key ally in the Senate. Chart 15A Democratic Sweep Would Aggravate The Equity Selloff A Democratic Sweep Would Aggravate The Equity Selloff A Democratic Sweep Would Aggravate The Equity Selloff Chart 16Supreme Court Battle Will Escalate Amid Extreme Polarization Supreme Court Battle Will Escalate Amid Extreme Polarization Supreme Court Battle Will Escalate Amid Extreme Polarization Not only might the court decide the election outcome, but future controversial legislation could live or die by the court’s vote, as occurred with Obamacare in 2012 (Chart 17). In the event that Democrats achieve a clean sweep, the conservative court will be their only obstacle and they will possess the means to remove it. Chart 17Supreme Court Battle Will Prove Market Relevant In Event Of Democratic Sweep Supreme Court Battle Will Prove Market Relevant In Event Of Democratic Sweep Supreme Court Battle Will Prove Market Relevant In Event Of Democratic Sweep Bottom Line: Earlier we saw a 25% chance that stimulus would fail – now we give it a 33% chance. However, the size of the stimulus is now even more likely to fall within the $2-$2.5 trillion range we have signaled in previous reports. The Supreme Court will become a major factor in domestic economic policy uncertainty if Democrats win a clean sweep of government. Turkey Hits Constraints In East Med – For Now … Turkish President Recep Tayyip Erdogan’s foreign policy assertiveness has once again put Turkey in conflict with NATO allies. Tensions escalated last month after Greece signed a maritime boundary deal with Egypt that Athens said nullified last November’s Libya-Turkey agreement (Map 1). Map 1Turkey Testing Maritime Borders In the East Med Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) In response, Turkey issued a navigational warning (which was renewed thrice) and dispatched its seismic research vessel, the Oruc Reis, to explore for hydrocarbons in disputed areas of the Eastern Mediterranean between Greece and Cyprus. In shows of force, Turkey and Greece both deployed their navies to the area last month, raising the risk of an armed confrontation.3 The motivation for Erdogan’s hard power tactics is multi-pronged. Chart 18Erdogan’s Foreign Adventurism Reflects Domestic Weakness Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) On a domestic level, Erdogan’s East Med excursions are an attempt to rally domestic support, where he and his party have lost ground (Chart 18). Given that popular opinion in Turkey indicates that the majority see the self-declared Turkish Republic of Northern Cyprus as a “kin country” and that they do not expect Turkey to be accepted into the EU, Ankara’s East Med strategy is likely to find support. On an international level, Turkey is flexing its muscles against the West. Erdogan has inserted Turkish forces into conflicts in Syria and Libya, confronting NATO allies there, and authorized the provocative purchase of the Russian S400 missile defense system at the expense of membership in the US F-35 program. The East Med gambit is another challenge to the West by testing EU unity. Specifically Erdogan is demonstrating that Turkey is willing to use military force to reject any unilateral attempts by foreign powers to impose maritime borders on Turkey – for instance through the EU’s Seville map.4 By demonstrating maritime strength, Turkey hopes to twist the EU’s arm into agreeing to a more favorable maritime partition plan in the East Med. As such the conflict is part of Turkey’s “Blue Homeland” strategy to expand its sphere of influence and secure energy supplies.5 Turkey is extremely vulnerable as a geopolitical actor because it depends on imports for three-quarters of its energy needs.6 With energy accounting for 20% of its import bill, these imports are weighing on the current account balance (Chart 19). Turkey’s exclusion from regional gas agreements has thus been a blow to its self-sufficiency goals. Meanwhile Greece, Italy, Egypt, Israel, Cyprus, and Jordan have recently formalized their cooperation through the Cairo-based East Mediterranean Gas Organization. Turkish agitation in the East Mediterranean is an attempt to prevent others from exploiting gas resources there so long as its demands remain unmet. Erdogan’s retreat demonstrates Turkey’s constraints in its challenge to the EU. While the EU has yet to impose sanctions or penalties, Erdogan has now backtracked. Oruc Reis returned to Antalya on September 13, despite official statements that it would continue its mission. Turkish and Greek military officials have been meeting at NATO headquarters. And following talks with French President Emmanuel Macron, German Chancellor Angela Merkel, and EU President Charles Michel, Erdogan’s office announced on September 22 that Turkey and Greece were prepared to resume talks. The postponement of the European Council’s special meeting to discuss Turkish sanctions to October 1-2 plays to Turkey’s favor by giving more time for talks. Chart 19Turkey's Energy Dependence A Geopolitical Vulnerability Turkey's Energy Dependence A Geopolitical Vulnerability Turkey's Energy Dependence A Geopolitical Vulnerability Erdogan’s retreat demonstrates Turkey’s constraints in its challenge to the EU. The possibility of damaging sanctions was too much at a time of economic vulnerability. Given Turkey’s dependence on the EU for export earnings and FDI inflows, the impact of sanctions on Turkey’s economy cannot be overstated (Chart 20). Chart 20EU Sanctions Could Destroy Turkey's Economy EU Sanctions Could Destroy Turkey's Economy EU Sanctions Could Destroy Turkey's Economy Turkey is also facing constraints diplomatically as two of its regional rivals – the United Arab Emirates (UAE) and Israel – have agreed to normalize relations and strengthen ties under the US-mediated Abraham Accords (Table 2). The UAE already dispatched F-16s to Crete to participate in joint training exercises in a show of support to Greece. Table 2The Abraham Accords Unify Turkey’s Regional Rivals Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Details about the potential sanctions have not been released. However, EU Minister of Foreign Affairs Josep Borrell has indicated that penalties could be levied not only on individuals, but also on assets, ships, and Turkish access to European ports and supplies. This could include banks financing energy exploration or even entire business sectors, such as the energy industry. Moreover, the EU could play other damaging cards such as halting EU accession talks, or limiting its customs union with Turkey, which Ankara hopes to modernize. Chart 21EU Needs Turkey’s Cooperation To Stem Flow Of Migrants Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) It is also in Europe’s interest to de-escalate the conflict. Sanctions on Turkey could accelerate Ankara’s re-orientation towards Russia and possibly China, expediting its transition to a hostile regional actor. In addition, Turkey has not shied away from using the 2016 migration deal, whereby Turkey has become the gatekeeper of Middle Eastern migrants fleeing to Europe, as a bargaining chip (Chart 21). Foreign Minister Mevlut Cavusoglu outright stated that Turkey will respond to EU sanctions by reneging on the deal, which could result in an influx of refugees into the EU and new challenges for Europe’s political establishment. Erdogan’s retreat is also likely a response to pressure from Washington. Secretary of State Mike Pompeo lent some support to Greece and Cyprus during his September 12 visit to Cyprus. While the US has distanced itself from recent developments in the East Med, leaving German Chancellor Angela Merkel to play the role of mediator, a deterioration in Ankara’s relations with NATO allies could accelerate Turkey’s de-coupling from the West. Some within Washington are already calling for a relocation of the US strategic Incirlik air base to Greek islands. Erdogan’s retreat from a hawkish stance is in line with similar behavior elsewhere. For instance, despite having taken delivery of all parts and completed all necessary tests, Turkey has yet to activate its Russian S-400 missile defense system. It is wary of US sanctions. Similarly, Ankara has paused its Libyan offensive toward the eastern oil crescent in face of the risk of an outright military confrontation with Egypt. In each case, Erdogan appears to be at least temporarily recognizing the limits to his foreign adventurism. Nevertheless, the recent de-escalation does not mark the end of the conflict. Rather it demonstrates that both sides have hit constraints and are pausing for a breather. Chart 22Erdogan's Tactical Retreat Will Pull Down Turkish Risk Erdogan's Tactical Retreat Will Pull Down Turkish Risk Erdogan's Tactical Retreat Will Pull Down Turkish Risk The tactical retreat will provide some relief for the lira, which hit