Geopolitics

Highlights Biden’s policy on China is hawkish so far, as expected, but temporary improvement is possible. We are cyclically bearish on the dollar but are taking a neutral tactical stance as the greenback’s bounce could go higher than expected if US-China relations take another downward dive. US-Iran tensions are on track to escalate in the second quarter as the pressure builds toward what we think will be a third quarter restoration of the 2015 nuclear deal. Oil price volatility is the takeaway. The anticipated US-Russia conflict has emerged and will bring negative surprises, especially for Russian and emerging European markets. Europe still enjoys relative political stability. A German election upset would bring upside risk to the euro and bund yields, while Scottish independence risk is contained for now. In this report we are launching the first in a new series of regular quarterly outlook reports that will supplement our annual Geopolitical Strategy strategic outlook. Feature The decline in global policy uncertainty and geopolitical risk that attended the US election and COVID-19 vaccine discovery has largely played out. Global investors have witnessed successful vaccine rollouts in the US and UK and can look forward to other countries, namely the EU-27, catching up. They have witnessed a splurge of US fiscal spending – $2.8 trillion since December – unprecedented in peacetime. And they have seen the Chinese government offer assurances that monetary tightening will not undermine the economic recovery. The risk of the US doubling down on belligerent trade protectionism has fallen by the wayside along with the Trump presidency. Going forward, there are signs that policy uncertainty and geopolitical risk will revive. First, as the global semiconductor shortage and Suez Canal blockage highlight, the world economy will sputter and strain at the sudden eruption of economic activity as the pandemic subsides and vast government spending takes effect. Financial instability is a likely consequence of the sudden, simultaneous adoption of debt monetization across a range of economies combined with a global high-tech race and energy overhaul. Second, the defeat of the Trump presidency does not reverse the secular increase in geopolitical tensions arising from America’s internal divisions and weakening hand relative to China, Russia, and others. On the contrary, large monetary and fiscal stimulus lowers the economic costs of conflict and encourages autarkic, self-sufficiency policies that make governments more likely to struggle with each other to secure their supply chains. Chart 1AThe Return Of Geopolitical Risk The Return Of Geopolitical Risk The Return Of Geopolitical Risk Chart 1BThe Return Of Geopolitical Risk The Return Of Geopolitical Risk The Return Of Geopolitical Risk If we look at simple, crude measures of geopolitical risk we can see the market awakening to the new wall of worry for this business cycle – Great Power struggle, the persistence of “America First” with a different figurehead, China policy tightening, and a vacuum of European leadership. The US dollar is rising, developed market equities are outperforming emerging markets, safe-haven currencies are ticking up against commodity currencies, and gold is perking back up (Charts 1A & 1B). The cyclical upswing should reverse most of these trends over the medium term but investors should be cautious in the short term. US Stimulus, Chinese Tightening, And The Greenback The US remains the world’s preponderant power despite its political dysfunction and economic decline relative to emerging markets. The US has struggled to formulate a coherent way to deal with declining influence, as shown by dramatic policy reversals toward Iraq, Iran, China, and Russia. The pattern of unpredictability will continue. The Biden administration’s longevity is unknown so foreign states will be cautious of making firm commitments, implementing deals, or taking irrevocable actions. This does not mean the Biden administration will have a small impact – far from it. Biden’s national policy seeks to fire up the American economy, refurbish alliances, export liberal democratic ideology, and compete with China and Russia. The firing up is largely already accomplished – the American Rescue Plan Act (ARPA) and Biden’s forthcoming “Build Back Better” proposals will ultimately rank with Johnson’s Great Society. The Fed estimates that US GDP growth will hit 6.5% this year, higher than the consensus of economic forecasts estimates 5.5%, driven by giant government pump-priming (Chart 2). The US, which is already an insulated economy, is virtually inured to foreign shocks for the time being. Chart 2US Injects Steroids Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Next comes the courting of allies to form a united democratic front against the world’s ambitious dictatorships. This process will be very difficult as the allies are averse to taking risks, especially on behalf of an erratic America. Chart 3US Stimulus Briefly Halts Decline In Global Economic Share Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" The Obama administration spent six full years creating a coalition to pressure an economically miniscule Iran into signing the 2015 nuclear deal. Imagine how long it will take Biden to convince the EU-27 and small Asian states to stick their necks out against Xi Jinping’s China. Especially if they suspect that the US’s purpose is to force China to open its doors primarily for the Americans. If the US grows at the rate of consensus forecasts then its share of global GDP will be 17.6% by 2025 (Chart 3). However, the US’s decline should not be exaggerated. Consider the lesson of the past year, in which the US seemed to flounder in the face of the pandemic. The US’s death count, on a population basis, was in line with other developed markets and yet its citizens exercised a greater degree of individual freedom. It maintained the rule of law despite extreme polarization, social unrest, and a controversial election. Its development of mRNA vaccines highlighted its ongoing innovation edge. And it has rolled out the vaccines rapidly. Internal divisions are still extreme and likely to produce social instability (we are still in the zone of “peak polarization”). But the US economic foundation is now fundamentally supported – political collapse is improbable. Chart 4US Vs China: The Stimulus Impulse US Vs China: The Stimulus Impulse US Vs China: The Stimulus Impulse In short, the US saw the “Civil War Lite” and has moved onto “Reconstruction Lite,” with a big expansion of the social safety net and infrastructure as well as taxes already being drafted. Meanwhile General Secretary Xi has managed to steer China into a good position for the much-ballyhooed 100th anniversary of the Communist Party on July 1. His administration is tightening monetary and fiscal policy marginally to resume the fight against systemic financial risk. China faces vast socioeconomic imbalances that, if left unattended, could eventually overturn the Communist Party’s rule. So far the tightening of policy is modest but the risk of a policy mistake is non-negligible and something global financial markets will have to grapple with in the second quarter. Comparing the US and China reveals an impending divergence in relative monetary and fiscal stimulus (Chart 4). China’s money and credit impulse is peaking – some signs of economic deceleration are popping up – even as the US lets loose a deluge of liquidity and pump-priming. The result is that the world is likely to experience waning Chinese demand and waxing US demand in the second half of the year. It is almost the mirror image of 2009-10, when China’s economy skyrocketed on a stimulus splurge while the US recovered more slowly with less policy support. The medium-to-long-run implication is that the US will have a bumpy downhill ride over the coming decade whereas China will recover more smoothly. Yet the analogy only goes so far. The structural transition facing China’s society and economy is severe and US-led international pressure on its economy will make it more severe. The short-run implication – for Q2 2021 – is that the US dollar’s bounce could run longer than consensus expects. Commodity prices, commodity currencies, and emerging market assets face a correction from very toppy levels. The global cyclical upswing will continue as long as China avoids a policy mistake of overtightening as we expect but the near-term is fraught with downside risk. Bottom Line: We are neutral on the dollar from a tactical point of view. While our bias is to expect the dollar to relapse, in line with the BCA House View and our Foreign Exchange Strategy, we are loathe to bet against the greenback given US stimulus and Chinese tightening. This is not to mention geopolitical tensions highlighted below that would reinforce the dollar. Biden’s China Policy And The Semiconductor Shortage Any spike in US-China strategic tensions in Q2 would exacerbate the above reasoning on the dollar. It would also lead to a deeper selloff in Chinese and EM Asian currencies and risk assets. A spike in tensions is not guaranteed but investors should plan for the worst. One of our core views for many years has been that any Democratic administration taking office in 2020 would remain hawkish on China, albeit less so than the Trump administration. So far this view is holding up. It may not have been the cause of the drop in Chinese and emerging Asian equities but it has not helped. However, the jury is still out on Biden’s China policy and the second quarter will likely see major actions that crystallize the relative hawkish or dovish change in policy. The acrimonious US-China meeting in Alaska meeting does not necessarily mean anything. The Biden administration has a full China policy review underway that will not be completed until around early June. The first bilateral summit between Biden and Xi could occur on Earth Day, April 22, or sometime thereafter, as the countries are looking to restart strategic dialogue and engage on nuclear non-proliferation and carbon emission reductions. Specifically China wants to swap its help on North Korea – which restarted ballistic missile launches as we go to press – for easier US policies on trade and tech. Only if and when a new attempt at engagement breaks down will the Biden administration conclude that it has a basis for pursuing a more offensive policy toward China. The problem is that new engagement probably will break down, sooner or later, for reasons we outlined last week: the areas of cooperation are limited – obviously so on health and cybersecurity, but even on climate change. Engagement on Iran and North Korea may have more success but the bigger conflicts over tech and Taiwan will persist. Ultimately China is fixated on strategic self-sufficiency and rapid tech acquisition in the national interest, leaving little room for US market access or removal of high-tech export controls. The threat that Biden will ultimately adopt and expand on Trump’s punitive measures will hang over Beijing’s head. The risk of a Republican victory in 2024 will also discourage China from implementing any deep structural concessions. The crux of the conflict remains the tech sector and specifically semiconductors.1 China is rapidly gaining market share but the US is using its immense leverage over chip design and equipment to cut off China’s access to chips and industry development. The ongoing threat of an American chip blockade is now being exacerbated by a global shortage of semiconductors as the economy recovers (Chart 5), exposing China’s long-term economic vulnerability. Chart 5Global Semiconductor Shortage Global Semiconductor Shortage Global Semiconductor Shortage There is room for some de-escalation but not much – and it is not to be counted on. The Biden administration, like the Obama administration, subscribes to the view that the US should prioritize maintaining its lead in tech innovation rather than trying to compete with China’s high-subsidy model, which is gobbling up the lower end of the computer chip market. Biden’s policy will at first be defensive rather than offensive – focused on improving US supply chain security rather than curtailing Chinese supply. Biden’s proposal for domestic infrastructure program will include funds for the semiconductor industry and research. While the Biden administration likely prizes leadership and innovation over the on-shoring of US chip production, the US government must also look to supply security, specifically for the military, so some on-shoring of production is inevitable.2 Ultimately the Biden administration can continue using export controls to slow China’s semiconductor development or it can pare these controls back. If it does nothing then China’s state-backed tech program will lead to a rapid increase in Chinese capabilities and market share as has occurred in other industries. If it maintains restrictions then it will delay China’s development, especially on the highest end of chips, but not prevent China from gaining the technology through circumventing export controls, subsidizing its domestic industry, and poaching from Taiwan and South Korea. Given that technological supremacy will lead to military supremacy the US is likely to maintain restrictions. But a full chip blockade on China would require expanding controls and enforcing them on third parties, and massively increases strategic tensions, should Biden ever decide to go this ultra-hawkish route. The Biden administration can adjust the pace and intensity of export controls but cannot give China free rein. Biden will want to block China’s access to the US market, or funds, or parts when these feed its military-industrial complex but relax pressure on China’s commercial trade. This is only a temporary fix. The commercial/military distinction is hard to draw when Beijing continually pursues “civil-military fusion” to maximize its industrial and strategic capabilities. Therefore US-China strategic tensions over tech will worsen over the long run even if Biden pursues engagement in the short run. Bottom Line: Biden’s China policy has started out hawkish as expected but the real policy remains unknown. The second quarter will reveal key details. Biden could pursue engagement, leading to a reduction in tensions. Investors should wait and see rather than bet on de-escalation, given that tensions will escalate anew over the medium and long term and therefore may never really decline. Iran And Oil Price Volatility Biden’s other foreign policy challenges in the second quarter hinge on Iran and Russia. The Biden administration aims to restore the 2015 Iranian nuclear deal and is likely to move quickly. This is not merely a matter of intention but of national capability since US grand strategy is pushing the US to shift focus to Asia Pacific, and an Iranian nuclear crisis divides US attention and resources. Biden has the ability to return to the 2015 deal with a flick of his wrist. The Iranians also have that ability, at least until lame duck President Hassan Rouhani leaves office in August – beyond that, a much longer negotiation would be necessary. US-Iran talks will lead to demonstrations of credible military threats, which means that geopolitical attacks and tensions in the Middle East will likely go higher before they fall on any deal. The past several years have already seen a series of displays of military force by the Iranians and the US and its allies and this process may escalate all summer (Map 1). Map 1Military Incidents In Persian Gulf Since Abqaiq Refinery Attack, 2019 Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" It is too soon to draw conclusions regarding the Israeli election on March 23 but it is possible that Prime Minister Benjamin Netanyahu will remain in power (Chart 6). If this is the case then Israel will oppose the American effort to rejoin the Iranian nuclear deal, culminating in a crisis sometime in the summer (or fall) in which the Israelis make a major show of force against Iran. Even if Netanyahu falls from power, the new Israeli government will still have to show Iran that it cannot be pushed around. Fundamentally, however, a change in leadership in Israel would bring the US and Israel into alignment and thus smooth the process for a deal that seeks to contain Iran’s nuclear program at least through 2025. Any better deal would require an entirely new diplomatic effort. Chart 6Israeli Ruling Coalition Share Of Knesset Shares In Recent Elections Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" The Russians or Saudi Arabians might reduce their oil production discipline once a deal becomes inevitable, so as not to lose market share to Iranian oil that will come back onto global markets. Thus oil markets could face unexpected oil supply outages due to conflict followed by OPEC or Iranian supply increases, implying that prices will be volatile. Our Commodity & Energy Strategy expects prices to average $65/barrel in 2021, $70/barrel in 2022, and $60-$80/barrel through 2025. Bottom Line: Oil prices will be volatile in the second quarter as they may be affected by the twists and turns of US-Iran negotiations, which may not reach a new equilibrium until July or August at earliest. Otherwise a multi-year diplomatic process will be required, which will suck away the Biden administration’s foreign policy capital, resulting either in precipitous reduction in Middle East focus or a neglect of greater long-term challenges from China and Russia. Russian Risks, Germany Elections, And Scottish Independence European politics are more stable than elsewhere in the world – marked by Italy’s sudden formation of a technocratic unity government under Prime Minister Mario Draghi. Draghi is focused on using EU recovery funds to boost Italian productivity and growth. Europe’s economic growth has underperformed that of the US so far this year. The EU is not witnessing the same degree of fiscal stimulus as the US (Chart 7). The core member states all face a fiscal drag in the coming two years and meanwhile the bloc has struggled to roll out COVID-19 vaccines efficiently. However, the vaccines are proven to be effective and will eventually be rolled out, so investors should buy into the discount in the euro and European stocks as a result of the various mishaps. Global and European industrial production and economic sentiment are bouncing back and German yields are rising albeit not as rapidly as American (Chart 8). Chart 7EU Stimulus Lags But Targets Productivity Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Chart 8Global And Euro Area Production To Accelerate Global And Euro Area Production To Accelerate Global And Euro Area Production To Accelerate Chart 9German Conservatives Waver in Polls German Conservatives Waver in Polls German Conservatives Waver in Polls The main exceptions to Europe’s relative political stability come from Germany and Scotland. German Chancellor Angela Merkel is a lame duck and her party is falling in opinion polls with only six months to go before the general election on September 26 (Chart 9). Merkel even faced the threat of a no-confidence motion in the Bundestag this week due to her attempt to extend COVID lockdowns over Easter and sudden retreat in the face of a public backlash. Merkel apologized but her party is looking extremely shaky after recent election losses on the state level. The rise of a new left-wing German governing coalition is much more likely than the market expects. The second quarter will see the selection of a chancellor-candidate for her Christian Democratic Union and its Bavarian sister party the Christian Social Union. Table 1 highlights the likeliest chancellor-candidates of all the parties and their policy stances, from the point of view of whether they have a “hawkish,” hard-line policy stance or “dovish,” easy policy stance on the major issues. What stands out is that the entire German political spectrum is now effectively centrist or dovish on monetary and fiscal policy following the lessons of the 13 years since the global financial crisis. Table 1German Chancellor Candidates, 2021 Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" In other words, while Germany’s conservatives will seek an earlier normalization of policy in the wake of the crisis, none of them are as hawkish as in the past, and an election upset would bring even more dovish leaders into power. Thus the German election is a political risk but not a global market risk. It should not fundamentally alter the trajectory of German equities or bond yields – which is up amid global and European recovery – and if anything it would boost the euro. The potential German chancellor candidates show more variation when it comes to immigration, the environment, and foreign policy. Germany has been leading the charge for renewable energy and will continue on that trajectory (Chart 10). However it has simultaneously pursued the NordStream II natural gas pipeline with Russia, which would bring 55 billion cubic meters of natural gas straight into Germany, bypassing eastern Europe and its fraught geopolitics. This pipeline, which could be completed as early as August, would improve Germany’s energy security and Russia’s economic security, which remain closely intertwined despite animosity in other areas (Chart 11). But the pipeline would come at the expense of eastern Europe’s leverage – and American interests – and therefore opposition is rising, including among the ascendant German Green Party. Chart 10Germany’s Switch To Renewables Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Chart 11Germany Puts Multilateralism To The Test Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Chart 12UK-EU Trade Deal Dampens Scots Nationalism UK-EU Trade Deal Dampens Scots Nationalism UK-EU Trade Deal Dampens Scots Nationalism While Merkel and the Christian Democrats are dead-set on completing the pipeline, global investors are underrating the possibility of a major incident in which the US uses diplomacy and sanctions to halt the project. This is not intuitive because Biden is focused on restoring the US alliance with Europe, particularly Germany. But he is doing so in order to counter Russian and Chinese authoritarianism. Therefore the pipeline could mark the first real test of Biden’s – and Germany’s – understanding of multilateralism. Importantly the US is not pursuing a diplomatic “reset” with Russia at the outset of Biden’s term. This has now been confirmed with Biden’s accusation that Russian President Vladimir Putin is a “killer” and the ensuing, highly symbolic Russian withdrawal of its ambassador to the United States, unseen even in the Cold War. The Americans are imposing sanctions in retaliation for Russia’s alleged interference in the 2016 and 2020 elections. Russia is largely inured to US sanctions at this point but if the US wanted to make a difference it would insist on a stop to NordStream by cutting off access to the US market to the various European engineering and insurance companies critical to construction.3 Yet German leaders would have to be cajoled and it may be more realistic for the US to demand other concessions from Germany, particularly on countering China. The US-German arrangement will go a long way toward defining Germany’s and the EU’s risk appetite in the context of Biden’s proposal to build a more robust democratic alliance to counter revisionist authoritarian states. The Russians say they want to avoid a permanent deterioration in relations with the US, which they warn is on the verge of occurring. There is some space for engagement, such as on restoring the Iran deal, which Russia ostensibly supports. Biden may want to keep Russia pacified until he has an Iranian deal in hand. Ultimately, however, US-Russian relations are headed to new lows as the Biden administration brings counter-pressure on the Russians in retribution for the past decade of actions to undermine the United States. Germany’s place in this conflict will determine its own level of geopolitical risk. Clearly we would favor German assets over those of emerging Europe or Russian in this environment. One final risk from Europe is worth mentioning for the second quarter: the UK and Scotland. Scottish elections on May 6 could enable the Scottish National Party to push for a second independence referendum. So far our assessment is correct that Scottish independence will lose momentum after Prime Minister Boris Johnson’s post-Brexit trade deal with the European Union. Scottish nationalists are falling (Chart 12) and support for independence has dropped back toward the 45% level where the 2014 referendum ended up. Nevertheless elections can bring surprises and this narrative bears vigilance as a threat to the pound’s sharp rebound. Bottom Line: Europe’s relative political stability is challenged by US-Russia geopolitical tensions, the higher-than-expected risk of a German election upset, and the tail risk of Scottish independence. Of these only a US-Russia blowup, over NordStream or other issues, poses a major downside risk to global investors. We continue to underweight EM Europe and Russian currency and financial assets. Investment Takeaways Our three key views for 2021, in addition to coordinated monetary and fiscal stimulus, are largely on track for the year so far: China’s Headwinds: China’s renminbi and stock market are indeed suffering due to policy tightening and US geopolitical pressure. Risk to our view: if Biden and Xi make major compromises to reengage, and Xi eases monetary and fiscal policy anew, then the global reflation trade and Chinese equities will receive another boost. US-Iran Triggered Oil Volatility: The US and Iran are still in stalemate and the window of opportunity for a quick restoration of the 2015 deal is rapidly narrowing. Tensions are indeed escalating prior to any resolution, which would come in the third quarter, thus producing first upside then downside pressures for oil prices. Risk to our view: the Biden administration has no need for a new Iran deal and tensions escalate in a major way that causes a major risk premium in oil prices and forces the US to downgrade its pressure campaign against China. Europe’s Outperformance: So far this year the dollar has rallied and the EU has botched its vaccine rollout, challenging our optimistic assessment of Europe. But as highlighted in this report, we anticipated the main risks – government change in Germany, a Scots referendum – and the former is positive for the euro while the downside risk to the pound is contained. The major geopolitical problem is Russia, where we always expected substantial market-negative risks to materialize after Biden’s election. Risk to our view: A US-Russian reset that lowers geopolitical tensions across eastern Europe or a German status quo election followed by a tightening of fiscal policy sooner than the market expects.