Turkey

Erdogan will most likely lose the Turkish election but it could go onto a second round. A strong opposition majority in the assembly would justify a tactical overweight in Turkish equities on a relative basis. For now, go long Turkish equity volatility.

Macro and geopolitical risks may spoil the narrow window for a stock market rally before recessionary trends rise to the fore.

Stay defensive in the second quarter. We can see a narrow window for risky assets to outperform but we recommend investors stay wary amid high rates, supply risks, extreme uncertainty, peak polarization, and structurally rising geopolitical risk.

Investors should avoid / stay underweight Turkish stocks and local currency bonds versus their respective EM benchmarks. Stay underweight Turkish sovereign credit.

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

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

Executive Summary Turkey is staring into an abyss: economic crisis that will morph into political crisis in the June 2023 election cycle. President Erdoğan will pursue populist economic policies and foreign policy adventurism to try to stay in power, leading to negative surprises and “black swan” risks over the coming 9-12 months. While Erdoğan and the ruling party are likely to be defeated in elections, which is good news, investors should not try to front-run the election given high uncertainty. Neither Turkey’s economy and domestic politics nor the global economy and geopolitics warrant a bullish view on Turkish assets. GEOPOLITICAL STRATEGY  Recommendation (TACTICAL) Initiation Date Return LONG JPY/TRY 2022-09-23     Erdoğan’s Net Negative Job Approval Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Bottom Line: The Lira will depreciate further versus the dollar. Both Turkish stocks and local currency bonds merit an underweight stance in an EM basket. EM sovereign credit investors, however, should be neutral on Turkish sovereign credit relative to the EM sovereign credit benchmark. Feature Turkey – now technically Türkiye – is teetering on the verge of a national meltdown. The inflation rate is the fastest in G20 countries, both because of a domestic wage-price spiral and soaring global food and fuel prices. President Recep Tayyip Erdoğan and his Justice and Development Party (AKP) have been in power since 2002, making them highly vulnerable to demands for change in the general election slated for June 18, 2023. Yet Erdoğan is a strongman who won a popular vote to revise the constitution in 2017 and increase his personal power over institutions. His populist Islamist movement is starkly at odds with the country’s traditional elite, including the secular military establishment. Given the poor state of the economy, Erdoğan will likely lose the 2023 election but he could refuse to leave office … or he could win the election and be ousted in a coup d'état, as happened in Turkey in 1960, 1971, and 1980.1 Meanwhile Turkey is beset by foreign dangers – including war in Ukraine and instability in the Middle East. Erdoğan will try to use foreign policy to bolster his popular standing. Turkey has inserted itself in various regional conflicts and could instigate conflicts of its own. While global investors are eager to buy steeply discounted Turkish financial assets ahead of what could be a monumental change in national policy in 2023, the country is extremely unstable. It is a source of “black swan” risks. The best bet is to remain underweight Turkish assets unless and until a pro-market election outcome shakes off the two-decade trend toward economic ruin. Turkish Grand Strategy Turkey is permanently at a crossroads. The land-bridge between Europe and Asia, it is secular and cosmopolitan but also Islamist and traditional. Its past consists of the greatness of empires – Byzantine, Ottoman – while its present consists of a frustrating search for new opportunities in a chaotic regional context. The core of the country consists of the disjointed coastal plains around the Bosporus and Dardanelles straits and the Sea of Marmara, where Istanbul is located. The Byzantine and Ottoman empires were seated on this strategic location at the juncture of the world’s east-west trade. To secure this area, the Turks needed to control the larger Anatolian peninsula – Asia Minor – to prevent roving Eurasian powers from invading, just as they themselves had originally invaded from Central Asia. During times of greatness the Turks could also expand their empire to control the Balkan peninsula and Danube river valley up to Vienna, Crimea