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Highlights President Trump’s support among Republicans and lack of smoking gun evidence will prevent his removal from office. Trade risk will increase if Trump’s approval benefits from impeachment proceedings and the U.S. economy is resilient. Political risk on the European mainland is falling. However, watch out for Russia and Turkey, and short 10-year versus 2-year gilts. A new election in Spain may not resolve the political deadlock. Book gains on our Hong Kong Hang Seng short. Feature Impeachment proceedings against U.S. President Donald Trump, the brazen Iranian attack on Saudi Arabia, the persistence of trade war risk, and additional weak data from China and Europe all suggest that investors should remain risk averse for now. Specifically, Trump’s impeachment could drive him to seek distractions abroad – abandoning the tactical retreat from aggressive foreign and trade policy that had only just begun. Geopolitical risk outside of the hot spots is falling, especially in Europe. The risk of a no-deal Brexit has collapsed in line with our expectations. Italy and Germany have pleased markets by providing some fiscal stimulus sans populism. In France, President Emmanuel Macron’s popularity is recovering. And – as we discuss in this report – Spain’s election will not add any significant fear factor. In what follows we introduce a new GeoRisk Indicator, review the signal from all of our indicators over the past month, and then focus on Spain. Fear U.S. Politics, Not Impeachment The House Democrats’ decision to impeach Trump gives investors another reason to remain cautious on risk assets. Why not be bullish? It is true that impeachment without smoking gun evidence increases Trump’s chances of reelection, which is market positive relative to a Democratic victory. President Trump is virtually invulnerable to Democratic impeachment measures as long as Republicans continue to support him at a 91% rate (Chart 1). Senators will not defect in these circumstances, so Trump will not be removed from office. Trump is invulnerable to impeachment measures as long as GOP support remains high. Moreover the transcript of his phone conversation with Ukrainian President Volodymyr Zelenskiy did not produce a bombshell: there is no explicit quid pro quo in which President Trump suggests he will withhold military aid to Ukraine in exchange for an investigation into former Vice President Joe Biden’s and his son Hunter’s doings involving Ukraine. Any wrongdoing is therefore debatable, pending further evidence. This includes evidence beyond the “whistleblower’s complaint,” which suggests that the Trump team attempted to stifle the transcript of the aforementioned phone call. The point is that the grassroots GOP and Senate are the final arbiters of the debate. The problem is that scandal and impeachment will still likely feed equity market volatility (Chart 2). The House Democrats could turn up new evidence now that they are fully focused on impeachment and hearing from whistleblowers in the intelligence community. Chart 1GOP Not Yet Willing To Impeach Trump Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 Impeachment also has a negative market impact via the Democratic Party’s primary election. Elizabeth Warren has not dislodged Biden in the early Democratic Primary yet. Chart 2Impeachment Proceedings Likely To Raise Vol Impeachment Proceedings Likely To Raise Vol Impeachment Proceedings Likely To Raise Vol If she does, it will have a sizable negative impact on equity markets, as President Trump will still be only slightly favored to win reelection. Under any circumstances, this election will be extremely close, it has significant implications for fiscal policy and regulation, and therefore it will create a lot of uncertainty between now and November 2020. The whistleblower episode has if anything aggravated this uncertainty. As mentioned at the top of the report, if impeachment proceedings ever gain any traction they could drive Trump to seek distractions abroad – abandoning the tactical retreat from aggressive foreign and trade policy that had only just begun. Finally, Trump’s reelection, while more market-friendly than the alternative and likely to trigger a relief rally, is not as bullish as meets the eye. Trump’s policies in the second term will not be as favorable to corporates as in the first term. Unshackled by electoral concerns yet still facing a Democratic House, Trump will not be able to cut taxes but he will be likely to conduct his foreign and trade policy even more aggressively. This is not a market-positive outlook, regardless of whether it is beneficial to U.S. interests over the long run. Bottom Line: President Trump’s approval among Republican voters is the critical data point. Unless they abandon faith, the senate will not turn, and Trump’s support may even go up. But this is not a reason to turn bullish. The coming year will inevitably see a horror show of American political dysfunction that will lead to volatility and potentially escalating conflicts abroad. Introducing … Our Sino-American Trade Risk Indicator This week we introduce a new GeoRisk Indicator for the U.S.-China trade war (Chart 3). The indicator is based on the outperformance of overall developed market equities relative to those same equities that have high exposure to China, and on China’s private credit growth (“total social financing”). As our chart commentary shows, the indicator corresponds with the course of events throughout the trade war. It also correlates fairly well with alternative measures of trade risk, such as the count of key terms in news reports. Chart 3Trade Risk Will Go Up From Here Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 As we go to press, our indicator suggests that trade-war related risk is increasing. Over the past month Trump has staged a tactical retreat on foreign and trade policy in order to control economic risks ahead of the election. Our indicator suggests this is now priced. The problem is that Trump’s re-election risk enables China to drive a harder bargain, which is tentatively confirmed by China’s detainment of a FedEx employee (signaling it can trouble U.S. companies) and its cancellation of a tour of farms in Montana and Nebraska. These were not major events but they suggest China smells Trump’s hesitation and is going on the offensive in the negotiations. Principal negotiators are meeting in early October for a highly significant round of talks. If these result in substantive statements of progress – and evidence that the near-finished draft text from April is being completed – they could set up a summit between Presidents Xi Jinping and Donald Trump in November at the APEC summit in Santiago, Chile. At this point we would need to upgrade our 40% chance that a deal is concluded by November 2020. If the talks do not conclude with positive public outcomes then investors should not take it lightly. The Q4 negotiations are possibly the last attempt at a deal prior to the U.S. election. If there is no word of a Trump-Xi summit, it will confirm our pessimistic outlook on the end game. U.S.-China trade talks are unlikely to produce a durable agreement. Ultimately we do not believe that the U.S.-China trade talks will produce a conclusive and durable agreement that substantially removes trade war risk and uncertainty. This is especially the case if financial market and economic pressure – amid global monetary policy easing – is not pressing enough to force policymakers to compromise. But we will watch closely for any signs that Trump’s tactical retreat is surviving the impeachment proceedings and eliciting reciprocation from China, as this would point to a more sanguine outlook. Bottom Line: As long as the president’s approval rating benefits from the Democratic Party’s impeachment proceedings, and the U.S. economy is resilient, as we expect, Trump can avoid any capitulation to a shallow deal with China. Trade risk could go up from here. By the same token, impeachment proceedings could eventually force Trump to change tactics yet again and stake out a much more aggressive posture in foreign affairs. If impeachment gains traction, or a bear market develops, he could become more aggressive than at any stage in his presidency – and this aggression could be directed at China (or Iran, North Korea, Venezuela, or another country). The risk to our view is that China accepts Trump’s trade position in order to win a reprieve for its economy and the two sides agree to a deal at the APEC summit. European Risk Falls, While Russian And Turkish Risk Can Hardly Fall Further Elsewhere our measures of geopolitical risk indicate a decrease in tensions for a number of developed and emerging markets (see Appendix). In Germany, risk can rise a bit from current levels but is mostly contained – this is not the case in the United Kingdom beyond the very short run. In Russia and Turkey, risk can hardly fall further. Take, for starters, Germany, where political risk declined after Chancellor Angela Merkel’s ruling coalition agreed to a 50 billion euro fiscal spending package to battle climate change. This agreement confirms our assessment that while German politics are fundamentally stable, the administration will be reactive rather than proactive in applying stimulus. Europe will have to wait for a global crisis, or a new German government, for a true “game changer” in German fiscal policy. Perhaps the Green Party, which is surging in polls and as such drove Merkel into this climate spending, will enable such a development. But it is too early to say. Meanwhile Merkel’s lame duck years and external factors will prevent political risk from subsiding completely. We see the odds of U.S. car tariffs at no higher than 30%, at least as long as Sino-American tensions persist. By contrast, the United Kingdom’s political risks are not contained despite a marked improvement this month. The Supreme Court’s decision on September 25 to nullify Prime Minister Boris Johnson’s prorogation of parliament drove another nail into the coffin of his threat to pull the country out of the EU without a deal. This was a gambit to extract concessions from the EU that has utterly flopped.1 Since it was the most credible threat of a no-deal exit that is likely to be mounted, its failure should mark a step down in political risk for the U.K. and its neighbors. However, paradoxically, our GeoRisk indicator failed to corroborate the pound’s steep slide throughout the summer and now, as no-deal is closed off, it has stopped falling. The reason is that the pound’s rate of depreciation remained relatively flat over the summer, while U.K. manufacturing PMI – one of the explanatory variables in our indicator – dropped off much faster as global manufacturing plummeted. As a result, our indicator registered this as a decrease in political risk. The world feared recession more than it feared a no-deal Brexit – and this turned out to be the right call by the market. But the situation will reverse if global growth improves and new British elections are scheduled, since the latter could well revive the no-deal exit risk, especially if the Tories are returned with thin majority under a coalition. The truth is that the Brexit saga is far from over and the U.K. faces an election, a possible left-wing government, and ultimately resilient populism once it becomes clear that neither leaving nor staying in the EU will resolve the middle class’s angst. Our long GBP-USD recommendation is necessarily tactical and we will turn sellers at $1.30. In emerging markets, Russia and Turkey have seen political risk fall so low that it is hard to see it falling any further without some political development causing an increase. Based on our latest assessment, Turkey is almost assured to see a spike in risk in the near future. This could happen because of the formation of a domestic political alliance against President Recep Erdogan or because of the increase in external risks centering on the fragile U.S.-Turkey deal on Syria. Tensions with Iran could also produce oil price shocks that weaken the economy and embolden the opposition. As for Russia, our base case is that Russia will continue to focus internal domestic problems to the neglect of foreign objectives, which helps geopolitical risk stay low. With U.S. politics in turmoil and a possible conflict with Iran on the horizon, Moscow has no reason to attract hostile attention to itself. Nevertheless Moscow has proved unpredictable and aggressive throughout the Putin era, it has no real loyalty to Trump yet could fall victim to the Democrats’ wrath, and it has an incentive to fan the flames in the Middle East and Asia Pacific. So to expect geopolitical risk to fall much further is to tempt the fates. Bottom Line: European political risk is falling, but Merkel’s lame duck status and trade war make German risk likely to rise from here despite stable political fundamentals. The United Kingdom still faces generationally elevated political risk despite the happy conclusion of the no-deal risk this summer. Go short 10-year versus 2-year gilts. Russia should remain quiet for now, but Turkey is almost guaranteed to experience a rise in political risk. Spain: Election Could Surprise But Risks Are Low Spanish voters will head to the polls on November 10 for the fourth time in four years after political leaders failed to reach a deal to form a permanent government. The Spanish Socialist Workers’ Party (PSOE) has served as a caretaker government after winning 123 out of 350 seats in the snap election in April. A new Spanish election will not resolve the current political deadlock. Prime Minister and PSOE leader Pedro Sanchez failed to be confirmed in July, and has since attempted to make a governing deal with the left-wing, anti-establishment party Podemos. However, PSOE is not looking for a full coalition but merely external support to continue governing in the minority. Hence it is only offering Podemos non-ministerial agencies (rather than high-level cabinet positions) in negotiations, leaving Podemos and other parties ready for an election. The outcome of the upcoming election may not differ much from the April election. The Spanish voter is not demanding change. Unemployment and underemployment have been decreasing, and wage growth has been positive since 2014 (Chart 4). In opinion polls, support for the various parties has not shifted significantly (Chart 5, top panel). PSOE is still leading by a considerable gap. Chart 4Spanish Voter Is Not Demanding Change Spanish Voter Is Not Demanding Change Spanish Voter Is Not Demanding Change However, the election will increase uncertainty at an inconvenient time, and it could produce surprises. PSOE’s support has slightly decreased since late July, when negotiations with Podemos started falling apart. Chart 5Not Much Change In Polls... Not Much Change In Polls... Not Much Change In Polls... Even if PSOE and Podemos form a governing pact, their combined popular support is not significantly higher than the combined support for the three main conservative parties. These are the Popular Party, Ciudadanos, and Vox (Chart 5, bottom panel) – which recently showed they can work together by making a governing deal to rule the regional government in Madrid. Chart 6…But Lower Turnout Could Hurt The Left Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 The Socialist Party hopes to capture borderline voters from Ciudadanos, namely those who are skeptical towards the party’s right-wing populist shift and hardening stance regarding Catalonia. However, even capturing as many as half of Ciudadanos’ voters would place PSOE support at ~37% – far short of what is needed to form a single-party majority government. Another factor that can hurt PSOE is voter turnout. Spanish voters have been less and less interested in supporting any party at all since the April election. A decrease in turnout would hurt left-wing parties the most, given that voters blame Podemos and PSOE more than PP and Ciudadanos for the failure to form a government (Chart 6). The most likely outcomes are the status quo, or a PSOE-Podemos alliance. But a conservative victory cannot be ruled out. In the former two cases, the implication is slightly more positive fiscal accommodation that is beneficial in the short-term, but at the risk of a loss of reform momentum that has long-term negative implications. To put this into context, Spanish politics remains domestic-oriented, not a threat to European integration. Voters in Spain are some of the most Europhile on the continent, both in terms of the currency and EU membership (Chart 7). Spain is a primary beneficiary of EU budget allocations, along with Italy. Even Spain’s extreme right-wing party Vox is not considered to be “hard euroskeptic.” Within Spain, however, political polarization is a problem. Inequality and social immobility are a concern, if not as extreme as in Italy, the U.K., or the United States. Moreover the Catalan separatist crisis is divisive. While a new Catalonian election is not scheduled until 2022, the pro-independence coalition of the Republican Left of Catalonia and Catalonia Yes has been gaining momentum in the polls, and Ciudadanos’s support plummeted since the party hardened its stance on Catalonia earlier this year (Chart 8). Catalonia is by no means going independent – support for independence in the region peaked in 2013 – but it remains a driving factor in Spanish politics. Chart 7Spaniards Love Europe Spaniards Love Europe Spaniards Love Europe Chart 8Catalonia Is A Divisive Issue Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 In the very short term, election paralysis introduces fiscal policy crosswinds. On one hand, regional governments may be forced to cut spending. The regions were expecting to receive EUR 5 billion more than last year, which was promised to be spent in part on healthcare and education. Until a stable (or at least caretaker) government can approve a 2019 budget, the regions will base their 2019 budgets on last year’s numbers, meaning they will have to cut any projected increases in spending. Yet on the other hand, the budget deficit will widen as taxes fail to be collected. In late 2018 Spain approved increases in pensions, civil servants’ salaries, and minimum wage by decree, but any corresponding revenue increases that were to be implemented in the 2019 budget will fail to materialize until government is in place, putting upward pressure on the deficit. Beyond the election the trend should be slightly greater fiscal thrust due to the continental slowdown. Spain has some fiscal room to play with – its budget deficit is projected to decrease to 2% in 2019 and 1.1% in 2020.2 The more conservative estimate by the European Commission forecasts the 2019 and 2020 deficits to be 2.3% and 2%, respectively (Chart 9). This means that Spain can provide roughly 10-15 billion euros worth of additional stimulus in 2020 without so much as hinting at triggering Excessive Deficit Procedures, a welcome change after nearly a decade of austerity. The risk is that Spain’s structural reform momentum could be lost with negative long-term consequences. In 2012 Spain undertook painful labor and pension reforms that underpinned its impressive economic recovery. The economy continues to grow faster than the average among its peers, unemployment has fallen by 12% in the past six years, and export competitiveness has had one of the sharpest recoveries in Europe since 2008 (Chart 10). This recovery has now begun to slow down, and the current political deadlock means that reforms could be rolled back farther than the market prefers. Chart 9Spain Has Some Fiscal Room Spain Has Some Fiscal Room Spain Has Some Fiscal Room This is more likely to be avoided if a surprise occurs and the conservatives come back into power, although that would also mean less accommodative near-term policies. Chart 10Recovery Starting To Slow Recovery Starting To Slow Recovery Starting To Slow Bottom Line: Our geopolitical risk indicator is signaling subdued levels of risk for Spain. This is fitting as the election may not change anything and at any rate the country will remain in an uneasy equilibrium. Politics are fundamentally more stable than in the populist-afflicted developed countries – the U.S., U.K., and Italy. However, an outcome that produces a left-wing government will lead to greater short-term fiscal accommodation at the expense of Spain’s recent outstanding progress on structural reforms. Housekeeping We are booking gains on our Hong Kong Hang Seng short. Unrest is not yet over, but is about to peak as we approach October 1, the National Day of the People’s Republic of China, and Beijing will look to avoid an aggressive intervention.   Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The Supreme Court deemed Johnson’s government’s prorogation of parliament an unlawful frustration of parliament’s role as sovereign lawgiver and government overseer without reasonable justification. The court was larger than usual, with 11 judges, and they ruled unanimously against the prorogation. We had expected the vote at least to be narrow – given the historic uses of prorogation, the fact that parliament still had time to act prior to October 31 Brexit Day, and the prime minister’s historical authority over foreign affairs and treaties. But the Supreme Court has risen to fill the power vacuum created by parliament’s paralysis amid the Brexit saga; it has “quashed” what might have become a neo-Stuart precedent that prime ministers can curtail parliament’s role at important junctures. The pragmatic, near-term consequence is the reduction in the political and economic risks of a no-deal exit; but the long-term consequence may be the rise of the judiciary to greater prominence within Britain’s ever-evolving constitutional system. 2 Please see “Stability Programme Update 2019-2022, Kingdom of Spain,” available at www.ec.europa.eu. U.K.: GeoRisk Indicator U.K.: GEORISK INDICATOR U.K.: GEORISK INDICATOR France: GeoRisk Indicator FRANCE: GEORISK INDICATOR FRANCE: GEORISK INDICATOR Germany: GeoRisk Indicator GERMANY: GEORISK INDICATOR GERMANY: GEORISK INDICATOR Spain: GeoRisk Indicator SPAIN: GEORISK INDICATOR SPAIN: GEORISK INDICATOR Italy: GeoRisk Indicator ITALY: GEORISK INDICATOR ITALY: GEORISK INDICATOR Russia: GeoRisk Indicator RUSSIA: GEORISK INDICATOR RUSSIA: GEORISK INDICATOR Turkey: GeoRisk Indicator TURKEY: GEORISK INDICATOR TURKEY: GEORISK INDICATOR Brazil: GeoRisk Indicator BRAZIL: GEORISK INDICATOR BRAZIL: GEORISK INDICATOR Taiwan: GeoRisk Indicator TAIWAN: GEORISK INDICATOR TAIWAN: GEORISK INDICATOR Korea: GeoRisk Indicator KOREA: GEORISK INDICATOR KOREA: GEORISK INDICATOR What's On The Geopolitical Radar? Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 Impeachment, Trade War, And A Sojourn To Spain – GeoRisk Update: September 27, 2019 Section III: Geopolitical Calendar

Following drone attacks on critical oil infrastructure in the Kingdom of Saudi Arabia (KSA) over the weekend, which removed ~ 5.7mm b/d of output, the U.S. is likely to conduct a limited retaliatory strike. In addition, the U.S. will continue to build up forces in the Persian Gulf to deter Iran and prepare for a larger response if necessary. After this initial response, the Trump administration will likely seek to contain tensions, as neither Trump nor the United States has an immediate interest in launching a large-scale conflict with Iran. But that does not mean that one will not happen – indeed, the odds are now higher that this risk could materialize. If the oil-price shock caused by these attacks becomes prolonged and unmanageable – either because of additional attacks against Saudi Arabian or other regional infrastructure, or direct Iranian action to restrict the flow of oil from the Persian Gulf – the negative impact on the global and U.S. economy will grow. Faced with a recession – which is not our base case but is possible – the incentive for Trump to engage war with Iran will rise sharply. Attack On KSA Will Prompt U.S. Retaliation If Iran is confirmed as the base, it will limit Trump’s options and ensure that any retaliation leads to a greater escalation of tensions. Over the weekend, Houthi rebels in Yemen claimed responsibility for attacks on two critical oil assets in Saudi Arabia, removing ~ 5.5% of world crude output – a historic shock to global oil supply, and the largest unplanned outage ever recorded (Chart 1).1 U.S. Secretary of State Mike Pompeo accused Iran of being behind the attacks and said there was no evidence that Houthis launched them from Yemen. As we go to press, neither Saudi Arabian officials nor President Trump have confirmed Iran was the culprit, although the sophistication of the attack’s targeting and execution suggest that they will. President Trump said the U.S. is “locked and loaded depending on verification” and offered U.S. support to KSA in a call to Crown Prince Mohammad Bin Salman.2 Chart 1Oil Supply Disruption + Volume Lost Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response A direct missile strike from Iran is the least likely source, as the Iranians have sought to act through proxies this year, in staging attacks to counter U.S. sanctions, precisely in order to maintain plausible deniability and avoid provoking a full-blown American retaliation. If Iran is confirmed as the base, it will limit Trump’s options and ensure that any retaliation leads to a greater escalation of tensions, relative to a situation where militant groups in Iraq or Yemen (or even in Saudi Arabia) are found to be responsible. Assuming the strike came from outside Iran, the U.S. and Saudi Arabia would presumably retaliate against its proxies in those locations – e.g., the Houthis in Yemen, or the Shia militias in Iraq. Washington is certain to dial up its military deterrent in the region and use the attacks to gain greater worldwide support for a tighter enforcement of sanctions to isolate Iran. This deterrence includes a multinational naval fleet in the Strait of Hormuz, at the entrance to the Gulf, where ~ 20% of the world’s crude oil supply transits daily. Electoral Constraints Facing Trump There are several reasons President Trump will not rush to a full-scale conflict with Iran. First, the attack did not kill U.S. troops or civilians. Miraculously, not even a single casualty is reported in Saudi Arabia. Yet, unlike the Iranian shooting of an American drone, which nearly brought Trump to launch air strikes on June 21, the latest attack clearly impacted critical infrastructure in a way that threatens global stability, making it more likely that some retaliation will occur. Second, Trump faces a significant electoral constraint from high oil prices. True, the U.S. economy is not as exposed to oil imports as it was (Chart 2). Also, global oil producers and strategic reserves including the U.S. Strategic Petroleum Reserve (SPR) can handle the immediate short-term loss from KSA (Chart 3). However, the duration of the cut-off is unknown and further disruptions will occur if the U.S. retaliates and Iranian-backed forces attack yet again. Third, there is still a chance to show restraint in retaliation, contain tensions over the coming months, limit oil supply loss and price spikes, and thus keep an oil-price shock from tanking the U.S. economy. Chart 2U.S. Imports Continue Falling U.S. Imports Continue Falling U.S. Imports Continue Falling But as tensions escalate in the short term, they could hit a point of no return at which the economic damage becomes so severe that President Trump can no longer seek re-election based on his economic record (Chart 4). At that point the incentive is to confront Iran directly – and run in 2020 as a “war president” intent on achieving long-term national security interests despite short-term economic pain. Chart 3Key SPRs Are Still Adequate Key SPRs Are Still Adequate Key SPRs Are Still Adequate Chart 4An Oil Price Shock Lowers Trump's Re-Election Chances An Oil Price Shock Lowers Trump's Re-Election Chances An Oil Price Shock Lowers Trump's Re-Election Chances U.S.’s Volatile Attempt At Diplomacy What triggered the attack and what does it say about the U.S. and Iranian positions going forward? Ever since Trump backed away from air strikes in June, he has become more inclined to de-escalate the conflict he began with Iran by withdrawing from the 2015 Joint Comprehensive Plan of Action (JCPOA), designating the Islamic Revolutionary Guard Corps (IRGC) as terrorists, and imposing crippling sanctions to bring Iran’s oil exports to zero. Even as Rouhani and Trump publicly mulled a summit and negotiations, Rouhani insisted that any negotiations with the United States would require Trump to rejoin the JCPOA and remove all sanctions. What prompted this backtracking was Iran’s demonstration of a higher pain threshold than Trump expected. President Hassan Rouhani, and his Foreign Minister Javad Zarif, were personally invested in the 2015 nuclear deal with the Obama administration, which they negotiated despite grave warnings from the regime’s conservative factions that they would be betrayed. Trump’s reneging on that deal confirmed their opponents’ expectations, while his sanctions have sent the economy into a crushing recession (Chart 5). Chart 5U.S. Sanctions Hammer Iran's Economy U.S. Sanctions Hammer Iran's Economy U.S. Sanctions Hammer Iran's Economy With Iranian parliamentary elections in February 2020, and a consequential presidential election in 2021 in which Rouhani will seek to support a political ally, the Rouhani administration needed to respond forcefully to Trump’s sanctions. Iran staged several provocations in the Strait of Hormuz to warn the U.S. against stringent sanctions enforcement (Map 1). And recently, even as Rouhani and Trump publicly mulled a summit and negotiations, Rouhani insisted that any negotiations with the United States would require Trump to rejoin the JCPOA and remove all sanctions, a very high bar for talks. Map 1Abqaiq Is At The Very Core Of Global Oil Supply Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response Realizing the large appetite for conflict in Tehran, and the ability to sustain sanctions and use proxy warfare damaging global oil supply, Trump took a step back – he withheld air strikes in late June, discussed a diplomatic path forward with French President Emmanuel Macron, and subsequently fired his National Security Adviser John Bolton, a known war hawk on Iran who helped mastermind the return to sanctions. The proximate cause of Bolton’s ouster was reportedly a disagreement about sanctions relief that would have been designed to enable a meeting with Rouhani at the United Nations General Assembly next week. Such a summit could possibly have led to a return to the pre-2017 U.S.