Geopolitics

Highlights Volatility subsided but we still think geopolitical risk is underrated in the near term. The new Biden administration faces critical tests on China/Taiwan and Iran. The Biden-Xi phone call did not resolve anything. We recommend investors hedge geopolitical risk by adding a tactical long CHF-USD. The medium-to-long-term macro backdrop is shifting in favor of frontier markets – but it is too soon to dive in. African frontier markets have not yet benefited from the global economic recovery – and may face more pain in the near term. The Ethiopian crisis will further destabilize the Horn of Africa region. Kenya is the relative beneficiary in geopolitical terms, though Kenyan stocks are expensive relative to other frontier markets. Feature Volatility subsided over the past two weeks, global stocks rallied, and bond yields rose. The US dollar bounce lost some of its steam. From a macro point of view, we understand investor exuberance. But from a geopolitical point of view, risks are now understated. President Joe Biden faces imminent tests from China, Iran, and Russia. Table 1 provides a checklist of what we need to see to conclude that a new US-China modus vivendi has been established. The phone conversation between Presidents Biden and Xi Jinping on February 10 is marginally positive but, judging by history, the call shows that tensions remain high.1 Until these conditions are met the two sides are hurtling toward a diplomatic crisis over the Taiwan Strait sometime after China emerges from its annual National People’s Congress. Incidentally, China’s ongoing policy shift toward slower and more disciplined growth will be the takeaway from this year’s legislative session, which is not positive for global cyclicals or China plays beyond the near term. China’s credit impulse has decisively rolled over and the combined fiscal-and-credit impulse is peaking now (Chart 1). Table 1First Biden-Xi Call Did Not Resolve US-China Tensions Frontier Markets And The Ethiopian Crisis Frontier Markets And The Ethiopian Crisis Chart 1China's Fiscal-And-Credit Stimulus Peaking Now China's Fiscal-And-Credit Stimulus Peaking Now China's Fiscal-And-Credit Stimulus Peaking Now A crisis is also brewing in the Middle East. Iran is not going to abandon its quest for nuclear weapons over the long run but it is willing to negotiate a deal in the short run that reduces US sanctions. Especially if lame duck President Hassan Rouhani gets it done before he steps down in August. The next Iranian president will not want to make the same mistake Rouhani made and bet his future on the unreliable United States. This requires Biden to rejoin the existing 2015 nuclear deal with a vague commitment to negotiate a better deal later. However, this outcome is precisely what Israeli officials have called a “calamity.” 2 The Biden team gives Iran three-to-four months before it has enough highly enriched uranium to make a bomb – it wants to move quickly on negotiations. Israel gives it a year – it wants to convince the Democrats to stick with Trump’s maximum pressure. Either way the first half of this year is crunch time. Otherwise Iran’s new administration will require a much longer negotiation. Negotiations will be checkered with attacks to demonstrate credible threats and red lines. Ultimately, since we expect Biden to forge a US-Iran détente, and since the China/Taiwan risk is negative for energy prices, we no longer express our Iran view in the form of a long oil position. Brent crude is close to our Commodity & Energy Strategy’s $63 per barrel target for this year’s average. The Saudis could abandon their production discipline when Iranian oil gets closer to coming online. Investors should distinguish these immediate geopolitical risks from the general, long-running US-China and US-Iran conflicts. These will wax and wane while global risk assets grind upward over the long haul. If China avoids over-tightening policy and the Biden administration passes early hurdles we will be more bullish. For now we recommend investors hedge their bets by increasing exposure to safe-haven assets. We remain long gold and Japanese yen. Tactically we recommend going long the Swiss franc versus the dollar as well. Finally, in what follows, we take a sojourn from these headline geopolitical risks to offer a special report on the Ethiopian crisis and implications for Africa, Europe, and frontier markets. Now is not the right time to dive headlong into African frontier markets given the risks outlined above but we do see an opportunity on the horizon. Is The Ethiopian Crisis Investment Relevant? Ethiopia is now in its fourth month of crisis. The country is grappling with internal conflict brought upon by political and ethnic differences among the former and current ruling elite. Over the past week, Ethiopian Prime Minister Abiy Ahmed spoke with US Secretary of State Antony Blinken, French President Emmanuel Macron, and German Chancellor Angela Merkel about reports that Eritrean soldiers have entered the fray. East Africa will become increasingly unstable as conflict persists, threatening security, migration, and investment into the region. Investors looking to frontier markets in light of the global liquidity explosion should exercise caution. Peacemaking Abiy Goes On The Offensive Ethiopian government forces continue to battle a minority group, the Tigray People Liberation Front (TPLF), in the north of the country. Large-scale attacks, like those seen at the start of the conflict, have mostly diminished. However, both sides continue to maintain their offensive positions. With the recent entry of Eritrean forces into Ethiopia to support the government’s battle against the TPLF, conflict between government forces and the TPLF will continue at the very least. Tensions between the government of Prime Minister Abiy and the Tigray people have been in play for years. The Tigray largely dominated Ethiopia’s ruling coalition and security forces until the past decade. Public protests in 2015 were driven by frustration over laws that denied Ethiopians basic civil and political rights. In 2018, a popular uprising brought Abiy to power and he ushered in democratic reforms and an end to conflict with neighboring Eritrea. Abiy’s “reforms” are so far of limited relevance to investors. He released several high-profile political prisoners, lifted a draconian state of emergency, and planned to amend the constitution to institute term limits for prime ministers. Some civil liberties were restored. The investment-relevant aspect of the reforms were proposals to end government monopolies in key economic sectors, including telecommunications, energy, and air transport – but these have yet to happen. Abiy was most eager to dismantle Ethiopia's previous ruling party, the Ethiopian People's Revolutionary Democratic Front (EPRDF), which was dominated by the Tigray and had run the country for 28 years. Abiy supplanted the EPRDF with a single national Prosperity Party, which was not organized on ethnic lines. Having controlled all facets of state power prior to its ouster in 2018, the TPLF views Abiy’s democratic reforms and proposals for economic liberalization with anxiety. Abiy’s interest in reforming the federalist structure of the Ethiopian state - which divides Ethiopia into nine self-governing ethnic territories - threatens to undermine the order that has historically permitted the small Tigrayan ethnic group to wield a power disproportionate to its population (Chart 2). Chart 2Major Ethnic Groups In Ethiopia Frontier Markets And The Ethiopian Crisis Frontier Markets And The Ethiopian Crisis Abiy is an Oromo by origin and thus a member of Ethiopia’s largest ethnic group. His espousal of a broader nationalist agenda over narrow ethnic priorities is viewed by many of the smaller ethnic groups as eroding the right to self-rule. This includes secession, which is granted by the Ethiopian Constitution to ethnically organized regions. The TPLF has also expressed unease with Abiy over his intentions to amend the Constitution, which provides the basis of the current ethnic federalism. In defiance, the TPLF broke away from the Prosperity Party and attempted to unite opposition forces under a new federalist coalition. Failing to do so led the TPLF to isolate itself from the country’s political process. Bottom Line: As is often the case in geopolitics, the media hype about the election of a young peacemaker and would-be reformer masked the reality that Ethiopia’s old regime was coming apart at the seams. Abiy And The TPLF Faceoff Since 2019, Abiy has accused the TPLF of trying to destabilize the country and suggested that the TPLF were responsible for several mass ethnic killings across Ethiopia. Matters worsened in March 2020, during the collapse of the global economy amid the COVID-19 pandemic, when Abiy postponed national and regional elections scheduled for August, causing mass discontent among the TPLF. Abiy claimed he postponed the election because of the pandemic, citing the risks involved in mass in-person voting. But Tigray leaders feared a power grab. This is because the 2020 election was to serve as a litmus test on Abiy. Furthermore, opposition parties believe the Prosperity Party has achieved little economic policy cooperation and support among other parties, which would weaken the prospect of Abiy forming a coalition government if need be. In essence they hoped to claw back some power during the election and its deferral sent them into revolt. Relations soured further in September 2020 when the TPLF went forward with elections in Tigray, despite the rest of the country holding out for the delayed 2021 elections. The TPLF reported an overwhelming victory in the popular vote. The newly installed regional legislators in Tigray immediately declared that Abiy’s government lacked legitimacy to govern the country and refused to recognize it. The national assembly countered by annulling Tigray’s election results and refusing to acknowledge the newly elected leadership. Federal funding to the region was slashed significantly, limiting the flow of resources only to local governments to keep basic services running. The leadership in Mekele, the capital of Tigray, called the cessation of funding a declaration of war. Tensions boiled over into physical violence between government troops and the TPLF in November 2020. Widespread military attacks had been reported almost weekly between November and December often with many casualties of military personnel, TPLF members, and civilians. In 2021, attacks have significantly decreased, but TPLF resistance remains strong and intact in the North of the country. While the local economy was hard-hit by the fighting, it is not clear how long the local economy can sustain the state of resistance by both government forces and the TPLF. Bottom Line: Violence and war will continue between Abiy and the TPLF for the foreseeable future. Peace is hard to see happening at the current juncture, as Abiy looks to increase the power of his government and the TPLF fights to retain vestiges of its former power. Conflict Derails Economic Progress Ethiopia has averaged double-digit growth over the past decade, driven by large-scale fiscal spending and foreign direct investment. The country’s consumer base is also rising – 110 million people make the country the second most populous in Africa, with 50% of working age. But COVID-19 has put the brakes on future growth expectations, now penned at levels last seen in the early 2000s (Chart 3). Post 2021, growth is expected to rise significantly, but protracted mass social unrest brought about by internal conflict will see the economy grow at much lower levels. Offering a reprieve to the country’s economic woes is coffee bean production, Ethiopia’s chief export, which is mostly to the east of the country. Futures markets have priced in rising risk since the onset of the conflict. Transporting coffee beans would have to move through the north east of the country to the nearest port for export, in Djibouti. Moving through this part of the country raises the risk of encountering sporadic conflict. Chart 3Ethiopia Economic Growth Frontier Markets And The Ethiopian Crisis Frontier Markets And The Ethiopian Crisis Chart 4Horn Of Africa Output Per Head Frontier Markets And The Ethiopian Crisis Frontier Markets And The Ethiopian Crisis In 2000, Ethiopia was the third-poorest country in the world. More than 50% of the population lived below the global poverty line—the highest poverty rate in the world. Just two decades later, Ethiopia almost doubled GDP per capita wealth – a noteworthy achievement. But the country is still only comparable to Uganda, a much smaller, less developed economy to the southwest (Chart 4). Whilst income shared across the country has been rising, Abiy’s government runs the risk of eroding several years of economic gains that have been felt throughout the population by maintaining its battle against the TPLF. An economic crisis now would exacerbate the conflict and pull Ethiopia’s economy further into recession and poverty. Bottom Line: The Ethiopian conflict will persist in the coming years, resulting in the deterioration of many years of hard-earned economic development. The TPLF’s military and economic resources may be fast declining, but the conflict is domiciled on home ground – the Tigray region – and is widely backed by the Tigray people. International criticism is unlikely to deter Abiy from trying to minimize the TPLF’s political prowess. His popularity will allow him to keep his hard line. Yet Abiy will have to deal with an economy that will further decline as fighting continues. Regional Stability At Risk? The Horn of Africa is a gateway to the Suez Canal and as such a strategically important region. Its coastal opening on the Red Sea positions it along the critical maritime trade artery linking Europe and Asia. The Horn of Africa is also a fragile region that has seen severe conflict over the past decades: a civil war in Somalia and continued attacks by Al-Shabaab; piracy off the coast of Somalia; civil war in Darfur and South Sudan; proximity to the civil war in Yemen; ethnic unrest in Ethiopia; and the securitization of the Red Sea, as exemplified by Djibouti, which now hosts more foreign military bases than any other country in the world. Ethiopia is the African linchpin of the region’s long-term stability. The country runs a successful peacekeeping mission in neighboring Somalia. This will end if conflict with the TPLF continues to escalate. The country contributes around 4,000 of the 17,000 troops under the African Union’s mission and has around 15,000 additional soldiers in Somalia on its own — more than any other nation. If need be, troops will be pulled from Somalia to fight the TPLF, creating a security vacuum in Somalia where Al-Shabaab would revive. To make matters worse, US troops began withdrawing from two bases in Somalia in October. Though former President Trump failed to pull all US troops from the country, and President Biden is ostensibly in favor of maintaining US global engagement, it remains to be seen whether the US will put real pressure on Ethiopia to halt the conflict, such as threatening to cut its roughly $1 billion in annual aid. Many of the 700-odd US forces in Somalia train and support Somali special forces (Danab), who seek to contain the Al-Shabaab insurgency. Considering that Al-Shabaab has carried out deadly attacks on civilians throughout the East African region, such as the Westgate shopping mall attack in Kenya eight years ago and an attack on a US military base in Kenya that killed 3 Americans in January 2020, terrorism will pick up if regional security efforts are reduced. Bottom Line: Neither Ethiopia nor international terrorism are high on the Biden administration’s list of things to do. At home Biden is focused on domestic legislation to handle the pandemic and economic recovery. Abroad he is focused on restoring the 2015 Iranian nuclear deal and countering China’s and Russia’s regional ambitions. The Europeans, for their part, will react with lukewarm punitive economic measures toward Ethiopia, as they are not wishing to destabilize the region any further. Migration Will Follow After Conflict For global investors a more pertinent concern may be the rise in displaced persons, asylum seekers, and refugee populations in the region. At the end of 2019, Sub-Saharan Africa had 16.5 million internally displaced persons and 6.5 million refugees. Of this, the Horn of Africa hosts 8.1 million internally displaced persons and 4.5 million refugees and Ethiopia hosts 1.7 million displaced persons and 700,000 refugees. Note that these numbers come from the year before Ethiopia’s tensions boiled over – Ethiopian refugees will surge in 2020-21. In terms of migrants outside of Africa and originating from Ethiopia, there were 170 000 refugees and asylum seekers at the end of 2019 (Chart 5). Refugees, asylum seekers, and displaced persons will multiply as conflict rages. Neighboring countries like South Sudan, Sudan, Eritrea, and Somalia, which are already stretched in their capacity to hold such persons, will be overwhelmed. Already, these four countries alone account for approximately 4.4 million refugees, making up more than half of Africa’s total number of refugees (Chart 6). While Ethiopia’s contribution to the continent’s migrant base (both refugees and asylum seekers) is small (2.2%) in comparison to its neighbors, it is this very reason that suggests destabilization will add significant numbers to the growing crisis on the continent. Chart 5Ethiopian Refugees And Asylum Seekers Frontier Markets And The Ethiopian Crisis Frontier Markets And The Ethiopian Crisis Chart 6African Refugees And Asylum Seekers Frontier Markets And The Ethiopian Crisis Frontier Markets And The Ethiopian Crisis Europe and the Middle East are the two preferred regions for Ethiopian migrants. Europe received approximately 22% of Ethiopian-born refugees and asylum seekers in 2019, again, prior to the outbreak of civil war (Chart 7).   Chart 7Ethiopian And African Refugees In The EU Frontier Markets And The Ethiopian Crisis Frontier Markets And The Ethiopian Crisis With reports suggesting that an additional 600,000 displaced persons have emerged due to this year’s conflict, and another 40,000 refugees, the EU could see an additional 10,000 migrants from Ethiopia alone over the next year. On top of that would be counted any increase in refugees and asylum seekers resulting from increasing instability in the Horn of Africa. A more intense conflict will drive the numbers up dramatically. Bottom Line: The effects resulting from conflict in the region’s most populous and stable economy will carry over into neighboring countries, such as Somalia, exacerbating the refugee and economic crises in the Horn of Africa and ultimately increasing the risk of greater immigration into Europe. In comparison to the Syrian refugee crisis, Ethiopia is not in a state of utter collapse like Syria but if it did collapse it would pose a larger risk to Europe. Ethiopia’s population is four times larger than that of Syria’s in 2011. Syria counted 6 million internally displaced persons and almost 5 million refugees (approximately 25% of the population) at the start of the civil war. From the 5 million refugees, 2% made their way into Europe. A civil war of a similar magnitude in Ethiopia would result in almost 28 million refugees (25% of 110 million population), and 600 000 refugees heading toward Europe, by the same metrics. Surrounding Markets Will Benefit From Re-Directed Investment Direct investment flows from the country’s primary benefactor, China, have helped to spur Ethiopia’s growth and development. The country has received approximately 67% of all Chinese direct investment funds into the Horn of Africa since 2005 and 8% of the total in Sub-Saharan Africa (Chart 8). Chart 8China Slows Investment In Africa Frontier Markets And The Ethiopian Crisis Frontier Markets And The Ethiopian Crisis The trend has turned down over the past couple of years, with Chinese officials citing over-exposure to Ethiopia as a reason for lower outward investment into the country. In this sense China appears to have recognized a growing problem in Ethiopia in recent years. Infrastructure projects such as the Addis Ababa-Djibouti railway have resulted in large losses for Chinese firms due to insecurity and liability risks. For example, parts of railway have at times been rendered inoperable due to infrastructure theft or sabotage, or by intentional accidents by civilians to claim liability against the railway line’s constructor and operators. Rising conflict in Ethiopia will squeeze Chinese interests out of the country and redirect them to more stable markets, such as Kenya, to expand its Belt and Road Initiative along the East African coast (Chart 9). Kenya has at times received more direct investment from China than Ethiopia. China’s various problems with investment projects in Kenya pale in comparison to Ethiopia’s general instability. A nudge toward a more sustained flow of funds to Kenyan projects is now on the horizon. China could build further economic interest in neighboring Uganda but political risk continues to rise in the country after a contested election saw the country’s ruler for the past 35 years, Museveni, win his sixth term in office. The same holds for other foreign investment flows into Ethiopia. On a net basis, foreign direct investment into Ethiopia has been declining since 2016, while neighboring Uganda and Kenya have recorded upticks over the same period (Chart 10). Chart 9China’s Investment In East Africa Frontier Markets And The Ethiopian Crisis Frontier Markets And The Ethiopian Crisis Chart 10Kenya And Uganda Will Get More Investment Frontier Markets And The Ethiopian Crisis Frontier Markets And The Ethiopian Crisis Bottom Line: Foreign direct investment into Ethiopia and the region has been declining, even from China and even prior to the 2020 crisis. Investors and foreign flows will look to relatively more stable markets, such as Uganda and Kenya, to take on longer-term risk. Where To From Here? The longer Abiy drags out military operations, the likelier the Tigray conflict could metastasize into an humanitarian crisis and ultimately civil war. While political survival is at the forefront of Abiy’s considerations, he has broadly staked his international reputation on being a reform-minded innovator who will usher in needed change to Ethiopia. A key question is whether Abiy will now move to de-escalate the conflict – to bring military operations to a close and turn his attention to reconciliation. The Ethiopian army’s convincing victory in Mekelle provides Abiy with a valuable off-ramp to enter negotiations and pivot back to his reform agenda. If Abiy does not take advantage of this moment, he risks undermining Ethiopia’s fledgling economy, fostering a prolonged humanitarian crisis, getting stuck in a protracted armed conflict, and destroying his international reputation. The EU has already delayed payment of 90 million euros in aid in the wake of the conflict, and is threatening to withhold more from the 2 billion euro aid package that the EU agreed to disperse to Ethiopia over several years. However, at present, Abiy remains defiant, stating that the offensive toward the TPLF is warranted and arguing that Ethiopia’s sovereignty is not “for sale” to international donors. Abiy will continue to put pressure on the TPLF unless they concede to federal supremacy. As the larger force in this battle, Abiy’s government will not back down. He has the backing of the military and neighboring forces such as the Eritrean military. His popularity has remained intact through the course of this latest conflict. With an upcoming national election, he is looking at the conflict as a way to consolidate control. Bottom Line: Abiy has the political capital to wait out the TPLF’s surrender, while the economy takes a knock from ongoing conflict. Investment Takeaways A major wave of immigration from the Horn of Africa into Europe would not