all-time lows against the dollar and euro, and thus pull down our Turkey GeoRisk indicator (Chart 22). But it does not guarantee that the Turkish risk premium will stay low. Talks between Greece and Turkey are unlikely to result in substantial breakthroughs. Instead the conflict will resurface – perhaps when Turkey is in a stronger economic position at home and the EU is distracted elsewhere, whether with internal political issues or conflicts with Russia, the UK, or any second-term Trump administration. Bottom Line: The recent de-escalation of East Med tensions does not mark the end of a bull market in Turkey-EU tensions. These tensions arise from geopolitical multipolarity – Turkey’s ability to act independently in foreign policy without facing an overwhelming, unified US-EU response. However, Turkey’s vulnerability to European economic sanctions shows that it faces real constraints. A major attempt to flout these constraints is a sell signal for the lira, as European sanctions could then become a reality. We remain negative on the lira, but will book gains on our short trade. Investment Takeaways We are booking gains on some of our tactical risk-off trades, given that we ultimately expect the US Congress to approve a new fiscal package. We are closing our long VIX December 2020 / short VIX January 2021 trade, which captured concerns about a contested election in the United States, for a gain of 4%. Volatility will still rise and a contested election is still possible, but the fiscal risk has gone up, COVID-19 cases have gone up, and Trump’s polling comeback has softened. The 4% gain does not include leverage or contract size. We were paid to put on the trade and now will be paid to exit it, so we are booking gains (Chart 23). Chart 23Book Gains On Bet On Near Term Volatility Book Gains On Bet On Near Term Volatility Book Gains On Bet On Near Term Volatility We are closing our short “EM Strongman Basket” of Turkish, Brazilian, and Philippine currencies for a gain of 4.5%. The trade has performed well but Turkey is not only recognizing its constraints abroad but also recognizing constraints at home by raising interest rates to defend the lira. In Brazil, Jair Bolsonaro’s approval rating has surged and our GeoRisk indicator has topped out. The latest readings on our GeoRisk Indicators provide confirmation of our major themes, views, and trades. The charts of each country’s indicator can be found in the Appendix. Short China, Long China Plays: Geopolitical risk continues on the uptrend that began with Xi Jinping’s consolidation of power and has not abated with the Phase One trade deal. Policymakers will remain entirely accommodative on fiscal and quasi-fiscal (credit) policy in the wake of this year’s recession. New financial regulations do not herald a return of the deleveraging campaign in any way comparable to 2017-18. The October Politburo meeting on the economy could conceivably sound a hawkish note, which could conveniently undermine sentiment ahead of the US election, but if this occurs then we would not expect follow-through. China plays and commodity plays should benefit, such as the Australian dollar, iron ore prices, and Brazilian and Swedish equities. Yet we remain short the renminbi, which has recently flagged after a fierce rally. Trump is negative for the RMB and Biden will ultimately be tough on China, contrary to the market consensus. Short Taiwan: US-China strategic relations have collapsed over the course of the year but financial markets have ignored it due to COVID-19 and stimulus. The only thing keeping US-China relations on an even keel is the Trump-Xi gentleman’s agreement, which expires on November 3 regardless of the election outcome. While outright military conflict over Taiwan cannot be ruled out, Beijing is much more likely to impose economic sanctions prior to any attempt to take the island by force. This has been our base case since 2016. Our GeoRisk indicator is just starting to price this risk so it remains highly underrated from the perspective of the Taiwanese dollar and equities. We are short and there is still time to put on shorts. Long South Korea: The rise in Korean geopolitical risk since the faltering of US-North Korean diplomacy in 2019 has peaked and fallen back, as expected. Pyongyang has not substantively tested President Trump during the election year and we still do not think he will – though a showdown would mark an October surprise that could boost Trump’s approval rating. South Korean political risk should continue falling and we are long Korean equities. Short Russia: Russian geopolitical risk has exploded upward, as we expected. We have been bearish on the Russian ruble and local currency bonds, though we should note that this differs from our Emerging Markets Strategy view based on macro fundamentals. Our reasoning predates the escalation of tensions with the EU over Belarus, but Belarus highlights the negative dynamic: Vladimir Putin in his fourth term is concerned about domestic social and political stability, and this concern is especially heightened after the global pandemic and recession. Therefore he has little ability to tolerate unrest in the former Soviet sphere. Moreover, he has a window of opportunity when the US administration is distracted, and not unfriendly, whereas that will change if the Democrats take over. If Democrats win, they will not try another diplomatic “reset” with Russia; they believe engagement has failed and want revenge for Putin’s undermining the Obama administration and 2016 election interference. The Nordstream 2 pipeline and Russian local currency bonds are at risk of new sanctions. The Democrats will also increase their efforts at cyber warfare and psychological warfare to counter Russia’s use of such measures. If Trump wins, the upside for Russia is limited as Trump’s personal preferences have repeatedly lost to the US political and military establishment when it comes to Russia. The US has remained vigilant against Russian threats and has increased support for countering Russia in eastern Europe and Ukraine. Chart 24Russia Is At Risk of US Sanctions Russia Is At Risk of US Sanctions Russia Is At Risk of US Sanctions In Belarus, President Lukashenko has been sworn in as president again, and he will not step down unless Russia and its allies orchestrate a replacement who is friendly toward Russian interests. Russia will not allow a pro-EU, pro-NATO government by any stretch of the imagination. The likeliest outcome is that Russia demonstrates its security and military superiority in a limited way, while the US and Europe respond with sanctions but not with military force. There is no appetite for the US or EU to engage in hot war with Russia over Belarus, which they have little hope of re-engineering in the Western image. We are short Russian currency and local bonds on the risk of sanctions stemming from either the US election cycle or the Belarus confrontation or both. We note that local currency bonds are not pricing in the risks that our geopolitical risk indicators are pricing (Chart 24). Long Europe: Our European geopolitical risk indicators show that the EU remains a haven of political stability in an unstable time. European integration is accelerating in the context of security threats from Russia, the potential for sustained economic conflict with the US (if Trump is re-elected), and economic competition with an increasingly authoritarian and mercantilist China. Europe’s latent strengths, when acting in unison, are brought out by the report on Turkey above. However, the 35% chance that the UK fails to reach a trade deal at the end of this year will still push our European risk indicators up in the near term.