Geopolitics

Highlights The Senate will pass the $1.9 trillion American Rescue Plan largely as it stands. Markets will now turn to Biden’s second major reconciliation bill for FY2022 – the one with tax hikes. Democrats will go forward with tax hikes on corporations and the wealthy. But they will spend more than they tax for fear of squandering their term in power. Tax hikes threaten sectors like tech that already face headwinds from rising bond yields. The health sector is also at risk. Stick with cyclicals and value plays.  Feature Markets have seesawed as volatility spikes in the face of rapidly rising bond yields. Value stocks such as financials stand to benefit relative to growth stocks as the market comes to grips with the first hint of normal inflation expectations since 2019 (Chart 1). Underlying the trend is a sea change in US fiscal policy. Chart 1Value Stocks To Reignite On Rising Bond Yields Value Stocks To Reignite On Rising Bond Yields Value Stocks To Reignite On Rising Bond Yields The House of Representatives passed the $1.9 trillion American Rescue Plan so it will now go to the Senate for revision, back to the House for approval, and then to President Biden’s desk by around March 14. Investors will now turn to Biden’s second major legislative act prior to the 2022 midterm election cycle: the fiscal year 2022 budget reconciliation process. Before we outline the time frame and tax hikes that that process will entail, we should take a moment to review the current bill. Senate Will Pass American Rescue Plan Largely As Is The House version of the $1.9 trillion American Rescue Plan contains $1,400 household rebates, direct checks via the Internal Revenue Service, for people who make less than $75,000 per year (double those numbers for married couples). Unemployment benefits are supposed to rise from $300 to $400 per week for 73 weeks instead of 50 weeks, with an expiration on August 29 instead of March 14. Those with children or other dependents will receive additional payments. The bill also includes $75 billion for fighting COVID-19, $350 billion for state and local governments, $170 billion for schools and universities, $225 billion for small business, $38 billion for the airline industry and various other tax benefits for families and workers.1 Those who have been let go from their jobs can more easily retain their previous health insurance. Chart 2 provides a visual comparison of the American Rescue Plan with the $900 billion in fiscal relief passed at the end of 2020 prior to House passage and Senate revision. Already the Senate version excludes a hike to the minimum wage, from $7.25 to $15 per hour, as the Senate parliamentarian ruled that does not qualify under the “Byrd rule” because it does not directly impact spending or taxation.2 Vice President Kamala Harris, who is also president of the Senate, could reverse this decision but otherwise the minimum wage will have to be considered in a separate bill later. Chart 2American Rescue Plan Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The Senate could pare back other aspects of the bill – such as state and local aid, given that local government revenues are in much better shape than expected. Chart 2 highlights that the state and local aid component is much larger this time around. Still, the purpose of Senate negotiations is to secure the votes of moderate Democrats, as winning over 10 Republicans is no longer feasible, and moderate senators are not going to sink the first legislative proposal of a president of their own party. The Senate is virtually guaranteed to pass the bill, likely by March 14 when current unemployment benefits expire. The bill’s economic impact will be to speed the vaccination process and provide another infusion of cash into households and various public institutions. Families are just starting to receive the last round of benefits passed in December and they had not exhausted the 14% year-on-year increase in real income that they saw as a result of last year’s CARES Act when the Coronavirus Response and Relief Act sent incomes soaring yet again (Chart 3). Economic growth will be supercharged as economic activity normalizes, consumer confidence recovers, and the service sector revives. Chart 3Washington Lavishes Households With Dole Washington Lavishes Households With Dole Washington Lavishes Households With Dole Biden’s Second Bill Will Pass This Fall The second budget reconciliation procedure, for fiscal year 2022, will begin in mid-April. The formal deadline to adopt a budget resolution is April 15 but the average delay would put the resolution in June.3 The maximum delay would see the resolution passed in October but that is unlikely in today’s context (Diagram 1). After the resolution passes, the House and Senate must reconcile their budgets, pass the same bill, and send it to the president for his signature.  Diagram 1Timeline Of Biden Administration’s Second Budget Reconciliation, FY2022 Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The average time between Congress adopting a budget resolution and the president signing a reconciliation bill into law is 150 days, putting completion on September 15, 2021. This period could easily extend to November. In the worst-case, judging by history, Democrats could fail to conclude the process until October 2022 – but that is highly unlikely. A delay till December of this year would be a fumble, but a more realistic fumble, say if moderate Democrats must be won over due to controversial provisions. The second reconciliation bill is supposed to consist of investments over a ten-year period rather than emergency relief for the lingering pandemic and economic recovery. Biden’s proposed $2-$3 trillion green infrastructure program is the highlight but we also expect Democrats to prioritize their health care plan, which is estimated to cost $1.7-$1.9 trillion. Hence $4 trillion is a reasonable expectation for new spending but in this case the headline spending figure will be at least partially defrayed by tax hikes, unlike the first reconciliation bill (Charts 4A & 4B). If Biden raises taxes by half as much as he intends, the full price tag would be $2 trillion. Chart 4ABiden Will Spend, Then Tax Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Chart 4BBiden Will Spend, Then Tax Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The precise contours of this bill will remain unknown until Biden presents an outline in April and the House of Representatives drafts a resolution. We test six different scenarios involving different assumptions about Biden’s tax-and-spend proposals, highlighted in Table 1. Generally, we assume that Democrats will much more readily compromise tax hikes rather than spending, given that they want to err on the side of firing up the economic recovery. They are just as capable as Republicans were in 2017 of manipulating the numbers when it comes to the reconciliation requirement that the budget deficit not increase beyond a ten-year time period. Table 1Scenarios For Biden’s Second Reconciliation Bill Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The results are broken down in terms of revenue, expenditure, and net interest costs in Chart 5. The baseline is Biden’s campaign proposal. Scenario 1 assumes that Biden gets all of the spending he wants but is forced to compromise on tax hikes. Scenario 2 is more realistic as it assumes that Biden gets half of what he wants on both spending and taxes. Scenarios 3-6 examine what would happen if Biden were forced to strike out either his green infrastructure plan or his health and social security plan, depending on different revenue assumptions. In Scenarios 5 and 6 we grant Biden only half of his proposed taxes on corporations and wealthy folks, leaving other tax proposals to the side – otherwise the result would be a net tightening of fiscal conditions, which is neither intended nor politically possible. Chart 5Scenarios For Biden’s Second Reconciliation Bill Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The impact on the budget deficit in each scenario is shown in Chart 6. The greatest economic stimulus would occur under Scenario 1, which would soon become a problem for investors as it would hasten inflation and rising interest rates. Chart 6Deficit Scenarios For Biden’s Second Reconciliation Bill Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Scenario 2 is the most realistic policy scenario while being the least inflationary. By contrast, Scenario 4 is realistic but hardly less inflationary than the baseline case. In each of these scenarios it is important to bear in mind that the new government programs would be administered over a ten-year period and therefore the increase to the budget deficit would be more gradual than is the case of the American Rescue Plan, which clearly aims to be disbursed in the first few years. In the case of the Obama administration’s American Recovery and Reinvestment Act (2009) the peak in spending occurred in 2013, four years after the bill was passed (analogous to 2025 today) (Chart 7). Infrastructure and green energy projects are also expected to increase productivity and hence potential growth. Chart 7Infrastructure Spending Could Peak Four Years After Bill’s Passage, As In 2009-13 Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The Byrd rule will become even more important with Biden’s second reconciliation bill because the bill will contain a mishmash of Biden’s campaign proposals. Democrats will try to pass as much of their agenda via fast track as possible so as to meet promises ahead of the 2022 midterm election. An advantage of health care spending is that it is unlikely to be struck down by the Senate parliamentarian given that the Obama administration relied on reconciliation to pass a critical second installment to the Affordable Care Act (Obamacare). Biden’s health care plan is more popular than climate change policy, with both the general public and moderate Democrats, and it is guaranteed to pass reconciliation. Infrastructure spending faces greater challenges under reconciliation but they are not insurmountable. Infrastructure is normally handled via the traditional budget process or the Highway Trust Fund and some measures are likely to run afoul of the Byrd rule. Still, workarounds can be found.4  Hence the infrastructure plan is likely to be compromised but not prohibited due to technicalities. Even if infrastructure fails to make it into reconciliation, Biden can use the deadline to top up the exhausted Highway Trust Fund or to reauthorize the Surface Transportation Act as alternative pathways. It is not impossible to get Republican cooperation on infrastructure though the green agenda will meet resistance. The reconciliation process is nominally forbidden from increasing the budget deficit beyond ten years. Short-term spending is exempt, as is the case with the American Rescue Plan and its crisis-response measures, but the purpose of the second reconciliation bill is to invest in long-term, productivity-enhancing programs. A new government health insurance option and/or a green infrastructure buildout will take many years to implement and could increase deficits beyond the ten-year window. But Democrats, like Republicans, will be able to use accounting chicanery and gimmicks to make the budget outlook serve their purposes in passing the legislation. As long as they keep moderate members of the party on their side.   Yes, Taxes Will Go Up … But That May Not Be All Bad For Markets Why should Democrats raise taxes at all? Why not focus on stimulus without taking on the political risk of higher taxes? After all, Republicans passed tax cuts via reconciliation without offsetting them by spending cuts. Was it not the higher taxes in Obamacare that greatly fueled resistance from Republicans and their victory in the House of Representatives in 2010? First, on the level of intentions, the Democrats clearly seek to increase taxes on corporations, high-income earners, and capital gains: Both Biden and Harris said they would raise taxes on the campaign trail and in the presidential debates despite the risk to their election prospects. Biden committed only to prevent tax hikes on those making less than $400,000 per year. Harris’s weakest moment in her debate with Mike Pence was her insistence that she would raise taxes but she stuck to her guns. Both factions of the Democratic Party want to raise taxes. Traditional Democrats view tax hikes as a way of paying for a larger government role in addressing social and economic imbalances. Populists view tax hikes as a way of redistributing from the ultra-rich. While budget deficits are not a general concern, combating inequality is a theme shared across the party. Second, on the level of capability, Democrats can get at least some of the tax increases that they want: The US is not overtaxed on the whole. True, Biden’s full tax agenda would push the US back up to the top of the OECD countries in terms of the corporate tax if an “integrated” view of both firm-level taxes and taxes on dividends and capital gains (Chart 8). But this point suggests that Biden will moderate his tax plan rather than abandon it altogether. Popular opinion did not favor Trump for cutting corporate taxes. Chart 8Biden’s Corporate Tax Proposal Would Make US An Outlier Again Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The macroeconomic impact of raising taxes is manageable in the context of the extraordinary fiscal stimulus that the US is passing. There is no clear relationship between tax rates and economic growth but it is natural for the Democrats to fear that they could squander their term in power by excessive fiscal tightening. Yet the negative economic impact of raising the corporate rate is only 0.8% of GDP over the long run, and half of that if the corporate rate is raised only halfway to what Biden intends (25% instead of 28%) (Table 2), according to the conservative-leaning Tax Policy Foundation. Table 2Economic Impact Of Corporate Tax Not Dramatic Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout President Biden has the political capital early in his term to revise the Trump tax cuts according to Democratic prerogatives. His popularity will not hold up for long (Chart 9). And he only just has enough legislative power. While household sentiment is weak and economic conditions are moderate, both are set to improve as the pandemic fades and fiscal stimulus takes effect (Table 3). While tax hikes will embolden Republican opposition and the Democrats will have lost their chance to affect the tax code if Republicans win in 2022. At the moment, Republicans are divided and unpopular, so Democrats have a window of opportunity (Chart 10). Chart 9Thesis, Antithesis, Synthesis? Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Chart 10Independents Up, Republicans Down Independents Up, Republicans Down Independents Up, Republicans Down Table 3Political Capital Index Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout While Democrats could chuck all the Senate rules out the window in order to pass their spending plans without any offsets, this would anger moderates who tend to uphold Senate rules and norms. The party cannot afford to lose a single vote from their caucus in the Senate. Yet moderate Democrats are not against tax increases in principle. What they would oppose is either excessive tax hikes or a fiscal spending bonanza without any revenue offsets at all.5  It is entirely feasible to back-load tax increases so that they take effect in the latter half of the ten-year budget window, especially after the 2024 election. Treasury Secretary Janet Yellen is advising precisely this course of action and has herself argued that corporate tax hikes will go through.6 There may be some risk that Democrats go full left-wing populist and abandon any semblance of fiscal responsibility so as to supercharge the economy. So far they have agreed to maintain the Senate filibuster and scrap the minimum wage hike but this acceptance of Senate norms may not last as pressure builds. The second reconciliation bill is the last chance to fast-track major initiatives before the midterm. Vice President Harris could overrule the Senate parliamentarian across the board. This scenario is unlikely. The White House and Congress will find a balance that raises some revenue but errs on the fiscally accommodative side, as our scenarios above highlight. Investment Takeaways The market’s concern is that the Democrats will “overdo” the fiscal response and we fully share this concern. The American Rescue Plan alone will plug the output gap by almost three times more than the amount required. The coming tax hikes will not offset the wave of new spending that is coming down the pike. Democrats will partially reverse Trump’s tax cuts in the context of additional pump-priming that constitutes a net increase to the budget deficit. The net effect is inflationary.   If Congress were to pass another $2 trillion bill without any substantial revenue offsets then the market would face an even bigger inflationary jolt and an even earlier return to rate hikes by the Fed. But this scenario is unlikely. So the inflationary risk is clear but investors need not panic in the short run.  Our infrastructure trade is back on track as the reflation trade rumbles onward (Chart 11). The Democrats will get at least one more major bill passed and it will likely include at least half of Biden’s agenda, including around $2 trillion on green infrastructure. We will discuss the renewable energy portion at length in a forthcoming report. The health care sector faces headwinds from both Biden’s health policies and corporate tax hikes. The sectors that stand to benefit the most from a higher corporate tax rate are those that benefited least from Trump’s Tax Cut and Jobs Act – namely energy, industrials, materials, and financials, in that order (Chart 12A). These are also the cyclical plays that we favor in today’s accommodative policy environment. Chart 11Infrastructure Trade Back On Track Infrastructure Trade Back On Track Infrastructure Trade Back On Track   Chart 12ACyclicals Outperforming Health Care Cyclicals Outperforming Health Care Cyclicals Outperforming Health Care Chart 12BCyclicals To Outperform Tech? Cyclicals To Outperform Tech? Cyclicals To Outperform Tech? The same cyclical sectors are also trying to make headway against the tech sector, which stands to suffer from higher interest rates as well as higher taxes, including a minimum tax on book earnings, if that part of Biden’s agenda makes it through the negotiations this fall (Chart 12B).   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Table A1BPolitical Capital: Household And Business Sentiment Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Table A1CPolitical Capital: The Economy And Markets Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Table A2Political Risk Matrix Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Table A3Biden’s Cabinet Position Appointments Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Footnotes 1See Jeff Drew, “House passes $1.9 trillion stimulus bill with a variety of small business relief,” and Alistair M. Nevius, “Tax provisions in the American Rescue Plan Act,” February 27, 2021, Journal of Accountancy, journalofaccountancy.com.     2See “The Budget Reconciliation Process: The Senate’s ‘Byrd Rule,’” Congressional Research Service, December 1, 2020, fas.org.            3The current delay centers on whether the Senate will confirm Biden’s appointee for director of the Office of Management and Budget, Neera Tanden, who lost support from key moderate Democrat Joe Manchin. If she does not receive a compensatory Republican vote then Biden will have to appoint someone else and the Senate will have to confirm. Thus the budget resolution could easily be delayed into May or June.       4For the difficulties, see Peter Cohn, “Democrats plan a spending blowout, but hurdles remain,” Roll Call, January 11, 2021, rollcall.com. For workarounds, see Zach Moller and Gabe Horwitz, “Reconciliation: How It Works and How to Use It to Help American Workers Recover,” Third Way, February 1, 2021, thirdway.org. 5See Alexander Bolton, “Democrats hesitant to raise taxes amid pandemic,” The Hill, February 25, 2021, thehill.com. 6See Saleha Mohsin and Christopher Condon, “Yellen Favors Higher Company Tax, Signals Capital Gains Worth a Look”, Bloomberg, February 22, 2021, Bloomberg.com  

Highlights The Biden administration will not attempt a major diplomatic “reset” with Russia. The era of engagement is over. Russia faces rising domestic political risk and rising geopolitical risk at the same time. A war in the Baltics is possible but unlikely. Putin has benefited from taking calculated risks and wants to keep the US and Europe divided. The Russian economy is weighed down by structural flaws as well as tight policy. Investors focused on absolute returns should sell Russian assets. For EM-dedicated investors, our Emerging Markets Strategy recommends a neutral allocation to Russian stocks and local currency bonds and an overweight allocation to US dollar-denominated sovereign and corporate debt. Feature “We will not hesitate to raise the cost on Russia.” – US President Joseph R. Biden, State Department, February 4, 2021 The Biden presidency will differ from its predecessors in that there will not be a major attempt to engage Russia at the outset. Previous US presidents sought to reach out to their Russian counterparts to create room for maneuver. This was true of Presidents Reagan, Clinton, Bush, Obama, and Trump. Even Biden has shown a semblance of reengagement by extending an arms reduction pact. But investors should not be misled. The United States and the Democratic Party have shifted their approach to Russia since the failure of the diplomatic “reset” that occurred in 2009-11 and Washington will take a fundamentally more hawkish approach. Russia is not Biden’s top foreign policy focus – that would be Iran and China. But as with China, engagement has given way to Great Power struggle and hence there will not be a grace period before geopolitical tensions re-escalate. Tensions will keep the risk premium elevated for Russia’s currency and assets. The same is true of emerging European markets that get caught up in any US-Russia conflicts. Putin, Biden, And Grand Strategy Understanding US-Russia relations in 2021 requires a brief outline of both the permanent and temporary strategies of the United States and Russia. Russia’s grand strategy over the centuries has focused on establishing a dominant central government, controlling as large of a frontier as possible, and maintaining a high degree of technological sophistication. The nightmare of the Russian elite consists of foreign powers manipulating and weaponizing the country’s extremely diverse peoples and territories against it, reducing the world’s largest nation-state to its historical origin as a geographically indefensible and technologically backward principality. Chart 1Russia's Revival In Perspective Russia's Revival In Perspective Russia's Revival In Perspective Russia can endure long stretches of austerity in order to undermine and outlast rival states in this effort to achieve defensible borders. Russia’s strategy since the rise of President Vladimir Putin has focused on rebuilding the state and military after the collapse of the Soviet Union so as to restore internal security and re-establish political dominance in the former Soviet space (Chart 1). Partial invasions of Georgia and Ukraine and a military buildup along the border with the Baltic states show Russia’s commitment to prevent American or US-allied control of strategic buffer spaces. Expansion of the North Atlantic Treaty Organization (NATO) and the European Union poses an enduring threat to Putin’s strategy. Putin has countered through conventional and nuclear deterrence as well as the use of “hybrid warfare,” trade embargoes, cyberattacks, and disinformation. To preempt challengers within the former Soviet space Russia also maintains a “veto” over geopolitical developments outside that space, as with nuclear proliferation (Iran), civil wars (Syria, Libya), or resource production (OPEC 2.0). The evident flaw in Putin’s strategy is the decay of the economy, the long depreciation of the ruble, and the drop in quality of life and labor force growth. See the macro sections below for a full discussion of these negative trends. Compare the American strategy: America’s grand strategy is to control North America, dominate the oceans, prevent the rise of regional empires, and maintain the leading position in technology and talent. A nightmare for American policymakers would be a collapse of the federal union among the disparate regions and the rise of a secure foreign empire that could supplant the US’s naval preponderance. This is especially true if the rival empire were capable of supplanting US supremacy in technology, since then the US would not even be safe within North America. America’s strategy under the Biden administration is to mitigate internal political divisions through economic growth, maintain its global posture by refurbishing alliances, and reassert its technological primacy by encouraging immigration and trade. The status quo of strong growth and rising polarization has been beneficial for US technology but not for foreign and defense policy (Chart 2). Political polarization has prevented the US from executing a steady long-term strategy for over 30 years. As a result, Russia has partially rebuilt the Soviet sphere of influence and China is constructing a sphere of its own. A few conclusions can be drawn from the above. First, China poses a greater challenge to the US than Russia from a strategic point of view. China is capable of creating a regional empire that can one day challenge the US for technological leadership. Modern Russia must summon all its strength to carve out small pieces of its former empire – it is not a contender for supremacy in technology or in any regions other than its own. Second, however, Russia’s resurgence under Putin poses a secondary challenge to American grand strategy. Russia can undermine US strategy very effectively. The effect today is to aid the rise of China, on which Russia’s economy increasingly depends (Chart 3). Chart 2US Tech Boom Coincided With Disinflation, Polarization US Tech Boom Coincided With Disinflation, Polarization US Tech Boom Coincided With Disinflation, Polarization Chart 3Russia’s Turn To The Far East Biden And Russia: No Diplomatic "Reset" This Time Biden And Russia: No Diplomatic "Reset" This Time Unlike the US, Russian leadership has not changed over the past year – and Vladimir Putin’s tactics are likely to be consistent. These were underscored by the constitutional revisions approved by popular vote in September 2020. Not only will Putin be eligible to remain president till 2036 but also Russia reaffirmed its willingness to intervene militarily into neighboring regions by asserting its right to defend Russian-speaking peoples everywhere. Finally, Russia ensured there would be no giving away of territories, thus ruling out a solution on Ukraine over Crimea.1 Bottom Line: The US-Russia conflict will continue under the Biden administration, even though Biden’s primary concern will be China. Biden’s Foreign Policy Intentions It is too soon to draw conclusions about Biden’s foreign policy “doctrine” as he has not yet faced any major challenges or taken any major actions. Biden’s first two foreign policy speeches and interim national security strategy guidance establish his foreign policy intentions, which will have to be measured against his administration’s capabilities.2 His chief intentions are to revive the economy and court US allies: First, Biden asserts that every foreign action will be taken with US working families in mind, co-opting Trump’s populism and emphasizing that US international strength rests on