have predictable financial consequences. The Syrian refugee crisis, which peaked in 2015, did not have a discernible impact on the Turkish lira, or Greek, Italian, or Turkish relative equity performance. It might have contributed to investor preference for the dollar over the euro but the real driver of euro weakness at that time stemmed from the European Central Bank’s quantitative easing and US relative growth and interest rates. A bounce in USD-EUR during the spike in refugees in mid-2016 cannot be attributed to interest rate differentials but it is brief (Chart 11). Thus the significance of any major wave of immigration in the post-COVID era will be found elsewhere – in politics and geopolitics. Chart 11Syrian Refugee Crisis A Political, Not Financial Event Syrian Refugee Crisis A Political, Not Financial Event Syrian Refugee Crisis A Political, Not Financial Event The geopolitical consequence of the Syrian refugee crisis was ultimately a rise in European populism or anti-establishment politics. The political establishment mostly blunted this trend by cracking down on migrant inflows. That could change in future if border controls are relaxed or the magnitude of migration increases. Falling GDP per capita in Africa over the past decade alongside superior quality of life in Europe will continue to motivate immigration, especially if Africa’s growth disappoints expectations in the aftermath of the crisis (Chart 12). Conflicts such as in Ethiopia will generate more emigration. What about African frontier markets? Ostensibly the global backdrop is as bullish for frontier markets and specifically African frontier markets. Valuations are deeply depressed after a decade of strong dollar and weak commodity prices. Now global central banks are flooding the world with liquidity, the dollar is falling, and commodity prices are rising. China, Europe, and the US have stabilized their economies. However, it should be noted that Sub-Saharan Africa’s exports have lagged and therefore the economic pain is not yet over for this region even though improvement is on the horizon (Chart 13). If growth returns to trend then Sub-Saharan Africa’s real GDP should grow in line with emerging markets at a little less than 5% per year. This is better than Latin America, which also has a slightly smaller stock of gross domestic savings, though both regions are savings-poor and struggling to form fixed capital. Chart 12Disparity Between Europe And Africa Frontier Markets And The Ethiopian Crisis Frontier Markets And The Ethiopian Crisis Chart 13Global Commodity Prices And African Exports Soaring Global Commodity Prices And African Exports Soaring Global Commodity Prices And African Exports Soaring Chart 14Sovereign Credit Spreads Sovereign Credit Spreads Sovereign Credit Spreads Emerging and frontier markets stand to benefit from low global interest rates and rising commodity prices but they need to see global economic stabilization first. Sovereign credit spreads have come down across the frontier markets, with African markets leading the way (Chart 14). However, debt levels are high in a number of these markets. Credit default swap rates are rising after their steep fall over the second half of last year (Chart 15). Emerging market equities have rallied sharply relative to developed markets and this trend should continue as the pandemic subsides and the global recovery gains steam. But frontier markets have underperformed emerging markets since mid-2019 and South Africa specifically since COVID-19, with no sign yet of reversing. Within frontier markets, African equities have outperformed since the first vaccines heralded a recovery in the global economy (Chart 16). Chart 15Credit Default Swaps Credit Default Swaps Credit Default Swaps The COVID-19 crisis has affected emerging and frontier markets differently than developed markets given that youthful populations are least susceptible to dying from the disease. However, the economic impact has required monetary easing and currency depreciation. EM and FM central banks have undertaken unprecedented and unorthodox easing actions – similar to what is seen in the developed world – to cushion the blow. Chart 16Emerging Markets Vs Frontier Markets Vs African Markets Emerging Markets Vs Frontier Markets Vs African Markets Emerging Markets Vs Frontier Markets Vs African Markets Not only have EM and FM central banks cut rates but they have also cut reserve requirements for banks, intervened in foreign exchange markets, and launched government bond purchases. South Africa has begun quantitative easing while Ghana has monetized debt. Table 2 provides a glimpse at equity performance, volatility, and relative valuations and momentum in frontier markets, including African frontier markets. Returns are paltry over the course of the COVID-19 crisis. African markets have generated a negative return during this period. The table shows valuations and momentum on a relative basis – that is, relative to other markets in the table. We include South Africa, a major emerging market, by comparison to indicate that frontier markets are not necessarily more volatile even though they are far cheaper. All of these stocks other than South Africa are cheap on a price-to-earnings basis and African markets look even better on a cyclically adjusted P/E basis. Table 2African Frontier Markets: Valuations, Momentum, Volatility Frontier Markets And The Ethiopian Crisis Frontier Markets And The Ethiopian Crisis Chart 17Hold Off From Frontier Markets Hold Off From Frontier Markets Hold Off From Frontier Markets Nigerian stocks are extremely cheap, they have benefited from the recovery in global oil prices, and they offer half as much volatility as South African stocks. They are even cheap relative to other African frontier markets like Kenya. However, the geopolitical situation is not stable. An incident of brutality from security forces last year did not lead to wider spread social unrest but the rapid growth of the population combined with the resource curse is not favorable for socio-political stability over the long term. Even in the short term Nigeria’s rally could be upset by a reversal in oil prices, which is possible if OPEC 2.0 fails to coordinate in the face of the eventual US-Iran deal. Moreover capital controls make risks excessive for most investors, as our Emerging Markets Strategy observes. Kenya is a geopolitical beneficiary of the Ethiopian crisis. It should receive greater foreign direct investment as a result of Ethiopia’s destabilization. However, this crisis is not a driver for Kenya’s equity markets. Rather, Kenya trades in line with the trade-weighted dollar. It is not a commodity play but a telecoms play. This has been a huge benefit over the past decade. Kenya is diversified and has a large manufacturing sector. It will eventually benefit from a revival of tourism. Kenyan stocks are cheap from a global point of view but not relative to frontier markets. The long-term trend of Kenyan stocks is flat whereas most African equities are falling (Chart 17). Our Emerging Markets Strategy team has highlighted that conditions will improve in the wake of material currency depreciation. From a tactical standpoint now is not the best time to dive into frontier markets or African frontier markets but an opportunity is around the corner. African exports have not recovered, several countries are pursuing monetary easing (thus weakening currencies), the US dollar is bouncing, and China’s credit impulse is rolling over. But the long-term global trends are supportive as long as China avoids over-tightening, interest rates stay low, and the dollar resumes its weakening path as we expect. Therefore we will devote more attention to frontier opportunities going forward as they offer the attraction of large capital gains and diversification.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Guy Russell Research Analyst GuyR@bcaresearch.com Footnotes 1 The absence of a Biden-Xi call would have been market-negative but the call itself does not suggest that tensions have declined yet. The American account shows Biden lecturing Xi Jinping. He kept the Trump administration’s language regarding a "free and open Indo-Pacific," chastised Xi for "coercive and unfair economic practices, crackdown in Hong Kong, human rights abuses in Xinjiang, and increasingly assertive actions in the region, including toward Taiwan." Cooperation will be "results-oriented" and based on the "interests" of the US. All of this, in diplomatic language, is fairly tough. The Chinese account consisted of Xi giving Biden an even longer lecture about the importance of cooperation over confrontation, equality of nations, and non-interference in domestic affairs, including core interests like Hong Kong, Xinjiang, and Taiwan. See "Readout of President Joseph R. Biden, Jr. Call with President Xi Jinping of China," the White House, February 10, 2021, whitehouse.gov; and "Xi speaks with Biden on phone," Xinhua, February 11, 2021, Xinhuanet.com. 2 See Yoav Limor, "IDF Crafting New Options To Counter Iranian Threat," Israel Hayom, January 14, 2021, israelhayom.com.

Highlights The Biden administration’s budget reconciliation bill will close the output gap, so markets will have to start thinking about upcoming tax hikes, rising wages, and eventual Fed interest rate hikes. Biden’s lax immigration policies will not have a major negative impact on wage growth. A doubling of the minimum wage, which could still make it into one of two budget reconciliation bills, would include a measure to index the post-2026 minimum wage to the average rate of wage rises. Biden’s industrial policy and support of labor unions would also increase wages. Stay long Treasury inflation-protected securities versus duration-matched Treasuries and long value stocks over growth stocks.  Feature The Senate and House of Representatives passed a concurrent resolution on the budget for FY2021, the first step in the budget reconciliation process that will enable Democratic leadership to pass President Joe Biden’s $1.9 trillion American Rescue Plan with only a simple majority in the Senate. The budget resolution is a fantasy that the ruling party uses to bypass the Senate filibuster, as was the case under George W. Bush, Barack Obama, and Donald Trump. The latest such resolution claims that the budget deficit will be smaller, not larger, after the Biden rescue plan than what is currently projected by the Congressional Budget Office (Chart 1). It envisions the entire $1.9 trillion being spent in 2021 and then a huge drop in expenditures in 2022. A fiscal cliff ahead of the 2022 midterm election will not occur. Instead the second budget reconciliation maneuver, for FY2022, will increase spending levels once again with infrastructure and green projects, as per Biden’s campaign platform. Chart 1Democrats Pass Budget Resolution Biden Opens The Border Biden Opens The Border The FY2021 budget resolution does not contain any tax increases, “revenue offsets,” to keep the budget in line because the COVID relief is emergency spending that is one-off, not recurring. The FY2022, however, will aim partially to repeal President Trump’s tax cuts. As such financial markets will continue to “buy the rumor” of additional fiscal spending for now but they will also sell the news given that the next reconciliation bill will push up inflation expectations even further, hasten the Federal Reserve’s policy normalization, and include tax hikes. And the current buy-the-rumor phase could be interrupted anyway by Biden’s immediate foreign policy challenges. Larry Summers And The Output Gap Democrats will err on the larger side of the $1.9 trillion stimulus because they regret erring on the smaller side back in 2009. But it is still possible for the price tag to be knocked down to around $1.5 trillion given that the economy is recovering and several moderate Democrats will balk at the enormous size. After all, $900 billion passed at the end of the year is not yet spent. Biden has already compromised by raising the eligibility requirements for households to receive $1,400 stimulus checks. Larry Summers, a frequent guest at the annual BCA conference and a veteran of the Clinton and Obama White Houses, has stirred up a firestorm over the past month by warning that too much federal money spent on short-term cash handouts today would crowd out the administration’s political capital and the amount of deficit spending that is available for long-term, productivity-enhancing investments. Summers warned that the current proposed stimulus is three times larger than required to fill the output gap. Chart 2 shows the output gap from 2009-12 and projected from 2021-24 alongside the size of the relevant stimulus packages to illustrate his point. Treasury Secretary Janet Yellen defended the $1.9 trillion price tag – like Summers, she is not normally one to worry about overheating the economy, but unlike Summers, she is now an administration official. She predicted that this size of package would bring the economy back to full employment by next year. The Congressional Budget Office, based on earlier congressional actions, had predicted employment would not return to its pre-COVID level until around 2024. The administration will look to Yellen now and in future to make the call on when enough stimulus is enough. With inflation expectations recovering rapidly, the Fed could be forced to hike rates as early as late 2022, though we think 2023 is more likely given our methodological bias as political analysts. This means the scope for overheating is quite large – a point reinforced by the comparison with the economic recovery back in 2009 (Chart 3). Summers’s criticism is not remiss and could come back to haunt the administration.1 When inflation picks up, the Fed will have to allow an overshoot according to its new policy of targeting average inflation. But once it is assured, it will have to start hiking rates. And once it starts hiking rates it could trigger a recession. Plus, even if we set recession risks aside, Summers’s critical point is that too much stimulus today will reduce the political and budgetary scope for Biden’s long-term agenda, which includes what will likely be his second major bill focused on infrastructure and renewables. The reconciliation process makes it highly likely that Democrats will drive through this initiative through the Senate but not if moderate Senate Democrats balk in the face of rising budget deficits and inflation. Chart 2How Much Is Too Much Stimulus? Biden Opens The Border Biden Opens The Border Our base case still holds that Democrats will pass both reconciliation bills over the next roughly 12 months but investors should keep Summers’s warning in mind. Chart 3Recovery Is Ahead Of The Previous Cycle Recovery Is Ahead Of The Previous Cycle Recovery Is Ahead Of The Previous Cycle There are tailwinds for Biden’s agenda. First, his political capital is moderate-to-strong and likely to strengthen over the coming year. It will get bumped up by improving economic conditions, including most recently a marked decline in bankruptcy filings from Q3 to Q4. Our updated Political Capital Index is shown in the  Appendix. Second, concern about budget deficits has eroded, as Republican fiscal largesse showed under Trump – the pandemic and atmosphere of crisis greatly reinforce this point. Third, divisions in the Republican Party have produced as many as five moderates who could assist Biden in winning close legislative votes – even beyond the relatively easy passage of the American Rescue Plan in his honeymoon period. This Republican Party split is the only significance of President Trump’s second impeachment. Trump’s legal woes will continue after he is acquitted in the Senate. The deeper Republicans are divided over Trump’s legacy the harder time they will have recovering in the 2022 midterms, where opposition parties are normally favored. But the Biden administration’s leftward agenda will bring Republicans together, especially once the country moves out of the crisis. One of the biggest battles looms over the southern border. Bottom Line: The $1.9 trillion American Rescue Plan will more than close the output gap and yet it is only one of two budget reconciliation bills that the Biden administration will seek to pass over the next 12 months. There are still domestic and international factors that could impede the recovery, not least China’s policy tightening, but the risk of excessively short-term stimulus at the expense of long-term public investment is clear. Republicans Will Regroup Over Immigration To Summers’s warning about Biden’s legislative window of opportunity, recall that President Trump never achieved his signature 2016 policy promise – to build a wall on the border with Mexico – because congressional Republicans led him to prioritize repealing and replacing the Affordable Care Act (which failed) and passing the Tax Cut and Jobs Act (which succeeded). There was no political capital left for a major legislative push on the border and immigration. Immigration is one of the areas where Biden has a major incentive to push his policies aggressively. Immigrants tend to skew Democratic in their party affiliations. Americans increasingly believe immigration should be increased, a trend that accelerated after Trump’s election on an avowedly anti-immigration platform (Chart 4, top panel). Today 34% believe it should be increased in addition to 36% who are comfortable with the current level. Meanwhile the number who believe it should be decreased has fallen to 28%, down from 34%-38% around the time of Trump’s election. An anti-immigration candidate may be able to win within the Republican Party (especially under the specific circumstances of 2015-16) but he or she will have trouble winning general elections. Trump himself discarded the topic in the 2020 race. For Democrats, immigration is also probably the single most effective way to drive a wedge between the populist and establishment factions of the Republican Party. For example, establishment Republican presidents oversaw huge infusions of foreigners into US society, the 1986 Immigration and Reform Control Act, which granted amnesty to three million illegal immigrants, and the 1990 Immigration Act, which increased the quota of legal immigrants. By contrast Trump rose to power by attacking the bipartisan consensus on “open borders.” As long as a substantial cohort of Republicans defends immigration on free market principles, and upholds the corporate interest in having plentiful availability of lower wage seasonal and specialized workers, the party will be divided. The above points explain why the Biden administration will pursue immigration reform more intently than public opinion would leave one to believe. Polls show that voters want to focus on the economic recovery, the pandemic response, and social and civil rights policies more than immigration. There is no question that Biden is prioritizing the pandemic, the economy, and health care (Chart 4, bottom panel). But the Democratic Party has a strategic interest in expanding immigration so Biden will continue to plow forward with executive orders and comprehensive immigration reform in Congress. The US does need immigration reform – to ensure the flow is orderly. President Trump’s “wall” proposal did not come out of nowhere. Like the “Know Nothing Party” that emerged in the 1840s and rose to prominence in the 1850s, the Trump movement arose amid a historic increase in the foreign-born share of the population (Chart 5). But Trump’s policies hardly made a dent in the flow of legal immigrants into the US. Now Biden will reverse them and encourage more incomers. Therefore immigration will persist as a bone of contention in the 2020s. Granted, immigration has amply attested positive effects on the economy – including most clearly by lifting the US’s fertility rate so that it does not suffer from as rapid of an aging process as other developed countries. Indeed, voters are primarily concerned about illegal, not legal, immigration. Still, Republicans will struggle to walk the line between tighter immigration policies and appealing to an audience beyond “old white folks.” This suggests the Biden administration has room to run. Chart 4Public Not Too Concerned About Immigration Public Not Too Concerned About Immigration Public Not Too Concerned About Immigration Chart 5Historically Large Foreign-Born Population Biden Opens The Border Biden Opens The Border It helps Biden that the post-World War II and post-Cold War booms in legal immigration are relatively measured when compared to the overall population. The inflow of migrants was around 0.3% in 2019, very far from its post-war peak of 0.7% per year (Chart 6). Thus the Biden administration will not be overly concerned about being too progressive on this issue. Chart 6Boom In Legal Immigration Less Impressive Relative To Population Biden Opens The Border Biden Opens The Border Chart 7Detainees On The Mexican Border Biden Opens The Border Biden Opens The Border Illegal immigration is the biggest factor motivating periodic public backlashes such as in 2016. Southwestern border apprehensions – the only credible way to measure the unauthorized flow of people over the Mexican border – spiked under President Obama as well as President Trump, though US agents detained nowhere near the numbers witnessed in the 1980s and 1990s (Chart 7). The stock of illegal immigrants in the US ranges from 10-11 million and has remained flat, or fallen slightly, since the financial crisis of 2008. The weakening of the US economy, in the context of tighter border security, reduced incentives to make the difficult journey (Chart 8). The fact that President Obama and Trump increased detentions suggests that the demand to get into the country recovered over the course of the last business cycle. Based on President Biden’s voting record in the Senate and statements during the 2020 campaign, he is not an ultra-dove on the border – but his party has moved to the left on the issue. This is clear from his rivals’ positions in the Democratic primary election. Even his Vice President Kamala Harris, who was not the most radical on stage, supported decriminalizing illegal border crossings and downgrading Immigration and Customs Enforcement. Still, until Democrats repeal the filibuster in the Senate, they will not have a chance of passing comprehensive immigration reform with Republicans unless they accept stronger enforcement provisions. Biden voted for the 2006 Secure Fence Act but more recently has emphasized high-tech upgrades to better monitor crossovers. Harris also accepted high-tech security funding that did not involve building a wall. Even with these compromises, it will still be a stretch to find 10 Republicans willing to cross the aisle on this issue while Trump and his faction remain active to punish them in primary elections. Chart 8Estimate Of Total Illegal Immigrants Biden Opens The Border Biden Opens The Border The demand to enter the US will revive once the pandemic is over. The big surge in illegal border crossings in the 1980s-90s coincided with a period in which US economic growth and wellbeing far outpaced that of Mexico and Central America (Chart 9). The gap in GDP per capita is the crudest possible measure and does not reflect the dramatic differences in quality of life that drive people to relocate. Nevertheless, the gap remains drastic, especially with Mexico. Chart 9The Grass Is Greener On The Other Side Biden Opens The Border Biden Opens The Border The gap in current economic activity, such as manufacturing PMIs, between the US and Mexico is as wide as ever. Even as manufacturing contracts in Mexico, the demand for workers in US service industries is soaring (Chart 10). Moreover the US economic revival will be super-charged by the gargantuan fiscal stimulus of 2020-21 whereas Mexican government support for the economy is comparatively austere (Chart 11) Chart 10Super-Charged US Recovery Opens Big Gap With Mexico Super-Charged US Recovery Opens Big Gap With Mexico Super-Charged US Recovery Opens Big Gap With Mexico Chart 11Less Government Support In Mexico Than US Less Government Support In Mexico Than US Less Government Support In Mexico Than US Bottom Line: Biden is opening up the borders at a time of economic disparity between the US and Latin America that will lead to an influx of immigration. This is positive for US labor force growth and productivity but it will be hard to pass a long-term solution through Congress. The Republican Party is deeply divided on the issue today but it is likely to become a rallying cry as numbers of newcomers increase and as Trump-style populism remains an active force within the party. Immigration, Wages, And The Minimum Wage   The macroeconomic and market impact of easier border and immigration controls boils down to the impact on wages. There is a vast literature on this subject and we will not pretend to be comprehensive. We will merely make a few observations. The foreign-to-native-born wage differential has narrowed substantially over the past twenty years. The discount to hire immigrants has shrunk from 24% to 15% (Chart 12). This is a reflection of the high demand for immigrant labor and especially the increase in high-skilled workers alongside the booming tech, legal, financial, personal care, and health care industries in the United States – the fastest growing sectors for foreign-born workers since 2003. Earnings growth for foreign workers is more cyclical than for native workers and has been rising faster in recent decades (Chart 13). Chart 12Immigrants Command A Higher Price Than They Used To Biden Opens The Border Biden Opens The Border Chart 13Immigrant Wages Grow In Boom Times Biden Opens The Border Biden Opens The Border Immigrants work the lowest-wage jobs and hence there is some correlation between the share of foreign-born workers in any given industry and the hourly wage, just as there was at the turn of the century (Chart 14). But it does not follow that an increase in immigration suppresses wages as a whole. Chart 15 shows that, over the last business cycle at least, a change in the foreign worker share of a given industry does not correlate with a change in wage growth. Of course, it stands to reason that increasing the supply of labor decreases the price. But not if demand is growing sufficiently to raise the price for all workers. As we have seen, since migrants are willing to undertake long and dangerous journeys for work, they are likely to go where the demand is strong and the price is right – and the flow drops when the jobs dry up. Chart 14Immigrants Work The Lowest Wage Jobs Biden Opens The Border Biden Opens The Border Chart 15More Immigration Not Necessarily A Pay Cut Biden Opens The Border Biden Opens The Border Academics debate the impact on wages. There could be a negative impact, especially for low-skilled native workers, but the aggregate effect is small. One study showed that wages for native workers fell by three percent cumulatively over the 20-year period from 1980-2000 due to immigration.2  This is not dramatic. We can test the connection between immigration and wage growth informally by plotting the growth of southwest border detentions and legal permanent residence admissions alongside that of real wages. There is no clear relationship either way (Chart 16). The same is true if we test it with real median wages – the surge in border apprehensions under President Trump coincided with a boom in wages across the spectrum.  