Germany

Highlights Germany’s election on September 26 is more of an opportunity than a risk for global investors. Coalition formation will prolong uncertainty but the key takeaway is that early or aggressive fiscal tightening is off the table for Germany … and hence the EU. Germany’s left wing is surprising to the upside as predicted, but it is the Social Democrats rather than the Greens who have momentum in the polls. This is a market-positive development. A coalition of only left-wing parties is entirely possible, but there is a 65% chance that the Christian Democrats (or Free Democrats) will take part in the next coalition to get a majority government. This would constrain business unfriendly outcomes. The German economy is likely to slow for the remainder of 2021, but the outlook for 2022 remains bright as the current headwinds facing the country will dissipate, especially if the risk of an aggressive fiscal drag is low. The underperformance of German equities relative to their Eurozone counterparts is long in the tooth. A combination of valuation, earnings momentum and technical factors suggests that German stocks will beat their peers next year. German equities will also outperform Bunds, which offer particularly unattractive prospective returns. Feature Germany’s federal election will be held on September 26. Our forecast that the left wing will surprise to the upside remains on track, albeit with the Social Democrats rather than the Greens surging to the forefront of opinion polls (Chart 1). However, the precise composition of the next government is very much in the air. Chart 1German Election: Social Democrats Take The Lead German Election: Social Democrats Take The Lead German Election: Social Democrats Take The Lead Our quantitative German election model – which we introduce in this special report – predicts that the ruling Christian Democratic Union will outperform their current 21% standing in opinion polls, winning as much as 33% of the popular vote. Subjectively, this seems like an overestimation, but it goes to show that outgoing Chancellor Angela Merkel’s popularity, a historically strong voting base, and the economic recovery will help the party pare its losses this year. This finding, combined with the strong momentum for the Social Democrats, suggests that the election outcome will not be decisive. Germany will end up with either a grand coalition that includes Merkel’s Christian Democrats or a left-wing coalition that lacks a majority in parliament.1 Investors should note that none of the election outcomes are hugely disruptive to domestic or foreign policy. The status quo is unexciting but not market-negative, while a surprise left-wing victory would mean more reflation in the short run but a roll back of some pro-business policies in the long run. More broadly Germany has established a national consensus that rests on European integration, looser fiscal policy, renewable energy, and qualified engagement with autocratic powers like Russia and China. The chief takeaway is that fiscal policy will not be tightened too soon – and could be loosened substantially. Germany’s Fiscal Question Outgoing Chancellor Angela Merkel is stepping down after ruling Germany since 2005. The Christian Democratic Union, and its Bavarian sister party the Christian Social Union, together form the “Union” that is hard to beat in German elections, having occupied the chancellor’s office for 57 out of 72 years. However, both the Christian Democrats and the Social Democrats, their main rivals, have been shedding popular vote share since 1990, as other parties like the Greens, Free Democrats, the Left, and Alternative for Germany have gained traction (Table 1). Table 1Germany: Traditional Parties Lose Vote Share Over Time German Election: Winds Of Change German Election: Winds Of Change The Great Recession and European sovereign debt crisis ushered in a new geopolitical and macroeconomic context that Merkel reluctantly helped Germany and the EU navigate. Germany’s clashes with the European periphery ultimately resulted in deeper EU integration, in accordance with Germany’s grand strategy and Merkel’s own strategy. But just as the euro crisis receded, a series of shocks elsewhere threatened to upend Germany’s position as one of the biggest economic winners of the post-Cold War world. The sluggish aftermath of the financial crisis, the Russian invasion of Crimea, the Syrian refugee crisis, the Brexit referendum, and President Trump’s election in the US sparked a retreat from globalization, a direct threat to an export-oriented manufacturing economy like Germany. In the 2017 election the Union lost 13.4 percentage points compared to the 2013 election. Minor parties have gradually gained ground since then. However, through a coalition with the Social Democrats, Merkel and her party managed to retain control of the government. This grand coalition eased the country’s fiscal belt in response to the trade war and global slowdown in 2019, signaling Germany’s own shift away from fiscal austerity. Then COVID-19 struck, prompting a much larger fiscal expansion to tide over the economy amid social lockdowns. Germany was not the largest EU member in terms of fiscal stimulus but nor was it the smallest (Chart 2). It joined with France to negotiate a mutual debt plan to rescue the broader EU economy and deepen integration. Chart 2Germany’s Fiscal Stimulus Ranks In The Middle Of Major Countries German Election: Winds Of Change German Election: Winds Of Change Germany’s pro-EU perspective has been reinforced by Brexit and is not on the ballot in 2021. Immigration and terrorism have temporarily subsided as voter concerns. The focus of the 2021 election is how to get through the pandemic and rebuild the German economy for the future. For investors the chief question is whether conservatives will have enough sway in the next government to try to semi-normalize policy and consolidate budgets in the coming years, or whether a left-wing coalition will take charge, expanding on Germany’s proactive fiscal turn. The latter has consequences for broader EU fiscal normalization as well since Germany is traditionally the prime enforcer of deficit limits. The latest opinion polls point to more proactive fiscal policy. The country’s left-leaning ideological bloc has taken the lead (Chart 3A) and the Social Democratic leader Olaf Scholz has sprung into first place among the chancellor candidates (Chart 3B). Chart 3AGermany: Voting Intentions Favor Left-Leaning Parties Germany: Voting Intentions Favor Left-Leaning Parties Germany: Voting Intentions Favor Left-Leaning Parties Chart 3BSocial Democrats Likely To Take Chancellery German Election: Winds Of Change German Election: Winds Of Change Scholz has served as finance minister and is the face of the country’s recent fiscal stimulus efforts. Public opinion is clearly rewarding him for this stance as well as his party, which was previously in the doldrums.2 The Social Democrats and Greens are calling for more fiscal expansion as well as wage hikes and tax hikes (wealth redistribution) in pursuit of social equality and a greener economy (Table 2). If the Christian Democrats retain a significant role in the future coalition, these initiatives will be blunted – not to say halted entirely. But if the left parties put together a ruling coalition without the Christian Democrats, then they will be able to launch more ambitious tax-and-spend policies. Opinion polls show that voters still slightly favor coalitions that include the Christian Democrats, although momentum has shifted sharply in favor of a left-wing coalition (Chart 4). Table 2German Party Platforms German Election: Winds Of Change German Election: Winds Of Change Chart 4Voters Evenly Split On Whether Next Coalition Should Include CDU German Election: Winds Of Change German Election: Winds Of Change This shift is what we forecast in previous reports but now the question is whether the left-wing parties can actually win enough seats to put together a majority coalition. That is a tall order. Our quantitative election model suggests that the Christian Democrats, having suffered a long overdue downgrade in expectations, will not utterly collapse when the final vote is tallied. While we do not expect them to retain the chancellorship, momentum will have to shift even further in the opposition’s favor over the next two weeks to produce a majority coalition that excludes the Union. Our Quantitative German Election Model Our model is based off the work of Norpoth and Geschwend, who created a simple linear model to predict the vote share that incumbent governing parties or coalitions will obtain in impending elections.3 Their model utilizes three explanatory variables and has a sample size of 18 previous elections, covering elections from 1953 to 2017. Our model updates their original work to make estimates for the 2021 election. Unlike our US Political Strategy Presidential Model, which makes use of both political and economic explanatory variables in real time, our German election model makes predictions based solely on historical political variables, all of which display a high degree of correlation with popular vote share. We will look at economic factors that may affect the election later in this report. The Three Explanatory Variables 1. Chancellor Approval Rating: This variable captures the short-term support rate of the incumbent chancellor. A positive relationship exists between chancellor approval and vote share: higher approval equates to higher vote share for the incumbent party. Merkel’s approval stands at 64% today which is a boon for the otherwise beleaguered Christian Democrats (Chart 5). Chart 5Merkel's Coattails A Boon But Not Enough To Save Her Party Merkel's Coattails A Boon But Not Enough To Save Her Party Merkel's Coattails A Boon But Not Enough To Save Her Party 2. Long-term partisanship: This variable shows the long-term support rate of voters for specific parties or coalitions in past elections. It is measured as the average vote share of the incumbent party over the past three elections. A positive relationship with vote share exists here too: higher historical partisanship equates to a higher share of votes in forthcoming elections, and vice versa. This variable clearly gives a boost to the Christian Democrats – although it could overrate them based on past performance, as occurred in 2017 when they underperformed the model’s prediction.4 3. “Time For Change”: This is a categorical variable measured by how many terms the parties or coalition have held office leading into an election. This variable has a negative relationship with vote share outcomes. The longer an incumbent party or coalition holds office, the less vote share they will receive. Effectively, our model punishes parties that hold office for long periods of time. In this case that would be the long-ruling Christian Democrats. Model Estimation And Results Our model is estimated by the following simple equation: Popular Vote Share = constant + ßChancellor Approval Rating + ßLong-Term Partisanship + ßTime For Change Estimating the above model for the 2021 election predicts that the Union will win 32.7% of the vote share (Table 3). If this prediction came true, it would suggest that the ruling party performed almost exactly the same as in 2017. In other words, the party’s strong voter base combined with Merkel’s long coattails are expected to shore up the party. This flies in opinion polling, however, so we think the model is overestimating the Christian Democrats. Table 3Our German Election Quant Model Says CDU Will Not Collapse German Election: Winds Of Change German Election: Winds Of Change Note that even if the Union performs this well, it still will not win enough seats to govern on its own. Potential Union-led coalitions are shown in Table 3, excluding the Social Democrats (see below). For a majority government, a coalition with the Free Democrats and the Greens would need to be formed. This coalition would equate to 53% of the vote share. Otherwise, to obtain a majority, the Union would have to team up with the Social Democrats, which is today’s status quo. We can use the same methodology to predict the vote share for the Social Democrats. We use the support rate of Social Democratic chancellor-candidate Olaf Scholz and calculate the long-term partisanship variable using past Social Democratic vote shares. In this case our model predicts that the Social Democrats will win 22.1% of the vote. If this result were to come true, it would not be enough for the party to govern own its own. Potential Social Democratic-led coalitions are shown in Table 4. The best coalition would be with the Greens and either the Left or the Free Democrats. But in this case the Social Democrats cannot form a government with a vote share above 50%, unless it pairs up with the Christian Democrats. Table 4Our German Election Quant Model Says SPD Has Not Yet Won It All German Election: Winds Of Change German Election: Winds Of Change In other words, either the left-wing parties must build on their current momentum and outperform their historical record in the final election tally, or they will need to form a coalition with the Christian Democrats. This kind of left-wing surge is precisely what we have predicted. But the model helps put into perspective how difficult it will be for the left-leaning parties to get a majority. Scholz is single-handedly trying to overcome the long downtrend of the Social Democrats. His party is rising at the expense of the Greens, and the Left, which puts a lid on the total left-wing coalition size. If these three parties all beat the model and slightly surpass their top vote share in recent memory (SPD at 26%, Greens at 11%, and the Left at 12%), they still only have 49% of the vote. While our model is reliant on historical political data, it is a robust predictor for past election results (Chart 6). The average vote share error between the predicted and realized outcomes over from 1953 to 2013 is 1.7 percentage points. The problem with relying on the model is that the Christian Democrats have broken down from their long-term trend in opinion polls. And while Merkel’s approval is strong, she is no longer on the ballot and her hand-picked successor, Armin Laschet, is floundering in the polls (see Chart 3B above). Chart 6Our German Election Quant Model Has Solid Track Record, But Merkel’s High Approval Rating Caused Overestimate In 2017 And May Do So In 2021 German Election: Winds Of Change German Election: Winds Of Change In short, the model is probably overrating the Union but it is also calling attention to the extreme difficulty of the left-wing parties forming a