Geopolitics

Highlights China’s Communist Party has overcome a range of challenges over the past 100 years, performed especially well over the past 42 years, but the macro and geopolitical outlook is darkening. The “East Asian miracle” phase of Chinese growth has ended. Potential GDP growth is slowing and it will be harder for Beijing to maintain financial and sociopolitical stability. The Communist Party has shifted the basis of its legitimacy from rapid growth to quality of life and nationalist foreign policy. The latter, however, will undermine the former by stirring up foreign protectionism. In the near term, global investors should favor developed market equities over China/EM equities. But they should favor China and Hong Kong stocks over Taiwanese stocks given significant geopolitical risk over the Taiwan Strait. Structurally, favor the US dollar and euro over the renminbi. Feature Ten years ago, in the lead up to the Communist Party’s 90th anniversary, I wrote a report called “China and the End of the Deng Dynasty,” referring to Deng Xiaoping, the Chinese Communist Party’s great pro-market reformer.1 The argument rested on three points: the end of the export-manufacturing economic model, an increasingly assertive foreign policy, and the revival of Maoist nationalism. After ten years the report holds up reasonably well but it did not venture to forecast what precisely would come next. In reality it is the rule of the Communist Party, and not the leader of any one man, that fits into China’s history of dynastic cycles. As the party celebrates a hundred years since its founding on July 23, 1921, it is necessary to pause and reflect on what the party has achieved over the past century and what the current Xi Jinping era implies for the country’s next 100 years. Single-Party Rule Can Bring Economic Success. Communism Cannot. Regime type does not preclude wealth. Countries can prosper regardless of whether they are ruled by one person, one party, or many parties. The richest countries in the world grew rich over centuries in which their governments evolved from monarchy to democracy and sometimes back again. Even today several of the world’s wealthy democracies are better described as republics or oligarchies. Chart 1China Outperformed Communism But Not Liberal Democracy China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? The rule of one person, or autocracy, is not necessarily bad for economic growth. For every Kim Il Sung of North Korea there is a Lee Kuan Yew of Singapore. But authority based on a single person often expires with that person and rarely survives his grandchild. In China, Chairman Mao Zedong’s death occasioned a power struggle. Deng Xiaoping’s attempts to step down led to popular unrest that threatened the Communist Party’s rule on two separate occasions in the 1980s. The rule of a single party is thought to be more sustainable. Japan and Singapore are effectively single-party states and the wealthiest countries in Asia. They are democracies with leadership rotation and a popular voice in national affairs. And yet South Korea’s boom times occurred under single-party military rule. The same goes for the renegade province of Taiwan. Only around the time these two reached about $11,000-$14,000 GDP per capita did they evolve into multi-party democracies – though their wealth grew rapidly in the wake of that transition. China and soon Vietnam will test whether non-democratic, single-party rule can persist beyond the middle-income economic status that brought about democratic transition in Taiwan (Chart 1). Vietnam and Taiwan are the closest communist and non-communist governing systems, respectively, to mainland China. Insofar as China and Vietnam succeed at catching up with Taiwan it will be for reasons other than Marxist-Leninist ideology. Most communist systems have failed. At the height of international communism in the twentieth century there were 44 states ruled by communist parties; today there are five. China and Vietnam are the rare examples of communist states that not only survived the Soviet Union’s fall but also unleashed market forces and prospered (Chart 2). North Korea survived in squalor; Cuba’s experience is mixed. States that close off their economies do not have a good record of generating wealth. Closed economies lack competition and investment, struggle with stagflation, and often succumb to corruption and political strife. Openness seems to be a more diagnostic variable than government type or ideology, given the prosperity of democratic Japan and non-democratic China. Has the CPC performed better than other communist regimes? Arguably. It performs better than Vietnam but worse than Cuba on critical measures like infant mortality rates and life expectancy. Has it performed better than comparable non-communist regimes? Not really, though it is fast approaching Taiwan in all of these measures (Chart 3). Chart 2Communist States Get Rich By Compromising Their Communism China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? Chart 3China Catching Up To Cuba On Basic Wellbeing China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? What can be said for certain is that, since China’s 1979 reform and opening up, the CPC has avoided many errors and catastrophes. It survived the 1980s, 1990s, and 2000s without succumbing to international isolation, internal divisions, or economic crisis. It has drastically increased its share of global power (Table 1). Contrast this global ascent with the litany of mistakes and crises in the US since the year 2000. The CPC also managed the past decade relatively well despite the Chinese financial turmoil of 2015-16, the US trade war of 2018-19, and the COVID-19 pandemic. However, these events hint at greater challenges to come. China’s transition to a consumer-oriented economy has hardly begun. The struggle to manage systemic financial risk is intensifying today at risk to growth and stability (Chart 4). The trade war is simmering despite the Phase One trade deal and the change of party in the White House. And it is too soon to draw conclusions about the impact of the global pandemic, though China suppressed the virus more rapidly than other countries and led the world into recovery. Table 1China’s Global Rise After ‘Reform And Opening Up’ China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? Chart 4China To Keep Struggling With Financial Instability China To Keep Struggling With Financial Instability China To Keep Struggling With Financial Instability Judging by the points above, there are two significant risks on the horizon. First, the CPC’s revival of neo-Maoist ideology, particularly the new economic mantra of self-reliance and “dual circulation” (import substitution), poses the risk of closing the economy and undermining productivity.2 Second, China’s sliding back into the rule of a single person – after the “consensus rule” that prevailed after Deng Xiaoping – increases the risk of unpredictable decision-making and a succession crisis whenever General Secretary Xi Jinping steps down. The party’s internal logic holds that China’s economic and geopolitical challenges are so enormous as to require a strongman leader at the helm of a single-party and centralized state. But because of the traditional problems with one-man rule, there is no guarantee that the country will remain as stable as it has been over the past 42 years. Slowing Growth Drives Clash With Foreign Powers Every major East Asian economy has enjoyed a “miracle” phase of growth – and every one of them has seen this phase come to an end. Now it is China’s turn. The country’s potential GDP growth is slowing as the population peaks, the labor force shrinks, wages rise, and companies outsource production to cheaper neighbors (Charts 5A & 5B). The Communist Party is attempting to reverse the collapse in the fertility rate by shifting from its historic “one Child policy,” which sharply reduced births. It shifted to a two-child policy in 2016 and a three-child policy in 2021 but the results have not been encouraging over the past five years. Chart 5AChina’s Demographic Decline Accelerating China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? Chart 5BChina’s Demographic Decline Accelerating China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? In the best case China’s growth will follow the trajectory of Taiwan and South Korea, which implies at most a 6% yearly growth rate over the next decade (Chart 6). This is not too slow but it will induce financial instability as well as hardship for overly indebted households, firms, and local governments. Chart 6China's Growth Rates Will Converge With Taiwan, South Korea China's Growth Rates Will Converge With Taiwan, South Korea China's Growth Rates Will Converge With Taiwan, South Korea The Communist Party’s legitimacy was not originally based on rapid economic growth but it came to be seen that way over the roaring decades of the 1980s through the 2000s. Thus when the Great Recession struck the party had to shift the party’s base of legitimacy. The new focus became quality of life, as marked by the Xi administration’s ongoing initiatives to cut back on corruption, pollution, poverty, credit excesses, and industrial overcapacity while increasing spending on health, education, and society (Chart 7). Chart 7China’s Fiscal Burdens Will Rise On Social Welfare Needs China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? The party’s efforts to improve standards of living and consumer safety also coincided with an increase in propaganda, censorship, and repression to foreclose political dissent. The country falls far short in global governance indicators (Chart 8). Chart 8China Lags In Governance, Rule Of Law China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? A second major new source of party legitimacy is nationalist foreign policy. China adopted a “more assertive” foreign and trade policy in the mid-2000s as its import dependencies ballooned. It helped that the US was distracted with wars of choice and financial crises. After the Great Recession the CPC’s foreign policy nationalism became a tool of generating domestic popular support amid slower economic growth. This was apparent in the clashes with Japan and other countries in the East and South China Seas in the early 2010s, in territorial disputes with India throughout the past decade, in political spats with Norway and most recently Australia, and in military showdowns over the Korean peninsula (2015-16) and today the Taiwan Strait (Chart 9). Chart 9Proxy Wars A Real Risk In China’s Periphery China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? If China were primarily focused on foreign policy and global strategy then it would not provoke multiple neighbors on opposite sides of its territory at the same time. This is a good way to motivate the formation of a global balance-of-power coalition that can constrain China in the coming years. But China’s outward assertiveness is not driven primarily by foreign policy considerations. It is driven by the secular economic slowdown at home and the need to use nationalism to drum up domestic support. This is why China seems indifferent to offending multiple countries at once (like India and Australia) as well as more distant trade partners whom it “should be” courting rather than offending (like Europe). Such assertive foreign policy threatens to undermine quality of life, namely by provoking international protectionism and sanctions on trade and investment. The US is galvanizing a coalition of democracies to put pressure on China over its trade practices and human rights. The Asian allies are mostly in step with the US because they fear China’s growing clout. The European states do not have as much to fear from China’s military but they do fear China’s state-backed industry and technological rise. Europe’s elites also worry about anti-establishment political movements just like American elites and therefore are trying to win back the hearts and minds of the working class through a more proactive use of fiscal and industrial policy. This entails a more assertive trade policy. China has so far not adapted to the potential for a unified front among the democracies, other than through rhetoric. Thus the international horizon is darkening even as China’s growth rates shift downward. China’s Geopolitical Outlook Is Dimming China’s government has overcome a range of challenges and crises. The country takes an ever larger role in global trade despite its falling share of global population because of its productivity and competitiveness. The drop in China’s outward direct investment is tied to the global pandemic and may not mark a top, given that the country will still run substantial current account surpluses for the foreseeable future and will need to recycle these into natural resources and foreign production (Chart 10). However, the limited adoption of the renminbi as a reserve currency in the face of this formidable commercial power reveals the world’s reservations about Beijing’s ability to maintain macroeconomic stability, good governance, and peaceful foreign relations. Chart 10China's Rise Continues China's Rise Continues China's Rise Continues Chart 11China's Policy Uncertainty: A Structural Uptrend China's Policy Uncertainty: A Structural Uptrend China's Policy Uncertainty: A Structural Uptrend China is not in a position to alter the course of national policy dramatically prior to the Communist Party’s twentieth national congress in 2022. The Xi administration is focused on normalizing monetary and fiscal policy and heading off any sociopolitical disturbances prior to that critical event, in which General Secretary Xi Jinping, who was originally slated to step down at this time according to the old rules, may be anointed the overarching “chairman” position that Mao Zedong once held. The seventh generation of Chinese leaders will be promoted at this five-year rotation of the Central Committee and will further consolidate the Xi administration’s grip. It will also cement the party’s rotation back to leaders who have ideological educations, as opposed to the norm in the 1990s and early 2000s of promoting leaders with technocratic skills and scientific educations.3 This does not mean that President Xi will refuse to hold a summit with US President Biden in the coming months nor does it mean that US-China strategic and economic dialogue will remain defunct. But it does mean that Beijing is unlikely to make any major course correction until after the 2022 reshuffle – and even then a course correction is unlikely. China has taken its current path because the Communist Party fears the sociopolitical consequences of relinquishing economic control just as potential growth slows. The new ruling philosophy holds that the Soviet Union fell because of Mikhail Gorbachev’s glasnost and perestroika, not because openness and restructuring came too late. Moreover it is far from clear that the US, Europe, and other democratic allies will apply such significant and sustained pressure as to force China to change its overall strategy. America is still internally divided and its foreign policy incoherent; the EU remains reactive and risk-averse. China has a well-established set of strategic goals for 2035 and 2049, the 100th anniversary of the People’s Republic, and the broad outlines will not be abandoned. The implication is that tensions with the US and China’s Asian neighbors will persist. Rising policy uncertainty is a secular trend that will pick back up sooner rather than later (Chart 11), to the detriment of a stable and predictable investment environment. Chart 12Chinese Government’s Net Worth High But Hidden Liabilities Pose Risks China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? Monetary and fiscal dovishness and a continued debt buildup are the obvious and necessary solutions to China’s combination of falling growth potential, rising social liabilities, the need to maintain the rapid military buildup in the face of geopolitical challenges. Sovereign countries can amass vast debts if they own their own debt and keep nominal growth above average bond yields. China’s government has a very favorable balance sheet when national assets are taken into consideration as well as liabilities, according to the IMF (Chart 12). On the other hand, China’s government is having to assume a lot of hidden liabilities from inefficient state-owned companies and local governments. In the short run there are major systemic financial risks even though in the long run Beijing will be able to increase its borrowing and bail out failing entities in order to maintain stability, just like Japan, the US, and Europe have had to do. The question for China is whether the social and political system will be able to handle major crises as well as the US and Europe have done, which is not that well. Investment Takeaways The rule of a single party is not a bar to economic success – but the rule of a single person is a liability due to the problem of succession. Marxism-Leninism is terrible for productivity unless it is compromised to allow for markets to operate, as in China and Vietnam. States that close their economies to the outside world usually atrophy. There is no compelling evidence that China’s Communist Party has performed better than a non-communist alternative would have done, given the province of Taiwan’s superior performance on most economic indicators. Since 1979, the Communist Party has avoided catastrophic errors. It has capitalized on domestic economic potential and a favorable international environment. Now, in the 2020s, both of these factors are changing for the worse. China’s “miracle” phase of growth has expired, as it did for other East Asian states before it. The maturation of the economy and slowdown of potential GDP have forced the Communist Party to shift the base of its political legitimacy to something other than rapid income growth: namely, quality of life and nationalist foreign policy. An aggressive foreign policy works against quality of life by provoking protectionism from foreign powers, particularly the United States, which is capable of leading a coalition of states to pressure China. The Communist Party’s policy trajectory is unlikely to change much through the twentieth national party congress in 2022. After that, a major course correction to improve relations with the West is conceivable, though we would not bet on it. Between 2021 and China’s 2035 and 2049 milestones, the Communist Party must navigate between rising socioeconomic pressures at home and rising geopolitical pressures abroad. An economic or political breakdown at home, or a total breakdown in relations with the US, could lead to proxy wars in China’s periphery, including but not limited to the Taiwan Strait. For now, global investors should favor the euro and US dollar over the renminbi (Chart 13). Chart 13Prefer The Dollar And Euro To The Renminbi Prefer The Dollar And Euro To The Renminbi Prefer The Dollar And Euro To The Renminbi Mainland investors should favor government bonds relative to stocks. Chinese stocks hit a major peak earlier this year and the government’s seizure of control over the tech sector is taking a toll. Investors should prefer developed market equities relative to Chinese equities until China’s current phase of policy tightening ends and there is at least a temporary improvement in relations with the United States. But investors should also prefer Chinese and Hong Kong stocks relative to Taiwanese due to the high risk of a diplomatic crisis and the tail risk of a war. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 The report concluded, “the emerging trends suggest a likely break from Deng's position toward heavier state intervention in the economy, more contentious relationships with neighbors, and a Party that rules primarily through ideology and social control.” Co-written with Jennifer Richmond, "China and the End of the Deng Dynasty," Stratfor, April 19, 2011, worldview.stratfor.com. 2 The Xi administration’s new concept of “dual circulation” entails that state policy will encourage the domestic economy whereas the international economy will play a secondary role. This is a reversal of the outward and trade-oriented economic model under Deng Xiaoping. See “Xi: China’s economy has potential to maintain long-term stable development,” November 4, 2020, news.cgtn.com. 3 See Willy Wo-Lap Lam, "China’s Seventh-Generation Leadership Emerges onto the Stage," Jamestown Foundation, China Brief 19:7, April 9, 2019, Jamestown.org.

