Geopolitics

Special Report

Dear Client, I am on vacation this week. Instead of our regular report, we are sending you a Special Report from my colleague Jonathan LaBerge. Jonathan explores the risks posed to commercial real estate and the banking system from work from home policies and the potential for urban flight towards less populated and more affordable areas. I hope you find his report insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights Despite pronouncements that the “office is dead,” there are several arguments against the idea that working from home policies or urban flight will become broad-based and spell disaster for commercial real estate loans and the economy. However, the reality is that no one truly knows what the office environment will look like as a result of COVID-19. It is quite likely to be negative on balance for owners of office properties, but it is not yet clear whether it will be a marginal or catastrophic effect. Within the US, small banks clearly have more commercial real estate loan exposure than large banks. Applying the recent Dodd-Frank Act Stress Test (DFAST) to small US banks highlights that roughly 2/3rds of small banks might need to raise capital in the scenario modeled by the Fed, underscoring that forbearance and fiscal relief are essential to avoid a very widespread erosion in small bank capital. Still, of the nearly 5,100 banks included in our analysis, only 5 would see their equity capital wiped out by the simulated losses. Incorporating outsized, Work From Home (WFH)-driven CRE loan losses into our test of small banks highlights that WFH policies may act as a moderate “kicker” to severe pandemic-related bank loan losses were they to occur. But it is clear that the latter is by far the core risk facing both the US economy and its financial system. To the extent that the “white flight” phenomenon of the 1950s to 1970s is a reasonable historical analogue for large-scale urban flight today, the experience of Michigan in the 1960s suggests that it would not likely cause widespread problems in the housing market and/or systemic stress in the banking system. But even if large-scale urban flight does not initially occur due to time-saving WFH policies or health & safety concerns, there are some concerning parallels to the severe decay and decline of the city of Detroit that could play out over the coming few years in America’s cities if not prevented by policymakers. This could spur large-scale urban flight for reasons unrelated to WFH policies. The possibility of inadequate fiscal support is the chief risk to our positive cyclical stance towards risk assets and must be continually monitored by investors over the next several months. We expect large bank outperformance at some point over the coming year, reinforcing our positive stance towards value over growth. Feature Chart 1Rising CRE Prices And Deteriorating Fundamentals, Even Before The Pandemic Concern had already been growing among investors over the past few years about the potentially systemic implications of a possible crash in sky-high US commercial real estate (CRE) prices. Chart 1 highlights that overall CRE prices have doubled over the past decade, which has occurred alongside falling real rents (and thus deteriorating fundamentals) in most CRE subcategories. But the COVID-19 pandemic has introduced new risks for US CRE that many investors view as potentially acute. CMBS delinquency rates surged in May and June (but fell in July), led by accommodation and retail properties. And while multifamily and office delinquencies have so far remained low, many investors have questioned whether this can continue if recently enacted work from home policies become permanent and “urban flight” towards less populated and more affordable areas durably takes hold in major US cities. In this report we focus on the issue of WFH policies, the potential for urban flight, and the risk that these factors may pose to the CRE loans of small domestically-chartered US banks (sometimes informally referred to as “community banks”). There are arguments for and against the idea that work from home policies and/or migration out of city centers will have an extremely negative impact on office properties, but the truth is that it is currently a risk of largely unknown magnitude. It is not likely to be positive for owners of office properties, but it is yet unclear how negative it will be. As a result, we address the question as a “what if?” scenario, by stress testing small bank balance sheets. We conclude that the impact of potential WFH-driven CRE loan losses on the banking system is minor compared with the core risks facing the economy and its capital markets: The deeply negative impact of the COVID-19 pandemic on production and spending, and the risk that fiscal relief will fall short of what is required. Did COVID-19 Really Kill The Office? Chart 2Employers Found That Teleworking Worked Well In mid-to-late March, COVID-19 was spreading rapidly in industrialized economies. Following recommended or mandatory stay at home orders from governments, most office-based businesses rapidly shifted to WFH arrangements as an emergency response. However, in the month or two following the beginning of stay at home orders, several national US surveys found many office workers preferred the flexibility afforded by WFH arrangements. Many employers, correspondingly, found that the productivity of their employees did not suffer while working from home, or that it even improved (Chart 2). These findings led many in the business community to conclude that WFH policies are not, in fact, emergency measures that will ultimately be reversed and instead reflect the “new normal” for work. The arrangement ostensibly appears to be a win-win scenario for workers and firms: Employees save time and money not commuting to the office and gain more control over their work schedules, and businesses save money on the rental or purchase of office space. The conclusion for many in the marketplace has thus been that “the office is dead,” with the focus shifting to the potential investment implications. When thinking about the potential consequences that permanent and widespread WFH options may have, there are two distinct issues that must be considered. The first is the degree to which these policies will push up office property vacancy rates, and the second is whether the availability of WFH policies will cause significant urban flight towards less populated and more affordable areas. On the margin, we agree that both events will occur at least to some degree, and thus are likely to be highly unwelcome developments for owners of prime central business district real estate. This is in line with the conclusions of a recent Special Report by my colleague Garry Evans.1 But there are at least a few arguments against the idea that these trends will occur en masse, or that they will spell economic disaster on their own: While surveys show that many employees expect to continue to work remotely after the pandemic ends, these results likely reflect the desire to retain some flexibility afforded by WFH policies. In terms of office property utilization, there is a large difference between an employee never working from an office again and permanently working from home one day per week, and many surveys that have been conducted on the topic are not structured to distinguish between the two. Surveys that specifically ask how long employees expect it will take for them to return to the office and that include “never” as a possible answer imply a considerably lower impact on office space utilization than other surveys would suggest (Chart 3). If the percentage of never-returning workers shown in Chart 3 (5%-7%) is accurate and maps closely to the expected rise in the office vacancy rate, Chart 4 highlights that the corresponding increase in vacancy would not be unprecedented: It rose from roughly 8% in 2000 to 17% in 2003, without causing a disastrous collapse in office property prices (they fell, but not enormously). Today the vacancy rate would be rising from a much higher level than in 2000, but the point is that very significant changes have occurred in the vacancy rate before without substantially destabilizing the office property market. Chart 3Employers Found That Teleworking Worked Well For offices that reopen before the end of the pandemic, the need for physical distancing will act to at least somewhat restrain a rise in the vacancy rate over the coming several months, as it implies the need for more physical space per employee rather than less. Chart 4Large, Non-Impactful Rises In The Office Vacancy Rate Have Occurred Before Some surveys suggest that Americans are already starting to change