North Korea

Go long KRW versus USD. Within an EM equity portfolio, overweight Korean tech and stay neutral on Korean non-tech. However, we are not bullish on the Korean bourse's absolute performance.

The global political system is destabilizing and the US will turn more hawkish in foreign policy, trade policy, or both, regardless of the election outcome. Tactically go long the dollar.

While 2024 will see various election risks, global geopolitical uncertainty is driven by the US election and its struggle with Russia, China, and Iran. The stock market can manage local domestic political risk. But it will correct upon a major outbreak of geopolitical uncertainty.

Middle East conflict, extreme US policy uncertainty, Chinese economic slowdown, US-Russian proxy war, and Asian military conflicts do not create a stable investment backdrop for 2024. Our top five “black swan” risks may be highly improbable, but they stem from these underlying trends.

Investors should bet against the global rally in risk assets and maintain a defensive positioning until recession risks verifiably abate.

Investors should bet against the global rally in risk assets and maintain a defensive positioning until recession risks verifiably abate.

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

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

Highlights China is taking advantage of global chaos to solidify its sphere of influence – beginning with Hong Kong. The crisis is also motivating the European Union to link arms more tightly through a symbolic step toward fiscal solidarity and transfers. US, Chinese, and European stimulus measures are cyclically positive but near-term risks abound. Hiccups in stimulus rollout are to be expected – and China’s disappointing stimulus thus far may cause market turmoil before policymakers do what we expect and add greater oomph. US-China relations are breaking down as we outlined, as renminbi depreciation coincides with Trump approval depreciation. The risks of the UK failing to agree to a trade deal with the EU are higher than prior to COVID-19. Stay defensive tactically – the risk-on rally is not yet confirmed by major reflation indicators yet geopolitical risks are spiking. Feature Chart 1Will Geopolitics Stunt The Early Bull's Growth? Will Geopolitics Stunt The Early Bull's Growth? Will Geopolitics Stunt The Early Bull's Growth? After wavering at the 2,900 level, the S&P 500 broke above 3,000. As we go to press, it is holding the line, despite a surge in geopolitical risk emanating from the efforts of the Great Powers to consolidate their spheres of influence at the expense of globalization. Key cyclical indicators are on the verge of breaking out. Our “China Play Index,” which consists of the Australian dollar, Swedish equities, Brazilian equities, and iron ore prices, is reviving smartly. The copper-to-gold ratio, however, is not really confirming the rally (Chart 1). Nor are Asian currencies. We recommend a tactically defensive stance. We are not dogmatic, but are not convinced that the rally will overcome near-term risks. We expect explosive political and geopolitical events throughout the summer. Near-Term Geopolitical Risks To The Rally Our reasons for near-term caution are as follows: Global stimulus hiccups: China’s National People’s Congress over the weekend disappointed expectations on the size of economic stimulus. This is a short-term risk, we argue below, but nevertheless a risk. The US Congress may not pass stimulus until July 2 and the final law will fall short of the House bill of $3 trillion. The European “Next Generation EU” recovery fund is only 750 billion euros in size and may not be agreed until July, or even September if the financial market does not impose urgency. We elaborate below. Ultimately policymakers will keep doing “whatever it takes” but there will be hiccups first and they will trouble the market in the near term (Chart 2). Chart 2Stimulus Tsunami Will Peak This Summer Spheres Of Influence (GeoRisk Update) Spheres Of Influence (GeoRisk Update) Sino-American conflict: The “phase one” trade deal was never going to bring durable comfort to markets about US-China cooperation, and the outbreak of COVID-19 prompted our March 13 argument that US-China tensions would erupt sooner than we thought. So far the market is grinding higher despite the materialization of this risk. Mega-stimulus and the equity rally enable the US and China to clash. At some point escalation will upset the market. Domestic stimulus is substituting for a collapse in globalization and risk markets are cheering. But increased domestic support will enable political leaders to clash with each other and keep upping the ante. The higher the market goes the more willing President Trump will be to expend some ammunition on China