Russia

Highlights There is a tentative decline in geopolitical risk: An orderly Brexit or no Brexit is the likely final outcome and the U.S.-China talks are coming together. The outstanding geopolitical risks still warrant caution on global equities in the near term. Internal and external instability in Saudi Arabia, any American persistence with maximum pressure sanctions on Iran, and domestic instability in Iraq pose a risk to global oil supply. Go long spot crude oil and GBP/JPY. Feature Chart 1A Tentative Decline In Geopolitical Risk A Tentative Decline In Geopolitical Risk A Tentative Decline In Geopolitical Risk Our views on Brexit and the U.S.-China trade talks are coming together, resulting in a tentative decline in geopolitical risk (Chart 1). The British parliament still needs to ratify Boris Johnson’s exit agreement, painstakingly negotiated with the EU in a surprise summit this week. He may not have the votes. If he fails then he will have a basis to seek an extension to the Brexit deadline on October 31. But it is clear that the EU is willing to allow compromises to prevent a no-deal exit shock from exacerbating the slowdown in the European economy. An orderly Brexit is the final outcome (or no Brexit at all if an election and new referendum should say so). We are removing the $1.30 target on our long GBP/USD call in light of these developments and going long GBP/JPY. Similarly, while uncertainty lingers over U.S.-China relations, it is clear that President Trump is sensitive to the impact of the manufacturing recession and the risk of an overall recession on his reelection prospects. He is therefore pursuing a ceasefire and delaying tariffs. China is minimally reciprocating to forestall a collapse in relations. The December 15 tariff hike will be delayed and, if a ceasefire fails to improve the economic outlook, we expect Trump to engage in some tariff rollback on the pretext that talks are “making progress.” However, we do not expect a bilateral trade agreement or total tariff rollback. And other factors (like political risks in Greater China) could still derail the process. The outstanding geopolitical risks still warrant caution on global equities in the near term. These risks include a collapse in the U.S.-China talks (e.g. due to Hong Kong, Taiwan, or the tech race), and the ascent of Elizabeth Warren as the front runner in the Democratic Party’s early primary election. There is also the risk of another oil price shock emanating from the Middle East, which we discuss in this report. The Aftermath Of Abqaiq It has been a geopolitically eventful summer in the Middle East (Diagram 1). While there were plenty of warning shots, the September 14 drone and missile strikes on Saudi Aramco infrastructure was the big bang – wiping out 5.7 mm b/d of crude oil supplies overnight (Chart 2). The attacks were significant not only in terms of their impact on global oil markets, but also because they exposed the U.S.’s and Saudi Arabia’s reluctance to engage in a full-scale military confrontation with Iran. It is too early to call peak tensions in the Persian Gulf. Diagram 1Timeline: Summer Fireworks In The Persian Gulf Around The Middle East Around The Middle East Chart 2Closing Hormuz Would Be The Biggest Oil Shock Ever Around The Middle East Around The Middle East It is too early to call peak tensions in the Persian Gulf. The October 11 strike on an Iranian-owned oil tanker in the Red Sea and the reported U.S. cyber-attacks against Iranian news outlets may well mark the “limited retaliation” that we expected. Nevertheless, last month’s events uncovered vulnerabilities that suggest that even if the U.S. and its Gulf allies back off, geopolitical risk will remain elevated. Chart 3Saudis Are Profligate Defense Spenders Around The Middle East Around The Middle East The most obvious outcome of the September 14 attack is the realization of just how vulnerable Saudi Arabia is to attacks by its regional enemies. Despite being the third most profligate defense spender in the world – and the first relative to GDP (Chart 3) – Saudi Arabia was unable to protect its critical infrastructure. For that, Crown Prince Mohamed bin Salman (MBS) will surely face domestic pressure. After five years, Saudi Arabia has little to show from its war in Yemen, other than a humanitarian crisis that has hurt its international standing. Instead, the operation has been a burden on the kingdom’s finances and a nuisance to security in the southwestern provinces of Najran, Jizan and Asir, where the Iran-allied Houthis have conducted regular attacks on oil infrastructure and airports. Some domestic disquiet will be defused if the Yemen war is downgraded or resolved. Saudi Arabia recently accepted the olive branch extended by the Houthis and is reportedly in talks to deescalate. But this will not fully eliminate domestic uncertainty. After all, MBS’s other initiatives – in Syria, in Iraq, in lobbying the U.S. – are also in jeopardy. The conspiracy theory surrounding the September 29 murder of General Abdulaziz al-Faghem, King Salman’s longstanding personal bodyguard, is case in point. Rumor has it that the king was enraged upon hearing of the Houthi movement’s September 28 capture of three Saudi military brigades, and decided to revoke the Crown Prince’s title, instead appointing the youngest Sudairi brother, Prince Ahmed bin Abdulaziz, in his place.1 The ploy was allegedly uncovered, resulting in General al-Faghem’s murder.2 This is entirely speculation and we find the idea of MBS’s removal to be highly doubtful. The King’s and Crown Prince’s joint appearance during President Vladimir Putin’s visit to the kingdom earlier this week should dispel speculation about a brewing palace coup. Nevertheless, the murder itself is extremely concerning and reinforces independent reasons for concerns about internal stability. Chart 4Impatient Diversification Threatens Domestic Stability Impatient Diversification Threatens Domestic Stability Impatient Diversification Threatens Domestic Stability The pursuit of the Saudi reform agenda, “Vision 2030,” is premised first and foremost on the consolidation of power in the hands of MBS and his faction. The appointment of King Salman’s son, Prince Abdulaziz, as energy minister was motivated by a desire to expedite the initial public offering of state oil giant Saudi Aramco, which could begin as early as November. This was preceded by the appointment of Yasir Al-Rumayyan, head of the sovereign wealth fund and a close ally of MBS, as chairman of Aramco. Moreover, wealthy Saudis – some of whom were detained at the Ritz Carlton in November 2017 – are reportedly being strong-armed into buying stakes in the pending IPO. While weaning Saudi Arabia’s economy off of crude oil is the best course of action for long-term stability (Chart 4), the transition will threaten domestic stability. Meanwhile the conflict with Iran is far from settled. Bottom Line: The September 14 drone strikes on key Saudi oil infrastructure revealed both Saudi Arabia’s and the U.S.’s unwillingness to engage in military action against and a full confrontation with Iran. This will raise concerns regarding the kingdom’s ability to defend itself. Moreover, Saudi Arabia remains vulnerable to domestic pressure as MBS strives to maintain his consolidation of power in recent years and pursues Vision 2030. Internal or external instability in Saudi Arabia poses a risk to global oil supply. Iran’s Resistance Economy Can Handle Trump’s Maximum Pressure Chart 5Iran's Economy Is Feeling The Bite Iran's Economy Is Feeling The Bite Iran's Economy Is Feeling The Bite On the other side of the