majority coalition. Scholz may have to form a coalition with the Free Democrats or pursue another grand coalition. And if the Social Democrats fail to get the largest vote share, German President Frank-Walter Steinmeier may ask Armin Laschet to try to form a government first. Still, Scholz is the most likely chancellor when all is said and done. Election Model Takeaway Our German election model predicts that the Union will receive 32.9% of the popular vote, while the Social Democrats will receive 22.1%. At the same time, the left-leaning parties, specifically the Social Democrats, clearly have the momentum. Therefore the model may be overrating the incumbent party. But it still calls attention to a high level of uncertainty, the likelihood of a messy election outcome, and a tricky period of coalition formation. The Social Democrats will have to pull off a major surprise, outperforming both history and our model, to lead a majority government without the Christian Democrats.5 We still think this is possible. But we will stick with our earlier subjective probabilities: 65% odds that the Christian Democrats take part in the next coalition, 35% odds that they do not. Bottom Line: The chancellorship will go to the Social Democrats but the coalition will constrain the business unfriendly aspects of their agenda. This is positive for Germany’s corporate earnings outlook. Macro Outlook: A Temporary Economic Dip Our election model does not account for the economic backdrop and hence ignores the “pocketbook voter.” Germany is recovering from the pandemic, which is marginally supportive for an otherwise faltering ruling party. However, the economic data is only good enough to suggest that the Union will not utterly collapse. A rise in unemployment, inflation, and the combination of the two (the “Misery Index”) is a tell-tale sign that the incumbent party will suffer a substantial defeat (Chart 7). However the German economy’s loss of momentum is temporary. Growth will re-accelerate in early 2022. The timing is politically inconvenient for the ruling party but positive news for investors. German economic confidence is deteriorating. The Ifo Business Climate survey has rolled over, lowered by a meaningful decline in the Expectations Survey. Additionally, consumer confidence is turning south, despite already being low (Chart 8). Chart 7Spike In German Misery Index A Tell-Tale Sign Of Poor Election For Incumbent Party Spike In German Misery Index A Tell-Tale Sign Of Poor Election For Incumbent Party Spike In German Misery Index A Tell-Tale Sign Of Poor Election For Incumbent Party Chart 8Deteriorating German Confidence Deteriorating German Confidence Deteriorating German Confidence A combination of factors weighs on German confidence: First, global supply chain bottlenecks are hurting growth. The automotive industry, which is paralyzed by a global chip shortage, accounts for about 20% of industrial production, and its output is once again declining after a sharp but short-lived rebound last year (Chart 9). Similarly, inventories of finished goods are collapsing, which is hurting growth today (Chart 9, second panel). Second, the Delta variant of COVID-19 is causing a spike in infections. The rise in cases prevents containment measures from easing as much as expected, while it also hurts the willingness of households to go out and spend their funds (Chart 9, third panel). Third, German real wages are weak. Negotiated wages are only growing at a 1.7% annual rate, and wages and salaries are expanding at 2.1% annually. Meanwhile, German headline CPI runs at 3.9%. The declining purchasing power of German households accentuates their current malaise. Three crucial forces counterbalance these negatives: First, German house prices are growing at a 9.4% annual rate, which is creating a potent, positive wealth effect (Chart 10). Chart 9Germany's Headwinds Germany's Headwinds Germany's Headwinds Chart 10A Strong Wealth Effect A Strong Wealth Effect A Strong Wealth Effect Second, German household credit remains robust. According to the Bundesbank, the strength in household credit mostly reflects the strong demand for mortgages. Historically, a healthy housing sector is an excellent leading indicator of economic vigor. Third, the Chinese credit impulse is too depressed for Beijing’s political security. The recent decline in the credit impulse to -2.4% of GDP reflects a policy decision in the fall of 2020 to trim down the credit expansion. As a result, Chinese economic growth is slowing. For example, both the Caixin Manufacturing and Services PMIs stand below 50, at post-pandemic lows of 49.2 and 46.7, respectively. In July authorities became uncomfortable and cut the Reserve Requirement Ratio as well as interbank rates to free liquidity and stabilize the economy. A boom is not forthcoming, but the drag on global activity will ebb by next year. Including the headwinds and tailwinds to the economy, German activity will slow down for the remainder of the year before improving anew in 2022. Our election case outlined above – that the conservatives will lose the chancellorship and either be excluded from power or greatly diminished in the Bundestag – means that fiscal policy will not be tightened abruptly and will not create a material risk to this outlook. Chart 11Vaccines Work Vaccines Work Vaccines Work Many of the headwinds will dissipate. The Delta-wave of COVID-19 will diminish. Already, Germany’s R0 is tentatively peaking, which normally precedes a drop in daily new cases. Moreover, Germany’s vaccination campaign is progressing, which limits the impact of the current wave on hospitalization and intensive care-unit usage (Chart 11). Inflation will peak in Germany, which will salvage real wages. As European Investment Strategy wrote last Monday,6 European inflation remains concentrated in sectors linked to commodity prices or directly affected by bottlenecks. Instead, trimmed-mean CPI is muted (Chart 12), which implies that underlying inflationary pressures are small, especially as wage gains are still well contained. Moreover, the one-off impact of the end of the German VAT rebate will also pass. Finally, a stabilization and eventual revival of the Chinese credit impulse will put a floor under German exports, industrial production, and capex (Chart 13). For now, the previous decline in the Chinese credit impulse is consistent with slower German output growth for the remainder of 2021. However, next year, the German industrial sector will start to feel the effect of the current efforts to improve Chinese liquidity conditions. Chart 12Narrow European Inflation Narrow European Inflation Narrow European Inflation Bottom Line: The German economy is set to deteriorate for the remainder of 2021. However, as the current wave of COVID-19 infections ebbs, real wages recover, and China’s credit impulse stabilizes, Germany’s economic activity will re-accelerate in 2022, especially if the upcoming election does not generate a meaningful fiscal shock. We do not think it will. Chart 13China: From Headwinds To Tailwind? China: From Headwinds To Tailwind? China: From Headwinds To Tailwind? Market Implications: German Stocks To Shine German equities are set to outperform their European counterparts and will significantly beat Bunds over the coming 18 months. During the past 5 months, the German MSCI index has underperformed the rest of the Eurozone by 6.2%. The poor performance of German equities is worse than meets the eye. If we adjust for sectoral differences by building equal sector-weight indexes, Germany has underperformed the Euro Area by 22% since early 2017 (Chart 14). Chart 14Not Delivering The Goods Not Delivering The Goods Not Delivering The Goods This underperformance is long in the tooth and should reverse because of four important dynamics. First, German equities are cheap relative to the European benchmark. As Chart 15 highlights, the relative performance of German stock prices has lagged that of profits. This underperformance is also true once we account for the different sectoral composition of the German market. As a result, Germany is cheap on a forward price-to-earnings, price-to-sales, and price-to-book basis versus the Euro Area. Additionally, analysts embed significantly lower long-term and one-year expected growth rates of earnings in Germany than in the rest of the Eurozone, which depresses the German PEG ratios. Second, German operating metrics do not justify the valuation discount of German equities. The return on equity of German stocks stands at 11.39%, which is similar to that of the Euro Area. Profit margins are also comparable, at 5.91% and 5.74%, respectively. However, German firms utilize their capital more efficiently, and their asset turnover stands at 0.3 times compared to 0.2 times for the Eurozone average. Meanwhile, German non-financial firms are less indebted than their Eurozone competitors, which implies that Germany’s return on assets is greater than that of Europe at large (Chart 16). Chart 15Lagging Prices, Not Earnings Lagging Prices, Not Earnings Lagging Prices, Not Earnings Chart 16Why The Discount? Why The Discount? Why The Discount? Third, the drivers of earnings support a German outperformance. Over the past thirty years, commodity prices led the performance of German stocks relative to that of the rest of the Eurozone (Chart 17). While the near-term outlook for natural resource prices is muddy, BCA’s commodity strategists expect Brent prices to average more than $80/bbl in 2023 and industrial metals to outperform energy over the coming years.7 Additionally, German Services PMI are bottoming compared to that of the Eurozone. Over the past decade, this process preceded periods of outperformance by German stocks (Chart 18). Similarly, the collapse in the Chinese credit impulse relative to the robust domestic economic activity in Europe is well reflected in the underperformance of German shares. The Eurozone’s Service PMI is near all-time highs and unlikely to improve further; however, the Chinese credit impulse should recover in the coming quarters. This phenomenon will help German stocks (Chart 19). Chart 17Commodity Bulls Pull Germany Commodity Bulls Pull Germany Commodity Bulls Pull Germany Chart 18German Vs European Activity Matters German Vs European Activity Matters German Vs European Activity Matters Chart 19German Vs Chinese Activity Matters German Vs Chinese Activity Matters German Vs Chinese Activity Matters The German MSCI index is also oversold. The 52-week rate of change of its performance compared to the rest of the Eurozone plunged to its lowest reading since the introduction of the euro in 1999 (Chart 20). Meanwhile, the 13-week rate of change remains low but has begun to improve (not shown). This combination usually heralds a forthcoming rebound in German relative performance. In relation to equities, German Bunds remain an unappealing investment. Based on historical experience, the current yield of -0.36% offered by German 10-year bonds condemns investors to negative returns over the next five years (Chart 21). Chart 20Oversold! Oversold! Oversold! Chart 21Bounded Bunds' Returns Bounded Bunds' Returns Bounded Bunds' Returns Even if realized inflation ebbs in Germany and Europe, inflation expectations remain low and an eventual return to full employment will force CPI swaps higher, especially if the ECB maintains easy monetary conditions and invites further risk-taking in the Eurozone. The global economic cycle will also move from a friend to a foe for Bunds. As Chart 22 illustrates, the recent deceleration in global export growth was consistent with the fresh uptick in the returns of German paper. However, if Chinese credit flows stabilize by year-end and reaccelerate in 2022 while supply-chain bottlenecks dissipate, global export growth will improve. This should hurt Bund prices, especially as the long-term terminal rate proxy embedded in the German curve remains too low. As a result, not only should Bunds underperform German equities, but the German yield curve will also steepen further relative to that of the US, where the Fed will lift the short-end of the curve faster than the ECB. Chart 22Economic Momentum And Bunds Prices Economic Momentum And Bunds Prices Economic Momentum And Bunds Prices Bottom Line: The underperformance of German equities relative to those of the rest of the Eurozone is well advanced, which makes German stocks a bargain. The current deceleration in global and German growth will not extend beyond 2021, which suggests that German stocks prices should converge toward their earnings outperformance next year. Our political forecast suggests that the odds of an early or aggressive fiscal retrenchment are very low. Additionally, German equities will outperform Bunds, which offer particularly poor prospective returns.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Mathieu Savary Senior Vice President Mathieu@bcaresearch.com Guy Russell Research Analyst GuyR@bcaresearch.com Jingnan Liu Research Associate JingnanL@bcaresearch.com Footnotes 1 Note that minority governments are rare and have a bad reputation in Germany, partly as a result of the series of weak governments leading up to the 1932 election and Nazi rule. 2 In addition, while the center-left parties can work with the far-left in the Bundestag, the center-right parties cannot work with the far-right Alternative for Germany. Indeed the slightest imputation of a willingness to work with Alternative for Germany cost Merkel’s first pick for successor, Annegret Kramp-Karrenbauer, her job. 3 See: Norpoth, Helmut & Gschwend, Thomas (2010) The chancellor model: Forecasting German elections, International Journal of Forecasting. 26. 42-53. 4 Our model performs well in back-testing but 2017 was an outlier. It correctly predicted the Union to win the highest share of the popular vote but overestimated that vote by seven percentage points. Our only short-term variable, the chancellor’s approval rate, caused a deviation from long-term voting trends. Our other two variables capture medium and long-term effects, which clearly favored the Union. The implication is that Merkel’s high approval rating today could give a misleading impression about the Christian Democrats’ prospects. 5 If they are forced to rely on the Free Democrats instead, that will also constrain the most anti-business elements of their agenda. 6 Please see BCA Research European Investment Strategy Weekly Report, "The ECB Taper Dilemma", dated September 6, 2021, available at eis.bcareseach.com. 7 Please see BCA Research Commodity & Energy Strategy Weekly Report, "Permian Output Approaches Pre-Covid Peak", dated August 19, 2021, available at ces.bcareseach.com.