and other political targets. But if you play with sticks, somebody always gets hurt. The market is betting that Trump is a typical US president, typically bashing China in an election year. We are arguing that he is atypical, that this is an atypical election year, and that China’s own ambition cannot be left out of the equation. Wild cards: Jokers, one-eyed jacks, suicidal kings, and aces are all wild in this deck. Emerging markets like Russia (Chart 3) – and rogue regimes like Iran – pose non-negligible risks of upsetting the global rebound this year. Chart 3ARussian Risk To Rise Further On Libya, US Tensions Russian Risk To Rise Further On Libya, US Tensions Russian Risk To Rise Further On Libya, US Tensions Chart 3BRussian Risk To Rise Further On Libya, US Tensions Russian Risk To Rise Further On Libya, US Tensions Russian Risk To Rise Further On Libya, US Tensions   Chart 4Equity Investors Wise To Erdogan's Mischief Equity Investors Wise To Erdogan's Mischief Equity Investors Wise To Erdogan's Mischief Investors cannot focus on tail risks all the time, but not all geopolitical risks are tail risks. This is particularly the case because of the US election, which heightens Washington’s willingness to retaliate to any provocations. Geopolitics in the Mediterranean are verifiably unstable, particularly in Libya where Russia looks to make a major intervention yet Turkey is also involved (Chart 4). This affects North African and European security. Iran is under historic stress and will attempt to undermine the Trump administration as it has no downside to Democratic victory in November. In a recent event we hosted with the CFA Institute in India and Asia Pacific, only 4% of participants highlighted Russia and 2% Iran as a significant source of political risk this year, while 93% highlighted the US and China. Clearly the US-China competition is the great game. But other risks are underrated, especially Russia. Stimulus hiccups this summer are likely to be overcome in the US, EU, and China, so perhaps the market will look through this risk while economies reopen and leading indicators inevitably improve. US-China tensions could remain bound within Trump’s desire to keep the stock market up during his election campaign and China’s desire not to incur Trump’s unmitigated wrath if he happens to be reelected. Russian, Iranian, and emerging market risks, if they materialize, may have merely localized and ephemeral market effects. However, Trump’s falling approval rating and executive decree to open the social media companies to litigation supports our thesis that he is not enslaved by the stock market. The market is expecting “the Art of the Deal” to lead to positive outcomes but that assumption is not as reliable in a recessionary context as it is in an economic boom. The Atlanta Fed’s second quarter real GDP growth estimate stands at -40.4%. Any state that provokes the US over the next five months risks a massive or unpredictable retaliation. China will ultimately bring stimulus to 15.5% of GDP. Deflation and unemployment are a massive constraint. We do not mention the well-known risks of weak consumer activity and business investment amid the pandemic, which itself is expected to revive in the fall with no guarantee of a vaccine by then. Bottom Line: In the near term, maintain safe haven trades such as long Japanese yen, US Treasuries, and defensive equity sectors. China Stimulus Hiccups Won’t Last, But Will Sow Doubt The most important question in China is the implication of the National People’s Congress with regard to the size of stimulus. After the stimulus blowout of 2015-16, Xi Jinping consolidated power and launched a deleveraging campaign. His administration is determined to keep a lid on systemic risks, especially the money and credit bubble. Chart 5China's Stimulus Faces Doubts But Will Prove Huge In The End China's Stimulus Faces Doubts But Will Prove Huge In The End China's Stimulus Faces Doubts But Will Prove Huge In The End Beijing’s targets for central and local government spending disappointed market observers. In Chart 2 above, we revised Beijing’s fiscal stimulus from 11% of GDP to 4.3% of GDP as a result of lower-than-expected targets for local government special bonds and central government special treasury bonds, as well as a corrected calculation of the fiscal relief for small and-medium-sized enterprises. This 4.3% understates the real size of China’s stimulus because it includes only fiscal elements. Since the Communist Party and state bureaucracy control the banks and many large enterprises, one must also include credit growth – it is a quasi-fiscal factor. Total social financing (total private credit) is usually the biggest element of China’s periodic bouts of stimulus. While Chinese authorities showed restraint in their