Persian Gulf, the Iranians are displaying a higher pain threshold than their enemies. The economy is suffering under the U.S.’s crippling sanctions, with exports at the lowest level since 2003 (Chart 5). The IMF expects Iran’s economy to contract by 9.5% this year, with annual inflation forecast at 35.7%. Oil exports, the lifeblood of its economy, are down 89% YoY. Nevertheless, Iran is well-versed in the game of chicken, it is methodically displaying its ability to create havoc across the region, and it has not waivered in its stance that President Trump must ease sanctions and rejoin the 2015 nuclear deal if it is to engage in bilateral talks. All the while, Iran continues to reduce its nuclear commitments. On September 5, Rouhani indicated plans to completely abandon research and development commitments under the Joint Comprehensive Plan of Action (JCPOA) and to begin working on more advanced uranium enrichment centrifuges which was capped at 3.7% under the JCPOA (Table 1). We also expect Iran to follow-through on its threat of withdrawing from the Nuclear Non-Proliferation Treaty (NPT) if Trump maintains sanctions. Table 1Iran Is Walking Away From 2015 Nuclear Deal Around The Middle East Around The Middle East The same resolve cannot be shown on the part of the United States or Saudi Arabia. Chart 6Americans Do Not Support War With Iran Around The Middle East Around The Middle East President Trump is constrained by the risk of an Iran-induced oil price shock ahead of the 2020 election. He is therefore eager to deescalate tensions with Iran. He is abandoning the field in Syria (on which more below), opting to add a symbolic 1,800 troops into Saudi Arabia for deterrent effect instead. This defensive posture is being undertaken within the context of American public opinion, which opposes war with Iran or additional military adventures in the Middle East (Chart 6). This signifies the U.S.’s strategic deleveraging from the Middle East in order to shift its focus to Asia Pacific, where America has a greater priority in managing the rise of China. At the same time, negotiations between the Saudis and Yemeni Houthis suggest a lack of Saudi appetite for all-out conflict with Iran, clearing the way for a diplomatic solution. As Rouhani stated “ending the war in Yemen will pave the ground for de-escalation in the region,” specifically between Saudi Arabia and Iran. The Saudis have amply signaled in the wake of the Abqaiq attack that they wish to avoid a direct confrontation, particularly given the Trump administration’s apparent unwillingness (under electoral constraint) to continue providing a “blank check” for MBS to conduct an aggressive foreign policy. Already the United Arab Emirates – a key player in the Saudi-led coalition against Yemen – has distanced itself from Riyadh and sought to ease tensions with Iran. It recently reduced its commitment to the Yemen war and engaged in high-level meetings with Iran. The UAE’s national security adviser, Tahnoun bin Zayed, visited Tehran on a secret mission, the latest in a series of backchannel efforts to mediate between Saudi Arabia and Iran. Other reported efforts at diplomacy include visits by Iraqi and Pakistani officials. The remaining uncertainty is whether Trump will quietly ease sanctions on Iran, and whether Iran will quit while it is ahead. If Trump maintains maximum pressure, Iran may need to stage further attacks and oil disruptions to threaten Trump’s economy and encourage sanction relief. Otherwise, Iran, smelling American and Saudi fear, could overstep its bounds and commit a provocation that requires a larger American response, thus re-escalating tensions. While Trump’s economic and electoral constraint suggests that he will ease sanctions underhandedly, Iran’s risk appetite is apparently very high: Abqaiq could have gone terribly wrong. It also has an opportunity to flex its muscles and demonstrate American inconstancy to the region. This could lead to miscalculation and a more significant oil price shock than already seen. Bottom Line: Iran has remained steadfast in its position while the United States, Saudi Arabia, and their allies appear to be capitulating. They have more to lose than gain from all-out conflict. But Iran’s decision-making is opaque and any American persistence with maximum pressure sanctions will motivate additional provocations, escalation, and oil supply disruption. Making Russia Great Again? Recent events in Turkey and Syria do not come as a surprise. We have long highlighted a deeper Turkish intervention into Syria as a regional “black swan” event. In August we warned clients that the Trump-Erdogan personal relationship would not save Turkey from impending U.S. sanctions. In September we warned that Turkish geopolitical risk premia had collapsed, as measured by our market-based GeoRisk indicator, and that this collapse was certain to reverse in a major way, sending the lira falling. As we go to press the Turks have declared a ceasefire to avoid sanctions but nothing is certain. Putin has pounced on the opportunity to capitalize on the U.S. retreat. If Turkey is the loser, who is the winner? First, Trump, who benefits from fulfilling a campaign pledge to reduce U.S. involvement in foreign wars – a stance that will ultimately be rewarded (or at least not punished) by a war-weary public. Second, Iran and Russia, Syria’s major allies, who have invested greatly in maintaining the regime of Bashar al-Assad throughout the civil war and now face American withdrawal and heightened U.S. tensions with its allies and partners in the region as a result. Iran benefits through the ability to increase its strategic arc, the so-called “Shia Crescent,” to the Mediterranean Sea. Russia benefits through solidifying its reclaimed status as a major player in the Middle East – an indication of global multipolarity. President Vladimir Putin has pounced on the opportunity to capitalize on the U.S. retreat with official visits to both Saudi Arabia and the UAE this week. He made promises of both stronger economic ties and the ability to broker regional power. On the economic front, the Russian Direct Investment Fund (RDIF) selected Saudi Arabia as the venue for its first foreign office, signaling its interest in the region. It has already approved 25 joint projects with investment valued at more than $2.5 billion. There are also talks of RDIF-Aramco projects in the oil services sector worth over $1 billion and oil and gas conversion projects worth more than $2 billion. Moreover, RDIF signed multiple deals worth $1.4 billion with UAE partners. Chart 7Russia Has Been Complying With OPEC 2.0 Cuts Russia Has Been Complying With OPEC 2.0 Cuts Russia Has Been Complying With OPEC 2.0 Cuts Most importantly, the Saudis and Russians share the same objective of supporting global oil prices and have been jointly managing OPEC 2.0 supply since 2017 (Chart 7). Russia’s approach to the region focuses on enhancing its all-around strategic influence. Chart 8Erdogan Is Playing Into Turkish Concerns About Syrian Refugees Around The Middle East Around The Middle East Although Russia’s allies include Iran and Syria – Saudi Arabia’s rivals – it has presented itself as a pragmatic partner to other powers, including Turkey and even the Saudis and Gulf states. As such, the Kremlin has leverage on both sides of the regional divide, giving it the potential to serve as a power broker. However, any Saudi purchase of the Russian S-400 defense system, long under negotiation, would unsettle the United States. Turkey is threatened with American sanctions for its purchase of the same system.3 The U.S. may be willing to tolerate