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 For an excellent recent review of the issues 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, issuu.com. 2 Alex Fang, "US Congress pushes $100bn research blitz to outcompete China," Nikkei Asia, March 23, 2021, asia.nikkei.com. In anticipation of the Biden administration’s dual attempt to promote, on one hand, innovation, and on the other hand, semiconductor supply security, the US semiconductor giant Intel has announced that it will build a $20 billion chip fabrication plant in Arizona. This is in addition to TSMC’s plans to build a plant in Arizona manufacturing chips that are necessary for the US Air Force’s F-35 jets. See Kif Leswing, "Intel is spending $20 billion to build two new chip plants in Arizona," CNBC, March 23, 2021, cnbc.com. 3 See Margarita Assenova, "Clouds Darkening Over Nord Stream Two Pipeline," Eurasia Daily Monitor 18:17 (2021), Jamestown Foundation, February 1, 2021, Jamestown.org.   Appendix: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights Biden has enough political capital to pass at least one more major piece of legislation. The next major bill will increase the budget deficit further, adding additional stimulus, though it will consist of structural reforms over a ten-year time frame and with a drag created by tax hikes. Our annual key views are on track: polarization has subsided but remains at peak levels from a historical point of view; structural reform is underway, although any chance of bipartisanship is slipping; the Republicans remain deeply divided despite some signs of regrouping. Investors should remain cyclically bullish although the sharp rise in bond yields, the bounce in the US dollar, China’s growth deceleration, and geopolitical risks all warrant tactical caution in the near term. Feature The first quarter of the year brought a few political surprises – from the Capitol Hill riot to Trump’s second impeachment – but the only significant surprise for the American investor was the Democratic victory in the Georgia Senate runoffs. This victory changed the policy setting, producing a Democratic majority in the US Senate and enabling the Biden administration to project three budget reconciliation bills (for FY2021, 2022, 2023) that require zero Republican votes.  The first of these bills was signed into law promptly as expected. The $1.9 trillion American Rescue Plan Act consists of short-term cash handouts and social spending that will supercharge an economic recovery that is rapidly accelerating due to the rollout of vaccines for COVID-19 (Chart 1). Chart 1American Rescue Plan Boosts GDP Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform The second major piece of legislation, likely the budget reconciliation bill for FY2022, will consist of net increases to the budget deficit, thus further stimulating the economy, albeit along with structural reform, i.e. social safety net and tax hikes, and a 10-year time horizon. In the second quarter investors will learn the parameters of the bill through Biden’s address to a joint session of Congress, an idealistic presidential budget proposal, a more realistic House and Senate budget resolution, and an extended negotiation. Yet Biden’s second bill will probably not be signed into law until the third or even fourth quarter. Big Government Is Back The American Rescue Plan Act cements a new era of “Big Government” that should be ascribed not to any particular party but to underlying populist pressures in the United States. President Trump’s big-spending ways and pandemic relief packages had already produced a major step up in the government contribution to economic output, as shown in Chart 2, and this will go higher once Biden’s 8.7% of GDP bill is added to the mix. This increase in the government role is likely to last beyond the pandemic given that President Trump had already taught the Republicans that fiscal austerity does not win votes. Republicans will still be the party of “limited government” but that is a relative concept and they will not be able to win elections on a platform of slashing spending, at least not until stagflation returns. In the meantime they are out of power and tax-and-spend liberals rule the roost. Chart 2Era Of Big Government Is Back Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Our updated budget projections show that the decline of stimulus spending will be gradual in the coming years if Biden delivers his second reconciliation bill for FY2022 (Chart 3). Major changes from previous versions have to do with changes to the Congressional Budget Office’s baseline outlook. Our new Democratic Low Spending scenario assumes a $2 trillion dollar green/infrastructure package, a $1 trillion health care reform, and a roughly $2 trillion increase in tax revenue. The Democrats will raise taxes – at least partially repealing Trump’s Tax Cut and Jobs Act and raising a few other taxes. We expect the market to be negatively surprised by the magnitude of tax hikes, at least initially, though the upside risk to the equity market is that tax hikes will be watered down by moderate Democrats in the Senate. We would not bet on a positive tax surprise because even moderate Democrats are in favor of taxing corporations and the wealthy, the taxes can be phased in over a 10-year period, and the economy is on a cyclical upswing combined with mammoth new spending programs. Chart 3US Budget Deficit Booms Under Biden Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Our presumption that Biden will sign his second major bill into law this fall (even as late as December) rests on the vulnerability of his administration and party. Traditional Democrats, embodied by Biden, Democratic leaders in Congress, and Biden’s technocratic cabinet (Appendix), face a historic accumulation of political pressure from their populist left-wing and from Trump’s populist Republican Party. If they cannot deliver on major “bread and butter” promises to the American people, while including just enough progressive elements to keep the far left at bay, they risk extinction in coming election cycles. This pressure is real and will enable at least one more major legislative achievement. Bottom Line: Government spending has taken a big step up and Biden’s second major legislative initiative will ensure that the step up is permanent rather than a temporary response to a crisis. The macro impact is inflationary on the margin. Biden’s Second Reconciliation Bill Is the Biden administration over-stimulating the economy and setting the US up for overheating? It looks like it, though the size of tax hikes is as yet unknown. Going forward the stock market will be extremely attentive to two risks that cut in different directions: excessive stimulus and excessive tax hikes. The American Rescue Plan alone is more than twice as large as the estimated output gap. The output gap is widely expected to be closed by the end of the year (Chart 4). Even a $1 trillion infrastructure package – much lower than the currently rumored $3 trillion – would be excessive in this context. Chart 4Output Gap Is Virtually Closed Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform The infrastructure package that is being planned – which would include a range of measures in addition to roads and bridges, such as green energy projects, supply chain on-shoring, and digital infrastructure – would take place over a ten-year period and will be coupled with a drag from new taxes. A modern-age infrastructure plan would boost productivity and hence potential GDP growth, which could offset some of the inflationary impact. Speculatively, the simplest path for achieving Biden’s objectives would be to put his health care reform (with other welfare proposals) in the FY2022 reconciliation bill along with tax reform. Tax changes are the purpose of the reconciliation process. Unlike infrastructure, health provisions are virtually guaranteed to pass the arcane rules of reconciliation. This is not a minor concern: the Senate parliamentarian ruled out a federal minimum wage hike in the American Rescue Plan because it was not directly germane to government revenues and expenditures and could do the same to infrastructure. Bear in mind that the Obama administration passed a key component of the Affordable Care Act (Obamacare) via reconciliation, setting a precedent that health care is germane. More broadly the Democratic Party has prioritized health care since 1992, now has a chance to clinch it, and has repeatedly benefited at the ballot box on the health agenda. Infrastructure, unlike health and tax reform, could conceivably pass in a regular bill, or piecemeal in annual spending bills, in which Biden would wheel and deal to try to get 60 votes (50 Democrats, 10 Republicans). However, the latest rumors as we go to press suggest the Democrats will prioritize infrastructure and link it to tax reform. Republicans will not vote for tax hikes so reconciliation would still be required in this case. Reconciliation is trickier with infrastructure spending than with health care, though not impossible. What is clear is that Biden’s agenda is too large to fit into one bill, that tax hikes are being planned, and that reconciliation is necessary for tax hikes. Based on our scenarios in Table 1, every realistic scenario involves an increase to the budget deficit, ranging from around $500 billion to $5.4 trillion over the 10-year period. Therefore the economy will receive additional stimulus on top of the unprecedented peacetime stimulus it has already received. Table 1Scenarios For Biden’s Second Reconciliation Bill Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Two other gleanings from Q1 bear mentioning: Biden’s policies on trade and immigration. On trade, Biden is coopting Trump’s hawkish China policy while trying to improve trade relations with allies and partners. The trade deficit is set to expand along with economic recovery and stimulus, resulting in larger twin deficits (Chart 5). This trend should weigh on the US dollar – but the dollar has strengthened so far this year. Given the US’s inherent strengths – rule of law, innovation, faster relative growth – and the structural rise in global geopolitical tensions, covered regularly by our twin Geopolitical Strategy, we are loathe to bet against a rising dollar. However, investors should note that the BCA House View expects the dollar to relapse and the dollar bear market to continue. On immigration, Biden faces his greatest domestic policy challenge. By easing border and immigration enforcement amid a hyper-charged economic recovery, he has invited a large flow of immigrants and refugees (Chart 6). He is thus forced to take urgent border actions to staunch the flow. If he does what is necessary to maintain order then he will widen the rift with the far left. Meanwhile Republicans are finding an issue over which they can start to reunite. Chart 5US Twin Deficits Balloon US Twin Deficits Balloon US Twin Deficits Balloon Chart 6Immigration A Looming Problem For Biden Immigration A Looming Problem For Biden Immigration A Looming Problem For Biden Bottom Line: The air of crisis is dissipating rapidly and proposed tax hikes will motivate opposition but Biden still has enough political capital to get at least one more budget reconciliation bill passed. The bill will focus on health/welfare (easier to pass but more inflationary) or infrastructure (harder but better for productivity). Either way the net deficit impact will be negative and the dual risk of higher taxes and economic overheating will create hurdles for the stock market rally.   Updating Our Three Key Views For 2021 How do the events of Q1 impact our three key views for 2021? At the start of the year we forecast (1) that the US’s political polarization would subside but remain at historically peak levels; (2) that the US would launch major structural reforms, in some cases on a bipartisan basis; (3) that Republican disunity would enable this contradictory environment of polarization yet occasional bipartisanship. Based on the first quarter’s events, we would draw the following conclusions for the second quarter and beyond: 1.   Peak Polarization: Polarization has indeed subsided (Chart 7). The country is still vulnerable to major polarizing events, including domestic extremists of whatever stripe, though any major terrorist attack would likely strengthen support for the sitting government. A fall in polarization is just one positive factor in Biden’s overall political capital, which we measure through our US Political Capital Index (Table 2). We consider Biden’s political capital moderate-to-strong because consumer confidence and the economy will likely improve. However, passing legislation will gradually get harder. The Obama administration had considerably greater strength in the Senate than the Biden administration, though, as mentioned, reconciliation guarantees Biden one or two more major pieces of legislation (Chart 8). Democrats can still overturn the filibuster, which requires a 60-vote majority on regular legislation, as we have long highlighted. But for now they seem to accept a watering-down of the filibuster (a “talking filibuster”) that will still give the minority Republicans the ability to halt controversial legislation. Chart 7Polarization Slips But Remains Elevated Polarization Slips But Remains Elevated Polarization Slips But Remains Elevated Table 2Biden’s Political Capital Is Moderate To Strong Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Chart 8Major Legislation Can Pass Early In Presidential Term Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform 2.   Bipartisan Structural Reform: The fact that not a single Republican senator voted for the American Rescue Plan Act, despite the lingering pandemic and air of crisis, suggests that bipartisanship is extremely limited, e.g. limited to the seven Republican senators who voted to convict Trump (Table 3). However, bipartisanship is still possible on an infrastructure package if the Democrats do not link it with tax hikes. Table 3Centrist Senators – And Republicans Who Voted To Convict Trump Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Beneath the surface there is bipartisanship when it comes to trade, supply chains, and countering China. Tariffs bottomed under the Obama administration and Biden started off with another round of “Buy America” provisions and a tentative decision to maintain Trump’s tariffs on China (Chart 9). Measures to boost US supply chain resilience in technology, health, and defense could be rolled up into an infrastructure package to help garner 10 Republican votes. Republicans have prepared for possible compromise by clearing the way for the use of “earmarks,” or constituency-based legislative incentives, otherwise known as pork-barrel spending.  Chart 9Tarriff Levels Bottomed Under Obama Tarriff Levels Bottomed Under Obama Tarriff Levels Bottomed Under Obama The market currently expects an infrastructure bill to pass, as indicated by the outperformance of infrastructure-related stocks, industrials, and materials relative to the market. Our BCA Infrastructure basket is outperforming (Chart 10). The market does not currently expect the Democrats to focus on health care policy, which creates the likelihood of a negative surprise for this sector (Chart 11). Chart 10Market Says Infrastructure Will Pass (One Way Or Another) Market Says Infrastructure Will Pass (One Way Or Another) Market Says Infrastructure Will Pass (One Way Or Another) The managed health care sub-sector (the insurance companies) staged a surprise rally over the past month that should reverse as Biden’s legislative proposals become known. However, Big Pharma and biotech continue to sell off as expected. Again, the simplest FY2022 reconciliation bill would consist of Biden’s health reform plus tax reform. The market is having some doubts about Democrats’ climate change agenda, which will be stuffed into the infrastructure package, given that the US renewable energy index has rolled over relative to global renewables. US cyclicals are also outperforming renewables (Chart 12). If Democrats do not use reconciliation, they may not get many green projects passed. If they do use reconciliation, their health and welfare reforms will have to wait until a FY2023 reconciliation bill that may not get passed. Chart 11More Pain Coming For Health Insurers, Big Pharma More Pain Coming For Health Insurers, Big Pharma More Pain Coming For Health Insurers, Big Pharma Chart 12Market Skeptical About Biden Climate Agenda Passage Market Skeptical About Biden Climate Agenda Passage Market Skeptical About Biden Climate Agenda Passage   3.   Republicans In The Wilderness: Although Republicans have begun to regroup faster than many expected, the divisions within the party have not been healed and will continue to flare up in disputes that threaten to wreck the party. Trump and the populist wing are preparing to put up primary election challengers to establishment Republican senators and representatives who voted against Trump or otherwise who vote against his “America First” agenda. Yet it is possible that 10 Republicans will find it impossible to vote against Biden’s infrastructure package if it is well-designed regarding supply chains and China and not linked with tax hikes. Trump could split the party via his personal following (which may be enhanced by a new social media outlet) and his ability to divide the party’s votes if he forms a “Patriot Party.” We recently showed, via the “Prisoner’s Dilemma” in game theory, that the Republicans must choose a Trumpist agenda of fiscal largesse, trade protectionism, and border security if they are to succeed. Yet Trump may or may not choose to run for president again or form a third party. The result is that Trump is more likely than not to be the Republican candidate in 2024 but there are huge risks to the party’s coherence as the party establishment tries to convince Trump to bow out and support a successor (Diagram 1). The point is that Trump remains a loose cannon and is capable of dividing the party single-handedly. Since investors cannot predict Trump’s behavior they should not expect the Republicans to unite in the near term. Diagram 1Game Theory Says Republicans Will Court Trump Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Bottom Line: Our three key views for 2021 are broadly on track – polarization is subsiding but still near peak levels, structural reform is underway (though bipartisanship is clearly at risk), and the Republicans remain divided and ineffectual. The Democrats’ handling of their infrastructure package will determine if bipartisanship can reinforce structural reform but the FY2022 reconciliation process enables them to achieve some reform regardless. Investment Takeaways The Federal Reserve expects GDP to grow by 6.5% in 2021 as a whole (up from the 4.2% estimate in December) and the unemployment rate to fall to 4.5% by the end of the year (down from 5% previously). Treasury Secretary Janet Yellen is expected to predict full employment by 2022. Households are likely to spend at least a third of the $699 billion in dole money they receive (stimulus checks and topped-up unemployment benefits), according to surveys highlighted by our Global Investment Strategy. This summer will have a party on every block, whether authorized or not. While details are scant about the exact makeup of the Biden administration’s next major legislation, what is clear is that it will have a net negative impact on the budget balance. Democrats will raise taxes but not so much as to jeopardize the economic recovery and their election prospects in 2022-24. This ultra-easy fiscal policy coincides with an ultra-easy monetary policy in which the Fed has insisted it will not raise rates through 2023. The market expects four rate hikes by that time, which would put the Fed funds rate at about 1.1%. The Fed will eventually have to adjust its path for the Fed funds rate and start thinking about thinking about tapering asset purchases. But the main thing to remember is that the Fed has committed to generating an inflation overshoot.   In this context, US investors should be cyclically bullish albeit tactically guarded given the sharp rise in bond yields and rising dollar. A pro-cyclical orientation would favor small caps over large caps, cyclicals over defensives, and value over growth stocks. All of these positions have recently met with some resistance and could face a healthy near-term correction. Cyclical stocks are historically very elevated relative to defensives (Chart 13). But over a 12-month period the recovery and stimulus will reinforce the bullish view, as rising bond yields will not stop equities from rising if the Fed stands pat. Chart 13Cyclicals Look Toppy Versus Defensives Cyclicals Look Toppy Versus Defensives Cyclicals Look Toppy Versus Defensives The chief risks to the pro-cyclical orientation stem from any breakout in the US dollar, the rollover in China’s growth momentum, and the Biden administration’s tax hikes and foreign policy challenges. These risks are all immediate and serious, especially given high stock market valuations. China’s policy tightening will not be fully felt in the economy until the second half of the year and Biden’s specific foreign policy challenges can result in negative geopolitical shocks at any time this year or over the next four years. The point is to buy on the dips unless surprise events fundamentally alter the reflationary cyclical backdrop. With regard to equity sectors, our US Political Risk Matrix highlights the chief policy risks to our US Equity Strategy’s views. Generally speaking Biden poses upside risks to industrials and consumer discretionary sectors and downside risks to energy, health care, tech, and communications (Table 4). After a quarter’s worth of information on markets and policy, these views are mostly confirmed: stay cyclically bullish on industrials and financials, bearish on tech and health care. Table 4US Political Risk Matrix Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform In the case of energy we continue to be neutral-to-bullish over a 12-month time horizon as long as demand is recovering, global inventories are drawing down, and the immediate geopolitical scene is conducive to tit-for-tat attacks in the Middle East, as is the case in the first half of the year. But Biden’s regulatory risks and disruptive climate change agenda can bring negative surprises for US oil producers and Biden’s foreign policy would ultimately be positive for Middle East oil supply. In the case of communications services we are neutral-to-bearish. The Biden administration is allied with Big Tech but it is tightening regulation and anti-trust enforcement gradually to gain greater control over the sector.1 The Treasury selloff is set to continue. Yields are starting to reach pre-COVID levels and have a way to go until they challenge 2018 levels. From peak to trough in the Bloomberg Barclays Treasury Index, the current selloff is not as bad as in the past four recoveries, as our US Bond Strategy has shown. As the economic rebound shows up in hard data over the course of this year, the Fed’s revised expectations will confirm the bond selloff in the financial market. We would thus favor high-yield corporate bonds. We remain overweight TIPS and municipal bonds relative to duration-matched nominal bonds. In recent years presidential approval has correlated remarkably well with the stock-to-bond ratio about two months later (Chart 14). The implication is that higher presidential approval is consistent with receding uncertainty and greater consumer optimism about the economy, which is reflected in rising bond yields and share prices. Neither Biden’s approval rating nor the stock-to-bond ratio is likely to go much higher without a consolidation phase, however, as implied by the chart. Chart 14Stock-To-Bond Ratio Needs A Breather In Q2 Stock-To-Bond Ratio Needs A Breather In Q2 Stock-To-Bond Ratio Needs A Breather In Q2 Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Table A1BPolitical Capital: Household And Business Sentiment Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform   Table A1CPolitical Capital: The Economy And Markets Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Table A2Biden’s Cabinet Position Appointments Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Footnotes 1     Biden is expected to nominate anti-trust scholar Lina Khan for FTC commissioner.  