Highlights An Iran crisis is imminent. We still think a US-Iran détente is possible but our conviction is lower until Biden makes a successful show of force. Oil prices will be volatile. Fiscal drag is a risk to the cyclical global macro view. But developed markets are more fiscally proactive than they were after the global financial crisis. Elections will reinforce that, starting in Germany, Canada, and Japan. The Chinese and Russian spheres are still brimming with political and geopolitical risk. But China will ease monetary and fiscal policy on the margin over the coming 12 months. Afghanistan will not upset our outlook on the German and French elections, which is positive for the euro and European stocks. Feature Chart 1Bull Market In Iran Tensions Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Iran is now the most pressing geopolitical risk in the short term (Chart 1). The Biden administration has been chastened by the messy withdrawal from Afghanistan and will be exceedingly reactive if it is provoked by foreign powers. Nuclear weapons improve regime survivability. Survival is what the Islamic Republic wants. Iran is surrounded by enemies in its region and under constant pressure from the United States. Hence Iran will never ultimately give up its nuclear program, as we have maintained. Chart 2Biden Unlikely To Lift Iran Sanctions Unilaterally Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) However, Supreme Leader Ali Khamenei could still agree to a deal in which the US reduces economic sanctions while Iran allows some restrictions on uranium enrichment for a limited period of time (the 2015 nuclear deal’s key provisions expire from 2023 through 2030). This would be a stopgap measure to delay the march into war. The problem is that rejoining the 2015 deal requires the US to ease sanctions first, since the US walked away from the deal in 2018. Iran would need domestic political cover to rejoin it. Biden has the executive authority to ease sanctions unilaterally but after Afghanistan he lacks the political capital to do so (Chart 2). So Biden cannot ease sanctions until Iran pares back its nuclear activities. But Iran has no reason to pare back if the US does not ease sanctions. Iran is now enriching some uranium to a purity of 60%. Israeli Defense Minister Benny Gantz says it will reach “nuclear breakout” capability – enough fissile material to build a bomb – within 10 weeks, i.e. mid-October. Anonymous officials from the Biden administration told the Associated Press it will be “months or less,” which could mean September, October, or November (Table 1). Table 1Iran Nearing "Breakout" Nuclear Capability Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Meanwhile the new Iranian government of President Ebrahim Raisi, a hardliner who is tipped to take over as Supreme Leader once Ali Khamenei steps down, is implying that it will not rejoin negotiations until November. All of these timelines are blurry but the implication is that Iran will not resume talks until it has achieved nuclear breakout. Israel will continue its campaign of sabotage against the regime. It may be pressed to the point of launching air strikes, as it did against nuclear facilities in Iraq in 1981 and Syria in 2007 under what is known as the “Begin Doctrine.” Chart 3Israel Cannot Risk Losing US Security Guarantee Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) The constraint on Israel is that it cannot afford to lose America’s public support and defense alliance since it would find itself isolated and vulnerable in its region (Chart 3). But if Israeli intelligence concludes that the Iranians truly stand on the verge of achieving a deliverable nuclear weapon, the country will likely be driven to launch air strikes. Once the Iranians test and display a viable nuclear deterrent it will be too late. Four US presidents, including Biden, have declared that Iran will not be allowed to get nuclear weapons. Biden and the Democrats favor diplomacy, as Biden made clear in his bilateral summit with Israeli Prime Minister Naftali Bennett last week. But Biden also admitted that if diplomacy fails there are “other options.” The Israelis currently have a weak government but it is unified against a nuclear-armed Iran. At very least Bennett will underscore red lines to indicate that Israel’s vigilance has not declined despite hawkish Benjamin Netanyahu’s fall from power. Still, Iran may decide it has an historic opportunity to make a dash for the bomb if it thinks that the US will fail to support an Israeli attack. The US has lost leverage in negotiations since 2015. It no longer has troops stationed on Iran’s east and west flanks. It no longer has the same degree of Chinese and Russian cooperation. It is even more internally divided. Iran has no guarantee that the US will not undergo another paroxysm of nationalism in 2024 and try to attack it. The faction that opposed the deal all along is now in power and may believe it has the best chance in its lifetime to achieve nuclear breakout. The only reason a short-term deal is possible is because Khamenei may believe the Israelis will attack with full American support. He agreed to the 2015 deal. He also fears that the combination of economic sanctions and simmering social unrest will create a rift when he dies or passes the leadership to his successor. Iran has survived the Trump administration’s “maximum pressure” sanctions but it is still vulnerable (Chart 4). Chart 4Supreme Leader Focuses On Regime Survival Supreme Leader Focuses On Regime Survival Supreme Leader Focuses On Regime Survival Moreover Biden is offering Khamenei a deal that does not require abandoning the nuclear program and does not prevent Iran from enhancing its missile capabilities. By taking the deal he might prevent his enemies from unifying, forestall immediate war, and pave the way for a smooth succession, while still pursuing the ultimate goal of nuclear weaponization. Bringing it all together, the world today stands at a critical juncture with regard to Iran and the unfinished business of the US wars in the Middle East. Unless the US and Israel stage a unified and convincing show of force, whether preemptively or in response to Iranian provocations, the Iranians will be justified in concluding that they have a once-in-a-generation opportunity to pursue the bomb. They could sneak past the global powers and obtain a nuclear deterrent and regime security, like North Korea did. This could easily precipitate a war. Biden will probably continue to be reactive rather than proactive. If the Iranians are silent then it will be clear that Khamenei still sees the value in a short-term deal. But if they continue their march toward nuclear breakout, as is the case as we go to press, then Biden will have to make a massive show of force. The goal would be to underscore the US’s red lines and drive Iran back to negotiating table. If Biden blinks, he will incentivize Iran to make a dash for the bomb. Either way a crisis is imminent. Israel will continue to use sabotage and underscore red lines while the Iranians will continue to escalate their attacks on Israel via militant proxies and attacks on tankers (Map 1). Map 1Secret War Escalates In Middle East Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Bottom Line: After a crisis, either diplomacy will be restored, or the Middle East will be on a new war path. The war path points to a drastically different geopolitical backdrop for the global economy. If the US and Iran strike a short-term deal, Iranian oil will flow and the US will shift its strategic focus to pressuring China, which is negative for global growth and positive for the dollar. If the US and Iran start down the war path, oil supply disruptions will rise and the dollar will fall. Implications For Oil Prices And OPEC 2.0 The probability of a near-term conflict is clear from our decision tree, which remains the same as in June 2019 (Diagram 1). Diagram 1US-Iran Conflict: Critical Juncture In Our Decision Tree Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Shows of force and an escalation in the secret war will cause temporary but possibly sharp spikes in oil prices in the short term. OPEC 2.0 remains intact so far this year, as expected. The likelihood that the global economic recovery will continue should encourage the Saudis, Russians, Emiratis and others to maintain production discipline to drain inventories and keep Brent crude prices above $60 per barrel. OPEC 2.0 is a weak link in oil prices, however, because Russians are less oil-dependent than the Gulf Arab states and do not need as high of oil prices for their government budget to break even (Chart 5). Periodically this dynamic leads the cartel to break down. None of the petro-states want to push oil prices up so high that they hasten the global green energy transition. Chart 5OPEC 2.0 Keeps Price Within Fiscal Breakeven Oil Price Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Chart 6Oil Price Risks Lie To Upside Until US-Iran Deal Occurs Oil Price Risks Lie To Upside Until US-Iran Deal Occurs Oil Price Risks Lie To Upside Until US-Iran Deal Occurs As long as OPEC 2.0 remains disciplined, average Brent crude oil prices will gradually rise to $80 barrels per day by the end of 2024, according to our Commodity & Energy Strategy (Chart 6). Imminent firefights will cause prices to spike at least temporarily when large amounts of capacity are taken offline. Global spare capacity is probably sufficient to handle one-off disruptions but an open-ended military conflict in the Persian Gulf or Strait of Hormuz would be a different story. After the next crisis, everything depends on whether the US and Israel establish a credible threat and thus restore diplomacy. Any US-Iran strategic détente would unleash Iranian production and could well motivate the Gulf Arabs to pump more oil and deny Iran market share. Bottom Line: Given that any US-Iran deal would also be short-term in nature, and may not even stabilize the region, some of the downside risks are fading at the moment. The US and China are also sucking in more commodities as they gear up for great power struggle. The geopolitical outlook is positive for oil prices in these respects. But OPEC 2.0 is the weak link in this expectation so we expect volatility. Global Fiscal Taps Will Stay Open Markets have wavered in recent months over softness in the global economic recovery, COVID-19 variants, and China’s policy tightening. The world faces a substantial fiscal drag in the coming years as government budgets correct from the giant deficits witnessed during the crisis. Nevertheless policymakers are still able to deliver some positive fiscal surprises on the margin. Developed markets have turned fiscally proactive over the past decade. They rejected austerity because it was seen as fueling populist political outcomes that threatened the established parties. Note that this change began with conservative governments (e.g. Japan, UK, US, Germany), implying that left-leaning governments will open the fiscal taps further whenever they come to power (e.g. Canada, the US, Italy, and likely Germany next). Chart 7Global Fiscal Taps Will Stay Open Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Chart 7 updates the pandemic-era fiscal stimulus of major economies, with light-shaded bars highlighting new fiscal measures that are in development but have not yet been included in the IMF’s data set. The US remains at the top followed by Italy, which also saw populist electoral outcomes over the past decade. Chart 8US Fiscal Taps Open At Least Until 2023 US Fiscal Taps Open At Least Until 2023 US Fiscal Taps Open At Least Until 2023 The Biden administration is on the verge of passing a $550 billion bipartisan infrastructure bill. We maintain 80% subjective odds of passage – despite the messy pullout from Afghanistan. Assuming it passes, Democrats will proceed to their $3.5 trillion social welfare bill. This bill will inevitably be watered down – we expect a net deficit impact of around $1-$1.5 trillion for both bills – but it can pass via the partisan “budget reconciliation” process. We give 50% subjective odds today but will upgrade to 65% after infrastructure passes. The need to suspend the debt ceiling will raise volatility this fall but ultimately neither party has an interest in a national debt default. The US is expanding social spending even as geopolitical challenges prevent it from cutting defense spending, which might otherwise be expected after Afghanistan and Iraq. The US budget balance will contract after the crisis but then it will remain elevated, having taken a permanent step up as a result of populism. The impact should be a flat or falling dollar on a cyclical basis, even though we think geopolitical conflict will sustain the dollar as the leading reserve currency over the long run (Chart 8). So the dollar view remains neutral for now. Bottom Line: The US is facing a 5.9% contraction in the budget deficit in 2022 but the blow will be cushioned somewhat by two large spending bills, which will put budget deficits on a rising trajectory over the course of the decade. Big government is back. Developed Market Fiscal Moves (Outside The US) Chart 9German Opinion Favors New Left-Wing Coalition Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Fiscal drag is also a risk for other developed markets – but here too a substantial shift away from prudence has taken place, which is likely to be signaled to investors by the outperformance of left-wing parties in Germany’s upcoming election. Germany is only scheduled to add EUR 2.4 billion to the 25.6 billion it will receive under the EU’s pandemic recovery fund, but Berlin is likely to bring positive fiscal surprises due to the federal election on September 26. Germany will likely see a left-wing coalition replace Chancellor Angela Merkel and her long-ruling Christian Democrats (Chart 9). The platforms of the different parties can be viewed in Table 2. Our GeoRisk Indicator for Germany confirms that political risk is elevated but in this case the risk brings upside to risk assets (Appendix). Table 2German Party Platforms Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) While we expected the Greens to perform better than they are in current polling, the point is the high probability of a shift to a new left-wing government. The Social Democrats are reviving under the leadership of Olaf Scholz (Chart 10). Tellingly, Scholz led the charge for Germany to loosen its fiscal belt back in 2019, prior to the global pandemic. Chart 10Germany: Online Markets Betting On Scholz Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Chart 11Canada: Trudeau Takes A Calculated Risk Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) In June, the cabinet approved a draft 2022 budget plan supported by Scholz that would contain new borrowing worth EUR 99.7 bn ($119 billion). This amount is not included in the chart above but it should be seen as the minimum to be passed under the new government. If a left-wing coalition is formed, as we expect, the amount will be larger, given that both the Social Democrats and the Greens have been restrained by Merkel’s party. Canada turned fiscally proactive in 2015, when the institutional ruling party, the Liberals, outflanked the more progressive New Democrats by calling for budget deficits instead of a balanced budget. The Liberals saw a drop in support in 2019 but are now calling a snap election. Prime Minister Trudeau is not as popular in general opinion as he is in the news media but his party still leads the polls (Chart 11). The Conservatives are geographically isolated and, more importantly, are out of step with the median voter on the key issues (Table 3). Table 3Canada: Liberal Agenda Lines Up With Top Voter Priorities Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Nevertheless it is a risky time to call an election – our GeoRisk Indicator for Canada is soaring (Appendix). Granting that the Liberals are very unlikely to fall from power, whatever their strength in parliament, the key point is that parliament already approved of CAD 100 billion in new spending over the coming three years. Any upside surprise would give Trudeau the ability to push for still more deficit spending, likely focused on climate change. Chart 12Japan: Suga Will Go, LDP Will Stimulate Japan: Suga Will Go, LDP Will Stimulate Japan: Suga Will Go, LDP Will Stimulate Japanese politics are heating up ahead of the Liberal Democrats’ leadership election on September 29 and the general election, due by November 28. Prime Minister Yoshihide Suga’s sole purpose in life was to stand in for Shinzo Abe in overseeing the Tokyo Olympics. Now they are done and Suga will likely be axed – if he somehow survives the election, he will not last long after, as his approval