internal unity which flows from a strong economy. This goal will largely be met as the administration is already passing a major economic stimulus and is likely to pass a second bill with long-term investments by October. The impact on Russia is mixed but the Biden administration is largely correct that a strong recovery in the US economy and reduction in political polarization will be a major asset in its dealings with Russia and other rivals. Second, Biden asserts that diplomacy will be the essence of his foreign policy. He aims to create or rebuild an alliance of democracies that spans from the UK and European Union to the East Asian democracies. The two goals of economy and diplomacy are connected because Biden envisions the democracies working together to make “historic investments” in technology, setting global standards and rules of trade, and defending against hacking and intellectual property theft. This goal will have mixed success: the EU and US will manage their own trade tensions reasonably well but they will disagree on how to handle Russia and especially China. Biden explicitly sets up this alliance of democracies against autocracies. He calls China the US’s “most serious competitor” but also highlights Russia: “The challenges with Russia may be different than the ones with China, but they’re just as real.”3 Table 1 shows the Biden administration’s notable comments and actions on Russia so far. What is clear is that the US will not seek an extensive new diplomatic engagement with Russia.4 The failure of the Obama administration’s “diplomatic reset” with Russia has disabused the Democratic Party of the notion that strategic patience and outreach are the right approaches to Putin’s regime. The reset and its failure are described in detail in Box 1. Table 1Biden Administration's First 100 Days: Key Statements And Actions On Russia Biden And Russia: No Diplomatic "Reset" This Time Biden And Russia: No Diplomatic "Reset" This Time Box 1: What Was The US-Russia Diplomatic Reset? What Comes Next? Most American presidents open their foreign policy with overtures to Russia to create space to maneuver, given that Russia is capable of undermining US aims in so many areas. The Barack Obama administration made a notable effort at this in 2009, which was dubbed the “diplomatic reset.” It was a rest because relations had collapsed over Russia’s use of natural gas pipelines as a weapon against Ukraine and especially its invasion of Georgia in 2008. Then Vice President Joe Biden led the reset. President Putin had stepped aside in accordance with constitutional term limits, putting his protégé Dmitri Medvedev in the presidential seat, which supported the reset because Medvedev had at least some desire to reform Russia’s economy. The reset lasted long enough for Washington and Moscow to agree on the need for a strategic settlement on the question of Iran – which would culminate in the 2015 nuclear deal – as well as to admit Russia to the World Trade Organization (WTO). But the aftermath of the financial crisis proved an inauspicious time for a reset. Along with the Arab Spring, popular unrest emerged in Moscow in 2011 and western influence crept into Ukraine – all of it allegedly fomented by Washington. Putin feared he would lose central control at home and frontier control abroad. He also sensed an opportunity given that commodity prices were filling state coffers while the US was focused on domestic policy, increasingly polarized, and unwilling to make the sacrifices necessary to solidify its influence in eastern Europe. Russia’s betrayal of the reset resulted in a string of losses for the US and its European allies: the Edward Snowden affair, the invasion of Ukraine, the intervention in Syria, the meddling in the 2016 US election, and most recently the SolarWinds hack. The Obama administration refrained from a strong reaction over Crimea partly to seal the Iran deal. But Russia pressed its advantage after that. It is doubtful that Russia’s influence decided the 2016 election but, regardless, the Democratic Party fell from power and then watched in dismay as the Trump administration revoked the Iran deal. Now that the Democrats are back in power they will seek to retaliate not only for the SolarWinds hack but also for the betrayal of the reset. However, retaliation will come at a time of Washington’s choosing. Bottom Line: The Biden administration’s foreign policy will emphasize alliances of democracies in opposition to autocracies like Russia and China. Biden is planning a more hawkish approach to Russia than previous recent administrations. Biden’s Foreign Policy Capabilities There are a few clear limitations on Biden’s foreign policy goals. First, his administration will largely be focused on domestic priorities. In foreign affairs there is at best the chance to salvage the Obama administration’s foreign policy legacy. Second, Biden’s dealings with China will take up most of his time and energy. China’s fourteenth five-year plan contains a state-driven technological Great Leap Forward that will frustrate any attempt by Biden to reduce tensions. Biden will not be able to devote much attention to Russia if he pursues China with the attention it deserves, i.e. to secure US interests yet avoid a war.5 Third, Biden will be limited by allied risk aversion and the need for consensus on difficult decisions. If his diplomacy with Europe is successful then China and Russia will face steeper costs for any provocative actions. If it fails then European risk aversion will prevail, the allies will remain divided, and China and Russia will faces few costs for maintaining current policies. Table 2Russia’s Pipeline Export Capacity Biden And Russia: No Diplomatic "Reset" This Time Biden And Russia: No Diplomatic "Reset" This Time The Nordstream Two pipeline will be a key test of European willingness to follow the US’s lead even if it means taking on greater risks: Nordstream Two is a major expansion of Russian-EU energy cooperation but contrary to America’s national interest. German Chancellor Angela Merkel still backs the project despite Russia’s poisoning and imprisonment of dissident Alexei Navalny and forceful suppression of protests. However, Merkel is a lame duck and there is some evidence that German commitment to the project is fraying.6 Biden has not tried to halt the pipeline project, but he still could. There are only 100 miles left to the pipeline. Construction resumed in January after a hiatus last year due to US sanctions. The project will take five months to complete at the rate of 0.6 miles per day. The Biden administration still has time to halt the project through sanctions. If it does, the Russians will react harshly to this significant loss of economic and strategic influence over Europe (Table 2). Biden will have a crisis on his hands in Europe. If Biden does nothing on Nordstream, then Russia will conclude that his administration is not serious and take actions that undermine the Biden administration in accordance with Putin’s established strategy. This would prompt Biden to act on his pledge to stand up to Putin’s provocations. Whereas if Biden imposes sanctions to halt Nordstream, Russia will retaliate. Elsewhere it is possible that Biden will be too confrontational with Russia for Europe’s liking. Biden plans to increase support for Ukraine, which will prompt an increase in military conflict this spring.7 The US will promote democracy across eastern Europe, including Belarus, and it is possible that Russia could overreact to this threat of turning peripheral regimes against Russia. The EU is on the front lines in the conflict with Russia and will not want the US to act aggressively – but the US is specifically seeking to “raise the cost” on Russia for its aggression.8 Bottom Line: Russia is not Biden’s priority. But his pledge both to promote democracy and retaliate against Russian provocations sets the US up for a period of higher tensions. US-Russia Engagement On Iran? Will the US not need to engage Russia to achieve various policy goals? Specifically, while highlighting competition, Biden says he will engage Russia and China on global challenges, namely the pandemic, climate change, cybersecurity, and nuclear proliferation. Nuclear proliferation is the only one of these areas where US-Russia cooperation might matter. After all, there is zero chance of cybersecurity cooperation. Whereas on nuclear issues, the US and Russia immediately extended the New START arms reduction treaty through 2026 and could also work together on Iran. Biden is determined to restore the Obama administration’s 2015 nuclear deal. Moscow does not have an interest in a nuclear-armed Iran so there is some overlap of interest. The Iranian issue will require Biden to consider whether he is willing to make major concessions to Russia: Compromise the hard line on Russia: A new Iranian administration takes office in August. Biden is likely to have to rush a return to the 2015 nuclear deal before that time if he wants a deal with Iran. Otherwise it would take years for Biden and the Europeans to reconstitute the P5+1 coalition with Russia and China and negotiate an entirely new deal. Biden would have to make major concessions to Russia and China. His stand against autocracy would be compromised from the get-go. Maintain the hard line on Russia: The alternative is for Biden to rejoin the 2015 nuclear deal with a flick of his wrist, with Iranian President Hassan Rouhani signing off by August. Biden would extract promises from the Iranians to keep talking about a broader deal in future. In this case Biden would not need to give the Russians or Chinese any new concessions. Chart 4China Enforces Iran Sanctions China Enforces Iran Sanctions China Enforces Iran Sanctions The Biden administration will be keen to make sure that Russia does not exploit the US eagerness for a deal with Iran as it did with the original deal in 2014-15. Iran has an individual interest in restoring the deal, which is to gain sanction relief and avoid air strikes. The Europeans have helped Iran keep the deal alive. China is at least officially enforcing sanctions (Chart 4). Russia is also urging a return to the deal and would be isolated if it tried to sabotage the deal. This could happen but it would escalate the conflict between the US and Russia. Otherwise, if a deal is agreed, the US will continue putting pressure on Russia in other areas. Bottom Line: The Biden administration is likely to seal an Iranian nuclear deal without any major concessions to Russia. Tail Risk – A War In The Baltics? It is well established that the Putin regime will use belligerent foreign adventures to distract from domestic woes. Just look at poor opinion polling tends to precede major foreign invasions (Chart 5). With the eruption of social unrest in the wake of COVID-19 and the imprisonment of opposition leader Alexei Navalny, it is entirely possible that Russia will activate this tool again. The implication is a new crisis in Ukraine, a larger Russian military presence in Belarus, or further escalation of hybrid warfare or cyberwar in other areas. What about an invasion of the Baltic states of Latvia, Lithuania, and Estonia? Unlike other hotspots in Russia's periphery this is a perennial "black swan" risk that would equate with a geopolitical earthquake in Europe. A Baltic war is conceivable based on Russia’s geographic proximity, military superiority, and military buildup on the border and in the Kaliningrad exclave. The combined military spending of NATO dwarfs that of Russia but NATO is extremely vulnerable in this far eastern flank (Chart 6). However, Europe would cutoff Russia’s economy and join the US in countermeasures while Russia would be left to occupy hostile countries.9 Chart 5Putin Lashes Out When Popularity Falls Putin Lashes Out When Popularity Falls Putin Lashes Out When Popularity Falls The Baltic states are members of NATO and thus an attack on one is theoretically an attack on all. President Trump ultimately endorsed Article V of the NATO treaty on collective self-defense and President Biden has enthusiastically reaffirmed it. The guarantee is meaningless without greater military support to enforce it, so NATO could try to reinforce its forward presence there. This could provoke Russia to retaliate, likely with measures short of full-scale war. Chart 6Russia Would Be Desperate To Invade Baltics Biden And Russia: No Diplomatic "Reset" This Time Biden And Russia: No Diplomatic "Reset" This Time Since the wars in Iraq and Afghanistan, US rivals have observed that the American public lacks the willingness to fight small wars. It responded weakly to Russia’s invasion of Crimea and China’s encroachments in the South China Sea and Hong Kong. However, foreign rivals do not know whether the unpredictable US leadership and public are willing to fight a major war. Hence Russia and China are likely to continue to focus on incremental gains and calculated risks rather than frontal challenges. Based on the Biden administration’s moderate political capital (very narrow electoral and legislative control), the US will continue to be divided and distracted. Russia, China, and other powers will test the administration and make an assessment before they attempt any major foreign adventures. The testing period is imminent, however, and thus holds out negative surprises for investors. It is also possible that Biden could make the first move – particularly on Russia, where retaliation for the 2020 SolarWinds hack should be expected. Bottom Line: A full-scale war in the Baltics is possible but unlikely as the Russians have succeeded through calculated risks whereas they face drastic limitations in a major war against the NATO alliance. Growth Weighed Down By Tight Policy We now turn to Russia’s domestic economic conditions. Here, Russia also faces major challenges. Authorities are determined to keep a tight lid on both monetary and fiscal policies. In particular, high domestic borrowing costs and negative fiscal thrust will weigh down domestic demand over the next six-to-12 months. There are three reasons authorities will maintain tight monetary and fiscal policies: First, concerns about high inflation are deeply entrenched among consumers, enterprises, and policymakers. Russian consumers and businesses tend to have higher-than-realized inflation expectations. This is due to the history of high inflation as well as stagflation in Russia. A recent consumer poll reveals that rising prices are the number one concern among households (Table 3). Remarkably, the poll was conducted in August amid the height of the pandemic and high unemployment. This suggests that households do not associate growth slumps with lower inflation but rather fear inflation even amid a major recession (i.e., worry about stagflation). Table 3Fear Of Inflation Prevalent Amongst Consumers’ Expectations Biden And Russia: No Diplomatic "Reset" This Time Biden And Russia: No Diplomatic "Reset" This Time Second, Central Bank of Russia Governor Elvira Nabiullina is one of the most hawkish central bankers in the world. Her early tenure was characterized by the 2014-15 currency crisis and a major inflation spike. To combat structural inflation and bring down persisting high inflation expectations, the central bank has adopted a very hawkish policy stance since 2014. There is no sign that the central bank is about to change its hawkish policy. Specifically, monetary authorities have been syphoning liquidity from the banking system. With relatively tight banking system liquidity and high borrowing costs, private credit growth will fail to accelerate from current levels. Third, the government still projects an austere budget for 2021. The fiscal thrust will be -1.7% of GDP this year (Chart 7). While a moderate spending increase is likely, it will not be sufficient to boost materially domestic demand. There are no signs yet that the fiscal rule10 will be further relaxed, potentially releasing more funds for the government to spend this year. The fiscal rule has become an important gauge of the country’s ability to weather swings in energy prices. In addition to the points listed above, policymakers’ inflation worries stem from the economy’s structural drawbacks: Despite substantial nominal currency depreciation in recent years, Russia runs a current account deficit excluding energy. When a country runs a chronic current account deficit, including periods of major domestic demand recessions and currency devaluations, it is a symptom of a lack of productivity gains. Real incomes grew at a quick pace from the mid-1990s, largely driven by the resource boom in the 2000s. Yet rising real incomes were not complemented by expanding domestic manufacturing capacity to produce consumer and industrial goods. As such, imports of consumer goods and services rose alongside real incomes. Russia has been underinvesting. Gross fixed capital formation excluding resources industries and residential construction has never surpassed 10% of GDP in either nominal or real terms (Chart 8). Chart 7Russia: Fiscal Policy Will Remain Austere In 2021 Russia: Fiscal Policy Will Remain Austere In 2021 Russia: Fiscal Policy Will Remain Austere In 2021 Chart 8Russia: Underinvestment Within Domestic Sectors Russia: Underinvestment Within Domestic Sectors Russia: Underinvestment Within Domestic Sectors Geopolitical tensions with the West have discouraged FDI inflows and hindered Russian companies’ ability to raise capital externally. This has inhibited capital spending and ”know-how” transfer and, hence, bodes ill for productivity gains. Russian domestic industries are highly concentrated and, in some cases, oligopolistic in nature. This allows incumbents to raise prices. The number of registered private enterprises has fallen below early 2000s levels (Chart 9). Despite chronic currency depreciation, Russian resource companies have failed to grab a large share of their respective export markets. For instance, Russia’s oil market share of total global oil production has been flat for over a decade and the nation has been losing market share in the global natural gas industry. A shrinking labor force due to poor demographics and meager immigration complements Russia’s sluggish productivity growth and caps its potential GDP growth (Chart 10). Chart 9Russia: Increasing Industry Concentration Russia: Increasing Industry Concentration Russia: Increasing Industry Concentration Some positive signs are appearing in the form of import substitution. Since the Ukraine conflict in 2014 and the resulting Western sanctions, the government has enacted various laws and decrees to incentivize domestic production, and with it providing substitutions for imported goods. Their impact is noticeable in certain sectors. Chart 10Russia: Poor Potential Growth Outlook Russia: Poor Potential Growth Outlook Russia: Poor Potential Growth Outlook In particular, the country has invested heavily in the food industry, as food imports are 16% of overall imports. Agricultural sector output has been rising while imports of key food categories have declined. Recent decrees on industrial goods will likely boost domestic production of some goods and processed resources. Around 40% of Russian imports are concentrated in machinery, industrial equipment, transportation parts, and vehicles. Hence, raising competitiveness in production of industrial goods is essential for Russia to reduce reliance on imports. In short, fewer imports of goods for domestic consumption will make inflation less sensitive to fluctuations in the exchange rate. The current trend is mildly positive, but its pace remains slow. Bottom Line: Russia needs to raise its productivity and labor force growth and, hence, potential GDP growth to deliver reasonable high-income growth without raising inflation. The Cyclical OutLook: Worry About Growth, Not Inflation Cyclically, high domestic borrowing costs and lackluster fiscal spending will weigh down domestic growth and cap inflation for the next 12 months. Russia’s real borrowing costs are among the highest in the EM space. High borrowing costs are causing notable financial stress amongst corporate and household debtors. Commercial banks’ NPLs and provisions are high and rising (Chart 11). Unwilling to take on more credit risk, banks have shunned traditional lending and have instead expanded their assets into financial securities. This trend will likely persist and corporate and consumer credit will fail to boost investment and consumption. The recent pickup in inflation was primarily due to rising food prices and the previous currency depreciation pass-through. Chart 12 illustrates the recent currency appreciation heralds a rollover in core inflation. Chart 11Russia: High Borrowing Costs Are Leading To Higher Credit Stress Russia: High Borrowing Costs Are Leading To Higher Credit Stress Russia: High Borrowing Costs Are Leading To Higher Credit Stress Chart 12Russia: Inflation Will Rollover Due To Stable RUB Russia: Inflation Will Rollover Due To Stable RUB Russia: Inflation Will Rollover Due To Stable RUB In fact, a broad range of inflation indicators suggest that core inflation remains within the central bank target (Chart 13). These measures of inflation are less correlated with the ruble movements. Chart 13Russia: Inflation Is At Central Bank Target Of 4% Russia: Inflation Is At Central Bank Target Of 4% Russia: Inflation Is At Central Bank Target Of 4% Chart 14Russia: Tame Recovery In Domestic Activity Russia: Tame Recovery In Domestic Activity Russia: Tame Recovery In Domestic Activity High-frequency data suggest that consumer spending and business activity remain tame (Chart 14). Bottom Line: The latest uptick in Russia’s core CPI is likely transitory. Cyclical conditions for a material rise in inflation and hence monetary tightening are not in place. Investment Takeaways Chart 15Russia Underperforms Amid Commodity Bull Run Russia Underperforms Amid Commodity Bull Run Russia Underperforms Amid Commodity Bull Run Russia’s sluggish economy and austere policy backdrop suggest that the fires of domestic political unrest will continue to burn. While political instability may force the Kremlin to ease fiscal policy, the easing so far envisioned is slight. The implication is that Russia faces rising domestic political risk simultaneously with the rise in international, geopolitical risk stemming from the Biden administration’s efforts to promote democracy in Russia’s periphery and push back against its regional and global attempts to undermine the US-led global order. So far the totality of Russia’s risks have outweighed the benefits of the global economic recovery as Russian assets are trailing the rally in commodity prices (Chart 15). The ruble is above the lows reached at the height of the Ukraine crisis, whether compared to the GBP or the EUR, suggesting further downside when US-Russia tensions spike (Chart 16). The currency is neither cheap nor expensive at present (Chart 17). Chart 16Ruble Will Fall Further On Geopolitical Risk But Floor Not Far Ruble Will Fall Further On Geopolitical Risk But Floor Not Far Ruble Will Fall Further On Geopolitical Risk But Floor Not Far Chart 17Russia: The Ruble Is Fairly Valued Russia: The Ruble Is Fairly Valued Russia: The Ruble Is Fairly Valued   Chart 18Geopolitical Risk Will Revive Despite Apparent Top Geopolitical Risk Will Revive Despite Apparent Top Geopolitical Risk Will Revive Despite Apparent Top Our Geopolitical Risk Indicator for Russia is forming a bottom, implying that global investors believe the worst has passed. This is a mistake and we expect the indicator to change course and price in new risk. The result will weigh on Russian equities, which are fairly well correlated with this indicator (Chart 18). Overall, we recommend investors who care about absolute returns to sell Russian assets. For dedicated EM equity as well as EM local currency bond portfolios, BCA's Emerging Markets Strategy recommends a neutral stance on Russia (Chart 19). Rising bond yields in the US will continue weighing especially on high-flying growth stocks. The low market-cap weight of technology/growth stocks in the Russian bourse makes the latter less vulnerable to rising global bond yields. Concerning local rates, we see value in 10-year swap rates, as tight monetary and fiscal policies will keep a lid on inflation. With the central bank unlikely to hike rates anytime soon, a steep yield curve offers good value in the long end of the curve for fixed income investors. Finally, orthodox macro policies will benefit fixed-income investors on the margin. In regard to EM credit (USD bonds) portfolio, the Emerging Markets Strategy team recommends overweighting Russia (Chart 20). The government has little local currency debt and minimal US dollar debt. Not surprisingly, Russia has been a low-beta credit market and it will outperform its EM peers in a broad sell off. Chart 19Russia: Move To Neutral Local Currency Bond Allocation Russia: Move To Neutral Local Currency Bond Allocation Russia: Move To Neutral Local Currency Bond Allocation Lastly, the Emerging Markets Strategy is moving Ukrainian local currency government bonds to underweight and closing the 5-year local currency bond position. Risks of military confrontation on the Ukraine front have escalated. Chart 20Russia: Remain Overweight On USD Credit Russia: Remain Overweight On USD Credit Russia: Remain Overweight On USD Credit     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Andrija Vesic Associate Editor Emerging Markets Strategy AndrijaV@bcaresearch.com   Footnotes 1 See Pavlo Limkin et al, “Putin’s new constitution spells out modern Russia’s imperial ambitions,” Atlantic Council, September 10, 2020, atlanticcouncil.org. 2 See White House, “Remarks by President Biden on America’s Place in the World,” February 4, 2021, and “Remarks by President Biden at the 2021 Virtual Munich Security Conference,” February 19, 2021, whitehouse.org. 3 See “Remarks … at the … Munich Security Conference” in footnote 2 above. 4 We first outlined this US-Russia disengagement in our last joint special report on Russia, “US-Russia: No Reverse Kissinger (Yet),” July 3, 2020, bcaresearch.com. 5 See Margarita Assenova, “Clouds Darkening Over Nord Stream Two Pipeline,” Jamestown Foundation, February 1, 2021, Jamestown.org. 6 Biden’s “Interim National Security Strategic Guidance,” White House, March 3, 2021, whitehouse.org, reinforces this point by focusing most of its attention on China and largely neglecting Russia. 7 See “Kremlin concerned about rising tensions in Donbass,” Tass, March 4, 2021, tass.com. 8 One way in which this could transpire would be a carbon border tax. The EU says imposing a tariff on carbon-intensive imports will proceed unilaterally if there is not a UN agreement in November because it is a “matter of survival” for its industry as it raises green regulation. The Biden administration also promised in its campaign to levy a “carbon adjustment fee.” Russia, which is exposed as a fossil fuel exporter that does not have a carbon pricing scheme, says such a fee would go against WTO rules. See Kate Abnett, “EU sees carbon border levy as ‘matter of survival’ for industry,” Reuters, January 18, 2021, reuters.com; Sam Morgan, “Moscow cries foul over EU’s planned carbon border tax,” Euractiv, July 27, 2020, euractiv.com. 9 See Heinrich Brauss and Dr. András Rácz, “Russia’s Strategic Interests and Actions in the Baltic Region,” German Council on Foreign Relations, DGAP Report, January 7, 2021, dgap.org; Christopher S. Chivvis et al, “NATO’s Northeastern Flank: Emerging Opportunities for Engagement,” Rand Corporation, 2017. 10 The rule stipulates that a portion of oil and gas revenues that the government can spend is determined by a fixed oil price benchmark. Currently, the benchmark oil price stands at $42 per barrel. The fiscal rule also encompasses constraints on the National Welfare Fund withdrawals in oil prices below $42 per barrel.