fiscal measures, they announced that credit growth would “significantly” exceed nominal GDP growth, which has collapsed due to the virus lockdowns. Our Emerging Markets Strategy estimates that credit growth will accelerate to 14% this year, making for an 11.2% of GDP increase in total credit, and a combined fiscal and credit impulse that will reach 15.5% of GDP (Chart 5). The dramatic global economic shock and the hit to China’s labor market ensure that additional stimulus will be applied as needed to plug the output gap. Soaring unemployment is a fundamental risk to social stability and hence to single-party rule. This means that the fiscal impulse will in the end likely exceed 4.3% as new measures are rolled out later this year. It also means that credit growth will surprise to the upside, as the regime loosens the reins on shadow banks as well as state-controlled lenders. Nevertheless, accepting our Emerging Market Strategy’s base case of 15.5% of GDP fiscal and credit impulse, we would note that China’s economy is much larger as a share of the global economy today than it was in previous rounds of stimulus. Thus while the stimulus may be smaller than that in 2008 as a proportion of China’s economy, it is larger as a proportion of the world’s (Table 1). China-linked asset prices, such as industrial metals, will see rising demand over time. Table 1China Fiscal+Credit Impulse Will Be Big Relative To World Spheres Of Influence (GeoRisk Update) Spheres Of Influence (GeoRisk Update) The Xi administration’s preference is not to overstimulate and exacerbate its problems of imbalanced growth, falling productivity, and excessive indebtedness. But its constraint is deflation, unemployment, and social instability. Insufficiently loose policy in the midst of a very deep global recession could prove to be the biggest policy mistake of all time. To refuse to loosen as needed, or to re-tighten policy too soon, would be to make a cruel joke out of the new policy slogan, “the Six Stabilities and Six Guarantees” and jeopardize Xi Jinping’s ability to reconsolidate power ahead of the twentieth National Party Congress in 2022. Rather the constraint will force policymakers to alter any hawkish preferences if growth looks to relapse. Bottom Line: Doubts about the sufficiency of China’s fiscal and monetary stimulus pose a near-term risk to global risk assets since investors face disappointing stimulus promises on the surface, combined with lack of certainty about Beijing’s willingness to increase stimulus going forward. We are confident that Beijing will ultimately do whatever it takes to stabilize employment and try to ensure social stability. But this implies near-term challenges and possibly a market riot prior to resolution. Before then, many market participants, including in China, will believe that the Xi Jinping administration will be hawkish and resistant to re-leveraging. China’s Sphere Of Influence Global geopolitical risk stems from the Xi Jinping regime at least as much as from the Donald Trump regime, as we have long pointed out. The scenario unfolding as we go to press is precisely the one we outlined back in March in which Beijing depreciates its currency to ease its economic woes while President Trump’s approval rating falls due to his own woes, prompting him to retaliate. The CNY-USD exchange rate is largely pricing out the phase one trade deal, which is marked by the peak in renminbi strength in Chart 6. Chart 6Phase One Trade Deal Priced Out Of Renminbi Already Phase One Trade Deal Priced Out Of Renminbi Already Phase One Trade Deal Priced Out Of Renminbi Already Chart 7China's Warning To Trump Could Scrap Trade Deal China's Warning To Trump Could Scrap Trade Deal China's Warning To Trump Could Scrap Trade Deal This depreciation is not merely the effect of market moves – though weakness in global and Asian trade and manufacturing certainly reinforce it. The People’s Bank of China’s fixing rate has been guiding the currency to its lowest point since 2008 amid the spike in US-China tensions over the past month (Chart 7). China says it will adhere to the phase one deal as long as it is mutual. It is buying more soybeans, cotton, pork, and beef from the United States relative to last year. Demand has collapsed. Unless China decides to dictate purchases as a subsidy to keep the agreement alive, its purchases will fall short of the huge expansion envisioned in the deal. US actions could nullify the deal anyway. President Trump and his Economic Director Larry Kudlow have both suggested that the administration no longer cares about maintaining the deal. China was fast becoming unpopular in the US and this trend has skyrocketed as a result of COVID-19. China’s other notable decision at the National People’s Congress was to state that it would impose a new