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com   We Read (And Liked) … Geopolitical Alpha: An Investment Framework For Predicting The Future What better way to revive the hallowed tradition of BCA Geopolitical Strategy book reviews than to give clients a sneak preview of our founder Marko Papic’s literary debut, Geopolitical Alpha: An Investment Framework for Predicting the Future?7 Long-time readers will know much of this book – it is the distillation of a decade of Marko’s work at BCA Research and, more recently, Clocktower Group. Here is the story of European integration – perhaps Marko’s greatest call, from back in 2011. Here is the story of multipolarity and investing. Here is the apex of globalization. Here is the decline of laissez-faire and the rise of dirigisme. Here is the end of Chimerica. Attendees of the BCA Research Academy will also recognize much in Marko’s formal exposition of his method. The categories of material constraints that bind policymakers. The practical application of the median voter theorem. The psychological lessons from Richards Heuer and Lee Ross. The occasional dash of game theory – and the workingman’s critique of it. The core teaching is the same: “Preferences are optional and subject to constraints, whereas constraints are neither optional nor subject to preferences.” There is also much that is new, notably Marko’s analysis of the COVID-19 pandemic, which is bound to generate controversy for classifying the whole episode as an example of mass hysteria comparable to the Salem witch trials, but which is as well-researched and well-argued as any section in the book. I was fortunate to learn the geopolitical method with Marko under the guidance of George Friedman, Peter Zeihan, Roger Baker, Fred Burton, Scott Stewart, and other colleagues at Stratfor (Strategic Forecasting, Inc.) in Austin, Texas from the era of the Iraq troop surge, the Russian invasion of Georgia, and the Lehman Brothers collapse. We both owe a lot to these teachers: the history of geopolitics, intelligence analysis, open source monitoring, net assessments, and, of course, forecasting. What Marko did was to take this armory of geopolitical analysis – which we both can testify is best taught in practice, not universities – and to put it to use in the financial context, where political analysis was long treated as optional and anecdotal despite the manifest and growing need for a rigorous framework. A hard-nosed analyst will never cease to be amazed by the gaps that emerge between the consensus view on Wall Street and a careful, disciplined net assessment of a nation or political movement. By the same token, the investor, trader, or economist will never cease to be amazed by the political analyst’s inability to grasp the concept of “already priced in” or “the second derivative.” What needed to be done was to master the art of macro investing and geopolitics. Marko took this upon himself. It was audacious and it provoked a lot of skepticism from the dismal scientists and the political scientists alike. But Geopolitical Alpha, the concept and the book, is the consequence – and we are now all the better for it. Marko is fundamentally a post-modern thinker. His methodological hero is Karl Marx for the development of materialist dialectic, the back-and-forth debate between economic forces that humans internalize in the form of competing ideologies. His foil is the humanist and republican, Niccolo Machiavelli – not for his amoral approach, but for prizing the virtue of the prince in the face of outrageous fortune. Human agency is Marko’s favorite punching bag – he excels at identifying the ways in which individuals will be frustrated despite their best efforts by the cold, insensitive walls of reality around them. If there is a critique of Marko’s book, then, it is that he gives short shrift to the classical liberal tradition – or as I like to think of it, the balance-of-power tradition. The idea that hegemony, or unipolarity, leads to a stable social and political environment conducive to peace and prosperity has a lot going for it. But it also partakes of an older tradition of thought that envisions a single, central political order as necessarily the most stable and predictable – a tradition that can be ascribed to Plato as well as Marx. You can see the positive implication for financial markets. But what if this tradition is only occasionally right – what if it too is subject to historical cycles? If that is the case, then the Beijing consensus is a mirage – and the US’s reversion to a blue-water strategy (not only under President Trump, but also under a future President Biden, according to his campaign agenda) does not necessarily herald the “end [of] American dominance on the world stage.” The classical tradition behind the Greco-Roman, British, and American constitutional systems, including their naval strategies, envisioned a multipolar order that was somewhat less stable but more durable, and this tradition has proven immensely beneficial for the creation of technology and wealth. Of course, Marko is very much alive to this tradition and, despite his critique of the ancients, shows himself to be highly sensitive to the interplay of virtue and fortune. Throughout the work, the analytical style can be characterized as restless energy in the service of cool, chess-playing logic. Marko is generous with his knowledge, merciless in drawing conclusions, and outrageously funny in delivery. He attacks the questions that matter most to investors and that experts too often leave shrouded in finely wrought uncertainty. He also shows himself to be a superb writer as well as strategist, interspersing his methodological training sessions with vivid anecdotes of a lifelong intellectual journey from a shattered Yugoslavia to the heights of finance. The bits of memoir are often the best, such as the intro to Chapter Six on geopolitics. To paraphrase a great author, Marko writes because he has a story to tell, not because he has to tell a story. The tale of the mysterious consulting firm Papic and Parsley will do a great public service by teaching readers precisely how skeptical of mainstream news journalism they should be. It isn’t enough to say that we read Geopolitical Alpha and liked it – the sole criterion for a review in this column. Rather, the book and its author are the reason this column exists. And Geopolitical Alpha is now the locus classicus of market-relevant geopolitical analysis.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 We favored the upper side of the range, first $2.5 trillion, and subsequently something closer to House Speaker Nancy Pelosi’s demand of $2.2 trillion. We have speculated that Republicans may get her to settle at $1.9 trillion. 2 Two of these cases were unique in that a vice president took over from a president who died and then won re-election – unlike Trump’s scenario. 3 On August 12 a Greek Navy frigate collided with a Turkish vessel guiding the Oruc Reis. Athens called the incident an accident while Ankara referred to it as a provocation. 4 The so-called Seville Map was prepared at the request of the European Union by researchers at the University of Seville, attempts to clarify the exclusive economic zones of Turkey and Greece in the Aegean Sea. The US announced on September 21 that it does not consider the Seville map to have any legal significance. 5 The Blue Homeland or Mavi Vatan doctrine announced in 2006 intends to secure Turkish control of maritime areas surrounding its coast (Mediterranean Sea, Aegean Sea, and Black Sea) in order to secure energy supplies and support Turkey’s economic growth. 6 Erdogan’s claim that gas from the recently discovered Sakarya gas field would reach consumers by 2023 is likely overly optimistic and unrealistic. The drilling costs and commercial viability of the field are yet to be determined. Thus, the find does not impact dynamics in the East Med. 7 New Jersey: Wiley, 2021. 286 pages. Section II: GeoRisk Indicators China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights The great political surprises of 2016 are approaching key deadlines on November 3 and December 31. Investors should not let Brexit take their eye off the US election. Globalization will retreat faster under Trump regardless of what happens in the United Kingdom. The market is starting to price several clear risks: a failure to extend fiscal relief in the US (25% chance); a surprise Trump tariff move (40%); a contested election (20%); or a failure of the UK and EU to seal a deal (35%). Trump is unlikely to pull off a landslide like Boris Johnson in December 2019. The backdrop has darkened and Biden is an acceptable alternative for voters, unlike Jeremy Corbyn. Go long GBP-USD at the 1.25 mark; go long GBP-EUR volatility. Feature The end game is approaching for the two great political shocks of 2016 – Brexit and Trump. November 3 is the US election and December 31 is the deadline for an UK-EU trade deal. Investor sentiment is starting to show some cracks for various reasons, some technical (Chart 1). But we do not believe near-term volatility and risk-off sentiment have fully run their course yet. Either the US election cycle or the UK’s brinkmanship with the EU, or both, will agitate markets as the deadlines approach. The former is a much weightier factor. Chart 1Market Starts To Price Bevy Of Near-Term Risks ... But Cyclical View Still Constructive Market Starts To Price Bevy Of Near-Term Risks ... But Cyclical View Still Constructive Market Starts To Price Bevy Of Near-Term Risks ... But Cyclical View Still Constructive The risks in play are a failure to extend fiscal relief in the US (25% chance); a conflict between Trump and one of America’s foreign rivals such as China, whether due to Trump’s reelection or lame duck status (40%); a contested election (20%); or a failure of the UK and EU to seal a deal, setting back their economic recovery (35%). Maybe all of