Highlights The US Innovation and Competition Act shows that the US is rediscovering industrial policy amid domestic populism and foreign geopolitical risk.  Fiscal accommodation is a basis for the economy to improve, political polarization to moderate, and Congress’s approval rating to continue to normalize.  Biden’s infrastructure bill still has a subjective 80% chance of passage, despite bipartisan talks faltering and his own caucus growing restive. The price tag is still around $1-$1.5 trillion. Senate passage will mark peak US stimulus for this cycle. Close long consumer staples for a gain of 6%. Cut losses on long materials/tech. Close our fiscal advantage trade relative to the NASDAQ. Feature Bipartisanship is not dead in the 117th Congress, though a bipartisan deal on infrastructure may not come together. Investors should still expect Congress to pass the president’s signature legislative proposal, the American Jobs Plan. Our subjective odds remain 80% with high conviction. The bill’s price tag is still ranging from $1-to-$1.5 trillion in deficit spending this year, or 4.4%-6.7% of GDP – i.e. not a number that financial markets can ignore. A budget resolution is being drafted with a rough headline value of $1.5 trillion. Financial markets are experiencing an inevitable period of doubts over whether the bill will actually pass. In the short run investors should stay invested in infrastructure plays, cyclical equity sectors, and value stocks. However, market dynamics are shifting and there is a basis for upgrading the tech and health sectors. The Senate’s passage of Biden’s infrastructure bill, in whatever form, will mark the peak of US fiscal stimulus for this cycle. Meanwhile our theme of bipartisan structural reform is apparent in the Senate’s passage of the Innovation and Competition Act on June 8 (Chart 1). This bill marks a rare bipartisan achievement in Congress and a sea change in American policymaking. The sea change is the US’s need to revive industrial policy in order to compete with adversaries abroad – a mission that the political establishment supports after being snapped out of its slumber by President Trump’s populist rebellion. In this report we take a look at the domestic consequences of this bill. We leave the international consequences to our sister Geopolitical Strategy service. Chart 1Newsflash: Bipartisan Bill Passes Senate Via Regular Order! A Bipartisan Congress? A Bipartisan Congress? We also look at the surprising recovery in Congress’s popular approval rating. While the US remains at “peak polarization” from a historic point of view, there is a cyclical drop in polarization after the quadruple crisis of 2020 (pandemic, recession, social unrest, contested election) (Chart 2). This cyclical drop may well become a secular decline over the coming decade, as fiscal accommodation at home and geopolitical risk abroad will generate domestic policy consensus on the topics of trade, manufacturing, industry, and technology. This trend will support Congress’s approval rating. Chart 2Polarization Subsides From Crisis Peaks Polarization Subsides From Crisis Peaks Polarization Subsides From Crisis Peaks While Congress will never be loved, it will not be as hated in the coming decade as the past decade. The reason is that Congress is taking a more active role in the economy. This is positive for markets in the short run but adds policy uncertainty over the long run. The Return Of Industrial Policy The US Innovation and Competition Act (USICA) is the outcome of a crisis in the American political system two decades in the making. The hyper-globalization of the Bill Clinton presidency, combined with the profligate economic and foreign policies of the George W. Bush presidency, led to the Great Recession. While the US was distracted with foreign wars and financial crisis, China emerged as a challenger to the US’s strategic dominance (Russia also revived and undermined US stability). The Obama administration began taking tougher action on China in 2015 but by then it was too late to accomplish much. The sluggish recovery and loss of national status triggered a populist rebellion in the form of the Trump administration, which provoked an even greater backlash from the political establishment in 2020. The Republicans imposed fiscal austerity, took power, then abandoned austerity and declared a trade war on China. The Democrats took back power, abandoned austerity, and are continuing the trade war. Now the two parties agree on the need to increase government support for the economy (infrastructure, industrial policy, protectionism) and to redirect foreign policy to confront major powers like China and Russia (as opposed to wasteful forever wars in the Middle East and South Asia). Public opinion has been coalescing around these twin goals since 2008 and the Biden administration so far can be said to represent a kind of synthesis of the Obama and Trump administrations. Even more powerful is the formation of a new consensus in Congress, which is the “first branch” of the US government and represents popular attitudes. Congress has always been more nationalist and more protectionist in its leanings than the executive and judicial branches, which represent policy elites and technocrats.1 While Congress is fickle when it comes to passing fancies of the day, it can be incredibly stubborn when it comes to a nationwide, once-in-a-generation popular consensus. Moreover China does not present a fleeting challenge like Iraq or Al Qaeda. It is more like the Soviet Union and will motivate a congressional consensus and policy consensus for decades. Great power competition will work against US political polarization. A Productivity Mini-Boom The USICA consists of about $115 billion in federal research and development funding, $52 billion in funding for the US semiconductor industry, and $10 billion for regional tech hubs. Funding will flow to the National Science Foundation, NASA, the Department of Energy, and the Defense Advanced Research Projects Agency (DARPA), among others. There are also specific measures to counter China (including intellectual property protections) as well as a regulatory overhaul to codify “Buy America” provisions and require that materials used in federally funded projects are produced in the United States (Table 1). Table 1US Senate Passes Bipartisan ‘Innovation And Competition Act’ To Counter China A Bipartisan Congress? A Bipartisan Congress? In research and development, the USICA formalizes the key technologies that the federal government should focus on and fund. These include: AI, machine learning, and autonomy High performance computing Quantum science and technology Natural and anthropogenic disaster prevention and mitigation Advanced communication technology Biotech, medical tech, genomics, and synthetic biology Data storage and cybersecurity Advanced energy, industrial efficiency, batteries, nuclear energy Advanced material science The $81 billion allocated to the National Science Foundation, covering fiscal 2022-26, will be allocated as shown in Table 2. The Department of Energy will focus on energy-related supply chain issues within the key technological areas of focus. Table 2NSF Gets Additional Dole A Bipartisan Congress? A Bipartisan Congress? Private research and development amount to more than twice the R&D spending of the federal government (Chart 3). Higher spending will augment private R&D, rather than substitute for it. It will likely boost US productivity, which has been in the doldrums over the past few years. Chart 3A Boost To R&D Spending A Boost To R&D Spending A Boost To R&D Spending While it is speculative to say whether the revival of industrial policy will cause productivity to break out of its long-term structural decline, a mini-boom seems warranted, especially when considering that foreign competition will remain a constant impetus (Chart 4). There is ample pork-barrel spending and plenty of potential for boondoggles, as will always be the case with fiscal spending splurges. But a rise in productivity will have a greater macro impact. Chart 4US Productivity Boom, Or At Least Mini-Boom US Productivity Boom, Or At Least Mini-Boom US Productivity Boom, Or At Least Mini-Boom Another aspect of the bill consists of funding for regional technology hubs. The office of Economic Development Administration will oversee three tech hubs in each region covered by the EDA’s regional office. These must be areas that are not already tech centers. No less than one third of the funding will go to small and rural communities and at least one consortium must be headquartered in a low-population state. The info-tech revolution and de-industrialization have created a problem of regional inequality, which these measures attempt to address. The USICA also funds the incentives for the domestic semiconductor industry first outlined in the national defense appropriations last year. The CHIPS Act, for example, helps incentivize investment in facilities and equipment for computer chip fabrication, assembly, testing, advanced packaging, and R&D. This funding was subject to the availability of appropriations but is now authorized under the USICA to the tune of $52 billion. Substantial breakthroughs in the 1980s-90s, in software and other areas, followed on much smaller public investments in education and research.2 The semiconductor industry is capital-intensive. For every one dollar in sales, 15 cents of capital expenditures are needed, compared to just seven cents in the tech sector as a whole and six cents across companies in the S&P 500 index. The capex requirement for the energy sector grew from six cents in 2004 to 17 cents in 2015, almost tripling in a decade due to the capital intensity of the shale boom (Chart 5). Thus lowering the cost of investment for the semiconductor companies will have a major positive impact. Quarterly capex for the chip makers stands at around $25 billion. An infusion of $52 billion in government incentives over five years amounts to $2.6 billion per quarter or roughly 10% of current capex. Chart 5A Boon For US Semi Capex A Boon For US Semi Capex A Boon For US Semi Capex Finally, the USICA consists of notable “Buy America” or protectionist measures. The bill holds that public works must be produced by American workers and funding should not be used to reward companies that “offshore” their operations, especially to countries that do not share US regulatory standards on workers, workplace safety, and the environment. The USICA gives a big sop to US manufacturing: all manufactured goods purchased with the bill’s funding must be made in the USA or have at least 55% of their total components sourced in the country. All iron and steel manufacturing processes, from melting through coatings, must occur in the United States. Buy America provisions will stir up some quarrels with US allies and trading partners but ultimately the US will need to increase imports as a result of the USICA. Private non-residential investment in the US moves closely with import growth, whereas US government investment has less of a relationship with imports (Chart 6). Chart 6Supply Constraints Amid US Fiscal Stimulus Supply Constraints Amid US Fiscal Stimulus Supply Constraints Amid US Fiscal Stimulus The Buy American provision will put new pressures on a supply chain that is already strained by the pandemic and the Trump administration’s tariffs. Industrial production is at an all-time high and so are producer prices, which means that producers have high pricing power. This is beneficial for the industrial and materials sectors over the medium term, even if the short-term inflation scare proves overdone (Chart 7). Buy American provisions will even improve the pricing power of the machinery sub-sector, as contractors will be forced to buy American-made machinery. The bottom line is that the Biden administration has coopted the Trump administration’s agenda on China, trade, and manufacturing, which itself was an attempt to steal thunder from the Obama administration. However, Biden and the Democrats bring a defensive and domestic-oriented approach rather than an offensive and