Highlights The Senate will pass the $1.9 trillion American Rescue Plan largely as it stands. Markets will now turn to Biden’s second major reconciliation bill for FY2022 – the one with tax hikes. Democrats will go forward with tax hikes on corporations and the wealthy. But they will spend more than they tax for fear of squandering their term in power. Tax hikes threaten sectors like tech that already face headwinds from rising bond yields. The health sector is also at risk. Stick with cyclicals and value plays.  Feature Markets have seesawed as volatility spikes in the face of rapidly rising bond yields. Value stocks such as financials stand to benefit relative to growth stocks as the market comes to grips with the first hint of normal inflation expectations since 2019 (Chart 1). Underlying the trend is a sea change in US fiscal policy. Chart 1Value Stocks To Reignite On Rising Bond Yields Value Stocks To Reignite On Rising Bond Yields Value Stocks To Reignite On Rising Bond Yields The House of Representatives passed the $1.9 trillion American Rescue Plan so it will now go to the Senate for revision, back to the House for approval, and then to President Biden’s desk by around March 14. Investors will now turn to Biden’s second major legislative act prior to the 2022 midterm election cycle: the fiscal year 2022 budget reconciliation process. Before we outline the time frame and tax hikes that that process will entail, we should take a moment to review the current bill. Senate Will Pass American Rescue Plan Largely As Is The House version of the $1.9 trillion American Rescue Plan contains $1,400 household rebates, direct checks via the Internal Revenue Service, for people who make less than $75,000 per year (double those numbers for married couples). Unemployment benefits are supposed to rise from $300 to $400 per week for 73 weeks instead of 50 weeks, with an expiration on August 29 instead of March 14. Those with children or other dependents will receive additional payments. The bill also includes $75 billion for fighting COVID-19, $350 billion for state and local governments, $170 billion for schools and universities, $225 billion for small business, $38 billion for the airline industry and various other tax benefits for families and workers.1 Those who have been let go from their jobs can more easily retain their previous health insurance. Chart 2 provides a visual comparison of the American Rescue Plan with the $900 billion in fiscal relief passed at the end of 2020 prior to House passage and Senate revision. Already the Senate version excludes a hike to the minimum wage, from $7.25 to $15 per hour, as the Senate parliamentarian ruled that does not qualify under the “Byrd rule” because it does not directly impact spending or taxation.2 Vice President Kamala Harris, who is also president of the Senate, could reverse this decision but otherwise the minimum wage will have to be considered in a separate bill later. Chart 2American Rescue Plan Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The Senate could pare back other aspects of the bill – such as state and local aid, given that local government revenues are in much better shape than expected. Chart 2 highlights that the state and local aid component is much larger this time around. Still, the purpose of Senate negotiations is to secure the votes of moderate Democrats, as winning over 10 Republicans is no longer feasible, and moderate senators are not going to sink the first legislative proposal of a president of their own party. The Senate is virtually guaranteed to pass the bill, likely by March 14 when current unemployment benefits expire. The bill’s economic impact will be to speed the vaccination process and provide another infusion of cash into households and various public institutions. Families are just starting to receive the last round of benefits passed in December and they had not exhausted the 14% year-on-year increase in real income that they saw as a result of last year’s CARES Act when the Coronavirus Response and Relief Act sent incomes soaring yet again (Chart 3). Economic growth will be supercharged as economic activity normalizes, consumer confidence recovers, and the service sector revives. Chart 3Washington Lavishes Households With Dole Washington Lavishes Households With Dole Washington Lavishes Households With Dole Biden’s Second Bill Will Pass This Fall The second budget reconciliation procedure, for fiscal year 2022, will begin in mid-April. The formal deadline to adopt a budget resolution is April 15 but the average delay would put the resolution in June.3 The maximum delay would see the resolution passed in October but that is unlikely in today’s context (Diagram 1). After the resolution passes, the House and Senate must reconcile their budgets, pass the same bill, and send it to the president for his signature.  Diagram 1Timeline Of Biden Administration’s Second Budget Reconciliation, FY2022 Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The average time between Congress adopting a budget resolution and the president signing a reconciliation bill into law is 150 days, putting completion on September 15, 2021. This period could easily extend to November. In the worst-case, judging by history, Democrats could fail to conclude the process until October 2022 – but that is highly unlikely. A delay till December of this year would be a fumble, but a more realistic fumble, say if moderate Democrats must be won over due to controversial provisions. The second reconciliation bill is supposed to consist of investments over a ten-year period rather than emergency relief for the lingering pandemic and economic recovery. Biden’s proposed $2-$3 trillion green infrastructure program is the highlight but we also expect Democrats to prioritize their health care plan, which is estimated to cost $1.7-$1.9 trillion. Hence $4 trillion is a reasonable expectation for new spending but in this case the headline spending figure will be at least partially defrayed by tax hikes, unlike the first reconciliation bill (Charts 4A & 4B). If Biden raises taxes by half as much as he intends, the full price tag would be $2 trillion. Chart 4ABiden Will Spend, Then Tax Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Chart 4BBiden Will Spend, Then Tax Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The precise contours of this bill will remain unknown until Biden presents an outline in April and the House of Representatives drafts a resolution. We test six different scenarios involving different assumptions about Biden’s tax-and-spend proposals, highlighted in Table 1. Generally, we assume that Democrats will much more readily compromise tax hikes rather than spending, given that they want to err on the side of firing up the economic recovery. They are just as capable as Republicans were in 2017 of manipulating the numbers when it comes to the reconciliation requirement that the budget deficit not increase beyond a ten-year time period. Table 1Scenarios For Biden’s Second Reconciliation Bill Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The results are broken down in terms of revenue, expenditure, and net interest costs in Chart 5. The baseline is Biden’s campaign proposal. Scenario 1 assumes that Biden gets all of the spending he wants but is forced to compromise on tax hikes. Scenario 2 is more realistic as it assumes that Biden gets half of what he wants on both spending and taxes. Scenarios 3-6 examine what would happen if Biden were forced to strike out either his green infrastructure plan or his health and social security plan, depending on different revenue assumptions. In Scenarios 5 and 6 we grant Biden only half of his proposed taxes on corporations and wealthy folks, leaving other tax proposals to the side – otherwise the result would be a net tightening of fiscal conditions, which is neither intended nor politically possible. Chart 5Scenarios For Biden’s Second Reconciliation Bill Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The impact on the budget deficit in each scenario is shown in Chart 6. The greatest economic stimulus would occur under Scenario 1, which would soon become a problem for investors as it would hasten inflation and rising interest rates. Chart 6Deficit Scenarios For Biden’s Second Reconciliation Bill Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Scenario 2 is the most realistic policy scenario while being the least inflationary. By contrast, Scenario 4 is realistic but hardly less inflationary than the baseline case. In each of these scenarios it is important to bear in mind that the new government programs would be administered over a ten-year period and therefore the increase to the budget deficit would be more gradual than is the case of the American Rescue Plan, which clearly aims to be disbursed in the first few years. In the case of the Obama administration’s American Recovery and Reinvestment Act (2009) the peak in spending occurred in 2013, four years after the bill was passed (analogous to 2025 today) (Chart 7). Infrastructure and green energy projects are also expected to increase productivity and hence potential growth. Chart 7Infrastructure Spending Could Peak Four Years After Bill’s Passage, As In 2009-13 Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The Byrd rule will become even more important with Biden’s second reconciliation bill because the bill will contain a mishmash of Biden’s campaign proposals. Democrats will try to pass as much of their agenda via fast track as possible so as to meet promises ahead of the 2022 midterm election. An advantage of health care spending is that it is unlikely to be struck down by the Senate parliamentarian given that the Obama administration relied on reconciliation to pass a critical second installment to the Affordable Care Act (Obamacare). Biden’s health care plan is more popular than climate change policy, with both the general public and moderate Democrats, and it is guaranteed to pass reconciliation. Infrastructure spending faces greater challenges under reconciliation but they are not insurmountable. Infrastructure is normally handled via the traditional budget process or the Highway Trust Fund and some measures are likely to run afoul of the Byrd rule. Still, workarounds can be found.4  Hence the infrastructure plan is likely to be compromised but not prohibited due to technicalities. Even if infrastructure fails to make it into reconciliation, Biden can use the deadline to top up the exhausted Highway Trust Fund or to reauthorize the Surface Transportation Act as alternative pathways. It is not impossible to get Republican cooperation on infrastructure though the green agenda will meet resistance. The reconciliation process is nominally forbidden from increasing the budget deficit beyond ten years. Short-term spending is exempt, as is the case with the American Rescue Plan and its crisis-response measures, but the purpose of the second reconciliation bill is to invest in long-term, productivity-enhancing programs. A new government health insurance option and/or a green infrastructure buildout will take many years to implement and could increase deficits beyond the ten-year window. But Democrats, like Republicans, will be able to use accounting chicanery and gimmicks to make the budget outlook serve their purposes in passing the legislation. As long as they keep moderate members of the party on their side.   Yes, Taxes Will Go Up … But That May Not Be All Bad For Markets Why should Democrats raise taxes at all? Why not focus on stimulus without taking on the political risk of higher taxes? After all, Republicans passed tax cuts via reconciliation without offsetting them by spending cuts. Was it not the higher taxes in Obamacare that greatly fueled resistance from Republicans and their victory in the House of Representatives in 2010? First, on the level of intentions, the Democrats clearly seek to increase taxes on corporations, high-income earners, and capital gains: Both Biden and Harris said they would raise taxes on the campaign trail and in the presidential debates despite the risk to their election prospects. Biden committed only to prevent tax hikes on those making less than $400,000 per year. Harris’s weakest moment in her debate with Mike Pence was her insistence that she would raise taxes but she stuck to her guns. Both factions of the Democratic Party want to raise taxes. Traditional Democrats view tax hikes as a way of paying for a larger government role in addressing social and economic imbalances. Populists view tax hikes as a way of redistributing from the ultra-rich. While budget deficits are not a general concern, combating inequality is a theme shared across the party. Second, on the level of capability, Democrats can get at least some of the tax increases that they want: The US is not overtaxed on the whole. True, Biden’s full tax agenda would push the US back up to the top of the OECD countries in terms of the corporate tax if an “integrated” view of both firm-level taxes and taxes on dividends and capital gains (Chart 8). But this point suggests that Biden will moderate his tax plan rather than abandon it altogether. Popular opinion did not favor Trump for cutting corporate taxes. Chart 8Biden’s Corporate Tax Proposal Would Make US An Outlier Again Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout The macroeconomic impact of raising taxes is manageable in the context of the extraordinary fiscal stimulus that the US is passing. There is no clear relationship between tax rates and economic growth but it is natural for the Democrats to fear that they could squander their term in power by excessive fiscal tightening. Yet the negative economic impact of raising the corporate rate is only 0.8% of GDP over the long run, and half of that if the corporate rate is raised only halfway to what Biden intends (25% instead of 28%) (Table 2), according to the conservative-leaning Tax Policy Foundation. Table 2Economic Impact Of Corporate Tax Not Dramatic Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout President Biden has the political capital early in his term to revise the Trump tax cuts according to Democratic prerogatives. His popularity will not hold up for long (Chart 9). And he only just has enough legislative power. While household sentiment is weak and economic conditions are moderate, both are set to improve as the pandemic fades and fiscal stimulus takes effect (Table 3). While tax hikes will embolden Republican opposition and the Democrats will have lost their chance to affect the tax code if Republicans win in 2022. At the moment, Republicans are divided and unpopular, so Democrats have a window of opportunity (Chart 10). Chart 9Thesis, Antithesis, Synthesis? Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Chart 10Independents Up, Republicans Down Independents Up, Republicans Down Independents Up, Republicans Down Table 3Political Capital Index Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout While Democrats could chuck all the Senate rules out the window in order to pass their spending plans without any offsets, this would anger moderates who tend to uphold Senate rules and norms. The party cannot afford to lose a single vote from their caucus in the Senate. Yet moderate Democrats are not against tax increases in principle. What they would oppose is either excessive tax hikes or a fiscal spending bonanza without any revenue offsets at all.5  It is entirely feasible to back-load tax increases so that they take effect in the latter half of the ten-year budget window, especially after the 2024 election. Treasury Secretary Janet Yellen is advising precisely this course of action and has herself argued that corporate tax hikes will go through.6 There may be some risk that Democrats go full left-wing populist and abandon any semblance of fiscal responsibility so as to supercharge the economy. So far they have agreed to maintain the Senate filibuster and scrap the minimum wage hike but this acceptance of Senate norms may not last as pressure builds. The second reconciliation bill is the last chance to fast-track major initiatives before the midterm. Vice President Harris could overrule the Senate parliamentarian across the board. This scenario is unlikely. The White House and Congress will find a balance that raises some revenue but errs on the fiscally accommodative side, as our scenarios above highlight. Investment Takeaways The market’s concern is that the Democrats will “overdo” the fiscal response and we fully share this concern. The American Rescue Plan alone will plug the output gap by almost three times more than the amount required. The coming tax hikes will not offset the wave of new spending that is coming down the pike. Democrats will partially reverse Trump’s tax cuts in the context of additional pump-priming that constitutes a net increase to the budget deficit. The net effect is inflationary.   If Congress were to pass another $2 trillion bill without any substantial revenue offsets then the market would face an even bigger inflationary jolt and an even earlier return to rate hikes by the Fed. But this scenario is unlikely. So the inflationary risk is clear but investors need not panic in the short run.  Our infrastructure trade is back on track as the reflation trade rumbles onward (Chart 11). The Democrats will get at least one more major bill passed and it will likely include at least half of Biden’s agenda, including around $2 trillion on green infrastructure. We will discuss the renewable energy portion at length in a forthcoming report. The health care sector faces headwinds from both Biden’s health policies and corporate tax hikes. The sectors that stand to benefit the most from a higher corporate tax rate are those that benefited least from Trump’s Tax Cut and Jobs Act – namely energy, industrials, materials, and financials, in that order (Chart 12A). These are also the cyclical plays that we favor in today’s accommodative policy environment. Chart 11Infrastructure Trade Back On Track Infrastructure Trade Back On Track Infrastructure Trade Back On Track   Chart 12ACyclicals Outperforming Health Care Cyclicals Outperforming Health Care Cyclicals Outperforming Health Care Chart 12BCyclicals To Outperform Tech? Cyclicals To Outperform Tech? Cyclicals To Outperform Tech? The same cyclical sectors are also trying to make headway against the tech sector, which stands to suffer from higher interest rates as well as higher taxes, including a minimum tax on book earnings, if that part of Biden’s agenda makes it through the negotiations this fall (Chart 12B).   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Table A1BPolitical Capital: Household And Business Sentiment Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Table A1CPolitical Capital: The Economy And Markets Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Table A2Political Risk Matrix Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Table A3Biden’s Cabinet Position Appointments Taxes Will Rise But It Is Still A Fiscal Blowout Taxes Will Rise But It Is Still A Fiscal Blowout Footnotes 1     See Jeff Drew, “House passes $1.9 trillion stimulus bill with a variety of small business relief,” and Alistair M. Nevius, “Tax provisions in the American Rescue Plan Act,” February 27, 2021, Journal of Accountancy, journalofaccountancy.com.     2     See “The Budget Reconciliation Process: The Senate’s ‘Byrd Rule,’” Congressional Research Service, December 1, 2020, fas.org.            3    The current delay centers on whether the Senate will confirm Biden’s appointee for director of the Office of Management and Budget, Neera Tanden, who lost support from key moderate Democrat Joe Manchin. If she does not receive a compensatory Republican vote then Biden will have to appoint someone else and the Senate will have to confirm. Thus the budget resolution could easily be delayed into May or June.       4    For the difficulties, see Peter Cohn, “Democrats plan a spending blowout, but hurdles remain,” Roll Call, January 11, 2021, rollcall.com. For workarounds, see Zach Moller and Gabe Horwitz, “Reconciliation: How It Works and How to Use It to Help American Workers Recover,” Third Way, February 1, 2021, thirdway.org. 5    See Alexander Bolton, “Democrats hesitant to raise taxes amid pandemic,” The Hill, February 25, 2021, thehill.com. 6    See Saleha Mohsin and Christopher Condon, “Yellen Favors Higher Company Tax, Signals Capital Gains Worth a Look”, Bloomberg, February 22, 2021, Bloomberg.com  

Highlights Market-based geopolitical analysis is about identifying upside as well as downside risk. So far this year upside risks include vaccine efficacy, coordinated monetary and fiscal stimulus, China’s avoidance of over-tightening policy, and Europe’s stable political dynamics. Downside risks include vaccine rollout problems, excessive US stimulus, a Chinese policy mistake, and traditional geopolitical risks in the Taiwan Strait and Persian Gulf. Financial markets may see more turmoil in the near-term over rising bond yields and the dollar bounce. But the macro backdrop is still supportive for this year. We are initiating and reinitiating a handful of trades: EM currencies ex-Brazil/Turkey/Philippines, the BCA rare earth basket, DM-ex-US, and the Trans-Pacific Partnership markets, and global value plays. Feature Chart 1Bond Yield Spike Threatens Markets In Near Term Bond Yield Spike Threatens Markets In Near Term Bond Yield Spike Threatens Markets In Near Term Investors hear a lot about geopolitical risk but the implication is always “downside risk.” What about upside risks? Where are politics and geopolitics creating buying opportunities? So far this year, on the positive side, the US fiscal stimulus is overshooting, China is likely to avoid overtightening policy, and Europe’s political dynamics are positive. However, global equity markets are euphoric and much of the good news is priced in. On the negative side, the US stimulus is probably too large. The output gap will be more than closed by the Biden administration’s $1.9 trillion American Rescue Plan yet the Democrats will likely pass a second major bill later this year with a similar amount of net spending, albeit over a longer period of time and including tax hikes. The countertrend bounce in the dollar and rising government bond yields threaten the US and global equity market with a near-term correction. The global stock-to-bond ratio has gone vertical (Chart 1). Meanwhile Biden faces immediate foreign policy tests in the Taiwan Strait and Persian Gulf. These two are traditional geopolitical risks that are once again underrated by investors. The near term is likely to be difficult for investors to navigate. Sentiment is ebullient and likely to suffer some disappointments. In this report we highlight a handful of geopolitical opportunities and offer some new investment recommendations to capitalize on them. Go Long Japan And Stay Long South Korea China’s stimulus and recovery matched by global stimulus and recovery have led to an explosive rise in industrial metals and other China-sensitive assets such as Swedish stocks and the Australian dollar that go into our “China Play Index” (Chart 2). Chart 2China Plays Looking Stretched (For Now) China Plays Looking Stretched (For Now) China Plays Looking Stretched (For Now) While a near-term pullback in these assets looks likely, tight global supplies will keep prices well-bid. Moreover long-term strategic investment plans by China and the EU to accelerate the technology race and renewable energy are now being joined by American investment plans, a cornerstone of Joe Biden’s emerging national policy program. We are long silver and would buy metals on the dips. Chinese President Xi Jinping’s “new era” policies will be further entrenched at the March National People’s Congress with the fourteenth five-year plan for 2021-25 and Xi’s longer vision for 2035. These policies aim to guide the country through its economic transition from export-manufacturing to domestic demand. They fundamentally favor state-owned enterprises, which are an increasingly necessary tool for the state to control aggregate demand as potential GDP growth declines, while punishing large state-run commercial banks, which are required to serve quasi-fiscal functions and swallow the costs of the transition (Chart 3). Xi Jinping’s decision to promote “dual circulation,” which is fundamentally a turn away from Deng Xiaoping’s opening up and liberal reform to a more self-sufficient policy of import substitution and indigenous innovation, will clash with the Biden administration, which has already flagged China as the US’s “most serious competitor” and is simultaneously seeking to move its supply chains out of China for critical technological, defense, and health goods. Chart 3Xi Jinping Leans On The Banks To Save The SOEs Xi Jinping Leans On The Banks To Save The SOEs Xi Jinping Leans On The Banks To Save The SOEs Chinese political and geopolitical risks are almost entirely priced out of the market, according to our GeoRisk Indicator, leaving Chinese equities exposed to further downside (Chart 4). Hong Kong equities have traded in line with GeoRisk Indicator for China, which suggests that they also have downside as the market prices in a rising risk premium due to the US’s attempt to galvanize its allies in a great circumvention of China’s economy in the name of democracy versus autocracy. Chart 4China/HK Political Risk Priced Out Of Market China/HK Political Risk Priced Out Of Market China/HK Political Risk Priced Out Of Market China has hinted that it will curtail rare earth element exports to the US if the US goes forward with a technological blockade. Biden’s approach, however, is more defensive rather than offensive – focusing on building up domestic and allied semiconductor and supply chain capacity rather than de-sourcing China. President Trump’s restrictions can be rolled back for US designed or manufactured tech goods that are outdated or strictly commercial. Biden will draw the line against American parts going into the People’s Liberation Army. Biden has a chance in March to ease the Commerce Department’s rules implementing Trump’s strictures on Chinese software apps in US markets as a gesture of engagement. Supply constraints and shortages cannot be solved quickly in either semiconductors or rare earths. But both China and the US can circumvent export controls by importing through third parties. The problem for China is that it is easier for the US to start pulling rare earths from the ground than it is for China to make a great leap forward in semiconductor production. Given the US’s reawakening to the need for a domestic industrial policy, strategic public investments, and secure supply chains, we are reinitiating our long rare earth trade, using the BCA rare earth basket, which features producers based outside of China (Chart 5). The renminbi is starting to rolling over, having reached near to the ceiling that it touched in 2017 after Trump’s arrival. There are various factors that drive the currency and there are good macro reasons for the currency to have appreciated in 2016-17 and 2020-21 due to strong government fiscal and monetary reflation. Nevertheless the People’s Bank allowed the currency to appreciate extensively at the beginning of both Trump’s and Biden’s terms and the currency’s momentum is slowing as it nears the 2017 ceiling. We are reluctant to believe the renminbi will go higher as China will not want to overtighten domestic policy but will want to build some leverage against Biden for the forthcoming strategic and economic dialogues. For mainland-dedicated investors we recommend holding Chinese bonds but for international investors we would highlight the likelihood that the renminbi has peaked and geopolitical risk will escalate. There is no substantial change on geopolitical risk in the Taiwan Strait since we wrote about it recently. A full-scale war is a low-probability risk. Much more likely is a diplomatic crisis – a showdown between the US and China over Taiwan’s ability to export tech to the mainland and the level of American support for Taiwan – and potentially a testing of Biden’s will on the cybersecurity, economic security, or maritime security of Taiwan. While it would make sense to stay long emerging markets excluding Taiwan, there is not an attractive profile for staying long emerging markets excluding all of Greater China. Therefore investors who are forced to choose should overweight China relative to Taiwan (Chart 6). Chart 5Rare Earth Miners Outside China Can Go Higher Rare Earth Miners Outside China Can Go Higher Rare Earth Miners Outside China Can Go Higher