-Iran détente. If Trump had compromised, Iran could have gone back to observing the 2015 nuclear pact provisions, which it has only gradually and carefully violated. Moreover the French proposal to convince Iran to rejoin talks by offering a $15 billion credit line for sanctions relief was gaining traction. Apparently these recent moves toward diplomacy posed a threat to various actors in the region that benefit from U.S.-Iran conflict and sanctions. Hardliners in Iran want to weaken the Rouhani administration and prevent further Rouhani-led negotiations (i.e. “surrender”) to American pressure. On August 29, three days after Rouhani hinted that he might still be willing to talk with Trump, Supreme Leader Ayatollah Ali Khamenei’s weekly publication warned that “negotiations with the U.S. are definitely out of the question.”3 The IRGC and others continue to benefit from black market activity fueled by sanctions. And Iranian overseas militant proxies have their own reasons to fear a return to U.S.-Iran détente. Saudi Arabia and Israel also worry that President Trump will follow in President Obama’s footsteps with Iran and strategic withdrawal from the Middle East, which has considerable popular support in the United States (Chart 6). Both the Saudis and Israelis have been emboldened by the Trump administration’s support and have expanded their regional military targeting of Iranian-backed forces, prompting Iranian pushback. The hard-line factions know that a full-fledged American attack would be devastating to Iranian missile, radar, and energy facilities and armed forces. The Iranians remember the devastating impact on their navy from Operation Praying Mantis in 1988. But with the Trump administration’s “maximum pressure” sanctions cutting oil exports nearly to zero, Iran’s economy is getting strangled and militant forces may feel they have no choice. Chart 6Americans Do Not Support War With Iran Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response Moreover Trump’s electoral constraint – his need to make deals in order to achieve foreign policy victories and lift his weak approval ratings ahead of the election – means that foreign enemies have the ability to drive up the price of a deal. This is what the Iranians just did. But negotiations may be impossible now before 2020. Rouhani may be forced to play the hawk, Supreme Leader Khamenei is opposed to talks, and the hard-line faction is apparently willing to court conflict with America to consolidate its power ahead of the dangerous and uncertain period that awaits the regime in the near future, when Khamenei’s inevitable succession occurs. Bottom Line: We argued in May that the risk of U.S. war with Iran stood as high as 22%, on a conservative estimate of the conditional probability that the U.S. would engage in strikes if Iran restarted its nuclear program outside of the provisions of the JCPOA. Recent events make the risk even higher. This does not mean that Rouhani and Trump cannot make bold diplomatic moves to contain tensions, but that the risk of widening conflict is immediate. Supply Risk Will Remain Front And Center The risk to supply made manifest in these drone attacks will remain with markets for the foreseeable future. They highlight the vulnerability of supply in the Gulf region, and, importantly, the now-limited availability of spare capacity to offset unplanned production outages. There’s ~ 3.2mm b/d of spare capacity available to the market, by the International Energy Agency’s reckoning, some 2mm b/d or so of which is in KSA (Chart 7). These drone attacks highlight the need to risk-adjust this spare capacity. When the infrastructure needed to deliver it to markets comes under attack, its availability must be adjusted downward. Chart 7Limited Availability Of Spare Capacity To Offset Outages Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response Chart 8Commercial Inventories Will Draw ... Commercial Inventories Will Draw ... Commercial Inventories Will Draw ... In the immediate aftermath of the temporary loss of ~ 5.7mm b/d of KSA crude production to the drone attacks, we expect commercial inventories to be drawn down hard, particularly in the U.S., where refiners likely will look to increase product exports to meet export demand (Chart 8). This will backwardate forward crude oil and product curves – i.e., promptly delivered oil will trade at a higher price than oil delivered in the future (Chart 9). Chart 9... Deepening Forward-Curve Backwardations ... Deepening Forward-Curve Backwardations ... Deepening Forward-Curve Backwardations We expect the U.S. SPR to monitor this evolution closely. It is near impossible to handicap the level of commercial inventories – or backwardation – that will trigger the U.S. SPR release, given the unknown length of the KSA output loss, however. Worth noting is the fact that U.S. crude-export capacity is limited to ~ 1mm b/d of additional capacity. Thus, the SPR cannot be directly exported to cover the entire loss of KSA barrels. Other members of OPEC 2.0 will be hard-pressed to lift light-sweet exports, which, combined with constraints on U.S. export capacity, mean the light-sweet crude oil market could tighten. Interestingly, these attacks come as the U.S. has been selling down its SPR. The sales to date have been to support modernization of the SPR, but, for a while now, the Trump administration has been signalling it no longer believes they are critical to U.S. security. That likely changes with these events. The EIA estimates net crude-oil imports in the U.S. are running at 3.4mm b/d. The SPR is estimated at 645mm barrels. There are 416mm barrels of commercial crude inventories in the U.S., giving ~ 1.06 billion barrels of crude oil in the SPR and commercial inventory in the U.S. This translates into about 312 days of inventory in the U.S. when measured in terms of net crude imports. China has been building its SPR, which we estimated at ~ 510mm barrels. As a rough calculation using only China imports of ~ 10mm b/d, and production of ~ 3.9mm b/d, net crude-oil imports are probably around 6mm b/d. With SPR of ~ 510mm barrels, the public SPR (i.e., state-operated stocks) equates to roughly 85 days of imports.4 Members of the IEA – for the most part OECD states – are required to have 90 days of oil consumption on hand. The IEA estimates its SPR totals 1.54 billion barrels, which consists of crude oil and refined products. Together, the IEA’s SPRs plus spare capacity likely could cover the loss of KSA’s crude exports, but the timing and coordination of these releases will be tested. KSA has ~ 190mm b/d of crude oil in storage as of June, the latest data available from the Joint Organizations Data Initiative (JODI) Oil World Database. If the 5.7mm b/d of output removed from the market by these oil attacks persists, these stocks would be exhausted in 33 days. Based on press reports, repairs to the KSA infrastructure will take weeks – perhaps months – which means the longer it takes to repair these facilities the tighter the global oil market will become. This is exacerbated if additional pipelines or infrastructure in KSA come under attack or are damaged. Critical Next Steps How the U.S. follows up Pompeo’s accusations against Iran will be critical. The next steps here are critical: Tactically, the Houthis or other Iranian proxies could continue with drone attacks aimed at KSA infrastructure. They’ve obviously figured out how to target Abqaiq, which is the lynchpin of KSA’s crude export system (desulfurization facilities there process most of the crude put on the water in the Eastern province). The Abqaiq facility has been hardened against attack, but these attacks show the supporting infrastructure remains vulnerable. In addition, militants could target KSA’s western operations on the Red Sea, which include pipelines and refineries. The Bab el-Mandeb Strait at the bottom of the Red Sea empties into the Arabia Sea. More than half the 6.2mm b/d of crude oil, condensates and refined-product shipments transiting the strait daily are destined for Europe, according to the U.S. EIA.5 In addition, the 750-mile East-West pipeline running across KSA terminates on the Red Sea at Yanbu. The Kingdom is planning to increase export capacity off the pipeline from 5mm b/d to 7mm b/d, a project that will take some two years to complete.6 During a July visit to India, former Energy Minister Khalid al-Falih stated importers of Saudi crude and products, “have to do what they have to do to protect their own energy shipments because Saudi Arabia cannot take that on its own.” On top of all this, Iran could ramp up its threats to shipping through the Strait of Hormuz once again. These actions could put the risk to supply into sharp relief in very short order. Even Iranian rhetoric will have a larger impact in this environment. In the immediate aftermath of the drone attacks on critical KSA infrastructure, markets will be hanging on every announcement coming from the Kingdom regarding the duration of the outage. How the U.S. follows up Pompeo’s accusations against Iran will be critical. Whether the deal being brokered with France – and the $15 billion oil-for-money loan from the U.S. that goes with it – is now DOA, or is put on a fast track to reduce tensions in the region will be telling. It is entirely possible the U.S. launches an attack on Yemen to take out these drone bases and to neutralize the threat there. If Iraq is identified as the source of the attacks, the U.S., along with Iraqi forces, likely would stage a special-forces operation to take out the bases used to launch the drone attacks. The U.S. has significant forces in theater right now: The U.S. 5th Fleet is in Bahrain, with the Abe Lincoln aircraft carrier and its strike force on station at the Strait of Hormuz; and the USS Boxer Amphibious Ready Group (ARG) and 11th Marine Expeditionary Unit (MEU) are on patrol in the Red Sea under the command of the U.S. 5th Fleet (Map 2). In addition, the U.S. also deployed B52s earlier this year to Qatar to have this capability in theater. Map 2U.S. Navy Carrier Battle Group Disposition, 9 September 2019 Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response Attacks On Critical Infrastructure In KSA Raise Questions About U.S. Response Bottom Line: In the immediate aftermath of the drone attacks on critical KSA infrastructure, markets will be hanging on every announcement coming from the Kingdom regarding the duration of the outage that removed 5.7mm b/d of crude-processing capacity from the market and damaged one Saudi Arabia’s largest oil fields. We expect the U.S. will conduct a limited retaliatory strike, and will continue to build up forces in the Persian Gulf to prepare for a larger response if necessary. While neither President Trump nor the United States has an immediate interest in a large-scale conflict with Iran, the risk of such an outcome has increased. If the oil-price shock caused by these attacks becomes unmanageable – either because of additional attacks against Saudi Arabian or other regional infrastructure, or direct Iranian action to restrict the flow of oil from the Persian Gulf – the risk of recession increases. While this is not our base case, it could push Trump to adopt a “war president” strategy going into the U.S. general election next year.   Matt Gertken, Chief Geopolitical Strategist mattg@bcaresearch.com Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1      The massive 7-million-barrel-per-day processing facility at Abqaiq and the Khurais oil field, which produces close to 2mm b/d, were attacked on Saturday, September 14, 2019.  Since then, press reports claim the attack could have originated in Iraq or Iran, and could have included cruise missiles – a major escalation in operations in the region involving Iran, KSA and their respective allies – in addition to drones.  Please see Suspicions Rise That Saudi Oil Attack Came From Outside Yemen, published by The Wall Street Journal September 14, 2019. 2      Please see "Houthi Drone Strikes Disrupt Almost Half Of Saudi Oil Exports", published September 14, 2019, by National Public Radio (U.S.). 3      See Omer Carmi, "Is Iran Negotiating Its Way To Negotiations?" Policy Watch 3172, The Washington Institute, August 30, 2019, available at www.washingtoninstitute.org. 4      China is targeting ~500mm bbls by 2020, and is aiming to have 90 days of import oil cover in its SPR. 5      Please see The Bab el-Mandeb Strait is a strategic route for oil and natural gas shipments, published by the EIA August 27, 2019. 6      Please see "Saudi Arabia aims to expand pipeline to reduce oil exports via Gulf," published by reuters.com July 25, 2019.

Highlights So What? Maintain a cautious stance on Turkish currency and risk assets. Why? Following the AKP’s defeat in Istanbul, Erdogan has doubled down on unorthodox economic policies. Improvements in the current account balance are temporary. Unless investor sentiment is meaningfully repaired, the lira will resume its decline in 2020. In the meantime, tensions with the West – especially the U.S. – will remain elevated. The imposition of secondary sanctions from the U.S. is likely. Feature U.S. President Donald Trump is wavering in the trade war, which is ostensibly positive news for global risk assets that are selling off dramatically amid very gloomy expectations about the near future. The question is whether the delay is too little, too late to halt the slide in financial markets in the near term. The reason to be optimistic is that interest rates have fallen and the global monetary policy “put” is fully in effect. Moreover, it is irrefutable now that President Trump is sensitive to the negative financial effects of the trade war. He is delaying new tariffs on some of the remaining $300 billion worth of imports from China not simply because consumer price inflation has ticked up but more fundamentally because the tightening of financial conditions increases the risk of a recession. A president can survive a small increase in inflation but not a big increase in unemployment. The reason to be pessimistic is that global economic expectations are threatening the crisis levels of 2008 (Chart 1) and Trump’s tariff delay offers cold comfort. His administration has not delayed all the tariffs, and the delay lasts only three months. Rather than renew the license for U.S. companies to do business with Chinese telecom giant Huawei, his Commerce Department has deferred any decision – leaving uncertainty to fester in the all-important tech sector. Chart 1Global Economic Expectations Near Crisis Levels Global Economic Expectations Near Crisis Levels Global Economic Expectations Near Crisis Levels Chart 2More China Stimulus Needed To Prevent EM Breakdown More China Stimulus Needed To Prevent EM Breakdown More China Stimulus Needed To Prevent EM Breakdown Beneath the surface is the fact that China’s money-and-credit growth faltered in July, suggesting that negative sentiment is still suppressing credit demand and preventing policy stimulus from having as big of a bang as in 2015-16. The late-July Politburo meeting signaled a more accommodative turn in policy, as we have expected, and BCA’s China strategist Jing Sima expects more fiscal stimulus to be announced after the October 1 National Day celebration. But high-beta economies and assets will suffer in the meantime – especially emerging market assets (Chart 2). Emerging markets are also seeing geopolitical risks rise across the board – and with the exception of China and Brazil, these risks are underrated by markets: Greater China: Beijing is getting closer to intervening in Hong Kong with police or military force. Such a crackdown will increase the odds of a confrontation with Taiwan and a backlash across the region and world, meaning that East Asian currencies in particular have more room to break down. India: The escalation in Kashmir is not a “red herring.” A single terrorist attack in India blamed on Pakistan could trigger a dangerous military standoff that hurts rather than helps Indian equities, unlike the heavily dramatized standoff ahead of the election earlier this year. Russia: Large-scale protests, overshadowed by Hong Kong, highlight domestic instability amid falling oil prices. These developments bode ill for Russian currency and equities. We will return to these risks in the coming weeks. This week we offer a special report on Turkey, where political risk is becoming extremely underrated as the lira rallies despite a further deterioration in governance (Chart 3). Chart 3Political Risks Are Underrated In Turkey Political Risks Are Underrated In Turkey Political Risks Are Underrated In Turkey Too Early To Write Off Erdogan “Whoever wins Istanbul, wins Turkey … Whoever loses Istanbul, loses Turkey.” President Recep Tayyip Erdogan Turkey’s ruling Justice and Development Party (AKP) has had a tough year. The March 31 local elections – especially the rerun election for mayor of Istanbul – dealt the party its biggest electoral losses since it emerged as the country’s dominant political force in 2002 (Chart 4). The elections came to be seen as a referendum on President Recep Tayyip Erdogan and thus raise the question of whether the party’s strongman leader is in decline – and what that might mean for emerging market investors. Erdogan’s grip on power has long been overrated – it is his vulnerability that has driven him to such extremes of policy over the past decade. The Gezi Park protests of 2013 and the attempted military coup of 2016 revealed significant strains of internal opposition in the aftermath of the Great Recession. Chart 4 With each case of dissent, the AKP responded by stimulating the economy and tightening state control over society (Chart 5). But this strategy faltered last year when monetary policy finally became overextended, the currency collapsed, and the country slid into recession. The opposition finally had its moment. Chart 5 The AKP is less a source of unity. Chart 6 As a consequence, the AKP is less a source of unity among Turkish voters. Both its share of seats in parliament and the overall level of party concentration in the Turkish parliament have declined since 2002 (Chart 6). Were it not for its coalition partner, the Nationalist Movement Party (MHP), the AKP would not have gained a majority in the 2018 parliamentary election. The AKP’s popular base consists of conservative, rural, and religious voters. This bloc is losing influence in parliament relative to centrist and left-wing parties (Chart 7). Moreover, the share of Turks identifying with political Islam, while still the largest grouping, is declining. Those who identify with more secular Turkish nationalism are on the rise (Chart 8). Chart 7 Does this shift entail a major turn in national policy? Will a new party emerge to challenge the AKP at last? Chart 8Secular Nationalism Is On The Rise Secular Nationalism Is On The Rise Secular Nationalism Is On The Rise There has long been speculation that former AKP leaders such as former Turkish president Abdullah Gul, former prime minister Ahmet Davutoglu, and former deputy prime minister Ali Babacan might form a political alternative. The latter resigned from the AKP on July 8, reviving speculation that a rival party could emerge that is capable of combining disillusioned AKP voters with the broader opposition movement at a time when Erdogan’s vulnerability has been made plain. However, the opposition is likely getting ahead of itself. The ruling party still has many tools at its disposal. Its share of seats in parliament is more than double that of the main opposition party, the Republican People’s Party (CHP). It is also viewed favorably in rural areas, and support for Erdogan there will not shift easily. Moreover, despite the negative electoral trend, the AKP has a lot of enthusiasm among its supporters – it is the party with the highest favorability among its own voters (Chart 9). The March election served as a wakeup call for the AKP – a warning not to take its power for granted. Erdogan can still salvage his position. The next election is not due until June 2023, leaving the party with four years to recuperate. While polls for the 2023 parliamentary election paint an ominous sign (Chart 10), they are very early, and the key will be whether Erdogan can divide the opposition and reconnect with his voter base. Above all, this will depend on what changes he makes to economic policy. Chart 9 Chart 10Erdogan Needs To Reconnect With Voter Base Erdogan Needs To Reconnect With Voter Base Erdogan Needs To Reconnect With Voter Base Bottom Line: Erdogan’s and the AKP’s popularity is waning, but it is too soon to write them off. The key question is how Erdogan will handle economic policy now that there are chinks in his armor. Doubling Down On Erdoganomics The fluctuation in the lira “is a U.S.-led operation by the West to corner Turkey … The inflation rate will drop as we lower interest rates.” President Recep Tayyip Erdogan Chart 11 Erdogan needs to see the economy back to recovery in order to secure his success in the next election. A survey conducted early this year reveals that Turks view unemployment, the high cost of living, and the depreciation of the lira as the most significant problems facing Turkey, with 27% of respondents indicating that unemployment is the most important problem facing the country (Chart 11). More importantly, Turks do not have much confidence in the government’s ability to manage this pain – only one-third of respondents viewed economic policies as successful, a 14pp decline from the previous year. This highlights the need for Erdogan to revive confidence in Turkey’s policymaking institutions and to deliver on the economic front.     The key is how Erdogan will handle economic policy. However, it is still too early to call for a sustainable improvement in the Turkish economy as many of the same fundamental imbalances continue to pose risks. While the current account has improved significantly – even registering a surplus in May – the improvement will not endure (Chart 12). On the one hand, the weaker lira has made exports more attractive relative to global competition. However, the improvement in the external balance is in large part due to weaker imports which are now more expensive for Turkey’s residents and have fallen by 19% y/y in 1H2019. Shrinking imports also reflect weak domestic demand which has been weighed down by tight monetary conditions (Chart 13). Chart 12Current Account Improvement Will Not Endure Current Account Improvement Will Not Endure Current Account Improvement Will Not Endure Chart 13Tight Monetary Conditions Weighed On Domestic Demand Tight Monetary Conditions Weighed On Domestic Demand Tight Monetary Conditions Weighed On Domestic Demand What is more, portfolio inflows which in the past were necessary to offset the large current account deficit, have collapsed (Chart 14). Were it not for the improvement in the trade balance, the central bank of the Republic of Turkey (CBRT) would have experienced a pronounced decline in its foreign reserves, and currency pressures would have been significant. A meaningful improvement in investor sentiment – which will remain cautious on the back of economic and geopolitical risks – is a necessary precondition for the return of these inflows. Nevertheless, the current account deficit will likely remain narrow in the second half of the year as the trade balance improves on the back of a weak lira and imports remain depressed due to soft domestic demand. This will keep the lira supported over this period. Although risks from a wide current account deficit have been temporarily put off, years of foreign debt accumulation are a hazard to a sustainable improvement in the lira. Foreign debt obligations (FDO) due over the coming 12 months are extremely elevated at $167 billion (Chart 15). It is not clear that they can be paid off. While the FDO figure is overly pessimistic as some of these debts will be rolled over, net central bank foreign exchange reserves can cover only 2.7% of these obligations. This poses downside risks on the lira at a time when inflows have not yet recovered.1 Moreover, unorthodox economic policies will eventually reverse any improvement in the currency. Chart 14Financial Account Does Not Lend Support Financial Account Does Not Lend Support Financial Account Does Not Lend Support Chart 15FDO Pose A Risk To The Currency FDO Pose A Risk To The Currency FDO Pose A Risk To The Currency While the 4 years between now and the next election could be an opportunity to embark on unpopular structural reforms that will improve the outlook by the time voting season rolls in, Erdogan has instead doubled down on his current strategy. Less than two weeks after the results of the Istanbul election rerun, CBRT governor Murat Cetinkaya was removed by presidential decree. A month later, key CBRT staff were dismissed.2 Chart 16 At his first monetary policy committee meeting as governor on July 25, Murat Uysal slashed the one-week repo rate by 425bps. Given Erdogan’s outspoken distaste for high interest rates, the president’s consolidation of power over economic decision making implies that the outlook for easier monetary policy is now guaranteed. However, the ramifications of this dovish shift will be concerning for voters. The depreciating lira was singled out as the most important economic problem facing Turkey by the largest number of survey respondents (Chart 16). Erdogan’s pursuit of dovish policies despite popular opinion shows that he is doubling down on unorthodox policy despite popular opinion. Monetary easing threatens to unwind the current account improvement and ultimately de-stabilize the lira. Assuming that the banking sector does not hold back the supply of credit to the private sector, lower rates will generate a pickup in demand which will raise imports and widen the current account deficit. Unless there is a marked improvement in investor sentiment – which will remain tainted by the erosion of central bank independence and increased tensions with the West – a return in portfolio inflows to pre-2018 levels is unlikely. As a consequence the lira will begin to soften anew in 2020. The lira will soften anew in 2020. While inflation will subside as the lira stabilizes this year, it will likely remain elevated relative to pre-2018 levels – in the 10% to 15% range. Contrary to Erdoganomics, traditional economic theory postulates that interest rate cuts pose upside pressure on prices. The resurgence in domestic demand will occur against a backdrop of rising wages (Chart 17). Chart 17Price Pressures Will Persist Price Pressures Will Persist Price Pressures Will Persist With foreign currency reserves running low, the CBRT recently adopted several measures to discourage locals from exchanging their liras for foreign currency. These efforts reflect attempts to mitigate the negative impact of monetary easing on the lira, and to ensure FX reserves are supported: A 1-percentage point increase in the reserve requirement ratio for foreign currency deposits and participation funds. A 1-percentage point reduction in the interest rate on dollar-denominated required reserves, reserve options and free reserves held at the bank. An increase in the tax on some foreign exchange sales to 0.1% from zero. These measures make it more expensive for banks to hold foreign currency, incentivizing lira holdings instead. They also raise the CBRT’s foreign reserves highlighting the downside risks on these holdings and the lira. However, given that these measures boost CBRT reserves only superficially – rather than mirroring an improvement in the underlying economic conditions – they highlight that need for policy tightening to defend the lira, even as the CBRT officially pursues an accommodative path. Bottom Line: The Turkish economy will be extremely relevant to Erdogan’s fate in 2023. However with large foreign debt obligations, a rate cutting cycle underway, and foreign investors who remain uneasy, the case for Turkey’s economic recovery – especially amid turbulent global conditions – is weak. In the meantime, Erdogan will continue to blame external factors for the nation’s malaise. Don’t Bet On Trump-Erdogan Friendship “Being Asian and in Asia is as important as being European and in Europe for us.” Turkish Foreign Minister Melvut Cavusoglu For several years Erdogan has attempted to distract the populace from the country’s economic slide by adopting an aggressive foreign policy, particularly toward the West. The immediate cause is Syria, where Turkey has fundamental security interests that clash with those of the U.S. and Europe. But tensions also stem from Erdogan’s economic and political instability. This aggressive foreign policy has not changed in the wake of the AKP’s electoral loss. Erdogan is continuing to test the U.S.’s and EU’s limits and the result is likely to be surprise events, such as U.S.-imposed sanctions, that hurt Turkey’s economy and financial assets. Erdogan clashes with the West both because of substantive regional disagreements and because it plays well domestically. Turks increasingly see the U.S. and other formal NATO allies as a threat, while looking more favorably upon American rivals like Russia, China, Iran, and Venezuela (Chart 18). The U.S., meanwhile, is expanding the use of “secondary sanctions” to impose costs on states that make undesirable deals with its rivals, and Turkey is now in its sights. The reason is Erdogan’s decision to purchase the S400 missile defense system from Russia. This decision exemplifies the breakdown in the U.S.