Trade
Highlights China’s July Politburo meeting signaled that policy is unlikely to be overtightened. The Biden administration is likely to pass a bipartisan infrastructure deal – as well as a large spending bill by Christmas. Geopolitical risk in the Middle East will rise as Iran’s new hawkish president stakes out an aggressive position. US-Iran talks just got longer and more complicated. Europe’s relatively low political risk is still a boon for regional assets. However, Russia could still deal negative surprises given its restive domestic politics. Japan will see a rise in political turmoil after the Olympic games but national policy is firmly set on the path that Shinzo Abe blazed. Stay long yen as a tactical hedge. Feature Chart 1Rising Hospitalizations Cause Near-Term Jitters, But UK Rolling Over? Our key view of 2021, that China would verge on overtightening policy but would retreat from such a mistake to preserve its economic recovery, looks to be confirmed after the Politburo’s July meeting opened the way for easier policy in the coming months. Meanwhile the Biden administration is likely to secure a bipartisan infrastructure package and push through a large expansion of the social safety net, further securing the American recovery. Growth and stimulus have peaked in both the US and China but these government actions should keep growth supported at a reasonable level and dispel disinflationary fears. This backdrop should support our pro-cyclical, reflationary trade recommendations in the second half of the year. Jitters continue over COVID-19 variants but new cases have tentatively peaked in the UK, US vaccinations are picking up, and death rates are a lot lower now than they were last year, that is, prior to widescale vaccination (Chart 1). This week we are taking a pause to address some of the very good client questions we have received in recent weeks, ranging from our key views of the year to our outstanding investment recommendations. We hope you find the answers insightful. Will Biden’s Infrastructure Bill Disappoint? Ten Republicans are now slated to join 50 Democrats in the Senate to pass a $1 trillion infrastructure bill that consists of $550 billion in new spending over a ten-year period (Table 1). The deal is not certain to pass and it is ostensibly smaller than Biden’s proposal. But Democrats still have the ability to pass a mammoth spending bill this fall. So the bipartisan bill should not be seen as a disappointment with regard to US fiscal policy or projections. The Republicans appear to have the votes for this bipartisan deal. Traditional infrastructure – including broadband internet – has large popular support, especially when not coupled with tax hikes, as is the case here. Both Biden and Trump ran on a ticket of big infra spending. However, political polarization is still at historic peaks so it is possible the deal could collapse despite the strong signs in the media that it will pass. Going forward, the sense of crisis will dissipate and Republicans will take a more oppositional stance. The Democratic Congress will pass President Joe Biden’s signature reconciliation bill this fall, another dollop of massive spending, without a single Republican vote (Chart 2). After that, fiscal policy will probably be frozen in place through at least 2025. Campaigning will begin for the 2022 midterm elections, which makes major new legislation unlikely in 2022, and congressional gridlock is the likely result of the midterm. Republicans will revert to belt tightening until they gain full control of government or a new global crisis erupts. Table 1Bipartisan Infrastructure Bill Likely To Pass Chart 2Reconciliation Bill Also Likely To Pass Chart 3Biden Cannot Spare A Single Vote In Senate Hence the legislative battle over the reconciliation bill this fall will be the biggest domestic battle of the Biden presidency. The 2021 budget reconciliation bill, based on a $3.5 trillion budget resolution agreed by Democrats in July, will incorporate parts of the American Jobs Plan that did not pass via bipartisan vote (such as $436 billion in green energy subsidies), plus a large expansion of social welfare, the American Families Plan. This bill will likely pass by Christmas but Democrats have only a one-seat margin in the Senate, which means our conviction level must be medium, or subjectively about 65%. The process will be rocky and uncertain (Chart 3). Moderate Democratic senators will ultimately vote with their party because if they do not they will effectively sink the Biden presidency and fan the flames of populist rebellion. US budget deficit projections in Chart 4 show the current status quo, plus scenarios in which we add the bipartisan infra deal, the reconciliation bill, and the reconciliation bill sans tax hikes. The only significant surprise would be if the reconciliation bill passed shorn of tax hikes, which would reduce the fiscal drag by 1% of GDP next year and in coming years. Chart 4APassing Both A Bipartisan Infrastructure Bill And A Reconciliation Bill Cannot Avoid Fiscal Cliff In 2022 … Chart 4B… The Only Major Fiscal Surprise Would Come If Tax Hikes Were Excluded From This Fall’s Reconciliation Bill Chart 5Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing There are two implications. First, government support for the economy has taken a significant step up as a result of the pandemic and election in 2020. There is no fiscal austerity, unlike in 2011-16. Second, a fiscal cliff looms in 2022 regardless of whether Biden’s reconciliation bill passes, although the private economy should continue to recover on the back of vaccines and strong consumer sentiment. This is a temporary problem given the first point. Monetary policy has a better chance of normalizing at some point if fiscal policy delivers as expected. But the Federal Reserve will still be exceedingly careful about resuming rate hikes. President Biden could well announce that he will replace Chairman Powell in the coming months, delivering a marginally dovish surprise (otherwise Biden runs the risk that Powell will be too hawkish in 2022-23). Inflation will abate in the short run but remain a risk over the long run. Essentially the outlook for US equities is still positive for H2 but clouds are forming on the horizon due to peak fiscal stimulus, tax hikes in the reconciliation bill, eventual Fed rate hikes (conceivably 2022, likely 2023), and the fact that US and Chinese growth has peaked while global growth is soon to peak as well. All of these factors point toward a transition phase in global financial markets until economies find stable growth in the post-pandemic, post-stimulus era. Investors will buy the rumor and sell the news of Biden’s multi-trillion reconciliation bill in H2. The bill is largely priced out at the moment due to China’s policy tightening (Chart 5). The next section of this report suggests that China’s policy will ease on the margin over the coming 12 months. Bottom Line: US fiscal policy is delivering, not disappointing. Congress is likely to pass a large reconciliation bill by Christmas, despite no buffer in the Senate, because Democratic Senators know that the Biden presidency hangs in the balance. China’s Khodorkovsky Moment? Many clients have asked whether China’s crackdown on private business, from tech to education, is the country’s “Khodorkovsky moment,” i.e. the point at which Beijing converts into a full, autocratic regime where private enterprise is permanently impaired because it is subject to arbitrary seizure and control of the state. The answer is yes, with caveats. Yes, China’s government is taking a more aggressive, nationalist, and illiberal stance that will permanently impair private business and investor sentiment. But no, this process did not begin overnight and will not proceed in a straight line. There is a cyclical aspect that different investors will have to approach differently. First a reminder of the original Khodorkovsky moment. After the Soviet Union’s collapse, extremely wealthy oligarchs emerged who benefited from the privatization of state assets. When President Putin began to reassert the primacy of the state, he arbitrarily imprisoned Khodorkovsky and dismantled his corporate energy empire, Yukos, giving the spoils to state-owned companies. Russia is a petro state so Putin’s control of the energy sector would be critical for government revenues and strategic resurgence, especially at the dawn of a commodity boom. Both the RUB-USD and Russian equity relative performance performed mostly in line with global crude oil prices, as befits Russia’s economy, even though there was a powerful (geo)political risk premium injected during these two decades due to Russia’s centralization of power and clash with the West (Chart 6). Investors could tactically play the rallies after Khodorkovsky but the general trend depended on the commodity cycle and the secular rise of geopolitical risk. Chart 6Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer President Xi Jinping is a strongman and hardliner, like Putin, but his mission is to prevent Communist China from collapsing like the Soviet Union, rather than to revive it from its ashes. To that end he must reassert the state while trying to sustain the country’s current high level of economic competitiveness. Since China is a complex economy, not a petro state, this requires the state-backed pursuit of science, technology, competitiveness, and productivity to avoid collapse. Therefore Beijing wants to control but not smother the tech companies. Hence there is a cyclical factor to China’s regulatory crackdown. A crackdown on President Xi Jinping’s potential rivals or powerful figures was always very likely to occur ahead of the Communist Party’s five-year personnel reshuffle in 2022, as we argued prior to tech exec Jack Ma’s disappearance. Sackings of high-level figures have happened around every five-year leadership rotation. Similarly a crackdown on the media was expected. True, the pre-party congress crackdowns are different this time around as they are targeted at the private sector, innovative businesses, tech, and social media. Nevertheless, as in the past, a policy easing phase will follow the tightening phase so as to preserve the economy and the mobilization of private capital for strategic purposes. The critical cyclical factor for global investors is China’s monetary and credit impulse. For example, the crackdown on the financial sector ahead of the national party congress in 2017 caused a global manufacturing slowdown because it tightened credit for the entire Chinese economy, reducing imports from abroad. One reason Chinese markets sold off so heavily this spring and summer, was that macroeconomic indicators began decelerating, leaving nothing for investors to sink their teeth into except communism. The latest Politburo meeting suggests that monetary, fiscal, and regulatory policy is likely to get easier, or at least stay just as easy, going forward (Table 2). Once again, the month of July has proved an inflection point in central economic policy. Financial markets can now look forward to a cyclical easing in regulation combined with easing in monetary and fiscal policy over the next 12-24 months. Table 2China’s Politburo Prepares To Ease Policy, Secure Recovery Despite all of the above, for global investors with a lengthy time horizon, the government’s crackdown points to a secular rise of Communist and Big Government interventionism into the economy, with negative ramifications for China’s private sector, economic freedoms, and attractiveness as a destination for foreign investment. The arbitrary and absolutist nature of its advances will be anathema to long-term global capital. Also, social media, unlike other tech firms, pose potential sociopolitical risks and may not boost productivity much, whereas the government wants to promote new manufacturing, materials, energy, electric vehicles, medicine, and other tradable goods. So while Beijing cannot afford to crush the tech sector, it can afford to crush some social media firms. Chart 7China's Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China’s equity market profile looks conspicuously like Russia’s at the time of Khodorkovsky’s arrest (Chart 7). Chinese renminbi has underperformed the dollar on a multi-year basis since Xi Jinping’s rise to power, in line with falling export prices and slowing economic growth, as a result of economic structural change and the administration’s rolling back Deng Xiaoping’s liberal reform era. We expect a cyclical rebound to occur but we do not recommend playing it. Instead we recommend other cyclical plays as China eases policy, particularly in European equities and US-linked emerging markets like Mexico. Bottom Line: The twentieth national party congress in 2022 is a critical political event that is motivating a cyclical crackdown on potential rivals to Communist Party power. Chinese equities will temporarily bounce back, especially with a better prospect for monetary and fiscal easing. But over the long run global investors should stay focused on the secular decline of China’s economic freedoms and hence productivity. What Happened To The US-Iran Deal? Our second key view for 2021 was the US strategic rotation from the Middle East and South Asia to Asia Pacific. This rotation is visible in the Biden administration’s attempt to withdraw from Iraq and Afghanistan while rejoining the 2015 nuclear deal with Iran. However, Biden here faces challenges that will become very high profile in the coming months. The Biden administration failed to rejoin the 2015 deal under the outgoing leadership of the reformist President Hassan Rouhani. This means a new and much more difficult negotiation process will now begin that could last through Biden’s term or beyond. On August 5, President Ebrahim Raisi will take office with an aggressive flourish. The US is already blaming Iran for an act of sabotage in the Persian Gulf that killed one Romanian and one Briton. Raisi will need to establish that he is not a toady, will not cower before the West. The new Israeli government of Prime Minister Naftali Bennett also needs to demonstrate that despite the fall of his hawkish predecessor Benjamin Netanyahu, Jerusalem is willing and able to uphold Israel’s red lines against Iranian nuclear weaponization and regional terrorism. Hence both Iran and its regional rivals, including Saudi Arabia, will rattle sabers and underscore their red lines. The Persian Gulf and Strait of Hormuz will be subject to threats and attacks in the coming months that could escalate dramatically, posing a risk of oil supply disruptions. Given that the Iranians ultimately do want a deal with the Americans, the pressure should be low-to-medium level and persistent, hence inflationary, as opposed to say a lengthy shutdown of the Strait of Hormuz that would cause a giant spike in prices that ultimately kills global demand. Short term, the US attempt to reduce its commitments in Iraq and Afghanistan will invite US enemies to harass or embarrass the Biden administration. The Taliban is likely to retake control of Afghanistan. The US exit will resemble Saigon in 1975. This will be a black eye for the Biden administration. But public opinion and US grand strategy will urge Biden to be rid of the war. So any delays, or a decision to retain low-key sustained troop presence, will not change the big picture of US withdrawal. Long term, Biden needs to pivot to Asia, while President Raisi is ultimately subject to the Supreme Leader Ali Khamenei, who wants to secure Iran’s domestic stability and his own eventual leadership succession. Rejoining the 2015 nuclear deal leads to sanctions relief, without requiring total abandonment of a nuclear program that could someday be weaponized, so Iran will ultimately agree. The problem will then become the regional rise of Iranian power and the balancing act that the US will have to maintain with its allies to keep Iran contained. Bottom Line: The risk to oil prices lies to the upside until a US-Iran deal comes together. The US and Iran still have a shared interest in rejoining the 2015 deal but the time frame is now delayed for months if not years. We still expect a US-Iran deal eventually but previously we had anticipated a rapid deal that would put downward pressure on oil prices in the second half of the year. What Comes After Biden’s White Flag On Nord Stream II? Our third key view for 2021 highlighted Europe’s positive geopolitical and macro backdrop. This view is correct so far, especially given that China’s policymakers are now more likely to ease policy going forward. But Russia could still upset the view. Italy has been the weak link in European integration over the past decade (excluding the UK). So the national unity coalition that has taken shape under Prime Minister Mario Draghi exemplifies the way in which political risks were overrated. Italy is now the government that has benefited the most from the overall COVID crisis in public opinion (Chart 8). The same chart shows that the German government also improved its public standing, although mostly because outgoing Chancellor Angela Merkel is exiting on a high note. Her Christian Democrat-led coalition has not seen a comparable increase in support. The Greens should outperform their opinion polling in the federal election on September 26. But the same polling suggests that the Greens will be constrained within a ruling coalition (Chart 9). The result will be larger spending without the ability to raise taxes substantially. Markets will cheer a fiscally dovish and pro-European ruling coalition. Chart 8European Political Risk Limited, But Rising, Post-COVID The chief risk to this view of low EU political risk comes from Russia. Russia is a state in long-term decline due to the remorseless fall in fertility and productivity. The result has been foreign policy aggression as President Putin attempts to fortify the country’s strategic position and frontiers ahead of an even bleaker future. Chart 9German Election Polls Point To Gridlock? Now domestic political unrest has grown after a decade of policy austerity and the COVID-19 pandemic. Elections for the Duma will be held on September 19 and will serve as the proximate cause for Russia’s next round of unrest and police repression. Foreign aggressiveness may be used to distract the population from the pandemic and poor economy. We have argued that there would not be a diplomatic reset for the US and Russia on par with the reset of 2009-11. We stand by this view but so far it is facing challenges. Putin did not re-invade Ukraine this spring and Biden did not impose tough sanctions canceling the construction of the Nord Stream II gas pipeline to Germany. Russia is tentatively cooperating on the US’s talks with Iran and withdrawal from Afghanistan. The US gave Germany and Russia a free point by condoning the NordStream II. Now the US will expect Germany to take a tough diplomatic line on Russian and Chinese aggression, while expecting Russia to give the US some goodwill in return. They may not deliver. The makeup of the new German coalition will have some impact on its foreign policy trajectory in the coming years. But the last thing that any German government wants is to be thrust into a new cold war that divides the country down the middle. Exports make up 36% of German output, and exports to the Russian and Chinese spheres account for a substantial share of total exports (Chart 10). The US administration prioritizes multilateralism above transactional benefits so the Germans will not suffer any blowback from the Americans for remaining engaged with Russia and China, at least not anytime soon. Russia, on the other hand, may feel a need to seize the moment and make strategic gains in its region, despite Biden’s diplomatic overtures. If the US wraps up its forever wars, Russia’s window of opportunity closes. So Russia may be forced to act sooner rather than later, whether in suppressing domestic dissent, intimidating or attacking its neighbors, or hacking into US digital networks. In the aftermath of the German and Russian elections, we will reassess the risk from Russia. But our strong conviction is that neither Russian nor American strategy have changed and therefore new conflicts are looming. Therefore we prefer developed market European equities and we do not recommend investors take part in the Russian equity rally. Chart 10Germany Opposes New Cold War With Russia Or China Bottom Line: German and European equities should benefit from global vaccination, Biden’s fiscal and foreign policies, and China’s marginal policy easing (Chart 11). Eastern European emerging markets and Russian assets are riskier than they appear because of latent geopolitical tensions that could explode around the time of important elections in September. Chart 11Geopolitical Tailwinds To European Equities What Comes After The Olympics In Japan? Japan is returning to an era of “revolving door” prime ministers. Prime Minister Yoshihide Suga’s sole purpose was to tie up the loose ends of the Shinzo Abe administration, namely by overseeing the Olympics. After the games end, he will struggle to retain leadership of the Liberal Democratic Party. He will be blamed for spread of Delta variant even if the Olympics were not a major factor. If he somehow retains the party’s helm, the October general election will still be an underwhelming performance by the Liberal Democrats, which will sow the seeds of his downfall within a short time (Chart 12). Suga will need to launch a new fiscal spending package, possibly as an election gimmick, and his party has the strength in the Diet to push it through quickly, which will be favorable for the economy. For the elections the problem is not the Liberal Democrats’ popularity, which is still leagues above the nearest competitor, but rather low enthusiasm and backlash over COVID. Abe’s retirement, and the eventual fall of Abe’s hand-picked deputy, does not entail the loss of Abenomics. The Bank of Japan will retain its ultra-dovish cast at least until Haruhiko Kuroda steps down in 2023. The changes that occurred in Japan from 2008-12 exemplified Japan’s existence as an “earthquake society” that undergoes drastic national changes suddenly and rapidly. The paradigm shift will not be reversed. The drivers were the Great Recession, the LDP’s brief stint in the political wilderness, the Tohoku earthquake and Fukushima nuclear crisis, and the rise of China. The BoJ became ultra-dovish and unorthodox, the LDP became more proactive both at home and abroad. The deflationary economic backdrop and Chinese nationalism are still a powerful impetus for these trends to continue – as highlighted by increasingly alarming rhetoric by Japanese officials, including now Shinzo Abe himself, regarding the Chinese military threat to Taiwan. In other words, Suga’s lack of leadership will not stand even if he somehow stays prime minister into 2022. The Liberal Democrats have several potential leaders waiting in the wings and one of these will emerge, whether Yuriko Koike, Shigeru Ishiba, or Shinjiro Koizumi, or someone else. The popular and geopolitical pressures will force the Liberal Democrats and various institutions to continue providing accommodation to the economy and bulking up the nation’s defenses. This will require the BoJ to stay easier for longer and possibly to roll out new unorthodox policies, as with yield curve control in the 2010s. Japan has some of the highest real rates in the G10 as a result of very low inflation expectations and a deeply negative output gap (Chart 13). Abenomics was bearing fruit, prior to COVID-19, so it will be justified to stay the course given that deflation has reemerged as a threat once again. Chart 12Japan: Back To Revolving Door Of Prime Ministers Chart 13Japan To Keep Fighting Deflation Post-Abe Bottom Line: The political and geopolitical backdrop for Japan is clear. The government and BoJ will have to do whatever it takes to stay the course on Abenomics even in the wake of Abe and Suga. Prime ministers will come and go in rapid succession, like in past eras of political turmoil, but the trajectory of national policy is set. We would favor JGBs relative to more high-beta government bonds like American and Canadian. Given deflation, looming Japanese political turmoil, and the secular rise in geopolitical risk, we continue to recommend holding the yen. These views conform with those of BCA’s fixed income and forex strategists. Investment Takeaways China’s policymakers are backing away from the risk of overtightening policy this year. Policy should ease on the margin going forward. Our number one key forecast for 2021 is tentatively confirmed. Base metals are still overextended but global reflation trades should be able to grind higher. The US fiscal spending orgy will continue through the end of the year via Biden’s reconciliation bill, which we expect to pass. Proactive DM fiscal policy will continue to dispel disinflationary fears. Sparks will fly in the Middle East. The US-Iran negotiations will now be long and drawn out with occasional shows of force that highlight the tail risk of war. We expect geopolitics to add a risk premium to oil prices at least until the two countries can rejoin the 2015 nuclear deal. Germany’s Green Party will surprise to the upside in elections, highlighting Europe’s low level of geopolitical risk. China policy easing is positive for European assets. Russia’s outward aggressiveness is the key risk. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com