Highlights The Federal Reserve’s ultra-dovish stance is not the only reason for markets to cheer. The US is booming, China is unlikely to overtighten monetary and fiscal policy, and Europe remains a source of positive political surprises. Still, the cornerstone of this cycle’s wall of worry has been laid: Biden faces a series of foreign policy challenges, the US is raising taxes, China is tightening policy, and Europe’s stimulus is not large enough to qualify as a game changer for potential GDP growth. Stay the course by maintaining strategic pro-cyclical trades yet building up tactical hedges and safe-haven plays. Feature Chart 1US Stimulus, Chinese Tightening, German Vaccine Hiccups US Stimulus, Chinese Tightening, German Vaccine Hiccups US Stimulus, Chinese Tightening, German Vaccine Hiccups The US is turning to tax hikes, China is returning to structural reforms, and Europe is bungling its vaccine rollout. Yet synchronized global debt monetization is nothing to underrate. Especially not in the context of a Great Power struggle that features a green energy race as well as a high-tech race. Governments are generating a cyclical growth boom and it is conceivably that their simultaneous pump-priming combined with a new capex cycle and private innovation could generate a productivity breakthrough. This upside risk is keeping global equity markets bullish even as it becomes apparent that construction has begun on this cycle’s wall of worry. The US dollar bounce should be watched closely in this context (Chart 1). After passing the $1.9 trillion American Rescue Plan Act, which consists largely but not entirely of short-term cash handouts (Chart 2), President Joe Biden’s policy agenda will now turn to tax hikes. Thus far the tax hike proposals are in line with Biden’s campaign literature (Table 1). It remains to be seen whether the market will “sell the news” that Biden is pivoting to tax hikes. After all, Biden was the most moderate of the Democratic candidates and his tax proposals only partially reverse President Trump’s tax cuts. Chart 2American Rescue Plan Act Building Back … The Wall Of Worry Building Back … The Wall Of Worry Table 1Biden’s Tax Hike Proposals On The Campaign Trail Building Back … The Wall Of Worry Building Back … The Wall Of Worry Nevertheless higher taxes symbolize a regime change in the US – it is very unlikely tax rates will go down anytime soon but they could go easily higher than expected in the coming decade – and the drafting process will bring negative surprises, as Treasury Secretary Janet Yellen highlighted by courting Europe to cooperate on a 12% minimum corporate tax and halt the global race to the bottom in taxes on multinational corporations. At the same time Biden’s foreign policy challenges are rising across the board: China is demanding a rollback of Trump’s policies: If Biden says yes, he will sacrifice hard-won American leverage on matters of national interest. If he says no, the Phase One trade deal will be null and void, as will sanctions on Iran and North Korea, and the new economic sanctions on Taiwan will expand beyond mere pineapples.1 Russia is recalling its US ambassador: Biden vowed to make Russia pay for alleged interference in the 2020 US election and sanctions are forthcoming.2 The real way to make Russia pay is to halt the construction of the Nordstream II natural gas pipeline, which reduces the leverage of eastern European democracies while increasing Germany’s energy dependence on Russia. But Germany is dead-set on that pipeline. If Biden levies sanctions the centerpiece of his diplomatic outreach to Europe will be further encouraged to chart an independent course from Washington (though the rest of Europe might cheer). North Korea is threatening to restart missile tests: North Korea is pouring scorn on the Biden administration for trying to restart negotiations.3 The North wants sanctions relief and it knows that Biden is willing to offer it but it may need to create an atmosphere of crisis first. China would be happy were that to happen as it could offer the US its good services on North Korea instead of concrete trade concessions. Iran is refusing to rejoin negotiations over the 2015 nuclear deal: Biden has about five months to arrange for the US and Iran to rejoin the 2015 nuclear deal. Beyond that he will enter into another long negotiation with the master negotiators, the Persians. But unlike President Obama from 2009-15, he will not have support from Russia and China … unless he sacrifices his doctrine of “extreme competition” from the get-go. It is not clear which of these challenges will be relevant to financial markets, or when. However, with US and global equities skyrocketing, it must be said that the geopolitical backdrop is not nearly as reassuring as the Federal Reserve, which announced on Saint Patrick’s Day that it will not hike interest rates until 2024 even in the face of a 6.5% growth rate and the prospect of an additional, yet-to-be passed $2 trillion in US deficit spending. Herein lies Biden’s first victory. He has stressed that boosting the American economy and middle class is critical to his foreign policy. He envisions the US regaining its global standing by defeating the virus, super-charging the economy, and then orchestrating a grand alliance of European and Asian democracies to write new global rules that will put pressure on China to reform its economy. “I say it to foreign leaders and domestic alike. It's never, ever a good bet to bet against the American people. America is coming back. The development, manufacturing, and distribution of vaccines in record time is a true miracle of science.”4 The pandemic and economic part of this agenda are effectively done and now comes the hard part: creating a grand alliance while China and Russia demonstrate to their neighbors the hard consequences of joining any new US crusade. The contradiction of Biden’s foreign policy is his desire to act multilaterally and yet also get a great deal done. The Europeans are averse to conflict with China and Russia. The Russians and Chinese are not inclined to do any great favors on Iran or North Korea. Nobody is opening up their economy – Biden himself is coopting Trump’s protectionism, if less brashly. Cooperation with Presidents Xi Jinping and Vladimir Putin on nuclear proliferation is possible – as long as Biden aborts his democracy agenda and his trade agenda. We continue with our pro-cyclical investment stance but have started building up hedges as we are convinced that geopolitical risk will deliver a rude awakening. This awakening will be a buying opportunity given the ultra-stimulating backdrop … unless it portends war in continental Europe or the Taiwan Strait. In the remainder of this report we highlight the takeaways from China’s National People’s Congress as well as recent developments in Germany. Our key views remain the same: China will not overtighten monetary/fiscal policy; Biden will be hawkish on China; Germany’s election may see an upset but that would be market-positive. China: No Overtightening So Far China concluded its National People’s Congress – the “Two Sessions” of legislation every year – and issued its 2021 Government Work Report. It also officially released the fourteenth five-year plan covering economic development for 2021-25. Table 2 shows the new plan’s targets as compared to the just expired thirteenth five-year plan that covered 2016-20. Table 2China’s Fourteenth Five Year Plan (2021-25) Building Back … The Wall Of Worry Building Back … The Wall Of Worry For a full run-down of the National People’s Congress we recommend clients peruse BCA’s latest China Investment Strategy report. From a geopolitical point of view we would highlight the following takeaways: The Tech Race: China added a new target for strategic emerging industry value added as percent of GDP – it wants this number to reach 17% by 2025 but there is nothing solid to benchmark this against. The point is that by including such a target China is putting more emphasis on emerging industries, including: information technology, robotics, green energy, electric vehicles, 5G networks, new materials, power equipment, aerospace and aviation equipment, and others. China’s technological “Great Leap Forward” continues, with a focus on domestic production and upgrading the manufacturing sector that is bound to stiffen the competition with the United States. China’s removal of a target for service industry growth suggests that Beijing does not want de-industrialization to occur any faster – another reason for global trade tensions to stay high. Research and Development: For R&D spending, previous five-year plans set targets for the desired level. For example, over the last five years China vowed to increase annual R&D spending to 2.5% of GDP. A reasonable expectation for the coming five years would have been a 3% target of GDP. However, this time the government set a target of an annual growth rate of no less than 7% during 2021-2025. The point is that China is continuing to ascend the ranks in R&D spending relative to the US and West in coordination with the overarching goal of forging an innovative and high-tech economy. Unemployment: China has restored an unemployment rate target. In its twelfth five-year plan Beijing aimed to keep the urban surveyed unemployment rate below 5% but over the past five years this target vanished. Now China restored the target and bumped it up slightly to 5.5%. This target should not be hard to meet given the reported sharp decline in urban unemployment to 5.2% already. However, China’s unemployment statistics are notoriously unreliable. The real takeaway is that unemployment will be higher as trend growth slows, while social stability remains the Communist Party’s ultimate prize – and any reform or deleveraging process will occur within that context. The Green Energy Race: China re-emphasized its pledge to tackle climate change, aiming for peak carbon emissions by 2030 and carbon neutrality by 2060. However, no detailed action plans were mentioned. Presumably China will not loosen its enforcement of existing environmental targets. Most of these were kept the same as over the past five years, except for pollution (PM2.5 concentration). Previously the government sought to reduce PM2.5 concentration by 18%. Now the target is set at 10% aggregate reduction, which is lower, though further reduction will be difficult after a 43% drop since 2014. Overall, China has not loosened up its environmental targets – if anything, enforcement will strengthen, resulting in an ongoing regulatory headwind to “Old China” industries. Military Power: Last week we noted that the government’s goals for the military have changed in a way that reinforces themes of persistently high geopolitical tensions. The info-tech upgrades to the People’s Liberation Army were supposed to be met by 2020, with full “modernization” achieved by 2035. However, last October the government created a new deadline, the one-hundredth anniversary of the PLA in 2027 (“military centenary goal”). No specific measures or targets are given but the point is that there is a new deadline of serious importance – an importance that matches the party’s much-ballyhooed centennial on July 1 of 2021 and the People’s Republic’s centennial in 2049. The fact that this deadline is only six years away suggests that a rapid program of military reform and upgrade is beginning. The official defense spending growth target of 6.8% is only slightly bigger than last year’s 6.6% but these targets mask the significance of the announcement. The takeaway is that the Chinese military is preparing for an earlier-than-expected contingency with the United States and its allies. What about China’s all-important monetary, fiscal, and quasi-fiscal credit targets? There is no doubt that China is tightening policy, as we highlight in our updated China Policy Tightening Checklist (Table 3). But will China overtighten? Probably not, at least not judging by the Two Sessions, but the risk is not negligible. Table 3A Checklist For Chinese Policy Tightening Building Back … The Wall Of Worry Building Back … The Wall Of Worry The government reiterated that money and credit growth should remain in a reasonable range in 2021, with “reasonable range” referring to nominal economic growth. Chinese economists estimate that the nominal growth rate will be around 8%-9% in 2021. The IMF projection is 8.1%, while latest OECD forecast is at 7.8%.5 Because China’s total private credit (total social financing) growth is inherently higher than M2 growth, we would use pre-pandemic levels as our benchmark for whether the government will tighten policy excessively: If total social financing growth plunges below 12%, then our view is disproved and Beijing is over-tightening (Chart 3). If M2 growth plunges below 8%, we can call it over-tightening. Anything above these benchmarks should be seen as reasonable and expected tightening, anything below as excessive. However, the Chinese and global financial markets could grow jittery at any time over the perennial risk of a policy mistake whenever governments try to prevent excessive leverage and bubbles. As for fiscal policy, the new quotas for local government net new bond issuance point to expected rather than excessive tightening. New bonds can be used to finance capital investment projects. The quota for total new bond issuance is 4.47 trillion CNY, down by 5.5% from last year. Though local governments may not use up all of the quota, the reduction is small. In fact, total local government bond issuance will be a whisker higher in 2021 than in 2020. The quota for net new bonds is only slightly below the 2020 level and much higher than the 2019 level. Therefore the chance of fiscal overtightening is small – and smaller than monetary overtightening. Chart 3China Policy Overtightening Benchmark China Policy Overtightening Benchmark China Policy Overtightening Benchmark Chart 4China’s Real Budget Deficit Is Huge Building Back … The Wall Of Worry Building Back … The Wall Of Worry China’s official budget balance is a fiction so we look at the IMF’s augmented net lending and borrowing, which reached a whopping -18.2 % of GDP in 2020. It is expected to decrease gradually to -13.8% by 2025. That level will be slightly higher than the pre-pandemic level from 2017-2019 (Chart 4).6 By contrast, China’s total augmented debt is expected to keep rising in the coming years and reach double the 2015 level by 2025. Efforts to constrain debt could lead to a larger debt-to-GDP ratio if growth suffers as a consequence, as our Global Investment Strategy points out. So China will tighten cautiously – especially given falling productivity, higher unemployment, and the threat of sustained pressure from the US and its allies. US-China: Biden As Trump-Lite Chinese and US officials will convene in Alaska on March 18-19. This is the first major US-China meeting under the Biden administration and global investors will watch closely to see whether tensions will drop. So far tensions have not fallen, highlighting a persistent and once again underrated risk to the global equity rally. Biden’s foreign policy team has not completed its review of China policy and Presidents Biden and Xi Jinping are trying to schedule a bilateral summit in April – so nothing concrete will be decided before then. Chart 5US-China: Beijing's Standing Offer US-China: Beijing's Standing Offer US-China: Beijing's Standing Offer The Biden administration is setting up a pragmatic policy, offering areas to engage with China while warning that it will not compromise on democratic values or national interests. China would welcome the opportunity to work with the Americans on nuclear non-proliferation, namely North Korea and Iran, as this would expend US leverage on an area of shared interest while leaving China a free hand over its economic and technological policies. China at least partially enforced sanctions on these countries in response to President Trump’s demands during the trade war and official statistics suggest it continues to do so. Oil imports from Iran remain extremely low while Chinese business with North Korea is, on paper, nil (Chart 5). If this data is accurate then North Korea’s economy has not benefited from China’s stimulus and snapback. If true, then Pyongyang will offer partial concessions on its nuclear program in exchange for sanctions relief. At the moment, instead of staging any major provocations to object to US-Korean military drills, the North is using fiery language and threatening to restart missile tests. This suggests a diplomatic opening. But investors should be prepared for Pyongyang to stage much bigger provocations than missile tests. In March 2010, while the world focused on the financial crisis, the North Koreans torpedoed a South Korean corvette, the Chonan, and shelled some islands, at the risk of a war. The problem under the Trump administration was that Trump wanted a verifiable and durable deal of economic opening for denuclearization whereas the North Koreans wanted to play for time, reduce sanctions, study the data from their flurry of missile tests during the Obama and early Trump years, and see if Trump would get reelected before offering any concrete concessions. Trump’s stance was not really different from Bill Clinton’s but he tried to accelerate the timeline and go for a big win. By Trump’s losing the election North Korea bought four more years on the clock. Chart 6US-China: Biden Lukewarm On China Building Back … The Wall Of Worry Building Back … The Wall Of Worry The Biden administration is willing to play for time if it gets concrete results in phases. This would keep North Korea at bay and retain a line of pragmatic engagement with Beijing. But if North Korea stages a giant provocation Biden will not hesitate to use threats of destruction like Clinton and Trump did. The American public is not much concerned about North Korea (or Iran) but is increasingly concerned about China, with a recent Gallup opinion poll showing that nearly 50% view China as America’s greatest enemy and Americans consistently overrate China’s economic power (Chart 6). Biden will not let grassroots nationalism run his policy. But it is true that he has little to gain politically from appearing to appease China. With progress at hand on the pandemic and economic recovery, Biden will devote more attention to courting the allies and attempting to construct his alliance of democracies to meet global challenges and to “stand up” to China and Russia. The allies, however, are risk-averse when it comes to confronting China. This is as true for the Europeans as it is for China’s Asian neighbors, who stand directly in its firing line. In fact, Europe’s total trade with China is equivalent to that of the US (Chart 7). The Europeans have said that they will pursue tougher trade enforcement through the World Trade Organization, which would tie the Biden administration’s hands. Biden and his cabinet officials insist that they will use the “full array” of tools at their disposal (e.g. tariffs and sanctions) to punish China for mercantilist trade policies. Chinese negotiators are said to be asking explicitly for Biden to roll back Trump’s policies. Some of these policies relate to trade and tech acquisition, others to strategic disputes. We doubt that Biden will compromise on the trade issues to get cooperation on North Korea and Iran. But he will have to offer major concessions if he wants durable denuclearization agreements on these rogue states. Otherwise it will be clear that his administration is mostly focused on competition with China itself and willing to sideline the minor nuclear aspirants. Our expectation is that Americans care about the China threat and the smaller threats will be used as pretexts with which to increase pressure and sanctions on China. Asian equities have corrected after going vertical, as expected. But contrary to our expectations geopolitics was not the cause (Chart 8). This selloff could eventually create a buying opportunity if the Biden administration is revealed to take a more dovish line on China, trade, and tech in exchange for progress on strategic disputes like North Korea. Any discount due to North Korean provocations in particular would be a buy. On Taiwan, however, China’s new 2027 military target underscores our oft-recited red flag. Chart 7EU Risk Averse On China EU Risk Averse On China EU Risk Averse On China Chart 8Asian Equity Correction And GeoRisk Indicators Asian Equity Correction And GeoRisk Indicators Asian Equity Correction And GeoRisk Indicators Bottom Line: Investors should stay focused on the US-China relationship. What matters is Biden’s first actions on tariffs and high-tech exports. So far Biden is hawkish as we anticipated. Investors should fade rumors of big new US-China cooperation prior to the first Biden-Xi summit. Any major North Korean aggression will create a buy-on-the-dips opportunity. Unless it triggers a war, that is – and the threshold for war is high given the Chonan incident in 2010. Germany: Markets Wake Up To Election Risk – And Smile This week’s election in the Netherlands delivered a fully expected victory to Prime Minister Mark Rutte’s liberal coalition. The German leadership ranks next to the Dutch in terms of governments that received an increase in popular support as a result of the COVID-19 crisis (Chart 9). However, in Germany’s case the election outcome is not a foregone conclusion. Chart 9German Leadership Saw Popularity Bounce Building Back … The Wall Of Worry Building Back … The Wall Of Worry As we highlighted in our annual forecast, an upset in which a left-wing bloc forms the government for the first time since 2005 is likelier than the market expects. This scenario presents an upside risk for equities and bund yields since Germany would become even more pro-Europe, pro-integration, and proactive in its fiscal spending. In the current context that would be greeted warmly by financial markets as it would reinforce the cyclical rotation into the euro, industrials, and European peripheral debt. Incidentally, it would also reduce tensions with Russia and China – even as the Biden administration is courting Germany. Recent state elections confirm that the electorate is moving to the left rather than the right. In Baden-Wurttemberg, the third largest state by population and economic output, and a southern state, the Christian Democrats slipped from the last election (-2.9%), the Social Democrats slipped by less (-1.7%), the Free Democrats gained (2.2%), the Greens gained (2.3%), and the far-right Alternative for Germany saw a big drop (-5.4%). In the smaller state of Rhineland-Palatinate the results were largely the same although the Greens did even better (Tables 4A & 4B).7 In both cases the Christian Democrats saw the worst result since prior to the financial crisis while the Greens tripled their support in Baden and doubled their support in the Palatinate over the same time frame. Table 4AGerman State Elections Show Voters’ Leftward Drift Continues Building Back … The Wall Of Worry Building Back … The Wall Of Worry Table 4BGerman State