-Turkish alliance and Turkey’s search for alternative partners and allies. The arms sale is likely – eventually – to trigger secondary sanctions under the U.S. International Emergency Economic Powers Act and especially the Countering America’s Adversaries Through Sanctions Act (CAATSA). Washington has already imposed sanctions on China for buying the same weapons from Russia. Erdogan recently accepted the first delivery of components for the S400s, which are supposed to go live by April 2020. He stuck with this decision in disregard of Washington’s warnings. He has a solid base of popular support across political parties for this act of foreign policy and military independence from the U.S. (Chart 19). But the full consequences have not yet been felt. Chart 18 Chart 19 President Trump’s response is muted thus far. He banned Turkish pilots from the U.S. F-35 program and training but has not yet imposed sanctions due to his special relationship with Erdogan and ongoing negotiations over Syria. Syria is the root of the breakdown in Turkish-American relations since 2014. Washington and Ankara have clashed repeatedly over their preferred means of intervening into the Syrian civil war and fighting the Islamic State. The U.S. relies on the Syrian Democratic Forces, led by the Kurdish People’s Protection Units (YPG), which are affiliated with the Kurdistan Workers’ Party (PKK). The PKK is based in Turkey and both the U.S. and Turkey designate it as a “terrorist organization” due to its militant activities in its long-running struggle for autonomy from Turkey. Chart 20 Turkey has intervened in Syria west of the Euphrates River and has repeatedly threatened to conduct deeper strikes against the Kurds. The latter would put U.S. troops in harm’s way and could result in lost leverage for Western forces seeking to maintain their YPG allies and force an acceptable settlement to the Syrian conflict. There is a basis for a deal between Presidents Trump and Erdogan that could keep sanctions from happening. Trump is attempting to wash its hands of Syria to fulfill a promise of limiting U.S. costs in wars abroad. Meanwhile an aggressive intervention in Syria is not a popular option in Turkey, which is why Erdogan has not acted on threats to seize a larger swath of territory (Chart 20). As a result, the U.S. and Turkey recently formed a joint operation center to coordinate and manage “safe zones” for Syrian refugees. If they can manage the gray area on the Turkish-Syrian border, the Trump administration can continue to prepare for withdrawal while preventing Erdogan from taking too much Kurdish territory. The tradeoff is clear, but similar agreements have fallen apart. First, the U.S. Congress is ready to impose sanctions over the S400s and Trump is under pressure to punish Turkey for undermining NATO and dealing with the Russians. Second, the Trump administration has not found an acceptable solution to the Syrian imbroglio that makes full withdrawal possible. If Trump becomes convinced that the risks of a total and rapid withdrawal from Syria are greater than the rewards (as many of his GOP allies staunchly believe), then he has less incentive to protect Erdogan. Meanwhile Erdogan could still decide he needs to plunge deeper into Syria to counteract the YPG. Or he could retaliate against any sanctions over the S400s and provoke a broader tit-for-tat exchange. He has threatened to cancel orders for Boeing aircraft worth $10 billion. Clearly U.S. sanctions will cause the lira to fall and send Turkey into another bout of financial turmoil. In the meantime Turkey’s relations with Europe also pose risks. While the refugee crisis has abated, in great part due to Turkish cooperation, other disagreements are still problematic: The EU is not upgrading Turkey’s customs union and both sides know that Turkey is not eligible for EU membership anytime soon. In response to what the EU has deemed as illegal drilling for oil and gas off the coast of Cyprus, the EU called off high-level political meetings with Turkey and suspended EUR 145.8 million in pre-accession aid. EU foreign ministers have also put off talks on the Comprehensive Air Transport Agreement between the two parties which would have led to an increase in passengers using Turkish airports as a transit hub. In addition, EU ministers asked the European Investment Bank to review its lending activities in Turkey, which amounted to EUR 358.8 million last year. Erdogan is taking a bolder approach to Cyprus. He has decided to send a fourth ship to drill for natural gas in Cyprus’s Exclusive Economic Zone in the Eastern Mediterranean. The purpose is to rally support for his government by calling on the public’s strong allegiance to Turkish Cypriots (Chart 21). The problem is that a confrontation sought as a domestic distraction could provoke negative policy reactions from the EU (or the U.S., which is reconsidering its arms embargo on the Greek Cypriot side). Relations with the West would get worse. Chart 21 Chart 22... But Turkey Cannot Afford To Flout The EU ... But Turkey Cannot Afford To Flout The EU ... But Turkey Cannot Afford To Flout The EU Turkey cannot afford to flout the U.S. and EU. Its economy is dependent on Europe (Chart 22). And the U.S. still underwrites Turkey’s NATO membership and access to the global financial system. The problem is that Erdogan is an ambitious and unorthodox leader and he has clearly wagered that he can rally domestic support through various confrontations with Western policies. This means that for the immediate future the country is more likely to clash with Western nations than it is to recognize its own limits. Political risks are frontloaded and investors should be cautious before trying to snap up the depressed lira or Turkish government bonds. Bottom Line: Tensions with the West – especially the U.S. – will likely lead to economic sanctions. While there is a basis for Presidents Trump and Erdogan to avoid a falling out, it is not reliable enough to underpin a constructive investment position – especially given Erdogan has not changed course in the wake of this year’s significant electoral loss. Investment Conclusions Chart 23Optimism On Lira Amid Unresolved Risks Optimism On Lira Amid Unresolved Risks Optimism On Lira Amid Unresolved Risks The lira has rallied by 3.6% since the Istanbul election. It has risen 0.3% since the replacement of CBRT Governor Murat Cetinkaya and rallied further despite the sacking of the central bank’s chief economist and other high-level staff (Chart 23). Given that the market knows that the central bank reshuffle entails interest rate cuts, is this a clear signal that the lira has hit a firm bottom and cannot fall further? Turkey is more likely to clash with Western nations.  We doubt it. First, Erdogan’s doubling down on unorthodox policy threatens the recovery in the currency and risk assets and his aggressive foreign policy raises the risk of sanctions and further economic pain. Second, although Turkey is not overly exposed to China, it is heavily exposed to Europe, which is on the brink of a full-fledged recession and depends heavily on the Chinese credit cycle – which had another disappointment in July. German manufacturing PMI has been sinking further below the 50 boom-bust mark since the beginning of the year, and the economy contracted in 2Q2019 (Chart 24). Chart 24Global Backdrop Not Yet Supportive Global Backdrop Not Yet Supportive Global Backdrop Not Yet Supportive Chart 25Improvement In Spread Will Be Fleeting Improvement In Spread Will Be Fleeting Improvement In Spread Will Be Fleeting Given these domestic and global economic risks and geopolitical tensions, we expect any improvement in the sovereign spread to be fleeting (Chart 25). While the lira may experience temporary improvement, pressures will re-emerge in 2020 as the lagged impact of Erdogan’s pursuit of growth at all costs re-emerge. Stay on the sidelines as any improvement in the near term is fraught with risk.     Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy roukayai@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See Emerging Markets Strategy Weekly Report, “Country Insights: Indonesia, Turkey, And The UAE” May 2, 2019, ems.bcaresearch.com. 2 Among those removed are the central bank’s chief economist Hakan Kara as well as the research and monetary policy general manager, markets general manager, and banking and financial institutions general manager.

Highlights So What? Prime Minister Boris Johnson’s threat to take the U.K. out of the EU without a withdrawal deal in place is a substantial 21% risk. Why? The odds of a no-deal exit could range from today’s 21% to around 30%, depending on whether Johnson manages to obtain some concessions from the EU in forthcoming negotiations. It is far too early to go bottom-feeding for the pound sterling, as Brexit risks are asymmetrical. We maintain our tactically cautious positioning, despite some cyclical improvements, due to elevated geopolitical risks in the United States, East Asia, and the Middle East. Feature Thank you Mr. Speaker, and of course I should welcome the prime minister to his place … the last prime minister of the United Kingdom. – Ian Blackford, head of the Scottish National Party in Westminster, July 25, 2019 Chart 1No-Deal Brexit Would Come At A Very Bad Time No-Deal Brexit Would Come At A Very Bad Time No-Deal Brexit Would Come At A Very Bad Time The Federal Reserve cut interest rates for the first time since the global financial crisis in 2008 on July 31. The Fed suggested that the door is open for future cuts, though Chairman Jerome Powell signaled that the cut should not be seen as the launch of a “lengthy rate cutting cycle” but rather as a “mid-cycle adjustment” comparable to cuts in 1995 and 1998. President Donald Trump responded by declaring a new 10% tariff on $300 billion worth of imports from China! He resumed criticizing Powell for insufficient dovishness – and Trump could in fact fire Powell, though the decision would be contested at the Supreme Court. The Fed’s move shows that Trump’s direct handle on interest rates comes from his ability to control trade policy and hence affect the “the external sector.” The trade war with China has exacerbated a global manufacturing slowdown that is keeping global growth and U.S. inflation weak enough to justify additional rate cuts with each future deterioration (Chart 1). Improvements in global monetary and fiscal policy suggest that the U.S. and global economic expansion will be extended to 2021 or beyond, which is positive for equities relative to government bonds or cash, but we remain defensively positioned in the near-term due to a range of geopolitical risks, highlighted by the new tariffs. The unconvincing U.S.-China tariff ceasefire agreed at the Osaka G20 has fallen apart as we expected; the period of “fire and fury” between the U.S. and Iran continues; and the U.S. is entering what we expect to be a period of socio-political instability in the lead up to the momentous 2020 presidential election. Moreover the risk of a “no deal” Brexit, in which the U.K. exits the European Union and reverts to basic World Trade Organization tariff levels, is rising and will create acute uncertainty over the next three months despite the world’s easy monetary policy settings (Charts 2A & 2B). In June we upgraded our odds of a no-deal Brexit to 21%, up from 7% this spring. While not our base case, the probability is too high for comfort and the critical timing for the rest of Europe warns against taking on additional risk. The risk of a “no deal” Brexit ... is rising and will create acute uncertainty. Chart 2AUncertainty And Sentiment Getting Worse ... Uncertainty And Sentiment Getting Worse ... Uncertainty And Sentiment Getting Worse ... Chart 2B... Despite Easy Monetary Policy ... Despite Easy Monetary Policy ... Despite Easy Monetary Policy BoJo’s Gambit Boris Johnson – aka “BoJo” – former mayor of London and foreign secretary, cemented his position as the U.K.’s 77th prime minister on July 24. He immediately launched a gambit to renegotiate the U.K.’s withdrawal. He is threatening not to pay the “divorce bill” (the U.K.’s outstanding budget contributions for the 2014-20 budget period and other liabilities in subsequent decades) of 39 billion pounds. He insists that the Irish backstop (which would keep Northern Ireland or the U.K. in the EU customs union to prevent a hard border between the two Irelands) must be abandoned. He has stacked his cabinet with pro-Brexit hardliners who share his “do or die” stance that Brexit must occur on October 31 regardless of whether an agreement for an orderly exit is in place. These developments were anticipated – hence the decline in our GeoRisk indicator – but the pound sterling is falling now that the confrontation is truly getting under way (Chart 3). Parliament is adjourned in August, so Johnson’s hardline negotiating tactics will get full play in the media cycle until early September, when the real showdown begins. Crunch time will likely run up to the eleventh hour, with Halloween marking an ominous deadline. There is plenty of room for the pound to fall further throughout this period, according to our European Investment Strategy’s handy measure (Chart 4), because the success of Boris’s gambit depends entirely upon creating a credible threat of crashing out of the EU in order to wring concessions that could conceivably pass through the British parliament. Chart 3Our Market-Based Indicator Suggests Still Some Complacency On Brexit Risks Our Market-Based Indicator Suggests Still Some Complacency On Brexit Risks Our Market-Based Indicator Suggests Still Some Complacency On Brexit Risks Chart 4GBP-EUR Still Has Room To Fall Under BoJo's Gambit GBP-EUR Still Has Room To Fall Under BoJo's Gambit GBP-EUR Still Has Room To Fall Under BoJo's Gambit Geopolitically, the United Kingdom is not prohibited from exiting the EU without a deal. Though the empire is a thing of the past, the U.K. remains a major world power. It has Europe’s second-largest economy, nuclear weapons, a blue-water navy, a leading voice in global political institutions, and is a close ally of the United States. It mints its own coin. It is a sovereign entity that can survive on its own just as Japan can survive on its own. This geopolitical foundation always supported our view that there was a 50% chance of the referendum passing in 2016, and today it supports the view that fears over a no-deal Brexit are not misplaced. Investors should therefore not confuse Johnson’s bluster with that of Alexis Tsipras in 2015. A British government dead-set on delivering this outcome – given the popular mandate from the 2016 referendum and the government’s constitutional handling of foreign affairs as opposed to parliament – can probably achieve it. However, the probability of a no-deal Brexit may become overstated in the next two-to-three months. Economically and politically, a no-deal exit is extremely difficult to follow through on – hence our 21% probability. Estimates of the negative economic impact range from a 2% reduction in GDP growth to an 11% reduction (Table 1). The 8% drop cited by Scottish National Party leader Ian Blackford in his denunciation of Prime Minister Johnson’s strategy is probably exaggerated. The U.K.’s recorded twentieth-century recessions range from 2%-7% (Chart 5). These offer as good of a benchmark as any. While a no-deal exit is probably not going to create a shock the same size as the Great Depression or the Great Recession, the recessions of 1979 and 1990 would be bad enough for any prime minister or ruling party. Table 1Wide Range Of Estimates For Impact Of No-Deal Brexit Tariffs ... And The Last Prime Minister Of The United Kingdom? Tariffs ... And The Last Prime Minister Of The United Kingdom? Chart 5 A small recession could also spiral out of control – it could create a vicious spiral with the European continent, which is already on the verge of recession. And it could damage consumer confidence more than anticipated – as it would be accompanied by immediate social and political unrest due to the half of the population that opposes Brexit in all forms. Politicians have to pay attention to the opinion polls as well as the referendum result, since opinion polls impact the next election. These show a plurality in favor of remaining in the EU and a strong trend against Brexit since 2017 – a factor that the currency markets are ignoring at the moment (Chart 6). While the evidence does not prove that a second referendum would result in Bremain, it is highly likely that a majority opposes a no-deal exit, given that at least a handful of pro-Brexit voters do not want to leave without a deal. The results of the European parliamentary elections in May (Chart 7) and the public’s preferences for different political parties (Chart 8) both support this conclusion. Chart 6Plurality Of Voters Still Favors Bremain Over Brexit Plurality Of Voters Still Favors Bremain Over Brexit Plurality Of Voters Still Favors Bremain Over Brexit Chart 7 Chart 8Voters Favor Bremain-Leaning Political Parties Voters Favor Bremain-Leaning Political Parties Voters Favor Bremain-Leaning Political Parties Parliament is also opposed to a no-deal Brexit. Though the Cooper-Letwin bill that forbad a no-deal exit initially passed by one vote in April (Chart 9A), the final amended version passed with a majority of 309 votes. Further, in July, with the rise of Boris Johnson, parliament passed a measure by 41 votes that requires parliament to sit this fall (Chart 9B), thus attempting to prevent Boris from proroguing parliament and forcing a no-deal Brexit that way. Technically Queen Elizabeth II could still prorogue parliament, but we highly doubt she would intervene in a way that would divide the nation. Johnson himself will have to face the reality of parliament and public opinion. Chart 9 Chart 9 Parliament has one crystal clear means of halting a no-deal exit: a vote of no confidence in Johnson’s government.1 Theresa May only survived her vote of no confidence by 19 seats. Yet Johnson is entering 10 Downing Street at a time when parliament is essentially hung. The Conservative Party’s coalition with Northern Ireland’s Democratic Union Party has been reduced to a majority of two, which is likely to fall to a single solitary seat after the Brecon and Radnorshire by-election, which is taking place as we go to press. Johnson has purged several Tories from his cabinet, and there are a handful of Conservatives who are firmly opposed to a no-deal Brexit. It would be an extremely tight vote as to whether these Tory rebels would be willing and able to bring down one of their own governments – a careful assessment suggests that there are about half a dozen swing voters on each side of the House of Commons.2 But 47 Conservatives contrived to block prorogation (see Chart 9B). The magnitude of the crisis members of parliament would face – an unpopular, self-inflicted no-deal exit and recession – is essential context that would motivate rebellious voting behavior. Parliament’s actions so far, the reality of the economic impact, and the popular polling suggest that MPs are likely to halt the Johnson government from forcing a no-deal exit if he makes a mad dash for it. More likely is that Johnson himself pushes to hold an election after securing some technical concessions from Brussels. He is galvanizing the Conservative vote and swallowing up the single-issue Brexit vote (UKIP and the Brexit Party), while the opposition remains divided between the Labour Party under the vacillating Jeremy Corbyn and the resurgent Liberal Democrats (Chart 10). In a first-past-the-post electoral system, this provides a window of opportunity for the Conservatives to improve their parliamentary majority – assuming that Johnson has renegotiated a deal with the EU and has something to show for it. Chart 10BoJo Could Call Election With Deal In Hand BoJo Could Call Election With Deal In Hand BoJo Could Call Election With Deal In Hand Chart 11Ireland Can Compromise For Stability's Sake Ireland Can Compromise For Stability's Sake Ireland Can Compromise For Stability's Sake This would require the EU to delay the deadline yet again (September 3 is the last date for a non-confidence vote to force a pre-Brexit October 24 election). The European Union has a self-interest in preventing a no-deal Brexit, as it needs to maintain economic stability. It ultimately would prefer to keep the U.K. in the bloc, which means that delays can ultimately be granted, especially to accommodate a new election. As to what kind of compromises are available, the Irish backstop can suffer technical changes to its provisions, time frames, or application. In the end, the Irish Sea is already a different kind of border than the other borders in the U.K. and therefore it is possible to enact additional checks that nevertheless have a claim to retaining the integrity of the United Kingdom. The Democratic Unionists could find themselves outnumbered on this issue. Certainly the Republic of Ireland has an interest in preventing a no-deal Brexit as long as a hard border with Northern Ireland is avoided, and Boris Johnson maintains that it will be (Chart 11). The risk of a no-deal Brexit is around 21% Our updated Brexit Decision Tree in Diagram 1 provides the outcomes. Former Prime Minister Theresa May failed three times to pass her Brexit deal. We allot a 30% chance, higher than consensus, that Boris Johnson can do it through galvanizing the Conservative vote – given that he is operating with a hung parliament and is at odds with the median voter on Brexit. We give 21% odds to a no-deal Brexit based on the difficulty of parliament outright halting Johnson if his government is absolutely determined to follow through with it. This is clearly a large risk but not our base case. We would upgrade these odds to around 30% in the event that negotiations with the EU completely fail to produce tangible outcomes. It is far more likely that a delay occurs and leads to new elections (49%) – and these odds rise to 70% if Johnson fails to extract concessions from the EU that enable him to pass a deal through parliament. Diagram 1Brexit Decision Tree (Updated As Of June 21 For Boris Johnson) Tariffs ... And The Last Prime Minister Of The United Kingdom? Tariffs ... And The Last Prime Minister Of The United Kingdom? A final constraint on Johnson comes from Scotland, as highlighted in the epigraph at the top of the report: the demand for a new Scottish independence referendum is reviving as a result of opposition to Brexit in general and specifically to Prime Minister Johnson’s hardline approach (Charts 12A & 12B). The SNP is also improving its favorability among Scottish voters relative to other parties (Chart 13). We have highlighted this risk in the past: support for Scottish independence does not have a clear ceiling amid the antagonism over Brexit, especially if an economic and political shock hits the union as a result of a forced no-deal exit. Chart 12 Chart 12 Chart 13Scottish Nationals Resurgent Scottish Nationals Resurgent Scottish Nationals Resurgent Bottom Line: The risk of a no-deal Brexit is around 21%, though a complete failure of negotiations with the EU could push it up to 30%. If it occurs it will induce a recession and eventually could result in the breakup of the union with Scotland. China And Investment Recommendations What can investors be certain of regardless of the different Brexit outcomes? The United Kingdom will reverse the fiscal austerity of recent years (Chart 14). Fiscal stimulus will be necessary either to offset the shock of a no-deal exit in the worst-case scenario, or to address the ongoing economic challenges and public grievances in a soft Brexit or no Brexit scenario. These grievances stem from the negative impact on the middle class of globalization, post-financial crisis deleveraging, low real wage growth, and the decline in productivity. Potential GDP growth is set to fall if immigration is curtailed and restrictions on trade with the EU go up. The government will have to offset this trend with spending to boost the social safety net and encourage investment. Chart 14Fiscal Austerity To Go Into Reverse Fiscal Austerity To Go Into Reverse Fiscal Austerity To Go Into Reverse The pound is clearly weak on a long-term and structural basis (Chart 15). Based on our assessment of the British median voter – opposed to a no-deal Brexit – and the fact that parliament is also opposed to a no-deal Brexit Chart 15Deep Value In Sterling Deep Value In Sterling Deep Value In Sterling and is the supreme lawgiving body in the British constitution, we expect that an enormous buying opportunity will emerge when Prime Minister Johnson’s gambit has reached its apex and he is either forced to accept what concessions the EU will give. But if forced out of office, election uncertainty due to a potential Prime Minister Jeremy Corbyn will prolong the pound’s weakness. Brexit is not the only risk affecting Europe this summer – a critical factor is Europe’s own economic status, which in great part hinges on our China view (Chart 16). The Chinese Communist Party’s mid-year Politburo meeting struck a more accommodative tone relative to the April meeting that sounded less dovish in the aftermath of the Q1 credit splurge. The emphasis of the remarks shifted back to the need to take additional measures to stabilize the economy, as in the October 2018 statement. This fits with our view since February that Chinese stimulus will surprise to the upside this year. Chart 16Chinese Reflation Positive For Europe Chinese Reflation Positive For Europe Chinese Reflation Positive For Europe Policymakers’ efforts are working thus far, with signs of stabilization occurring in the all-important labor market (Chart 17). There is some evidence that Xi Jinping’s anti-corruption campaign is moderating, which also supports the view that policy settings in the broadest sense are becoming more supportive of growth (Chart 18). Chart 17China Will Reflate More China Will Reflate More China Will Reflate More Chart 18Relaxing Anti-Corruption Campaign Another Form Of Easing Relaxing Anti-Corruption Campaign Another Form Of Easing Relaxing Anti-Corruption Campaign Another Form Of Easing Chart 19Hong Kong Equities Have Farther To Fall Hong Kong Equities Have Farther To Fall Hong Kong Equities Have Farther To Fall We still are long European equities versus Chinese equities and are short the CNY-USD. From a geopolitical point of view, the U.S.-China conflict is intensifying with President Trump’s threat to raise an additional 10% tariff on $300 billion of Chinese imports despite the resumption of talks. In addition, the Hong Kong protests are intensifying, with China’s People’s Liberation Army (PLA) warning that it may have to intervene. There is high potential for violence to erupt, leading to a more heavy-handed approach by Hong Kong security forces and even eventual PLA deployment. This suggests there is downside in the Hang Seng index (Chart 19) – and PLA intervention could lead to broader investor concerns about China’s internal stability and another reason for tensions with the United States and its allies. The U.S.-China conflict is intensifying. Our alarmist view on Taiwan in advance of the January 2020 election is finally taking shape. Not only has the Hong Kong unrest prompted a notable uptick in Taiwanese people’s view of themselves as exclusively Taiwanese (Chart 20), but Beijing has also announced additional restrictions on travel and tourism to Taiwan – an economic sanction that will harm the economy (Chart 21). These actions and escalation in Hong Kong raise the odds that the ruling Democratic Progressive Party will remain in power in Taiwan after January and hence that cross-strait relations (and by extension Sino-American relations) will remain strained and will require a higher risk premium to be built in. The latest trade war escalation could easily spill into strategic saber-rattling, as the U.S. blames China for North Korea’s return to bad behavior and China blames the U.S. for dissent in Hong Kong and likely Taiwan. Chart 20 Chart 21Beijing To Sanction Taiwan Tourism Again Beijing To Sanction Taiwan Tourism Again Beijing To Sanction Taiwan Tourism Again The U.S.-China trade negotiations are falling apart at the moment. We had argued that China’s stimulus and stabilization would create a negative reaction from President Trump, who would regret the Osaka ceasefire when he saw that China’s bargaining leverage had improved. This has come to pass, vindicating our 60% odds of an escalation post-G20. The U.S. Commerce Department could still conceivably renew the Temporary General License for U.S. companies to deal with Chinese tech firm Huawei on August 19, in order to create an environment conducive to progress for the next round of trade talks in September, but with the latest round of tariffs we think it is more likely that we will get a major escalation of strategic tensions and even saber-rattling. China’s new announcements regarding reforms to make local officials more accountable and to make it easier for companies to go bankrupt, including unprofitable “zombie” state-owned enterprises, could be a thinly veiled structural concession to the United States, but it remains to be seen whether these will be implemented and reinforced. Beijing rebooted structural reforms at the nineteenth national party congress but we expect stimulus to overwhelm reform amid trade war. We are converting our long non-Chinese rare earth producers recommendation to a strategic trade, after it hit our 5% stop-loss, as it is supported by our major theme of Sino-American strategic rivalry. The secular nature of this rivalry has been greatly confirmed by the fact that President Trump is now responding to American election dynamics. The U.S. Democratic Party’s primary debates have revealed that the candidates most likely to take on President Trump (Bernie Sanders and Elizabeth Warren) are adopting his hawkish foreign policy and trade policy stance toward China. The frontrunner former Vice President Joe Biden is the exception, as he is maintaining President Obama’s more dovish and multilateral approach. Trump’s clear response is to ensure that he still owns the trade and manufacturing narrative, to call Biden weak on trade, and to prevent the left-wing populists from outflanking him. Short the Hang Seng index as a tactical trade and close long Q1 2020 Brent futures versus Q1 2021 at the market bell tonight.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See Maddy Thimont Jack, “A New Prime Minister Intent On No Deal Brexit Can’t Be Stopped By MPs,” May 22, 2019, www.instituteforgovernment.org.uk. 2 See Dominic Walsh, “Would MPs really back a no confidence motion to stop no-deal?” The New Statesman, July 15, 2019, www.newstatesman.com.