foreign-oriented approach. Tariffs and investment restrictions will stay on China but they are not being increased or tightened (at least not yet). Instead the emphasis falls on fiscal largesse for US industry and manufacturing as well as research and development, promotion of STEM education (science, technology, education, and mathematics), and semiconductor subsidies. Chart 7Sustained Proactive Fiscal Policy Is Inflationary Sustained Proactive Fiscal Policy Is Inflationary Sustained Proactive Fiscal Policy Is Inflationary The goal is to increase the pace of US innovation, notwithstanding the fact that countries will continue to borrow, spy, and steal from each other. The international context of competition – and the widespread resort to debt monetization – will have a positive impact on productivity over the long run. But the protectionist regulations will combine with US supply constraints to put upward pressure on material and industrial prices over the short and medium run. Will Americans Hate Congress Less? A bipartisan industrial agenda in Congress raises the question of whether a bipartisan infrastructure deal can also be achieved. We remain optimistic, though the talks are currently wobbling. Biden’s approval among Democrats is falling as the Democratic caucus abandons his attempt to forge a bipartisan infrastructure deal and presses for a Democrat-only reconciliation bill. However, his overall approval rating is not likely to settle at a lower level than that of Presidents Obama and Trump. His approval rating on handling the economy has probably already hit its floor (Chart 8). He still has the ability to pass a signature piece of legislation, according to our Political Capital Index (Appendix). Chart 8Biden Struggles With Democratic Party A Bipartisan Congress? A Bipartisan Congress? Chart 9US Public Approving Of Congress?!? A Bipartisan Congress? A Bipartisan Congress? The sharp increase in public approval for Congress is another signal of Biden’s political capital (Chart 9). About 36% of Americans now say they approve of the job Congress is doing while 61% disapprove. This is not very good in absolute terms but relative to Congress’s history it is notable. The sharp uptick is due in large part to the expanded unemployment benefits, stimulus checks, and other social subsidies doled out during the pandemic. A fleeting spike in approval also occurred around the GFC-era stimulus, only to give way to new lows. Yet there is a deeper source. Approval of Congress has risen continually since the bruising debt ceiling standoffs and government shutdowns of 2010-14, when the Obama administration squared off against a Republican Congress in the context of a sluggish economy (Chart 10). With Gallup polling data going back to the 1970s, the big picture is that Americans lost faith in Congress during the stagflationary 1970s, the first Gulf War and recession of the early 1990s, and especially the Iraq/Afghanistan wars and Great Recession. It is now slowly recovering to normally low (rather than abnormally low) levels. Chart 10A Longer View Of Public Attitudes Toward Congress A Bipartisan Congress? A Bipartisan Congress? Aside from fleeting rallies around the flag, such as after the September 11, 2001 terrorist attacks, public approval of Congress rarely rises above 50%. The reasons are obvious: Congress is an institution in which power-hungry politicians engage in endless and petty quarrels over the minutiae of public policy in full view of the world. Its job is inherently unpopular.3 But as partisanship and polarization have increased dramatically since the 1980s, Congress has lost effectiveness at its primary function of forging compromises and passing laws. The public differs on what laws should be passed but it generally disapproves of the lack of compromise (Chart 11). A clear uptrend in congressional approval has emerged since the near-recession of 2015. The one overriding change in national policy since that time has been the activation of the fiscal lever. Trump unleashed a bipartisan spending binge as well as tax cuts. COVID-19 encouraged a Trump-Biden spending binge. Now Biden’s measures are adding to this anti-austerity blowout. While voters rewarded Congress for balancing the budget in the 1990s, the Great Recession marked a secular change. Disapproval rose with the process of fiscal tightening from 2010-14 (budget sequestration) and fell as the fiscal deficit has widened since then (Chart 12). Chart 11Public Approves Of Lawmakers Who … Make Laws A Bipartisan Congress? A Bipartisan Congress? Chart 12Public Approves Of Spendthrift Congress? A Bipartisan Congress? A Bipartisan Congress? Voters do not approve of Congress based on wonky policy views. Their approval, like their approval of the president, tracks with the state of the nation. There is a fairly close correlation between the two approval ratings. A major deviation emerged in 2010-14 when President Obama partially restored public faith in the presidency (albeit with historically low approval ratings) while Congress sank to even lower lows than it witnessed during the Iraq war on the back of Republican obstructionism and Obama’s second-term legislative failures (Chart 13). The current trend is for presidential approval to remain flat at its post-2010 levels while Congress regains some support. Chart 13Approval Of Congress Tracks Approval Of President A Bipartisan Congress? A Bipartisan Congress? Congressional infighting will resume after Biden passes the American Jobs Plan. His American Families Plan is much less likely to pass. Opposition Republicans have a subjective 75% chance of retaking the House of Representatives in 2022, which would result in gridlock. However, congressional approval is normalizing from the depths of the disinflationary 2010s to around the 30%-40% range. It will probably continue tracking presidential approval. And history shows that presidential approval ultimately hinges on peace and prosperity as opposed to war, recession, and scandal (Chart 14). This will dictate the direction under the Biden administration and beyond. Chart 14Approval Of President Tracks ‘Peace And Prosperity’ A Bipartisan Congress? A Bipartisan Congress? A critical factor is whether polarization will continue to subside. High polarization makes it so that voters identify the passage or failure of government policy exclusively with the ruling party; this incentivizes the opposition to obstruct.4 Lower polarization enables bipartisan deals and thus forces the two parties to share the praise and the blame of new policies. Compromise and lawmaking increase congressional approval; higher congressional approval increases the odds of compromise. The current legislative agenda reveals several areas of emerging consensus, not only on industrial policy and manufacturing but also on anti-trust law and infrastructure (Table 3). Table 3Pending Legislation In Congress Under Biden A Bipartisan Congress? A Bipartisan Congress? The Biden administration may only get one or two more major bipartisan legislative accomplishments. Polarization is still at historically elevated levels. In the next two-to-five years polarization could easily re-escalate, given the ongoing power struggle between the two dominant parties and the grievances over the 2020 election. However, over the next five-to-ten years, polarization should settle at levels beneath the record highs witnessed in 2020 due to foreign competition and fiscal accommodation. The USICA shows how this trend could take shape. Investment Takeaways The macro implications of Biden’s political capital and Congress’s rising approval rating consist of trends and themes that we have emphasized before: the return of Big Government; populist monetary and fiscal policy; protectionist industrial policy; nation building at home; and geopolitical struggle abroad. There is no direct market impact of a less unpopular Congress – the implication can be positive or negative depending on the policies, assets, and time frames in question. For example, the congressional effect, in which markets rally while Congress is at recess, is debatable.5 Congress is least active in January, July, August, and December and yet this recess schedule manifestly has no consistent impact on well-known equity market calendar effects (Chart 15). Chart 15Calendar Effects But No Congressional Calendar Effect A Bipartisan Congress? A Bipartisan Congress? Markets under congressional gridlock often outperform markets under single-party sweeps but the difference is small and debatable (Chart 16). Markets dislike both effective congresses that pursue market-unfriendly policies and ineffective congresses that would be pursuing market-friendly policies. The pandemic and recession required an effective congress, bipartisan stimulus resulted, and approval has gone up. Sustaining this approval will require avoiding both deflationary and stagflationary environments in the coming years, as well as gratuitous wars and massive scandals. That will be difficult. Chart 16Sweeps Don’t Always Underperform Gridlock A Bipartisan Congress? A Bipartisan Congress? Still, a floor in congressional approval has probably been established over the past decade as the US political establishment has rediscovered proactive fiscal policy at home and nationalism abroad. These two key trends create cross-currents for the dollar. The macroeconomic backdrop for the dollar is bearish but the political and geopolitical backdrop is bullish. At present the dollar stands at a critical juncture. Any increase in global policy uncertainty and geopolitical risk abroad should push the dollar up (Chart 17). Given the dollar-bearish BCA House View, we are therefore neutral and will revisit the issue in our upcoming third quarter outlook report. We are adjusting our equity sector risk matrix. Our new US Equity Strategist, Irene Tunkel, argues convincingly that investors should continue favoring cyclicals but also take a more optimistic outlook on the tech and health sectors. We agree on health in particular since the Biden administration’s policy risks have largely been passed up. We are closing our long materials / short tech trade for a loss of 8.2% and our long fiscal advantage / NASDAQ trade for a loss of 1.3%. We will also close our long consumer staples trade for a gain of 6.5%. Chart 17Relative Policy Uncertainty Rising, Greenback On Edge Relative Policy Uncertainty Rising, Greenback On Edge Relative Policy Uncertainty Rising, Greenback On Edge   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com   Appendix Table A1USPS Trade Table A Bipartisan Congress? A Bipartisan Congress? Table A2Political Risk Matrix A Bipartisan Congress? A Bipartisan Congress? Table A3Political Capital Index A Bipartisan Congress? A Bipartisan Congress? Table A4APolitical Capital: White House And Congress A Bipartisan Congress? A Bipartisan Congress? Table A4BPolitical Capital: Household And Business Sentiment A Bipartisan Congress? A Bipartisan Congress? Table A4CPolitical Capital: The Economy And Markets A Bipartisan Congress? A Bipartisan Congress? Footnotes 1     See David R. Mayhew, “Is Congress ‘The Broken Branch?,’” Boston University Law Review 89 (2009), 357-69, bu.edu. 2     See Danny Crichton, Chris Miller, and Jordan Schneider, “Labs Over Fabs: How The U.S. Should Invest In The Future Of Semiconductors,” Foreign Policy Research Institute, March 2021, www.fpri.org. 3    See John R. Hibbing and Christopher W. Larimer, “The American Public’s View Of Congress,” Faculty Publications: Political Science 27 (2008), digitalcommons.unl.edu/poliscifacpub/27.  4    See David R. Jones, “Partisan Polarization and the Effect of Congressional Performance Evaluations on Party Brands and American Elections,” Political Research Quarterly 68:4 (2015), 785-801, jstor.org. See also Jones, “Declining Trust In Congress: Effects of Polarization and Consequences for Democracy,” The Forum 13:3 (2015), degruyter.com. 5    Some market participants and researchers have uncovered a “Congressional effect” in which stock market returns are higher on average on days when Congress is on recess than on days when it is in session.   