rating is in freefall. The Liberal Democrats are still the only game in town. They will try to minimize the downside risks they face in the general election by passing a new stimulus package (Chart 12). Rumor has it that the new package will nominally be worth JPY 10-15 trillion, though we expect the party to go bigger, and LDP heavyweight Toshihiro Nikai has proposed a 30 trillion headline number. It is extremely unlikely that the election will cause a hung parliament or any political shift that jeopardizes passage of the bill. Abenomics remains the policy setting – and consumption tax hikes are no longer on the horizon to impede the second arrow of Abenomics: fiscal policy. Not all countries are projecting new spending. A stronger-than-expected showing by the Christian Democrats would result in gridlock in Germany. Meanwhile the UK may signal belt-tightening in October. Bottom Line: Germany, Canada, and Japan are likely to take some of the edge off of expected fiscal drag next year. Emerging Market Fiscal Moves (And China Regulatory Update) Among the emerging markets, Russia and China are notable in Chart 7 above for having such a small fiscal stimulus during this crisis. Russia has announced some fiscal measures ahead of the September 19 Duma election but they are small: $5.2 billion in social spending, $10 billion in strategic goals over three years, and a possible $6.8 billion increase in payments to pensioners. Fiscal austerity in Russia is one reason we expect domestic political risk to remain elevated and hence for President Putin to stoke conflicts in his near abroad (see our Russian risk indicator in the Appendix). There are plenty of signs that Belarussian tensions with the Baltic states and Poland can escalate in the near term, as can fighting in Ukraine in the wake of Biden’s new defense agreement and second package of military aid. China’s actual stimulus was much larger than shown in Chart 7 above because it mostly consisted of a surge in state-controlled bank lending. China is likely to ease monetary and fiscal policy on the margin over the coming 12 months to secure the recovery in time for the national party congress in 2022. But China’s regulatory crackdown will continue during that time and our GeoRisk Indicator clearly shows the uptick in risk this year (Appendix). Chart 13China Expands Unionization? China Expands Unionization? China Expands Unionization? The regulatory crackdown is part of a cyclical consolidation of Xi Jinping’s power as well as a broader, secular trend of reasserting Communist Party and centralization in China. The latest developments underscore our view that investors should not play any technical rebound in Chinese equities. The increase in censorship of financial media is especially troubling. Just as the government struggles to deal with systemic financial problems (e.g. the failing property giant Evergrande, a possible “Lehman moment”), the lack of transparency and information asymmetry will get worse. The media is focusing on the government’s interventions into public morality, setting a “correct beauty standard” for entertainers and limiting kids to three hours of video games per week. But for investors what matters is that the regulatory crackdown is proceeding to the medical sector. High health costs (like high housing and education costs) are another target of the Xi administration in trying to increase popular support and legitimacy. Central government-mandated unionization in tech companies will hurt the tech sector without promoting social stability. Chinese unions do not operate like those in the West and are unlikely ever to do so. If they did, it would compound the preexisting structural problem of rising wages (Chart 13). Wages are forcing an economic transition onto Beijing, which raises systemic risks permanently across all sectors. Bottom Line: Political and geopolitical risk are still elevated in China and Russia. China will ease monetary and fiscal policy gradually over the coming year but the regulatory crackdown will persist at least until the 2022 political reshuffle. Afghanistan: The Refugee Fallout September 2021 will officially mark the beginning of Taliban’s second bout of power in Afghanistan. Will Afghanistan be the only country to spawn an outflux of refugees? Will the Taliban wresting power in Afghanistan trigger another refugee crisis for Europe? How is the rise of the Taliban likely to affect geopolitics in South Asia? Will Afghanistan Be The Last Major Country To Spawn Refugees? Absolutely not. We expect regime failures to affect the global economy over the next few years. The global growth engine functions asymmetrically and is powered only by a fistful of countries. As economic growth in poor countries fails to keep pace with that of top performers, institutional turmoil is bound to follow. This trend will only add to the growing problem of refugees that the world has seen in the post-WWII era. History suggests that the number of refugees in the world at any point in time is a function of economic prosperity (or the lack thereof) in poorer continents (Chart 14). For instance, the periods spanning 1980-90 and 2015-20 saw the world’s poorer continents lose their share in global GDP. Unsurprisingly these phases also saw a marked increase in the number of refugees. With the world’s poorer continents expected to lose share in global GDP again going forward, the number of refugees in the world will only rise. Chart 14Refugee Flows Rise When Growth Weak In Poor Continents Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Citizens of Syria, Venezuela, Afghanistan, South Sudan, and Myanmar today account for two-thirds of all refugees globally. To start with, these five countries’ share in global GDP was low at 0.8% in the 1980s. Now their share in global GDP is set to fall to 0.2% over the next five years (Chart 15). Chart 15Refugee Exporters Hit All-Time Low In Global GDP Share Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Per capita incomes in top refugee source countries tend to be very low. Whilst regime fractures appear to be the proximate cause of refugee outflux, an economic collapse is probably the root cause of the civil strife and waves of refugee movement seen out of the top refugee source countries. Another factor that could have a bearing is the rise of multipolarity. Shifting power structures in the global economy affect the stability of regimes with weak institutions. Instability in Afghanistan has been a direct result of the rise and the fall of the British and Russian empires. American imperial overreach is just the latest episode. If another Middle Eastern war erupts, the implications are obvious. But so too are the implications of US-China proxy wars in Southeast Asia or Russia-West proxy wars in eastern Europe. Bottom Line: With poorer continents’ economic prospects likely to remain weak and with multipolarity here to stay, the world’s refugee problem is here to stay too. Is A Repeat Of 2015 Refugee Crisis Likely In 2021? No. 2021 will not be a replica of 2015. This is owing to two key reasons. First, Afghanistan has long witnessed a steady outflow of refugees – especially at the end of the twentieth century but also throughout the US’s 20-year war there. The magnitude of the refugee problem in 2021 will be significantly smaller than that in 2015. Secondly, voters are now differentiating between immigrants and refugees with the latter entity gaining greater acceptance (Chart 16). Chart 16DM Attitudes Permissive Toward Refugees Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Chart 17Refugees Will Not Change Game In German/French Elections Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Concerns about refugees will gain some political traction but it will reinforce rather than upset the current trajectory in the most important upcoming elections, in Germany in September and France next April. True, these countries feature in the list of top countries to which Afghan refugees flee and will see some political backlash (Chart 17). But the outcome may be counterintuitive. In the German election, any boost to the far-right will underscore the likely underperformance of the ruling Christian Democrats. So the German elections will produce a left-wing surprise – and yet, even if the Greens won the chancellorship (the true surprise scenario, looking much less likely now), investors will cheer the pro-Europe and pro-fiscal result. The French election is overcrowded with right-wing candidates, both center-right and far-right, giving President Macron the ability to pivot to the left to reinforce his incumbent advantage next spring. Again, the euro and the equity market will rise on the status quo despite the political risk shown in our indicator (Appendix). Of course, immigration and refugees will cause shocks to European politics in future, especially as more regime failures in the third world take place to add to Afghanistan and Ethiopia. But in the short run they are likely to reinforce the fact that European politics are an oasis of stability given what is happening in the US, China, Brazil, and even Russia and India. Bottom Line: 2021 will not see a repeat of the 2015 refugee crisis. Ironically Afghan refugees could reinforce European integration in both German and French elections. The magnitude of the Afghan crisis is smaller than in the past and most Afghan refugees are likely to migrate to Pakistan and Iran (Chart 17). But more regime failures will ensure that the flow of people becomes a political risk again sometime in the future. What Does The Rise Of Taliban Mean For India? The Taliban first held power in Afghanistan from 1996-2001. This was one of the most fraught geopolitical periods in South Asia since the 1970s. Now optimists argue that Taliban 2.0 is different. Taliban leaders are engaging in discussions with an ex-president who was backed by America and making positive overtures towards India. So, will this time be different? It is worth noting that Taliban 2.0 will have to function within two major constraints. First, Afghanistan is deeply divided and diverse. Afghanistan’s national anthem refers to fourteen ethnic groups. Running a stable government is inherently challenging in this mountainous country. With Taliban being dominated by one ethnic group and with limited financial resources at hand, the Taliban will continue to use brute force to keep competing political groups at bay. Chart 18Taliban In Line With Afghanis On Sharia Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) At the same time, to maintain legitimacy and power, the Taliban will have to support aligned political groups operating in Afghanistan and neighboring Pakistan. Second, an overwhelming majority of Afghani citizens want Sharia law, i.e. a legal code based on Islamic scripture as the official law of the land (Chart 18). Hence if the Taliban enforces a Sharia-based legal system in Afghanistan then it will fall in line with what the broader population demands. It is against this backdrop that Taliban 2.0 is bound to have several similarities with the version that ruled from 1996-2001. Additionally, US withdrawal from Afghanistan will revive a range of latent terrorist movements in the region. This poses risks for outside countries, not least India, which has a long history of being targeted by Afghani terrorist groups. The US will remain engaged in counter-terrorism operations. To complicate matters, India’s North has an even more unfavorable view of Pakistan than the rest of India. With the northern voter’s importance rising, India’s administration may be forced to respond more aggressively to a terrorist event than would have been the case about a decade ago. It is also possible that terrorism will strike at China over time given its treatment of Uighur Muslims in Xinjiang. China’s economic footprint in Afghanistan could precipitate such a shift. Bottom Line: US withdrawal from Afghanistan is bound to add to geopolitical risks as latent terrorist forces will be activated. India has a long history of being targeted by Afghani terrorist movements. Incidentally, it will take time for transnational terrorism based in Afghanistan to mount successful attacks at the West once again, given that western intelligence services are more aware of the problem than they were in 2000. But non-state actors may regain the element of surprise over time, given that the western powers are increasingly focused on state-to-state struggle in a new era of great power competition.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Section II: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator United Kingdom UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights China’s July Politburo meeting signaled that policy is unlikely to be overtightened. The Biden administration is likely to pass a bipartisan infrastructure deal – as well as a large spending bill by Christmas. Geopolitical risk in the Middle East will rise as Iran’s new hawkish president stakes out an aggressive position. US-Iran talks just got longer and more complicated. Europe’s relatively low political risk is still a boon for regional assets. However, Russia could still deal negative surprises given its restive domestic politics. Japan will see a rise in political turmoil after the Olympic games but national policy is firmly set on the path that Shinzo Abe blazed. Stay long yen as a tactical hedge. Feature Chart 1Rising Hospitalizations Cause Near-Term Jitters, But UK Rolling Over? China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Our key view of 2021, that China would verge on overtightening policy but would retreat from such a mistake to preserve its economic recovery, looks to be confirmed after the Politburo’s July meeting opened the way for easier policy in the coming months. Meanwhile the Biden administration is likely to secure a bipartisan infrastructure package and push through a large expansion of the social safety net, further securing the American recovery. Growth and stimulus have peaked in both the US and China but these government actions should keep growth supported at a reasonable level and dispel disinflationary fears. This backdrop should support our pro-cyclical, reflationary trade recommendations in the second half of the year. Jitters continue over COVID-19 variants but new cases have tentatively peaked in the UK, US vaccinations are picking up, and death rates are a lot lower now than they were last year, that is, prior to widescale vaccination (Chart 1). This week we are taking a pause to address some of the very good client questions we have received in recent weeks, ranging from our key views of the year to our outstanding investment recommendations. We hope you find the answers insightful. Will Biden’s Infrastructure Bill Disappoint? Ten Republicans are now slated to join 50 Democrats in the Senate to pass a $1 trillion infrastructure bill that consists of $550 billion in new spending over a ten-year period (Table 1). The deal is not certain to pass and it is ostensibly smaller than Biden’s proposal. But Democrats still have the ability to pass a mammoth spending bill this fall. So the bipartisan bill should not be seen as a disappointment with regard to US fiscal policy or projections. The Republicans appear to have the votes for this bipartisan deal. Traditional infrastructure – including broadband internet – has large popular support, especially when not coupled with tax hikes, as is the case here. Both Biden and Trump ran on a ticket of big infra spending. However, political polarization is still at historic peaks so it is possible the deal could collapse despite the strong signs in the media that it will pass. Going forward, the sense of crisis will dissipate and Republicans will take a more oppositional stance. The Democratic Congress will pass President Joe Biden’s signature reconciliation bill this fall, another dollop of massive spending, without a single Republican vote (Chart 2). After that, fiscal policy will probably be frozen in place through at least 2025. Campaigning will begin for the 2022 midterm elections, which makes major new legislation unlikely in 2022, and congressional gridlock is the likely result of the midterm. Republicans will revert to belt tightening until they gain full control of government or a new global crisis erupts. Table 1Bipartisan Infrastructure Bill Likely To Pass China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 2Reconciliation Bill Also Likely To Pass China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 3Biden Cannot Spare A Single Vote In Senate China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Hence the legislative battle over the reconciliation bill this fall will be the biggest domestic battle of the Biden presidency. The 2021 budget reconciliation bill, based