Highlights So What? U.S. policy uncertainty adds to a slew of geopolitical reasons to remain tactically cautious on risk assets. Why? U.S. fiscal policy should ultimately bring market-positive developments – though the budget negotiation process could induce volatility in the near-term. We expect spending to go up and do not expect a default due to the debt ceiling or another prolonged government shutdown. Former Vice President Joe Biden remains the frontrunner for the Democratic Party’s presidential nomination in 2020. But left-wing progressive candidates are gaining on him and their success will trouble financial markets. With Persian Gulf tensions still elevated, go long Q1 2020 Brent crude relative to Q1 2021. Feature Chart 1U.S. Politics Poses Risks Through Next November U.S. Politics Poses Risks Through Next November U.S. Politics Poses Risks Through Next November Economic policy uncertainty is rising in the United States even as it falls around the world (Chart 1). Ongoing budget negotiations and the Democratic primary election give equity investors another reason to remain cautious in the near term. We expect more volatility. There also remain several persistent global threats to markets posed by unresolved geopolitical risks – rising Brexit risks with Boris Johnson likely to take the helm in the United Kingdom; oil supply threats amid Iran’s latest rejection of U.S. offers to negotiate its missile program; and a major confirmation of our theme of geopolitical risk rotation to East Asia, with Japan, South Korea, Hong Kong, Taiwan, and the South China Sea all heating up at once. In sum, political and geopolitical risks are showing investors a yellow light, even though the macroeconomic outlook still supports BCA’s cyclical (12-month) equity overweight. U.S. Fiscal Policy Will Remain Accommodative While U.S. monetary policy has taken a dovish turn – supported by other central banks – fiscal spending is now coming into focus for investors. We expect the budget battle to be market-relevant this year, injecting greater economic policy uncertainty, but the end-game should be market-positive. Brinkmanship will not get as bad as during the debt ceiling crises of 2011 and 2013, though market jitters will be frontloaded if Pelosi and the White House fail to conclude a deal immediately. Chart 2The 'Stimulus Cliff' Awaits President Trump The 'Stimulus Cliff' Awaits President Trump The 'Stimulus Cliff' Awaits President Trump The U.S. budget process is always rocky and is usually concluded well into the fiscal year under discussion. This year the fight will be more important than over the past few years because, as the two-year bipartisan agreement of 2018 lapses, the so-called “stimulus cliff” looms over the U.S. economy and will get caught up in the epic battle over the 2020 election. The stimulus cliff is the automatic imposition of fiscal spending cuts (“sequestration”) in FY2020 that would take effect as a result of the Budget Control Act of 2011. Standard estimates of the U.S. budget deficit expect that the deficit will shrink in 2020 if the spending caps are not raised, resulting in a negative fiscal thrust (Chart 2). The result would be to decrease aggregate demand at a time when the risk of recession is relatively high (Chart 3). Chart 3Recession Odds Still High Over Next 12 Months Recession Odds Still High Over Next 12 Months Recession Odds Still High Over Next 12 Months This is clearly not in President Trump’s interest, since a recession would devastate his reelection odds. Hence, Treasury Secretary Steve Mnuchin and other White House officials are pushing for a budget deal before the House of Representatives goes on recess on July 26 and the Senate on August 2. Ideally, an agreement would raise the spending caps, appropriate funds for the rest of the budget, and lift the “debt ceiling,” the statutory limit on U.S. debt. But it would be surprising if a deal came together as early as next week. A failure to agree on a budget deal before Congress goes on recess will make the market increasingly jittery. Congress can cancel the August recess, or wait until September 9 when they reconvene, but a failure to agree on something between now and then will make the market increasingly jittery. The U.S. has already surpassed the current debt limit and the latest estimates suggest that the Treasury Department’s “extraordinary measures” to meet U.S. debt payments could be exhausted by early-to-mid September.1 This would give Congress only a week in September to raise the debt limit. There are three main reasons to expect that the debt ceiling fight will not get out of hand: Chart 4Americans Stopped Worrying And Love Debt Americans Stopped Worrying And Love Debt Americans Stopped Worrying And Love Debt First, a technical default on U.S. debt could result in a failure to meet politically explosive obligations, such as sending social security checks to seniors. No one in Washington would benefit from such a failure and President Trump would suffer the most. Second, the public is not as worried about national deficits and debt today as it was in the aftermath of the financial crisis (Chart 4). Democrats, as the pro-government party, do not have an incentive to stage a showdown over the debt like Tea Party Republicans did under the previous administration. To be fair, they did do so in January 2018, but backed off after merely two days due to high political costs. Third, the one budget conflict that could create a catastrophic impasse – funding for Trump’s border wall – can be assuaged by Trump’s use of executive action, as he demonstrated by declaring a national emergency and appropriating military funds for fencing. Trump is fighting a general election in 2020 and is unlikely to use the debt ceiling as leverage to the point that the U.S. defaults on its obligations. The risk to investors, however, is that he goes back to threatening a 25% tariff on Mexico if it fails to staunch the flow of immigrants from Central America. What if the Republicans and Democrats cannot agree on the budget and spending caps? Democrats say they will not raise the debt limit unless they get non-defense spending increases. House Democrats need to reward their constituents for voting for them in 2018 and want to increase non-defense spending at “parity” with increases to defense spending. They also want to reduce the defense increases that Republicans seek in order to pay for non-defense increases. President Trump and the Republicans have a higher defense target and a lower non-defense target. The truth is that the Republicans and Democrats have agreed three times to increase spending caps beyond the levels required under the 2011 law – and they have done so most emphatically under President Trump with the FY2018-19 agreement (Chart 5). This year the two parties stand about $17 billion apart on defense and $30 billion apart on non-defense spending.2 We would expect both sides to splurge on spending and get what they want, but they could also split the difference: the amounts are small but the acrimony between the two parties could extend the talks. Congress may have to pass one or more “continuing resolutions” (stopgap measures keeping spending levels constant) to negotiate further. A continuing resolution could at least raise the debt ceiling and leave the rest of the budget negotiation until later, removing the majority of the political risk under discussion. Chart 5 Chart 6 Is another government shutdown possible? Yes, but not to the extent of early 2019. Trump saw a sharp drop in his approval ratings during the longest-ever government shutdown last year (Chart 6). Brinkmanship could lead to another shutdown, but he is likely to capitulate before it becomes prolonged. In early 2020, he wants to be lobbing grenades into the Democratic primary election rather than giving all of the Democrats an easy chance to criticize him for dysfunction in Washington. Ultimately, Trump can simply refrain from vetoing whatever the House and Senate agree – it is not in his interest to shrink the budget deficit in an election year. The Democrats’ spending increases would boost aggregate demand and are thus in President Trump’s personal interest. Trump is the self-professed “king of debt” – he is not afraid to agree to a deal that will be criticized by fiscal hawks. The latter have far less influence in Congress anyway since the 2018 midterm election. Why should House Democrats extend the economic expansion knowing that it would likely improve President Trump’s reelection chances? Because Trump will capitulate to most of their spending demands; voters would punish them if they are seen deliberately engineering “austerity”; and they need to show voters that they can govern. As for the 2020 race, they will focus on other issues: they will attack Trump on trade and immigration and focus on social policy: health care, the minimum wage, taxes and inequality, climate change, and student debt. What will be the fiscal and economic impact of a budget deal? The budget deal under negotiation ($750 billion in defense discretionary spending, $639 billion in non-defense discretionary spending) would raise the spending cap by about $145 billion – this is slightly above the $112 billion negative fiscal thrust expected in 2020.3 The result is that the U.S. fiscal drag expected in 2020 will at least be eliminated (if not turned into a fiscal boost), helping to prolong the cycle. The removal of fiscal drag will coincide with monetary easing, which is positive for markets since inflation is subdued. The Federal Reserve abandoned rate hikes this year (after four last year) because of the asymmetric risk of deflation relative to inflation (Chart 7). The FOMC believes that they can always jack up interest rates to combat an inflation overshoot, as their predecessors did in the 1980s, but that they are constrained by the zero lower-bound in interest rates. They may never recover from a loss of credibility and collapse of inflation expectations, so an insurance policy is necessary. The result is likely to be one or two rate cuts this year, which has already improved financial conditions. Chart 7The Fed Fears The Asymmetric Threat Of Deflation The Fed Fears The Asymmetric Threat Of Deflation The Fed Fears The Asymmetric Threat Of Deflation Bottom Line: Budget brinkmanship could become a near-term source of volatility but it is ultimately likely to be resolved with the pro-market outcome of less fiscal drag in 2020. The debt ceiling debate is unlikely to result in a U.S. default and any government shutdown is likely to resemble the short one of 2018 more than the long one of 2019. We expect U.S. equities to grind higher over the 12-month cyclical horizon, but we remain exceedingly cautious on a three-month tactical horizon. The price of Trump’s capitulation on border funding could be a renewed threat of tariffs against Mexico. The Budget Deal, Geopolitics, And The Dollar Chart 8China Shifts From Reform To Stimulus China Shifts From Reform To Stimulus China Shifts From Reform To Stimulus What does this fiscal outlook imply for the U.S. dollar? Near-term moves will probably be negative, since the fiscal boost outlined above will not be comparable to 2018-19, and meanwhile our view on China’s stimulus is bearing out reasonably well (Chart 8). Improvements in global growth, Fed cuts, and rising oil prices will weigh on the greenback even though later we expect the dollar to recover on the back of renewed U.S.-China conflict and global recession in 2021 or thereafter. Beyond the recession, two of our major political and geopolitical themes continue to point to large downside risk to the dollar: populist politics and multipolarity, or geopolitical competition among the world’s great powers. Beyond the recession, two of our major political and geopolitical themes continue to point to large downside risk to the dollar: populist politics and multipolarity. Populism and the Fed: Domestically, the United States is seeing a rise in populism that is continuing across administrations and political parties. This is conducive to easier monetary policy. Left-wing firebrand Alexandria Ocasio-Cortez’s (AOC) recent exchange with Fed Chairman Jay Powell highlights the trend. AOC asked one of the most frequent questions that BCA’s clients ask: Does the Phillips Curve still work? Powell answered that in recent years it has not. President Trump’s Economic Director Larry Kudlow applauded AOC, saying “she kind of nailed that” (obviously the administration is pushing for lower rates). If inflation is not a risk, monetary policy need not guard against it. This interchange should be taken in the context of President Trump’s attempts to jawbone Powell into rate cuts and the notable monetary promiscuousness of his ostensibly “hard money” Federal Reserve nominees. The extremely different ideological and institutional profiles of these various policymakers suggests that a new consensus is forming that is conducive to more dovish monetary policy than otherwise expected over the long run. Populists of any stripe, from Trump to AOC, would like to see lower interest rates, higher nominal GDP growth, and a lower real debt burden on households. We are reminded of an oft-overlooked point about the stagflation of the 1970s. Fed Chair Arthur Burns is usually depicted as a lackey of President Richard Nixon who succumbed to political influence and failed to raise interest rates adequately to fight inflation. But this is only part of the story. Leaving aside that the Fed only had a single mandate of minimizing unemployment at that time, Burns was conflicted. He saw the need to fight inflation, but he had more than Nixon’s wrath to fear. He also dreaded the impact on the Fed’s credibility and popular support as an institution if he hiked rates too aggressively and stoked unemployment (Chart 9).4 Chart 9Rate Hikes Are Hard To Defend Amid High Unemployment Rate Hikes Are Hard To Defend Amid High Unemployment Rate Hikes Are Hard To Defend Amid High Unemployment In other words, populism can constrain the Fed from the bottom up as well as from the top down in a context of rising unemployment.5 Multipolarity and Currency War: Since President Trump’s election we have highlighted that dollar depreciation is likely to be the administration’s ultimate aim if President Trump’s overall economic strategy is truly to stimulate growth, reduce the trade deficit, and repatriate manufacturing. Jacking up growth rates relative to the rest of the world while disrupting global trade via tariffs is a recipe for a strong dollar that undermines the attempt to bring jobs back from overseas. We have always argued that China would not grant the U.S. “shock therapy” liberalization and market opening – and that neither China, nor Europe, nor Japan would or could engage in currency appreciation along the lines of a new Smithsonian or Plaza Accord. The U.S. does not have as much geopolitical clout as it had in the 1970s-80s when it forced major currency deals on its allies and partners. The remaining option is for the U.S. to attempt unilateral depreciation. The combination of profligate spending, easy monetary policy, and populism may do the trick. But it is also possible that President Trump will attempt to engineer depreciation through Treasury Department intervention. If a slide toward recession threatens his reelection – or he is reelected and hence gets rid of the first-term reelection constraint – his unorthodox policies pose a significant risk to the dollar. Bottom Line: The U.S. dollar faces near-term risks as growth rebalances towards rest of the world, but will probably resume its rise in the impending recessionary environment and expected re-escalation of tensions with China. Over the long run, it faces severe risks due to fiscal mismanagement, domestic populism, and geopolitical struggle. A Progressive Overshoot Will Hurt Democrats … And Equities Chart 10A Democratic Win Will Weigh On Animal Spirits A Democratic Win Will Weigh On Animal Spirits A Democratic Win Will Weigh On Animal Spirits The Democratic Party’s primary election is also a risk to the equity rally. We see a 45% risk that President Trump will be unseated in November 2020 and hence that the U.S. will once again experience a dramatic policy reversal (as in 2000, 2008, and 2016). The risks are to the downside because the market is at all-time highs and Democratic proposals include raising taxes on corporations and re-regulating the economy (Chart 10). Whether you accept our 55% odds of Trump reelection, the race will be a continual source of uncertainty for investors going forward. How extreme is the uncertainty? Former Vice President Joe Biden remains the frontrunner in the race, though he has lost his initial bump in opinion polls (Chart 11). Biden’s success is market-positive relative to the other Democratic candidates since he is an establishment politician and a known quantity. Given his age, a Biden presidency would likely last for one term and focus on repudiating Trumpism and consolidating the Obama administration’s signature achievements (the Affordable Care Act, Dodd-Frank, the Joint Comprehensive Plan of Action, environmental regulation, etc). Greater predictability in the health care sector and a return to lower-level tensions with Iran would be market-positive. The financial sector would be consoled by the fact that nothing worse than Dodd-Frank would be in the offing. Chart 11 A Biden victory would be more likely to yield Democratic control of the senate than a progressive candidate’s victory.6 This means that the risk of Democrats taking full control of government and passing more than one major piece of legislation after 2020 increases with Biden. Yet any candidate capable of defeating Trump is likely to take the senate in our view; and Biden’s legislative initiatives are likely to be more centrist.7 So as long as Biden remains in the lead in primary polling, he increases his chances of winning the nomination, maximizes the 45% chance of Democrats winning the White House, and decreases the intensity of the relative policy uncertainty facing markets. The risk to the Democrats is … a left-wing or progressive overshoot that knocks out Biden in the primary, replacing him with a progressive candidate who may not be as electable in the general election.  Chart 12 The risk to the Democrats is that the leftward policy shift within the party (Chart 12) may lead to a left-wing or progressive overshoot that knocks out Biden in the primary, replacing him with a progressive candidate who may not be as electable in the general election. This would give President Trump the ability to capitalize on his advantage as the incumbent by inveighing against socialism. Most of the major progressive candidates are electable – they have a popular and electoral path to the White House – as revealed by their successful head-to-head polling against Trump in battleground state opinion polling (Chart 13). But these pathways are narrower than Biden’s. Biden is the only candidate whose name has been on the ballot in two presidential elections carrying the critical Rust Belt swing states Michigan, Pennsylvania, and Wisconsin (not to mention Ohio and Florida). He is from Pennsylvania. And he is more competitive than most of his rivals in the American south and southwest, giving him the potential to pick up Florida or Arizona in the general election. But none of this matters if Biden cannot win the Democratic nomination first. Chart 13 The risk of a progressive overshoot is growing at present. Biden is losing his lead in the primary polling, as mentioned. Progressive candidates taken together are polling better than centrists, contrary to previous Democratic primaries (Chart 14). This is true even if we define centrists broadly, for instance to include Buttigieg (Chart 15). Biden is in a weaker position than Hillary Clinton in 2007 – and the more progressive candidate Obama ultimately defeated her (Chart 16). Biden has now slipped to second place in one national poll and some state polls. Chart 14 The second round of Democratic debates on July 30-31 will be a critical testing period for whether Biden can maintain frontrunner status. The first round fulfilled our expectation of boosting the progressives at his expense, especially Elizabeth Warren. It surprised us in dealing a blow to the campaign of Bernie Sanders, the independent Senator from Vermont who initiated the progressive left’s surge with his hard-fought race against Hillary Clinton in 2016. Chart 15 Chart 16 Sanders is more competitive than the other progressives in the Rust Belt, and in the general election, based on his head-to-head polling against Trump. Yet he has fallen behind in recent Democratic primary polling, ceding ground to Warren, Harris, and Buttigieg, who are all his followers in some sense. The second debate is a critical opportunity for him to arrest the loss of momentum. Otherwise he is likely to be fatally wounded: a collapse in polling beneath his floor of about 15%, and relative to other progressives, despite extensive name recognition, will make it very difficult for him to recover in the third round of debates in September. His votes will go toward other progressives, particularly Buttigieg – the other white male progressive-leaning candidate who is competitive in the Midwest.8 Our 55% base case that Trump is reelected rests on the high historical reelection rate for incumbents, particularly in the event of no recession during the first term – yet discounted due to Trump’s relatively low nationwide popularity, as it is reminiscent of a president in a recessionary environment (Chart 17). Trump has his ideological base more fired up than Obama did (Chart 18), which helps drive voter turnout, although as a result he risks losing support from the rest of the population. Still, Trump’s approval rating is in line with Obama’s at this stage in his first term. As long as the economy holds up and Trump does not suffer a foreign policy humiliation, he should be seen as a slight favorite. Chart 17 Chart 18 A Trump victory is not positive for risk assets, aside from a relief rally on policy continuity. This is because in a second term he cannot reproduce the same magnitude of pro-market effects (huge tax cuts and deregulation) yet, freed from the need for reelection, he has fewer political constraints in producing higher magnitude anti-market effects (tariffs and/or sanctions on China, Iran, Russia, and possibly the EU and Mexico). This view dovetails with the BCA House View which remains overweight equities relative to bonds and cash over a cyclical (12 month) horizon but underweight over the longer run with the expectation that a recession will loom. Bottom Line: The Democratic Primary election should start having an impact on markets – the general election is likely to be too close for market participants to have a high conviction, driving up uncertainty. Uncertainty will be especially pronounced if, and as, leftwing or progressive candidates outperform in the primary races and poll well against Trump in the general election. This dynamic is negative for business sentiment and the profit outlook, especially if Biden’s polling falls further in the wake of the second debate. Investment Conclusions We recommend staying long JPY-USD, long gold, and short CNY-USD. We remain overweight Thai equities within emerging markets, a defensive play. And we would not close our tactical overweight in health care sector and health care equipment sub-sector relative to the S&P 500. The rally in Chinese equities – despite China’s Q2 GDP growth rate of 6.2%, the worst in 27 years – brings full circle the view we initiated in April 2017 that Chinese President Xi Jinping’s consolidation of power would result in a major deleveraging drive that would drag on the global economy. Since February we have argued that the U.S. trade war has pushed Chinese policymakers to favor stimulus over reform – but we have also maintained that the effectiveness of stimulus is declining, especially as a result of the trade war hit to sentiment. Nevertheless, as a result of this turn in Chinese policy – along with the turn in U.S. monetary and fiscal policy – we see the global macroeconomic outlook improving. Combining this view with ongoing tensions in the Persian Gulf and the expectation that oil markets will tighten, we recommend our Commodity & Energy Strategy’s trade of going long Brent crude Q1 2020 versus Q1 2021.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See U.S. Department of Treasury, “Secretary Mnuchin Sends Debt Limit Letter to Congress,” July 12, 2019, home.treasury.gov. Jordan LaPier, “New Projection: Debt Limit “X Date” Could Arrive in September,” July 8, 2019, bipartisanpolicy.org. 2 See Jordain Carney and Niv Elis, White House, Congress inch toward debt, budget deal,” July 17, 2019, thehill.com. 3 See the Congressional Budget Office, “The Budget and Economic Outlook: 2019 to 2029,” January 2019; “Final Sequestration Report for Fiscal Year 2019,” February 2019; and Theresa Gullo, “Discretionary Appropriations Under the Budget Control Act,” Testimony before the Committee on the Budget, United States Senate, February 27, 2019, www.cbo.gov. 4 See James L. Pierce, “The Political Economy of Arthur Burns,” The Journal of Finance 34: 2 (1979), pp. 485-96, esp p. 489 regarding a congressional testimony: “Interestingly, no questions were raised or innuendo offered that monetary expansion would be excessive to support Richard Nixon’s reelection efforts. Instead, Burns was urged by the Democrats to follow an expansionary monetary policy in order to reduce the level of unemployment.” See also Athanasios Orphanides and John C. Williams, “Monetary Policy Mistakes and the Evolution of Inflation Expectations,” Federal Reserve Bank of San Francisco, Working Paper 2010-12 (2011), www.frbsf.org. 5 An analogy might be drawn with the Supreme Court, whose independence as one of three constitutional branches is much more firmly grounded in U.S. law than the Fed’s, but nevertheless cannot make decisions in an ivory tower. It must consider the effects of its judgments on popular opinion, since universally deplored decisions would reduce the court’s credibility and legitimacy in the eyes of the public over time and ultimately the other government branches’ adherence to those decisions. 6 This is both because Biden is more electable (thus more likely to bring a vice president who can break a tie vote in the senate) and because his candidacy can help Democrats in all of the senate swing races – for example, Arizona as well as Colorado and Maine. Harris is not as helpful in Maine while Warren and Sanders are not as helpful in Arizona. 7 Biden would return to the 39.6% top marginal individual tax rate and double the capital gains tax on those earning incomes of more than $1 million. See Biden For President, “Health Care,” joebiden.com. 8 Conversely, if Biden somehow collapses, Buttigieg unlike Sanders has the option of moving toward the political center to absorb Biden’s large reservoir of support.