Chart 16Border Influx Does Not Suppress Wages Border Influx Does Not Suppress Wages Border Influx Does Not Suppress Wages Thus we cannot rule out the possibility that the Biden administration’s relaxation of border controls will have a dampening effect on wages over the long run but we cannot endorse it either. Chances are that the rollout of COVID-19 vaccines and government spending will continue to power a recovery that tightens the labor market and lifts wages for most workers.   What about the administration’s simultaneous policy of doubling the federal minimum wage to $15 per hour by the year 2026 – and indexing wage growth after that date to the median hourly wage? The minimum wage hike might yet make it into the budget reconciliation bill under negotiation – but Biden has already signaled it can be delayed. There is a growing fear about the negative impact on small businesses struggling during the pandemic. The Congressional Budget Office estimates that anywhere from 1 million to 2.7 million jobs could be lost in 2025 if the wage hike were implemented now and businesses would pay $333 billion.3 But the proposal will return when the second budget reconciliation bill is up for consideration unless the Senate parliamentarian rules it out, in which case its passage becomes much less likely. Only about 2% of workers are paid at or below the current minimum wage of $7.25 per hour so a minimum wage hike but the CBO estimates that 10 percent of workers would be below the proposed wage level by 2025 (Chart 17). The states with higher proportions of minimum wage workers will be the ones most affected and are mostly in the south, including South Carolina, Mississippi, Kentucky, and Texas, though there are a few in the north such as New Hampshire and Pennsylvania (Chart 18). Chart 17Most Workers Earn More Than Minimum Wage Biden Opens The Border Biden Opens The Border Chart 18Minimum Wage Workers By State Biden Opens The Border Biden Opens The Border Previous minimum wage hikes did not prevent the economy from reaching full employment – nor did they lead to a lasting pickup in overall wage growth. But indexation to overall wage growth would mark a big change in favor of an eventual wage-price spiral. It cannot be ruled out given that the reconciliation option might be available to Democrats, though it would not take effect till 2026. Bottom Line: There is no firm link between immigration growth and wage growth. Increased immigration flows often coincide with higher incomes and wages as growth and productivity improve. Meanwhile a change in the minimum wage will have a limited impact from a macro point of view alone but a bigger impact if it is indexed to wage growth after 2026, which is possible. In the coming years the much greater impact of Biden’s policies will stem from the massive infusion of fiscal spending he is likely to pass through Congress, which will close the output gap quickly and put upward pressure on wages.    Investment Takeaways Easier immigration and a higher minimum wage are not the only Biden policies that will affect wages. One of the biggest developments since Biden took office is his confirmation that he will maintain a tougher trade policy than his predecessors, excluding Trump. Biden won the election among Midwestern blue collar voters at least partly by stealing Trump’s thunder on trade and globalization. Since taking office he has issued a “Buy American” executive order and declared that he will maintain “extreme” competition with China. His cabinet appointees – notably Antony Blinken at the State Department and Janet Yellen at the Treasury – have given words of warning to China over trade as well. Geopolitical risk is one reason we are cutting back on our participation in the market’s exuberance at the moment, given that critical foreign policy stances are likely to be tested early in Biden’s term. But there is also a long-term implication of the Democrats’ marginal increase in protectionism.   It was the overall policy context of hyper-globalization that led to sluggish wage growth in the United States over the previous forty years. A major factor was the decline of manufacturing and unionization as a result of a lack of competitiveness in the US as global production came online. The erosion in manufacturing jobs only stopped in recent years (Chart 19). Popular support for unions has risen to levels last seen in the late 1970s and 1990s since the Great Recession – under Trump even Republicans talked up unions. Chart 19Blame Fall In Manufacturing, Not Foreign Workers, For Flat Wages Blame Fall In Manufacturing, Not Foreign Workers, For Flat Wages Blame Fall In Manufacturing, Not Foreign Workers, For Flat Wages Biden’s policies outlined above are reminiscent of the “third way” Democrats in the 1990s – particularly Bill Clinton, who oversaw an increase in the minimum wage and a surge in both legal and illegal immigration. But on trade Biden is shaping up to be more like Trump than Clinton, albeit directing his protectionism more at China than other trade partners. His spending bills will also use fiscal spending to promote industrial policy. Meanwhile labor protections will go up and unionization will at least stem its multi-decade decline.    For the stock market the risk of higher wages looms mostly due to the super-charging of the economy with stimulus. But shoring up domestic manufacturing, unions, labor perks and protections, and possibly indexing the minimum wage will contribute to faster wage growth and – to corporations – higher employment costs (Chart 20). This is a headwind to the corporate earnings outlook. But like the Biden administration’s tax hikes it is not yet affecting the market’s overall bullishness – and may not until the first reconciliation bill passes and the narrative shifts from stimulus to structural reform. Investors may soon find out that they will be dealing with higher wages, higher taxes, higher inflation, and a higher cost of capital. Chart 20Higher Wages, Lower Corporate Profits Higher Wages, Lower Corporate Profits Higher Wages, Lower Corporate Profits 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 Biden Opens The Border Biden Opens The Border Table A1BPolitical Capital: Household And Business Sentiment Biden Opens The Border Biden Opens The Border Table A1CPolitical Capital: The Economy And Markets Biden Opens The Border Biden Opens The Border Table A2Political Risk Matrix Biden Opens The Border Biden Opens The Border Table A3Biden’s Cabinet Position Appointments Biden Opens The Border Biden Opens The Border     Footnotes 1     See BCA Global Investment Strategy, “Fiscal Stimulus: How Much Is Too Much?” January 8, 2021, bcaresearch.com. 2     George J. Borjas and Stephen J. Trejo, “The Evolution of the Mexican-Born Workforce in the United States,” in Borjas, ed, Mexican Immigration to the United States (Chicago: Chicago University Press, 2005), pp.13-55.     3    See “The Budgetary Effects of the Raise the Wage Act of 2021,” Congressional Budget Office, February 2021, cbo.gov.  

Highlights Italy looks like it will form a national unity coalition under Super Mario Draghi – though it is not yet a done deal. A snap election is still our base case, whether in 2021 or 2022, but the ECB will do “whatever it takes,” as will Draghi if he becomes Italy’s prime minister. Even if the right-wing populist parties win power in a snap election, their goal is to expand fiscal spending, not exit the Euro Area. And they would rule in a world where even Germany and Brussels concede the need for soft budgets. Go long BTPs versus German bunds, and Italian stocks versus Spanish stocks, on a tactical 3-6 month horizon. The structural outlook for Italy is still bearish until Italy can secure its recovery and launch structural reforms. Feature In 2016-17 we wrote two special reports on Italy under the heading of “Europe’s Divine Comedy.” In “Inferno” we focused on Italy’s structural flaws and in “Purgatorio” we explained why Italy would stay in the European Union. We have long awaited the chance to write the third installment, which must be called “Paradiso” in honor of Dante Alighieri. But the tragedy of the pandemic makes this title sadly inappropriate. The new government that is tentatively taking shape is not the solution to the country’s long-term problems either. Former European Central Bank President Mario Draghi is an excellent policymaker and would ensure that Italy does not add political chaos to its pandemic woes this year. A unity government under Draghi – which is not yet a done deal as we go to press – would be a tactical and even cyclical positive for Italian equity and bond prices but not a structural positive. The paradise of national revival will have to wait for a later date. In the meantime Italy’s performance will be dictated by its surroundings. The Black Death Italy suffered worse than the rest of Europe from COVID-19, judging both by deaths and the economic slump (Chart 1). It was the first western country to suffer a major outbreak. Outgoing Prime Minister Giuseppe Conte was the first western leader to impose a Chinese-style lockdown – which came as a shock for democratic populations unfamiliar with such draconian measures. Few will forget the terrifying moment in March when the military was deployed in Bergamo to help dispose of the bodies.1 Chart 1Italy's National Crisis Italy's National Crisis Italy's National Crisis Chart 2Italy’s Unemployment Problem – Especially In The South Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? The crisis struck at an awkward time in Italian politics as well. Like the US and UK, Italy saw a surge of populism in the 2010s. Hostility toward the political elite arose largely in reaction to hyper-globalization, the adoption of the euro, and deep structural flaws that have engendered a sluggish and unequal economy: Poor demographics: Italy’s population peaked in 2017 and is expected to fall from 61 million to 31 million by the year 2100. Its fertility rate is 1.3, the lowest in the OECD except South Korea. It has the third smallest youth share of population (13%) and stands second only to Japan in elderly share of population (23%).2 North-South division: Southern Italy, the Mezzogiorno, is poorer, less educated, less efficient, and less well governed than northern Italy. Unemployment is 7 percentage points higher in the south than in Italy on average (Chart 2). In our “Inferno” report we concluded that regional divisions discourage exiting the Eurozone and EU, since southern Italy benefits from EU transfers and northern Italy would refuse to subsidize southern Italy without EU support (Chart 3).   Chart 3EU Budget Allocations Favor Italy Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Low productivity: Italy’s real output per hour has lagged that of its European peers as the country has struggled to adjust to globalization, digitization, aging, and emerging technologies (Chart 4). Chart 4Italy's Lagging Productivity Italy's Lagging Productivity Italy's Lagging Productivity High debt: Italy’s debt-to-GDP ratio is expected to rise from to 134.8% to 152.6% by the year 2025, putting it on a higher-debt trajectory than even the worst case projections prior to the pandemic (Chart 5). Normally Italy runs a current account surplus and primary budget surplus, although the pandemic has pushed the country down the road of budget deficits (Chart 6). The debt problem is manageable as long as inflation is low and the ECB purchases Italian government bonds – which it will do in the interest of financial stability. But it sucks away growth and investment over time, a problem that will revive whenever the EU Commission tries to return to semi-normal fiscal policy restraints. Chart 5Italy’s Debt Pile Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Chart 6Italy’s Budget Surplus Destroyed By COVID-19 Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Italy’s predicament can be illustrated simply by comparing the growth of GDP per capita over the past decade to that of Spain, which is a structurally comparable Mediterranean European economy and yet has generated a lot more wealth for its people after having slashed government spending and reformed the labor market and pension system in the wake of the debt crisis (Chart 7). Chart 7Spain Reformed, Italy Didn't Spain Reformed, Italy Didn't Spain Reformed, Italy Didn't Structural reforms undertaken by the technocratic Mario Monti government in the wake of the sovereign debt crisis proved insufficient. Subsequent reform efforts went up in a puff of smoke when Matteo Renzi’s pro-reform constitutional referendum failed in 2016. Italy’s government is congenitally gridlocked because the lower and upper houses of the legislature have equal powers, like in the US, but its parliamentary governments can be easily toppled by either house. The 2016 constitutional reforms would have given the central government historic new powers to force through painful yet necessary structural changes – but centrist voters of different stripes hesitated to grant these new powers since they looked likely to go to populist parties on the brink of victory in the looming 2017 elections. The populists – the right-wing League in the north and the left-wing Five Star Movement in the south – did indeed come to power in 2017 but Italian’s political establishment subsequently restrained them from pursuing either serious euroskepticism or massive fiscal spending. Pro-establishment President Sergio Mattarella rejected any cabinet members who would attack the monetary union. Subsequent battles with Brussels and Germany prevented Italy from passing a blowout stimulus that challenged EU fiscal orthodoxy and threatened to precipitate a solvency crisis in the banking system. In 2019 the ambitious League broke with the Five Star Movement, which collaborated with the center-left Democratic Party to form a new coalition. But the resulting compromise government, its populism diluted, only managed one structural reform – to reduce the size of parliament – plus a moderate increase in government spending. The populist parties ended up being right about the need for more proactive fiscal policy, as Germany conceded in late 2019 and as COVID-19 lockdowns made absolutely necessary in early 2020. French President Emmanuel Macron and German Chancellor Angela Merkel agreed to launch a €750 billion EU Recovery Fund that enabled jointly issued debt for EU members, solidifying a proactive fiscal turn in the bloc. Italy now has €209 billion coming its way. This is a boon for the recovery, though it is also the origin of the politicking that brought down the ruling coalition last month. With central banks monumentally dovish, European and American fiscal engines firing on all cylinders, and China’s 2020 stimulus still coursing through the world’s veins, the macro backdrop is positive for Italy. But with Italy’s economy still shackled by fundamental flaws, it will not be a lead actor or an endogenous growth story. Bottom Line: Italy missed the chance in the 2010s to undertake structural reforms that could lift productivity and potential growth. Now it is struggling to maintain political order in the wake of a devastating pandemic and recession. The vaccine and global recovery will lift Italian assets but the future remains extremely uncertain, given the eventual need to climb down from extreme stimulus and impose painful structural reforms. Paradiso? Or Paradiso Perduto? The latest political turmoil arose over the EU Recovery Fund and how Italy will spend the €209 billion allotted to it, as well as the €38.6 billion allotted to the country under the EU’s structural budget for 2021-28. Ostensibly Matteo Renzi pulled his Italia Viva party out of the ruling coalition because he feared that former Prime Minister Conte, together with his economy and industry ministers, would spend the funds on short-term vote-winning handouts rather than long-term structural fixes in health, education, and culture. But Renzi was not appeased when Conte offered to spend more on health and education as requested. Renzi’s party fares poorly in opinion polls and the recent electoral reforms were not favorable to it, so he can hardly have wanted a new election. He wanted Italy to tap €36 billion from the European Stability Mechanism in addition to taking EU recovery funds, since this would come with strings attached in the form of structural reform. He apparently wanted to precipitate a new pro-establishment coalition. President Mattarella’s appointment of Mario Draghi to lead a national unity coalition is the solution. But as we go to press it is not certain that Draghi will be able to command a majority in parliament. Chart 8Salvini's League Lost Steam But Populist Right Still Powerful Salvini's League Lost Steam But Populist Right Still Powerful Salvini's League Lost Steam But Populist Right Still Powerful Matteo Salvini and the League are the pivotal players now. Salvini and his party suffered loss of popular support in 2019 as a result of his ambitious attempt to break from the government, force new elections, and rule on its own. The party especially suffered from the pandemic, which hit its base of voters in Lombardy hard and sent voters in support of the central government as well as the political establishment (Chart 8). Salvini must now decide whether to try to rebuild his status by joining Draghi in the national interest, to show he can be a team player, albeit at risk of being seen as an institutional politician. If so, he would cede the right-wing anti-establishment space to his partner Giorgia Meloni, who leads the Brothers of Italy, which has eaten up all the support Salvini has lost since the European parliament election of 2019. What is clear is that his current strategy is not working, and he played ball with the big boys during the 2017-19 period, so we would not rule him out of a Draghi government. If Draghi does not win over Salvini and the League, he would need to win the support of the Five Star Movement to form a coalition. The party’s leaders initially said they would not join Draghi, who epitomizes the establishment of which they are sworn enemies. Yet Five Star has not lost any popular support for working with the conventional Democratic Party, in stark contrast with the League, which stayed ideologically pure but lost supporters. Some Five Star members, including Foreign Minister Luigi Di Maio, former leader of the party, want to work with Draghi and stay in government. Hence the party could still join Draghi, or it could break apart with some members defecting. It would require 33% of Five Star members in the Chamber of Deputies and 28% of Five Star members in the Senate to join Draghi to give him a majority, assuming the League and Brothers of Italy refuse to cooperate (Table 1). Interestingly, if the League is absent from the vote, and all parties other than the Brothers and Five Star join Draghi, then he could also form a government. This would give cover to the League under the pretense of COVID vigilance, without being seen as actively preventing a government formation. Table 1'Whatever It Takes' To Build A National Unity Coalition Under Super Mario Draghi Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? We have favored an early election and this could still occur. If there is an election it will happen before June because an election cannot happen within the last six months of the current president’s term, as per Article 88 of the Constitution. If Italy avoids a snap election till June, political stability is ensured at least till January. The pandemic was the justification for avoiding a snap election but the pandemic did not prevent the regional elections or constitutional referendum in September. The referendum was a hurdle that needed to be cleared before the next election, so now the way is open. All of the parties are greedily eying the presidency, with President Mattarella’s seven-year term set to expire next January. Mattarella has emerged as a staunch defender of the establishment and a check on anti-establishment parties. If the populists gain a plurality prior to January, then they can try to get a more sympathetic or neutral policymaker in that position. By contrast, the pro-establishment parties are hoping that a Draghi coalition can last long enough to ensure that one of their own holds that post. Since the latter need either the League or Five Star to govern, they would have to compromise on the next president – which is a very big concession. In distributing EU recovery funds, there is little doubt that a unity government under Draghi would be a credible way of proceeding. Draghi has joined other central