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Highlights As US and China’s grand strategies collide, expect major and minor geopolitical earthquakes whose epicenter will now lie in South Asia and the Indian Ocean basin. Another tectonic change will drive South Asia’s emergence as a new geopolitical battle ground - South Asia is now heavily weaponized. All key players operating in this theater are nuclear powers. South Asia’s democratic traditions are well-known but notable institutional and social fault lines exist. These could trigger major geopolitical events in Afghanistan, Pakistan and in pockets of India too. We are bullish on India strategically but bearish tactically. Dangerous transitions are underway to India’s east and west. Within India, key elections are approaching, and it is possible that growth may disappoint. For reasons of geopolitics, we are strategically bullish on Bangladesh but strategically bearish on Pakistan and Sri Lanka. We are booking gains of 9% on our long rare earths basket and 1% on our long GBP-CZK trade. Feature Over the 1900s, East Asia and the Middle East emerged as two key geopolitical focal points on the world map. Global hegemons flexed their muscles and clashed in these two theaters. Meanwhile South Asia was a geopolitical backstage at best. The majority of South Asia was a British colony until the second half of the twentieth century. After WWII it struggled with the difficulties of independence and mostly missed out on the prosperity of East Asia and the Pacific. But will the twenty-first century be any different? Absolutely so. We expect the current century to be marked by major and minor geopolitical earthquakes in which South Asia and the Indian Ocean basin will play a major part. This seismic change is likely to be the result of several tectonic forces: Population: A quarter of the world’s people live in South Asia today and this share will keep growing for the next four decades. India will be the most populous country in the world by 2027 and will account for about a fifth of global population. Supply: China’s growth model has left it heavily dependent on imports of raw materials from abroad. It is clashing with the West over markets and supply chains. Beijing is building supply lines overland while developing a navy to try to secure its maritime interests. These interests increasingly overlap with India’s, creating economic competition and security concerns over vital sea lines of communication. Access: Whilst the Himalayas and Tibetan plateau have historically prevented China from expanding its influence in South Asia, China’s alliance with Pakistan is strengthening. Physical channels like the China Pakistan Economic Corridor (CPEC), and other linkages under the Belt and Road Initiative, now provide China a foot in the South Asian door like never before (Map 1). Weapons: The second half of the twentieth century saw China, India, and Pakistan acquire nuclear arms. Consequently, South Asia today is one of the most weaponized geographies globally (Map 1). Map 1South Asia To Emerge As A Key Geopolitical Theater In The 21st Century South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater With the South Asian economy ever developing, and US-China confrontation here to stay, we expect China to make its presence felt in South Asia over the coming decades. The US’s recent withdrawal from Afghanistan, and the failure of democratization in Myanmar, are but two symptoms of a grand strategic change by which China seeks to prevent US encirclement and Indo-American cooperation develops to counter China. Throw in the abiding interests of all these powers in the Middle East and it becomes clear that South Asia and the Indian Ocean basin writ large will become increasingly important over the coming decades. The Lay Of The Land - India Is The Center Of Gravity Chart 1South Asia Managed Rare Feat Of ‘Steady’ Growth South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater South Asia stands out amongst developing regions of the world for its large and young population. In recent decades, South Asia has also managed to grow its economy steadily, surpassing Sub-Saharan Africa and rivaling the Middle East (Chart 1). While South Asia’s growth rates have not been as miraculous as East Asia post World War II, its growth engine has managed to hum slowly but surely. India and Bangladesh have been the star performers on the economic growth front (Chart 2). Despite decent growth rates, the South Asian region is characterized by very low per capita incomes due to large population. On per capita incomes, Sri Lanka leads whilst Pakistan finds itself at the other end of the spectrum (Chart 3). Chart 2India And Bangladesh Have Been Star Performers South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 3Per Capita Incomes In South Asia Have Grown, But Remain Low South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 4India Accounts For About 80% Of South Asia’s GDP South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater South Asia constitutes eight nations. However only four are material from an investment perspective: India, Pakistan, Sri Lanka, and Bangladesh. India is the center of gravity as it offers the most liquid scrips and accounts for 80% of the region’s GDP (Chart 4). In addition: India accounts for 101 of the 110 companies from South Asia listed on MSCI’s equity indices. MSCI India’s market capitalization is about $1 trillion. In fact, India’s equity market could soon become larger than that of the UK and join the world’s top-five club.1 The combined market cap of MSCI Bangladesh, Sri Lanka, and Pakistan amounts to only about $6 billion. Liquidity is a constraint that investors must contend with whilst investing in these three countries in South Asia. Pakistan is the home of 220 million – set to grow to 300 million by 2040. It lags its neighbors on economic growth and governance but has nuclear weapons and a 650,000-strong military. Bottom Line: India is the center of gravity for the regional economy and financial markets in South Asia. Sri Lanka and Bangladesh are small but are developing. Pakistan is the laggard, but is militarily strong, which raises political and geopolitical risks. South Asia: Major Consumer, Minor Producer Chart 5Manufacturing Capabilities Of South Asian Economies Are Weak South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater South Asia’s defining economic characteristic is that it is a major consumer. This feature contrasts with the region’s East Asian cousins, which worked up economic miracles based on their manufacturing capabilities. South Asia’s appetite to consume is partly driven by population and partly driven by the fact that this region’s economies have an unusually underdeveloped manufacturing base (Chart 5). It’s no surprise that all countries in South Asia (with the sole exception of Afghanistan) are set to have a current account deficit over the next five years (Charts 6A and 6B). Chart 6ASouth Asian Economies Tend To Be Net Importers South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 6BSouth Asian Economies Tend To Be Net Importers South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater India is set to become the third largest global importer of goods and services (after the US and UK) over the next five years. Its rise as a large client state of the world will be both a blessing and a curse, as increased business leverage will coincide with geopolitical insecurity. Structurally, Sino-Indian tensions are rising and growing bilateral trade will not be enough to prevent them. Meanwhile dependency on the volatile Middle East is a geopolitical vulnerability. Either way, India and its region become more important to the rest of the world over time. Whilst the structure of South Asia’s economy is relatively rudimentary, it is worth noting that Bangladesh and Sri Lanka present an exception. Bangladesh has embarked on a path of manufacturing-oriented development via labor-intensive production. Sri Lanka has a well-developed services sector (Chart 7). In particular: Bangladesh: Within South Asia, Bangladesh’s manufacturing sector stands out as being better developed than regional peers. More than 95% of Bangladesh’s exports are manufactured goods –a level that is comparable to China (Chart 8). China’s share in the global apparel and footwear market has been systematically declining and Bangladesh is one of the countries that has benefited most from this shift. Bangladesh’s share in global apparel and footwear exports to the US as well as EU has been rising steadily and today stands at 4.5% and 13% respectively.2 Chart 7Bangladesh’s And Sri Lanka’s Economies Are Relatively Modern South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 8Bangladesh Has The Most Developed Exports Franchise In South Asia South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Sri Lanka: Whilst Sri Lanka social complexities are lower and per capita incomes are higher as compared to peers in South Asia, its transition from a long civil war to a focus on economic development recently suffered a body blow, first owing to terrorist attacks in 2019 and then owing to the pandemic. The economic predicament was then worsened by its government’s hasty transition to organic farming which hit domestic food production. Geopolitically it is worth noting that China is one of the largest lenders to Sri Lanka. Whilst Sri Lanka’s central bank may be able to convince markets of the nation’s ability to meet debt obligations for now, its foreign exchange reserves position remains precarious and public debt levels remain high. Sri Lanka’s vulnerable finances are likely to only increase Sri Lanka’s reliance on capital-rich China. Despite Democracy, South Asia Has Political Tinderboxes Another factor that sets South Asia apart from developing regions like Africa, the Middle East, and Central Asia is the region’s democratic moorings. India and Sri Lanka lead the region on this front, although the last decade may have seen minor setbacks to the quality of democracy in both countries (Chart 9). Pockets of South Asia are socially and politically unstable, characterized by religious or communal strife, terrorist activity, and even the occasional coup d'état. Risk Of Social Conflict Most Elevated In Pakistan And Afghanistan India’s demographic dividend is real, but its benefits should not be overstated. For instance, India’s northern region is a demographic tinderbox. It is younger than the rest of the country, yet per capita incomes are lower, youth underemployment is higher, and society is more heterogeneous. The rise of nationalism in India is an important consequence and could engender potential social unrest. Chart 9India’s Democracy Strongest, But May Have Had Some Setbacks South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 10South Asia Is Young And Will Age Slowly South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater   Chart 11Social Complexities Are High In Afghanistan & Pakistan South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater A similar problem confronts South Asia as a whole. Pakistan and Afghanistan are younger than India by a wide margin (Chart 10). But both countries are economically backward and have either poor or non-existent democratic traditions. Lots of poor youths and inadequate political valves to release social tensions make for an explosive combination. These countries are highly vulnerable to social conflict that could cause political instability at home or across the region via terrorism (Chart 11). The Gatsby Effect Most Prominent In Pakistan While various regions struggle with inequality, South Asia has less of a problem that way (Chart 12). However South Asia is characterized by very low levels of social mobility as compared to peer regions. This can partially be attributed to two centuries of colonial rule as well as to endemic traditions of social stratification. Chart 12Gatsby Effect: Social Mobility Is Lowest In Pakistan South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Within South Asia it is worth noting that social mobility is the lowest in Pakistan and highest in Sri Lanka. Chart 13Military’s Influence Most Elevated In Pakistan And Nepal Too South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Military Influential In Pakistan (And Nepal) Events that transpired over January 2020 in the US showed that even the oldest constitutional democracy in the world is not immune to a breakdown of civil-military relations. South Asia has seen the occasional coup d'état, one reason for the political tinderboxes highlighted above. Obviously, Myanmar is the worst – it saw its nascent democratization snuffed out just last year. But other countries in the region could also struggle to maintain civilian order in the coming decades. The military’s influence is outsized in Pakistan as well as Nepal (Chart 13). India maintains high levels of defense spending but has a strong tradition of civilian control (Chart 14). Chart 14Pakistan’s Military Budget Is Most Generous, India A Close Second South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater South Asia: A New Global Battle Ground Historically global hegemons have sought to assert their dominance by staking claim over coastal regions in Europe and Asia. Over the past two centuries Asia has emerged as a geopolitical theater second only to Europe. Naval and coastal conflicts have emerged from the rise of Japan (the Russo-Japanese War) and the Cold War (the Korean War & the Vietnam War). Today the rise of China is the destabilizing factor. The “frozen conflicts” of the Cold War are thawing in Taiwan, South Korea, and elsewhere. China is pursuing territorial disputes around its entire periphery, including notably in the East and South China Seas but also South Asia. Meanwhile the US, fearful of China, is struggling to strike a deal with Iran and shift its focus from the Middle East to reviving its Pacific strategic presence. A budding US-China competition is creating conditions for a new cold war or a series of “proxy battles” in Asia. Over the next few decades, we expect disputes to continue. But the focal points are likely to cover South Asia too. In specific, landlocked regions in South Asia are likely to see rising tensions in the twenty-first century (Map 2). Also as mentioned above, China’s naval expansion and the US’s attempt to form a “quadrilateral” alliance with India, Japan, and Australia will generate tensions and potentially conflict. European allies are also becoming more active in Asia as a result of US alliances as well as owing to Europe’s independent need for secure supply lines. Map 2China’s Interest In Landlocked Regions Of South Asia Is Rising South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater While border clashes between India and China will ebb and flow, Indo-Chinese confrontations along India’s eastern border will become a structural theme. Arguably, Sino-Indian rivalries pre-date the twenty-first century. But in a world in which the Asian giants are increasingly economically and technologically developed, Sino-Indian confrontations are likely to persist and result in major geopolitical events. Consider: China is adopting nationalism and an assertive foreign policy to cope with rising socioeconomic pressures on the Communist Party as potential GDP growth slows. China is developing a navy as well as a stronger alliance with Pakistan, which includes greater lines of communication. North India is a key constituency for the political party in power in India today (i.e., the Bhartiya Janata Party or BJP) and this geography harbors especially unfavorable views of Pakistan (Chart 15). Thus, there is a risk that the India of today could respond far more decisively or aggressively to threats or even minor disputes. More broadly, nationalism is rising in India as well as China. India is shedding its historical stance of neutrality and aligning with the US, which fuels China’s distrust (Chart 16). Chart 15Northern India Views Pakistan Even More Unfavorably Than Rest Of India South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 16India Has Aligned With The QUAD To Counter The Sino-Pak Alliance South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Turning attention to India’s western border, clashes between India and Pakistan relating to landlocked areas in Kashmir will also be a recurring theme. Whilst India currently has a ceasefire agreement in place with Pakistan, peace between the two countries cannot possibly be expected to last. This is mainly because: Kashmir: Core problems between the two countries, like India’s control over Kashmir and Pakistan’s use of militant proxies, remain unaddressed. India’s unexpected decision in 2019 to abrogate article 370 of the Indian constitution has reinforced Pakistan’s attention on Kashmir. Sino-Pak Alliance: Pakistan accounted for 38% of China’s arms exports over 2016-20. Pakistan accounts for the lion’s share of Chinese investments made in South Asia (Chart 17). Sino-India rivalries will spill into the Indo-Pak relationship (and vice versa). Revival Of Taliban: The US withdrawal from Afghanistan has revived Taliban rule in that country. Taliban’s rise will resuscitate a range of dormant terrorist movements in Afghanistan as well as in Pakistan. India has a long history of being targeted. South Asia today is very different from what it looked like for most of the post-WWII era: it is heavily weaponized. India, Pakistan, and China became nuclear powers in the second half of the twentieth century