Highlights So What? Saudi Arabia’s geopolitical risks and still-elevated domestic risks reinforce our cyclically constructive view on oil prices. Why? Saudi Arabia is still in a “danger zone” of internal political risk due to the structural transformation of its economy and society. External risks arising from the Iran showdown threaten to cutoff oil production or transportation, adding to the oil risk premium. We expect oil price volatility to persist, but on a cyclical basis we are constructive on prices. We are maintaining our long EM oil producer equities trade versus the EM equity benchmark excluding China. This basket includes Saudi equities, although in the near term these equities face downside risks. Feature The pace of change in Saudi Arabia has been brisk. Women are driving, the IPO of Aramco is in the works, and the next monarch is likely to be a millennial. Changes to the global energy economy have raised the urgency for an economic transformation that will have political and social consequences, forcing a structural transformation. While the results thus far are attractive, the adjustment phase will be rocky. Saudi Arabia’s successful transition depends on its ability to navigate three main threats: Chart 1The Epic Shale Shake-Up Continues The Epic Shale Shake-Up Continues The Epic Shale Shake-Up Continues The growth of U.S. shale producers and the dilution of Saudi Arabia’s pricing power: Since the emergence of shale technology, Saudi Arabia faces a new reality in oil markets (Chart 1). Even in the current environment of supply disruptions from major producers such as Iran, Venezuela, and Libya, Brent prices have averaged just $66/bbl so far this year, weighed down by the global slowdown, and the macro context of rising U.S. production. Saudi Arabia has had to enlist the support of Russia in the production management agreement (OPEC 2.0) in effort to support oil prices. But continued oil production cuts come at the expense of the coalition’s market share, and crude exports are no longer a dependable source of revenue for Saudi Arabia. Domestic social and political uncertainties: The successful functioning of the political system has been dependent on the government’s ability to support the lifestyles of its citizens, who have grown accustomed to the generosity of their rulers. But economic challenges bring fiscal challenges. Moreover, shifting powers within the state raise the level of uncertainty and risks during the transition phase. Saber-rattling in the region: Heightened tensions with arch-enemy Iran are posing significant risks of instability and armed conflict that could affect oil production and transportation. And as the war in Yemen enters its fifth year, it poses risks to Saudi finances and oil infrastructure – as highlighted by the multiple drone attacks on Saudi oil facilities in May. These structural risks now dominate Saudi Arabia’s policy-making. OPEC 2.0’s decision at the beginning of this month to extend output cuts into 2020 aims to smooth the economic transition by maintaining a floor under oil prices. Meanwhile Crown Prince Mohammad bin Salman’s Vision 2030 is underway – it is a blueprint for a future Saudi Arabia less dependent on oil (Table 1). Table 1Vision 2030 Highlights Saudi Arabia: Changing In Fits And Starts Saudi Arabia: Changing In Fits And Starts Saudi leadership will struggle to minimize near term instability without jeopardizing necessary structural change. In addition to an acute phase of tensions with Iran that could lead to destabilizing surprises this year or next, Saudi Arabia’s economy has just bottomed and is not yet out of the woods. Saudi Arabia’s Economy And Global Oil Markets: Adapting To The New Normal The trajectory of Saudi Arabia’s economic performance has improved since the U-turn in its oil-price management. From 2014-16 Riyadh attempted to drive U.S. shale producers out of business by cranking up production and running prices down. Since then it has supported prices through OPEC 2.0’s production cuts (Chart 2). Export earnings have rebounded over the past two years, reversing the current account deficit (Chart 3). Although net inflows from trade in real terms contribute a much smaller share of overall economic output compared to the mid-2000s, the good news is that the trade balance is back in surplus. Chart 2Return To Cartel Tactics Boosted Economy Return To Cartel Tactics Boosted Economy Return To Cartel Tactics Boosted Economy Nevertheless, the external balance remains hostage to oil prices and may weaken anew over a longer time horizon. Chart 3Current Account Balance Has Improved Current Account Balance Has Improved Current Account Balance Has Improved Chart 4Oil Revenues Easing Budget Strain ... For Now Oil Revenues Easing Budget Strain ... For Now Oil Revenues Easing Budget Strain ... For Now Greater government revenues are helping to improve the budget (Chart 4), but it remains in deficit. Moreover, we do not expect Saudi Arabia to flip the budget to a surplus over the coming two years. Despite our Commodity & Energy Strategy team’s expectation of higher oil prices in 2019 and 2020,1 Saudi Arabia will struggle to balance its budget in the coming 18 months (Chart 5). Their average Brent projection of $73-$75/bbl over the next 18 months still falls short of Saudi’s fiscal breakeven oil price. Most importantly, the kingdom’s black gold is no longer a reliable source of income. Chart 5 Weak oil revenues create a “do-or-die” incentive for Saudi policymakers to diversify the economy. As Chart 1 above illustrates, Saudi Arabia is losing global oil influence to U.S. shale producers. While OPEC 2.0 restrains production, the U.S. will continue dominating production growth, with shale output expected to grow ~1.2mm b/d this year and ~1 mm b/d in 2020.2 Saudi Aramco has been the driving force behind the production cuts (Chart 6), yielding more and more of its market share to American producers. Chart 6 The bad news for Saudi Arabia is that shale producers are here to stay. The kingdom is poorly positioned for this loss of control over oil markets (Chart 7) and is being forced to adapt by diversifying its economy at long last. Chart 7A Long Way To Go In Diversifying Exports A Long Way To Go In Diversifying Exports A Long Way To Go In Diversifying Exports Little progress has been made on this front, despite the fanfare surrounding the Vision 2030 plan. 70% of government revenues were derived from the oil sector last year, an increase from the 64% share from two years prior, and Saudi Arabia’s dependence on oil trade has actually increased over the past year (Chart 8).3 This week’s announcement of Aramco’s plans to increase output capacity by 550k b/d does not support the diversification strategy. Nevertheless, the Saudis appear to be redoubling their efforts on Aramco’s delayed initial public offering. The IPO is an important aspect of the diversification process. It is also a driver of Saudi oil price management – other things equal, higher prices support the Saudis’ rosy assessments of the company’s total worth. While an excessively ambitious timeline and indecision over where to list the shares have been setbacks to the plan, last weekend’s meeting between King Salman and British finance minister Philip Hammond follows Crown Prince Mohammad bin Salman’s reassertion last month that the IPO would take place in late 2020 or early 2021.4 On the non-oil front, given that Saudi Arabia’s fiscal policy is procyclical, activity in that sector is dependent on the performance of the oil sector. Strong oil sales not only improve liquidity, but also allow for greater government expenditures – both of which stimulate non-oil activity (Chart 9). This means the improvement in the non-oil sector is more a consequence of the rebound in oil revenues than an indication of successful diversification. Chart 8Saudi Reliance On Oil Not Falling Yet Saudi Reliance On Oil Not Falling Yet Saudi Reliance On Oil Not Falling Yet Yet the reform vision is not dead. Weak oil revenues may be a blessing in disguise, presenting Saudi policymakers with a “do-or-die” incentive to intensify diversification efforts. Chart 9Non-Oil Activity Still Depends On Oil Sales Non-Oil Activity Still Depends On Oil Sales Non-Oil Activity Still Depends On Oil Sales Bottom Line: By enlisting the support of Russia, Saudi Arabia has managed to maintain a floor beneath oil prices. However, this comes at the expense of falling market share. This leaves authorities with no choice but to diversify the economy – a feat yet to be performed. Domestic Instability Is A Potential Threat Political and social instability in Saudi Arabia is the second derivative of the new normal in global oil markets. So far instability has been limited, but the transition phase is ongoing and the government may not always manage the rapid pace of structural change as effectively as it has over the past two years. Traditionally, Saudi decision-making has comprised the interests of three main social actors: (1) the ruling al Saud family and Saudi elites (2) religious rulers, and (3) Saudi citizens. In the past, the royal family has been able to mitigate social dissent and maintain stability by ensuring that the financial interests of its citizens are satisfied while granting extensive authority to religious groups. The government has transferred profits amassed from oil to Saudi citizens in the form of subsidies for housing, fuel, water, and electricity; public services; and employment opportunities in bloated and inefficient bureaucracies. Going forward, pressure on Riyadh to reduce expenditures and adapt its budget to the changing oil landscape will persist. The authorities will have to continue to shake down elites for funds, or make cuts to these entitlements, or both. Hence policymakers are attempting to walk a thin line between near-term stability and long-term structural change. Several instances of official backtracking show that authorities fear the potential backlash. Following mass discontent in 2017, the Saudi government rolled back most of a series of cuts to public sector wages and benefits that would have led to massive fiscal savings. Instead, the government raised revenue by increasing prices of subsidized goods and services, including fuel, while doling out support to low-income families. The government also introduced a 5% value-added tax in January 2018. Unemployment – especially youth unemployment – is elevated. This is frightening for the authorities. What about the guarantee of cushy government jobs? 45% of employed Saudis work in the public sector. The consequence is an unproductive labor force lacking the skills necessary to succeed in the private sector. Declining oil revenues remove the luxury of supporting a large, unproductive labor force. Chart 10Youth And Woman Unemployment A Structural Constraint Youth And Woman Unemployment A Structural Constraint Youth And Woman Unemployment A Structural Constraint Against this backdrop, unemployment – especially youth unemployment – is elevated (Chart 10). This is frightening for the authorities as over half of Saudi citizens are below 30 years of age and the fertility rate is above replacement level implying continued rapid population growth. It will be a challenge to find employment for the rising number of young people. All the while, jobs in the private sector – which will need to take in the growing labor force – are dominated by expatriate workers. Saudi citizens hold only 20% of jobs in the private sector – but this sector makes up 60% of the country’s employment. Fixing these distortions is challenging. Overall, monthly salaries of nationals are more than double those of expatriates (Chart 11). High wage gaps also exist among comparably skilled workers, reducing the incentive to hire nationals. Chart 11 With non-Saudis holding over 75% of the jobs, the incentive to employ low-wage expatriate workers has also weighed on the current account balance through large remittance outflows (Chart 12). And while the share of jobs held by Saudi citizens increased, this is not on the back of an increase in the number of employed Saudis. Rather, while the number of nationals with jobs contracted by nearly 10% in 2018, jobs held by non-Saudis declined at a faster pace. The absolute number of employed Saudis is down 37% since 2015. “Saudization” efforts are aimed at reducing the wage gap – such as a monthly levy per worker on firms where the majority of workers are non-Saudi; wage subsidies for Saudi nationals working in the private sector; and quotas for hiring nationals. But these have mixed results. While Saudi employment has improved, the associated reduced productivity and higher costs have been damaging. Thus, these labor market challenges pose risks to both domestic stability, and the economy. Moreover, even though improved liquidity conditions have softened interbank rates, loans to government and quasi-government entities still outpace loans to the private sector (Chart 13). This “crowding out” effect is not conducive to a private sector revival. It is conducive to central government control, which the leadership is tightening. Chart 12Jobs For Expatriate Workers Have Declined Jobs For Expatriate Workers Have Declined Jobs For Expatriate Workers Have Declined Chart 13Monetary Conditions Ease But Private Credit Lags Monetary Conditions Ease But Private Credit Lags Monetary Conditions Ease But Private Credit Lags Facing these structural factors, authorities are attempting to appease the population through social change. There has been a marked relaxation in the ultra-conservative rules governing Saudi society. Permission for women to drive cars has been granted and the first cinemas and music venues opened their doors last year. Critically, religious rulers are seeing their wide-ranging powers curtailed. The hai’a or religious police are now only permitted to work during office hours. They no longer have the authority to detain or make arrests, and may only submit reports to civil authorities. While these changes appeal to the new generation, they also run the risk of provoking a “Wahhabi backlash.” This risk is still alive despite the past two years of policy change. The recently approved “public decency law” – which requires residents to adhere to dress codes and bans taking photos or using phrases deemed offensive – reveals the authorities’ need to mitigate this risk. Popular social reforms are occurring against a backdrop of an unprecedented centralization of power. Mohammad bin Salman will be the first Saudi ruler of his millennial generation. The evolving balance of power between the 15,000 members of the royal family will hurl the kingdom into the unknown. The concentration of power into the Sudairi faction of the ruling family, through events such as the 2017 Ritz Carlton detentions, is still capable of provoking a destabilizing backlash. Discontent among royal family members and Saudi elites may give rise to a new, fourth faction, resentful of the social and political changes. At the moment, the state’s policies have generated some momentum. A number of major hardline religious scholars and clerics have apologized for past extremism and differences over state policy and have endorsed MBS’s vision of a modern Saudi state and “moderate” Islam – the crackdown on radicalism has moved the dial within the religious establishment.5 But structural change is not quick and the social pressures being unleashed are momentous. Saudi Arabia’s oil production and transportation infrastructure are currently in danger from saber-rattling or conflict in the region. The government is guiding the process, but the consensus is correct that internal political risk remains extremely high. There has been a structural increase in that risk, as outlined in this report – and it is best to remain cautious even regarding the cyclical increase in political risk over the past two years. Bottom Line: Saudi Arabia’s new economic reality is ushering in social and political change at an unprecedented pace. Unless the interests of the three main social actors – the royal family, religious elites, and Saudi citizens – are successfully managed, a new faction comprised of disaffected elites may arise. A Dangerous Neighborhood Putting aside the longer term threat from U.S. energy independence, Saudi Arabia’s oil production and transportation infrastructure are currently in danger from saber-rattling or conflict in the region. Saudi officials originally expected the war in Yemen to last only a few weeks, but the conflict is now in its fifth year and still raging. The claim by the Iran-backed Houthi insurgents that a recent drone attack on Saudi oil installations was assisted by supporters in Saudi Arabia’s Eastern province – home to the majority of the country’s 10%-15% Shia population and oil production – is also troubling as it shows that the above domestic risks can readily combine with external, geopolitical risks. The U.S. is also joining Israel and Saudi Arabia in applying increasing pressure on Iran, which risks sparking a war. Our Iran-U.S. Tensions Decision Tree illustrates that the probability of war between the U.S. and Iran – which would involve the Saudis – is as high as 40% (Diagram 1). Diagram 1Iran-U.S. Tensions Decision Tree Saudi Arabia: Changing In Fits And Starts Saudi Arabia: Changing In Fits And Starts We are not downgrading this risk in the wake of President Trump’s decision not to conduct strikes on Iranian radars and missile launchers on June 20. President Trump claims he wants negotiations instead of war, but his administration’s pressure tactics have pushed Iran into a corner. The Iranian regime is capable of pushing the limits further (both in terms of its nuclear program as well as regional oil production and transport), which could easily lead to provocations or miscalculation. The Saudi-Iranian rivalry is structurally unstable as a result of Iran’s capitalization on major strategic movements of the past two decades. The Saudis have lost a Sunni-dominated buffer in Iraq, they have lost influence in Syria and Yemen, and their aggressive military efforts to counter these trends have failed.6 The Israelis are equally alarmed by these developments and trying to persuade the Americans to take a much more aggressive posture to contain Iran. As a result, the Trump administration reneged on the 2015 U.S.-Iran nuclear agreement and broader détente – intensifying a cycle of distrust with Iran that will be difficult to reverse even if the Democratic Party takes the White House in 2020. Hence there is a real possibility of attacks on Saudi oil production facilities, domestic pipelines, and tankers in transit in the near term. Moreover, the majority of Saudi Arabia’s exports transit through two major chokepoints making these barrels vulnerable to sabotage: The Strait of Hormuz, which Iran has resumed threatening to block; The Bab-el-Mandeb Strait, located between Yemen and East Africa, which was the site of an attack on two Saudi Aramco tankers last year, forcing a temporarily halt in shipments. Chart 14 Saudi Arabia is acutely aware of these risks. It is the top buyer of U.S. arms and, as a result of the dramatic strategic shifts since the American invasion of Iraq, it is the world’s leading spender on military equipment as a share of GDP (Chart 14). One of our key “Black Swan” risks of the year is that the Saudis may be emboldened by the Trump administration’s writing them a blank check. Bottom Line: In addition to the structural risks associated with Saudi Arabia’s economic, social and political transition, geopolitical tensions in the region are elevated. Warning shots are still being fired by Iran and their proxies (such as the Houthis), and oil supplies are at the mercy of additional escalation. Investment Implications Saudi Arabia’s equity market is halfway through the process of joining the benchmark MSCI EM index. The process will finish on August 29, 2019 with Saudi taking up a total 2.9% weighting in the index. Research by our colleague Ellen JingYuan He at BCA’s Emerging Markets Strategy shows that in the case of the United Arab Emirates, Qatar, and Pakistan, inclusion into MSCI created a “buy the rumor, sell the news” phenomenon and suggested that a top of the market was at hand.7 Saudi equities have recently peaked in absolute terms and relative to the emerging market benchmark, supporting this thesis. Saudi equity volatility has especially spiked relative to the emerging market average, which is appropriate. We expect ongoing bouts of volatility due to the immediate, market-relevant political risks outlined above. The risk of a disruptive conflict stemming from the Saudi-Iran and U.S.-Iran confrontation is significant enough that investors should, at minimum, expect minor conflicts or incidents to disrupt oil markets in the immediate term. We expect oil price volatility to persist. Because Riyadh is maintaining OPEC 2.0 discipline in this environment, oil prices should experience underlying upward pressure. It is not that the Saudis are refusing to support the Trump administration’s maximum pressure against Iran but rather that they are calibrating their support in a way that hedges against the risk that Trump will change his mind, since that risk is quite high. This is the 55% chance of an uneasy status quo in U.S.-Iran relations in Diagram 1, which requires at least secret U.S. relaxation of oil sanction enforcement. Moreover, the Saudis want to reduce the downside risk of weak global growth and support their national interest in pushing Brent prices toward $80/bbl for fiscal and strategic purposes. Our pessimistic assessment of the Osaka G20 tariff truce between the U.S. and China is more than offset by our expectation since February that China’s economic policy has shifted toward stimulus rather than the deleveraging of 2017-18. We assign a 68% probability to additional trade war escalation in Q4 this year or at least before November 2020. But since a dramatic trade war escalation would lead to even greater stimulus, we still share our Commodity & Energy Strategy’s cyclical view that the underlying trend for oil prices is up. We are maintaining our recommendation of being long EM oil producers’ equities relative to EM-ex-China. This trade includes Saudi Arabian equities, but as a whole it has upside in the near-term as Brent prices are below our expected average and Chinese equities are still down 10% from their April highs.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Our Commodity & Energy Strategy team expects Brent prices to average $73/bbl this year and $75/bbl in 2020. For their latest monthly balances assessment, please see “Supply-Demand Balances Consistent With Higher Oil Prices,” dated June 20, 2019, available at ces.bcaresearch.com. 2 Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Supply-Demand Balances Consistent With Higher Oil Prices,” dated June 20, 2019, available at ces.bcaresearch.com. 3 The higher export dependence on oil reflects the rebound in oil prices in 2018, rather than a decline in non-oil exports. Given the strong relationship between activity in the oil and non-oil sectors, non-oil exports also increased in 2018. 4 Saudi Aramco’s purchase of a 70 percent stake in SABIC from the Saudi Public Investment Fund (PIF) earlier this year reportedly contributed to the IPO delay. The deal will capitalize the PIF, enabling it to diversify the economy. 5 See, for example, James M. Dorsey, “Clerics and Entertainers Seek to Bolster MBS’s Grip on Power,” BESA Center Perspectives Paper No. 1220, July 7, 2019, available at besacenter.org. 6 The U.S., Saudi Arabia, and their allies are trying to restore Iraq as a geopolitical buffer by cultivating an Iraq that is more independent of Iranian influence – and this is part of rising regional frictions. Iraqi Prime Minister Adel Abdul Mahdi’s recently issued decree to reduce the power of Iraq’s Iran-backed milita, the Popular Mobilization Forces (PMF) and integrate them into Iraq’s armed forces by forcing them to choose between either military or political activity. Just over a year ago, Iraq’s previous Prime Minister Haider al-Abadi issued a decree granting members of the PMF many of the same rights as members of the military. 7 Please see BCA Frontier Markets Strategy, “Pakistani Stocks: A Top Is At Hand,” March 13, 2017, available at fms.bcaresearch.com.