Market forces have only begun to register the fact that Taiwan is the epicenter of geopolitical risk in the twenty-first century. The bottleneck for semiconductors and Taiwan’s role as middleman in the trade war have supported Taiwanese stocks. It will take a long time for China, the US, and Europe to develop alternative suppliers for chips. But geopolitical pressures will occasionally spike and when they do Taiwanese equities will plunge (Chart 7). Chart 6EM Investors Need Either China Or Taiwan ... Taiwan Most At Risk EM Investors Need Either China Or Taiwan ... Taiwan Most At Risk EM Investors Need Either China Or Taiwan ... Taiwan Most At Risk South Korean geopolitical risk is also beneath the radar, though stocks have corrected recently and emerging market investors should generally favor Korea, especially over Taiwan. The first risk to Korea is that the US will apply more pressure on Seoul to join allied supply chains and exclude shipments of sensitive goods to China. The second risk is that North Korea – which Biden is deliberately ignoring in his opening speeches – will demand America’s attention through a new series of provocations that will have to be rebuked with credible threats of military force. Chart 7Markets Starting To Price Taiwan Strait Geopolitical Risk Markets Starting To Price Taiwan Strait Geopolitical Risk Markets Starting To Price Taiwan Strait Geopolitical Risk Chart 8South Korea Favored In EM But Still Faces Risks Over Chips, The North South Korea Favored In EM But Still Faces Risks Over Chips, The North South Korea Favored In EM But Still Faces Risks Over Chips, The North   Chart 9Don't Worry About Japan's Revolving Door Don't Worry About Japan's Revolving Door Don't Worry About Japan's Revolving Door The North Korean risk is usually very fleeting for financial markets. The tech risk is more serious but the Biden administration is not seeking to force South Korea to stop trading with China, at least not yet. The US would need to launch a robust, multi-year diplomatic effort to strong-arm its allies and partners into enforcing a chip and tech ban on China. Such an effort would generate a lot of light and heat – shuttle diplomacy, leaks to the press, and public disagreements and posturing. Until this starts to occur, US export controls will be a concern but not an existential threat to South Korea (Chart 8). Japan is the geopolitical winner in Asia Pacific. Japan is militarily secure, has a mutual defense treaty with the US, and stands to benefit from the recovery in global trade and growth. Japan is a beneficiary of a US-driven tech shift away from excess dependency on China and is heavily invested in Southeast Asia, which stands to pick up manufacturing share. Higher bond yields and inflation expectations will detract from growth stocks more than value stocks, and value stocks have a larger market-cap weight in European and Japanese equity markets. Japanese politics are not a significant risk despite a looming election. While Prime Minister Yoshihide Suga is unpopular and likely to revive the long tradition of a “revolving door” of short-lived prime ministers, and while the Liberal Democratic Party will lose the super-majorities it held under Shinzo Abe, nevertheless the party remains dominant and the national policy consensus is behind Abe’s platform of pro-growth reforms, coordinated dovish monetary and fiscal policy, and greater openness to trade and immigration (Chart 9). Favor EU And UK Over Russia And Eastern Europe Russian geopolitical risk appears to be rolling over according to our indicator but we disagree with the market’s assessment and expect it to escalate again soon (Chart 10). Not only will Russian social unrest continue to escalate but also the Biden administration will put greater pressure on Russia that will keep foreign investors wary. Chart 10Russia Geopolitical Risk Will Not Roll Over Russia Geopolitical Risk Will Not Roll Over Russia Geopolitical Risk Will Not Roll Over While geopolitics thus poses a risk to Russian equities – which are fairly well correlated (inversely) with our GeoRisk indicator – nevertheless they are already cheap and stand to benefit from the rise in global commodity prices and liquidity. Russia is also easing fiscal policy to try to quiet domestic unrest. The pound and the euro today are higher against the ruble than at any time since the invasion of Ukraine. It is possible that Russia will opt for outward aggressiveness amidst domestic discontent, a weak and relapsing approval rating for Vladimir Putin and his government, and the Biden administration’s avowed intention to prioritize democracy promotion, including in Ukraine and Belarus (Chart 11). The ruble will fall on US punitive actions but ultimately there is limited downside, at least as long as the commodity upcycle continues. Chart 11Ruble Can Fall But Probably Not Far Ruble Can Fall But Probably Not Far Ruble Can Fall But Probably Not Far Biden stated in his second major foreign policy speech, “we will not hesitate to raise the cost on Russia.” There are two areas where the Biden administration could surprise financial markets: pipelines and Russian bonds. Biden could suddenly adopt a hard line on the Nordstream 2 pipeline between Russia and Germany, preventing it from completion. This would require Biden to ask the Germans to put their money where their mouths are when it comes to trans-Atlantic solidarity. Biden is keen to restore relations with Germany, and is halting the withdrawal of US troops from there, but pressuring Germany on Russia is possible given that it lies in the US interest and Biden has vowed to push back against Russia’s aggressive regional actions and interference in American affairs. The US imposed sanctions on Russian “Eurobonds” under the Chemical and Biological Weapons Control and Warfare Elimination Act of 1991 (CBW Act) in the wake of Russia’s poisoning of secret agent Sergei Skripal in the UK in 2018. Non-ruble bank loans and non-ruble-denominated Russian bonds in primary markets were penalized, which at the time accounted for about 23% of Russian sovereign bonds. This left ruble-denominated sovereign bonds to be sold along with non-ruble bonds in secondary markets. The Biden administration views Russia’s poisoning of opposition leader Alexei Navalny as a similar infraction and will likely retaliate. The Defending American Security from Kremlin Aggression Act is not yet law but passed through a Senate committee vote in 2019 and proposed to halt most purchases of Russian sovereign debt and broaden sanctions on energy projects and Kremlin officials. Biden is also eager to retaliate for the large SolarWinds hack that Russia is accused of conducting throughout 2020. Cybersecurity stocks are an obvious geopolitical trade in contemporary times. Authoritarian nations have benefited from the use of cyber attacks, disinformation, and other asymmetric warfare tactics. The US has shown that it does not have the appetite to fight small wars, like over Ukraine or the South China Sea, whereas the US remains untested on the question of major wars. This incentivize incremental aggression and actions with plausible deniability like cyber. Therefore the huge run-up in cyber stocks is well-supported and will continue. The world’s growing dependency on technology during the pandemic lockdowns heightened the need for cybersecurity measures but the COVID winners are giving way to COVID losers as the pandemic subsides and normal economic activity resumes. Traditional defense stocks stand to benefit relative to cyber stocks as the secular trend of struggle among the Great Powers continues (Chart 12). Specifically a new cycle of territorial competition will revive military tensions as commodity prices rise. Chart 12Back To Work' Trade: Long Defense Versus Cyber Back To Work' Trade: Long Defense Versus Cyber Back To Work' Trade: Long Defense Versus Cyber By contrast with Russia, western Europe is a prime beneficiary of the current environment. Like Japan, Europe is an industrial, trade-surplus economy that benefits from global trade and growth. It benefits as the geopolitical middleman between the US and its rivals, China and Russia, especially as long as the Biden administration pursues consultation and multilateralism and hesitates to force the Europeans into confrontational postures against these powers. Chart 13Political Risk Still Subsiding In Continental Europe Political Risk Still Subsiding In Continental Europe Political Risk Still Subsiding In Continental Europe Meanwhile Russia and especially China need to court Europe now that the Biden administration is using diplomacy to try to galvanize a western bloc. China looks to substitute European goods for American goods and open up its market to European investors to reduce European complaints of protectionism. European domestic politics will become more interesting over the coming year, with German and French elections, but the risks are low. The rise of a centrist coalition in Italy under Mario Draghi highlights how overstated European political risk really is. In the Netherlands, Mark Rutte’s center-right party is expected to remain in power in March elections based on opinion polling, despite serious corruption scandals and COVID blowback. In Germany, Angela Merkel’s center-right party is also favored, and yet an upset would energize financial markets because it would result in a more fiscally accommodative and pro-EU policy (Chart 13). The takeaway is that there is limit to how far emerging European countries can outperform developed Europe, given the immediate geopolitical risk emanating from Russia that can spill over into eastern Europe (Chart 14). Developed European stocks are at peak levels, comparable to the period of Ukraine’s election, but Ukraine is about to heat up again as a battleground between Russia and the West, as will other peripheral states. Chart 14Favor DM Europe Over EM Europe Favor DM Europe Over EM Europe Favor DM Europe Over EM Europe Chart 15GBP: Watch For Scottish Risk Revival In May GBP: Watch For Scottish Risk Revival In May GBP: Watch For Scottish Risk Revival In May Finally, in the UK, the pound continues to surge in the wake of the settlement of a post-Brexit trade deal, notwithstanding lingering disagreements over vaccines, financial services, and other technicalities. British equities are a value play that can make up lost ground from the tumultuous Brexit years. There is potentially one more episode of instability, however, arising from the unfinished business in Scotland, where the Scottish National Party wants to convert any victory in parliamentary elections in May into a second push for a referendum on national independence. At the moment public opinion polls suggest that Prime Minister Boris Johnson’s achievement of an EU trade deal has taken the wind out of the sails of the independence movement but only the election will tell whether this political risk will continue to fall in the near term (Chart 15). Hence the pound’s rally could be curtailed in the near term but unless Scottish opinion changes direction the pound and UK domestic-oriented stocks will perform well. Short EM Strongmen Throughout the emerging world the rise of the “Misery Index” – unemployment combined with inflation – poses a persistent danger of social and political instability that will rise, not fall, in the coming years. The aftermath of the COVID crisis will be rocky once stimulus measures wane. South Africa, Turkey, and Brazil look the worst on these measures but India and Russia are also vulnerable (Chart 16). Brazilian geopolitical risk under the turbulent administration of President Jair Bolsonaro has returned to the 2015-16 peaks witnessed during the impeachment of President Dilma Rousseff amid the harsh recession of the middle of the last decade. Brazilian equities are nearing a triple bottom, which could present a buying opportunity but not before the current political crisis over fiscal policy exacts a toll on the currency and stock market (Chart 17). Chart 16EM Political Risk Will Bring Bad Surprises EM Political Risk Will Bring Bad Surprises EM Political Risk Will Bring Bad Surprises Chart 17Brazil Risk Hits Impeachment Peaks On Bolso Fiscal Populism Brazil Risk Hits Impeachment Peaks On Bolso Fiscal Populism Brazil Risk Hits Impeachment Peaks On Bolso Fiscal Populism Bolsonaro’s signature pension reform was an unpopular measure whose benefits were devastated by the pandemic. The return to fiscal largesse in the face of the crisis boosted Bolsonaro’s support and convinced him to abandon the pretense of austere reformer in favor of traditional Brazilian fiscal populist as the 2022 election approaches. His attempt to violate the country’s fiscal rule – a constitutional provision passed in December 2016 that imposes a 20-year cap on public spending growth – that limits budget deficits is precipitating a shakeup within the ruling coalition. Our Emerging Market Strategists believe the Central Bank of Brazil will hike interest rates to offset the inflationary impact of breaking the fiscal cap but that the hikes will likely fall short, prompting a bond selloff and renewed fears of a public debt crisis. The country’s political crisis will escalate in the lead up to elections, not unlike what occurred in the US, raising the odds of other negative political surprises. Chart 18Reinitiate Long Mexico / Short Brazil Reinitiate Long Mexico / Short Brazil Reinitiate Long Mexico / Short Brazil While Latin America as a whole is a shambles, the global cyclical upturn and shift in American policy creates investment opportunities – particularly for Mexico, at least within the region. Investors should continue to prefer Mexican equities over Brazilian given Mexico’s fundamentally more stable economic policy backdrop and its proximity to the American economy, which will be supercharged with stimulus and eager to find ways to use its new trade deal with Mexico to diversify its manufacturing suppliers away from China (Chart 18). In addition to Brazil, Turkey and the Philippines are also markets where “strongman leaders” and populism have undercut economic orthodoxy and currency stability. A basket of emerging market currencies that excludes these three witnessed a major bottom in 2014-16, when Turkish and Brazilian political instability erupted and when President Rodrigo Duterte stormed the stage in the Philippines. These three currencies look to continue underperforming given that political dynamics will worsen ahead of elections in 2022 (possibly 2023 for Turkey) (Chart 19). Chart 19Keep Shorting The Strongmen Keep Shorting The Strongmen Keep Shorting The Strongmen Investment Takeaways We closed out some “risk-on” trades at the end of January – admittedly too soon – and since then have hedged our pro-cyclical strategic portfolio with safe-haven assets, while continuing to add risk-on trades where appropriate. The Biden administration still faces one or more major foreign policy tests that can prove disruptive, particularly to Taiwanese, Chinese, Russian, and Saudi stocks. Biden’s foreign policy doctrine will be established in the crucible of experience but his preferences are known to favor diplomacy, democracy over autocracy, and to pursue alliances as a means of diversifying supply chains away from China. We will therefore look favorably upon the members of the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP) and recommend investors reinitiate the long CPTPP equities basket. These countries, which include emerging markets with decent governance as well as Japan, Australia, New Zealand, and Canada all stand to benefit from the global upswing and US foreign policy (Chart 20). Chart 20Reinitiate Long Trans-Pacific Partnership Reinitiate Long Trans-Pacific Partnership Reinitiate Long Trans-Pacific Partnership Chart 21Reinitiate Long Global Value Over Growth Reinitiate Long Global Value Over Growth Reinitiate Long Global Value Over Growth The Biden administration will likely try to rejoin the CPTPP but even if it fails to do so it will privilege relations with these countries as it strives to counter China and Russia. The UK, South Korea, Thailand and others could join the CPTPP over time – though an attempt to recruit Taiwan would exacerbate the geopolitical risks highlighted above centered on Taiwan. The dollar is perking up, adding a near-term headwind to global equities, but the cyclical trend for the dollar is still down due to extreme monetary and fiscal dovishness. Tactically, go long Mexican equities over Brazilian equities. From a strategic point of view we still favor value stocks over growth stocks and recommend investors reinitiate this global trade (Chart 21). Strategically, wait to overweight UK stocks in a global portfolio until the result of the May local elections is known and the risk of Scottish independence can be reassessed. Strategically, favor developed Europe over emerging Europe stocks as a result of Russian geopolitical risks that are set to escalate. Strategically go long global defense stocks versus cyber security stocks as a geopolitical “back to work” trade for a time when economic activity resumes and resource-oriented territorial, kinetic, military risks reawaken. Strategically, favor EM currencies other than Brazil, Turkey, and the Philippines to minimize exposure to economic populism, poor macro fundamentals, and election risk. Strategically, go long the BCA Rare Earths Basket to capture persistent US-China tensions under Biden and the search for alternatives to China.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   We Read (And Liked) … Supply-Side Structural Reform Supply-Side Structural Reform, a compilation of Chinese economic and policy research, discusses several aspects of Chinese economic reform as it is practiced under the Xi Jinping administration, spanning the meaning and importance of supply-side structural reform in China as well as five major tasks.1 The book consists of contributions by Chinese scholars, financial analysts, and opinion makers in 2015, so we have learned a lot since it was published, even as it sheds light on Beijing’s interpretation of reform. 2015 was a year of financial turmoil that saw a dramatic setback for China’s 2013 liberal reform blueprint. It also saw the launch of a new round of reforms under the thirteenth Five Year Plan (2016-20), which aimed to push China further down the transition from export-manufacturing to domestic and consumer-led growth. Beijing’s renewed reform push in 2017, which included a now infamous “deleveraging campaign,” ultimately led to a global slowdown in 2018-19 that was fatefully exacerbated by the trade war with the United States – only to be eclipsed by the COVID-19 pandemic in 2020. Built on fundamental economic theory and the social background of China, the book’s authors examine the impact of supply-side reform on the Chinese financial sector, industrial sector, and macroeconomic development. The comprehensive analysis covers short-term, mid-term and long-term effects. From the perspective of economic theory, there is consensus that China's supply-side structural reform framework did not forsake government support for the demand side of the economy, nor was it synonymous with traditional, liberal supply-side economics in the Western world. In contrast to Say’s Law, Reaganomics, and the UK’s Thatcherite privatization reforms, China's supply-side reform was concentrated on five tasks specific to its contemporary situation: cutting excessive industrial capacity, de-stocking, deleveraging, cutting corporate costs, and improving various structural “weaknesses.” The motives behind the new framework were to enhance the mobility and efficiency of productive factors, eliminate excess capacity, and balance effective supply with effective demand. Basically, if China cannot improve efficiencies, capital will be misallocated, corporations will operate at a loss, and the economy’s potential will worsen over the long run. The debt buildup will accelerate and productivity will suffer. Regarding implementation, the book sets forth several related policies, including deepening the reform of land use and the household registration (hukou) system, and accelerating urbanization, which are effective measures to increase the liquidity of productive factors. Others promote the transformation from a factor-driven economy to efficiency and innovation-driven economy, including improving the property rights system, transferring corporate and local government debt to the central government, and encouraging investment in human capital and in technological innovation. The book also analyzes and predicts the potential costs of reform on the economy in the short and long term. In the short run, authors generally anticipated that deleveraging and cutting excessive industrial capacity would put more pressure on the government’s fiscal budget. The rise in the unemployment rate, cases of bankruptcy, and the negative sentiment of investors would slow China’s economic growth. In the medium and long run, this structural reform was seen as necessary for a sustainable medium-speed economic growth, leading to more positive expectations for households and corporates. The improved efficiency in capital allocation would provide investors with more confidence in the Chinese economy and asset market. Authors argued that overall credit risk was still controllable in near-term, as the corresponding policies such as tax reduction and urbanization would boost private investment and consumption in the short run. These policies increased demand in the labor market and created working positions to counteract adverse impacts. Employment in industries where excessive capacity was most severe only accounted for about 3% of total urban employment in 2013. Regarding the rise in credit risk during de-capacity, the asset quality of banks had improved since the 1990s and the level of bad debt was said to be within a controllable range, given government support. Moreover, in the long run, the merger and reorganization of enterprises would increase the efficient supply and have a positive effect on economic innovation-driven transformation. We know from experience that much of the optimism about reform would confront harsh realities in the 2016-21 period. The reforms proceeded in a halting fashion as the US trade war interrupted their implementation, prompting the government to resort to traditional stimulus measures in mid-2018, only to be followed by another massive fiscal-and-credit splurge in 2020 in the face of the pandemic. Yet investors could be surprised to find that the Politburo meeting on April 17, 2020 proclaimed that China would continue to focus on supply-side structural reform even amid efforts to normalize the economy and maintain epidemic prevention and control. Leaders also pledged to maintain the supply-side reform while emphasizing demand-side management during annual Central Economic Work Conference in December 2020. In other words, Xi administration’s policy preferences remain set, and compromises forced by exogenous events will soon give way to renewed reform initiatives. This is a risk to the global reflation trade in 2021-22. There has not been a total abandonment of supply-side reform. The main idea of demand-side reform – shifts in the way China’s government stimulates the economy – is to fully tap the potential of the domestic market and call for an expansion of consumption and effective investment. Combined with the new concept of “dual circulation,” which emphasizes domestic production and supply chains (effectively import substitution), the current demand-side reforms fall in line with the supply-side goal of building a more independent and controllable supply chain and produce higher technology products. These combined efforts will provide “New China” sectors with more policy support, less regulatory constraint, and lead to better economic and financial market performance. Despite the fluctuations in domestic growth and the pressure from external demand, China will maintain the focus on reform in its long-term planning. The fundamental motivation is to enhance efficiency and innovation that is essential for China’s productivity and competitiveness in the future. Thus, investors should not become complacent over the vast wave of fiscal and credit stimulus that is peaking today as we go to press. Instead they should recognize that China’s leaders are committed to restructuring. This means that the economic upside of stimulus has a cap on it– a cap that will eventually be put in place by policymakers, if not by China’s lower capacity for debt itself. It would be a colossal policy mistake for China to overtighten monetary and fiscal policy in 2021 but any government attempts to tighten, the financial market will become vulnerable. A final thought: it is unclear whether there is potential for an improvement in China’s foreign relations contained in this conclusion. What the western world is demanding is for China to rebalance its economy, open up its markets, cut back on the pace of technological acquisition, reduce government subsidies for state-owned companies, and conform better to US and EU trade rules. There is zero chance that China will provide all of these things. But its own reform program calls for greater intellectual property protections, greater competition in non-strategic sectors (which the US and EU should be able to access under recent trade deals), and targeted stimulus for sustainable energy, where the US and EU see trade and investment opportunities. Thus there is a basis for an improvement in cooperation. What remains to be seen is how protectionist dual circulation will be in practice and how aggressively the US will pursue international enforcement of technological restrictions on China under the Biden administration. Jingnan Liu Research Associate JingnanL@bcaresearch.com Footnotes 1 Yifu L, et al. Supply-Side Structural Reform (Beijing: Democracy & Construction Publishing House, 2016). 351 pages. 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