their minds about their desire to move out of the city. In April and early-May, upwards of 35%-40% of people responding to a Harris poll said that the pandemic made them want to live either in a rural area more than 21 miles outside of a major city or a suburb within 10 miles of a major city. As of late-July / early-August, that number had fallen to 26% (Chart 5), with only 9% reporting that it is “very likely.” This suggests that the end or reduction of lockdown measures may have returned a sense of normality for many Americans, and that the ultimate degree of urban flight may end up being considerably smaller than some investors expect. Chart 5Few People Say It Is Very Likely They Will Move Due To COVID-19 Finally, the example set by Facebook in May suggests that employees who wish to work from home permanently and relocate to more affordable areas will experience salary reductions, as part of a plan to “localize employees' compensation.”2 If adopted on a widespread basis among firms offering their employees the option to permanently work from home, localized compensation will very likely erode some of the cost advantages of moving to a cheaper area, and thus is likely to result in even fewer employees choosing permanent WFH arrangements. However, even after considering these arguments, the bottom line for investors is that no one truly knows what the office environment will look like as a result of COVID-19, because it hinges both on the evolution/resolution of the pandemic as well as potentially ephemeral human sentiment and behavior – both of which are extraordinarily difficult to predict with high accuracy. It is quite likely to be negative on balance for owners of office properties, but it is not yet clear whether it will be a marginal or catastrophic effect. As such, we agree that the chance of a major and lasting shock to the holders of US commercial real estate loans warrants a thorough investigation, focused on its potential to affect the stability of the US financial system. We first present an overview of CRE exposure for all US banks, and then examine in detail the risk facing small domestically-chartered US banks. Reviewing US Bank CRE Exposure Table 1 presents an overview of CRE loan exposure for domestically-chartered US banks from the Fed’s H.8 data release (Assets and Liabilities of Commercial Banks in the United States), as well as a breakdown in exposure for large and small banks. Investors should note that different definitions of “large banks” exist in the US, and in the H.8 release they are defined as the top 25 domestically-chartered banks ranked by domestic assets. Table 1Most US Commercial Real Estate Loans Are Held By Small Banks Table 1 highlights two points. First, while CRE loans account for approximately 13% of total US domestically-chartered bank assets, exposure is clearly more concentrated for smaller banks than for the largest banks. CRE loans account for a full 1/4th of total assets for small banks, compared to just 6% for the top 25 domestic banks. Given this, the focus of our report will be on small rather than large bank exposure to CRE loans. Second, the table makes it clear that loans backed by nonfarm nonresidential structures account for just 2/3rds of total CRE exposure; the remaining exposure is to apartment buildings, construction and land development loans, and farmland. While not shown in Table 1, bank call reports also highlight that 1-4 family residential construction loans are included in the overall construction and land development category, accounting for up to 20% of those loans for small domestically-chartered banks. Chart 6Office Properties Make Up About 40% Of The Value Of Commercial Structures Unfortunately, it is difficult to break down small bank nonfarm nonresidential structure exposure by property type from a top-down perspective. Chart 6 highlights that office properties (including all financial buildings) make up approximately 37% of the current-cost net stock of US nonresidential commercial and health care structures, whereas office loans make up approximately 30%-40% of those included in US commercial mortgage-backed securities. For the purposes of our analysis, we assume that 40% of small domestically-chartered US banks’ nonfarm nonresidential property loans are secured by office properties. Stress Testing Small US Banks The first step in stress testing small US bank CRE exposure is to simply apply the recent Dodd-Frank Act Stress Test (DFAST) that was focused on large banks to the approximately 5,100 small banks in the US. We use Q1 bank call reports (which we use as a pre-COVID benchmark) sourced from the Federal Financial Institutions Examination Council (FFIEC) to test the breadth of the impact on small banks, and include essentially all US banks in our list except the top 25 banks by assets (those designated as “large” in the Fed’s H.8 release). The Federal Reserve recently released the 2020 DFAST results, which examined the impact on capital ratios of 33 large US banks in a “severely adverse” economic scenario. The scenario modeled by the Fed resulted in $553 billion in projected losses on loans and other positions for the banks included in the test over a 2-year period, of which $433 billion were from accrual loan portfolios (Table 2). These projected loan losses corresponded to a 6.3% loan portfolio loss rate; for comparison, Chart 7 highlights that this would represent even higher losses than what occurred during the worst two-year period following the global financial crisis (Q1 2009 – Q4 2010) by roughly one percentage point. Table 2The Fed’s Recent Stress Test Modeled A 6.3% Loan Loss Rate Over 2 Years Chart 7The Fed's Main Loss Scenario Is Meaningfully Worse Than What Occurred After 2008 In combination with additional provisioning, these assumed losses caused a 1.8% projected decline in the aggregate tier 1 capital ratio for the 33 firms participating in the stress test – from 13.6% to 11.8% – and a 1.7% projected decline in the common equity tier 1 capital ratio – from 12% to 10.3% (Table 3). While these declines are not trivial, they are far from a disastrous outcome for the US financial system. The capital ratios shown in Table 3 are relative to risk-weighted assets, and it is important to note that the projected change in capital ratios shown do not match the projected loan losses (plus provisioning) as a percent of risk-weighted assets. This is because projected losses are netted out against the banks’ projected pre-provision net revenue (“PPNR”) in the Fed’s exercise. In short, while the banks’ capital ratios declined roughly 2% in the DFAST scenario, simulated loan losses amounted to roughly 4% of risk-weighted assets and about 1/3rd of tier 1 common equity capital. Table 3Large Bank Capital Ratios Fell In The Stress Test, But Not Dramatically SoTo avoid the need to project PPNR for thousands of small US banks, we use these loan loss metrics (4% of risk-weighted assets and 33% of tier 1 common equity capital) from the 2020 DFAST to represent whether any individual small bank would likely have to raise capital. We also use the overall portfolio loan loss rate of 6.3% to stress small bank balance sheets, rather than a set of loan loss rates by loan type. Chart 8In The Fed’s Main Stress Test Scenario, Many Small Banks Would Likely Have To Raise Capital Chart 8 illustrates the number of small US banks that would “fail” the stated tier 1 common equity and risk-weighted asset thresholds given the DFAST assumptions. Roughly 64% of small banks would fail the equity test and 94% would fail the risk-weighted assets test. Weighting these results by bank assets rather than the number of banks does not generate a materially different result; instead, 63% and 97% of small bank assets would be held by banks failing the equity and risk-weighted assets tests, respectively. This exercise clearly highlights how much better capitalized large US banks are relative to smaller banks, and underscores that the existing forbearance programs and fiscal relief are essential to avoid a very widespread erosion in small bank capital. Still, of the nearly 5,100 banks included in our analysis, only 5 would see their equity capital wiped out by the simulated losses – meaning that while widespread capital raising and the accompanying tightening in lending standards would undoubtedly have a major impact on the economy and capital markets, the solvency of the US banking system is not in question in the scenario modeled by the Fed. Stress Testing Outsized CRE Losses As noted above, we employed the same average loan portfolio loss rate across all loan categories when testing the impact of the DFAST scenario on small banks, including commercial real estate loans. In order to gauge