bankers, like the Fed’s Janet Yellen, in voicing strong support for fiscal policy to get the developed democracies out of their current low-growth morass. He would have the authority and expertise to direct spending to productivity-enhancing projects at home while working with Brussels to allow Italy the greatest possible flexibility. Italy’s portion of EU recovery funds is shown in Chart 9, with the black bar indicating the part consisting of loans. The sector breakdown of total EU recovery fund is shown in Table 2. Chart 9Italy’s Fiscal Stimulus To Receive EU Top-Up Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Table 2Composition Of EU Recovery Fund By Economic Sector Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Yet a Draghi government is not a permanent solution to Italy’s political crisis or its economic malaise. Currently the political parties are squabbling over how to distribute a windfall of special funds – Italy is benefiting from a more pragmatic EU policy as it emerges from a crisis. But in future the parties will be fighting over what to do when the funds are spent. Even if the EU continues to be generous the stimulus will decelerate, while structural reforms will have to be attempted yet again. A technocratic Draghi government would be well positioned to institute the reforms that Italy needs but the economic medicine could sow the seeds for another voter backlash – in which case the anti-establishment right would be in prime position. This would set up a giant clash with Germany and Brussels. Italy, The EU, And Global Power Politics Geopolitically, Italy matters because it is a test of whether the European Union will continue consolidating power within its sphere of influence. If Draghi can form a unity government, oversee economic recovery and long-delayed structural reforms, and survive to reap the benefits at the voting booth, it would mark a historic victory for the EU as it lurches from crisis to crisis in pursuit of deeper integration and ever closer union. The Italian question would effectively be resolved and the EU would have the capacity to handle other challenges elsewhere. Europe’s geopolitical coherence is critical for global geopolitics as well. Europe is the prime beneficiary of US-China competition – at least until such time as it is forced to choose sides. Since Europe is a great power, it can remain neutral for a long time, using America as a stick against Chinese technology theft while expanding market share in China as it diversifies away from the United States (Chart 10). Chancellor Merkel has already signaled to Biden that she is not eager to join any “bloc” against China. Biden will have to devote a massive diplomatic effort to convince the Europeans, who are not as concerned about China’s military and strategic threat, that it is necessary to form a grand alliance toward containing China’s rise. Chart 10EU Balances Between US And China Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? The EU’s efforts to carve out a sphere of influence have momentum. The German and EU approach to fiscal policy has become more dovish and proactive, a concession to the southern European economies that will improve their support for the European project. Across the Atlantic the EU states see President Trump’s rise and fall as a story of America’s declining influence, which improves the EU’s authority over its own populace, and yet has not resulted in an American-imposed trade war that would undermine the recovery. To the east, EU states see Russian authoritarianism and its discontents, which reinforce the public’s commitment to democratic values and the single market. To the north, they see the negative example of Brexit, which continues to plague the UK, with Scotland pushing for independence again. To the south, Europeans have become less concerned about illegal immigration, having watched the inflow of migrants from Turkey, the Middle East, and North Africa fall sharply – at least until the next major regime failure in these regions causes a new wave of refugees (Chart 11). These events have encouraged various countries to fall in line behind the consensus of European solidarity and geopolitical independence. A technocratic government in Italy would reinforce these trends but a populist government would not be able to avoid or override them. Chart 11Europe Less Concerned About Refugees (For Now) Europe Less Concerned About Refugees (For Now) Europe Less Concerned About Refugees (For Now) Chart 12Italian Euroskeptics Constrained By Public Opinion Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? The Italian populist parties are still in the ascent but they do not seek to exit the EU or monetary union (Chart 12). We fully expect Italy to see snap elections in 2022 if not 2023, given the fragility of any new coalition to emerge today. If the right-wing League and Brothers should win control of government, and clash with Germany and Brussels, they would still operate within an environment circumscribed by these geopolitical limitations. Otherwise greater solidarity gives the EU greater room for maneuver among the US, China, and Russia. Investment Takeaways In the short run, the Draghi government is bullish for Italian assets. If Draghi fails and snap elections are called, the downside to European equities and the euro is limited, since any risk of an Italian exit from the EU dissipated back in 2016-18. Past turmoil resulted in higher Italian bond yields and wider spreads between BTPs and German bunds because markets had to price in the risk that the Euro Area would break up. We have long highlighted that this risk was overstated and markets are well aware of that by now. The market’s muted reaction to this latest kerfuffle proves the point (Chart 13). Chart 13Markets Unimpressed By Italian Political Turmoil Markets Unimpressed By Italian Political Turmoil Markets Unimpressed By Italian Political Turmoil On overweight stance toward Italian government bonds has been one of the highest conviction calls of our fixed income strategist, Rob Robis, over the past year. He expects that Italian bond yields (and spreads over German debt) will converge to Spanish levels, thus restoring a relationship last seen sustainably in 2016. He also notes that the ECB is willing to use quantitative easing to support Italy when its politics inject a risk premium into government bonds and spreads widen. The central bank is also providing additional support to Italy via cheap bank funding (TLTROs) that helps limit Italian risk premia at a time when underlying credit growth is exceedingly weak. During the height of the COVID lockdowns last year, the ECB increased its buying of Italian bonds higher than levels implied by its Capital Key weighting scheme, which officially governs bond purchases. Once Italian yields fell back to pre-pandemic levels, the ECB slowed the pace of purchases to levels at or below the Capital Key weights. As long as the pandemic lingers, the ECB will have the ability and pretext to ensure that Italian spreads do not rise too high (Chart 14). Chart 14Overweight Italian Government Bonds Overweight Italian Government Bonds Overweight Italian Government Bonds True, investors may be more reluctant to drive Italian yields and spreads to new lows as long as there is a risk of elections this year or next that could bring anti-establishment leaders to power and trigger an increase in Italian political risk premia. But this trap between politics and QE still justifies an overweight stance within global bond portfolios, as Italian yields will remain too attractive for investors to ignore given the puny levels of alternative sovereign bond yields available elsewhere in the Euro Area. Go tactically long Italian BTPs relative to German bunds. Italian stocks have seen a long and dreary downtrend versus global stocks, whether relative to developed or emerging markets, including or excluding the US and China. However, they are trading at a heavy discount in terms of price-to-book and price-to-sales metrics and a Draghi government to direct stimulus funding is doubly good news. Italian stocks have rebounded against Spanish equities since 2017 – as have Italian banks versus Spanish banks. Italian non-performing loans declined from a peak of €178 billion in 2015 to €63 billion in 2020. The banks raised enough equity capital to cover these NPLs. Since banks form a significant part of the Italian bourse, an improvement in bank balance sheets would be positive for the overall market. A Draghi government would reinvigorate this tendency, especially if it credibly commits to structural reforms that elevate potential growth. Spain’s structural reforms are priced in and it is next in line for a post-COVID political shakeup (Chart 15). Go tactically long Italian stocks relative to Spanish. While a Draghi coalition is marginally positive for the euro there are several factors motivating the dollar’s counter-trend bounce in the near term (Chart 16). US and Eurozone growth are diverging, with the EU struggling to roll out its COVID vaccine while the US prepares to pile a new $1.5-$1.9 trillion fiscal stimulus on top of the unspent $900 billion stimulus passed at the end of last year. Chart 15Italian Stocks Have Upside Versus Spanish Italian Stocks Have Upside Versus Spanish Italian Stocks Have Upside Versus Spanish Chart 16Wait For Geopolitical Risk To Clear Before Shorting USD-EUR Wait For Geopolitical Risk To Clear Before Shorting USD-EUR Wait For Geopolitical Risk To Clear Before Shorting USD-EUR Over the long run, a Draghi government provides limited upside with regard to Italian assets. The new coalition serves to avoid an election, not enable structural reform. An unstable ruling coalition will lose support over time in what will be a difficult post-pandemic environment. An early election and anti-establishment victory are not unlikely, if not in 2021 then in 2022 when Italy faces a falling stimulus impulse and the need for painful reforms. For now the truly bullish development is Germany’s dovish shift on fiscal policy rather than any temporary sign of Italian political functionality. Dysfunction can return to Italy fairly quickly but an accommodative Germany is hard to be gotten. Hence Italy’s biggest political risks will come if populist parties win full control of government in the next election while Germany and Brussels seek to normalize fiscal policy and impose some semblance of restraint in the wake of the crisis. It is also possible that a new economic shock or wave of immigration could bring Italy’s populists not only to take power but to rediscover their original euroskepticism. Thus any preference for Italian assets should be seen as a cyclical play on global growth and European solidarity and reflation – not a structural play on Italy’s endogenous strengths. Last week we shifted to the sidelines of the stock rally due to our concern that political and geopolitical risks have fallen too much off the radar. The Biden administration faces tests over China/Taiwan and Iran/Israel. Biden’s tax hikes will come into view soon. Chinese policy tightening is also a concern, even for those of us who do not expect overtightening. These factors pose downside risk to bubbly global stock markets in the near term.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Angela Giuffrida and Lorenzo Tondo, "‘A generation has died’: Italian province struggles to bury its coronavirus dead," The Guardian, March 19, 2020, theguardian.com. 2 See Stein Emil Vollset et al, "Fertility, mortality, migration, and population scenarios for 195 countries and territories from 2017 to 2100: a forecasting analysis for the Global Burden of Disease Study," The Lancet, July 14, 2020, thelancet.com.

Highlights We are hesitant to call a top to the volatility spike just yet. The US dollar is experiencing a counter-trend bounce. We also see political and geopolitical risks flashing yellow. House Democrats are drafting a reconciliation bill that will remind financial markets of looming tax hikes. President Biden faces imminent tests on China/Taiwan and Iran. The tech sector has bounced amid the setback to the reflation trade. Over the long run the Biden administration’s reflationary agenda suggests tech will no longer outperform. Biden’s regulatory risk to the tech sector is not immediate but still a downside risk. No major piece of bipartisan legislation is forthcoming but the Department of Justice, FCC, and FTC can bring negative surprises. We are hitting pause on our S&P trades until Biden passes some early hurdles. Feature Volatility has room to run, judging by past post-crisis periods (Chart 1), and this time we are especially concerned with brewing geopolitical risks, namely the US-China tensions over the Taiwan Strait. This geopolitical risk comes on top of the short squeezes and battles that retail investors are having against hedge funds all over the market. China is reminding the world of its red line against Taiwanese independence while testing the newly seated Joe Biden administration over whether it will seek a technological blockade against the mainland. Economic and trade policy uncertainty have collapsed but they would surge in the event of a crisis incident (Chart 2). While war is not likely, it is possible, so we need to see the Biden administration defuse the situation and pass this first test before we are willing to take on more risk on a tactical three-to-six-month time frame. Chart 1Volatility Can Go Higher Still Volatility Can Go Higher Still Volatility Can Go Higher Still Chart 2Uncertainty Down But Beijing Testing Biden Uncertainty Down But Beijing Testing Biden Uncertainty Down But Beijing Testing Biden Chart 3Biden's Approval Starts At 55% Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same President Biden’s average approval rating in his first two weeks in office is 55%, right where former President Trump’s disapproval rating would have suggested (Chart 3). This is a significant but not extravagant improvement in political capital for the White House. Our Political Capital Index shows Biden’s position as moderate-to-strong (Table 1). Table 1Biden’s Political Capital Moderate-To-Strong Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same The implication is that he still has a chance of passing his $1.9 trillion American Rescue Plan as a bipartisan bill with 10 Republican senators, a feat that would likely lower the topline value to around $1.3 trillion (Republicans proposed $618 billion) and exclude an increase in the federal minimum wage to $15 per hour. There is also a strong swing of independents in favor of Democrats in the opinion polling, in the wake of the incident on Capitol Hill on January 6, despite the fact that Republican and Democratic party identification are both stuck at around 30% — meaning that the Biden administration does have something to gain by appearing bipartisan (Chart 4).1 Republicans might cooperate to staunch the bleeding of their own support. Even Republicans approve of stimulus amid the pandemic and they would later be able to oppose Biden’s more controversial proposals with better optics having demonstrated bipartisan intent at the outset. However, House Democrats are already proceeding with a budget resolution, the first step in the budget reconciliation process that enables them to bypass Republicans entirely and get almost everything they want (Diagram 1). Chart 4Will Independents Keep Breaking Toward Democrats? Will Independents Keep Breaking Toward Democrats? Will Independents Keep Breaking Toward Democrats? Diagram 1Timeline Of Impeachment, Budget Reconciliation, And Regular Legislation Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Biden’s political capital should strengthen over the next year as the vaccine rollout improves and the economy comes roaring back. Official economic projections suggest that growth will glide solidly above potential until 2026 and that the output gap will close by 2024 (Chart 5). These estimates will be disappointed in various ways, of course, but in the near-term the risk is to the upside as they do not include Biden’s proposed $1.9 trillion rescue plan or his remaining, post-COVID agenda afterwards, which could cost anywhere from $3.7-$6.4 trillion over a ten-year period.2 The economy will be at less risk of relapsing than of overheating. This is especially true given the Federal Reserve’s new average inflation targeting strategy, which will discourage rate hikes till next year at the very earliest (and, from a political point of view, we would think 2023). Looking at the chart, Biden’s economic backdrop is far more propitious than that of his former boss Barack Obama’s back in 2009. Biden’s political momentum is therefore sustainable when it comes to the two budget reconciliation bills he wants to pass this year and next year. Republican internal divisions will help him. These were highlighted this week by Republican National Committee Chair Ronna McDaniel’s criticism of former New York Mayor Rudy Giuliani’s claims of voter fraud after the election and Senate Minority Leader Mitch McConnell’s recent scathing criticism of controversial pro-Trump freshman House member Marjorie Taylor Greene of Georgia. Republicans are only beginning their internal struggle and it is not certain that it will be resolved in time for the 2022 midterm elections. This is another reason to think that Biden’s political capital will be sustained and that moderate Republicans might assist with some Democratic legislation. The risks to Biden’s momentum stem from foreign policy (China, Iran, Russia), rapidly emerging financial instability, his party’s attempts at social control, and any major (not minor) negative developments involving the still-running pandemic and vaccine rollout. Chart 5US Economic Outlook Over Biden’s Term Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Macro Reflation Says Stay Underweight Tech The tech sector experienced a manic phase last year when COVID-19 struck and lockdowns kept consumers at home with nothing to do but work, shop, and stare at their phones. The big five companies – Apple, Microsoft, Google, Amazon, and Facebook – together witnessed an extraordinary run up relative to the other 495 companies in the S&P index that has since peaked and dropped off (Chart 6). Chart 6Fade The Big Tech Bounce Over Long Run Fade The Big Tech Bounce Over Long Run Fade The Big Tech Bounce Over Long Run Tech stock market capitalization accounts for 34% of American economic output – an extreme sign of over-concentration at a time when the market is generally inflated, according to the Buffett Index of stock market cap relative to GDP (Chart 7). Tech outperformance rests on strong earnings growth – supercharged due to the COVID crisis – as well as the secular fall in bond yields as a result of the global backdrop of excessive savings, low inflation, and scarce growth. Tech stocks are especially sensitive to bond yields because markets are projecting their earnings far into the future, as our colleague Mathieu Savary explained back in August. Ultra-dovish monetary policy with zero interest rates for longer and longer time frames is a perennial gift to these companies (Chart 8). Chart 7Buffett Indicator Says Big Tech Too Big Buffet Indicator Says Big Tech Too Big Buffet Indicator Says Big Tech Too Big Chart 8Big Tech Maxing Out As Bond Yields Rise? Big Tech Maxing Out As Bond Yields Rise? Big Tech Maxing Out As Bond Yields Rise? The catch is when and if growth and inflation expectations pick up. Even during the Dotcom bubble in the 1990s, the tech sector could not withstand rising interest rates (Chart 9). Eventually higher inflation will translate into central bank hikes and rising real interest rates – which should be very bad for tech as future cash flows lose value. Rising rates increase the cost of capital, while cyclical industries perform better in high growth environments with rising commodity prices. A recovery of inflation is becoming a more visible risk to investors over the coming few years. Even though unemployment is still elevated, and the output gap negative, the sea change in fiscal policy is likely to close this gap quickly and put upward pressure on expectations and prices. It will still take time to close the gap but each new dose of government spending on top of what is needed to plug the gap in demand due to the pandemic-stricken service sector will accelerate the time frame in which the labor market will tighten and price pressure will return. Investors are increasingly wary of this inflation risk as it is the logical consequence of the new combination of extreme monetary and fiscal accommodation. Earnings in the tech sector relative to the rest of the market have also peaked – and did not exceed their previous high point in 2010 despite the uniquely favorable backdrop (Chart 10). The big five have nearly saturated a lot of markets which raises the possibility that if the policy backdrop darkens, then they will see earnings disappointments. The Biden administration’s plan to raise the corporate tax rate to 28% and impose a 15% minimum tax on company book income would come as a double whammy for tech earnings, as they are relatively more exposed to increases in effective tax rates than other sectors. Chart 9Big Tech Wants Deflation, Big Government Wants Reflation Big Tech Wants Deflation, Big Government Wants Reflation Big Tech Wants Deflation, Big Government Wants Reflation Chart 10Big Tech Earnings Outperformance Hit Ceiling Amid Pandemic Big Tech Earnings Outperformance Hit Ceiling Amid Pandemic Big Tech Earnings Outperformance Hit Ceiling Amid Pandemic Finally, there is the long building problem of regulatory risk, as Americans have clearly become more concerned about Big Tech’s power and influence over their daily lives and politics. Here we do not think the Biden administration poses an immediate threat of frontal legislative assault, but we do think the end game is greater regulation, including tougher enforcement from antitrust agencies. Combined with geopolitical risk from Europe and other countries also seeking to tax and regulate these companies, the recent global semiconductor shortage, and the potential for a Taiwanese tech blockade, the political risk is clearly to the downside. Bottom Line: The macro backdrop has darkened for the tech sector. With governments turning more reflationary via a sea change in fiscal policy on top of ultra-easy monetary policy, inflation expectations should recover and inflation-sensitive sectors like tech should underperform. This risk is clear despite the fact that inflation requires the labor market to heal first. Any political, geopolitical, or regulatory risks would only further undermine the case for tech sector outperformance. Tech, Polarization, And Disinflation A critical question for investors is the relationship between US political polarization, the tech sector, and the disinflationary macroeconomic context that has proven so beneficial for Big Tech’s stock market performance. If polarization leads to gridlock, austerity, and disinflation, then tech can continue to enjoy the policy environment. But if polarization subsides, or if it coexists with a reflationary backdrop – as is the case today – then tech faces a new risk. It is fair to hypothesize that the rise of Silicon Valley and especially of social media has something to do with the explosion in US polarization over the past three decades. A simple chart of the S&P 500 alongside our polarization proxy – which measures the difference in presidential approval based on party – suggests that polarization could have some connection with tech sector outperformance (Chart 11). This is not a coincidence but the causality may work differently than some assume. The first period of tech sector outperformance, which rested on the “peace dividend” period of hyper-globalization, strong growth, strong dollar, low inflation, and technical innovation, occurred during the explosion of US polarization in the wake of the Cold War, when the US’s common enemy fell and the country’s political parties turned to do battle with each other for