and the Black Sea coasts, and the eastern Mediterranean island approaches. During the Ottoman empire’s golden days Turkish power extended all the way into North Africa, Mesopotamia, the Nile river valley, and Mecca and Medina. The empire – and the Islamic Ottoman Caliphate – collapsed in 1924 after centuries of erosion and the catastrophes of World War I. Subsequently Turkey emerged as a secular republic. It adapted to the post-WWII world order by allying with the United States and NATO, in conflict with the Soviet Union which encircled the Turks on all sides. The Russians are longstanding rivals of Turkey, notably in the Black Sea and Crimea, and Stalin wanted to get his hands on the Dardanelles and Bosporus straits. Hence alliance with the US and NATO fulfilled one of the primary demands of Turkish grand strategy: a navy that could defend the straits and Turkish interests in the Black Sea and eastern Mediterranean. The collapse of the Soviet Union seemed to usher in an era of opportunity for Turkey. Turkey benefited from democratization, globalization, and foreign capital inflows. But then America’s wars and crises, Russia’s resurgence, and Middle Eastern instability created a shatter-belt surrounding Turkey, impinging on its national security. In this context of limited foreign policy options, Turkey’s domestic politics coalesced around Erdoğan, the AKP, political Islam, and investment-driven economic growth. Erdoğan and the AKP represent the Anatolian, religious, and Middle Eastern interests in Turkey, as opposed to the maritime, secular, and Euro-centric interests rooted in Istanbul. This point can be illustrated by observing that the poorer interior regions have grown faster than the national average over the period of AKP rule, whereas the more developed coastal regions have tended to lag (Map 1). Voting patterns from the 2018 general election overlap with these economic outcomes. The AKP has steered investment capital into the interior to fund infrastructure and property construction while currency depreciation, rather than productivity enhancement, has merely maintained the status quo with the manufacturing export sector in the coastal regions (Chart 1). Map 1Turkey’s Anatolian Model And The Struggle With The Coasts Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Chart 1Turkey's Export Competitiveness Turkey's Export Competitiveness Turkey's Export Competitiveness Today Turkey faces three distinct obstacles to its geopolitical expansion: Russian aggression: Russia’s resurgence, especially with the seizure of Crimea in 2014 and broader invasion of Ukraine in 2022, threatens Turkey’s interests in the Black Sea and eastern Mediterranean. Turkey must always deal with Russia carefully but over the past 14 years Russia has become belligerent, forcing Turkey to come to terms with Putin while maintaining the NATO alliance. Today Erdoğan tries to mediate the conflict as it does not want to encourage Russian aggression but also does not want NATO to provoke Russia. For instance, Turkey is willing to condone Finland and Sweden joining NATO but only if the West grants substantial benefits to Turkey itself. Ultimately Turkish ties with Russia are overrated. For both economic reasons and grand strategic reasons outlined above, Turkey will cleave to the West (Chart 2). Chart 2Turkey Still Linked To The West Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan ​​​​​ Chart 3Turkish Energy Ties With Russia Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Western liberal hegemony: The EU and NATO foreclosed any Turkish ambitions in Europe. The EU has consolidated with each new crisis while rejecting Turkish membership. This puts limits on Turkish access to European markets and influence in the Balkans. Turkey has guarded its independence jealously against the West. After the Cold War the US expected Turkey to serve American interests in the Middle East and Eurasia. The EU expected it to serve European interests as an energy transit state and a blockade against Middle Eastern refugees. But Turkish interests were often sidelined while its domestic politics did not allow blind loyalty to the West. This led Turkey to push back against the West and cultivate other options, such as deeper economic ties with Russia and China. Turkish dependency on Russian energy is substantial and Turkey has tried to play a mediating role in Russia’s conflict with NATO (Chart 3). Recently Turkey offered to join the Shanghai Cooperation Organization (SCO), a military alliance of Asian powers. However, as with trade, Turkish defense and security ties with the Russo-Chinese bloc are ultimately overrated (Chart 4).  