on a $3.5 trillion budget resolution agreed by Democrats in July, will incorporate parts of the American Jobs Plan that did not pass via bipartisan vote (such as $436 billion in green energy subsidies), plus a large expansion of social welfare, the American Families Plan. This bill will likely pass by Christmas but Democrats have only a one-seat margin in the Senate, which means our conviction level must be medium, or subjectively about 65%. The process will be rocky and uncertain (Chart 3). Moderate Democratic senators will ultimately vote with their party because if they do not they will effectively sink the Biden presidency and fan the flames of populist rebellion. US budget deficit projections in Chart 4 show the current status quo, plus scenarios in which we add the bipartisan infra deal, the reconciliation bill, and the reconciliation bill sans tax hikes. The only significant surprise would be if the reconciliation bill passed shorn of tax hikes, which would reduce the fiscal drag by 1% of GDP next year and in coming years. Chart 4APassing Both A Bipartisan Infrastructure Bill And A Reconciliation Bill Cannot Avoid Fiscal Cliff In 2022 … China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 4B… The Only Major Fiscal Surprise Would Come If Tax Hikes Were Excluded From This Fall’s Reconciliation Bill China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 5Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing There are two implications. First, government support for the economy has taken a significant step up as a result of the pandemic and election in 2020. There is no fiscal austerity, unlike in 2011-16. Second, a fiscal cliff looms in 2022 regardless of whether Biden’s reconciliation bill passes, although the private economy should continue to recover on the back of vaccines and strong consumer sentiment. This is a temporary problem given the first point. Monetary policy has a better chance of normalizing at some point if fiscal policy delivers as expected. But the Federal Reserve will still be exceedingly careful about resuming rate hikes. President Biden could well announce that he will replace Chairman Powell in the coming months, delivering a marginally dovish surprise (otherwise Biden runs the risk that Powell will be too hawkish in 2022-23). Inflation will abate in the short run but remain a risk over the long run. Essentially the outlook for US equities is still positive for H2 but clouds are forming on the horizon due to peak fiscal stimulus, tax hikes in the reconciliation bill, eventual Fed rate hikes (conceivably 2022, likely 2023), and the fact that US and Chinese growth has peaked while global growth is soon to peak as well. All of these factors point toward a transition phase in global financial markets until economies find stable growth in the post-pandemic, post-stimulus era. Investors will buy the rumor and sell the news of Biden’s multi-trillion reconciliation bill in H2. The bill is largely priced out at the moment due to China’s policy tightening (Chart 5). The next section of this report suggests that China’s policy will ease on the margin over the coming 12 months. Bottom Line: US fiscal policy is delivering, not disappointing. Congress is likely to pass a large reconciliation bill by Christmas, despite no buffer in the Senate, because Democratic Senators know that the Biden presidency hangs in the balance. China’s Khodorkovsky Moment? Many clients have asked whether China’s crackdown on private business, from tech to education, is the country’s “Khodorkovsky moment,” i.e. the point at which Beijing converts into a full, autocratic regime where private enterprise is permanently impaired because it is subject to arbitrary seizure and control of the state. The answer is yes, with caveats. Yes, China’s government is taking a more aggressive, nationalist, and illiberal stance that will permanently impair private business and investor sentiment. But no, this process did not begin overnight and will not proceed in a straight line. There is a cyclical aspect that different investors will have to approach differently. First a reminder of the original Khodorkovsky moment. After the Soviet Union’s collapse, extremely wealthy oligarchs emerged who benefited from the privatization of state assets. When President Putin began to reassert the primacy of the state, he arbitrarily imprisoned Khodorkovsky and dismantled his corporate energy empire, Yukos, giving the spoils to state-owned companies. Russia is a petro state so Putin’s control of the energy sector would be critical for government revenues and strategic resurgence, especially at the dawn of a commodity boom. Both the RUB-USD and Russian equity relative performance performed mostly in line with global crude oil prices, as befits Russia’s economy, even though there was a powerful (geo)political risk premium injected during these two decades due to Russia’s centralization of power and clash with the West (Chart 6). Investors could tactically play the rallies after Khodorkovsky but the general trend depended on the commodity cycle and the secular rise of geopolitical risk. Chart 6Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer President Xi Jinping is a strongman and hardliner, like Putin, but his mission is to prevent Communist China from collapsing like the Soviet Union, rather than to revive it from its ashes. To that end he must reassert the state while trying to sustain the country’s current high level of economic competitiveness. Since China is a complex economy, not a petro state, this requires the state-backed pursuit of science, technology, competitiveness, and productivity to avoid collapse. Therefore Beijing wants to control but not smother the tech companies. Hence there is a cyclical factor to China’s regulatory crackdown. A crackdown on President Xi Jinping’s potential rivals or powerful figures was always very likely to occur ahead of the Communist Party’s five-year personnel reshuffle in 2022, as we argued prior to tech exec Jack Ma’s disappearance. Sackings of high-level figures have happened around every five-year leadership rotation. Similarly a crackdown on the media was expected. True, the pre-party congress crackdowns are different this time around as they are targeted at the private sector, innovative businesses, tech, and social media. Nevertheless, as in the past, a policy easing phase will follow the tightening phase so as to preserve the economy and the mobilization of private capital for strategic purposes. The critical cyclical factor for global investors is China’s monetary and credit impulse. For example, the crackdown on the financial sector ahead of the national party congress in 2017 caused a global manufacturing slowdown because it tightened credit for the entire Chinese economy, reducing imports from abroad. One reason Chinese markets sold off so heavily this spring and summer, was that macroeconomic indicators began decelerating, leaving nothing for investors to sink their teeth into except communism. The latest Politburo meeting suggests that monetary, fiscal, and regulatory policy is likely to get easier, or at least stay just as easy, going forward (Table 2). Once again, the month of July has proved an inflection point in central economic policy. Financial markets can now look forward to a cyclical easing in regulation combined with easing in monetary and fiscal policy over the next 12-24 months. Table 2China’s Politburo Prepares To Ease Policy, Secure Recovery China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Despite all of the above, for global investors with a lengthy time horizon, the government’s crackdown points to a secular rise of Communist and Big Government interventionism into the economy, with negative ramifications for China’s private sector, economic freedoms, and attractiveness as a destination for foreign investment. The arbitrary and absolutist nature of its advances will be anathema to long-term global capital. Also, social media, unlike other tech firms, pose potential sociopolitical risks and may not boost productivity much, whereas the government wants to promote new manufacturing, materials, energy, electric vehicles, medicine, and other tradable goods. So while Beijing cannot afford to crush the tech sector, it can afford to crush some social media firms. Chart 7China's Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China's Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China's Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China’s equity market profile looks conspicuously like Russia’s at the time of Khodorkovsky’s arrest (Chart 7). Chinese renminbi has underperformed the dollar on a multi-year basis since Xi Jinping’s rise to power, in line with falling export prices and slowing economic growth, as a result of economic structural change and the administration’s rolling back Deng Xiaoping’s liberal reform era. We expect a cyclical rebound to occur but we do not recommend playing it. Instead we recommend other cyclical plays as China eases policy, particularly in European equities and US-linked emerging markets like Mexico. Bottom Line: The twentieth national party congress in 2022 is a critical political event that is motivating a cyclical crackdown on potential rivals to Communist Party power. Chinese equities will temporarily bounce back, especially with a better prospect for monetary and fiscal easing. But over the long run global investors should stay focused on the secular decline of China’s economic freedoms and hence productivity. What Happened To The US-Iran Deal? Our second key view for 2021 was the US strategic rotation from the Middle East and South Asia to Asia Pacific. This rotation is visible in the Biden administration’s attempt to withdraw from Iraq and Afghanistan while rejoining the 2015 nuclear deal with Iran. However, Biden here faces challenges that will become very high profile in the coming months. The Biden administration failed to rejoin the 2015 deal under the outgoing leadership of the reformist President Hassan Rouhani. This means a new and much more difficult negotiation process will now begin that could last through Biden’s term or beyond. On August 5, President Ebrahim Raisi will take office with an aggressive flourish. The US is already blaming Iran for an act of sabotage in the Persian Gulf that killed one Romanian and one Briton. Raisi will need to establish that he is not a toady, will not cower before the West. The new Israeli government of Prime Minister Naftali Bennett also needs to demonstrate that despite the fall of his hawkish predecessor Benjamin Netanyahu, Jerusalem is willing and able to uphold Israel’s red lines against Iranian nuclear weaponization and regional terrorism. Hence both Iran and its regional rivals, including Saudi Arabia, will rattle sabers and underscore their red lines. The Persian Gulf and Strait of Hormuz will be subject to threats and attacks in the coming months that could escalate dramatically, posing a risk of oil supply disruptions. Given that the Iranians ultimately do want a deal with the Americans, the pressure should be low-to-medium level and persistent, hence inflationary, as opposed to say a lengthy shutdown of the Strait of Hormuz that would cause a giant spike in prices that ultimately kills global demand. Short term, the US attempt to reduce its commitments in Iraq and Afghanistan will invite US enemies to harass or embarrass the Biden administration. The Taliban is likely to retake control of Afghanistan. The US exit will resemble Saigon in 1975. This will be a black eye for the Biden administration. But public opinion and US grand strategy will urge Biden to be rid of the war. So any delays, or a decision to retain low-key sustained troop presence, will not change the big picture of US withdrawal. Long term, Biden needs to pivot to Asia, while President Raisi is ultimately subject to the Supreme Leader Ali Khamenei, who wants to secure Iran’s domestic stability and his own eventual leadership succession. Rejoining the 2015 nuclear deal leads to sanctions relief, without requiring total abandonment of a nuclear program that could someday be weaponized, so Iran will ultimately agree. The problem will then become the regional rise of Iranian power and the balancing act that the US will have to maintain with its allies to keep Iran contained. Bottom Line: The risk to oil prices lies to the upside until a US-Iran deal comes together. The US and Iran still have a shared interest in rejoining the 2015 deal but the time frame is now delayed for months if not years. We still expect a US-Iran deal eventually but previously we had anticipated a rapid deal that would put downward pressure on oil prices in the second half of the year. What Comes After Biden’s White Flag On Nord Stream II? Our third key view for 2021 highlighted Europe’s positive geopolitical and macro backdrop. This view is correct so far, especially given that China’s policymakers are now more likely to ease policy going forward. But Russia could still upset the view. Italy has been the weak link in European integration over the past decade (excluding the UK). So the national unity coalition that has taken shape under Prime Minister Mario Draghi exemplifies the way in which political risks were overrated. Italy is now the government that has benefited the most from the overall COVID crisis in public opinion (Chart 8). The same chart shows that the German government also improved its public standing, although mostly because outgoing Chancellor Angela Merkel is exiting on a high note. Her Christian Democrat-led coalition has not seen a comparable increase in support. The Greens should outperform their opinion polling in the federal election on September 26. But the same polling suggests that the Greens will be constrained within a ruling coalition (Chart 9). The result will be larger spending without the ability to raise taxes substantially. Markets will cheer a fiscally dovish and pro-European ruling coalition. Chart 8European Political Risk Limited, But Rising, Post-COVID China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients The chief risk to this view of low EU political risk comes from Russia. Russia is a state in long-term decline due to the remorseless fall in fertility and productivity. The result has been foreign policy aggression as President Putin attempts to fortify the country’s strategic position and frontiers ahead of an even bleaker future. Chart 9German Election Polls Point To Gridlock? German Election Polls Point To Gridlock? German Election Polls Point To Gridlock? Now domestic political unrest has grown after a decade of policy austerity and the COVID-19 pandemic. Elections for the Duma will be held on September 19 and will serve as the proximate cause for Russia’s next round of unrest and police repression. Foreign aggressiveness may be used to distract the population from the pandemic and poor economy. We have argued that there would not be a diplomatic reset for the US and Russia on par with the reset of 2009-11. We stand by this view but so far it is facing challenges. Putin did not re-invade Ukraine this spring and Biden did not impose tough sanctions canceling the construction of the Nord Stream II gas pipeline to Germany. Russia is tentatively cooperating on the US’s talks with Iran and withdrawal from Afghanistan. The US gave Germany and Russia a free point by condoning the NordStream II. Now the US will expect Germany to take a tough diplomatic line on Russian and Chinese aggression, while expecting Russia to give the US some goodwill in return. They may not deliver. The makeup of the new German coalition will have some impact on its foreign policy trajectory in the coming years. But the last thing that any German government wants is to be thrust into a new cold war that divides the country down the middle. Exports make up 36% of German output, and exports to the Russian and Chinese spheres account for a substantial share of total exports (Chart 10). The US administration prioritizes multilateralism above transactional benefits so the Germans will not suffer any blowback from the Americans for remaining engaged with Russia and China, at least not anytime soon. Russia, on the other hand, may feel a need to seize the moment and make strategic gains in its region, despite Biden’s diplomatic overtures. If the US wraps up its forever wars, Russia’s window of opportunity closes. So Russia may be forced to act sooner rather than later, whether in suppressing domestic dissent, intimidating or attacking its neighbors, or hacking into US digital networks. In the aftermath of the German and Russian elections, we will reassess the risk from Russia. But our strong conviction is that neither Russian nor American strategy have changed and therefore new conflicts are