global supremacy. The structural changes of Reaganomics and NAFTA coincided with the political battles of the Republican revolution of 1994 and Bill Clinton’s sex scandal and impeachment. This heady period came to a peak in 2000 when the dotcom bubble burst and the US suffered its first contested election since 1876. Essentially globalization led to a deflationary backdrop that favored tech but also triggered the political struggle within the US for the spoils of victory in the Cold War. Chart 11Big Tech Likes Polarization And Gridlock Big Tech Likes Polarization And Gridlock Big Tech Likes Polarization And Gridlock The second period of tech sector outperformance emerged from the Great Recession, still higher wealth inequality, and the slow-burn economic recovery of the 2010s. The disinflationary environment and dollar bull market proved beneficial to the tech companies. In this case globalization’s deflationary effects continued but were compounded with US household deleveraging, which was far more malicious for the American middle class. Crucially, polarization created gridlock in Congress from 2010, preventing the US from pursuing a robust fiscal policy in the wake of the crisis that might have led to a more rapid recovery. Instead an extended disinflationary environment fed into social unrest and populism. While public animus naturally turned against Wall Street and the Big Banks in the wake of the financial crisis, the Dodd-Frank financial reform helped to pacify the public’s anger (though not entirely – and financial regulation is gradually reemerging as a relevant political risk). As the financial crisis faded from memory, but the low-growth, disinflationary environment continued to take a toll on households, an angry electorate began to freely express itself in the digital realm. Tech companies were happy to ride this wave and outperformed other sectors. As the backlash continued mounting, tech companies failed to rein in the angry userbase they had cultivated, and now they are staring at massive regulatory and legal risks from policymakers. Both Barack Obama and Donald Trump used Twitter and social media as a tool to establish direct engagement with their political base, much as Franklin Delano Roosevelt had used the radio and the fireside chat. This rising political heft ultimately made the companies conspicuous as conservatives blamed them for supporting the Obama administration (and Clinton campaign) while liberals especially blamed them for getting Trump elected. The Trump saga in particular gave rise to the so-called “tech-lash,” or backlash, as the companies’ core base of young, urbanized, cosmopolitan, and international users called on the tech companies to stop the spread of Russian propaganda, or other propaganda they disagreed with, and undertake socially progressive causes. Meanwhile the older, conservative, and rural population doubted that Russian interference caused the 2016 election result and sensed that the tech companies’ content moderators might not be all that scrupulous regarding the difference between conservative views and Russian information warfare (Chart 12, top panel). In combination with the heated election year campaigning, the pandemic and the backlash against lockdown, tension in the virtual world came to a peak last year and spilled out into the real world. This all came to a head with Twitter and Facebook first censoring and then banning President Trump from their platforms amid his claims of voter fraud and the riot on Capitol Hill. Chart 12Big Tech Not The Chief Driver Of Polarization Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Two major policy changes have occurred that threaten to reverse this macro backdrop. First, as a result of the 2020 crisis the Democrats won control of the White House and Congress and can now pass their mammoth spending agenda, which goes beyond pandemic relief to expanding the role of government in American economy and society – including by reflating the economy and imposing higher taxes on corporations, both of which threaten to undermine the tech sector’s outperformance. Second, China’s secular slowdown, reduction of trade dependency, and divorce from the US economy have undermined hyper-globalization. The Biden administration is pursuing on-shoring and China restrictions albeit to a lesser extent than its predecessor. If technological advance and social media cause political polarization, then these policy shifts may not last long or have a durable macro effect. But technology and communication tools have advanced throughout history regardless of whether polarization in any given country was rising or falling. Older people are the most partisan in the US yet they are the least enthusiastic users of social media (Chart 12, bottom panel). Tech and social media have proliferated across the world and yet polarization has fallen in Germany, Australia, Sweden, and other economies even as it has risen in the United States and arguably the United Kingdom (Chart 13). If social media enabled populist outcomes like Trump and Brexit, then why did populism fall short in France, Spain, Italy, and Germany? Social media participation thrived on the rise of polarization through the 2000s and 2010s but it exacerbated the problem – and once polarization erupted in the form of an anti-establishment presidency, Russian interference, the Cambridge Analytica scandal, and real world riots and social unrest, the tech platforms found themselves in the crosshairs of both of the political factions and the various politicians trying to appease their anger. Silicon Valley and the FAANGs operate in a power struggle – not merely a politicized environment – that is here to stay and will direct their attention away from their primary business and toward paying for lobbyists in Washington, Brussels, and elsewhere. This in itself is a danger to their business models even if it were not the case that the macro and policy backdrop is less supportive. Bottom Line: The reflationary fiscal and policy backdrop will continue in the coming years, a macro headwind for tech outperformance, while political risks to the tech sector have grown substantially. Chart 13Polarization Falls In Many Countries Despite Social Media Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Congress In Check But Regulatory Risk Persists Democrats and Republicans have a different and opposed set of grievances against Big Tech, which is likely to prevent comprehensive legislation from developing anytime soon. But legislation is still possible, and in the meantime risks will come from emboldened regulators. Based on the House judiciary hearing in July 2020, Democrats are concerned with content moderation and market concentration. They want to fortify their recent gains in preventing social media companies from aiding what they regard as the spread of seditious and libelous material or propaganda that favors the anti-establishment Trumpist right wing. Judging by the Senate Republicans’ hearings in October and November 2020, Republicans are primarily concerned with content moderation– i.e. preventing conservatives from being de-platformed, and conservative views from being censored. Republicans are less concerned about market concentration, i.e. accusations of monopolistic and anti-competitive behavior.3 Now that the social media companies have more or less thrown in with the Democrats on content moderation, Democratic priorities are likely to shift to antitrust and anti-competitive behavior. But serious changes would require either abolishing the filibuster in the Senate (which is not happening for the time being due to last month’s bipartisan power-sharing arrangement) or winning over 10 Republicans. This will be difficult, especially when it comes to the Democratic belief that a generational shift in antitrust doctrine and practice is necessary. A frontal assault on the sector would require passing a law that resolves a number of jurisprudential issues so that the courts could be instructed to interpret antitrust issues with a greater focus on rooting out anti-competitive or collusive behavior (as opposed to lowering prices and preventing consumer harm). This is possible but Republican agreement would require major compromises that the Democrats are not inclined to make. A bipartisan bill is still possible because last year’s hearings revealed that there is common ground between the two parties. Both have agreed that anti-trust agencies should be strengthened and empowered to examine Big Tech; that data should be portable and platforms should be interoperable (rather than favoring their own services or imposing penalties for users who would switch services); that mergers and acquisitions should be examined with the presumption that consumers will be harmed, so that the merging parties must show that they cannot otherwise achieve the desired consumer benefits and that their actions will serve some public good; and that regulators need not trouble themselves excessively about the problem of accurately defining the market, which is always a sticking point for such fast evolving services.4 Moreover there is overlap between the populist sides of both parties, comparable to the bipartisan populist demands to give larger household rebates amid the COVID crisis. For example, Democrats want to revise Section 230 of the Communications Decency Act, which protects the tech companies from being held liable for the actions and comments of third parties on their platforms. The Democratic proposal is to break down the distinction between neutral tools and content creation, arguing that tech platforms can be “negligent” and that in order to benefit from the liability protections they should have to demonstrate that they have taken reasonable steps to prevent unlawful misuse of their platforms that cause harm to others. This idea of “reasonable moderation” would leave a very vague standard for judges that would lead to a complex operating environment across different jurisdictions, but it is attractive to Trumpists and right-wing populists who support greater ability to sue the platforms for alleged bias.5 Thus revising Section 230 could create a bridge between the two parties, albeit isolating the free-market contingent in either party. It would foist huge new liabilities not only on the tech giants but also on startups and market entrants with far fewer lawyers. The mechanism will be a decisive feature of any future legislative proposal, however. Republicans are staunchly opposed to creating an Internet oversight committee, similar to the Consumer Financial Protection Bureau, or anything that smacks of Big Brother and would risk too cozy of a relationship between the regulatory state and the immense capabilities of the tech companies. But they could be amenable to law that strengthens the antitrust agencies and alters the parameters of judicial scrutiny if they believed it would make consumer choice and innovation more likely. If popular opinion suggested great urgency on this issue then perhaps the parties’ differences could be resolved more quickly in the form of a major bill. But polls suggest the populace is also divided on tech regulation – in part because the pandemic left consumers largely thankful for the Internet services that they relied on so heavily while under lockdown. A bare majority of conservative Republicans and liberal Democrats now favor tech regulation, the average voter is lukewarm, and moderates of both parties show little enthusiasm (Chart 14). By contrast, at the height of Democratic anxiety over Trump’s election and Russian interference, a clear majority of Democrats and Democrat-leaning independents favored tougher regulation. Chart 14Public Split On Government Regulation Of Big Tech Companies Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same In short, the public is split, the parties are split, and the various 2020 crises have temporarily subsided, so tech regulatory risk will emanate from regulatory authorities but not from major new legislation anytime soon. Regulatory agencies thus threaten to give tech stocks negative surprises – even if the process takes time. Biden will replace one commissioner on the Federal Trade Commission (FTC) immediately but may only be able to replace two Republican commissioners toward the end of his term, in September 2023 and 2024, meaning that the commission will be divided (Table 2). Any major crackdown on market concentration will have to proceed upon bipartisan grounds unless Democrats gain control of this commission sooner. Meanwhile Biden will be able to replace outgoing Republican Ajit Pai on the Federal Communications Commission (FCC) right away, giving a Democratic tilt to this body, which is capable of pursuing the administration’s goals on content regulation (Table 3). Here the Supreme Court may eventually weigh in to defend free speech and press rights, which Section 230 ultimately reinforces, but the tech companies will be in the firing line until then. Table 2Federal Trade Commission Balance Of Power Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Table 3Federal Communications Commission Balance Of Power Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Finally, Biden’s nominee for the US Assistant Attorney General for the antitrust division will be a critical post to watch for the Department of Justice’s involvement in tech regulation and antitrust, though this position requires Senate confirmation, which will rule out any populist candidate. If Biden picks a former Facebook lawyer as rumored then he clearly will not be prioritizing a tough antitrust stance.6 Bottom Line: With the Senate filibuster intact for the time being, Democrats need 10 Republican senators to join them to pass any significant legislation that would amount to a frontal assault on the tech sector. This is possible but not probable in the short run, as Congress prioritizes the fight against the pandemic, Republicans and Democrats remain divided and the public is lukewarm about regulation. Much more likely is a regulatory slow boil at the hands of the DOJ, FCC, FTC, and the states. Biden Maintains Obama Alliance With Silicon Valley Public opinion is wishy washy about Big Tech, as mentioned above. Compare attitudes toward Wall Street and the major pharmaceutical corporations. Opinion shifted against the banks drastically during the financial crisis and has since recovered to about 24% net approval, although there are also polls showing that consumers of all stripes believe the banking sector got off easy and could use more regulation (Chart 15). The health care industry also took a hit during the Great Recession, when laid off workers also lost their health insurance, and has also largely recovered due to its conduct during the pandemic. The exception is Big Pharma, which is widely blamed for excessive drug prices, got bashed under President Trump, and is about to get bashed by President Biden in the form of price caps and Medicare negotiations. By contrast with these sectors, the computer and Internet industry has seen a hit to its popular support since Trump’s election but never dipped into net negative territory and may be recovering due to its helpful role during the COVID lockdowns. When net popular approval turns negative then it will be a flashing red light for the tech sector that sweeping regulation is imminent. While some of the opinion polling is lagging, the crisis over the election is unlikely to produce this effect because the public views break down along partisan lines. Chart 15Big Tech More Popular Than Big Banks, Big Pharma Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Thus unlike the Trumpists, or the populists in the Democratic Party, the Biden administration is only inclined gradually to dial up the pressure on Big Tech. Biden would bite off more than any president could chew if he tackled tech aggressively along with other big corporations. His campaign platform and early executive orders show that he is already tackling Big Health Insurance and Big Oil, sectors that make up 7.5% and 1.4% of GDP respectively. There is at least some focus on re-regulating the financial industry as well (7.7% of value add), albeit with lower priority. To attempt a major overhaul of Big Tech (at least 5.3% of GDP) on top of all this would be impracticable even if Biden were inclined to listen to the anti-monopoly crusaders in his party. Information services are obviously important to the economies of solid blue states like California, New York, and Washington but they are increasingly important to critical swing states like Georgia and Pennsylvania – places where voters will be skeptical of Biden’s policies on energy and immigration. The information sector is growing fastest in blue states and in battlegrounds like Arizona. It employs more people in blue states and in battlegrounds like Georgia. And it is rapidly employing more people in the grand prize of Democratic designs, Texas, where an exodus of Californians fleeing poor governance and high costs holds out the possibility of creating a decisive Democratic ascendancy in the Electoral College. Silicon Valley and other tech clusters will maintain their unique strengths and network effects for a long time but the dispersion of the tech sector to cheaper heartland regions has electoral consequences that mainline Democrats will not want to suppress. Not only did the tech firms help Biden get elected through votes and media controls but also through campaign contributions. The financial and health care industries punished the Democrats for passing the Affordable Care Act (Obamacare) and Dodd-Frank reforms in 2009-12 (Chart 16). By contrast the tech heavily favors Democrats over Republicans (with donations at $170 million versus $20 million in the 2020 election). Biden’s priorities are two budget reconciliation bills that will partially reverse the Trump tax cuts in order to pay for the entrenchment and expansion of Obamacare and other aspects of his health care and child care agenda. He is also focused on infrastructure, particularly green infrastructure and renewables, to create jobs and galvanize the climate change coalition. Broad re-regulation is coming down the pike, but health, immigration, energy, and labor are higher priorities than tech. The tech sector faces greater scrutiny than before, first from the FCC and later from the DOJ and FTC, but the administration will have more room for maneuver later in its term. Bottom Line: The Obama administration forged an alliance with Silicon Valley that Biden will largely maintain. The purpose of regulatory pressure is to build leverage over the tech giants. Chart 16Big Tech A Big Donor To Democratic Party Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Investment Takeaways Not all of the dominoes are lined up to topple Big Tech in a massive display of federal monopoly busting. The public is lukewarm and the political elite are divided. Nevertheless the long-term trajectory points to greater government scrutiny – and the tech sector has no margin of safety for political risk as the macro backdrop has started to shift in a more inflationary direction. Our colleague Juan Correa Ossa has shown that antitrust action to curb corporate power has tended to occur at times in US history where stock market earnings are elevated or rising rapidly relative to average wages, when inflation is running hot, and yet the economy has entered a bust phase where politicians are looking for a scapegoat to deflect public anger (Table 4). Table 4Stock Performance In Selected Judicial Events Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same While inflation is not an immediate problem (at least not yet), it was not a problem when the FTC and DOJ went after Microsoft starting in 1998. The distressed economy and tech bubble are good enough reason for investors to expect the government to increase antitrust pressure (Chart 17). If inflation recovers in the coming years around the time the Biden administration gains room to maneuver on this issue then it is doubly bad for the tech sector. Chart 17Anti-Trust Usually Follows Economic Bust Anti-Trust Usually Follows Economic Bust Anti-Trust Usually Follows Economic Bust In Microsoft’s case, the stock fell when the government first brought charges but rallied throughout the twists and turns of the courtroom – especially after 2002 when the case was settled, and ever since (Chart 18). Fortunately for the company the DOJ backed away from breakup and instead ordered it to open up its application programming to others. But even firms that are broken up usually create buying opportunities. Note that Microsoft cleared its image and has not become the subject of government or popular scrutiny again today. Today’s regulators are likely to place a greater burden of proof on tech companies attempting mergers and acquisitions. The alternative for startups is to hold an initial public offering – and IPOs have exploded amid the current context of low rates, easy money, investor exuberance, a chilling effect on M&A, and a lingering pandemic. The markets are frothy, buyer beware (Chart 19). Chart 18Microsoft's Anti-Trust Warning Microsoft's Anti-Trust Warning Microsoft's Anti-Trust Warning Chart 19Regulators Will Crack Down On M&A Regulators Will Crack Down On M&A Regulators Will Crack Down On M&A Strategically we remain favorable toward value stocks over growth stocks given the changing macro and policy backdrop outlined above (Chart 20). However, in the very near term we would not encourage investors to take on any additional risk. The latest bout of volatility is not necessarily over, political and geopolitical risks are now underrated after a period in which they subsided from peak levels, and exuberant markets are subject to very sharp corrections.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com Chart 20Take A Pause Amid Value Vs Growth Setback Take A Pause Amid Value Vs Growth Setback Take A Pause Amid Value Vs Growth Setback   Appendix Table A1Political Risk Matrix Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Table A2Biden’s Cabinet Position Appointments Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same   Footnotes 1     Congressional Budget Office, “Overview of the Economic Outlook: 2021-2031,” February 2021, cbo.gov. 2     Committee for a Responsible Federal Budget, “The Cost of the Trump and Biden Campaign Plans” October 7, 2020, and “The Cost of the Trump and Biden COVID Response Plans,” October 29, 2020, October 7, 2020, crfb.org. 3    The huge gap between the two parties can be illustrated by the recent case of Parler, the microblog that sought to rival Twitter by maintaining laissez faire content moderation standards. When Parler came under fire for attracting conservatives in the wake of the Twitter ban against Trump, Apple and Amazon teamed up to block it from their app purchasing and cloud services, thus effectively banning the app for 99% of users. There is no doubt that any private platform can regulate content according to its own standards on its own sites. In the words of Section 230, this extends not only to “obscene” or “excessively violent” material but to anything “otherwise objectionable.” But once tech companies prevent the emergence of competitors and alternatives, and cooperate in doing so, they enter much more dangerous legal territory. And yet the response from the House Democrats on the oversight committee was to ask the FBI to investigate Parler for hosting far-right extremists. Conservatives are therefore up in arms. The courts have not yet weighed in but the case represents a larger risk to the tech firms than the usual challenges under Section 230. 4    Representative Ken Buck, “The Third Way,” House Judiciary Committee, Subcommittee on Antitrust, Commercial, and Administrative Law 5    See Will Duffield, “Circumventing Section 230: Product Liability Lawsuits Threaten Internet Speech,” Cato Institute, January 26, 2021, cato.org. 6    See Ryan Grim and David Dayen, “Merrick Garland Wants Former Facebook Lawyer To Top Antitrust Division,” The Intercept, January 28, 2021, theintercept.com. 