Highlights So What? U.S.-Iran risk is front-loaded, but U.S.-China is the greater risk overall. In the medium-to-long run the trade war with China should reaccelerate while the U.S. should back away from war with Iran. But for now the opposite is happening. A full-fledged cold war with China will put a cap on American political polarization, putting China at a disadvantage. By contrast, a U.S. war with Iran would exacerbate polarization, giving China a huge strategic opportunity. War with Iran or trade war escalation with China are both ultimately dollar bullish – even though tactically the dollar may fall. Feature Two significant geopolitical events occurred over the past week. First, U.S. President Donald Trump declared his third pause to the trade war with China. The terms of the truce are vague and indefinite, but it has given support to the equity rally temporarily. Second, Iran edged past the limits on uranium stockpiling, uranium enrichment, and the Arak nuclear reactor imposed by the 2015 nuclear pact. Trump instigated this move by walking away from the pact and re-imposing oil sanctions. If these events foreshadow things to come, global financial markets should position for lower odds of a deflationary trade shock and higher odds of an inflationary oil shock in the coming six-to-18 months. But is this conclusion warranted? Is the American “Pivot to Asia” about to shift into reverse? If the White House pursued a consistent strategy to contain China, it would bring Americans together and require forming alliances. In the short run, perhaps – but the conflict with China is ultimately the greater of the two geopolitical risks. We expect it to intensify again, likely in H2, but at latest by Q3 of 2020, ahead of the U.S. presidential election. Our highest conviction call on this matter, however, is that any trade deal before that date will be limited in scope. It will fall far short of a “Grand Compromise” that ushers in a new era of U.S.-China engagement – and hence it will be a disappointment to global equities. Our trade war probabilities, updated on June 14 to account for the expected resumption of negotiations at the G20, can be found in Diagram 1. The combined risk of further escalation is 68%. Diagram 1Trade War Decision Tree (Updated June 13, 2019 To Include G20 Tariff Pause) The Polybius Solution The Polybius Solution The risk to the view? The U.S.-Iran conflict could spiral out of control and the Trump administration could get entangled in the Middle East. This would create a very different outlook for global politics, economy, and markets over the next decade than a concentrated conflict with China.  The Missing Corollary Of The “Thucydides Trap” The idea of the “Thucydides Trap” has gone viral in recent years – for good reason. The term, coined by Harvard political scientist Graham Allison, refers to the ancient Greek historian Thucydides (460-400 BC), author of the seminal History of the Peloponnesian War. The “trap” is the armed conflict that most often develops when a dominant nation that presides over a particular world order (e.g. Sparta, the U.S.) faces a young and ambitious rival that seeks fundamental change to that order (e.g. Athens, China).1  This conflict between an “established” and “revisionist” power was highlighted by the political philosopher Thomas Hobbes in his translation of Thucydides in the seventeenth century; every student of international relations knows it. Allison’s contribution is the comparative analysis of various Thucydides-esque episodes in the modern era to show how today’s U.S.-China rivalry fits the pattern. The implication is that war (not merely trade war) is a major risk. We have long held a similar assessment of the U.S.-China conflict. It is substantiated by hard data showing that China is gaining on America in various dimensions of power (Chart 1). Assuming that the U.S. does not want to be replaced, the current trade conflict will metastasize to other areas. There is an important but overlooked corollary to the Thucydides Trap: if the U.S. and China really engage in an epic conflict, American political polarization should fall. Polarization fell dramatically during the Great Depression and World War II and remained subdued throughout the Cold War. It only began to rise again when the Soviet threat faded and income inequality spiked circa 1980. Americans were less divided when they shared a common enemy that posed an existential threat; they grew more divided when their triumph proved to benefit some disproportionately to others (Chart 2).    Chart 1China Is Gaining On The U.S. China Is Gaining On The U.S. China Is Gaining On The U.S. Chart 2U.S. Polarization Falls During Crisis U.S. Polarization Falls During Crisis U.S. Polarization Falls During Crisis   If the U.S. and China continue down the path of confrontation, a similar pattern is likely to emerge in the coming years – polarization is likely to decline. China possesses the raw ability to rival or even supplant the United States as the premier superpower over the very long run. Its mixed economy is more sustainable than the Soviet command economy was, and it is highly integrated into the global system, unlike the isolated Soviet bloc. As long as China’s domestic demand holds up and Beijing does not suppress its own country’s technological and military ambitions, Trump and the next president will face a persistent need to respond with measures to limit or restrict China’s capabilities. Eventually this will involve mobilizing public opinion more actively. Further, if the U.S.-China conflict escalates, it will clarify U.S. relations with the rest of the world. For instance, Trump’s handling of trade suggests that he could refrain from trade wars with American allies to concentrate attention on China, particularly sanctions on its technology companies. Meanwhile a future Democratic president would preserve some of these technological tactics while reinstituting the multilateral approach of the Barack Obama administration, which launched the “Pivot to Asia,” the Trans-Pacific Partnership, and intensive freedom of navigation operations in the South China Sea. These are all aspects of a containment strategy that would reinforce China’s rejection of the western order.   Bottom Line: If the White House, any White House, were to pursue a consistent strategy to contain China, the result would be a major escalation of the trade conflict that would bring Americans together in the face of a common enemy. It would also encourage the U.S. to form alliances in pursuit of this objective. So far these things have not occurred, but they are logical corollaries of the Thucydides Trap and they will occur if the Thucydides thesis is validated. How Would China Fare In The Thucydides Trap? China would be in trouble in this scenario. The United States, if the public unifies, would have a greater geopolitical impact than it currently does in its divided state. And a western alliance would command still greater coercive power than the United States acting alone (Chart 3). External pressure would also exacerbate China’s internal imbalances – excessive leverage, pollution, inefficient state involvement in the economy, poor quality of life, and poor governance (Chart 4).  China has managed to stave off these problems so far because it has operated under relative American and western toleration of its violations of global norms (e.g. a closed financial system, state backing of national champions, arbitrary law, censorship). This would change under concerted American, European, and Japanese efforts. Chart 3China Fears A Western 'Grand Alliance' China Fears A Western 'Grand Alliance' China Fears A Western 'Grand Alliance' Chart 4China's Domestic Risks Underrated China's Domestic Risks Underrated China's Domestic Risks Underrated How would the Communist Party respond? First, it could launch long-delayed and badly needed structural reforms and parlay these as concessions to the West. The ramifications would be negative for Chinese growth on a cyclical basis but positive on a structural basis since the reforms would lift productivity over the long run – a dynamic that our Emerging Markets Strategy has illustrated, in a macroeconomic context, in Diagram 2. This is already an option in the current trade war, but China has not yet clearly chosen it – likely because of the danger that the U.S. would exploit the slowdown. Diagram 2Foreign Pressure And Structural Reform = Short-Term Pain For Long-Term Gain The Polybius Solution The Polybius Solution Alternatively the Communist Party could double down on confrontation with the West, as Russia has done. This would strengthen the party’s grip but would be negative for growth on both a cyclical and structural basis. The effectiveness of China’s fiscal-and-credit stimulus would likely decline because of a drop in private sector activity and sentiment – already a nascent tendency – while the lack of “reform and opening up” would reduce long-term growth potential. This option makes structural reforms look more palatable – but again, China has not yet been forced to make this choice. None of the above is to say that the West is destined to win a cold war with China, but rather that the burden of revolutionizing the global order necessarily falls on the country attempting to revolutionize it. Bottom Line: If the Thucydides Trap fully takes effect, western pressure on China’s economy will force China into a destabilizing economic transition. China could lie low and avoid conflict in order to undertake reforms, or it could amplify its aggressive foreign policy. This is where the risk of armed conflict rises. Introducing … The Polybius Solution The problem with the above is that there is no sign of polarization abating anytime soon in the United States. Extreme partisanship makes this plain (Chart 5). Rising polarization could prevent the U.S. from responding coherently to China. The Thucydides Trap could be avoided, or delayed, simply because the U.S. is distracted elsewhere. The most likely candidate is Iran. Chart 5 A lesser known Greek historian – who was arguably more influential than Thucydides – helps to illustrate this alternative vision for the future. This is Polybius (208-125 BC), a Greek who wrote under Roman rule. He described the rise of the Roman Empire as a result of Rome’s superior constitutional system. Polybius explains domestic polarization whereas Thucydides explains international conflict. Polybius took the traditional view that there were three primary virtues or powers governing human society: the One (the king), the Few (the nobles), and the Many (the commons). These powers normally ran the country one at a time: a dictator would die; a group of elites would take over; this oligarchy would devolve into democracy or mob-rule; and from the chaos would spring a new dictator. His singular insight – his “solution” to political decay – was that if a mixture or balance of the three powers could be maintained, as in the Roman republic, then the natural cycle of growth and decay could be short-circuited, enabling a regime to live much longer than its peers (Diagram 3). Diagram 3Polybius: A Balanced Political System Breaks The Natural Cycle Of Tyranny And Chaos The Polybius Solution The Polybius Solution In short, just as post-WWII economic institutions have enabled countries to reduce the frequency and intensity of recessions (Chart 6), so Polybius believed that political institutions could reduce the frequency and intensity of revolutions. Eventually all governments would decay and collapse, but a domestic system of checks and balances could delay the inevitable. Needless to say, Polybius was hugely influential on English and French constitutional thinkers and the founders of the American republic. Chart 6Orthodox Economic Policy Has Made Recessions Less Frequent And Less Acute Orthodox Economic Policy Has Made Recessions Less Frequent And Less Acute Orthodox Economic Policy Has Made Recessions Less Frequent And Less Acute What is the cause of constitutional decay, according to Polybius? Wealth, inequality, and corruption, which always follow from stable and prosperous times. “Avarice and unscrupulous money-making” drive the masses to encroach upon the elite and demand a greater share of the wealth. The result is a vicious cycle of conflict between the commons and the nobles until either the constitutional system is restored or a democratic revolution occurs. Compared to Thucydides, Polybius had less to say about the international balance of power. Domestic balance was his “solution” to unpredictable outside events. However, states with decaying political systems were off-balance and more likely to be conquered, or to overreach in trying to conquer others. Bottom Line: The “Polybius solution” equates with domestic political balance. Balanced states do not allow the nation’s leader, the elite, or the general population to become excessively powerful. But even the most balanced states will eventually decline. As they accumulate wealth, inequality and corruption emerge and cause conflict among the three powers.  Why Polybius Matters Today It does not take a stretch of the imagination to apply the Polybius model to the United States today. Just as Rome grew fat with its winnings from the Punic Wars and decayed from a virtuous republic into a luxurious empire, as Polybius foresaw, so the United States lurched from victory over the Soviet Union to internal division and unforced errors. For instance, the budget surplus of 2% of GDP in the year 2000 became a budget deficit of 9% of GDP after a decade of gratuitous wars, profligate social spending and tax cuts, and financial excesses. It is on track to balloon again when the next recession hits – and this is true even without any historic crisis event to justify it. The rise in polarization has coincided with a rise in wealth inequality, much as Polybius would expect (Chart 7). In all likelihood the Trump tax cuts will exacerbate both of these trends (Chart 8). Even worse, any attempts by “the people” to take more wealth from the “nobles” will worsen polarization first, long before any improvements in equality translate to a drop in polarization. Chart 7Polarization Unlikely To Drop While Inequality Rises Polarization Unlikely To Drop While Inequality Rises Polarization Unlikely To Drop While Inequality Rises Chart 8Trump Tax Cuts Fuel Inequality Trump Tax Cuts Fuel Inequality Trump Tax Cuts Fuel Inequality Most importantly, from a global point of view, U.S. polarization is contaminating foreign policy. Just as the George W. Bush administration launched a preemptive war in Iraq, destabilizing the region, so the Obama administration precipitously withdrew from Iraq, destabilizing the region. And just as the Obama administration initiated a hurried détente with Iran in order to leave Iraq, the Trump administration precipitously withdrew from this détente, provoking a new conflict with Iran and potentially destabilizing Iraq. Major foreign policy initiatives have been conducted, and revoked, on a partisan basis under three administrations. And a Democratic victory in 2020 would result in a reversal of Trump’s initiatives. In the meantime Trump’s policy could easily entangle him in armed conflict with Iran – as nearly occurred on June 21. Iranian domestic politics make it very difficult, if not impossible, to go back to the 2015 setting. Despite Trump’s recent backpedaling, his administration runs a high risk of getting sucked into another Middle Eastern quagmire as long as it enforces the sanctions on Iranian oil stringently. Persian Gulf risks are coming to the fore. But over the next six-to-18 months, U.S.-China conflict will be the dominant market-mover. China would be the big winner if such a war occurred, just as it was one of the greatest beneficiaries of the long American distraction in Afghanistan and Iraq. It would benefit from another 5-10 years of American losses of blood and treasure. It would be able to pursue regional interests with less Interference and could trade limited cooperation with the U.S. on Iran for larger concessions elsewhere. And a nuclear-armed Iran – which is a long-term concern for the U.S. – is not in China’s national interest anyway. Chart 9Will The Pivot To Asia Reverse? Will The Pivot To Asia Reverse? Will The Pivot To Asia Reverse? Bottom Line: The U.S. is missing the “Polybius solution” of balanced government; polarization is on the rise. As a result, the grand strategy of “pivoting to Asia” could go into reverse (Chart 9). If that occurs, the conflict with China will be postponed or ineffective. Iran Is The Wild Card A war with Iran manifestly runs afoul of the Trump administration’s and America’s national interests, whereas a trade war with China does not. First, although an Iranian or Iranian-backed attack on American troops would give Trump initial support in conducting air strikes, the consequences of war would likely be an oil price shock that would sink his approval rating over time and reduce his chances of reelection (Chart 10). We have shown that such a shock could come from sabotage in Iraq as well as from attacks on shipping in the Strait of Hormuz. Iran could be driven to attack if it believes the U.S. is about to attack. Second, not only would Democrats oppose a war with Iran, but Americans in general are war-weary, especially with regard to the Middle East (Chart 11). President Trump capitalized on this sentiment during his election campaign, especially in relation to Secretary Hillary Clinton who supported the war in Iraq. Over the past two weeks, he has downplayed the Iranian-backed tanker attacks, emphasized that he does not want war, and has ruled out “boots on the ground.” Chart 10Carter Gained Then Lost From Iran Oil Shock Carter Gained Then Lost From Iran Oil Shock Carter Gained Then Lost From Iran Oil Shock Chart 11 Third, it follows from the above that, in the event of war, the United States would lack the political will necessary to achieve its core strategic objectives, such as eliminating Iran’s nuclear program or its power projection capabilities. And these are nearly impossible to accomplish from the air alone. And U.S. strategic planners are well aware that conflict with Iran will exact an opportunity cost by helping Russia and China consolidate spheres of influence. The wild card is Iran. President Hassan Rouhani has an incentive to look tough and push the limits, given that he was betrayed on the 2015 deal. And the regime itself is probably confident that it can survive American air strikes. American military strikes are still a serious constraint, but until the U.S. demonstrates that it is willing to go that far, Iran can test the boundaries. In doing so it also sends a message to its regional rivals – Saudi Arabia, the Gulf Arab monarchies, and Israel – that the U.S. is all bark, no bite, and thus unable to protect them from Iran. This may lead to a miscalculation that forces Trump to respond despite his inclinations. The China trade war, by contrast, is less difficult for the Trump administration to pursue. There is not a clear path from tariffs to economic recession, as with an oil shock: the U.S. economy has repeatedly shrugged off counter-tariffs and the Fed has been cowed. While Americans generally oppose the trade war, Trump’s base does not, and the health of the overall economy is far more important for most voters. And a majority of voters do believe that China’s trade practices are unfair. Strategic planners also favor confronting China – unlike Trump they are not concerned with reelection, but they recognize that China’s advantages grow over time, including in critical technologies. Bottom Line: While short-term events are pushing toward truce with China and war with Iran, the Trump administration is likely to downgrade the conflict with Iran and upgrade the conflict with China over the next six-to-18 months. Neither politics nor grand strategy support a war with Iran, whereas politics might support a trade war with China and grand strategy almost certainly does. China Could Learn From Polybius Too China also lacks the Polybius solution. It suffers from severe inequality and social immobility, just like the Latin American states and the U.S., U.K., and Italy (Chart 12). But unlike the developed markets, it lacks a robust constitutional system. Political risks are understated given the emergence of the middle class, systemic economic weaknesses, and poor governance. Over the long run, Xi Jinping will need to step down, but having removed the formal system for power transition, a succession crisis is likely. Chart 12 China’s imbalances could cause domestic instability even if the U.S. becomes distracted by conflict in the Middle East. But China has unique tools for alleviating crises and smoothing out its economic slowdown, so the absence of outside pressure will probably determine its ability to avoid a painful economic slump. This helps to explain China’s interest in dealing with the U.S. on North Korea. President Xi Jinping’s first trip to Pyongyang late last month helped pave the way for President Trump to resume negotiations with the North’s leader Kim Jong Un at the first-ever visit of an American president north of the demilitarized zone (DMZ). China does not want an unbridled nuclear North Korea or an American preventative war on the peninsula. If Beijing could do a short-term deal with the U.S. on the basis of assistance in reining in North Korea’s nuclear and missile programs, it could divert U.S. animus away from itself and encourage the U.S. to turn its attention toward the next rogue nuclear aspirant, Iran. It would also avoid structural economic concessions. Of course, a smooth transition today means short-term gain but long-term pain for Chinese and global growth. Productivity and potential GDP will decline if China does not reform (Diagram 4). But this kind of transition is the regime’s preferred option since Beijing seeks to minimize immediate threats and maintain overall stability. Diagram 4Stimulus And Delayed Reforms = Socialist Put = Stagflation The Polybius Solution The Polybius Solution If Chinese internal divisions do flare up, China’s leaders will take a more aggressive posture toward its neighbors and the United States in order to divert public attention and stir up patriotic support. Bottom Line: China suffers from understated internal political risk. While U.S. political divisions could lead to a lack of coherent strategy toward China, a rift in China could lead to Chinese aggression in its neighborhood, accelerating the Thucydides Trap. Investment Conclusions Chart 13An Iran War Will Bust The Budget An Iran War Will Bust The Budget An Iran War Will Bust The Budget If the U.S. reverses the pivot to Asia, attacks Iran, antagonizes European allies, and exhausts its resources in policy vacillation, its budget deficit will balloon (Chart 13), oil prices will rise, and China will be left to manage its economic transition without a western coalition against it. The implication is a weakening dollar, at least initially. But the U.S. is nearing the end of its longest-ever business expansion and an oil price spike would bring forward the next recession, both of which will push up the greenback. Much will depend on the extent of any oil shock – whether and how long the Strait of Hormuz is blocked. Beyond the next recession, the dollar could suffer severe consequences for the U.S.’s wild policies. If the U.S. continues the pivot to Asia, and the U.S. and China proceed with tariffs, tech sanctions, saber-rattling, diplomatic crises, and possibly even military skirmishes, China will be forced into an abrupt and destabilizing economic transition. The U.S. dollar will strengthen as global growth decelerates. Developed market equities will outperform emerging market equities, but equities as a whole will underperform sovereign bonds and other safe-haven assets. Over the past week, developments point toward the former scenario, meaning that Persian Gulf risks are coming to the fore. But over the next six-to-18 months, we think the latter scenario will prevail.  We are maintaining our risk-off trades: long JPY/USD, long gold, long Swiss bonds, and long USD/CNY.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1      See Graham Allison, “The Thucydides Trap: Are The U.S. And China Headed For War?” The Atlantic, September 24, 2015, and Destined For War: Can America and China Escape Thucydides’s Trap? (New York: Houghton Mifflin Harcourt, 2017).  

Highlights So What? Economic stimulus will encourage key nations to pursue their self-interest – keeping geopolitical risk high. Why? The U.S. is still experiencing extraordinary strategic tensions with China and Iran … simultaneously. The Trump-Xi summit at the G20 is unlikely to change the fact that the United States is threatening China with total tariffs and a technology embargo. The U.S. conflict with Iran will be hard to keep under wraps. Expect more fireworks and oil volatility, with a large risk of hostilities as long as the U.S. maintains stringent oil sanctions. All of our GeoRisk indicators are falling except for those of Germany, Turkey and Brazil. This suggests the market is too complacent. Maintain tactical safe-haven positioning. Feature “That’s some catch, that Catch-22,” he observed. “It’s the best there is,” Doc Daneeka agreed. -Joseph Heller, Catch-22 (1961)   One would have to be crazy to go to war. Yet a nation has no interest in filling its military’s ranks with lunatics. This is the original “Catch-22,” a conundrum in which the only way to do what is individually rational (avoid war) is to insist on what is collectively irrational (abandon your country). Or the only way to defend your country is to sacrifice yourself. This is the paradox that U.S. President Donald Trump faces having doubled down on his aggressive foreign policy this year: if he backs away from trade war to remove an economic headwind that could hurt his reelection chances, he sacrifices the immense leverage he has built up on behalf of the United States in its strategic rivalry with China. “Surrender” would be a cogent criticism of him on the campaign trail: a weak deal will cast him as a pluto-populist, rather than a real populist – one who pandered to China to give a sop to Wall Street and the farm lobby just like previous presidents, yet left America vulnerable for the long run. Similarly, if President Trump stops enforcing sanctions against Iranian oil exports to reduce the threat of a conflict-induced oil price shock that disrupts his economy, then he reduces the United States’s ability to contain Iran’s nuclear and strategic advances in the wake of the 2015 nuclear deal that he canceled. The low appetite for American involvement in the region will be on full display for the world to see. Iran will have stared down the Great Satan – and won. In both cases, Trump can back down. Or he can try to change the subject. But with weak polling and yet a strong economy, the point is to direct voters’ attention to foreign policy. He could lose touch with his political base at the very moment that the Democrats reconnect with their own. This is not a good recipe for reelection. More important – for investors – why would he admit defeat just as the Federal Reserve is shifting to countenance the interest rate cuts that he insists are necessary to increase his economic ability to drive a hard bargain with China? Why would he throw in the towel as the stock market soars? And if Trump concludes a China deal, and the market rises higher, will he not be emboldened to put more economic pressure on Mexico over border security … or even on Europe over trade? The paradox facing investors is that the shift toward more accommodative monetary policy (and in some cases fiscal policy) extends the business cycle and encourages political leaders to pursue their interests more intently. China is less likely to cave to Trump’s demands as it stimulates. The EU does not need to fear a U.K. crash Brexit if its economy rebounds. This increases rather than decreases the odds of geopolitical risks materializing as negative catalysts for the market. Similarly, if geopolitical risk falls then the need for stimulus falls and the market will be disappointed. The result is still more volatility – at least in the near term. The G20 And 2020 As we go to press the Democratic Party’s primary election debates are underway. The progressive wave on display highlights the overarching takeaway of the debates: the U.S. election is now an active political (and geopolitical) risk to the equity market. A truly positive surprise at the G20 would be a joint statement by Trump and Xi plus some tariff rollback. Whenever Trump’s odds of losing rise, the U.S. domestic economy faces higher odds of extreme policy discontinuity and uncertainty come 2021, with the potential for a populist-progressive agenda – a negative for financials, energy, and probably health care and tech. Chart 1 Yet whenever Trump’s odds of winning rise, the world faces higher odds of an unconstrained Trump second term focusing on foreign and trade policy – a potentially extreme increase in global policy uncertainty – without the fiscal and deregulatory positives of his first term. We still view Trump as the favored candidate in this race (at 55% chance of reelection), given that U.S. underlying domestic demand is holding up and the labor market has not been confirmed to be crumbling beneath the consumer’s feet. Still Chart 1 highlights that Trump’s shift to more aggressive foreign and trade policy this spring has not won him any additional support – his approval rating has been flat since then. And his polling is weak enough in general that we do not assign him as high of odds of reelection as would normally be afforded to a sitting president on the back of a resilient economy. This raises the question of whether the G20 will mark a turning point. Will Trump attempt to deescalate his foreign conflicts? Yes, and this is a tactical opportunity. But we see no final resolution at hand. With China, Trump’s only reason to sign a weak deal would be to stem a stock market collapse. With Iran, Trump is no longer in the driver’s seat but could be forced to react to Iranian provocations. Bottom Line: Trump’s polling has not improved – highlighting the election risk – but weak polling amid a growing economy and monetary easing is not a recipe for capitulating to foreign powers. The Trump-Xi Summit On China the consensus on the G20 has shifted toward expecting an extension of talks and another temporary tariff truce. If a new timetable is agreed, it may be a short-term boon for equities. But we will view it as unconvincing unless it is accompanied with a substantial softening on Huawei or a Trump-Xi joint statement outlining an agreement in principle along with some commitment of U.S. tariff rollback. Otherwise the structural dynamic is the same: Trump is coercing China with economic warfare amid a secular increase in U.S.-China animosity that is a headwind for trade and investment. Table 1 shows that throughout the modern history of U.S.-China presidential-level summits, the Great Recession marked a turning point: since then, bilateral relations have almost always deteriorated in the months after a summit, even if the optics around the summit were positive. Table 1U.S.