these risks will dissipate by mid-November, but maybe not. The market has not discounted any of them fully. So investors should buy insurance now. Vox Populi Is The Biggest Constraint For global investors Brexit is far less consequential than President Trump’s “America First” policy but the UK does punch above its economic weight in financial markets (Chart 2). Chart 2Brexit: Why Should We Care? UK Punches Above Its Economic Weight In Financial Markets Brexit: Why Should We Care? UK Punches Above Its Economic Weight In Financial Markets Brexit: Why Should We Care? UK Punches Above Its Economic Weight In Financial Markets Geopolitical analysis teaches that limitations on policymakers should be the starting point of analysis. For democracies, the biggest constraint of all is the vox populi – the voice of the people, or popular will. The Brexit movement faced a vociferous “Resistance” that won over the media and financial market consensus until reality struck in the general election of December 12, in which the Conservative Party won a historic victory. Chart 3Joe Biden Is Not Jeremy Corbyn The End-Game For Trump And Brexit The End-Game For Trump And Brexit The election vindicated Prime Minister Boris Johnson’s brinkmanship and “hard Brexit” terms, while once again chastening the elites and experts – including an innovative Supreme Court. Johnson’s single-party majority, combined with COVID-19 and the surge in domestic economic stimulus, have increased the odds that the UK will choose sovereignty over the economy and walk away from trade talks. Trump’s supporters show the same enthusiasm as Brexiteers and the same scorn for conventional wisdom and opinion polls. Will they be similarly vindicated? Beyond any knee-jerk equity rally, that would entail a “Phase Two” trade war with China – and possibly a new trade war with Europe or a global trade war. However, Trump faces much worse odds than Boris Johnson did. First, Johnson’s snap election took place at the top of the business cycle, back when a novel coronavirus was just starting to be discovered in Wuhan, China. This is how Harry Truman won his surprise victory in 1948, in defiance of all the opinion polls. Had Truman run in 1949, after a deep recession, the story would have gone differently – which is a problem for both Trump and the near-term equity market. Second, the political alternative was not acceptable in the United Kingdom but it is in the United States. Johnson led Jeremy Corbyn, a far-left rival for the premiership, by around 15%-20% in the polls. The Conservative Party itself led the Labour Party by 10%. By contrast, former Vice President Joe Biden is a center-left Democrat who has many flaws but is not out of the mainstream. He leads President Trump in the polling, as do Democrats over Republicans, though only by single digits. There is no contest between Biden and Corbyn (Chart 3). Trump might still win, but an American version of the UK landslide in 2019 is unlikely. Trump will lose the popular vote even if he wins the Electoral College, and Republicans have a very slim chance of winning the House of Representatives. The implication for financial markets is doubly negative, at least in the near term: there is about a 35% chance that the UK will leave without a deal and about a 35% chance that Trump will win. He could also kick China in the interim period if he loses. Won’t stocks cheer a Trump comeback and victory? Perhaps, but a data-dependent approach suggests that a “blue sweep” is still the base case, and that would be a good trigger for a full equity correction. Nor would a Trump win be positive for long-term equity returns in the final analysis. Trump is reflationary, but a larger trade war would hamper the global economic recovery and thus keep earnings suppressed. There is a 35% chance that Trump will win re-election. Trump is unlikely to win the national vox populi, like Brexit did, but he obviously can win the popular vote in the critical regions – the Sun Belt and the Rust Belt. If he does, the revolution in the global system will be confirmed: the retreat of globalization will accelerate. If he does not, then Brexit alone cannot confirm de-globalization; rather the UK will face even more pressure to make concessions and get a trade deal. Trump’s Path To Victory Chart 4Sitting Presidents Win Half The Time If Recession Ends In H1 Sitting Presidents Win Half The Time If Recession Ends In H1 Sitting Presidents Win Half The Time If Recession Ends In H1 We may well be forced to upgrade Trump’s odds of winning if his comeback gains momentum. Our subjective odds of a Trump win come from the historical record – incumbent parties only retain the White House amid recessions five out of 13 times in American history – but there are some important exceptions. First, the longest-serving American president, Franklin Delano Roosevelt, served during the Great Depression. So obviously a bad economy does not always disqualify a president. Nevertheless FDR got lucky with the timing of the fluctuations and he was personally popular, unlike President Trump. Second, an incumbent president wins 50% of the time if the recession ends before the election – namely in 1900, 1904, and 1924 (contrasted with defeats in 1888, 1912, and 1980). Today’s market performance looks similar to these cases, though premature fiscal tightening is now jeopardizing Trump’s bid (Chart 4). Assuming new stimulus passes, it is extremely beneficial for President Trump that COVID-19 cases are subsiding (Chart 5). Chart 5COVID-19 Subsides In Nick Of Time For Trump? The End-Game For Trump And Brexit The End-Game For Trump And Brexit Chart 6Even Approval Of Trump’s Pandemic Response Improving The End-Game For Trump And Brexit The End-Game For Trump And Brexit His approval rating on handling COVID-19 is somewhat recovering at the moment (Chart 6). Trump’s “law and order” message is also benefiting him amid the rise in vandalism, rioting, and homicide, judging by his improvement in national approval rating across almost all demographic groups, including many that are otherwise averse to Trump. Finally, Trump’s Abraham Accords – a potentially major peace deal between Israel and an expanding list of Arab states – could give his image another boost (Table 1). Foreign policy will not decide the election but these peace deals should not be underrated because they underscore a more important argument for voters: that the US should withdraw from its endless foreign wars and pursue peace and prosperity instead. If Trump’s typically weak approval rating on foreign policy starts to rise then his comeback gains breadth. Table 1The Abraham Accords Give Boost To Trump Image As Peacemaker The End-Game For Trump And Brexit The End-Game For Trump And Brexit We will upgrade our 35% odds of Trump’s re-election if Congress passes a new fiscal relief package, assuming Trump’s polling continues to improve. Our quantitative model is now giving Trump a 45% chance, which is in line with the consensus view but well above our subjective odds (Chart 7). We will upgrade our view if Congress passes a new fiscal relief package, assuming Trump’s polling continues to improve. Chart 7Quantitative US Election Model Puts Trump Win At 45% Odds The End-Game For Trump And Brexit The End-Game For Trump And Brexit Chart 8Stimulus Hiccups Cause Market To Sell Stimulus Hiccups Cause Market To Sell Stimulus Hiccups Cause Market To Sell The stock market does not perform well during periods in which fiscal cliff negotiations are prolonged – the failure of the Emergency Economic Stabilization Act in 2008 is one thing, but today’s impasse is more reminiscent of the debt ceiling crises of 2011 and 2013. Trump is now directly pressuring Senate Republicans to capitulate to House Democratic spending demands. If Republican senators abandon him, market turmoil will undercut his argument that he is the best man to revive the economy and he will lose the election (Chart 8). We do not think they will – and House Speaker Nancy Pelosi’s pledge to keep the House in session until a deal is passed is very positive news – but until the deal is sealed the market is vulnerable. As mentioned above we give a 25% chance of a failure to pass any stimulus bill in September or October. The next chance for stimulus will be in late January or February. Trump stands for growth at all costs, which will be received well by equity markets, other things being equal. But a Trump victory implies more trade war and that the GOP will retain the Senate, creating a steeper fiscal cliff next year – so any relief rally will be short-lived. Meanwhile a Trump defeat raises the risk he will take aggressive actions on the way out to cement his legacy as the Man Who Confronted China, and bind the Biden administration to decoupling policy. This is not a favorable outlook for