some increased Russian influence in the Middle East, but a defense agreement may be its red line. The Trump administration still wields the stick of economic sanctions. Growing Russian influence extends beyond the Gulf states. The U.S.’s withdrawal from northeast Syria last week and the Turkish invasion is a gift to the Russians. They are now the only major power from outside the Middle East engaged in Syria. They have embraced this position, positioning themselves as peace brokers between the Syrian regime, with whom they are allied, and Turkey, as well as the Turkish arch-enemy, the Kurds, who now lack American support and must turn to Syria and Russia for some kind of arrangement to protect themselves. Russia has therefore cemented its return as a strategic player in the region, after its initial intervention in Syria in 2015. Turkey’s incursion into Syria is an attempt by President Erdogan to confront the battle-hardened Syrian Kurds and prevent a Kurdish-controlled continuous border with Syria, and to distract from his weakened domestic position. He is striving to garner support by playing to broad Turkish concerns about Syrian refugees in Turkey (Chart 8). The intervention will seek to create a space for refugees to be placed on the Syrian side of the border. However given that there is little domestic popular support for a military intervention, he runs the risk of further alienating voters, who are already losing patience with his ruling Justice and Development Party (AKP). So far, the incursion has the official support of all Turkey’s political parties except the Kurdish Peoples’ Democratic Party (HDP). However this will change as the intervention entails western economic sanctions, a drawn-out military conflict, and limited concrete benefits other than the removal of refugees. Chart 9Turkey's Already Vulnerable Economy Will Take A Hit Turkey's Already Vulnerable Economy Will Take A Hit Turkey's Already Vulnerable Economy Will Take A Hit The already vulnerable economy is likely to take a hit (Chart 9). Markets have reacted to the penalties imposed by the U.S. so far with a sigh of relief as they are not as damaging as they could have been – i.e. Turkish banks were spared.4 However, this is just the opening salvo and more sanctions are on the way – Congress is moving to impose sanctions of its own, which Trump is unlikely to veto. Moreover, the European Union is following suit and imposing sanctions of its own, including on military equipment. Volkswagen already announced it is postponing a final decision on whether to build a $1.1 billion plant in Turkey. This comes at a time of already existing sensitivities with the EU over Turkish oil and gas drilling activities in waters off Cyprus. EU foreign ministers are responding by drawing up a list of economic sanctions. These economic risks will likely hold back the central bank’s rate cutting cycle as the lira and financial assets will take a hit. Bottom Line: The U.S. pivot away from the Middle East is a boon for Moscow, which is pursuing increased cooperation in the Gulf and gaining influence in Syria. Russia is marketing itself as a strategic player and effective power broker. Erdogan’s incursion in Syria, while motivated by domestic weakness, will backfire on the Turkish economy. Maintain a cautious stance on Turkish currency and risk assets. Iraq Is The Fulcrum Iraq’s geographic position, wedged between Saudi Arabia and Iran, renders it the epicenter of the regional power struggle. In the wake of the Trump administration’s maximum pressure campaign on Iran we have frequently highlighted that a dramatic means of Iranian pushback, short of closing shipping in the Strait of Hormuz, is fomenting unrest in an already unstable Iraq. This would be a threat to U.S. strategy as well as to global oil supplies. Iraq is the epicenter of the regional power struggle. In this context, Iraq’s revered Shia cleric Muqtada al-Sadr’s visit to Iran on September 10, just four days ahead of the September Saudi Aramco attack, raises eyebrows. Sadr is the key player in Iraq today and over the past two years he had staked out a position of national independence for Iraq, eschewing overreliance on Iran. A rapprochement between Sadr and Iran is a negative domestic development for Iraq, which has recently been making strides to reduce Iran’s political and military grip. It would undermine Iraqi stability by increasing divisions over ideology, sect, economic patronage, and national security. There is speculation that Sadr’s trip was intended to discuss Prime Minister Adel Abdul Mahdi, who is perceived as weak and incapable of managing the various powers on Iraq’s political scene. The violent protests rocking Iraq since early September support this assessment. Protestors are motivated by discontent over unemployment, poor services, and government corruption, which are perceived to have mostly deteriorated since the start of Abdul Mahdi’s term (Chart 10). While Abdul Mahdi has announced some reforms in response to the popular discontent, including a cabinet reshuffle and promises of handouts for the poor, they have done little to quell the protests. The popular demands are only one of the existential threats facing the government. The second and potentially more serious risk is the security threat. Iraq has been failing at its attempts to formally integrate the Popular Mobilization Units (PMU) – Iran-backed paramilitary groups that were instrumental in ISIS’s defeat – into the national security forces. This is essential in order to prevent Iran from maintaining direct control of security forces within Iraq. A majority of the public agrees that the PMU should not play a role in politics (Chart 11), reflecting the underlying trend demanding Iraqi autonomy from Iran. Chart 10Rising Discontent In Iraq Around The Middle East Around The Middle East Chart 11Little Support For A Political Role For The PMU Around The Middle East Around The Middle East Given that the PMU is in effect an umbrella term for ~50 predominantly Shia paramilitary groups, internal divisions exist within the forces which compete for power, legitimacy, and resources. Recently, it has been purging group leaders perceived as a threat to the overall forces and the senior leadership which maintain strong links to Iran. Chart 12Iraq Is Divided Across Political Affiliation Around The Middle East Around The Middle East This internal struggle also reflects the intra-Shia struggle for power among Iraq’s main political parties. On the one side there is the conservative, pro-Khamenei bloc led by former Prime Minister Nouri al-Maliki and PMU commander Hadi al-Ameri, and on the other is the reformist, nationalist leader Muqtada al-Sadr’s joined by Ammar al-Hakim. Given that most Iraqis view their country as a divided nation across political affiliation, this is a risk to domestic stability (Chart 12). Thus even if the wider risk of regional tensions abates and reduces the threat of sabotage to oil infrastructure and transportation, the current domestic situation in Iraq remains uneasy. But given that we do not see the regional tensions abating yet – due to either American maximum pressure or Iranian hubris – this dynamic translates into an active threat to oil supplies, with 3.4 mm b/d of exports concentrated in the southern city of Basra. Bottom Line: Heightened domestic instability in Iraq poses a non-negligible threat to oil supplies. This risk is compounded by Iraq’s location as a geographic buffer between regional rivals Iran and Saudi Arabia, and Iran’s interest in fomenting unrest to pressure the U.S. into relaxing sanctions. Investment Conclusions The