For this month’s Special Report, we are sending you a collaboration between our US Investment Strategy and US Political Strategy teams. US Political Strategy is our newest strategy service and it extends the proprietary framework of our Geopolitical Strategy service to provide analysis of political developments that is relevant for US-focused investors. Please contact your relationship manager if you would like more information or to begin trialing the service. Highlights Ronald Reagan cast a long shadow over the elected officials who followed him … :The influence of the economic policies associated with Ronald Reagan held such persistent sway that even the Clinton and Obama administrations had to follow their broad outlines. … just as Paul Volcker did over central bankers at home and abroad … : The Volcker Fed’s uncompromising resistance to the 1970s’ runaway inflation established the Fed’s credibility and enshrined a new global central banking orthodoxy. … but it appears their enduring influence may have finally run its course … : The pandemic overrode everything else in real time, but investors may ultimately view 2020 as the year in which Democrats broke away from post-Reagan orthodoxy and the Fed decided Volcker’s vigilance was no longer relevant. … to investors’ potential chagrin: If inflation, big government and organized labor come back from the dead, globalization loses ground, regulation expands, anti-trust enforcement regains some bite and tax rates rise and become more progressive, then the four-decade investment golden age that Reagan and Volcker helped launch may be on its last legs. Feature The pandemic dominated everything in real time in 2020, as investors scrambled to keep up with its disruptions and the countermeasures policymakers deployed to shelter the economy from them. With some distance, however, investors may come to view it as a year of two critical policy inflection points: the end of the Reagan fiscal era and the end of the Volcker monetary era. The shifts could mark a watershed because Reagan’s and Volcker’s enduring influence helped power an investment golden age that has lasted for nearly 40 years. What comes next may not be so supportive for financial markets. Political history often unfolds in cycles even if their starting and ending dates are never as clear cut in real life as they are in dissertations. Broadly, the FDR administration kicked off the New Deal era, a 48-year period of increased government involvement in daily life via the introduction and steady expansion of the social safety net, broadened regulatory powers and sweeping worker protections. It was followed by the 40-year Reagan era, with a continuous soundtrack of limited government rhetoric made manifest in policies that sought to curtail the spread of social welfare programs, deregulate commercial activity, devolve power to state and local government units and the private sector and push back against unions. The Obama and Trump administrations challenged different aspects of Reaganism, but the 2020 election cycle finally toppled it. Ordinarily, that might only matter to historians and political scientists, but the Reagan era coincided with a fantastic run in financial markets. So, too, did the inflation vigilance that lasted long after Paul Volcker’s 1979-1987 tenure at the helm of the Federal Reserve, which drove an extended period of disinflation, falling interest rates and rising central bank credibility. Our focus here is on fiscal policy, and we touch on monetary policy only to note that last summer’s revision of the Fed’s statement of long-run monetary policy goals shut the door on the Volcker era. The end of both eras could mark an inflection point in the trajectory of asset returns. The Happy Warrior The nine most terrifying words in the English language are, “I’m from the government, and I’m here to help.”1 Chart II-1After The Recession, Reagan Was A Hit After The Recession, Reagan Was A Hit After The Recession, Reagan Was A Hit Ronald Reagan held his conservative views with the zeal of the convert that he was.2 Those views were probably to the right of much of the electorate, but his personal appeal was strong enough to make them palatable to a sizable majority (Chart II-1). Substitute “left” for “right” and the sentiment just as easily sums up FDR’s ability to get the New Deal off the ground. Personal magnetism played a big role in each era’s rise, with both men radiating relatability and optimism that imbued their sagging fellow citizens with a sense of comfort and security that made them willing to try something very different. 1980 was hardly 1932 on the distress scale, but America was in a funk after the upheaval of the sixties, the humiliating end to Vietnam, Watergate, stagflation and a term and a half of uninspiring and ineffectual presidential leadership. Enter the Great Communicator, whose initial weekly radio address evoked the FDR of the Fireside Chats – jovial, resolute and confident, with palpable can-do energy – buffed to a shine by a professional actor and broadcaster whose vocal inflections hit every mark.3 The Gipper,4 with his avuncular bearing, physical robustness and ever-present twinkle in his eye, was just what the country needed to feel better about itself. Reaganomics 101 Government does not tax to get the money it needs; government always finds a need for the money it gets.5 President Reagan’s economic plan had three simple goals: cut taxes, tame government spending and reduce regulation. From the start of his entry into politics in the mid-sixties, Reagan cast himself as a defender of hard-working Americans’ right to keep more of the fruits of their labor from a grasping federal government seeking funding for wasteful, poorly designed programs. He harbored an intense animus for LBJ’s Great Society, which extended the reach of the federal government in ways that he characterized as a drag on initiative, accomplishment and freedom, no matter how well intentioned it may have been. That message hung a historic loss on Barry Goldwater in 1964 when inflation was somnolent but it proved to be far more persuasive after the runaway inflation of the seventies exposed the perils of excessive government (Chart II-2). Chart II-2Inflation Rises When The Labor Market Heats Up Inflation Rises When The Labor Market Heats Up Inflation Rises When The Labor Market Heats Up As the Reagan Foundation website describes the impact of his presidency’s economic policies, “Millions … were able to keep more of the money for which they worked so hard. Families could reliably plan a budget and pay their bills. The seemingly insatiable Federal government was on a much-needed diet. And businesses and individual entrepreneurs were no longer hassled by their government, or paralyzed by burdensome and unnecessary regulations every time they wanted to expand.” “In a phrase, the American dream had been restored.” The Enduring Reach Of Reaganomics I’m not in favor of abolishing the government. I just want to shrink it down to the size where we can drown it in the bathtub. – Grover Norquist Though President-Elect Clinton bridled at limited government’s inherent restrictions, bursting out during a transition briefing, “You mean to tell me that the success of the economic program and my re-election hinges on the Federal Reserve and a bunch of f***ing bond traders?” his administration largely observed them. This was especially true after the drubbing Democrats endured in the 1994 midterms, when the Republicans captured their first House majority in four decades behind the Contract with America, a skillfully packaged legislative agenda explicitly founded on Reagan principles. Humbled in the face of Republican majorities in both houses of Congress, and hemmed in by roving bands of bond vigilantes, Clinton was forced to tack to the center. James Carville, a leading architect of Clinton’s 1992 victory, captured the moment, saying, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or … a .400 … hitter. But now I would like to come back as the bond market. You can intimidate everybody.” Reagan’s legacy informed the Bush administration’s sweeping tax cuts (and its push to privatize social security), and forced the Obama administration to tread carefully with the stimulus package it devised to combat the Great Recession. Although the administration’s economic advisors considered the $787 billion (5%-of-peak-GDP) bill insufficient, political staffers carried the day and the price tag was kept below $800 billion to appease the three Republican senators whose votes were required to pass it. Even with the economy in its worst state since the Depression, the Obama administration had to acquiesce to Reaganite budget pieties if it wanted any stimulus bill at all. Its leash got shorter after it agreed with House Republicans to “sequester” excess spending under the Budget Control Act of 2011. On the Republican side of the aisle, Grover Norquist, who claims to have founded Americans for Tax Reform (ATR) at Reagan’s request, enforced legislative fealty to the no-new-tax mantra. ATR, which opposes all tax increases as a matter of principle, corrals legislators with the Taxpayer Protection Pledge, “commit[ting] them to oppose any effort to increase income taxes on individuals and businesses.” ATR’s influence has waned since its 2012 peak, when 95% of Republicans in Congress had signed the pledge, and Norquist no longer strikes fear in the hearts of Republicans inclined to waver on taxes. His declining influence is testament to Reaganism’s success on the one hand (the tax burden has already been reduced) and the fading appeal of its signature fiscal restraint on the other. Did Government Really Shrink? When the legend becomes fact, print the legend. – The Man Who Shot Liberty Valance For all of its denunciations of government spending, the Reagan administration ran up the largest expansionary budget deficits (as a share of GDP) of any postwar administration until the global financial crisis (Chart II-3). Although it aggressively slashed non-defense discretionary spending, it couldn’t cut enough to offset the Pentagon’s voracious appetite. The Reagan deficits were not all bad: increased defense spending hastened the end of the Cold War, so they were in a sense an investment that paid off in the form of the ‘90s peace dividend and the budget surpluses it engendered. Chart II-3Cutting The Federal Deficit Is Harder Than It Seems Cutting The Federal Deficit Is Harder Than It Seems Cutting The Federal Deficit Is Harder Than It Seems Nonetheless, the Reagan experience reveals the uncomfortable truth that there is little scope for any administration or Congressional session to cut federal spending. Mandatory entitlement spending on social security, Medicare and Medicaid constitutes the bulk of federal expenditures (Chart II-4) and they are very popular with the electorate, as the Trump campaign shrewdly recognized in the 2016 Republican primaries (Table II-1). Discretionary spending, especially ex-defense, is a drop in the bucket, thanks largely to a Reagan administration that already cut it to the bone (Chart II-5). Chart II-4The Relentless Rise In Mandatory Spending ... The Relentless Rise In Mandatory Spending ... The Relentless Rise In Mandatory Spending ... Chart II-5Overwhlems Any Plausible Discretionary Cuts Overwhlems Any Plausible Discretionary Cuts Overwhlems Any Plausible Discretionary Cuts   Table II-1How Trump Broke Republican Orthodoxy On Entitlement Spending March 2021 March 2021 The Reagan tax cuts therefore accomplished the easy part of the “starve the beast” strategy but his administration failed to make commensurate cuts in outlays (Chart II-6). If overall spending wasn’t cut amidst oppressive inflation, while the Great Communicator was in the Oval Office to make the case for it to a considerably more fiscally conservative electorate, there is no chance that it will be cut this decade. As our Geopolitical Strategy service has flagged for several years, the median US voter has moved to the left on economic policy. Reagan-era fiscal conservatism has gone the way of iconic eighties features like synthesizers, leg warmers and big hair, even if it had one last gasp in the form of the post-crisis “Tea Party” and Obama’s compromise on budget controls. Chart II-6Grover Norquist Is Going To Need A Bigger Bathtub Grover Norquist Is Going To Need A Bigger Bathtub Grover Norquist Is Going To Need A Bigger Bathtub Do Republicans Still Want The Reagan Mantle? Chart II-7“Limited Government” Falling Out Of Fashion March 2021 March 2021 Reaganism is dead, killed by a decided shift in broad American public opinion, and within the Republican and Democratic parties themselves. Americans are just as divided today as they were in Reagan’s era about the size of the government but the trend since the late 1990s is plainly in favor of bigger government (Chart II-7). Recent developments, including the 2020 election, reinforce our conviction that trend will not reverse any time soon. The Republicans are the natural heirs of Reagan’s legacy. Much of President Trump’s appeal to conservatives lay in his successful self-branding as the new Reagan. Though he lacked the Gipper’s charisma and affability, his unapologetic assertion of American exceptionalism rekindled some of the glow of Morning-in-America confidence. Following the outsider trail blazed by Reagan, he lambasted the Washington establishment and promised to slash bureaucracy, deregulate the economy and shake things up. Trump’s signature legislative accomplishment was the largest tax reform since Reagan’s in 1986. He oversaw defense spending increases to take on China, which he all but named the new “evil empire.”6 Like Reagan, he was willing to weather criticism for face-to-face meetings with rival nations’ dictators. Even his trade protectionism had more in common with the Reagan administration than is widely recognized.7 Chart II-8Reagan’s Amnesty On Immigration March 2021 March 2021 But major differences in the two presidents’ policy portfolios underline the erosion of the Reagan legacy’s hold. President Trump outflanked his Republican competitors for the 2016 nomination by running against cutting government spending – he was the only candidate who opposed entitlement reform. His signature proposal was to stem immigration by means of a Mexican border wall. While Reagan had sought to crack down on illegal immigration, he pursued a compromise approach and granted amnesty to 2.9 million illegal immigrants living in America to pass the Immigration Reform and Control Act of 1986, sparing businesses from having to scramble to replace them (Chart II-8). While Reagan curtailed non-defense spending, Trump signed budget-busting bills with relish, even before the COVID pandemic necessitated emergency deficit spending. Trump tried to use the power of government to intervene in the economy and alienated the business community, which revered Reagan, with his scattershot trade war. Trump’s greater hawkishness on immigration and trade and his permissiveness on fiscal spending differentiated him from Reagan orthodoxy and signaled a more populist Republican Party. Chart II-9Trump Could Start Third Party, Give Democrats A Decade-Plus Ascendancy March 2021 March 2021 More fundamentally, Trump represents a new strain of Republican that is at odds with the party’s traditional support for big business and disdain for big government. If he leads that strain to take on the party establishment by challenging moderate Republicans in primary elections and insisting on running as the party’s next presidential candidate, the GOP will be swimming upstream in the 2022 and 2024 elections. It is too soon to make predictions about either of these elections other than to say that Trump is capable of splitting the party in a way not seen since Ross Perot in the 1990s or Theodore Roosevelt in the early 1900s (Chart II-9).8 If he does so, the Democrats will remain firmly in charge and lingering Reaganist policies will be actively dismantled. Even if the party manages to preserve its fragile Trumpist/traditionalist coalition, it is hard to imagine it will recover its appetite for shrinking entitlements, siding against labor or following a laissez-faire approach to corporate conduct and combinations. Republicans will pay lip service to fiscal restraint but Trump’s demonstration that austerity does not win votes will lead them to downplay spending cuts and entitlement reform as policy priorities – at least until inflation again becomes a popular grievance (Chart II-10). Republicans will also fail to gain traction with voters if they campaign merely on restoring the Trump tax cuts after Biden’s likely partial repeal of them. Support for the Tax Cut and Jobs Act hardly reached 40% for the general public and 30% for independents and it is well known that the tax reform did little to help Republicans in the 2018 midterm elections, when Democrats took the House (Chart II-11). Chart II-10Republicans Have Many Priorities Above Budget Deficits March 2021 March 2021 Chart II-11Trump Tax Cuts Were Never Very Popular March 2021 March 2021 On immigration the Republican Party will follow Trump and refuse amnesty. Immigration levels are elevated and Biden’s lax approach to the border, combined with a looming growth disparity with Latin America, will generate new waves of incomers and provoke a Republican backlash. On trade and foreign policy, Republicans will follow a synthesis of Reagan and Trump in pursuing a cold war with China. The Chinese economy is set to surpass the American economy by the year 2028 and is already bigger in purchasing power parity terms (Chart II-12). The Chinese administration is becoming more oppressive at home, more closed to liberal and western ideas, more focused on import substitution, and more technologically ambitious. The Chinese threat will escalate in the coming decade and the Republican Party will present itself as the anti-communist party by proposing a major military-industrial build-up. Yet it is far from assured that the Democrats will be soft on China, which is to say that they will not be able to cut defense spending substantially. Chart II-12China Is the New "Evil Empire" For GOP China Is the New "Evil Empire" For GOP China Is the New "Evil Empire" For GOP Will Biden Take Up The Cause? One might ask if the Biden administration might seek to adopt some elements of the Reagan program. President Biden is among the last of the pro-market Democrats who emerged in the wake of the Reagan revolution. Those “third-way” Democrats thrived in the 1990s by accommodating themselves to Reagan’s free-market message while maintaining there was a place for a larger federal role in certain aspects of the economy and society. The 2020 election demonstrated that the Democrats’ political base is larger than the Republicans’ and third-way policies could be a way to make further inroads with affluent suburbanites who helped deliver Georgia and Virginia. Alas, the answer appears to be no. The Democrats’ base increasingly abhors Reagan-era economic and social policies, and the country’s future demographic changes reinforce the party’s current, progressive trajectory. That means fiery younger Democrats don’t have to compromise their principles with third-way policies when they can just wait for Texas to turn blue. Chart II-13Democrats Look To New Deal, Eschew ‘Third Way’ March 2021 March 2021 Biden has only been in office for one month but a rule of thumb is that his party will pull him further to the left the longer Republicans remain divided and ineffective. His cabinet appointments have been center-left, not far-left, though his executive orders have catered to the far-left, particularly on immigration. In order to pass his two major legislative proposals through an evenly split Senate he must appeal to Democratic moderates, as every vote in the party will be needed to get the FY2021 and FY2022 budget reconciliation bills across the line, with Vice President Kamala Harris acting as the Senate tie breaker. Nevertheless his agenda still highlights that the twenty-first century Democrats are taking a page out of the FDR playbook and unabashedly promoting big government solutions (Chart II-13). Biden’s $1.9 trillion American Rescue Plan is not only directed at emergency pandemic relief but also aims to shore up state and local finances, education, subsidized housing, and child care. His health care proposals include a government-provided insurance option (originally struck from the Affordable Care Act to secure its passage in 2010) and a role for Medicare in negotiating drug prices. And his infrastructure plan is likely to provide cover for a more ambitious set of green energy projects that will initiate the Democratic Party’s next big policy pursuit after health care: environmentalism. The takeaway is not that Biden’s administration is necessarily radical – he eschews government-administered health care and is only proposing a partial reversal of Trump’s tax cuts – but rather that his party has taken a decisive turn away from the “third-way” pragmatism that defined his generation of Democrats in favor of a return to the “Old-Left” and pro-labor policies of the New Deal era (Chart II-14). The party has veered to the left in reaction to the Iraq War, the financial crisis, and Trumpism. Vice President Harris, Biden’s presumptive heir, had the second-most progressive voting record during her time in the Senate and would undoubtedly install a more progressive cabinet. Table II-2 shows her voting record alongside other senators who ran against Biden in the Democratic primary election. All of them except perhaps Senator Amy Klobuchar stood to his left on the policy spectrum. Chart II-14Democrats Eschew Budget Constraints March 2021 March 2021 Fundamentally the American electorate is becoming more open to a larger role for the government in the economy and society. While voters almost always prioritize the economy and jobs, policy preferences have changed. The morass of excessive inflation, deficits, taxation, regulation, strikes and business inefficiencies that gave rise to the Reagan movement is not remembered as ancient history – it is not even remembered. The problems of slow growth, inadequate health and education, racial injustice, creaky public services, and stagnant wages are by far the more prevalent concerns – and they require more, not less, spending and government involvement (Chart II-15). Insofar as voters worry about foreign threats they focus on the China challenge, where Biden will be forced to adopt some of Trump’s approach. Table II-2Harris Stood To The Left Of Democratic Senators March 2021 March 2021 Chart II-15Public Concern For Economy Means Greater Government Help March 2021 March 2021 When inflation picks up in the coming years, voters will not reflexively ask for government to be pared back so that the economy becomes more efficient, as they did once they had a taste of Reagan’s medicine in the early 1980s. Rather, they will ask the government to step in to provide higher wages, indexation schemes, price caps, and assistance for labor, as is increasingly the case. The ruling party will be offering these options and the opposition Republicans will render themselves obsolete if they focus single-mindedly on austerity measures. Americans will have to experience a recession caused by inflation – i.e. stagflation – before they call for anything resembling Reagan again. The Post-Reagan Market Landscape Many investors and conservative economists were shocked9 that the Bernanke Fed’s mix of zero interest rates and massive securities purchases did not foster runaway inflation and destroy the dollar. They failed to anticipate that widespread private-sector deleveraging would put a lid on money creation (and that other major central banks would follow in the Fed’s ZIRP and QE footsteps). But a longer view of four decades of disinflation suggests another conclusion: Taking away the monetary punch bowl when the labor party gets going and pursuing limited-government fiscal policy can keep inflation pressures from gaining traction. Globalization, technology-enabled elimination of many lower-skilled white-collar functions and the hollowing out of the organized labor movement all helped as well, though they helped foment a revolt among a meaningful segment of the Republican rank-and-file against Reagan-style policies. The Volcker Fed set the tone for pre-emptive monetary tightening and subsequent FOMCs have reliably intervened to cool off the economy when the labor market begins heating up. The Phillips Curve may be out of favor with investors, but wage inflation only gathers steam when the unemployment rate falls below its natural level (Chart II-16), and the Fed did not allow negative unemployment gaps to persist for very long in the Volcker era. Without wage inflation putting more money in the hands of a broad cross-section of households with a fairly high marginal propensity to consume, it’s hard to get inflation in consumer prices. Chart II-16Taking The Punch Bowl Away From The Union Hall Taking The Punch Bowl Away From The Union Hall Taking The Punch Bowl Away From The Union Hall The Fed took the cyclical wind from the labor market’s sails but the Reagan administration introduced a stiff secular headwind when it crushed PATCO, the air traffic controllers’ union, in 1981, marking an inflection point in the relationship between management and labor. That watershed event opened the door for employers to deploy much rougher tactics against unions than they had since before the New Deal.10 Reagan’s championing of free markets helped establish globalization as an economic policy that the third-way Clinton administration eagerly embraced with NAFTA and a campaign to admit China to the WTO. The latter coincided with a sharp decline in labor’s share of income (Chart II-17). Chart II-17Outsourcing Has Not Been Good For US Labor Outsourcing Has Not Been Good For US Labor Outsourcing Has Not Been Good For US Labor The core Reagan tenets – limited government, favoring management over labor, globalization, sleepy anti-trust enforcement, reduced regulation and less progressive tax systems with lower rates – are all at risk of Biden administration rollbacks. While the easy monetary/tight fiscal combination promoted a rise in asset prices rather than consumer prices ever since the end of the global financial crisis, today’s easy monetary/easy fiscal could promote consumer price inflation and asset price deflation. We do not think inflation will be an issue in 2021 but we expect it will in the later years of Biden’s term. Ultimately, we expect massive fiscal accommodation will stoke inflation pressures and those pressures, abetted by a Fed which has pledged not to pre-emptively remove accommodation when the labor market tightens, will eventually bring about the end of the bull market in risk assets and the expansion. Investment Implications Business revered the Reagan administration and investors rightfully associate it with the four-decade bull market that began early in its first term. Biden is no wild-eyed liberal, but rolling back core Reagan-era tenets has the potential to roll back juicy Reagan-era returns. Only equities have the lengthy data series to allow a full comparison of Reagan-era returns with postwar New Deal-era returns (Table II-3), but the path of Treasury bond yields in the three-decade bear market that preceded the current four-decade bull market suggests that bonds generated little, if any, real returns in the pre-Reagan postwar period (Chart II-18). Stagnant precious metal returns point to tame Reagan-era inflation and downward pressure on input costs. Table II-3Annualized Real Market Returns Before And After Reagan March 2021 March 2021 Chart II-18Bond Investors Loved Volcker And The Gipper Bond Investors Loved Volcker And The Gipper Bond Investors Loved Volcker And The Gipper Owning the market is not likely to be as rewarding going forward as it was in the Reagan era. Active management may again have its day in the sun as the end of the Reagan tailwinds open up disparities between sectors, sub-industries and individual companies. Even short-sellers may experience a renaissance. We recommend that multi-asset investors underweight bonds, especially Treasuries. We expect the clamor for bigger government will contribute to a secular bear market that could rival the one that persisted from the fifties to the eighties. Within Treasury portfolios, we would maintain below-benchmark duration and favor TIPS over nominal bonds at least until the Fed signals that its campaign to re-anchor inflation expectations higher has achieved its goal. Gold and/or other precious metals merit a place in portfolios as a hedge against rising inflation and other real assets, from land to buildings to other resources, are worthy of consideration as well. BCA has been cautioning of a downward inflection in long-run financial asset returns for a few years, based on demanding valuations and a steadily shrinking scope for ongoing declines in inflation and interest rates. Mean reversion has been part of the thesis as well; trees simply don’t grow to the sky. Now that the curtain has fallen on the Volcker and Reagan eras, the inevitable downward inflection has received a catalyst. We remain constructive on risk assets over the next twelve months, but we expect that intermediate- and long-term returns will fall well short of their post-1982 pace going forward. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 August 12, 1986 Press Conference News Conference | The Ronald Reagan Presidential Foundation & Institute (reaganfoundation.org), accessed February 4, 2021. Reagan makes the quip in his prepared opening remarks. 2 Reagan was a Democrat until he entered politics in his fifties. He claimed to have voted for FDR four times. 3 April 3, 1982 Radio Address President Reagan's Radio Address to the Nation on the Program for Economic Recovery - 4/3/82 - YouTube, accessed February 4, 2021. 4 As an actor, Reagan was perhaps best known for his portrayal of Notre Dame football legend George Gipp, who is immortalized in popular culture as the subject of the “win one for the Gipper” halftime speech. 5 July 22, 1981 White House Remarks to Visiting Editors and Broadcasters reaganfoundation.org, accessed February 8, 2021. 6 Reagan famously urged his followers, in reference to the USSR, “I urge you to beware the temptation of pride—the temptation of blithely declaring yourselves above it all and label both sides equally at fault, to ignore the facts of history and the aggressive impulses of an evil empire.” See his “Address to the National Association of Evangelicals,” March 8, 1983, voicesofdemocracy.umd.edu. 7 Robert Lighthizer, the Trump administration trade representative who directed its tariff battles, was a veteran of Reagan’s trade wars against Japan in the 1980s. 8 “Exclusive: The Trump Party? He still holds the loyalty of GOP voters,” USA Today, February 21, 2021, usatoday.com. 9 Open Letter to Ben Bernanke,” November 15, 2010. Open Letter to Ben Bernanke | Hoover Institution Accessed February 23, 2021. 10 Please see the following US Investment Strategy Special Reports, “Labor Strikes Back, Parts 1, 2 and 3,” dated January 13, January 20 and February 3, 2020, available at usis.bcaresearch.com.