and have been steadily building their nuclear stockpiles ever since (Chart 18). North Korea’s growing arsenal is theoretically able to target India, while Iran (more friendly toward India) may also obtain nuclear weapons. Chart 17China And Pakistan: Joined At The Hip? South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 18South Asia: The New Epicenter For Nuclear Activity South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater While nuclear arms create a powerful incentive for nations to avoid total war, they can also create unmitigated fear and uncertainty during incidents of major strategic tension. This is especially true when countries have not yet worked out a mode of living with each other, as with the US and USSR in the early days of the Cold War. Investment Takeaways For investors with an investment horizon exceeding 12 months, we highlight that India presents a long-term buying opportunity for two key reasons: China’s Internal And External Troubles Will Benefit India: As long as US and China do not reengage in a major way, global corporations will fall under pressure to diversify from China and the US will pursue closer relations with India. China faces an array of challenges across its periphery, whereas India need only focus on the South Asian sphere. India Is Rising As A Global Consumer: As long as a major Middle East war and oil shock is avoided (not a negligible risk), India should see more benefits than costs from its growing importance as a client of the world. However, over the next 12 months we worry that India is priced for perfection. India currently trades at a punchy premium relative to emerging markets (Table 1) at a time of when both geopolitical and macroeconomic headwinds are at play. In particular: Table 1We Are Bearish On India Tactically, But Bullish On India & Bangladesh Strategically South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Major Transitions Are Dangerous: Recent developments in South Asia have added to geopolitical risks for India. The assumption of power by Taliban in Afghanistan will activate latent terrorist forces that could target India. Pakistan’s chronic instability combined with the change of power in Afghanistan could set off an escalation in Indo-Pakistani tensions, sooner rather than later. On India’s eastern front, China’s need to distract its population from a souring economy could trigger a clash between China and India. Down south, China’s rising influence over crisis-hit Sri Lanka is notable and could potentially engender security risks for India. Chart 19Politics Can Trump Economics In Run Up To General Elections South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Growth Slowing, Elections Approaching: We worry that India’s growth engine may throw up a downside surprise over the next 12 months owing to poor jobs growth and poor investment growth. History suggests that politics often trumps economics in the run up to general elections (Chart 19). Hence there is a real risk that policy decisions will be voter-friendly but not market-friendly over 2022. As both India and Pakistan are gearing up for elections in the coming years, major military showdown or saber rattling should not be ruled out. Both countries may engineer a rally around the flag effect to bump up their pandemic-battered approval. Tension with China may escalate as Xi Jinping extends his term in power next year and seeks to enforce red lines in China’s eastern and western borders. Globally what are the key geopolitical factors that could lead to India’s underperformance in the short run? We highlight a checklist here: China Stimulates: The near-term clash between markets and policymakers in China should eventually give way to meaningful fiscal stimulus by Chinese authorities. This buoys China as well as emerging markets that depend on China for their growth. However, even if China flounders, India may not continue to outperform. The correlation between MSCI India and China equities has been positive. Fed Tightens Quickly: A faster-than-expected taper and tightening guidance could cause those emerging markets that are richly priced like India to correct. A Crisis Over Iran’s Nuclear Program: If the US is unable to return to diplomacy, tensions in the Middle East will rise and stoke oil prices. This will affect India adversely, given global price pressures and India’s high dependence on oil imports. Conversely, if these developments fail to materialize then that would lower our conviction regarding India’s underperformance in the short run. In summary, we are bullish India strategically but bearish tactically. As regards the three other investable markets in South Asia: We are bearish on Pakistan and Sri Lanka on a strategic time horizon. Whilst both nations’ rising alignment with China could be an advantage ceteris paribus, ironically their deteriorating finances are driving their proximity to capital-rich China (Chart 20). To boot, Sri Lanka’s ability to pay its way out of its economic crisis on its own steam is worsening. This is evident from its rising debt to GDP ratio (Chart 21). Chart 20Pakistan And Sri Lanka Running Low On Reserves South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Pakistan faces elevated risks of internal social conflict, must deal with a rapidly changing external environment, has a weak democracy and an unusually influential military. Sri Lanka’s social risks are low, but its economic crisis appears likely to persist. The fact that both markets have been characterized by a high degree of volatility in earnings in the recent past implies that even a cyclical “Buy” case for either of these markets is fraught with risks (Table 1). The outlook for Bangladesh is better. Exports account for 15% of GDP and the US and Europe account for around 70% of its exports. Strong fiscal stimulus in these developed markets should augur well for this frontier market. Additionally, Bangladesh is characterized by moderate social risks, reasonably strong democracy scores and low levels of influence from the military. Its healthy public finances (Chart 21) and the fact that it shares no border with China creates the potential to leverage a symbiotic relationship with China. Chart 21Sri Lanka’s Debt Now Exceeds Its GDP South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater But there is a catch. Bangladesh as a market has a low market cap and hence offers low levels of liquidity (Table 1). We thus urge investors to avoid making cyclical investment calls on this South Asian market. However, from a long-term perspective we highlight our strategic bullish view on Bangladesh given supportive geopolitical factors. Watch out for an upcoming report from our Emerging Markets Strategy team, that will delve into the macroeconomic aspects of Bangladesh.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 Abhishek Vishnoi and Swetha Gopinath, "India's stock market on track to overtake UK in terms of m-cap: Report" Business Standard, October 2021. 2 Arianna Rossi, Christian Viegelahn, and David Williams, "The post-COVID-19 garment industry in Asia" Research Brief, International Labour Organization, July 2021. Open Trades & Positions South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater

Highlights The fourth quarter will be volatile as China still poses a risk of overtightening policy and undermining the global recovery. US political risks are also elevated. A debt default is likely to be averted in the end. Fiscal stimulus could be excessive. There is a 65% chance that taxes will rise in the New Year. A crisis over Iran’s nuclear program is imminent. Oil supply disruptions are likely. A return to diplomacy is still possible but red lines need to be underscored. European political risks are comparatively low, although they cannot go much lower, Russia still poses threats to its neighbors, and China’s economic wobbles will weigh on European assets. Our views still support Mexican equities and EU industrials over the long run but we are booking some gains in the face of higher volatility. Feature Our annual theme for 2021 was “No Return To Normalcy” and events have borne this out. The pandemic has continued to disrupt life while geopolitics has not reverted to pre-Trump norms. Going forward, the pandemic may subside but the geopolitical backdrop will be disruptive. This is primarily due to Chinese policy, unfinished business with Iran, and the struggle among various nations to remain stable in the aftermath of the pandemic. Chart 1Delta Recedes With Vaccinations Delta Recedes With Vaccinations Delta Recedes With Vaccinations Chart 2Global Recovery Marches On Global Recovery Marches On Global Recovery Marches On Chart 3Global Labor Markets On The Mend Global Labor Markets On The Mend Global Labor Markets On The Mend The underlying driver of markets in the fourth quarter will be the fact that the COVID-19 pandemic is waning as vaccination campaigns make progress (Chart 1). New cases of the Delta variant have rolled over in numerous countries and in US states that are skeptical toward vaccines. Global growth will still face crosswinds. US growth rates are unlikely to be downgraded further while Europe’s growth has been upgraded. However, forecasters are likely to downgrade Chinese growth expectations in the face of the government’s regulatory onslaught against various sectors and property sector instability (Chart 2). Barring a Chinese policy mistake, the global composite PMI is likely to stabilize. Labor markets will continue healing (Chart 3). The tug of war between unemployment and inflation will continue to give way in favor of inflation, given that wage pressures will emerge, stimulus-fueled household demand will be strong, and supply shortages will persist. Central banks will try to normalize policy but will not move aggressively in the face of any new setbacks to the recovery. Will China Spoil The Recovery? Maybe. Chinese policy and structural imbalances pose the greatest threat to the global economic recovery both in the short and the long run. The immediate risk to the recovery is clear from our market-based Chinese growth indicator, which has not yet bottomed (Chart 4). The historic confluence of domestic political and geopolitical risks in China is our key view for the year. China is attempting to make the economic transition that other East Asian states have made – away from the “miracle” manufacturing phase of growth toward something more sustainable. But there are two important differences: China is making its political and economic system less open and free (the opposite of Taiwan and South Korea) and it is confronting rather than befriending the United States. The Xi administration is focused on consolidating power ahead of the twentieth national party congress in fall 2022. Xi is attempting to stay in power beyond the ten-year limit that was in place when he took office. On one hand he is presenting a slate of socioeconomic reforms – dubbed “common prosperity” – to curry popular favor. This agenda represents a tilt from capitalism toward socialism within the context of the Communist Party’s overarching idea of socialism with Chinese characteristics. On the other hand, Xi is cracking down on the private sector – Big Tech, property developers – which theoretically provides the base of power for any political opposition. The crackdowns have caused Chinese equities to collapse relative to global and have reaffirmed the long trend of underperformance of cyclical sectors relative to defensives within Chinese investable shares (Chart 5, top panel). Chart 4China Threatens To Spoil The Party China Threatens To Spoil The Party China Threatens To Spoil The Party In terms of financial distress, so far only high-yield corporate bonds have seen spreads explode, not investment grade. But current policies force property developers to liquidate their holdings, pay off debts, and raise cash while forcing banks to cut bank on loans to property developers and homebuyers. (Not to mention curbs on carbon emissions and other policies squeezing industrial and other sectors.) Chart 5Beijing Could Easily Trigger Global Market Riot Beijing Could Easily Trigger Global Market Riot Beijing Could Easily Trigger Global Market Riot If these policies are not relaxed then property developers will continue to struggle, property prices will fall, credit tightening will intensify, and local governments will be starved of revenue and forced to cut back on their own spending. Yet the government’s signals of policy easing are so far gradual and behind the curve. If policy is not relaxed, then onshore equities will sell off (as well as offshore) and credit spreads will widen more generally (Chart 5, bottom panel). Broad financial turmoil cannot be ruled out in the fourth quarter. Ultimately, however, China will be forced to do whatever it takes to try to secure the post-pandemic recovery. Otherwise it will instigate a socioeconomic crisis ahead of the all-important political reshuffle in fall 2022. That would be the opposite of what Xi Jinping needs as he tries to consolidate power. Chinese households have stored their wealth, built up over decades of economic success, in the housing sector (Chart 6). Economic instability could translate to political instability. Chart 6Beijing Will Provide Bailouts And Stimulus … Or Face Political Instability Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! Investors often ask how the government can ease policy if doing so will further inflate housing prices, which hurts the middle class and is the opposite of the common prosperity agenda. High housing prices are the biggest of the three “mountains” that are said to be crushing the common folks and weighing on Chinese birthrates and fertility (the other two are high education and medical costs). The answer is that while policymakers want to cap housing prices and encourage fertility, they must prevent a general collapse in prices and economic and financial crisis. There is no evidence that suppressing housing prices will increase fertility or birthrates – if anything, falling fertility is hard to reverse and goes hand in hand with falling prices. Rather, evidence from the US, Japan, South Korea, Thailand, and other countries shows that a bursting property bubble certainly does not increase fertility or birthrates (Charts 7A and 7B). Chart 7AEconomic Crash Not A Recipe For Higher Fertility Economic Crash Not A Recipe For Higher Fertility Economic Crash Not A Recipe For Higher Fertility Chart 7BEconomic Crash Not A Recipe For Higher Fertility Economic Crash Not A Recipe For Higher Fertility Economic Crash Not A Recipe For Higher Fertility Bringing it all together, investors should not play down negative news and financial instability emerging from China. There are no checks and balances on autocrats. Our China Investment Strategy has a high conviction view that policy stimulus is not forthcoming and regulatory curbs will not be eased. The implication is that China’s government could make major policy mistakes and trigger financial instability in the near term before changing its mind to try to preserve overall stability. At that point it could be too late. Will Countries Add More Stimulus? Yes. Chart 8Global Monetary Policy Challenges Global Monetary Policy Challenges Global Monetary Policy Challenges With China’s stability in question, investors face a range of crosswinds. Central banks are struggling with a surge in inflation driven by stimulus-fueled demand and supply bottlenecks. The global output gap is still large but rapid economic normalization will push inflation up further if kinks are not removed (Chart 8). A moderating factor in this regard is that budget deficits are contracting in 2022 and coming years – fiscal policy will shift from thrust to drag (Chart 9). However, the fiscal drag is probably overstated as governments are also likely to increase deficit spending on the margin. The US is certainly likely to do so. But before considering US fiscal policy we must address the immediate question: whether the US will default on national debt. Treasury Secretary Janet Yellen has designated October 18 as the “X-date” at which the Treasury will run out of extraordinary measures to make debt payments if Congress does not raise the statutory debt ceiling. There is presumably a few weeks of leeway after this date but markets will grow very jittery and credit rating agencies will start to downgrade the United States, as Standard & Poor’s did in 2011. Chart 9Global Fiscal Drag Rears Its Head Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! Democrats have full control of Congress and can therefore suspend the debt ceiling through a party-line vote. They can do this through regular legislation, if Republicans avoid raising a filibuster, though that requires Democrats to make concessions in a back-room deal with Republicans. Or they can compromise the filibuster, though that requires convincing moderate Democrats who support the filibuster that they need to make an exception to preserve the faith and credit of the US. Or they can raise the debt ceiling via budget reconciliation, though this would run up against the time limit and so far Senate Leader Chuck Schumer claims to refuse this option. While the odds of a debt default are not zero, the Democrats have the power to avoid it and will also suffer the most in public opinion if it occurs. Therefore the debt limit will likely be suspended at the last minute in late October or early November. Investors should expect volatility but should view it as short-term noise