Highlights Geopolitical risk is trickling back into financial markets. China’s fiscal-and-credit impulse collapsed again. The Global Economic Policy Uncertainty Index is ticking back up after the sharp drop from 2020. All of our proprietary GeoRisk Indicators are elevated or rising. Geopolitical risk often rises during bull markets – the Geopolitical Risk Index can even spike without triggering a bear market or recession. Nevertheless a rise in geopolitical risk is positive for the US dollar, which happens to stand at a critical technical point. The macroeconomic backdrop for the dollar is becoming less bearish given China’s impending slowdown. President Biden’s trip to Europe and summit with Russian President Vladimir Putin will underscore a foreign policy of forming a democratic alliance to confront Russia and China, confirming the secular trend of rising geopolitical risk. Shift to a defensive tactical position. Feature Back in March 2017 we wrote a report, “Donald Trump Is Who We Thought He Was,” in which we reaffirmed our 2016 view that President Trump would succeed in steering the US in the direction of fiscal largesse and trade protectionism. Now it is time for us to do the same with President Biden. Our forecast for Biden rested on the same points: the US would pursue fiscal profligacy and mercantilist trade policy. The recognition of a consistent national policy despite extreme partisan divisions is a testament to the usefulness of macro analysis and the geopolitical method. Trump stole the Democrats’ thunder with his anti-austerity and anti-free trade message. Biden stole it back. It was the median voter in the Rust Belt who was calling the shots all along (after all, Biden would still have won the election without Arizona and Georgia). We did make some qualifications, of course. Biden would maintain a hawkish line on China and Russia but he would reject Trump’s aggressive foreign and trade policy when it came to US allies.1 Biden would restore President Obama’s policy on Iran and immigration but not Russia, where there would be no “diplomatic reset.” And Biden’s fiscal profligacy, unlike Trump’s, would come with tax hikes on corporations and the wealthy … even though they would fall far short of offsetting the new spending. This is what brings us to this week’s report: New developments are confirming this view of the Biden administration. Geopolitical Risk And Bull Markets Chart 1Global Geopolitical Risk And The Dollar Global Geopolitical Risk And The Dollar Global Geopolitical Risk And The Dollar In recent weeks Biden has adopted a hawkish policy on China, lowered tensions with Europe, and sought to restore President Obama’s policy of détente with Iran. The jury is still out on relations with Russia – Biden will meet with Putin on June 16 – but we do not expect a 2009-style “reset” that increases engagement. Still, it is too soon to declare a “Biden doctrine” of foreign policy because Biden has not yet faced a major foreign crisis. A major test is coming soon. Biden’s decision to double down on hawkish policy toward China will bring ramifications. His possible deal with Iran faces a range of enemies, including within Iran. His reduction in tensions with Russia is not settled yet. While the specific source and timing of his first major foreign policy crisis is impossible predict, structural tensions are rebuilding. An aggregate of our 13 market-based GeoRisk indicators suggests that global political risk is skyrocketing once again. A sharp spike in the indicator, which is happening now, usually correlates with a dollar rally (Chart 1). This indicator is mean-reverting since it measures the deviation of emerging market currencies, or developed market equity markets, from underlying macroeconomic fundamentals. The implication is positive for the dollar, although the correlation is not always positive. Looking at both the DXY’s level and its rate of change shows periods when the global risk indicator fell yet the dollar stayed strong – and vice versa. The big increase in the indicator over the past week stems mostly from Germany, South Korea, Brazil, and Australia, though all 13 of the indicators are now either elevated or rising, including the China/Taiwan indicators. Some of the increase is due to base effects. As global exports recover, currencies and equities that we monitor are staying weaker than one would expect. This causes the relevant BCA GeoRisk indicator to rise. Base effects from the weak economy in June 2020 will fall out in coming weeks. But the aggregate shows that all of the indicators are either high or rising and, on a country by country level, they are now in established uptrends even aside from base effects. Chart 2Global Policy Uncertainty Revives Global Policy Uncertainty Revives Global Policy Uncertainty Revives Meanwhile the global Economic Policy Uncertainty Index is recovering across the world after the drop in uncertainty following the COVID-19 crisis (Chart 2). Policy uncertainty is also linked to the dollar and this indicator shows that it is rising on a secular basis. The Geopolitical Risk Index, maintained by Matteo Iacoviello and a group of academics affiliated with the Policy Uncertainty Index, is also in a secular uptrend, although cyclically it has not recovered from the post-COVID drop-off. It is sensitive to traditional, war-linked geopolitical risk as reported in newspapers. By contrast our proprietary indicators are sensitive to market perceptions of any kind of risk, not just political, both domestic and international. A comparison of the Geopolitical Risk Index with the S&P 500 over the past century shows that a geopolitical crisis may occur at the beginning of a business cycle but it may not be linked with a recession or bear market. Risk can rise, even extravagantly, during economic expansions without causing major pullbacks. But a crisis event certainly can trigger a recession or bear market, particularly if it is tied to the global oil supply, as in the early 1970s, 1980s, and 1990s (Chart 3). Chart 3Secular Rise In Geopolitical Risk Soon To Reassert Itself Secular Rise In Geopolitical Risk Soon To Reassert Itself Secular Rise In Geopolitical Risk Soon To Reassert Itself While geopolitical risk is normally positive for the dollar, the macroeconomic backdrop is negative. The dollar’s attempt to recover earlier this year faltered. This underlying cyclical bearish dollar trend is due to global economic recovery – which will continue – and extravagant American monetary expansion and budget deficits. This is why we have preferred gold – it is a hedge against both geopolitical risk and inflation expectations. Tactically this year we have refrained from betting against the dollar except when building up some safe-haven positions like Japanese yen. Over the medium and long term we expect geopolitical risk to put a floor under the greenback. The bottom line is that the US dollar is at a critical technical crossroads where it could break out or break down. Macro factors suggest a breakdown but the recovery of global policy uncertainty and geopolitical risk suggests the opposite. We remain neutral. A final quantitative indicator of the recovery of geopolitical risk is the performance of global aerospace and defense stocks (Chart 4). Defense shares are rising in absolute and relative terms. Chart 4Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Can The WWII Peace Be Prolonged? Qualitative assessments of geopolitical risk are necessary to explain why risk is on a secular upswing – why drops in the quantitative indicators are temporary and the troughs keep getting higher. Great nations are returning to aggressive competition after a period of relative peace and prosperity. Over the past two decades Russia and China took advantage of America’s preoccupations with the Middle East, the financial crisis, and domestic partisanship in order to build up their global influence. The result is a world in which authority is contested. The current crisis is not merely about the end of the post-Cold War international order. It is much scarier than that. It is about the decay of the post-WWII international order and the return of the centuries-long struggle for global supremacy among Great Powers. The US and European political establishments fear the collapse of the WWII settlement in the face of eroding legitimacy at home and rising challenges from abroad. The 1945 peace settlement gave rise to both a Cold War and a diplomatic system, including the United Nations Security Council, for resolving differences among the great powers. It also gave rise to European integration and various institutions of American “liberal hegemony.” It is this system of managing great power struggle, and not the post-Cold War system of American domination, that lies in danger of unraveling. This is evident from the following points: American preeminence only lasted fifteen years, or at best until the 2008 Georgia war and global financial crisis. The US has been an incoherent wild card for at least 13 years now, almost as long as it was said to be the global empire. Russian antagonism with the West never really ended. In retrospect the 1990s were a hiatus rather than a conclusion of this conflict. China’s geopolitical rise has thawed the frozen conflicts in Asia from the 1940s-50s – i.e. the Chinese civil war, the Hong Kong and Taiwan Strait predicaments, the Korean conflict, Japanese pacifism, and regional battles for political influence and territory. Europe’s inward focus and difficulty projecting power have been a constant, as has its tendency to act as a constraint on America. Only now is Europe getting closer to full independence (which helped trigger Brexit). Geopolitical pressures will remain historically elevated for the foreseeable future because the underlying problem is whether great power struggle can be contained and major wars can be prevented. Specifically the question is whether the US can accommodate China’s rise – and whether China can continue to channel its domestic ambitions into productive uses (i.e. not attempts to create a Greater Chinese and then East Asian empire). The Great Recession killed off the “East Asia miracle” phase of China’s growth. Potential GDP is declining, which undermines social stability and threatens the Communist Party’s legitimacy. The renminbi is on a downtrend that began with the Xi Jinping era. The sharp rally during the COVID crisis is over, as both domestic and international pressures are rising again (Chart 5). Chart 5Biden Administration Review Of China Policy: More China Bashing Biden Administration Review Of China Policy: More China Bashing Biden Administration Review Of China Policy: More China Bashing While the data for China’s domestic labor protests is limited in extent, we can use it as a proxy for domestic instability in lieu of official statistics that were tellingly discontinued back in 2005. The slowdown in credit growth and the cyclical sectors of the economy suggest that domestic political risk is underrated in the lead up to the 2022 leadership rotation (Chart 6). Chart 6China's Domestic Political Risk Will Rise China's Domestic Political Risk Will Rise China's Domestic Political Risk Will Rise Chart 7Steer Clear Of Taiwan Strait Steer Clear Of Taiwan Strait Steer Clear Of Taiwan Strait The increasing focus on China’s access to key industrial and technological inputs, the tensions over the Taiwan Strait, and the formation of a Russo-Chinese bloc that is excluded from the West all suggest that the risk to global stability is grave and historic. It is reminiscent of the global power struggles of the seventeenth through early twentieth centuries. The outperformance of Taiwanese equities from 2019-20 reflects strong global demand for advanced semiconductors but the global response to this geopolitical bottleneck is to boost production at home and replace Taiwan. Therefore Taiwan’s comparative advantage will erode even as geopolitical risk rises (Chart 7). The drop in geopolitical tensions during COVID-19 is over, as highlighted above. With the US, EU, and other countries launching probes into whether the virus emerged from a laboratory leak in China – contrary to what their publics were told last year – it is likely that a period of national recriminations has begun. There is a substantial risk of nationalism, xenophobia, and jingoism emerging along with new sources of instability. An Alliance Of Democracies The Biden administration’s attempt to restore liberal hegemony across the world requires a period of alliance refurbishment with the Europeans. That is the purpose of his current trip to the UK, Belgium, and Switzerland. But diplomacy only goes so far. The structural factor that has changed is the willingness of the West to utilize government in the economic sphere, i.e. fiscal proactivity. Infrastructure spending and industrial policy, at the service of national security as well as demand-side stimulus, are the order of the day. This revolution in economic policy – a return to Big Government in the West – poses a threat to the authoritarian powers, which have benefited in recent decades by using central strategic planning to take advantage of the West’s democratic and laissez-faire governance. If the West restores a degree of central government – and central coordination via NATO and other institutions – then Beijing and Moscow will face greater pressure on their economies and fewer strategic options. About 16 American allies fall short of the 2% of GDP target for annual defense spending – ranging from Italy to Canada to Germany to Japan. However, recent trends show that defense spending did indeed increase during the Trump administration (Chart 8). Chart 8NATO Boosts Defense Spending Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was The European Union as a whole has added $50 billion to the annual total over the past five years. A discernible rise in defense spending is taking place even in Germany (Chart 9). The same point could be made for Japan, which is significantly boosting defense spending (as a share of output) after decades of saying it would do so without following through. A major reason for the American political establishment’s rejection of President Trump was the risk he posed to the trans-Atlantic alliance. A decline in NATO and US-EU ties would dramatically undermine European security and ultimately American security. Hence Biden is adopting the Trump administration’s hawkish approach to trade with China but winding down the trade war with Europe (Chart 10). Chart 9Europe Spending More On Guns Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 10US Ends Trade War With Europe? Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was A multilateral deal aimed at setting a floor in global corporate taxes rates is intended to prevent the US and Europe from undercutting each other – and to ensure governments have sufficient funding to maintain social spending and reduce income inequality (Chart 11). Inequality is seen as having vitiated sociopolitical stability and trust in government in the democracies. Chart 11‘Global’ Corporate Tax Deal Shows Return Of Big Government, Attempt To Reduce Inequality In The West Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Risks To Biden’s Diplomacy It is possible that Biden’s attempt to restore US alliances will go nowhere over the course of his four-year term in office. The Europeans may well remain risk averse despite their initial signals of willingness to work with Biden to tackle China’s and Russia’s challenges to the western system. The Germans flatly rejected both Biden and Trump on the Nord Stream II natural gas pipeline linkage with Russia, which is virtually complete and which strengthens the foundation of Russo-German engagement (more on this below). The US’s lack of international reliability – given the potential of another partisan reversal in four years – makes it very hard for countries to make any sacrifices on behalf of US initiatives. The US’s profound domestic divisions have only slightly abated since the crises of 2020 and could easily flare up again. A major outbreak of domestic instability could distract Biden from the foreign policy game.2 However, American incapacity is a risk, not our base case, over the coming years. We expect the US economic stimulus to stabilize the country enough that the internal political crisis will be contained and the US will continue to play a global role. The “Civil War Lite” has mostly concluded, excepting one or two aftershocks, and the US is entering into a “Reconstruction Lite” era. The implication is negative for China and Russia, as they will now have to confront an America that, if not wholly unified, is at least recovering. Congress’s impending passage of the Innovation and Competition Act – notably through regular legislative order and bipartisan compromise – is case in point. The Senate has already passed this approximately $250 billion smorgasbord of industrial policy, supply chain resilience, and alliance refurbishment. It will allot around $50 billion to the domestic semiconductor industry almost immediately as well as $17 billion to DARPA, $81 billion for federal research and development through the National Science Foundation, which includes $29 billion for education in science, technology, engineering, and mathematics, and other initiatives (Table 1). Table 1Peak Polarization: US Congress Passes Bipartisan ‘Innovation And Competition Act’ To Counter China Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was With the combination of foreign competition, the political establishment’s need to distract from domestic divisions, and the benefit of debt monetization courtesy of the Federal Reserve, the US is likely to achieve some notable successes in pushing back against China and Russia. On the diplomatic front, the US will meet with some success because the European and Asian allies do not wish to see the US embrace nationalism and isolationism. They have their own interests in deterring Russia and China. Lack Of Engagement With Russia Russian leadership has dealt with the country’s structural weaknesses by adopting aggressive foreign policy. At some point either the weaknesses or the foreign policy will create a crisis that will undermine the current regime – after all, Russia has greatly lagged the West in economic development and quality of life (Chart 12). But President Putin has been successful at improving the country’s wealth and status from its miserably low base in the 1990s and this has preserved sociopolitical stability so far. Chart 12Russia's Domestic Political Risk Russia's Domestic Political Risk Russia's Domestic Political Risk It is debatable whether US policy toward Russia ever really changed under President Trump, but there has certainly not been a change in strategy from Russia. Thus investors should expect US-Russia antagonism to continue after Biden’s summit with Putin even if there is an ostensible improvement. The fundamental purpose of Putin’s strategy has been to salvage the Russian empire after the Soviet collapse, ensure that all world powers recognize Russia’s veto power over major global policies and initiatives, and establish a strong strategic position for the coming decades as Russia’s demographic decline takes its toll. A key component of the strategy has been to increase economic self-sufficiency and reduce exposure to US sanctions. Since the invasion of Ukraine in 2014, Putin has rapidly increased Russia’s foreign exchange reserves so as to buffer against shocks (Chart 13). Chart 13Russia Fortified Against US Sanctions Russia Fortified Against US Sanctions Russia Fortified Against US Sanctions Putin has also reduced Russia’s reliance on the US dollar to about 22% (Chart 14), primarily by substituting the euro and gold. Russia will not be willing or able to purge US dollars from its system entirely but it has been able to limit America’s ability to hurt Russia by constricting access to dollars and the dollar-based global financial architecture. Russian Finance Minister Anton Siluanov highlighted this process ahead of the Biden-Putin summit by declaring that the National Wealth Fund will divest of its remaining $40 billion of its US dollar holdings. Chart 14Russia Diversifies From USD Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was In general this year, Russia is highlighting its various advantages: its resilience against US sanctions, its ability to re-invade Ukraine, its ability to escalate its military presence in Belarus and the Black Sea, and its ability to conduct or condone cyberattacks on vital American food and fuel supplies (Chart 15). Meanwhile the US is suffering from deep political divisions at home and strategic incoherence abroad and these are only starting to be mended by domestic economic stimulus and alliance refurbishment. Chart 15Cyber Security Stocks Recover Cyber Security Stocks Recover Cyber Security Stocks Recover Europe’s risk-aversion when it comes to strategic confrontation with Russia, and the lack of stability in US-Russia relations, means that investors should not chase Russian currency or financial assets amid the cyclical commodity rally. Investors should also expect risk premiums to remain high in developing European economies relative to their developed counterparts. This is true despite the fact that developed market Europe’s outperformance relative to emerging Europe recently peaked and rolled over. From a technical perspective this outperformance looks to subside but geopolitical tensions can easily escalate in the near term, particularly in advance of the Russian and German elections in September (Chart 16). Chart 16Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Europe trades in line with EUR-RUB and these pair trades all correspond closely to geopolitical tensions with Russia (Chart 17). A notable exception is the UK, whose stock market looks attractive relative to eastern Europe and is much more secure from any geopolitical crisis in this region (Chart 17, bottom panel). The pound is particularly attractive against the Czech koruna, as Russo-Czech tensions have heated up in advance of October’s legislative election there (Chart 18). Chart 17Long UK Versus Eastern Europe Long UK Versus Eastern Europe Long UK Versus Eastern Europe Chart 18Long GBP Versus CZK Long GBP Versus CZK Long GBP Versus CZK Meanwhile Russia and China have grown closer together out of strategic necessity. Germany’s Election And Stance Toward Russia Germany’s position on Russia is now critical. The decision to complete the Nord Stream II pipeline against American wishes either means that the Biden administration can be safely ignored – since it prizes multilateralism and alliances above all things and is therefore toothless when opposed – or it means that German will aim to compensate the Americans in some other area of strategic concern. Washington is clearly attempting to rally the Germans to its side with regard to putting pressure on China over its trade practices and human rights. This could be the avenue for the US and Germany to tighten their bond despite the new milestone in German-Russia relations. The US may call on Germany to stand up for eastern Europe against Russian aggression but on that front Berlin will continue to disappoint. It has no desire to be drawn into a new Cold War given that the last one resulted in the partition of Germany. The implication is negative for China on one hand and eastern Europe on the other. Germany’s federal election on September 26 will be important because it will determine who will succeed Chancellor Angela Merkel, both in Germany and on the European and global stage. The ruling Christian Democratic Union (CDU) is hoping to ride Merkel’s coattails to another term in charge of the government. But they are likely to rule alongside the Greens, who have surged in opinion polls in recent years. The state election in Saxony-Anhalt over the weekend saw the CDU win 37% of the popular vote, better than any recent result, while Germany’s second major party, the Social Democrats, continued their decline (Table 2). The far-right Alternative for Germany won 21% of the vote, a downshift from 2016, while the Greens won 6% of the vote, a slight improvement from 2016. All parties underperformed opinion polling except the CDU (Chart 19). Table 2Saxony-Anhalt Election Results Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 19Germany: Conservatives Outperform In Final State Election Before Federal Vote, But Face Challenges Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 20Germany: Greens Will Outperform in 2021 Vote Germany: Greens Will Outperform in 2021 Vote Germany: Greens Will Outperform in 2021 Vote The implication is still not excellent for the CDU. Saxony-Anhalt is a middling German state, a CDU stronghold, and a state with a popular CDU leader. So it is not representative of the national campaign ahead of September. The latest nationwide opinion polling puts the CDU at around 25% support. They are neck-and-neck with the Greens. The country’s left- and right-leaning ideological blocs are also evenly balanced in opinion polls (Chart 20). A potential concern for the CDU is that the Free Democratic Party is ticking up in national polls, which gives them the potential to steal conservative votes. Betting markets are manifestly underrating the chance that Annalena Baerbock and the Greens take over the chancellorship (Charts 21A and 21B). We still give a subjective 35% chance that the Greens will lead the next German government without the CDU, a 30% that the Greens will lead with the CDU, and a 25% chance that the CDU retains power but forms a coalition with the Greens. A coalition government would moderate the Greens’ ambitious agenda of raising taxes on carbon emissions, wealth, the financial sector, and Big Tech. The CDU has already shifted in a pro-environmental, fiscally proactive direction. Chart 21AGerman Greens Will Recover Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 21BGerman Greens Still Underrated Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was No matter what the German election will support fiscal spending and European solidarity, which is positive for the euro and regional equities over the next 12 to 24 months. However, the Greens would pursue a more confrontational stance toward Russia, a petro-state whose special relations with the German establishment have impeded the transition to carbon neutrality. Latin America’s Troubles A final aspect of Biden’s agenda deserves some attention: immigration and the Mexican border. Obviously this one of the areas where Biden starkly differs from Trump, unlike on Europe and China, as mentioned above. Vice President Kamala Harris recently came back from a trip to Guatemala and Mexico that received negative media attention. Harris has been put in charge of managing the border crisis, the surge in immigrant arrivals over 2020-21, both to give her some foreign policy experience and to manage the public outcry. Despite telling immigrants explicitly “Do not come,” Harris has no power to deter the influx at a time when the US economy is fired up on historic economic stimulus and the Democratic Party has cut back on all manner of border and immigration enforcement. From a macro perspective the real story is the collapse of political and geopolitical risk in Mexico. From 2016-20 Mexico faced a protectionist onslaught from the Trump administration and then a left-wing supermajority in Congress. But these structural risks have dissipated with the USMCA trade deal and the inability of President Andrés Manuel López Obrador to follow through with anti-market reforms, as we highlighted in reports in October and April. The midterm election deprived the ruling MORENA party of its single-party majority in the Chamber of Deputies, the lower house of the legislature (Chart 22). AMLO is now politically constrained – he will not be able to revive state control over the energy and power sectors. Chart 22Mexican Midterm Election Constrained Left-Wing Populism, Political Risk Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 23Buy Mexico (And Canada) On US Stimulus Buy Mexico (And Canada) On US Stimulus Buy Mexico (And Canada) On US Stimulus American monetary and fiscal stimulus, and the supply-chain shift away from China, also provide tailwinds for Mexico. In short, the Mexican election adds the final piece to one of our key themes stemming from the Biden administration, US populism, and US-China tensions: favor Mexico and Canada (Chart 23). A further implication is that Mexico should outperform Brazil in the equity space. Brazil is closely linked to China’s credit cycle and metals prices, which are slated to turn down as a result of Chinese policy tightening. Mexico is linked to the US economy and oil prices (Chart 24). While our trade stopped out at -5% last week we still favor the underlying view. Brazilian political risk and unsustainable debt dynamics will continue to weigh on the currency and equities until political change is cemented in the 2022 election and the new government is then forced by financial market riots into undertaking structural reforms. Chart 24Brazil's Troubles Not Truly Over - Mexico Will Outperform Brazil's Troubles Not Truly Over - Mexico Will Outperform Brazil's Troubles Not Truly Over - Mexico Will Outperform Elsewhere in Latin America, the rise of a militant left-wing populist to the presidency in a contested election in Peru, and the ongoing social unrest in Colombia and Chile, are less significant than the abrupt slowdown in China’s credit growth (Charts 25A and 25B). According to our COVID-19 Social Stability Index, investors should favor Mexico. Turkey, the Philippines, South Africa, Colombia, and Brazil are the most likely to see substantial social instability according to this ranking system (Table 3). Chart 25AMexico To Outperform Latin America Mexico To Outperform Latin America Mexico To Outperform Latin America Chart 25BChina’s Slowdown Will Hit South America China's Slowdown Will Hit South America China's Slowdown Will Hit South America Table 3Post-COVID Emerging Market Social Unrest Only Just Beginning Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Investment Takeaways Close long emerging markets relative to developed markets for a loss of 6.8% – this is a strategic trade that we will revisit but it faces challenges in the near term due to China’s slowdown (Chart 26). Go long Mexican equities relative to emerging markets on a strategic time frame. Our long Mexico / short Brazil trade hit the stop loss at 5% but the technical profile and investment thesis are still sound over the short and medium term. Chart 26China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets Chart 27Relative Uncertainty And Safe Havens Relative Uncertainty And Safe Havens Relative Uncertainty And Safe Havens China’s sharp fiscal-and-credit slowdown suggests that investors should reduce risk exposure, take a defensive tactical positioning, and wait for China’s policy tightening to be priced before buying risky assets. Our geopolitical method suggests the dollar will rise, while macro fundamentals are becoming less dollar-bearish due to China. We are neutral for now and will reassess for our third quarter forecast later this month. If US policy uncertainty falls relative to global uncertainty then the EUR-USD will also fall and safe-haven assets like Swiss bonds will gain a bid (Chart 27). Gold is an excellent haven amid medium-term geopolitical and inflation risks but we recommend closing our long silver trade for a gain of 4.5%. Disfavor emerging Europe relative to developed Europe, where heavy discounts can persist due to geopolitical risk premiums. We will reassess after the Russian Duma election in September. Go long GBP-CZK. Close the Euro “laggards” trade. Go long an equal-weighted basket of euros and US dollars relative to the Chinese renminbi. Short the TWD-USD on a strategic basis. Prefer South Korea to Taiwan – while the semiconductor splurge favors Taiwan, investors should diversify away from the island that lies at the epicenter of global geopolitical risk. Close long defense relative to cyber stocks for a gain of 9.8%. This was a geopolitical “back to work” trade but the cyber rebound is now significant enough to warrant closing this trade.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Trump’s policy toward Russia is an excellent example of geopolitical constraints. Despite any personal preferences in favor of closer ties with Russia, Trump and his administration ultimately reaffirmed Article 5 of NATO, authorized the sale of lethal weapons to Ukraine, and deployed US troops to Poland and the Czech Republic. 2 As just one example, given the controversial and contested US election of 2020, it is possible that a major terrorist attack could occur. Neither wing of America’s ideological fringes has a monopoly on fanaticism and violence. Meanwhile foreign powers stand to benefit from US civil strife. A truly disruptive sequence of events in the US in the coming years could lead to greater political instability in the US and a period in which global powers would be able to do what they want without having to deal with Biden’s attempt to regroup with Europe and restore some semblance of a global police force. The US would fall behind in foreign affairs, leaving power vacuums in various regions that would see new sources of political and geopolitical risk crop up. Then the US would struggle to catch up, with another set of destabilizing consequences.