common thread across the Middle East is a persistent threat to global oil supply in the wake of the extraordinary Abqaiq attack. First, it cannot be stated with confidence that Iran will refrain from causing additional oil disruptions, as it is convinced that President Trump’s appetite for conflict is small (and Trump is indeed constrained by fear of an oil shock). President Rouhani has an interest in removing Trump from power, which an oil shock might achieve, and the Supreme Leader may even be willing to risk a conflict with the United States as a means of increasing support for the regime and infusing a new generation with revolutionary spirit. Iran loses in a total war, but Tehran is convinced that the U.S. does not have the will to engage in total war. Second, Russia’s interest in the region is not in generating a durable peace but in filling the vacuum left by the United States and making itself a power broker. Any instability simply increases oil prices which is positive for Russia. Third, Iraq’s instability is both domestically and internationally driven. It is nearly impossible to differentiate between the two. Iranian hubris could manifest in sabotage in Iraq. Or Iraq could destabilize under the regional pressures with minimal Iranian encouragement. Either way the world’s current below-average spare oil production capacity could be hit sooner than expected if shortages result. Go long spot crude oil. On equities, with a U.S.-China ceasefire in the works, and little chance of a no-deal Brexit, we see our cyclically positive outlook reinforced, though we maintain near-term caution due to U.S. domestic politics. In terms of equity focus, we are overweight European equities in developed markets and Southeast Asian equities in emerging markets.   Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 The Sudairi branch of the al-Saud family is made up of the seven sons of the late King Abdulaziz and Hussa al-Sudairi of the powerful Najd tribe. 2 Please see TRT World “Killing of Saudi King’s Personal Bodyguard Triggers Speculation,” October 2, 2019, available at https://www.trtworld.com. 3 In the wake of the attack on Saudi Aramco oil facilities, President Putin trolled the U.S. by recommending that Saudi Arabia follow the footsteps of Iran and Turkey in purchasing Russia’s S-300 or S-400 air defense systems. 4 The U.S. penalties include sanctions against current and former officials of the Turkish government, a hike in tariffs on imports of Turkish steel back up to 50 percent, and the halt in negotiations on a $100 billion trade deal.

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

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

Russian financial markets and the ruble have entered a low-beta paradigm. A combination of ultra-conservative fiscal and monetary policies over the past four years will help Russian equities, local bonds as well as sovereign and corporate credit to continue outperforming their respective EM benchmarks.   Chart I-1Fiscal Balance Is In Large Surplus Fiscal Balance Is In Large Surplus Fiscal Balance Is In Large Surplus First, both the overall and primary fiscal surpluses now stand at over 3% of GDP (Chart I-1). The authorities have sufficient fiscal leeway to undertake substantial fiscal easing. They have announced a major fiscal spending program, which is planned to be in the order of $390 billion or 25% of GDP, over the next six years. Importantly, government non-interest expenditures have dropped to 15.5% of GDP from 18% in 2016. Therefore, it makes perfect sense to ease fiscal policy materially to counteract the impact of lower commodities prices on the economy. What’s more, gross public debt is at 13% of GDP – out of which the foreign component is only 4% of GDP – and remains the lowest in the EM space. A fiscal fortress, as well as the potential for significant fiscal stimulus amid the current EM selloff, will help the Russian currency, local bonds and sovereign and corporate credit markets behave as a lower beta play within the EM universe. Second, there is scope for the Central Bank of Russia (CBR) to cut interest rates. Both nominal and real interest rates have remained high, particularly lending rates (Chart I-2). Furthermore, growth has been mediocre and inflation is likely to fall again (Chart I-3). Chart I-2Russian Real Interest Rates Are High Russian Real Interest Rates Are High Russian Real Interest Rates Are High Chart I-3Russia: Growth Has Been Weakening Prior To Oil Price Decline Russia: Growth Has Been Weakening Prior To Oil Price Decline Russia: Growth Has Been Weakening Prior To Oil Price Decline   Although overwhelming evidence warrants lower interest rates in Russia, it is not clear if the ultra-conservative Central Bank Governor Elvira Nabiullina will resort to rate reductions as oil prices and EM assets continue selling off – as we expect. Even if Governor Elvira Nabiullina delivers rate cuts, they will be delayed and small. Hence, real rates will remain high, helping the ruble outperform other EM currencies. Provided the central bank remains behind the curve, odds are that the yield curve will probably invert as long-term bond yields drop below the policy rate (Chart I-4). In short, a conservative central bank will provide a friendly environment for fixed-income and currency investors. Third, the Russian ruble will depreciate only modestly despite the ongoing carnage in oil prices due to high foreign exchange reserves and a positive balance of payments. The current account surplus stands at 7.5% of GDP, or $115 billion. Chart I-4Russia: Yield Curve Will Probably Invert Russia: Yield Curve Will probably Invert Russia: Yield Curve Will probably Invert Both the central bank and the Ministry of Finance (MoF) have been buying foreign currency. In particular, based on the fiscal rule, the MoF buys U.S. dollars when oil prices are above $40/barrel and sells U.S. dollars when the oil price is below that level. As such, policymakers have created a counter-cyclical ballast to counteract any negative shocks. Remarkably, the monetary authorities have siphoned out the additional liquidity that has been injected as part of their foreign currency purchases. In fact, the CRB’s net liquidity injections have been negative. This is in contrast to what has been happening in many other EMs. These prudent macro policies will limit the downside in the ruble versus the dollar and the euro. Finally, rising profits in the non-financial corporate sector and balance sheet improvements justify Russian equity outperformance relative to EM. Specifically, Russian firms’ cash flows from operation have been diverging from EM, suggesting the former is in better financial health than its EM counterparts (Chart I-5). Chart I-5Cash Flow From Operations: Russia Versus EM Cash Flow From Operations: Russia Versus EM Cash Flow From Operations: Russia Versus EM Chart I-6Continue Overweighting Russian Stocks And Bonds Continue Overweighting Russian Stocks And Bonds Continue Overweighting Russian Stocks And Bonds Bottom Line: Even though we expect oil prices to drop further,1 investors should continue to overweight Russian equities, sovereign and corporate credit and local currency bonds relative to their respective EM benchmarks (Chart I-6). To express our positive view on the ruble, we have been recommending a long RUB / short COP trade since May 31, 2018. This position has generated a 10.8% gain, and remains intact. Andrija Vesic, Research Analyst andrijav@bcaresearch.com   Footnotes 1      The Emerging Markets Strategy team’s negative view on oil prices is different from the BCA house view which is bullish on oil.