national security law on Hong Kong SAR, after the autonomous financial center’s long reluctance to do so. Beijing has sought greater direct control of the city since early in Xi’s term, in contravention of the promise of 50 years of substantial autonomy enshrined in the Sino-British Joint Declaration of 1984. Beijing’s action comes after Hong Kong’s widespread civil unrest last year and ahead of the city’s Legislative Council elections in September, which will likely become a major geopolitical flashpoint. The United States is retaliating by removing Hong Kong’s designation as an autonomous region. This entails higher tariffs, tougher export controls, stricter visa requirements, and likely sanctions directed at mainland entities that will enforce the national security law in various ways, including eventually some Chinese banks. The US also accelerated sanctions against China for its civil rights abuses in Xinjiang – sanctions that target tech and security companies – and is moving forward with a bill to threaten Chinese companies that hold American Depository Receipts (ADRs) with delisting from American stock exchanges if they do not meet the same auditing requirements as other foreign companies. This potentially affects $1.8 trillion in market capitalization over a 3-4 year period. China’s power grab in Hong Kong initiates a market-negative Sino-American dynamic that will last all year. It cannot be assumed that Trump will accept Beijing’s implicit offer of swapping phase one trade deal implementation for China’s historic encroachment on Hong Kong’s autonomy. The imposition of legislative dependency on Hong Kong should not have been a surprise to investors given recent trends, but it was, as Hong Kong equities fell by 6% at first blush. There is more downside, judging by our China GeoRisk Indicator, which is in a clear uptrend for all of these reasons and correlates reasonably well with the Hang Seng index (Chart 8). Chart 8Hong Kong Equities Face More Downside From Geopolitics Hong Kong Equities Face More Downside From Geopolitics Hong Kong Equities Face More Downside From Geopolitics While the US will retaliate over Hong Kong, the question for global investors is whether the conflict spills over into the rest of China’s periphery. This would highlight the systemic nature of the geopolitical risk and make it harder for the market to swallow the new cold war. Our Taiwan Strait GeoRisk Indicator (Chart 9) is pricing zero political risk despite the clear risk that Beijing will eventually resort to economic sanctions to penalize the mainland-skeptic government there; that the US will seek to shore up the diplomatic and defense relationship in significant ways in what may be the final five months of the Trump administration; and that Taiwan may seek to draw the US into granting greater economic and security assurances. Chart 9Taiwan Equities Pricing ZERO Geopolitical Risk ... Huge Mispricing Taiwan Equities Pricing ZERO Geopolitical Risk ... Huge Mispricing Taiwan Equities Pricing ZERO Geopolitical Risk ... Huge Mispricing Our Korea GeoRisk Indicator (Chart 10) has also fallen drastically. This risk indicator deviates from Korean equities frequently due to North Korean risks, which equity investors tend (usually correctly) to ignore. This year is different, however, because Kim Jong Un’s decision whether to give Trump a diplomatic win, or frustrate him with the test of a nuclear device or intercontinental ballistic missile, actually has a bearing on Trump’s election odds and the pace of US-China escalation. If Kim humiliates Trump then we expect Trump to make a major show of force in the region that would draw China into a strategic standoff. Chart 10North Korea Is Relevant In 2020 Due To Trump North Korea Is Relevant In 2020 Due To Trump North Korea Is Relevant In 2020 Due To Trump China is attempting to solidify its sphere of influence, first in Hong Kong but later in Taiwan and the Korean peninsula. The United States is pushing back and the US election cycle combined with massive stimulus means that push will come to shove. Bottom Line: Investors should steer clear of Chinese, Taiwanese, and Korean currencies and risk assets in the near term. We recommend playing the cyclical China recovery via Korean equities over the long run. The European Sphere Of Influence The European Union is also attempting to strengthen and expand its sphere of influence – namely with steps in the direction of a fiscal union. Our GeoRisk Indicators are generally flagging a huge drop in political risk for Germany, France, Italy, and Spain (Charts 11A & 11B). The reason is that the economies have collapsed yet the equity market has bounded back on ECB quantitative easing and huge promises of fiscal support. In the coming months these risk indicators will rise even as