Highlights Biden’s initial political capital is moderate-to-strong according to our Political Capital Matrix. He will pass his American Rescue Plan and one or two budget reconciliation bills over the next 18 months. Investors will need to discount the impact of tax hikes eventually.  The Democrats’ second impeachment of President Trump is a distraction but the party will not let it derail their legislative agenda. The bipartisan power-sharing agreement in the Senate will keep the filibuster in place for now (though not permanently). This does not affect the most market-relevant aspects of Biden’s policies, at least not in 2021, but beyond that it is an open question.  The stock rally is stretched, so prepare for volatility in the near term. But over the long run continue to prefer stocks over bonds, cyclicals over defensives, and value over growth stocks. Feature The US equity rally is getting frothy even as President Joe Biden kicks off his administration with a flurry of executive orders. Financial exuberance stems from combined monetary and fiscal stimulus that will provide a positive backdrop for risk assets for most of this year. Still, most of the good news is priced so we expect volatility to revive in the short run. The BCA Equity Capitulation Indicator is nearing the highest points of its historic range, which is typically a signal for a 10% equity correction or more (Chart 1). Not all indicators point decisively to a bubble that will pop imminently but several suggest that a bubble is being formed.1 The policy backdrop of fiscal largesse combined with an ultra-dovish Fed makes it easy to see why some parts of the market are getting manic. In this context, the Biden administration’s regulatory and tax agenda will become a negative catalyst in the short run even though its big spending will secure the economic recovery, which is positive in the long run. Chart 1Mania Unfolding Mania Unfolding Mania Unfolding Biden’s First Executive Orders Biden’s initial decrees brought zero surprises so far. He rejoined the Paris climate agreement, canceled the Keystone XL pipeline, suspended new oil and gas leasing on federal land, reversed President Trump’s border emergency and immigration curbs, ordered federal workers to wear masks, and directed the federal government to “Buy American.” The energy sector suffered the brunt of Biden’s initial regulatory salvo but the relative performance of energy stocks did not drop as much as financials, where Biden’s regulatory risks are less immediate. Biden’s policies are negative for health care stocks but they suffered least from what was a general setback for value plays in the context of a small bounce in the dollar and fears about global growth weakness stemming from the pandemic which has not yet been quelled. Large caps in all three of these sectors are underperforming small caps, suggesting that Biden’s new regulations and looming tax hikes are not driving the markets – at least not yet (Chart 2). Rather these cyclical small caps stand to benefit from the administration’s large spending plans, which include the $1.9 trillion American Rescue Plan currently being negotiated (Table 1). These plans are highly likely to pass as explained below.    Chart 2Biden's Executive Orders: No Surprises So Far Biden's Executive Orders: No Surprises So Far Biden's Executive Orders: No Surprises So Far Table 1Biden’s American Rescue Plan (With Previous COVID Relief) Biden's Political Capital Biden's Political Capital Going forward, Biden’s regulatory onslaught will bring negative surprises eventually as it expands and deepens but these will not counteract the stronger tailwinds of the vaccine and fiscal spending. Democrats have yet to invoke the Congressional Review Act, which enables them rapidly to reverse the regulations that the Trump administration ordered just before leaving office.2 The regulatory risk is greater for health care and energy than it is for financials and tech, though the latter two are not void of risk. Health care is the Democrats’ top priority outside of pandemic relief and economic recovery. (See Appendix for our updated political risk matrix by sector.) While the market can look through Biden’s regulatory threat, at least for now, it cannot look through the impact of higher taxes on corporate earnings forever. Over the next two months House Democrats will start revealing details of their budget proposals, which could serve as a negative catalyst for the overstretched equity rally. Other negative catalysts from an ambitious new administration are also possible with a market at such dizzy heights. Secretary of Treasury Janet Yellen has discouraged raising taxes initially but investors know that taxes will go up sooner or later. Moreover the specific legislative vehicle for Biden to push his agenda – “budget reconciliation” – requires tax hikes to offset spending increases. Thus if Democrats initiate a reconciliation bill in February or March then it will imply at least some revenue offsets, even if the biggest tax increases are saved for the second reconciliation bill for FY2022. Bottom Line: Value stocks have taken a breather but will continue to outperform over the cyclical 12-month time horizon. Looming Democratic tax proposals are more likely to serve as a near-term negative catalyst for the overstretched equity rally than Biden’s regulatory onslaught, which will take time to be felt. We are sticking with value over growth stocks due to the extremely accommodative fiscal and monetary policy setting. The Filibuster Preserved (For Now) A critical check on lawmaking in the Senate, the filibuster, has been preserved – at least for the moment. This is positive news for markets as it lowers the odds of major legislative surprises this year. The filibuster enables senators to block normal legislation through endless debate. Sixty senators are needed to invoke “cloture” and bring debate to a close. Otherwise the bill goes nowhere. With the Senate divided evenly at 50-50 seats between the two parties, Biden’s agenda will now depend on any bills that can garner 10 Republican senators, plus two “budget reconciliation” bills for fiscal 2021-22. Reconciliation bills only require a simple 51-seat majority in the Senate. Eliminating the filibuster will remain a risk over the long run. It was only preserved because two centrist Democratic senators, Joe Manchin of West Virginia and Kyrsten Sinema of Arizona, declared that they would not vote to abolish it. This prompted Republican Senate Minority Leader Mitch McConnell to drop his chief demand, that the filibuster be kept, in his negotiations with Democratic Majority Leader Chuck Schumer toward an agreement for the two evenly divided parties in the Senate to share power. Now a power-sharing agreement is in place so the legislative process can begin, albeit within the filibuster’s guardrails. Notice that Schumer never conceded to McConnell that the filibuster would be preserved. And two Democrats is not very many. Later these centrists may succumb to party pressure, say amid Republican obstructionism of a voting rights bill, to eliminate the filibuster. The last time the Senate was evenly divided, after the 2000 election, the power-sharing agreement only lasted six months, from January to June 2001. A single retirement or death could turn the balance. Moreover since Democrats have the option of two reconciliation bills first, the filibuster is not a substantial check on them until 2022 or beyond, at which point the centrists could fall under sustained pressure.3 Bottom Line: Preserving the filibuster provides a source of stability – it reduces policy uncertainty and polarization. It restricts Biden’s agenda largely to his major initiatives: entrenching the Affordable Care Act, expanding infrastructure spending, partially repealing Trump tax cuts, and various other tax-and-spend measures known to investors. It lowers the chance that financial markets will be blindsided in 2021 by a sweeping new legislative initiative – for example, the Green New Deal – or radical redistributive schemes. While markets will need to discount the tax hikes they will be able to recover more quickly than if they also expected a stream of unpredictable legislation from a Senate unshackled from the filibuster. Stimulus And The Tax Hike Timeline The American Rescue Plan could pass in February at the earliest or April at the latest. If at least 10 Republican senators cooperate then it will fly through Congress. The advantage of this bipartisan route is that it would achieve an early Biden objective while still leaving Democrats with two full chances to pass reconciliation bills covering fiscal 2021-22. The economic recovery would be on sure footing thereafter, giving Biden more room to maneuver (Charts 3 and 4). Chart 3Is More Stimulus Necessary? Is More Stimulus Necessary? Is More Stimulus Necessary? Bipartisan talks are under way. Senator Joe Manchin of West Virginia set up talks with about 15 other senators and three White House aides, including National Economic Council director Brian Deese, toward revising and passing the rescue plan.4 Winning over ten Republicans is a tall order but GOP senators are aware that the pandemic is still going and even Republican voter opinion favors more relief. So far Democrats have not allowed any compromise in the size of the deal but that could change to get 60 votes, since they can always make up the difference through reconciliation later. The rescue plan is unlikely to be passed before Trump’s second impeachment trial begins on February 8, however. If 10 Republicans cannot be found, the Senate will be slowed down by juggling reconciliation and impeachment. Trump’s first impeachment took 49 days, leaving the average at 65 days (Table 2). It will keep the Senate busy at least through mid-March. Chart 4More Checks Coming For Households? More Checks Coming For Households? More Checks Coming For Households? Table 2Impeachment Takes At Least A Month Biden's Political Capital Biden's Political Capital Since Democrats are highly unlikely to win over 17 Republicans to convict Trump of inciting insurrection, the impeachment could be a policy mistake. Democrats are determined not to let slide the opportunity to position themselves as the arch defenders of democracy. Acquitting Trump would put several prominent Republicans on record endorsing him even after his alleged interference with the peaceful transition of power. However, impeachment will not be allowed to derail Biden’s agenda. The Democratic Party controls both processes. The Senate can wrap up the trial if it becomes an obstacle. Diagram 1 presents the timeline for these events to occur. The implication is that March 14, when the latest expansion of unemployment benefits starts to expire, will serve as a deadline for Biden’s rescue plan. Diagram 1Timeline Of Impeachment, Budget Reconciliation, And Regular Legislation Biden's Political Capital Biden's Political Capital Budget reconciliation takes seven months on average but it only took three months in 2017, which is the proper analogy for today. Even if tax hikes are passed in Q2 there is an open question as to when they would take effect (Diagram 2). Prudent investors should be prepared for a retroactive January 1, 2021 effective date, even if it is more likely that they will kick in on January 1, 2022 to give the economy more time to recover. Again, taxes pose a risk to the rally. Diagram 2How Long Does It Take To Pass A Budget Reconciliation Bill? Biden's Political Capital Biden's Political Capital If Republicans do not cooperate on Biden’s rescue plan then Democrats will cite it as obstructionism from the beginning, despite Biden’s call to unity, and it will play into any future efforts to eliminate the filibuster. But those will likely center on the period after the two reconciliation bills. Bottom Line: As the House Democrats begin to draft their first budget resolution, to initiate the reconciliation process, tax hikes will come more into focus. The near-term upside risk is that Democrats skip taxes in the first bill and save it for later. But there will have to be at least some revenue raisers in any reconciliation bill. So a near-term pullback is entirely reasonable to expect. We would be buyers on the dip given the extremely accommodative fiscal and monetary backdrop. Introducing Our Political Capital Index To assess any government’s capability – namely its ability to alter the policy setting that affects the economy and financial markets – we need to measure its political capital or grounds of support. To this end we have constructed a Political Capital Index to measure the strength and capability of US ruling parties and presidencies (Table 3). Table 3Political Capital Index Biden's Political Capital Biden's Political Capital The Political Capital Index shows a series of political and economic indicators, as of the latest available data (December or January), as well as the change since Biden’s election in November.5 Below we describe the political and economic categories of political capital that we chose and the data we use to represent them: Political Strength: The most basic measure of political capital is President Biden’s margin of victory in the popular vote (4.4%) and Electoral College vote (306/538), the number of days he has been in power, his party’s Congressional majorities, and the Supreme Court’s ideological leaning. These components will last for two-to-four years and can only be changed by new elections or deaths (Table 4). Even a president elected in a landslide would see his political capital decay over time. The sooner the next election, the less political capital the ruling party has. The president and Congress will have more trouble passing legislation just before the election and will be more careful about what they do pass to avoid punishment at the ballot box. Any difficult economic policies or reforms will tend to be done at the beginning of the term, as political capital is still abundant and the next election is not a clear and present danger. President Biden has moderate political capital. His popular victory was solid, his electoral victory was the same as President Trump’s, but his congressional majorities are weak. His initial legislative efforts should be assumed to pass but aside from his rescue plan and one or two reconciliation bills he will not be able to get much else done. Table 4Political Capital: White House And Congress Biden's Political Capital Biden's Political Capital Household Sentiment: Household sentiment is the origin of political capital since households are voters. We measure it through presidential net approval ratings, both in general and in handling the economy, as well as through consumer confidence (Chart 5). Household sentiment changes easily – it can drive policies and react to them. Even if the economy is objectively improving, sentiment can remain downbeat if politicians fail to communicate their policies, which could cost them the election. Measures that improve household pocketbooks or welfare are more popular than those that impose structural changes like taxes and regulation. But reforms are possible when a politician has sufficient political capital, or when a worse outcome would follow from doing nothing. Biden will start with a higher approval rating than President Trump but his average approval is not much higher at present and consumer confidence has ticked down as a result of the pandemic. His economic stimulus should create an improvement in household sentiment in the coming year. Chart 5US Households: Still Downbeat US Households: Still Downbeat US Households: Still Downbeat Business Sentiment: Business sentiment is another important element of political capital. Businesses that are confident about the economy’s prospects will spend on capex, new orders, and new hires, and they will also deplete their inventories (Table 5). Animal spirits respond to spending, taxation, regulation, and trade – all areas where politicians have some control. Table 5Political Capital: Household And Business Sentiment Biden's Political Capital Biden's Political Capital Policymakers can run down business sentiment by enacting painful policies for business, in favor of government or households or personal whim – or they can pass business-friendly policies to boost animal spirits. Businesses cannot vote like households but they have a powerful influence over politicians through lobbyists and political donations and a powerful influence on voters through employment. Higher animal spirits encourage new employment, which improves household welfare, thus boosting political capital. Biden is starting out fairly strong with respect to business sentiment, with the exception of the service sector, which is still beaten down by the pandemic. This is an area where his political capital could decay over time. Big business was happy to get rid of Trump’s trade war but now it faces larger government encroachment. This risk is flagged by small businesses, which are already highly distrustful of new taxes and regulation (Chart 6). Chart 6US Business Sentiment US Business Sentiment US Business Sentiment Chart 7Measures Of Polarization Measures Of Polarization Measures Of Polarization Political Polarization: Starkly divided populations and governments are often gridlocked or obstructionist, preventing policies from getting approved or implemented (Chart 7). Our polarization proxy measures the difference in approval of the sitting president according to party, while our economic polarization measure does the same for economic sentiment. Structural polarization is a low-frequency data series from political science literature that measures whether House members and senators tend to vote with the “party line” or “reach across the aisle.”6 The Philly Fed Partisan Index also measures the degree of political disagreement among politicians at the federal level. A highly polarized environment ensures that there will be strong opposition to any policy put forward by lawmakers and a higher likelihood of reversal by the next governing party. This leads to erratic policymaking and policy uncertainty among households and businesses. Lower polarization increases the durability of policies. Fiscal Policy: The government sector contributes to political capital through fiscal policy, especially fiscal thrust (the change in the cyclically adjusted primary budget deficit) (Table 6). An expansionary fiscal policy affords policymakers greater latitude – especially in times and places where inflation is not a public concern. It can also be an effort by the ruling party to boost its political capital when it is low, or when an election looms. The Biden administration is lucky to start off with a new business cycle, as Obama did in 2009, but the large dose of fiscal support today will become a fiscal drag by 2024 so the long-term effectiveness of today’s “pump priming” will be essential. Table 6Political Capital: The Economy And Markets Biden's Political Capital Biden's Political Capital Economic Conditions: Economic conditions are arguably the most important component of political capital. We included several objective measures of household wellbeing such as unemployment, inflation, gasoline prices at the pump, and wage growth. If voters have seen their quality of life improve under the current set of leaders then they are more likely to vote to continue their windfall. To judge whether a party will be re-elected, it is critical to know whether household wellbeing has changed since the last election. High unemployment, high inflation, high economic uncertainty, and high bankruptcy levels point to struggling voters who are more likely to take their grievances to the ballot box. By the same token, leaders will struggle to get anything done if voters are beset with these ills. Asset Markets: Asset markets play at least some role in determining political capital. Most voters are not highly exposed to the stock market, though they care about their pension fund. Most voters are highly exposed to the property market. A euphoric stock market will not necessarily buoy the political capital of a president or ruling party, as demonstrated by the recent election: President Trump’s approval was closely linked to the stock market, which also restrained his actions, yet a rallying market did not get him re-elected. A market crash will always hurt policymakers, especially if it happens just before an election. We watch the stock market primarily as a downside risk to the ruling party’s political capital rather than upside. Bottom Line: Our Political Capital Index is how we will monitor President Biden’s and the Democratic Party’s capability in the coming months and years. The administration begins with moderate political capital but it is likely to improve on economic recovery, which will be secured through control of Congress and the purse strings. Our confidence that Biden’s American Rescue Plan and one or two reconciliation bills will pass stems from this assessment. This means a large spending program and tax hikes are highly probable and investors should prepare for them. Investment Takeaways Signs of mania – from Bitcoin to TESLA to GameStop – have gripped the market as the combined effect of ultra-dovish monetary and fiscal policy is priced. This process can continue beyond reasonable expectations. Nevertheless we are prepared for near-term volatility and a correction at any time. The rollout of the COVID-19 vaccine faces inevitable bumps and the pandemic is still triggering government lockdown measures and consumer caution – though these will improve over time. Biden’s regulatory agenda and especially looming tax hikes will also spur some risk aversion in the near term as the House Democrats begin preparing a reconciliation bill. Overcoming the hurdle of Trump’s impeachment will free up the Senate to move forward on reconciliation as well, which means tax hikes will fall under the market’s radar sooner or later. A regular bill could be passed in February without new taxes but otherwise a reconciliation bill will pass as early as April and include at least some new taxes, even if they take effect next year. We would still use the opportunity to buy into any further weakness in value plays relative to growth plays (Chart 8). Fundamentally the economy is set to improve this year, the pandemic is set to subside, and the policy support will be reinforced and expanded as necessary. Chart 8A Setback For Growth Versus Value A Setback For Growth Versus Value A Setback For Growth Versus Value Chart 9Equity Correction Looms Equity Correction Looms Equity Correction Looms The reflation trade is technically over-extended, investors are complacent, and some profit-taking is due. The extremely depressed put-to-call ratio tracks well with the US dollar index, both of which are showing signs of life (Chart 9). We would fade a rebound in the dollar, however, as the Democratic Party’s policies will ensure widening twin deficits (budget and trade deficits) even as the Fed demonstrates its commitment to its new goal of allowing an inflation overshoot to make up for past undershoots.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com   Appendix Table A1Political Risk Matrix Biden's Political Capital Biden's Political Capital Table A2Biden’s Cabinet Position Appointments Biden's Political Capital Biden's Political Capital   Footnotes 1     See BCA Research US Equity Strategy, “Overdose?” January 25, 2021, bcaresearch.com. 2     The Congressional Review Act of 1996 enables Congress to speed up the removal of regulations that were adopted recently, in this case since August 21, 2020. The process requires both houses of Congress to repeal a regulation but the Senate cannot prevent repeal via filibuster. The Trump administration used the law aggressively to remove several of President Barack Obama’s outgoing regulations. See Jonathan H. Adler, “Will Democrats Learn To Love The Congressional Review Act?” Reason, January 23, 2021, reason.com.  3    Democrats are explicitly interested in repealing the filibuster, as Biden and Senate Majority Leader Chuck Schumer have indicated (not to mention former President Obama who characterized it as a relic of the racist Jim Crowe era). 4    See Ed O’Keefe et al, “16 senators from both parties meet with White House on COVID-19 relief plan,” CBS News, January 25, 2021, cbsnews.com; Aamer Madhani and Lisa Mascaro, “White House Begins Talks With Lawmakers On COVID-19 Relief,” Associated Press, January 25, 2021, apnews.com.  5    Biden’s term technically began on January 20 but voters in 2024 will judge the president and ruling party based on whether they are better off than they were four years ago, i.e. when they last made a major judgment. 6    See Jeffrey Lewis, Keith Poole, Howard Rosenthal, et al, at voteview.org.  