the specific risks facing commercial properties if recent WFH trends persist, we perform two additional exercises. First, we raise CRE loan losses beyond what was assumed in the DFAST scenario (see Box 1) while employing the same 6.3% loan loss rate on all other loan types to measure the incremental WFH effect on small bank balance sheets in a very negative economic scenario. Second, we examine a high CRE loan loss scenario alone, in order to isolate the potential impact of sustained WFH policies. Box 1Simulating Outsized CRE Loan Loss Rates The assumptions detailed in Box 1 result in an overall CRE loan loss estimate of 11.1%, versus the 6.3% assumed in the DFAST. Chart 9 replicates the DFAST scenario shown in Chart 8 but with our outsized CRE loss rate, whereas Chart 10 highlights the isolated impact (i.e., without any losses assumed for other loan categories). Chart 9Adding Outsized CRE Loans To The Stress Test Scenario Only Moderately Increases “Failure” Chart 10Big CRE Losses Alone, With No Other Loan Losses, Would Be A Relatively Minor Problem Two important observations emerge from Charts 9 and 10. First, despite the fact that small US banks carry disproportionately higher exposure to commercial real estate loans than large banks, it seems clear that the isolated effect of WFH policies on CRE loans, even in the extreme, do not amount to a major risk for the banking system. 80% of small US banks would pass our equity capital test, and 70% would pass the risk-weighted assets test, with absolutely devastating and unprecedented office and retail property losses but no losses outside of their commercial real estate portfolio. Second, while our outsized CRE losses would raise the number of banks that fail our equity capital test relative to the base DFAST scenario (from 64% to 74%), it is clear that this pales in comparison to the effect of the other loan losses assumed in the Fed’s stress test. The bottom line for investors is that while WFH policies may act as a “kicker” to severe pandemic-related bank loan losses were they to occur, it is clear that the latter is by far the core risk facing both the US economy and its financial system. Outsized Residential Real Estate Losses: The Elephant In The Room As noted above, the results shown in Charts 8 - 10 only include outsized losses on nonresidential CRE loans (excluding multifamily) in order to test the risk to bank balance sheets of widespread and continued use of highly permissive WFH policies and significantly reduced demand for office properties. On top of that, banks also face the risk of additional potential disruptions to residential real estate loans if the WFH phenomenon morphs into full-blown urban flight. In this scenario, migration out of densely-populated urban areas towards considerably cheaper suburbs and exurbs could possibly lead to significant house price declines in richly-valued metro-areas, leading in turn to defaults on underwater mortgages. Table 2 highlighted that the Fed’s base 2020 DFAST scenario assumed a 1.5% loan loss rate on first-lien mortgages, and a 3.1% loss rate on junior liens and HELOCs over a two-year period. Unfortunately for investors, it is exceedingly difficult to pinpoint the magnitude of urban migration that would be necessary to cause loss rates in line with the DFAST scenario or higher, forcing us to rely on an inferential approach based on historical example. Chart 11“White Flight” In The US: An Analogue For Urban Flight Today? The only meaningful historical analogue that we can identify for the idea of WFH-driven urban flight is the “white flight” phenomenon that occurred in the US from the 1950s to 1970s. During this period, many white middle-class Americans moved from increasingly racially mixed city centers to racially homogenous suburban or exurban areas. The city of Detroit is often cited as an example of the "white flight" phenomenon. Chart 11 shows Detroit’s white population over time, and highlights the sharp decline in the number of white residents that occurred during the 1950s and 1960s. The white share of Detroit’s population fell earlier, beginning after WWII, but this mostly reflected larger increases of the non-white population. Actual “white flight” occurred during the 50s and 60s, when several episodes of racial violence occurred in the United States. In Detroit, this was most clearly epitomized by the 12th Street Riot in 1967, which involved Federal troop deployment and resulted in over 40 deaths and the damage or destruction of over 2,500 businesses. Did “white flight” cause widespread problems for urban housing markets and/or systemic stress in the banking system? Table 4 and Chart 12 suggest that the answer is no. Table 4 highlights that the median real house price in Michigan rose in the 1960s, grew faster than nationwide house prices, and was modestly higher than the national average in 1970. While it is very likely that this reflects outsized suburban house price gains and that urban center prices fell, Chart 12 highlights that there was no noticeable uptick in US banking failures as a share of total depository institutions in the 1960s. Chart 13 also highlights that the late-1960s did not exhibit any particularly unusual behavior for bank stock prices, after considering interest rates and the state of the business cycle. Table 4Real Michigan Home Prices “Outperformed” The US In The 60s Chart 12No Uptick In Bank Failures In The 1960s Chart 13No Unusual Bank Underperformance In The 1960s     The US economy is very different today than it was in the 1960s, and it is possible that “white flight” serves as an insufficient analogue for potential urban flight today. It is also true that real house prices today are considerably higher than in the 1960s and thus have room to fall further. Nevertheless, based on the Detroit experience, our best inference (for now) is that urban flight does not pose a risk of outsized mortgage loan losses for banks. This is reinforced by the fact that mortgage interest rates have fallen to a record low and have the potential to fall even further based on their spread to 30-year Treasury yields (Chart 14), which may act to boost house prices outright or cushion any potential declines. Chart 14Low And Potentially Lower Mortgage Rates Will Help Cushion Any House Prices Declines Is The Real Risk To Cities Urban Flight, Or Urban Blight? In our view, the city of Detroit is a useful case study for two reasons. First, as noted above, it provides us with some sense of whether urban flight has the potential to pose a systemic threat to the financial system. But, second, it also serves as an example of another potential risk of the COVID-19 pandemic: urban “blight,” or decay. Chart 15Progressive Post-War Deindustrialization Hammered Cities Like Detroit The economic and sociological decay of the city of Detroit has taken place over several decades and has been caused by multiple factors whose relative importance is still debated today. But broadly-speaking, Detroit’s decline can be boiled down to three interacting and self-reinforcing sets of factors: Sociological factors: the general post-WWII trend towards suburbanization, rising levels of violent crime, the “white flight” phenomenon, and the outright decline in Detroit’s population that began in the 1950s; Economic factors: the progressive deindustrialization of the US economy that began in the early 1950s, as well as the debilitating effects of high inflation and energy prices in the 1970s and the double-dip recession of the early-1980s on manufacturing employment (Chart 15); Policy factors: the negative impact on city finances, tax competitiveness, and service quality from the previous two factors, as well as poor governance and outright corruption. Even if large-scale urban flight does not initially occur due to time-saving WFH policies or pandemic-related health & safety concerns, there are some worrying parallels to Detroit’s experience that could play out over the coming few years in America’s cities that could cause similarly self-reinforcing effects if not prevented by policymakers. On the economic front, very acute income and wealth inequality arrayed against stout house price gains over the past decade have made home ownership unaffordable for some, increasing the allure of urban flight even if localized compensation programs apply. In addition, the pandemic has most severely affected small retail businesses, raising the specter of a “hollowed out” or abandoned urban retail landscape which could push consumers to avoid shopping and travelling downtown. On the policy front, there is a clear risk that inadequate state & local government funding could contribute to a potential downward spiral of higher taxes, reduced city services, and