Highlights Globalization is recovering to its pre-pandemic trajectory. But it will fail to live up to potential, as the “hyper-globalization” trends of the 1990s are long gone. China was the biggest winner of hyper-globalization. It now faces unprecedented risks in the context of hypo-globalization. Global investors woke up to China’s domestic political risks this year, which include arbitrary regulatory crackdowns on tech and private business. While Chinese officials will ease policy to soothe markets, the cyclical and structural outlook is still negative for this economy. Growth and stimulus have peaked. Political risk will stay high through the national party congress in fall 2022. US-China relations have not stabilized. India, the clearest EM alternative for global investors, is high-priced relative to China and faces troubles of its own. It is too soon to call a bottom for EM relative to DM. Feature Global investors woke up to China’s domestic political risk over the past week, as Beijing extended its regulatory crackdown to private education companies. Our GeoRisk Indicator shows Chinese political risk reaching late 2017 levels while the broad Chinese stock market continued this year’s slide against emerging market peers (Chart 1). Chart 1China: Domestic Political Risk Takes Investors By Surprise A technical bounce in Chinese tech stocks will very likely occur but we would not recommend playing it. The first of our three key views for 2021 is the confluence of internal and external headwinds for China. True, today’s regulatory blitz will pass over like previous ones and the fast money will snap up Chinese tech firms on the cheap. The Communist Party is making a show of force, not destroying its crown jewels in the tech sector. However, the negative factors weighing on China are both cyclical and structural. Until Chinese President Xi Jinping adjusts his strategy and US-China relations stabilize, investors do not have a solid foundation for putting more capital at risk in China. Globalization is in retreat and this is negative for China, the big winner of the past 40 years. Hypo-Globalization Globalization in the truest sense has expanded over millenia. It will only reverse amid civilizational disasters. But the post-Cold War era of “hyper-globalization” is long gone.1 The 2010s saw the emergence of de-globalization. In the wake of COVID-19, global trade is recovering to its post-2008 trend but it is nowhere near recovering the post-1990 trend (Chart 2). Trade exposure has even fallen within the major free trade blocs, like the EU and USMCA (Chart 3). Chart 2Hypo-Globalization Chart 3Trade Intensity Slows Even Within Trade Blocs Of course, with vaccines and stimulus, global trade will recover in the coming decade. We coined the term “hypo-globalization” to capture this predicament, in which globalization is set to rebound but not to its previous trajectory.2 We now inhabit a world that is under-globalized and under-globalizing, i.e. not as open and free as it could be. A major factor is the US-China economic divorce, which is proceeding apace. China’s latest state actions – in diplomacy, finance, and business – underscore its ongoing disengagement from the US-led global architecture. The US, for its part, is now on its third presidency with protectionist leanings. American and European fiscal stimulus are increasingly protectionist in nature, including rising climate protectionism. Bottom Line: The stimulus-fueled recovery from the global pandemic is not leading to re-globalization so much as hypo-globalization. A cyclical reboot of cross-border trade and investment is occurring but will fall short of global potential due to a darkening geopolitical backdrop. Still No Stabilization In US-China Relations Chart 4Do Nations Prefer Growth? Or Security? A giant window of opportunity is closing for China and Russia – they will look back fondly on the days when the US was bogged down in the Middle East. The US current withdrawal from “forever wars” incentivizes Beijing and Moscow to act aggressively now, whether at home or abroad. Investors tend to overrate the Chinese people’s desire for economic prosperity relative to their fear of insecurity and domination by foreign powers. China today is more desirous of strong national defense than faster economic growth (Chart 4). The rise of Chinese nationalism is pronounced since the Great Recession. President Xi Jinping confirmed this trend in his speech for the Communist Party’s first centenary on July 1, 2021. Xi was notably more concerned with foreign threats than his predecessors in 2001 and 2011 (Chart 5).3 China has arrived as a Great Power on the global stage and will resist being foisted into a subsidiary role by western nations. Chart 5Xi Jinping’s Centenary Speech Signaled Nationalist Turn Meanwhile US-China relations have not stabilized. The latest negotiations did not produce agreed upon terms for managing tensions in the relationship. A bilateral summit between Presidents Biden and Xi Jinping has not been agreed to or scheduled, though it could still come together by the end of October. Foreign Minister Wang Yi produced a set of three major demands: that the US not subvert “socialism with Chinese characteristics,” obstruct China’s development, or infringe on China’s sovereignty and territorial integrity (Table 1). The US’s opposition to China’s state-backed economic model, export controls on advanced technology, and attempts to negotiate a trade deal with the province of Taiwan all violate these demands.4 Table 1China’s Three Demands From The United States (July 2021) The removal of US support for China’s economic, development – recently confirmed by the Biden administration – will take a substantial toll on sentiment within China and among global investors. US President Joe Biden and four executive departments have explicitly warned investors not to invest in Hong Kong or in companies with ties to China’s military-industrial complex and human rights abuses. The US now formally accuses China of genocide in the Xinjiang region.5 Bottom Line: There is no stabilization in US-China relations yet. This will keep the risk premium in Chinese currency and equities elevated. The Sino-American divorce is a major driver of hypo-globalization. China’s Regulatory Crackdown President Xi Jinping’s strategy is consistent. He does not want last year’s stimulus splurge to create destabilizing asset bubbles and he wants to continue converting American antagonism into domestic power consolidation, particularly over the private economy. Now China’s sweeping “anti-trust” regulatory crackdown on tech, education, and other sectors is driving a major rethink among investors, ranging from Ark-founder Cathie Wood to perma-bulls like Stephen Roach. The driver of the latest regulatory crackdown is the administration’s reassertion of central party control. The Chinese economy’s potential growth is slowing, putting pressure on the legitimacy of single-party rule. The Communist Party is responding by trying to improve quality of life while promoting nationalism and “socialism with Chinese characteristics,” i.e. strong central government control and guidance over a market economy. Beijing is also using state power and industrial policy to attempt a great leap forward in science and technology in a bid to secure a place in the sun. Fintech, social media, and other innovative platforms have the potential to create networks of information, wealth, and power beyond the party’s control. Their rise can generate social upheaval at home and increase vulnerability to capital markets abroad. They may even divert resources from core technologies that would do more to increase China’s military-industrial capabilities. Beijing’s goal is to guide economic development, break up the concentration of power outside of the party, prevent systemic risks, and increase popular support in an era of falling income growth. Sociopolitical Risks: Social media has demonstrably exacerbated factionalism and social unrest in the United States, while silencing a sitting president. This extent of corporate power is intolerable for China. Economic And Financial Risks: Innovative fintech companies like Ant Group, via platforms like Alipay, were threatening to disrupt one of the Communist Party’s most important levers of power: the banking and financial system. The People’s Bank of China and other regulators insisted that Ant be treated more like a bank if it were to dabble in lending and wealth management. Hence the PBoC imposed capital adequacy and credit reporting requirements.6 Data Security Risks: Didi Chuxing, the ride-sharing company partly owned by Uber, whose business model it copied and elaborated on, defied authorities by attempting to conduct its initial public offering in the United States in June. The Communist Party cracked down on the company after the IPO to show who was in charge. Even more, Beijing wanted to protect its national data and prevent the US from gaining insights into its future technologies such as electric and autonomous vehicles. Foreign Policy Risks: Beijing is also preempting the American financial authorities, who will likely take action to kick Chinese companies that do not conform to common accounting and transparency standards off US stock exchanges. Better to inflict the first blow (and drive Chinese companies to Hong Kong and Shanghai for IPOs) than to allow free-wheeling capitalism to continue, giving Americans both data and leverage. Thus Beijing is continuing the “self-sufficiency” drive, divorcing itself from the US economy and capital markets, while curbing high-flying tech entrepreneurs and companies. The party’s muscle-flexing will culminate in Xi Jinping’s consolidation of power over the Politburo and Central Committee at the twentieth national party congress in fall 2022, where he is expected to take the title of “Chairman” that only Mao Zedong has held before him. The implication is that the regulatory crackdown can easily last for another six-to-12 more months. True, investors will become desensitized to the tech crackdown. But health care and medical technology are said to be in the Chinese government’s sights. So are various mergers and acquisitions. Both regulatory and political risk premia in different sectors can persist. The current administration has waged several sweeping regulatory campaigns against monopolies, corruption, pollution, overcapacity, leverage, and non-governmental organizations. The time between the initial launch of one of these campaigns and their peak intensity ranges from two to five years (Chart 6). Often, but not always, central policy campaigns have an express, three-year plan associated with them. Chart 6ABeijing Cracked Down On Monopolies, Corruption, Pollution... Chart 6B...NGOs, Overcapacity, And Leverage Chart 7China Tech: Buyer Beware The first and second year mark the peak impact. The negative profile of Chinese tech stocks relative to their global peers suggests that the current crackdown is stretched, although there is little sign of bottom formation yet (Chart 7). The crackdown began with Alibaba founder Jack Ma, and Alibaba stocks have yet to arrest their fall either in absolute terms or relative to the Hang Seng tech index. Bottom Line: A technical bounce is highly likely for Chinese stocks, especially tech, but we would not recommend playing it because of the negative structural factors. For instance, we fully expect the US to delist Chinese companies that do not meet accounting standards. The Chinese Government’s Pain Threshold? The government is not all-powerful – it faces financial and economic constraints, even if political checks and balances are missing. Beijing does not have an interest in destroying its most innovative companies and sectors. Its goal is to maintain the regime’s survival and power. China’s crackdown on private companies goes against its strategic interest of promoting innovation and therefore it cannot continue indefinitely. The hurried meeting of the China Securities Regulatory Commission with top bankers on July 28 suggests policymakers are already feeling the heat.7 In the case of Ant Group, the company ultimately paid a roughly $3 billion fine (which is 18% of its annual revenues) and was forced to restructure. Ant learned that if it wants to behave more like a bank athen it will be regulated more like a bank. Yet investors will still have to wrestle with the long-term implications of China’s arbitrary use of state power to crack down on various companies and IPOs. This is negative for entrepreneurship and innovation, regardless of the government’s intentions. Chart 8China's Pain Threshold = Property Sector Ultimately the property sector is the critical bellwether: it is a prime target of the government’s measures against speculative asset bubbles. It is also an area where authorities hope to ease the cost of living for Chinese households, whose birth rates and fertility rates are collapsing. While there is no risk of China’s entire economy crumbling because of a crackdown on ride-hailing apps or tutoring services, there is a risk of the economy crumbling if over-zealous regulators crush animal spirits in the $52 trillion property sector, as estimated by Goldman Sachs in 2019. Property is the primary store of wealth for Chinese households and businesses and falling property prices could well lead to an unsustainable rise in debt burdens, a nationwide debt-deflation spiral, and a Japanese-style liquidity trap. Judging by residential floor space started, China is rapidly approaching its overall economic pain threshold, meaning that property sector restrictions should ease, while monetary and credit policy should get easier as necessary to preserve the economic recovery (Chart 8). The economy should improve just in time for the party congress in late 2022. Bottom Line: China will be forced to maintain relatively easy monetary and fiscal policy and avoid pricking the property bubble, which should lend some support to the global recovery and emerging markets economies over the cyclical (12-month) time frame. China’s Regulation And Demographic Pressures Is the Chinese government not acting in the public interest by tamping down financial excesses, discouraging anti-competitive corporate practices, and combating social ills? Yes, there is truth to this. But arbitrary administrative controls will not increase the birth rate, corporate productivity, or potential GDP growth. First, it is true that Chinese households cite high prices for education, housing, and medicine as reasons not to have children (Chart 9). However, price caps do not attack the root causes of these problems. The lack of financial security and investment options has long fueled high house prices. The rabid desire to get ahead in life and the exam-oriented education system have long fueled high education prices. Monetary and fiscal authorities are forced to maintain an accommodative environment to maintain minimum levels of economic growth amid high indebtedness – and yet easy money policies fuel asset price inflation. In Japan, fertility rates began falling with economic development, the entrance of women in the work force, and the rise of consumer society. The fertility rate kept falling even when the country slipped into deflation. It perked up when prices started rising again! But it relapsed after the Great Recession and Fukushima nuclear crisis (Chart 10, top panel). Chart 9China: Concerns About Having Children China’s fertility rate bottomed in the 1990s and has gradually recovered despite the historic surge in property prices (Chart 10, second panel), though it is still well below the replacement rate needed to reverse China’s demographic decline in the absence of immigration. A lower cost of living and a higher quality of life will be positive for fertility but will require deeper reforms.8 Chart 10Fertility Fell In Japan Despite Falling Prices At the same time, arbitrary regulatory crackdowns that punish entrepreneurs are not likely to boost productivity. Anti-trust actions could increase competition, which would be positive for productivity, but China’s anti-trust actions are not conducted according to rule of law, or due process, so they increase uncertainty rather than providing a more stable investment environment. China’s tech crackdown is also aimed at limiting vulnerability to foreign (American) authorities. Yet disengagement with the global economy will reduce competition, innovation, and productivity in China. Bottom Line: China’s demographic decline will require larger structural changes. It will not be reversed by an arbitrary game of whack-a-mole against the prices of housing, education, and health. India And South Asia Chart 11China Will Ease Policy... Or India Will Break Out Global investors have turned to Indian equities over the course of the year and they are now reaching a major technical top relative to Chinese stocks (Chart 11). Assuming that China pulls back on its policy tightening, this relationship should revert to mean. India faces tactical geopolitical and macroeconomic headwinds that will hit her sails and slow her down. In other words, there is no great option for emerging markets at the moment. Over the long run, India benefits if China falters. Following the peak of the second COVID-19 wave in May 2021, some high frequency indicators have showed an improvement in India’s economy. However, activity levels appear weaker than of other emerging markets (Chart 12). Given the stringency levels of India’s first lockdown last spring, year-on-year growth will look faster than it really is. As the base effect wanes, underlying weak demand will become evident. Moreover India is still vulnerable to COVID-19. Only 25% of the population has received one or more vaccine shots which is lower than the global level of 28%. The result will be a larger than expected budget deficit. India refrained from administering a large dose of government spending in 2020 (Chart 13). With key state elections due from early 2022 onwards, the government could opt for larger stimulus. This could assume the form of excise duty cuts on petroleum products or an increase in revenue expenditure. These kinds of measures will not enhance India’s productivity but will add to its fiscal deficit. Chart 12Weak Post-COVID Rebound In India – And Losing Steam Chart 13India Likely To Expand Fiscal Spending Soon Such an unexpected increase in India’s fiscal deficit could be viewed adversely by markets. India’s fiscal discipline tends to be poorer than that of peers (see Chart 13 above). Meanwhile India’s north views Pakistan unfavorably and key state elections are due in this region. Consequently, Indian policy makers may be forced to adopt a far more aggressive foreign policy response to any terrorist strikes from Pakistan or territorial incursions by China over August 2021. The US withdrawal from Afghanistan poses risks for India as it has revived the Taliban’s influence. India has a long history of being targeted by Afghani terrorist groups. And its diplomatic footprint in Afghanistan has been diminishing. Earlier in July, India decided temporarily to close its consulate in Kandahar and evacuated about 50 diplomats and security personnel. As August marks the last month of formal US presence in Afghanistan, negative surprises emanating from Afghanistan should be expected. Bottom Line: Pare exposure to Indian assets on a tactical basis. Our Emerging Markets Strategy takes a more optimistic view but geopolitical changes could act as a negative catalyst in the short term. We urge clients to stay short Indian banks. Investment Takeaways US stimulus contrasts with China’s turmoil. The US Biden administration and congressional negotiators of both parties have tentatively agreed on a $1 trillion infrastructure deal over eight years. Even if this bipartisan deal falls through, Democrats alone can and will pass another $1.3-$2.5 trillion in net deficit spending by the end of the year. Stay short the renminbi. Prefer a balance of investments in the dollar and the euro, given the cross-currents of global recovery yet mounting risks to the reflation trade. A technical bounce in Chinese stocks and tech stocks is nigh. China’s policymakers are starting to respond to immediate financial pressures. However, growth has peaked and structural factors are still negative. The geopolitical outlook is still gloomy and China’s domestic political clock is a headwind for at least 12 more months. Prefer developed market equities over emerging markets (Chart 14). Emerging markets failed to outperform in the first half of the year, contrary to our expectation that the global reflation trade would lift them. China/EM will benefit when Beijing eases policy and growth rebounds. Chart 14Emerging Markets: Not Out Of The Woods Yet Stay short Indian banks and strongman EM currencies, including the Turkish lira, the Brazilian real, and the Philippine peso. The biggest driver of EM underperformance this year is the divergence between the US and China. But until China’s policy corrects, the rest of EM faces downside risks. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 Dani Rodrik, The Globalization Paradox: Democracy and the Future of the World Economy (New York: Norton, 2011). 2 See my "Nationalism And Globalization After COVID-19," Investments & Wealth Monitor (Jan/Feb 2021), pp13-21, investmentsandwealth.org. 3 Our study of Xi’s speech is not limited to this quantitative, word-count analysis. A fuller comparison of his speech with that of his predecessors on the same occasion reveals that Xi was fundamentally more favorable toward Marx, less favorable toward Deng Xiaoping and the pro-market Third Plenum, utterly silent on notions of political reform or liberal reform, more harsh in his rhetoric toward the outside world, and hawkish about the mission of reunifying with Taiwan. 4 The Chinese side also insisted that the US stop revoking visas, punishing companies and institutes, treating the press as foreign agents, and detaining executives. It warned that cooperation – which the US seeks on the environment, Iran, North Korea, and other areas – cannot be achieved while the US imposes punitive measures. 5 See US Department of State, "Xinjiang Supply Chain Business Advisory," July 13, 2021, and "Risks and Considerations for Businesses Operating in Hong Kong," July 16, 2021, state.gov. 6 Top business executives are also subject to these displays of state power. For example, Alibaba founder Jack Ma caricatured China’s traditional banks as “pawn shops” and criticized regulators for stifling innovation. He is now lying low and has taken to painting! 7 See Emily Tan and Evelyn Cheng, "China will still allow IPOs in the United States, securities regulator tells brokerages," CNBC, July 28, 2021, cnbc.com. Officials are sensitive to the market blowback but the fact remains that IPOs in the US have been discouraged and arbitrary regulatory crackdowns are possible at any time. 8 Increasing social spending also requires local governments to raise more revenue but the central government had been cracking down on the major source of revenues for local government: land sales and local government financing vehicles. With the threat of punishment for local excesses and lack of revenue source, local governments have no choice but to cut social services, pushing affluent residents towards private services, while leaving the less fortunate with fewer services. As with financial regulations, the central government may backpedal from too tough regulation of local governments, but more economic and financial pain will be required to make it happen. The Geopolitics Of The Olympics The 2020 Summer Olympics are currently underway in Tokyo, even though it is 2021. The arenas are mostly empty given the global pandemic and economic slowdown. Every four years the Summer Olympics create a golden opportunity for the host nation to showcase its achievements, infrastructure, culture, and beauty. But the Olympics also have a long history of geopolitical significance: terrorist acts, war protests, social demonstrations, and boycotts. In 1906 an Irish athlete climbed a flag pole to wave the Irish flag in protest of his selection to the British team instead of the Irish one. In 1968 two African American athletes raised their fists as an act of protest against racial discrimination in the US after the assassination of Martin Luther King Jr. In 1972, the Palestinian terrorist group Black September massacred eleven Israeli Olympians in Munich, Germany. In 1980 the US led the western bloc to boycott the Moscow Olympics while the Soviet Union and its allies retaliated by boycotting the 1984 Los Angeles Olympics. In 2008, Russia used the Olympics as a convenient distraction from its invasion of Georgia, a major step in its geopolitical resurgence. So far, thankfully, the Tokyo Olympics have gone without incident. However, looking forward, geopolitics is already looming over the upcoming 2022 Winter Olympics in Beijing. How the world has changed. The 2008 Summer Olympics marked China’s global coming-of-age celebration. The breathtaking opening ceremony featured 15,000 performers and cost $100 million. The $350 million Bird’s Nest Stadium showcased to the world China’s long history, economic prowess, and various other triumphs. All of this took place while the western democratic capitalist economies grappled with what would become the worst financial and economic crisis since the Great Depression. In 2008, global elites spoke of China as a “responsible stakeholder” that was conducting a “peaceful rise” in international affairs. The world welcomed its roughly $600 billion stimulus. Now elites speak of China as primarily a threat and a competitor, a “revisionist” state challenging the liberal world order. China is blamed for a lack of transparency (if not virological malfeasance) in handling the COVID-19 pandemic. It is blamed for breaking governance promises and violating human rights in Hong Kong, for alleged genocide in Xinjiang, and for a list of other wrongdoings, including tough “Wolf Warrior” diplomacy, cyber-crime and cyber-sabotage, and revanchist maritime-territorial claims. Even aside from these accusations it is clear that China is suffering greater financial volatility as a result of its conflicting economic goals. Talk of a diplomatic or even full boycott of Beijing’s winter games is already brewing. Sponsors are also second-guessing their involvement. More than half of Canadians support boycotting the winter games. Germany is another bellwether to watch. In 2014, Germany’s president (not chancellor) boycotted the Sochi Olympics; in 2021, the EU and China are witnessing a major deterioration of relations. Parliamentarians in the UK, Italy, Sweden, Switzerland, and Norway have asked their governments to outline their official stance on the winter games. In the age of “woke capitalism,” a sponsorship boycott of the games is a possibility. This is especially true given the recent Chinese backlash against European multinational corporations for violating China’s own rules of political correctness. A boycott which includes any members of the US, Norway, Canada, Sweden, Germany, or the Netherlands would be substantial as these are the top performers in the Winter Olympics. Even if there is no boycott, there is bound to be some political protests and social demonstrations, and China will not be able to censor anything said by Western broadcasters televising the events. Athletes usually suffer backlash at home if they make critical statements about their country, but they run very little risk of a backlash for criticizing China. If anything, protests against China’s handling of human rights will be tacitly encouraged. Beijing, for its part, will likely overreact, as these days it not only controls the message at home but also attempts more actively to export censorship. This is precisely what the western governments are now trying to counteract, for their own political purposes. The bottom line is that the 2008 Beijing Olympics reflected China’s strengths in stark contrast with the failures of democratic capitalism, while the 2022 Olympics are likely to highlight the opposite: China’s weaknesses, even as the liberal democracies attempt a revival of their global leadership. Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Section II: GeoRisk Indicator China Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia Section III: Geopolitical Calendar
Highlights The US is withdrawing from the Middle East and South Asia and making a strategic pivot to Asia Pacific. The third quarter will see risks flare around Iran and the US rejoin the 2015 Iranian nuclear deal. The result is briefly negative for oil prices but the rise of Iran is a new geopolitical trend that will increase Middle Eastern risk over the long run. The geopolitical outlook is dollar bullish, while the macroeconomic outlook is getting less dollar-bearish due to China’s risk of over-tightening policy. Stay neutral USD and be wary of commodities and emerging markets in the third quarter. European political risk is bottoming. The German and French elections are at best minor risks. However, the continent is ripe for negative black swans, especially due to Russian aggression. Go tactically long global large caps and defensives. Feature Chart 1Three Key Views On Track (So Far) We chose “No Return To Normalcy” as the theme of our 2021 outlook. While the COVID-19 vaccine promised economic recovery, we argued that normalization would create complacency regarding fundamental changes that have taken place in the geopolitical environment. A contradiction between an improving macroeconomic backdrop and a foreboding geopolitical backdrop would develop in 2021 and beyond. The “reflation trade” has begun to lose steam as we go to press. However, global recovery will still be the dominant story in the second half of the year as vaccination spreads. The question for the third quarter and the rest of the year is whether reflation will continue. As a matter of forecasting, we think it will. But as a matter of investment strategy, we are taking a more defensive stance until China relaxes economic policy. In our annual outlook we highlighted three key geopolitical views: (1) China’s headwinds, both at home and abroad (2) US détente with Iran and pivot to Asia (3) Europe’s opportunity. All three trends are broadly on track and can be illustrated by looking at equity performance in the relevant regions for the year so far: Chinese stocks sold off, UAE stocks rallied, and European stocks rallied (Chart 1). However, these trends are not exclusively tied to absolute equity performance. The most important question is what happens to global growth and the US dollar as these three key views continue. Stay Neutral On The Dollar It paid off for us to maintain a neutral stance on the dollar. True, the global recovery and exorbitant US trade and budget deficits are bearish for the dollar and bullish for other currencies. But the greenback’s “counter-trend bounce” is proving more formidable than many investors expected. The fundamentals of the American economy and global position remain strong. Since the outbreak of COVID-19, the US has secured its recovery with fiscal policy, maintained rule of law amid a contested election, innovated and distributed vaccines, benefited from more flexible social restrictions, refurbished global alliances, and put pressure on its geopolitical rivals. In essence, the combined effect of President Trump’s and Biden’s policies has been to make America “great again” (Chart 2). From a geopolitical perspective, the dollar is appealing. Chart 2Trump-Biden Make America Great Again? In addition, the first two geopolitical views mentioned above – China’s headwinds and the US-Iran détente – imply a negative environment for China and the renminbi. The reason for the US to do a suboptimal deal with Iran, both in 2015 and 2021, is to reduce the risk of war and buy time to enable a strategic pivot to Asia Pacific. Three US presidents have been elected on the pledge to conclude the “forever wars” in the Middle East and South Asia. Biden is withdrawing US troops from Afghanistan in September. There can be little doubt Biden is committed to an Iran deal, which is supposed to free up the US’s hands (Chart 3). Meanwhile the US public and Congress are unified in their desire to better defend US interests against China’s economic and military rise. There has not yet been a stabilization of US-China policies. Biden is not likely to hold a summit with Chinese President Xi Jinping until late October at earliest – and that is a guess, not a confirmed summit. The Biden administration has completed its review of China policy and is maintaining the Trump administration’s hawkish posture, as predicted. The US and China may resume their strategic and economic dialogue at some point but it is impossible to go back to the status quo ante 2015. That was the year the US adopted a more confrontational stance toward China – a stance later supercharged by Trump’s election and trade tariffs. The hawkish consensus on China is one of the rare unifying factors in a deeply divided America. The Biden administration explicitly says the US-China relationship is now defined by “competition” instead of “engagement.”1 One exception to this neutral view on the dollar has been our decision to go long the Japanese yen and Swiss franc, which has not panned out so far. Our reasoning is that geopolitical risk will boost these currencies but otherwise the reduction of geopolitical risk will weigh on the dollar in the context of global growth recovery. So far geopolitical risk has remained subdued while the US dollar has outperformed. We are still sympathetic to these safe-haven currencies, however, as they are attractively valued as long as one expects geopolitical risks to materialize (Chart 4). Chart 3US Pivot To Asia Runs Through Iran Our third key view, that EU was the real winner of the US election last year, remains on track. This is marginally positive for the euro at the expense of the dollar. Given the above points, we favor an equal-weighted basket of the euro and the dollar relative to the renminbi (Chart 5). Chart 4Safe-Haven Currencies Attractive Chart 5Favor Euro And Dollar Over Renminbi The geopolitical outlook is dollar-bullish. The macroeconomic outlook is dollar-bearish, except that China’s economy looks to slow down. We expect China to ease policy in the second half of the year but it may come late. We remain neutral dollar in the third quarter. Wait For China To Relax Policy July 1 marks the centenary of the Communist Party of China. The main thing investors should know is that the Communist Party predates China’s capitalist phase by sixty years. The party adopted capitalism to improve the economy – it never sacrificed its political or foreign policy goals. This poses a major geopolitical problem today because the Communist Party’s consolidation of power across Greater China, symbolized by Beijing’s revocation of Hong Kong’s special status in 2019, has convinced the western democracies that China is no longer compatible with the liberal world order. China launched a 13.8% of GDP monetary-and-fiscal stimulus over 2018-20 due to the trade war and COVID-19 pandemic. So the economy is stable for the hundredth anniversary celebration. The centenary goals are largely accomplished: GDP is larger, poverty is nearly extinguished, although urban incomes are still lagging (Chart 6). General Secretary Xi Jinping will mark the occasion with a speech. The speech will contribute to his governing philosophy, Xi Jinping Thought, a synthesis of communist Mao Zedong Thought and the pro-capitalist “socialism with Chinese characteristics” pioneered by General Secretary Deng Xiaoping in the 1980s-90s. The effect is to reassert Communist Party and central government primacy after the long period of decentralization that enabled China’s rapid growth phase. It is also to endorse an inward economic turn after the four-decade export-manufacturing boom. The Xi administration’s re-centralization of policy has entailed mini-cycles of tightening and loosening control over the economy. The administration leans against the country’s tendency to gorge itself on debt and grow at any cost – until it must lean the other way for fear of triggering a destabilizing slowdown. For this reason Beijing tightened policy proactively last year, producing a sharp drop in money, credit, and fiscal expansion in 2021 that now threatens to undermine the global recovery. By our measures, any further tightening will result in undershooting the regime’s money and credit targets, i.e. overtightening, and hence threaten to drag on the global recovery (Chart 7). Chart 6China's Communist Party Centenary Goals Chart 7China Verges On Over-Tightening Policy Overtightening would be a policy mistake with potentially disastrous consequences. So the base case should be that the government will relax policy rather than undermine the post-COVID recovery. However, investors cannot be confident about the timing. The 2015 financial turmoil and renminbi devaluation occurred because policymakers reacted too slowly. One reason to believe policy will be eased is that after July 1 the government will turn its attention to the twentieth national party congress in 2022, the once-in-five-years rotation of the Central Committee and Politburo. The party congress begins at the local level at the beginning of next year and culminates in the fall of 2022 with the national rotation of top party leaders. Xi Jinping was originally slated to step down in 2022. So he needs to squash any last-minute push against him by opposing factions of the party. He may have himself named chairman of the Communist Party, like Mao before him. Most importantly he will put his stamp on the “seventh generation” of China’s leaders by promoting his followers into key positions. All of this suggests that the Xi administration cannot risk triggering a recession, even if its preferences remain hawkish on economic policy. Policy easing could come as early as the end of July. As a rule of thumb, we have noticed that the Politburo’s July meeting on economic policy is often an inflection point, as was the case in 2007, 2015, 2018, and 2020 (Table 1). Some observers claim the April Politburo meeting already signaled an easing in policy, although we do not see that. If July clearly signals relaxation, global investors will cheer and emerging market assets and commodities will rise. Table 1China’s Politburo Often Hits Inflection Point On Economic Policy In July Still we maintain a defensive posture going into the third quarter because we do not have a high level of confidence that policymakers will act preemptively. A market riot may precede and motivate the inflection point in policy. Also the negative impact of previous policy tightening will be felt in the third quarter. China plays and industrial metals are extremely vulnerable to further correction (Chart 8). Chart 8China Plays And Metals Vulnerable To Further Correction The earliest occasion for a Biden-Xi summit comes at the end of October, as mentioned. While US-China talks will occur at some level, relations will remain fundamentally unstable. While a Biden-Xi summit may improve the atmosphere and lead to a new round of strategic and economic dialogue, or Phase Two trade talks, the fact is that the US is seeking to contain China’s rise and China is seeking to break out of the strictures of the US-led world order. The global elite and mainstream media will put a lot of emphasis on the post-Trump return to diplomatic “normalcy” and summits. But this is to overemphasize style at the expense of substance. Note that the positive feelings of the Biden-Putin summit on June 16 fizzled in less than a week when Russia allegedly dropped bombs in the path of a British destroyer in the Black Sea. The US and UK were training Ukraine’s military. Britain denies any bombs were dropped but Russia says next time they will hit their target. (More on this below.) This episode is instructive for US-China relations: summitry is overrated. China is building a sphere of influence and the US no longer believes dialogue alone is the answer. Tit-for-tat punitive measures and proxy battles in China’s neighboring areas, from the Korean peninsula to the Taiwan Strait to the South and East China Seas, are the new normal. Bottom Line: Tactically, stay defensive on global risk assets, especially China plays. Strategically, maintain a constructive outlook on the cycle given the global recovery and China’s need eventually to relax monetary and fiscal policy. US-Iran Deal Likely – Then The Real Trouble Starts The US will likely rejoin the 2015 Iranian nuclear deal (Joint Comprehensive Plan of Action) by August and pull out of its longest-ever war in Afghanistan in September. The US is wrapping up its “forever wars” to meet the demands of a war-weary public. Ironically, the long-term consequence is to create power vacuums that invite new geopolitical conflicts in the context of the US’s great power struggle with China and Russia. But for now a deal with Iran – once it is settled – reduces geopolitical risk by reducing the odds of military escalation in the region. The Iran talks are more significant than the Afghanistan pullout. We are confident in a deal because Biden can rejoin the 2015 deal unilaterally – it was never approved by the US Senate as a formal treaty. The Iranians will not support any militant action so aggressive as to scupper a deal that offers them the chance of reviving their economy at a critical time in the regime’s history. Reviving the deal poses a downside risk for oil prices in the third quarter though not over the long run. It is negative in the short run because investors will have to price not only Iran’s current and future production (Chart 9) but also any resulting loss of OPEC 2.0 discipline. Brent crude is trading at $76 per barrel as we go to press, above the $65-$70 per barrel average that our Commodity & Energy Strategy service expects to see over the coming five years (Chart 