looming. Therefore we prefer developed market European equities and we do not recommend investors take part in the Russian equity rally. Chart 10Germany Opposes New Cold War With Russia Or China China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Bottom Line: German and European equities should benefit from global vaccination, Biden’s fiscal and foreign policies, and China’s marginal policy easing (Chart 11). Eastern European emerging markets and Russian assets are riskier than they appear because of latent geopolitical tensions that could explode around the time of important elections in September. Chart 11Geopolitical Tailwinds To European Equities Geopolitical Tailwinds To European Equities Geopolitical Tailwinds To European Equities What Comes After The Olympics In Japan? Japan is returning to an era of “revolving door” prime ministers. Prime Minister Yoshihide Suga’s sole purpose was to tie up the loose ends of the Shinzo Abe administration, namely by overseeing the Olympics. After the games end, he will struggle to retain leadership of the Liberal Democratic Party. He will be blamed for spread of Delta variant even if the Olympics were not a major factor. If he somehow retains the party’s helm, the October general election will still be an underwhelming performance by the Liberal Democrats, which will sow the seeds of his downfall within a short time (Chart 12). Suga will need to launch a new fiscal spending package, possibly as an election gimmick, and his party has the strength in the Diet to push it through quickly, which will be favorable for the economy. For the elections the problem is not the Liberal Democrats’ popularity, which is still leagues above the nearest competitor, but rather low enthusiasm and backlash over COVID. Abe’s retirement, and the eventual fall of Abe’s hand-picked deputy, does not entail the loss of Abenomics. The Bank of Japan will retain its ultra-dovish cast at least until Haruhiko Kuroda steps down in 2023. The changes that occurred in Japan from 2008-12 exemplified Japan’s existence as an “earthquake society” that undergoes drastic national changes suddenly and rapidly. The paradigm shift will not be reversed. The drivers were the Great Recession, the LDP’s brief stint in the political wilderness, the Tohoku earthquake and Fukushima nuclear crisis, and the rise of China. The BoJ became ultra-dovish and unorthodox, the LDP became more proactive both at home and abroad. The deflationary economic backdrop and Chinese nationalism are still a powerful impetus for these trends to continue – as highlighted by increasingly alarming rhetoric by Japanese officials, including now Shinzo Abe himself, regarding the Chinese military threat to Taiwan. In other words, Suga’s lack of leadership will not stand even if he somehow stays prime minister into 2022. The Liberal Democrats have several potential leaders waiting in the wings and one of these will emerge, whether Yuriko Koike, Shigeru Ishiba, or Shinjiro Koizumi, or someone else. The popular and geopolitical pressures will force the Liberal Democrats and various institutions to continue providing accommodation to the economy and bulking up the nation’s defenses. This will require the BoJ to stay easier for longer and possibly to roll out new unorthodox policies, as with yield curve control in the 2010s. Japan has some of the highest real rates in the G10 as a result of very low inflation expectations and a deeply negative output gap (Chart 13). Abenomics was bearing fruit, prior to COVID-19, so it will be justified to stay the course given that deflation has reemerged as a threat once again. Chart 12Japan: Back To Revolving Door Of Prime Ministers China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 13Japan To Keep Fighting Deflation Post-Abe Japan To Keep Fighting Deflation Post-Abe Japan To Keep Fighting Deflation Post-Abe Bottom Line: The political and geopolitical backdrop for Japan is clear. The government and BoJ will have to do whatever it takes to stay the course on Abenomics even in the wake of Abe and Suga. Prime ministers will come and go in rapid succession, like in past eras of political turmoil, but the trajectory of national policy is set. We would favor JGBs relative to more high-beta government bonds like American and Canadian. Given deflation, looming Japanese political turmoil, and the secular rise in geopolitical risk, we continue to recommend holding the yen. These views conform with those of BCA’s fixed income and forex strategists. Investment Takeaways China’s policymakers are backing away from the risk of overtightening policy this year. Policy should ease on the margin going forward. Our number one key forecast for 2021 is tentatively confirmed. Base metals are still overextended but global reflation trades should be able to grind higher. The US fiscal spending orgy will continue through the end of the year via Biden’s reconciliation bill, which we expect to pass. Proactive DM fiscal policy will continue to dispel disinflationary fears. Sparks will fly in the Middle East. The US-Iran negotiations will now be long and drawn out with occasional shows of force that highlight the tail risk of war. We expect geopolitics to add a risk premium to oil prices at least until the two countries can rejoin the 2015 nuclear deal. Germany’s Green Party will surprise to the upside in elections, highlighting Europe’s low level of geopolitical risk. China policy easing is positive for European assets. Russia’s outward aggressiveness is the key risk.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

Highlights Portfolio Duration: The decline in US bond yields is overdone. We anticipate that strong US employment data will catalyze a jump in bond yields this fall and that the 10-year US Treasury yield will reach a range of 2% - 2.25% by the time that the Fed is ready to lift rates, likely by the end of 2022. Maintain below-benchmark duration in bond portfolios. US Yield Curve: Investors should position for a rebound in bond yields but not a reversal of recent US Treasury curve flattening. In fact, we advocate owning 2/10 flatteners on the US Treasury curve as we see ample room for further curve flattening as Fed rate hikes approach in late-2022. ECB: The ECB’s new forward interest rate guidance has moved it that much closer to the Fed’s ultra-accommodative stance. This reinforces the defensive nature of the European bond market. Investors should overweight European bonds within global fixed income portfolios with a particular emphasis on peripheral European bond markets like Italy and Spain. Feature Chart 1Can The Bond Rally Continue? Can The Bond Rally Continue? Can The Bond Rally Continue? The bond rally continues to rip. The selloff that started last August when Jay Powell officially announced the Federal Reserve’s adoption of an Average Inflation Target ended on March 31st 2021. Since then, the 10-year US Treasury yield has retraced from 1.74% to 1.29% and the Bloomberg Barclays US Treasury index has clawed back 285 bps of excess return versus cash, partially offsetting the 465 bps that were lost between August 2020 and March 2021 (Chart 1). The US Bond Strategy Weekly Report from two weeks ago and last week’s Global Fixed Income Strategy Weekly Report both discuss the reasons for recent bond market strength.1 We won’t re-hash those arguments this week except to reiterate our conclusion that the decline in US bond yields is overdone. We anticipate that strong US employment data will catalyze a jump in bond yields this fall and that the 10-year US Treasury yield will reach a range of 2% - 2.25% by the time that the Fed is ready to lift rates, likely by the end of 2022. The first section of this week’s report looks at whether correlations between different asset classes have held up during the recent bond rally, with a focus on whether those relationships give us any information about the near-term direction for bond yields. The second section considers the outlook for the slope of the US Treasury curve and the third section discusses the recently released results of the European Central Bank’s strategy review. Cross-Market Correlations During The Bond Rally The bond rally has been just as intense as the prior sell-off. The US Treasury index has outperformed a position in cash by an annualized 9% since March 31st, matching the annualized losses of 9% seen between August 2020 and March 2021 (Chart 2). An important question to answer is whether this bond market performance is consistent with other asset classes. If it is, then it may suggest that the economy is experiencing a deflationary episode and that bond yields have further downside. If it isn’t, then it is more likely that the drop in bond yields will be temporary. Chart 2Bonds Versus Credit And Equities Bonds Versus Credit And Equities Bonds Versus Credit And Equities Bonds Versus Equities And Corporate Credit Chart 3Equity Sector Performance Consistent With Yields Equity Sector Performance Consistent With Yields Equity Sector Performance Consistent With Yields Looking first at corporate bonds, we find that – consistent with stronger Treasury performance – excess US corporate bond returns have slowed since March 31st. Baa-rated corporates have been outperforming at an annualized rate of 3% since March 31st compared to an annualized rate of 12% between August 2020 and March 2021 (Chart 2, panel 2). Equities, on the other hand, have maintained their strong performance. The S&P 500 returned an annualized 30% between August 2020 and March 2021 and has returned an even greater 42% (annualized) since the end of March (Chart 2, panel 3). Extremely tight spreads are the most likely explanation for lower corporate bond excess returns. Meanwhile, the fact that equities continue to perform well is an indication that the drop in bond yields may be overdone. Interestingly, while overall equity returns haven’t dropped in line with bond yields, the relative performance of equity sectors has been totally consistent with the movement in yields (Chart 3). Cyclical equity sectors (Industrials, Energy and Materials) have underperformed defensive equity sectors (Healthcare, Telecoms, Consumer Staples and Utilities) and Banks have underperformed the overall index. The correlation between long-maturity real Treasury yields and the relative performance of value and growth stocks has also held up, with growth stocks outperforming since the end of March (Chart 3, bottom panel). Bonds Versus Commodities Chart 4Commodities And Bonds Have Diverged Commodities And Bonds Have Diverged Commodities And Bonds Have Diverged We see the biggest divergence in relative performance between bond yields and commodities. Historically, the ratio between the CRB Raw Industrials commodity price index and Gold is tightly correlated with the 10-year US Treasury yield. However, the CRB/Gold ratio has increased since the end of March while bond yields have fallen (Chart 4). In our view, this is the strongest piece of evidence suggesting that bond yields have overshot to the downside. Bonds Versus Currencies Chart 5Bonds Versus Currencies Bonds Versus Currencies Bonds Versus Currencies Finally, we observe that the US dollar has strengthened as bond yields have dropped. This is not that unusual. There are other periods when significant declines in US bond yields have coincided with dollar strength, 2019 and 2014/15 immediately come to mind (Chart 5). The common theme of those prior episodes is that the global economy was experiencing a deflationary shock. Commodity prices also fell during those periods and Emerging Market (EM) currencies depreciated versus the dollar. However, so far this year, EM currencies have held firm versus the dollar (Chart 5, bottom panel) and commodity prices continue to rise. On balance, financial markets don’t appear to be pricing-in a deflationary economic shock. In summary, since US Treasury yields peaked on March 31st, we have observed a sector rotation within US equities, but overall stock market performance has been strong. Corporate bonds continue to outperform Treasuries, though gains are limited by tight valuations. Commodity prices have held up and while the US dollar has firmed, dollar strength has not bled into EM currency weakness. All in all, we don’t view financial market performance as consistent with a deflationary economic episode. This suggests that bond yields are an outlier within the financial landscape and that the recent drop in yields won’t persist. A Quick Word On Sentiment And Positioning Chart 6A Rebound In Yields May Require A Shift In Sentiment A Rebound In Yields May Require A Shift In Sentiment A Rebound In Yields May Require A Shift In Sentiment One possible reason why bond performance has been inconsistent with some other markets is that there had simply been too much consensus around the “bond-bearish trade”. It’s certainly true that portfolio managers have been running large net-short positions and that the MarketVane survey of bond bullish sentiment is much less bullish than it was last year (Chart 6). We suspect that we may need to see bond market positioning and sentiment get more bullish before yields move meaningfully higher. Chart 6 shows that major troughs in the 30-year US Treasury yield often occur when portfolio manager positioning is “net long” bonds and when bond bullish sentiment is significantly higher than current levels. For this reason, we don’t anticipate an immediate rebound in bond yields. Rather, we suspect that yields will remain near current levels for the next month or two before strong employment data in the fall sets off the next phase of bearish bond action.   Position For A Rebound In Bond Yields, But Don’t Expect Much Curve Steepening Chart 7The 5-Year/5-Year Yield Remains Close To Target The 5-Year/5-Year Yield Remains Close To Target The 5-Year/5-Year Yield Remains Close To Target We see bond yields re-gaining their March 2021 highs, and then some, on a 6-12 month investment horizon. However, we don’t think this rebound in yields will coincide with a significant re-steepening of the US Treasury curve. For context, the 2/10 US Treasury slope peaked at 159 bps near the end of March. It is currently 51 bps lower, at 108 bps. We can categorize periods of yield curve steepening as falling into two categories. Bull-steepening: The curve steepens as yields fall. This tends to occur when the Fed is cutting interest rates. Bear-steepening: The curve steepens as yields rise. We can identify these periods as being when the 5-year/5-year forward Treasury yield rises from low levels toward its fair value range. Since 2012, we can identify a fair value range for the 5-year/5-year forward US Treasury yield using survey estimates of the long-run neutral fed funds rate. At present, the fair value range from the New York Fed’s Survey of Primary Dealers is from 2.06% to 2.50%, with a median of 2.31%. The fair value range from the New York Fed’s Survey of Market Participants is from 1.75% to 2.50%, with a median of 2.00%. The 5-year/5-year forward US Treasury yield is currently 1.93% (Chart 7). We identify seven significant periods of 2/10 Treasury curve steepening since 2009 (Table 1). Six of those episodes were bear-steepening episodes that coincided with an increase in the 5-year/5-year yield, the other was a bull-steepening episode that coincided with Fed rate cuts in 2019/20. If we assume that our fair value ranges provide a reasonable target for how high the 5-year/5-year forward US Treasury yield can rise during the next bear-steepening move, it means that – at most – we could see an increase of 57 bps in the 5-year/5-year yield as it moves all the way up to the 2.50% top-end of our target ranges. A linear regression of changes in the 2/10 slope versus changes in the 5-year/5-year forward yield during the six bear-steepening episodes we identified suggests that a 57 bps increase in the 5-year/5-year yield would lead to 12 bps of 2/10 curve steepening (Chart 8). In fact, we can see in both Table 1 and Chart 8 that it would take about 100 bps of upside in the 5-year/5-year yield to bring the 2/10 slope back to its March highs. This is extremely unlikely. Table 1Periods Of US Treasury Curve Steepening In The Zero-Lower-Bound Era A Bump On The Road To Recovery A Bump On The Road To Recovery Chart 8Bear-Steepening Episodes Since 2009 A Bump On The Road To Recovery A Bump On The Road To Recovery   In fact, if the 5-year/5-year forward Treasury yield only rises back to the middle of its fair value range – somewhere between 2% and 2.31% - then our regression suggests that the yield curve slope will probably stay close to its current level. The bottom line is that while investors should position for a rebound in bond yields by keeping portfolio duration low, they should avoid US Treasury curve steepeners. In fact, we advocate owning 