Highlights Ronald Reagan cast a long shadow over the elected officials who followed him … : The influence of the economic policies associated with Ronald Reagan held such persistent sway that even the Clinton and Obama administrations had to follow their broad outlines.  … just as Paul Volcker did over central bankers at home and abroad … : The Volcker Fed’s uncompromising resistance to the 1970s’ runaway inflation established the Fed’s credibility and enshrined a new global central banking orthodoxy.  … but it appears their enduring influence may have finally run its course … : The pandemic overrode everything else in real time, but investors may ultimately view 2020 as the year in which Democrats broke away from post-Reagan orthodoxy and the Fed decided Volcker’s vigilance was no longer relevant.  … to investors’ potential chagrin: If inflation, big government and organized labor come back from the dead, globalization loses ground, regulation expands, anti-trust enforcement regains some bite and tax rates rise and become more progressive, then the four-decade investment golden age that Reagan and Volcker helped launch may be on its last legs. Feature The pandemic dominated everything in real time in 2020, as investors scrambled to keep up with its disruptions and the countermeasures policymakers deployed to shelter the economy from them. With some distance, however, investors may come to view it as a year of two critical policy inflection points: the end of the Reagan fiscal era and the end of the Volcker monetary era. The shifts could mark a watershed because Reagan’s and Volcker’s enduring influence helped power an investment golden age that has lasted for nearly 40 years. What comes next may not be so supportive for financial markets. Political history often unfolds in cycles even if their starting and ending dates are never as clear cut in real life as they are in dissertations. Broadly, the FDR administration kicked off the New Deal era, a 48-year period of increased government involvement in daily life via the introduction and steady expansion of the social safety net, broadened regulatory powers and sweeping worker protections. It was followed by the 40-year Reagan era, with a continuous soundtrack of limited government rhetoric made manifest in policies that sought to curtail the spread of social welfare programs, deregulate commercial activity, devolve power to state and local government units and the private sector and push back against unions. The Obama and Trump administrations challenged different aspects of Reaganism, but the 2020 election cycle finally toppled it. Ordinarily, that might only matter to historians and political scientists, but the Reagan era coincided with a fantastic run in financial markets. So, too, did the inflation vigilance that lasted long after Paul Volcker’s 1979-1987 tenure at the helm of the Federal Reserve, which drove an extended period of disinflation, falling interest rates and rising central bank credibility. Our focus here is on fiscal policy, and we touch on monetary policy only to note that last summer’s revision of the Fed’s statement of long-run monetary policy goals shut the door on the Volcker era. The end of both eras could mark an inflection point in the trajectory of asset returns. The Happy Warrior The nine most terrifying words in the English language are, “I’m from the government, and I’m here to help.”1 Ronald Reagan held his conservative views with the zeal of the convert that he was.2 Those views were probably to the right of much of the electorate, but his personal appeal was strong enough to make them palatable to a sizable majority (Chart 1). Substitute “left” for “right” and the sentiment just as easily sums up FDR’s ability to get the New Deal off the ground. Personal magnetism played a big role in each era’s rise, with both men radiating relatability and optimism that imbued their sagging fellow citizens with a sense of comfort and security that made them willing to try something very different. Chart 1After The Recession, Reagan Was A Hit After The Recession, Reagan Was A Hit After The Recession, Reagan Was A Hit 1980 was hardly 1932 on the distress scale, but America was in a funk after the upheaval of the sixties, the humiliating end to Vietnam, Watergate, stagflation and a term and a half of uninspiring and ineffectual presidential leadership. Enter the Great Communicator, whose initial weekly radio address evoked the FDR of the Fireside Chats – jovial, resolute and confident, with palpable can-do energy – buffed to a shine by a professional actor and broadcaster whose vocal inflections hit every mark.3 The Gipper,4 with his avuncular bearing, physical robustness and ever-present twinkle in his eye, was just what the country needed to feel better about itself. Reaganomics 101 Government does not tax to get the money it needs; government always finds a need for the money it gets.5 President Reagan’s economic plan had three simple goals: cut taxes, tame government spending and reduce regulation. From the start of his entry into politics in the mid-sixties, Reagan cast himself as a defender of hard-working Americans’ right to keep more of the fruits of their labor from a grasping federal government seeking funding for wasteful, poorly designed programs. He harbored an intense animus for LBJ’s Great Society, which extended the reach of the federal government in ways that he characterized as a drag on initiative, accomplishment and freedom, no matter how well intentioned it may have been. That message hung a historic loss on Barry Goldwater in 1964 when inflation was somnolent but it proved to be far more persuasive after the runaway inflation of the seventies exposed the perils of excessive government (Chart 2). Chart 2Inflation Rises When The Labor Market Heats Up Inflation Rises When The Labor Market Heats Up Inflation Rises When The Labor Market Heats Up As the Reagan Foundation website describes the impact of his presidency’s economic policies, “Millions … were able to keep more of the money for which they worked so hard. Families could reliably plan a budget and pay their bills. The seemingly insatiable Federal government was on a much-needed diet. And businesses and individual entrepreneurs were no longer hassled by their government, or paralyzed by burdensome and unnecessary regulations every time they wanted to expand.” “In a phrase, the American dream had been restored.” The Enduring Reach Of Reaganomics I’m not in favor of abolishing the government. I just want to shrink it down to the size where we can drown it in the bathtub. – Grover Norquist Though President-Elect Clinton bridled at limited government’s inherent restrictions, bursting out during a transition briefing, “You mean to tell me that the success of the economic program and my re-election hinges on the Federal Reserve and a bunch of f***ing bond traders?” his administration largely observed them. This was especially true after the drubbing Democrats endured in the 1994 midterms, when the Republicans captured their first House majority in four decades behind the Contract with America, a skillfully packaged legislative agenda explicitly founded on Reagan principles. Humbled in the face of Republican majorities in both houses of Congress, and hemmed in by roving bands of bond vigilantes, Clinton was forced to tack to the center. James Carville, a leading architect of Clinton’s 1992 victory, captured the moment, saying, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or … a .400 … hitter. But now I would like to come back as the bond market. You can intimidate everybody.” Reagan’s legacy informed the Bush administration’s sweeping tax cuts (and its push to privatize social security), and forced the Obama administration to tread carefully with the stimulus package it devised to combat the Great Recession. Although the administration’s economic advisors considered the $787 billion (5%-of-peak-GDP) bill insufficient, political staffers carried the day and the price tag was kept below $800 billion to appease the three Republican senators whose votes were required to pass it. Even with the economy in its worst state since the Depression, the Obama administration had to acquiesce to Reaganite budget pieties if it wanted any stimulus bill at all. Its leash got shorter after it agreed with House Republicans to “sequester” excess spending under the Budget Control Act of 2011. On the Republican side of the aisle, Grover Norquist, who claims to have founded Americans for Tax Reform (ATR) at Reagan’s request, enforced legislative fealty to the no-new-tax mantra. ATR, which opposes all tax increases as a matter of principle, corrals legislators with the Taxpayer Protection Pledge, “commit[ting] them to oppose any effort to increase income taxes on individuals and businesses.” ATR’s influence has waned since its 2012 peak, when 95% of Republicans in Congress had signed the pledge, and Norquist no longer strikes fear in the hearts of Republicans inclined to waver on taxes. His declining influence is testament to Reaganism’s success on the one hand (the tax burden has already been reduced) and the fading appeal of its signature fiscal restraint on the other. Did Government Really Shrink? When the legend becomes fact, print the legend. – The Man Who Shot Liberty Valance For all of its denunciations of government spending, the Reagan administration ran up the largest expansionary budget deficits (as a share of GDP) of any postwar administration until the global financial crisis (Chart 3). Although it aggressively slashed non-defense discretionary spending, it couldn’t cut enough to offset the Pentagon’s voracious appetite. The Reagan deficits were not all bad: increased defense spending hastened the end of the Cold War, so they were in a sense an investment that paid off in the form of the ‘90s peace dividend and the budget surpluses it engendered. Chart 3Cutting The Federal Deficit Is Harder Than It Seems Cutting The Federal Deficit Is Harder Than It Seems Cutting The Federal Deficit Is Harder Than It Seems Nonetheless, the Reagan experience reveals the uncomfortable truth that there is little scope for any administration or Congressional session to cut federal spending. Mandatory entitlement spending on social security, Medicare and Medicaid constitutes the bulk of federal expenditures (Chart 4) and they are very popular with the electorate, as the Trump campaign shrewdly recognized in the 2016 Republican primaries (Table 1). Discretionary spending, especially ex-defense, is a drop in the bucket, thanks largely to a Reagan administration that already cut it to the bone (Chart 5). Chart 4The Relentless Rise In Mandatory Spending ... The Relentless Rise In Mandatory Spending ... The Relentless Rise In Mandatory Spending ... Chart 5Overwhlems Any Plausible Discretionary Cuts Overwhlems Any Plausible Discretionary Cuts Overwhlems Any Plausible Discretionary Cuts Table 1How Trump Broke Republican Orthodoxy On Entitlement Spending Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper The Reagan tax cuts therefore accomplished the easy part of the “starve the beast” strategy but his administration failed to make commensurate cuts in outlays (Chart 6). If overall spending wasn’t cut amidst oppressive inflation, while the Great Communicator was in the Oval Office to make the case for it to a considerably more fiscally conservative electorate, there is no chance that it will be cut this decade. As our Geopolitical Strategy service has flagged for several years, the median US voter has moved to the left on economic policy. Reagan-era fiscal conservatism has gone the way of iconic eighties features like synthesizers, leg warmers and big hair, even if it had one last gasp in the form of the post-crisis “Tea Party” and Obama’s compromise on budget controls. Chart 6Grover Norquist Is Going To Need A Bigger Bathtub Grover Norquist Is Going To Need A Bigger Bathtub Grover Norquist Is Going To Need A Bigger Bathtub Do Republicans Still Want The Reagan Mantle? Reaganism is dead, killed by a decided shift in broad American public opinion, and within the Republican and Democratic parties themselves. Americans are just as divided today as they were in Reagan’s era about the size of the government but the trend since the late 1990s is plainly in favor of bigger government (Chart 7). Recent developments, including the 2020 election, reinforce our conviction that that trend will not reverse any time soon. The Republicans are the natural heirs of Reagan’s legacy. Much of President Trump’s appeal to conservatives lay in his successful self-branding as the new Reagan. Though he lacked the Gipper’s charisma and affability, his unapologetic assertion of American exceptionalism rekindled some of the glow of Morning-in-America confidence. Following the outsider trail blazed by Reagan, he lambasted the Washington establishment and promised to slash bureaucracy, deregulate the economy and shake things up. Chart 7"Limited Government" Falling Out Of Fashion Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Trump’s signature legislative accomplishment was the largest tax reform since Reagan’s in 1986. He oversaw defense spending increases to take on China, which he all but named the new “evil empire.”6  Like Reagan, he was willing to weather criticism for face-to-face meetings with rival nations’ dictators. Even his trade protectionism had more in common with the Reagan administration than is widely recognized.7 But major differences in the two presidents’ policy portfolios underline the erosion of the Reagan legacy’s hold. President Trump outflanked his Republican competitors for the 2016 nomination by running against cutting government spending – he was the only candidate who opposed entitlement reform. His signature proposal was to stem immigration by means of a Mexican border wall. While Reagan had sought to crack down on illegal immigration, he pursued a compromise approach and granted amnesty to 2.9 million illegal immigrants living in America to pass the Immigration Reform and Control Act of 1986, sparing businesses from having to scramble to replace them (Chart 8). While Reagan curtailed non-defense spending, Trump signed budget-busting bills with relish, even before the COVID pandemic necessitated emergency deficit spending. Trump tried to use the power of government to intervene in the economy and alienated the business community, which revered Reagan, with his scattershot trade war. Trump’s greater hawkishness on immigration and trade and his permissiveness on fiscal spending differentiated him from Reagan orthodoxy and signaled a more populist Republican Party. More fundamentally, Trump represents a new strain of Republican that is at odds with the party’s traditional support for big business and disdain for big government. If he leads that strain to take on the party establishment by challenging moderate Republicans in primary elections and insisting on running as the party’s next presidential candidate, the GOP will be swimming upstream in the 2022 and 2024 elections. It is too soon to make predictions about either of these elections other than to say that Trump is capable of splitting the party in a way not seen since Ross Perot in the 1990s or Theodore Roosevelt in the early 1900s (Chart 9).8 If he does so, the Democrats will remain firmly in charge and lingering Reaganist policies will be actively dismantled. Chart 8Reagan’s Amnesty On Immigration Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Chart 9Trump Could Start Third Party, Give Democrats A Decade-Plus Ascendancy Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Even if the party manages to preserve its fragile Trumpist/traditionalist coalition, it is hard to imagine it will recover its appetite for shrinking entitlements, siding against labor or following a laissez-faire approach to corporate conduct and combinations. Republicans will pay lip service to fiscal restraint but Trump’s demonstration that austerity does not win votes will lead them to downplay spending cuts and entitlement reform as policy priorities – at least until inflation again becomes a popular grievance (Chart 10). Republicans will also fail to gain traction with voters if they campaign merely on restoring the Trump tax cuts after Biden’s likely partial repeal of them. Support for the Tax Cut and Jobs Act hardly reached 40% for the general public and 30% for independents and it is well known that the tax reform did little to help Republicans in the 2018 midterm elections, when Democrats took the House (Chart 11). Chart 10Republicans Have Many Priorities Above Budget Deficits Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper On immigration the Republican Party will follow Trump and refuse amnesty. Immigration levels are elevated and Biden’s lax approach to the border, combined with a looming growth disparity with Latin America, will generate new waves of incomers and provoke a Republican backlash. Chart 11Trump Tax Cuts Were Never Very Popular Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper On trade and foreign policy, Republicans will follow a synthesis of Reagan and Trump in pursuing a cold war with China. The Chinese economy is set to surpass the American economy by the year 2028 and is already bigger in purchasing power parity terms (Chart 12). The Chinese administration is becoming more oppressive at home, more closed to liberal and western ideas, more focused on import substitution, and more technologically ambitious. The Chinese threat will escalate in the coming decade and the Republican Party will present itself as the anti-communist party by proposing a major military-industrial build-up. Yet it is far from assured that the Democrats will be soft on China, which is to say that they will not be able to cut defense spending substantially. Chart 12China Is the New "Evil Empire" For GOP China Is the New "Evil Empire" For GOP China Is the New "Evil Empire" For GOP Will Biden Take Up The Cause? One might ask if the Biden administration might seek to adopt some elements of the Reagan program. President Biden is among the last of the pro-market Democrats who emerged in the wake of the Reagan revolution. Those “third-way” Democrats thrived in the 1990s by accommodating themselves to Reagan’s free-market message while maintaining there was a place for a larger federal role in certain aspects of the economy and society. The 2020 election demonstrated that the Democrats’ political base is larger than the Republicans’ and third-way policies could be a way to make further inroads with affluent suburbanites who helped deliver Georgia and Virginia. Alas, the answer appears to be no. The Democrats’ base increasingly abhors Reagan-era economic and social policies, and the country’s future demographic changes reinforce the party’s current, progressive trajectory. That means fiery younger Democrats don’t have to compromise their principles with third-way policies when they can just wait for Texas to turn blue. Biden has only been in office for one month but a rule of thumb is that his party will pull him further to the left the longer Republicans remain divided and ineffective. His cabinet appointments have been center-left, not far-left, though his executive orders have catered to the far-left, particularly on immigration. In order to pass his two major legislative proposals through an evenly split Senate he must appeal to Democratic moderates, as every vote in the party will be needed to get the FY2021 and FY2022 budget reconciliation bills across the line, with Vice President Kamala Harris acting as the Senate tie breaker. Nevertheless his agenda still highlights that the twenty-first century Democrats are taking a page out of the FDR playbook and unabashedly promoting big government solutions (Chart 13). Chart 13Democrats Look To New Deal, Eschew 'Third Way' Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Biden’s $1.9 trillion American Rescue Plan is not only directed at emergency pandemic relief but also aims to shore up state and local finances, education, subsidized housing, and child care. His health care proposals include a government-provided insurance option (originally struck from the Affordable Care Act to secure its passage in 2010) and a role for Medicare in negotiating drug prices. And his infrastructure plan is likely to provide cover for a more ambitious set of green energy projects that will initiate the Democratic Party’s next big policy pursuit after health care: environmentalism. The takeaway is not that Biden’s administration is necessarily radical – he eschews government-administered health care and is only proposing a partial reversal of Trump’s tax cuts – but rather that his party has taken a decisive turn away from the “third-way” pragmatism that defined his generation of Democrats in favor of a return to the “Old-Left” and pro-labor policies of the New Deal era (Chart 14). The party has veered to the left in reaction to the Iraq War, the financial crisis, and Trumpism. Vice President Harris, Biden’s presumptive heir, had the second-most progressive voting record during her time in the Senate and would undoubtedly install a more progressive cabinet. Table 2 shows her voting record alongside other senators who ran against Biden in the Democratic primary election. All of them except perhaps Senator Amy Klobuchar stood to his left on the policy spectrum. Chart 14Democrats Eschew Budget Constraints Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Fundamentally the American electorate is becoming more open to a larger role for the government in the economy and society. While voters almost always prioritize the economy and jobs, policy preferences have changed. The morass of excessive inflation, deficits, taxation, regulation, strikes and business inefficiencies that gave rise to the Reagan movement is not remembered as ancient history – it is not even remembered. The problems of slow growth, inadequate health and education, racial injustice, creaky public services, and stagnant wages are by far the more prevalent concerns – and they require more, not less, spending and government involvement (Chart 15). Insofar as voters worry about foreign threats they focus on the China challenge, where Biden will be forced to adopt some of Trump’s approach. Table 2Harris Stood To The Left Of Democratic Senators Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Chart 15Public Concern For Economy Means Greater Government Help Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper When inflation picks up in the coming years, voters will not reflexively ask for government to be pared back so that the economy becomes more efficient, as they did once they had a taste of Reagan’s medicine in the early 1980s. Rather, they will ask the government to step in to provide higher wages, indexation schemes, price caps, and assistance for labor, as is increasingly the case. The ruling party will be offering these options and the opposition Republicans will render themselves obsolete if they focus single-mindedly on austerity measures. Americans will have to experience a recession caused by inflation – i.e. stagflation – before they call for anything resembling Reagan again. The Post-Reagan Market Landscape Many investors and conservative economists were shocked9 that the Bernanke Fed’s mix of zero interest rates and massive securities purchases did not foster runaway inflation and destroy the dollar. They failed to anticipate that widespread private-sector deleveraging would put a lid on money creation (and that other major central banks would follow in the Fed’s ZIRP and QE footsteps). But a longer view of four decades of disinflation suggests another conclusion: Taking away the monetary punch bowl when the labor party gets going and pursuing limited-government fiscal policy can keep inflation pressures from gaining traction. Globalization, technology-enabled elimination of many lower-skilled white-collar functions and the hollowing out of the organized labor movement all helped as well, though they helped foment a revolt among a meaningful segment of the Republican rank-and-file against Reagan-style policies. The Volcker Fed set the tone for pre-emptive monetary tightening and subsequent FOMCs have reliably intervened to cool off the economy when the labor market begins heating up. The Phillips Curve may be out of favor with investors, but wage inflation only gathers steam when the unemployment rate falls below its natural level (Chart 16), and the Fed did not allow negative unemployment gaps to persist for very long in the Volcker era. Without wage inflation putting more money in the hands of a broad cross-section of households with a fairly high marginal propensity to consume, it’s hard to get inflation in consumer prices. Chart 16Taking The Punch Bowl Away From The Union Hall Taking The Punch Bowl Away From The Union Hall Taking The Punch Bowl Away From The Union Hall The Fed took the cyclical wind from the labor market’s sails but the Reagan administration introduced a stiff secular headwind when it crushed PATCO, the air traffic controllers’ union, in 1981, marking an inflection point in the relationship between management and labor. That watershed event opened the door for employers to deploy much rougher tactics against unions than they had since before the New Deal.10 Reagan’s championing of free markets helped establish globalization as an economic policy that the third-way Clinton administration eagerly embraced with NAFTA and a campaign to admit China to the WTO. The latter coincided with a sharp decline in labor’s share of income (Chart 17). Chart 17Outsourcing Has Not Been Good For US Labor Outsourcing Has Not Been Good For US Labor Outsourcing Has Not Been Good For US Labor The core Reagan tenets – limited government, favoring management over labor, globalization, sleepy anti-trust enforcement, reduced regulation and less progressive tax systems with lower rates – are all at risk of Biden administration rollbacks. While the easy monetary/tight fiscal combination promoted a rise in asset prices rather than consumer prices ever since the end of the global financial crisis, today’s easy monetary/easy fiscal could promote consumer price inflation and asset price deflation. We do not think inflation will be an issue in 2021 but we expect it will in the later years of Biden’s term. Ultimately, we expect massive fiscal accommodation will stoke inflation pressures and those pressures, abetted by a Fed which has pledged not to pre-emptively remove accommodation when the labor market tightens, will eventually bring about the end of the bull market in risk assets and the expansion. Investment Implications Business revered the Reagan administration and investors rightfully associate it with the four-decade bull market that began early in its first term. Biden is no wild-eyed liberal, but rolling back core Reagan-era tenets has the potential to roll back juicy Reagan-era returns. Only equities have the lengthy data series to allow a full comparison of Reagan-era returns with postwar New Deal-era returns (Table 3), but the path of Treasury bond yields in the three-decade bear market that preceded the current four-decade bull market suggests that bonds generated little, if any, real returns in the pre-Reagan postwar period (Chart 18). Stagnant precious metal returns point to tame Reagan-era inflation and downward pressure on input costs. Chart 18Bond Investors Loved Volcker And The Gipper Bond Investors Loved Volcker And The Gipper Bond Investors Loved Volcker And The Gipper Table 3Annualized Real Market Returns Before And After Reagan Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Owning the market is not likely to be as rewarding going forward as it was in the Reagan era. Active management may again have its day in the sun as the end of the Reagan tailwinds open up disparities between sectors, sub-industries and individual companies. Even short-sellers may experience a renaissance. We recommend that multi-asset investors underweight bonds, especially Treasuries. We expect the clamor for bigger government will contribute to a secular bear market that could rival the one that persisted from the fifties to the eighties. Within Treasury portfolios, we would maintain below-benchmark duration and favor TIPS over nominal bonds at least until the Fed signals that its campaign to re-anchor inflation expectations higher has achieved its goal. Gold and/or other precious metals merit a place in portfolios as a hedge against rising inflation and other real assets, from land to buildings to other resources, are worthy of consideration as well. BCA has been cautioning of a downward inflection in long-run financial asset returns for a few years, based on demanding valuations and a steadily shrinking scope for ongoing declines in inflation and interest rates. Mean reversion has been part of the thesis as well; trees simply don’t grow to the sky. Now that the curtain has fallen on the Volcker and Reagan eras, the inevitable downward inflection has received a catalyst. We remain constructive on risk assets over the next twelve months, but we expect that intermediate- and long-term returns will fall well short of their post-1982 pace going forward.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Table A1BPolitical Capital: Household And Business Sentiment Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Table A1CPolitical Capital: The Economy And Markets Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Table A2Political Risk Matrix Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Table A3Political Capital Index Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Table A4Biden’s Cabinet Position Appointments Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper       Footnotes 1     August 12, 1986 Press Conference News Conference | The Ronald Reagan Presidential Foundation & Institute (reaganfoundation.org), accessed February 4, 2021. Reagan makes the quip in his prepared opening remarks. 2     Reagan was a Democrat until he entered politics in his fifties. He claimed to have voted for FDR four times. 3    April 3, 1982 Radio Address President Reagan's Radio Address to the Nation on the Program for Economic Recovery - 4/3/82 - YouTube, accessed February 4, 2021. 4    As an actor, Reagan was perhaps best known for his portrayal of Notre Dame football legend George Gipp, who is immortalized in popular culture as the subject of the “win one for the Gipper” halftime speech. 5    July 22, 1981 White House Remarks to Visiting Editors and Broadcasters reaganfoundation.org, accessed February 8, 2021. 6    Reagan famously urged his followers, in reference to the USSR, “I urge you to beware the temptation of pride—the temptation of blithely declaring yourselves above it all and label both sides equally at fault, to ignore the facts of history and the aggressive impulses of an evil empire.” See his “Address to the National Association of Evangelicals,” March 8, 1983, voicesofdemocracy.umd.edu.   7     Robert Lighthizer, the Trump administration trade representative who directed its tariff battles, was a veteran of Reagan’s trade wars against Japan in the 1980s. 8    “Exclusive: The Trump Party? He still holds the loyalty of GOP voters,” USA Today, February 21, 2021, usatoday.com. 9    Open Letter to Ben Bernanke,” November 15, 2010. Open Letter to Ben Bernanke | Hoover Institution Accessed February 23, 2021. 10   Please see the following US Investment Strategy Special Reports, “Labor Strikes Back, Parts 1, 2 and 3,” dated January 13, January 20 and February 3, 2020, available at usis.bcaresearch.com.