10). Chart 9Iran's Oil Production Will Return Chart 10Brent Price Faces Short-Term Downside Risk From Iranian Crude The oil price ceiling is enforced by the cartel of oil producers who fear that too high of prices will incentivize US shale oil production as well as the global shift to renewable energy. The Russians have always dragged their feet over oil production cuts and are now pushing for production hikes. The government needs an oil price of around $50-55 per barrel for the budget to break even. The Saudis need higher prices to break even, at $70-75 per barrel. Moscow must coordinate various oil producers, led by the country’s powerful oligarchs and their factions, which is inherently more difficult than the Saudi position of coordinating one producer, Aramco. The Russians and Saudis have maintained cartel discipline so far in 2021, as expected, because the wounds of the market-share war last year are still raw. They retreated from that showdown in less than a month. However, a major escalation in Saudi Arabia’s strategic conflict with Iran could push the Saudis to seek greater market share at Iran’s expense, as occurred before the original Iran deal in 2014-15. Hence our view that the risk to oil prices will shift from the upside to the downside in the second half of the year if the US-Iran deal is reconstituted. Over the long run, the deal is not negative for oil prices. The deal is a tradeoff for lower geopolitical risk today but higher risk in the future. The reason is that Iran’s economic recovery will strengthen its strategic hand and generate a backlash in the region. The global oil supply and demand balance will fluctuate according to circumstances but regional conflict will inject a risk premium over time. Biden’s likely decision to rejoin the 2015 deal should be seen as a delaying tactic. It is impossible to go back to 2015, when the US had mustered a coalition of nations to pressure Iran and when Iran’s “reformist” faction stood to receive a historic boost from the opening of the country’s economy. Now the US lacks a coalition and the reformists are leaving office in disgrace, with the hardliners (“principlists”) taking full power for the foreseeable future. Iran is happy to go back to complying with a deal that consists of sanctions relief in exchange for temporary limits on its nuclear program. The 2015 deal’s restrictions on Iran’s nuclear program begin expiring in 2023 and continue to expire through 2040. Biden has no chance of negotiating a newer and more expansive deal that extends these sunset clauses while also restricting Iran’s ballistic missile program and regional militant activities. He will say that easing sanctions is premised on a broader “follow on” deal to achieve these US goals. But the broader deal is unlikely to materialize anytime soon. The Iranians will commit to future talks but they will have no intention of agreeing to a more expansive deal unless forced. The country’s leaders will never abandon their nuclear program after witnessing the invasions of non-nuclear Libya and Ukraine – in stark contrast with nuclear-armed North Korea. Moreover Biden cannot possibly reassemble the P5+1 coalition with Russia and China anytime soon. The US is directly confronting these states. They could conceivably work with the US when Iran is on the brink of obtaining nuclear weapons but not before then. They did not prevent North Korea. The Supreme Leader Ali Khamenei, the soon-to-be-inaugurated President Ebrahim Raisi, the Iranian Revolutionary Guard Corps, the Ministry of Intelligence, and other pillars of the regime are focused exclusively on strengthening the regime in advance of Khamenei’s impending succession sometime in the coming decade. The succession could easily lead to domestic unrest and a political crisis, which makes the 2020s a critical period for the Islamic Republic. With Tehran focused on a delicate succession, it is not a foregone conclusion that Iran will go on the offensive to expand its sphere of influence immediately after the US deal. But sooner or later a major new geopolitical trend will emerge: the rise of Iran. With sanctions removed, trade and investment increasing, and Chinese and Russian support, Iran will be capable of pursuing its strategic aims in the region more effectively. It will extend its influence across the “Shia Crescent,” including Iraq. The fear that this will inspire in Israel and the Gulf Arab states has already generated a slow-boiling war in the region. This war will intensify as the US will be reluctant to intervene. The purpose of the deal is to enable the war-weary US to reduce its active involvement in the region. The US foreign policy and defense establishment do not entirely see it this way – they emphasize that the US will remain engaged. But US allies in the Middle East will not be convinced. The region already has a taste for the way this works after the US’s precipitous withdrawal from Iraq in 2011, which lead to the rise of the Islamic State terrorist group. Biden will try not to be so precipitous but the writing is on the wall: the US will reduce its focus and commitment. A scramble for power in the region will begin the moment the ink dries on Biden’s signature of the JCPA. Israel and the Arab states are forming a de facto alliance – based on last year’s Abraham Accords – to prepare for Iran’s push to dominate the region. Even if Iran is not overly aggressive (a big if), Israel and the Gulf Arabs will overreact as a result of their fear of abandonment. They will also seek to hedge their bets by improving ties with the Chinese and Russians, making the Middle East the scene of a major new proxy battle in the global great power struggle. As a risk to our view: if the Biden administration changes course this summer and refuses to lift sanctions or rejoin the Iran deal – low but not zero probability – then tensions with Iran will explode almost instantaneously. The Iranians will threaten to close the Strait of Hormuz and a crisis will erupt in the third or fourth quarter. Bottom Line: The US will most likely rejoin the Iranian nuclear deal by August to avoid an immediate crisis or war. The Biden administration will wager that it can lend enough support to regional allies to keep Iran contained. This might work, as the Iranians will focus on fortifying the regime ahead of its leadership succession. However, Iran’s hardline leadership will see an opportunity in America’s withdrawal from its “forever wars.” Iran will increasingly cooperate with Russia and China. Iran’s conflict with Israel and Saudi Arabia will be extremely difficult to manage and will escalate over time, quite possibly creating a revolution or war in Iraq. The Gulf Arabs are already under immense pressure from the green energy revolution. Thus while oil prices might temporarily fall on the return of Iranian exports, they will later see upward pressure from a new wave of Middle Eastern instability. European Political Risk Has (Probably) Bottomed By contrast with all the above we have viewed Europe as a negligible source of (geo)political risk in 2021. European policy uncertainty is falling in Europe relative to these other powers and the rest of the world (Chart 11). Chart 11Europe's Relative Policy Uncertainty Bottoming Chart 12EU Break-Up Risk Hits Floor (Again) The risk of a break-up of the European Union has wilted and remains at historic lows (Chart 12). There is no immediate threat of any European countries emulating the UK and attempting to exit. Even Italian support for the euro has surged. Immigration flows have plummeted. European solidarity is not on the ballot in the upcoming German and French elections. Germany is choosing between the status quo and a “green revolution” that would not really be a revolution due to the constraints of coalition politics. The Greens have lost some momentum relative to their polling earlier this year but underlying trends suggest they will surprise to the upside in the September 26 vote (Charts 13A and 13B). They embrace EU solidarity, robust government spending, weariness with the Merkel regime, and concerns about climate change, Russia, China, and social justice. Chart 13AGerman Greens Will Surprise To Upside Chart 13BGerman Greens Will Surprise To Upside We expect the Greens to surprise to the upside. But as they are forced into a coalition with the ruling Christian Democrats then they will be limited to raising spending rather raising taxes (Table 2). The market will cheer this result. Table 2German Greens’ Ambitious Tax Hike Proposals If the Greens disappoint then a right-leaning government and too early fiscal tightening could become a risk – but it is a minor risk because Merkel’s hand-picked successor, the CDU Chancellor Candidate Armin Laschet, will be pro-Europe and fiscally dovish, just like the mainstream of his party under Merkel. The only limitation on this dovishness is that it would take another global shock for there to be enough votes in the Bundestag to loosen the schuldenbremse or “debt brake.” In France, President Emmanuel Macron is likely to win re-election – the populist candidate Marine Le Pen remains an underdog who is unlikely to make it through France’s two-round electoral system. In Italy, Prime Minister Mario Draghi is overseeing a national unity coalition that will dole out EU recovery funds. An election cannot be held ahead of the presidential election in January, which will be secured by the establishment parties as a major check on any future populist ruling coalition. The risk in these countries, as in Spain and elsewhere, is that neoliberal structural reform and competitiveness are falling by the wayside. Fiscal largesse is positive for securing the recovery but long-term growth potential will remain depressed (Chart 14). Chart 14European And Global Fiscal Stimulus (Updated June 2021) Europe remains stuck in a liquidity trap over the long run. It depends on the rest of the world for growth. This is a problem given that China’s potential growth is slowing and there is no ready substitute that will prop up global growth. Europe is increasingly ripe for negative “black swan” events. The power vacuum in the Middle East described above will lead to instability and regime failures that will threaten European security. Russia will remain aggressive, a reflection of its crumbling structural foundations. The Putin administration has not changed its strategy of building a sphere of influence in the former Soviet Union and pushing back against the West, as signaled by the threat to bomb ships that sail in Crimean waters – a unilateral expansion of Russia’s territorial waters following the Crimean invasion. The Biden administration is not seeking anything comparable to the diplomatic “reset” with Russia from 2009-11, which ended in acrimony. In other words, European political risk may be bottoming as we speak. Investment Takeaways Chart 15Limited Equity Upside From Likely US Infrastructure Bill US Peak Fiscal Stimulus: The Biden administration is highly likely to pass an infrastructure package through Congress, either as a bipartisan deal with Republicans or as part of the American Jobs Plan. The result is another $1-$1.5 trillion fiscal stimulus, albeit over an eight-year period, with infrastructure funding taking until 2024-25 to ramp up. Biden’s other plans probably will not pass before the 2022 midterm election, which will likely bring gridlock. Investors are well aware of these proposals and the policy setting will probably be frozen after this year. Hence there is limited remaining upside for global materials sector and US infrastructure plays (Chart 15). The extravagant US fiscal thrust of 2020-21 will turn into a huge fiscal drag in 2022 (Chart 16). The Federal Reserve, however, will remain ultra-dovish as long as labor market slack persists – regardless of who is at the helm. Chart 16US Fiscal Drag Very Large In 2022 Chart 17Go Long Large Caps And Defensives China’s Headwinds Persist: China may or may not ease policy in time to prevent a market riot. China plays and industrial metals are highly exposed to a correction and we recommend steering clear. US-Iran Deal Weighs On Oil Price: Tactically we are neutral on oil and oil plays. An Iran deal could depress oil prices temporarily – and potentially in a major way if the Saudis agree with the Russians on increasing production. Fundamentals are positive but depend on the OPEC 2.0 cartel. The cartel faces the risk that higher prices will incentivize both alternative oil providers and the green revolution. Europe’s Opportunity: We continue to see the euro and European stocks offering value. Given the troubles with Russia we favor developed Europe plays over emerging Europe. The German election would be a bullish catalyst for European assets but headwinds from China will prevail, which is negative for cyclical European stocks. The Russian Duma election, also in September, creates high potential for Russia to clash with the West between now and then. Tactically, go long global large caps and defensives (Chart 17). Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Independent Vermont Senator Bernie Sanders recently felt it was necessary to warn against a second cold war. Sanders, a democratic socialist, is a reliable indicator of the left wing of the Democratic Party and a dissenter who puts pressure on the center-left Biden administration. His fears underscore the dominance of the new hawkish consensus. Appendix China Russia UK Germany France Italy Canada Spain Taiwan – Province Of China Korea Turkey Brazil Australia
Highlights Geopolitical risk is trickling back into financial markets. China’s fiscal-and-credit impulse collapsed again. The Global Economic Policy Uncertainty Index is ticking back up after the sharp drop from 2020. All of our proprietary GeoRisk Indicators are elevated or rising. Geopolitical risk often rises during bull markets – the Geopolitical Risk Index can even spike without triggering a bear market or recession. Nevertheless a rise in geopolitical risk is positive for the US dollar, which happens to stand at a critical technical point. The macroeconomic backdrop for the dollar is becoming less bearish given China’s impending slowdown. President Biden’s trip to Europe and summit with Russian President Vladimir Putin will underscore a foreign policy of forming a democratic alliance to confront Russia and China, confirming the secular trend of rising geopolitical risk. Shift to a defensive tactical position. Feature Back in March 2017 we wrote a report, “Donald Trump Is Who We Thought He Was,” in which we reaffirmed our 2016 view that President Trump would succeed in steering the US in the direction of fiscal largesse and trade protectionism. Now it is time for us to do the same with President Biden. Our forecast for Biden rested on the same points: the US would pursue fiscal profligacy and mercantilist trade policy. The recognition of a consistent national policy despite extreme partisan divisions is a testament to the usefulness of macro analysis and the geopolitical method. Trump stole the Democrats’ thunder with his anti-austerity and anti-free trade message. Biden stole it back. It was the median voter in the Rust Belt who was calling the shots all along (after all, Biden would still have won the election without Arizona and Georgia). We did make some qualifications, of course. Biden would maintain a hawkish line on China and Russia but he would reject Trump’s aggressive foreign and trade policy when it came to US allies.1 Biden would restore President Obama’s policy on Iran and immigration but not Russia, where there would be no “diplomatic reset.” And Biden’s fiscal profligacy, unlike Trump’s, would come with tax hikes on corporations and the wealthy … even though they would fall far short of offsetting the new spending. This is what brings us to this week’s report: New developments are confirming this view of the Biden administration. Geopolitical Risk And Bull Markets Chart 1Global Geopolitical Risk And The Dollar In recent weeks Biden has adopted a hawkish policy on China, lowered tensions with Europe, and sought to restore President Obama’s policy of détente with Iran. The jury is still out on relations with Russia – Biden will meet with Putin on June 16 – but we do not expect a 2009-style “reset” that increases engagement. Still, it is too soon to declare a “Biden doctrine” of foreign policy because Biden has not yet faced a major foreign crisis. A major test is coming soon. Biden’s decision to double down on hawkish policy toward China will bring ramifications. His possible deal with Iran faces a range of enemies, including within Iran. His reduction in tensions with Russia is not settled yet. While the specific source and timing of his first major foreign policy crisis is impossible predict, structural tensions are rebuilding. An aggregate of our 13 market-based GeoRisk indicators suggests that global political risk is skyrocketing once again. A sharp spike in the indicator, which is happening now, usually correlates with a dollar rally (Chart 1). This indicator is mean-reverting since it measures the deviation of emerging market currencies, or developed market equity markets, from underlying macroeconomic fundamentals. The implication is positive for the dollar, although the correlation is not always positive. Looking at both the DXY’s level and its rate of change shows periods when the global risk indicator fell yet the dollar stayed strong – and vice versa. The big increase in the indicator over the past week stems mostly from Germany, South Korea, Brazil, and Australia, though all 13 of the indicators are now either elevated or rising, including the China/Taiwan indicators. Some of the increase is due to base effects. As global exports recover, currencies and equities that we monitor are staying weaker than one would expect. This causes the relevant BCA GeoRisk indicator to rise. Base effects from the weak economy in June 2020 will fall out in coming weeks. But the aggregate shows that all of the indicators are either high or rising and, on a country by country level, they are now in established uptrends even aside from base effects. Chart 2Global Policy Uncertainty Revives Meanwhile the global Economic Policy Uncertainty Index is recovering across the world after the drop in uncertainty following the COVID-19 crisis (Chart 2). Policy uncertainty is also linked to the dollar and this indicator shows that it is rising on a secular basis. The Geopolitical Risk Index, maintained by Matteo Iacoviello and a group of academics affiliated with the Policy Uncertainty Index, is also in a secular uptrend, although cyclically it has not recovered from the post-COVID drop-off. It is sensitive to traditional, war-linked geopolitical risk as reported in newspapers. By contrast our proprietary indicators are sensitive to market perceptions of any kind of risk, not just political, both domestic and international. A comparison of the Geopolitical Risk Index with the S&P 500 over the past century shows that a geopolitical crisis may occur at the beginning of a business cycle but it may not be linked with a recession or bear market. Risk can rise, even extravagantly, during economic expansions without causing major pullbacks. But a crisis event certainly can trigger a recession or bear market, particularly if it is tied to the global oil supply, as in the early 1970s, 1980s, and 1990s (Chart 3). Chart 3Secular Rise In Geopolitical Risk Soon To Reassert Itself While geopolitical risk is normally positive for the dollar, the macroeconomic backdrop is negative. The dollar’s attempt to recover earlier this year faltered. This underlying cyclical bearish dollar trend is due to global economic recovery – which will continue – and extravagant American monetary expansion and budget deficits. This is why we have preferred gold – it is a hedge against both geopolitical risk and inflation expectations. Tactically this year we have refrained from betting against the dollar except when building up some safe-haven positions like Japanese yen. Over the medium and long term we expect geopolitical risk to put a floor under the greenback. The bottom line is that the US dollar is at a critical technical crossroads where it could break out or break down. Macro factors suggest a breakdown but the recovery of global policy uncertainty and geopolitical risk suggests the opposite. We remain neutral. A final quantitative indicator of the recovery of geopolitical risk is the performance of global aerospace and defense stocks (Chart 4). Defense shares are rising in absolute and relative terms. Chart 4Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Can The WWII Peace Be Prolonged? Qualitative assessments of geopolitical risk are necessary to explain why risk is on a secular upswing – why drops in the quantitative indicators are temporary and the troughs keep getting higher. Great nations are returning to aggressive competition after a period of relative peace and prosperity. Over the past two decades Russia and China took advantage of America’s preoccupations with the Middle East, the financial crisis, and domestic partisanship in order to build up their global influence. The result is a world in which authority is contested. The current crisis is not merely about the end of the post-Cold War international order. It is much scarier than that. It is about the decay of the post-WWII international order and the return of the centuries-long struggle for global supremacy among Great Powers. The US and European political establishments fear the collapse of the WWII settlement in the face of eroding legitimacy at home and rising challenges from abroad. The 1945 peace settlement gave rise to both a Cold War and a diplomatic system, including the United Nations Security Council, for resolving differences among the great powers. It also gave rise to European integration and various institutions of American “liberal hegemony.” It is this system of managing great power struggle, and not the post-Cold War system of American domination, that lies in danger of unraveling. This is evident from the following points: American preeminence only lasted fifteen years, or at best until the 2008 Georgia war and global financial crisis. The US has been an incoherent wild card for at least 13 years now, almost as long as it was said to be the global empire. Russian antagonism with the West never really ended. In retrospect the 1990s were a hiatus rather than a conclusion of this conflict. China’s geopolitical rise has thawed the frozen conflicts in Asia from