Highlights Chinese equities have rallied enthusiastically since the COVID-19 outbreak and are now exposed to underlying political and geopolitical risks. Xi Jinping’s intention is to push forward reform and restructuring, creating a significant risk of policy overtightening over the coming two years. In the first half of 2021, the lingering pandemic and fragile global environment suggest that overtightening will be avoided. But the risk will persist throughout the year. Beijing’s fourteenth five-year plan and new focus on import substitution will exacerbate growing distrust with the US. We still doubt that the Biden administration will reduce tensions substantially or for very long. Chinese equities are vulnerable to a near-term correction. The renminbi is at fair value. Go long Chinese government bonds on the basis that political and geopolitical risks are now underrated again. Feature The financial community tends to view China’s political leadership as nearly infallible, handling each new crisis with aplomb. In 2013-15 Chinese leaders avoided a hard landing amid financial turmoil, in 2018-20 they blocked former President Trump’s trade war, and in 2020 they contained the COVID-19 pandemic faster than other countries. COVID was especially extraordinary because it first emerged in China and yet China recovered faster than others – even expanding its global export market share as the world ordered more medical supplies and electronic gadgets (Chart 1). COVID-19 cases are spiking as we go to press but there is little doubt that China will use drastic measures to curb the virus’s spread. It produced two vaccines, even if less effective than its western counterparts (Chart 2). Monetary and fiscal policy will be utilized to prevent any disruptions to the Chinese New Year from pulling the rug out from under the economic recovery. Chart 1China Grew Global Market Share, Despite COVID China Grew Global Market Share, Despite COVID China Grew Global Market Share, Despite COVID Chart 2China Has A Vaccine, Albeit Less Effective China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 In short, China is seen as a geopolitical juggernaut that poses no major risk to the global bull market in equities, corporate bonds, and commodities – the sole backstop for global growth during times of crisis (Chart 3). The problem with this view is that it is priced into markets already, the crisis era is fading (despite lingering near-term risks), and Beijing’s various risks are piling up. Chart 3China Backstopped Global Growth Again China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 First, as potential GDP growth slows, China faces greater difficulty managing the various socioeconomic imbalances and excesses created by its success – namely the tug of war between growth and reform. The crisis shattered China’s attempt to ensure a smooth transition to lower growth rates, leaving it with higher unemployment and industrial restructuring that will produce long-term challenges (Chart 4). Chart 4China's Unemployment Problem China's Unemployment Problem China's Unemployment Problem The shock also forced China to engage in another blowout credit surge, worsening the problem of excessive leverage and reversing the progress that was made on corporate deleveraging in previous years. Second, foreign strategic opposition and trade protectionism are rising. China’s global image suffered across the world in 2020 as a result of COVID, despite the fact that President Trump’s antics largely distracted from China. Going forward there will be recriminations from Beijing’s handling of the pandemic and its power grab in Hong Kong yet Trump will not be there to deflect. By contrast, the Biden administration holds out a much greater prospect of aligning liberal democracies against China in a coalition that could ultimately prove effective in constraining its international behavior. China’s turn inward, toward import substitution and self-sufficiency, will reinforce this conflict. In the current global rebound, in which China will likely be able to secure its economic recovery while the US is supercharging its own, readers should expect global equity markets and China/EM stocks to perform well on a 12-month time frame. We would not deny all the positive news that has occurred. But Chinese equities have largely priced in the positives, meaning that Chinese politics and geopolitics are underrated again and will be a source of negative surprises going forward. The Centennial Of 1921 The Communist Party will hold a general conference to celebrate its 100th birthday on July 1, just as it did in 1981, 1991, 2001, and 2011. These meetings are ceremonial and have no impact on economic policy. We examined nominal growth, bank loans, fixed asset investment, industrial output, and inflation and observed no reliable pattern as an outcome of these once-per-decade celebrations. In 2011, for example, General Secretary Hu Jintao gave a speech about the party’s triumphs since 1921, reiterated the goals of the twelfth five-year plan launched in March 2011, and reminded his audience of the two centennial goals of becoming a “moderately prosperous society” by 2021 and a “modern socialist country” by 2049 (the hundredth anniversary of the People’s Republic). China is now transitioning from the 2021 goals to the 2049 goals and the policy consequences will be determined by the Xi Jinping administration. Xi will give a speech on July 1 recapitulating the fourteenth five-year plan’s goals and his vision for 2035 and 2049, which will be formalized in March at the National People’s Congress, China’s rubber-stamp parliament. As such any truly new announcements relating to the economy should come over the next couple of months, though the broad outlines are already set. There would need to be another major shock to the system, comparable to the US trade war and COVID-19, to produce a significant change in the economic policy outlook from where it stands today. Hence the Communist Party’s 100th birthday is not a driver of policy – and certainly not a reason for authorities to inject another dose of massive monetary and credit stimulus following the country’s massive 12% of GDP credit-and-fiscal impulse from trough to peak since 2018 (Chart 5). The overarching goal is stability around this event, which means policy will largely be held steady. Chart 5China's Big Stimulus Already Occurred China's Big Stimulus Already Occurred China's Big Stimulus Already Occurred Far more important than the centenary of the Communist Party is the political leadership rotation that will begin on the local level in early 2022, culminating in the twentieth National Party Congress in the fall of 2022.1 This was supposed to be the date of Xi’s stepping down, according to the old schedule, but he will instead further consolidate power – and may even name himself Chairman Xi, as the next logical step in his Maoist propaganda campaign. This important political rotation will enable Xi to elevate his followers to higher positions and cement his influence over the so-called seventh generation of Chinese leaders, pushing his policy agenda far into the future. Ahead of these events, Beijing has been mounting a new battle against systemic risks, as it did in late 2016 and throughout 2017 ahead of the nineteenth National Party Congress. The purpose is to prevent the economic and financial excesses of the latest stimulus from destabilizing the country, to make progress on Xi’s policy agenda, and to expose and punish any adversaries. This new effort will face limitations based on the pandemic and fragile economy but it will nevertheless constitute the default setting for the next two years – and it is a drag on growth rather than a boost. The importance of the centenary and the twentieth party congress will not prevent various risks from exploding between now and the fall of 2022. Some political scandals will likely emerge as foreign or domestic opposition attempts to undermine Xi’s power consolidation – and at least one high-level official will inevitably fall from grace as Xi demonstrates his supremacy and puts his followers in place for higher office. But any market reaction to these kinds of events will be fleeting compared to the reaction to Xi’s economic management. The economic risk boils down to the implementation of Xi’s structural reform agenda and his threshold for suffering political pain in pursuit of this agenda. For now the risk is fairly well contained, as the pandemic is still somewhat relevant, but going forward the tension between growth and reform will grow. Bottom Line: The hundredth birthday of the Communist Party is overrated but the twentieth National Party Congress in 2022 is of critical importance to the governance of China over the next ten years. These events will not prompt a major new dose of stimulus and they will not prevent a major reform push or crackdown on financial excesses. But as always in China there will still be an overriding emphasis on economic and social stability above all. For now, this is supportive of the new global business cycle, commodity prices, and emerging market equities. The Fourteenth Five-Year Plan (2021-25) The draft proposal of China’s fourteenth five-year plan (2021-25) will be ratified at the annual “two sessions” in March (Table 1). The key themes are familiar from previous five-year plans, which focused on China’s economic transition from “quantity” to “quality” in economic development. Table 1China’s 14th Five Year Plan China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 China is seen as having entered the “high quality” phase of development – and the word quality is used 40 times in the draft. As with the past five years, the Xi administration is highlighting “supply-side structural reform” as a means of achieving this economic upgrade and promoting innovation. But Xi has shifted his rhetoric to highlight a new concept, “dual circulation,” which will now take center stage. Dual circulation marks a dramatic shift in Chinese policy: away from the “opening up and reform” of the liberal 1980s-2000s and toward a new era of import substitution and revanchism that will dominate the 2020s. Xi Jinping first brought it up in May 2020 and re-emphasized it at the July Politburo meeting and other meetings thereafter. It is essentially a “China First” policy that describes a development path in which the main economic activity occurs within the domestic market. Foreign trade and investment are there to improve this primary domestic activity. Dual circulation is better understood as a way of promoting import substitution, or self-reliance – themes that emerged after the Great Recession but became more explicit during the trade war with the US from 2018-20. The gist is to strengthen domestic demand and private consumption, improve domestic rather than foreign supply options, attract foreign investment, and build more infrastructure to remove internal bottlenecks and improve cross-regional activity (e.g. the Sichuan-Tibet railway, the national power grid, the navigation satellite system). China has greatly reduced its reliance on global trade already, though it is still fairly reliant when Hong Kong is included (Chart 6). The goals of the fourteenth five-year plan are also consistent with the “Made in China 2025” plan that aroused so much controversy with the Trump administration, leading China to de-emphasize it in official communications. Just like dual circulation, the 2025 plan was supposed to reduce China’s dependency on foreign technology and catapult China into the lead in areas like medical devices, supercomputers, robotics, electric vehicles, semiconductors, new materials, and other emerging technologies. This plan was only one of several state-led initiatives to boost indigenous innovation and domestic high-tech production. The response to American pressure was to drop the name but maintain the focus. Some of the initiatives will fall under new innovation and technology guidelines while others will fall under the category of “new types of infrastructure,” such as 5G networks, electric vehicles, big data centers, artificial intelligence operations, and ultra-high voltage electricity grids. With innovation and technology as the overarching goals, China is highly likely to increase research and development spending and aim for an overall level of above 3% of GDP (Chart 7). In previous five-year plans the government did not set a specific target. Nor did it set targets for the share of basic research spending within research and development, which is around 6% but is believed to need to be around 15%-20% to compete with the most innovative countries. While Beijing is already a leader in producing new patents, it will attempt to double its output while trying to lift the overall contribution of technology advancement to the economy. Chart 6China Seeks To Reduce Foreign Dependency China Seeks To Reduce Foreign Dependency China Seeks To Reduce Foreign Dependency Dual circulation will become a major priority affecting other areas of policy. Reform of state-owned enterprises (SOEs), for example, will take place under this rubric. The Xi administration has dabbled in SOE reform all along, for instance by injecting private capital to create mixed ownership, but progress has been debatable. Chart 7China Will Surge R&D Spending China Will Surge R&D Spending China Will Surge R&D Spending The new five-year plan will incorporate elements of an existing three-year action plan approved last June. The intention is to raise the competitiveness of China’s notoriously bloated SOEs, making them “market entities” that play a role in leading innovation and strengthening domestic supply chains. However, there is no question that SOEs will still be expected to serve an extra-economic function of supporting employment and social stability. So the reform is not really a broad liberalization and SOEs will continue to be a large sector dominated by the state and directed by the state, with difficulties relating to efficiency and competitiveness. Notwithstanding the focus on quality, China still aims to have GDP per capita reach $12,500 by 2025, implying 5%-5.5% annual growth from 2021-25, which is consistent with estimates of the International Monetary Fund (Chart 8). This kind of goal will require policy support at any given time to ensure that there is no major shortfall due to economic shocks like COVID-19. Thus any attempts at reform will be contained within the traditional context of a policy “floor” beneath growth rates – which itself is one of the biggest hindrances to deep reform. Chart 8China's Growth Target Through 2025 China's Growth Target Through 2025 China's Growth Target Through 2025 Chart 9Stimulus Correlates With Carbon Emissions Stimulus Correlates With Carbon Emissions Stimulus Correlates With Carbon Emissions As the economy’s potential growth slows the Communist Party has been shifting its focus to improving the quality of life, as opposed to the previous decades-long priority of meeting the basic material needs of the society. The new five-year plan aims to increase disposable income per capita as part of the transition to a domestic consumption-driven economy. The implied target will be 5%-5.5% growth per year, down from 6.5%+ previously, but the official commitment will be put in vague qualitative terms to allow for disappointments in the slower growing environment. The point is to expand the middle-income population and redistribute wealth more effectively, especially in the face of stark rural disparity. In addition the government aims to increase education levels, expand pension coverage, and, in the midst of the pandemic, increase public health investment and the number of doctors and hospital beds relative to the population. Beijing seems increasingly wary of too rapid of a shift away from manufacturing – which makes sense in light of the steep drop in the manufacturing share of employment amid China’s shift away from export-dependency. In the thirteenth five-year plan, Beijing aimed to increase the service sector share of GDP from 50.5% to 56%. But in the latest draft plan it sets no target for growing services. Any implicit goal of 60% would be soft rather than hard. Given that manufacturing and services combined make up 93% of the economy, there is not much room to grow services further unless policymakers want to allow even faster de-industrialization. But the social and political risks of rapid de-industrialization are well known – both from the liquidation of the SOEs in the late 1990s and from the populist eruptions in the UK and US more recently. Beijing is likely to want to take a pause in shifting away from manufacturing. But this means that China’s exporting of deflation and large market share will persist and hence foreign protectionist sentiment will continue to grow. The fourteenth five-year plan ostensibly maintains the same ambitious targets for environmental improvement as in its predecessor, in terms of water and energy consumption, carbon emissions, pollution levels, renewable energy quotas, and quotas for arable land and forest coverage. But in reality some of these targets are likely to be set higher as Beijing has intensified its green policy agenda and is now aiming to hit peak carbon emissions by 2030. China aims to be a “net zero” carbon country by 2060. Doubling down on the shift away from fossil fuels will require an extraordinary policy push, given that China is still a heavily industrial economy and predominantly reliant on coal power. So environmental policy will be a critical area to watch when the final five-year plan is approved in March, as well as in future plans for the 2026-30 period. As was witnessed in recent years, ambitious environmental goals will be suspended when the economy slumps, which means that achieving carbon emissions goals will not be straightforward (Chart 9), but it is nevertheless a powerful economic policy theme and investment theme. Xi Jinping’s Vision: 2035 On The Way To 2049 At the nineteenth National Party Congress, the critical leadership rotation in 2017, Xi Jinping made it clear that he would stay in power beyond 2022 – eschewing the nascent attempt of his predecessors to set up a ten-year term limit – and establish 2035 as a midway point leading to the 2049 anniversary of the People’s Republic. There are strategic and political goals relevant to this 2035 vision – including speculation that it could be Xi’s target for succession or for reunification with Taiwan – but the most explicit goals are, as usual, economic. Chart 10Xi Jinping’s 2035 Goals China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Officially China is committing to descriptive rather than numerical targets. GDP per capita is to reach the level of “moderately developed countries.” However, in a separate explanation statement, Xi Jinping declares, “it is completely possible for China to double its total economy or per capita income by 2035.” In other words, China’s GDP is supposed to reach 200 trillion renminbi, while GDP per capita should surpass $20,000 by 2035, implying an annual growth rate of at least 4.73% (Chart 10). There is little reason to believe that Beijing will succeed as much in meeting future targets as it has in the past. In the past China faced steady final demand from the United States and the West and its task was to bring a known quantity of basic factors of production into operation, after lying underutilized for decades, which made for high growth rates and fairly predictable outcomes. In the future the sources of demand are not as reliable and China’s ability to grow will be more dependent on productivity enhancements and innovation that cannot be as easily created or predicted. The fourteenth five-year plan and Xi’s 2035 vision will attempt to tackle this productivity challenge head on. But restructuring and reform will advance intermittently, as Xi is unquestionably maintaining his predecessors’ commitment to stability above all. Outlook 2021: Back To The Tug Of War Of Stimulus And Reform The tug of war between economic stimulus and reform is on full display already in 2021 and will become by far the most important investment theme this year. If China tightens monetary and fiscal policy excessively in 2021, in the name of reform, it will undermine its own and the global economic recovery, dealing a huge negative surprise to the consensus in global financial markets that 2021 will be a year of strong growth, rebounding trade, a falling US dollar, and ebullient commodity prices. Our view is that Chinese policy tightening is a significant risk this year – it is not overrated – but that the government will ultimately ease policy as necessary and avoid what would be a colossal policy mistake of undercutting the economic recovery. We articulated this view late last year and have already seen it confirmed both in the Politburo’s conclusions at the annual economic meeting in December, and in the reemergence of COVID-19, which will delay further policy tightening for the time being. The pattern of the Xi administration thus far is to push forward domestic reforms until they run up against the limits of economic stability, and then to moderate and ease policy for the sake of recovery, before reinitiating the attack. Two key developments initially encouraged Xi to push forward with a new “assault phase of reform” in 2021: First, a new global business cycle is beginning, fueled by massive monetary and fiscal stimulus across the world (not only in China), which enables Xi to take actions that would drag on growth. Second, Xi Jinping has emerged from the US trade war stronger than ever at home. President Trump lost the election, giving warning to any future US president who would confront China with a frontal assault. The Biden administration’s priority is economic recovery, for the sake of the Democratic Party’s future as well as for the nation, and this limits Biden’s ability to escalate the confrontation with China, even though he will not revoke most of Trump’s actions. Biden’s predicament gives Beijing a window to pursue difficult domestic initiatives before the Biden administration is capable of turning its full attention to the strategic confrontation with China. The fact that Biden seeks to build a coalition of states first, and thus must spend a great deal of time on diplomacy with Europe and other allies, is another advantageous circumstance. China is courting and strengthening relations with Europe and those very allies so as to delay the formation of any effective coalition (Chart 11). Chart 11China Courts EU As Substitute For US China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Thus, prior to the latest COVID-19 spike, Beijing was clearly moving to tighten monetary and fiscal policy and avoid a longer stimulus overshoot that would heighten the country’s long-term financial risks and debt woes. This policy preference will continue to be a risk in 2021: Central government spending down: Emergency fiscal spending to deal with the pandemic will be reduced from 2020 levels and the budget deficit will be reined in. The Politburo’s chief economic planning event, the Central Economic Work Conference in December, resulted in a decision to maintain fiscal support but to a lesser degree. Fiscal policy will be “effective and sustainable,” i.e. still proactive but lower in magnitude (Chart 12). Local government spending down: The central government will try to tighten control of local government bond issuance. The issuance of new bonds will fall closer to 2019 levels after a 55% increase in 2020. New bonds provide funds for infrastructure and investment projects meant to soak up idle labor and boost aggregate demand. A cut back in these projects and new bonds will drag on the economy relative to last year (Chart 13). Chart 12China Pares Government Spending On The Margin China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Chart 13China Pares Local Government Spending Too China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Monetary policy tightening up: The People’s Bank of China aims to maintain a “prudent monetary policy” that is stable and targeted in 2021. The intention is to avoid any sharp change in policy. However, PBoC Governor Yi Gang admits that there will be some “reasonable adjustments” to monetary policy so that the growth of broad money (M2) and total social financing (total private credit) do not wildly exceed nominal GDP growth (which should be around 8%-10% in 2021). The risk is that excessive easiness in the current context will create asset bubbles. The implication is that credit growth will slow to 11%-12%. This is not slamming on the brakes but it is a tightening of credit policy. Macro-prudential regulation up: The People’s Bank is reasserting its intention to implement the new Macro-Prudential Assessment (MPA) framework designed to tackle systemic financial risk. The rollout of this reform paused last year due to the pandemic. A detailed plan of how the country’s various major financial institutions will adopt this new mechanism is expected in March. The implication is that Beijing is turning its attention back to mitigating systemic financial risks. This includes closer supervision of bank capital adequacy ratios and cross-border financing flows. New macro-prudential tools are also targeting real estate investment and potentially other areas. Larger established banks will have a greater allowance for property loans than smaller, riskier banks. At the same time, it is equally clear that Beijing will try to avoid over-tightening policy: The COVID outbreak discourages tightening: This outbreak has already been mentioned and will pressure leaders to pause further policy tightening at least until they have greater confidence in containment. The vaccine rollout process also discourages economic activity at first since nobody wants to go out and contract the disease when a cure is in sight. Local government financial support is still robust: Local governments will still need to issue refinancing bonds to deal with the mountain of debt coming into maturity and reduce the risk of widespread insolvency. In 2020, they issued more than 1.8 trillion yuan of refinancing bonds to cover about 88% of the 2 trillion in bonds coming due. In 2021, they will have to issue about 2.2 trillion of refinancing bonds to maintain the same refinancing rate for a larger 2.6 trillion yuan in bonds coming due (Table 2). Thus while Beijing is paring back its issuance of new bonds to fund new investment projects, it will maintain a high level of refinancing bonds to prevent insolvency from cascading and undermining the recovery. Table 2Local Government Debt Maturity Schedule China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Monetary policy will not be too tight: The People’s Bank’s open market operations in January so far suggest that it is starting to fine-tune its policies but that it is doing so in an exceedingly measured way so as not to create a liquidity squeeze around the traditionally tight-money period of Chinese New Year. The seven-day repo rate, the de facto policy interest rate, has already rolled over from last year’s peak. The takeaway is that while Beijing clearly intended to cut back on emergency monetary and fiscal support this year – and while Xi Jinping is clearly willing to impose greater discipline on the economy and financial system prior to the big political events of 2021-22 – nevertheless the lingering pandemic and fragile global environment will ensure a relatively accommodative policy for the first half of 2021 in order to secure the economic recovery. The underlying risk of policy tightening is still significant, especially in the second half of 2021 and in 2022, due to the underlying policy setting. Investment Takeaways The CNY-USD has experienced a tremendous rally in the wake of the US-China phase one trade deal last year and Beijing’s rapid bounce-back from the pandemic. The trade weighted renminbi is now trading just about at fair value (Chart 14). We closed our CNY-USD short recommendation and would stand aside for now. China’s current account surplus is still robust, real reform requires a fairly strong yuan, and the Biden administration will also expect China not to depreciate the currency competitively. Thus while we anticipate the CNY-USD to suffer a surprise setback when the market realizes that the US and China will continue to clash despite the end of the Trump administration, nevertheless we are no longer outright short the currency. Chinese investable stocks have rallied furiously on the stimulus last year as well as robust foreign portfolio inflows. The rally is likely overstretched at the moment as the COVID outbreak and policy uncertainties come to the fore. This is also true for Chinese stocks other than the high-flying technology, media, and telecom stocks (Chart 15). Domestic A-shares have rallied on the back of Alibaba executive Jack Ma’s reappearance even though the clear implication is that in the new era, the Communist Party will crack down on entrepreneurs – and companies like fintech firm Ant Group – that accumulate too much power (Chart 16). Chart 14Renminbi Fairly Valued Renminbi Fairly Valued Renminbi Fairly Valued Chart 15China: Investable Stocks Overbought China: Investable Stocks Overbought China: Investable Stocks Overbought Chart 16Communist Party, Jack Ma's Boss Communist Party, Jack Ma's Boss Communist Party, Jack Ma's Boss Chart 17Go Long Chinese Government Bonds Go Long Chinese Government Bonds Go Long Chinese Government Bonds Chinese government bond yields are back near their pre-COVID highs (though not their pre-trade war highs). Given the negative near-term backdrop – and the longer term challenges of restructuring and geopolitical risks over Taiwan and other issues that we expect to revive – these bonds present an attractive investment (Chart 17). Housekeeping: In addition to going long Chinese 10-year government bonds on a strategic time frame, we are closing our long Mexican industrials versus EM trade for a loss of 9.1%. We are still bullish on the Mexican peso and macro/policy backdrop but this trade was premature. We are also closing our long S&P health care tactical hedge for a loss of 1.8%. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Yushu Ma Research Associate yushu.ma@bcaresearch.com   Footnotes 1 Indeed the 2022 political reshuffle has already begun with several recent appointments of provincial Communist Party secretaries.