Dear Client, Tomorrow we will publish a debate piece on China shedding more light on the ongoing discussions at BCA on this topic. This report will articulate the conceptual and analytical differences between my colleague, Peter Berezin, and I relating to our respective outlooks on China’s credit cycle. Peter believes that the credit boom in China is a natural outcome of a high household “savings” rate. I maintain that household “savings” have no bearing on credit growth, debt or bank deposit levels. Rather, China’s credit and money excesses are pernicious and will precipitate negative macro outcomes. I hope you will find this report valuable and interesting. Today we are publishing analysis and market strategy updates on Russia and Chile. Best regards, Arthur Budaghyan Chief Emerging Markets Strategist   Russia: A Fiscal And Monetary Fortress Underpins A Low-Beta Status Russian financial markets and the ruble have entered a low-beta paradigm. A combination of ultra-conservative fiscal and monetary policies over the past four years will help Russian equities, local bonds as well as sovereign and corporate credit to continue outperforming their respective EM benchmarks.   First, both the overall and primary fiscal surpluses now stand at over 3% of GDP (Chart I-1). The authorities have sufficient fiscal leeway to undertake substantial fiscal easing. They have announced a major fiscal spending program, which is planned to be in the order of $390 billion or 25% of GDP, over the next six years. Chart I-1Fiscal Balance Is In Large Surplus Fiscal Balance Is In Large Surplus Fiscal Balance Is In Large Surplus Importantly, government non-interest expenditures have dropped to 15.5% of GDP from 18% in 2016. Therefore, it makes perfect sense to ease fiscal policy materially to counteract the impact of lower commodities prices on the economy. What’s more, gross public debt is at 13% of GDP – out of which the foreign component is only 4% of GDP – and remains the lowest in the EM space. A fiscal fortress, as well as the potential for significant fiscal stimulus amid the current EM selloff, will help the Russian currency, local bonds and sovereign and corporate credit markets behave as a lower beta play within the EM universe. Second, there is scope for the Central Bank of Russia (CBR) to cut interest rates. Both nominal and real interest rates have remained high, particularly lending rates (Chart I-2). Furthermore, growth has been mediocre and inflation is likely to fall again (Chart I-3). Chart I-2Russian Real Interest Rates Are High Russian Real Interest Rates Are High Russian Real Interest Rates Are High Chart I-3Russia: Growth Has Been Weakening Prior To Oil Price Decline Russia: Growth Has Been Weakening Prior To Oil Price Decline Russia: Growth Has Been Weakening Prior To Oil Price Decline   Although overwhelming evidence warrants lower interest rates in Russia, it is not clear if the ultra-conservative Central Bank Governor Elvira Nabiullina will resort to rate reductions as oil prices and EM assets continue selling off – as we expect. Even if Governor Elvira Nabiullina delivers rate cuts, they will be delayed and small. Hence, real rates will remain high, helping the ruble outperform other EM currencies. Provided the central bank remains behind the curve, odds are that the yield curve will probably invert as long-term bond yields drop below the policy rate (Chart I-4). In short, a conservative central bank will provide a friendly environment for fixed-income and currency investors. Third, the Russian ruble will depreciate only modestly despite the ongoing carnage in oil prices due to high foreign exchange reserves and a positive balance of payments. The current account surplus stands at 7.5% of GDP, or $115 billion. Both the central bank and the Ministry of Finance (MoF) have been buying foreign currency. In particular, based on the fiscal rule, the MoF buys U.S. dollars when oil prices are above $40/barrel and sells U.S. dollars when the oil price is below that level. As such, policymakers have created a counter-cyclical ballast to counteract any negative shocks. A fiscal fortress, as well as the potential for significant fiscal stimulus amid the current EM selloff, will help the Russian currency, local bonds and sovereign and corporate credit markets behave as a lower beta play within the EM universe. Remarkably, the monetary authorities have siphoned out the additional liquidity that has been injected as part of their foreign currency purchases. In fact, the CRB’s net liquidity injections have been negative. This is in contrast to what has been happening in many other EMs. These prudent macro policies will limit the downside in the ruble versus the dollar and the euro. Chart I-4Russia: Yield Curve Will Probably Invert Russia: Yield Curve Will probably Invert Russia: Yield Curve Will probably Invert Chart I-5Cash Flow From Operations: Russia Versus EM Cash Flow From Operations: Russia Versus EM Cash Flow From Operations: Russia Versus EM Finally, rising profits in the non-financial corporate sector and balance sheet improvements justify Russian equity outperformance relative to EM. Specifically, Russian firms’ cash flows from operation have been diverging from EM, suggesting the former is in better financial health than its EM counterparts (Chart I-5). Bottom Line: Even though we expect oil prices to drop further,1 investors should continue to overweight Russian equities, sovereign and corporate credit and local currency bonds relative to their respective EM benchmarks (Chart I-6). Chart I-6Continue Overweighting Russian Stocks And Bonds Continue Overweighting Russian Stocks And Bonds Continue Overweighting Russian Stocks And Bonds To express our positive view on the ruble, we have been recommending a long RUB / short COP trade since May 31, 2018. This position has generated a 10.8% gain, and remains intact. Andrija Vesic, Research Analyst andrijav@bcaresearch.com   Chile: Heading Into A Recession? Our recommended strategy2 for Chile has been to (1) receive three-year swap rates, (2) favor local bonds versus stocks for domestic investors, (3) short the peso versus the U.S. dollar, and (4) overweight Chilean equities within an EM equity portfolio. Chart II-1Chile's Central Bank Is Behind The Curve Chile's Central Bank Is Behind The Curve Chile's Central Bank Is Behind The Curve The first three strategies have played out nicely as the economy has slowed, rate expectations have dropped and the peso has plunged (Chart II-1). Yet the Chilean bourse has recently substantially underperformed the EM benchmark, challenging our overweight equity stance. At the moment, we recommend staying with these recommendations, as the growth slowdown in Chile has much further to run and the central bank will cut rates substantially: Our proxy for marginal propensity to spend among both households and companies – which leads the business cycle by six months – has been falling (Chart II-2). The outcome is that growth conditions will worsen, and a recession is probable. There are already segments of the economy – retail sales volumes, car sales, non-mining exports and mining output, to name a few – that are contracting (Chart II-3). Chart II-2More Growth Retrenchment In The Next 6 Months More Growth Retrenchment In The Next 6 Months More Growth Retrenchment In The Next 6 Months Chart II-3Chilean Economy: Certain Segments Are Contracting Chilean Economy: Certain Segments Are Contracting Chilean Economy: Certain Segments Are Contracting   Shockwaves from the global slump in general and China’s slowdown in particular are taking a toll on this open economy. Copper prices are breaking down, and Chile’s industrial pulp and paper prices are falling in dollar terms (Chart II-4). Bank loan growth as well as employment growth have not yet decelerated. The latter are typically lagging indicators in