economic decay – similar to what occurred in Detroit. Chart 16 highlights that the financial situation of state & local governments following the global financial crisis caused persistent fiscal drag for several years into the expansion that followed. This significant fiscal drag contributed importantly to the subpar nature of the expansion, and the odds that this will occur again without federal funding are high. Chart 16 shows that the contribution to real GDP growth from state & local government spending has again turned negative, and the US Center on Budget and Policy Priorities is currently forecasting state budget shortfalls of approximately $555 billion over state fiscal years 2020-2022 – in line with the $510 billion cumulative shortfall that occurred from 2009-2011.4 Finally, in this scenario, the sociological factor somewhat mimicking Detroit’s experience could be a significant rise in urban crime (especially if violent). This could cause urban flight for reasons totally unrelated to WFH policies, but if it occurred it would likely reinforce both the failure of urban center businesses and the deterioration in state & local government finances (risking a downward spiral). Chart 17 highlights that murders have already significantly increased this year in major American cities (by mid-year) relative to 2019, although other types of violent crimes have fallen.5 A trend of rising urban crime could also be sparked or accelerated if recent calls to cut police department funding in favor of other social services succeed, and if those newly funded initiatives fail to effectively prevent criminal activity. Chart 16Persistent State & Local Fiscal Drag Must Be Prevented This Time Chart 17Will US Cities Become Unsafe? While this scenario is far from our base case view, it underscores how urban flight and the accompanying second round effects on commercial real estate loans and the banking system could occur following the pandemic even if not triggered by WFH policies. It also underscores the great importance of Federal fiscal relief efforts: not only to households and businesses, but as well to state & local governments. Investment Conclusions Our analysis above points to three main investment conclusions: First, while there are arguments for and against the idea of significant CRE losses stemming from the widespread adoption of permanent WFH policies and the potential for large-scale urban flight, the uncertainty surrounding the question will likely linger for the coming few months, at a minimum. This suggests that the equity risk premium applied to bank stock prices may remain elevated in the near term. Chart 18Large US Banks Unduly Cheap Second, while large-cap banks may struggle to outperform in the near term due to this elevated risk premium, it is clear that large banks are far less susceptible than small banks to not only potential CRE loan losses, but also to the severely adverse economic scenario modeled in the Fed’s recent stress test. Our calculations suggest that large bank capital ratios would only marginally decline from the ending ratios shown in the DFAST scenario even with the outsized CRE loan loss scenarios that we used to stress test small bank balance sheets, and we highlighted how the Fed’s main stress test scenario involved 2-year loan losses in excess of what occurred in 2009-2010. Consequently, the collapse in large-cap bank valuation ratios seems unwarranted (Chart 18), and we would expect large banks to outperform the broad market at some point over the coming 6-12 months (and possibly even over the coming 0-3 months). This is also consistent with our expectation that value stocks are likely to outperform growth stocks at some point over the coming year.6 Third, while investors are often right to ask what risk they are “missing,” our analysis above highlights that the impact of potential WFH-driven CRE loan losses on the banking system is minor compared with the core risk facing the economy and its capital markets: The deeply negative impact of the COVID-19 pandemic on production and spending, and the risk that fiscal relief will fall short of what is required. This need for relief extends very significantly to state & local governments, and a failure to adequately resolve the substantial state budget shortfalls that will occur due to the pandemic and its aftermath would all but guarantee a repeat of the persistent fiscal drag that contributed to the subpar nature of the recent economic expansion. Our base case view remains that US policymakers will do what is necessary to avoid a very negative economic outcome and that the hiccup in congressional negotiations is temporary, but the possibility of inadequate fiscal support is the chief risk to our positive cyclical stance towards risk assets and must be continually monitored by investors over the next several months. Stay tuned! Jonathan LaBerge, CFA Vice President Special Reports Footnotes 1  Please see Global Asset Allocation / Global Investment Strategy Special Report, “The World After COVID-19: What Will Change, What Will Not?” dated August 7, 2020. 2 “Facebook employees could receive pay cuts as they continue to work from home,” USA Today, dated May 21, 2020. 3 Please see US Investment Strategy Special Report, “Mallpocalypse, Part 1: An Overnight Collapse Decades In The Making,” dated August 17, 2020 for the first of two reports presenting a detailed analysis of the challenges facing US retail properties. 4 Elizabeth McNichol and Michael Leachman, “States Continue to Face Large Shortfalls Due to COVID-19 Effects,” Center on Budget and Policy Priorities, Updated July 7, 2020. 5 Jeff Asher and Ben Horwitz, “It’s Been ‘Such a Weird Year.’ That’s Also Reflected in Crime Statistics.,” The New York Times, Updated August 24, 2020. 6 Please see Global Investment Strategy Weekly Report, “The Return Of Nasdog,” dated August 21, 2020. Global Investment Strategy View Matrix Current MacroQuant Model Scores  

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

Highlights The stock market can apparently ignore the intensifying US-China conflict as long as massive monetary and fiscal stimulus continues. Hence the ongoing “stimulus hiccup” is a big problem. Ultimately a stimulus bill will pass, but risks are rising that it will come too late or fall short in size. The longer the negotiations drag on, the more likely that the absence of fiscal support, the spiraling US-China conflict, US political instability, and other risks will take center stage and upset the equity rally. Assuming a new stimulus package will ultimately pass, it will fuel Trump’s tentative comeback in opinion polls, increasing the risk that the revolution in the global trading system gets a new lease on life. Thus volatility is likely to rise from here until the US succession is settled. Stay long JPY-USD and health stocks in the near term and bullion in the long term. Feature Two of the key views we have hammered since May are coming to fruition: Stimulus Hiccup: The White House and Congress are struggling to get a new relief bill passed. We have argued that the next round of fiscal stimulus would face execution risks that would cause equity volatility to rise again, which is now occurring (Chart 1). Ultimately we expect the Republican Senate to capitulate to a major new stimulus bill. But the very near term is murky and the negotiations pose a clear and present danger to an equity market that has now surpassed its pre-COVID-19 highs (Chart 2). Chart 1Volatility Is Bottoming, Will Rise Ahead Of US Election Chart 2Markets Recovered, Near-Term Risk To Downside US-China Conflict: The White House has revoked Chinese tech giant Huawei’s general license, leaving the company in thrall to periodic Commerce Department allowances that will impede business. It has also expanded punitive measures to a slew of subsidiaries and Chinese software companies like TikTok (ByteDance) and WeChat (Tencent). We have argued that President Trump’s electoral vulnerability and economic stimulus in both countries lowered the bar to conflict and decoupling. Both countries have an interest in reducing their interdependency and the COVID-19 crisis has given them an opportunity to make structural changes that were previously more difficult. Neither the US tech sector, nor China-exposed US stocks, nor Taiwanese equities are pricing this monumental geopolitical risk at present (Chart 3). Combining these two views results in a dangerous outlook for global risk assets in the near term. The reason we argued that US-China tensions would escalate to the point of disrupting markets this year was that we viewed domestic stimulus as lowering the economic and financial bar that prevented conflict. Hence US and Chinese confrontational steps