2/10 flatteners on the US Treasury curve as we see ample room for further curve flattening as Fed rate hikes approach in late-2022. The ECB’s New Guidance Solidifies The Defensive Nature Of European Bonds Last week, the European Central Bank (ECB) revised its forward rate guidance in light of its recently concluded Strategy Review.2 The ECB’s new rate guidance is as follows: In support of its symmetric two per cent inflation target and in line with its monetary policy strategy, the Governing Council expects the key ECB interest rates to remain at their present or lower levels until it sees inflation reaching two per cent well ahead of the end of its projection horizon and durably for the rest of the projection horizon, and it judges that realised progress in underlying inflation is sufficiently advanced to be consistent with inflation stabilising at two per cent over the medium term. This may also imply a transitory period in which inflation is moderately above target.3   This may sound familiar, and it should. Though not explicitly an Average Inflation Target, the ECB has moved a long way toward the Federal Reserve’s new dovish reaction function. Specifically, both the ECB and Federal Reserve now acknowledge that a temporary period of above-2% inflation will be tolerated, if not explicitly sought. Also, both central banks have linked the timing of the first rate increase to some form of outcome-based forward guidance. The Federal Reserve has explicitly said that it will not lift rates until inflation is above 2% and the economy has reached “maximum employment”. The ECB now claims that interest rates won’t rise until inflation is seen reaching 2% “well ahead of its projection horizon”, a criterion that Christine Lagarde described as having an element of outcome-based guidance.4 The ECB’s new forward guidance may not be as explicitly dovish as the Fed’s. The ECB has no “maximum employment” target and its inflation trigger for lifting rates still relies on the Governing Council’s forecasts. But for investors, the big signal is that the ECB has recognized that the risk of tightening policy prematurely is greater than the risk of remaining on hold for too long. This gives us even more confidence that there will be no ECB tightening on the horizon, and we should continue to view European bond markets as being highly defensive. This is hardly news. European bond markets performed relatively well during the bearish bond episode that lasted from August 2020 to March 2021, they have then gained less than cyclical bond markets (like US and Canada) since March (Table 2). The ECB’s new reaction function ensures that this relationship will remain place for many years to come. Table 27-10 Year Government Bond Returns (In USD, %) A Bump On The Road To Recovery A Bump On The Road To Recovery The new reaction function is also a boon for peripheral European bond markets (like Italy and Spain) where yields trade at a spread above German bunds. The ECB’s commitment to staying dovish will only reinforce the downward pressure on peripheral European bond spreads versus Germany (Chart 9). Chart 9Grab The Extra Spread In Spanish And Italian Bonds Grab The Extra Spread In Spanish And Italian Bonds Grab The Extra Spread In Spanish And Italian Bonds The bottom line is that investors should continue to overweight European bonds within global fixed income portfolios, with a particular emphasis on peripheral European bond markets like Italy and Spain. The defensive nature of European bonds will protect investors from losses during the next move higher in global yields. Italian and Spanish bond markets may not perform quite as well during the next bond bear market as they did between August 2020 and March 2021, as spreads have already compressed a lot. But ultra-accommodative ECB policy will limit the amount of spread widening that can occur, making any additional spread worth grabbing.  Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Overreaction”, dated July 13, 2021 and Global Fixed Income Strategy Weekly Report, “The Message From Falling US Bond Yields”, dated July 21, 2021. 2 The results of the Strategy Review itself are discussed in Global Fixed Income Strategy Weekly Report, “The Reflationary Backdrop Is Still In Place”, dated July 14, 2021. 3 https://www.ecb.europa.eu/press/pr/date/2021/html/ecb.mp210722~48dc3b436b.en.html 4 https://www.ecb.europa.eu/press/pressconf/2021/html/ecb.is210722~13e7f5e795.en.html Recommended Portfolio Specification Other Recommendations A Bump On The Road To Recovery A Bump On The Road To Recovery Treasury Index Returns A Bump On The Road To Recovery A Bump On The Road To Recovery Spread Product Returns A Bump On The Road To Recovery A Bump On The Road To Recovery

Highlights The US is withdrawing from the Middle East and South Asia and making a strategic pivot to Asia Pacific. The third quarter will see risks flare around Iran and the US rejoin the 2015 Iranian nuclear deal. The result is briefly negative for oil prices but the rise of Iran is a new geopolitical trend that will increase Middle Eastern risk over the long run. The geopolitical outlook is dollar bullish, while the macroeconomic outlook is getting less dollar-bearish due to China’s risk of over-tightening policy. Stay neutral USD and be wary of commodities and emerging markets in the third quarter. European political risk is bottoming. The German and French elections are at best minor risks. However, the continent is ripe for negative black swans, especially due to Russian aggression. Go tactically long global large caps and defensives. Feature Chart 1Three Key Views On Track (So Far) Three Key Views On Track (So Far) Three Key Views On Track (So Far) We chose “No Return To Normalcy” as the theme of our 2021 outlook. While the COVID-19 vaccine promised economic recovery, we argued that normalization would create complacency regarding fundamental changes that have taken place in the geopolitical environment. A contradiction between an improving macroeconomic backdrop and a foreboding geopolitical backdrop would develop in 2021 and beyond. The “reflation trade” has begun to lose steam as we go to press. However, global recovery will still be the dominant story in the second half of the year as vaccination spreads. The question for the third quarter and the rest of the year is whether reflation will continue. As a matter of forecasting, we think it will. But as a matter of investment strategy, we are taking a more defensive stance until China relaxes economic policy. In our annual outlook we highlighted three key geopolitical views: (1) China’s headwinds, both at home and abroad (2) US détente with Iran and pivot to Asia (3) Europe’s opportunity. All three trends are broadly on track and can be illustrated by looking at equity performance in the relevant regions for the year so far: Chinese stocks sold off, UAE stocks rallied, and European stocks rallied (Chart 1). However, these trends are not exclusively tied to absolute equity performance. The most important question is what happens to global growth and the US dollar as these three key views continue. Stay Neutral On The Dollar It paid off for us to maintain a neutral stance on the dollar. True, the global recovery and exorbitant US trade and budget deficits are bearish for the dollar and bullish for other currencies. But the greenback’s “counter-trend bounce” is proving more formidable than many investors expected. The fundamentals of the American economy and global position remain strong. Since the outbreak of COVID-19, the US has secured its recovery with fiscal policy, maintained rule of law amid a contested election, innovated and distributed vaccines, benefited from more flexible social restrictions, refurbished global alliances, and put pressure on its geopolitical rivals. In essence, the combined effect of President Trump’s and Biden’s policies has been to make America “great again” (Chart 2). From a geopolitical perspective, the dollar is appealing. Chart 2Trump-Biden Make America Great Again? Trump-Biden Make America Great Again? Trump-Biden Make America Great Again? In addition, the first two geopolitical views mentioned above – China’s headwinds and the US-Iran détente – imply a negative environment for China and the renminbi. The reason for the US to do a suboptimal deal with Iran, both in 2015 and 2021, is to reduce the risk of war and buy time to enable a strategic pivot to Asia Pacific. Three US presidents have been elected on the pledge to conclude the “forever wars” in the Middle East and South Asia. Biden is withdrawing US troops from Afghanistan in September. There can be little doubt Biden is committed to an Iran deal, which is supposed to free up the US’s hands (Chart 3). Meanwhile the US public and Congress are unified in their desire to better defend US interests against China’s economic and military rise. There has not yet been a stabilization of US-China policies. Biden is not likely to hold a summit with Chinese President Xi Jinping until late October at earliest – and that is a guess, not a confirmed summit. The Biden administration has completed its review of China policy and is maintaining the Trump administration’s hawkish posture, as predicted. The US and China may resume their strategic and economic dialogue at some point but it is impossible to go back to the status quo ante 2015. That was the year the US adopted a more confrontational stance toward China – a stance later supercharged by Trump’s election and trade tariffs. The hawkish consensus on China is one of the rare unifying factors in a deeply divided America. The Biden administration explicitly says the US-China relationship is now defined by “competition” instead of “engagement.”1 One exception to this neutral view on the dollar has been our decision to go long the Japanese yen and Swiss franc, which has not panned out so far. Our reasoning is that geopolitical risk will boost these currencies but otherwise the reduction of geopolitical risk will weigh on the dollar in the context of global growth recovery. So far geopolitical risk has remained subdued while the US dollar has outperformed. We are still sympathetic to these safe-haven currencies, however, as they are attractively valued as long as one expects geopolitical risks to materialize (Chart 4). Chart 3US Pivot To Asia Runs Through Iran US Pivot To Asia Runs Through Iran US Pivot To Asia Runs Through Iran Our third key view, that EU was the real winner of the US election last year, remains on track. This is marginally positive for the euro at the expense of the dollar. Given the above points, we favor an equal-weighted basket of the euro and the dollar relative to the renminbi (Chart 5). Chart 4Safe-Haven Currencies Attractive Safe-Haven Currencies Attractive Safe-Haven Currencies Attractive Chart 5Favor Euro And Dollar Over Renminbi Favor Euro And Dollar Over Renminbi Favor Euro And Dollar Over Renminbi The geopolitical outlook is dollar-bullish. The macroeconomic outlook is dollar-bearish, except that China’s economy looks to slow down. We expect China to ease policy in the second half of the year but it may come late. We remain neutral dollar in the third quarter. Wait For China To Relax Policy July 1 marks the centenary of the Communist Party of China. The main thing investors should know is that the Communist Party predates China’s capitalist phase by sixty years. The party adopted capitalism to improve the economy – it never sacrificed its political or foreign policy goals. This poses a major geopolitical problem today because the Communist Party’s consolidation of power across Greater China, symbolized by Beijing’s revocation of Hong Kong’s special status in 2019, has convinced the western democracies that China is no longer compatible with the liberal world order. China launched a 13.8% of GDP monetary-and-fiscal stimulus over 2018-20 due to the trade war and COVID-19 pandemic. So the economy is stable for the hundredth anniversary celebration. The centenary goals are largely accomplished: GDP is larger, poverty is nearly extinguished, although urban incomes are still lagging (Chart 6). General Secretary Xi Jinping will mark the occasion with a speech. The speech will contribute to his governing philosophy, Xi Jinping Thought, a synthesis of communist Mao Zedong Thought and the pro-capitalist “socialism with Chinese characteristics” pioneered by General Secretary Deng Xiaoping in the 1980s-90s. The effect is to reassert Communist Party and central government primacy after the long period of decentralization that enabled China’s rapid growth phase. It is also to endorse an inward economic turn after the four-decade export-manufacturing boom. The Xi administration’s re-centralization of policy has entailed mini-cycles of tightening and loosening control over the economy. The administration leans against the country’s tendency to gorge itself on debt and grow at any cost – until it must lean the other way for fear of triggering a destabilizing slowdown. For this reason Beijing tightened policy proactively last year, producing a sharp drop in money, credit, and fiscal expansion in 2021 that now threatens to undermine the global recovery. By our measures, any further tightening will result in undershooting the regime’s money and credit targets, i.e. overtightening, and hence threaten to drag on the global recovery (Chart 7). Chart 6China's Communist Party Centenary Goals China's Communist Party Centenary Goals China's Communist Party Centenary Goals Chart 7China Verges On Over-Tightening Policy China Verges On Over-Tightening Policy China Verges On Over-Tightening Policy Overtightening would be a policy mistake with potentially disastrous consequences. So the base case should be that the government will relax policy rather than undermine the post-COVID recovery. However, investors cannot be confident about the timing. The 2015 financial turmoil and renminbi devaluation occurred because policymakers reacted too slowly. One reason to believe policy will be eased is that after July 1 the government will turn its attention to the twentieth national party congress in 2022, the once-in-five-years rotation of the Central Committee and Politburo. The party congress begins at the local level at the beginning of next year and culminates in the fall of 2022 with the national rotation of top party leaders. Xi Jinping was originally slated to step down in 2022. So he needs to squash any last-minute push against him by opposing factions of the party. He may have himself named chairman of the Communist Party, like Mao before him. Most importantly he will put his stamp on the “seventh generation” of China’s leaders by promoting his followers into key positions. All of this suggests that the Xi administration cannot risk triggering a recession, even if its preferences remain hawkish on economic policy. Policy easing could come as early as the end of July. As a rule of thumb, we have noticed that the Politburo’s July meeting on economic policy is often an inflection point, as was the case in 2007, 2015, 2018, and 2020 (Table 1). Some observers claim the April Politburo meeting already signaled an easing in policy, although we do not see that. If July clearly signals relaxation, global investors will cheer and emerging market assets and commodities will rise. Table 1China’s Politburo Often Hits Inflection Point On Economic Policy In July Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Still we maintain a defensive posture going into the third quarter because we do not have a high level of confidence that policymakers will act preemptively. A market riot may precede and motivate the inflection point in policy. Also the negative impact of previous policy tightening will be felt in the third quarter. China plays and industrial metals are extremely vulnerable to further correction (Chart 8). Chart 8China Plays And Metals Vulnerable To Further Correction China Plays And Metals Vulnerable To Further Correction China Plays And Metals Vulnerable To Further Correction The earliest occasion for a Biden-Xi summit comes at the end of October, as mentioned. While US-China talks will occur at some level, relations will remain fundamentally unstable. While a Biden-Xi summit may improve the atmosphere and lead to a new round of strategic and economic dialogue, or Phase Two trade talks, the fact is that the US is seeking to contain China’s rise and China is seeking to break out of the strictures of the US-led world order. The global elite and mainstream media will put a lot of emphasis on the post-Trump return to diplomatic “normalcy” and summits. But this is to overemphasize style at the expense of substance. Note that the positive feelings of the Biden-Putin summit on June 16 fizzled in less than a week when Russia allegedly dropped bombs in the path of