Elections Show Voters’ Leftward Drift Continues Building Back … The Wall Of Worry Building Back … The Wall Of Worry To put this into perspective: Outgoing Chancellor Angela Merkel and her coalition have seen a net 6% increase in popular support since COVID-19. The coalition, led by the Christian Democratic Union and its Bavarian sister party, the Christian Social Union, still leads national opinion polling. What we are highlighting are chinks in the armor. The gap with the combined left-leaning bloc is less than 10% points (Chart 10). Chart 10German Party Polling German Party Polling German Party Polling Merkel is a lame duck whose party has been in power for 17 years. She is struggling to find an adequate successor. Her current frontrunner for chancellor-candidate, Armin Laschet, is suffering in public opinion, especially after the state election defeats, while her previous successor was ousted last year. Other chancellor-candidates, like Friedrich Merz, Markus Söder, and Norbert Röttgen may find themselves to the right of the median voter, which has been shifting to the left. Merkel’s party’s handling of COVID-19 first received praise and now, in the year of the vote, is falling under pressure due to difficulties rolling out the vaccine. Even as conditions improve over the course of the year her party may struggle to recover from the damage, since the underlying reality is that Germany has suffered a recession and is beset by global challenges. While the Christian Democrats performed relatively well in the 2009 election, in the teeth of the global financial crisis, times have changed. Today the Social Democrats are no longer in free fall – ever since their Finance Minister Olaf Scholz led the charge for fiscal stimulus in 2019 – while third parties like the Free Democrats, Greens, and Die Linke all gained in 2009 and look to gain this year (Table 5). In today’s context it is even more likely that other parties will rise at the ruling party’s expense. Still, the Christian Democrats have stout support in polls and do not have to split votes with the far-right, which is in collapse. Table 5German Federal Election Results Show 2021 Could Throw Curveball For Ruling Party Building Back … The Wall Of Worry Building Back … The Wall Of Worry Therein lies the real market takeaway: right-wing populism has flopped in Germany. The risk to the consensus view that Merkel will hand off the baton seamlessly to a successor and secure her party another term in leadership is that the establishment left will take power (the Greens in Germany are essentially an establishment party). Chart 11German Bunds Respond To Macro Shifts, State Elections German Bunds Respond To Macro Shifts, State Elections German Bunds Respond To Macro Shifts, State Elections Near-term pandemic and economic problems have caused bund yields to fall and the yield curve to flatten so far this year (Chart 11). But that trend is unlikely to continue given the global and national outlook. Election uncertainty should work against this trend since the only possible uncertainty gives more upside to the fiscal outlook and bond yields. If the consensus view indeed comes to pass and the Christian Democrats remain in power, the election holds out policy continuity – at least on economic policy. Fiscal tightening would happen sooner under the Christian Democrats but it would not be aggressive or premature, at least not in the 2021-22 period. It is the current coalition that first loosened Germany’s belt – and it did so in 2019, prior to COVID-19. Germany’s and the EU’s proactive fiscal turn will have a major positive impact on growth prospects, at least cyclically, though it is probably too small thus far to create a structural improvement in potential growth. Fiscal thrust is negative over next two years even with the EU’s Next Generation Recovery Fund being distributed. A structural increase in growth is possible given that all of the major countries are simultaneously pursuing monetary and fiscal stimulus as well as big investments in technology and renewable energy that will help engender a new private capex cycle. But productivity has been on a long, multi-decade decline so it remains to be seen if this can be reversed. Geopolitically speaking, Germany’s and the EU’s policy shift arrived in the nick of time to deepen European integration before divisions revive. Integration is broadly driven by European states’ need to compete on a grand scale with the US, Russia, and China. But Putin, Brexit, and Mario Draghi demonstrate the more tactical pressures: Brexit discourages states from exiting, especially with ongoing trade disputes and the risk of a new Scottish independence referendum; Putin’s aggressive foreign policy drives eastern Europeans into the arms of the West; and the formation of a unity government in Italy encourages European solidarity and improves Italian growth prospects. The outlook for structural reforms is not hopeless. Prime Minister Draghi’s government has a good chance of succeeding at some structural reforms where his predecessors have failed. Meanwhile French President Emmanuel Macron is still favored to win the French election in 2022, which is good for French structural reform. The fact that the EU tied its recovery fund to reform is positive. Most importantly the green energy agenda is replacing budget cutting for the time being, which, again, is positive for capex and could create positive long-term productivity surprises. Of course, structural reform intensity slowed just prior to COVID, in Spain, France, and Italy. Once the recovery funds are spent the desire to persist with reform will wane. This is clear in Spain, which has rolled back some reforms and has a weak government that could dissolve any time, and Italy, where the Draghi coalition may not last long after funds are spent. If the global upswing persists and Chinese/EM growth improves, then Europe will benefit from a macro backdrop that enables it to persist with some structural reforms and crawl out of its liquidity trap. But if China/EM growth relapses then Europe will fall back into a slump. Thus it is a very good thing for Europe, the euro, and European equities that the US is engaged in an epic fiscal blowout and that China’s Two Sessions dampened the risk of overtightening. Incidentally, if the German government does shift, relations with Russia would improve on the margin. While US-Russia tensions will remain hot, German mediation could reduce Russia’s insecurity and lower geopolitical risks for both Russia and emerging Europe, which are very cheaply valued at present in part because they face a persistent geopolitical risk premium. Bottom Line: German politics will drive further EU integration whether the Christian Democrats stay in power or whether the left-wing parties manage a surprise victory. Europe will have to provide more fiscal stimulus but otherwise the global context is favorable for Europe. Investors should not be too pessimistic about short-term hiccups with the vaccine rollout. Investment Takeaways The US is stimulating, China is not overtightening, and German’s election risk is actually an upside risk for European and global risk assets. These points reaffirm a bullish cyclical outlook on global stocks and commodities and a bearish outlook on government bonds. It is especially positive for global beneficiaries of US stimulus excluding China, such as Canada and Mexico. It is also beneficial for industrial metals and emerging markets exposed to China over the medium term, after frenzied buying suffers a healthy correction. Any premium in European equities should be snapped up. However, the cornerstone has been laid for the wall of worry in this global economic cycle: the US is raising taxes, China is tightening policy, and Europe’s fiscal stimulus will probably fall short. Moreover a consensus outcome from the German election would be a harbinger of earlier-than-expected fiscal normalization. There is not yet a clear green light in US-China relations – on the contrary, our view that Biden would be hawkish is coming to pass. Biden faces foreign policy tests across the board and now is a good time to hedge against the inevitable return of downside risks given the remorseless increase in tensions between the Great Powers. Housekeeping A number of clients have written to ask follow-up questions about our contrarian report last week taking a positive view on cybersecurity stocks despite the tech selloff and a positive view on global defense stocks, especially in relation to cybersecurity. The main request is, Which companies offer the best value? So we teamed up with BCA’s new Equity Analyzer to highlight the companies that receive the best BCA scores utilizing a range of factors including value, safety, payout, quality, technicals, sentiment, and macro context – all relative to a universe of global stocks with a minimum market cap of $1 billion. The results are shown in the Appendix, which we hope will come in handy. Separately our tactical hedge, long US health care equipment versus the broad market, has stopped out at -5%. This makes sense in light of the pro-cyclical rotation. Health care equipment is still likely to outperform the rest of the US health care sector amid a policy onslaught of higher taxes, government-provided insurance, and pharmaceutical price caps.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Yushu Ma Research Associate yushu.ma@bcaresearch.com   Appendix Appendix Table ABCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Building Back … The Wall Of Worry Building Back … The Wall Of Worry Appendix Table BBCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Building Back … The Wall Of Worry Building Back … The Wall Of Worry Appendix Table CBCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Building Back … The Wall Of Worry Building Back … The Wall Of Worry Footnotes 1 China is asking for export controls that have hamstrung Huawei and SMIC to be removed as well as for sanctions and travel bans on Communist Party members and students to be lifted. See Lingling Wei and Bob Davis, "China Plans To Ask U.S. To Roll Back Trump Policies In Alaska Meeting," Wall Street Journal, March 17, 2021, wsj.com; Helen Davidson, "Taiwanese urged to eat ‘freedom pineapples’ after China import ban," The Guardian, March 2, 2021, theguardian.com. 2 "Putin on Biden: Russian President Reacts To US Leader’s Criticism," BBC, March 18, 2021, bbc.com. 3 Pyongyang is likely to test a new, longer range intercontinental ballistic missile for the first time since its self-imposed missile test moratorium began in 2018 after President Trump’s summit with leader Kim Jong Un. See Lara Seligman and Natasha Bertrand, "U.S. ‘On Watch’ For New North Korean Missile Tests," Politico, March 16, 2021, politico.com. 4 See ABC News, "Transcript: Joe Biden delivers remarks on 1-year anniversary of pandemic", ABC News, Mar. 11, 2021, abcnews.com. 5 Please see IMF Staff, "World Economic Outlook Reports", IMF, Jan. 2021, imf.org and OECD Staff, "OECD Economic Outlook, Interim Report March 2021", OECD, March 9, 2021, oecd.org. 6 Please see IMF Asia and Pacific Dept, "People’s Republic of China : 2020 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the People's Republic of China", IMF, Jan. 8, 2021, imf.org. 7 The other state elections coming up this year will coincide with the federal election on September 26, with one minor exception (Saxony-Anhalt). Opinion polls show the Christian Democrats slipping below the Greens in Berlin and the Social Democrats in Mecklenburg-Vorpommern. The Alternative for Germany is falling in all regions.

Highlights We are lowering our expectation for oil-demand growth this year, bringing it more in line with levels expected by OPEC, the IEA and EIA.  Our GDP-driven demand estimates have proven too bullish for 1Q21, considering the wide margin by which we missed actual demand in January and February.  Our expectation for oil demand growth this year is lowered to 5.5mm b/d, down from 6.6mm b/d last month.  For 2022, we are increasing our growth assumption to 4.1mm b/d, up from 2.8mm b/d. We continue to expect Brent prices to reflect an accommodation between Russia's and KSA's preferred Brent ranges of $50-$55/bbl and $70-$75/bbl, respectively.  We are keeping our forecast for average prices at $65/bbl and $70/bbl for this year and next, with WTI averaging $2-$3/bbl below that (Chart of the Week). Brent benchmark pricing confusion subsided, following the decision of S&P Global Platts to revert to free-on-board (FOB) reporting of prices.  However, as the center of gravity for crude oil demand settles on Asia, confusion around the North Sea benchmark could provide an opening for regional benchmarks and consolidation of futures platforms trading crudes delivered to the region. Feature The decision by the Kingdom of Saudi Arabia (KSA) to voluntarily remove 1mm b/d of its production from the market over February – April will be remembered as one of the more prescient reads on the state of global oil demand during the COVID-19 pandemic. KSA's insistence on seeing improvement in actual demand – as opposed to forecasted demand – before it commits to returning production to the market could not have been more clear-sighted. The upcoming April 1 meeting of OPEC 2.0 will convey useful information to the market re changes, if any, to the production-management strategy of the coalition, which is led by KSA and Russia. Perhaps the most important information coming out of the meeting will be how KSA reads the current state of global oil demand, as it has not committed to a date-certain when it will return this production to market. We expect the Kingdom to extend its production cuts and to lobby for continued restraint by the other member states of OPEC 2.0 at the meeting. Going into the meeting, OPEC 2.0 will be assessing global demand against a deteriorating public-health backdrop in important consuming markets. The EU's policy failures in securing sufficient vaccinations to protect its population, and public-health missteps regarding the AstraZeneca vaccine continue to retard Europe's efforts to contain the pandemic.1 Chart of the WeekOPEC 2.0 Expected To Maintain Production Discipline OPEC 2.0 Expected To Maintain Production Discipline OPEC 2.0 Expected To Maintain Production Discipline Increasing lockdowns in several EU countries and a higher likelihood of a resurgence in COVID-19 infection rates in the US – particularly in the states that are reopening before they have achieved herd immunity or have vaccinated a large share their populations – will slow demand recovery. The annual Spring Break holidays in the US potentially could become a world-class super-spreader event. Elsewhere, LatAm is distressed, particularly Brazil, which, like the EU, has misjudged and mishandled its vaccination policy and rollout, leaving its populations at higher risk for infection. This also has the attendant risk of producing an environment ripe for further COVID-19 mutations and the spread of new variants. Lower Oil Demand Forecast For 2021 We were wrong on our call expecting stronger demand growth in 1Q21 – our consumption forecasts exceeded realized demand an average of 2.3mm b/d in 1Q21. We are now more aligned with demand expectations of IEA, EIA, and OPEC (Chart 2). Our expectation for oil demand growth this year is lowered to 5.5mm b/d, down from 6.6mm b/d last month. For 2022, we are increasing our growth assumption to 4.1mm b/d, up from 2.8mm b/d. We expect non-OECD oil consumption, our proxy for EM demand, to average 53.2mm b/d this year and 55.5mm b/d next year, vs. 54mm b/d and 55.4mm b/d last month. DM demand, proxied by OECD oil consumption, is expected to average 44.5mm b/d and 46.3mm b/d next year, versus our previous forecast of 44.9mm and 46.3mm b/d last month. Chart 2Lower Oil Demand In 2021, Higher Next Year Lower Oil Demand In 2021, Higher Next Year Lower Oil Demand In 2021, Higher Next Year We continue to expect the massive fiscal and monetary stimulus to support markets and lead to stronger growth going forward. The recently approved package by the US Congress calling for an additional $1.9 trillion of fiscal stimulus will have global knock-on effects, which will be bullish for commodity demand, once the COVID-19 pandemic is contained (Chart 3). Chart 3Pandemic Recovery Will Spur Pent-Up Demand OPEC 2.0 Production Discipline Still Required To Balance Markets OPEC 2.0 Production Discipline Still Required To Balance Markets OPEC 2.0 Production Discipline Persists The salient feature of the oil market during the pandemic has been the cohesion of OPEC 2.0 and its production discipline. We expect that to continue going into and coming out of the coalition's April 1 meeting. Our view that OPEC 2.0 's overall strategy as the dominant producer in the market is to calibrate the level of supply to the level of demand remains intact. We expect production for the coalition to average 46.0mm b/d in 2021 and 46.2mm b/d in 2022 (Chart 4). We do not expect OPEC 2.0 to raise production, given the increasing uncertainty around demand vis-à-vis getting the COVID-19 pandemic under control in large consuming markets like the EU and LatAm, and higher infection rates out of the US. However, as we noted above, we are closely watching what KSA does and says at the upcoming meeting for any clue that global demand is improving faster than we now expect. Chart 4OPEC 2.0 Production Discipline Persists OPEC 2.0 Production Discipline Persists OPEC 2.0 Production Discipline Persists Outside OPEC 2.0, our expectation for the bellwether US shale-oil producers' output remains relatively unchanged. We continue to expect production to move higher, and to remain constrained by capital availability. US shale output is expected to average 10.7mm b/d this year, and 12.1mm b/d next year. In our modeling, the shale producers lead the price-taking cohort, which produces whatever the market allows it to produce. We continue to expect capital-market discipline to keep US oil producers from getting too far out ahead of their balance sheets' ability to profitably grow production. The same holds for producers outside the OPEC 2.0 coalition ex-US (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) OPEC 2.0 Production Discipline Still Required To Balance Markets OPEC 2.0 Production Discipline Still Required To Balance Markets Markets Balance On OPEC 2.0 Discipline OPEC 2.0's production strategy will keep markets balanced, as relatively high compliance among those producers capable of increasing production is observed and markets are not over-supplied (Chart 5). This will allow inventories to continue to draw then stabilize around mid-year. It is important to point out that this balancing is an iterative process, driven by OPEC 2.0's read on the state of demand, which, perforce, is occurring with lags in the data it is responding to. We continue to keep a weather eye on the USD, given the impact it has on commodity fundamentals. We continue to expect dollar weakening and model for that, but the path of the USD has been difficult to call, given it is highly correlated with global economic policy uncertainty, which is heavily influenced by the evolution of the COVID-19 pandemic (Chart 6). Chart 5Markets Remain Balanced... Markets Remain Balanced... Markets Remain Balanced... Chart 6The USD's Evolution Remains Important The USD's Evolution Remains Important The USD's Evolution Remains Important A Hue and Cry In Brent Additional uncertainty is entering oil markets from an unlikely corner: The Brent benchmark pricing index used to set prices on some two-thirds of all the oil traded in the world. Brent benchmark pricing was thrown into wide-eyed confusion when S&P Global Platts – the leading price reporting agency for the index used as a reference in Brent physical contracts (Dated Brent) – decided to convert the index from a free-on-board (FOB) index to a cost-insurance-freight (CIF) index. Platts' proposed Brent reporting changes two weeks ago essentially would have transformed the pricing index from a pure spot index that assumes the buyer will arrange insurance and freight after purchasing a cargo at a North Sea terminal into a delivered index reflecting CIF-Rotterdam terms provided by the seller. After a great hue and cry went up, Platts reverted to quoting Brent on an FOB basis. But that hardly ends the drama. Brent production is collapsing – by next year, only one 600k-barrel cargo a day of Brent will be loaded out of North Sea terminals. This is a very thin reed supporting the global oil market's primary price index. In an effort to expand the Brent pricing pool, Platts also is looking to include US WTI in one form or another, but nothing's been settled upon to date. The confusion around Brent pricing comes as the center of gravity for crude oil demand and trading continues its inexorable shift to Asia. This could provide an opening for regional benchmarks – e.g., the UAE's Murban crude oil, which supports a just-launched futures contract calling for delivery in Asia, where most of the demand for oil is met by Middle East suppliers. It could even allow for consolidation of other futures platforms in the region (e.g., the Dubai Mercantile Exchange), which also are used to price and hedge Asia-bound crude cargoes out of the Gulf. As interesting and complex as the global oil market is, it is nothing without a viable pricing benchmark. Much of the world's oil business hinges on that index being determined by the price of a single cargo loaded every day. We will be following this with great interest.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish An exceptionally cold winter resulted in a sharp drawdown US natgas inventories down, which are expected to end the 2020-21 winter season at 2021 at 1.6 Tcf by the US EIA's reckoning (Chart 7). This would be 13% lower than the 5-year average level of inventories, according to the EIA. Over the April-October injection season, EIA is expecting natgas inventories to finish at ~ 3.7 Tcf, or ~ 2% below their 5-year average. Spot natgas prices at Henry Hub, LA – the delivery point for NYMEX/CME futures – averaged $5.35/MMBtu in February, the highest level since February 2014, the EIA noted. Natural gas for April 2021 delivery at Henry Hub closed at $2.562/MMBtu on Tuesday. Base Metals: Bullish COMEX copper came close to its 2011 highs late last month, at $4.30/lb but has since retreated.  However, we believe fundamental supply-demand factors will keep copper prices moving higher over the longer term. As highlighted in an earlier report (BCA Research - Renewables, China's FYP Underpin Metals Demand), the move to EVs and renewable energy will keep demand for copper and the overall base metals complex well-bid during this decade. The International Renewable Energy Agency (World Energy Transitions Outlook: 1.5°C Pathway (Preview) (irena.org)) reported on Tuesday that copper-intensive renewable power capacity will have to increase by more than 10-fold by 2050 to avert severe climate change. On the supply side, in our recent report entitled BCA Research - Copper's Supply Challenges, we noted falling copper investment and declining copper ore quality inexorably will increase production costs. Only higher copper prices will incentivize producers to increase mining activity. Rising demand and stagnant supply will put copper supply-demand balances in a deficit over the short-to-medium term, causing inventories to decline over this period as well.  