Highlights US labor-market disappointments notwithstanding, the global recovery being propelled by real GDP growth in the world's major economies is on track to be the strongest in 80 years. This growth will fuel commodity demand, which increasingly confronts tighter supply.  Higher commodity prices will ensue, and feed through to realized and expected inflation.  Manufacturers will continue to see higher input and output prices. Our modeling suggests the USD will weaken to end-2023; however, most of the move already has occurred.  Real US rates will remain subdued, as the Fed looks through PCE inflation rates above its 2% target and continues to focus on its full-employment mandate (Chart of the Week). Given these supportive inflation fundamentals, we remain long gold with a price target of $2,000/oz for this year.  We are upgrading silver to a strategic position, expecting a $30/oz price by year-end.  We remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to steepen backwardations in forward curves, and long the Global Metals & Mining Producers ETF (PICK). Global economic policy uncertainty will remain elevated until broader vaccine distributions reduce lockdown risks. Feature The recovery of the global economy catalyzed by massive monetary accommodation and fiscal stimulus is on track to be the strongest in the past 80 years, according to the World Bank.1 The Bank revised its growth expectation for real GDP this year sharply higher – to 5.6% from its January estimate of 4.1%. For 2022, the rate of global real GDP growth is expected to slow to 4.3%, which is still significantly higher than the average 3% growth of 2018-19. DM economies are expected to grow at a 4% rate this year – double the average 2018-19 rate – while EM growth is expected to come in at 6% this year vs a 4.2% average for 2018-19. The big drivers of growth this year will be China, where the Bank expects an unleashing of pent-up demand to push real GDP up by 8.5%, and the US, where massive fiscal and monetary support will lift real GDP 6.8%. The Bank expects other DM economies will contribute to this growth, as well. Growth in EM economies will be supported by stronger demand and higher commodity prices, in the Bank's forecast. Commodity demand is recovering faster than commodity supply in the wake of this big-economy GDP recovery. As a result, manufacturers globally are seeing significant increases in input and output prices (Chart 2). Chart of the WeekUS Real Rates Continue To Languish Gold, Silver, Indexes Favored As Inflation Looms Gold, Silver, Indexes Favored As Inflation Looms Chart 2Global Manufacturers' Prices Moving Higher Gold, Silver, Indexes Favored As Inflation Looms Gold, Silver, Indexes Favored As Inflation Looms These price increases at the manufacturing level reflect the higher-price environment in global commodity markets, particularly in industrial commodities – i.e., bulks like iron ore and steel; base metals like copper and aluminum; and oil prices, which touch most processes involved in getting materials out of the ground and into factories before they make their way to consumers, who then drive to stores to pick up goods or have them delivered. Chart 3Commodity Price Increases Reflected in CPI Inflation Expectations Commodity Price Increases Reflected in CPI Inflation Expectations Commodity Price Increases Reflected in CPI Inflation Expectations These price pressures are being picked up in 5y5y CPI swaps markets, which are cointegrated with commodity prices (Chart 3). This also is showing up in shorter-tenor inflation gauges – monthly CPI and 2y CPI swaps. Oil prices, in particular, will be critical to the evolution of 5-year/5-year (5y5y) CPI swap rates, which are closely followed by fixed-income markets (Chart 4). Chart 4Oil Prices Are Key To 5Y5Y CPI Swap Rates Oil Prices Are Key To 5Y5Y CPI Swap Rates Oil Prices Are Key To 5Y5Y CPI Swap Rates Higher Gold Prices Expected CPI inflation expectations drive 5-year and 10-year real rates, which are important explanatory variables for gold prices (Chart 5).2 In addition, the massive monetary and fiscal policy out of the US also is driving expectations for a lower USD: Currency debasement fears are higher than they otherwise would be, given all the liquidity and stimulus sloshing around global markets, which also is bullish for gold (Chart 6). Chart 5Weaker Real Rates Bullish For Gold Weaker Real Rates Bullish For Gold Weaker Real Rates Bullish For Gold Chart 6Weaker USD Supports Gold Weaker USD Supports Gold Weaker USD Supports Gold All of these effects, particularly the inflationary impacts, are summarized in our fair-value gold model (Chart 7). At the beginning of 2021, our fair-value gold model indicated price would be closer to $2,005/oz, which was well above the actual gold price in January. Gold prices have remained below the fair value model since the beginning of 2021. The model explains gold prices using real rates, TWIB, US CPI and global economic policy uncertainty. Based on our modeling, we expect these variables to continue to be supportive of gold, bolstering our view the yellow metal will reach $2000/ oz this year. Unlike industrial commodities, gold prices are sensitive to speculative positioning and technical indicators. Our gold composite indicator shows that gold prices may be reflecting bullish sentiment. This sentiment likely reflects increasing inflation expectations, which we use as an explanatory variable for gold prices. The fact that gold is moving higher on sentiment is corroborated by the latest data point from Marketvane’s gold bullish consensus, which reported 72% of the traders expect prices to rise further (Chart 8). Chart 7BCAs Gold Fair-Value Model Supports 00/oz View BCAs Gold Fair-Value Model Supports $2000/oz View BCAs Gold Fair-Value Model Supports $2000/oz View Chart 8Sentiment Supports Oil Prices Sentiment Supports Oil Prices Sentiment Supports Oil Prices Investment Implications The massive monetary and fiscal stimulus that saw the global economy through the worst of the economic devastation of the COVID-19 pandemic is now bubbling through the real economy, and will, if the World Bank's assessment proves out, result in the strongest real GDP growth in 80 years. Liquidity remains abundant and interest rates – real and nominal – remain low. In its latest Global Economic Prospects, the Bank notes, " The literature generally suggests that monetary easing, both conventional and unconventional, typically boosts aggregate demand and inflation with a lag of 1-3 years …" The evidence for this is stronger for DM economies than EM; however, as the experience in China shows, scale matters. If the Bank's assessment is correct, the inflationary impulse from this stimulus should be apparent now – and it is – and will endure for another year or two. This stimulus has catalyzed organic growth and will continue to do so for years, particularly in economies pouring massive resources into renewable-energy generation and the infrastructure required to support it, a topic we have been writing about for some time.3 We remain long gold with a price target of $2,000/oz for this year. We are long silver on a tactical basis, but given our growth expectations, are upgrading this to a strategic position, expecting a $30/oz price by year-end. As we have noted in the past, silver is sensitive to all of the financial factors we consider when assessing gold markets, and it has a strong industrial component that accounts for more than half of its demand.4 Supportive fundamentals remain in place, with total supply (mine output and recycling) falling, demand rising and balances tightening (Chart 9). Worth noting is silver's supply is constrained because of underinvestment in copper production at the mine level, where silver is a by-product. On the demand side, continued recovery of industrial and consumer demand will keep silver prices well supported. In terms of broad commodity exposure, we remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to continue to draw down inventories – particularly in energy and metals markets – which will lead to steeper backwardations in forward curves. Backwardation is the source of roll-yields for long commodity index investments. Investors initially have a long exposure in deferred commodity futures contracts, which are then liquidated and re-established when these contracts become more prompt (i.e., closer to delivery). If the futures' forward curves are backwardated, investors essentially are buying the deferred contracts at a lower price than the price at which the position likely is liquidated. We also remain long the Global Metals & Mining Producers ETF (PICK), an equity vehicle that spans miners and traders; the longer discounting horizon of equity markets suits our view on metals. Chart 9Upgrading Silver To Strategic Position Gold, Silver, Indexes Favored As Inflation Looms Gold, Silver, Indexes Favored As Inflation Looms Chart 10Wider Vaccine Distribution Will Support Gold Demand Gold, Silver, Indexes Favored As Inflation Looms Gold, Silver, Indexes Favored As Inflation Looms Global economic policy uncertainty will remain elevated until broader vaccine distributions reduce lockdown risks. We expect the wider distribution of vaccines will become increasingly apparent during 2H21 and in 2022. This will be bullish for physical gold demand – particularly in China and India – which will add support for our gold position (Chart 10).       Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish The US EIA expects Brent crude oil prices to fall to $60/bbl next year, given its call higher production from OPEC 2.0 and the US shales will outpace demand growth. The EIA expects global oil demand will average just under 98mm this year, or 5.4mm b/d above 2020 levels. For next year, the EIA is forecasting demand will grow 3.6mm b/d, averaging 101.3mm b/d. This is slightly less than the demand growth we expect next year – 101.65mm b/d. We are expecting 2022 Brent prices to average $73/bbl, and $78/bbl in 2023. We will be updating our oil balances and price forecasts in next week's publication. Base Metals: Bullish Pedro Castillo, the socialist candidate in Peru's presidential election, held on to a razor-thin lead in balloting as we went to press. Markets have been focused on the outcome of this election, as Castillo has campaigned on increasing taxes and royalties for mining companies operating in Peru, which accounts for ~10% of global copper production. The election results are likely to be contested by opposition candidate rival Keiko Fujimori, who has made unsubstantiated claims of fraud, according to reuters.com. Copper prices traded on either side of $4.50/lb on the CME/COMEX market as the election drama was unfolding (Chart 11). Precious Metals: Bullish As economies around the world reopen and growth rebounds, car manufacturing will revive. Stricter emissions regulations mean the demand for autocatalysts – hence platinum and palladium – will rise with the recovery in automobile production. Platinum is also used in the production of green hydrogen, making it an important metal for the shift to renewable energy. On the supply side, most platinum shafts in South Africa are back to pre-COVID-19 levels, according to Johnson Matthey, the metals refiner. As a result, supply from the world’s largest platinum producer will rebound by 40%, resulting in a surplus. South Africa accounts for ~ 70% of global platinum supply. The fact that an overwhelming majority of platinum comes from a nation which has had periodic electricity outages – the most recent one occurring a little more than a week ago – could pose a supply-side risk to this metal. This could introduce upside volatility to prices (Chart 12). Ags/Softs: Neutral As of 6 June, 90% of the US corn crop had emerged vs a five-year average of 82%; 72% of the crop was reported to be in good to excellent condition vs 75% at this time last year. Chart 11 Political Risk in Chile and Peru Could Bolster Copper Prices Political Risk in Chile and Peru Could Bolster Copper Prices Chart 12 Platinum Prices Going Up Platinum Prices Going Up Footnotes 1     Please see World Bank's Global Economic Prospects update, published June 8, 2021. 2     In fact, US Treasury Inflation-Indexed securities include the CPI-U as a factor in yield determination.  3    For our latest installment of this epic evolution, please see A Perfect Energy Storm On The Way, which we published last week.  It is available at ces.bcareserch.com. 4    Please see Higher Inflation Expectations Battle Lower Risk Premia In Gold Markets, which we published February 4, 2021. It is available at ces.bcareserch.com.     Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Highlights The Fed’s independence from politics is illusory. President Biden has the potential to reshape the Fed’s Board of Governors through three personnel picks, two of which are due by January 2022. While monetary policy could only get marginally more dovish, the Democratic Party’s goals would be furthered by new appointments. If Biden retains Powell then he is convinced that Powell is fully committed to today’s ultra-dovish monetary policy strategy. If he does not, then the new Fed chair will be still more dovish. Nevertheless the excessive expansion of the US money supply is reminiscent of the Arthur Burns era and suggests that any Fed chair faces a sea of troubles from 2022-26. For now stay long TIPS, infrastructure plays, cyclicals, and value stocks. Feature I do not recall a single instance where somebody in the political realm said, “We need to raise rates, they’re too low.”                         -Alan Greenspan, CNBC, October 18, 2018 Just before the 2020 election I held a call with a client in New York and the question arose of whether the expected winner, then candidate Joe Biden, would reappoint Federal Reserve Chairman Jerome Powell when his term expired on January 31, 2022. I argued that the odds of Biden keeping Powell in place were higher than one might think. After all, Powell reversed his stance on rate hikes in the winter of 2018-19 and then oversaw the Fed’s adoption of a new monetary policy strategy that deliberately targets an inflation overshoot. Powell would be a reliable dove for a president who would seek economic recovery above all things. The client drily responded, “There is no way that is going to happen.”   