and buy on dips – i.e. the opposite of any volatility that stems from Chinese financial turmoil. Congress is likely to pass Biden’s $550 billion bipartisan infrastructure bill (80% subjective odds). It is also likely to pass a partisan social welfare reconciliation bill over the coming months (65% subjective odds). The full impact on the deficit of both bills should range from $1.1-$1.6 trillion over ten years. This will not be enough to prevent the fiscal drag in 2022 but it will provide for a gradually expanding budget deficit over the course of the decade (Chart 10). Chart 10New Fiscal Stimulus Will Reduce Fiscal Drag On Margin Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! The reconciliation package will be watered down and late in coming. Investors will likely buy the rumor and sell the news. If reconciliation fails, markets may cheer, as it will also include tax hikes and pose the risk of pushing up inflation and hastening Fed rate hikes. Elsewhere governments are also providing “soft budgets.” The German election results confirmed our forecast that the government will change to left-wing leadership that will be able to boost domestic investment but not raise taxes. This is due to the inclusion of at least one right-leaning party, most likely the Free Democrats. Fiscal deficits will go up. Germany has a national policy consensus on most matters of importance and thus can pass some legislation. But the new coalition will be ideologically split and barely have a majority in the Bundestag, so controversial or sweeping legislation will be unlikely. This outcome is positive for German markets and the euro. Looking at popular opinion toward western leaders and their ruling coalitions since the outbreak of COVID-19, the takeaway is that the Europeans have the strongest political capital (Chart 11). Governments are either supported by leadership changes (Italy, Germany) or likely to be supported in upcoming elections (France). The UK does not face an election until 2024, unless an early election is called. This seems doubtful to us given the government’s strong majority. Chart 11DM Shifts In Popular Opinion Since COVID-19 Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! Chart 12EM Shifts In Popular Opinion Since COVID-19 Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! After all, Canada called an early election and it became a much riskier affair than the government intended and did not increase the prime minister’s political capital. Spain is far more likely to see tumult and an early election. Japan’s election in November will not bring any surprises: as we have written, Kishidanomics will be Abenomics by a different name. The implication is that after November, most developed markets will be politically recapitalized and fiscal policy will continue to be accommodative across the board. In emerging markets, popular opinion has been much more damning for leaders, calling attention to our expectation that the aftershocks of the global pandemic will come in the form of social and political instability (Chart 12). Russia has a record of pursuing more aggressive foreign policy to distract from its domestic ills. The next conflict could already be emerging, with allegations that it is deliberately pushing up natural gas prices in Europe to try to force the new German government to certify and operate the NordStream II pipeline. The Americans are already brandishing new sanctions. Chart 13Stary Neutral Dollar For Now Stary Neutral Dollar For Now Stary Neutral Dollar For Now Brazil and Turkey both face extreme social instability in the lead-up to elections in 2022 and 2023. India has been the chief beneficiary of today’s climate but it also faces an increase in political and geopolitical risk due to looming state elections and its increasing alliance with the West against China. Putting it all together, the US is likely to stimulate further and pump up inflation expectations. Europe is politically stable but Russia disrupt it. Other emerging markets, including China, will struggle with economic, political, and social instability. This is an environment in which the US dollar will remain relatively firm and the renminbi will depreciate – with negative effects on EM currencies more broadly (Chart 13). Annual Views On Track Our three key views for 2021 are so far on track but face major tests in the fourth quarter: 1. China’s internal and external headwinds: If China overtightens policy and short-circuits the global economic recovery, then its domestic political risks will have exceeded even our own pessimistic expectations. We expect China to ease fiscal policy and do at least the minimum to secure the recovery. Investors should be neutral on risky assets until China provides clearer signals that it will not overtighten policy (Chart 14). 2. Iran is the crux of the US pivot to Asia: A crisis over Iran is imminent since Biden did not restore the 2015 nuclear deal promptly upon taking office. Any disruption of Middle Eastern energy flows will add to global supply bottlenecks and price pressures. Brent crude oil prices will see upside risks relative both to BCA forecasts and the forward curve (Chart 15). Chart 14Wait For China To Relax Policy Wait For China To Relax Policy Wait For China To Relax Policy Chart 15Expect A Near-Term Crisis Over Iran Expect A Near-Term Crisis Over Iran Expect A Near-Term Crisis Over Iran The reason is that Iran is expected to reach nuclear “breakout” capability by November or December (i.e. obtain enough highly enriched uranium to make a nuclear device). The Biden administration is focused on diplomacy and so far hesitant to impose a credible threat of war to halt Iranian advances. Israel’s new government has belatedly admitted that it would be a good thing for the US and Iran to rejoin the 2015 nuclear deal – if not, it supports a global coalition to impose sanctions, and finally a military option as a last resort. Biden will struggle to put together a global coalition as effective as Obama did, given worse relations with China and Russia. The US and Israel are highly likely to continue using sabotage and cyberattacks to slow Iran’s nuclear and missile progress. Chart 16Pivot To Asia Runs Through Iran Pivot To Asia Runs Through Iran Pivot To Asia Runs Through Iran Chart 17Europe: A Post-Trump Winner? Depends On China Europe: A Post-Trump Winner? Depends On China Europe: A Post-Trump Winner? Depends On China Thus the Iranians are likely to reach breakout capability at which point a crisis could erupt. The market is not priced for the next Middle East crisis (Chart 16). Incidentally, any additional foreign policy humiliation on top of Afghanistan could undermine the Biden administration more broadly, in both domestic and foreign policy. 3. Europe benefits most from a post-pandemic, post-Trump world: Europe is a cyclical economy and is also relatively politically stable in a world of structurally rising policy uncertainty and geopolitical risk. We thought it stood to benefit most from the global recovery and the passing of the Trump administration. However, China’s policy tightening has undermined European assets and will continue to do so. Therefore this view is largely contingent on the first view (Chart 17). Investment Takeaways Strategically we maintain a diversified portfolio of trades based on critical geopolitical themes: long gold, short China/Taiwan, long developed markets, long aerospace/defense, long rare earths, and long value over growth stocks. Taiwanese equities have continued to outperform despite bubbling geopolitical tensions. We maintain our view that Taiwan is overpriced and vulnerable to long-term semiconductor diversification as well as US-China conflict. Our rare earths basket, which focuses on miners outside China, has been volatile and stands to suffer if China’s growth decelerates. But global industrial, energy, and defense policy will continue to support rare earths and metals prices. Russian tensions with the West have been manageable over the course of the year and emerging European stocks have outperformed developed European peers, contrary to our recommendation. However, fundamental conflicts remain unresolved and the dispute over the recently completed Nord Stream II pipeline to Germany could still deal negative surprises. We will reassess this recommendation in a future report. We are booking gains on the following trades: long Mexico (8%), long aerospace and defense in absolute terms (4%), long EU industrials relative to global (4%), and long Italian BTPs relative to bunds (0.2%).   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix: 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 Appendix: Geopolitical Calendar

Highlights We cannot predict how China will manage Evergrande precisely but we have a high conviction that it will do whatever it takes to prevent contagion across the property sector. However, China’s stimulus tools are losing their effectiveness over time. The country is due for a prolonged struggle with financial and economic instability regardless of whether Evergrande defaults. A messy default would obviously exacerbate the problem. China’s regulatory crackdowns target private companies and will continue to weigh on animal spirits in the private sector. The government will be forced to use fiscal policy to compensate. The US’s and China’s switch from engagement to confrontation poses a persistent headwind for investor sentiment toward China. The new consensus that investors should buy into China’s “strategic sectors” to avoid arbitrary regulatory crackdowns is vulnerable to its own logic and to sanctions by the US and its allies. Feature China poses a unique confluence of domestic and foreign political risks and global markets are now pricing them. Property giant Evergrande could default on $120 million in onshore and offshore interest payments as early as September 23, or next month, prompting investors to run for cover. Is this crisis fleeting or part of a larger systemic failure? It is a larger systemic failure. We expect a slow-motion, Japanese-style crisis over the coming decade, marked with periodic bailouts and stimulus packages. We recommend investors stay the course: steer clear of China and stay short the renminbi and Taiwanese dollar. Tactically, stick with large caps, defensive sectors, and developed markets within the global equity universe. Strategically, prefer emerging markets that benefit from forthcoming Chinese (and American) stimulus. 1. A “Minsky Moment” Cannot Be Ruled Out The chief fear is whether the approaching default of Evergrande marks China’s “Minsky Moment.” Hyman Minsky’s financial instability hypothesis held that long periods of stable revenues lead to risky financial deals and large accumulations of systemic risk that are underpriced. When revenues cannot cover interest payments, a crash ensues followed by deleveraging. Minsky’s hypothesis speaks to debt crises in an entire economy, yet nobody knows for sure whether China’s economy has reached such a breaking point. China’s national savings rate stands at 45.7% of GDP and nominal growth exceeds the long-term government bond yield. However, a sharp drop in asset prices, especially in the property sector, could change everything, as it could lead to balance sheet recession among corporates and a fall in national income. Evergrande is supposed to make an $84 million interest payment on offshore debt and a $36 million payment on onshore debt this week, and after 30 days it would default. It owes $37 billion in debt payments over the next 12 months but only has $13 billion cash on hand (as of June 30, 2021). Authorities can opt for a full bailout or a partial bailout, in which the company defaults on offshore bonds but not onshore. They could even let the company fail categorically, though that would produce exactly the kind of precipitous drop in property asset prices that would lead to wider financial contagion. State intervention to smooth the crisis is more likely – and the government can easily pressure other companies into acquiring Evergrande’s assets and business divisions. Chart 1Yes, This Could Be China's Minsky Moment Yes, This Could Be China's Minsky Moment Yes, This Could Be China's Minsky Moment Chart 1 shows that China’s corporate debt-to-GDP ratio stands head and shoulders above other countries that experienced financial crises in recent decades, courtesy of our Emerging Markets Strategy. While China can undoubtedly bear large debts due to its savings, the implication is that China has large enough financial imbalances to suffer a full-fledged financial crisis, even if the timing is hard to predict. Household credit is also elevated at 61.7% of GDP, and the household debt-to-disposable-income ratio is now higher than in the United States. About two-thirds of China’s corporate debt is held by state-owned or state-controlled entities, prompting some investors to dismiss the gravity of the risk. However, financial crises often involve the transfer of debt from the state to private sector or vice versa. 59% of bond defaults in H1 2021 have involved state companies. Total debt is the main concern. Don’t take our word for it: China’s Communist Party has warned for the past decade about the danger of “implicit guarantees” and “moral hazard” that encourage financial excesses in the corporate sector. The Xi Jinping administration has tried to induce a deleveraging process since it came to power in 2012-13. Xi’s “three red lines” for the property sector precipitated the current turmoil. Even if Evergrande’s troubles are managed, China’s systemic risks will continue to boil over as its potential growth rate slows and the government continues trying to wring out financial excesses. Chart 2Policy Uncertainty, Financial Stress Can Rise Higher Policy Uncertainty, Financial Stress Can Rise Higher Policy Uncertainty, Financial Stress Can Rise Higher More broadly China is experiencing an unprecedented overlap of economic and political crises: The population is aging and labor force is shrinking; The economic model since 2009 has been changing from export-manufacturing to domestic-oriented, investment-driven growth; Indebtedness is spreading from corporates to households and ultimately the government; The governance model is shifting from “single-party rule” to “single-person rule” or autocracy; The population is reaching middle class status and demanding better quality of life; The international trade environment is turning from hyper-globalization to hypo-globalization; The geopolitical backdrop is darkening with the US and its allies attempting to contain China’s ambitions of regional supremacy. Almost all of these changes bring more risks than opportunities to China over the long haul. The need for rapid policy shifts provides the ostensible reasoning for President Xi Jinping’s decision not to step down but to remain president for the foreseeable future. He will clinch this position at the twentieth national party congress in fall 2022. The implication is that policy uncertainty will continue climbing up to at least 2019 peaks while offshore equity markets will continue to trend lower, as they have done since the onset of the US trade war (Chart 2). Credit default swap rates have so far been subdued but they are showing signs of life. A sharp rise in policy uncertainty and property sector stress would pull them up. Domestic equities (A-shares) have rallied since 2019 but we would expect them to fall back given China’s historic confluence of structural and cyclical challenges, which will create further negative surprises (Chart 2, bottom panel). 