Highlights In the wake of COVID-19, the low-probability, high-impact “Black Swan” event is as relevant as ever. Investors should already expect US terrorist incidents, a fourth Taiwan Strait crisis, and crises involving Turkey – these are no longer black swans. What if Russia had a color revolution, Japan confronted China, or Saudi Arabia collapsed? What if the US and China brokered a North Korean deal? Or a major terrorist attack caused government change in Germany? Ultimately this exercise illustrates what the market is not prepared for – a new rally in the US dollar – though some scenarios would fuel the rise of the euro and renminbi. Feature The COVID-19 pandemic reminded us all of the power of the “Black Swan” – the random, unpredictable event with massive ramifications. As historian Niall Ferguson pointed out at the BCA Conference last fall, COVID-19 was not really a black swan, as epidemiologists had predicted that a pandemic would occur and the world was not ready. Astrophysicist Martin Rees made a bet with psychologist and linguist Steven Pinker that “bioterror or bioerror will lead to one million casualties in a single event within a six month period starting no later than 31 December 2020.”1 Tellingly, countries neighboring China were the best prepared for the outbreak, having dealt with SARS and bird flu. COVID accelerated major trends building up throughout the past decade – notably the shift toward pro-active fiscal policy, which had been gaining traction in policy circles ever since the austerity debates of the early 2010s. In that sense forecasting is still necessary. If solid trends can be identified, then random shocks may simply reinforce them (Chart 1). Chart 1US Fiscal Stimulus About To Get Even Bigger Five Black Swans For 2021 Five Black Swans For 2021 In this year’s “Five Black Swans” report, we focus on geopolitical risks that are highly unlikely, not at all being discussed, and yet would have a major impact on financial markets. Domestic terrorist events in the United States in 2021 would not qualify as a black swan by this definition. A crisis in the Taiwan Strait, which we have warned about for several years, is now widely (and rightly) expected. Black Swan #1: A Color Revolution In Russia Russia is one of the losers of the US election. Not because Trump was a Russian agent – the Trump administration ended up authorizing a fairly hawkish posture toward Russia in eastern Europe – but rather because the Democratic Party threatens Russia with a strengthening of the trans-Atlantic alliance and a recovery of liberal democratic ideology. Geopolitical risk surrounding Russia is therefore elevated, as we argued last year. Both President Vladimir Putin and his government have seen their approval rating drop, a development that has often led Russia to lash out abroad (Chart 2). But our expectation of rising political risk within Russia’s sphere has been reinforced by Russia’s alleged poisoning of opposition politician Alexei Navalny and the eruption of pro-democracy protests in Belarus. Vladimir Putin is increasingly focusing on home affairs due to domestic instability worsened by the pandemic and recession. Fiscal and monetary austerity have weighed on the public. The largest protests since 2011 occurred in mid-2019 in opposition to the fixing of the Moscow municipal elections. This could be a harbinger of larger unrest around the Russian legislative elections on September 19, 2021. Nominal wage growth has collapsed and is scraping its 2015-16 lows (Chart 3). Chart 2Black Swan #1: A Color Revolution In Russia Black Swan #1: A Color Revolution In Russia Black Swan #1: A Color Revolution In Russia Chart 3Russia's Fiscal Austerity Russia's Fiscal Austerity Russia's Fiscal Austerity Meanwhile US policy toward Russia will become more confrontational. New US presidents always start with outreach to Russia, but the Democratic Party blames Russia for betraying the good faith of the Obama administration’s “diplomatic reset” from 2009-11. Russia invaded Ukraine and took Crimea in exchange for cooperating on the 2015 Iran nuclear deal. Adding in the Snowden affair, the 2016 election interference, and now the monumental SolarWinds cyberattack, the Democratic Party will want to strike back and reestablish deterrence against Russia’s asymmetrical warfare. While Biden will seek to negotiate an extension of the New START missile treaty from February 5, 2021 until 2026, he will gear up for confrontation in other areas. The US could seek to go on offense with Russia’s wonted tools: psychological warfare and cyberattacks. The Americans are not willing or able to attempt regime change in Moscow. That would be taken as an act of war among nuclear powers. But if Russia is less stable internally than it appears, then US meddling could hit a weak spot and set off a chain reaction. Even if the US is incapable of anything of the sort, Russia is still ripe for social unrest. Should the authorities mishandle it, it could metastasize. Russia has a long tradition of peasant uprisings – a descent into anarchy is not out of the question. The regime would not be devoting so much attention to suppressing domestic dissent if the conditions for it were not ripe.2 Putin’s constitutional reforms in mid-2020, which could extend his term until 2036, also speak to concerns about regime stability. A successful Russian uprising would threaten to raise serious instability in Europe and the world. When great but decadent empires are destabilized, political struggle can intensify rapidly and spill out to affect the neighbors. Bottom Line: Russian domestic political instability could produce a black swan. The ruble would tank and the US dollar would catch a bid against European currencies. Black Swan #2: A Major Terror Attack In Germany 2020 was a banner year for European solidarity. Brexit went forward but none of the European states have followed – nor would any want to follow given the political turmoil it aroused. Brussels initiated a recovery fund to combat the global pandemic that consisted of a mutual debt scheme – in what has been hailed somewhat excessively as a “Hamiltonian moment,” a move toward federalism. Germany stood at the center of this process. After opening the doors to a flood of migrants from Syria in 2015, Chancellor Angela Merkel suffered a blow to her popularity and was eventually forced to make plans for her exit. But she stuck to her core liberal policies and her fortunes have recovered (Chart 4). She is stepping down in 2021 as the longest-serving chancellor since Helmut Kohl and an influential European stateswoman. The EU member states are more integrated than ever while Germany has taken another step toward improving its international image. The public has rewarded the ruling coalition for its relatively competent handling of the global pandemic (Chart 5). Chart 4Black Swan #2: A Major Terror Attack In Germany Black Swan #2: A Major Terror Attack In Germany Black Swan #2: A Major Terror Attack In Germany Chart 5German People Happy With Their Government Five Black Swans For 2021 Five Black Swans For 2021 Merkel’s approval coincides with a recovery of the liberal democratic consensus in Europe after a series of challenges from anti-establishment and populist parties. Only in Italy did populists take power, and they were forced to back down from their extravagant fiscal policy demands while modifying their policy platform with regard to membership in the monetary union. Even today, as Italy’s ruling coalition comes apart at the seams, the risk of a populist backlash is lower than it was in most of the past decade. One of the main ways the European establishment neutralized the populist challenge was by tightening control over immigration and cracking down on terrorism (Charts 6 and 7). These two forces have played a large role in generating support for right wing parties, and these parties have declined in popularity as these two forces have abated. Chart 6Terrorist Attacks Have Fallen In Europe Terrorist Attacks Have Fallen In Europe Terrorist Attacks Have Fallen In Europe Chart 7Europeans Softening Toward Immigrants? Europeans Softening Toward Immigrants? Europeans Softening Toward Immigrants? Still, the risk posed by terrorist groups has not disappeared – and it is always possible that disaffected individuals could evade detection. French President Emmanuel Macron faced seven terrorist attacks over the past year, which partly stemmed over the commemoration of the Charlie Hebdo massacre but also points to the persistence of underground extremist networks (Chart 8).3 Chart 8French Fear Of Terrorism Has Increased Five Black Swans For 2021 Five Black Swans For 2021 Chart 9European Breakup Risk At Testing Point European Breakup Risk At Testing Point European Breakup Risk At Testing Point What would happen if a major attack occurred in Germany in 2021? Would it upset the country’s liberal consensus and fuel another surge in popular support for far-right parties like the Alternative for Germany? Only a major attack would have a lasting impact. A systemically important attack in the pivotal year of Merkel’s retirement could create more uncertainty in domestic German politics than has been seen since the 1990s and early 2000s. It is possible that an attack could strengthen the ruling coalition and the public’s desire to continue with the leadership of the Christian Democrats after Merkel. More likely, however, it would divide the conservative and right-wing parties among themselves. Merkel’s chosen successor, Defense Minister Annagret Kramp-Karrenbauer, was forced to abandon her bid for the chancellorship last year after members of her Christian Democratic Union in the state of Thuringia voted along with the anti-establishment Alternative for Germany to remove the state’s left-wing leader. The cooperation was minimal but it set off a firestorm by suggesting that Kramp-Karrenbauer was willing to work together with the far right.4 She bowed out and now the party is about to pick a new leader. The point is that if any event strengthens the far right, it would suck away votes from the Christian Democrats. The latter could also see divisions emerge with their Bavarian sister party, the Christian Social Union, which has differed on immigration in the past. Or the conservatives could alienate the median German voter by tacking too far to the right to preempt the anti-establishment vote (e.g. overreacting to the attack). Either way, German politics would be rocked. Ironically, if the coalition was seen as mishandling the response, a left-wing coalition of the Greens and the Social Democrats could be the beneficiaries. The risk of a government change – in the wake of Merkel and the pandemic – is greatly underrated, entirely aside from black swans. Nevertheless a major shock that strengthens the far right would be a black swan by forcing the question of whether the center-right is willing to cooperate with its fringe. If that occurred, then Europe would be stunned. If it did not, then the conservatives could lose the election and plunge into intra-party turmoil. The takeaway of a rightward shift on the back of any shock would be a renewed risk of fiscal hawkishness – a partial relapse from the past two years’ fiscal expansion to the more traditionally austere German posture. The takeaway of a leftward shift would be the opposite – a doubling down on that fiscal expansion. German hawkishness would increase the European breakup risk premium, while a confirmation of the new German dovishness would further suppress it (Chart 9). Bottom Line: The fiscal dovish turn is the more likely response to such a black swan in today’s climate, but a major terrorist attack could have unpredictable consequences. Black Swan #3: A US-China Deal On North Korea Critics misunderstood President Trump’s policy on North Korea. Trump’s policy – even his belligerent rhetoric – echoed that of Bill Clinton in the 1990s. The intention of the US show of force was to create an overwhelming threat that would force Pyongyang into serious negotiations toward a nuclear deal. That in turn would pave the way to economic cooperation. Trump’s efforts failed – Kim Jong Un stonewalled him in the final year and a half. Kim’s bet paid off since he avoided making major concessions and now Biden must start from scratch. Pyongyang has ramped up its threats and Kim has elevated his sister, Kim Yo Jong, to a higher standing in the party – apparently to lob attacks at South Korea full-time. Biden will put the technocrats and Korea experts in charge. Pyongyang may test nuclear weapons or launch intercontinental ballistic missiles to attract Biden’s attention. But Kim could also go straight to negotiations. Optimistically, a few years of talks could result in a phased reduction of sanctions in exchange for nuclear inspections. Kim has the incentive and the dictatorial powers to open up the economy and engage in market reforms while managing any backlash among the army. He has already prepared the ground by elevating economic policy to the level of military policy in the national program. For years he has allowed some market activity to little effect. The North must have suffered from the pandemic, as Kim publicly confessed to the failure of economic management at the latest party meeting. His country needs a vaccine for COVID. And if he intends to go the way of Vietnam, then he needs to open up the doors while a new global business cycle is beginning (Chart 10). The black swan would emerge if the Biden administration’s attempt to reboot relations with China produced a unified effort to force a resolution onto Kim. It is undeniable that Trump broke diplomatic ice by meeting with Kim directly, giving Biden the option of doing so quickly and with minimal controversy if he should so desire. Most importantly, China has enforced sanctions, if official statistics can be trusted (Chart 11). Beijing made no secret that it saw North Korea as an area of compromise to appease US anger. After all, success on the peninsula would remove the reason for the US to keep troops there. Chart 10Black Swan #3: A US-China Deal On North Korea Five Black Swans For 2021 Five Black Swans For 2021 Chart 11An Area Of US-China Cooperation Under Biden? An Area Of US-China Cooperation Under Biden? An Area Of US-China Cooperation Under Biden? The last point is the material point. If the North sought to open up, it would likely have to do so through talks with the US, China, South Korea, and Japan. Success would mean that US-China engagement is still effective. Bottom Line: A breakthrough on the Korean peninsula would mean that investors could begin imagining a future in which the US and China are not “destined for war” but rather capable of reviving their old cooperative approach. This has far-reaching positive implications, but most concretely the Korean won and Chinese renminbi would rally against the US dollar and Japanese yen on the historic reduction of war risk. Black Swan #4: Saudi Arabia (And Oil Prices) Collapse Saudi Arabia is an even greater loser from the US election than Russia. The Saudis came face to face with their geopolitical nightmare of US abandonment under the Obama administration, as the US gained energy independence while reaching out to Iran. The 2015 nuclear deal gave Iran a strategic boost and enabled it to resume pumping oil (Chart 12). The Saudis, like the Israelis, lobbied hard to stop the deal but failed. They threw their full support behind President Trump, who reciprocated, and now face the restoration of the Obama policy under Joe Biden. Chart 12Black Swan #4: Saudi Arabia (And Oil Prices) Collapse Black Swan #4: Saudi Arabia (And Oil Prices) Collapse Black Swan #4: Saudi Arabia (And Oil Prices) Collapse Chart 13Fiscal Pressure On Saudis Fiscal Pressure On Saudis Fiscal Pressure On Saudis Global investors should expect Biden to return to the nuclear deal with Iran as quickly as possible, notwithstanding Iran’s latest nuclear provocations, since the latter are designed to increase negotiating leverage. The Joint Comprehensive Plan of Action was an executive agreement that Biden could restore with the flick of his wrist, as long as Iranian President Hassan Rouhani returned to compliance. Rouhani can do so before a new president is inaugurated in August – he could secure his legacy at the cost of taking the blame for “dealing with the devil.” This would save the regime from further economic and social instability as it prepares for the all-important succession of the supreme leader in the coming years. A black swan would occur if this diplomatic situation led to a breakdown in support for Crown Prince Mohammed bin Salman (MBS). MBS, whose nickname is “reckless,” in part because his foreign policies have backfired, could attempt to derail or sabotage the US-Iran détente. If he tried and failed, the US could effectively abandon Saudi Arabia – energy self-sufficiency, public war-weariness, and Iranian détente would pave the way for the US to downgrade its commitment. This would create an existential risk for the kingdom, which depends on the US for national security. It could also be the final straw for MBS, who already faces opposition from elites who have been shoved aside and do not wish to see him ascend the throne in a few years’ time. A different trigger for the same black swan would be a collapse of the OPEC 2.0 oil cartel. The Saudis and Russians have fought two market-share wars over the past seven years. They could relapse into conflict in the face of shifting global dynamics, such as the green energy revolution, that disfavor oil. Arthur Budaghyan and Andrija Vesic, of BCA’s Emerging Markets Strategy, have argued that financial markets will start pricing in a higher probability of Saudi currency depreciation versus the US dollar in coming years. Lower-for-longer oil prices (say $40 per barrel average over next few years) would pose a dilemma to the authorities: either (1) cut fiscal spending further and tighten liquidity or (2) resort to local banks financing (money creation “out of thin air”) to sustain economic activity. The first scenario would impose severe fiscal austerity on the population (Chart 13), which is politically difficult to endure in the long run. The second scenario will lead to depleting the country’s FX reserves, robust money growth and some inflation culminating in downward pressure on the currency. The main reason for believing the devaluation will not happen is that it would topple the regime. Currency devaluation would result in unbearable inflation in a country that lacks domestic production and domestically sourced staples. But that is precisely why it is a black swan risk. After all, prolonged fiscal austerity may not be feasible either. Bottom Line: MBS controls the security forces and has consolidated power for years but that may not save him if his foreign policies led to American abandonment or a breakdown of the peg. Black Swan #5: A Sino-Japanese Crisis For the first time since 2016, we are not including US-China tensions over Taiwan in our list of black swans. A crisis in the strait is only a matter of time and the global news media is increasingly aware of it (Chart 14). It would not necessarily have to be a war or even a show of military force, though either are possible. A mere Chinese boycott or embargo of Taiwan would violate the US’s Taiwan Relations Act and trigger a US-China crisis from the get-go of the Biden administration. What is less widely recognized is that peaceful resolution of the China-Taiwan predicament is not just a concern for the United States. It is a concern for Japan and South Korea as well – whose vital supplies must travel around the island one way or another. These two nations would face constriction if mainland China reunified Taiwan by force – and therefore Beijing’s signals of increasing willingness to contemplate armed action are already reverberating among the neighbors. Japan sounded an uncharacteristically stark warning just last month. The hawkish statement from State Minister of Defense Yasuhide Nakayama is worth quoting at length: We are concerned China will expand its aggressive stance into areas other than Hong Kong. I think one of the next targets, or what everyone is worried about, is Taiwan … There’s a red line in Asia – China and Taiwan. How will Joe Biden in the White House react in any case if China crosses this red line? The United States is the leader of the democratic countries. I have a strong feeling to say: America, be strong!5 China and Japan have improved trade relations through the RCEP agreement, as Beijing looks to diversify from the United States. But China’s rise is of enormous strategic concern for Japanese policymakers. COVID-19 and the rollback of Hong Kong’s freedoms have made matters worse. The belt of sea and land around China – the “first island chain” – is the critical area from which Beijing seeks to expel American and foreign military presence. With China already having shown a willingness to clash with India and Australia simultaneously in 2020 – as it carves a sphere of influence in the absence of American pushback – it should be no surprise to see conflicts erupt in the East or South China Sea (Chart 15). Chart 14Differences In The Taiwan Strait Differences In The Taiwan Strait Differences In The Taiwan Strait Chart 15Black Swan #5: A Sino-Japanese Crisis Black Swan #5: A Sino-Japanese Crisis Black Swan #5: A Sino-Japanese Crisis In the aftermath of the last global crisis, in 2010, China and Japan clashed mightily over maritime-territorial disputes in the East China Sea. China imposed a brief embargo on exports of rare earth elements to Japan. The two clashed again the following year and tensions escalated dramatically when China rolled out an Air Defense Identification Zone (ADIZ) in 2013. Tense periods come and go and are often attended by mass anti-Japanese protests, as in 2005 and 2012. Usually these events are of passing importance, though they have the potential to escalate. What would truly be a black swan would be if Japan took the initiative to challenge China and test the Biden administration’s commitment to Japanese security. With the US internally divided and distracted, and China ascendant, Japan could grow increasingly insecure and seek to take precautions. China could see these as offensive. A new Sino-Japanese crisis could ensue that would catch investors by surprise. It is highly unlikely that Tokyo would provoke China – hence the black swan designation – but the effective absence of the Americans is a strategic liability that Tokyo may wish to resolve sooner rather than later. In this case the market reaction would be predictable – the yen would appreciate while the renminbi and Taiwanese dollar would fall. The risk-off period could be extended if the US failed to reinforce the Japanese alliance for fear of China, with the whole world watching. Bottom Line: Global investors would be blindsided if a sudden explosion of Sino-Japanese tensions prevented any US-China thaw and confirmed their worst fears about China’s economic decoupling from the West. Investment Takeaways This exercise in identifying black swans may be useful in at least one way: it exposes the vulnerability of financial markets to a sudden reversal of the US dollar’s weakening trend (Chart 16). The dollar would surge on broad Russian instability, Sino-Japanese conflict, or another exogenous geopolitical shock. This kind of dollar surprise would be much greater than a temporary counter-trend bounce, which our Foreign Exchange Strategist Chester Ntonifor fully expects. It would upset the financial community’s dollar-bearish consensus, with far-reaching ramifications for the global economy and financial markets. A rising dollar against the backdrop of a recovering global economy represents a de facto tightening of global financial conditions. Equity markets, for example, have only started to rotate away from the US and this trend would be reversed (Chart 17). Whereas further appreciation of the euro and the renminbi is not only expected but would support global reflation. Chart 16The USD Over Trump's Four Years The USD Over Trump's Four Years The USD Over Trump's Four Years Chart 17Global Market Cap Over Trump's Four Years Global Market Cap Over Trump's Four Years Global Market Cap Over Trump's Four Years There is a much plainer and straighter way to an upset of the dollar-bearish consensus. Rather than a black swan it is a “gray rhino,” the term that Michele Wucker uses for risks that are common, expected, and staring you right in the face.6 This would be the peak of China’s stimulus, which holds out the risk of a major reversal to the pro-cyclical global financial market rally in late 2021 (Chart 18). Chart 18China Impulse Will Linger In 2021, But EM Stocks Tactically Stretched China Impulse Will Linger In 2021, But EM Stocks Tactically Stretched China Impulse Will Linger In 2021, But EM Stocks Tactically Stretched It would be a colossal error if Beijing over-tightened monetary and fiscal policy in 2021 in the context of high debt, deflation, and unemployment (Chart 19). Chart 19Three Reasons China Will Avoid Over-Tightening (If It Can) Three Reasons China Will Avoid Over-Tightening (If It Can) Three Reasons China Will Avoid Over-Tightening (If It Can) Nevertheless the government’s renewed efforts to contain asset bubbles and credit excesses clearly increase the risk. Financial policy tightening is always a risky endeavor, as global policymakers routinely discover. Chart 20Book Profits But Stay Cyclically Positive On Reflation Trades Book Profits But Stay Cyclically Positive On Reflation Trades Book Profits But Stay Cyclically Positive On Reflation Trades We maintain that China’s major stimulus will have a lingering positive effects for the economy for most of this year and that the authorities will relax policy and regulation as needed to secure the recovery. The Central Economic Work Conference in December suggested that the Politburo still views downside economic risks as the most important. But this is a clear and present risk that will have to be monitored closely. Clearly the global reflation trend has extended to dangerous technical extremes over the past month on the realization that US fiscal stimulus will surprise to the upside. Therefore we are doing some housekeeping. We will book 31.1% profit on long cyber security, 16.7% on long US infrastructure, and 24.3% on long US materials. We will also book 9.5% gains on our long EM-ex-China equity trade, which has gone vertical (Chart 20).     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Such epidemiologists include Michael Osterholm and Lawrence Brilliant. For Pinker and Rees, see George Eaton, "Steven Pinker interview: How does a liberal optimist handle a pandemic?" The New Statesman, July 22, 2020, newstatesman.com. 2 Thomas Grove, "New Russian Security Force Will Answer To Vladimir Putin," Wall Street Journal, April 24, 2016, wsj.com. 3 Elaine Ganley, "Grisly beheading of teacher in terror attack rattles France," Associated Press, October 16, 2020, apnews.com. 4 Philip Oltermann, "German politician elected with help from far right to step down," The Guardian, February 6, 2020, theguardian.com. 5 Ju-min Park, "Japan official, calling Taiwan ‘red line,’ urges Biden to ‘be strong,’" Reuters, December 25, 2020, reuters.com. 6 See www.wucker.com.