a British destroyer in the Black Sea. The US and UK were training Ukraine’s military. Britain denies any bombs were dropped but Russia says next time they will hit their target. (More on this below.) This episode is instructive for US-China relations: summitry is overrated. China is building a sphere of influence and the US no longer believes dialogue alone is the answer. Tit-for-tat punitive measures and proxy battles in China’s neighboring areas, from the Korean peninsula to the Taiwan Strait to the South and East China Seas, are the new normal. Bottom Line: Tactically, stay defensive on global risk assets, especially China plays. Strategically, maintain a constructive outlook on the cycle given the global recovery and China’s need eventually to relax monetary and fiscal policy. US-Iran Deal Likely – Then The Real Trouble Starts The US will likely rejoin the 2015 Iranian nuclear deal (Joint Comprehensive Plan of Action) by August and pull out of its longest-ever war in Afghanistan in September. The US is wrapping up its “forever wars” to meet the demands of a war-weary public. Ironically, the long-term consequence is to create power vacuums that invite new geopolitical conflicts in the context of the US’s great power struggle with China and Russia. But for now a deal with Iran – once it is settled – reduces geopolitical risk by reducing the odds of military escalation in the region. The Iran talks are more significant than the Afghanistan pullout. We are confident in a deal because Biden can rejoin the 2015 deal unilaterally – it was never approved by the US Senate as a formal treaty. The Iranians will not support any militant action so aggressive as to scupper a deal that offers them the chance of reviving their economy at a critical time in the regime’s history. Reviving the deal poses a downside risk for oil prices in the third quarter though not over the long run. It is negative in the short run because investors will have to price not only Iran’s current and future production (Chart 9) but also any resulting loss of OPEC 2.0 discipline. Brent crude is trading at $76 per barrel as we go to press, above the $65-$70 per barrel average that our Commodity & Energy Strategy service expects to see over the coming five years (Chart 10). Chart 9Iran's Oil Production Will Return Iran's Oil Production Will Return Iran's Oil Production Will Return Chart 10Brent Price Faces Short-Term Downside Risk From Iranian Crude Brent Price Faces Short-Term Downside Risk From Iranian Crude Brent Price Faces Short-Term Downside Risk From Iranian Crude The oil price ceiling is enforced by the cartel of oil producers who fear that too high of prices will incentivize US shale oil production as well as the global shift to renewable energy. The Russians have always dragged their feet over oil production cuts and are now pushing for production hikes. The government needs an oil price of around $50-55 per barrel for the budget to break even. The Saudis need higher prices to break even, at $70-75 per barrel. Moscow must coordinate various oil producers, led by the country’s powerful oligarchs and their factions, which is inherently more difficult than the Saudi position of coordinating one producer, Aramco. The Russians and Saudis have maintained cartel discipline so far in 2021, as expected, because the wounds of the market-share war last year are still raw. They retreated from that showdown in less than a month. However, a major escalation in Saudi Arabia’s strategic conflict with Iran could push the Saudis to seek greater market share at Iran’s expense, as occurred before the original Iran deal in 2014-15. Hence our view that the risk to oil prices will shift from the upside to the downside in the second half of the year if the US-Iran deal is reconstituted. Over the long run, the deal is not negative for oil prices. The deal is a tradeoff for lower geopolitical risk today but higher risk in the future. The reason is that Iran’s economic recovery will strengthen its strategic hand and generate a backlash in the region. The global oil supply and demand balance will fluctuate according to circumstances but regional conflict will inject a risk premium over time. Biden’s likely decision to rejoin the 2015 deal should be seen as a delaying tactic. It is impossible to go back to 2015, when the US had mustered a coalition of nations to pressure Iran and when Iran’s “reformist” faction stood to receive a historic boost from the opening of the country’s economy. Now the US lacks a coalition and the reformists are leaving office in disgrace, with the hardliners (“principlists”) taking full power for the foreseeable future. Iran is happy to go back to complying with a deal that consists of sanctions relief in exchange for temporary limits on its nuclear program. The 2015 deal’s restrictions on Iran’s nuclear program begin expiring in 2023 and continue to expire through 2040. Biden has no chance of negotiating a newer and more expansive deal that extends these sunset clauses while also restricting Iran’s ballistic missile program and regional militant activities. He will say that easing sanctions is premised on a broader “follow on” deal to achieve these US goals. But the broader deal is unlikely to materialize anytime soon. The Iranians will commit to future talks but they will have no intention of agreeing to a more expansive deal unless forced. The country’s leaders will never abandon their nuclear program after witnessing the invasions of non-nuclear Libya and Ukraine – in stark contrast with nuclear-armed North Korea. Moreover Biden cannot possibly reassemble the P5+1 coalition with Russia and China anytime soon. The US is directly confronting these states. They could conceivably work with the US when Iran is on the brink of obtaining nuclear weapons but not before then. They did not prevent North Korea. The Supreme Leader Ali Khamenei, the soon-to-be-inaugurated President Ebrahim Raisi, the Iranian Revolutionary Guard Corps, the Ministry of Intelligence, and other pillars of the regime are focused exclusively on strengthening the regime in advance of Khamenei’s impending succession sometime in the coming decade. The succession could easily lead to domestic unrest and a political crisis, which makes the 2020s a critical period for the Islamic Republic. With Tehran focused on a delicate succession, it is not a foregone conclusion that Iran will go on the offensive to expand its sphere of influence immediately after the US deal. But sooner or later a major new geopolitical trend will emerge: the rise of Iran. With sanctions removed, trade and investment increasing, and Chinese and Russian support, Iran will be capable of pursuing its strategic aims in the region more effectively. It will extend its influence across the “Shia Crescent,” including Iraq. The fear that this will inspire in Israel and the Gulf Arab states has already generated a slow-boiling war in the region. This war will intensify as the US will be reluctant to intervene. The purpose of the deal is to enable the war-weary US to reduce its active involvement in the region. The US foreign policy and defense establishment do not entirely see it this way – they emphasize that the US will remain engaged. But US allies in the Middle East will not be convinced. The region already has a taste for the way this works after the US’s precipitous withdrawal from Iraq in 2011, which lead to the rise of the Islamic State terrorist group. Biden will try not to be so precipitous but the writing is on the wall: the US will reduce its focus and commitment. A scramble for power in the region will begin the moment the ink dries on Biden’s signature of the JCPA. Israel and the Arab states are forming a de facto alliance – based on last year’s Abraham Accords – to prepare for Iran’s push to dominate the region. Even if Iran is not overly aggressive (a big if), Israel and the Gulf Arabs will overreact as a result of their fear of abandonment. They will also seek to hedge their bets by improving ties with the Chinese and Russians, making the Middle East the scene of a major new proxy battle in the global great power struggle. As a risk to our view: if the Biden administration changes course this summer and refuses to lift sanctions or rejoin the Iran deal – low but not zero probability – then tensions with Iran will explode almost instantaneously. The Iranians will threaten to close the Strait of Hormuz and a crisis will erupt in the third or fourth quarter. Bottom Line: The US will most likely rejoin the Iranian nuclear deal by August to avoid an immediate crisis or war. The Biden administration will wager that it can lend enough support to regional allies to keep Iran contained. This might work, as the Iranians will focus on fortifying the regime ahead of its leadership succession. However, Iran’s hardline leadership will see an opportunity in America’s withdrawal from its “forever wars.” Iran will increasingly cooperate with Russia and China. Iran’s conflict with Israel and Saudi Arabia will be extremely difficult to manage and will escalate over time, quite possibly creating a revolution or war in Iraq. The Gulf Arabs are already under immense pressure from the green energy revolution. Thus while oil prices might temporarily fall on the return of Iranian exports, they will later see upward pressure from a new wave of Middle Eastern instability. European Political Risk Has (Probably) Bottomed By contrast with all the above we have viewed Europe as a negligible source of (geo)political risk in 2021. European policy uncertainty is falling in Europe relative to these other powers and the rest of the world (Chart 11). Chart 11Europe's Relative Policy Uncertainty Bottoming Europe's Relative Policy Uncertainty Bottoming Europe's Relative Policy Uncertainty Bottoming Chart 12EU Break-Up Risk Hits Floor (Again) EU Break-Up Risk Hits Floor (Again) EU Break-Up Risk Hits Floor (Again) The risk of a break-up of the European Union has wilted and remains at historic lows (Chart 12). There is no immediate threat of any European countries emulating the UK and attempting to exit. Even Italian support for the euro has surged. Immigration flows have plummeted. European solidarity is not on the ballot in the upcoming German and French elections. Germany is choosing between the status quo and a “green revolution” that would not really be a revolution due to the constraints of coalition politics. The Greens have lost some momentum relative to their polling earlier this year but underlying trends suggest they will surprise to the upside in the September 26 vote (Charts 13A and 13B). They embrace EU solidarity, robust government spending, weariness with the Merkel regime, and concerns about climate change, Russia, China, and social justice. Chart 13AGerman Greens Will Surprise To Upside Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Chart 13BGerman Greens Will Surprise To Upside Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran We expect the Greens to surprise to the upside. But as they are forced into a coalition with the ruling Christian Democrats then they will be limited to raising spending rather raising taxes (Table 2). The market will cheer this result. Table 2German Greens’ Ambitious Tax Hike Proposals Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran If the Greens disappoint then a right-leaning government and too early fiscal tightening could become a risk – but it is a minor risk because Merkel’s hand-picked successor, the CDU Chancellor Candidate Armin Laschet, will be pro-Europe and fiscally dovish, just like the mainstream of his party under Merkel. The only limitation on this dovishness is that it would take another global shock for there to be enough votes in the Bundestag to loosen the schuldenbremse or “debt brake.” In France, President Emmanuel Macron is likely to win re-election – the populist candidate Marine Le Pen remains an underdog who is unlikely to make it through France’s two-round electoral system. In Italy, Prime Minister Mario Draghi is overseeing a national unity coalition that will dole out EU recovery funds. An election cannot be held ahead of the presidential election in January, which will be secured by the establishment parties as a major check on any future populist ruling coalition. The risk in these countries, as in Spain and elsewhere, is that neoliberal structural reform and competitiveness are falling by the wayside. Fiscal largesse is positive for securing the recovery but long-term growth potential will remain depressed (Chart 14). Chart 14European And Global Fiscal Stimulus (Updated June 2021) Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Europe remains stuck in a liquidity trap over the long run. It depends on the rest of the world for growth. This is a problem given that China’s potential growth is slowing and there is no ready substitute that will prop up global growth. Europe is increasingly ripe for negative “black swan” events. The power vacuum in the Middle East described above will lead to instability and regime failures that will threaten European security. Russia will remain aggressive, a reflection of its crumbling structural foundations. The Putin administration has not changed its strategy of building a sphere of influence in the former Soviet Union and pushing back against the West, as signaled by the threat to bomb ships that sail in Crimean waters – a unilateral expansion of Russia’s territorial waters following the Crimean invasion. The Biden administration is not seeking anything comparable to the diplomatic “reset” with Russia from 2009-11, which ended in acrimony. In other words, European political risk may be bottoming as we speak. Investment Takeaways Chart 15Limited Equity Upside From Likely US Infrastructure Bill Limited Equity Upside From Likely US Infrastructure Bill Limited Equity Upside From Likely US Infrastructure Bill US Peak Fiscal Stimulus: The Biden administration is highly likely to pass an infrastructure package through Congress, either as a bipartisan deal with Republicans or as part of the American Jobs Plan. The result is another $1-$1.5 trillion fiscal stimulus, albeit over an eight-year period, with infrastructure funding taking until 2024-25 to ramp up. Biden’s other plans probably will not pass before the 2022 midterm election, which will likely bring gridlock. Investors are well aware of these proposals and the policy setting will probably be frozen after this year. Hence there is limited remaining upside for global materials sector and US infrastructure plays (Chart 15). The extravagant US fiscal thrust of 2020-21 will turn into a huge fiscal drag in 2022 (Chart 16). The Federal Reserve, however, will remain ultra-dovish as long as labor market slack persists – regardless of who is at the helm. Chart 16US Fiscal Drag Very Large In 2022 Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Third Quarter Outlook 2021: The Pivot To Asia Runs Through Iran Chart 17Go Long Large Caps And Defensives Go Long Large Caps And Defensives Go Long Large Caps And Defensives China’s Headwinds Persist: China may or may not ease policy in time to prevent a market riot. China plays and industrial metals are highly exposed to a correction and we recommend steering clear. US-Iran Deal Weighs On Oil Price: Tactically we are neutral on oil and oil plays. An Iran deal could depress oil prices temporarily – and potentially in a major way if the Saudis agree with the Russians on increasing production. Fundamentals are positive but depend on the OPEC 2.0 cartel. The cartel faces the risk that higher prices will incentivize both alternative oil providers and the green revolution. Europe’s Opportunity: We continue to see the euro and European stocks offering value. Given the troubles with Russia we favor developed Europe plays over emerging Europe. The German election would be a bullish catalyst for European assets but headwinds from China will prevail, which is negative for cyclical European stocks. The Russian Duma election, also in September, creates high potential for Russia to clash with the West between now and then. Tactically, go long global large caps and defensives (Chart 17).   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Independent Vermont Senator Bernie Sanders recently felt it was necessary to warn against a second cold war. Sanders, a democratic socialist, is a reliable indicator of the left wing of the Democratic Party and a dissenter who puts pressure on the center-left Biden administration. His fears underscore the dominance of the new hawkish consensus. Appendix China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan – Province Of China Taiwan Territory: GeoRisk Indicator Taiwan Territory: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator

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