Precious Metals: Bullish The sharp run-up in 10-year US real rates since the end of 2020 pulled gold prices from down from their 2021 high of ~ $1,950/oz in January to ~ $1,680/oz earlier this month (Chart 8). Price have since rebounded above $1,740/oz as real rates weakened. We expect markets to re-price gold when it becomes apparent the rally in rates was more a function of higher growth expectations for the US economy than a higher likelihood of Fed tightening. Our view that the Fed's ultra-accommodative monetary policy and massively expansive US fiscal policy will spur growth and inflation has not changed. We expect the Fed to remain behind the inflation curve in its rate hikes, which will keep US real rates on their downward trajectory. Chart 7 OPEC 2.0 Production Discipline Still Required To Balance Markets OPEC 2.0 Production Discipline Still Required To Balance Markets Chart 8 Gold Prices Down From Their 2021 High Gold Prices Down From Their 2021 High     Footnotes 1     Please see Extent of damage to AstraZeneca vaccine’s perceived safety in Europe revealed published by yougov.co.uk 7 March 2021.  See also States lift Covid restrictions, drop mask mandates and reopen businesses despite warnings from Biden officials published by cnbc.com 11 March 2021, and European travel restrictions: Non-essential travel curbed published by dw.com 15 March 2021. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Highlights The American Rescue Plan Act confirms the shift to “Big Government” and proactive fiscal policy in US politics. This sea change in policy is durable for now, given that Democrats can pass one or two more budget reconciliation bills without a Republican vote. Details of forthcoming tax hikes are starting to leak from Washington. Investors should not assume that progressive proposals like a wealth tax, a financial transactions tax, or a minimum corporate tax are dead on arrival. Taxing corporations and the rich is popular. The Republican Party is likely to choose a Trumpian agenda going forward and Trump has a good chance of being the presidential candidate in 2024. But cyclical and structural factors disfavor Republicans at this early stage. Industrials have rallied sharply in advance of Biden’s first law and are now overbought. But we would favor them over health care over a 12-month period, given the macro backdrop and relative policy risks. Feature Were there any surprises in the American Rescue Plan Act (ARPA) signed by President Biden on March 11? Only that some of Biden’s health care and infrastructure agenda slipped into the bill, alongside a provision holding that if states cut taxes and lose revenue, they will lose an equivalent amount in state and local aid. The plan illustrates that the budget reconciliation process is an effective tool for the ruling party to get most of what it wants. The Biden administration will be able to pass one or two more reconciliation bills for FY2022 and FY2023. While the next bills will be harder to pass than the first, and moderate Democratic senators will limit Congress’s options somewhat, the point is that Democrats have just enough political capital to achieve their policy agenda without a single Republican vote. As always, our Political Capital Index is updated in the Appendix and highlights falling political polarization and improving business sentiment, which is positive for Biden’s political capital.  Investors will continue to bet on a cyclical recovery but will also become more concerned about tax hikes on one hand and excessive deficit spending on the other. The latter threatens eventually to overheat the economy and speed up the Fed’s rate hike cycle. In this report we conduct a quick recap of the ARPA now that it is official law, we review the tax hike proposals swirling out of the Washington rumor mill, and we update the status of the civil war in the Republican Party. We conclude with a look at industrial stocks, which have rallied tremendously on the back of the cyclical economic upturn (Chart 1) but may still offer some value relative to sectors like health care that face policy risks. Chart 1Cyclical Indicators High On Stimulus Cyclical Indicators High On Stimulus Cyclical Indicators High On Stimulus ARPA Symbolizes The ‘Big Government’ Shift The well-known provisions of the ARPA include: Treasury checks of $1,400 sent directly to individuals who earn less than $80,000 per year; extended unemployment benefits and a renewed federal top-up of $300 per week through September 6, 2021; $65 billion in business aid; and generous funding for various welfare programs such as the expanded Child Tax Credit and larger subsidies for enrollees in the Affordable Care Act health insurance marketplaces (Chart 2).1 Chart 2American Rescue Plan Act Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors In total the US fiscal stimulus amounts to $5 trillion or 23% of GDP since COVID-19 emerged, with $2.8 trillion or 13% of GDP passed since December. It is a gargantuan fiscal stimulus that will supercharge the economy today but lead to a rocky descent once it is exhausted in the coming years (Chart 3). Expiring provisions will occasion political showdowns over whether to make them permanent and how to address waste, corruption, and the long-term budget deficit. Chart 3The COVID-19 Fiscal Blowout Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors The provisions are so far flung that educated American citizens living abroad are reportedly receiving stimulus checks. Nevertheless the bulk of the impact will be felt by low-income people with high marginal propensities to consume. They are the prime beneficiaries of the $850 billion share of the law that funnels cash to individuals as opposed to businesses (Chart 4). This means that at least one-third of the money will be spent, while around two-thirds will be used to pay down debt, enabling consumers to spend more later, according to our Global Investment Strategy. The general effects are very supportive of the recovery. For example, the number of children living in poverty is estimated to fall by 40%, while about one in five renters are expected to catch up on their rent.2 Evictions, bankruptcies, and loan delinquencies will not revive in this context. The total amount of spending is almost twice the size of the output gap, which is now widely expected to be filled by the end of 2022.  Chart 4Cash Handouts To Families With High Propensity To Consume Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors While ARPA mainly consists of short-term cash relief – with pro-productivity investments to come in the reconciliation bill for FY2022 focused on infrastructure and renewables – nevertheless it is not wholly devoid of long-term investment. Each of the 50 states will receive $500 million in aid (more depending on their unemployment rate). Since state and local government revenues are not as dire as expected, some of this money will go into infrastructure, including soft infrastructure like the rural broadband buildout. States will be discouraged from cutting taxes, as mentioned.3 The most important takeaway is that the ARPA will reinforce the shift in public attitudes in favor of a larger government role in the economy. Democrats passed their “liberal wish list” and the result is that a range of constituencies – from those on food and housing programs to those working in the health and education systems – will receive a windfall of federal support. In this way a one-off and probably excessive relief bill will contribute to a sea change in American attitudes toward government. Conservatives and Republicans will still argue in favor of limited government but that is a relative concept and the goalposts just moved. Bottom Line: The ARPA secures the recovery, plugs the output gap, and likely reinforces the shift in public attitudes in favor of a larger role of government in society and the economy. The amount of stimulus is likely excessive, assuming the economy avoids any other bad shocks in the coming years. Hence the law marks a historic shift from reactive to proactive fiscal policy and sets the stage for an inflation overshoot in the long run if not the short run.  Yellen Becomes Warren? Not Quite, But Expect Negative Tax Surprises The next budget reconciliation bill is expected to be a 10-year green infrastructure package that will be partially offset by tax hikes. Whether in the same bill, or prioritized above it, we expect Biden to push for his expansion of the Affordable Care Act (only a small part of his health agenda was included in the ARPA). The House will draft its version in April and Biden may sign the final bill into law as early as September or as late as December. We discussed the bill in our March 3 missive. Rumors about the tax proposals are starting to leak out of Washington. At present none of the rumors change the policy consensus, based on Biden’s campaign proposal shown in Table 1. However, they do tentatively support our view that tax hikes will deliver negative surprises to the equity market this year, given that investors have so far been unperturbed by the prospect of higher taxes. Table 1Taxman Cometh Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Secretary of Treasury Janet Yellen raised some eyebrows when she indicated that a wealth tax is being considered by the Biden administration.4 Previously a tax on a person’s (or trust’s) net assets, as opposed to a tax on their income, was the domain of Biden’s progressive-left rivals such as Senators Bernie Sanders and Elizabeth Warren. Warren’s proposal would levy a 2% annual tax on those who possess more than $50 million in net wealth, rising to 3% on billionaires. During the Democratic primary election their proposals were estimated to raise anywhere from $1.4 trillion – if Warren’s proposal met with extreme tax avoidance – to $4.5 trillion, as estimated by Sanders.5  Yellen has also spoken to the finance ministers of France and Germany as part of a diplomatic initiative through the OECD to encourage global participation in a minimum corporate tax rate of around 12%. In exchange for enacting this tax floor, Yellen signaled to the Europeans that she would not insist on providing American Big Tech with a “safe harbor” from Europe’s planned digital tax.6 Whatever ends up happening internationally, the implication is that the Biden administration will push forward with its proposed 15% minimum tax on corporation’s book income. Yellen says that she expects tax hikes to be phased in the latter part of the 10-year budget window for FY2022 so as to make sure that the government’s interest burden is manageable over the long run. She is not concerned about excess deficits or debt in the short run, as they are related to the pandemic relief and economic recovery and interest rates are below the nominal growth rate of the economy. But she has endorsed passing tax hikes for later in the decade, as did both President Biden and Vice President Kamala Harris on the campaign trail.  Several of the more ambitious tax proposals face limitations in Congress. Moderate senators like Joe Manchin of West Virginia have raised objections to a large tax hike during trying times. He might be joined by other moderates like John Tester of Montana and the four narrowly elected senators from Arizona and Georgia. However, while these moderates will keep the tax agenda in check, it is important to understand their position. None of these senators are against tax hikes in principle – that would be a Republican stance. They are against tax hikes that increase the burden on the middle class or jeopardize the economic recovery. From that point of view Biden’s proposals are fairly palatable: the highest individual income tax bracket would go back to where it stood in 2016, the corporate rate would go halfway (at most) to its pre-Trump level, and the estate tax would be restored. These proposals focus on big corporations and the wealthy and are likely to be watered down in negotiation, so we would not rule out moderate Democratic support.  Investors should not rest easy about the tax agenda until more information is known. Negative surprises are likely. The consensus is that the Democrats will not pass a wealth tax, or a “Wall Street tax” on financial transactions, or other progressive proposals. But these taxes would be popular and politically defensible – some polls even show a majority of Republicans supporting a wealth tax.  Therefore these taxes cannot be ruled out in advance.7 Bottom Line: The tax debate is underway and our expectation of negative surprises is looking more, not less, likely. How Will Republicans Respond To The Big Government Onslaught?   Republicans have duly retreated to the political wilderness after their election loss and the January 6 Capitol Hill riot. The critical question is whether and how they will regroup to contest future elections – the deeper their divisions, the more certain Democratic policy becomes. At the center of this question is whether the Republican Party will adopt Trumpist policy and whether Trump himself will continue to be the flagbearer and presumptive nominee for the presidential election in 2024. Our answer is that the Republicans will adopt a Trumpist agenda of tough trade and immigration policies combined with fiscal largesse but they will struggle over Trump himself and how to broaden their base. Every election is unique. COVID-19 reinforces the point. There is a clear case to be made that Trump would have won the election if not for the pandemic and recession. We favor this view given how narrowly he lost in the midst of the crisis. But there is also a clear case to be made that he would have lost anyway.8 The problem for the Republicans going forward is that cyclical and structural trends work against them. Cyclically, the economy should be in full stride in 2022-24 and the Federal Reserve is highly likely to play a supportive role. This may or may not prevent the usual midterm opposition gains but it will make it very hard for an opposition presidential candidate to win. True, Democrats will not have a full incumbent advantage if President Biden passes the baton to Vice President Harris. Inflation and other problems will emerge. But given the timing of the pandemic, election, and vaccine, voters will probably be much better off in four years than they were last November, which is the most reliable prediction of whether the incumbent party will stay in power.      Structurally, demographic change in America diminishes Trump’s base. A generational shift is transforming the American electorate, as the Silent Generation, which is the most reliably Republican, passes on (Chart 5). Millennials favored the Democratic Party by 6% in the 2020 election (10% in Georgia and 21% in Pennsylvania). Chart 5Generational Shift A Risk To Unreconstructed Republicans Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Ethnic minorities also skew Democratic, generally speaking, and are taking a much larger share of the electorate, especially in critical swing states – as highlighted by Biden’s victories in Arizona and Georgia (Chart 6). Hispanics favored Biden by 33% (24% in Arizona). Chart 6US Demographics Drive Political Change Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Demographic extrapolations by the Center for American Progress show that even if post-Millennial generations grow more conservative over time, the Electoral College will shift inexorably against the Republicans as long as current trends continue (Chart 7). Chart 7Electoral Math Frowns On Republicans Even Without Generational Shift Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Demographics are not destiny: Trump would never have won in 2016 if projections based on age and race were so predictive. Yet Republicans cannot merely wait on cyclical or exogenous events to discredit the Democrats. The electoral math is devastating if they do not broaden their appeal. Their quandary is that generating enthusiasm among their base of white voters with less formal education may exclude the very groups to whom they need to appeal: suburban women, educated whites, and ethnic minorities. The immediate question is what to do about Trump, who has divided the party over the Capitol riot, culminating in seven Republican votes against him in his second impeachment. On the surface the Republican Party is a much older entity than any single member or leader and can therefore play a longer strategy. It could choose the correct electoral strategy of courting independents, women, and Hispanics even if it meant losing an election or two due to divisions with the Trumpists. The problem is that Trump’s personal following is uniquely threatening to the viability of the party. Trump alone could split the Republican Party and nullify its chances in 2022-24 and beyond. Trump has suggested starting his own party, the Patriot Party. Opinion polls show that 46% of Republicans would join it while only 27%would insist on sticking with the Republican Party (Chart 8). Even if a Trumpist party stole only 2-3% of Republican voters it would be enough to ensure a Democratic victory in any election given the very small margins of victory in swing states in recent decades. Trump would easily spoil the Republican bid, just as Ross Perot did in the 1990s, Robert La Follette did for the Democrats in the 1930s, and Theodore Roosevelt did in 1912 (Table 2). As Senator Lindsey Graham said of Trump and the Republican Party, after holding post-election negotiations with the former president: “He can make it bigger. He can make it stronger. He can make it more diverse. And he also could destroy it.”9 Chart 8Trump Could Start Third Party, Give Democrats A Decade-Plus Ascendancy Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table 2Major Third Party Breakaway Candidates Undercut Their Former Party Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors So What Will Republicans Do? We conducted an exercise using game theory to determine the likeliest strategy that Trump and the party will take. We used the famous “Prisoner’s Dilemma” as our template because both sides have a lot to gain if they cooperate and a lot to lose if not.10 But they do not trust each other. And each side will lose the most if it stays true while the other betrays it, worsening the distrust. Diagram 1 shows the outcome. Republicans could win eight years in the Oval Office if they adopted Trump’s agenda yet put forward a young new candidate with Trump’s personal endorsement; or they could win four years if they chose Trump himself (the constitutional limitation). By contrast, if they chose an establishment Republican agenda, they could win eight years (reduced to four in Diagram 1 because less likely) or zero years if Trump opposed. Trump, for his part, would win zero years if he bowed out to support the Republicans regardless of whether they adopted his agenda, but he would have a chance of winning four more years if he ran at the head of a Trumpist Republican Party. The outcome is that the Republicans will adopt Trumpism while Trump himself could easily run for president again, given his sway over the party. Diagram 1Game Theory Says Republicans Will Court Trump Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors The game works out the same way if we assign minimal positive payoffs (e.g. one point for a win, zero points for a loss), various other probability weighted payoffs (50% chance of winning), or negative payoffs for time spent out of power. In each variation a stable equilibrium emerges in which Republicans adopt Trump’s agenda and Trump runs again in 2024. Of course, if one changes the structure of the game or assigns subjective scores a different outcome can be produced. But the clearest and most logical games all produce the same outcome: Trump 2024.   This view fits with the consensus in online betting markets. According to the bookies, Trump has between a 20% and 35% chance of running as the Republican nominee in 2024. The same markets give Republicans a 44%-50% chance of winning the White House that year. At this early stage we would take the “over” on Trump and the “under” on a GOP victory given the above points about the cyclical and structural factors weighing against Republicans (Chart 9). Our quantitative US election model, which produced the correct result for all states except Arizona, Georgia and Michigan in 2020, gives the Republicans a 44% chance of winning in 2024 but that number will fall sharply as the economy improves. Chart 9Trump's Odds Of Winning The Republic Nomination In 2024 Trump's Odds Of Winning The Republic Nomination In 2024 Trump's Odds Of Winning The Republic Nomination In 2024 What might change this outcome, according to game theory? Republicans could offer a powerful sweetener to convince Trump to bow out of the race and support the party’s candidate, such as letting one of his children or his son-in-law Jared Kushner run in his place. Alternately Democrats could increase the danger to Trump of their winning again, perhaps by threatening to throw him in jail. Otherwise Trump may not be sufficiently convinced of his party’s loyalty, or frightened of Democratic rule, to bow out of the race.  