There is room for some cooperation but Turkey is not eager to abandon American military backing in a period in which Russia is threatening to control the Black Sea rim, cut off grain exports arbitrarily, and use tactical nuclear weapons. Chart 4Turkey’s Defense Alliance With The West Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Middle Eastern instability: The Middle East is a potential area for Turkey to increase influence, especially given the AKP’s embrace of political Islam. Turkey benefits from regional economic development and maintains relations with all players. But the region’s development is halting and Turkey is blocked by competitors. The US toppled Iraq in 2003, which strengthened Iran’s regional clout over the subsequent decades. But Iran is not stable and the US has not prevented Iran from achieving nuclear breakout capacity. Turkey cannot abide a nuclear-armed Iran. At the same time, the US continues to support Israel and the Gulf Arab monarchies, which oppose Turkey’s combination of Islam and democratic populism. Russia propped up Syria’s regime in league with Iran, which threatens Turkey’s border integrity. Developments in Syria, Iraq, and Iran have all complicated Turkey’s management of Kurdish militancy and separatism. Kurds make up nearly 20% of Turkey’s population and play a central role in the country’s political divisions. Erdoğan’s Anatolian power base is antagonistic toward the Kurds and regional Kurdish aspirations. China’s strategic rise brings both risks and rewards for Turkey but China is too distant to become the focus of Turkish strategy: China’s dream of reviving the Silk Road across Eurasia harkens back to the glory days of Ottoman power. The Belt and Road Initiative and other investments help to develop Central Asia and the Middle East, enabling Turkey to benefit once again as the middleman in east-west trade (Chart 5). Chart 5Turkey Benefits From East-West Trade Turkey Benefits From East-West Trade Turkey Benefits From East-West Trade But insofar as China’s Eurasian strategy is successful, it could someday impinge on Turkish ambitions, particularly by buttressing Russian and Iranian power. In recent years Erdoğan has experimented with projecting Turkish power in the Middle East (Syria), North Africa (Libya), the Caucasus (Armenia), and the eastern Mediterranean (Cyprus). He cannot project power effectively because of the obstacles outlined above. But he can manipulate domestic and foreign security issues to try to prolong his hold on power. Bottom Line: Boxed in by Russian aggression, western liberal hegemony, and Middle Eastern instability, Turkey cannot achieve its geopolitical ambitions and has concentrated on internal development over the past two decades. However, the country retains some imperial ambitions and these periodically flare up in unpredictable ways as the modern Turkish state attempts to fend off the chaotic forces that loom in the Black Sea, Middle East, North Africa, and Caucasus. The Erdoğan regime is focused on consolidating Anatolian control of Turkey and projecting military power abroad so that the military does not become a political problem for his faction at home. Erdoğan’s Domestic Predicament President Erdoğan has stayed in power for 20 years under the conditions outlined above but he faces a critical election by June 18, 2023 that could see him thrown from power. The result will be extreme political turbulence over the coming nine months until the leadership of the country is settled by hook or by crook. Erdoğan has pursued a strongman or authoritarian leadership style, especially since domestic opposition emerged in the wake of the Great Recession. By firing three central bankers, he has pressured the central bank into running an ultra-dovish monetary policy, producing a 12% inflation rate prior to the Covid-19 pandemic and an 80% inflation rate today. He has also embraced populist fiscal handouts and foreign policy adventurism. Taken together his policies have eroded the country’s political as well as economic stability. From the last general election in 2018 to the latest data in 2022: Real household disposable income  growth has fallen from -7.4% to -18.7% (Chart 6). Chart 6Real Incomes Falling Real Incomes Falling Real Incomes Falling ​​​​​​ Chart 7Turkish Activity Slows Ahead Of Election Turkish Activity Slows Ahead Of Election Turkish Activity Slows Ahead Of Election ​​​​​ The manufacturing PMI has fallen from 49.0 to 47.4 (Chart 7). Consumer confidence has