We still do not know what President Biden will decide with seven months before the decision is due. Personnel appointments are a matter of information and intelligence, not political or macroeconomic analysis. From a macro point of view all that can be said is that Biden does not face the situation President Trump faced: Biden has entered early in the business cycle, under a new, ultra-easy average inflation targeting regime at the Fed. Trump entered in the middle of a business cycle, while the Fed was hiking rates (Chart 1). Chart 1Biden's and Powell's Context Biden's and Powell's Context Biden's and Powell's Context Almost any new Fed chair will be largely constrained by the policy consensus on the Federal Open Market Committee (FOMC). Biden is an establishment player whose appointments so far suggest that he is unlikely to nominate a maverick capable of bucking the entire FOMC. But personalities can still make a difference at critical junctures. Nobody should be surprised if Biden opts to replace Powell with a candidate who is marginally more committed to keeping rates lower for longer.   Investors should bet on dovish surprises for three reasons. First, the Fed as an institution has reached a consensus on its current policy framework, which is geared toward an inflation overshoot. Second, Powell may wish to retain his job. Third, the aforementioned client could be right and Biden may replace Powell with a more fervent proponent of ultra-easy policy. The takeaway is bullish for the time being. The Dependency Of Central Banks Central banks are part of the political bureaucracy of the nation state. Insofar as they achieve policy autonomy, or independence, it is at the forbearance of the executive or legislative branch. The ability to contain personal influences shows institutional maturity but institutions can never be fully independent. Fiscal policy is controlled by the ruling party, which will legislate in its interest. The “political business cycle” is an empirical phenomenon in which policymakers attempt to manipulate fiscal policy ahead of elections either to help or hurt the incumbent. A “political monetary cycle” also exists but its prevalence is debatable. It is more widely observed in developing countries.1 Politics in the developed world are more democratic and institutionalized so central banks have achieved considerable autonomy. In many cases their independence is enshrined in law, although the legal basis is often questionable and exaggerated.2  Not only are there checks and balances but they are reinforced by asynchronous cycles between the institutions. Term limits constrict politicians as much as or more so than monetary policymakers. Federal Reserve chairmen William McChesney Martin, Arthur F. Burns, and Jerome H. Powell were not immune to political influence but were able in their own ways to “wait out” the tenure of manipulative presidents Lyndon B. Johnson, Richard M. Nixon, and Donald J. Trump. Still, the latter examples highlight that developed markets cannot claim to be purely rationalist in their conduct of monetary policy. President Trump publicly asked, “Who is our bigger enemy, Jay Powell or Chairman Xi?” Yet this was mild compared to the treatment that Nixon gave Burns and especially that Johnson gave Martin. Johnson physically shoved Martin around a private room demanding policy easing and accused him of not caring about the lives of young American soldiers dying in Vietnam. Martin held his ground and hiked rates in 1966 despite the war.3 Arthur Burns was subjected to a relentless campaign of public and private verbal abuse by Nixon and his staffers. Nixon was convinced that he lost the 1960 election because of overly tight Fed policies and was determined not to let it happen again in 1972. Greenspan kept rates low during the Iraq war and inflated the housing bubble. Plenty of unsavory examples of political influence and interference can be drawn from other developed markets.4 All governments and monetary systems are built and run by humans and therefore fallible. Even aside from individuals and anecdotes, structural forms of central bank manipulation within the developed world include: (1)  Debt accommodation: Central banks face an inexorable pressure to provide liquidity to governments running irresponsible fiscal deficits. The consequences if they refused could be devastating (Chart 2). Chart 2The Fed's Biggest Political Constraint: Debt The Fed's Biggest Political Constraint: Debt The Fed's Biggest Political Constraint: Debt (2)  Appointments: Presidents and executives appoint and remove leaders. In the US, the tendency for members of the Board of Governors to resign often gives the president substantial influence even aside from picking the Fed chairman, who can indeed be removed at will.5 (3)  Bureaucracy: Administrative structures exert a powerful influence over the personnel, policy frameworks, and behavior of central bank leadership and staff. The candidates for top positions are heavily filtered – and once they achieve high office, their options are constrained.6 Today’s Federal Reserve supports these three points: it is highly accommodative toward the US’s soaring federal debt and its leadership consists of a tight coterie of experts and academics who share a robust consensus regarding the appropriate theory and practice of monetary policy. The outstanding question stems from item number two, appointments, where President Biden has the opportunity to influence the Fed’s board. But the third point mostly controls the available personnel. Still, the choice of the Fed chair could prove decisive under unforeseen circumstances. Historical accounts of the Fed show that the chairman exerts substantial influence over monetary policy decisions.7 Most investors know from experience that individuals and leaders can still exert an outsized influence at critical junctures. For example, premature monetary tightening occurred with negative consequences in the US in 1937, Japan in 2000, and Europe in 2011. Investors are safest to bet on institutions rather than individuals. But the choice of the Fed chair can hardly be ignored. The current context features an extraordinary expansion of the money supply, and “excess money supply,” comparable only to the inflationary 1970s (Chart 3). The Fed chair in the coming years faces an unstable and difficult sea of troubles to navigate.  Chart 3Excess Money Supply Unseen In Modern Memory Excess Money Supply Unseen In Modern Memory Excess Money Supply Unseen In Modern Memory Fed Chairs Care About Their Careers But Not Midterm Elections Political influence over monetary policy is measurable. A substantial body of academic literature reveals not only the above structural political factors but also that ideological affiliation – i.e. the political party whose president appointed the Fed chair – influences interest rates. So do elections and the career interests of Fed chairmen. Consider the following findings:  Abrams and Iossifov show evidence of abnormally expansionary monetary policy if the president and the chair are affiliated with the same political party.8 Gamber and Hakes show evidence of a lowered federal funds rate if the Fed chair stands for reappointment in the two years following a national election – i.e. Fed chairmen accommodate political pressures in the latter part of term to increase odds of reappointment.9 Dentler shows that while the Fed funds rate does not fall in advance of elections to help presidents in general, it is found to fall when the Fed chair and president have the same partisan affiliation, especially when the Fed chair’s reappointment is looming. Also the Fed funds rate is abnormally high before elections if the Fed chair hails from the opposite party of the incumbent president.10 Dentler shows specifically that Fed chair career motivations matter. If you omit career considerations, then it is not so much partisan affiliation as partisan opposition that can influence monetary policy. In effect, there is a potential increase in policy rate before elections. Dentler calls this a “reverse political monetary policy cycle.”11 In essence, a Fed chair is more likely to lean into his partisan affiliation as an incumbent president seeks reelection. It is hard to prove this behavior is partisan because it conforms with the idea of a staunchly independent central bank. Now let us look at the data first hand. In the following analysis we focus on the nominal Fed funds rate alongside (1) the headline consumer price index and (2) an implied policy rate following a simple Taylor Rule using potential GDP, the core PCE deflator, and the unemployment rate.12 We chose the nominal Fed funds rate and headline consumer price index because they should provide an indication of how the US president and public perceived interest rates and inflation. These factors are critical for the president’s decisions as to whether to reappoint or replace sitting Fed chairmen. However, we also use the Taylor Rule as a proxy for the correct or appropriate policy rate at the time, recognizing that headline CPI is insufficient. We observe the following: Burns worked closely with President Nixon and his tenure has always been controversial. The simple evidence shown here suggests that he accommodated Nixon in 1972 but did not accommodate President Ford’s bid for the presidency in 1976. He might have stayed easy a bit longer than necessary in 1977 ahead of President Carter’s decision on whether to reappoint him (Chart  4).  Chart 4AArthur Burns As Fed Chair Arthur Burns As Fed Chair Arthur Burns As Fed Chair Chart 4BArthur Burns As Fed Chair Arthur Burns As Fed Chair Arthur Burns As Fed Chair Miller’s tenure was marred by stagflation. He did not accommodate the Democrats during the 1978 midterm election and probably could not have done so. Carter promoted him to Treasury Secretary as a way of removing him from the Fed chair. The episode is a reminder that the president can remove the Fed chair – as the best constitutional studies show – but he may need to get creative about how to do it to avoid a political storm (Chart 5). Volcker may have accommodated Carter somewhat but not entirely in 1980. His actions are debatable around Reagan’s election in 1984. But Volcker laid inflation low and his reappointment by Reagan in 1983 makes sense in the context of that triumph (Chart 6).  Chart 5William Miller As Fed Chair William Miller As Fed Chair William Miller As Fed Chair Chart 6Paul Volcker As Fed Chair Paul Volcker As Fed Chair Paul Volcker As Fed Chair Greenspan cannot really be said to have accommodated Bush in 1992 though rates fell. He cracked down on inflation regardless of the 1994 midterm election, which turned out badly for President Clinton and the Democrats. But Clinton did not hold it against him – inflation had been brought down without a recession. Greenspan was tame during Clinton’s reelection bid in 1996 despite rising inflation – he hiked rates immediately thereafter. Clinton reappointed him in the midst of a rate-hike cycle justified by rising inflation, regardless of any risk to the Democratic bid in the 2000 election (Chart 7).   Chart 7AAlan Greenspan As Fed Chair Alan Greenspan As Fed Chair Alan Greenspan As Fed Chair Chart 7BAlan Greenspan As Fed Chair Alan Greenspan As Fed Chair Alan Greenspan As Fed Chair Bernanke’s tenure was dominated by the subprime mortgage crisis and Great Recession. He cannot be said to have accommodated the Republicans in 2008, though they were doomed anyway. President Obama’s decision to reappoint him in 2009 was a clear example of an urgent need to maintain policy continuity. Obama announced his replacement in 2013, after the crisis had passed (Chart 8). Chart 8ABen Bernanke As Fed Chair Ben Bernanke As Fed Chair Ben Bernanke As Fed Chair Chart 8BBen Bernanke As Fed Chair Ben Bernanke As Fed Chair Ben Bernanke As Fed Chair Yellen’s decision to pause hiking interest rates in 2016 is debatable and can be said to have accommodated the Democratic Party that year. She was replaced by President Trump in the midst of a rate-hike cycle justified by conditions (Chart 9). Powell hiked rates four times in 2018 despite the onset of a trade war with China. Powell cannot be said to have accommodated the Republicans in the 2018 midterm election. His behavior in 2020 was dominated by the COVID-19 crisis (Chart 10). Chart 9Janet Yellen As Fed Chair Janet Yellen As Fed Chair Janet Yellen As Fed Chair Chart 10Jerome Powell As Fed Chair Jerome Powell As Fed Chair Jerome Powell As Fed Chair The point is not to claim that politics is the driving factor behind monetary policy but rather to observe the cruxes in which personal and political motivations are at least mixed with technocratic and institutional decisions. Incidentally our observations largely corroborate the relevant academic literature.  If there is one solid rule that emerges from this analysis, it is that Fed chairmen and chairwomen do not accommodate midterm elections. There are no exceptions in the data shown here. If anything they are more hawkish. At the same time, it is true (though sometimes exaggerated) that rate hikes tend to be put on pause during presidential election years. And this tendency is observable not only during times in which a crisis makes rate hikes impossible. Furthermore a close examination of these charts supports the contention that Fed chairs tend to avoid or delay rate hikes prior to the president’s decision whether to reappoint them. There are exceptions but the charts do not disconfirm the hypothesis, which is intuitive because it fits with the central banker’s self-interest.  