Chile. Therefore, as weakening growth erodes business and consumer confidence, credit growth as well as hiring and wages will retrench. Finally, both core consumer prices and service inflation rates are at the lower end of the central bank’s inflation target band. It is a matter of time before the growth deterioration leads to even lower inflation. We argued in our last analysis on Chile3 that large net immigration has boosted labor supply and is hence disinflationary. This, along with forthcoming hiring cutbacks, will depress wages and lead to lower inflation. Overall, Chile’s central bank is well behind the curve. A major rate reduction cycle is in the cards, as both growth and inflation will undershoot the Chilean central bank’s targets. Chart II-4Chile: Industrial Paper And Pulp Prices Are Deflating Chile: Industrial Paper And Pulp Prices Are Deflating Chile: Industrial Paper And Pulp Prices Are Deflating Chart II-5The Chilean Peso Is Not Cheap The Chilean Peso Is Not Cheap The Chilean Peso Is Not Cheap Lower interest rates, shrinking exports and a large current account deficit will weigh on the exchange rate. In addition, Chilean companies have large amounts of foreign currency debt ($75 billion or 26% of GDP), and peso depreciation is forcing them to hedge their foreign currency liabilities. This will heighten selling pressure on the peso. Notably, the currency is not yet cheap and bear markets usually do not end until valuations become cheap (Chart II-5). That said, the main reasons to continue overweighting Chilean equities within an EM universe are potential monetary and fiscal easing in Chile that many other EM are not in a position to do amid their own ongoing currency depreciation. Besides, this bourse’s relative equity performance versus the EM benchmark is already very oversold and is likely to rebound as the EM stock index drops more than Chilean share prices. The main reasons to continue overweighting Chilean equities within an EM universe are potential monetary and fiscal easing in Chile that many other EM are not in a position to do. Our recommended strategy remains intact: Fixed-income investors should continue receiving three-year swap rates; Local investors should overweight domestic bonds versus stocks; Currency traders should maintain the short CLP / long U.S. dollar trade; Dedicated EM equity portfolio managers should maintain an overweight in this bourse versus the EM benchmark. One trade we are closing is our short copper / long CLP, which has returned a 1.6% gain since its initiation on September 6, 2017. The original motive for this trade was to express our negative view on copper. While we believe copper prices have more downside, the peso could undershoot, which tips the balances in favor of closing this trade. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña, Research Associate juane@bcaresearch.com Footnotes 1      The Emerging Markets Strategy team’s negative view on oil prices is different from the BCA house view which is bullish on oil. 2      Please see "Chile: Stay Overweight Equities, Receive Rates," dated May 31, 2018 and "Chile: Favor Bonds Over Stocks," dated February 7, 2019. 3      Please see "Chile: Favor Bonds Over Stocks," dated February 7, 2019. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights So what? Quantifying geopolitical risk just got easier. Why?   In this report we introduce 10 proprietary, market-based indicators of country-level political and geopolitical risk. Featured countries include France, U.K., Germany, Italy, Spain, Russia, South Korea, Taiwan, Turkey, and Brazil. Other countries, and refinements to these beta-version indicators, will come in due time. We remain committed to qualitative, constraint-based analysis. Our GeoRisk Indicators will help us determine how the market is pricing key risks, so we can decide whether they are understated or overstated. Feature For the past three months we have been tracking a “Witches’ Brew” of political risks that threaten the late-cycle bull market. Some of these risks have abated for the time being: the Fed is on pause, China’s stimulus has surprised to the upside, and Brexit has been delayed. Other risks we have flagged, however, are heating up: Iran And Oil Market Volatility: Surprisingly the Trump administration has chosen not to extend oil sanction waivers on Iran from May 2, putting 1.3 million barrels per day of oil on schedule to be removed from international markets by an unspecified time.  It remains to be seen how rapidly and resolutely the administration will enforce the sanctions on specific allies and partners (Japan, India, Turkey) as well as rivals (China, others). Because the decision coincides with rising production risks from renewed fighting in Libya and regime failure in Venezuela, we expect President Trump to phase in the new enforcement over a period of months, particularly on China and India. But official rhetoric is draconian. Hence the potential for full and immediate enforcement is greater than we thought. In the short term, individual political leaders, and very powerful nations like the United States, can ignore material economic and political constraints. Since the Trump administration’s decision exemplifies this point, geopolitical tail risks will get fatter this year and next. Global oil price volatility and equity market volatility will increase with sanction enforcement actions and retaliation. We would think that Trump’s odds of reelection will marginally suffer, though for now still above 50%, as any full-fledged confrontation with Iran will raise the chances of an oil price-induced recession. U.S.-EU Trade War: Neither the Trump administration nor the U.S. has a compelling interest in imposing Section 232 tariffs on imports of autos and auto parts. Nevertheless the risk of some tariffs remains high – we put it at 35% – because President Trump is legally unconstrained. The decision is technically due by May 18 but Economic Council Director Larry Kudlow has said Trump may adjust the deadline and decide later. Later would make sense given the economic and financial risks of the administration’s decision to ramp up the pressure on Iran.1 But the risk that tariffs will pile onto a weak German and European economy will hang over investors’ heads. U.S.-China Talks Not A Game Changer: The ostensible demand that China cease Iranian oil imports immediately and the stalling of U.S. diplomacy with North Korea are not conducive to concluding a trade deal in May. We have highlighted many times that strategic tensions will persist even if Beijing and Washington quarantine these issues to agree to a short-term trade truce. The June 28-29 G20 meeting in Japan remains the likeliest date for a summit between Presidents Trump and Xi Jinping, but even this timeframe could be too optimistic. Continued uncertainty or a weak deal will fail to satisfy financial markets expecting a very positive outcome.   With a 70% chance that U.S. tariffs on China will not increase this year and, contingent on a U.S.