the 1940s-50s – i.e. the Chinese civil war, the Hong Kong and Taiwan Strait predicaments, the Korean conflict, Japanese pacifism, and regional battles for political influence and territory. Europe’s inward focus and difficulty projecting power have been a constant, as has its tendency to act as a constraint on America. Only now is Europe getting closer to full independence (which helped trigger Brexit). Geopolitical pressures will remain historically elevated for the foreseeable future because the underlying problem is whether great power struggle can be contained and major wars can be prevented. Specifically the question is whether the US can accommodate China’s rise – and whether China can continue to channel its domestic ambitions into productive uses (i.e. not attempts to create a Greater Chinese and then East Asian empire). The Great Recession killed off the “East Asia miracle” phase of China’s growth. Potential GDP is declining, which undermines social stability and threatens the Communist Party’s legitimacy. The renminbi is on a downtrend that began with the Xi Jinping era. The sharp rally during the COVID crisis is over, as both domestic and international pressures are rising again (Chart 5). Chart 5Biden Administration Review Of China Policy: More China Bashing While the data for China’s domestic labor protests is limited in extent, we can use it as a proxy for domestic instability in lieu of official statistics that were tellingly discontinued back in 2005. The slowdown in credit growth and the cyclical sectors of the economy suggest that domestic political risk is underrated in the lead up to the 2022 leadership rotation (Chart 6). Chart 6China's Domestic Political Risk Will Rise Chart 7Steer Clear Of Taiwan Strait The increasing focus on China’s access to key industrial and technological inputs, the tensions over the Taiwan Strait, and the formation of a Russo-Chinese bloc that is excluded from the West all suggest that the risk to global stability is grave and historic. It is reminiscent of the global power struggles of the seventeenth through early twentieth centuries. The outperformance of Taiwanese equities from 2019-20 reflects strong global demand for advanced semiconductors but the global response to this geopolitical bottleneck is to boost production at home and replace Taiwan. Therefore Taiwan’s comparative advantage will erode even as geopolitical risk rises (Chart 7). The drop in geopolitical tensions during COVID-19 is over, as highlighted above. With the US, EU, and other countries launching probes into whether the virus emerged from a laboratory leak in China – contrary to what their publics were told last year – it is likely that a period of national recriminations has begun. There is a substantial risk of nationalism, xenophobia, and jingoism emerging along with new sources of instability. An Alliance Of Democracies The Biden administration’s attempt to restore liberal hegemony across the world requires a period of alliance refurbishment with the Europeans. That is the purpose of his current trip to the UK, Belgium, and Switzerland. But diplomacy only goes so far. The structural factor that has changed is the willingness of the West to utilize government in the economic sphere, i.e. fiscal proactivity. Infrastructure spending and industrial policy, at the service of national security as well as demand-side stimulus, are the order of the day. This revolution in economic policy – a return to Big Government in the West – poses a threat to the authoritarian powers, which have benefited in recent decades by using central strategic planning to take advantage of the West’s democratic and laissez-faire governance. If the West restores a degree of central government – and central coordination via NATO and other institutions – then Beijing and Moscow will face greater pressure on their economies and fewer strategic options. About 16 American allies fall short of the 2% of GDP target for annual defense spending – ranging from Italy to Canada to Germany to Japan. However, recent trends show that defense spending did indeed increase during the Trump administration (Chart 8). Chart 8NATO Boosts Defense Spending The European Union as a whole has added $50 billion to the annual total over the past five years. A discernible rise in defense spending is taking place even in Germany (Chart 9). The same point could be made for Japan, which is significantly boosting defense spending (as a share of output) after decades of saying it would do so without following through. A major reason for the American political establishment’s rejection of President Trump was the risk he posed to the trans-Atlantic alliance. A decline in NATO and US-EU ties would dramatically undermine European security and ultimately American security. Hence Biden is adopting the Trump administration’s hawkish approach to trade with China but winding down the trade war with Europe (Chart 10). Chart 9Europe Spending More On Guns Chart 10US Ends Trade War With Europe? A multilateral deal aimed at setting a floor in global corporate taxes rates is intended to prevent the US and Europe from undercutting each other – and to ensure governments have sufficient funding to maintain social spending and reduce income inequality (Chart 11). Inequality is seen as having vitiated sociopolitical stability and trust in government in the democracies. Chart 11‘Global’ Corporate Tax Deal Shows Return Of Big Government, Attempt To Reduce Inequality In The West Risks To Biden’s Diplomacy It is possible that Biden’s attempt to restore US alliances will go nowhere over the course of his four-year term in office. The Europeans may well remain risk averse despite their initial signals of willingness to work with Biden to tackle China’s and Russia’s challenges to the western system. The Germans flatly rejected both Biden and Trump on the Nord Stream II natural gas pipeline linkage with Russia, which is virtually complete and which strengthens the foundation of Russo-German engagement (more on this below). The US’s lack of international reliability – given the potential of another partisan reversal in four years – makes it very hard for countries to make any sacrifices on behalf of US initiatives. The US’s profound domestic divisions have only slightly abated since the crises of 2020 and could easily flare up again. A major outbreak of domestic instability could distract Biden from the foreign policy game.2 However, American incapacity is a risk, not our base case, over the coming years. We expect the US economic stimulus to stabilize the country enough that the internal political crisis will be contained and the US will continue to play a global role. The “Civil War Lite” has mostly concluded, excepting one or two aftershocks, and the US is entering into a “Reconstruction Lite” era. The implication is negative for China and Russia, as they will now have to confront an America that, if not wholly unified, is at least recovering. Congress’s impending passage of the Innovation and Competition Act – notably through regular legislative order and bipartisan compromise – is case in point. The Senate has already passed this approximately $250 billion smorgasbord of industrial policy, supply chain resilience, and alliance refurbishment. It will allot around $50 billion to the domestic semiconductor industry almost immediately as well as $17 billion to DARPA, $81 billion for federal research and development through the National Science Foundation, which includes $29 billion for education in science, technology, engineering, and mathematics, and other initiatives (Table 1). Table 1Peak Polarization: US Congress Passes Bipartisan ‘Innovation And Competition Act’ To Counter China With the combination of foreign competition, the political establishment’s need to distract from domestic divisions, and the benefit of debt monetization courtesy of the Federal Reserve, the US is likely to achieve some notable successes in pushing back against China and Russia. On the diplomatic front, the US will meet with some success because the European and Asian allies do not wish to see the US embrace nationalism and isolationism. They have their own interests in deterring Russia and China. Lack Of Engagement With Russia Russian leadership has dealt with the country’s structural weaknesses by adopting aggressive foreign policy. At some point either the weaknesses or the foreign policy will create a crisis that will undermine the current regime – after all, Russia has greatly lagged the West in economic development and quality of life (Chart 12). But President Putin has been successful at improving the country’s wealth and status from its miserably low base in the 1990s and this has preserved sociopolitical stability so far. Chart 12Russia's Domestic Political Risk It is debatable whether US policy toward Russia ever really changed under President Trump, but there has certainly not been a change in strategy from Russia. Thus investors should expect US-Russia antagonism to continue after Biden’s summit with Putin even if there is an ostensible improvement. The fundamental purpose of Putin’s strategy has been to salvage the Russian empire after the Soviet collapse, ensure that all world powers recognize Russia’s veto power over major global policies and initiatives, and establish a strong strategic position for the coming decades as Russia’s demographic decline takes its toll. A key component of the strategy has been to increase economic self-sufficiency and reduce exposure to US sanctions. Since the invasion of Ukraine in 2014, Putin has rapidly increased Russia’s foreign exchange reserves so as to buffer against shocks (Chart 13). Chart 13Russia Fortified Against US Sanctions Putin has also reduced Russia’s reliance on the US dollar to about 22% (Chart 14), primarily by substituting the euro and gold. Russia will not be willing or able to purge US dollars from its system entirely but it has been able to limit America’s ability to hurt Russia by constricting access to dollars and the dollar-based global financial architecture. Russian Finance Minister Anton Siluanov highlighted this process ahead of the Biden-Putin summit by declaring that the National Wealth Fund will divest of its remaining $40 billion of its US dollar holdings. Chart 14Russia Diversifies From USD In general this year, Russia is highlighting its various advantages: its resilience against US sanctions, its ability to re-invade Ukraine, its ability to escalate its military presence in Belarus and the Black Sea, and its ability to conduct or condone cyberattacks on vital American food and fuel supplies (Chart 15). Meanwhile the US is suffering from deep political divisions at home and strategic incoherence abroad and these are only starting to be mended by domestic economic stimulus and alliance refurbishment. Chart 15Cyber Security Stocks Recover Europe’s risk-aversion when it comes to strategic confrontation with Russia, and the lack of stability in US-Russia relations, means that investors should not chase Russian currency or financial assets amid the cyclical commodity rally. Investors should also expect risk premiums to remain high in developing European economies relative to their developed counterparts. This is true despite the fact that developed market Europe’s outperformance relative to emerging Europe recently peaked and rolled over. From a technical perspective this outperformance looks to subside but geopolitical tensions can easily escalate in the near term, particularly in advance of the Russian and German elections in September (Chart 16). Chart 16Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Europe trades in line with EUR-RUB and these pair trades all correspond closely to geopolitical tensions with Russia (Chart 17). A notable exception is the UK, whose stock market looks attractive relative to eastern Europe and is much more secure from any geopolitical crisis in this region (Chart 17, bottom panel). The pound is particularly attractive against the Czech koruna, as Russo-Czech tensions have heated up in advance of October’s legislative election there (Chart 18). Chart 17Long UK Versus Eastern Europe Chart 18Long GBP Versus CZK Meanwhile Russia and China have grown closer together out of strategic necessity. Germany’s Election And Stance Toward Russia Germany’s position on Russia is now critical. The decision to complete the Nord Stream II pipeline against American wishes either means that the Biden administration can be safely ignored – since it prizes multilateralism and alliances above all things and is therefore toothless when opposed – or it means that German will aim to compensate the Americans in some other area of strategic concern. Washington is clearly attempting to rally the Germans to its side with regard to putting pressure on China over its trade practices and human rights. This could be the avenue for the US and Germany to tighten their bond despite the new milestone in German-Russia relations. The US may call on Germany to stand up for eastern Europe against Russian aggression but on that front Berlin will continue to disappoint. It has no desire to be drawn into a new Cold War given that the last one resulted in the partition of Germany. The implication is negative for China on one hand and eastern Europe on the other. Germany’s federal election on September 26 will be important because it will determine who will succeed Chancellor Angela Merkel, both in Germany and on the European and global stage. The ruling Christian Democratic Union (CDU) is hoping to ride Merkel’s coattails to another term in charge of the government. But they are likely to rule alongside the Greens, who have surged in opinion polls in recent years. The state election in Saxony-Anhalt over the weekend saw the CDU win 37% of the popular vote, better than any recent result, while Germany’s second major party, the Social Democrats, continued their decline (Table 2). The far-right Alternative for Germany won 21% of the vote, a downshift from 2016, while the Greens won 6% of the vote, a slight improvement from 2016. All parties underperformed opinion polling except the CDU (Chart 19). Table 2Saxony-Anhalt Election Results Chart 19Germany: Conservatives Outperform In Final State Election Before Federal Vote, But Face Challenges Chart 20Germany: Greens Will Outperform in 2021 Vote The implication is still not excellent for the CDU. Saxony-Anhalt is a middling German state, a CDU stronghold, and a state with a popular CDU leader. So it is not representative of the national campaign ahead of September. The latest nationwide opinion polling puts the CDU at around 25% support. They are neck-and-neck with the Greens. The country’s left- and right-leaning ideological blocs are also evenly balanced in opinion polls (Chart 20). A potential concern for the CDU is that the Free Democratic Party is ticking up in national polls, which gives them the potential to steal conservative votes. Betting markets are manifestly underrating the chance that Annalena Baerbock and the Greens take over the chancellorship (Charts 21A and 21B). We still give a subjective 35% chance that the Greens will lead the next German government without the CDU, a 30% that the Greens will lead with the CDU, and a 25% chance that the CDU retains power but forms a coalition with the Greens. A coalition government would moderate the Greens’ ambitious agenda of raising taxes on carbon emissions, wealth, the financial sector, and Big Tech. The CDU has already shifted in a pro-environmental, fiscally proactive direction. Chart 21AGerman Greens Will Recover Chart 21BGerman Greens Still Underrated No matter what the German election will support fiscal spending and European solidarity, which is positive for the euro and regional equities over the next 12 to 24 months. However, the Greens would pursue a more confrontational stance toward Russia, a petro-state whose special relations with the German establishment have impeded the transition to carbon neutrality. Latin America’s Troubles A final aspect of Biden’s agenda deserves some attention: immigration and the Mexican border. Obviously this one of the areas where Biden starkly differs from Trump, unlike on Europe and China, as mentioned above. Vice President Kamala Harris recently came back from a trip to Guatemala and Mexico that received negative media attention. Harris has been put in charge of managing the border crisis, the surge in immigrant arrivals over 2020-21, both to give her some foreign policy experience and to manage the public outcry. Despite telling immigrants explicitly “Do not come,” Harris has no power to deter the influx at a time when the US economy is fired up on historic economic stimulus and the Democratic Party has cut back on all manner of border and immigration enforcement. From a macro perspective the real story is the collapse of political and geopolitical risk in Mexico. From 2016-20 Mexico faced a protectionist onslaught from the Trump administration and then a left-wing supermajority in Congress. But these structural risks have dissipated with the USMCA trade deal and the inability of President Andrés Manuel López Obrador to follow through with anti-market reforms, as we highlighted in reports in October and April. The midterm election deprived the ruling MORENA party of its single-party majority in the Chamber of Deputies, the lower house of the legislature (Chart 22). AMLO is now politically constrained – he will not be able to revive state control over the energy and power sectors. Chart 22Mexican Midterm Election Constrained Left-Wing Populism, Political Risk Chart 23Buy Mexico (And Canada) On US Stimulus American monetary and fiscal stimulus, and the supply-chain shift away from China, also provide tailwinds for Mexico. In short, the Mexican election adds the final piece to one of our key themes stemming from the Biden administration, US populism, and US-China tensions: favor Mexico and Canada (Chart 23). A further implication is that Mexico should outperform Brazil in the equity space. Brazil is closely linked to China’s credit cycle and metals prices, which are slated to turn down as a result of Chinese policy tightening. Mexico is linked to the US economy and oil prices (Chart 24). While our trade stopped out at -5% last week we still favor the underlying view. Brazilian political risk and unsustainable debt dynamics will continue to weigh on the currency and equities until political change is cemented in the 2022 election and the new government is then forced by financial market riots into undertaking structural reforms. Chart 24Brazil's Troubles Not Truly Over - Mexico Will Outperform Elsewhere in Latin America, the rise of a militant left-wing populist to the presidency in a contested election in Peru, and the ongoing social unrest in Colombia and Chile, are less significant than the abrupt slowdown in China’s credit growth (Charts 25A and 25B). According to our COVID-19 Social Stability Index, investors should favor Mexico. Turkey, the Philippines, South Africa, Colombia, and Brazil are the most likely to see substantial social instability according to this ranking system (Table 3). Chart 25AMexico To Outperform Latin America Chart 25BChina’s Slowdown Will Hit South America Table 3Post-COVID Emerging Market Social Unrest Only Just Beginning Investment Takeaways Close long emerging markets relative to developed markets for a loss of 6.8% – this is a strategic trade that we will revisit but it faces challenges in the near term due to China’s slowdown (Chart 26). Go long Mexican equities relative to emerging markets on a strategic time frame. Our long Mexico / short Brazil trade hit the stop loss at 5% but the technical profile and investment thesis are still sound over the short and medium term. Chart 26China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets Chart 27Relative Uncertainty And Safe Havens China’s sharp fiscal-and-credit slowdown suggests that investors should reduce risk exposure, take a defensive tactical positioning, and wait for China’s policy tightening to be priced before buying risky assets. Our geopolitical method suggests the dollar will rise, while macro fundamentals are becoming less dollar-bearish due to China. We are neutral for now and will reassess for our third quarter forecast later this month. If US policy uncertainty falls relative to global uncertainty then the EUR-USD will also fall and safe-haven assets like Swiss bonds will gain a bid (Chart 27). Gold is an excellent haven amid medium-term geopolitical and inflation risks but we recommend closing our long silver trade for a gain of 4.5%. Disfavor emerging Europe relative to developed Europe, where heavy discounts can persist due to geopolitical risk premiums. We will reassess after the Russian Duma election in September. Go long GBP-CZK. Close the Euro “laggards” trade. Go long an equal-weighted basket of euros and US dollars relative to the Chinese renminbi. Short the TWD-USD on a strategic basis. Prefer South Korea to Taiwan – while the semiconductor splurge favors Taiwan, investors should diversify away from the island that lies at the epicenter of global geopolitical risk. Close long defense relative to cyber stocks for a gain of 9.8%. This was a geopolitical “back to work” trade but the cyber rebound is now significant enough to warrant closing this trade. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Trump’s policy toward Russia is an excellent example of geopolitical constraints. Despite any personal preferences in favor of closer ties with Russia, Trump and his administration ultimately reaffirmed Article 5 of NATO, authorized the sale of lethal weapons to Ukraine, and deployed US troops to Poland and the Czech Republic. 2 As just one example, given the controversial and contested US election of 2020, it is possible that a major terrorist attack could occur. Neither wing of America’s ideological fringes has a monopoly on fanaticism and violence. Meanwhile foreign powers stand to benefit from US civil strife. A truly disruptive sequence of events in the US in the coming years could lead to greater political instability in the US and a period in which global powers would be able to do what they want without having to deal with Biden’s attempt to regroup with Europe and restore some semblance of a global police force. The US would fall behind in foreign affairs, leaving power vacuums in various regions that would see new sources of political and geopolitical risk crop up. Then the US would struggle to catch up, with another set of destabilizing consequences.