Highlights Both the US and Iran have the intention and capability of restoring the 2015 nuclear deal so investors should presume that an escalation in tensions will conclude with a new arrangement by August this year. However, the deal that the Iranians will offer, and that Biden can accept, may be unacceptable to the Israeli government, depending on Israel’s March 23 election. Moreover if a deal is not clinched by August, the timeframe will stretch out for most of Biden’s term and strategic tensions will escalate. Major Middle Eastern conflicts and crises tend to occur at the top of the business cycle when commodity prices are soaring rather than in the early stages where we stand today. But regional instability is possible regardless, especially if the US-Iran talks fall apart. Maintain gold and safe-haven assets as the Iranian question can lead to near-term escalation even if a deal is the end-game. Feature Geopolitics is far from investors’ concerns today, so it could create some nasty surprises. Two urgent tests await the Biden administration – China/Taiwan and Iran – and provide a basis for investors to add some safe-haven assets and hedges amidst an exuberant stock rally in which complacency is very high. The past week’s developments underscore these two tests. First, Chinese officials flagged that they would cut off rare earth elements to the US, implying that they would retaliate if Biden refuses to issue waivers for US export controls on semiconductors to China.1 Second, Biden spoke on the phone with Benjamin Netanyahu for the first time. The delay signaled Biden’s distance from Netanyahu and intention to normalize ties with Israel’s arch-enemy Iran. In both the Taiwan Strait and the Persian Gulf, the base case is not a full-fledged military conflict in the short run. This is positive for the bull market. But major incidents short of war are likely in the near term and major wars cannot be ruled out. In this report we update our view of the Iran risk. A long-term solution to the nuclear threat is not at hand, which means that Israel could in the worst-case take military action on its own. Meanwhile tensions and attacks will escalate until a deal is agreed. Iranian-backed forces in Iraq have already attacked a US base near Erbil, killing an American military contractor.2 In the event of an Iranian diplomatic crisis, the stock market selloff will be short. The macro backdrop is highly reflationary and investors will buy on the dips. In the event of full-scale war, the US dollar will suffer for a longer period. Oil Price A Boon But Middle East Regimes Still Vulnerable Chart 1Oil Recovery A Boon For Middle East Markets Oil Recovery A Boon For Middle East Markets Oil Recovery A Boon For Middle East Markets Brent crude oil prices have rebounded to $65 per barrel on the global economic recovery. Middle Eastern equities are rallying in absolute terms, though not relative to other emerging markets (Chart 1). This underperformance is fitting given that the region suffers from poor governance, obstacles to doing business, resource dependency, insufficient technology and capital, and high levels of political and geopolitical risk. Non-oil producers and non-oil sectors in the Middle East have generally lagged the global economic recovery (Chart 2). The continuation of the recovery is essential to these regimes because most of them lack the fiscal room to provide large fiscal relief packages. The global average in fiscal support over the past year has been 7.4% but most Middle Eastern governments have provided 2% or less (Chart 3). Current account deficits have plagued oil producers since the commodity bust of 2014 and twin deficits have become a feature of the region, limiting the fiscal response to the global pandemic. Chart 2Middle East Economy Starts To Recover Middle East Economy Starts To Recover Middle East Economy Starts To Recover Chart 3Middle Eastern Regimes Fiscally Constrained Biden, Iran, Markets Biden, Iran, Markets The good news is that the recovery is likely to continue on the back of vaccines and fiscal pump-priming in all of the major economies. The bad news is that a black cloud hangs over the Middle East in the form of geopolitics. Given the underperformance of regional equities, global investors are not ignoring these risks – but they are a persistent factor until the Biden administration survives its initial tests in the region to create a new equilibrium. The unfinished geopolitical business in the region centers on the role of the US and the question of Iran. It is widely understood that the US has less and less interest in the region due to its newfound energy independence on the back of the shale revolution (Chart 4). This is why the US can afford to sign and break deals as it pleases under different administrations, namely the 2015 Iranian nuclear deal, otherwise known as the Joint Comprehensive Plan of Action (JCPA). The Obama administration spent two terms concluding the deal while the Trump administration spent one term nullifying it, leaving the central geopolitical question of the region in limbo. Israel and Arab governments feel increasingly insecure in light of the US’s apparent lack of foreign policy coherence and declining interest in the region. The US has not truly abandoned the region – if anything the Biden administration is looking to maintain or increase US international involvement.3 Washington still sees the need to preserve a strategic balance between Iran and the Arab states, prevent Iran from gaining nuclear weapons, and maintain security in the critical oil chokepoint of the Persian Gulf and Strait of Hormuz (Chart 5). But Washington’s appetite for commitment and sacrifice is obviously waning. The American public is openly hostile to the idea of Middle Eastern entanglements, and three presidents in a row have been elected on the assurance that they would scale down America’s “forever wars.” A decisive majority of Americans, including military veterans and Republicans, believe the wars in Afghanistan and Iraq were not worth fighting.4 And only 6% of Americans view Iran as the top threat to their country. Chart 4Waning US Interest In Middle East Waning US Interest In Middle East Waning US Interest In Middle East Chart 5Strait Of Hormuz Critical To Global Stability Biden, Iran, Markets Biden, Iran, Markets America’s lack of concern about the Iranian threat marks a difference from the early 2000s and especially from its critical Middle Eastern ally Israel. Naturally Israelis have a much greater fear of Iran, and 58% see it as the nation’s top threat (Chart 6). Israel and the Gulf Arab states are drawing together, under the framework of the Trump administration’s Abraham Accords, in case the US abandons the region. A deal normalizing relations with Iran would enable Iran to expand its power and influence and, if unchecked by the US, would pose a long-lasting threat to US allies. Chart 6No US Appetite For War With Iran – Israel A Different Story Biden, Iran, Markets Biden, Iran, Markets Chart 7China/Asia, Not Iran, The Strategic Priority For The US China/Asia, Not Iran, The Strategic Priority For The US China/Asia, Not Iran, The Strategic Priority For The US The US’s reason for dealing with Iran is that it needs to devote more attention to its strategy in the western Pacific in countering China (Chart 7). But China is also a reason for the US to stay involved in the Middle East. China’s role is expanding because of resource dependency and the desire to expand economic integration. Beijing wants to deepen its global investments, open up new markets, and create closer links with Europe (Chart 8). Chart 8AChina's Expanding Role In Middle East China's Expanding Role In Middle East China's Expanding Role In Middle East Chart 8BChina's Expanding Role In Middle East China's Expanding Role In Middle East China's Expanding Role In Middle East Chart 9Unresolved US-Iran Deal A Geopolitical Risk Unresolved US-Iran Deal A Geopolitical Risk Unresolved US-Iran Deal A Geopolitical Risk The opening of the Iranian economy would give the US (and EU) a greater role in Iran’s development, where China has a special advantage as long as Iran is a pariah. The US would add economic leverage to its military leverage in a region that provides China with its energy. The Chinese are not yet as capable of projecting power into the region but that is changing rapidly. There is a possible strategic balance to be established between these simultaneous foreign policy revolutions: the US-Iran détente, the Israeli-Arab détente, and the rise of Mideast-China ties. But balance is an ideal and not yet a reality. In the meantime these foreign policy revolutions must actually take place – and revolutions are rarely bloodless. It is possible for a meltdown to occur in light of the region’s profound changes. In particular, the US-Iran détente is incomplete and faces Israeli/Arab opposition, Iranian paranoia, and US foreign policy incoherence. At the moment it is premature to declare an end to the bull market in US-Iran tensions. That will come when a deal is actually sealed, and then tested and enforced. In the meantime Iranian incidents will occur (Chart 9). Geopolitical risks threaten to reduce global oil supply. Different regimes and their militant proxies will strike out against each other to establish red lines. But a US-Iran deal is highly likely – and once that occurs, the risk to oil supply shifts to the upside, as Iran’s economy will open up. Not only will Iran start exporting again but Gulf Arab producers will want to preserve their market share, which means they will pump more oil. Iran’s Regime Hardens Its Shell Ahead Of Leadership Succession The COVID-19 crisis has weakened regimes in the Middle East, much like the Great Recession sowed the seeds for the Arab Spring and many other sweeping changes in the region. But unlike the Arab Spring, the regimes most at risk today are majority Shia Muslim – with Lebanon, Iran, and Iraq all teetering on the verge of chaos (Chart 10). Chart 10Iranian Sphere De-Stabilized Amid COVID Biden, Iran, Markets Biden, Iran, Markets Chart 11Iranian Economy Weak (Despite Green Shoots) Iranian Economy Weak (Despite Green Shoots) Iranian Economy Weak (Despite Green Shoots) Chart 12Jobless Iranian Youth Jobless Iranian Youth Jobless Iranian Youth The Iranian economy is starting to show the faintest green shoots but it is far too soon to give the all-clear signal. US sanctions have shut off access to oil export revenues. Domestic demand is weak and imports are still contracting, albeit much less rapidly. The country has seen a double dip recession over the past ten years (Chart 11). Unemployment is rife, especially among the youth. The working-age population makes up 60% of total and periodically rises up in protest (Chart 12). Inflation is soaring and the currency is still wallowing in deep depreciation (Chart 13). All of these points suggest Iran is weaker than it looks and will seek to negotiate a deal with the Biden administration. But Iran cannot trust the US so it will simultaneously prepare for the worst outcome – no deal, sanctions, and eventually war. Chart 13Iran Still Ripe For Social Unrest Iran Still Ripe For Social Unrest Iran Still Ripe For Social Unrest Chart 14Iranian Regime Turning Hawkish Biden, Iran, Markets Biden, Iran, Markets Iran’s response to the US’s withdrawal from the 2015 nuclear deal and imposition of maximum pressure sanctions has been to adopt a siege mentality and fortify the regime for a potential military confrontation. The country is preparing for a highly uncertain and vulnerable transition from Supreme Leader Ali Khamenei to a future leader or group of leaders. The government fixed the 2020 parliamentary elections so that hardliners or “principlists” rose to prominence at the expense of independents and especially the so-called reformists. The reformists have been humiliated by the US betrayal of the deal and re-imposition of sanctions, which exploded the economic reforms of President Hassan Rouhani, who will step down in August (Chart 14). The Timeline Of Biden’s Iran Deal Still, it is likely that the US and Iran will return to some form of the 2015 nuclear deal. Lame duck Rouhani is politically capable of returning to the deal: President Rouhani is a lame duck president whose popularity has cratered. If he can restore the deal before August then he can salvage his legacy and provide a pathway for Iran out of economic ruin by removing sanctions. It is manifestly in Iran’s interests to restore the deal – one reason why it has never left the deal and has only made incremental and reversible infractions against it. If Rouhani falls on his sword he provides the Supreme Leader and the next administration with a convenient scapegoat to enable the deal to be restored. Freshman President Biden has enough political capital to return to the deal: Biden is capable of restoring the deal, as he clearly intends to do judging by his statements, cabinet appointments, and diplomatic actions thus far. He has demanded that Iran enter back into full compliance with the deal before he eases sanctions but even this demand can be fudged. After all, it was the US that exited the deal in the first place, and Iran remains in partial compliance, so it stands to reason that the US should make the first concession to bring Iran back into compliance. None of the signatories have nullified the deal other than the US, and it was an executive (not legislative) deal, so President Biden can ultimately rejoin it by fiat. This would not be a popular move at home but the US public is preoccupied. Biden would achieve a foreign policy objective early in his term. The timeline is critical – an early deal is our base case. But if it falls through, then it could take the rest of Biden’s term in office, or longer, to forge a deal. Tensions would skyrocket over that period. The timeline is shown in Table 1. The US has identified April or May as the time when Iran will reach “breakout” capability, i.e. produce enough highly enriched uranium to make a nuclear bomb. The Israelis, for their part, estimate that breakout phase will be reached in August – the same month Rouhani is set to step down. Both the US and Israel view breakout as a red line, though there is some room for interpretation. Table 1Can Lame Duck Rouhani Salvage US Deal For Legacy By August? Biden, Iran, Markets Biden, Iran, Markets The option of rejoining the old deal with Rouhani as a scapegoat will end when Rouhani exits in August. The next Iranian president is unlikely to repeat Rouhani’s mistake of pinning his administration on a promise from the Americans that could be revoked as early as January 20, 2025. The next Iranian president will be a nationalist or hardliner. Opinion shows that the public looks most favorably upon the firebrand ex-President Mahmoud Ahmadinejad or the hardline candidate from 2017 Ebrahim Raisi. Another possible candidate is Hossein Dehghan, a brigadier general. The least favorable political figures are the reformists like Rouhani (Chart 15). Chart 15Iran’s Next President Will Be Hawkish Biden, Iran, Markets Biden, Iran, Markets We cannot vouch for the quality of these opinion polls but they are corroborated by other polls we have seen and they make sense with what we know and have observed in recent years. Apparently the public has turned its back on the dream of greater economic opening, with self-sufficiency making a comeback in the face of US sanctions (Chart 16). The regime will promote this attitude in advance of the leadership transition as it must be prepared to conduct a smooth succession even under the worst-case scenario of sanctions or war. Chart 16Iran Preparing For Supreme Leader’s Succession Biden, Iran, Markets Biden, Iran, Markets Chart 17Nuclear Bomb Key To Regime Survival Biden, Iran, Markets Biden, Iran, Markets The hitch is that Iran is interested in rejoining the deal it signed in 2015, not a grander deal. It will not sign an expanded deal that covers its regional militant proxies and ballistic missile program or requires irreversible denuclearization. The Supreme Leader has witnessed that an active nuclear weapon program and ballistic missile program provide the surest guarantees of regime survival over the long haul. The contrasting cases of Libya and North Korea illustrate the point (Chart 17). Libya gave up its nuclear program and weapons of mass destruction in the wake of the US invasion of Iraq in 2003 only to see the regime collapse in 2011 and leader Muammar Gaddafi die under NATO military pressure. By contrast, North Korea refused to give up its nuclear and missile programs and repeatedly cut deals with the US that served only to buy time and ease sanctions, and today North Korea possesses an estimated 30-45 nuclear weapons deliverable through multiple platforms. Leader Kim Jong Un has used this leverage to bargain with the great powers. The lesson for Iran could not be clearer: a short-term deal with the Americans may buy time and a reprieve from sanctions. But total, verifiable, and irreversible denuclearization means regime suicide. The Biden administration would prefer to create a much more robust deal rather than suffer the criticism of rejoining the 2015 deal, given its flaws and that the first set of deadlines in 2025 is only four years away. But Biden cannot possibly reconstruct the P5+1 coalition of countries to force Iran into a grander bargain in the context of US-Russia and US-China tensions. The sacrifices that would be necessary to bring Russia and China on board would not be worth it. Therefore Biden’s solution will be to rejoin the existing deal plus an Iranian promise to enter negotiations on a more comprehensive deal in future. The Iranians can accept this option since it serves their purpose of buying time without making irreversible concessions on their nuclear and missile programs. Israel then becomes the sticking point, as Iranian officials have said that the US rejoining the original 2015 deal would be a “calamity” and unacceptable. The Israeli government is studying options for military action in the event that Iran reaches nuclear breakout. However, the Israeli election on March 23 will determine the fate of Benjamin Netanyahu and his government’s hawkish approach to Iran. A change of government in Israel would likely bring the US and Israel into line on concluding a deal with Iran so as to avoid military conflict for the time being. If Netanyahu wins, yet the US and Iran fall back into compliance with the 2015 deal (Table 2), then Iran is still limiting its nuclear capabilities through 2025, obviating the need for a unilateral Israeli strike in the near term. Israel will not launch a unilateral strike except as a last resort, as it fears permanent alienation from its greatest security guarantor, the United States. Table 2Iran’s Compliance (And Non-Compliance) With The Joint Comprehensive Plan Of Action Biden, Iran, Markets Biden, Iran, Markets If a deal cannot be put together by the time Rouhani steps down then the risk of conflict will increase as there will not be a prospect of a short-term fix. A much longer diplomatic arc will be required as Iran would draw out negotiations and the US would have to court allies to pressure Iran. The US and/or Israel could conduct sabotage or air strikes to set back the Iranian nuclear program. It is possible that the Iranian leadership or the increasingly powerful Iranian Revolutionary Guard Corps could overplay their hand in the belief that the US has no stomach for waging war. While it is true that the US public is war-weary, it is also true that that attitude would change overnight in the event of a national humiliation or attack. Investment Takeaways The Trump administration drew a hard line on nuclear proliferation. Trump’s defeat marks a softening in the US line regarding proliferation. This does not mean that the Biden administration will be ineffective – it could be even more effective with a more flexible approach – but it does mean that nuclear aspirants currently feel less pressure to make major concessions. This will hold at least until Biden demonstrates that he too can impose maximum pressure. Hence nuclear and missile tests will go up in the near term – as will various countries’ demonstrations of credible threats and red lines. The global economic recovery will strengthen oil producers by giving them greater government revenues with which to stabilize their domestic politics and restart foreign policy initiatives. The global oil price is reasonably correlated with international conflicts involving oil producers (Chart 18). With rising oil revenues, Russia, Saudi Arabia, Iran, Iraq, and others will be emboldened to pursue their national interests. Chart 18Oil Price And Global Conflict Go Hand In Hand Biden, Iran, Markets Biden, Iran, Markets While the Biden administration’s end-game is a nuclear deal with Iran, the period between now and the conclusion of a deal will see an increase rather than a decrease in tensions and tit-for-tat military strikes across the region. Unexpected cutoffs of oil supplies and a risk premium in the oil price will be injected first, as we have argued. When a deal is visible on the horizon then oil prices face a downside risk, due to the resumption of Iranian oil exports and any loss of OPEC 2.0 discipline. It is possible that this moment is already upon us. This report shows a clear path to a US-Iran deal by August. US Secretary of State Anthony Blinken is reaching out to the Iranians. Saudi Arabia has recently announced that it will not continue with large production cuts. Russian oil officials have argued that the global market is balanced and production cuts are no longer necessary.5 But given that the Russians and Saudis fought an oil market share war as recently as last year, it is not clear that a collapse in OPEC 2.0 discipline is imminent. What will be the market impact if hostilities revive in anticipation of a deal? Or worse, if a deal cannot be achieved and a much longer period of US-Iran conflict opens up for Biden’s term in office? Table 3 provides a list of major geopolitical incidents and crises in the Middle East since the Yom Kippur war. We look at the S&P500’s peak and trough within the three months before and after each crisis. The median drawdown is 8% and the market has usually recovered within one month. Twelve months later the S&P is up by 12%. Table 3Stock Market Reaction To Middle East Geopolitical Crises Biden, Iran, Markets Biden, Iran, Markets Table 4 shows a shortened list of the same incidents with the impact on the trade-weighted dollar, which is notable in the short run but is only persistent in the long run in the case of full-fledged wars like the first and second Persian Gulf wars. Table 4US Dollar Falls On Middle East Geopolitical Crises Biden, Iran, Markets Biden, Iran, Markets The stock market impact can last for a year if the crisis coincides with a bear market and recession. Middle Eastern crises tend to occur at the height of business cycles when economic activity is running hot, inflationary pressures are high, and governments feel confident enough in their economic foundation to take foreign policy risks. The Yom Kippur war and first oil shock initiated a recession in 1973. The first Iraq war also coincided with the onset of a recession. The terrorist attack on the USS Cole occurred near the height of the Dotcom bubble and was followed by the 2001 recession. The 2019 Iranian attack on Saudi Arabia’s Abqaiq refinery also occurred at the peak of the cycle. More analogous to the situation today are crises that occurred in the early stages of the global cycle. The Arab Spring and related events in 2011 coincided with a period of market weakness that lasted for most of the year as the aftershocks of the Great Recession rippled across the emerging world. This scenario is relevant in 2021 and especially 2022, as global stimulus wears off and governments strive to navigate the deceleration in growth. Middle Eastern instability could compound that problem. The chief risk in the coming years would be a failure to resolve the Iranian question followed by a US-Iran or Israel-Iran conflict that generates instability across the Middle East. Such a catastrophe could cause major energy supply shock that would short-circuit the global economy. History shows this risk is more likely to come late in the cycle rather than early but the above analysis indicates that a failure of the Biden administration to conclude a deal this year could lead to a multi-year escalation in strategic tensions with a new hawkish Iranian president. That path, in turn, could bring forward the time frame of a major war and supply shock. The Iranians have taken a hawkish turn, are fortifying their regime for the future, and will reject total denuclearization. The US is fundamentally less interested in the region and thus susceptible to continued foreign policy incoherence. The Israelis are just capable of taking military action on their own in the event of impending Iranian nuclear weaponization. These points suggest that the risk of war with Iran is non-trivial, even though a US-Iran deal is the base case.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Sun Yu and Demetri Sevastopulo, "China targets rare earth export curbs to hobble US defence industry," Financial Times, February 15, 2021, ft.com. 2 For the US response to the Erbil attack see Jim Garamone, "Austin Pleased With Discussions With NATO Leaders," Department of Defense News, February 17, 2021, defense.gov. 3 For example, Biden is unlikely to withdraw precipitously from the region, including Afghanistan, as Trump intended, especially as long as he is in a high-stakes negotiation with Iran. 4 Ruth Igielnik and Kim Parker, "Majorities of U.S. veterans, public say the wars in Iraq and Afghanistan were not worth fighting," Pew Research, July 10, 2019, pewresearch.org. 5 See Benoit Faucon and Summer Said, "Saudi Arabia Set to Raise Oil Output Amid Recovery in Prices," Wall Street Journal, February 17, 2021, wsj.com; Yuliya Fedorinova and Olga Tanas, "Global Oil Markets Are Now Balanced, Russia’s Novak Says," Bloomberg, February 14, 2021, Bloomberg.com.