investor sentiment or the economic recovery over the next few months. Brexit: The Three Kingdoms Will Force A Trade Deal Chart 9Sterling Will Fall Before It Bounces Back On A Deal Sterling Will Fall Before It Bounces Back On A Deal Sterling Will Fall Before It Bounces Back On A Deal In December 2016 we pointed to the three kingdoms – England, Ireland, and Scotland – as the origin of the geopolitical and constitutional crisis that would arise from the Brexit referendum and act as a powerful bar against a no-deal Brexit. That framework remains salient today as the risk of no-deal escalates due to quarrels over Northern Ireland Protocol, which was agreed in October 2019 as part of the formal Withdrawal Agreement that made Brexit happen on January 31, 2020. The implication is that the pound has not bottomed yet, though we see a buying opportunity around the corner (Chart 9). No one should doubt that the UK could walk away from the EU without a deal this December: The Tories’ single-party majority gives them the raw capability to push through plans they decide on – and raises the risk that they will overreach. The tariff shock of a no-deal exit is frequently exaggerated. The UK would suffer a tariff shock of about 1.38% of GDP, larger than what the US suffered in its tariff-war with China but hardly a death knell (Table 2). (The costs of losing single-market access would grow over time, however.) Table 2A No-Trade-Deal Brexit Would Create A Minimum Tariff Shock Of 1.4% Of GDP The End-Game For Trump And Brexit The End-Game For Trump And Brexit COVID-19 has supplanted the worst-case outcome of a no-deal exit by producing a much worse recession than anyone feared. The US is using the disruption to decouple from China and the UK could do the same with the EU. The result of COVID-19 is massive domestic stimulus that raises the UK’s and Europe’s threshold for pain. Any failure of trade talks would spur more stimulus. The Bank of England still has some bond-buying ammunition left and parliament, again, is undivided. Given that Boris Johnson has until 2024 before the next election, there is theoretically time for his personal and party approval ratings to improve as the economy recovers from the pandemic and any messy Brexit (Chart 10). Chart 10Bojo Has Until 2024 To Recover From Crises The End-Game For Trump And Brexit The End-Game For Trump And Brexit Chart 11UK Would Face WTO-Level Tariffs If No Deal The End-Game For Trump And Brexit The End-Game For Trump And Brexit The UK’s position in the quarrel over Ireland is rational – but so is the EU’s. If the trade talks collapse, the UK will need to remove any regulatory or customs divisions with Northern Ireland. Yet in preparing to do so it vitiates trust with the EU and makes a trade deal less likely. However, weighing all these points up, an UK-EU trade deal is still the most likely outcome (65% chance), as the economic and political costs are crystal clear while the benefits of a hard break are not so clear. Allow us to explain. Northern Ireland is the latest cause of tensions, although it was inevitable that tensions would arise ahead of the end-of-year deadline for a trade deal. Westminster has proposed an Internal Market Bill, which has passed with solid majorities in two readings in parliament, to reclaim aspects of sovereignty over Northern Ireland that were traded away to clinch the Withdrawal Agreement last year. The Johnson government’s position should be seen as a negotiating tactic to build leverage in the talks but also as a real fallback position if the talks fail. The House of Lords could delay the bill by a year, meaning that it may not take effect until end of 2021 – but a trade deal would make it moot. The Northern Ireland Protocol solved the riddle of how to preserve the integrity of the EU’s single market after Brexit yet avoid a return to a hard customs border with the Republic of Ireland. Customs checks were removed with the Good Friday (or Belfast) Agreement in 1998, which ended the Troubles between the two Irelands. The Protocol introduces a pseudo-customs border on the Irish Sea, requiring declarations on exports to Great Britain and EU oversight of UK state aid for Northern Irish firms, so that Northern Ireland can stay in the EU customs area while the UK can leave and still preserve a semblance of its own customs area in Northern Ireland. If the UK and EU get a trade deal, then all trade is tariff-free and the Protocol becomes redundant. Also, the Protocol enables a Joint Committee to review disputes over exports to Northern Ireland that are “at risk” of making their way into the EU without duties. The Protocol is supposed to operate even if the UK and EU fail to get a trade deal. Yet it is politically untenable for the UK to subject trade within its own country to EU rules or duties, or allow the EU to supervise state corporate subsidies across the UK, if no deal is agreed. The UK is more likely to violate the treaty to preserve its internal integrity. As Northern Ireland Secretary Brandon Lewis admitted, “Yes, this [Internal Market Bill] does break international law in a very specific and limited way.” While the EU’s threat to slap tariffs on British food exports to Northern Ireland is the proximate trigger of the Internal Market Bill, another key reason for the UK’s aggressive shift is the issue of state aid. All governments are extending emergency aid to major corporations to keep them from insolvency amid the recession. This will be the case for some time and it is even more true of the EU than of the United Kingdom. However, under the Protocol, the EU would be able to penalize companies in Great Britain that receive subsidies if goods or firms in Northern Ireland can be shown to benefit. Northern Ireland is supposed to operate within the EU’s standards on state aid. London obviously bristles at this backdoor for letting in EU regulation, not least because, in the event that a trade deal is not reached, it will need to pump the country full of state aid to compensate for the shock of seeing exports to the EU rise by 3% across the board according to Most Favored Nation status under the World Trade Organization (Chart 11). An UK-EU trade deal is the most likely outcome. As Dhaval Joshi of BCA’s European Investment Strategy points out, Boris needs to keep his own Tories under his heel (Chart 12). The Internal Market Bill provoked a backlash among 30 moderates. If that number rises to 40 Johnson loses his majority. This is a problem that he is seeking to address by giving parliament a veto over any future uses of the bill that would violate international law (this is an acceptable compromise because he has a majority). But a failure to drive a hard bargain with the EU would cause a much bigger rebellion among hard Brexit Conservative MPs and threaten his job. Chart 12Bojo Must Balance Hard Brexit Tories The End-Game For Trump And Brexit The End-Game For Trump And Brexit Geopolitics is about might, not right – the UK can assert its sovereignty and violate these international agreements, while the EU can then apply punitive tariffs, non-tariff barriers, and sanctions under the Withdrawal Agreement. Brexit is a power-political struggle that could devolve into a trade war. Obviously that would be a very bad outcome for the market, particularly for the UK, which is overmatched (Chart 13). But this risk is also a key limitation on the UK that will prevent this worst-case outcome. Indeed, despite all of the above, our base case is still that the UK and EU will get a deal. First, the economy will clearly suffer without a deal. After all, the US-China tariffs produced a negative effect for these two economies in 2019 and the impact on the UK would be bigger than that on the US (Chart 14). Chart 13The Brick Wall The UK Cannot Avoid The Brick Wall The UK Cannot Avoid The Brick Wall The UK Cannot Avoid Chart 14UK Faces Trade Shock If No Deal UK Faces Trade Shock If No Deal UK Faces Trade Shock If No Deal Second, the public doesn’t support a no-deal exit (Chart 15). Northern Ireland itself voted against Brexit in the referendum and as such would rather see an agreement that groups the UK and the EU under a single zero-tariff free trade agreement. Third, Boris faces a rebellion in Scotland if he pursues a hard break. The Scottish National Party would revive ahead of Scottish elections in May 2021 and demand a second independence referendum (Chart 16). The Irish Sea is a natural division that makes a more intrusive customs presence more supportable than otherwise. A little more paperwork is an acceptable cost to keep the United Kingdom from falling apart. Scotland is much more likely to go independent than Ireland is to unite. Chart 15Only 25% Think 'No Deal' A Good Outcome The End-Game For Trump And Brexit The End-Game For Trump And Brexit Boris is now prime