could go farther than the market expected and eventually something would snap (Chart 4). Chart 3Market Ignores US-China Escalation Chart 4US And Global Stimulus Enable US-China Fight Yet today tensions are escalating despite the failure to arrange a new jolt of domestic stimulus. This is true on both sides, as China is also seeing a deceleration in stimulus provision, mainly on the monetary side, that we also expect to be temporary but nevertheless has negative implications in the near term. The longer fresh stimulus is delayed, the more likely that markets will respond to the historic breakdown in US-China relations, US political instability, and other risks to corporate earnings and the economic recovery. Constraints On Politicians Support Cyclical Recovery To be sure, there is evidence that politicians are aware of their limits and already heading back to the negotiating table. Even with talks ongoing, the risks of delayed stimulus or Chinese retaliation are substantial. First, the White House, House Democrats, and Senate Republicans are continuing to negotiate despite being on recess while hosting national party conventions this week and next. House members are rushing back to Washington to vote on measures to boost the US postal service amid a controversy over how to handle mail-in voting for the election amid the pandemic. This has opened a pathway for stimulus talks to get back on track. It could result in a “skinny” stimulus bill quickly, or otherwise new developments could lead to the roughly $2.5 trillion blowout that we expect based on the two sides splitting the difference on most issues (Table 1). Table 1Stimulus Bill Will Hit $2.5 Trillion If Democrats And Republicans Split The Difference Chart 5Trump’s Reelection Bid Stands On The Economy Second, the US and China are arranging to keep talking. Ostensibly they are checking up on the status of the Phase One trade deal. The Trump administration cannot easily walk away from this deal– unless Trump irredeemably becomes a lame duck making a desperate bid to turn the tables on the Democrats. To do so would hurt Trump’s credibility on renegotiating US trade deals and likely trigger a selloff in the stock market that could set back the economic recovery and remove the last leg that his reelection bid stands on (Chart 5). The Chinese, for their part, have stuck with the deal despite US punitive measures because they do not want to provoke Trump, lest he attempt to inflict maximum damage on their economy in his final months or in a second presidential term. The renminbi is not depreciating relative to the dollar, suggesting that the tenuous truce is intact for now (Chart 6). Chart 6Renminbi Signals Phase One Trade Deal Intact ... For Now Yet The Market May Sell Before Politicians Soften Their Line Nevertheless in the very near term investors have very low visibility on what happens next. Congress could still fumble and cause greater doubts. It could easily fail to reach a new stimulus deal until after September 8 when the Senate returns or September 14 when the House returns. President Trump’s executive orders, and negotiating gestures from Republicans, are a tenuous bridge for markets as they fall far short of even the Republicans’ $1 trillion asking price. The stock market will plunge if the talks collapse, but it will also drop if the stimulus falls short. The market may have to sell off to force politicians to provide stimulus and temper strategic competition. Trump’s complicated attempt to extend relief via executive orders, and/or a skinny deal that does not include direct rebates to households and funding for state and local governments, would be inadequate for the needs of the economy (Chart 7). It is imperative for Senate Republicans to capitulate and come closer to the Democrats $2.4 trillion standing offer (down from $3.4 trillion) – but it is possible they could miscalculate and fail to compromise. Democrats will not cave because they ultimately benefit at the ballot box if stimulus flops and financial turmoil returns. Chart 7US Economy Needs Extended Period Of Fiscal Support On the China front, it is not guaranteed that China will refrain from retaliation against tech companies like Apple that depend on China for their operations. The market is betting that a rally entirely based on the tech sector can be sustained even in the face of an expanding tech war between the world’s biggest economies (Chart 8). Yet China suffers an economic and strategic blow from the US imposition of a technological cordon and Xi Jinping could decide to retaliate immediately. He could come to believe that the risk of not retaliating – which would entail continuing economic recovery and possibly Trump’s reelection on an anti-China platform – is greater than the risk of retaliation and financial turmoil. He has the ability to stimulate the domestic economy and benefits if he sets a precedent that American presidents lose if they attack China. China may not turn to Taiwan immediately, but since 2016 we have highlighted that Taiwan, not Hong Kong, is the major geopolitical risk stemming from the US-China crisis. Saber-rattling, cyber-rattling, and punitive economic measures are picking up in the Taiwan Strait and could lead to a global geopolitical crisis at any time. Here, too, the base case is that China will remain in a holding pattern until after the US election. It also should use economic sanctions long before it resorts to the final military option (Chart 9). But there is a large risk of miscalculation as the US seeks to cut off Taiwan semiconductor trade with China while Taiwan reduces its economic dependency on the mainland and tightens its defense relations with the United States. The Trump administration presents a window of opportunity so the risks are elevated in the lead up to and aftermath of the US election. Chart 8Tech Bubble Amid Tech War An Obvious Danger Chart 9China's Economic Card May Be Only Thing Preventing War We do not view Chinese economic sanctions on Taiwan as a tail risk but rather as our base case. Of course, we eschew conspiracy theories and usually seek to curb enthusiasm over war risks, as with Sino-Indian saber-rattling. But Taiwan is the epicenter of the political, military, and technological struggle between Washington and Beijing. War is a tail-risk, but even minor clashes would have a major impact on global financial markets. Other Risks Come To Forefront Amid Stimulus Hiccup Chart 10Trump’s Comeback Substantial If Stimulus Passes, Pandemic Subsides The longer stimulus is delayed, the more likely that other risks will rise to the forefront and trouble the equity market. The US election does not offer much upside for markets at this point. Other risks stem from Iran and Russia. In the US election, President Trump is beginning to make a comeback in the opinion polling (Chart 10). Trump’s approval rating benefits from signing off on deals, so a final stimulus bill from Congress is essential. But a stimulus bill, a continued rollover in new cases of COVID-19, and a revival of support among his base would improve his odds of winning. Former Vice President Joe Biden is not polling much better against Trump than former Secretary of State Hillary Clinton did back in 2016 (Chart 11). Biden’s momentum in national opinion polling has been arrested, especially in battleground states, and the lower end of the “band of uncertainty” around the polling also suggests that Trump is within striking distance (Chart 12). Chart 11Biden Polling About Same As Hillary Versus Trump   Chart 12Trump Still Within Striking Distance Of Biden Our election model suggests that Trump has a 42% chance of winning, which is higher than our subjective 35% (Chart 13). We will upgrade if a stimulus bill is agreed. A Trump comeback may be received well by US equity markets – as it prevents tax hikes, re-regulation, higher minimum wages, and a federal push to revive labor unions, all promoted by Biden and the Democrats. But then again, Biden’s agenda is more reflationary, whereas Trump faces obstacles in a still-Democratic House, leaving global trade as the path of least resistance – which is market-negative. The dollar may bounce on the prospect of a Trump second term (Chart 14). Tech stocks, Chinese currency, and other cyclicals, such as the euro and European stocks, will suffer a setback if Trump is reelected. Chart 13We Give Trump 35% Odds, Quant Model Shows Upside At 42% Lesser risks, still notable, include Iran and Russia. Chart 14Trump Could Trigger Near-Term Dollar Bounce We have maintained that the US and Iran are in a bull market of geopolitical tensions and that this could result in crisis around the election. The US’s decision on August 20 unilaterally to maintain the expiring