We are never beholden to game theory and there are countless real-world ways in which the 2022-24 election outlook could change. But as things stand today, Republicans are highly likely to adopt Trump’s agenda. Trump may or may not do what is best for the party. He is unpredictable and at critical junctures over the past year he has not done so. He could start his own party just for the fun of it and in doing so break the party of Lincoln. This irrational factor creates an imbalance in the game that the Republican Party will be anxious to prevent, reinforcing its likely decision to adopt his agenda and let him seek the nomination freely. If the Republican Party does split, officially or unofficially, the Democrats will be guaranteed to expand their hold on Congress in 2022 and keep the White House in 2024. Note that Republicans would normally be heavily favored to retake the House of Representatives in 2022, though not the Senate, so such an outcome would be a political earthquake. A Democratic ascendancy could last for more than one election cycle: Republicans held the White House from 1980-92 and Democrats held it from 1932-52. Since we cannot reliably forecast Trump’s individual behavior, we cannot rule out a deep Republican rift. On the other hand, while the demographic trends point to Democratic rule out to 2036 and beyond, no Democratic ascendancy would last that long, given economic cycles, international threats, and the inevitable corruptions of single-party rule. But policy uncertainty would collapse over the 2022-24 cycle, pushing the timing of major policy change to 2026 or later. Investors would face a high probability that a sweeping Democratic agenda would be enacted, even assuming the persistence of checks and balances provided by moderate Democratic senators and the judicial branch. One clear implication is that financial markets may not evade the risk of negative regulatory and tax surprises over the long run even if they manage to do so in the FY2022 and FY2023 reconciliation bills – which we doubt. Bottom Line: Republicans cannot win the White House in 2024 without Trump’s popular base, even though they would prefer to have a fresh face capable of expanding that base. Trump cannot win without the Republican Party but he can unpredictably decide to do something other than win, i.e. endorse a Republican successor or start a third party. As a result a true Republican split cannot be ruled out. Meanwhile Republicans will have to court Trump rather than vice versa. Democratic policy is well ensconced for now, an underrated risk to the equity market. Investment Takeaways We know that Democrats are pushing forward on their legislative agenda and capable of passing one or two more budget reconciliation bills. We know that cyclical and especially structural factors will put Republicans at a disadvantage in the 2024 presidential race and possibly even the 2022 midterm. We also know that the Republican Party has a non-negligible risk of fracturing due to Trump’s personal following and unpredictability. These points suggest investors should not bet against the current policy setup. The macro backdrop favors cyclical sectors such as industrials, energy, materials, and financials. In our US Political Risk Matrix we have highlighted that the policy backdrop is especially beneficial to industrials (Appendix, Table A1). This is reinforced by ARPA and Biden’s forthcoming reconciliation bills on infrastructure and green projects, subsidies for domestic production, and simultaneous attempts to reduce trade tensions with US allies and partners – if not with China. Of course, industrials have rallied enthusiastically alongside a sharp rebound in core durable goods orders, a more gradual improvement in non-residential capital expenditures, and an environment in which capex intentions will respond to a general domestic and global upswing (Chart 10). A weak dollar, premised on a global recovery, excess liquidity, lower interest rates for longer, and large budget and trade deficits, also favors the industrial sector and reinforces the recovery in global trade and growth. Rising commodity prices are driven by supply constraints as much as global demand, as our Commodity & Energy Strategy has showed in depth, and help to restore pricing power to industrial firms  (Chart 11). Chart 10Industrials Outperform On Recovery And Stimulus Industrials Outperform On Recovery And Stimulus Industrials Outperform On Recovery And Stimulus Chart 11Commodity Boom Supports Industrials' Pricing Power Commodity Boom Supports Industrials' Pricing Power Commodity Boom Supports Industrials' Pricing Power Hence the good news is largely priced into industrials, which are tactically overvalued according to our BCA valuation indicator. The sector looks more or less expensive on all valuation metrics other than price-to-sales (Chart 12). Therefore the best value must be sought on a relative basis, where industrials are outperforming communications services and just beginning to outperform the superstars, tech and health care. From a policy point of view, health care is one of the biggest losers of the Biden administration, which aims to expand health insurance coverage and reduce drug prices. This may be for the benefit of society but it comes at the expense of old cash cows. Investors should stay guarded against a near-term correction in industrials due to looming tax hikes but strategically favor them over health care and tech (Chart 13), which are even more vulnerable to higher taxes. We will execute this trade by going long against health care over a strategic time frame. Chart 12Industrials Overvalued On Most Measures Industrials Overvalued On Most Measures Industrials Overvalued On Most Measures Chart 13Favor Industrials Over Health Care Favor Industrials Over Health Care Favor Industrials Over Health Care Industrials also have a favorable profile against consumer discretionary stocks but we maintain a positive outlook on the US consumer in an era of government largesse. Our Geopolitical Strategy has also highlighted that Great Power struggle will prevent the Biden administration from cutting defense spending – another boon for industrials. Instead it will have to increase spending for defense as well as supply chain resilience and research and development in the midst of a cold war with China.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1Political Risk Matrix Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A2Political Capital Index Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A3APolitical Capital: White House And Congress Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A3BPolitical Capital: Household And Business Sentiment Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A3CPolitical Capital: The Economy And Markets Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A4Biden’s Cabinet Position Appointments Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors         Footnotes 1     Garrett Watson and Erica York, “The American Rescue Plan Act Greatly Expands Benefits Through The Tax Code In 2021,” Tax Foundation, March 12, 2021, taxfoundation.org.              2     Committee for a Responsible Federal Budget, “American Rescue Plan Act Will Help Millions And Bolster The Economy,” March 15, 2021, cbpp.org. 3    See footnote 2 above. 4    Paul Kiernan and Catherine Lucey, “Yellen Says Biden Administration Undecided On Wealth Tax,” Wall Street Journal, wsj.com. 5    Kyle Pomerleau, “How Much Revenue Would A Wealth Tax Raise?” On The Margin, American Enterprise Institute, April 20, 2020, aei.org. 6    Jeff Stein, “Yellen pushes global minimum tax as White House eyes new spending plan,” Washington Post, March 15, 2021, washingtonpost.com. 7     Howard Schneider and Chris Kahn, “Majority of Americans favor wealth tax on very rich: Reuters/Ipsos poll,” Reuters, January 10, 2020, reuters.com; Matthew Sheffield, “New poll finds overwhelming support for an annual wealth tax,” The Hill, February 6, 2019, thehill.com. 8    A recession could have happened as a result of the cyclical slowdown from the trade war, which hurt the Midwestern swing states. The yield curve had inverted and the economy’s margin of safety was low. There would not have been any fiscal stimulus without the pandemic. 9    James Walker, “Lindsey Graham Warns Donald Trump Could ‘Destroy’ GOP After Combative CPAC Speech,” Newsweek, March 8, 2021, newsweek.com. 10   The Prisoner’s Dilemma involves two prisoners detained separately and pressured into confessing their crimes. If they both stay quiet, nothing can be proved and they only spend one year in jail. If they both confess, they are proven guilty and both spend five years in jail. If only one of them confesses while the other stays silent, the confessor goes scot free while the other spends 20 years in jail! The incentive is to confess. The equilibrium is for both to confess. The traditional game reveals the benefits of trust as well as the difficulty of maintaining it in isolation and doubt.   

Highlights The report from last week’s National People’s Congress (NPC) indicates a gradual pullback in policy support this year. Fiscal thrust will be neutral in 2021, whereas the rate of credit expansion will be slightly lower compared with last year. China’s economy should run on its own momentum in the first half, before slowing to a benign and managed rate. Nonetheless, the risk of policy overtightening is nontrivial and could threaten the cyclical outlook on China’s economy and corporate profits. The recent price correction in Chinese stocks has not yet run its course. Moreover, equity prices in both onshore and offshore markets are breaching their technical resistance. We are downgrading our tactical (0 to 3 months) and cyclical (6 to 12 months) positions on Chinese stocks to underweight relative to global benchmarks. Feature China’s budget and key economic initiatives unveiled at last week’s NPC indicate that policy tightening will be gradual this year. Overall, maintaining stability, both socially and economically, remains the focal point of Premier Li Keqiang’s work plan presented at the NPC’s annual plenary session in Beijing. However, investors have centered on the government’s plan to have a smaller policy push on growth in its budget compared with last year, fearing that economic and corporate profit rebound will disappoint. The Shanghai Composite Index dropped by 6% during the week when the NPC took place. In our view, the risks of a policy over-tightening in the next six months are high. As such, with this report we are downgrading our cyclical call on Chinese stocks to underweight within a global equity portfolio.      Reading Policy Tea Leaves China's growth trajectory since the middle of 2020 has given the government comfort in staying the course on policy normalization. The question is how much Chinese policymakers are willing to pull back support for the economy this year. Overall, the central government plans a smaller policy push in this year's budget and intends to let the economy run on its own steam. Further policy reflation is not in the cards unless a relapse in the economy threatens job creation. The NPC outlined a growth target “above 6%” for 2021 and did not set a numerical goal for the 14th Five-Year Plan from 2021 to 2025. However, de-emphasizing growth does not mean China has abandoned its GDP targets (Table 1). Indeed, in most years in the past two decades, China’s expansion in GDP has overshot objectives set at the NPC (Chart 1). Our baseline estimate is that real GDP will increase by 8% in 2021. Table 12021 Economic And Policy Targets National People’s Congress Sets Tone For 2021 Growth National People’s Congress Sets Tone For 2021 Growth Chart 1Actual Econ Growth Rates Have Overshot Targets In Most Years Actual Econ Growth Rates Have Overshot Targets In Most Years Actual Econ Growth Rates Have Overshot Targets In Most Years   We also maintain our view that the rate of credit expansion will be reduced by 2 to 3 percentage points this year to about 11% annually, which is in line with nominal GDP growth (Chart 2). On the fiscal front, the target for a budget deficit was cut by less than half percentage point compared with last year. When taking into account both the government’s budgetary and fund expenditures, the broad-measure fiscal deficit will probably be around 8% of GDP (about the same as last year), which implies there will not be any fresh fiscal thrust in 2021 (Chart 3) Chart 2Credit Growth Will Decelerate From Last Year Credit Growth Will Decelerate From Last Year Credit Growth Will Decelerate From Last Year Chart 3Neutral Fiscal Thrust Neutral Fiscal Thrust Neutral Fiscal Thrust The pullback in fiscal impulse is larger than in 2010, 2014, and 2017, following the previous three fiscal expansionary cycles. However, the government's eased budget deficit target this year does not mean government expenditure growth will slow. Government revenues climbed sharply by the end of 2020 and will continue to improve this year (Chart 4). Higher revenues will allow more government spending while keeping the fiscal deficit within its objectives. Chart 4Gov Revenue Is On The mend But Spending Has Yet To Pick Up Gov Revenue Is On The mend But Spending Has Yet To Pick Up Gov Revenue Is On The mend But Spending Has Yet To Pick Up Chart 5A Small Reduction In ##br##LG Bond Quota National People’s Congress Sets Tone For 2021 Growth National People’s Congress Sets Tone For 2021 Growth Furthermore, the quota for local government special purpose bonds was reduced by only 2% from last year.  It should help to support a steady growth in China’s infrastructure investment (Chart 5). The data from January and February total social financing shows a noticeable improvement in corporate demand for bank loans, as well as the composition of bank loans. Corporate demand for medium- and long-term loans remains on a strong uptrend, which reflects an ongoing recovery in corporate profits and supports an optimistic view on capital investment in the months ahead (Chart 6). Chart 6More Demand For Longer-Term Loans Reflects Better Investment Propensity More Demand For Longer-Term Loans Reflects Better Investment Propensity More Demand For Longer-Term Loans Reflects Better Investment Propensity Bottom Line: The growth and budget targets set at this year’s NPC suggest only a modest pullback in policy support. Downside Risks To The Economy Chart 7Econ Growth Usually Peaks Six To Nine Months After Credit Expansion Rate Slows Econ Growth Usually Peaks Six To Nine Months After Credit Expansion Rate Slows Econ Growth Usually Peaks Six To Nine Months After Credit Expansion Rate Slows Despite a relatively dovish tone from the NPC, investors should not be complacent about the risk of a policy-tightening overshoot, which could lead to disappointing economic and profit growth this year.  In most of the previous policy tightening cycles, China’s economic activities remained resilient in the first 6 to 9 months (Chart 7). One exception was 2014, when nominal GDP growth dropped sharply as soon as credit growth slowed. The reason is that Chinese authorities kept a very disciplined fiscal stance and aggressively tightened monetary policy, while allowing the RMB to soft peg to a rising USD. In other words, macroeconomic policies were too restrictive during the 2013/14 cycle. Although messages from the NPC do not suggest that Chinese authorities are on such an aggressive tightening path this year, investors should watch the following signs that could threaten China's cyclical economic health: Policymakers may keep monetary conditions too tight, by allowing the RMB to rise too fast while lifting bank lending and policy rates. Currently rates are maintained at historically low levels, much lower than in previous policy tightening cycles (Chart 8). However, the trade-weighted RMB has appreciated by 6% since its trough in July last year and has returned to its pre US-China trade war level (Chart 9).  The Chairman of China’s Banking and Insurance Regulatory Commission recently signaled that bank lending rates would climb. Although we do not expect the rate to return to its 2014 or 2017 level, China is much more indebted than in previous cycles. Even a small bump in interest rates will place a burden on corporates and local governments’ debt servicing cost, dampening their propensity to invest (Chart 10).  Chart 8Aggressive Rate Hikes Are ##br##Unlikely This Year Aggressive Rate Hikes Are Unlikely This Year Aggressive Rate Hikes Are Unlikely This Year Chart 9Rising RMB Should Refrain Chinese Policymakers From Further Tightening Monetary Stance Rising RMB Should Refrain Chinese Policymakers From Further Tightening Monetary Stance Rising RMB Should Refrain Chinese Policymakers From Further Tightening Monetary Stance Chart 10Chinese Private Sector Has Become Much More Sensitive To Rising Interest Rates Chinese Private Sector Has Become Much More Sensitive To Rising Interest Rates Chinese Private Sector Has Become Much More Sensitive To Rising Interest Rates Chart 11Bank Lending To Property Sector Has Become Increasingly Restrictive Bank Lending To Property Sector Has Become Increasingly Restrictive Bank Lending To Property Sector Has Become Increasingly Restrictive   Policies could become too restrictive in key old-economy industries. Chinese authorities have reiterated their determination to contain price bubbles in the property sector. For the first time since 2017, bank lending to real estate developers grew at a pace far below overall bank loans and continued to trend downward in February this year (Chart 11). Moreover, household mortgage loans have reached their slowest expansion rate since 2013.  At 22% of China’s total bank lending, a sharp setback in the property sector’s loan growth will be a significant drag on total credit and the economy.   A worsened imbalance in supply and demand could lead to too much buildup in industrial inventory. Manufacturing inventories recovered sharply following last year’s massive stimulus and many sectors have surpassed their pre-pandemic levels (Chart 12). Strong external demand helped to boost China’s production and propensity to restock on raw materials. However, both China’s core CPI and producer prices for consumer goods remain in the doldrums, which indicates that domestic final demand has yet to fully recover (Chart 13).  As discussed in last week’s report, reopening the world economy in 2H21 should benefit the service sector more than tradeable goods. China’s inventory buildup, particularly in the upstream industries, could turn excessive when export growth slows and domestic demand fails to pick up the slack. Chart 12How Far Can Chinas Inventory Restocking Cycle Go? How Far Can Chinas Inventory Restocking Cycle Go? How Far Can Chinas Inventory Restocking Cycle Go? Chart 13Final Demand Remains ##br##Weak Final Demand Remains Weak Final Demand Remains Weak The service sector could take longer than expected to recuperate, even though China’s domestic COVID-19 situation is under control. China’s services sector has flourished in recent years and accounted for 54% of the nation’s pre-pandemic economic output. However, about half of the service sector output is tied to real estate and financial services. Increasing pressures from tighter policy regulations targeting both the property and online financial service sectors could dampen their support to the economy more than policymakers anticipated. At the same time, wage and household income growth could remain tame by China’s standards (Chart 14).   The NPC’s targeted 7% annual increase in spending for national research and development – far below the 12% annual average reached during the past five years – will not be enough to offset the slowdowns in real estate and financial services (Chart 15). Chart 14Household Income Growth Has Yet To Recover Household Income Growth Has Yet To Recover Household Income Growth Has Yet To Recover Chart 15Chinas Pace Of R&D Investment Has Slowed Along With Econ Growth Chinas Pace Of R&D Investment Has Slowed Along With Econ Growth Chinas Pace Of R&D Investment Has Slowed Along With Econ Growth Bottom Line: The downside risks to China’s cyclical growth trajectory are nontrivial. A tug-of-war between policy tightening and growth support will likely persist throughout this year. Investment Implications We recommend investors to underweight Chinese stocks within a global equity portfolio, in the next 0 to 9 months (Chart 16A and 16B). Chart 16AChinese Stocks Are At Their Technical Resistance Chinese Stocks Are At Their Technical Resistance Chinese Stocks Are At Their Technical Resistance Chart 16BChinese Stocks Are At Their Technical Resistance Chinese Stocks Are At Their Technical Resistance Chinese Stocks Are At Their Technical Resistance On January 13, we tactically downgraded Chinese stocks from overweight to neutral, anticipating that China’s equity markets are sensitive to rising expectations of policy tightening, due to higher corporate debt-servicing costs and lofty valuations.  Chinese stock prices peaked in mid-February, but in our view the correction has not yet run its course. In terms of the economy, we maintain our baseline view that China's overall policy environment this year will be more accommodative than in 2017/18. The growth momentum carried over from last year's stimulus should prevent China's economy and corporate profits from slumping by too much this year. However, as policy supports are scaled back, investors will increasingly focus on the intensity of China’s domestic policy tightening and the uncertainties surrounding it. Downside risks are nontrivial and will continue to weigh on investors' sentiment. For investors that are mainly exposed to the Chinese domestic equity market, the near-term setbacks in the A-share market are taking some air out of Chinese equities' frothy valuations, and may pave the way for a more optimistic cyclical outlook beyond the next 9 to 12 months. We recommend domestic investors to stay on the sidelines for now, but will start recommending sector rotations in the next few months when opportunities arise. Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights The Biden administration’s early actions suggest it will be hawkish on China as expected – and the giant Microsoft hack merely confirms the difficulty of reducing strategic tensions. US-China talks are set to resume and piecemeal engagement is possible. However, most of the areas of engagement touted in the media are overrated. Competition will prevail over cooperation. Cybersecurity stocks have corrected, creating an entry point for investors seeking exposure to a secular theme of Great Power conflict in the cyber realm and beyond. Global defense stocks are even more attractive than cyberstocks as a “back to work” trade in the geopolitical context. Continue to build up safe-haven hedges as geopolitical risk remains structurally elevated and underrated by financial markets. Feature The Biden administration passed its first major law, the $1.9 trillion American Rescue Plan, on March 10. This gargantuan infusion of fiscal stimulus accounts for about 2% of global GDP and 9% of US GDP, a tailwind for risky assets when taken with a receding pandemic and normalizing global economy. The US dollar has perked up so far this year on the back of this extraordinary pump-priming and the rapid rollout of COVID-19 vaccines, which have lifted relative growth expectations with the rest of the world. Hence the dollar is rising for fundamentally positive reasons that will benefit global growth rather than choke it off. Our Foreign Exchange Strategist Chester Ntonifor argues that the dollar has 2-3% of additional upside before relapsing under the weight of rising global growth, inflation expectations, commodity prices, and relative equity flows into international markets. We agree with the dollar bear market thesis. But there are two geopolitical risks that investors must monitor: Cyclically, China’s combined monetary and fiscal stimulus is peaking, growth will decelerate, and the central government runs a non-negligible risk of overtightening policy. However, China’s National People’s Congress so far confirms our view that Beijing will not overtighten. Structurally, the US-China cold war is continuing apace under President Biden, as expected. The two sides are engaging in normal diplomacy as appropriate to a new US administration but the Microsoft Exchange hack (see below) underscores the trend of confrontation over cooperation. Chart 1Long JPY / Short KRW As Geopolitical Risk Is Underrated Long JPY / Short KRW As Geopolitical Risk Is Underrated Long JPY / Short KRW As Geopolitical Risk Is Underrated The second point reinforces the first since persistent US pressure on China will discourage it from excessive deleveraging at home. In a world where China is struggling to cap excessive leverage, the US is pursuing “extreme competition” with China (Biden’s words), and yet the US rule of law is intact, global investors will not abandon the US dollar in a general panic and loss of confidence. They will, however, continue to diversify away from the dollar on a cyclical basis given that global growth will accelerate while US policy will remain extremely accommodative. Reinforcing the point, geopolitical frictions are rising even outside the US-China conflict. A temporary drop in risk occurred in the New Year as a result of the rollout of vaccines, the defeat of President Trump, and the resolution of Brexit. But going forward, geopolitical risk will reaccelerate, with various implications that we highlight in this report. While we would not call an early end to the dollar bounce, we will keep in place our tactical long JPY-USD and long CHF-USD hedges. These currencies offer a good hedge in the context of a dollar bear market and structurally high geopolitical risk. If the dollar weakens anew on good news for global growth then the yen and franc will benefit on a relative basis as they are cheap, whereas if geopolitical risk explodes they will benefit as safe havens. We also recommend going long the Japanese yen relative to the South Korean won given the disparity in valuations highlighted by our Emerging Markets team, and the fact that geopolitical tensions center on the US and China (Chart 1). “Our Most Serious Competitor, China” Why are we so sure that geopolitical risk will remain structurally elevated and deliver negative surprises to ebullient equity markets? Our Geopolitical Power Index shows that China’s rise and Russia’s resurgence are disruptive to the US-led global order (Chart 2). If anything this process has accelerated over the COVID-19 crisis. China and Russia have authoritarian control over their societies and are implementing mercantilist and autarkic economic policies. They are carving out spheres of influence in their regions and using asymmetric warfare against the US and its allies. They have also created a de facto alliance in their shared interest in undermining the unity of the West. The US is meanwhile attempting to build an alliance of democracies against them, heightening their insecurities about America’s power and unpredictability (Chart 3). Chart 2Great Power Struggle Continues Great Power Struggle Continues Great Power Struggle Continues Massive fiscal and monetary stimulus is positive for economic growth and corporate earnings but it reduces the barriers to geopolitical conflict. Nations can pursue foreign and trade policies in their self-interest with less concern about the blowback from rivals if they are fueled up with artificially stimulated domestic demand. Chart 3Biden: ‘Our Most Serious Competitor, China’ More Reasons To Buy Cybersecurity And Defense Stocks More Reasons To Buy Cybersecurity And Defense Stocks Total trade between the US and China, at 3.2% and 4.7% of GDP respectively in 2018, was not enough to prevent trade war from erupting. Today the cost of trade frictions is even lower. The US has passed 25.4% of GDP in fiscal stimulus so far since January 1, 2020. China’s total fiscal-and-credit impulse has risen by 8.4% of GDP over the same time period. The Biden administration is co-opting Trump’s hawkish foreign and trade policy toward China, judging by its initial statements and actions (Appendix Table 1). Specifically, Biden has issued an executive order on securing domestic supply chains that demonstrates his commitment to the Trumpian goal of diversifying away from China and on-shoring production, or at least offshoring to allied nations. The Democratic Party is also unveiling bipartisan legislation in Congress that attempts to reduce reliance on China.1 These executive decrees are partly spurred on by the global shortage of semiconductors. China, the US, and the US’s allies are all attempting to build alternative semiconductor supply chains that bypass Taiwan, a critical bottleneck in the production of the most advanced computer chips. The Taiwanese say they will coordinate with “like-minded economies” to alleviate shortages, by which they mean fellow democracies. But this exposes Taiwan to greater geopolitical risk insofar as it excludes mainland China from supplies, either due to rationing or American export controls. The surge in semiconductor sales and share prices of semi companies (especially materials and equipment makers) will continue as countries will need a constant supply of ever more advanced chips to feed into the new innovation and technology race, the renewable energy race, and the buildout of 5G networks and beyond (Chart 4). It takes huge investments of time and capital to build alternative fabrication plants and supply lines yet governments are only beginning to put their muscle into it via stimulus packages and industrial policy. Chart 4Semiconductor Supply Shortage Semiconductor Supply Shortage Semiconductor Supply Shortage Supply shocks have geopolitical consequences. The oil shocks of the 1970s and early 1990s motivated the US to escalate its interventions and involvement in the Middle East. They also motivated the US to invest in stockpiles of critical goods and alternative sources of production so as to reduce dependency (Chart 5). Although semiconductors are not fungible like commodities, and the US has tremendous advantages in semiconductor design and production, nevertheless the bottleneck in Taiwan will take years to alleviate. Hence the US will become more active in supply security at home and more active in alliance-building in Asia Pacific to deter China from taking Taiwan by force or denying regional access to the US and its allies. China faces the same bottleneck, which threatens its technological advance, economic productivity, and ultimately its political stability and international defense. Chart 5ASupply Shortages Motivate Strategic Investments Supply Shortages Motivate Strategic Investments Supply Shortages Motivate Strategic Investments Chart 5BSupply Shortages Motivate Strategic Investments Supply Shortages Motivate Strategic Investments Supply Shortages Motivate Strategic Investments Semiconductor and semi equipment stock prices have gone vertical as highlighted above but one way to envision the surge in global growth and capex for chip makers is to compare these stocks relative to the shares of Big Tech companies in the communication service sector, i.e. those involved in social networking and entertainment, such as Twitter, Facebook, and Netflix. On a relative basis the semi stocks can outperform these interactive media firms which face a combination of negative shocks from rising interest rates, regulation, economic normalization, and ideologically fueled competition (Chart 6). Chart 6Long Chips Versus Big Tech Long Chips Versus Big Tech Long Chips Versus Big Tech What about the potential for the US and China to enhance cooperation in areas of shared interest? Generally the opportunity for re-engagement is overrated. The Biden administration says there will be engagement where possible. The first high-level talks will occur in Alaska on March 18-19 between Secretary of State Antony Blinken, National Security Adviser Jake Sullivan, Central Foreign Affairs Commissioner Yang Jiechi, and Foreign Minister Wang Yi. Presidents Biden and Xi Jinping may hold a bilateral summit sometime soon and the old strategic and economic dialogue may resume, enabling cabinet-level officials to explore a range of areas for cooperation independently of high-stakes strategic negotiations. However, a close look at the policy areas targeted for engagement reveals important limitations: Health: There is little room for concrete cooperation on the COVID-19 pandemic given that the pandemic is already receding, the Chinese have not satisfied American demands for data transparency, Chinese officials have fanned theories that the virus originated in the US, and the US is taking measures to move pharmaceutical and health equipment supply chains out of China. Trade: Trade is an area of potential cooperation given that the two countries will continue trading while their economies rebound. The Phase One trade deal remains in place. However, China only made structural concessions on agriculture in this deal so any additional structural changes will have to be the subject of extensive negotiations. Secretary of Treasury Janet Yellen says the US will use the “full array of tools” to ensure compliance and will punish China for abuses of the global trade system. Cybersecurity: On cybersecurity, China greeted the Biden administration by hacking the Microsoft Exchange email system, an even larger event than Russia’s SolarWinds hack last year. Both hacks highlight how cyberspace is a major arena of modern Great Power struggle, making it unlikely that there will be effective cooperation. The hack suggests Beijing remains more concerned about accessing technology while it can than reducing tensions. The Americans will make demands of China at the Alaska meetings. Environment: As for the environment, the US is a net oil exporter while China imports 73% of its oil, 42% of its natural gas and 7.8% of its coal consumption, with 40% and 10% of its oil and gas coming from the Middle East. The US wants to be at the cutting edge of renewable energy technology but it has nowhere near the impetus of China (or Europe), which are diversifying away from fossil fuels for the sake of national security. Moreover China will want its own companies, not American, to meet its renewable needs. This is true even if there is success in reducing barriers for green trade, since the whole point of diversifying from Middle Eastern oil supplies is strategic self-sufficiency. The Americans would have to accept less energy self-sufficiency and greater renewable dependence on China. Nuclear Proliferation: Cooperation can occur here as the Biden administration will seek to return to a deal with the Iranians restraining their nuclear ambitions while maintaining a diplomatic limiting North Korea’s nuclear weapons stockpile and ballistic missile development. China and Russia will accept the US rejoining the 2015 Iranian nuclear deal but they will require significant concessions if they are to join the US in forcing anything more substantial on the Iranians. China may enforce sanctions on North Korea but then it will expect concessions on trade and technology that the Biden administration will not want to give merely for the sake of North Korea. Bottom Line: The Biden administration’s China strategy is taking shape and it is hawkish as expected. It is not ultra-hawkish, however, as the key characteristic is that it is a defensive posture in the wake of the perceived failures of Trump’s strategy of “attack, attack, attack.” This means largely maintaining the leverage that Trump built for the US while shifting the focus to actions that the US can take to improve its domestic production, supply chain resilience, and coordination with allied producers. Punitive measures are an option, however, and if relations deteriorate over time, as expected, they will be increasingly relied on. Buy The Dip In Cybersecurity Stocks A linchpin of the above analysis is the Microsoft Exchange hack, which some have called the largest hack in US history, since it confirms the view that the Biden administration will not be able to de-escalate strategic tensions with China much. China has been particularly frantic to acquire technology through hacking and cyber-espionage over the past decade as it attempts to achieve a Great Leap Forward in productivity in light of slowing potential growth that threatens single-party rule over the long run. The breakdown in ties between Presidents Barack Obama and Xi Jinping occurred not only because of Xi’s perceived violation of a personal pledge not to militarize the South China Sea but also because of the failure of a cybersecurity cooperation deal between the two. When the Trump administration arrived on the scene it sought to increase pressure on China and cybersecurity was immediately identified as an area where pushback was long overdue. Cyber conflict is highly likely to persist, not only with Russia but also with China. Cyber operations are a way for states to engage in Great Power struggle while still managing the level of tensions and avoiding a military conflict in the real world. The cyber realm is a realm of anarchy in which states are insecure about their capabilities and are constantly testing opponents’ defenses and their own offensive capabilities. They can also act to undermine each other with plausible deniability in the cyber realm, since multiple state and quasi-state actors and a vast criminal underworld make it difficult to identify culprits with confidence. Revisionist states like China, North Korea, Russia, and Iran have an advantage in asymmetric warfare, including cyber, since it enables them to undermine the US and West without putting their weaker conventional forces in jeopardy. Cybersecurity stocks have corrected but the general up-trend is well established and fully justified (Chart 7). It is not clear, however, that investors should favor cybersecurity stocks over the general NASDAQ index (Chart 8). The trend has been sideways in recent years and is trying to form a bottom. Cybersecurity stocks are volatile, as can be seen compared to tech stocks as a whole, and in both cases the general trend is for rising volatility as the macro backdrop shifts in favor of higher interest rates and inflation expectations (Chart 9). Chart 7Cyber Security Stocks Corrected Cyber Security Stocks Corrected Cyber Security Stocks Corrected Chart 8Major Hacks Failed To Boost Cyber Vs NASDAQ Major Hacks Failed To Boost Cyber Vs NASDAQ Major Hacks Failed To Boost Cyber Vs NASDAQ Chart 9Volatility Of Cyber & Tech Stocks Rising Volatility Of Cyber & Tech Stocks Rising Volatility Of Cyber & Tech Stocks Rising Great Power struggle will not remain limited to the cyber realm. There is a fundamental problem of military insecurity plaguing the world’s major powers. Furthermore the global economic upturn and new energy and industrial innovation race will drive up commodity prices, which will in turn reactivate territorial and maritime disputes. Turf battles will re-escalate in the South and East China Seas, the Persian Gulf and Indian Ocean basin, the Mediterranean, and even the Baltic Sea and Arctic. One way to play this shift is as a geopolitical “back to work” trade – long defense stocks relative to cybersecurity stocks (Chart 10). The global defense sector saw a run-up in demand, capital expenditures, and profits late in the last business cycle. That all came crashing down with the pandemic, which supercharged cybersecurity as a necessary corollary to the swarm of online activity as households hunkered down to avoid the virus and obey government social restrictions. Cybersecurity stocks have higher EV/EBITDA ratios and lower profit margins and return on equity compared to defense stocks or the broad market. Chart 10Long Defense / Short Cyber Security: 'Back To Work' For Geopolitics Long Defense / Short Cyber Security: 'Back To Work' For Geopolitics Long Defense / Short Cyber Security: 'Back To Work' For Geopolitics The trade does not mean cybersecurity stocks will fall in absolute terms – we maintain our bullish case for cybersecurity stocks – but merely that defense stocks will make relative gains as economic normalization continues in the context of Great Power struggle. Bottom Line: Structurally elevated geopolitical risks will continue to drive demand for cybersecurity in absolute terms. However, we would favor global defense stocks on a relative basis. The US Is Not As War-Weary As People Think America is consumed with domestic divisions and distractions. Since 2008 Washington has repeatedly demonstrated an unwillingness to confront foreign rivals over small territorial conquests. This risk aversion has created power vacuums, inviting ambitious regional powers like China, Russia, Iran, and Turkey to act assertively in their immediate neighborhoods. However, the US is not embracing isolationism. Public opinion polling shows Americans are still committed to an active role in global affairs (Chart 11). The 2020 election confirms that verdict. Nor are Americans demanding big cuts in defense spending. Only 31% of Americans think defense spending is “too much” and only 12% think the national defense is stronger than it needs to be (Chart 12). Chart 11No Isolationism Here No Isolationism Here No Isolationism Here True, the Democratic Party is much more inclined to cut defense spending than the Republicans. About 43% of Democrats demand cuts, while 32% are complacent about the current level of spending (compared to 8% and 44% for Republicans). But it is primarily the progressive wing of the party that seeks outright cuts and the progressives are not the ones who took power. Chart 12Americans Against ‘Forever Wars’ But Not Truly Dovish More Reasons To Buy Cybersecurity And Defense Stocks More Reasons To Buy Cybersecurity And Defense Stocks Biden and his cabinet represent the Washington establishment, including the military-industrial complex. Even if Vice President Kamala Harris should become president she would, if anything, need to prove her hawkish credentials. Defense spending cuts might be projected nominally in Biden’s presidential budgets but they will not muster majorities in the two narrowly divided chambers of Congress. Biden has co-opted Trump’s (and Obama’s) message of strategic withdrawal and military drawdown. He is targeting a date of withdrawal from Afghanistan on May 1, notwithstanding the leverage that a military presence there could yield in its priority negotiations with Iran. Yet he is not jeopardizing the American troop presence in Germany and South Korea, much more geopolitically consequential spheres of action in a long competition with Russia and China. While it is true (and widely known) that Americans have turned against “forever wars,” this really means Middle Eastern quagmires like Iraq and Afghanistan and does not mean that the American public or political establishment have truly become anti-war “doves.” The US public recognizes the need to counter China and Russia and Congress will continue appropriating funds for defense as well as for industrial policy. The Biden administration will increase awareness about the risks of a lack of deterrence and alliance-building. This is especially apparent given the military buildup in China. The annual legislative session has revealed an important increase in military focus in Beijing in the context of the US rivalry. Previously, in the thirteenth five-year plan and the nineteenth National Party Congress, the People’s Liberation Army aimed to achieve “informatization and mechanization” reforms by 2020 and total modernization by 2035. However, at the fifth plenum of the central committee in October, the central government introduced a new military goal for the PLA’s 100th anniversary in 2027 – a “military centennial goal” to match with the 2021 centennial of the Communist Party and the 2049 centennial goal of the founding of the People’s Republic. While details about this new military centenary are lacking, the obvious implication is that the Communist Party and PLA are continuing to shift the focus to “fighting and winning wars,” particularly in the context of the need to deter the United States. The official defense budget is supposed to grow 6.8% in 2021, only slightly higher than the 6.6% goal in 2020, but observers have long known that China’s military budget could be as much as twice as high as official statistics indicate. The point is that defense spending is going up, as one would expect, in the context of persistent US-China tensions. Bottom Line: Just as US-China cooperation will be hindered by mutual efforts to reduce supply chain dependency and support domestic demand, so too it will be hindered by mutual efforts to increase defense readiness and capability in the event of military conflict. The beneficiary of continued high levels of US defense spending and Chinese spending increases – in the context of a more general global arms buildup – will be global arms makers. Investment Takeaways Geopolitical risk remains structurally elevated despite the temporary drop in tensions in late 2020 and early 2021. The China-backed Microsoft Exchange hack reinforces the Biden administration’s initial foreign policy comments and actions suggesting that US policy will remain hawkish on China. While Biden will adopt a more defensive rather than offensive strategy relative to Trump, there is no chance that he will return to the status quo ante. The Obama administration itself grew more hawkish on China in 2015-16 in the face of cyber threats and strategic tensions in the South China Sea. Cybersecurity stocks will continue to benefit from secular demand in an era of Great Power competition where nations use cyberattacks as a form of asymmetric warfare and a means of minimizing the risks of conflict. The recent correction in cybersecurity stocks creates a good entry point. We closed our earlier trade in January for a gain of 31% but have remained thematically bullish and recommend going long in absolute terms. We would favor defense over cybersecurity stocks as a geopolitical version of the “back to work” trade in which conventional economic activity revives, including geopolitical competition for territory, resources, and strategic security. Defense stocks are undervalued and relative share prices are unlikely to fall to 2010-era lows given the structural increase in geopolitical risk (Chart 13). Chart 13Global Defense Stocks Oversold Global Defense Stocks Oversold Global Defense Stocks Oversold Chart 14Global Defense Stocks Profitable, Less Indebted Global Defense Stocks Profitable, Less Indebted Global Defense Stocks Profitable, Less Indebted Defense stocks have seen profit margins hold up and are not too heavily burdened by debt relative to the broad market (Chart 14). Defense stocks have a higher return on equity than the average for non-financial corporations and cash flow will improve as a new capex cycle begins in which nations seek to improve their security and gain access to territory and resources (Chart 15). Chart 15Defense Stocks: High RoE, Capex Will Revive Defense Stocks: High RoE, Capex Will Revive Defense Stocks: High RoE, Capex Will Revive Chart 16Discount On Global Defense Stocks Discount On Global Defense Stocks Discount On Global Defense Stocks Valuation metrics show that global defense stocks are trading at a discount (Chart 16).     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table 1 Appendix Table 1Biden Administration's First 100 Days: Key Statements And Actions On China More Reasons To Buy Cybersecurity And Defense Stocks More Reasons To Buy Cybersecurity And Defense Stocks Footnotes 1 See Federal Register, "America’s Supply Chains", Mar. 1, 2021, federalregister.gov and Richard Cowan and Alexandra Alper, "Top U.S. Senate Democrat directs lawmakers to craft bill to counter China", Feb. 23, 2021, reuters.com.