Biden Faces Zero Risk From A New Chair Or Some Risk From Powell A flat application of the rules of thumb in the previous section would suggest that Powell will push for easier policy than necessary ahead of Biden’s decision whether to reappoint him. It would also suggest that, if reappointed, Powell will not make any special accommodation for the Democrats in the critical 2022 midterms or in 2023. Obviously the reality might work out differently this time. But it is legitimate to suggest that retaining Powell poses a risk to the Democrats’ control of the economy ahead of the 2024 elections, even though we know we will get hate mail for saying it. Investors should not assume that there is a powerful norm in favor of the president’s retaining the sitting Fed chair in the name of continuity and “doing no harm.” The modern period of the Federal Reserve begins with the Fed-Treasury Accord in 1951. There have been seven changes of the Fed chair since that time and three of them occurred because of a change of political party in the White House (Martin to Burns, Burns to Miller/Volcker, and Yellen to Powell). While President Obama retained Bernanke, the reappointment came in early 2009, in the midst of a historic crisis. Biden has much greater flexibility than that today. And while Clinton retained Greenspan, the above analysis suggests that Democrats may warn Biden against doing the same. Most importantly Biden is president at a period of peak polarization in the US, when most of his Democratic Party and the US political establishment believe that democracy itself is at risk of dying at the hands of the Trumpist populism that is overtaking the Republican Party. If this is the view then even marginal risks to Democratic election prospects over the next four years should not be willingly taken. Biden’s dilemma can be illustrated easily by game theory. If he retains Powell he runs some risk of a hawkish surprise, however small, whereas if he replaces Powell he can avoid that risk. Powell regains some individual discretion if he is reappointed and therefore a hawkish surprise cannot be ruled out. The game theory implies that Biden will opt to remove Powell, but obviously that is up to Biden. Note that there is no stable equilibrium as Powell’s decision is shown as data-dependent and indifferent to the outcome (which may not truly be the case) (Diagram 1).   Diagram 1Game Theory: Will The President Reappoint The Fed Chair? Will Biden Re-Appoint Powell? Does It Matter? Will Biden Re-Appoint Powell? Does It Matter? Biden must also choose a replacement for Vice Chair Richard Clarida, whose term expires in January 2022. Later, in June 2023, John Williams’s tenure on the board will expire (Diagram 2). With three new appointments Biden would be able to remake the board both slightly more dovish and considerably more diverse. Diversity and inclusiveness in top government positions are key aspects of Biden’s and the Democrats’ overall agenda.  Diagram 2Biden Could Replace At Least Three Fed Governors Will Biden Re-Appoint Powell? Does It Matter? Will Biden Re-Appoint Powell? Does It Matter? The history of the Fed shows that leaders tend to be captured by the institution. Powell is fully absorbed into the new Fed consensus and his personal legacy depends on executing the new ultra-dovish monetary policy strategy that he himself ushered into being. While Modern Monetary Theory (MMT) has made great strides, it is not easy for Biden to get a true believer confirmed in the Senate. In this sense, it does not matter whether Biden replaces Powell – the result will be largely the same and in line with the Fed’s current policy framework. We have a lot of sympathy with this argument. It emphasizes the checks and balances on the individual policymaker, which is the method we use to analyze US politics. The Fed has given very explicit criteria for lifting rates off the zero lower bound that are tied to specific economic outcomes. They have removed a lot of the discretion from that decision. Anyone qualified to take up the Fed chair would understand that it would be very risky to deviate from that specific guidance: the Fed would lose a lot of credibility. It would have to be a very non-mainstream pick to do that. That is not likely to happen. But again – personalities can matter at inflection points. Some would argue that Biden will not be able to find any credible candidates who can pass Senate confirmation and still be significantly more dovish than Powell (the Senate being divided equally between the two parties). However, Lael Brainard, Raphael Bostic, and Neel Kashkari are all Fed insiders who would be likely to pass the Senate and marginally more dovish than Powell, albeit supporters of the current policy framework. They would also advance the diversity agenda in different ways. They are more likely nominees than other potential candidates (Table 1).   Table 1Potential Successors To Powell As Fed Chair Will Biden Re-Appoint Powell? Does It Matter? Will Biden Re-Appoint Powell? Does It Matter? Note that the focus on inclusiveness is not only about personnel but also about the inclusiveness of the economy and hence it could affect monetary policy decisions. Inclusiveness as well as climate change and inequality are concerns outside of the Fed’s official mandate, where monetary policy will have a limited effect, but any influence of these issues whatsoever would point to dovish surprises. Biden can advance this agenda without legislative change through appointments.   Investment Takeaways The Fed chair appointment is a misleading win-win situation for markets. If Biden retains Powell, it is because Powell has proved thoroughly committed to the Fed’s new ultra-dovish monetary policy strategy, whereas if Biden replaces him, the replacement will be ultra-dovish. However, this win-win is misleading because beyond the near term the Fed will have to normalize policy. The Fed will ultimately remain data-dependent and the rapid closing of the output gap combined with a historic increase in excess money supply will push up inflation and require Fed responses regardless of the future chairman or chairwoman (Chart 11). Our US Bond Strategist Ryan Swift emphasizes that the Fed’s policy framework is very explicit. In order to normalize policy it needs to see inflation above the 2% target, the economy at maximum employment, and a convincing inflation overshoot (Table 2). The first goal is already met, with 12-month PCE inflation above target. An inflation overshoot will necessarily follow from the first goal combined with the second goal. Therefore the focal point for investors should be the second goal, “maximum employment,” i.e. the unemployment rate and labor participation rate (Chart 12). Positive data surprises on the employment front will accelerate the time frame. Chart 11Output Gap To Close Rapidly Output Gap To Close Rapidly Output Gap To Close Rapidly Table 2Checklist For Fed Liftoff Will Biden Re-Appoint Powell? Does It Matter? Will Biden Re-Appoint Powell? Does It Matter? Chart 12Charting The Checklist For Fed Liftoff Charting The Checklist For Fed Liftoff Charting The Checklist For Fed Liftoff For now we remain long TIPS relative to duration-matched nominal Treasuries in expectation of dovish policy surprises. We may modify this trade in the near future. The upside is limited now that ten-year breakevens and five-year/five-year forward breakevens have reached the point where they are consistent with the Fed’s goal of well-anchored inflation expectations. But the above analysis supports this trade. Of course, the Fed’s actions should be taken into context with fiscal policy as well as external events and the US dollar. In the near term we continue to advise a cautious approach given that the US dollar is resting at a critical juncture, around 90 on the DXY. If the dollar breaks down beneath this level then it could fall substantially further. From a macro perspective this is what we would expect given the standing of budget deficit and real interest rates. Today’s historic combination of loose fiscal, loose monetary policy is dollar-bearish (Chart 13). The implication is positive for equities, especially cyclical and value sectors, so we maintain our current positioning.  Chart 13Loose Monetary, Loose Fiscal Policy Threaten The Dollar Loose Monetary, Loose Fiscal Policy Threaten The Dollar Loose Monetary, Loose Fiscal Policy Threaten The Dollar Our sister Geopolitical Strategy highlights China among other foreign policy challenges to the bearish dollar view and global risk appetite. This summer should provide some clarity on whether global policy uncertainty will rise and reinforce the dollar’s floor (Chart 14).     Chart 14Geopolitical Risk And Policy Uncertainty Put Floor Under Dollar? Geopolitical Risk And Policy Uncertainty Put Floor Under Dollar? Geopolitical Risk And Policy Uncertainty Put Floor Under Dollar? Biden is still highly likely to pass an infrastructure bill this year (80% subjective odds). Any failure of bipartisan talks with Republicans will simply result in an all-Democratic bill via budget reconciliation. West Virginia Senator Joe Manchin will not prevent the passage of a bipartisan infrastructure bill and/or Biden’s next reconciliation bill (the American Jobs Plan). Manchin’s current tensions with the Democratic caucus center on the so-called “For The People” voting rights bill and the Senate filibuster, not the question of infrastructure and corporate tax hikes. Indeed Manchin may be forced to accept a higher corporate tax rate than his preferred 25% if he wants to make peace with his party. It is not inconceivable that he could defect from his party – the Republicans lost a 50-seat majority in the Senate this way as recently as 2001. But we have long argued that Manchin will support Biden’s signature legislative achievement. The market may be temporarily disappointed by stimulus hiccups but we view the infrastructure bill as a “buy the rumor, sell the news” dynamic for US cyclicals. While a fiscal policy weak spot will develop late in 2021 and early 2022, after the American Rescue Plan Act’s provisions expire but before new funds arrive from the American Jobs Plan, nevertheless the recovery of the private economy both at home and abroad should provide a bridge. The implication of the above analysis is to stay invested in the stock market and maintain a constructive outlook over the cyclical (12-month) time horizon while exercising near-term caution due to the dollar and geopolitical risk.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1USPS Trade Table Will Biden Re-Appoint Powell? Does It Matter? Will Biden Re-Appoint Powell? Does It Matter? Table A2Political Risk Matrix Will Biden Re-Appoint Powell? Does It Matter? Will Biden Re-Appoint Powell? Does It Matter? Table A3Political Capital Index Will Biden Re-Appoint Powell? Does It Matter? Will Biden Re-Appoint Powell? Does It Matter? Table A4APolitical Capital: White House And Congress Will Biden Re-Appoint Powell? Does It Matter? Will Biden Re-Appoint Powell? Does It Matter? Table A4BPolitical Capital: Household And Business Sentiment Will Biden Re-Appoint Powell? Does It Matter? Will Biden Re-Appoint Powell? Does It Matter? Table A4CPolitical Capital: The Economy And Markets Will Biden Re-Appoint Powell? Does It Matter? Will Biden Re-Appoint Powell? Does It Matter?   Footnotes 1     For political monetary cycles see Edward N. Gamber and David R. Hakes, “The Federal Reserve’s response to aggregate demand and aggregate supply shocks: Evidence of a partisan political cycle,” Southern Economic Journal 63:3 (1997), 680-91. For developed versus developing market political monetary cycles, see S. Alpanda and A. Honig, “The impact of central bank independence on political monetary cycles in advanced and developing nations,” Journal of Money, Credit and Banking 41:7 (2009), 1365-1389. 2     In the US, the Fed’s independence rests on dubious constitutional and legal supports but is nevertheless well-established in legal and political practice. See Peter Conti-Brown, “The Institutions of Federal Reserve Independence,” Yale Journal on Regulation 32 (2015), 257-310. 3    Lawrence Bauer and Alex Faseruk, “Understanding Political Pressures, Monetary Policy, and the Independence of the Federal Reserve in the United States from 1960-2019,” Journal of Management Policy and Practice 21:3 (2020), 41-63. 4    Kuttner and Posen (2007) demonstrate that financial markets respond to newsworthy developments with central bankers across the developed world. See footnote 7 below. 5    See Conti-Brown, footnote 2 above. See also Kelly H. Chang, Appointing Central Bankers: The Politics of Monetary Policy in the United States and European Union (Cambridge: CUP, 2003). 6    See Alexander W. Salter and Daniel J. Smith, “Political economists or political economists? The role of political environments in the formation of Fed policy under Burns, Greenspan, and Bernanke,” The Quarterly Review of Economics and Finance 71 (2019), 1-13. 7     See Dentler, 241. See also Ellen E. Mead, “The FOMC: Preferences, Voting, and Consensus,” Federal Reserve Bank of St. Louis Reivew 87:2 (2005), 93-101; Kenneth N. Kuttner and Adam S. Posen, “Do Markets Care Who Chairs the Central Bank?” National Bureau of Economic Research, Working Paper 13101 (May 2007), nber.org.  8    B. A. Abrams and P. Iossifov, “Does the Fed contribute to a political business cycle?” Public Choice 129 (2006), 249-62. 9    Gamber and Hakes, “The Taylor rule and the appointment cycle of the chairperson of the Federal Reserve,” Journal of Economics and Business 58 (2006), 55-66. 10   Alexander Dentler, “Did the Fed raise interest rates before elections?” Public Choice 181 (2019), 239-73. 11    Dentler, 259, characterizes the Fed chairs as follows: “We believe that Martin was more susceptible to political infuences than his colleagues, but he never worked in opposition to a president in our sample period. Neither did Arthur Burns; however, we find him to be a moderating force with respect to ideological biases, though he appears to have been vulnerable to threats regarding his career. We find Volcker to respond more strongly than most other chairs to ideological motives and career incentives. Greenspan, on the other hand, did not fall prey to biased behavior that characterizes the other chairs. Bernanke’s tenure is probably the most difficult to interpret.” 12    Real Potential GDP Growth + Core PCE Deflator + 0.5 * (Core PCE Deflator – 2% Target) - 0.5 * (Unemployment Rate – NAIRU). We prefer real potential GDP to estimates of the real neutral rate because it is simpler and more transparent.