-China Leaders Summits: A Chronology The G20 Catch-22 ... GeoRisk Indicators Update: June 28, 2019 The G20 Catch-22 ... GeoRisk Indicators Update: June 28, 2019 The last summit in Buenos Aires was no exception, given that the positive aura was ultimately followed by a tariff hike and technology-company blacklistings. Of course, the market rallied for five months in between. Why should this time be the same? First, the structural factors undermining Sino-American trust are worse, not better, with Trump’s latest threats to tech companies. Second, Trump will ultimately resent any decision to extend the negotiations. China’s economy is rebounding, which in the coming months will deprive Trump of much of the leverage he had in H2 2018 and H1 2019. He will be in a weaker position if they convene in three months to try to finalize a deal. Tariff rollback will be more difficult in that context given that China will be in better shape and that tariffs serve as the guarantee that any structural concessions will be implemented. Bottom Line: Our broader view regarding the “end game” of the talks – on the 2020 election horizon – remains that China has no reason to implement structural changes speedily for the United States until Trump can prove his resilience through reelection. Yet President Trump will suffer on the campaign trail if he accepts a deal that lacks structural concessions. Hence we expect further escalation from where we are today, knowing full well that the G20 could produce a temporary period of improvement just as occurred on December 1, 2018. The Iran Showdown Is Far From Over Disapproval of Trump’s handling of China and Iran is lower than his disapproval rating on trade policy and foreign policy overall, suggesting that despite the lack of a benefit to his polling, he does still have leeway to pursue his aggressive policies to a point. A breakdown of these opinions according to key voting blocs – a proxy for Trump’s ability to generate support in Midwestern swing states – illustrates that his political base is approving on the whole (Chart 2). Chart 2 Yet the conflict with Iran threatens Trump with a hard constraint – an oil price shock – that is fundamentally a threat to his reelection. Hence his decision, as we expected, to back away from the brink of war last week (he supposedly canceled air strikes on radar and missile installations at the last minute on June 21). He appears to be trying to control the damage that his policy has already done to the 2015 U.S.-Iran equilibrium. Trump has insisted he does not want war, has ruled out large deployments of boots on the ground, and has suggested twice this week that his only focus in trying to get Iran back into negotiations is nuclear weapons. This implies a watering down of negotiation demands to downplay Iran’s militant proxies in the region – it is a retreat from Secretary of State Mike Pompeo’s more sweeping 12 demands on Iran and a sign of Trump’s unwillingness to get embroiled in a regional conflict with a highly likely adverse economic blowback. The Iran confrontation is not over yet – policy-induced oil price volatility will continue. This retreat lacks substance if Trump does not at least secretly relax enforcement of the oil sanctions. Trump’s latest sanctions and reported cyberattacks are a sideshow in the context of an attempted oil embargo that could destabilize Iran’s entire economy (Charts 3 and 4). Similarly, Iran’s downing of a U.S. drone pales in comparison to the tanker attacks in Hormuz that threatened global oil shipments. What matters to investors is the oil: whether Iran is given breathing space or whether it is forced to escalate the conflict to try to win that breathing space. Chart 3 Chart 4Iran’s Rial Depreciated Sharply Iran's Rial Depreciated Sharply Iran's Rial Depreciated Sharply The latest data suggest that Iran’s exports have fallen to 300,000 barrels per day, a roughly 90% drop from 2018, when Trump walked away from the Iran deal. If this remains the case in the wake of the brinkmanship last week then it is clear that Iran is backed into a corner and could continue to snarl and snap at the U.S. and its regional allies, though it may pause after the tanker attacks. Chart 5More Oil Volatility To Come More Oil Volatility To Come More Oil Volatility To Come Tehran also has an incentive to dial up its nuclear program and activate its regional militant proxies in order to build up leverage for any future negotiation. It can continue to refuse entering into negotiations with Trump in order to embarrass him – and it can wait until Trump’s approach is validated by reelection before changing this stance. After all, judging by the first Democratic primary debate, biding time is the best strategy – the Democratic candidates want to restore the 2015 deal and a new Democratic administration would have to plead with Iran, even to get terms less demanding than those in 2015. Other players can also trigger an escalation even if Presidents Trump and Rouhani decide to take a breather in their conflict (which they have not clearly decided to do). The Houthi rebels based in Yemen have launched another missile at Abha airport in Saudi Arabia since Trump’s near-attack on Iran, an action that is provocative, easily replicable, and not necessarily directly under Tehran’s control. Meanwhile OPEC is still dragging its feet on oil production to compensate for the Iranian losses, implying that the cartel will react to price rises rather than preempt them. The Saudis could use production or other means to stoke conflict. Bottom Line: Given our view on the trade war, which dampens global oil demand, we expect still more policy-induced volatility (Chart 5). We do not see oil as a one-way bet … at least not until China’s shift to greater stimulus becomes unmistakable.   North Korea: The Hiccup Is Over Chart 6China Ostensibly Enforces North Korean Sanctions China Ostensibly Enforces North Korean Sanctions China Ostensibly Enforces North Korean Sanctions The single clearest reason to expect progress between the U.S. and China at the G20 is the fact that North Korea is getting back onto the diplomatic track. North Korea has consistently been shown to be part of the Trump-Xi negotiations, unlike Taiwan, the South China Sea, Xinjiang, and other points of disagreement. General Secretary Xi Jinping took his first trip to the North on June 20 – the first for a Chinese leader since 2005 – and emphasized the need for historic change, denuclearization, and economic development. Xi is pushing Kim to open up and reform the economy in exchange for a lasting peace process – an approach that is consistent with China’s past policy but also potentially complementary with Trump’s offer of industrialization in exchange for denuclearization. President Trump and Kim Jong Un have exchanged “beautiful” letters this month and re-entered into backchannel discussions. Trump’s visit to South Korea after the G20 will enable him and President Moon Jae-In to coordinate for a possible third summit between Trump and Kim. Progress on North Korea fits our view that the failed summit in Hanoi was merely a setback and that the diplomatic track is robust. Trump’s display of a credible military threat along with Chinese sanctions enforcement (Chart 6) has set in motion a significant process on the peninsula that we largely expect to succeed and go farther than the consensus expects. It is a long-term positive for the Korean peninsula’s economy. It is also a positive factor in the U.S.-China engagement based on China’s interest in ultimately avoiding war and removing U.S. troops from the peninsula. From an investment point of view, an end to a brief hiatus in U.S.-North Korean diplomacy is a very poor substitute for concrete signs of U.S.-China progress on the tech front or opening market access. There has been nothing substantial on these key issues since Trump hiked the tariff rate in May. As a result, it is perfectly possible for the G20 to be a “success” on North Korea but, like the Buenos Aires summit on December 1, for markets to sell the news (Chart 7). Chart 7The Last Trade Truce Didn't Stop The Selloff The Last Trade Truce Didn't Stop The Selloff The Last Trade Truce Didn't Stop The Selloff Chart 8China Needs A Final Deal To Solve This Problem China Needs A Final Deal To Solve This Problem China Needs A Final Deal To Solve This Problem Bottom Line: North Korea is not a basis in itself for tariff rollback, but only as part of a much more extensive U.S.-China agreement. And a final agreement is needed to improve China’s key trade indicators on a lasting basis, such as new export orders and manufacturing employment, which are suffering amid the trade war. We expect economic policy uncertainty to remain elevated given our pessimistic view of U.S.-China trade relations (Chart 8). What About Japan, The G20 Host? Chart 9 Japan faces underrated domestic political risk as Prime Minister Abe Shinzo approaches a critical period in his long premiership, after which he will almost certainly be rendered a “lame duck,” likely by the time of the 2020 Tokyo Olympics. The question is when will this process begin and what will the market impact be? If Abe loses his supermajority in the July House of Councillors election, then it could begin as early as next month. This is a real risk – because a two-thirds majority is always a tall order – but it is not extreme. Abe’s polling is historically remarkable (Chart 9). The Liberal Democratic Party and its coalition partner Komeito are also holding strong and remain miles away from competing parties (Chart 10). The economy is also holding up relatively well – real wages and incomes have improved under Abe’s watch (Chart 11). However, the recent global manufacturing slowdown and this year’s impending hike to the consumption tax in October from 8% to 10% are killing consumer confidence. Chart 10Japan's Ruling Coalition Is Strong Japan's Ruling Coalition Is Strong Japan's Ruling Coalition Is Strong The collapse in consumer confidence is a contrary indicator to the political opinion polling. The mixed picture suggests that after the election Abe could still backtrack on the tax hike, although it would require driving through surprise legislation. He can pull this off in light of global trade tensions and his main objective of passing a popular referendum to revise the constitution and remilitarize the country. Chart 11Japanese Wages Up, But Consumer Confidence Diving Japanese Wages Up, But Consumer Confidence Diving Japanese Wages Up, But Consumer Confidence Diving We would not be surprised if Japan secured a trade deal with the U.S. prior to China. Because Abe and the United States need to enhance their alliance, we continue to downplay the risk of a U.S.-Japan trade war. Bloomberg recently reported that President Trump was threatening to downgrade the U.S.-Japan alliance, with a particular grievance over the ever-controversial issue of the relocation of troops on Okinawa. We view this as a transparent Trumpian negotiating tactic that has no applicability – indeed, American military and diplomatic officials quickly rejected the report. We do see a non-trivial risk that Trump’s rhetoric or actions will hurt Japanese equities at some point this year, either as Trump approaches his desired August deadline for a Japan trade deal or if negotiations drag on until closer to his decision about Section 232 tariffs on auto imports on November 14. But our base case is that there will be either no punitive measures or only a short time span before Abe succeeds in negotiating them away. We would not be surprised if the Japanese secured a deal prior to any China deal as a way for the Trump administration to try to pressure China and prove that it can get deals done. This can be done because it could be a thinly modified bilateral renegotiation of the Trans-Pacific Partnership, which had the U.S. and Japan at its center. Bottom Line: Given the combination of the upper house election, the tax hike and its possible consequences, a looming constitutional referendum which poses risks to Abe, and the ongoing external threat of trade war and China tensions, we continue to see risk-off sentiment driving Japanese and global investors to hold then yen. We maintain our long JPY/USD recommendation. The risk to this view is that Bank of Japan chief Haruhiko Kuroda follows other central banks and makes a surprisingly dovish move, but this is not warranted at the moment and is not the base case of our Foreign Exchange Strategy. GeoRisk Indicators Update: June 28, 2019 Our GeoRisk indicators are sending a highly complacent message given the above views on China and Iran. All of our risk measures, other than our German, Turkish, and Brazilian indicators, are signaling a decrease geopolitical tensions. Investors should nonetheless remain cautious: Our German indicator, which has proven to be a good measure of U.S.-EU trade tensions, has increased over the first half of June (Chart 12). We expect Germany to continue to be subject to risk because of Trump’s desire to pivot to European trade negotiations in the wake of any China deal. The auto tariff decision was pushed off until November. We assign a 45% subjective probability to auto tariffs on the EU if Trump seals a final China deal. The reason it is not our base case is because of a lack of congressional, corporate, or public support for a trade war with Europe as opposed to China or Mexico, which touch on larger issues of national interest (security, immigration). There is perhaps a 10% probability that Trump could impose car tariffs prior to securing a China deal. Chart 12U.S.-EU Trade Tensions Hit Germany U.S.-EU Trade Tensions Hit Germany U.S.-EU Trade Tensions Hit Germany Chart 13German Greens Overtaking Christian Democrats! German Greens Overtaking Christian Democrats! German Greens Overtaking Christian Democrats! Germany is also an outlier because it is experiencing an increase in domestic political uncertainty. Social Democrat leader Andrea Nahles’ resignation on June 2 opened the door to a leadership contest among the SPD’s membership. This will begin next week and conclude on October 26, or possibly in December. The result will have consequences for the survivability of Merkel’s Grand Coalition – in case the SPD drops out of it entirely. Both Merkel and her party have been losing support in recent months – for the first time in history the Greens have gained the leading position in the polls (Chart 13). If the coalition falls apart and Merkel cannot put another one together with the Greens and Free Democrats, she may be forced to resign ahead of her scheduled 2021 exit date. The implication of the events with Trump and Merkel is that Germany faces higher political risk this year, particularly in Q4 if tariff threats and coalition strains coincide. Meanwhile, Brazilian pension reform has been delayed due to an inevitable breakdown in the ability to pass major legislation without providing adequate pork barrel spending. As for the rest of Europe, since European Central Bank President Mario Draghi’s dovish signal on June 18, all of our European risk indicators have dropped off. Markets rallied on the news of the ECB’s preparedness to launch another round of bond-buying monetary stimulus if needed, easing tensions in the region. Italian bond spreads plummeted, for instance. The Korean and Taiwanese GeoRisk indicators, our proxies for the U.S.-China trade war, are indicating a decrease in risk as the two sides moved to contain the spike in tensions in May. While Treasury Secretary Steve Mnuchin notes that the deal was 90% complete in May before the breakdown, there is little evidence yet that any of the sticking points have been removed over the past two weeks. These indicators can continue to improve on the back of any short-term trade truce at the G20. The Russian risk indicator has been hovering in the same range for the past two months. We expect this to break out on the back of increasing mutual threats between the U.S. and Russia. The U.S. has recently agreed to send an additional 1000 rotating troops to Poland, a move that Russia obviously deems aggressive. The Russian upper chamber has also unanimously supported President Putin’s decree to suspend the Intermediate Nuclear Forces treaty, in the wake of the U.S. decision to do so. This would open the door to developing and deploying 500-5500 km range land-based and ballistic missiles. According to the deputy foreign minister, any U.S. missile deployment in Europe will lead to a crisis on the level of the Cuban Missile Crisis. Russia has also sided with Iran in the latest U.S.-Iran tension escalation, denouncing U.S. plans to send an additional 1000 troops to the Middle East and claiming that the shot-down U.S. drone was indeed in Iranian airspace. We anticipate the Russian risk indicator to go up as we expect Russia to retaliate in some way to Poland and to take actions to encourage the U.S. to get entangled deeper into the Iranian imbroglio, which is ultimately a drain on the U.S. and a useful distraction that Russia can exploit. In Turkey, both domestic and foreign tensions are rising. First, the re-run of the Istanbul mayoral election delivered a big defeat for Turkey’s President Erdogan on his home turf. Opposition representative Ekrem Imamoglu defeated former Prime Minister Binali Yildirim for a second time this year on June 23 – increasing his margin of victory to 9.2% from 0.2% in March. This was a stinging rebuke to Erdogan and his entire political system. It also reinforces the fact that Erdogan’s Justice and Development Party (AKP) is not as popular as Erdogan himself, frequently falling short of the 50% line in the popular vote for elections not associated directly with Erdogan (Chart 14). This trend combined with his personal rebuke in the power base of Istanbul will leave him even more insecure and unpredictable. Chart 14 Second, the G20 summit is the last occasion for Erdogan and Trump to meet personally before the July 31 deadline on Erdogan’s planned purchase of S-400 missile defenses from Russia. Erdogan has a chance to delay the purchase as he contemplates cabinet and policy changes in the wake of this major domestic defeat. Yet if Erdogan does not back down or delay, the U.S. will remove Turkey from the F-35 Joint Strike Fighter program, and may also impose sanctions over this purchase and possibly also Iranian trade. The result will hit the lira and add to Turkey’s economic woes. Geopolitically, it will create a wedge within NATO that Russia could exploit, creating more opportunities for market-negative surprises in this area. Finally, we expect our U.K. risk indicator to perk up, as the odds of a no-deal Brexit are rising. Boris Johnson will likely assume Conservative Party leadership and the party is moving closer to attempting a no-deal exit. We assign a 21% probability to this kind of Brexit, up from our previous estimate of 14%. It is more likely that Johnson will get a deal similar to Theresa May’s deal passed or that he will be forced to extend negotiations beyond October.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator U.K.: GeoRisk Indicator U.K.: GeoRisk Indicator U.K.: GeoRisk Indicator Germany: GeoRisk Indicator Germany: GeoRisk Indicator Germany: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Korea: GeoRisk Indicator Korea: GeoRisk Indicator Korea: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator What's On The Geopolitical Radar? Chart 25 Section III: Geopolitical Calendar

Highlights So What? Geopolitical risks are not about to ease. Why? Fiscal policy becomes less accommodative next year unless politicians act. Financial conditions give President Trump room to expand his tariff onslaught. Our Iran view is confirmed by rapid escalation of tensions – war risk is high. The odds of a no-deal Brexit have risen. Feature The AUD-JPY cross and copper-to-gold ratio – two market indicators that flag global growth and risk-on sentiment – are hovering over critical points at which a further breakdown would catalyze a renewed flight to quality (Chart 1). Chart 1Risk-On Indicators Breaking Down? Risk-On Indicators Breaking Down? Risk-On Indicators Breaking Down? Global sentiment remains depressed amid a rash of negative economic surprises and bonds continue to rally despite a more dovish outlook from the Fed (Chart 2). Chart 2Global Sentiment Remains Depressed Global Sentiment Remains Depressed Global Sentiment Remains Depressed The cavalry is on the way: European Central Bank President Mario Draghi oversaw a dramatic easing of monetary policy on June 18, driving the Italian-German sovereign bond spread down to levels not seen since before the populist election outcome of March 2018 (Chart 2, bottom panel). The Federal Reserve adjusted its policy rate projections to countenance an interest rate cut in the not-too-distant future. More needs to be done, however, to sustain the optimism that has propelled the S&P 500 and global equities upward since the volatility catalyzed by President Donald Trump’s announcement of a tariff rate hike on May 6. Political and geopolitical risks are higher, not lower, since that time as market-negative scenarios are playing out with U.S. policy, Iran, and Brexit, while we take a dim view of the end-game of the U.S.-China negotiations despite recent improvements. Fiscal And Trade Uncertainties This year’s growth wobbles have occurred in the context of expansive fiscal policy in the developed markets. Next year, however, the fiscal thrust (the change in the cyclically adjusted budget balance) is projected to decline in the U.S. and Japan and nearly to do so in Europe (Chart 3). We expect President Trump and the House Democrats to raise spending caps (or at least keep spending at current levels) and thus prevent the budget deficit from contracting in FY2020 – this is their only substantial point of agreement. But this at best neutralizes what would otherwise be a negative fiscal backdrop. Meanwhile it is not at all clear that Brussels will relax its scrutiny of member states seeking to cut taxes and boost spending, such as Italy. Japanese Prime Minister Abe Shinzo would need to arrange for the Diet to pass a new law to avoid the consumption tax hike from 8% to 10% on October 1. He can pull this off, especially if the U.S. trade war escalates – or if he decides to turn next month’s upper house election into a general election and needs to boost his popularity. But as things currently stand in law, the world’s third biggest economy will face a deep fiscal pullback next year (Chart 3, bottom panel). In short, DM fiscal policy will not really become contractionary in 2020, but this is a view and not yet a reality (Chart 4). Chart 3Fiscal Pullback Likely Next Year Fiscal Pullback Likely Next Year Fiscal Pullback Likely Next Year Chart 4Only The U.S. Is Profligate Only The U.S. Is Profligate Only The U.S. Is Profligate Meanwhile China’s stimulus is still in question – in fact it remains the major macro question this year. The efficacy of China’s stimulus is declining ... An escalating trade war will bring greater stimulus but also greater transmission problems.  Since February we have argued that the Xi administration has shifted to sweeping fiscal-and-credit stimulus in the face of the unprecedented external threat posed by the Trump administration (Charts 5A and 5B). We expect China’s credit growth to continue its upturn in June and in H2. Ultimately, we think the whole package will be comparable to 2015-16 – and anything even close to that will prolong the global economic expansion. We do not see a massive 2008-style stimulus occurring unless relations with the U.S. completely collapse and a global recession occurs. Chart 5AStimulus Amid The Trade War Stimulus Amid The Trade War Stimulus Amid The Trade War Chart 5 The catch – as we have shown – is that the efficacy of China’s stimulus is declining over time because of over-indebtedness and bearish sentiment in China’s private sector. These tepid animal spirits stem from epochal changes: Xi’s reassertion of communism and America’s withdrawal of strategic support for China’s rise. An escalating trade war will bring greater stimulus but also greater transmission problems. The magnitude of the tariffs that President Trump is threatening to impose on China, Mexico, the EU, and Japan is mind-boggling. We illustrate this with a simple simulation of duties collected as a share of total imports under different scenarios (Chart 6). Chart 6 China and Mexico are fundamentally different from the EU and Japan and hence the threat of tariffs will continue to weigh on markets for Trump’s time in office – China because of a national security consensus and Mexico because of the Trump administration’s existential emphasis on curbing illegal immigration. But we still put the risk of auto tariffs (or other punitive measures) on Europe at 45% if Trump seals a China deal. The odds are lower for Japan but it is still at risk. Global supply chains are shifting – a new source of costs and uncertainty for companies – as a slew of recent news has highlighted. Already 40% of companies surveyed by the American Chamber of Commerce in China say they are relocating to Southeast Asia, Mexico, and elsewhere (Chart 7). If the G20 is a flop – or results in nothing more than a pause in tariffs for another three-month dialogue – relocations will gain steam, forcing companies’ bottom lines to take a hit. Chart 7 Even in the best case, in which the Trump-Xi summit produces a joint statement outlining a “deal in principle” accompanied by a rollback of the May 10 tariff hike, uncertainty will persist due to President Trump’s unpredictability, China’s incentive to wait until after the U.S. election, and Trump’s incentive to corner the “China hawk” platform prior to the election. We maintain that, by November 2020, there is a roughly 70% chance of further escalation. At least the U.S.-China conflict is nominally improving. The same cannot be said for other geopolitical risks discussed below: the U.S. and Iran are flirting with war; the U.S. presidential election is injecting a steady trickle of market-negative news; the chances of a no-deal Brexit are rising; and Trump may turn on Europe at a moment when it lacks leadership. This list assumes that Russia takes advantage of American distraction by improving domestic policy rather than launching into a new foreign adventure – say in Ukraine or Kaliningrad. If there is any doubt as to whether political risk can outweigh more accommodative monetary policy, remember that President Trump actually can remove Chairman Jerome Powell. Legally he is only allowed to do so “for cause” as opposed to “at will.” But the meaning of this term is a debate that would go to the Supreme Court in the event of a controversial decision. Meanwhile the stock market would dive. Now, this is precisely why Trump will not try. But the implication, as with Congress and the border wall, is that Trump is constrained on domestic policy and hence tariffs are his most effective tool to try to achieve policy victories. With an ebullient stock market and a Fed that is adjusting its position, Trump can try to kill two birds with one stone: wring concessions from trade partners while forcing the FOMC to keep responding to rising external risks. Bottom Line: Central banks are riding to the rescue, but there is only so much they can do if global leaders are tightening budgets and imposing barriers on immigration and trade. We remain tactically cautious. Oh Man, Oh Man, Oman Iran has swiftly responded to the Trump administration’s imposition of “maximum pressure” on oil exports. The shooting down of an American drone that Tehran claims violated its airspace on June 20 is the latest in a spate of incidents, including a Houthi first-ever cruise missile attack on Abha airport in Saudi Arabia. Two separate attacks on tankers near the Strait of Hormuz (Map 1) demonstrate that Iran is threatening to play its most devastating card in the renewed conflict with the U.S. Chart Chart 8 Hormuz ushers through a substantial share of global oil demand and liquefied natural gas demand (Chart 8). The amount of spare pipeline capacity that the Gulf Arab states could activate in the event of a disruption is merely 3.9 million barrels per day, or 6 million if questionable pipelines like the outdated Iraqi pipeline in Saudi Arabia prove functional (Table 1). Table 1No Sufficient Alternatives To Hormuz Escalation ... Everywhere Escalation ... Everywhere A conflict with Iran could cause the biggest oil shock of all time. Even if this spare capacity were immediately utilized, a conflict could cause the biggest oil shock of all time – considerably bigger than that of the Iranian Revolution (Chart 9). Chart 9 We have shown in the past that Iran has the military capability of interrupting the flow of traffic in Hormuz for anywhere from 10 days to four months. A preemptive strike by Iran would be most effective, whereas a preemptive American attack would include targets to reduce Iran’s ability to retaliate via Hormuz. The impact on oil prices ranges from significant to devastating. Needless to say, blocking the Strait of Hormuz would initiate a war so Iran is attempting to achieve diplomatic goals with the threats themselves – it will only block the strait as a last resort, say if it is convinced that the U.S. is about to attack anyway. As the experience of President Jimmy Carter shows, Americans may rally around the flag during a crisis but they will also kick a president out of office for higher prices and an economic slowdown. President Trump cannot be unaware of this precedent. The intention of his Iran policy is to negotiate a “better deal” than the 2015 one – a deal that includes Iran’s regional power projection and ballistic missile capabilities as well as its nuclear program. The problem is that Trump has already been forced to deploy a range of forces to the region, including additional troops (albeit so far symbolic at 2,500) (Chart 10). He is also sending Special Representative for Iran, Brian Hook, to the region to rally support among Gulf Cooperation Council. The week after Hook will court Britain, Germany, and France, three of the signatories of the 2015 deal. Trump ran on a campaign of eschewing gratuitous wars in the Middle East – a popular stance among war-weary Americans (Chart 11) – but there is a substantial risk that he could get entangled in the region. First, he is adopting a more aggressive foreign policy to attempt to compensate for the lack of payoff in public opinion from the strong economy. Second, Iran is not shrinking from the fight, which could draw him deeper into conflict. Third, there is always a high risk of miscalculation when nations engage in such brinkmanship. Chart 10Is The 'Pivot To Asia' About To Reverse? Is The 'Pivot To Asia' About To Reverse? Is The 'Pivot To Asia' About To Reverse? Chart 11 The Iranian response has been, first, to reject negotiations. When Trump sent a letter to Rouhani via Japanese Prime Minister Abe Shinzo, Abe was rebuffed – and one of the tankers attacked near Oman was a Japanese flagged vessel, the Kokuka Courageous. This is a posture, not a permanent position, as the Iranian release of an American prisoner demonstrates. But the posture can and will be maintained in the near term – with escalation as the result. Second, Iran is increasing its own leverage in any future negotiation by demonstrating that it can sow instability across the region and bring the global economy grinding to a halt. Iran cannot assume that Trump means what he says about avoiding war but must focus on the United States’ actions and capabilities. Cutting off all oil exports is a recipe for extreme stress within the Iranian regime – it is an existential threat. Therefore, the Iranians have signaled that the cost of a total cutoff will be a war that will cause a global oil price shock. The Iranian leaders are also announcing that they are edging closer to walking away from the 2015 nuclear pact (Table 2). If so, they could quickly approach “breakout” capacity in the uranium enrichment – meaning that they could enrich to 20% and then in short order enrich to 90% and amass enough of this fuel to make a nuclear device one year thereafter. The Trump administration has reportedly reiterated that this one-year limit is the U.S. government’s “red line,” just as the Obama administration had done. Table 2Iran Threatens To Walk Away From 2015 Nuclear Deal Escalation ... Everywhere Escalation ... Everywhere This Iranian threat is a direct reaction to Trump’s decision