-China deal, only a 35% chance that the U.S. slaps tariffs on German cars, we sound optimistic to some clients. But the Trump administration’s decision on Iran is highly market-relevant and portends greater volatility. We expect to see a geopolitical risk premium creep higher into oil markets as well as a greater risk of “Black Swan” events in strategically critical or oil-producing parts of the Middle East. There is limited research devoted to quantifying geopolitical risk. We are late in the business cycle and President Trump has emphatically decided to increase rather than decrease geopolitical risk. Quantifying Geopolitical Risk Geopolitical analysis has taken a bigger role in investors’ decision-making over the last decade. Surveys show that geopolitical risks rank among global investors’ top concerns overall. In the oft-cited Bank of America Merrill Lynch survey, geopolitical and related issues have dominated the “top tail risk” responses for the past half-decade (Chart 1). In other surveys, the most worrisome short-term risks are mostly political or geopolitical in nature, ranking above socio-economic and environmental risks (Chart 2). Chart 1 Chart 2 Despite this high level of concern, there is limited research devoted to quantifying geopolitical risk. Isolating and measuring the range of risks under this umbrella term remains a challenge. As such, for many investors, geopolitics remains an ad hoc, exogenous factor that is often mentioned but rarely incorporated into portfolio construction. For the past four decades the predominant ways of measuring political or geopolitical risk have been qualitative or semi-qualitative. The Delphi technique, developed on the basis of low-quality data sets in social sciences, relies on pooled expert opinions.2 Independently selected experts are asked to provide risk assessments and their responses are then interpreted by analysts to create a measure of risk. Another semi-qualitative method of measuring geopolitical risk ranks countries according to a set of political and socio-economic variables. These variables – such as governance, political and social stability, corruption, law and order, or formal and informal policies – are extremely important but inherently difficult to quantify.3 These results are useful but suffer from dependency on expert opinion, data quality, and institutional biases. More importantly, these methods are slow to react to breaking events in a rapidly changing world. The same goes for bottom-up assessments using political intelligence. The weakness of these methods is that it is highly unlikely that they will produce statistically significant estimates of risk. The odds of getting a “silver bullet” insight from a “key insider” are decent for simple political systems, but not in the complex jurisdictions that host the vast majority of global, liquid investments. Quantitative approaches to measuring geopolitical risk have since become more widespread. The most prominent method is based on quantifying the occurrence of words related to political and geopolitical tensions that appear in international newspapers. These word-counts typically include terms like “terrorism,” “crisis,” “war,” “military action,” etc. As a result, the indices reflect incidents of physical violence or other “Black Swan” events that may not have direct relevance to financial markets. Moreover, while news-based indices accurately capture dramatic one-time peaks at the time of a crisis, they are largely flat aside from these, as they rely on popular topics rather than underlying structural trends (Chart 3). They fail to capture geopolitical developments associated with electoral cycles, protest movements, paradigm shifts in economic policy, or other policy changes.4 Notice, for instance, that the fall of the Soviet Union in late 1991 and the resulting chaos in Russia and many other parts of the emerging world hardly register in Chart 3. Chart 3News-Based Indices Only Capture Crisis Peaks, Not Geopolitical Developments News-Based Indices Only Capture Crisis Peaks, Not Geopolitical Developments News-Based Indices Only Capture Crisis Peaks, Not Geopolitical Developments Introducing BCA’s GeoRisk Indicators The past 70 years have taught BCA Research to listen and respect the market. Why would we suddenly follow the media instead? Most quantitative geopolitical indicators begin with the premise that journalists and the news-reading public have accurately emphasized the most relevant risks and uncertainties. They proceed to quantify the terms of these assessments with increasingly sophisticated methods. This approach solves only part of the puzzle. News-based indices ... fail to capture geopolitical developments associated with underlying policy changes. At BCA Geopolitical Strategy, we aim to generate geopolitical alpha.5 This means identifying where financial media and markets overstate or understate geopolitical risks. We do not primarily aim to predict events or crises. As such, traditional news-based indicators that capture only major events, even those ex post facto, are of little relevance to our analysis. What is needed is a better way to quantify how the market is calculating risks. We start with a simple premise: the market is the greatest machine ever created for gauging the wisdom of the crowd. Furthermore, it puts its money where its predictions are, unlike other methods of geopolitical risk quantification which have no “value at risk.” Chart 4USD/RUB Captures Geopolitical Risk In Russia... USD/RUB Captures Geopolitical Risk In Russia... USD/RUB Captures Geopolitical Risk In Russia... To this end, we have introduced market-based indicators over the years that rely on currency movements, which are often the simplest and most immediate means of capturing the process of pricing risk. In 2015, for instance, we introduced an indicator that measures Russia’s geopolitical risk premium (Chart 4). It is constructed using the de-trended residual from a regression of USD/RUB against USD/NOK and Russian CPI relative to U.S. CPI. We can show empirically that it captures geopolitical risk priced into the ruble, as the indicator increases following critical incidents. These include the downing of Malaysian Airlines Flight 17 over eastern Ukraine in 2014; the warnings that Russia aimed to stage a “spring offensive” in Ukraine in 2015; Russian military intervention in the Syrian Civil War later that year; and the poisoning of former intelligence agent Sergei Skripal in the U.K. in 2018 and subsequent tensions. Using similar methods, we created a proxy to capture geopolitical risk in Taiwan, based on USD/JPY and USD/KRW exchange rates and relative Taiwanese/American inflation (Chart 5). The indicator tracks well with previous cross-strait crises. It jumped upon Taiwan’s election of President Tsai Ing-wen and her pro-independence government in January 2016 – and this was well before any tensions actually flared. It even registered a small increase upon her controversial phone call congratulating Donald Trump upon winning the U.S. election. Chart 5...And USD/TWD Captures Geopolitical Risk In Taiwan ...And USD/TWD Captures Geopolitical Risk In Taiwan ...And USD/TWD Captures Geopolitical Risk In Taiwan This year we have expanded on this work, constructing a set of ten standardized GeoRisk Indicators for five developed economies and five emerging economies: U.K., France, Germany, Spain, Italy, Russia, Turkey, Brazil, Korea, and Taiwan. Indicators for the U.S., China, and others will be rolled out in a future report. These indicators attempt to capture risk premiums priced into the various currencies – except for Euro Area countries, where the risk is embedded in equity prices. In each case, we look at whether the relevant assets are decreasing in value at a faster rate than implied by key explanatory variables. The explanatory variables consist of (1) an asset that moves together with the dependent variable while not responding to domestic geopolitical risks, and (2) a variable to capture the state of the economy. This set of indicators differs from our earlier indicators in the following ways: We aim to create a simple methodology that we can apply consistently to all countries, both in the DM and EM universes. We therefore omitted using regression models that can prove to be quite whimsical. Instead, we simply looked at the deviation of the dependent variable from the explanatory variables, all in expanding standardized terms, to create the GeoRisk proxy. We wanted an indicator that would immediately respond to priced-in risks, so we opted for a daily frequency rather than the weekly frequency we used in our initial work. To get as accurate of a signal as possible, we use