Highlights The US has largely passed a “stress test” of its political system. Rule of law is intact. The US dollar and treasuries may fall further due to cyclical and macro developments but not due to a structural loss of confidence in US governance. The judicial system will become the key check on the Biden administration as it shifts from short-term economic relief to its longer-term agenda, especially on executive orders. The court becomes even more important as a check if the Democrats muster the votes to remove the filibuster. This is possible but not imminent. Packing the court is much harder. Major court cases only sometimes have a major impact on the stock market but key sectors can be given certainty through court verdicts after being disrupted by policy. The US dollar is bouncing on the basis of economic recovery and political stability which poses a near-term risk to cyclical sectors. Feature US government bonds continued to sell off over the past week as the economic recovery gained steam and investors rotated into cyclical equities and commodities. The US Senate passed the $1.9 trillion American Rescue Plan – a massive and likely excessive infusion of fiscal relief – sending it to the House where it will be ratified shortly and passed over to President Joe Biden for signing. Across America shops and restaurants are opening up as immunization to COVID-19 advances and hospitalizations collapse. Meanwhile the Supreme Court announced its first set of rulings under the Biden administration: it dismissed former President Trump’s last challenge to the 2020 election and ruled on other issues such as free speech. The country has tentatively passed a political “stress test.” The rule of law remains intact. On the surface these two trends stand in opposition. US treasuries have been attractive to a savings-rich world not just because of the size of the US economy but also because of the country’s 245-year tradition of good governance – the balance of freedom and stability in its government and financial markets. The share of foreign holdings of US treasuries is declining but the reason is that the Federal Reserve is increasing its share (Chart 1). Foreigners are not liquidating their holdings just yet, although it is a risk given the US’s combination of extremely easy monetary and fiscal policy and populist politics. Chart 1Foreign Holdings Of US Treasuries Foreign Holdings Of US Treasuries Foreign Holdings Of US Treasuries In this report we focus on governance in the wake of the Trump administration and COVID-19 pandemic. Is US governance eroding? If so, how will it impact the markets? How will the courts interact with the Biden administration? Should investors care about the rule of law? With a new business cycle beginning, any assurance of a basic level of US governance allows risk appetite to recover and enables investors to pursue higher-yielding cyclical assets with less inhibition. But it also suggests that US assets will remain safe havens. How Rule Of Law Matters To Investors Rule of law and the independence of the judiciary are critical aspects of good governance that make a market attractive to foreign investors and secure for domestic investors. Nowhere is this clearer than in the breakdown of global reserve currencies. The United States and its developed market allies hold pride of place (Chart 2). Nevertheless the US has lost some of its reserve status to other currencies over two decades of partisanship and repeated crises, from 9/11 through Trump’s trade war. Chart 2Rule Of Law: Bedrock For Reserve Currencies Court Rulings And The Market Court Rulings And The Market Government bond yields exhibit some degree of correlation, inversely, with rule of law: better governance implies lower yields and vice versa. As the global savings glut grew over the past few decades, investors sought to preserve capital in securities perceived to be the safest. This is apparent whether judging by a simple comparison of developed and emerging market bond yields or by the World Bank’s Worldwide Governance Indicators.1 The relationship between governance and bond yields is strongest with emerging markets but it loosely holds among developed markets like the US, as shown in Chart 3. Chart 3Bond Yields Lower Where Laws Rule Court Rulings And The Market Court Rulings And The Market It is the level of governance rather than any change matters, since bond yields have fallen for all developed markets regardless of changes in governance over the past decade. However, governments that take negative steps that harm governance attract fewer foreign purchases of their debt than those that improve governance (Chart 4). This is true of developed and emerging economies. The implication is that demand for US treasuries would have been even greater over the past decade if the US political system had remained stable like Canada’s. Chart 4Improved Rule Of Law Attracts Bond Investors Court Rulings And The Market Court Rulings And The Market Differences in developed economy governance only slightly (if at all) correlate with portfolio or direct investment flows (Charts 5 and 6). This is not surprising as governance does not translate into short-term corporate earnings growth and foreign countries invest directly in developed markets to access technology and consumer markets. By contrast, in emerging markets, better governance goes along with stronger equity demand and foreign direct investment. Chart 5Rule Of Law A Boon For Equity Flows? Court Rulings And The Market Court Rulings And The Market Chart 6Eroding Rule Of Law Discourages Direct Investment Court Rulings And The Market Court Rulings And The Market Still the global phenomenon suggests that an erosion of rule of law can shake up one’s faith in a government’s ability or willingness to make debt payments and its operating environment for private companies. Domestically focused investors have to be concerned about rule of law since its collapse would undermine political stability as well as property rights, the surety of contracts, and the redress of grievances. US Rule Of Law Post-Trump And Post-COVID The US has the world’s longest continuously running constitution and one of the highest standards of living. Other countries with similarly high standards of living have similar constitutions or even adopted theirs from the United States. At the same time US governance has deteriorated in recent years, raising the question of whether bond investors or private entrepreneurs face greater governance risk. The drop in rule of law is apparent in the World Bank’s index (Chart 7A). The turmoil of the 2020 election cycle proves beyond doubt that the US suffers from some serious governance problems. At the same time the independence of the US judiciary is rising in the ranks (Chart 7B). Looking ahead, this trend will likely continue as the judicial system managed to get through the disruptive Trump presidency and the 2020 pandemic and election with minimal damage to its independence. Chart 7AUS Rule Of Law Erosion Will Pause Court Rulings And The Market Court Rulings And The Market Chart 7BUS Judicial Independence Has Improved Court Rulings And The Market Court Rulings And The Market This is a remarkable feat as the underlying problem in the US system – political polarization – threatens to entangle the judiciary as much as any other institution. Today, with polarization subsiding yet still at a historically high level, the court’s integrity and credibility are critical to the overall maintenance of the rule of law (Chart 8). Chart 8US Polarization Set To Fall US Polarization Set To Fall US Polarization Set To Fall Chart 9Trust In Supreme Court Fairly Steady Court Rulings And The Market Court Rulings And The Market Polarization creates gridlock in Congress, which forces other branches of government to fill the vacuum and deliver solutions, thus becoming more controversial. This process has ensnared the high court from time to time as well as the central bank and other institutions.2 Over the past ten years the courts have struggled to minimize the damage from polarization. Confidence in the high court has fallen, but not catastrophically, and most voters feel about the same as ever toward the court (Chart 9). Meanwhile disapproval of Congress is stuck around 80%. The Trump era featured a range of claims about the rule of law in America that can now be assessed with some distance. The Democratic Party was not able to remove President Trump through extra-electoral means, while President Trump was not able to ride roughshod over the courts via executive order. Several of Trump’s initiatives were upheld, such as his immigration ban, while others were shot down, such as his attempt to deport the so-called “Dreamers” or add a question about citizenship on the US census. The 2020 election irregularities were not enough to sway the outcome of the electoral vote while the insurrection at the Capitol stood no chance of overthrowing the system. Supreme Court Justice John Roberts refrained from presiding over Trump’s second impeachment – differentiating it from the impeachment of a sitting president – without intervening to tell the Senate whether it could impeach a previous president. Going forward, however, the courts will act as a check on the Biden administration and therefore new controversies will arise. One of the Trump administration’s lasting legacies was to appoint three justices to the high court, creating a six-to-three conservative ideological leaning on the court. Since the Democrats won control of both the White House and Congress, the Supreme Court becomes a critical check on the administration and will thus attract opposition (Chart 10). Speculation about a conservative ideological takeover of the court has proved overrated, based on the court’s neutrality amid the election. Antagonism will inevitably increase going forward as Biden moves away from COVID relief and economic welfare to his larger legislative agenda. Yet the second reconciliation bill, which features infrastructure and green energy investments, would have to include major surprises to create anything as controversial as the dispute over the individual mandate, which imposed a tax on citizens who did not purchase health insurance.3 In other words, a major clash over legislation is more likely only when the Senate Democratic majority removes the filibuster, the rule that effectively requires 60 votes in the Senate to pass regular legislation. This can happen but it does not appear imminent. Senator Joe Manchin of West Virginia opposes removing it, keeping the Democrats at least one vote shy of repealing it, though he has recently shown some flexibility by suggesting that the Senate return to the good old days when senators had to deliver a filibuster in person (and therefore the procedural hurdle was more burdensome to maintain). Chart 10Balance Of Power In The Three Branches Court Rulings And The Market Court Rulings And The Market Thus the main arena of friction between the Biden administration and the judiciary will boil down to executive action, as with the Trump administration. Not all of this friction will be partisan but certainly ideological leanings will matter in the most important cases. While the number of Trump’s judicial appointments is often exaggerated – President Obama appointed more (Chart 11) – it is still the case that conservatives possess an improved ideological advantage due to the past few decades of appointments (Chart 12). So far Biden has faced pushback on his 100-day deportation moratorium. Chart 11Trump's Judicial Impact Overstated Court Rulings And The Market Court Rulings And The Market Chart 12Federal Courts A Bulwark For Conservatives Court Rulings And The Market Court Rulings And The Market Table 1 highlights the most investment-relevant Supreme Court cases coming due in the current session. The court will determine, among other things, whether Facebook can be treated similar to a telephone company in some respects; whether the federal government or states oversee cases brought against oil and natural and gas companies over climate change; and to what extent tech company acquisitions include patents and copyrights. The use of executive authority to reallocate funds that Congress has appropriated for different reasons, and state exemptions for Medicaid requirements, are also on the docket. Table 1Major Cases Pending At Supreme Court Court Rulings And The Market Court Rulings And The Market In addition we would identify several policy areas that are likely to become relevant to investors due to contemporary political and geopolitical concerns combined with historical precedent: National Security: The Trump administration relied heavily on the Supreme Court’s historic deference to presidents on issues involving national security and foreign policy. This tendency will likely continue, giving President Biden a freer hand in cases where he claims a national security justification, particularly in dealing with export controls vis-à-vis China. The hack into Microsoft’s Exchange email system, allegedly committed by Chinese state-backed hackers, highlights our Geopolitical Strategy view that the Biden administration will not reduce the US-China power struggle. Industrial Policy: The Supreme Court famously rebuked President Harry Truman for trying to seize control of private steel production during the Korean war (Youngstown Sheet & Tube Company v. Sawyer, 1952). Similar cases could emerge in an era in which the president is attempting to assert US government control over critical supply chains in health, tech, and defense. Immigration: The Supreme Court rebuked the Trump administration on the question of the “Dreamers,” undocumented immigrants brought to the US as children, whom the Obama administration refused to deport under an initiative called Deferred Action for Childhood Arrivals (DACA). The court said the Trump administration failed to provide adequate procedural justification for revoking the DACA program. Now the Biden administration’s executive orders loosening immigration and border controls face challenges from lower courts that could ascend the ladder. Also, following from the logic of Trump’s defeat on this issue, it is possible that the Supreme Court could overturn some of Biden’s revocations of Trump’s orders if not adequately justified. Environment: The Biden administration has pledged to phase out the fossil fuel industry over time, yet legislative majorities will be lacking and much of the activity occurs on private land free from direct federal control. The result is that Biden administration will revive regulatory expansions from the Obama era to attempt to raise the cost of carbon emissions. These actions will likely provoke court rulings. Labor: One of the Clinton presidency’s biggest legal controversies, outside the impeachment, centered on executive orders aimed at stopping businesses from hiring replacements for workers who went on strike. The Biden administration explicitly aims to have a muscular policy on labor regulation and to promote union interests and these could run afoul of the courts. Big Tech and free speech: The court has just ruled with an eight-to-one majority in favor of a free speech case on campus. The only reason Chief Justice Roberts dissented was because the case was moot. Future cases may not be moot in an era in which first amendment quarrels are heating up as Big Business, Big Tech, and mainstream media ramp up censorship of disfavored speech. The Supreme Court is likely to enforce first amendment protections robustly which could result in breaking open the digital arena for alternative platforms and services with looser standards. Bottom Line: With Democratic control over the White House and Congress, the judicial branch will become a critical source of limitations on the Biden administration’s policies. While controversial cases could possibly arise from any ambitious proposals in Biden’s second reconciliation bill, the main source of friction will center on executive orders. This is the case at least until the filibuster is removed, which is possible down the road but not imminent. Could Democrats Pack The Court? Finally there is an ongoing concern over the risk of “court packing,” i.e. partisan enlargement of the Supreme Court, under the Biden administration. During the 2020 campaign several leading Democratic Party figures suggested the party could increase the size of the high court so as to reduce the six-to-three conservative leaning. The threat was partly intended to motivate the progressive voting base and deter the Republicans from going forward with the confirmation of Supreme Court Justice Amy Coney Barrett ahead of the election. However, the possibility of court packing remains as long as polarization is extreme and the ruling party has at least 51 votes needed to repeal the filibuster in the Senate. President Biden said he was “not a fan” of court packing but one of his first acts in office was to appoint a commission of experts to study the idea of Supreme Court reform. This can be interpreted as a way of sidelining the question or as a preliminary to packing the court should it become possible later. Packing the court is politically explosive so while Democrats could remove the filibuster if and when they get the votes, they are less likely to succeed at packing the vote due to public opinion (though it cannot be ruled out over the long run). The bar to altering the filibuster is much lower than that to changing the composition of the court. History suggests that it would be a market-relevant episode if court packing were attempted. Franklin Delano Roosevelt attempted to pack the court after it ruled elements of the New Deal unconstitutional, notably a wage hike mandated by the National Industrial Recovery Act (Schechter Poultry Corp. v. United States, 1935). Roosevelt narrowly fell short of expanding the court after the Senate majority leader, a key ally, passed away unexpectedly. The S&P rallied when higher wages were struck down but there are many reasons for these developments – industrial production was rallying at the time, and when industrial production recovered later, and court packing was ruled out, the market remained low. At minimum one cannot say the case was inconsequential to the market (Chart 13). Chart 13FDR Tried To Stack The Courts FDR Tried To Stack The Courts FDR Tried To Stack The Courts In a more recent example of a Supreme Court ruling having a substantial market impact, the court ruled with a narrow five-to-four vote to uphold the legality of most of the Affordable Care Act, or Obamacare, the signature legislative effort of Obama’s presidency (National Federation of Independent Business v. Sebelius, 2012). The market reaction at that time was positive, even in the health care sector, as the result removed uncertainty. Only later, in 2015, when the major provisions of the law took effect, did the sector start to feel the negative effects (Chart 14). It is reasonable to expect that any showdown over a major piece of legislation and the courts would have a similar impact today: the market would struggle with uncertainty but rally on the verdict. Chart 14Supreme Court Ruling On Obamacare Had Market Impact Supreme Court Ruling On Obamacare Had Market Impact Supreme Court Ruling On Obamacare Had Market Impact Otherwise the Supreme Court’s ideological balance will likely be in place for a while. Justice Stephen Breyer, appointed by President Clinton, is 82 years old while Justice Clarence Thomas, appointed by President Bush, is 72 years old. The other justices are all younger than 66, meaning that conservatives would retain a five-to-four advantage even if Biden had the chance to replace both Breyer and Thomas. Bottom Line: As things stand, court packing is out of reach, more so than removing the filibuster, and therefore the current Supreme Court balance will remain an effective check on the Biden administration. Investment Takeaways The judicial system will become the major check on the Biden administration if its second reconciliation bill contains surprisingly ambitious and controversial provisions or if the Democrats ever get the votes to remove the filibuster. Otherwise the court is primarily a check on Biden’s executive orders. Climate policy is a likely area of friction given that the Biden administration will attempt to pioneer new areas of federal involvement in raising the cost of private industry when it comes to carbon emissions. At the same time the court could insist that the digital arena is a common forum where different voices must be heard, which could open the way to competitors to the tech giants. While the energy sector faces policy risks, it is favored by cyclical economic factors and will also benefit from checks and balances. Whereas the tech sector is not cyclically favored and could face some pushback from courts regarding competition (Chart 15). US rule of law is mostly intact. The selloff in the dollar and treasuries is driven by cyclical factors, not a structural loss of confidence in the rule of law or the American legal and political system. The Trump saga did not in itself trigger a collapse of the US dollar or government bonds – what did that was the Federal Reserve’s shift back to ultra-easy policy and the blowout fiscal spending stemming from the COVID-19 crisis. The US dollar is bouncing on the strong outlook for the economy as well as political stabilization. Chart 16 highlights that this is a near-term risk to cyclical sectors. Assuming the dollar resumes its cyclical weakening path it will power the next leg of outperformance for these sectors. Chart 15Courts Could Impact Energy, Tech Courts Could Impact Energy, Tech Courts Could Impact Energy, Tech Chart 16Dollar Bounce A Near-Term Risk To Cyclical Outperformance Dollar Bounce A Near-Term Risk To Cyclical Outperformance Dollar Bounce A Near-Term Risk To Cyclical Outperformance   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com     Appendix Table A1Political Risk Matrix Court Rulings And The Market Court Rulings And The Market Table A2Political Capital Index Court Rulings And The Market Court Rulings And The Market Table A3APolitical Capital: White House And Congress Court Rulings And The Market Court Rulings And The Market Table A3BPolitical Capital: Household And Business Sentiment Court Rulings And The Market Court Rulings And The Market Table A3CPolitical Capital: The Economy And Markets Court Rulings And The Market Court Rulings And The Market Table A4Biden’s Cabinet Position Appointments Court Rulings And The Market Court Rulings And The Market   Footnotes 1     The World Bank uses expert judgment and opinion polls to evaluate rule of law, defined as quality of contract enforcement, property rights, and functioning of the law and justice systems. Biases stem from the policy elite and non-governmental organizations of the western world. For instance, Hong Kong’s high rankings have all too predictably been undercut by Communist China’s power grab there.              2     Polarization escalated after Roe v. Wade and similar rulings that legalized abortion (1973), the Bush v. Gore ruling that decided the 2000 election, the NFIB v. Sebelius ruling that approved the Affordable Care Act (2012), and the Obergefell v. Hodges ruling that legalized gay marriage (2015).   3    The individual mandate is not expected to get shot down by the court this year, though it is conceivable. Even so, Biden’s second reconciliation bill would give the Democrats the chance to respond to any court ruling on health care reform. Biden’s health initiatives of automatic enrollment and government-provided insurance will be challenged but do not seem as controversial as the individual mandate in principle.