international conventional arms embargo on Iran is a clear trigger for a military incident. The macro and market implications are different and less dire than with a US-China crisis. But oil price volatility would rise due to regional instability, President Trump’s reelection bid could benefit, and that would carry the implication of expanding trade war with China. Meanwhile our expectation of sharply rising Russian geopolitical risk is materializing both within Russia and in relations with Europe, which is preparing sanctions over the suppression of dissent within both Russia and its satellite state Belarus. Russia is capable of interfering in the US election while a Democratic victory would likely lead to a US policy offensive against Russia. Investors must look beyond the short term. If stimulus is passed, the stock market will go up, but the US and China will be further enabled and ultimately their strategic showdown will cap the gains by harming the tech sector. Meanwhile, if the stimulus fails, then the market will plunge. Investment Takeaways At present the stock market seems prepared for Trump to remain in the White House – or for Republicans to retain the Senate. The market’s YTD profile matches that of past elections that result in gridlock, as opposed to the Democratic “clean sweep” scenario that we have flagged as the likeliest outcome (Chart 15). However, this profile will change, the market will correct, if Trump does not sign a new relief act. Assuming stimulus ultimately passes, markets will cheer and Trump’s comeback in the polls will get a boost. He could still lose the election, given fundamental political and economic weaknesses captured in our state-by-state quantitative model above. But the election itself would be more closely fought – with a contested outcome more likely to occur and roil markets. Finally a Trump victory would give a new mandate to the US-China breakdown and the revolution in the global trading system, which is ultimately negative for risk assets and the cyclical recovery. Hence our confidence that the next few months will be marked by volatility. Ultimately geopolitical and macro fundamentals are negative for the dollar even if Trump provides the occasion for a last gasp in the past decade’s dollar bull market. The US is monetizing its debt and flooding the world with dollar liquidity. Meanwhile China and other powers are diversifying away from the dollar and into gold, the euro, the yen, and other reserve currencies over the long run (Chart 16). Chart 15Dollar Outlook Bearish In Medium Term Chart 16Stock Market Preparing For Trump Win And More Gridlock? The great US fiscal debate is over, regardless of Trump or Biden, as populism has made austerity impracticable and massive twin deficits will ensue. Thus we remain long gold and the Japanese yen. We have refrained from re-initiating our long EUR-USD trade given our expectation of stimulus hiccups and US-China tensions, but will reconsider if and when these hurdles are cleared. Our strategic portfolio continues to expect a global recovery over the next twelve months and beyond but tactically we are positioned against downside risks.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

Special Report

Highlights The Beirut blast calls attention to instability in the Shia Crescent. A turbulent push for political change will now ensue in Lebanon. Hezbollah’s and Iran’s political capital in Lebanon will suffer significantly. Lebanon is a red herring, but Iraq is a Black Swan. It is at risk of social unrest contagion. Iran’s financial troubles are weighing on its ability to maintain its sphere of influence. It is adopting a strategy of measured sabotage and deterrence against US interests in Iraq. The double whammy of low oil prices and pandemic is weighing on Saudi Arabia’s finances. Nevertheless it is prioritizing a cooperative relationship with Iraq. Iran could stage a major attack or President Trump’s poor election prospects could force him to “wag the dog.” Massive excess oil capacity will mute the oil market impact of a supply shortfall in Iraq. However, the risk becomes more relevant as demand recovers and markets rebalance in the second half of the year. Stay long Brent crude oil and gold. Feature The August 4 explosion at the Port of Beirut was devastating. It killed more than 220, wounded over 6000, left 300,000 homeless, and damaged buildings as far away as 9km from the site of the explosion. The blast added insult to injury to the country’s already troubled finances. Estimates for the cost of repair range anywhere between $5 billion and $15 billion. Global investors can largely write off the incident as an idiosyncratic shock. Even though emigration is likely to pick up, Lebanon’s population is only a third of Syria’s prior to its civil war. Assuming that a third of Lebanese become displaced abroad – a generous assumption more suitable to Syrian-style civil war than Lebanon’s situation – about 2 million Lebanese will be displaced, half of which will make their way to Europe or elsewhere outside the Middle East. As long as an antagonistic Turkey upholds its agreement with the EU, a mass exodus from Lebanon does not risk an unmanageable migrant crisis for Europe (Chart 1). Political tensions will rise and potentially lead to a populist backlash, given Europe’s battered economy. But Lebanon alone is not enough. The risk is broader Middle Eastern instability, which is a credible risk. Chart 1Middle Eastern Instability Could Fuel European Populism Thus Lebanon in itself is a red herring, but it is a bellwether for further unrest in the Middle East in countries that are not red herrings (Map 1). Map 1Lebanon Is A Red Herring; Iraq And Saudi Arabia Are Relevant A major conflict in Iraq is an underrated risk to global oil supply. The catastrophe calls attention to instability the Shia Crescent – a region in a tug of war between rival sectarian and geopolitical interests. Whereas the 2008 crisis led to the largely Sunni Arab states in the so-called Arab Spring, the 2020 crisis is piling pressure onto already unstable Shia states and regions: Iran, Iraq, Lebanon, Syria, and possibly eastern Saudi Arabia. Of particular significance is the fate of Iraq. Popular grievances are eerily similar to Lebanon’s. Baghdad is on shaky ground, yet the ramp up in US-Iran tensions going into the November US elections makes the threat of instability in Iraq more acute. As OPEC’s second ranked oil producer, a major conflict in Iraq poses an underrated risk to global oil supply. Supply losses are a tailwind to oil prices when market conditions are tight. However OPEC 2.0’s 8.3mm b/d of voluntary cuts means massive spare capacity is available globally to offset potential losses in Iraq, reducing the potential upside to oil prices. Nevertheless, this risk becomes more relevant as markets tighten on the back of a demand-side recovery, i.e. as balance is restored to the oil market and as excess spare capacity is eliminated. With oil markets likely rebalancing in 3Q20, unrest in Iraq poses an upside risk to our Commodity & Energy Strategy service’s expectation that 2H20 Brent prices will average $44/bbl and 2021 prices will average $65/bbl (Chart 2). Even though gold has already rallied 30% since mid-March, geopolitical risks including US-Iran tensions suggest any near-term selloff is a buying opportunity (Chart 3). The bullish gold narrative – geopolitical risks, falling dollar, and low real interest rates for the foreseeable future – remain intact even as the downturn gives way to a cyclical recovery. We continue to recommend gold on a strategic time horizon. Chart 2Oil Price Rally Remains Intact Chart 3Gold Is Due For A Breather Lebanon’s economic collapse highlights risks to other regional economies tied to the oil dependent Arab economies of the Persian Gulf. As the latter grapple with record low oil prices, production cuts, and the pandemic-induced recession, second-order effects will reverberate throughout the region, hitting economies such as Egypt and Jordan whose economic as well as political structures are intimately intertwined with Gulf Cooperation Council finances and policies. Lebanon’s Collapse Was Inevitable Lebanon was already going through an economic and financial meltdown before the explosion (Chart 4). Aside from the humanitarian loss, the economic impact is also profound. The country – highly dependent on imports of basic goods and suffering from food insecurity – must now contend with the loss of its main port and most of its grain reserves, destroyed in the explosion. As the dust settles, grief is morphing into anger on the streets. Regardless of whether the blast was due to happenstance or malice, the immediate cause was 2,750 tons of ammonium