Highlights Political and corporate climate activism will increase the cost of developing the resources required to produce and deliver energy going forward – e.g., oil and gas wells; pipelines; copper mines, and refineries. Over the short run, the fastest way for investor-owned companies (IOCs) to address accelerated reductions in CO2 emissions imposed by courts and boards is to walk away from the assets producing them, which could be disruptive over the medium term. Longer term, state-owned companies (SOCs) not facing the constraints of IOCs likely will be required to provide an increasing share of the resources needed to produce and distribute energy. The real difficulty will come in the medium term. Capex for critical metals like copper languishes, just as the call on these metals steadily increases over the next 30 years (Chart of the Week). The evolution to a low-carbon future has not been thought through at the global policy level. A real strategy must address underinvestment in base metals and incentivize the development of technology via a carbon tax – not emissions trading schemes – so firms can innovate to avoid it. We remain long energy and metals exposures.1 Feature And you may ask yourself, "Well … how did I get here?" David Byrne, Once In A Lifetime Energy markets – broadly defined – are radically transforming from week to week. The latest iteration of these markets' evolution is catalyzed by climate activists, who are finding increasing success in court and on corporate boards – sometimes backed by major institutional investors – and forcing oil and gas producers to accelerate CO2 emission-reduction programs.2 Climate activists' arguments are finding increasing purchase because they have merit: Years of stiff-arming investors seeking clarity on the oil and gas producers' decarbonization agendas, coupled with a pronounced failure to provide returns in excess of their cost of capital, have given activists all of the ammo needed to argue their points. Chart of the WeekCall On Metals For Energy Will Increase This activism is not limited to the courts or boardrooms. Voters in democratic societies with contested elections also are seeking redress for failures of their governments to effectively channel mineral wealth back into society on an equitable basis, and to protect their environments and the habitats of indigenous populations. This voter activism is especially apparent in Chile and Peru, where elections and constitutional conventions likely will result in higher taxes and royalties on metals IOCs operating in these states, which will increase production costs and ultimately be passed on to consumers.3 These states account for ~ 40% of world copper output. IOCs Walk Away Earlier this week, Exxon walked away from an early-stage offshore oil development project in Ghana.4 This followed the unfavorable court rulings and boardroom setbacks experienced by Royal Dutch Shell, Chevron and Exxon recently (referenced in fn. 2). While the company had no comment on its abrupt departure, its action shows how IOCs can exercise their option to put a project back to its host government, thus illustrating one of the most readily available alternatives for energy IOCs to meet court- or board-mandated CO2 emissions targets. If these investments qualify as write-offs, the burden will be borne by taxpayers. As climate activism increases, state-owned companies (SOCs) not facing the constraints of IOCs likely will be required to provide an increasing share of the resources – particularly oil and gas – needed to produce and distribute energy going forward. This is not an unalloyed benefit, as the SOCs still face stranded-asset risks, if they invest in longer-lived assets that are obviated by a successful renewables + grid buildout globally. That is a cost that will have to be compensated, when the SOCs work up their capex allocations. Still, if legal and investor activism significantly accelerates IOCs' capex reductions in oil and gas projects, the SOCs – particularly those in OPEC 2.0 – will be able to expand their position as the dominant supplier in the global oil market, and could perhaps increase their influence on price levels and forward-curve dynamics (Chart 2).5 Chart 2OPEC 2.0s Could Expand If Investor Activism Increases Higher Call On Metals At present, there is a lot of talk about the need to invest in renewable electricity generation and the grid structure supporting it, but very little in the way of planning for this transition. Other than repeated assertions of its necessity, little is being said regarding how exactly this strategy will be executed given the magnitude of the supply increase in metals required. Nowhere is this more apparent than in the refined copper market, which has been in a physical deficit – i.e., production minus consumption is negative – for the last 6 years (Chart 3). Physical copper markets in China, which consumes more than 50% of refined output, remain extremely tight, as can be seen in the ongoing weakness of treating charges and refining charges (TC/RC) for the past year (Chart 4). These charges are inversely correlated to prices – when TC/RCs are low, it means there is surplus refining capacity for copper – unrefined metal is scarce, which drives down demand for these services. Chart 3Coppers Physical Deficit Likely Persist Chart 4Chinas Refined Copper Supply Remains TightTheoretically, high prices will incentivize higher levels of production. However, after the last decade’s ill-timed investment in new mine discoveries and expansions, mining companies have become more wary with their investments, and are using earnings to pay dividends and reduce debt. This leads us to believe that mining companies will not invest in new mine discoveries but will use capital expenditure to expand brownfield projects to meet rising demand. In the last decade, as copper demand rose, capex for copper rose from 2010-2012, and fell from 2013-2016 (Chart 5). During this time, the copper ore grade was on a declining trend. This implies that the new copper brought online was being mined from lower-grade ore, due to the expansion of existing projects(Chart 6). Chart 5Copper Capex Growth Remains Weak Chart 6Copper Ore-Quality Declines Persist Through Capex Cycle Capex directed at keeping ore production above consumption will not be sufficient to avoid major depletions of ore supplies beginning in 2024, according to Wood Mackenzie. The consultancy foresees a cumulative deficit of ~ 16mm MT by 2040. Plugging this gap will require $325-$500 billion of investment in the copper mining sector.6 The Case For A Carbon Tax The low-carbon future remains something of a will-o'-the-wisp – seen off in the future but not really developed in the present. Most striking in discussions of the low-carbon transition is the assumption of resource availability – particularly bases metals –in, e.g., the IEA's Net Zero by 2050, A Roadmap for the Global Energy Sector, published last month. In the IEA's document, further investment in hydrocarbons is not required beyond 2025. The copper, aluminum, steel, etc., required to build the generation and supporting grid infrastructure will be available and callable as needed to build all the renewable generation the world requires. The document is agnostic between carbon trading and carbon taxes as a way to price carbon and incentivize the technology that would allow firms and households to avoid a direct cost on carbon. A real strategy must address the fact that most of the world will continue to rely on fossil fuels for decades, as development goals are pursued. Underinvestment in base metals and its implications for the buildout of generation and grids has to be a priority if these assets are to be built. Given the 5-10-year lead times base metals mines require to come online, it is obvious that beyond the middle of this decade, the physical reality of demand exceeding supply will assert itself. A good start would be a global effort to impose and collect carbon taxes uniformly across states.7 This would need to be augmented with a carbon club, which restricts admission and trading privileges to those states adopting such a scheme. Harmonizing the multiple emissions trading schemes worldwide will be a decades-long effort that is unlikely to succeed. Such schemes also can be gamed by larger players, producing pricing distortions. A hard and fast tax that is enforced in all of the members of such a carbon club would immediately focus attention on the technology required to avoid paying it – mobilizing capital, innovation and entrepreneurial drive to make it a reality. This would support carbon-capture, use and storage technologies as well, thus extending the life of existing energy resources as the next generation of metals-based resources is built out. In addition, a carbon tax raises revenue for governments, which can be used for a variety of public policies, including reducing other taxes to reduce the overall burden of taxation. Lastly, a tax eliminates the potential for short-term price volatility in the pricing of carbon – as long as households and firms know what confronts them they can plan around it. Tax revenues also can be used to reduce the regressive nature of such levies. Investment Implications The lack of a coherent policy framework that addresses the very real constraints on the transition to a low-carbon economy makes the likelihood of a volatile, years-long evolution foreordained. We believe this will create numerous investment opportunities as underinvestment in hydrocarbons and base metals production predisposes oil, natural gas and base metals prices to move higher in the face of strong and rising demand. We remain long commodity index exposure – the S&P GSCI and GSCI Commodity Dynamic Roll Strategy ETF (COMT), which is optimized to take advantage of the most backwardated commodity forward curves in the index. These positions were up 5.3% and 7.2% since inception on December 7, 2017 and March 12, 2021, respectively, at Tuesday's close. We also remain long the MSCI Global Metals & Mining Producers ETF (PICK), which is up 33.9% since it was put on December 10, 2020. Expecting continued volatility in metals – copper in particular – we will look for opportunities to re-establish positions in COMEX/CME Copper after being stopped out with gains. A trailing stop was elected on our long Dec21 copper position established September 10, 2020, which was closed out with a 48.2% gain on May 21, 2021. Our long calendar 2022 vs short calendar 2023 COMEX copper backwardation trade established April 22, 2021, was closed out on May 20, 2021, leaving us with a return of 305%. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish OPEC 2.0 offered no surprises to markets this week, as it remained committed to returning just over 2mm b/d of production to the market over the May-July period, 70% of which comes from the Kingdom of Saudi Arabia (KSA), according to Platts. While Iran's return to the market is not a given in OPEC 2.0's geometry, we have given better than even odds it will return to the market beginning in 3Q21 and restore most of the 1.4mm b/d not being produced at present to the market over the course of the following year. OPEC itself expects demand to increase 6mm b/d this year, somewhat above our expectation of 5.3mm b/d. Stronger demand could raise Brent prices above our average $63/bbl forecast for this year (Chart 7). Brent was trading above $71/bbl as we went to press. Base Metals: Bullish BHP declared operations at its Escondida and Spence mines were running at normal rates despite a strike by some 200 operations specialists. BHP is employing so-called substitute workers to conduct operation, according to reuters.com, which also reported separate unions at both mines are considering strike actions in the near future. Precious Metals: Bullish The Fed’s reluctance to increase nominal interest rates despite indications of higher inflation will reduce real rates, which will support higher gold prices (Chart 8). We agree with our colleagues at BCA Research's US Bond Strategy that the Fed is waiting for the US labor market to reach levels consistent with its assessment of maximum employment before it makes its initial rate hike in this interest-rate cycle. Subsequent rate changes, however, will be based on realized inflation and inflation expectations. In our opinion, the Fed is following this ultra-accommodative monetary policy approach to break the US liquidity trap, brought about by a rise in precautionary savings due to the pandemic. In addition, we continue to expect USD weakness, which also will support gold and precious metals prices. We remain long gold, expecting prices to clear $2,000/oz this year. Ags/Softs: Neutral Corn prices fell more than 2% Wednesday, following the release of USDA estimates showing 95% of the corn crop was planted by 31 May 2021, well over the 87% five-year average. This was in line with expectations. However, the Department's assessment that 76% of the crop was in good-to-excellent condition exceeded market expectations. Chart 7 Chart 8 Footnotes 1 Please see Trade Tables below. 2 Please see OPEC, Russia seen gaining more power with Shell Dutch ruling and EXCLUSIVE BlackRock backs 3 dissidents to shake up Exxon board -sources published by reuters.com June 1, 2021 and May 25, 2021. 3 Please see Chile's govt in shock loss as voters pick independents to draft constitution published by reuters.com May 17, 2021, and Peru’s elite in panic at prospect of hard-left victory in presidential election published by ft.com June 1, 2021. Peru has seen significant capital flight on the back of these fears. See also Results from Chile’s May 2021 elections published by IHS Markit May 21, 2021 re a higher likelihood of tax increases for the mining sector. The risk of nationalization is de minimis, according to IHS. 4 Please see Exxon walks away from stake in deepwater Ghana block published by worldoil.com June 1, 2021. 5 Please see OPEC 2.0's Production Strategy In Focus, which we published on May 20, 2021, for a recap our how we model OPEC 2.0's strategy. It is available at ces.bcaresearch.com. 6 Please see Will a lack of supply growth come back to bite the copper industry?, published by Wood Mackenzie on March 23, 2021. 7 Please see The Challenges and Prospects for Carbon Pricing in Europe published by the Oxford Institute for Energy Studies last month for a discussion of carbon taxes vs. emissions trading schemes. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
Highlights President Biden has called for the US intelligence community to investigate the origins of COVID-19 and one of Biden’s top diplomats has stated the obvious: the era of “engagement” with China is over. This clinches our long-held view that any Democratic president would be a hawk like President Trump. The US-China conflict – and global geopolitical risk – will revive and undermine global risk appetite. China faces a confluence of geopolitical and macroeconomic challenges, suggesting that its equity underperformance will continue. Domestic Chinese investors should stay long government bonds. Foreign investors should sell into the bond rally to reduce exposure to any future sanctions. The impending agreement of a global minimum corporate tax rate has limited concrete implications that are not already known but it symbolizes the return of Big Government in the western world. Our updated GeoRisk Indicators are available in the Appendix, as well as our monthly geopolitical calendar. Feature In our quarterly webcast, “Geopolitics And Bull Markets,” we argued that geopolitical themes matter to investors when they have a demonstrable relationship with the macroeconomic backdrop. When geopolitics and macro are synchronized, a simple yet powerful investment thesis can be discerned. The US war on terror, Russia’s resurgence, the EU debt crisis, and Brexit each provided cases in which a geopolitically informed macro view was both accessible and actionable at an early stage. Investors generally did well if they sold the relevant country’s currency and disfavored its equities on a relative basis. Chart 1China's Decade Of Troubles Of course, the market takeaway is not always so clear. When geopolitics and macroeconomics are desynchronized, the trick is to determine which framework will prevail over the financial markets and for how long. Sometimes the market moves to its own rhythm. The goal is not to trade on geopolitics but rather to invest with geopolitics. One of our key views for this year – headwinds for China – is an example of synchronization. Two weeks ago we discussed China’s macroeconomic challenge. In this report we discuss China’s foreign policy challenge: geopolitical pressure from the US and its allies. In particular we address President Biden’s call for a deeper intelligence dive into the origins of COVID-19. The takeaway is negative for China’s currency and risk assets. The Great Recession dealt a painful blow to the Chinese version of the East Asian economic miracle. By 2015, China’s financial turmoil and currency devaluation should have convinced even bullish investors to keep their distance from Chinese stocks and the renminbi. If investors stuck with this bearish view despite the post-2016 rally, on fear of trade war, they were rewarded in 2018-19. Only with China’s containment of COVID-19 and large economic stimulus in 2020 has CNY-USD threatened to break out (Chart 1). We expect the renminbi to weaken anew, especially once the Fed begins to taper asset purchases. Our cyclical view is still bullish but US-China relations are unstable so we remain tactically defensive. Forget Biden’s China Review, He’s A Hawk Chinese financial markets face a host of challenges this year, despite the positive factors for China’s manufacturing sector amid the global recovery. At home these challenges consist of a structural economic slowdown, a withdrawal of policy stimulus, bearish sentiment among households, and an ongoing government crackdown on systemic risk. Abroad the Democratic Party’s return to power in Washington means that the US will bring more allies to bear in its attempt to curb China’s rise. This combination of factors presents a headwind for Chinese equities and a tailwind for government bonds (Chart 2). This is true at least until the government should hit its pain threshold and re-stimulate. Chart 2Global Investors Still Wary New stimulus may not occur in 2022. The Communist Party’s leadership rotation merely requires economic stability, not rapid growth. While the central government has a record of stimulating when its pain threshold is hit, even under the economically hawkish President Xi Jinping, a financial market riot is usually part of this threshold. This implies near-term downside, particularly for global commodities and metals, which are also facing a Chinese regulatory backlash to deter speculation. In this context, President Biden’s call for a deeper US intelligence investigation into the origin of COVID-19 is an important confirming signal of the US’s hawkish turn toward China. Biden gave 90 days for the intelligence community to report back to him. We will not enter into the debate about COVID-19’s origins. From a geopolitical point of view it is a moot point. The facts of the virus origin may never be established. According to Biden’s statement, at least one US intelligence agency believes the “lab leak theory” is the most likely source of the virus (while two other agencies decided in favor of animal-to-human transmission). Meanwhile Chinese government spokespeople continue to push the theory that the virus originated at the US’s Fort Detrick in Maryland or at a US-affiliated global research center. What is certain is that the first major outbreak of a highly contagious disease occurred in Wuhan. Both sides are demanding greater transparency and will reject each other’s claims based on a lack of transparency. If the US intelligence report concludes that COVID originated from the Wuhan Institute of Virology, the Chinese government and media will reject the report. If the report exonerates the Wuhan laboratory, at least half of the US public will disbelieve it and it will not deter Biden from drawing a hard line on more macro-relevant policy disputes with China. The US’s hawkish bipartisan consensus on China took shape before COVID. Biden’s decision to order the fresh report introduces skepticism regarding the World Health Organization’s narrative, which was until now the mainstream media’s narrative. Previously this skepticism was ghettoized in US public discourse: indeed, until Biden’s announcement on May 26, the social media company Facebook suppressed claims that the virus came from a lab accident or human failure. Thus Biden’s action will ensure that a large swathe of the American public will always tend to support this theory regardless of the next report’s findings. At the same time Biden discontinued a State Department effort to prove the lab leak theory, which shows that it is not a foregone conclusion what his administration will decide. The good news is that even if the report concluded in favor of the lab leak, the Biden administration would remain highly unlikely to demand that China pay “reparations,” like the Trump administration demanded in 2020. This demand, if actualized, would be explosive. The bad news is that a future nationalist administration could conceivably use the investigation as a basis to demand reparations. Nationalism is a force to be reckoned with in both countries and the dispute over COVID’s origin will exacerbate it. Traditionally the presidents of both countries would tamp down nationalism or attempt to keep it harnessed. But in the post-Xi, post-Trump era it is harder to control. The death toll of COVID-19 will be a permanent source of popular grievance around the world and a wedge between the US and China (Chart 3). China’s international image suffered dramatically in 2020. So far in 2021 China has not regained any diplomatic ground. Chart 3Death Toll Of COVID-19 The US is repairing its image via a return to multilateralism while the Europeans have put their Comprehensive Agreement on Investment with China on hold due to a spat over sanctions arising from western accusations of genocide (a subject on which China pointedly answered that it did not need to be lectured by Europeans). Notably Biden’s Department of State also endorsed its predecessor’s accusation of genocide in Xinjiang. Any authoritative US intelligence review that solidifies doubts about the WHO’s initial investigation – even if it should not affirm the lab leak theory – would give Biden more ammunition in global opinion to form a democratic alliance to pressure China (for example, in Europe). An important factor that enables the US to remain hawkish on China is fiscal stimulus. While stimulus helps bring about economic recovery, it also lowers the bar to political confrontation (Chart 4). Countries with supercharged domestic demand do not have as much to fear from punitive trade measures. The Biden administration has not taken new punitive measures against China but it is clearly not worried about Chinese retaliation. Chart 4Large Fiscal Stimulus Lowers The Bar To Geopolitical Conflict China’s stimulus is underrated in this chart (which excludes non-fiscal measures) but it is still true that China’s policy has been somewhat restrained and it will need to stimulate its economy again in response to any new punitive measures or any global loss of confidence. At least China is limited in its ability to tighten policy due to the threat of US pressure and western trade protectionism. Simultaneous with Biden’s announcement on COVID-19, his administration’s coordinator for Indo-Pacific affairs, Kurt Campbell, proclaimed in a speech that the era of “engagement” with China is officially over and the new paradigm is one of “competition.” By now Campbell is stating the obvious. But this tone is a change both from his tone while serving in President Obama’s Department of State and from his article in Foreign Affairs last year (when he was basically auditioning for his current role in the Biden administration).1 Campbell even said in his latest remarks that the Trump administration was right about the “direction” of China policy (though not the “execution”), which is candid. Campbell was speaking at Stanford University but his comments were obviously aimed for broader consumption. Investors no longer need to wait for the outcome of the Biden administration’s comprehensive review of policy toward China. The answer is known: the Biden administration’s hawkishness is confirmed. The Department of Defense report on China policy, due in June, is very unlikely to strike a more dovish posture than the president’s health policy. Now investors must worry about how rapidly tensions will escalate and put a drag on global sentiment. Bottom Line: US-China relations are unstable and pose an immediate threat to global risk appetite. The fundamental geopolitical assessment of US-China relations has been confirmed yet again. The US is seeking to constrain China’s rise because China is the only country capable of rivaling the US for supremacy in Asia and the world. Meanwhile China is rejecting liberalization in favor of economic self-sufficiency and maintaining an offensive foreign policy as it is wary of US containment and interference. Presidents Biden and Xi Jinping are still capable of stabilizing relations in the medium term but they are unlikely to substantially de-escalate tensions. And at the moment tensions are escalating. China’s Reaction: The Example Of Australia How will China respond to Biden’s new inquiry into COVID’s origins? Obviously Beijing will react negatively but we would not expect anything concrete to occur until the result of the inquiry is released in 90 days. China will be more constrained in its response to the US than it has been with Australia, which called for an international inquiry early last year, as the US is a superior power. Australia was the first to ban Chinese telecom company Huawei from its 5G network (back in 2018) and it was the first to call for a COVID probe. Relations between China and Australia have deteriorated steadily since then, but macro trends have clearly driven the Aussie dollar. The AUD-JPY exchange rate is a good measure for global risk appetite and it is wavering in recent weeks (Chart 5). Chart 5Australian Dollar Follows Macro Trends, Rallies Amid China Trade Spat Tensions have also escalated due to China’s dependency on Australian commodity exports at a time of spiking commodity prices. This is a recurring theme going back to the Stern Hu affair. The COVID spat led China to impose a series of sanctions against Australian beef, barley, wine, and coal. But because China cannot replace Australian resources (at least, not in the short term), its punitive measures are limited. It faces rising producer prices as a result of its trade restrictions (Chart 6). This dependency is a bigger problem for China today than it was in previous cycles so China will try to diversify. Chart 6Constraints On China's Tarrifs On Australia By contrast, China is not likely to impose sanctions on the US in response to Biden’s investigation, unless Biden attacks first. China’s imports from the US are booming and its currency is appreciating sharply. Despite Beijing’s efforts to keep the Phase One trade deal from collapsing, Biden is maintaining Trump’s tariffs and the US-China trade divorce is proceeding (Chart 7). Bilateral tariff rates are still 16-17 percentage points higher than they were in 2018, with US tariffs on China at 19% (versus 3% on the rest of the world) while Chinese tariffs on the US stand at 21% (versus 6% on the rest of the world). The Biden administration timed this week’s hawkish statements to coincide with the first meeting of US trade negotiators with China, which was a more civil affair. Both countries acknowledged that the relationship is important and trade needs to be continued. However, US Trade Representative Katherine Tai’s comments were not overly optimistic (she told Reuters that the relationship is “very, very challenging”). She has also been explicit about maintaining policy continuity with the Trump administration. We highly doubt that China’s share of US imports will ever surpass its pre-Trump peaks. The Biden administration has also refrained so far from loosening export controls on high-tech trade with China. This has caused a bull market in Taiwan while causing problems for Chinese semiconductor stocks’ relative performance (Chart 8). If Biden’s policy review does not lead to any relaxation of export controls on commercial items then it will mark a further escalation in tensions. Chart 7US Tarrifs Reduce China In Trade Deficit Bottom Line: Until Presidents Biden and Xi stabilize relations at the top, the trade negotiations over implementing the Phase One trade deal – and any new Phase Two talks – cannot bring major positive surprises for financial markets. Chart 8US Export Controls Amid Chip Shortage Congress Is More Hawkish Than Biden Biden’s ability to reduce frictions with China, should he seek to, will also be limited by Congress and public opinion. With the US deeply politically divided, and polarization at historically high levels, China has emerged as one of the few areas of agreement. The hawkish consensus is symbolized by new legislation such as the Strategic Competition Act, which is making its way through the Senate rapidly. Congress is also trying to boost US competitiveness through bills such as the Endless Frontier Act. These bills would subject China to scrutiny and potential punitive measures over a broad range of issues but most of all they would ignite US industrial policy , STEM education, and R&D, and diversify the US’s supply chains. We would highlight three key points with regard to the global impact of this legislation: Global supply chains are shifting regardless: This trend is fairly well established in tech, defense, and pharmaceuticals. It will continue unless we see a major policy reversal from China to try to court western powers and reduce frictions. The EU and India are less enthusiastic than the US and Australia about removing China from supply chains but they are not opposed. The EU Commission has recommended new defensive economic measures that cover supply chains in batteries, cloud services, hydrogen energy, pharmaceuticals, materials, and semiconductors. As mentioned, the EU is also hesitating to ratify the Comprehensive Agreement on Investment with China. Hence the EU is moving in the US’s direction independently of proposed US laws. After all, China’s rise up the tech value chain (and its decision to stop cutting back the size of its manufacturing sector) ultimately threatens the EU’s comparative advantage. The EU is also aligned with the US on democratic values and network security. India has taken a harder stance on China than usual, which marks an important break with the past. India’s decision to exclude Huawei from its 5G network is not final but it is likely to be at least partially implemented. A working group of democracies is forming regardless. The Strategic Competition Act calls for the creation of a working group of democracies but the truth is that this is already happening through more effective forums like the G7 and bilateral summits. Just as the implementation of the act would will ultimately depend on President Biden, so the willingness of other countries to adopt the recommendations of the working group would depend on their own executives. Allies have leeway as Biden will not use punitive measures against them: Any policy change from the EU, UK, India, and Australia will be independent of the US Congress passing the Strategic Competition Act. These countries will be self-directed. The US would have to devote diplomatic energy to maintaining a sustained effort by these states to counter China in the face of economic costs. This will be limited by the fact that the Biden administration will be very reluctant to impose punitive measures on allies to insist on their cooperation. The allies will set the pace of pressure on China rather than the United States. This gives the EU an important position, particularly Germany. And yet the trends in Germany suggest that the government will be more hawkish on China after the federal elections in September. Bottom Line: The Biden administration is unlikely to use punitive measures against allies so new US laws are less important than overall US diplomacy with each of the allies. Some allies will be less compliant with US policies given their need for trade with China. But so far there appears to be a common position taking shape even with the EU that is prejudicial to China’s involvement in key sectors of emerging technologies. If China does not respond by reducing its foreign policy assertiveness, then China’s economic growth will suffer. That drag would have to be offset by new supply chain construction in Southeast Asia and other countries. Investment Takeaways The foregoing highlights the international risks facing China even at a time when its trend growth is slowing (Chart 9) and its ongoing struggle with domestic financial imbalances is intensifying. China’s debt-service costs have risen sharply and Beijing is putting pressure on corporations and local governments to straighten out their finances (Chart 10), resulting in a wave of defaults. This backdrop is worrisome for investors until policymakers reassure them that government support will continue. Chart 9China's Growth Potential Slowing Chart 10China's Leaders Struggle With Debt China’s domestic stability is a key indicator of whether geopolitical risks could spiral out of control. In particular we think aggressive action in the Taiwan Strait is likely to be delayed as long as the Chinese economy and regime are stable. China has rattled sabers over the strait this year in a warning to the United States not to cross its red line (Chart 11). It is not yet clear how Biden’s policy continuity with the Trump administration will affect cross-strait stability. We see no basis yet for changing our view that there is a 60% chance of a market-negative geopolitical incident in 2021-22 and a 5% chance of full-scale war in the short run. Chart 11China PLA Flights Over Taiwan Strait Putting all of the above together, we see substantial support for two key market-relevant geopolitical risks: Chinese domestic politics (including policy tightening) and persistent US-China tensions (including but not limited to the Taiwan Strait). We remain tactically defensive, a stance supported by several recent turns in global markets: The global stock-to-bond ratio has rolled over. China is a negative factor for global risk appetite (Chart 12). Global cyclical equities are no longer outperforming defensives. There is a stark divergence between Chinese cyclicals and global cyclicals stemming from the painful transition in China’s bloated industrial economy (Chart 13). Global large caps are catching a bid relative to small caps (Chart 14). Chart 12Global Stock-To-Bond Ratio Rolled Over Chart 13Global Cyclicals-To-Defensives Pause Chart 14Global Large Caps Catch A Bid Versus Small Caps Cyclically the global economic recovery should continue as the pandemic wanes. China will eventually relax policy to prevent too abrupt of a slowdown. Therefore our strategic portfolio reflects our high-conviction view that the current global economic expansion will continue even as it faces hurdles from the secular rise in geopolitical risk, especially US-China cold war. Measurable geopolitical risk and policy uncertainty are likely to rebound sooner rather than later, with a negative impact on high-beta risk assets. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Coda: Global Minimum Tax Symbolizes Return Of Big Government On Thursday, the US Treasury Department released a proposal to set the global minimum corporate tax rate at 15%. The plan is to stop what Treasury Secretary Janet Yellen has referred to as a global “race to the bottom” and create the basis for a rehabilitation of government budgets damaged by pandemic-era stimulus. Although the newly proposed 15% rate is significantly below President Biden’s bid to raise the US Global Intangible Low-Taxed Income (GILTI) rate to 21% from 10.5%, it is the same rate as his proposed minimum tax on corporate book income. Biden is also raising the headline corporate tax rate from 21% to around 25% (or at highest 28%). Negotiators at the OECD were initially discussing a 12.5% global minimum rate. The finance ministers of both France and Germany – where the corporate income tax rates are 32.0% and 29.9%, respectively – both responded positively to the announcement. However, Ireland, which uses low corporate taxes as an economic development strategy, is obviously more comfortable with a minimum closer to its own 12.5% rate. Discussions are likely to occur when G7 finance ministers meet on June 4-5. Countries are hoping to establish a broad outline for the proposal by the G20 meeting in early July. It is highly likely that the OECD will come to an agreement. However, it is not a truly “global” minimum as there will still be tax havens. Compliance and enforcement will vary across countries. A close look at the domestic political capital of the relevant countries shows that while many countries have the raw parliamentary majorities necessary to raise taxes, most countries have substantial conservative contingents capable of preventing stiff corporate tax hikes (Table 1, in the Appendix). Our Geopolitical strategists highlight that the Biden administration’s compromise on the minimum rate reflects its pragmatism as well as emphasis on multilateralism. Any global deal will be non-binding but the two most important low-tax players are already committed to raising corporate rates well above this level: Biden’s plan is noted above, while the UK’s budget for March includes a jump in the business rate to 25% in April 2023 from the current 19%. Ireland and Hungary are the only outliers but they may eventually be forced to yield to such a large coalition of bigger economies (Chart 15). Chart 15Global Minimum Corporate Tax Impact Is Symbolic Rather Than Concrete Thus a nominal minimum corporate tax rate is likely to be forged but it will not be truly global and it will not change the corporate rate for most countries. The reality of what companies pay will also depend on loopholes, tax havens, and the effective tax rate. Bottom Line: On a structural horizon, the global minimum corporate tax is significant for showing a paradigm shift in global macro policy: western governments are starting to raise taxes and revenue after decades of cutting taxes. The experiment with limited government has ended and Big Government is making a comeback. On a cyclical horizon, the US concession on global minimum tax is that the Biden administration aims to be pragmatic and “get things done.” Biden is also working with Republicans to pass bills covering some bipartisan aspects of his domestic agenda, such as trade, manufacturing, and China. The takeaway from a global point of view is that Biden may prove to be a compromiser rather than an ideologue, unlike his predecessors. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim Vice President Daily Insights RoukayaI@bcaresearch.com Footnotes 1 Kurt M. Campbell and Jake Sullivan, "Competition Without Catastrophe," Foreign Affairs, September/October 2019, foreignaffairs.com. Section II: Appendix Table 1OECD: Which Countries Are Willing And Able To Raise Corporate Tax Rates? GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan – Province Of China Korea Turkey Brazil Australia Section III: Geopolitical Calendar
Highlights Global stocks are very vulnerable to a correction. But cyclically the Fed is committed to an inflation overshoot and the global economy is recovering. China’s fiscal-and-credit impulse fell sharply, which leaves global cyclical stocks and commodities exposed to a pullback. Beyond the near term, China’s need for political stability should prevent excessive policy tightening. The risk is frontloaded. China’s population census underscores one of our mega-themes: China’s domestic politics are unstable and can bring negative surprises. India’s state elections, held amid a massive COVID-19 wave, suggest that the ruling party is still favored in 2024. This implies policy continuity. Stick with a bullish cyclical bias but be prepared to shift if China commits a policy mistake. Feature Chart 1Inflation Rears Its Head Global markets shuddered this week in the face of a strong core inflation print in the US as well as broader fears as inflation rears its head after a long slumber (Chart 1). Cyclically we still expect investors to rotate away from US stocks into international stocks and for the US dollar to fall as the global economy recovers (Chart 2). However, this view also entails that emerging market stocks should start outperforming their developed market peers, which has not panned out so far this year. Emerging markets are not only technology-heavy and vulnerable to rising US bond yields but also further challenged now by China’s stimulus having peaked. Chart 2Equity Market Trembles Chart 3Global Economy And Sentiment Recovering Chart 4Global Cyclicals Versus Defensives Wavering The one thing we can rely on is that the COVID-19 vaccine rollout will continue to enable a global growth recovery (Chart 3). The US dollar is signaling as much. The greenback bounced in the first quarter on US relative growth outperformance but it has since fallen back. A falling dollar is positive for cyclical stocks relative to defensives, although cyclicals are flagging that the reflation trade is overdone in the near term (Chart 4). China’s growth now becomes the critical focal point. A policy mistake in China would upset the bullish cyclical view. China’s tightening of monetary and fiscal policy is a major global policy risk that we have highlighted this year and it is now materializing. However, we have also highlighted the constraints to tightening. At present China is standing right on the threshold of overtightening according to our benchmarks. If China tightens further, we will take a fundamentally more defensive view. Also in this report we will review the results of China’s population census and the implications of India’s recent state elections in the face of the latest big wave of COVID-19 infections. We are not making any changes to our bullish view on India yet but we are putting it on watch. China: The Overtightening Risk China’s troubles stem from the ongoing change of its economic model from reliance on foreign trade to reliance on domestic demand. This was a strategic decision that the Communist Party made prior to the rise of President Xi Jinping. Xi also has come to embody it and reinforce it through his strategic vision and confrontation with the United States. Beijing’s goal was to manage a smooth and stable transition. The financial turmoil of 2015 and the trade war of 2018-19 jeopardized that goal but policymakers ultimately prevailed. Then COVID-19 broke out and caused the first real economic contraction since the 1970s. While China contained the virus and