2. Beijing Will Provide Bailouts And Stimulus Ad Nauseum Evergrande’s future may be in doubt but Beijing will throw all its power at stopping nationwide financial contagion. True, a policy miscalculation is possible. A tardy or failed intervention cannot be ruled out. However, investors should remember that a clear pattern of bailouts and stimulus has emerged over the course of the Xi Jinping administration whenever a “hard landing” or financial collapse loomed. The government tightens controls on bloated sectors until the financial fallout threatens to undermine general economic and social stability, at which point the government eases policy. It is often forced to stimulate the economy aggressively. Chart 3 shows these cycles in two ways: China’s control of credit through the state-controlled banks, and the frequency of news stories mentioning important terms associated with financial and economic distress: defaults, layoffs, and bankruptcies. These three terms used to be unheard of among China watchers. Under the Xi administration, a higher tolerance of creative destruction has served as the way to push forward reform. The current rise in distress is not extended, suggesting that more bad news is coming, but it also shows that the government has repeatedly been forced to provide stimulus even under the Xi administration. Chart 3Xi Jinping Has Bailed Out System Three Times Already Xi Jinping Has Bailed Out System Three Times Already Xi Jinping Has Bailed Out System Three Times Already Could this time be different? Not likely. The American experience and the pandemic will also force China’s government to ease policy: China learns from US mistakes. The US lurched from Lehman’s failure into a financial crisis, an impaired credit channel, a sluggish economic recovery, a spike in polarization, policy paralysis, a near-default on the national debt, a surge in right- and left-wing populism, the tumultuous Trump presidency, widespread social unrest, a contested leadership succession, and a mob storming the nation’s capitol (Chart 4). This is obviously the nightmare of any Chinese leader and a trajectory that the Xi administration will avoid at any cost. Chart 4Lehman Brothers A Powerful Disincentive For China To Let Evergrande Fail Lehman Brothers A Powerful Disincentive For China To Let Evergrande Fail Lehman Brothers A Powerful Disincentive For China To Let Evergrande Fail Chinese households store their wealth in the property sector, so any attempt at policy restraint or austerity faces a massive constraint. Only a few countries are comparable to China with respect to the share of non-financial household wealth (property and land) within total household wealth. All of them are hosts of property sector bubbles, including the bubbles in Spain and Ireland back in 2007 (Chart 5). A property collapse would destroy the savings of the Chinese people over four decades of prosperity. Chart 5Property Is The Bedrock Of Chinese Households Five Points On China’s Crisis Five Points On China’s Crisis Social instability is already flaring up. Almost all China experts agree that “social stability” is the Communist Party’s bottom line. But note that the Evergrande saga has already led to protests, not only at the company’s headquarters in Shenzhen but also in other cities such as Shenyang, Guangzhou, Chongqing. Protests were filmed and shown on social media (posts have been censored). Protesters demanded repayment for wealth management products gone sour and properties they are owed that have not been built. This is only a taste of the cross-regional protests that would emerge if the broader property sector suffered. The lingering COVID-19 pandemic is still relevant. Investors should not underrate the potential threat that the pandemic poses to the regime. Severe epidemics have occurred about 11% of the time over the course of China’s history and they often have major ramifications. Disease has played a role in the downfall of six out of ten dynasties – and in four cases it played a major role. It would be suicidal for any regime to add self-inflicted economic collapse to a lingering pandemic (Table 1). Table 1Disease Threatens Chinese Dynasties – Not A Time To Self-Inflict A Recession Five Points On China’s Crisis Five Points On China’s Crisis Easing policy does not necessarily mean bringing out the “bazooka” and splurging on money and credit growth, though that is increasingly likely as the crisis intensifies. Notably the July Politburo statement specifically removed language that said China would “avoid sharp turns in policy.” In other words, sharp turns might be necessary. That can only mean sharp reflationary turns, as there is very little chance of doubling down on policy tightening. A counterargument holds that the Chinese government is now exclusively focused on power consolidation to the neglect of financial and economic stability. Perhaps the leadership is misinformed, overconfident, or thinks a financial collapse will better purge its enemies – along the lines of the various political purges under Chairman Mao Zedong. Wealthy tech magnates and property owners could conceivably challenge the return of autocracy. After all, the US political establishment almost “fell” to a rich property baron – why couldn’t China’s Communist Party? Political purges should certainly be expected ahead of next year’s party congress. But not to the point of killing the economy. The government would not be trying to balance policy tightening and loosening so carefully if it sought to induce chaos. It must be admitted, however, that the change to autocracy means that the odds of irrational or idiosyncratic policy have gone up substantially and permanently. Of course, the high likelihood that Beijing will provide bailouts and stimulus should not be read as a bullish investment thesis, even though it would create a pop in oversold assets. The Chinese system is saturated with money and credit, which have been losing their effectiveness in driving growth. Financial imbalances get worse, not better, with each wave of credit stimulus. Beijing is caught between a rock and a hard place. Hence stimulus comes only reluctantly and reactively. But it does come in the end because a financial crash would threaten the life of the regime and preclude all other policy priorities, domestic and foreign. 3. Yes, China’s Regulatory Crackdown Targets The Private Sector Global growth and other emerging economies will get most of the benefit once China stimulates, since China’s own firms will still face a negative domestic political backdrop. Bullish investors argue that the government’s regulatory tightening is misunderstood and overblown. The claim is that China is not targeting the private sector generally but only isolated sectors causing social problems. Costs need to be reduced in property, education, and health to improve quality of life. China shares the US’s and EU’s desire to rein in tech giants that monopolize their markets, abuse consumer data and privacy, and benefit from distorted tax systems. Most of these arguments are misleading. China does not have a strong record on data privacy, equality, social safety nets, rule of law, or “sustainable” growth (as opposed to “unsustainable,” high-debt, high-polluting growth). China actively encourages state champions that monopolize key sectors. Many developed markets have better records in these areas, notably in Europe, yet China is eschewing these regulatory models in preference for an approach that is arbitrary and absolutist, i.e. negative for governance. As for the private sector, animal spirits have been in a long decline throughout the past decade. This is true whether judging by money velocity – i.e. the pace of economic activity relative to the increase in money supply – or by households’ and businesses’ marginal propensity to save (Chart 6). The 2015-16 period shows that even periodic bouts of government stimulus have not reversed the general trend. Regulatory whack-a-mole and financial turmoil will not improve the situation. Chart 6Private Sector Animal Spirits Depressed Throughout Xi Era Private Sector Animal Spirits Depressed Throughout Xi Era Private Sector Animal Spirits Depressed Throughout Xi Era Chart 7Even Official Data Shows Consumer Confidence Flagging Even Official Data Shows Consumer Confidence Flagging Even Official Data Shows Consumer Confidence Flagging Surveys of sentiment confirm that the latest developments will have a negative effect (Chart 7). Cumulatively, the changes in China’s domestic and international policy context are being interpreted as negative for business, entrepreneurship, and economic freedom – notwithstanding the government’s claims to expand opportunity in its “common prosperity” plan. 4. The Withdrawal Of US Friendship Is A Headwind For China Chart 8Other Asians Sought US Friendship, Not Conflict, When Export Models Expired Other Asians Sought US Friendship, Not Conflict, When Export Models Expired Other Asians Sought US Friendship, Not Conflict, When Export Models Expired All of the successful Asian economies – including China for most of the past forty years of prosperity – have tried to stay on the good side of the United States. By contrast, China and the US today are shifting from engagement to confrontation and breaking up their economic ties (Chart 8). This is a problem for China because the US and to some extent its allies will seek to undermine China’s economy and its autocratic model as part of this great power competition. The rise in geopolitical risk is underscored by the Australia-UK-US (AUKUS) agreement, by which the US will provide Australia with nuclear submarines over the next decade. This was a clear demonstration of the US’s “pivot to Asia” and the fact that the US and China are preparing for war – if only to deter it. China’s return to autocracy and clash with the US and Asian neighbors is also leading to a deterioration of its global image, particularly over issues of transparency and information sharing. The dispute over the origins of COVID-19 is a major source of division with the US and other countries. Transparency is important for investors. The World Bank has discontinued its “Ease of Doing Business” rankings after a scandal was revealed in which China’s ranking was artificially bumped up. The last-published trend is still downward (Chart 9). Most recently China has stepped up censorship of its financial news media amid the current market turmoil, which makes it harder for investors to assess the full extent of property and financial risks.1 The US political factions agree on China-bashing if nothing else. The Biden administration has little political impetus to eschew tariffs and export controls. One important penalty will come from the Securities and Exchange Commission, which is likely to ban Chinese firms from US stock exchanges unless they conform to common accounting standards. Hence the dramatic fall in the share prices of Chinese companies listed via American Depository Receipts (ADRs), in both absolute and relative terms (Chart 10, top panel). This threat prompted China’s recent crackdown on its own firms that were attempting to hold initial public offerings on US exchanges. Chart 9US Conflict Exposes China’s Global Influence Campaign Five Points On China’s Crisis Five Points On China’s Crisis The Quadrilateral Forum – the US, Japan, Australia, and India – has agreed to link the semiconductor supply chain to human rights standards, foreclosing China’s participation in that supply chain. US semiconductor firms are among the most exposed to China but they have not suffered over the course of the US-China tech war, suggesting that US vulnerabilities are limited (Chart 10, bottom panel). Chart 10US Regulators Will Kick Chinese Firms While They Are Down US Regulators Will Kick Chinese Firms While They Are Down US Regulators Will Kick Chinese Firms While They Are Down The point is not to exaggerate the strength of the US and its allies but rather the costs to China of actively opposing them. The US has a difficult enough time cobbling together a coalition of states to impose sanctions on Iran over its nuclear program, not to mention forming any coalition that would totally exclude and isolate China. China is far more important to US allies than Iran – it is irreplaceable in the global economy (Chart 11). The EU and China’s Asian neighbors will typically restrain the US’s more aggressive impulses so as not to upset the global recovery or end up on the front lines of a war.2 Chart 11No Substitute For China In Global Economy Five Points On China’s Crisis Five Points On China’s Crisis This diplomatic constraint on the US is probably positive for global growth but not for China per se. American allies are still able to increase the costs on China for pursuing its own state-backed development path and geopolitical sphere of influence. Japan, Australia, and others are likely to veto China’s application to join the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), while the UK and eventually the US are likely to join it. Investors should view US-China ties as a headwind at least until the two powers manage to negotiate a diplomatic thaw, i.e. substantial de-escalation of tensions. A thaw is unlikely in the lead-up to Xi Jinping’s consolidation of power and the US midterm elections in fall 2022. Presidents Biden and Xi are still working on a bilateral summit, not to mention a more substantial improvement in ties. We doubt a diplomatic thaw would be durable anyway but the important point is that until it happens China will face periodic bouts of negative sentiment from the emerging cold war. Other Asian economies thrived under US auspices – China is sailing in uncharted waters. 5. Global Investors Cannot Separate Civilian From State And Military Investments The word on Wall Street is that investors should align their strategies with those of China’s leaders so as not to run afoul of arbitrary and draconian regulators. For example, instead of “soft tech” or consumer-oriented companies – like those that give people rides, deliver food, or make creative video games – investors should invest in “hard tech” or strategic companies like those that make computer chips, renewable energy, biotechnologies, pharmaceuticals, and capital equipment. There is no question that the trend in China – and elsewhere – is for governments to become more active in picking winners and losers. Industrial policy is back. Investors have no choice but to include policy analysis in their toolbox. However, for global investors, an investment strategy of buying whatever the government says is far from convincing. The most basic investment strategy in keeping with the Xi administration’s goals would be to invest in state-owned enterprises in domestic equity markets. So SOEs should have outperformed the market, right? Wrong. They were in a downtrend prior to the 2015 bubble, the burst of which caused a further downtrend (Chart 12, top panel). Similarly, the preference for “hard tech” over “soft tech” is promising in theory but complicated in practice: hard tech is flat-to-down over the decade and down since COVID-19 (Chart 12, middle panel). It has underperformed its global peers (Chart 12, bottom panel). China’s policy disposition should be beneficial for industrials, health care, and renewable energy. First, China is doubling down on its manufacturing economy. Second, the population is aging and health care is a critical part of the common prosperity plan. Third, green energy is a way of diversifying from dependency on imported oil and natural gas. However, the profile of these sectors relative to their global counterparts is only unambiguously attractive in the case of industrials, which began to outperform even during the trade war (Chart 13). Chart 12State Approved' Trades Still Bring Risks State Approved' Trades Still Bring Risks State Approved' Trades Still Bring Risks Chart 13Beware 'State Approved' Trades Beware 'State Approved' Trades Beware 'State Approved' Trades In Table 2 we outline the valuations and political risks of onshore equity sectors. Valuations are not cheap. Domestic and foreign risks are not fully priced. Table 2China Onshore Equities, Valuations, And (Geo)Political Risks Five Points On China’s Crisis Five Points On China’s Crisis There is a bigger problem for global investors, especially Americans: investing in China’s strategic sectors directly implicates investors in the Communist Party’s domestic human rights practices, state-owned enterprises, and national security goals. “Civil-military fusion” is a well-established doctrine that calls for the People’s Liberation Army to have access to the cutting-edge technology developed by civilians and vice versa. These investments will eventually be subject to punitive measures since the US policy establishment believes it can no longer afford to let US wealth buttress China’s military and technological rise. Investment Takeaways China may or may not work out a partial bailout for Evergrande but it will definitely provide state assistance and fiscal stimulus to try to prevent contagion across the property sector and financial system. Bad news in the coming weeks and months will be replaced by good news in this sense. However, the fact that China will eventually be forced to undertake traditional stimulus yet again will increase its systemic financial risks, in a well-established pattern. The best equity opportunities will lie outside of China, where companies will benefit from global recovery yet avoid suffering from China’s unique confluence of domestic and foreign political risks. We prefer developed markets and select emerging markets in Latin America and Asia-ex-China. Chinese households and businesses are downbeat. This behavior cannot be separated from the historic changes in the economy, domestic politics, and foreign policy. It is hard to see an improvement until the government boosts growth and the 2022 political reshuffle is over. American opposition is a bigger problem for China than global investors realize. Not only are the two economies divorcing but other democracies will distance themselves from China as well – not because of US demands but because their own manufacturing, national security, and ideological space is threatened by China’s reversion to autocracy and assertive foreign policy. Investing in China’s “hard tech” and strategic sectors with government approval is not a simple solution. This approach will directly funnel capital into China’s state-owned enterprises, domestic security forces, and military. As such the US and West will eventually impose controls. Investments may not be liquid since China would suffer if capital ever fled these kinds of projects. Both American and Chinese stimulus is looming this winter but the short run will see more volatility. We are closing our long JPY-KRW tactical trade for a gain of 4.4%   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 We have often noted in these pages over the past decade that multilateral organizations overrated improvements in China’s governance based on policy pronouncements rather than structural changes. 2 Still, tensions among the allies should not be overrated since they share a fundamental concern over China’s increasing challenge to the current global order. The EU is pursuing trade talks with Taiwan, and there are ways that the US can compensate France over the nullification of its submarine sales to Australia (most of which are detrimental to China’s security).