minister, not just party leader, and he will ultimately have to decide whether he wants to be the last prime minister of a United Kingdom. Assuming Boris is at least focused on the next election, he will have to decide if he wants the rest of his premiership to be consumed with a self-inflicted double-dip recession and democratic revolt in Scotland, or a recovery on the back of a functional if uninspiring trade deal enabling him to head off the Scottish threat and save the union. Chart 16No Deal' Would Boost Scottish Independence Movement No Deal' Would Boost Scottish Independence Movement No Deal' Would Boost Scottish Independence Movement Obviously the final deal may not be clinched until the eleventh hour. The October 15 deadline can be delayed but talks must conclude in November or December in time to be ratified by the EU member states by December 31. US Election Drives Geopolitics, But Not The Brexit Outcome One factor that will not play much of a role in the UK’s decision-making is the US election. It is true that the Johnson government would benefit from President Trump’s reelection. But the EU is a much bigger market for the UK and the UK’s best strategy is to focus on its national interest regardless of what the US does. The US election may not be decided in mid-December in time for the UK to agree to a deal that can be ratified by year’s end anyway. Moreover the UK’s best strategy is to conclude a deal with the EU first, and then pursue a deal with the United States. This is because President Trump will be inclined to sign at least an executive deal, while a congressional deal requires support from the Democrats, which is only possible if Northern Ireland is resolved without hard border checks. Because the EU makes up such a larger share of British trade, an American deal does not give the UK much leverage in negotiating with the EU, but an EU deal does give the UK greater leverage in negotiating with the US. As Diagrams 1 and 2 show, this strategic logic holds even if the UK knows the outcome of the US election ahead of time: the scenarios with the least benefit and the greatest cost would still be scenarios involving no deal with the European Union. Diagrams 1 & 2United Kingdom Wants An EU Trade Deal (Regardless Of Trump/Biden) The End-Game For Trump And Brexit The End-Game For Trump And Brexit Diagram 3 boils all of this down to a single decision tree. First, the diagram shows that the economic costs are not prohibitive and therefore the risk of a no-deal exit is substantial – we would say 35%. Second, it shows that the risks of the negotiation are skewed to the downside. Third, it highlights that the UK will settle its affairs directly with the EU and not hinge its actions on the US election cycle. Diagram 3No-Deal Brexit Cost Not Prohibitive, But Best Strategy Is To Get A Deal The End-Game For Trump And Brexit The End-Game For Trump And Brexit Clearly the best strategy and best outcome involve seeking a trade deal with the EU, and hence it is our base case. This means an opportunity to buy the pound and domestic-oriented British equities, and turn neutral on gilts, is just around the corner. Investment Takeaways The GBP-EUR is the best measure of the market’s sensitivity to Brexit risks, so it should fall in the near term and rally sharply after resolution. However, the US election complicates things. The euro’s response is fairly binary: it is one of the biggest winners if Biden wins and one of the biggest losers if Trump wins. Hence GBP-EUR volatility will rise in the coming months (Chart 17). We recommend going long 1-month implied volatility contracts for October and November. The pound sterling, by contrast, will ultimately rise regardless of US election result, since the UK will pursue a trade deal out of its own national interest. Trump is less negative for the US dollar than Biden and a comeback and victory will drive a counter-trend dollar bounce. However, in the medium term we expect the dollar to fall regardless due to debt monetization and global growth recovery. Thus we recommend going long GBP-USD on a strategic basis when political risks peak over the next two-to-three months and GBP-USD falls to around 1.25, as recommended by our Foreign Exchange Strategist Chester Ntonifor (Chart 18). Chart 17EUR-GBP Volatility Will Rise EUR-GBP Volatility Will Rise EUR-GBP Volatility Will Rise Sterling bears are forgetting that the sound defeat of Corbyn ruled out a sharp left-wing turn in domestic economic policy (higher taxes), while the Tories have made a clear turn against fiscal austerity. Therefore the worst-case scenario is a failure to agree to a trade deal by the end of this year. But that is not the base case and the risk will be priced within a month or two. Chart 18Pound Will Rally After Deal Concluded In November Or December Pound Will Rally After Deal Concluded In November Or December Pound Will Rally After Deal Concluded In November Or December Chart 19Yes, China Is Opening The Taps Yes, China Is Opening The Taps Yes, China Is Opening The Taps We remain tactically cautious and defensive even though the US fiscal negotiations are improving. The market is underrating too many clear and concrete risks to sentiment and the corporate earnings outlook, so the current bout of volatility can continue until there is greater clarity on US fiscal spending, the US election cycle, associated geopolitical risks, and the Brexit showdown. Book gains on long Brent trade for a return of 69.7%. We initiated this trade on March 27 in our “No Depression” report, which marked our shift to a strategic risk-on positioning. We remain bullish on oil prices and commodities on the back of global stimulus and our assessment that the OPEC 3.0 cartel will maintain discipline overall, but the next three-to-six months are crowded with downside risk. Cyclically, we see a global economic recovery deepening and broadening. China’s stimulus is surprising to the upside, as we have long written and the latest credit numbers bear this view out (Chart 19), which is critical for global reflation.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

Highlights Abenomics was working – prior to trade war and COVID-19 – and it will remain Japan’s economic policy setting, albeit in a new guise. This is true even if a dark horse candidate wins the Liberal Democratic Party’s leadership race. Japan’s strategic alliance with the United States is based on a shared interest to balance China’s rise and will not change regardless of the 2020 and 2021 elections. Abe failed to make peace with Russia, but Russo-Japanese relations remain the bellwether of a revolution in Russian policy toward China. We are far from that now. Stay long JPY-USD. The yen’s safe haven properties will buoy it during the coming three-to-six months of extreme political risk. The dollar is set to fall in the medium term due to US debt monetization, twin deficits, and global growth recovery. Feature Japanese equities have rallied despite trailing their American and global counterparts (Chart 1). Yet the good news for markets is now coinciding with the emergence of political uncertainty, as Prime Minister Shinzo Abe, now the longest-serving in Japan’s history, announced he will step down due to illness. Abe’s departure marks the end of a chapter in the country’s modern history and raises questions about the future of “Abenomics,” the eponymous economic policy consisting of ultra-dovish monetary policy, accommodative fiscal policy, and neoliberal structural reforms aimed at lifting productivity and growth. Chart 1Japan's Rally Trails Global Counterparts Japan's Rally Trails Global Counterparts Japan's Rally Trails Global Counterparts Chart 2… As Longest-Serving Prime Minister Steps Down Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name Japanese leaders rarely last as long as Abe so the market will likely have to familiarize itself with more churn in top-level government policies going forward (Chart 2). But will the churn change the secular direction? No. Abenomics: A Concise Post-Mortem Chart 3Population And Workforce Decline Population And Workforce Decline Population And Workforce Decline The driver of Abenomics was not Abe, or his central bank Governor Haruhiko Kuroda, or even the long-dominant Liberal Democratic Party. It was geopolitics – an accumulation of social, political, economic, and strategic pressures demanding that the ruling elite shake up decades-long policies in pursuit of the national interest. Everyone knows that Japan’s population is aging and shrinking, but the key to understanding the Abe era is the recognition that the 2008 global financial crisis coincided almost exactly with the peak in Japan’s total population. This came 18 years after the working age population’s peak in the very year of Japan’s own financial crisis (Chart 