point-in-time data. Since economic data tends to be released with a one-to-two-month lag, we lagged the economic independent variable to correspond to its release date. All ten indicators are shown in the Appendix. Across all countries, they track well with both short-term events and long-term trends in geopolitical risk. In the case of France, for example, the indicator steadily climbs during the period of domestic tensions and protests in the early 2000s; as the European debt crisis flares up; again during the rise of the anti-establishment Front National and the Russian military intervention in Ukraine; and finally during the U.S. trade tariffs and Yellow Vest protests (Chart 6). Our GeoRisk indicators isolate risks that either originate internally or otherwise affect the country more so than others. Similarly, in Germany, there is a general increase in perceived risk as Chancellor Gerhard Schröder implements structural reforms in the early 2000s; another increase leading up to the leadership change as Angela Merkel is elected Chancellor; another during the global and European financial crises; another during the Ukraine invasion and refugee influx; and finally another with the U.S.-China trade war (Chart 7). Chart 6Our French Indicator Picks Up Domestic And European Unrest Our French Indicator Picks Up Domestic And European Unrest Our French Indicator Picks Up Domestic And European Unrest Chart 7Greater German Risk Amid The Trade War Greater German Risk Amid The Trade War Greater German Risk Amid The Trade War   We have annotated each country’s GeoRisk indicator heavily in the appendix so that readers can see for themselves the correspondence with political events. The indicators are affected by international developments – like the Great Recession – but we have done our best to isolate risks that either originate internally or otherwise affect the country more than other countries. (As a consequence, the Great Recession is muted in some cases.) What are the indicators telling us now? Most obviously, they highlight the extreme risk we have witnessed in the U.K. over the now-delayed March 29 Brexit deadline. We would bet against this risk as the political reality has demonstrated that a “hard Brexit” is very low probability: the U.K. has the ability to back off unilaterally while the EU is willing to extend for the sake of regional stability. In this sense the pound is a tactical buy, which our foreign exchange strategist Chester Ntonifor has highlighted.6 Our U.K. risk indicator has been fairly well correlated with the GBP/USD since the global financial crisis and it suggests that the pound has more room to rally (Chart 8). Chart 8Betting Against A Hard Brexit, the GBP Is A Tactical Buy Betting Against A Hard Brexit, the GBP Is A Tactical Buy Betting Against A Hard Brexit, the GBP Is A Tactical Buy Meanwhile, Spanish risks are overstated while Italy’s are understated. As for the emerging world, Turkish risks should be expected to spike yet again, as divisions emerge within the ruling coalition in the wake of critical losses in local elections and a failure to reassure investors over monetary policy and the currency. Brazilian risks will probably not match the crisis points of the impeachment and the 2018 election, at least not until controversial pension reforms reach a period of peak uncertainty over legislative passage. Both our new Russian indicator and its prototype are collapsing (see Chart 4 above). This captures the fact that we stand at a critical juncture in Russian affairs, where President Putin is attempting to shift focus to domestic stability even as the U.S. and the West maintain pressure on the economy to deter Russia from its aggressive foreign policy. Given that both Putin’s and the government’s approval ratings are low amid rising oil prices, the stage is set for Russia to take a provocative foreign policy action meant to distract the populace from its poor living conditions. Venezuela is the obvious candidate, but there are others. Moscow will want to test Ukraine’s newly elected, inexperienced president; it may also make a show of support for Iran. With Russia equities having rallied on a relative basis over the past year and a half, and with the Iranian waiver decision already boosting oil prices as we go to press, the window of opportunity to buy Russian stocks is starting to close. (We remain overweight relative to EM on a tactical horizon; our Emerging Markets Strategy is also overweight.) Going forward, we will update these risk indicators regularly as needed and publish the full appendix at the end of every month along with our long-running Geopolitical Calendar. We will also fine-tune the indicators as new information comes to light. In other words, here we present only the beta version. We hope that these indicators will help inform investors as to the direction, and even magnitude, of political risks as the market prices them. Our GeoRisk indicators are not predictive, as establishing a trend is not a prediction. The main purpose of this exercise is to answer the critical question, “What is already priced in?” How is the market currently calculating geopolitical risk for a country? After that, it is the geopolitical strategist’s job to unpack this question through qualitative, constraint-based analysis. It is when our qualitative assessments disagree with what is priced in that we can generate geopolitical alpha.    Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Marko Papic Consulting Editor marko@bcaresearch.com Footnotes 1      See Sean Higgins, “Auto tariffs decision could be delayed, Kudlow says,” Washington Examiner, April 3, 2019, www.washingtonexaminer.com. 2      Norman C. Dalkey and Olaf Helmer-Hirschberg, “An Experimental Application of the Delphi Method to the Use of Experts,” Management Science, Vol. 9, Issue: 3 (April 1963) pp. 458- 467. 3      Darryl S. L. Jarvis, “Conceptualizing, Analyzing and Measuring Political Risk: The Evolution of Theory and Method,” Lee Kuan Yew School of Public Policy Research Paper No. LKYSPP08-004 (July 2008).  William D. Coplin and Michael K. O'Leary, "Political Forecast For International Business," Planning Review, Vol. 11 Issue: 3 (1983) pp.14-23. The PRS Group, “Political Risk Services”™ (PRS) or the “Coplin-O’Leary Country Risk Rating System”™ Methodology. Daniel Kaufmann, Aart Kraay, and Massimo Mastruzzi, “The Worldwide Governance Indicators: Methodology and Analytical Issues,” World Bank Policy Research Working Paper No. 5430 (September 2010). 4      Scott R. Baker, Nicholas Bloom, and Steven J. Davis, “Measuring Economic Policy Uncertainty,” The Quarterly Journal of Economics, Volume 131, Issue 4, November 2016 (July 2016) pp.1593–1636. Dario Caldara and Matteo Iacoviello, “Measuring Geopolitical Risk,” Board of Governors of the Federal Reserve Board, Working Paper (January 2018). 5      Please see BCA Research Geopolitical Strategy Special Report, “Five Myths On Geopolitical Forecasting,” dated July 9, 2018, available at gps.bcaresearch.com. 6      Please see BCA Foreign Exchange Strategy Weekly Report, “Not Out Of The Woods Yet,” April 5, 2019, available at www.bcaresearch.com.   Appendix Appendix France France: GeoRisk Indicator France: GeoRisk Indicator Appendix U.K. U.K.: GeoRisk Indicator U.K.: GeoRisk Indicator Appendix Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator Appendix Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Appendix Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Appendix Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator Appendix Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Appendix Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Appendix Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Appendix Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator What’s On The Geopolitical Radar? Chart 19      Geopolitical Calendar