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 The US dollar’s reserve status will remain intact for the foreseeable future. While this privilege is fraying at the edges, there are no viable alternatives just yet. There is an overarching incentive for any country to hold onto its currency’s power. For the US, it is still well within their ability to keep this “exorbitant privilege.” That said, there will be rolling doubts about the ability of the US to maintain its large currency sphere. This will create tidal waves in the currency’s path, providing plenty of trading opportunities for investors. China is on track to surpass the US in economic size, but it is far from dethroning the US in the military realm. However, it is gradually gaining the ability to deny the US access to its immediate offshore areas and may already be capable of winning a war over nearby islands like Taiwan. Watch the RMB over the next few decades. From a macro and cyclical perspective, the dollar is likely to decline as global growth picks up and the Fed lags market expectations in raising rates. From a geopolitical perspective, however, the backdrop is neutral-to-bullish for the dollar over the next three to five years. Feature Having the world’s reserve currency comes with a few advantages, which any governments would be loath to give up. The most important advantage is the ability to settle one’s balance of payments in one’s own currency. This not only facilitates trade for the reserve nation, it also reinforces the turnover of the reserve currency internationally. The value of this privilege is as much symbolic as economic. This “first mover advantage” or adoption of one’s currency internationally automatically ordains the resident central bank as the world’s bank. The primary advantage here is being able to dictate global financial conditions, expanding and contracting money supply to address domestic and global funding pressures. As compensation for this task, the world provides one with non-negligible seigniorage revenue. Being the world’s central bank also comes with another crucial advantage: being able to choose which international projects will be funded, while using cheaply issued local debt to finance these investments. Of course, any sensible society will earn more on its investments than it pays on the debt issued. There is a geopolitical angle to having the world’s reserve currency. A nation’s currency is widely held because of strategic depth—its ability to secure the people who trade in that currency and the property denominated in it. Deposits and transactions can be monitored, secured, or even halted at the behest of the sovereign. Holding the currency means one can maintain one’s purchasing power, given that it is backed by the most powerful country in the world. As the reserve currency becomes the de facto international medium of exchange, having stood the test of time through various crises, this allows the resident country to alter its purchasing power to achieve both national and international goals. Throughout history, having the world’s reserve currency has been the pursuit of many governments and kingdoms. In the current paradigm, the US enjoys this privilege. But could that change? And if so, how and when? Our goal in this report is threefold. First, why would any country want to maintain reserve status? Second, does the US still possess the apparatus to keep the dollar as a reserve asset over the next decade? And finally, are there any identifiable threats to the US dollar reserve status beyond a ten-year horizon? The Imperative To Maintain Status Quo Global trade is still largely conducted in US dollars. According to the BIS triennial central bank survey, 88.3% of transactions globally were in dollars just before the pandemic, a percentage that has been rather resilient over the last two decades (Chart I-1). It is true that currencies such as the Chinese renminbi have been gaining international acceptance, but displacing a currency that dominates almost 90% of global transactions is a herculean task. Surprisingly, the world has been transacting less often in euros and Japanese yen, currencies that also commanded international appeal in recent history. Chart I-1The US Dollar Still Dominates Global Transactions Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? The big benefit for the US comes from being able to settle its balance of payments in dollars. This not only lowers transaction costs (by lowering exchange rate risk), but it also provides the ability to cheaply borrow in your own currency to pay for imports. Having global trade largely denominated in US dollars also establishes a network of systems that make it much easier to settle trade in that currency. It is remarkable that, despite running a persistent current account deficit, the US dollar has tended to appreciate during crises, a privilege other deficit countries do not enjoy (Chart I-2). Strong network effects make the US dollar the currency of choice during crises. Chart I-2Despite Running A Current Account Deficit, The Dollar Tends To Rise During Crises Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Chart I-3The US Generates Non-Negligible Seignorage Revenue The US Generates Non-Negligible Seignorage Revenue The US Generates Non-Negligible Seignorage Revenue Being at the center of the global financial architecture comes with an important benefit beyond trade: the ability to dictate financial conditions both domestically and globally. Consider a scenario in which the US and the global economy are facing a downturn. In this scenario, the Federal Reserve can be instrumental in turning the tide: To stimulate the US economy, the Fed lowers interest rates and/or runs a wider fiscal deficit. The central bank helps finance this fiscal deficit by expanding the monetary base (benefitting from seigniorage revenue). As the Fed drops interest rates, the yield curve steepens. Banks use the positive term structure to borrow at the short end of the curve and lend at the longer end. This boosts the US money supply. As firms borrow to invest, this increases demand for imports (machinery, commodities, consumer goods), widening the US current account deficit. US trade is settled in dollars, increasing the international supply of the greenback. To maintain competitiveness, other central banks purchase these dollars from the private sector, in exchange for their local currency. As global USD reserves rise, they can be reinvested back into Treasuries and held in custody at the Fed. In essence, the US can finance its budget deficit through a strong capital account surplus. The seigniorage revenue that the US enjoys by easing both domestic and international financing conditions is about $100 billion a year or roughly 0.5% of GDP (Chart I-3). But the goodwill from being able to dictate both domestic and international financial conditions is far greater. At BCA, one of our favorite measures of global dollar liquidity is the sum of the Fed’s custody holdings together with the US monetary base. Every time this measure has severely contracted in the past, the shortage of dollars has triggered a financial crisis somewhere, typically among other countries running deficits (Chart I-4), a highlight of the importance of the US as a global financier. Chart I-4US Money Supply And Global Liquidity US Money Supply And Global Liquidity US Money Supply And Global Liquidity Chart I-5Despite A Liability Shortfall, US Assets Generate A Net Profit Despite A Liability Shortfall, US Assets Generate A Net Profit Despite A Liability Shortfall, US Assets Generate A Net Profit Beyond seigniorage revenue, the US enjoys another advantage—being able to earn much more on its international investments than it pays on its liabilities. The US generates an excess return of 1% of GDP from its external assets, despite having a net liability shortfall of 67% of GDP (Chart I-5). The ability to issue debt that will be gobbled up by foreigners, and in part use these proceeds to generate a higher overall return on investments made abroad, does indeed constitute an “exorbitant privilege.” In a nutshell, there is a very strong incentive for the US to keep the dollar as the world’s reserve currency. One short-term implication is that the Fed might only taper asset purchases and/or raise interest rates in an environment in which both global and US growth are strong, or it could otherwise trigger a global liquidity crisis. This will be particularly the case given the Delta variant of COVID-19 is still hemorrhaging global economic activity. An Overreach In The Dollar’s Influence There is a political advantage to the US dollar’s reserve status that is often overlooked: transactions conducted in US dollars anywhere in the world fall under US law. In simple terms, if a company in any country buys energy from Iran and the transaction is done in US dollars, the Treasury has powers to sanction the parties involved. Since most companies across the world cannot afford to be locked out of the US financial system, they will tend to comply with US sanctions. Even companies that operate under the umbrella of great powers, such as China and Russia, still tend to adhere to US sanctions, because they do not want to jeopardize their trade with US allies, such as the European Union. Of course, China, Russia, and Iran are actively seeking alternative transaction systems to bypass the dollar and US sanctions. But they do not yet trust each other’s currencies. Chart I-6A Deep And Liquid Pool Of Treasurys A Deep And Liquid Pool Of Treasurys A Deep And Liquid Pool Of Treasurys The euro is the only viable alternative; however, the euro’s share of global transactions has fallen, despite the EU’s solidification as a monetary union over the past decade and despite the unprecedented deterioration of US relations with China and Russia. The EU could do great damage to the USD’s standing if it joined Russia’s and China’s efforts wholeheartedly, but the EU is still a major trading partner of the US and shares many of the same foreign policy aims. It is also chronically short of aggregate demand and runs trade and current account surpluses, depriving trade partners of euro savings or a debt market to recycle those savings (Chart I-6). Historically, having the world’s reserve currency allows the US to conduct international accords that serve both domestic and foreign interests. The Plaza Accord, signed in the 1980s to depreciate the US dollar, served both US interests in rebalancing the deficit and international interests in financing global trade. The 1980s were golden years for Japan and the Asian tigers on the back of a weak USD, allowing entities to borrow in greenbacks and profitably invest in Asian growth. Once the US dollar had depreciated by a fair amount, threatening its store of value, the US engineered the Louvre Accord to stabilize exchange rates. Ultimately, when various Asian bubbles popped, investors thought of nowhere better to flee than to the safety of the US dollar. The same thing happened after the emerging market boom of the 2000s and the eventual bust of the 2010s. Today, the US may not be able to organize an international intervention, if one should be necessary in the coming years. Past experience shows that countries act unilaterally and coordinated interventions lack staying power. Neither Europe nor Japan is in the position today to allow currency appreciation, as they were in the past. And the US has shown itself unable to combat its trading partners’ depreciation, as in the case of China, whose renminbi remains below 2014 levels. The bottom line is that there is nothing to stop the US from attempting to stretch its overreach too far, which would create a backlash that diminishes the dollar’s status. This is especially the case given trust in the US government is quite low by historical standards, which for now points to a lower dollar cyclically (Chart I-7). Chart I-7Trust In The US Government And The Dollar Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? This is not to say that other countries with reserve aspirations can tolerate sustained appreciation. China has recommitted to manufacturing supremacy in its latest five-year plan, as it fears the political consequences of rapid deindustrialization. As such, the renminbi will be periodically capped to maintain competitiveness. Can The US Maintain Status Quo? Chart I-8A Lifespan Of Reserve Currencies Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Over the last few centuries, reserve currencies have tended to have a lifespan of about 100 years (Chart I-8). The reason is that global wars tend to knock the leading power off its geopolitical pedestal, devaluing its currency and giving rise to a new peace settlement with a new ascendant country whose currency then becomes the basis for international trade. Such was the case for Spain, France, the UK, and the United States in a pattern of war and peace since the sixteenth century. Granting that the US dollar took the baton from sterling in the 1920s and that the post-World War II peace settlement is eroding in the face of escalating geopolitical competition, it is reasonable to ask whether or not the US might lose its grip on this power. To assess this possibility, it is instructive to revisit the anatomy of a reserve currency: Typically, a reserve currency tends to be that of the “greatest” nation. For the same reason, the reserve nation tends to be the wealthiest, which ensures that its currency is a store of value and that it can act as a buyer of last resort during crisis (Chart I-9). This reasoning is straightforward when a global empire is recognizable and unopposed. But in the current context of multipolarity, or great power competition, the paradigm could start to shift. Global trade is slowing globally, but it is accelerating in Asia (Chart I-10). China is a larger trading partner than the US for many emerging markets and is slated to surpass the US economy over the next decade. The renminbi has a long way to go to rival the dollar, but it is gradually rising and its place within the global reserve currency basket is much smaller than its share of global trade or output, implying room for growth (Chart I-11). Chart I-9Wealth And Reserve Currency Status Go Hand-In-Hand Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Chart I-10Trade In Asia Is Booming Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Chart I-11Adoption Of The RMB Has Room To Grow Adoption Of The RMB Has Room To Grow Adoption Of The RMB Has Room To Grow To maintain hegemonic power (especially controlling the vital supply routes of prosperity), the reserve nation needs military might above and beyond everyone else. It helps that US military spending remains the biggest in the world, in part financed by US liabilities (Chart I-12). China is far from dethroning the US in the military realm. But it is gradually gaining the ability to deny the US access to its immediate offshore areas and may already be capable of winning a war over nearby islands like Taiwan. Moreover, its naval power is set to grow substantially between now and 2030 (Table I-1). Already, over the past decade, the US stood helplessly by when Russia and China annexed Crimea and the reefs of the South China Sea. It is possible to imagine a series of events that erode US security guarantees in the region, even as the US loses economic primacy. Chart I-12The US Still Maintains Military Might Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Table I-1China’s Economic And Naval Growth Slated To Reduce American Primacy In Asia Pacific Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? The reserve currency nation needs to run deficits to finance activity in the rest of the world. That requires having deep and liquid capital markets to absorb global savings. There is considerable trust or “goodwill” that makes the US Treasury market the most liquid debt exchange pool in the world. This remains the case today (previously mentioned Chart I-6). Even so, this trend is shifting. The growth in euro- and yen-denominated debt is exploding. This mirrors the gradual shift in the allocation of FX reserves away from dollars into other currencies. If the US began to use the dollar as a geopolitical weapon recklessly, foreign entities may have no other choice but to rally into other currency blocks, including the euro (and perhaps eventually the yuan). This will take years, but it is worth noting that global allocation to FX reserves have fallen from around 80% toward USDs in the 70s to around 60% today (Chart I-13). Chart I-13The Dollar Reserve Status Has Been Ebbing The Dollar Reserve Status Has Been Ebbing The Dollar Reserve Status Has Been Ebbing On the political front, there is some evidence that public opinion on the dollar is fading, although it is far from damning. A Pew survey on the trust in the US government is near decade lows and has tracked the ebb and flow of changes in the dollar (previously shown Chart I-7). Trust in government will probably not get much worse in the coming years, as the pandemic will wane and stimulus will secure the economic recovery, but too much stimulus could conceivably ignite an inflation problem that weighs on trust. True, populism has driven the US government under two administrations into extreme deficit spending. With the pandemic as a catalyst, US deficits have reached WWII levels despite the absence of a war. However, the Biden administration’s $3.5 trillion spending bill will be watered down heavily – and the 2022 midterms will likely restore gridlock in Congress, freezing fiscal policy through at least 2025. In other words, fiscal policy is negative for the dollar in the very near term, but the fiscal outlook is not yet so extravagant as to suggest a loss of reserve currency status. After all, there is some positive news for the US. The US demonstrated its leadership in innovation with the COVID-19 vaccines; it survived its constitutional stress test in the 2020 election; it is now shifting from failed “nation building” abroad to nation building at home; and its companies remain the most innovative and efficient, judging by global equity market capitalization (Chart I-14). China, meanwhile, is facing the most severe test of its political and economic system since it marketized its economy in 1979. Investors should not lose sight of the fact that, since the rise of President Xi Jinping and Russia’s invasion of Ukraine, global policy uncertainty has tended to outpace US policy uncertainty, attracting flows into the dollar (Chart I-15). Given that China and Russia are both pursuing autocratic governments at the expense of the private economy, it would not be surprising to see global policy uncertainty take the lead once again, confirming the decade trend of global flows favoring the US when uncertainty rises. Chart I-14American Primacy Still Clear In Equity Market American Primacy Still Clear In Equity Market American Primacy Still Clear In Equity Market Chart I-15Higher Policy Uncertainty Good For Dollar Higher Policy Uncertainty Good For Dollar Higher Policy Uncertainty Good For Dollar The bottom line is that the US dollar is gradually declining as a share of the global currency reserve basket, just as the US economy and military are gradually declining as a share of global output and defense spending. Yet the US will remain the first or second largest economy and premier military power for a long time, and the dollar still lacks a viable single replacement. A major war or geopolitical crisis is probably necessary to precipitate a major breakdown. The Iranian Revolution and September 11 attacks both had this kind of effect (see 1979 and 2001 in Chart I-13 above). But COVID-19 is less clear. If China and Europe emerge as more stable than the US, then the post-pandemic aftermath will bring more bad news for the dollar. Investment Implications From a geopolitical perspective, the backdrop is neutral for the dollar beyond the next twelve to eighteen months. An escalating conflict with Iran—which is possible in the near term—would echo the early 2000s and weigh on the currency. But a deal with Iran and a strategic pivot to Asia would compound China’s domestic political problems and likely boost the greenback. Chart I-16US Twin Deficits And The Dollar US Twin Deficits And The Dollar US Twin Deficits And The Dollar From a macro and cyclical perspective, however, the view is clearly negative for the dollar. Over the next five years, the U.S. Congressional Budget Office (CBO) estimates that the U.S. budget deficit will shrink and then begin expanding again to -5% of GDP. If one assumes that the current account deficit will widen somewhat, then stabilize, the twin deficits will be pinned at around -10% of GDP. Markets have typically punished the dollar on rising twin deficits (Chart I-16). This suggests near-term pressure on the dollar’s reserve status is to the downside. EM currencies may hold a key to the performance of the dollar. While most EM economies remain hostage to the virus, a coiled-spring rebound cannot be ruled out as populations become vaccinated. China’s Politburo signaled in July that it will no longer tighten monetary and fiscal policy. We would expect policy easing over the next twelve months to ensure the economy is stable in advance of the fall 2022 party congress. If the virus wanes and China’s economy is stimulated, global growth will improve and the dollar will fall.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com