3). The first crisis triggered Japan’s slide into price deflation; the second crisis threatened the permanent entrenchment of deflation along with a series of existential threats to the wellbeing of the nation. The driver of Abenomics was geopolitics, not Abe. First came global recession in 2008. Next the institutional ruling party – Liberal Democrats – fell from power for the first substantial period of time in modern memory in 2009. Then China fully emerged as a great power, brandishing its new foreign policy assertiveness and igniting a maritime-territorial clash and minor trade war from 2010 (Chart 4). Japan’s decline reached its nadir with a literal nuclear meltdown, following the devastating Tohoku earthquake and tsunami in 2011. The country’s strategic import dependency combined its ongoing financial instability, as shuttered nuclear plants required a surge in high-priced energy imports that wiped away Japan’s all-important current account surplus (Chart 5). Chart 4Geopolitical Status Anxiety Geopolitical Status Anxiety Geopolitical Status Anxiety Chart 5Nuclear Meltdown And Resource Anxiety Nuclear Meltdown And Resource Anxiety Nuclear Meltdown And Resource Anxiety The Liberal Democrats returned to power in a sweeping election victory after this ill-fated experiment with opposition rule. Party leader Shinzo Abe was relatively popular and willing to oversee a drastic overhaul of stale policies. Abenomics was never going to solve all of Japan’s deep structural challenges – population decline, massive debt, overregulation, lifetime employment. But its critics failed to recognize that the country had hit rock-bottom and policymakers had no choice but to stimulate, reform, and open up the economy. Otherwise they would go straight back into the political wilderness at the next election.1 Abenomics was about as successful as an overhyped political policy program can be: The economic boom drew in workers from all parts of society, particularly women, whose participation rate soared (Chart 6). Abe flung open the doors to immigration in a traditionally xenophobic country, attracting Chinese, Vietnamese, and Filipinos to live and work in Japan (Chart 7). Chart 6Abe Got People To Work Abe Got People To Work Abe Got People To Work Chart 7Abe Broke The Taboo On Immigration Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name Kuroda at the Bank of Japan flew into action with aggressive asset purchases, triggering a sharp devaluation of the yen (Chart 8). Nominal GDP growth and core CPI trends both improved, critical to easing debt burdens, lowering real rates, stimulating economic activity, and shaking off the deflationary mindset (Chart 9). Chart 8Abe Kicked The BoJ Into Action Abe Kicked The BoJ Into Action Abe Kicked The BoJ Into Action Chart 9Abe Combatted Deflation Abe Combatted Deflation Abe Combatted Deflation Stagnant wages finally started to grow, with an extremely tight labor market (Chart 10). This was all the more remarkable due to the simultaneous surge in foreign workers. Corporate investment stabilized and turned upward, finally overcoming the long decline since 1990 (Chart 11). Chart 10Wage Growth Improved (Until Trade War, Pandemic) Wage Growth Improved (Until Trade War, Pandemic) Wage Growth Improved (Until Trade War, Pandemic) Chart 11Abe Revived Corporate Investment Abe Revived Corporate Investment Abe Revived Corporate Investment Abe also opened the door to foreign trade, taking on powerful vested interests, including his own party’s base, to join the Trans-Pacific Partnership (TPP) along with the United States in a bid to create an advanced new trade framework that sidestepped China. Chart 12Abe Opened The Doors, A Bonus With Or Without Trade War Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name When US President Donald Trump pulled out of the bloc in accordance with his protectionist campaign promises, Abe led the charge in preserving it. Japan stands to benefit from opening up these markets whether the US-China trade war continues or not (Chart 12). This was generally effective leadership, but none of it happened by sheer force of personality. It happened because Japan glimpsed the specter of national failure in 2011 under the combined weight of internal malaise and external domination. Economic revival was as much about shoring up Japan’s national security as it was about improving Japanese lives and livelihoods. Abenomics was the economic component of a broader national revival. The goal was to become a “normal” nation, capable of self-defense and independent policy, and a pro-active world power at that. China’s rise and a distracted US will pressure Japan to maintain Abe’s policies. The drivers of Japan’s political earthquake in 2011 are not spent. COVID-19 dashed many of Abe’s gains in the fight against deflation. China’s rise is a greater challenge than ever before. The US is even more divided and distracted. The next prime minister would not be able to change course even if he wanted to do so. Suganomics, Kishidanomics … Ishibanomics? Chart 13Still No Alternative To Institutional Ruling Party Still No Alternative To Institutional Ruling Party Still No Alternative To Institutional Ruling Party The Liberal Democrats and their longtime coalition partners, New Komeito, have not only lost about 5% of popular support since their triumphant comeback in 2012, standing at 40% support today – and with some improvement since 2017. More importantly, their nearest rivals all poll under 5% of the popular vote (Chart 13). There is no political competition as yet. The ruling party will choose a new leader with little fanfare. Abe’s Chief Cabinet Secretary and chosen successor Yoshihide Suga is the frontrunner as we go to press. Political uncertainty, such as it is in Japan, will emerge ahead of the September 2021 election. Abe’s retirement and the aftermath of the global recession create an opening for disgruntled factions and opposition parties to challenge the ruling party. It will not succeed but it will portend a less predictable period in the absence of a unifying figure like Abe. In fact, Abe’s influence peaked in July 2019 when he lost a single-party super-majority in the House of Councillors, the upper house of parliament (Chart 14). The 2021 election now raises the prospect of additional erosion of support. Chart 14US-Japan Alliance Versus China Will Persist Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name Opposition is particularly likely if Suga attempts to achieve Abe’s major unfinished task: the revision of Article Nine of the constitution to countenance Japan’s de facto armed forces and right to self-defense. At very least Suga will mark the return of the “revolving door,” in which weak prime ministers come and go in rapid succession. The top candidates for the leadership race lack differentiation: the leading contenders are dovish on monetary and fiscal policy, hawkish on national security and foreign policy, just like Shinzo Abe (Table 1). The exception is former Defense Minister Shigeru Ishiba, but a close examination of his statements and actions suggests that he does not pose a real risk to the policy status quo (Box 1 at bottom). Should Ishiba rise to power, now or later, we would be buyers of any risk premium in financial markets on his account. Table 1The Return Of The Revolving Door Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name The prime minister over the 2021-22 period will have the occasion to appoint up to four members of the Bank of Japan’s Policy Board (Table 2). Theoretically, the appointment of neutral or less dovish candidates could lead to a 5-4 majority on the board by 2023. But this is very unlikely. Table 2Dovish BoJ Is Here To Stay Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name First, it would require all vacant seats to be filled with members who hold hawkish views, which would mark a sharp departure from the current thinking both within the BoJ and the LDP. Second, Kuroda is still governor and could hold that post until 2028. Third, Japan’s economic demands will still require easy monetary policy, as the population will still be shrinking and the country’s vast debt pile will remain a burden. Fiscal austerity is impossible. There is no reason to expect Abe’s successors to be fiscal hawks either. Abe proved to be more of a hawk than expected, by going forward with statutory increases to the consumption tax rate. These are now complete, at 10%, with no future tax hikes scheduled. If Abe managed to create small positive surprises in fiscal thrust throughout his term despite this effort at fiscal consolidation, then his successor should be able to do so in the wake of COVID-19 without any consolidation as yet on the books (Chart 15). Chart 15Despite Mistakes, Fiscal Thrust Surprised To Upside Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name