nitrate in storage for six years. The government was warned about the risks of the explosive chemicals at least four times this year – with the latest being on the day of the blast. Chart 4Beirut Port Explosion Accelerated Lebanon’s Collapse Mass protests are already taking place, calling on the government to be held accountable for criminal negligence. A controversial petition to return Lebanon to French mandate has gained more than 60,000 signatures. Prime Minister Hassan Diab’s seven-month-old cabinet has resigned. (It was put in place last year amid an earlier bout of unrest.) Official incompetence and neglect are in fact the best-case explanations for the explosion. Many questions remain unanswered. For instance, what triggered the fire? Israel swiftly denied any connection and offered humanitarian aid, while Hezbollah’s leader Hassan Nasrallah claimed to know more about the Port of Haifa than about Beirut Port. Early parliamentary elections and the cabinet’s resignation will not appease the protesters. Photos of Nasrallah, President Aoun, Speaker of Parliament Nabih Berri, and former Prime Minister Saad Hariri were among those hung by protesters in gallows in Martyrs’ Square over the weekend. Berri and Gebran Bassil are known to be the source of the cabinet’s decision-making power.1 They have veto over all decisions, large and small. During the mass protests in October 2019, Nasrallah stated that Hezbollah has two red lines:     Aoun must finish his term, which expires in 2022;     No early elections will be held, i.e. the speaker of the house will not be changed. While early elections have now been promised, these red lines highlight that corruption runs deep in Lebanon and opposition groups face an uphill battle against the establishment. A turbulent push for political change will now ensue. Hezbollah’s and Iran’s political capital in Lebanon will suffer significantly. Another Israeli confrontation with Hezbollah is not the base case but it could occur. Bottom Line: Lebanon is a failed state. As with the Arab Spring, the question is whether popular anger will prove contagious and spread to more market-relevant neighboring countries. The rally in the Israeli shekel in trade weighted terms since mid-March has already started to fizzle and may be tested further as turmoil in Lebanon raises the risk of confrontation. Contagion? In order for a geopolitical event in the Middle East to warrant investors’ attention, it must affect at least two of the following factors : (1) global oil supply, (2) geography of existential significance to a regional power, or (3) sectarian conflict which could lead to contagion. In this context, Lebanon is a red herring, but Iraq is not – therefore investors should watch to see if anything causes destabilization in Iraq. A decline in Iranian funds will weaken Tehran’s sphere of influence. Like Lebanon, Iraq is dominated by a highly corrupt sectarian system that has been plundering the wealth; people are suffering from rising rates of unemployment; and the regime is in the crosshairs of competing foreign agendas (Chart 5). Chart 5Iraqis And Lebanese Suffer Similar Grievances Iraq is in Iran’s sights because it aspires to establish a land bridge to the Mediterranean through a friendly “Shia Crescent” (Map 2). Iran’s modus operandi is to establish a presence in its neighbors’ domestic politics through Iran-backed factions. Map 2Iraq Essential To Iran’s Aspirational ‘Land Bridge’ To The Mediterranean Given the current state of Iran’s economy, it is not far-fetched to envision a significant drop in the funding of its foreign proxies (Chart 6). Historically these funds have followed the ebbs and flows of oil prices. For instance, in 2009, when faced with declining oil prices and US sanctions Iran’s funds to Hezbollah were estimated to have fallen by 40%. This happened again in 2014-16 and is not too different from today. Thus Iraq is at risk of contagion. Iran’s financial troubles are weighing on its ability to maintain its sphere of influence. Syrian fighters have reported paychecks being slashed, Iranian projects in Syria have stalled, and Hezbollah employees report to have missed paychecks and lost other benefits. Tehran’s finances are essential for Hezbollah’s survival.2 Iran’s proxies in Iraq are facing a similar fate.3 Chart 6Iran Suffering Under "Maximum Pressure" Bottom Line: Iraq faces an uptick in social unrest due to the poor living conditions and possible contagion from Lebanon. Meanwhile, Iran-backed groups there face a decline in funds from Tehran, which will send them searching for replacement funds. If Lebanon falters the world can usually ignore it but if Iraq falters the world will have to take notice. Saudi Arabia Prioritizes Revenue Over Growth Beirut’s foreign policy stances in recent years have been seen as appeasing Iran at the expense of Gulf Arab states.4 This trend coincides with a decline in Gulf Cooperation Council financing to Lebanon. Now the collapse in oil prices and pandemic have weighed on Saudi Arabia’s budget, which still depends on the energy sector for most of its revenues despite efforts to diversify. State revenues were down 49% year-on-year in Q2 pulling the budget deficit down to $29 billion (Chart 7). Riyadh is reassessing its priorities. Opting for revenue at the expense of growth, Riyadh has tightened the screws on its citizens. The government has had to pare back some of the benefits Saudis have long been accustomed to. The value-added-tax rate tripled from 5% to 15%, and a bonus cost-of-living allowance of $266 for public sector employees ended. The kingdom also announced plans to reduce spending on major projects by $26 billion – including some of those associated with Crown Prince Mohammed bin Salman’s reform agenda, Vision 2030. Chart 7Saudi Arabia Under Pressure From Double Whammy Severe economic turmoil poses a risk to the Saudi social contract in which citizens pledge allegiance to the ruling class in exchange for financial and social guarantees. The risk now is that the fiscal challenges dent Saudi citizens’ pocketbooks and thus impact social and political stability. However, oil prices are recovering to levels consistent with the kingdom’s fiscal breakeven oil price next year. The global economic recovery will begin to support the kingdom’s economy in the second half of this year (Chart 8). This will ease pressure on the budget and hence households. Moreover the slowdown is likely to hit foreign workers hardest and thus hasten the Saudization process. Foreign workers are the lowest hanging fruit and will be the first to find themselves jobless. In that sense the crisis is expediting some of Riyadh’s long-term reform targets. That said, there is still some risk of internal instability or even a palace coup. Tehran could incite sectarian tensions in the kingdom’s Eastern Province where an estimated 30-50% of the population is believed to be Shia. This is relevant given that nearly all Saudi oil production is located there. Chart 8KSA Benefits From EM GDP Growth ... Regarding the possibility of a palace coup, Crown Prince Mohammed bin Salman has spent this year cracking down on potential dissidents. Former Crown Prince Mohammed bin Nayef and King Salman’s only surviving full-brother Prince Ahmed bin Abdulaziz – both influential and well-liked – were among those detained in March. The kingdom’s contradictory policies – reform through repression – may eventually culminate in an overt political crisis. Though such a crisis may not occur until the time of royal succession. These economic and political challenges may force Saudi Arabia to adopt an inward stance. Its foreign interventions to date have been costly and come with little benefit – judging by the war in Yemen. It is also possible that Saudi Arabia, which is already the third largest defense spender globally, will try to strengthen its position vis-à-vis Iran. Crown Prince Mohammed bin Salman has already stated that the kingdom will pursue a nuclear program if Iran develops a nuclear bomb. This is relevant in today’s context with Iran no longer complying with restrictions to its nuclear program (Table 1). Saudi Arabia, like Iran, claims its nuclear program is for peaceful purposes – in order to generate nuclear power as part of efforts to diversify its economy.5 Table 1Iran No Longer Complying With 2015 Nuclear Deal Still, low oil prices tend to discourage petro states from engaging in conflict (Chart 9). Arab petro states may show restraint, at least until oil markets recover. Chart 9Low Oil Prices Discourage Petro States From Engaging In Conflict Overall weakness in oil-producing economies will hurt various countries that rely on remittances (Chart 10). The downturn will also hurt countries