Highlights China’s new plan for “common prosperity” is a long-term strategic plan to bulk up the middle class that will strengthen China – if it is implemented successfully. The record on implementing reforms is mixed. Large budget deficits to provide subsidies for households and key industries are inevitable. But fiscal reforms will be more difficult. Implementation will proceed gradually and some provinces will move faster than others. Cyclically, the common prosperity plan will not be allowed to interfere with the post-pandemic economic recovery. Beijing will have to ease monetary and fiscal policy to secure the recovery. But large debt levels create a limit on the ability to push through key reforms. Macro policy easing is beneficial for the rest of the world but Chinese investors must deal with a rise in uncertainty and an anti-business turn in the policy environment. Beijing has centralized political power to move rapidly on reforms. However, centralization creates new structural problems while antagonizing foreign nations. Feature Chinese President Xi Jinping laid out a plan on August 18 for “common prosperity” in China that will help guide national policy over the coming decades. The plan seeks to reduce social and economic imbalances and hence strengthen China and reinforce the Communist Party’s rule. The plan confirms our top key view for the year – China’s confluence of internal and external risks – as well as our long-running theme that Chinese domestic political risk is greater than it looks because of underlying problems like inequality and weak governance. The market has woken up to these views and themes (Chart 1). Now Beijing is turning to address these problems, which is positive if it follows through. But investors will have to cope with new policies and laws that reverse the pro-business context of recent decades. In this report we review the new plan and its implications in the context of overall Chinese economic policy. The chief investment takeaway is that while China will push forward various reforms, Beijing cannot afford to self-inflict an economic collapse. Monetary and fiscal policy will ease over the coming 12 months. As such China policy tightening will not short-circuit the global recovery. However, Chinese corporate earnings and the renminbi will not benefit from the country’s anti-business turn. Chart 1Market Wakes Up To China's Political Risk Market Wakes Up To China's Political Risk Market Wakes Up To China's Political Risk What Is In The Common Prosperity Plan? The first thing to understand about Beijing’s new plan for “common prosperity” is that it is aspirational: it contains few specific targets or concrete policies. It builds on existing policy goals set for 2049, the hundredth anniversary of the People’s Republic. Implementation will be gradual. The plan is consistent with the Xi administration’s previous emphasis on improving the country’s quality of life and tackling systemic risks. It takes aim at social immobility, income and wealth inequality, poor public services, a weak social safety net, and other problems that did not receive enough attention during China’s rapid growth phase over the past forty years. Left unattended, China’s socioeconomic imbalances could fester and eventually destabilize the regime. From the beginning, the Xi administration has tackled the most pressing popular concerns to try to rebuild the party’s legitimacy, increase public support, and avoid crises. Crackdowns on pollution and excessive debt are prime examples. China does indeed suffer from high income inequality and low social mobility, as we have highlighted in key reports. It is comparable to the United States as well as Italy, Argentina, and Chile, all of which have suffered from significant social and political upheaval in recent memory (Chart 2). By contrast, Japan, Germany, and Australia have been relatively politically stable. Chart 2China Risks Social Unrest Like The Americas China Spreads The Wealth Around China Spreads The Wealth Around Table 1 summarizes the common prosperity plan. The key takeaways are the long 2049 deadline, the emphasis on “mixed ownership” in the corporate sphere (retaining a big role for state control and state-owned enterprises but attracting private capital), the redistribution of household income (reform the tax code), the establishment of property rights, the censorship of media/discourse, and the need to reduce rural disparity. The most important point of all is that Beijing intends to grow the size and wellbeing of the middle class – the foundation of a country’s strength. Table 1China’s “Common Prosperity” Plan For 2049 China Spreads The Wealth Around China Spreads The Wealth Around Coastal China today has reached Taiwanese and Korean levels of per capita income and has slightly exceeded their levels of wealth inequality (Chart 3). These countries witnessed social unrest and regime change in the 1980s due to such problems. The urban-rural gap is even more problematic in China due to its large rural population and territory. The Chinese public is expected to become more demanding as it evolves. Hence Beijing is pledging to redistribute wealth, grow the middle class, speed up income growth among the poorest, reduce rural disparities, expand access to elderly care, medicine, and housing, and establish a better legal framework for business. These goals are positive in principle, especially for household sentiment, social stability, and political support for the administration. But they also entail a higher tax/wage/regulation environment for business and corporate earnings. The question for investors centers on implementation. Chart 3China's Wealth Disparities Outstrip Comparable Neighbors China's Wealth Disparities Outstrip Comparable Neighbors China's Wealth Disparities Outstrip Comparable Neighbors What About Vested Interests? Table 1 above shows that the super-committee that issued the common prosperity plan also addressed China’s ongoing battle against financial risk. The financial policy statement was neither new nor surprising but it highlights something important: “preventing risks” will have to be balanced with “ensuring stable growth.” This balancing of reform and growth is essential to Chinese government and will guide the implementation of the common prosperity plan just as it has guided President Xi’s crackdown on shadow banking. This is an especially pertinent point today, as Beijing runs the risk of overtightening monetary, fiscal, and regulatory policies. While Beijing’s vision of a better regulated, more heavily taxed, and higher-wage society should not be underrated, reform initiatives will be delayed if they threaten to derail the post-pandemic recovery. Time and again the Xi administration has ruled against a rapid, resolute, and disruptive approach to reform, such as the “assault phase of reform” spearheaded by Premier Zhu Rongji in the late 1990s. In the plan’s own words: “achieving common prosperity will be a long-term, arduous, and complicated task and it should be achieved in a gradual and progressive manner.” Having said that, the pattern of reform has been a vigorous launch, a market riot, and then backtracking or delay. This means markets face more volatility first before things settle down. An initial volley of policy actions should be expected between now and spring of 2023, when the National People’s Congress solidifies the plans of the twentieth National Party Congress in fall 2022. As with the ongoing regulatory crackdown on Big Tech, the market may experience a technical rebound but the political assessment suggests government pressure will be sustained for at least the next 12 months. We do not recommend bottom feeding in Chinese equities. Will the reforms be effective over time? When the Xi administration took power in 2012-13, it issued a visionary policy document calling for wide-ranging reforms to China’s economy (“Decision on Several Major Questions About Deepening Reform”).1 Over the past decade these reforms have had mixed success. Rhodium Group maintains a reform tracker to monitor progress – the results are lackluster (Table 2). Some core principles, such as the claim that China would make market forces “decisive” in allocating resources, have been totally reversed. Table 2China’s Progress On Reforms Over Past Decade China Spreads The Wealth Around China Spreads The Wealth Around While China’s government model is absolutist, there are still social and economic limits on what the government can achieve. Beijing cannot raise a nationwide property tax, estate tax, and capital gains tax overnight just to reduce inequality. In fact, the long saga of the property tax tells a very different story. Beijing is limited in how it can tax the bubbling property sector because Chinese households store their wealth in houses and because any sustained price deflation would lead to a national debt crisis. Officials have pledged to advance a nationwide property tax in the past three five-year plans with little progress. A serious effort to impose the tax in 2014 was only implemented in two provinces, notably Shanghai’s tax on second or third homes owned by the same household.2 The common prosperity plan entails that the government will revive the property tax but the rollout will still be gradual and step-by-step reform. The tax will focus on major urban areas, not minor ones where population decline could weigh on prices. The government work report in early 2023 will be a key watchpoint for where and when the property tax will be levied but there can be little doubt that it will gradually be levied for top-tier cities. Other aspects of the common prosperity plan will be implemented with provincial trial runs. It all begins with a “demonstration zone,” namely Zhejiang province, a wealthy coastal state where President Xi Jinping once served as party secretary and first army secretary. Zhejiang is expected to make some progress by 2025 and achieve most the goals by 2035 (in keeping with Xi’s 2035 strategic vision). The Zhejiang plan includes concrete numerical targets and as such sheds light on the broader national plan and how other provinces will implement it. The most important target is the desire to have 80% of the population earn an annual disposable income of CNY 100,000-500,000 ($15,400-77,000). The labor share of output should be greater than 50%, compared to a national average of 35%-40%. The urbanization rate should hit 75%, up from 72%. Urban incomes should be capped at just short of twice that of rural income. Enrollment rates in higher education will go up, life expectancy should reach above 80 years, pollution should be further controlled, and the unemployment rate should stay below 5.5%. A host of other goals, ranging from technology to fertility and the social safety net, are shown in Table 3. Table 3China: Zhejiang Province As Bellwether For “Common Prosperity” Plan China Spreads The Wealth Around China Spreads The Wealth Around Some of the plan’s intentions will be undermined by Chinese governance. It is difficult to improve social fairness and property rights in the context of autocracy because the central and local governments create distortions and cannot be held to account for their own mistakes and abuses. The immediate political context of the common prosperity plan should not be missed: the president is outlining a bright future to justify the fact that he will not step down from power as earlier term limits required in fall 2022. The president’s 2035 vision implies an important strategic window in which to accomplish ambitious goals but the lack of checks and balances suggests that the next 14 years could be very similar to the last 10 years, in which arbitrary and absolutist decisions govern policy. The problem is highlighted by China’s recent 10-point plan on government under rule of law, which is undercut by the arbitrary actions of regulators in the tech crackdown (see Appendix). In other words, while social stability may improve in many ways, the shift away from consensus rule, toward rule of a single person, will increase policy uncertainty and create new governance problems at the same time that could produce greater instability over the long run. Having said all that, it is essential to acknowledge that a comprehensive plan to grow the middle class and expand the social safety net could be very positive for China if implemented. A Global Social Justice Race? If investors are thinking that the Xi administration’s calls for “social fairness and justice” and big new investments in “elderly care, medical security, and housing supply” resemble those of US President Joe Biden in his American Families Plan, then they are right. But while the US is already at historic levels of social division after failing to deal with inequality, China is attempting to learn from the US’s problems and rebalance society before polarization, factionalization, and social unrest occur. The Communist Party tends to take major action in response to American crises. Beijing’s crackdown on extremism and domestic terrorism in the early 2000s followed from the September 11 attacks. Its crackdown on local government debt and shadow banking stemmed from the 2008 financial crisis. And its crackdown on Big Tech, social media, and inequality today responds to the rise of populism in the US and Europe. The fact that deindustrialization has led to political crises in the developed world, and that social media companies can both exacerbate social unrest and silence a sitting president, is not lost on the Chinese administration. Unfortunately, China’s approach will probably escalate conflict with the West. First, Beijing is coupling its new social agenda with an aggressive campaign of military modernization and technological acquisition. It is doubling down on advanced manufacturing as its future economic model. The liberal democracies will not only be forced to defend their own political systems and governance models but will also be pressured into more hawkish stances on foreign, trade, and defense policy toward China. So far China is still attractive to foreign investors but the combination of socialist policy, import substitution, and foreign protectionism should put a cap on investment flows over time (Chart 4). What is the net effect of social largesse at home and great power competition abroad? Larger budget deficits. Fiscal expansionism is the key mechanism for the US and China to reboot their economies, reduce social pressures, secure supply chains, and compete with other each other. And expansionary fiscal policies will boost inflation expectations on the margin. One thing is clear: China’s regime will be imperiled if instead of common prosperity and “national rejuvenation” it gets economic collapse. Beijing is already seeing capital outflows reminiscent of the crisis period in 2014-15 when aggressive reforms triggered a collapse in risk appetite and a stock market crash (Chart 5). The implication is that monetary and fiscal easing will accompany the reform agenda. Chart 4China's New Policies Will Deter Foreign Investment China's New Policies Will Deter Foreign Investment China's New Policies Will Deter Foreign Investment Chart 5Capital Flight And Capital Controls A Risk If Implementation Aggressive Capital Flight And Capital Controls A Risk If Implementation Aggressive Capital Flight And Capital Controls A Risk If Implementation Aggressive That would be marginally positive for global growth and EM countries that export to China. Investors in China, however, will have to deal with greater policy uncertainty as China attempts to redistribute wealth while waging a cold war abroad. Investment Takeaways None of Beijing’s social goals can be met if overall growth and job creation slow too much. Reforms are constantly subject to the ultimate constraint of maintaining overall stability. Already in 2021 Beijing is verging on excessive monetary and fiscal policy tightening (Chart 6). The Politburo signaled in July that it would take its foot off the brakes but policy uncertainty is still wreaking havoc in the equity market and overall animal spirits are downbeat. We expect policy to ease over the coming year to ensure stability ahead of the twentieth national party congress. This would be marginally good news for global growth, contingent on the effects of the global pandemic. Of course we cannot deny that more bad news for global risk assets may be necessary in the very near term to prompt the policy easing that we expect. Policymakers will backtrack on various policies when the market revolts or when the risk of debt-deflation rears its ugly head. Corporate and even household debt have expanded so much in recent years that Chinese policymakers have their hands tied when they try to push reforms too aggressively (Chart 7). A Japanese-style combination of a shrinking and graying population could create a feedback loop with debt deleveraging in the event of a sharp drop in asset prices. On the whole we maintain a pessimistic outlook on Chinese currency and assets. Chart 6China Runs Risk Of Overtightening Policy China Runs Risk Of Overtightening Policy China Runs Risk Of Overtightening Policy Chart 7Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com     Appendix Table A1China: 10-Point Guidelines On Government Under Rule Of Law (2021-25) China Spreads The Wealth Around China Spreads The Wealth Around Footnotes 1     See Arthur R. Kroeber, “Xi Jinping’s Ambitious Agenda for Economic Reform in China,” Brookings, November 17, 2013, brookings.edu. 2     Chongqing’s property tax only affects luxury houses. Shenzhen and Hainan are the next pilot projects.