Chart 16Fiscal Austerity Impossible Abenomics Will Smell As Sweet By Any Other Name Abenomics Will Smell As Sweet By Any Other Name Fiscal austerity is impossible as nearly 60% of the budget is dedicated to social spending for the graying and shrinking society as well as interest payments on the national debt – leaders will continue to avail themselves of the ancient imperial practice of tokusei, or debt forgiveness, rather than draconian spending cuts or tax increases that would drag down the economy and hence increase the debt even faster (Chart 16). Of course, the major failure of Abenomics will still dog Abe’s successors over the long run: the inability to lift Japanese productivity. Despite Abe’s attempts to shake up the labor market, spark corporate investment, reform corporate governance, and open up the economy to foreign trade, productivity has still declined, underperforming both the EU and the UK (Chart 17). Japan will continue to depend heavily on foreign demand, especially Chinese demand. In the short term this is positive, since China’s deleveraging campaign and the COVID-19 shock are giving way to another major bout of Chinese fiscal and credit stimulus. China will be forced to keep stimulating to cope with its secular slowdown and manufacturing dislocation. Japan is still a cyclical economy and stands to benefit (Chart 18). Chart 17No Quick Fix For Poor Productivity No Quick Fix For Poor Productivity No Quick Fix For Poor Productivity Chart 18Chinese Stimulus Will Be Steady Chinese Stimulus Will Be Steady Chinese Stimulus Will Be Steady In the long run, however, Japan’s future darkens considerably when its own demographic decline and deflationary tendencies are coupled with China’s inheritance of these same trends. The Communist Party is doubling down on import substitution and foreign policy assertiveness, ensuring that trade and strategic conflict with the US will escalate over time. Japan will remain allied with the United States, out of its own strategic interest, but will pay the price in periodic headwinds to growth. Its ability to relocate manufacturing to Japan is limited in all but the most sophisticated of industries. It will have to embrace ever more unorthodox monetary and fiscal policy while investing heavily in new technologies and emerging markets ex-China in search of growth. Geopolitically speaking, Shinzo Abe helped the United States formulate its new strategic plan of promoting a “free and open Indo-Pacific” and the spirit of this policy will outlive Abe and President Trump. The US’s “pivot to Asia” began under the Democratic Party, which will rejoin the Trans-Pacific Partnership, with a few tweaks, if it returns to power. The US and Japan are both interested in forming a grand coalition of nations surrounding China to contain its ambitions, whether military, political, or technological. China would be naïve not to see the quadrilateral security dialogue between these countries and India and Australia as the blueprint of a naval alliance designed to contain it. The Taiwan Strait, the South and East China Seas, Vietnam, the Philippines, and the Korean Peninsula will become the sites of “proxy battles” as the US and Japan strive to contain China. Japan will retain its safe haven status – in both the geopolitical and financial sense – while other countries will see a higher geopolitical risk premium. Japanese and Korean trade tensions will persist, unless the US takes a leadership role in strengthening the trilateral relationship. Russia has chosen to throw in its lot with China, which will not change anytime soon. But if Abe’s successor is able to get peace negotiations back on track, in pursuit of another of Abe’s major unfinished initiatives, then this would serve as an important bellwether of Russia’s own fear of China’s growing power. Investment Takeaways Chart 19Japanese Stocks Look Attractive... Japanese Stocks Look Attractive... Japanese Stocks Look Attractive... Japanese equities are exceedingly cheap and hence attractive over the long run, given that a new global business cycle is beginning and governments around the world are committed to providing as much support as they are able. At a dividend yield of less than 2.5%, the real return on Japanese stocks over the next ten years could be 20% (Chart 19). However, over the next three-to-six months, the world faces extreme uncertainty over the US election and rapidly deteriorating US-China relations. The Japanese economy is slowing and monetary policy, at the zero lower bound, will play a marginal role. The yen is set to appreciate as a safe-haven in this environment (Chart 20), and until there is a total divergence of the inverse correlation of the yen and Japanese equities, the latter will struggle to outperform those of other developed markets on a sustained basis. Chart 20... But Yen Rally Will Continue ... But Yen Rally Will Continue ... But Yen Rally Will Continue Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Box 1: Ishiba Is Not A Real Risk To The Policy Status Quo Shigeru Ishiba, while not favored to succeed Abe in the short run, is a compelling Japanese politician and one of the few Liberal Democratic leadership candidates who would mark a change with Abe, as Table 1 above indicates. If Ishiba looks to become prime minister, now or later, he would create some financial market jitters primarily because he would not symbolize seamless policy continuity. He is a major rival of Abe and has publicly criticized Abenomics, including in his 2018 book.2 He is reputed to be a hawk on monetary and fiscal policy. However, a close look at his record shows that he is not ideological and would not revolutionize Japanese national policy once in office. Ishiba is a careful and rational thinker and an institutional and establishment LDP politician. Both Ishiba and his father (Jiro Ishiba) were scions of the Tanaka/Takeshita factions whose base was agriculture, construction industry, defense industry, and the postal service.3 His is not the background of a radical fiscal hawk. One of Ishiba’s major concerns is generating growth outside of the major cities, but he does not take a slash and burn approach to the central government budget. For example, at a forum on Abenomics, the director of the Japanese Civilization Institute spoke with Ishiba in his capacity as Minister of Regional Revitalization. The moderator gave Ishiba the opportunity to denounce excess government spending and promote central spending cuts, saying, “Maybe you must arrange fiscal discipline more appropriately. Then, you can supply that money to regional areas.” Ishiba responded drily, “But I think regional areas must make their own money too.” The yen could rally on a bout of political uncertainty if Ishiba at any time looks likely to become LDP leader and he criticizes excessively easy economic policies. But, as we noted above in the report above, the BoJ Policy Board, not the prime minister’s office, will set monetary policy – and Ishiba would struggle to stack the board with hawks due to institutional resistance. Moreover in the wake of a global recession, the next prime minister will not have much ability to drive parliament into budget cuts or tax hikes. Ishiba would more likely seek to pursue deregulation. If he insisted on austerity, the economy would slump and his premiership would be ruined. Chances are he would listen to his advisers. The one policy that concerns Ishiba above all is national defense and security. Ishiba previously served as defense minister and was known for his hawkish tone, particularly over disputes in the East China Sea and domestic protests against the country’s new security law. More recently he differed with Abe’s constitutional revision – not over the need to normalize Japan’s self-defense forces, but because Abe tried to avoid an explicit mention of Japan’s right to maintain armed forces. If anything, Ishiba would be inclined to increase military spending. Yet his foreign policy is not a risk to the markets, beyond rhetoric, as he is also more willing to engage China than some other LDP leaders. Footnotes 1 In truth, something of a national awakening had already begun in the early 2000s under Prime Minister Junichiro Koizumi. This is reflected in the improvement of the fertility rate from 2005. But it fell to Abe to pick up where Koizumi had left off, fighting deflation and strengthening Japan’s international position. 2 See "Abe’s rival to declare bid to become Japan’s next leader," Nikkei, July 13, 2018, asia.nikkei.com. See a campaign synopsis at ishiba.com. 3 See Jojin V. John, "Developments in Japanese Politics: LDP Presidential Election and the Future of Prime Minister Shinzo Abe," Indian Council of World Affairs, August 29, 2018, icwa.in

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