in May not to renew the oil sanction waivers. Previously the Iranians had sought to preserve the 2015 deal, along with the Europeans, in order to wait out Trump’s first term. These developments push us to the brink of war. Iran is retaliating with both military force and a nuclear restart. This comes very close to meeting our conditions for an American (and Israeli) retaliation that is military in nature. Diagram 1 is an update of our decision tree that we have published since last year when Trump reneged on the 2015 deal. The window to de-escalate is closing rapidly. The Appendix provides a checklist for air strikes and/or the closure of Hormuz. Diagram 1Iran-U.S. Tensions Decision Tree Escalation ... Everywhere Escalation ... Everywhere At very least we expect to see the U.S. attempt to create a large international fleet to assert freedom of navigation in the Persian Gulf and Strait of Hormuz. While Iran may lay low during a large show of force, it will later want to demonstrate that it has not been cowed. And it has the capacity to retaliate elsewhere, including in Iraq, an area we have highlighted as a major geopolitical risk to oil supply. The U.S. government has already reacted to recent threats there from Iranian proxies by pulling non-essential personnel. Iran has several incentives to test the limits of conflict if the U.S. insists on the oil embargo. First, tactically, it seeks to deter President Trump, take advantage of American war-weariness, drive a wedge between the U.S. and Europe, and force a relaxation of the sanctions. This would also demonstrate to the region that Iran has greater resolve than the United States of America. This goal has not been achieved by the recent spate of actions, so there is likely more conflict to come. Second, President Hassan Rouhani’s government is also likely to maintain a belligerent posture – at least in the near term – to compensate for its loss of face upon the American betrayal of the 2015 nuclear deal. Rouhani negotiated the deal against the warnings of hardline revolutionaries. The 2020 majlis elections make this an important political goal for his more reform-oriented faction. Negotiations with Trump can only occur if Rouhani has resoundingly demonstrated his superiority in the clash of wills. Structurally, Iran faces tremendous regime pressures in the coming years and decades because of its large youth population, struggling economy, and impending power transition from the 80 year-old Supreme Leader Ali Khamanei. A patriotic war against America and its allies – while not desirable – is a risk that Khamenei can take, as an air war is less likely to trigger regime change than it is to galvanize a new generation in support of the Islamic revolution. For oil markets the outcome is volatility in the near term – reflecting the contrary winds of trade war and global growth fears with rising supply risks. Because we expect more Chinese stimulus, both as the trade talks extend and especially if they collapse, we ultimately share BCA’s Commodity & Energy Strategy view that the path of least resistance for oil prices is higher on a cyclical horizon, as demand exceeds supply (Chart 12). We remain long EM energy producers relative to EM ex-China. Chart 12Crude Oil Supply-Demand Balance Should Send Prices Higher Crude Oil Supply-Demand Balance Should Send Prices Higher Crude Oil Supply-Demand Balance Should Send Prices Higher Bottom Line: The risk of military conflict has risen materially. This also drastically elevates the risk of a supply shock in oil prices that would kill global demand. The U.S. Election Adds To Geopolitical Risk The 2020 U.S. election poses another political risk for the rising equity market. The Democratic Party’s first debate will be held on June 26-27. The leftward shift in the party will be on full display, portending a possible 180-degree reversal in U.S. policy if the Democrats should win the election, with the prospect of a rollback of Trump’s tax cuts and deregulation of health, finance, and energy. The uncertainty and negative impact on animal spirits will be modest if current trends persist through the debates. Former Vice President Joe Biden remains the frontrunner despite having naturally lost the bump to his polling support after announcing his official candidacy (Chart 13). Biden is a known quantity and a centrist, especially compared to the farther left candidates ranked second and third in popular support– Vermont Senator Bernie Sanders and Massachusetts Senator Elizabeth Warren. Chart 13 Chart 14 Biden is not only beating Sanders in South Carolina, which underscores the fact that he is competitive in the South and hence has a broader path to the White House, but also in New Hampshire, where the Vermont native should be ahead (Chart 14). These states hold the early primaries and caucuses and if Biden maintains his large lead then he will start to appear inevitable very early in the primary campaign next year. Hence a poor showing in the debate on June 27 is a major risk to Biden – he should be expected to be eschew the limelight and play the long game. Elizabeth Warren, by contrast, has the most to gain as she appears on the first night and does not share a stage with the other heavy hitters. If she or other progressive candidates outperform then the market will be spooked. The market could begin to trade off the polls. All of these candidates are beating Trump in current head-to-head polling – Biden is even ahead in Texas (Chart 15). This means that any weakness from Biden does not necessarily offer the promise of a Trump victory and policy continuity. Chart 15 The Democrats also have a powerful demographic tailwind. The just-released projections from the U.S. Census Bureau reveal how Trump’s narrow margins of victory in the swing states in 2016 are in serious jeopardy in 2020 as a result of demographics if he does not improve his polling among the general public (Chart 16). Chart 16 We still give Trump the benefit of the doubt as the incumbent president amid an expanding economy, but it is essential to recognize that his popular approval rating is reminiscent of a president during recession – i.e. one who is about to lose the White House for his party (Chart 17). Chart 17 Even if there is not a recession, an increase in unemployment is likely to cost him the election – and even a further decrease in unemployment cannot guarantee victory (Chart 18). This is why we see Trump making a bid to become a foreign policy president and seek reelection on the basis that it is unwise to change leaders amid an international crisis. Chart 18 We still give Trump the benefit of the doubt ... but his popular approval rating is reminiscent of a president during recession. The race for the U.S. senate is extremely important for the policy setting from 2021. If Republicans maintain control, they will be able to block sweeping Democratic legislation – which is particularly relevant if a progressive candidate should win the White House. However, if Democrats can muster enough votes to remove a sitting president with a strong economy – including a strong economy in the key senate swing races (Chart 19) – then they will likely win over the senate as well. Chart 19Hard To Win The Senate In 2020 While Key States Prosper Hard To Win The Senate In 2020 While Key States Prosper Hard To Win The Senate In 2020 While Key States Prosper Bottom Line: The 2020 election poses a double risk to the bull market. First, the Democratic primary campaign threatens sharp policy discontinuity, especially if and when developments cause Biden to drop in the polls (dealing a blow to centrism or the political establishment). Second, Trump’s vulnerability makes him more likely to act aggressive on the international stage, whether on trade, immigration, or national security, reinforcing the risks outlined above with regard to China, Iran, Mexico, and even Europe. Rising Odds Of A No-Deal Brexit Former Mayor of London and former foreign secretary Boris Johnson looks increasingly likely to seal the Conservative Party leadership contest in the United Kingdom. It is not yet a done deal, but the shift within the party in favor of accepting a “no deal” exit is clear. None of the remaining candidates is willing to forgo that option. The newest development advances us along our decision tree in Diagram 2, altering the conditional probabilities for this year’s events. We expect the next prime minister to try to push a deal substantially similar to outgoing Prime Minister Theresa May before attempting any kamikaze run as the October 31 deadline approaches. The attempt to leverage the EU’s economic weakness will not produce a fundamental renegotiation of the exit deal, but some element of diplomatic accommodation is possible as the EU seeks to maintain overall stability and a smooth exit if that is what the U.K. is determined to accomplish. Diagram 2Brexit Decision Tree Escalation ... Everywhere Escalation ... Everywhere Hence the prospect of passing a deal substantially similar to outgoing Prime Minister Theresa May’s deal is about 30%, roughly equal to the chance of a delay (28%). These options are believable as the new leader will have precious little time between taking the reins and Brexit day. The EU can accept a delay because it ultimately has an interest in keeping the U.K. bound into the union. Public opinion polling is not conducive to the new prime minister seeking a new election unless the change of face creates a massive shift in support for the Conservatives, both by swallowing the Brexit Party and outpacing Labour. If the purpose is to deliver Brexit, then the risk of a repeat of the June 2017 snap election would seem excessive. Nevertheless, the Tories’ working majority in parliament is vanishingly small, at five MPs, so a shift in polling could change the thinking on this front. The pursuit of a no-deal exit would create a backlash in parliament that we reckon has a 21% chance of ending in a no-confidence motion and new election. Bottom Line: The odds of a crash Brexit have moved up from 14% to 21% as a result of the leadership contest. The threat that the U.K. will crash out of the EU is not merely a negotiating ploy, although it will be a last resort even for the new hard-Brexit prime minister. Public opinion is against a no-deal Brexit, as is the majority of parliament, but the risk to the U.K. and EU economies will loom large over global risk assets in the coming months. Investment Conclusions Political and geopolitical risks to the late-cycle expansion are rising, not falling. U.S. foreign policy remains the dominant risk but U.S. domestic policy pre-2020 is an aggravating factor. Easing financial conditions give President Trump more ammunition to use tariffs and sanctions. Meanwhile our view that this summer will feature “fire and fury” between the U.S. and Iran has been confirmed by the tanker attacks in Oman. Tensions will likely escalate from here. Ultimately, we believe Trump is more likely to back off from the Iran conflict than the China conflict. This is part of our long-term theme that the U.S. really is pivoting to China and geopolitical risk will rotate from the Middle East to East Asia. But as highlighted above, the risk of entanglement is very high due to Trump’s approach and Iran’s incentives to raise the stakes. Oil prices will not resume their upward drift until Chinese stimulus is reconfirmed – and even then they will continue to be volatile. We remain cautious and are maintaining our safe-haven tactical trades of long gold and long JPY/USD.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Image

Highlights So What? U.S.-China relations are still in free fall as we go to press. Why? The trade war will elicit Chinese stimulus but downside risks to markets are front-loaded. The oil risk premium will remain elevated as Iran tensions will not abate any time soon. The odds of a no-deal Brexit are rising. Our GeoRisk Indicators show that Turkish and Brazilian risks have subsided, albeit only temporarily. Maintain safe-haven trades. Short the CNY-USD and go long non-Chinese rare earth providers. Feature The single-greatest reason for the increase in geopolitical risk remains the United States. The Democratic Primary race will heat up in June and President Trump, while favored in 2020 barring a recession, is currently lagging both Joe Biden and Bernie Sanders in the head-to-head polling. Trump’s legislative initiatives are bogged down in gridlock and scandal. The remaining avenue for him to achieve policy victories is foreign policy – hence his increasing aggressiveness on both China and Iran. The result is negative for global risk assets on a tactical horizon and possibly also on a cyclical horizon. A positive catalyst is badly needed in the form of greater Chinese stimulus, which we expect, and progress toward a trade agreement. Brexit, Italy, and European risks pale by comparison to what we have called “Cold War 2.0” since 2012. Nevertheless, the odds of Brexit actually happening are increasing. The uncertainty will weigh on sentiment in Europe through October even if it does not ultimately conclude in a no-deal shock that prevents the European economy from bouncing back. Yet the risk of a no-deal shock is higher than it was just weeks ago. We discuss these three headline geopolitical risks below: China, Iran, and the U.K. No End In Sight For U.S.-China Trade Tensions U.S.-China negotiations are in free fall, with no date set for another round of talks. On March 6 we argued that a deal had a 50% chance of getting settled by the June 28-29 G20 summit in Japan, with a 30% chance talks would totally collapse. Since then, we have reduced the odds of a deal to 40%, with a collapse at 50%, and a further downgrade on the horizon if a positive intervention is not forthcoming producing trade talks in early or mid-June (Table 1). Table 1U.S.-China Trade War: Probabilities Of A Deal By End Of June 2019 GeoRisk Indicators Update: May 31, 2019 GeoRisk Indicators Update: May 31, 2019 We illustrate the difficulties of agreeing to a deal through the concept of a “two-level game.” In a theoretical two-level game, each country strives to find overlap between its international interests and its rival’s interests and must also seek overlap in such a way that the agreement can be sold to a domestic audience at home. The reason why the “win-win scenario” is so remote in the U.S.-China trade conflict is because although China has a relatively large win set – it can easily sell a deal at home due to its authoritarian control – the U.S. win set is small (Diagram 1). Diagram 1Tiny Win-Win Scenario In U.S.-China Trade Conflict GeoRisk Indicators Update: May 31, 2019 GeoRisk Indicators Update: May 31, 2019 The Democrats will attack any deal that Trump negotiates, making him look weak on his own pet issue of trade with China. This is especially the case if a stock market selloff forces Trump to accept small concessions. His international interest might overlap with China’s interest in minimizing concessions on foreign trade and investment access while maximizing technological acquisition from foreign companies. He would not be able to sell such a deal – focused on large-scale commodity purchases as a sop to farm states – on the campaign trail. Democrats will attack any deal that Trump negotiates. While it is still possible for both sides to reach an agreement, this Diagram highlights the limitations faced by both players. Meanwhile China is threatening to restrict exports of rare earths – minerals which are critical to the economy and national defense. China dominates global production and export markets (Chart 1), so this would be a serious disruption in the near term. Global sentiment would worsen, weighing on all risk assets, and tech companies and manufacturers that rely on rare earth inputs from China would face a hit to their bottom lines. Chart 1China Dominates Rare Earths Supply France: GeoRisk Indicator France: GeoRisk Indicator Over the long haul, this form of retaliation is self-defeating. First, China would presumably have to embargo all exports of rare earths to the world to prevent countries and companies from re-exporting to the United States. Second, rare earths are not actually rare in terms of quantity: they simply occur in low concentrations. As the world learned when China cut off rare earths to Japan for two months in 2010 over their conflict in the East China Sea, a rare earths ban will push up prices and incentivize production and processing in other regions. It will also create rapid substitution effects, recycling, and the use of stockpiles. Ultimately demand for Chinese rare earths exports would fall. Over the nine years since the Japan conflict, China’s share of global production has fallen by 19%, mostly at the expense of rising output from Australia. A survey of American companies suggests that they have diversified their sources more than import statistics suggest (Chart 2). Chart 2Import Stats May Be Overstating China’s Dominance U.K.: GeoRisk Indicator U.K.: GeoRisk Indicator The risk of a rare earths embargo is high – it fits with our 30% scenario of a major escalation in the conflict. It would clearly be a negative catalyst for companies and share prices. But as with China’s implicit threat of selling U.S. Treasuries, it is not a threat that will cause Trump to halt the trade war. The costs of conflict are not prohibitive and there are some political gains. Bottome Line: The S&P 500 is down 3.4% since our Global Investment Strategists initiated their tactical short on May 10. This is nearly equal to the weighted average impact on the S&P 500 that they have estimated using our probabilities. Obviously the selloff can overshoot this target. As it does, the chances of the two sides attempting to contain the tensions will rise. If we do not witness a positive intervention in the coming weeks, it will be too late to salvage the G20 and the risk of a major escalation will go way up. We recommend going short CNY-USD as a strategic play despite China’s recent assurances that the currency can be adequately defended. Our negative structural view of China’s economy now coincides with our tactical view that escalation is more likely than de-escalation. We also recommend going long a basket of companies in the MVIS global rare earth and strategic metals index – specifically those companies not based in China that have seen share prices appreciate this year but have a P/E ratio under 35. U.S.-Iran: An Unintentional War With Unintentional Consequences? “I really believe that Iran would like to make a deal, and I think that’s very smart of them, and I think that’s a possibility to happen.” -President Donald Trump, May 27, 2019 … We currently see no prospect of negotiations with America ... Iran pays no attention to words; what matters to us is a change of approach and behavior.” -Iranian Foreign Ministry spokesman Abbas Mousavi, May 28, 2019 The U.S. decision not to extend sanction waivers on Iran multiplied geopolitical risks at a time of already heightened uncertainty. Elevated tensions surrounding major producers in the Middle East could impact oil production and flows. In energy markets, this is reflected in the elevated risk premium – represented by the residuals in the price decompositions that include both supply and demand factors (Chart 3). Chart 3The Risk Premium Is Rising In Brent Crude Oil Prices Germany: GeoRisk Indicator Germany: GeoRisk Indicator Tensions surrounding major oil producers ... are reflected in the elevated risk premium – represented by the residuals in the Brent price decomposition. Already Iranian exports are down 500k b/d in April relative to March – the U.S. is acting on its threat to bring Iran’s exports to zero and corporations are complying (Chart 4). Chart 4Iran Oil Exports Collapsing Italy: GeoRisk Indicator Italy: GeoRisk Indicator What is more, the U.S. is taking a more hawkish military stance towards Iran – recently deploying a carrier strike group and bombers, partially evacuating American personnel from Iraq, and announcing plans to send 1,500 troops to the Middle East. The result of all these actions is not only to reduce Iranian oil exports, but also to imperil supplies of neighboring oil producers such as Iraq and Saudi Arabia which may become the victims of retaliation by an incandescent Iran. Our expectation of Iranian retaliation is already taking shape. The missile strike on Saudi facilities and the drone attack on four tankers near the UAE are just a preview of what is to come. Although Iran has not claimed responsibility for the acts, its location and extensive network of militant proxies affords it the ability to threaten oil supplies coming out of the region. Iran has also revived its doomsday threat of closing down the Strait of Hormuz through which 20% of global oil supplies transit – which becomes a much fatter tail-risk if Iran comes to believe that the U.S. is genuinely pursuing immediate regime change, since the first-mover advantage in the strait is critical. This will keep markets jittery. Current OPEC spare capacity would allow the coalition to raise production to offset losses from Venezuela and Iran. Yet any additional losses – potentially from already unstable regions such as Libya, Algeria, or Nigeria – will raise the probability that global supplies are unable to cover demand. Going into the OPEC meeting in Vienna in late June, our Commodity & Energy Strategy expects OPEC 2.0 to relax supply cuts implemented since the beginning of the year. They expect production to be raised by 0.9mm b/d in 2H2019 vs. 1H2019.1 Nevertheless, oil producers will likely adopt a cautious approach when bringing supplies back online, wary of letting prices fall too far. This was expressed at the May Joint Ministerial Monitoring Committee meeting in Jeddah, which also highlighted the growing divergence of interests within the group. Russia is in support of raising production at a faster pace than Saudi Arabia, which favors a gradual increase (conditional on U.S. sanctions enforcement). Both the Iranians and Americans claim that they do not want the current standoff to escalate to war. On the American side, Trump is encouraging Prime Minister Shinzo Abe to try his hand as a mediator in a possible visit to Tehran in June. We would not dismiss this possibility since it could produce a badly needed “off ramp” for tensions to de-escalate when all other trends point toward a summer and fall of “fire and fury” between the U.S. and Iran. If forced to make a call, we think President Trump’s foreign policy priority will center on China, not Iran. But this does not mean that downside risks to oil prices will prevail. China will stimulate more aggressively in June and subsequent months. And regardless of Washington’s and Tehran’s intentions, a wrong move in an already heated part of the world can turn ugly very quickly. Bottom Line: President Trump’s foreign policy priority is China, not Iran. Nevertheless, a wrong move can trigger a nasty escalation in the current standoff, jeopardizing oil supplies coming out of the Gulf region. In response to this risk, OPEC 2.0 will likely move to cautiously raise production at the next meeting in late June. Meanwhile China’s stimulus overshoot in the midst of trade war will most likely shore up demand over the course of the year. Can A New Prime Minister Break The Deadlock In Westminster? “There is a limited appetite for change in the EU, and negotiating it won’t be easy.” - Outgoing U.K. Prime Minister Theresa May Prime Minister Theresa May’s resignation has hurled the Conservative Party into a scramble to select her successor. While the timeline for this process is straightforward,2 the impact on the Brexit process is not. The odds of a “no-deal Brexit” have increased but so has the prospect of parliament passing a soft Brexit prior to any new election or second referendum. The odds of a “no-deal Brexit” have increased. Eleven candidates have declared their entry to the race and the vast majority are “hard Brexiters” willing to sacrifice market access on the continent (Table 2). Prominent contenders such as Boris Johnson and Dominic Raab have stated that they are willing to exit the EU without a deal. Table 2“Hard Brexiters” Dominate The Tory Race GeoRisk Indicators Update: May 31, 2019 GeoRisk Indicators Update: May 31, 2019 Given that the average Tory MP is more Euroskeptic than the average non-conservative voter or Brit, the final two contenders left standing at the end of June are likely to shift to a more aggressive Brexit stance. They will say they are willing to deliver Brexit at all costs and will avoid repeating Theresa May’s mistakes. This means at the very least the rhetoric will be negative for the pound in the coming months. A clear constraint on the U.K. in trying to negotiate a new withdrawal agreement is that the EU has the upper hand. It is the larger economy and less exposed to the ramifications of a no-deal exit (though still exposed). This puts it in a position of relative strength – exemplified by the European Commission’s insistence on keeping the current Withdrawal Agreement. Whoever the new prime minister is, it is unlikely that he or she will be able to negotiate a more palatable deal with the EU. Rather, the new leader will lead a fractured Conservative Party that still lacks a strong majority in parliament. The no-deal option is the default scenario if an agreement is not finalized by the Halloween deadline and no further extension is granted. However, Speaker of the House of Commons John Bercow recently stated that the prime minister will be unable to deliver a no-deal Brexit without parliamentary support. This will likely manifest in the form of a bill to block a no-deal Brexit. Alternatively, an attempt to force a no-deal exit could prompt a vote of no confidence in the government, most likely resulting in a general election.3 Chart 5British Euroskeptics Made Gains In EP Election Spain: GeoRisk Indicator Spain: GeoRisk Indicator While the Brexit Party amassed the largest number of seats in the European Parliament elections at the expense of the Labour, Conservative, and UKIP parties (Chart 5), the results do not suggest that British voters have generally shifted back toward Brexit. In fact, if we group parties according to their stance, the Bremain camp has a slight lead over the Brexit camp (Chart 6). Thus, it is not remotely apparent that a hard Brexiter can succeed in parliament; that a new election can be forestalled if a no-deal exit is attempted; or that a second referendum will repeat the earlier referendum’s outcome. Chart 6Bremain Camp Still Dominates Russia: GeoRisk Indicator Russia: GeoRisk Indicator Bottom Line: While the new Tory leader is likely to be more on the hard Brexit end of the spectrum than Theresa May, this does not change the position of either the European Commission or the British MPs and voters on Brexit. The median voter both within parliament and the British electorate remains tilted towards a softer exit or remaining in the EU. This imposes constraints on the likes of Boris Johnson and Dominic Raab if they take the helm of the Tory Party. These leaders may ultimately be forced to try to push through something a lot like Theresa May’s plan, or risk a total collapse of their party and control of government. Still, the odds of a no-deal exit – the default option if no agreement is reached by the October 31 deadline – have gone up. In the meantime, the GBP will stay weak, gilts will remain well-bid, and risk-off tendencies will be reinforced. GeoRisk Indicators Update – May 31, 2019 Last month BCA’s Geopolitical Strategy introduced ten indicators to measure geopolitical risk implied by the market. These indicators attempt to capture risk premiums priced into various currencies – except for Euro Area countries, where the risk is embedded in equity prices. A currency or bourse that falls faster than it should fall, as implied by key explanatory variables, indicates increasing geopolitical risk. All ten indicators can be found in the Appendix, with full annotation. We will continue to highlight key developments on a monthly basis. This month, our GeoRisk indicators are picking up the following developments: Trade war: Our Korean and Taiwanese risk indicators are currently the best proxies to measure geopolitical risk implications of the U.S.-China trade war, as they are both based on trade data. Both measures, as expected, have increased more than our other indicators over the past month on the back of a sharp spike in tensions between the U.S. and China. Currently, the moves are largely due to depreciation in currencies, as trade is only beginning to feel the impact. We believe that we will see trade decline in the upcoming months. Brexit: While it is still too early to see the full effect of Prime Minister May’s resignation captured in our U.K. indicator, it has increased in recent days. We expect risk to continue to increase as a leadership race is beginning among the Conservatives that will raise the odds of a “no-deal exit” relative to “no exit.” EU elections: The EU elections did not register as a risk on our indicators. In fact, risk decreased slightly in France and Germany during the past few weeks, while it has steadily fallen in Spain and Italy. Moreover, the results of the election were largely in line with expectations – there was not a surprising wave of Euroskepticism. The real risks will emerge as the election results feed back into political risks in certain European countries, namely the U.K., where the hardline Conservatives will be emboldened, and Italy, where the anti-establishment League will also be emboldened. In both countries a new election could drastically increase uncertainty, but even without new elections the respective clashes with Brussels over Brexit and Italian fiscal policy will increase geopolitical risk. Emerging Markets: The largest positive moves in geopolitical risk were in Brazil and Turkey, where our indicators plunged to their lowest levels since late 2017 and early 2018. Brazilian risk has been steadily declining since pension reform – the most important element of Bolsonaro’s reform agenda – cleared an initial hurdle in Congress. While we would expect Bolsonaro to face many more ups and downs in the process of getting his reform bill passed, we have a high conviction view that the decrease in our Turkish risk indicator is unwarranted. This decrease can be attributed to the fact that the lira’s depreciation in recent weeks is slowing, which our model picks up as a decrease in risk. Nonetheless, uncertainty will prevail as a result of deepening political divisions (e.g. the ruling party’s attempt to overturn the Istanbul election), poor governance, ongoing clashes with the West, and an inability to defend the lira while also pursuing populist monetary policy. Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy roukayai@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com   France: GeoRisk Indicator Image U.K.: GeoRisk Indicator Image Germany: GeoRisk Indicator Image Italy: GeoRisk Indicator Image Spain: GeoRisk Indicator Image Russia: GeoRisk Indicator Image Korea: GeoRisk Indicator Image Taiwan: GeoRisk Indicator Image Turkey: GeoRisk Indicator Image Brazil: GeoRisk Indicator Image What's On The Geopolitical Radar? Image Footnotes 1 Please see BCA Research Commodity & Energy Strategy Weekly Report titled “Policy Risk Sustains Oil’s Unstable Equilibrium,” dated May 23, 2019, available at ces.bcaresearch.com. 2 The long list of candidates will be whittled down to two by the end of June through a series of votes by Tory MPs. Conservative Party members will then cast their votes via a postal ballot with the final result announced by the end of July, before the Parliament’s summer recess. 3 A vote of no confidence would trigger a 14-day period for someone else to form a government, otherwise it will result in a general election. Geopolitical Calendar