Highlights The chaotic US withdrawal from Afghanistan is symbolic – the US is conducting a strategic pivot to Asia Pacific to confront China. US-Iran negotiations are the linchpin of this pivot. If they fail, war risk will revive in the Middle East and the US will remain entangled in the region. At the moment, there is no deal, so investors should brace for a geopolitical risk premium in oil prices. That is, as long as global demand holds up despite COVID-19, and as long as the OPEC 2.0 cartel remains disciplined. We think they will in the short run. The US and Iran still have fundamental reasons to agree to a deal. If they do, the US will regain global room for maneuver while China’s and Russia’s window of opportunity will close. The implication is that markets face near-term oil supply risks – and long-term geopolitical risks due to Great Power rivalry in Eastern Europe and East Asia. Feature Events in Afghanistan have little macroeconomic significance but the geopolitical changes underway are profound and should be viewed through the lens of our second key view for 2021: the US strategic pivot to Asia. Chart 1The US Pivot To Asia Runs Through Iran Not Afghanistan The US Pivot To Asia Runs Through Iran Not Afghanistan The US Pivot To Asia Runs Through Iran Not Afghanistan As we go to press the Taliban is reconquering swathes of Afghanistan while US armed forces evacuate embassy staff and civilians. The chaotic scenes are reminiscent of the US’s humiliating flight from Saigon, Vietnam in 1975. As with Vietnam, the immediate image is one of American weakness but the reality over the long run is likely to be different. Over the past decade we have chronicled the US’s efforts to disentangle itself from wars of choice in the Middle East and South Asia. In accordance with US grand strategy, Washington is refocusing its attention on its rivalries with Russia and especially China, the only power capable of supplanting the US as a global leader (Chart 1). The US has struggled to conduct this “pivot to Asia” over the past decade but the underlying trajectory is clear: while trying to manage its strategic interests in the Middle East through naval power, the US will need to devote greater resources and attention to shoring up its economic and military ties in Asia Pacific (Map 1). The Middle East still plays a critical role – notably through China’s energy import needs – but primarily via the Persian Gulf. Map 1The US Seeks Balance In Middle East In Order To Pivot To Asia And Confront China Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China Thus the critical geopolitical risks today stem from Iran and the Middle East on one hand, and China on the other. They do not stem from the US’s belated and messy exit from Afghanistan, which has limited market relevance outside of South Asia. First, however, we will address the political impact in the United States. US Political Implications Chart 2Americans Agree With Biden And Trump On Exit From Afghanistan Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China American popular opinion has long turned against the “forever wars” in Iraq and Afghanistan, which cumulatively have cost $6.4 trillion and about 7,000 American troops dead1 (Chart 2). Three presidents, from two political parties, campaigned and won election on the basis of winding down these wars. The only presidential candidate since Republicans George W. Bush and John McCain who took a hawkish stance for persistent military engagement, Hillary Clinton, nearly lost the Democratic nomination and did lose the general election to a Republican, President Trump, who had reversed his party’s stance to advocate strategic withdrawal. War hawks have been sidelined in both parties. This is notable even if it were not the case that the current President Biden, whose son Beau fought in Afghanistan, had opposed the troop surge there under Obama. True, Biden will use drones, surgical strikes, and limited troop rotations to manage the aftermath in Afghanistan, both militarily and politically. Americans are still concerned about terrorism in general and any sign of a resurgent terrorist threat to the US homeland will be politically potent (Chart 3). But neither Biden nor the US can roll back the Taliban’s latest gains or achieve anything in Afghanistan that has not been achieved over the past twenty years.   Chart 3American Public Cares About Terrorism, Not Afghanistan Per Se Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China True, Biden will suffer a political black eye from Afghanistan. His approval rating has already fallen to 49.6%, slipping beneath 50% for the first time, in the face of the Delta variant of COVID-19 and the Afghan debacle. In both cases his early optimistic statements have now become liabilities. Biden is also 79 years old, which will make the 2024 campaign questionable, and he faces mounting problems in other areas, from lax border security and immigration enforcement to rising domestic crime. Nevertheless, Biden still has sufficient political capital to push through one or both of his major domestic legislative proposals by the end of the year, despite thin majorities in both the House and Senate. Afghanistan will not affect that, for three reasons: 1. The US economy is likely to continue to recover despite hiccups due to the lingering pandemic, since the vaccines so far are effective. The labor market is recovering and business capex and government support are robust. Setbacks, such as volatile consumer confidence, will help Biden pass bills designed to shore up the economy. 2. The public fundamentally agrees with Biden (and Trump) on military withdrawal, as mentioned. Voters will only turn against him if a major attack reinforces an image of weakness on terrorism. A major attack based in Afghanistan is not nearly as likely to succeed as it was prior to the September 11, 2001 attacks. But Biden also faces an imminent increase in tensions in the Middle East that could result in attacks on the US or its allies, or other events that reinforce any image of foreign policy failure. 3. Biden has broad popular support for his infrastructure deal, which also has bipartisan buy-in, with 19 Republican Senators already having voted for it. Further, the Democratic Party has a special fast-track mechanism for passing his social spending agenda, though conviction levels must be modest on this $3.5 trillion bill, which is controversial and will have to be winnowed to pass on a partisan vote in the Senate. If we are correct that Afghanistan will not derail Biden’s legislative efforts then it will not fundamentally affect US fiscal policy or the global macro outlook. Note, however, that a failure of Biden’s bills would be significant for both domestic and global economy and financial markets as it would suggest that US fiscal policy is dysfunctional even under single party rule and would thus help to usher back in a disinflationary context. Might Afghanistan affect the midterm elections and hence the US policy setup post-2022? Not decisively. Republicans are more likely than not to retake at least the House of Representatives regardless. This is a cyclical aspect of US politics driven by voter turnout and other factors. Democrats are partly shielded in public opinion due to the Trump administration’s attempts to pull out of foreign wars. But surely a black eye on terrorism or foreign policy would not help. Similarly, a major failure to manage the Middle East, South Asia, and the pivot to Asia Pacific would marginally hurt the Democrats in 2024, but that is a long way off. Geopolitical Implications The Taliban’s reconquest of Afghanistan has very little if any direct significance for global financial markets. Pakistan and India are the two major markets most likely to be directly affected – and their own geopolitical tensions will escalate as a result – yet both equity markets have been outperforming over the course of the Taliban’s military gains (Chart 4). Afghanistan’s impacts are indirect at best. However, the US withdrawal connects with major geopolitical currents, with both macro and market significance. Afghanistan often marks the tendency of empires to overreach. Russia’s failure in Afghanistan contributed to the collapse of the Soviet Union, though Russia’s command economy was unsustainable anyway. British failures in Afghanistan in the nineteenth and twentieth centuries did not lead to the British empire’s decline – that was due to the world wars – but Afghanistan did accentuate its limitations. Since 9/11 and the US’s wars in Iraq and Afghanistan, the US public’s economic malaise, political polarization, and loss of faith in public institutions have gotten worse. In turn, political divisions have impeded the government’s ability to respond cogently to financial and economic crisis, the resurgence of Russia, the rise of China, nuclear proliferation, constitutional controversies, and the COVID-19 pandemic. Once again Afghanistan marked imperial overreach. It is natural for investors to be concerned about the stability of the United States. And yet the US’s global power has recently stabilized (Chart 5). The US survived the 2020 stress test and innovated new vaccines for the pandemic. It is passing laws to upgrade its domestic technological, manufacturing, and infrastructural base and confronting its global rivals. Chart 4If Indo-Pak Markets Shrug Off Taliban Wins, So Can You If Indo-Pak Markets Shrug Off Taliban Wins, So Can You If Indo-Pak Markets Shrug Off Taliban Wins, So Can You Chart 5US Geopolitical Power Is Stabilizing Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China Chart 6US Not Shrinking From Global Role US Not Shrinking From Global Role US Not Shrinking From Global Role The US is not retreating from its global role, judging by defense spending or trade balances (Chart 6). While the desire to phase out wars could theoretically open the way to defense cuts, the reality is that the great power confrontation with China and Russia will demand continued large defense spending. The US also continues to run large trade deficits, due to its shortage of domestic savings, which gives it influence as a consumer and provider of dollar liquidity across the world. The critical geopolitical problem is Iran, where events have reached a critical juncture: To create a semblance of a balance of power in the Middle East, the US needs an understanding with Iran, which is locked in a struggle with Saudi Arabia over the vulnerable buffer state of Iraq. President Biden was not able to rejoin the 2015 détente with Iran prior to the inauguration of the new president, Ebrahim Raisi, who is a hawk and whose confrontational policies will lead to an escalation of Middle Eastern geopolitical risk in the short term – and, if no US-Iran deal is reached, over the long term. Iran recognizes the US’s war-weariness, as demonstrated by withdrawals from Iraq and Afghanistan. It was also exposed to economic sanctions after the US’s 2018-19 abrogation of the 2015 nuclear deal – it cannot trust the US to hold to a deal across administrations. Still, both the US and Iran face substantial strategic forces pressuring them to conclude a deal. The US needs to pivot to Asia while Iran needs to improve its economy and reduce social unrest prior to its looming leadership succession. But the time frame for negotiation is uncertain. Any failure to agree would revive the risk of a major war that would keep the US entangled in the region. Thus the pivot to Asia could be disrupted again, with major consequences for global politics, not because of Afghanistan but because of a failure to cut a deal with Iran. If the US succeeds in reducing its commitments to the Middle East and South Asia, the window of opportunity that China and Russia have enjoyed since 2001 will close. They will face a United States that has greater room for maneuver on a global scale. This is a threat to their own spheres of influence. But neither Beijing nor Moscow has an interest in a nuclear-armed Iran, so a US-Iran deal is still possible. Unless and until the US and Iran normalize relations, the Middle East is exposed to heightened geopolitical risk and hence oil supply risk. Global oil spare capacity is sufficient to swallow small disturbances but not major risks to stability, such as in Iraq or the Strait of Hormuz. Investment Takeaways Chart 7Near-Term US-Iran Risks Help Oil...Long-Term US-China Risks Help Dollar Near-Term US-Iran Risks Help Oil...Long-Term US-China Risks Help Dollar Near-Term US-Iran Risks Help Oil...Long-Term US-China Risks Help Dollar Back in 2001, the combination of American war spending, and conflict in the Middle East, combined with China’s massive economic opening after joining the WTO, led to a falling US dollar and an oil bull market. Today the US’s massive budget deficits and current account deficits present a structural headwind to the US dollar. Yet the greenback has remained resilient this year. While the pandemic will fade as long as vaccines continue to be effective, China’s potential growth is slowing even as it faces an unprecedented confrontation with the US and its allies. Until the US and Iran normalize relations, geopolitics will tend to threaten Middle Eastern oil supply and put upward pressure on oil prices. However, if the US manages the pivot to Asia, China will face more resolute opposition in its sphere of influence, which will tend to strengthen the dollar. The dollar and oil still tend to move in opposite directions. These geopolitical trends will be influential in determining which direction prevails (Chart 7). Thus geopolitics poses an upward risk to oil prices for now.     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Please see Crawford, Neta, "United States Budgetary Costs and Obligations of Post 9/11 Wars Through FY 2020: $6.4 trillion", Watson Institute, Brown University.