Highlights Health care remains a top priority of the Democratic Party even though it is flying under the radar at the moment. Health care embodies the shift from small government to big government. While the 2021 budget reconciliation will hit Big Pharma and expand Medicaid, the 2022 reconciliation will seek a public health insurance option and Medicare role in price negotiations. If forced to choose between health care and climate change priorities, Democrats will choose health care. It is a bigger vote-winner. Stay short managed health care relative to the S&P 500. Go long health care facilities and equipment relative to the rest of the health sector. Feature The US Senate acquitted former President Donald Trump on a vote of 57-43 on February 13. No one was hanged.1 The trial was not economically or financially significant except insofar as it underscored peak US political polarization, US distraction from the global stage, and the extent of divisions within the Republican Party. Equity market volatility melted away as stocks surged higher on the generally positive backdrop of COVID vaccines and stimulus.   Seven Republicans joined Democrats in voting to convict the former president of “incitement to insurrection.” Trump’s performance was worse than Bill Clinton’s but better than Andrew Johnson’s, though neither Clinton nor Johnson saw defections from their own party (Chart 1). The Republicans’ internal differences are serious enough to hobble them in the 2022 or 2024 elections but it is too soon to draw any hard conclusions. The Democratic agenda is also capable of bringing Republicans back together. Meanwhile the maximum of seven Republican defectors shows that it will be extremely difficult for Democrats to get 10 Republicans to join them in passing any controversial legislation in the Senate (Table 1). Hence the filibuster will remain in jeopardy over the long run if not in the short run. Also, in 2022, the Democrats have a chance to pick up seats in Pennsylvania and North Carolina. Chart 1Trump’s Acquittal And Historic Impeachment Results Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table 1The Seven Senate Republicans Who Defected From Trump Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Biden’s Agenda After The American Rescue Plan Democrats are plowing forward with the first of two budget reconciliation bills, which enables them to pass legislation with a simple majority in the Senate. They hope to pass President Biden’s $1.9 trillion American Rescue Plan by mid-March, when unemployment benefits expire under the Consolidated Appropriations Act of 2020. The final sum might be a bit less than this headline number. The second budget reconciliation bill, for fiscal year 2022, will be passed in the autumn or next spring and will contain anywhere from $4 trillion to $8 trillion worth of additional spending on health care, child care, infrastructure, and green projects over a ten-year period (Chart 2). This number will be watered down in negotiation as the pandemic subsides and the aura of crisis dies down, reducing the willingness of moderate Democrats to vote for anything controversial. But investors should not doubt Biden’s agenda at this stage. If there is anything we know about the reconciliation process it is that the ruling party will get what it wants. Investors should plan accordingly: the output gap will be closed sooner than expected and inflationary pressures will build faster than expected, even though it will take a while for the labor market to heal. Chart 2Biden’s Agenda AFTER The American Rescue Plan Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy This policy combination of “loose fiscal, loose monetary” policy continues to drive stocks higher (and the dollar lower) despite the misgivings we noted about underrated geopolitical risks (Chart 3). A critical question is when the Fed will normalize monetary policy. This is not an apolitical question. Fed chair Jerome Powell’s term ends in February of 2022. He may contemplate tapering asset purchases prior to that date, causing troubles in the equity market, but actual tapering is more likely to occur in 2022, in the view of our US Bond Strategist Ryan Swift. Powell would only taper in 2022 if he is forced to do so by an ironclad policy consensus precipitated by robust inflation and possibly financial instability concerns. This timing gives President Biden an opportunity to nominate an ultra-dovish Fed chair. Rate hikes are entirely possible in 2022 but our political bias implies they are unlikely before 2023 (unless an ironclad consensus develops that they are necessary). Even in 2023, an ultra-dove will be reluctant to hike, depending on the context. And rate hikes are virtually off limits in 2024, at least until after the November election. This political timeline reinforces the view that the Fed will not be hiking anytime soon and investors should prepare for inflation risks to surprise to the upside over the coming years. Chart 3"Easy Fiscal, Easy Monetary" Policy Combination "Easy Fiscal, Easy Monetary" Policy Combination "Easy Fiscal, Easy Monetary" Policy Combination The Senate parliamentarian has not yet ruled whether a federal minimum wage hike to $15 per hour can be included in the bill. Biden has accepted it may be cut but his party will push it through if possible. Last week we found that a higher minimum wage would not have a dramatic macroeconomic impact. Still, wages will rise in the coming years due to the cumulative effect of the Democratic Party’s policies. Higher wages, taxes, and regulatory hurdles will cut into corporate profits. But the passage of a higher minimum wage today would not in itself be a negative catalyst for equities. Rather, we would expect the rally to take a breather once the first reconciliation bill is finished (next week or in the coming weeks), since it will bring wage hikes, rate hikes, and tax hikes more clearly into view on the investment horizon.  Unlike minimum wages, there is little controversy over whether budget reconciliation can be used to change the health care system. This was done in 2010 as the second critical part to President Barack Obama’s Affordable Care Act (Obamacare). Hence Biden is highly likely to get his health agenda passed, which is largely an agenda of entrenching and expanding Obamacare. That is, as long as he prioritizes health care above other structural reforms like climate change. We think he will. In the rest of this report we look at Biden’s health care policy and the implications for US financial markets. Biden’s Health Care Policy Health care has been a top priority of the Democrats since 1992 yet they have repeatedly lost control of the agenda due to surprise Republican victories in 2000 and 2016. Republicans expanded Medicare under Bush but then failed to repeal and replace Obamacare under Trump. Now Democrats have only the narrowest of majorities in the House and Senate and will push hard to solidify and build on Obamacare. There is a low chance that they will leave this issue unsettled under the Biden administration. If new obstacles arise, more political capital will be spent to secure health care reform at the expense of other policies on the agenda. COVID-19 reinforces the Democrats’ focus on health care. The US has seen around 1,500 deaths per million people, making it one of the worst performers amid the crisis, comparable to the UK and Italy (Chart 4). Yet COVID is only the latest in a line of US public health failings and it is important to put COVID into perspective. For example, among US adults aged 25-44 years old, all-cause excess mortality from March to July last year was about 11,899 more than expected. By contrast, during the same period in 2018, there were 10,347 unintentional deaths due to opioids (Chart 5).2 In other words, the COVID crisis last year was comparable to the opioid crisis in magnitude, at least for middle-aged people. Obviously COVID has taken a terrible toll and is a more deadly disease for the old and the sick. The point is that the public’s wrath over poor public health and the US government’s ineffectiveness is well established. A pandemic was foreseeable, and foreseen, yet not prepared for, and it came on top of the opioid crisis and the debate about 30 million Americans who lack health insurance. The Biden administration has the intention and the capability to address these issues. Chart 4US Handling Of COVID-19 Left Much To Be Desired Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy   Chart 5Opioid Crisis Versus COVID Crisis Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy  The structural problem is well-known: The US spends more than other countries on health care but achieves worse results (Charts 6A & 6B). When workers get fired they lose health care, as insurance is tied to employment. Those whose employers do not provide health care or who are unemployed count among the ranks of the roughly 30 million uninsured. This number has fallen from its peak at 47 million in 2010 when Obamacare was enacted but has crept upward again since Trump’s attempt to dismantle that law and the lockdowns of 2020 (Chart 7). This is a driver of popular discontent that has proven again and again to generate votes, including in key swing states. Chart 6AThe US Spends More On Health Care … Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Chart 6B… But Sees Worse Avoidable Mortality Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Chart 7Rising Number Of Uninsured Even Pre-COVID Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy A range of public opinion polling over many years shows that health care is a close second or third to the economy and jobs in voter priorities. Voters care more about COVID and health care than they do about climate change and the environment (Chart 8, first panel). Chart 8Public Opinion On Biden’s Priorities: Jobs, Health, Then Climate Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Another important takeaway from this opinion polling is that voters could not care less about budget deficits. Big spending solutions are all the rage (Chart 8, second panel). The Biden administration is prioritizing economic recovery and the pandemic response but will also pursue its health care reforms. If this policy requires a tradeoff with infrastructure and renewables, we would expect health care to get the greater attention.  Over the long run Obamacare can be replaced but not repealed. The law is getting more popular over time and entitlements get harder to repeal over time. Slightly more than half of voters have a favorable view of the law and only 34% have an unfavorable view. Only 29%of voters want to repeal or scale back the law while about 62% want to build on it or keep it as it is (Chart 9). Underscoring this polling is the fact that the law was modeled on a Republican plan and even Trump adopted several of the most popular provisions: requiring insurance coverage for patients with preexisting conditions and slapping caps on pharmaceutical prices through import and pricing schemes. The Supreme Court has ruled Obamacare constitutional and is not expected to change that ruling this spring. It could object to the individual mandate – the most controversial part of Obamacare that required each person to pay a tax penalty if they did not purchase health insurance. But if parts of the law are stricken, Democrats have the votes to patch it up or provide an alternative.  Chart 9Obamacare Has Grown On American Public Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Biden simultaneously shows that Democrats rejected the most popular alternative to Obamacare – “Medicare for All,” or single-payer government-provided health care – at least for the current presidential cycle. Medicare for All was co-sponsored by Vice President Kamala Harris and is still a long-term goal of the progressive wing of the Democratic Party. However, voters do not like the proposal when asked about its practical consequences (Chart 10). In the Democratic primary, only Senators Bernie Sanders and Elizabeth Warren argued for wholesale revolution in US health care that would see private insurance cease to exist and 176 million voters moved onto a public health system. Sanders’s plan would have cost an estimated $31 trillion, increasing the budget deficit by $13 trillion over 10 years, and would have encouraged the overuse of medical services due to the absence of a co-pay or fixed cost. This idea will not vanish but the Biden administration’s likely success in expanding Obamacare will lead the party to focus on other things (e.g. climate change). Chart 10Insufficient Public Demand For Government-Provided Health Care (For Now) Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Biden’s big proposal is to add a public insurance option that would exist alongside current private insurance options. This idea was originally part of Obamacare but was removed during negotiations – precisely because the Democrats eschewed the use of budget reconciliation (again, not a constraint this time).3 The Biden plan is estimated to cost $2.25 trillion over 10 years and includes larger subsidies, the ability of workers to choose whether they want their employer-provided plan or the public option, automatic enrollment, a lower age of eligibility for Medicare (from 65 to 60), drug price caps, and various other provisions (Table 2). Table 2Biden’s Health Care Plan Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Medicare, a giant consumer, would be able to negotiate drug prices directly with companies to drive down the price. Tax hikes on high-income earners and capital gains would pay for Biden’s policy.  With public backing and full Democratic control of Congress, there is little that can stop Biden from achieving this health care policy, other than a change in direction from his party, which we do not expect. The first budget reconciliation only contains small parts of the Biden agenda, such as incentives for states to expand Medicaid under Obamacare and a reduction in Medicaid rebates for drug manufacturers.4 The second budget reconciliation process will have to cover health care and tax hikes. But the consensus view is that the second reconciliation will focus on infrastructure and green energy. This is a conflict of priorities that will have to be resolved. The research above suggests it will be resolved in favor of health care. This would leave the regular budget process as the means to advance infrastructure and green projects. Macro Impact Of Biden’s Health Care Policy The great health care debate over the past decade reflected the broad post-Cold War debate in the US over the role of government in the economy. It centered on whether government involvement should increase to expand health insurance coverage. Although private US health care spending accounts for 31% of total health care spending, and is thus larger than either Medicare (21%) or Medicaid (16%), the government has control of 44% of spending when all of its functions are added together. This share is set to increase now that the debate has been decided in favor of Big Government (at least for now). Future administrations might carve out more space for private choice and competition in health care but a permanent step-up in government involvement and regulation has occurred given the above points about Obamacare’s irrevocability. What are the macro consequences of such a change?   The imposition of Obamacare may have contributed to the sluggish economic recovery in the wake of the Great Recession but the case is hard to examine objectively because the tax penalties only took effect in 2015-16 and then a new administration ceased implementation in 2017. In 2015 the Congressional Budget Office estimated that repealing Obamacare would increase the budget deficit by $353 billion over a ten year period but that it would also increase GDP by an average of 0.7% per year during the latter end of full implementation, thus boosting revenues and producing a net $137 billion increase in the budget deficit over ten years.5 In other words, Obamacare marginally tightened fiscal policy and encouraged some workers to cut their hours or stop working due to expanded subsidies, tax credits, and Medicaid eligibility.6 Repealing it would have reduced the tax burden on corporations and reduced the subsidy benefits to households but possibly with a slight boost to growth (Chart 11). Going forward, Biden’s policies are adjustments rather than a total overhaul but they would ostensibly add $2.25 trillion in spending and $1.4 trillion in revenue, resulting in a negative impact on the budget deficit (fiscal loosening) of $850 billion. The implication is that Biden’s plan would increase rather than decrease aggregate demand, albeit marginally in an era of already gigantic deficits. It would also remove some labor supply and eventually drag on GDP growth. Yet the impact of these effects is still uncertain given the general context of loose fiscal and loose monetary policy, the reduction in the number of uninsured people, and the potentially positive second-order effects of this increase in the social safety net for low-income families with high marginal propensities to consume. The bottom line is that the macro effects of Biden’s health plan will not be known for many years but the headline effect in the short run is an incremental addition to an already extremely loose fiscal policy setting.  Chart 11Macro Effects Of Obamacare Repeal Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy The negative effects will largely fall on high-income earners, capital gains earners, and corporations who will provide the revenue to pay for the plan. The private health insurance industry faced an existential threat from the Sanders plan but it still faces a loss of customers and earnings from the Biden plan. The major difference between Obamacare and Bidencare is that Obamacare forced insurance companies to provide a basic insurance option to the public but did not offer a public option to compete with them. Therefore their customer base increased albeit at a lower profit. Whereas Biden’s plan will create a public competitor that will siphon off customers from private insurance. Biden proposed giving workers this choice anytime but in the presidential debates suggested there would be limits. Either way private insurers stand to lose customers over time. This is not a major political constraint given that Big Insurance gets little sympathy from the public but it will have a negative impact on innovation and productivity in the health sector. Meanwhile Medicare would reimburse hospitals, clinics, and drug providers less for their services and goods. This would weigh on the profitability of small and private medical outfits and favor large and public providers that receive government subsidies and can stomach higher costs. It would also take a toll on Big Pharma and biotech sectors which have operated in a lucrative environment of low taxes, low regulation, and sizable pricing power. The US government has enormous negotiating power in the market, especially over home care, hospitals, nursing homes, and prescription drugs. Private and public investment are roughly evenly split, with public money dominating health care research and private money dominating structures and equipment. The government accounts for about 40% of total drug spending and both political parties believe this influence should be used to keep costs down, as public opinion is increasingly dissatisfied with high drug costs.7 There is a lot more to be said about the US health care system. A risk of Biden’s health reform is that it will increase the demand for health services without arranging for consummate increases in supply. In this sense it is inflationary. Investment Takeaways Health care stocks and each of the health care sub-sectors – pharmaceuticals, biotech, managed health care, facilities, and equipment – underperformed the S&P500 index amid the passage of Obamacare from March 23 to November 20, 2010. Within the sector, managed health care (health insurance) and biotech suffered most when the legislation first hit while facilities and equipment suffered most over the whole legislative episode. Once the law took full effect in 2014-15, equipment and managed health care outperformed, facilities were flat, and pharma and biotech underperformed. A look at the performance of the health care sector relative to the S&P 500 over the past 13 years shows that the sector rallied on President Obama’s victories in 2008, fell during the passage of Obamacare, staged a recovery that continued through the Supreme Court’s decision to uphold the new law in June of 2012, and then dropped off (Chart 12 A). Health stocks benefited from the global macro backdrop from 2011-15. After 2015, when Obamacare took full effect, the business cycle entered its later stage, and populism emerged (with Sanders threatening a government takeover and Trump firing up the cyclical economy), health care stocks underperformed the market. Chart 12AHealth Sector's Response To Obamacare Saga Health Sector's Response To Obamacare Saga Health Sector's Response To Obamacare Saga Subsequent rallies have occurred, notably on the outbreak of COVID-19, but have not been sustainable. When Republicans failed to repeal Obamacare, when various crises gave defensive plays a tailwind, when Biden won the Democratic nomination over Sanders or Warren, and when the pandemic arose, the sector surged, often due to risk aversion in financial markets. In the end the negative trend reasserted itself as the combination of rising risk sentiment and policy headwinds outweighed the underlying demographic tailwind for earnings as society aged. Since the Democratic sweep of government in the 2020 elections the sector is testing new lows in relative performance. Pharmaceuticals charted a similar course to the overall health sector but never regained their pre-Obamacare peak in relative performance. They have underperformed again and again since the rise of Bernie Sanders and are today touching new lows (Chart 12B). Chart 12BBig Pharma's Response To Obamacare Saga Big Pharma's Response To Obamacare Saga Big Pharma's Response To Obamacare Saga A closer look at the sector since the 2020 election and especially the Democratic victory in the Senate shows that it continues to underperform the broad market. Facilities are the most resilient, pharma and biotech are trying to find a bottom, and equipment and managed health care have sold off. Relative to the health care sector, equipment and facilities are the outperformers but, again, pharma and biotech are trying to bottom (Chart 13). These results make sense as Biden’s biggest policy impact will be to stimulate demand for health care facilities and equipment while constraining profits for Big Insurance and Big Pharma via the public insurance option and allowing Medicare to negotiate drug prices. Thus equipment and facilities benefit from the political environment, pharma and biotech should be monitored to see if they break down to new lows on the passage of legislation, and managed health care gets the short end of the stick. Our US Equity Strategy service is neutral on the sector as a whole, overweight equipment, and underweight pharma. Chart 13Health Care Sector Response To Biden's Democratic Sweep Health Care Sector Response To Biden's Democratic Sweep Health Care Sector Response To Biden's Democratic Sweep Putting it all together, health care stocks are good candidates for a short-term, tactical bounce when the exuberant stock rally suffers a correction but they are not yet candidates for strategic investments. They are not likely to find a bottom until Biden’s policies are passed, or the pro-cyclical macro backdrop has changed. Biden’s policies are high priority for his party and face low legislative and political hurdles to passage, yet will have a huge impact on the relevant industries – undercutting the private health insurance customer base and capping the profits of America’s drug makers. These changes will have long-term ramifications so they are not likely to be fully discounted yet. Previously health care firms had huge pricing power – they could charge whatever they wanted while they did not face the full might of the government in setting prices – but going forward that will change. Biotech and pharma have large profit margins that are exposed to this policy shift so they are exposed to further downside – we would not be bottom-feeders. Moreover pharmaceuticals make up 28% of the health sector while biotech makes up 13%, so that these sectors will weigh down the whole sector. One would think that health care would outperform during a global pandemic – and most sectors did see a big bounce during the height of the COVID-19 outbreak. But the pandemic has created the impetus for a stimulus splurge that has fired up the cyclical parts of the economy. It has also underscored the industry’s public role and undercut its profit-making capabilities, not least by producing a Democratic sweep bent on improving US health outcomes – at the expense of US health industry profits. In sum, from a tactical point of view, health care stocks are well-positioned for a near-term rally in relative performance but from a strategic point of view they continue to face policy headwinds and should be underweighted relative to the broad S&P 500. Tactically, stay short the managed health care sub-sector relative to the S&P 500 (Chart 14). Strategically, go long health care facilities and equipment relative to the health care sector. Chart 14Health Stocks Outlook Under Biden Administration Health Stocks Outlook Under Biden Administration Health Stocks Outlook Under Biden Administration     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table A1BPolitical Capital: Household And Business Sentiment Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table A1CPolitical Capital: The Economy And Markets Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table A2Political Risk Matrix Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table A3Biden’s Cabinet Position Appointments Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy           Footnotes 1     During the election crisis [of 1876], Kentucky Democrat Henry Watterson urged that “a hundred thousand petitioners” and “ten thousand unarmed Kentuckians” go to Washington to see that justice was done. Years later, when he was sitting next to [Ulysses S.] Grant at a dinner party, Watterson told him, “I have a bone to pick with you.” “Well, what is it?” asked Grant. “You remember in 1876,” said Watterson, “when it was said I was coming to Washington at the head of a regiment, and you said you would hang me if I came.” “Oh, no,” cried Grant, “I never said that.” “I am glad to hear it,” smiled Watterson. “I like you better than ever.” “But,” added Grant drily, “I would, if you had come.” See Paul F. Boller, Jr, Presidential Campaigns: From George Washington To George W. Bush (Oxford: Oxford University Press, 2004 [1984]), p. 141. 2     See Jeremy Samuel Faust, Harlan M. Krumholz, and Chengan Du, “All-Cause Excess Mortality and COVID-19-Related Mortality Among US Adults Aged 25-44 Years, March-July 2020,” Journal of the American Medical Association, December 16, 2020, jamanetwork.com. 3    The death of Senator Edward Kennedy forced the Democrats to use reconciliation for the second part of President Obama’s health care reform, the Healthcare and Education Reconciliation Act of 2010.  4    Currently the Medicaid rebate cap is set at 100% of the cost of making a drug. Other provisions would include a boost for rural health care services (a partial reallocation of headline COVID relief funds) and an expansion of Obamacare tax credits and subsidies for unemployed workers to keep their former employer-provided insurance. These are mainly COVID relief measures rather than aspects of Biden’s long-term health agenda. See Julie Rovner, “KHN’s ‘What the Health?’: All About Budget Reconciliation,” Kaiser Family Foundation, February 11, 2021, khn.org; see also Nick Hut, “A look at some of the healthcare-specific provisions in the pending COVID-19 relief legislation,” Healthcare Financial Management Association, February 10, 2021, hfma.org. 5    For the CBO’s original report on repeal, see “Budgetary and Economic Effects of Repealing the Affordable Care Act,” Congressional Budget Office, June 19, 2015, cbo.gov. More recently see Paul N. Van de Water, “Affordable Care Act Still Reduces Deficits, Despite Tax Repeals,” Center for Budget and Policy Priorities, January 9, 2020, cbpp.org. 6    See BCA Global Investment Strategy, “The Fed’s Dilemma,” May 12, 2017 and “Four Key Questions On The 2018 Global Growth Outlook,” January 5, 2018, bcaresearch.com. Regarding the debate around Obamacare, promoters highlight the recovery in US growth and jobs – including full-time jobs and small-business jobs – by 2015. Critics say the recovery would have been stronger if not for the law. See e.g. Casey B. Mulligan, “Has Obamacare Been Good for the Economy?” Manhattan Institute, Issues Brief, June 27, 2016, manhattan-institute.org; Cathy Schoen, “The Affordable Care Act and the U.S. Economy: A Five-Year Perspective,” Commonwealth Fund, February 2016, commonwealthfund.org. 7     Republican Senator Chuck Grassley co-sponsored a bill with his Democratic counterpart Ron Wyden of Oregon that would penalize drug companies that raised drug prices faster than inflation. In a separate bill with Senator Amy Klobuchar of Minnesota, he also proposed to prevent big name drug companies from paying generic drug-makers to delay the introduction of generics to the market. These bills were not debated on the main floor because then-Senate Majority Leader Mitch McConnell was unenthused about them but they exemplify the bipartisan consensus on government intervention to push down drug prices.