dependent on remittances from petro states in the region such as Egypt and Jordan. Bottom Line: The collapse in oil prices is forcing Saudi Arabia to reconsider its priorities and is expediting some long-term reforms. For now, it is adopting a pro-revenue rather than a pro-growth stance. This is likely to result in a focus inward for the kingdom. The implication is that countries that are leveraged to the petro-economies of the Gulf for remittances, bilateral aid, and capital flows will take a hit. These include Lebanon, Egypt, and Jordan. Chart 10Egypt And Jordan Also Vulnerable To Petro State Weakness Iraq Is The Prize Not unlike Lebanon, Iraq’s political class has been suffering a legitimacy crisis since protests erupted there last October resulting in the resignation of then-Prime Minister Adel Abdul Mahdi. However unlike Lebanon, Iraq is a significant geography for global investors. It is a major OPEC producer – second only to Saudi Arabia – accounting for 16% of the cartel’s production last year. The Iraqi oil minister’s first foreign trip was to the Saudi capital. This is not surprising. Iraq not only seeks Saudi leniency in OPEC 2.0 cuts, but also needs financial assistance to develop a natural gas field that will allow it to reduce dependence on Iran. Saudi Arabia also hopes to reduce Iraq’s dependence on Iranian natural gas and coax it into its sphere of influence. When it comes to crude oil, the additional 1mm b/d of voluntary cuts in June announced unilaterally by Saudi Arabia beyond its agreed OPEC 2.0 commitments are also a sign of Saudi willingness to accommodate Iraq and its non-compliance  (Chart 11).6 Saudi Arabia does not want to see Iraq’s newly elected government failing on the back of budgetary strain. In fact, al-Kadhimi is an opportunity for the Saudis. Formerly the director the National Intelligence Service with warm ties to the US, he is a champion of Iraqi sovereignty. Even though Iraq is being forced to compensate for past overproduction of oil in August and September, it was cajoled by the promise of a $500 million “bridging” loan from Saudi Arabia, to be repaid when oil markets recover. While financial assistance shows the kingdom’s commitment to Iraq, more significantly it reflects Riyadh’s desperation to revive oil markets and bring prices closer to its fiscal breakeven oil price amid the still uncertain demand outlook. Chart 11Saudi Arabia Willing To Accommodate Iraq Neither Saudi Arabia’s nor al-Kadhimi’s efforts are guaranteed to succeed in pulling Iraq out of Iran’s sphere. The prime minister received a rude awakening upon his arrest of 14 Kata’ib Hezbollah fighters in June on grounds of a plan to launch a rocket attack on US interest in Baghdad. They were swiftly released, and the case against them dropped. It is hard to curb Iranian influence. For its part, Iran stood behind al-Kadhimi’s nomination despite him being perceived as pro-Western. Tehran needed to avoid an anti-Iranian backlash on the streets of Baghdad if it had stood against him. Instead, Iran’s calculus was that it is in its best interest to swallow the pill and work with the new government at a time when Iraqi anger was targeted against US involvement rather than at Iranian interference. Prior to the US assassination of Qassem al-Suleimani and Abu Mahdi al-Muhandis on Iraqi soil, Iraqis were rebelling against Iran’s influence. That being said, Iran will maintain pressure on Iraq through continued attacks on US interests there (Table A1 in Appendix). This is also reflected in the July assassination of top Iraqi security expert Hisham al-Hashimi, who had previously advised the government on how to curb Iranian control. Iran was looking to make it to the US election in November without an escalation in tensions, hoping the US elections will result in a more dovish Democratic Party leadership averse to conflict with Iran. However, recent cyber-attacks on key Iranian infrastructure raise the likelihood that tensions will escalate ahead of the elections. The US is also threatening to maintain maximum sanctions even if the United Nations Security Council disagrees. As always, Iraq will find itself in the crossfire of any deterioration in relations. Bottom Line: Maintaining a cooperative relationship with Iraq aligns with both of Saudi Arabia’s interests there: limiting Iranian interference and supporting global oil markets through supply-side discipline. Iran will maintain pressure on Iraq’s new government through continued attacks on US interests. However, these attacks are supposed to fall short of killing US citizens and giving President Trump a reason to launch air strikes that could give him a patriotic boost in opinion polls. Nevertheless, tensions in the Gulf could escalate if Iran stages a major attack or if President Trump’s poor election prospects force him to “wag the dog.” In that case Iraqi oil supply would be disrupted. Investment Implications The Shia Crescent remains at heightened risk of instability on the back of Iran’s economic deterioration. Massive excess oil capacity will mute the oil market impact of a supply shortfall in Iraq. However, the risk becomes more relevant as demand recovers and markets rebalance in the second half of the year. Given that the Saudi loan will ensure Iraq’s commitment to compensatory production cuts in August and September, supply-side risks are a tailwind to oil prices in H2. The elevated risk of an escalation in US-Iran tensions also favors holding gold. President Trump’s polling has bottomed, yet he remains the underdog in the election – we maintain his odds of winning reelection are 35%. This raises the risk that he adopts a “war president” posture. Iran could become a target as the financial price of confronting Iran is negligible for Trump, whereas a major China confrontation could sink the stock market. The collapse in oil prices and pandemic have weighed on Saudi Arabia’s budget. It has adopted a revenue over growth posture. While this could be a risk to domestic stability, our base case is that it accelerates the kingdom’s long-term reforms. The oil market rout and economic downturn will hurt other countries in the region that are leveraged to Arab petro states – chiefly Egypt and Jordan. Investors should monitor risks to state stability in the coming years. Lebanon’s crisis will incentivize emigration, but given the relatively small size of its population, the major risk to Europe comes from any broader state failures and Middle Eastern instability rather than from Lebanon’s failure alone. If the Democratic Party wins the US election, as expected, then the US-Iran strategic détente will resume and Iran will get a lifeline. But the immediate transition will still be rocky given the Israeli and Saudi desire to exploit Iran’s extreme vulnerability and build leverage with Washington. The COVID-19 crisis heralds another round of Middle Eastern crisis, much as the 2008 crisis led to the Arab Spring. Stay strategically long Brent crude oil and gold. Also, in the wake of yesterday’s 15% pullback in silver, go strategically long silver (XAGUSD), which will continue benefiting from the same structural trends favoring gold but also outperform gold as the global economy recovers, given its greater industrial utility.     Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com       Appendix Table A1Iran Adopting Deterrence Strategy In Iraq   Footnotes 1     Berri is of the Hezbollah-allied Amal Movement and has been parliamentary speaker since 1992, while Bassil is President Aoun’s son-in-law and president of the Free Patriotic Movement, which has the most seats in parliament. 2     Hezbollah gains legitimacy at home through its charity work that plugs the gap in services normally provided for by the government. 3    According to a commander of an Iran-backed paramilitary group in Iraq, Iran slashed its monthly funding to the top four militias by nearly half this year. Please see “Coronavirus and sanctions hit Iran’s support of proxies in Iraq,” Reuters, July 2, 2020. 4    Hezbollah has gained control over the foreign policy and Lebanon has recently taken stances that are seen as bowing to Iranian pressure. Lebanon did not attend a March 22, 2018 extraordinary Arab League meeting discussing violations committed by Iran. Prior to that, Beirut did not condemn Iranian attacks on a Saudi diplomatic mission in Tehran. 5    However an undisclosed facility for processing uranium ore in the northeast of the kingdom has recently appeared. 6    This is not unlike the US’s decision to extend sanction waivers by four months, allowing Baghdad to import Iranian energy in order to ensure that the new government of Prime Minister Mustafa al-Kadhimi can stand on its own and is not overly dependent on Iran.