economies reopen because the debate over fiscal and monetary policies is heating up. Our base case is that both the debate over EU recovery funds and the German constitutional court’s objections to QE will resolve in dovish compromises. Chart 11AEurope’s Not-Quite Hamiltonian Moment Europe's Not-Quite Hamiltonian Moment Europe's Not-Quite Hamiltonian Moment Chart 11BEurope’s Not-Quite Hamiltonian Moment Europe's Not-Quite Hamiltonian Moment Europe's Not-Quite Hamiltonian Moment At issue on the fiscal front is the EU Commission’s “Next Generation EU” recovery fund. Commission President Ursula von der Leyen is offering to create a 750 billion euro relief fund (500 billion in grants, 250 billion in loans). The decision is contentious because it would entail the EU Commission issuing bonds – essentially joint bonds among the EU states – to raise funds that would then be distributed through the EU Commission seven-year budget (2021-7). Joint issuance would be a symbolic step toward greater solidarity. This proposal began with an agreement between French President Emmanuel Macron and German Chancellor Angela Merkel to launch the 500 billion in grants. Merkel signaled earlier this year that she was prepared to accept joint bond issuance focused on the immediate crisis. When more fiscally hawkish or euroskeptic states objected that loans should be used instead of grants, von der Leyen simply added their proposal to the total, despite the fact that the ECB and European Stability Mechanism (ESM) already offer emergency loans to help states through the global crisis. The proposal marks a victory of the fiscally dovish Mediterranean states (once called “Club Med”) over the frugal Germans, with Macron prevailing on Merkel to foist yet another major compromise onto her conservative German power base in the name of European integration and solidarity before she exits the chancellorship in 2021. But it is not as if German elites like Merkel and von der Leyen are running amok: German public opinion is Europhile and supportive of bolder actions to share burdens, save the union, and shore up the continental economy. The market is not pricing any political risk in Taiwan despite clear dangers. Stay short Taiwanese equities. The recovery fund itself is limited in size, relative to overall stimulus actions thus far. But it would plug an important gap for states like Italy and Spain, which are constrained by large public debt loads and have not provided enough stimulus as yet. The “Frugal Four,” the Netherlands, Austria, Sweden, and Denmark, are leading the opposition to the use of grants rather than loans and any effort to establish a track leading to European fiscal union. But they are also willing to negotiate. Estonia and other nations are also objecting, with the eastern Europeans seeking to ensure that southern Europe does not take the lion’s share of the funds, while the core European states will use the funds to pressure populist and euroskeptic eastern states that have defied the European Court of Justice and other institutions (Chart 12). Chart 12Europe: Distribution Of ‘NextGen EU’ Fund Spheres Of Influence (GeoRisk Update) Spheres Of Influence (GeoRisk Update) A final decision may not be settled by the time of a special summit in July but some compromise should be expected by the fall or (latest) end of year. The proposal would do the very thing that its opponents resist: pave the way toward jointly issued bonds in future that do not have a time limit or a single purpose (today’s sole purpose being pandemic relief). Hence the negotiations will be intense and it will likely require a return of financial instability to bring them to a conclusion. The global financial crisis and its aftermath provoked a higher degree of integration among the EU member states despite the tendency of the mainstream media to assume that the dissonance between monetary and fiscal policy would create an unbridgeable rupture. COVID-19 is now supporting this pattern of Brussels not letting a good crisis go to waste. Chart 13Europe Fends Off Latest Doubts About Solidarity Europe Fends Off Latest Doubts About Solidarity Europe Fends Off Latest Doubts About Solidarity The reason is that the EU is a geopolitical project. As Russia revived, the US began to act unilaterally and unpredictably, and China emerged as a global heavyweight, European powers were forced to huddle together ever more tightly to create economies of scale and improve their security against various external and unconventional threats. Influential German Finance Minister Olaf Scholz has compared the new recovery fund to the work of American founding father Alexander Hamilton in mutualizing the early American states’ war debt so as to create a tighter fiscal union among the states. For that very reason the more Euroskeptic