Highlights A critical aspect of the diffusion of global geopolitical power – “multipolarity” – is the structural rise of India. India will gain influence in the coming five years as a growing importer of goods, services, oil, and capital. Trade with China is a positive factor in Sino-Indian relations but it will not be enough to offset the build-up of strategic tensions. Indo-Russian relations will also wane. India’s slow transition to green energy will give it greater sway in the Middle East but will not remove its vulnerability if the region destabilizes anew over Iran. Sino-Indian tensions have already affected capital flows, with the US building on its position as a major foreign investor. Feature Chart 1Sino-Pak Alliance’s Geopolitical Power Is Thrice That Of India The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil India’s geopolitical power pales in comparison to that of the China-Pakistan alliance (Chart 1). India is traditionally an independent and “non-aligned” power that has managed conflicts with its neighbors by influencing either Russia or America to display a pro-India tilt. This strategy has held India in good stead as it helps create the illusion of a “balance of power” in the South Asian region. Structural changes are now afoot: Sino-Pakistani assertiveness toward India continues. But in a break from the past India’s Modi-led Bhartiya Janata Party (BJP) has been constrained to adopt a far more assertive stance itself. Russo-Indian relations face new headwinds. Russia has been a close historical partner of India. But Russia under President Vladimir Putin has courted closer ties with China, while the US has tried to warm up with India since President Bush. Under Presidents Trump and Biden, the US is taking a more confrontational approach to Russia and China and will continue to court India. Against this backdrop the key question is this: In a multipolar world, how will India’s relations with the Great Powers evolve over the next five years? Will the alliances of the early 2000s stay the same or will they change? And if they change, what will it mean for global investors? In this special report we provide a helicopter view of India’s relations with key countries. We do so by examining India’s trade and capital flows with the world. A country’s power to a large extent is a function not only of its population and military strength but also of the business interests it represents. India today is the second largest arms importer globally (guns), fifth largest recipient of global FDI flows (capital) and third largest importer of energy (oil). Looking at the trajectory of these business relations, we quantify the magnitude and sources of India’s geopolitical power over the next five years and its investment implications. Trade: India’s Imports Not Enough To Offset China Tensions “The 11th Law of Power - Learn to Keep People Dependent on You. To maintain your independence, you must always be needed and wanted. The more you are relied on, the more freedom you have.” – Robert Greene, The 48 Laws of Power1 A small and closed economy in the 1980s, India today is large and open. Since India lacked industrial capabilities, and was energy-deficient to start with, its import needs grew manifold over this period. India’s current account deficit has increased by nine times from 1980 to 2019. The magnitude of India’s appetite for imports is such that its current account deficit is the fifth largest in the world today (Chart 2). Chart 2India Is The Fifth Largest Importer Of Goods And Services The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Given its lack of domestic energy and industrial capabilities, India’s role as a client of the world will only become more pronounced as it grows. In fact, India appears all set to become the third largest importer of goods and services globally over the next five years (Chart 3). Chart 3India Will Become The Third Largest Net Importer, After US And UK, By 2026 The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Global history suggests that the client is king. The rise and fall of empires have been driven by the strength of their economies and militaries. Great powers import lots of goods and resources – and tend to export arms. The UK’s geopolitical decline over the nineteenth century, and America’s rise over the twentieth, were linked to their respective status as importers within the global economy. India’s rise as a large global importer will prove to be a key source of diplomatic leverage over the next five years. For example, India’s high appetite for imports from China will give India much-needed leverage in bilateral relations. Also, India’s slow transition to green energy continued reliance on oil will strengthen its bargaining power vis-à-vis oil producers. But these trends also bring challenges. Structurally, Sino-Indian tensions are rising and trade will not be enough to prevent them. Meanwhile dependency on the volatile Middle East is a geopolitical vulnerability. China: India’s Growing Might As A Consumer Increases Leverage Vis-à-Vis China China’s rising assertiveness in South Asia and India’s own inclination to adopt an assertive foreign policy stance will lead to structurally higher geopolitical tensions in the region. So, is a full-blooded confrontation between the two nigh? No. First, Sino-Indian wars have always been constrained by geography: they are separated by the Himalayas, which help to keep their territorial disputes contained, driving them toward proxy battles rather than direct and total war. Second, India, Pakistan, and China are nuclear-armed powers which means that war is constrained by the principle of mutually assured destruction. This principle is not absolute – world history is filled with tragedy. There are huge structural tensions lurking in the combination of China’s Eurasian strategy and growing Sino-Indian naval competition that will keep Sino-Indian geopolitical risks elevated. Nevertheless, the bar to a large-scale war remains high. In the meantime, India’s growing might as a consumer could act as a much-needed deterrent to conflict. The last two decades saw America’s share in Chinese exports decline from a peak of 21% to 17% today. With US-China relations expected to remain fraught under Biden and with the US looking to revive its strategic anchor in the Pacific and shore up its domestic manufacturing strength, China’s trade relations with America will continue to deteriorate regardless of which party holds the White House. Against such a backdrop, China will try to build stronger trading ties with countries like India whose share in China’s exports has been growing (Chart 4). After excluding Hong Kong, India today is the eighth-largest exporting destination for China. While it only accounts for 3% of China’s exports, this ratio is comparable to that of larger exporting partners like Vietnam (4% share in China’s exports), South Korea (4%), Germany (3%), Netherlands (3%), and the UK (3%). In other words, China’s need for India is underrated and growing. There are two problems with Sino-Indian trade going forward. First, the strategic tensions mentioned above could prevent trade ties from improving. Over the past decade, Sino-Indian maritime and territorial disputes have escalated while Sino-Indian trade has merely grown in line with that of other emerging markets (Chart 5). China’s rising import dependency has led it to develop both a navy and an overland Eurasian strategy. The Eurasian strategy threatens India’s security in border areas of South Asia, while India’s own naval rise and alliances heighten China’s maritime supply insecurity. These trends may or may not prevent trade from living up to its potential, but they could result in strategic conflict regardless. Chart 4Amongst Top Chinese Export Clients, India’s Importance Has Increased The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 5India’s Imports From China Have Broadly Grown In Line With Peers India's Imports From China Have Broadly Grown In Line With Peers India's Imports From China Have Broadly Grown In Line With Peers Second, the trade relationship itself is imbalanced. India imports heavily from China but sells little into China. China is responsible for more than a third of India’s trade deficit. At the same time, India increasingly shares the western world’s concern about network security in a world where cheap Chinese hardware could become integral to the digital economy. If Sino-Indian diplomacy cannot redress trade imbalances, then trade will generate new geopolitical tensions rather than resolve other ones. One should expect China to court India in the context of rising American and western strategic pressure. Yet China has failed to do so. Why? Because China’s economic transition – falling export orientation and declining potential GDP – is motivating a rise in nationalism and an assertive foreign policy. Meanwhile India’s own economic difficulties – the need to create jobs for a growing population – are generating an opposing wave of nationalism. Thus, while Sino-Indian trade will discourage conflict on the margin, it may not be enough to prevent it over the long run. Oil: As India Lags On Green Transition, Its Significance As An Oil Consumer Will Rise Whilst renewable energy’s share of India’s energy mix is expected to grow, the pace will be slow. Moreover, India’s increased reliance on green energy sources over the next decade will come at the expense of coal and not oil (Chart 6). Consequently, India’s reliance on oil for its energy needs is expected to stay meaningful. Chart 6India’s Reliance On Oil Will Persist For The Next Decade And Beyond The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 7India’s Importance As An Oil Client Has Been Rising The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil The International Energy Agency (IEA) forecasts that India’s net dependence on imported oil for its overall oil needs will increase from 75% today to above 90% by 2040. But India’s relative importance as an oil client will also grow as most large oil consumers will be able to transition to green energy faster than India. In fact, data pertaining to the last decade confirms that this trend is already underway. India’s share of the global oil trade has been rising (Chart 7). In particular, India has taken advantage of Iraq’s rise as a producer after the second Gulf War and has marginally increased imports from Saudi Arabia (Chart 8). Chart 8India’s Importance As A Client Has Been Rising For Top Oil Exporters The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Iran is the country most likely to gain from this dynamic in the coming years – if the US and Iran strike a deal to curb Iran’s nuclear program in exchange for the US lifting economic sanctions. India has maintained stable imports from the Middle East over the past decade despite nominally eliminating imports of oil from Iran (Chart 9). Chart 9India Has Maintained Stable Imports From The Middle East The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil However, while India will have greater bargaining power between OPEC and non-OPEC suppliers, dependency on the unstable Middle East is always a geopolitical liability. If the US and Iran fail to arrive at a deal, a regional conflict is likely, in which case India’s slow green transition and vulnerability to supply disruptions will become a costly liability. Bottom Line: India’s growing importance to both Chinese manufacturers and global oil producers will give it leverage in trade negotiations. However, ultimately, national security will trump economics when it comes to China, while India will remain extremely vulnerable to instability in the Middle East. Guns: Indo-Russian Relations Weaken “When the war broke out [between India & Pakistan in 1971], the Soviet Union cast aside all pretentions of neutrality and non-partisanship… the Russians were in no hurry to terminate the fighting since their interest was better served by the continuation of hostilities leading to an India victory … The factors that decisively determined the outcome of the war were: first, Soviet military assistance to India; secondly the USSR’s role in the UN Security council; and thirdly, Russia strategy to prevent a direct Chinese intervention in the war.” – Zubeida Mustafa, "The USSR and the Indo-Pakistan War"2 The true origins of Russia’s pro-India tilt can be traced back to 1971. The former Soviet Union’s support for India played a critical role in helping India win the Indo-Pakistan war of 1971. Half a century later the Indo-Russia relationship persists, but its intensity has declined and will continue declining over the next few years. We see three reasons: America’s withdrawal from Iraq and Afghanistan will allow the US to focus more intently on its rivalry with China and Russia – a dynamic that is reinforcing China’s and Russia’s move closer together. Meanwhile India’s relationship with the US continues to improve. The China-Pakistan alliance continues to strengthen. Beyond cooperation on China’s ambitious Belt and Road Initiative, Pakistan shares a deep relationship with China based on defense and trade (Chart 10). Hence India is distrustful of closer Russo-Chinese relations. In light of this strategic re-alignment, Russia may see value in developing a closer defense relationship with China. Trading relations between Russia and India are minimal even today. Hence unlike in the case of China, there exists no backstop on weakening of Russo-Indian relations. Less than 1.5% of India’s merchandise imports come from Russia and less than 1% of India’s exports go to Russia. Russia’s share of Indian oil imports has grown in recent years but only to 1.4% of total. Meanwhile the US share of India’s imports has catapulted to 5.7% since the US became an exporter. Any removal of Iran sanctions will come at the cost of other Middle Eastern exporters, not these two alternatives to the risky Persian Gulf, but Russia’s share is still small. Now the backbone of Indo-Russia relations has been their arms trade. However, India’s reliance on Russia for arms could decline over the next five years. India today is Russia’s largest arms client accounting for 23% of its arms sales (Chart 10). However, second in line is China which accounts for 18% of Russia’s arms sales. Given that Russia’s share in global arms exports has been declining (Chart 11), Russia will be keen to reverse or at least halt this trend. Russia can do so most easily by selling more arms to India or to China. Even as China appears to be increasingly focused on developing indigenous arms production capabilities, for reasons of strategy, China appears like a better client for Russia to bank on for the next decade. After all, in 1989, when western countries imposed an arms embargo against China in response to events at Tiananmen Square, Russia became the prime supplier of arms to China. Chart 10India Is A Key Client For Russia, As Is China The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil By contrast, for reasons of strategy India appears like a less promising client to bank on for Russia. India’s import demand for arms has been declining while China’s demand is increasing (Chart 12). India under the Modi-led Bhartiya Janata Party (BJP) has been reducing its reliance on imported arms. Last month, for example, the Indian Ministry of Defense (MoD) said that it has set aside 64% of the defense capital budget for acquisitions from domestic companies.3 This is an increase of 6% over last year, which was the first time such a distinction between domestic and foreign defense expenditure was made. Whilst it will take years for India to develop its domestic arms production capabilities, India’s inward tilt is worrying for traditional suppliers like Russia. Chart 11Among Top Arms Exporters, Russia Is Losing Market Share The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 12India’s Appetite For Arms Imports Is Falling The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Moreover, Russia is aware that the situation is rife for US-India arms trade to strengthen given that India is starting to display a pro-US tilt. Groundwork for a sound defense relationship with India has already been laid out by the US as evinced by: Foundational agreements: India and the US signed the Communications, Compatibility, and Security Agreement (COMCASA) in 2018 and the Basic Exchange and Cooperation Agreement (BECA) in 2020. Sanction exemptions: The US had applied sanctions on Turkey under the Countering America's Adversaries Through Sanctions Act (CAATSA) for Ankara’s purchase of Russia’s S-400 missile defense system in 2020. The US has threatened India with CAATSA sanctions for buying S-400 missile defense systems from Russia but has not applied these sanctions to India (at least not yet). Not applying CAATSA sanctions to India allows the US to strengthen its strategic relations with India that can help further the American goal of creating a counter to China in Asia. Bottom Line: India-Russia relations will remain amicable, but this relationship is bound to fade over the next five years as the US counters China and Russia. Limited backstops exist for Indo-Russia ties. Economic ties between India and Russia are minimal, as India is cutting back on arms imports and only marginally increasing oil imports. Capital: China Investment Down, US Investment Up “America has no permanent friends or enemies, only interests.” – Henry Kissinger, Former US Secretary of State India’s economic growth rates could be higher if it did not have to deal with the paradox of plentiful savings alongside capital scarcity. Even as Indian households are known to be thrifty, only a limited portion of their savings is available for being borrowed by small firms. Almost a quarter of bank deposits are blocked in government securities. More than a third of adjusted net bank credit must be made available for government-directed lending. With what is left, banks prefer lending the residual funds to large top-rated corporates. It is against this backdrop that foreign direct investment (FDI) flows provide much needed succor to Indian corporates, particularly capital-guzzling start-ups. FDI inflows into India have become a key source of funding for Indian corporates over the last decade with annual FDI flows often exceeding new bank credit. Correspondingly, for FDI investors, India provides the promise of high returns on investment in an emerging market that offers political stability. India emerged as the fifth largest FDI destination globally in 2020. Amongst suppliers of FDI into India (excluding tax havens like Cayman Islands), the US and China have been top contributors. Whilst China has been a leading investor into the Indian start-up space, geopolitical tensions have translated into regulatory barriers that prevent Chinese funds from investing in India. Separately, as Indo-US relations improve, the symbiotic relationship between capital-rich US funds and capital-hungry Indian start-ups should strengthen. In fact, in 2020 itself, Chinese private equity (PE) and venture capital (VC) investments into India shrank whilst American investments into India doubled, according to Venture Intelligence (Chart 13). Distinct from Chinese funds’ restrained ability to invest in Indian firms, Indian tech start-ups could potentially benefit from reduced global investor appetite in Chinese tech stocks owing to China’s regulatory crackdown and breakup with the United States. China’s foreign policy assertiveness and domestic policy uncertainty may lead to a reallocation of FDI flows away from China and into India. China (including Hong Kong) has been a top host country for FDI, attracting 4x times more funds than India (Chart 14). However, India’s ability to absorb these reallocated funds over the next five years will be a function of sectoral competencies. For instance, India’s information and communications technology (ICT) sector appears best positioned to benefit from this trend. But the same may not be the case for sectors like manufacturing that traditionally attract large FDI flows in China yet are relatively underdeveloped in India. On the goods’ front, given that India’s comparative advantage lies in the production of capital-light, labor-light and medium-tech intensive products, pharmaceuticals and chemicals could be two other industries that attract FDI flows in India. Chart 13Chinese PE/VC Investments Into India In 2020 Slowed Significantly The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 14China Has Been A Top Host Country For FDI, Attracting 4x More Flows Than India The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Bottom Line: Whilst trade between India and China has not been affected much by geopolitical tensions, capital flows have been. Given that the US historically has been a top FDI contributor in India, and given improving Indo-US relations, FDI investment into India from the US appears set to rise steadily over the next five years, particularly into the ICT sector. Investment Conclusions China-India geopolitical tensions are here to stay and will be a recurring feature of South Asia’s geopolitical landscape. However, a growing trade relationship could discourage conflict, especially if it becomes more balanced. It may not be enough to prevent conflict forever but it is an important constraint to acknowledge. India’s current account deficit will remain vulnerable to swings in oil prices, but it may be able to manage its energy bill better as its bargaining power relative to oil suppliers improves. The problem then will become energy insecurity, particularly if the US and Iran fail to normalize relations. As India and Russia explore new alignments with USA and China respectively, the historic Indo-Russia relationship will weaken. It will not collapse entirely because Russia provides a small but growing alternative to Mideast oil. US-India business interests may deepen as India considers joint ventures with American arms manufacturers and American funds court India’s capital-hungry information and communications technology sector. Against this backdrop we reiterate our constructive strategic view on India. However, for the next 12 months, we remain worried about near-term geopolitical and macro headwinds that India must confront.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 (Viking Press, 1998). 2 Mustafa, Zubeida. "The USSR and the Indo-Pakistan War, 1971" Pakistan Horizon 25, No. 1 (1972): 45-52. 3 Ajai Shukla, "Local procurement for defence to see 6% hike this year: Govt to Parliament" Business Standard, July 2021.

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