bounced back with another massive round of stimulus (13.8% of GDP from the onset of the trade war to the 2021 peak), it now faces an even more difficult transition. Chart 5China's Rising Propensity To Save The need to improve quality of life is more urgent given that potential GDP has slowed. The need to contain systemic financial risk is more urgent given the big new increase in debt. And the need to diversify the economy is more urgent given that the US is now creating a coalition of democracies to confront China over a range of policies. The spike in the “marginal propensity to save” among Chinese people and corporations – as measured by the ratio of long-term cash deposits to short-term deposits – is an indication that the country is beset by troubles and animal spirits are depressed (Chart 5). China’s fiscal-and-credit impulse is turning down after the large expansion in 2018-21. Policymakers have signaled since last year that they would withdraw emergency stimulus and now the impact is apparent in the hard data. China’s money, credit, and combined credit-and-fiscal impulses all correlate with economic growth after a six-to-nine-month lag. This is true regardless of which indicators one uses for China’s money and credit cycles and economic activity (Charts 6A and 6B). China’s economic momentum is peaking and will become a headwind for the global economy later this year and in 2022, even though the world is otherwise enjoying the tailwinds of vaccination and economic reopening. Chart 6AChina’s Fiscal-And-Credit Impulse Falls Sharply … Chart 6B… As Do Money-And-Credit Impulses The downshift in the fiscal-and-credit impulse portends a slowdown in demand for commodities, materials, and other goods that China imports, especially for domestic consumption. (Chinese imports of parts and inputs that go into its manufacturing exports to the rest of the world look healthier as the rest of the world recovers.) This shift will make it hard for high-flying metals prices and other China plays, such as Swedish stocks, to continue rising without a correction (Chart 7). Speculative positioning is heavily in favor of commodities at the moment. The divergence between China and the metals markets that it dominates looks untenable in the short run (Chart 8). Chart 7China Reflation Trades Near Peaks Chart 8Money Cycle And Commodity Prices Clash The global shift to green or renewable energy systems (i.e. de-carbonization) is bullish for metals, especially copper, but will not be able to make up for the fall in Chinese demand in the short run, as our Emerging Markets Strategy has shown. China’s domestic uses of copper for construction and industry make up about 56.5% of global copper demand while the green energy race – namely the production of solar panels, windmills, electric cars – makes up only about 3.5% of global demand. This number somewhat understates the green program since re-gearing and retrofitting existing systems and structures is also projected, such as with electricity grids. But the point is that a drop in China’s copper consumption will work against the big increase in American and European consumption – especially given that the US infrastructure program will not kick in until 2022 at the earliest. Hence global copper demand will slow over the next 12 months in response to China even though the rest of the world’s demand is rising. Chinese policymakers have not yet signaled that they are worried about overtightening policy or that they will ease policy anew. The Politburo meeting at the end of April did not contain a major policy change from the Central Economic Work Conference in December or the Government Work Report in March (Table 1). But if there was a significant difference, it lay in reducing last year’s sense of emergency further while projecting some kind of scheme to hold local government officials accountable for hidden debt. The implication is continued tight policy – and hence the risk of overtightening remains substantial. Table 1China’s Recent Macroeconomic Policy Statements: Removing Stimulus Chart 9Benchmarks For China's Policy Tightening True, the tea leaves of the April meeting can be read in various ways. The April statement left out phrases about “maintaining necessary policy support” from the overarching macroeconomic policy guidance, which would imply less support for the economy. But it also left out the goal of keeping money supply (M2) and credit growth (total social financing) in line with nominal GDP growth, which could be seen as enabling a new uptick in credit growth. However, the People’s Bank of China did maintain this credit goal in its first quarter monetary policy report, so one cannot be sure. Notice that according to this rubric, China is right on the threshold of “overtightening” policy that we have utilized to measure the risk (Chart 9). Based on Chinese policymaking over the past two decades, we would expect any major inflection point to be announced at the July Politburo meeting, not the April one. We do not consider April a major change from the preceding meetings – nor does our China Investment Strategy. Therefore excessive policy tightening remains a genuine risk for the Chinese and global economy over the next 12 months. Our checklist for excessive tightening underscores this point (Table 2). Table 2Checklist For Chinese Policy Tightening China’s fiscal-and-credit downshift is occurring in advance of the twentieth national party congress, which will take place throughout 2022 and culminate with the rotation of the top leadership (the Politburo Standing Committee) in the autumn. The economy is sufficiently stimulated for the Communist Party’s hundredth birthday on July 1 of this year, so policymakers are focused on preventing excesses. Financial risk prevention, anti-monopoly regulation, and tamping down on the property bubble are the orders of the day. The increase in corporate and government bond defaults and bankruptcies underscore the leadership’s willingness to push forward with economic restructuring and reform, which is well-attested in recent years (Chart 10). Chart 10Creative Destruction In China Investors cannot assume that the party congress in 2022 is a reason for the leadership to ease policy. The contrary occurred in the lead-up to the 2017 party congress. However, investors also cannot assume that China will overtighten and sink its own economy ahead of such an important event. Stability will be the goal – as was the case in 2017 and previous party congresses – and this means that policy easing will occur at some point if the current round of tightening becomes too painful financially and economically. China-linked assets are vulnerable in the short run until policymakers reach their inflection point. Incidentally, the approach of the twentieth national party congress will be a magnet for political intrigue and shocking events. The top leader normally sacks a prominent rival ahead of a party congress as a show of force in the process of promoting his faction. The government also tightens media controls and cracks down on dissidents, who may speak up or protest around the event. But in 2022 the stakes are higher. President Xi was originally expected to step down in 2022 but now he will not, which will arouse at least some opposition. Moreover, under Xi, China has undertaken three historic policy revolutions: it is adopting a strongman leadership model, to the detriment of the collective leadership model under the two previous presidents; it is emphasizing economic self-sufficiency, at the expense of liberalization and openness; and it is emphasizing great power status, at the expense of cooperation with the United States and its allies. Bottom Line: Global equities, commodities, and “China plays” stand at risk of a substantial correction as a result of China’s policy tightening. Our base case is that China will avoid overtightening but the latest money and credit numbers run up against our threshold for changing that view. Another sharp drop in these indicators will necessitate a change. China’s Disappearing Workforce Ultimately one of the constraints on overtightening policy is the decline in China’s potential GDP growth as a result of its shrinking working-age population. China’s seventh population census came out this week and underscored the deep structural changes affecting the country and its economy. Population growth over the past ten years slowed to 5.4%, the lowest rate since the first census in 1953. The fertility rate fell to 1.3 in 2020, lower than the 2.1 replacement rate and the 1.8 target set when Chinese authorities relaxed the one-child policy in 2016. The fertility rate is also lower than the World Bank’s estimates (1.7 in 2019) and even Japan’s rate. The birthrate (births per 1,000 people) also fell, with the number of newborns in 2020 at the lowest point since 1961, the year of the Great Famine. The birth rate has converged to that of high-income countries, implying that economic development is having the same effect of discouraging childbearing in China, although China is less developed than these countries. Chart 11China’s Working Population Falling Faster Than Japan’s In 1990s The youngest cohort rose from 16.6% to 17.95% of the population, the oldest cohort rose 8.9% in 2010 to 13.5% today, while the working-age cohort fell from 75.3% to 68.6%. The working-age population peaked in 2010 and fell by 6.79 percentage points over the past ten years. By contrast, Japan’s working-age population peaked in 1992 and fell 2.18 percentage points in the subsequent decade (Chart 11). In other words China is experiencing the demographic transition that hit Japan in the early 1990s – but China’s working-age population might fall even faster. The country is experiencing this tectonic socioeconomic shift at a lower level of per capita wealth than Japan had attained. The demographic challenge will put pressure on China’s socioeconomic and political system. The China miracle, like other Asian miracles, was premised on the use of export-manufacturing to generate large piles of savings that could be repurposed for national development. The decline in China’s working-age population coincides with economic development and a likely decline in the saving rate over the long run. This is shown in Chart 12, which shows two different pictures of China’s working population alongside the gross national saving rate. As China’s dependency ratio rises the saving rate will fall and fewer funds will be available for repurposing. The cost of capital will rise and economic restructuring will accelerate. In the case of Japan, the demographic shift coincided with the 1990 financial crisis and then a nationwide shift in economic behavior. The saving rate fell as the economy evolved but the savings that were generated still exceeded investment due to the shortfall in private demand and the pressure of large debt burdens. Companies focused on paying down debt rather than expanding investment and production (Chart 13). All of this occurred when the external environment was benign, whereas China faces a similar demographic challenge in the context of rising economic pressure due to geopolitical tensions. Chart 12Chinese Workers Getting Scarcer Chart 13High Savings Enable Debt Splurge Until Debt Overwhelms China has so far avoided a debilitating financial crisis and collapse in real estate prices that would saddle the country with a traumatizing liquidity trap. The Chinese authorities are painfully aware of the danger of the property bubble and are therefore eager to prevent financial excesses and curb bubble-like activity. This is what makes the risk of overtightening significant. But a mistake in either direction can lead to a slide into deflation. The Xi administration has stimulated the economy whenever activity slowed too much or financial instability threatened to get out of hand, as noted above, but this is a difficult balancing act, which is why we monitor the risk of excessive tightening so closely. A few other notable takeaways from China’s population census include: The two-child policy is not succeeding so far. COVID-19 might have had a negative effect on fertility but it could not have affected births very much due to the timing. So the trends cannot be distorted too much by the pandemic. Rapid urbanization continues, with the rate hitting 64% of the population, up 14 percentage points from 2010. Policy discussions are emphasizing lifting the retirement age; providing financial incentives for having babies; a range of price controls to make it more affordable to have babies, most notably by suppressing the property bubble; and measures to ensure that property prices do not fall too rapidly in smaller cities as migration from the country continues. China’s ethnic minority population, which consists of 9% of the total population, grew much faster (10% rate) over the past decade than the Han majority, which makes up 91% of the population (growing at a 5% rate). Minorities are exempt from the one-child (and two-child) policy. Yet ethnic tensions have arisen, particularly in autonomous regions like Xinjiang, prompting greater international scrutiny of China’s policies toward minorities. China’s demographic challenge is widely known but the latest census reinforces the magnitude of the challenge. China’s potential growth is falling while the rising dependency ratio underscores social changes that will make greater demands of government. Greater fiscal and social spending needs will require difficult economic tradeoffs and unpopular political decisions. Economic change and the movement of people will also deepen regional and wealth disparities. All of these points underscore one of our consistent Geopolitical Strategy mega-themes: China’s domestic political risks are underrated. Bottom Line: China’s 2020 census reinforces the demographic decline that lies at the root of China’s rising socioeconomic and political challenges. While China has a strong central government with power consolidated under a single ruling party, and a track record of managing its various challenges successfully in recent decades, nevertheless the magnitude of the changes happening are overwhelming and will bring negative economic and political surprises. India: State Elections Not A Turning Point Against Modi At the height of the second COVID-19 wave in India, elections were held in five Indian states. Results for the state of West Bengal were most important. West Bengal is a large state, accounting for nearly a-tenth of legislators at India’s national assembly, and the ruling Bharatiya Janata Party (BJP) of Prime Minister Narendra Modi had declared that it would win nearly 70% of the 294 seats there. In the event West Bengal delivered a landslide victory for the All India Trinamool Congress (AITMC), a regional party. Despite the fact that the AITMC was facing a two term anti-incumbency, the AITMC seat count hit an all-time high. Few had seen this coming as evinced by the fact that AITMC’s performance exceeded forecasts made by most pollsters. What should investors make of the BJP’s loss in this key state? Was it a backlash against Modi’s handling of the pandemic? Does it portend a change of government and national policy in the general elections in 2024? Not really. Here we highlight three key takeaways: Takeaway #1: The BJP’s performance was noteworthy Chart 14India: BJP Gets Foot In Door In West Bengal Whilst the BJP fell short of its goals in West Bengal, the state is not a BJP stronghold. The BJP is known to have natural traction in Hindi-speaking regions of India and West Bengal is a non-Hindi speaking state where the BJP was traditionally seen as an outsider. Also, this state is known to be unusually unwilling to accept change. For instance, before AITMC, the Left was in power for a record spell of 34 years in this state. In such a setting, the BJP’s performance in 2021 in West Bengal is noteworthy: the party increased its seat count to 77 seats, compared to only 3 seats in 2016 (Chart 14). This performance now catapults the BJP into becoming the key opposition party in West Bengal. It also indicates that the BJP may take time but has what it takes to build traction in states that are not traditional strongholds. Given that it achieved this feat in a state where it has little historic strength, its performance is noteworthy as a sign that the BJP remains a force to be reckoned with. Takeaway #2: The BJP’s popularity slipped but it is still favored to retain power in 2024 Whilst discontent against the BJP is rising on account of its poor handling of COVID-19 and the accompanying economic distress, there remains no viable alternative to the BJP at the national level. The recent state elections, not only in West Bengal, confirm that the opposition Indian National Congress (INC) is yet to get its act in order. The Congress party collapsed from 44 seats in Bengal to 0 seats. More importantly, the Congress is yet to resolve two critical issues, i.e. the need to appoint or elect an internal leader with mass appeal, and the need to develop an identifiable policy agenda. The weakness of the Congress means that while the BJP’s seat count could diminish as against its 2019 peak performance, nevertheless our base-case scenario for 2024 remains that of a BJP-led government maintaining power in India. Policy continuity and the chance of some structural reform are still the base case. Takeaway #3: The rise and rise of India’s regional parties The rise of the BJP over the last decade has coincided with losses in seats by both the Congress party and India’s regional parties. However, the most recent round of state elections signals that the BJP cannot compress regional parties’ seat share drastically. For instance, in West Bengal, it managed to win 77 seats by itself but this was not at the expense of the AITMC, which is the dominant player in this state. In another large state where elections were held earlier this month, i.e. Tamil Nadu, control continues to fluctuate between two well-entrenched regional parties. Chart 15India: BJP Peaked In 2019 But Still Favored 2024 The 2019 general elections saw the share of regional parties (defined as all parties excluding the BJP and Congress) fall to 35% from the near 40% levels seen at the general elections of 2014 (Chart 15). The 2024 elections could in fact see regional parties’ seat share move up a notch as the BJP’s peak seat count could diminish from the highs of 2019. The coming rise of India’s regional parties is a trend rooted in a simple dynamic. With the BJP as a two-term incumbent in the 2024 elections, voters could choose to gratify regional parties at the margin, in the absence of any alternative to the BJP at the national level. The BJP remains in a position to be the single largest party in India in 2024 with a seat count in excess of the half-way mark. But could a situation arise where the ruling party pulls in a regional party to stay ahead of the half-way mark with a large buffer? Absolutely. But of course 2024 is a long way away. Managing COVID-19 and its economic fallout will make it harder than otherwise for the BJP to beat its 2019 performance. The next bout of key state elections in India are due in February 2022 and India’s largest state, Uttar Pradesh, will see elections. With the BJP currently in power in this Hindi-speaking state, the February 2022 elections will shed more light on BJP’s ability to mitigate the anti-incumbency effect of the pandemic and economic shock. Bottom-Line: BJP’s popularity in India has been shaken but not dramatically so. The BJP remains firmly in a position to be the single largest party in India with a seat count that should cross the half-way mark in 2024. So government stability is not a concern in this emerging market for now. In light of China’s domestic political risks, and India’s political continuity, we will maintain our India trades for the time being (Charts 16A and 16B). However, we are undertaking a review of India as a whole and will update clients with our conclusions in a forthcoming special report. Chart 16AStay Long Indian Bonds Versus EM Chart 16BStick To Long India / Short China Investment Takeaways Maintain near-term safe-haven trades. Close long natural gas futures for a 19.8% gain. Maintain cyclical (12-month) bullish positioning with a preference for value over growth stocks. Maintain long positions in commodities, including rare earth metals, and emerging markets. But be prepared to cut these trades if China overtightens policy according to our benchmarks. For now, continue to overweight Indian local currency bonds relative to emerging market peers and Indian stocks relative to Chinese stocks. But we are reviewing our bullish stance on India. Chart 17Cyber Security Stocks Perk Up Amid Tech Rout Stay long cyber security stocks – though continue to prefer aerospace and defense over cyber security as a geopolitical “back to work” trade. Cyber security stocks perked up relative to the tech sector during the general tech selloff over the past week. The large-scale Colonial Pipeline ransomware cyber attack in the US temporarily shuttered a major network that supplies about 45% of the East Coast’s fuel (Chart 17). Nevertheless the attack on critical infrastructure highlights that cyber security is a secular theme and investors should maintain exposure. Cyber stocks have outperformed tech in general since the vaccine discovery (Chart 18). Chart 18Cyber Security Is A Secular Theme Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Yushu Ma Research Associate yushu.ma@bcaresearch.com Ritika Mankar, CFA Editor/Strategist Ritika.Mankar@bcaresearch.com