member states oppose the proposal – long rejecting the idea of a “United States of Europe.” Today’s proposals are more symbolic, less substantial, than Hamilton’s famous Compromise of 1790. Nevertheless we would not underrate them as they highlight the way the European states continually turn crisis moments that worry the markets about European break-up into new opportunities to combine more closely. As such it is fitting that the European break-up risk premium has fallen, signifying a drop in peripheral bond spreads (Chart 13). The battle over debt mutualization is not over yet so spreads could widen again, but the trend will be down as the bloc develops new tools to combat the latest crisis. The United Kingdom obviously marks a major exception to this reinforcement of the European sphere of influence. The Brits are historically and geopolitically opposed to a unified continental political power. Having decided to leave, they lack the ability to obstruct from within. But they are also not necessarily more likely to yield in their trade negotiations. British political risks are understandably low because Prime Minister Boris Johnson and his Conservative Party won a strong mandate in December and technically do not have to face voters again until 2024. The major limitation on a “no trade deal” outcome in talks with Brussels was a recession – yet that has already occurred. London could ultimately bite the bullet and accept that outcome if the trade talks turn acrimonious. The GBP/EUR is not pricing a full “no deal” exit. Stimulus and economic recovery suggest that it is a good time to go long sterling but we will pass on this trade in the short run due to resilient dollar strength and the reduced barrier to exiting without a trade deal (Charts 14A & 14B). Chart 14ABrexit Trade Talks Not Globally Relevant Brexit Trade Talks Not Globally Relevant Brexit Trade Talks Not Globally Relevant Chart 14BBrexit Trade Talks Not Globally Relevant Brexit Trade Talks Not Globally Relevant Brexit Trade Talks Not Globally Relevant Bottom Line: We do not yet recommend reinstituting our long EUR/USD trade, which we initiated late last year as part of our annual forecast. The COVID-19 crisis has created such a spike in geopolitical and political risk that we expect the US dollar to remain surprisingly strong throughout the coming months and for US equities to outperform global equities beyond expectation. Nevertheless we will look to reinitiate this long-term trade at an appropriate time, as it fits squarely with our “European Integration” theme since 2012. Investment Takeaways Our contention that “geopolitics is the next shoe to drop” has materialized. This has negative near-term implications for global risk assets. However, thus far, market positives have outweighed negatives for global investors faced with the reopening of economies and wartime-magnitude fiscal and monetary stimulus. Buying risky assets makes sense for investors with a long-term investment horizon – and we recommend cyclical plays like commodities, corporate bonds, infrastructure stocks, and defense stocks in our strategic portfolio. We also recognize that if key cyclical and reflation indicators break out from here, then a cyclical bull market could take shape. Yet our analytical framework reveals that recession and mega-stimulus have diminished the financial and economic constraints that would normally deter geopolitical actors from ambitious actions on the international stage. Most notably, the US election dynamic has turned upside-down. President Trump is the underdog and will need to develop a reelection bid that does not hinge on the economy. Doubling down on “America First” foreign policy and trade policy makes the most sense and the ramifications are negative for the markets over the next five months. This is the key dynamic that makes US-China, US-North Korea, US-Russia, and US-Iran tensions more market-relevant than they would otherwise be. It also will dampen an otherwise positive story for the euro, in the short run.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Section II: Appendix : GeoRisk Indicator China: China: GeoRisk Indicator China: GeoRisk Indicator Russia: Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK: UK: GeoRisk Indicator UK: GeoRisk Indicator Germany: Germany: GeoRisk Indicator Germany: GeoRisk Indicator France: France: GeoRisk Indicator France: GeoRisk Indicator Italy: Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada: Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain: Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan: Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea: Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey: Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil: Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar