Regulation

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary China’s Property Bust To Dwarf Japan’s China Geopolitical Outlook 2022 China Geopolitical Outlook 2022 China’s confluence of internal and external risks will continue to weigh on markets in 2022. Internally China’s property sector turmoil is one important indication of a challenging economic transition. The Xi administration will clinch another term but sociopolitical risks are underrated. Externally China faces economic and strategic pressure from the US and its allies. The US is distracted with other issues in 2022 but US-China confrontation will revive beyond that. China will strengthen relations with Russia and Iran, though it will not encourage belligerence. It needs their help to execute its Eurasian strategy to bypass US naval dominance and improve its supply security over the long run. China will ease monetary and fiscal policies in 2022 but it has no interest in a massive stimulus. Policy easing will be frontloaded in the first half of the year. Featured Trade: Strategically stay short the renminbi versus an equal-weighted basket of the dollar and the euro. Stay short TWD-USD as well. Recommendation INCEPTION Date Return SHORT TWD / USD 2020-06-11 0.5% SHORT CNY / EQUAL-WEIGHTED BASKET OF EURO AND USD 2021-06-21 -3.9% Bottom Line: Beijing is easing policy to secure the post-pandemic recovery, which is positive for global growth and cyclical financial assets. But structural headwinds will still weigh on Chinese assets in 2022. China’s Historic Confluence Of Risks Global investors continue to clash over China’s outlook. Ray Dalio, founder of Bridgewater Associates, recently praised China’s “Common Prosperity” plan and argued that the US and “a lot of other countries” need to launch similar campaigns of wealth redistribution. He warned about the US’s 2024 elections and dismissed accusations of human rights abuses by saying that China’s government is a “strict parent.”1 By contrast George Soros, founder of the Open Society Foundations, recently warned against investing in China’s autocratic government and troubled property market. He predicted that General Secretary Xi Jinping would fail to secure another ten years in power in the Communist Party’s upcoming political reshuffle.2 Geopolitics can bring perspective to the debate: China is experiencing a historic confluence of internal (political) and external (geopolitical) risk, unlike anything since its reform era began in 1979. At home it is struggling with the Covid-19 pandemic and a difficult economic transition that began with the Great Recession of 2008-09. Abroad it faces rising supply insecurity and an increase in strategic pressure from the United States and its allies. The implication is that the 2020s will be an even rockier decade than the 2010s. In the face of these risks the Chinese Communist Party is using the power of the state to increase support for the economy and then repress any other sources of instability. Strict “zero Covid” policies will be maintained for political reasons as much as public health reasons. Arbitrary punitive measures will put pressure on the business elite and foreigners. The geopolitical outlook is negative over the long run but it will not worsen dramatically in 2022 given America’s preoccupation with Russia, Iran, and midterm elections. Bottom Line: Global investor sentiment toward China will remain pessimistic for most of the year – but it will turn more optimistic toward foreign markets, especially emerging markets, that sell into China. China’s Internal Risks Chart 1China's Demographic Cliff China's Demographic Cliff China's Demographic Cliff By the end of 2021, China accounted for 17.7% of global economic output and 12.1% of global imports. However, the secular slowdown in economic growth threatens to generate opposition to the single-party regime, forcing the Communist Party to seek a new base of political legitimacy. Most countries saw a drop in fertility rates in the third quarter of the twentieth century but China’s “one child policy” created a demographic cliff (Chart 1). At first this generated savings needed for national development. But now it leaves China with excess capacity and insufficient household demand. Across the region, falling fertility rates have led to falling potential growth and falling rates of inflation. Excess savings increased production relative to consumption and drove down the rate of interest. The shift toward debt monetization in the US and Japan, in the post-pandemic context, is now threatening this trend with a spike in inflation. China is also monetizing debt after a decade of deflationary fears. But it remains to be seen whether inflation is sustainable when fertility remains below the replacement rate over the long run, as is projected for China as well as its neighbors (Chart 2). China’s domestic situation is fundamentally deflationary as a result of chronic over-investment over the past 40 years. China’s gross fixed capital formation stands at 43% of GDP, well above the historic trend of other major countries for the past 30 years (Chart 3). Chart 2Will Inflation Decouple From Falling Fertility? Will Inflation Decouple From Falling Fertility? Will Inflation Decouple From Falling Fertility? ​​​​​​ Chart 3Over-Investment Is Deflationary, Not Inflationary China Geopolitical Outlook 2022 China Geopolitical Outlook 2022 Like other countries, China financed this buildup of fixed capital by means of debt, especially state-owned corporate debt. While building a vast infrastructure network and property sector, it also built a vast speculative bubble as investors lacked investment options outside of real estate. The growth in property prices has tracked the growth in private non-financial sector debt. The downside is that if property prices fall, debt holders will begin a long and painful process of deleveraging, just like Japan in the 1990s and 2000s. Japan only managed to reverse the drop in corporate investment in the 2010s via debt monetization (Chart 4). Chart 4Japan’s Property Bust Coincided With Debt Deleveraging China Geopolitical Outlook 2022 China Geopolitical Outlook 2022 ​​​​​​ Chart 5China's Debt Growth Halts China's Debt Growth Halts China's Debt Growth Halts Looking at the different measures of Chinese debt, it is likely that deleveraging has begun. Total debt, public and private, peaked and rolled over in 2020 at 290% of GDP. Corporate debt has peaked twice, in 2015 and again in 2020 at around 160% of GDP. Even households are taking on less debt, having gone on a binge over the past decade (Chart 5). In short China is following the Japanese and East Asian growth model: the stark drop in fertility and rise in savings created a huge manufacturing workshop and a highly valued property sector, albeit at the cost of enormous private and considerable public debt. If the private sector’s psychology continues to shift in favor of deleveraging, then the government will be forced to take on greater expenses and fund them through public borrowing to sustain aggregate demand, maximum employment, and social stability. The central bank will be forced to keep rates low to prevent interest rates from rising and stunting growth. China’s policymakers are stuck between a rock and a hard place. New regulations aimed at controlling the property bubble (the “three red lines”) precipitated distress across the sector, emblematized by the failure of the world’s most indebted property developer, Evergrande. Other property developers are looking to raise cash and stay solvent. Property prices peaked in 2015-16 and are now dropping, with third-tier cities on the verge of deflation (Chart 6). Chart 6China's Property Crisis Weighs On Construction China's Property Crisis Weighs On Construction China's Property Crisis Weighs On Construction As the property bubble tops out, Chinese policymakers are looking for new sources of productivity and growth. Chart 7Productivity In Decline China Geopolitical Outlook 2022 China Geopolitical Outlook 2022 ​​​​​​ Productivity growth is subsiding after the export and property boom earlier in the decade, in keeping with that of other Asian economies. And sporadic initiatives to improve governance, market pricing, science, and technology have not succeeded in lifting total factor productivity (Chart 7). The initial goal of the Xi administration’s reforms, to rebalance the economy away from manufacturing toward services, has stumbled and will continue to face headwinds from the financial and real estate sectors that powered much of the recent growth in services (Chart 8). Chart 8China’s Structural Transition Falters China Geopolitical Outlook 2022 China Geopolitical Outlook 2022 Indeed the Communist Party is rediscovering the value of export-manufacturing in the wake of the pandemic, which led to a surge in durable goods orders as global consumers cut back on services and businesses initiated a new cycle of capital expenditures (Chart 9). The party encouraged the workforce to shift out of manufacturing over the past decade but is now rethinking that strategy in the face of the politically disruptive consequences of deindustrialization in the US and UK – such that the state can be expected to recommit to supporting manufacturing going forward (Chart 10). Policymakers are emphasizing economic self-sufficiency and “dual circulation” (import substitution) as solutions to the latent socioeconomic and political threat posed by disillusioned former manufacturing workers. Chart 9China Turns Back To Exports China Turns Back To Exports China Turns Back To Exports ​​​​​​ Chart 10De-Industrialization Will Be Halted De-Industrialization Will Be Halted De-Industrialization Will Be Halted Even beyond ex-manufacturing workers, the country’s economic transition risks generating social instability. The middle class, defined as those who consume from $10 to $50 per day in purchasing power parity terms, now stands at 55% of total population, comparable to where it stood when populist and anti-populist political transformations occurred in Turkey, Thailand, and Brazil (Chart 11). China’s middle class may not be willing or able to intervene into the political process, but the government is still concerned about the long-term potential for discontent. Otherwise it would not have launched anti-corruption, anti-pollution, and anti-industrial measures in recent years. These measures vary in effectiveness but they all share the intention to boost the government’s legitimacy through social improvements and thus fall in line with the new mantra of “common prosperity.” For decades the ruling party claimed that the “principle contradiction” in society arose from a failure to meet the people’s “material needs,” but beginning in 2021 it emphasized that the principle contradiction is the people’s need for a “better life.” Real wages continue to grow but the pace of growth has downshifted from previous decades. The bigger problem is the stark rise in inequality, here proxied by skyrocketing housing prices. Hong Kong’s inequality erupted into social unrest in recent years even though it has a much higher level of GDP per capita than mainland China (Chart 12). In major cities on the mainland, housing prices have outpaced disposable income over the past two decades. Youth unemployment also concerns the authorities. Chart 11Social Instability A Genuine Risk China Geopolitical Outlook 2022 China Geopolitical Outlook 2022 Bottom Line: The Chinese regime faces historic social and political challenges as a result of a difficult structural economic transition. The ongoing emphasis on “common prosperity” reveals the regime’s fear of social instability. The underlying tendency is deflationary, though Beijing’s use of debt monetization introduces a long-term inflationary risk that should be monitored. Chart 12Causes Of Hong Kong Unrest Also Present In China Causes Of Hong Kong Unrest Also Present In China Causes Of Hong Kong Unrest Also Present In China ​​​​​​ China’s External Risks Geopolitically speaking, China’s greatest challenge throughout history has been maintaining domestic stability. Because China is hemmed in by islands that superior foreign powers have often used as naval bases, it is isolated as if it is a landlocked state. A stark north-south division within its internal geography and society creates inherent political tension, while buffer regions are difficult to control. Hence foreign powers can meddle with internal affairs, undermine unity and territorial integrity, and exploit China’s large labor force and market. However, in the twenty-first century China has the potential to project power outward – as long as it can maintain internal stability. Power projection is increasingly necessary because China’s economy increasingly depends on imports of energy, leaving it vulnerable to western maritime powers (Chart 13). Beijing’s conversion of economic into military might has also created frictions with neighbors and aroused the antagonism of the United States, which increasingly seeks to maintain the strategic anchor in the western Pacific that it won in World War II. Chart 13Import Dependency A Strategic Security Threat Import Dependency A Strategic Security Threat Import Dependency A Strategic Security Threat As China’s influence expands into East Asia and the rest of Asia, conflicts with the US and its allies are increasingly likely, especially over critical sea lines of communication, including the Taiwan Strait. China’s reinforcement of its manufacturing prowess will also provoke the United States, while the US’s erratic attempts to retain its strategic position in Asia Pacific will threaten to contain China. Yet the US cannot concentrate exclusively on countering China – it is distracted by internal politics and confrontations with Russia and Iran, especially in 2022. China will strengthen relations with Russia and Iran. As an energy importer, China would prefer that neither Russia nor Iran take belligerent actions that cause a global energy shock. But both Moscow and Tehran are essential to China’s Eurasian strategy of bypassing American naval dominance to reduce its supply insecurity. And yet, in 2022 specifically, the US and China are both concerned about maintaining positive domestic political dynamics due to the midterm elections and twentieth national party congress. This includes a desire to reduce inflation. Hence both would prefer diplomacy over trade war, with regard to each other, and over real war, with regard to Ukraine and Iran. So there is a temporary overlap in interests that will discourage immediate confrontation. China might offer limited cooperation on Iranian or North Korean nuclear and missile talks. But the same domestic political dynamics prevent a significant improvement in US-China relations, as neither side will grant trade concessions in 2022, and the underlying strategic tensions will revive over the medium and long run. Bottom Line: China faces historic external risks stemming from import dependency and conflict with the United States. In the short run, the US conflicts with Russia and Iran might lead to energy shocks that harm China’s economy. Japan never recovered its rapid growth rates after the 1973 Arab oil embargo. In the long run, while Washington has little interest in fighting a war with China, its strategic competition will focus on galvanizing allies to penalize China’s economy and to substitute away from China, in favor of India and ASEAN. China’s Macro Policy In 2022: Going “All In” For Stability In last year’s China Geopolitical Outlook, we maintained our underweight position on Chinese equities and warned that Beijing’s policy tightening posed a significant risk to global cyclical assets – and yet we concluded that policymakers would avoid overtightening policy to the extent of spoiling the global recovery. This view prevailed over the course of 2021. Policymakers tightened monetary and fiscal policy in the first half of the year, then started loosening up in the summer. Chinese equities crashed but global equities powered through the year. In December 2020, at the Central Economic Work Conference, policymakers stated that China would “maintain necessary policy support for economic recovery and avoid sharp turns in policy” in 2021. In the event they did the minimal necessary, though they did avoid sharp turns. For 2022, the key word is “stability.” At the Central Economic Work Conference last month, the final communique mentioned “stability” or “stabilize” 25 times (Table 1). Hence the main objective of Chinese policymakers this year is to prioritize both economic and social stability ahead of the twentieth national party congress. Authorities will avoid last year’s tight policies. Table 1Key Chinese Policy Guidance 2021-22 China Geopolitical Outlook 2022 China Geopolitical Outlook 2022 China’s quarterly GDP growth slipped to just 4% in Q4 2021, from rapid recovery growth of 18.3% in Q1 2021. Considering the low base effect of 2020, the average growth of 2020 and 2021 ranged from 5-5.5% (Chart 14). This growth rate is in line with the pre-pandemic trajectory of 2015-2019. In Jan 2022, the IMF cut China’s 2022 growth forecast to 4.8%, while the World Bank lowered its forecasts to 5.1%. Considering the two-year average growth and government’s goal of “all in for stability,” we see an implicit GDP target of 5-5.5%. Chart 14Breakdown Of China’s GDP Growth China Geopolitical Outlook 2022 China Geopolitical Outlook 2022 Does this target matter? Although China stopped announcing explicit GDP growth targets, understanding the implicit target helps investors predict the turning point in macro policy. Due to robust global demand, net exports are now making a sizable contribution to GDP growth. However, due to the high base effect of 2021, there is limited room for exports to grow in 2022. Hence economic growth has to rely on final consumption expenditure and gross capital formation. Yet as a result of policy tightening, gross capital formation’s contribution to GDP has decreased significantly, from positive in H1 2021 to a rare negative contribution to GDP in the second half. At the same time, the contribution from final consumption expenditure also slipped over the course of 2021, due to worsening Covid conditions, one of the three pressures stated by the government. What does that mean? It means that loosening up macro policies is the pre-condition for stabilizing growth and the economy. Just like the officials said (see Table 1), the Chinese economy is “facing triple pressure from demand contraction, supply shocks, and weakening expectations,” so that “all sides need to take the initiative and launch policies conducive to economic stability.” Bottom Line: It is reasonable to expect accommodative fiscal and monetary policies in 2022, at least until the party congress ends. In fact, authorities have already started to make these adjustments since Q4 2021. China Avoids Monetary Overtightening Credit growth can be seen as an indicator for gross capital formation. In the second half of 2021, China’s total social financing (total private credit) growth plunged below 12% (Chart 15), the threshold we identified for determining whether authorities overtightened policy. Correspondingly, gross capital formation’s contribution to GDP dropped into the negative zone (see Chart 14 above). However, money growth did not dip below the threshold, and authorities are now trying to boost credit growth. Starting from December 2021, the market has seen marginally positive news out of the People’s Bank of China: December 15, 2021: The PBOC conducted its second reserve requirement ratio (RRR) cut in 2021. The 50 bps cut was expected to release $188 billion in liquidity to support the real economy. December 20, 2021: The PBOC conducted its first interest rate cut since April 2020 by cutting 1-Year LPR by 5 bps on December 20 (Chart 16). Chart 15China's Money And Credit Growth Hits Pain Threshold China's Money And Credit Growth Hits Pain Threshold China's Money And Credit Growth Hits Pain Threshold ​​​​​​ Chart 16China Monetary Policy Easing China Monetary Policy Easing China Monetary Policy Easing ​​​​​​ January 17, 2022: The PBOC cut the interest rate on medium-term lending facility (MLF) loans and 7-day reverse repurchase (repos) rate both by 10 bps. January 20, 2022: The PBOC further lowered the 1-year LPR by 10 basis points and cut the 5-year LPR by 5 basis points, the first cut since April 2020. Chart 17China Policy Easing Will Boost Import Volumes China Policy Easing Will Boost Import Volumes China Policy Easing Will Boost Import Volumes The timing and size of the last two rate cuts came as a surprise to the market, signaling more comprehensive easing than was expected (confirming our expectations).3 The market saw a clear turning point: Chinese authorities are now fully aware of the need to loosen up monetary policy to counter intensifying downward pressure on the economy. Incidentally, the fine-tuning of the different lending facilities suggests the government aims to lower borrowing costs and stimulate the market without over-heating the property sector again. PBOC officials claim there is still some space for further cuts, though narrower now, when asked about if there is any room to further cut the RRR and interest rates in Q1. They added that the PBOC should “stay ahead of the market curve” and “not procrastinate.”4 Recent movements have validated this point. Going forward, M2 growth should stay above 8%. Total social financing growth should move up above our “too tight” threshold, although weak sentiment among private borrowers could force authorities to ease further to ensure that credit growth picks up. If the government is still committed to fighting housing speculation, as before, then we could see a smaller adjustment to the 5-Year LPR in the future. Otherwise the government is taking its foot off the brake for stability reasons, at least temporarily. Bottom Line: China will keep easing monetary policy in 2022, at least in the first half. This will result in an improvement in Chinese import volumes and ultimately emerging market corporate earnings, albeit with a six-to-12-month lag (Chart 17). China Avoids Fiscal Overtightening China will also avoid over-tightening fiscal policy in 2022. In December the government stressed the need to “maintain the intensity of fiscal spending, accelerate the pace, and moderately advance infrastructure investment.” In 2021, local government bond issuance did not pick up until the second half of the year. Considering the time lag of construction projects, it was too late for local government investment to stimulate the economy. By Q3 2021, local government bond issuance had just completed roughly 70% of the annual quota. By comparison, in 2018-2020, local governments all completed more than 95% of the annual quota by the end of September each year (Chart 18A). Chart 18AChina: No Pause In Local Bond Issuance In H1 2022 China Geopolitical Outlook 2022 China Geopolitical Outlook 2022 ​​​​​ Chart 18BChina: No Pause In Local Bond Issuance In H1 2022 China Geopolitical Outlook 2022 China Geopolitical Outlook 2022 ​​​​​​ There are several reasons behind the slow pace last year. The central government refused to pre-approve and pre-authorize the quota for bond issuance at the beginning of the year in 2021, in order to restore discipline after the massive 2020 stimulus measures. The quota was not released until after the Two Sessions in March, which means local government bond issuance did not pick up until April 2021, causing a 3-month vacuum in local government fiscal support (see Chart 18B). In contrast, for 2019 and 2020, the central government pre-authorized the bond issuance quota ahead of time to try to provide fiscal support evenly throughout the year. Starting from 2020, the central government strengthened supervision and evaluation of local government investment projects, again to instill discipline. Previously local governments could easily issue general-purpose bonds and the funds were theirs to spend. But now local governments are required to increase the transparency of their investment projects and mainly finance these projects via special-purpose bonds, i.e. targeted money for authorized projects (Table 2). In 2021 local governments were less willing to issue bonds. At the April 2021 Politburo meeting, the central government vowed to “establish a disposal mechanism that will hold local government officials accountable for fiscal and financial risks.” This triggered risk-aversion. Beijing wanted to prevent a growth “splurge” in the wake of its emergency stimulus, like what happened in 2008-11. The fiscal turning point came in the second half of the year. The central government called for accelerating local government bond issuance several times from July to October. The pace significantly picked up in the second half of 2021 and Q4 accounted for a significant portion of annual issuance (Chart 18). As a result, fixed asset investment and fiscal impulse should pick up in Q1 2022. Thus, unlike last year, authorities are trying to avoid a sharp drop in the fiscal impulse. The Ministry of Finance has already frontloaded 1.46 trillion yuan ($229 billion) from the 2022 special purpose bonds quota. This amount is part of the 2022 annual local government bond issuance quota, with the rest to be released at the Two Sessions in March. Pulling these funds forward indicates the rising pressure to stabilize economic growth in Q1 this year. That being said, investors should differentiate easing up fiscal policy and “flood-like” stimulus in the past. The government still claims it will “contain increases in implicit local government debts.” In fact, pilot programs to clean up implicit debts have already started in Shanghai and Guangdong. This means, China will not reverse past efforts on curbing hidden debts. Hence fiscal support will be more tightly controlled in future, like water taps in the hands of the central government. The risk of fiscal tightening is backloaded in 2022. The tremendous amount of local government bonds issued in Q4 2021 will start to kick in early 2022. These will combine with the frontloaded special purposed bonds. Fiscal impulse should tick up in Q1. However, fiscal impulse might decelerate in the second half. A total of $2.7 trillion yuan worth of local government bonds will reach maturity this year, with $2.2 trillion yuan reaching maturity after June 2022 (Table 3). This means that in the second half, local governments will need to issue more re-financing bonds to prevent insolvency risk, thus undermining fiscal support for the economy. And this last point underscores the threat of economic and financial instability that China faces over the long run. Table 2Breakdown Of China Local Government Bond Issuance China Geopolitical Outlook 2022 China Geopolitical Outlook 2022 Bottom Line: Stability is the top priority in 2022. China will continue to easy up monetary and fiscal policy in H1, to combat the economic downward pressure ahead of the twentieth national party congress (Chart 19). Policy tightening risk is backloaded. Structural reforms will likely subside for now until the Xi administration re-consolidates power for the next ten years. Table 3China: Local Government Debt Maturity Schedule China Geopolitical Outlook 2022 China Geopolitical Outlook 2022 ​​​​​​ Chart 19Policy Support Expected For 20th Party Congress Policy Support Expected For 20th Party Congress Policy Support Expected For 20th Party Congress Note: An error in an earlier version of this report has been corrected. Chinese fixed asset investment in Chart 19 is growing at 0.1%, not 57.6% as originally shown. The chart has been adjusted. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Yushu Ma Research Associate yushu.ma@bcaresearch.com Footnotes 1      See Bei Hu and Bloomberg, “Ray Dalio thinks the U.S. needs more of China’s common prosperity drive to create a ‘fairer system,’” Fortune, January 10, 2022, fortune.com. 2     See George Soros, “China’s Challenges,” Project Syndicate, January 31, 2022, project-syndicate.org. 3     The 5-year LPR had remained unchanged after the December 2021 cut. At that time, only the 1-Year LPR was cut by 5bps. Furthermore, the different magnitudes of the January 20 LPR cut also have some implications. The 1-Year LPR mostly affects new and outstanding loans, short-term liquidity loans of firms, and consumer loans of households. In comparison, the 5-Year LPR has a larger impact, affecting the borrowing costs of total social financing, including mortgage loans, medium- to long-term investment loans, etc. The MLF rate was cut by 10 basis points on January 17; in theory the LPR should also be cut by the same size. However, the 5-Year LPR adjustments was very cautious and was only cut by 5 bps, smaller than the MLF cut and the 1-Year LPR cut. The 5-year LPR serves as the benchmark lending rate for mortgage loans. 4     To combat the negative shock caused by the initial outburst of COVID-19, altogether China lowered the MLF and 1-year LPR by 30 bps and 5-year LPR by 15 bps in H1 2020. This also suggests that there is still room for future interest rate cuts or RRR cuts in the coming months. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Highlights Our three strategic themes over the long run: (1) great power rivalry (2) hypo-globalization (3) populism and nationalism. The implications are inflationary over the long run. Nations that gear up for potential conflict and expand the social safety net to appease popular discontent will consume a lot of resources. Our three key views for 2022: (1) China’s reversion to autocracy (2) America’s policy insularity (3) petro-state leverage. The implications are mostly but not entirely inflationary: China will ease policy, the US will pass more stimulus, and energy supply may suffer major disruptions. Stay long gold, neutral US dollar, short renminbi, and short Taiwanese dollar. Stay tactically long global large caps and defensives. Buy aerospace/defense and cyber-security stocks. Go long Japanese and Mexican equities – both are tied to the US in an era of great power rivalry. Feature Chart 1US Resilience US Resilience US Resilience Global investors have not yet found a substitute for the United States. Despite a bout of exuberance around cyclical non-US assets at the beginning of 2021, the year draws to a close with King Dollar rallying, US equities rising to 61% of global equity capitalization, and the US 30-year Treasury yield unfazed by inflation fears (Chart 1). American outperformance is only partly explained by its handling of the lingering Covid-19 pandemic. The US population was clearly less restricted by the virus (Chart 2). But more to the point, the US stimulated its economy by 25% of GDP over the course of the crisis, while the average across major countries was 13% of GDP. Americans are still more eager to go outdoors and the government has been less stringent in preventing them (Chart 3). Chart 2 ​​​​​ Chart 3Social Restrictions Short Of Lockdown Social Restrictions Short Of Lockdown Social Restrictions Short Of Lockdown ​​​​​​ Going forward, the pandemic should decline in relevance, though it is still possible that a vaccine-resistant mutation will arise that is deadlier for younger people, causing a new round of the crisis. The rotation into assets outside the US will be cautious. Across the world, monetary and credit growth peaked and rolled over this year, after the extraordinary effusion of stimulus to offset the social lockdowns of 2020 (Chart 4). Government budget deficits started to normalize while central banks began winding down emergency lending and bond-buying. More widespread and significant policy normalization will get under way in 2022 in the face of high core inflation. Tightening will favor the US dollar, especially if global growth disappoints expectations. Chart 4Waning Monetary And Credit Stimulus Waning Monetary And Credit Stimulus Waning Monetary And Credit Stimulus Chart 5Global Growth Stabilization Global Growth Stabilization Global Growth Stabilization Global manufacturing activity fell off its peak, especially in China, where authorities tightened monetary, fiscal, and regulatory policy aggressively to prevent asset bubbles from blowing up (Chart 5). Now China is easing policy on the margin, which should shore up activity ahead of an important Communist Party reshuffle in fall 2022. The rest of the world’s manufacturing activity is expected to continue expanding in 2022, albeit less rapidly. This trend cuts against US outperformance but still faces a range of hurdles, beginning with China. In this context, we outline three geopolitical themes for the long run as well as three key views for the coming 12 months. Our title, “The Gathering Storm,” refers to the strategic challenge that China and Russia pose to the United States, which is attempting to form a balance-of-power coalition to contain these autocratic rivals. This is the central global geopolitical dynamic in 2022 and it is ultimately inflationary. Three Strategic Themes For The Long Run The international system will remain unstable in the coming years. Global multipolarity – or the existence of multiple, competing poles of political power – is the chief destabilizing factor. This is the first of our three strategic themes that will persist next year and beyond (Table 1). Our key views for 2022, discussed below, flow from these three strategic themes. Table 1Strategic Themes For 2022 And Beyond 2022 Key Views: The Gathering Storm 2022 Key Views: The Gathering Storm 1. Great Power Rivalry Multipolarity – or great power rivalry – can be illustrated by the falling share of US economic clout relative to the rest of the world, including but not limited to strategic rivals like China. The US’s decline is often exaggerated but the picture is clear if one looks at the combined geopolitical influence of the US and its closest allies to that of the EU, China, and Russia (Chart 6). Chart 6 China’s rise is the most destabilizing factor because it comes with economic, military, and technological prowess that could someday rival the US for global supremacy. China’s GDP has surpassed that of the US in purchasing power terms and will do so in nominal terms in around five years (Chart 7). Chart 7 True, China’s potential growth is slowing and Chinese financial instability will be a recurring theme. But that very fact is driving Beijing to try to convert the past 40 years of economic success into broader strategic security. Chart 8America's Global Role Persists (If Lessened) America's Global Role Persists (If Lessened) America's Global Role Persists (If Lessened) ​​​​​ Since China is capable of creating an alternative political order in Asia Pacific, and ultimately globally, the United States is reacting. It is penalizing China’s economy and seeking to refurbish alliances in pursuit of a containment policy. The American reaction to the loss of influence has been unpredictable, contradictory, and occasionally belligerent. New isolationist impulses have emerged among an angry populace in reaction to gratuitous wars abroad and de-industrialization. These impulses appeared in both the Obama and Trump administrations. The Biden administration is attempting to manage these impulses while also reinforcing America’s global role. The pandemic-era stimulus has enabled the US to maintain its massive trade deficit and aggressive defense spending. But US defense spending is declining relative to the US and global economy over time, encouraging rival nations to carve out spheres of influence in their own neighborhoods (Chart 8). Russia’s overall geopolitical power has declined but it punches above its weight in military affairs and energy markets, a fact which is vividly on display in Ukraine as we go to press. The result is to exacerbate differences in the trans-Atlantic alliance between the US and the European Union, particularly Germany. The EU’s attempt to act as an independent great power is another sign of multipolarity, as well as the UK’s decision to distance itself from the continent and strengthen the Anglo-American alliance. If the US and EU do not manage their differences over how to handle Russia, China, and Iran then the trans-Atlantic relationship will weaken and great power rivalry will become even more dangerous. 2. Hypo-Globalization The second strategic theme is hypo-globalization, in which the ancient process of globalization continues but falls short of its twenty-first century potential, given advances in technology and governance that should erode geographic and national boundaries. Hypo-globalization is the opposite of the “hyper-globalization” of the 1990s-2000s, when historic barriers to the free movement of people, goods, and capital seemed to collapse overnight. Chart 9From 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization The volume of global trade relative to industrial production  peaked with the Great Recession in 2008-10 and has declined slowly but surely ever since (Chart 9). Many developed markets suffered the unwinding of private debt bubbles, while emerging economies suffered the unwinding of trade manufacturing. Periods of declining trade intensity – trade relative to global growth – suggest that nations are turning inward, distrustful of interdependency, and that the frictions and costs of trade are rising due to protectionism and mercantilism. Over the past two hundred years globalization intensified when a broad international peace was agreed (such as in 1815) and a leading imperial nation was capable of enforcing law and order on the seas (such as the British empire). Globalization fell back during times of “hegemonic instability,” when the peace settlement decayed while strategic and naval competition eroded the global trading system. Today a similar process is unfolding, with the 1945 peace decaying and the US facing the revival of Russia and China as regional empires capable of denying others access to their coastlines and strategic approaches (Chart 10).1 Chart 10Hypo-Globalization And Hegemonic Instability Hypo-Globalization And Hegemonic Instability Hypo-Globalization And Hegemonic Instability Chart 11Hypo-Globalization: Temporary Trade Rebound Hypo-Globalization: Temporary Trade Rebound Hypo-Globalization: Temporary Trade Rebound No doubt global trade is rebounding amid the stimulus-fueled recovery from Covid-19. But the upside for globalization will be limited by the negative geopolitical environment (Chart 11). Today governments are not behaving as if they will embark on a new era of ever-freer movement and ever-deepening international linkages. They are increasingly fearful of each other’s strategic intentions and using fiscal resources to increase economic self-sufficiency. The result is regionalization rather than globalization. Chinese and Russian attempts to revise the world order, and the US’s attempt to contain them, encourages regionalization. For example, the trade war between the US and China is morphing into a broader competition that limits cooperation to a few select areas, despite a change of administration in the United States. The further consolidation of President Xi Jinping’s strongman rule will exacerbate this dynamic of distrust and economic divorce. Emerging Asia and emerging Europe live on the fault lines of this shift from globalization to regionalism, with various risks and opportunities. Generally we are bullish EM Asia and bearish EM Europe. 3. Populism And Nationalism A third strategic theme consists of populism and nationalism, or anti-establishment political sentiment in general. These forces will flare up in various forms across the world in 2022 and beyond. Even as unemployment declines, the rise in food and fuel inflation will make it difficult for low wage earners to make ends meet. The “misery index,” which combines unemployment and inflation, spiked during the pandemic and today stands at 10.8% in the US and 11.4% in the EMU, up from 5.2% and 8.1% before the pandemic, respectively (Chart 12). Large budget deficits and trade deficits, especially in the US and UK, feed into this inflationary environment. Most of the major developed markets have elected new governments since the pandemic, with the notable exception of France and Spain. Thus they have recapitalized their political systems and allowed voters to vent some frustration. These governments now have some time to try to mitigate inflation before the next election. Hence policy continuity is not immediately in jeopardy, which reduces uncertainty for investors. By contrast, many of the emerging economies face higher inflation, weak growth, and are either coming upon elections or have undemocratic political systems. Either way the result will be a failure to address household grievances promptly. The misery index is trending upward and governments are continually forced to provide larger budget deficits to shore up growth, fanning inflation (Chart 13). Chart 12DM: Political Risk High But New Governments In Place DM: Political Risk High But New Governments In Place DM: Political Risk High But New Governments In Place ​​​​​ Chart 13EM: Political Risk High But Governments Not Recapitalized EM: Political Risk High But Governments Not Recapitalized EM: Political Risk High But Governments Not Recapitalized ​​​​​​ Chart 14EM Populism/Nationalism Threatens Negative Surprises In 2022 EM Populism/Nationalism Threatens Negative Surprises In 2022 EM Populism/Nationalism Threatens Negative Surprises In 2022 Just as social and political unrest erupted after the Great Recession, notably in the so-called “Arab Spring,” so will new movements destabilize various emerging markets in the wake of Covid-19. Regime instability and failure can lead to big changes in policies, large waves of emigration, wars, and other risks that impact markets. The risks are especially high unless and until Chinese imports revive. Investors should be on the lookout for buying opportunities in emerging markets once the bad news is fully priced. National and local elections in Brazil, India, South Korea, the Philippines, and Turkey will serve as market catalysts, with bad news likely to precede good news (Chart 14). Bottom Line: These three themes – great power rivalry, hypo-globalization, and populism/nationalism – are inflationary in theory, though their impact will vary based on specific events. Multipolarity means that governments will boost industrial and defense spending to gear up for international competition. Hypo-globalization means countries will attempt to put growth on a more reliable domestic foundation rather than accept dependency on an unreliable international scene, thus constraining supplies from abroad. Populism and nationalism will lead to a range of unorthodox policies, such as belligerence abroad or extravagant social spending at home. Of course, the inflationary bias of these themes can be upset if they manifest in ways that harm growth and/or inflation expectations, which is possible. But the general drift will be an inflationary policy setting. Inflation may subside in 2022 only to reemerge as a risk later. Three Key Views For 2022 Within this broader context, our three key views for 2022 are as follows: 1. China’s Reversion To Autocracy As President Xi Jinping leads China further down the road of strongman rule and centralization, the country faces a historic confluence of internal and external risks. This was our top view in 2021 and the same dynamic continues in 2022. The difference is that in 2021 the risk was excessive policy tightening whereas this coming year the risk is insufficient policy easing. Chart 15China Eases Fiscal Policy To Secure Recovery In 2022 China Eases Fiscal Policy To Secure Recovery In 2022 China Eases Fiscal Policy To Secure Recovery In 2022 China’s economy is witnessing a secular slowdown, a deterioration in governance, property market turmoil, and a rise in protectionism abroad. The long decline in corporate debt growth points to the structural slowdown. Animal spirits will not improve in 2022 so government spending will be necessary to try to shore up overall growth. The Politburo signaled that it will ease fiscal policy at the Central Economic Work Conference in early December, a vindication of our 2021 view. Neither the combined fiscal-and-credit impulse nor overall activity, indicated by the Li Keqiang Index, have shown the slightest uptick yet (Chart 15). Typically it takes six-to-nine months for policy easing to translate to an improvement in real economic activity. The first half of the year may still bring economic disappointments. But policymakers are adjusting to avoid a crash. Policy will grow increasingly accommodative as necessary in the first half of 2022. The key political constraint is the Communist Party’s all-important political reshuffle, the twentieth national party congress, to be held in fall 2022 (usually October). While Xi may not want the economy to surge in 2022, he cannot afford to let it go bust. The experience of previous party congresses shows that there is often a policy-driven increase in bank loans and fixed investment. Current conditions are so negative as to ensure that the government will provide at least some support, for instance by taking a “moderately proactive approach” to infrastructure investment (Chart 16). Otherwise a collapse of confidence would weaken Xi’s faction and give the opposition faction a chance to shore up its position within the Communist Party. Chart 16China Aims For Stability, Not Rapid Growth, Ahead Of 20th National Party Congress China Aims For Stability, Not Rapid Growth, Ahead Of 20th National Party Congress China Aims For Stability, Not Rapid Growth, Ahead Of 20th National Party Congress Party congresses happen every five years but the ten-year congresses, such as in 2022, are the most important for the country’s overall political leadership. The party congresses in 1992, 2002, and 2012 were instrumental in transferring power from one leader to the next, even though the transfer of power was never formalized. Back in 2017 Xi arranged to stay in power indefinitely but now he needs to clinch the deal, lest any unforeseen threat emerge from at home or abroad. Xi’s success in converting the Communist Party from “consensus rule” to his own “personal rule” will be measurable by his success in stacking the Politburo and Politburo Standing Committee with factional allies. He will also promote his faction across the Central Committee so as to shape the next generations of party leaders and leave his imprint on policy long after his departure. The government will be extremely sensitive to any hint of dissent or resistance and will move aggressively to quash it. Investors should not be surprised to see high-level sackings of public officials or private magnates and a steady stream of scandals and revelations that gain prominence in western media. The environment is also ripe for strange and unexpected incidents that reveal political differences beneath the veneer of unity in China: defections, protests, riots, terrorist acts, or foreign interference. Most incidents will be snuffed out quickly but investors should be wary of “black swans” from China in 2022. Chinese government policies will not be business friendly in 2022 aside from piecemeal fiscal easing. Everything Beijing does will be bent around securing Xi’s supremacy at all levels. Domestic politics will take precedence over economic concerns, especially over the interests of private businesses and foreign investors, as is clear when it comes to managing financial distress in the property sector. Negative regulatory surprises and arbitrary crackdowns on various industrial sectors will continue, though Beijing will do everything in its power to prevent the property bust from triggering contagion across the economic system. This will probably work, though the dam may burst after the party congress. Relations with the US and the West will remain poor, as the democracies cannot afford to endorse what they see as Xi’s power grab, the resurrection of a Maoist cult of personality, and the betrayal of past promises of cooperation and engagement. America’s midterm election politics will not be conducive to any broad thaw in US-China relations. While China will focus on domestic politics, its foreign policy actions will still prove relatively hawkish. Clashes with neighbors may be instigated by China to warn away any interference or by neighbors to try to embarrass Xi Jinping. The South and East China Seas are still ripe for territorial disputes to flare. Border conflicts with India are also possible. Taiwan remains the epicenter of global geopolitical risk. A fourth Taiwan Strait Crisis looms as China increases its military warnings to Taiwan not to attempt anything resembling independence (Chart 17A). China may use saber-rattling, economic sanctions, cyber war, disinformation, and other “gray zone” tactics to undermine the ruling party ahead of Taiwan’s midterm elections in November 2022 and presidential elections in January 2024. A full-scale invasion cannot be ruled out but is unlikely in the short run, as China still has non-military options to try to arrange a change of policy in Taiwan. Chart 17 ​​​​​​ Chart 17BMarket-Based Risk Indicators Say China/Taiwan Risk Has Not Peaked Market-Based Risk Indicators Say China/Taiwan Risk Has Not Peaked Market-Based Risk Indicators Say China/Taiwan Risk Has Not Peaked China has not yet responded to the US’s deployment of a small number of troops in Taiwan or to recent diplomatic overtures or arms sales. It could stage a major show of force against Taiwan to help consolidate power at home. China also has an interest in demonstrating to US allies and partners that their populations and economies will suffer if they side with Washington in any contingency. Given China’s historic confluence of risks, it is too soon for global investors to load up on cheap Chinese equities. Volatility will remain high. Weak animal spirits, limited policy easing, high levels of policy uncertainty, regulatory risk, ongoing trade tensions, and geopolitical risks suggest that investors should remain on the sidelines, and that a large risk premium can persist throughout 2022. Our market-based geopolitical risk indicators for both China and Taiwan are still trending upwards (Chart 17B). Global investors should capitalize on China’s policy easing indirectly by investing in commodities, cyclical equity sectors, and select emerging markets. 2. America’s Policy Insularity Our second view for 2022 centers on the United States, which will focus on domestic politics and will thus react or overreact to the many global challenges it faces. The US faces the first midterm election after the chaotic and contested 2020 presidential election. Political polarization remains at historically high levels, meaning that social unrest could flare up again and major domestic terrorist incidents cannot be ruled out. So far the Biden administration has focused on the domestic scene: mitigating the pandemic and rebooting the economy. Biden’s signature “Build Back Better” bill, $1.75 trillion investment in social programs, has passed the House of Representatives but not the Senate. The spike in inflation has shaken moderate Democratic senators who are now delaying the bill. We expect it to pass, since tax hikes were dropped, but our conviction is low (65% subjective odds), as a single defection would derail the bill. The implication would be inflationary since it would mark a sizable increase in government spending at a time when the output gap is already virtually closed. Spending would likely be much larger than the Congressional Budget Office estimate, shown in Chart 18, because the bill contains various gimmicks and hard-to-implement expiration clauses. Equity markets may not sell if the bill fails, since more fiscal stimulus would put pressure on the Federal Reserve to hike rates faster. Chart 18 Chart 19 Whether the bill passes or fails, Biden’s legislative agenda will be frozen thereafter. He will have to resort to executive powers and foreign policy to lift his approval rating and court the median voter ahead of the midterm elections. Currently Democrats are lined up to lose the House and probably also the Senate, where a single seat would cost them their majority (Chart 19). The Senate is still in play so Biden will be averse to taking big risks. For the same reason, Biden’s foreign policy goal will be to stave off various bubbling crises. Restoring the Iranian nuclear deal was his priority but Russia has now forced its way to the top of the agenda by threatening a partial reinvasion of Ukraine. In this context Biden will not have room for maneuver with China. Congress will be hawkish on China ahead of the midterms, and Xi Jinping will be reviving autocracy, so Biden will not be able to improve relations much. Biden’s domestic policy could fuel inflation, while his domestic-focused foreign policy will embolden strategic rivals, which increases geopolitical risks. 3. Petro-State Leverage A surge in gasoline prices at the pump ahead of the election would be disastrous for a Democratic Party that is already in disarray over inflation (Chart 20). Biden has already demonstrated that he can coordinate an international release of strategic oil reserves this year. Oil and natural gas producers gain leverage when the global economy rebounds, commodity prices rise, and supply/demand balances tighten. The frequency of global conflicts, especially those involving petro-states, tend to rise and fall in line with oil prices (Chart 21). Chart 20Inflation Constrains Biden Ahead Of Midterms Inflation Constrains Biden Ahead Of Midterms Inflation Constrains Biden Ahead Of Midterms Chart 21 Both Russia and Iran are vulnerable to social unrest at home and foreign strategic pressure abroad. Both have long-running conflicts with the US and West that are heating up for fundamental reasons, such as Russia’s fear of western influence in the former Soviet Union and Iran’s nuclear program. Both countries are demanding that the US make strategic concessions to atone for the Trump administration’s aggressive policies: selling lethal weapons to Ukraine and imposing “maximum pressure” sanctions on Iran. Biden is not capable of making credible long-term agreements since he could lose office as soon as 2025 and the next president could reverse whatever he agrees. But he must try to de-escalate these conflicts or else he faces energy shortages or price shocks, which would raise the odds of stagflation ahead of the election. The path of least resistance for Biden is to lift the sanctions on Iran to prevent an escalation of the secret war in the Middle East. If this unilateral concession should convince Iran to pause its nuclear activities before achieving breakout uranium enrichment capability, then Biden would reduce the odds of a military showdown erupting across the region. Opposition Republicans would accuse him of weakness but public opinion polls show that few Americans consider Iran a major threat. The problem is that this logic held throughout 2021 and yet Biden did not ease the sanctions. Given Iran’s nuclear progress and the US’s reliance on sanctions, we see a 40% chance of a military confrontation with Iran over the coming years. With regard to Ukraine, an American failure to give concessions to Russia will probably result in a partial reinvasion of Ukraine (50% subjective odds). This in turn will force the US and EU to impose sanctions on Russia, leading to a squeeze of natural gas prices in Europe and eventually price pressures in global energy markets. If Biden grants Russia’s main demands, he will avoid a larger war or energy shock but will make the US vulnerable to future blackmail. He will also demoralize Taiwan and other US partners who lack mutual defense treaties. But he may gain Russian cooperation on Iran. If Biden gives concessions to both Russia and Iran, his party will face criticism in the midterms but it will be far less vulnerable than if an energy shock occurs. This is the path of least resistance for Biden in 2022. It means that the petro-states may lose their leverage after using it, given that risk premiums would fall on Biden’s concessions. Of course, if energy shocks happen, Europe and China will suffer more than the US, which is relatively energy independent. For this reason Brussels and Beijing will try to keep diplomacy alive as long as possible. Enforcement of US sanctions on Iran may weaken, reducing Iran’s urgency to come into compliance. Germany may prevent a hardline threat of sanctions against Russia, reducing Russia’s fear of consequences. Again, petro-states have the leverage. Therefore investors should guard against geopolitically induced energy price spikes or shocks in 2022. What if other commodity producers, such as Saudi Arabia, crank up production and sink oil prices? This could happen. Yet the Saudis prefer elevated oil prices due to the host of national challenges they face in reforming their economy. If the US eases sanctions on Iran then the Saudis may make this decision. Thus downside energy price shocks are possible too. The takeaway is energy price volatility but for the most part we see the risk as lying to the upside. Investment Takeaways Traditional geopolitical risk, which focuses on war and conflict, is measurable and has slipped since 2015, although it has not broken down from the general uptrend since 2000. We expect the secular trend to be reaffirmed and for geopolitical risk to resume its rise due to the strategic themes and key views outlined above. The correlation of geopolitical risk with financial assets is debatable – namely because some geopolitical risks push up oil and commodity prices at the expense of the dollar, while others cause a safe-haven rally into the dollar (Chart 22).  Global economic policy uncertainty is also measurable. It is in a secular uptrend since the 2008 financial crisis. Here the correlation with the US dollar and relative equity performance is stronger, which makes sense. This trend should also pick up going forward, which is at least not negative for the dollar and relative US equity performance (Chart 23). Chart 22Geopolitical Risk Will Rise, Market Impacts Variable Geopolitical Risk Will Rise, Market Impacts Variable Geopolitical Risk Will Rise, Market Impacts Variable ​​​​​​ Chart 23Economic Policy Uncertainty Will Rise, Not Bad For US Assets Economic Policy Uncertainty Will Rise, Not Bad For US Assets Economic Policy Uncertainty Will Rise, Not Bad For US Assets ​​​​​​ We are neutral on the US dollar versus the euro and recommend holding either versus the Chinese renminbi. We are short the currencies of emerging markets that suffer from great power rivalry, namely the Taiwanese dollar versus the US dollar, the Korean won versus the Japanese yen, the Russian ruble versus the Canadian dollar, and the Czech koruna versus the British pound.     We remain long gold as a hedge against both geopolitical risk and inflation. We recommend staying long global equities. Tactically we prefer large caps and defensives. Within developed markets, we favor the UK and Japan. Japan in particular will benefit from Chinese policy easing yet remains more secure from China-centered geopolitical risks than emerging Asian economies. Within emerging markets, Mexico stands to benefit from US economic strength and divorce from China. We would buy Indian equities on weakness and sell Chinese and Russian equities on strength. We remain long aerospace and defense stocks and cyber-security stocks.   -The GPS Team We Read (And Liked) … Conspiracy U: A Case Study “Crazy, worthless, stupid, made-up tales bring out the demons in susceptible, unthinking people.” Thus the author’s father, a Holocaust survivor translated from Yiddish, on conspiracy theories and the real danger they present in the world. Scott A. Shay, author and chairman of Signature Bank, whose first book was a finalist for the National Jewish Book Award, has written an intriguing new book on the topic and graciously sent it our way.2 Shay is a regular reader of BCA Research’s Geopolitical Strategy and an astute observer of international affairs. He is also a controversialist who has written essays for several of America’s most prominent newspapers. Shay’s latest, Conspiracy U, is a bracing read that we think investors will benefit from. We say this not because of its topical focus, which is too confined, but because of its broader commentary on history, epistemology, the US higher education system – and the very timely and relevant problem of conspiracy theories, which have become a prevalent concern in twenty-first century politics and society. The author and the particular angle of the book will be controversial to some readers but this very quality makes the book well-suited to the problem of the conspiracy theory, since it is not the controversial nature of conspiracy theories but their non-falsifiability that makes them specious. As the title suggests, the book is a polemical broadside. The polemic arises from Shay’s unique set of moral, intellectual, and sociopolitical commitments. This is true of all political books but this one wears its topicality on its sleeve. The term “conspiracy” in the title refers to antisemitic, anti-Israel, and anti-Zionist conspiracy theories, particularly the denial of the Holocaust, coming from tenured academics on both the right and the left wings of American politics. The “U” in the title refers to universities, namely American universities, with a particular focus on the author’s beloved alma mater, Northwestern University in Chicago, Illinois. Clearly the book is a “case study” – one could even say the prosecution of a direct and extended public criticism of Northwestern University – and the polemical perspective is grounded in Shay’s Jewish identity and personal beliefs. Equally clearly Shay makes a series of verifiable observations and arguments about conspiracy theories as a contemporary phenomenon and their presence, as well as the presence of other weak and lazy modes of thought, in “academia writ large.” This generalization of the problem is where most readers will find the value of the book. The book does not expect one to share Shay’s identity, to be a Zionist or support Zionism, or to agree with Israel’s national policies on any issue, least of all Israeli relations with Arabs and Palestinians. Shay’s approach is rigorous and clinical. He is a genuine intellectual in that he considers the gravest matters of concern from various viewpoints, including viewpoints radically different from his own, and relies on close readings of the evidence. In other words, Shay did not write the book merely to convince people that two tenured professors at Northwestern are promoting conspiracy theories. That kind of aberration is sadly to be expected and at least partially the result of the tenure system, which has advantages as well, not within the scope of the book. Rather Shay wrote it to provide a case study for how it is that conspiracy theories can manage to be adopted by those who do not realize what they are and to proliferate even in areas that should be the least hospitable – namely, public universities, which are supposed to be beacons of knowledge, science, openness, and critical thinking, but also other public institutions, including the fourth estate. Shay is meticulous with his sources and terminology. He draws on existing academic literature to set the parameters of his subject, defining conspiracy theories as “improbable hypotheses [or] intentional lies … about powerful and sinister groups conspiring to harm good people, often via a secret cabal.” The definition excludes “unwarranted criticism” and “unfair/prejudiced perspectives,” which are harmful but unavoidable. Many prejudices and false beliefs are “still falsifiable in the minds of their adherents,” which is not the case with conspiracy theories, although deep prejudices can obviously be helpful in spreading such theories. Conspiracy theories often depend on “a stunning amount of uniformity of belief and coordination of action without contingencies.” They also rely excessively on pathos, or emotion, in making their arguments, as opposed to logos (reason) and ethos (credibility, authority). Unfortunately there is no absolute, infallible distinction between conspiracy theories and other improbable theories – say, yet-to-be-confirmed theories about conspiracies that actually occurred. Conspiracy theories differ from other theories “in their relationship to facts, evidence, and logic,” which may sound obvious but is very much to the point. Again, “the key difference is the evidence and how it is evaluated.” There is no ready way to refute the fabrications, myths, and political propaganda that people believe without taking the time to assess the claims and their foundations. This requires an open mind and a grim determination to get to the bottom of rival claims about events even when they are extremely morally or politically sensitive, as is often the case with wars, political conflicts, atrocities, and genocides: Reliable historians, journalists, lawyers, and citizens must first approach the question of the cause or the identity of perpetrators and victims of an event or process with an open mind, not prejudiced to either party, and then evaluate the evidence. The diagnosis may be easy but the treatment is not – it takes time, study, and debate, and one’s interlocutors must be willing to be convinced. This problem of convincing others is critical because it is the part that is so often left out of modern political discourse. Conspiracy theories are often hateful and militant, so there is a powerful urge to censor or repress them. Openly debating with conspiracy theorists runs the risk of legitimizing or appearing to legitimize their views, providing them with a public forum, which seems to grant ethos or authority to arguments that are otherwise conspicuously lacking in it. In some countries censorship is legal, almost everywhere when violence is incited. The problem is that the act of suppression can feed the same conspiracy theories, so there is a need, in the appropriate context, to engage with and refute lies and specious arguments. Clients frequently email us to ask our view of the rise of conspiracy theories and what they entail for the global policy backdrop. We associate them with the broader breakdown in authority and decline of public trust in institutions. Shay’s book is an intervention into this topic that clients will find informative and thought-provoking, even if they disagree with the author’s staunchly pro-Israel viewpoint. It is precisely Shay’s ability to discuss and debate extremely contentious matters in a lucid and empirical manner – antisemitism, the history of Zionism, Holocaust denialism, Arab-Israeli relations, the Rwandan genocide, QAnon, the George Floyd protests, various other controversies – that enables him to defend a controversial position he holds passionately, while also demonstrating that passion alone can produce the most false and malicious arguments. As is often the case, the best parts of the book are the most personal – when Shay tells about his father’s sufferings during the Holocaust, and journey from the German concentration camps to New York City, and about Shay’s own experiences scraping enough money together to go to college at Northwestern. These sequences explain why the author felt moved to stage a public intervention against fringe ideological currents, which he shows to have gained more prominence in the university system than one might think. The book is timely, as American voters are increasingly concerned about the handling of identity, inter-group relations, history, education, and ideology in the classroom, resulting in what looks likely to become a new and ugly episode of the culture and education wars. Let us hope that Shay’s standards of intellectual freedom and moral decency prevail.   Matt Gertken, PhD Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1      The downshift in globalization today is even worse than it appears in Chart 10 because several countries have not yet produced the necessary post-pandemic data, artificially reducing the denominator and making the post-pandemic trade rebound appear more prominent than it is in reality. 2     Scott A. Shay, Conspiracy U: A Case Study (New York: Post Hill Press, 2021), 279 pages. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Appendix: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator United Kingdom UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan Territory: GeoRisk Indicator Taiwan Territory: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator South Africa South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Section III: Geopolitical Calendar

Dear Client, We will be working on our 2022 Outlook for China, which will be published on December 8. Next week we will be sending you BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic and financial market outlook for the year ahead. Best regards, Jing Sima China Strategist Feature In meetings with our North American clients this past week, we expressed the view that China’s economic growth is on a downward trend and easing measures have been gradual and modest in scope. Most clients agreed that China’s economy faces tremendous headwinds, however, some investors were more optimistic about the outlook for Chinese stocks in the next 6 to 12 months. Valuations in both China’s onshore and offshore equity markets have dropped to multi-year lows and macro policies have started to ease. Cheaply valued Chinese stocks should have more upside in the wake of policy support. Policy tone recently pivoted to a more growth supporting bias, but the existing easing measures will not offset the deceleration in both credit growth and domestic demand. China’s economic activity may worsen before it stabilizes in mid-2022. Moreover, China’s financial markets do not seem to have priced in the economic weakness. Therefore, in the next one to two quarters, risks to Chinese stocks are tilted toward the downside. Chart 1Chinese Stocks Will Truly Bottom When The Economy Troughs Chinese Stocks Will Truly Bottom When The Economy Troughs Chinese Stocks Will Truly Bottom When The Economy Troughs Below are some of the main questions from our meetings and our answers. Q: Policies have started to be more pro-growth. Why do you still underweight Chinese stocks? A: There are two reasons that we maintain a cautious view on Chinese stocks for at least the next six months, in both absolute terms and relative to global equities. First, we do not think that the magnitude of existing easing measures is sufficient to offset the economy’s downward momentum. Secondly, China’s business cycle lags credit growth by about six to nine months. The timing of a turnaround in the economy and stock prices may be later than investors have priced in. In short, we need to see more reflationary measures and a rebound in credit growth to have a legitimate macro fundamental basis to overweight Chinese stocks (Chart 1). Credit growth on a year-on-year basis stopped falling in October. The underlying data in credit creation, however, points to a weakening in demand for corporate loans (Chart 2). Loans to the housing sector are well below a year ago (Chart 3). Chart 2Weakening Loan Demand Weakening Loan Demand Weakening Loan Demand Chart 3Bank Loans To The Housing Sector Have Not Turned Around Bank Loans To The Housing Sector Have Not Turned Around Bank Loans To The Housing Sector Have Not Turned Around Chart 4It Will Take Time For Policy Easing To Restore Confidence In The Corporate Sector It Will Take Time For Policy Easing To Restore Confidence In The Corporate Sector It Will Take Time For Policy Easing To Restore Confidence In The Corporate Sector Despite an acceleration in local government bond issuance in October and RMB300 billion in additional bank loans to support small and medium enterprises, growth in medium- to long-term corporate loans peaked (Chart 4). In previous cycles, a rollover in corporate demand for longer-term bank lending on average lasted more than nine months, suggesting that any policy adjustments will take a while to restore confidence in the corporate sector. Without a decisive pickup in credit growth, corporate earnings growth will be at risk of deteriorating. Moreover, policy tightening since earlier this year is still working its way through the economy and major economic indicators in China continue to decline (Chart 5). We think that China’s economy is set to decelerate even more in the next several months, suggesting that earnings uncertainty will likely rise. This, combined with reactive policymakers, already slowing earnings momentum, and a downward adjustment in 12-month forward earnings, suggests that investors have not yet reached the maximum bearishness for Chinese stock prices (Chart 6). Chart 5No Signs Of Improvement In The Economy No Signs Of Improvement In The Economy No Signs Of Improvement In The Economy Chart 6The Earnings Adjustement Process Is Only Beginning The Earnings Adjustement Process Is Only Beginning The Earnings Adjustement Process Is Only Beginning   Q: What is the impact of China’s property market slowdown on the economy? Will recent policy easing stop deterioration in the real estate sector? A: Policy has been recalibrated by relaxing restrictions on mortgage lending and rules for land sales.1 However, the negative financing loop among developers, households and local governments may take longer to improve. Meanwhile, the market may underestimate the downside risks in housing-related activity in the next 6 to 12 months. Chart 7Households' Home Buying Intentions Have Plummeted Households' Home Buying Intentions Have Plummeted Households' Home Buying Intentions Have Plummeted Our view is based on the following: Home sales will likely remain in contraction in the next two quarters. Aggressive crackdowns on property market speculation in the past 12 months have fundamentally shifted consumers’ expectations for future home prices. The impending pilot property tax reform2 (details yet to be disclosed) will only encourage the wait-and-see sentiment of potential buyers. Home sales contracted by 24% in October from a year ago. In previous cycles, contractions in home sales normally lasted for more than 12 months. Moreover, the proportion of households planning to buy a house dropped to only 7.7% in Q3 2021 from 11.6% in Q4 2020 (Chart 7). Real estate developers have slashed new projects and land purchases to preserve liquidity for debt servicing (Chart 8, first and second panels). Policymakers may succeed in prompting banks to resume lending to developers in order to alleviate the escalating risk of widespread defaults. However, so far the marginal easing has failed to reverse the downward trend in bank credit to developers along with home sales (Chart 8, third and bottom panels). Funding constraints for real estate developers will probably be sustained for another six months, despite the recent easing measures. Construction activity, housing starts, and real estate investment will likely remain in doldrum at least through 1H22 (Chart 9). Chart 8Housing Activities Are Still Falling Housing Activities Are Still Falling Housing Activities Are Still Falling Chart 9Less Funding = Less Investment And Completions Less Funding = Less Investment And Completions Less Funding = Less Investment And Completions The marked reduction in land sales will impede local governments’ revenues and weigh on infrastructure investment (Chart 10). Real estate and infrastructure financing contributed 50% of the increase in total Chart 10Local Government Revenues Largely Depend On The Housing Sector Local Government Revenues Largely Depend On The Housing Sector Local Government Revenues Largely Depend On The Housing Sector social financing in 2020. Given that local governments face funding constraints from a slump in land sale incomes, policies on leverage from local government financing vehicles (LGFVs) will have to meaningfully loosen up to allow a rise in bank lending to support infrastructure investment. As discussed in previous reports, an acceleration in local government special-purpose bond issuance can only partially offset weak credit growth. Furthermore, shadow banking activity, which comprises LGFV borrowing and is highly correlated with China’s infrastructure investment growth, remains in contraction and indicates that growth in infrastructure investment is unlikely to rebound strongly (Chart 11). The sharp weakening of real estate construction activities will drag down the demand for building materials, machinery, home appliances and automobiles. Real estate accounts for about 60% of Chinese households’ wealth, thus any substantial drop in home prices will further weaken households’ propensity to consume (Chart 12). Chart 11More Easing Needed For A Meaningful Pickup In Infrastructure Investment More Easing Needed For A Meaningful Pickup In Infrastructure Investment More Easing Needed For A Meaningful Pickup In Infrastructure Investment Chart 12Falling Demand For Commodities And Consumer Goods Falling Demand For Commodities And Consumer Goods Falling Demand For Commodities And Consumer Goods Chart 13AOn The Surface Housing Inventories Are Lower Than Six Years Ago... On The Surface Housing Inventories Are Lower Than Six Years Ago... On The Surface Housing Inventories Are Lower Than Six Years Ago... There are nontrivial risks that the real estate slowdown will evolve into a downturn similar to that of 2014-15. Although the existing housing inventory is more modest than the start of the 2014/15 property downturn, developers have accumulated more debt and unfinished projects in this cycle than in the past (Charts 13A & 13B). Policymakers will have to relax property sector policies much more forcefully to prevent the downturn from intensifying. In the interim, we will likely witness more deterioration in the sector. Chart 13B...But Developers Have Built Up Massive Leverages And Hidden Inventories In The Past Three Years ...But Developers Have Built Up Massive Leverages And Hidden Inventories In the Past Three Years ...But Developers Have Built Up Massive Leverages And Hidden Inventories In the Past Three Years   Q: If the property market accounts for such a big portion of local governments’ revenues, why hasn’t the waning housing market forced policymakers to loosen restrictions? A: We think regulators have been slow to backtrack property market reforms because this year China’s fiscal deficit has narrowed from last year due to lower government spending and improved income from corporate taxes. In previous property market downturns, such as 2011/12, 2015/16 and 2019, property policy restrictions were lightened following major declines in government revenues (Chart 14). However, in 2021 China’s fiscal balance sheet has been stronger than in previous cycles; central and local governments have collected much more taxes, particularly corporate taxes, than in 2020 (Chart 15). Meanwhile, government expenditures so far this year have been lower, resulting in a large improvement in the country’s fiscal deficit (Chart 16). Chart 14Falling Gov Revenues Forced Policymakers To Backtrack Reforms In The Past... Falling Gov Revenues Forced Policymakers To Backtrack Reforms In The Past... Falling Gov Revenues Forced Policymakers To Backtrack Reforms In The Past... Chart 15...But This Year Gov Tax Revenues Have Been Strong ...But This Year Gov Tax Revenues Have Been Strong ...But This Year Gov Tax Revenues Have Been Strong Chart 16Fiscal Deficit Improved This Year Despite Falling evenues From Land Sales Fiscal Deficit Improved This Year Despite Falling evenues From Land Sales Fiscal Deficit Improved This Year Despite Falling evenues From Land Sales As discussed above, slightly loosened restrictions on land purchases by some regional governments will not restore developers’ confidence and boost the demand for land. The sharp increase in government's corporate tax collection will also start to ebb as economic growth slows and corporate profits decline. As such, even if government expenditures remain the same next year, the fiscal deficit will grow because revenues will be under substantial downward pressure. We expect that Chinese policymakers will have to take more actions to stabilize fiscal conditions. Forecasting exactly when this will occur is difficult, but a benign government balance sheet in much of this year is delaying policymakers’ response to the flagging housing market. Meantime, both policymakers and investors may be complacent about the state of the economy until the full scale of the property sector spillover risk becomes clear.   Q: Rates are low and industrial profit growth has been strong this year. Why has capex been so sluggish? A: Investment growth in the manufacturing sector has been lackluster because their profit margins have been squeezed by rising input costs. On the other hand, investment in the mining industry has been constrained by policy restrictions. An acceleration in China’s de-carbonization efforts this year has likely constrained investment in the mining sector. Even though industrial profit growth has been concentrated among the upstream industries such as mining which profits grew by a stunning 100% this year, investment in the sector was mostly flat from a year ago (Chart 17). During the first half of the year, mid- to downstream firms were caught between rising input prices and a weak recovery in domestic consumption. Manufacturing investment grew faster than the mining sector, but manufacturing profit growth only increased by about 30% year to date (Chart 18). However, we think manufacturing investment growth may improve slightly into 2022 as the sector continues to gain pricing power. Chart 17Mining Sector's Profit Growth Way Outpaced Investment Mining Sector's Profit Growth Way Outpaced Investment Mining Sector's Profit Growth Way Outpaced Investment Chart 18Manufacturing Sector Profit Growth Has Been Much More Muted Than Upstream Industries Manufacturing Sector Profit Growth Has Been Much More Muted Than Upstream Industries Manufacturing Sector Profit Growth Has Been Much More Muted Than Upstream Industries   Q: The RMB has been strong against the dollar, despite China’s maturing business cycle. What is your outlook for the RMB next year? A: The RMB exchange rate has been boosted by China’s record current account surplus, wide interest rate differentials and speculation that tension between the US and China will abate. However, all three favorable conditions supporting the RMB are in danger of reversing next year. Chart 19The RMB Has Been Appreciating Despite A Strong USD The RMB Has Been Appreciating Despite A Strong USD The RMB Has Been Appreciating Despite A Strong USD Chart 20The RMB's Appreciation Deviates From Economic Fundamentals The RMB's Appreciation Deviates From Economic Fundamentals The RMB's Appreciation Deviates From Economic Fundamentals Despite broad-based dollar strength, the CNY/USD has appreciated by 4.5% year to date (Chart 19). The RMB’s appreciation deviates from China’s economic fundamentals (Chart 20).       Strong global demand for goods has boosted Chinese exports while travel restrictions curbed foreign exchange outflows by domestic households (Chart 21). China-US real interest rate differentials have been in favor of the CNY versus USD, bringing net foreign inflows to China’s onshore bond market (Chart 22). Additionally, the recent meeting between President Joe Biden and President Xi Jinping has prompted speculation that the US will lessen tariffs on Chinese imports. Chart 21Large Current Account Surplus Large Current Account Surplus Large Current Account Surplus Chart 22Favorable Interest Rate Differentials And Strong Fund Inflows Favorable Interest Rate Differentials And Strong Fund Inflows Favorable Interest Rate Differentials And Strong Fund Inflows Chart 23China's Extremely Robust Export Growth Unlikely To Sustain In 2022 China's Extremely Robust Export Growth Unlikely To Sustain In 2022 China's Extremely Robust Export Growth Unlikely To Sustain In 2022 Chart 24A Strong RMB Does Not Bode Well For Chinese Exporters' Profits A Strong RMB Does Not Bode Well For Chinese Exporters' Profits A Strong RMB Does Not Bode Well For Chinese Exporters' Profits These factors will likely turn against the CNY next year. First, export growth will moderate as the composition of US consumption rotates from goods to services (Chart 23). Secondly, it would not be in the PBoC’s best interests to let the RMB strengthen too rapidly because an appreciating currency would be a deflationary force on China’s export and manufacturing sectors (Chart 24). While we expect policymakers to maintain their preference for a gradual approach to stimulus, we assign a high probability to a reserve requirement ratio (RRR) cut in early 2022. In this environment, Chinese bond yields will decline, which would narrow the China-US interest rate differential. Finally, while there may be some changes to US tariffs on China, it is doubtful that there would be a broad-based removal of tariffs. Chart 25The CNY/USD Will Likely Fall And Converge To Chinese Stocks' (Under)performance The CNY/USD Will Likely Fall And Converge To Chinese Stocks' (Under)performance The CNY/USD Will Likely Fall And Converge To Chinese Stocks' (Under)performance The CNY’s outperformance stands out as it marks a break from its correlation with China’s relative equity performance vis-à-vis the US (Chart 25). The signal from the currency suggests that either global equity investors are overly pessimistic about economic and regulatory risks in China, or overly optimistic about the value of China’s currency. The latter option is more likely at the moment, and the CNY/USD exchange rate is at the risk of converging to the underperformance of Chinese investable stocks next year.   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1  China Cities Ease Land Bidding Rules as Property Stress Spreads - Bloomberg 2  China’s Pilot Property Tax Reforms Benefit Markets Despite Short-Term Pain, Analysts Say - Caixin Global Market/Sector Recommendations Cyclical Investment Stance

Highlights Geopolitical conflicts point to energy price spikes and could add to inflation surprises in the near term. However, US fiscal drag and China’s economic slowdown are both disinflationary risks to be aware of.  Specifically, energy-producers like Russia and Iran gain greater leverage amid energy shortages. Europe’s natural gas prices could spike again. Conflict in the Middle East could disrupt oil flows.    President Biden’s $1.75 trillion social spending bill is a litmus test for fiscal fatigue in developed markets. It could fail, and even assuming it passes it will not prevent overall fiscal drag in 2022-23. However, it is inflationary over the long run. China’s slowdown poses the chief disinflationary risk. But we still think policy will ease to avoid an economic crash ahead of the fall 2022 national party congress.  We are closing this year’s long value / short growth trade for a loss of 3.75%. Cyclical sectors ended up being a better way to play the reopening trade. Feature Equity markets rallied in recent weeks despite sharp upward moves in core inflation across the world (Chart 1). Inflation is fast becoming a popular concern and we see geopolitical risks that could drive headline inflation still higher in the short run. We also see underrated disinflationary factors, namely China’s property sector distress and economic slowdown.     Several major developments have occurred in recent weeks that we will cover in this report. Our conclusions: Biden’s domestic agenda will pass but risks are high and macro impact is limited. Congress passed Biden’s infrastructure deal and will probably still pass his signature social spending bill, although inflation is creating pushback. Together these bills have little impact on the budget deficit outlook but they will add to inflationary pressures.  Energy shortages embolden Russia and Iran. Winter weather is unpredictable, the energy crisis may not be over. But investors are underrating Russia’s aggressive posture toward the West. Any conflict with Iran could also cause oil disruptions in the near future. US-China relations may improve but not for long. A bilateral summit between Presidents Joe Biden and Xi Jinping will not reduce tensions for very long, if at all. Climate change cooperation is an insufficient basis to reverse the cold war-style confrontation over the long run. Chart 1Inflation Rattles Policymakers Inflation Rattles Policymakers Inflation Rattles Policymakers The investment takeaway is that geopolitical tensions could push energy prices still higher in the short term. Iran and Russia need to be monitored. However, China’s economic slowdown will weigh on growth. China poses an underrated disinflationary risk to our views. US Congress: Bellwether For Fiscal Fatigue While inflation is starting to trouble households and voters, investors should bear in mind that the current set of politicians have long aimed to generate an inflation overshoot. They spent the previous decade in fear of deflation, since it generated anti-establishment or populist parties that threatened to disrupt the political system. They quietly built up an institutional consensus around more robust fiscal policy and monetary-fiscal coordination. Now they are seeing that agenda succeed but are facing the first major hurdle in the form of higher prices. They will not simply cut and run. Inflation is accompanied by rising wages, which today’s leaders want to see – almost all of them have promised households a greater share of the fruits of their labor, in keeping with the new, pro-worker, populist zeitgeist. Real wages are growing at 1.1% in the US and 0.9% across the G7 (Chart 2). Even more than central bankers, political leaders are focused on jobs and employment, i.e. voters. Yet the labor market still has considerable slack (Chart 3). Almost all of the major western governments have been politically recapitalized since the pandemic, either through elections or new coalitions. Almost all of them were elected on promises of robust public investment programs to “build back better,” i.e. create jobs, build infrastructure, revitalize industry, and decarbonize the energy economy. Thus while they are concerned about inflation, they will leave that to central banks, as they will be loathe to abandon their grand investment plans.  Chart 2Higher Wages: Real Or Nominal? Higher Wages: Real Or Nominal? Higher Wages: Real Or Nominal? Still, there will be a breaking point at which inflation forces governments to put their spending plans on hold. The US Congress is the immediate test of whether today’s inflation will trigger fiscal fatigue and force a course correction.      Chart 3Policymakers Fear Populism, Focus On Employment Policymakers Fear Populism, Focus On Employment Policymakers Fear Populism, Focus On Employment President Biden’s $550 billion infrastructure bill passed Congress last week and will be signed into law around November 15. Now he is worried that his signature $1.75 trillion social spending bill will falter due to inflation fears. He cannot spare a single vote in the Senate (and only three votes in the House of Representatives). Odds that the bill fails are about 35%. Democratic Party leaders will not abandon the cause due to recent inflation prints. They see a once-in-a-generation opportunity to expand the role of government, the social safety net, and the interests of their constituents. If they miss this chance due to inflation that ends up being transitory then they will lose the enthusiastic left wing of the party and suffer a devastating loss in next year’s midterm elections, in which they are already at a disadvantage.   Biden’s social bill is also likely to pass because the budget reconciliation process necessary to pass the bill is the same process needed to raise the national debt limit by December 3. A linkage of the two by party leaders would ensure that both pass … and otherwise Democrats risk self-inflicting a national debt default. The reconciliation bill is more about long-term than short-term inflation risk. The bill does not look to have a substantial impact on the budget outlook: the new spending is partially offset by new taxes and spread out over ten years. The various legislative scenarios look virtually the same in our back-of-the-envelope budget projections (Chart 4). Chart 4 However, given that the output gap is virtually closed, this bill combined with the infrastructure bill will add to inflationary pressures. The fiscal drag will diminish by 2024, not coincidentally the presidential election year 2024, not coincidentally the presidential election year. The deficit is not expected to increase or decrease substantially between 2023 and 2024. From then onward the budget deficit will expand. The increased government demand for goods and services and the increased disposable income for low-earning families will add to inflationary pressures. Other developed markets face a similar situation: inflation is picking up, but big spending has been promised and normalizing budgets will marginally weigh on growth in the next few years (Chart 5). True, growth should hold up since the private economy is rebounding in the wake of the pandemic. But politicians will not be inclined to renege on campaign promises of liberal spending in the face of fiscal drag. The current crop of leaders is primed to make major public investments. This is true of Germany, Japan, Canada, and Italy as well as the United States. It is partly true in France, where fiscal retrenchment has been put on hold given the presidential election in the spring. The effect will be inflationary, especially for the US where populist spending is more extravagant than elsewhere. Chart 5 The long run will depend on structural factors and how much the new investments improve productivity. Bottom Line: A single vote in the US Senate could derail the president’s social spending bill, so the US is now the bellwether for fiscal fatigue in the developed world. Biden is likely to pass the bill, as global fiscal drag is disinflationary over the next 12 months. Yet inflation could stay elevated for other reasons. And this fiscal drag will dissipate later in the business cycle. Russia And Iran Gain Leverage Amid Energy Crunch The global energy price spike arose from a combination of structural factors – namely the pandemic and stimulus. It has abated in recent weeks but will remain a latent problem through the winter season, especially if La Niña makes temperatures unusually cold as expected. Rising energy prices feed into general producer prices, which are being passed onto consumers (Chart 6). They look to be moderating but the weather is unpredictable.   There is another reason that near-term energy prices could spike or stay elevated: geopolitics. Tight global energy supply-demand balances mean that there is little margin of safety if unexpected supply disruptions occur. This gives greater leverage to energy producers, two of which are especially relevant at the moment: Russia and Iran.      Russia’s long-running conflict with the West is heating up on several fronts, as expected. Russia may not have caused the European energy crisis but it is exacerbating shortages by restricting flows of natural gas for political reasons, as it is wont to do (Chart 7). Moscow always maintains plausible deniability but it is currently flexing its energy muscles in several areas: Chart 6Energy Price Depends On Winter ... And Russia/Iran! Energy Price Depends On Winter ... And Russia/Iran! Energy Price Depends On Winter ... And Russia/Iran! Ukraine: Russia has avoided filling up and fully utilizing pipelines and storage facilities in Ukraine, where the US is now warning that Russia could stage a large military action in retaliation for Ukrainian drone strikes in the still-simmering Russia-Ukraine war.    Belarus: Russia says it will not increase the gas flow through the major Yamal-Europe natural gas pipeline in 2022 even as Belarus threatens to halt the pipeline’s operation entirely. Belarus, backed by Russia, is locked in a conflict with Poland and the EU over Belarus’s funneling of migrants into their territory (Chart 8). The conflict could lead not only to energy supply disruptions but also to a broader closure of trade and a military standoff.1 Russia has flown two Tu-160 nuclear-armed bombers over Belarus and the border area in a sign of support. Moldova: Russia is withholding natural gas to pressure the new, pro-EU Moldovan government. Chart 7 Chart 8 Russia’s main motive is obvious: it wants Germany and the EU to approve and certify the new Nord Stream II pipeline. Nord Stream II enables Germany and Russia to bypass Ukraine, where pipeline politics raise the risk of shortages and wars. Lame duck German Chancellor Angela Merkel worked with Russia to complete this pipeline before the end of her term, convincing the Biden administration to issue a waiver on congressional sanctions that could have halted its construction. However, two of the parties in the incoming German government, the Greens and the Free Democrats, oppose the pipeline. While these parties may not have been able to stop the pipeline from operating, Russia does not want to take any chances and is trying to force Germany’s and the EU’s hand. The energy crisis makes it more likely that the pipeline will be approved, since the European Commission will have to make its decision during a period when cold weather and shortages will make it politically acceptable to certify the pipeline.2 The decision will further drive a wedge between Germany and eastern EU members, which is what Russia wants. EU natural gas prices will likely subside sometime next year and will probably not derail the economic recovery, according to both our commodity and Europe strategists. A bigger and longer-lasting Russian energy squeeze would emerge if the Nord Stream II pipeline is not certified. This is a low risk at this point but the next six months could bring surprises. More broadly, the West’s conflict with Russia can easily escalate from here. First, President Vladimir Putin faces economic challenges and weak political support. He frequently diverts popular attention by staging aggressive moves abroad. There is no reason to believe his post-2004 strategy of restoring Russia’s sphere of influence in the former Soviet space has changed. High energy prices give him greater leverage even aside from pipeline coercion – so it is not surprising that Russia is moving troops to the Ukraine border again. Growing military support for Belarus, or an expanded conflict in Ukraine, are likely to create a crisis now or later.   Second, the US-Germany agreement to allow Nord Stream II explicitly states that Russia must not weaponize natural gas supply. This statement has had zero effect so far. But when the energy shortage subsides, the EU could pursue retaliatory measures along with the United States. Of course, Russia has been able to weather sanctions. But tensions are already escalating significantly.  After Russia, Iran also gains leverage during times of tight energy supplies. With global oil inventories drawing down, Iran is in the position to inflict “maximum pressure” on the US and its allies, a role reversal from the 2017-20 period in which large inventories enabled the US to impose crippling sanctions on Iran after pulling out of the 2015 nuclear deal (Chart 9). Iran is rapidly advancing on its nuclear program and a new round of diplomatic negotiations may only serve to buy time before it crosses the “breakout” threshold of uranium enrichment capability as early as this month or next. In a recent special report we argued that there is a 40% chance of a crisis over Iran in the Middle East. Such a crisis could ultimately lead to an oil shock in the Persian Gulf or Strait of Hormuz.  Chart 9Now Iran Can Use 'Maximum Pressure' Now Iran Can Use 'Maximum Pressure' Now Iran Can Use 'Maximum Pressure' Bottom Line: Russia’s natural gas coercion of Europe could keep European energy prices high through March or May. More broadly Russia’s renewed tensions with the West confirm our view that oil producers gain geopolitical leverage amid the current supply shortages. Iran also gains leverage and its conflict with the US could lead to global oil supply disruptions anytime over the next 12 months. Until Nord Stream II is certified and a new Iranian nuclear agreement is signed, there are two clear sources of potential energy shocks. Moreover in today’s inflationary context there is limited margin of safety for unexpected supply disruptions regardless of source. Xi’s Historical Rewrite China continues to be a major source of risk for the global economy and financial markets in the lead-up to the twentieth national party congress in fall 2022. While Chinese assets have sold off this year, global risk assets are still vulnerable to negative surprises from China.  The five-year political reshuffle in 2022 is more important than usual since President Xi Jinping was originally supposed to step down but will instead stick around as leader for life, like China’s previous strongmen Mao Zedong and Deng Xiaoping.3 Xi’s rejection of term limits became clear in 2017 and is not really news. But Xi will fortify himself and his faction in 2022 against any opposition whatsoever. He is extremely vigilant about any threats that could disrupt this process, whether at home or abroad.  The Communist Party’s sixth plenary session this week highlights both Xi’s success within the Communist Party and the sensitivity of the period. Xi produced a new “historical resolution,” or interpretation of the party’s history, which is only the third such resolution. A few remarks on this historical resolution are pertinent: Mao’s resolution: Chairman Mao wrote the first such resolution in 1945 to lay down his version of the party’s history and solidify his personal control. It is naturally a revolutionary leftist document. Deng’s revision of Mao: General Deng Xiaoping then produced a major revision in 1981, shortly after initiating China’s economic opening and reform. Deng’s interpretation aimed to hold Mao accountable for “gross mistakes” during the Cultural Revolution and yet to recognize the Communist Party’s positive achievements in founding the People’s Republic. His version gave credit to the party and collective leadership rather than Mao’s personal rule. Two 30-year periods: The implication was that the party’s history should be divided into two thirty-year periods: the period of foundations and conflict with Mao as the party’s core and the period of improvement and prosperity with Deng as the core. Jiang’s support of Deng: Deng’s telling came under scrutiny from new leftists in the wake of Tiananmen Square incident in 1989. But General Secretary Jiang Zemin largely held to Deng’s version of the story that the days of reform and opening were a far better example of the party’s leadership because they were so much more stable and prosperous.4 Xi’s reaction to Jiang and Deng: Since coming to power in 2012, Xi Jinping has shown an interest in revising the party’s official interpretation of its own history. The central claim of the revisionists is that China could never have achieved its economic success if not for Mao’s strongman rule. Mao’s rule and the Communist Party’s central control thus regain their centrality to modern China’s story. China’s prosperity owes its existence to these primary political conditions. The two periods cannot be separated.  Xi’s synthesis of Deng and Mao: Now Xi has written himself into that history above all other figures – indeed the communique from the Sixth Plenum mentions Xi more often than Marx, Mao, or Deng (Chart 10). The implication is that Xi is the synthesis of Mao and Deng, as we argued back in 2017 at the end of the nineteenth national party congress. The synthesis consists of a strongman who nevertheless maintains a vibrant economy for strategic ends. Chart 10 What are the practical policy implications of this history lesson? Higher Country Risk: China’s revival of personal rule, as opposed to consensus rule, marks a permanent increase in “country risk” and political risk for investors. Autocratic governments lack institutional guardrails (checks and balances) that prevent drastic policy mistakes. When Xi tries to step down there will probably be a succession crisis. Higher Macroeconomic Risk: China is more likely to get stuck in the “middle-income trap.” Liberal or pro-market economic reform is de-emphasized both in the new historical resolution and in the Xi administration’s broader program. Centralization is already suppressing animal spirits, entrepreneurship, and the private sector.  Higher Geopolitical Risk: The return to autocracy and the withdrawal from economic liberalism also entail a conflict with the United States, which is still the world’s largest economy and most powerful military. The US is not what it once was but it will put pressure on China’s economy and build alliances aimed at strategic containment. Bottom Line: China is trying to escape the middle-income trap, like Taiwan, Japan, and South Korea, but it is trying to do so by means of autocracy, import substitution, and conflict with the United States. These other Asian economies improved productivity by democratizing, embracing globalization, and maintaining a special relationship with the United States. China’s odds of succeeding are low. China will focus on power consolidation through fall 2022 and this will lead to negative surprises for financial markets.    China Slowdown: The Disinflationary Risk While it is very unlikely that Xi will face serious challenges to his rule, strange things can happen at critical junctures. Therefore the regime will be extremely alert for any threats, foreign or domestic, and will ultimately prioritize politics above all other things, which means investors will suffer negative surprises. The lingering pandemic still poses an inflationary risk for the rest of the world while the other main risk is disinflationary:    Inflationary Risk – Zero COVID: The “Covid Zero” policy of attempting to stamp out any trace of the virus will still be relevant at least over the next 12 months (Chart 11). Clampdowns serve a dual purpose since the Xi administration wants to minimize foreign interference and domestic dissent before the party congress. Hence the global economy can suffer more negative supply shocks if ports or factories are closed.  Inflationary Risk – Energy Closures: The government is rationing electricity amid energy shortages to prioritize household heating and essential services. This could hurt factory output over the winter if the weather is bad. Disinflationary Risk – Property Bust: The country is still flirting with overtightening monetary, fiscal, and regulatory policies. Throughout the year we have argued that authorities would avoid overtightening. But China is still very much in a danger zone in which policy mistakes could be made. Recent rumors suggest the government is trying to “correct the overcorrection” of regulatory policy. The government is reportedly mulling measures to relax the curbs on the property sector. We are inclined to agree but there is no sign yet that markets are responding, judging by corporate defaults and the crunch in financial conditions (Chart 12). Chart 11 Chart 12China Has Not Contained Property Turmoil China Has Not Contained Property Turmoil China Has Not Contained Property Turmoil Evergrande, the world’s most indebted property developer, is still hobbling along, but its troubles are not over. There are signs of contagion among other developers, including state-owned enterprises, that cannot meet the government’s “three red lines.” 5 Credit growth has now broken beneath the government’s target range of 12%, though money growth has bounced off the lower 8% limit set for this year (Chart 13). China is dangerously close to overtightening.   China’s economic slowdown has not yet been fully felt in the global economy based on China’s import volumes, which are tightly linked to the combined credit-and-fiscal-spending impulse (Chart 14). The implication is that recent pullbacks in industrial metal prices and commodity indexes will continue. Chart 13China Tries To Avoid Over-Tightening China Tries To Avoid Over-Tightening China Tries To Avoid Over-Tightening Chart 14China Slowdown Not Yet Fully Felt China Slowdown Not Yet Fully Felt China Slowdown Not Yet Fully Felt ​​​​​​​Until China eases policy more substantially, it poses a disinflationary risk and a strong point in favor of the transitory view of global inflation.    It is difficult for China to ease policy – let alone stimulate – when producer prices are so high (see Chart 6 above). The result is a dangerous quandary in which the government’s regulatory crackdowns are triggering a property bust yet the government is prevented from providing the usual policy support as the going gets tough. Asset prices and broader risk sentiment could go into free fall. However, the party has a powerful incentive to prevent a generalized crisis ahead of the party congress. So we are inclined to accept signs that property curbs and other policies will be eased. Bottom Line: The full disinflationary impact of China’s financial turmoil and economic slowdown has yet to be felt globally.     Biden-Xi Summit Not A Game Changer As long as inflation prevents robust monetary and fiscal easing, Beijing is incentivized to improve sentiment in other ways. One way is to back away from the regulatory crackdown in other sectors, such as Big Tech. The other is to improve relations with the United States. A stabilization of US ties would be useful before the party congress since President Xi would prefer not to have the US interfering in China’s internal affairs during such a critical hour. No surprise that China is showing signs of trying to stabilize the relationship.   The US is apparently reciprocating. Presidents Biden and Xi also agreed to hold a virtual bilateral summit next week, which could lead to a new series of talks. The US Trade Representative also plans to restart trade negotiations. The plan is to enforce the Phase One trade deal, issue waivers for tariffs that hurt US companies, and pursue new talks over outstanding structural disputes. The Phase One trade deal has fallen far short of its goals in general but on the energy front it is doing well. China will continue importing US commodities amid global shortages (Chart 15). Chart 15 Chart 15 The summit alone will have a limited impact. Biden had a summit with Putin earlier this year but relations could deteriorate tomorrow over cyber-attacks, Ukraine, or Belarus. However, there is some basis for the US and China to cooperate next year: Iran. Xi is consolidating power at home in 2022 and probably wants to use negotiations to keep the Americans at bay. Biden is pivoting to foreign policy in 2022, since Congress will not get anything done, and will primarily focus on halting Iran’s nuclear program. If China assists the US with Iran, then there is a basis for a reduction in tensions. The problem is not only Iran itself but also that China will not jump to enforce sanctions on Iran amid energy shortages. And China is not about to make sweeping structural economic concessions to the US as the Xi administration doubles down on state-guided industrial policy. Meanwhile the US is pursuing a long-term policy of strategic containment and Biden will not want to be seen as appeasing China ahead of midterm elections, especially given Xi’s reversion to autocracy. What about cooperation on climate change? The US and China also delivered a surprise joint statement at the United Nations climate change conference in Scotland (COP26), confirming the widely held expectation that climate policy is an area of engagement. These powers and Europe have a strategic interest in reducing dependency on Middle Eastern oil (Chart 16). Climate talks will begin in the first half of next year. However, climate cooperation is not significant enough alone to outweigh the deeper conflicts between the US and China. Moreover climate policy itself is somewhat antagonistic, as the EU and US are looking at applying “carbon adjustment fees” to carbon-intensive imports, e.g. iron and steel exports from China and other high-polluting producers (Chart 17). While the EU and US are not on the same page yet, and these carbon tariffs are far from implementation, the emergence of green protectionism does not bode well for US-China relations even aside from their fundamental political and military disputes. Chart 16 Bottom Line: Some short-term stabilization of US-China relations is possible but not guaranteed. Markets will cheer if it happens but the effect will be fleeting. Chinese assets are still extremely vulnerable to political and geopolitical risks.   Chart 17 Investment Takeaways Gold can still go higher. Financial markets are pricing higher inflation and weak real rates. Gold has been our chief trade to prepare both for higher inflation and geopolitical risk. We are closing our long value / growth equity trade for a loss of 3.75%. We are maintaining our long DM Europe / short EM Europe trade. This trade has performed poorly due to the rally in energy prices and hence Russian equities. But while energy prices may overshoot in the near term, investors will flee Russian equities as geopolitical risks materialize. We are maintaining our long Korea / short Taiwan trade despite its being deeply in the red. This trade is valid over a strategic or long-term time horizon, in which a major geopolitical crisis and/or war is likely. Our expectation that China will ease policy to stabilize the economy ahead of fall 2022 should support Korean equities.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com       Footnotes 1     Over the past year President Alexander Lukashenko’s repression of domestic unrest prompted the EU to impose sanctions. Lukashenko responded by organizing an immigration scheme in which Middle Eastern migrants are flown into Belarus and funneled into the EU via Poland. The EU is threatening to expand sanctions while Belarus is threatening to cut off the Yamal-Europe pipeline amid Europe’s energy crisis. See Pavel Felgenhauer, “Belarus as Latest Front in Acute East-West Standoff,” Jamestown Foundation, November 11, 2021, Jamestown.org. 2     Both Germany and the EU must approve of Nord Stream II for it to enter into operation. The German Federal Network Agency has until January 8, 2022 to certify the project. The Economy Ministry has already given the green light. Then the European Commission has two-to-four months to respond. The EU is supposed to consider whether the pipeline meets the EU’s requirement that gas transport be “unbundled” or separated from gas production and sales. This is a higher hurdle but Germany’s clout will be felt. Hence final approval could come by March 8 or May 8, 2022. The energy crisis will put pressure for an early certification but the EU Commission may take the full time to pretend that it is not being blackmailed. See Joseph Nasr and Christoph Steitz, “Certifying Nord Stream 2 poses no threat to gas supply to EU – Germany,” Reuters, October 26, 2021, reuters.com. 3    Xi is not serving for an “unprecedented third term,” as the mainstream media keeps reporting. China’s top office is not constant nor were term limits ever firmly established. Each leader’s reign should be measured by their effective control rather than technical terms in office. Mao reigned for 27 years (1949-76), Deng for 14 years or more (1978-92), Jiang Zemin for 10 years (1992-2002), and Hu Jintao for 10 years (2002-2012).  4    See Joseph Fewsmith, “Mao’s Shadow” Hoover Institution, China Leadership Monitor 43 (2014), and “The 19th Party Congress: Ringing In Xi Jinping’s New Age,” Hoover Institution, China Leadership Monitor 55 (2018), hoover.org.  5    Liability-to-asset ratios less than 70%, debt-to-equity less than 100%, and cash-to-short-term-debt ratios of more than 1.0x.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Open Trades & Positions  Image

Highlights Short-term inflation risk will escalate further if politics causes new supply disruptions. Long-term inflation risk is significant as well. There is a distinct risk of a geopolitical crisis in the Middle East that would push up energy prices: the US’s unfinished business with Iran. The primary disinflationary risk is China’s property sector distress. However, Beijing will strive to maintain stability prior to the twentieth national party congress in fall 2022. South Asian geopolitical risks are rising. The Indo-Pakistani ceasefire is likely to break down, while Afghani terrorism will rebound. Book gains on our emerging market currency short targeting “strongman” regimes. Feature Chart 1 Investors are underrating the risk of a global oil shock. This was our geopolitical takeaway from the BCA Conference this year. Investors are focused on the risk of inflation and stagflation, always with reference to the 1970s. The sharp increase in energy prices due to the Arab Oil Embargo of 1973 and the Iranian Revolution of 1979 are universally cited as aggravating factors of stagflation at that time. But these events are also given as critical differences between the situation in the 1970s and today. Unfortunately, there could be similarities. From a strictly geopolitical perspective, the risk of a conflict in the Middle East is significant both in the near term and over the coming year or so. The risk stems from the US’s unfinished business with Iran. More broadly, any supply disruption would have an outsized impact as global energy inventories decline. OPEC’s spare capacity at present can cover a 5 million barrel shock (Chart 1). In this week’s report we also provide tactical updates on China, Russia, and India. Geopolitics And The 1970s Inflation Chart 2Wage-Price Spiral, Stagflation In 1970s Wage-Price Spiral, Stagflation In 1970s Wage-Price Spiral, Stagflation In 1970s Fundamentally the stagflation of the 1970s occurred because global policymakers engendered a spiral of higher wages and higher prices. The wage-price spiral was exacerbated by a falling dollar, after President Nixon abandoned the gold standard, and a commodity price surge (Chart 2). Monetary policy clearly played a role. It was too easy for too long, with broad money supply consistently rising relative to nominal GDP (Chart 3). Central banks including the Federal Reserve were focused exclusively on employment. Policymakers saw the primary risk to the institution’s credibility as recession and unemployment, not inflation. Fear of the Great Depression lurked under the surface. Fiscal policy also played a role. The size of the US budget deficit at this time is often exaggerated but there is no question that they were growing and contributed to the bout of inflation and spike in bond yields (Chart 4). The reason was not only President Johnson’s large social spending program, known as the “Great Society.” It was also Johnson’s war – the Vietnam war. Chart 3Central Banks Focused On Employment, Not Prices, In 1970s Central Banks Focused On Employment, Not Prices, In 1970s Central Banks Focused On Employment, Not Prices, In 1970s On top of this heady mix of inflationary variables came geopolitics. The Yom Kippur war in 1973 prompted Arab states to impose an embargo on Israel’s supporters in the West. The Arab embargo cut off 8% of global oil demand at the time. Oil prices skyrocketed, precipitating a deep recession (Chart 5). Chart 4Johnson's 'Great Society' And Vietnam War Spending Johnson's 'Great Society' And Vietnam War Spending Johnson's 'Great Society' And Vietnam War Spending The embargo came to a halt in spring of 1974 after Israeli forces withdrew to the east of the Suez Canal. The oil shock exacerbated the underlying inflationary wave that continued throughout the decade. The Iranian revolution triggered another oil shock in 1979, bringing the rise in general prices to their peak in the early 1980s, at which point policymakers intervened decisively. Chart 5Arab Oil Embargo And Iranian Revolution Arab Oil Embargo And Iranian Revolution Arab Oil Embargo And Iranian Revolution There is an analogy with today’s global policy mix. Fear of the Great Recession and deflation rules within policymaking circles, albeit less so among the general public. The Fed and the European Central Bank have adjusted their strategies to pursue an average inflation target and “maximum employment.” Chart 6Wage-Price Spiral Today? Wage-Price Spiral Today? Wage-Price Spiral Today? ​​​​​​ The Biden administration is reviving big government with a framework agreement of around $1.2 trillion in new deficit spending on infrastructure, green energy, and social programs likely to pass Congress before year’s end. In short, the macro and policy backdrop are changing in a way that is reminiscent of the 1970s despite various structural differences between the two periods. It is too early to declare that a wage-price spiral has developed but core inflation is rising and investors are right to be concerned about the direction and potential for inflation surprises down the road (Chart 6). These trends would not be nearly as concerning if they were not occurring in the context of a shift in public opinion in favor of government versus markets, labor versus capital, onshoring versus offshoring, and protectionism versus free trade. Investors should note that the last policy sea change (in the opposite direction) lasted roughly 30-40 years. The global savings glut – shown here as the combined current account balances of the world’s major economies – has begun to decline, implying that a major deflationary force might be subsiding. Asian exporters apparently have substantial pricing power, as witnessed by rising export prices, although they have yet to break above the secular downtrend of the post-2008 period (Chart 7). Chart 7Hypo-Globalization Is Inflationary Hypo-Globalization Is Inflationary Hypo-Globalization Is Inflationary A commodity price surge is also underway, of course, though it is so far manageable. The US and EU economies are less energy-intensive than in the 1970s and there is considerable buffer between today’s high prices and an economic recession (Chart 8). Chart 8Wage-Price Spiral Today? Wage-Price Spiral Today? Wage-Price Spiral Today? The problem is that there is a diminishing margin of safety. Furthermore, a crisis in the Middle East is not far-fetched, as there is a concrete and distinct reason for worrying about one: the US’s unresolved collision course with Iran. A crisis in the Persian Gulf would greatly exacerbate today’s energy shortages. Iran: The Risk Of An Oil Shock Iran now says it will rejoin diplomatic talks over its nuclear program in late November. This development was expected, and is important, but it masks the urgent and dangerous trajectory of events that could blow up any day now. It is emphatically not an “all clear” sign for geopolitical risk in the Persian Gulf. The US is hinting, merely hinting, that it is willing to use military force to prevent Iran from going nuclear. The Iranians doubt US appetite for war and have every reason to think that nuclear status will guarantee them regime survival. Thus the Iranians are incentivized to use diplomacy as a screen while pursuing nuclear weaponization – unless the US and Israel make a convincing display of military strength to force Iran back to genuine diplomacy. A convincing display is hard to do. A secret war is taking place, of sabotage and cyber-attacks. On October 26 a cyber-attack disrupted Iranian gas stations. But even attacks on nuclear scientists and facilities have not dissuaded the Iranians from making progress on their nuclear program yet. Iran does not want to be attacked but it knows that a ground invasion is virtually impossible and air strikes alone have a poor record of winning wars. The Iranians have achieved 60% highly enriched uranium and are expected to achieve nuclear breakout capacity – the ability to make a nuclear device – sometime between now and December (Table 1). The IAEA no longer has any visibility in Iran. The regime’s verified production of uranium metal can only be used for the construction of a warhead. Recent technical progress may be irreversible, according to the Institute for Science and International Security.1 If that is true then the upcoming round of diplomatic negotiations is already doomed. Table 1Iran’s Compliance With Nuclear Deal And Time Until Breakout (Oct 2021) Bad Time For An Oil Shock! (GeoRisk Update) Bad Time For An Oil Shock! (GeoRisk Update) American policymakers seem overconfident in the face of this clear nuclear proliferation risk. This is strange given that North Korea successfully manipulated them over the past three decades and now has an arsenal of 40-50 nuclear weapons. The consensus goes as follows: Regime instability: Americans emphasize that the Iranian regime is unstable, lacks genuine support, and faces a large and restive youth population. This is all true. Indeed Iran is one of the most likely candidates for major regime instability in the wake of the COVID-19 shock. Chart 9AIran's Economy Sees Inflation Spike ... Iran's Economy Sees Inflation Spike ... Iran's Economy Sees Inflation Spike ... ​​​​​​ Chart 9B... Yet Some Green Shoots Are Rising ... Yet Some Green Shoots Are Rising ... Yet Some Green Shoots Are Rising However, popular protest has not had any effect on the regime over the past 12 years. Today the economy is improving and illicit oil revenues are rising (Chart 9). A new nationalist government is in charge that has far greater support than the discredited reformist faction that failed on both the economic and foreign policy fronts (Chart 10). The sophisticated idea that achieving nuclear breakout will somehow weaken the regime is wishful thinking.  If it provokes US and/or Israeli air strikes, it will most likely see the people rally around the flag and convince the next generation to adopt the revolutionary cause.2 If it does not provoke a war, then the regime’s strategic wisdom will be confirmed. American military and economic superiority: Americans tend to think that Iran will back down in the face of the US’s and Israel’s overwhelming military and economic superiority. It is true that a massive show of force – combined with the sale of specialized weaponry to Israel to enable a successful strike against extremely hardened nuclear facilities – could force Iran to pause its nuclear quest and go back to negotiations. Yet the US’s awesome display of military power in both Iraq and Afghanistan ended in ignominy and have not deterred Iran, just next door, after 20 years. Nor have American economic sanctions, including “maximum pressure” sanctions since 2019. The US is starkly divided, very few people view Iran as a major threat, and there is an aversion to wars in the Middle East (Chart 11). The Iranians could be forgiven for doubting that the US has the appetite to enforce its demands. Chart 10 ​​​​​​ Chart 11 ​​​​​​ In short the US is attempting to turn its strategic focus to China and Asia Pacific, which creates a power vacuum in the Middle East that Iran may attempt to fill. Meanwhile global supply and demand balances for energy are tight, with shortages popping up around the world, giving Iran greater leverage. From an investment point of view, a crisis is likely in the near term regardless of what happens afterwards. A crisis is necessary to force the US and Iran to return to a durable nuclear deal like in 2015. Otherwise Iran will reach nuclear breakout and an even bigger crisis will erupt, potentially forcing the US and Israel (or Israel alone) to take military action. Diplomatic efforts will need to have some quick and substantial victories in the coming months to convince us that the countries have moved off their collision course. A conflict with Iran will not necessarily go to the extreme of Iran shutting down the Strait of Hormuz and cutting off 21% of the world’s oil and 26% of liquefied natural gas (Chart 12). If that happens a global recession is unavoidable. It would more likely involve lesser conflicts, at least initially, such as “Tanker War 2.0” in the Persian Gulf.3 Or it could involve a flare-up of the ongoing proxy war by missile and drone strikes, such as with the Abqaiq attack in 2019 that knocked 5.7 million barrels per day offline overnight. The impact on oil markets will depend on the nature and magnitude of the event. Chart 12 What are the odds of a military conflict? In past reports we have demonstrated that there is a 40% chance of conflict with Iran. The country’s nuclear program is at a critical juncture. The longer the world goes without a diplomatic track to defuse tensions, the more investors should brace for negative surprises. Bottom Line: There is a clear and present danger of a geopolitical oil shock. The implication is that oil and LNG prices could spike in the coming zero-to-12 months. The implication would be a dramatic “up then down” movement in global energy prices. Inflation expectations should benefit from simmering tensions but a full-blown war would cause an extreme price spike and global recession. China: The Return Of The Authoritative Person Another reason that today’s inflation risk could last longer than expected is that China’s government is likely to backpedal from overtightening monetary, fiscal, and regulatory policy. If this is true then China will secure its economic recovery, the global recovery will continue, commodity prices will stay elevated, and the inflation expectations and bond yields will recover. If it is not true then investors will start talking about disinflation and deflation again soon. We are not bullish on Chinese assets – far from it. We see China entering a property-induced debt-deflation crisis over the long run. But over the 2021-22 period we have argued that China would pull back from the brink of overtightening. Our GeoRisk Indicator for China highlights how policy risk remains elevated (see Appendix). So far our assessment appears largely accurate. The government has quietly intervened to prevent the troubled developer Evergrande from suffering a Lehman-style collapse. The long-delayed imposition of a nationwide property tax is once again being diluted into a few regional trial balloons. Alibaba founder Jack Ma, whom the government disappeared last year, has reappeared in public view, which implies that Beijing recognizes that its crackdown on Big Tech could cause long-term damage to innovation. At this critical juncture, a mysterious “authoritative” commentator has returned to the scene after five years of silence. Widely believed to be Vice Premier Liu He, a Politburo member and Xi Jinping confidante on economic affairs, the authoritative person argues in a recent editorial that China will stick with its current economic policies.4 However, the message was not entirely hawkish. Table 2 highlights the key arguments – China is not oblivious to the risk of a policy mistake. Table 2Messages From China’s ‘Authoritative Person’ On Economic Policy (2021) Bad Time For An Oil Shock! (GeoRisk Update) Bad Time For An Oil Shock! (GeoRisk Update) Readers will recall that a similar “authoritative Person” first appeared in the People’s Daily in May 2016. At that time, the Chinese government had just relented in the face of economic instability and stimulated the economy. It saw a 3.5% of GDP increase in fiscal spending and a 10.0% of GDP increase in the credit impulse from the trough in 2015 to the peak in 2016. The authoritative person was explaining that the intention to reform would persist despite the relapse into debt-fueled growth. So one must wonder today whether the authoritative person is emerging because Beijing is sticking to its guns (consensus view) or rather because it is gradually being forced to relax policy by the manifest risk of financial instability. To be fair, a recent announcement on government special purpose bonds does not indicate major fiscal easing. If local governments accelerate their issuance of new special purpose bonds to meet their quota for the year then they are still not dramatically increasing the fiscal support for the economy. But this announcement could protect against downside growth risks. The first quarter of 2022 will be the true test of whether China will remain hawkish. Going forward there are two significant dangers as we see it. The first is that policymakers prove ideological rather than pragmatic. An autocratic government could get so wrapped up in its populist campaign to restrain high housing costs that it refuses to slacken policies enough and causes a crash. The second danger is that inflation stays higher for longer, preventing authorities from easing policy even when they know they need to do so to stabilize growth. The second danger is the bigger of the two risks. As for the first risk, ideology will take a backseat to necessity. Xi Jinping needs to secure key promotions for his faction in the top positions of the Communist Party at the twentieth national party congress in 2022. He cannot be sure to succeed if the economy is in free fall. A self-induced crash would be a very peculiar way of trying to solidify one’s stature as leader for life at the critical hour. Similarly China cannot maintain a long-term great power competition with the United States if it deliberately triggers property deflation and financial turmoil. It can and will continue modernizing and upgrading its military, e.g. developing hypersonic missiles, even if it faces financial turmoil. But it will have a much greater chance of neutralizing US regional allies and creating a regional buffer space if its economic growth is stable. Ultimately China cannot prevent financial instability, economic distress, and political risk from rising in the coming years. There will be a reckoning for its vast imbalances, as with all countries. It could be that this reckoning will upset the Xi administration’s best-laid plans for 2022. But before that happens we expect policy to ease. A policy mistake today would mean that very negative economic outcomes will arrive precisely in time to affect sociopolitical stability ahead of the party congress next fall. We will keep betting against that. Bottom Line: China’s “authoritative” media commentator shows that policymakers are not as hawkish as the consensus holds. The main takeaway is that policymakers will adjust the intensity of their reform efforts to maintain stability. This is standard Chinese policymaking and it is more important than usual ahead of the political rotation in 2022. Otherwise global inflation risk will quickly give way to deflation risk as defaults among China’s property developers spread and morph into broader financial and economic instability. Indo-Pakistani Ceasefire: A Breakdown Is Nigh India and Pakistan agreed to a ceasefire along the line of control in February 2021. While the agreement has held up so far, a breakdown is probably around the corner. It was never likely to last for long. Over the short run, the ceasefire made sense for both countries: COVID-19 Risks: The first wave of the pandemic had abated but COVID-19-related risks loomed large. India had administered less than 15 million vaccine doses back then and Pakistan only 100,000. Dangerous Transitions Were Underway: With America’s withdrawal from Afghanistan in the works, Pakistan was fully focused on its western border. India was pre-occupied with its eastern front, where skirmishes with Chinese troops forced it to redirect some of its military focus. As we now head towards the end of 2021, these constraints are no longer binding. COVID-19 Risks Under Control: The vaccination campaign in India and Pakistan has gathered pace. More than 50% of India’s population and 30% of Pakistan’s have been given at least one dose. Pakistan’s Ducks Are Lined-up In Afghanistan: America’s withdrawal from Afghanistan has been completed. Afghanistan is under Taliban’s control and Pakistan has a better hold over the affairs of its western neighbor. One constraint remains: India and China remain embroiled in border disputes. Conciliatory talks between their military commanders broke down a fortnight ago. Winter makes it nearly impossible to undertake significant operations in the Himalayas but a failure of coordination today could set up a conflict either immediately or in the spring. While India may see greater value in maintaining the ceasefire than Pakistan, India has elections due in key northern states in 2022. India’s northern states harbor even less favorable views of Pakistan than the rest of India. Hence any small event could trigger a disproportionate response from India. Bottom Line: While it is impossible to predict the timing, a breakdown in the Indo-Pakistani ceasefire may materialize in 2022 or sooner. Depending on the exact nature of any conflict, a geopolitically induced selloff in Indian equities could create a much-needed consolidation of this year’s rally and ultimately a buying opportunity. Russia, Global Terrorism, And Great Power Relations Part of Putin’s strategy of rebuilding the Russian empire involves ensuring that Russia has a seat at the table for every major negotiation in Eurasia. Now that the US has withdrawn forces from Afghanistan, Russia is pursuing a greater role there. Most recently Russia hosted delegations from China, Pakistan, India, and the Taliban. India too is planning to host a national security advisor-level conference next month to discuss the Afghanistan situation. Do these conferences matter for global investors? Not directly. But regional developments can give insight into the strategies of the great powers in a world that is witnessing a secular rise in geopolitical risk. Chart 13 China, Russia, and India have skin in the game when it comes to Afghanistan’s future. This is because all three powers have much to lose if Afghanistan becomes a large-scale incubator for terrorists who can infiltrate Russia through Central Asia, China through Xinjiang, or India through Pakistan. Hence all three regional powers will be constrained to stay involved in the affairs of Afghanistan. Terrorism-related risks in South Asia have been capped over the last decade due to the American war (Chart 13). The US withdrawal will lead to the activation of latent terrorist activity. This poses risks specifically for India, which has a history of being targeted by Afghani terrorist groups. And yet, while China and Russia saw the Afghan vacuum coming and have been engaging with Taliban from the get-go, India only recently began engaging with Taliban. The evolution of Afghanistan under the Taliban will also influence the risk of terrorism for the rest of the world. In the wake of the global pandemic and recession, social misery and regime failures in areas with large youth populations will continue to combine with modern communications technology to create a revival of terrorist threats (Chart 14). Chart 14 American officials recently warned of the potential for transnational attacks based in Afghanistan to strike the homeland within six months. That risk may be exaggerated today but it is real over the long run, especially as US intelligence turns its strategic focus toward states and away from non-state actors. India, Europe, and other targets are probably even more vulnerable than the United States. If Russia and China succeed in shaping the new Afghanistan’s leadership then the focus of militant proxies will be directed elsewhere. Beyond terrorism, if Russia and China coordinate closely over Afghanistan then India may be left in the cold. This would reinforce recent trends in which a tightening Russo-Chinese partnership hastens India’s shift away from neutrality and toward favoring the US and the West in strategic matters. If these trends continue to the point of alliance formation, then they increase the risk that any conflicts between two powers will implicate others. Bottom Line: Afghanistan is now a regional barometer of multilateral cooperation on counterterrorism, the exclusivity of Russo-Chinese cooperation, and India’s strategic isolation or alignment with the West. Investment Takeaways It is too soon to play down inflation risks. We share the BCA House View that they will subside next year as pandemic effects wane. But we also see clear near-term risks to this view. In the short run (zero to 12 months), a distinct risk of a Middle Eastern geopolitical crisis looms. A gradual escalation of tensions is inflationary whereas a sharp spike in conflict would push energy prices into punitive territory and kill global demand. Over the next 12 months, China’s economic and financial instability will also elicit policy easing or fiscal stimulus as necessary to preserve stability, as highlighted by the regime’s mouthpiece. Obviously stimulus will not be utilized if the economic recovery is stable, given elevated producer prices. In a future report we will show that Russia is willing and able to manipulate natural gas prices to increase its bargaining leverage over Europe. This dynamic, combined with the risk of cold winter weather exacerbating shortages, suggests that the worst is not yet over. Geopolitical conflict with Russia will resume over the long run. Stay long gold as a hedge against both inflation and geopolitical crises involving Iran, Taiwan/China, and Russia. Maintain “value” plays as a cheap hedge against inflation. Book a profit of 2.5% on our short trade for currencies of emerging market “strongmen,” Turkey, Brazil, and the Philippines. Our view is still negative on these economies. Stay long cyber-security stocks. Over the long run, inflation risk must be monitored. We expect significant inflation risk to persist as a result of a generational change in global policy in favor of government and labor over business and capital. But the US is maintaining easy immigration policy and boosting productivity-enhancing investments. Meanwhile China’s secular slowdown is disinflationary. The dollar may remain resilient in the face of persistently high geopolitical risk. The jury is still out.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1      David Albright and Sarah Burkhard, "Iran’s Recent, Irreversible Nuclear Advances," Institute for Science and International Security, September 22, 2021, isis-online.org. 2     Ray Takeyh, "The Bomb Will Backfire On Iran," Foreign Affairs, October 18, 2021, foreignaffairs.com. 3     See Aaron Stein and Afshon Ostovar, "Tanker War 2.0: Iranian Strategy In The Gulf," Foreign Policy Research Institute, August 10, 2021, fpri.org. 4     "Ten Questions About China’s Economy," Xinhua, October 24, 2021, news.cn.     Section II: Appendix: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator United Kingdom UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan-Province of China: GeoRisk Indicator Taiwan-Province of China: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator South Africa South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Section III: Geopolitical Calendar

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

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