fallen from 92.1 to 72.2 (Chart 8). Chart 8Consumer Confidence: Not Better Off Than At Last Election Consumer Confidence: Not Better Off Than At Last Election Consumer Confidence: Not Better Off Than At Last Election ​​​​​​ Chart 9Erdoğan’s Net Negative Job Approval Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan ​​​​​​ Bad economic news is finally altering public opinion, with polls now shifting against the president and incumbent party: Since the pandemic erupted, Erdoğan’s approval rating has fallen from a peak of 57% to 40% today. Disapproval has Erdoğan’s risen to 54%, leaving him a net negative job approval (Chart 9). Bear in mind that Erdoğan won the election with 52.6% of the vote in 2018, only slightly better than the 51.8% he received in 2014 and well below the 80% that his AKP predecessor received in 2007. Meanwhile the AKP, which never performs as well as Erdoğan himself, has fallen from a 45% support rate to 30% today in parliamentary polls, dead even with the main opposition Republican People’s Party (Chart 10). The AKP won 42.6% of the vote in 2018, down from 49.5% in the second election of 2015, 49.8% in 2011, and 46.6% in 2007. Chart 10Justice And Development Party Neck And Neck With Republican Opposition Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan The gap between Erdoğan and his Republican rivals has narrowed sharply since the global food and fuel price spike began to bite in late 2021 (Chart 11). Chart 11Erdoğan Faces Tough Re-Election Race Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan However, the 2023 election is not straightforward. There are several caveats to the clear anti-incumbent tendency of economic and political data: Soft Economic Landing? The election takes place in nine months, enough time for surprises to salvage Erdoğan’s presidential campaign, given his and his party’s heavily entrenched rule. For example, it is possible – not probable – that Russia will resume energy exports, enabling Europe to recover, and that central banks will achieve a “soft landing” for the global economy. Turkey’s economy would bounce just in time to help the incumbent party. This is not what we expect (see below) but it could happen. Foreign Policy Victories? Erdoğan could achieve some foreign policy victories. He has negotiated a tenuous deal with Russia and Ukraine, along with the UN, to enable grain exports out of Odessa. He could build on this process to negotiate a broader ceasefire in Ukraine. He could also win major concessions from the US and NATO to secure Finnish and Swedish membership in that bloc. If he did he would come off looking like a grand statesman and might just buy another term in office. Unfortunately what is more likely is that Erdoğan will pursue an aggressive foreign policy in an attempt to distract voters from their bread-and-butter woes, only to destabilize Turkey and the region further. Stolen Election? Erdoğan revised the constitution in 2017 – winning 51.4% of the votes in a popular referendum – to give the presidency substantial new powers across the political system. Using these powers he could manipulate the election to produce a favorable outcome or even cling to power despite unfavorable election results. He does not face nearly as powerful and motivated of a liberal establishment as President Trump faced in 2020 or as Brazilian President Jair Bolsonaro faces in 2022. As noted Erdoğan has a contentious relationship with the Turkish military, so while investors cannot rule out a stolen election, they also cannot rule out a military coup in reaction to an attempted stolen election. Thus the election could produce roughly four outcomes, which we rank below from best to worst in terms of their favorability for global investors: 1.  Best Case: Decisive Opposition Victory – 25% Odds – A resounding electoral defeat for the AKP would reverse its unorthodox economic policies in the short term and serve as a lasting warning to future politicians that populism and economic mismanagement lead to political ruin. This outcome would also provide the political capital and parliamentary strength necessary to impose tough reforms and restore a semblance of macroeconomic stability. 2.  Good Case: Narrow AKP Defeat – 50% Odds – A narrow or contested election would produce a weak new government that would at least put a stop to the most inflationary AKP policies. It would improve global investor sentiment around Turkey’s eventual ability to stabilize its economy. The new government would lack the ability to push through structural reforms but it could at least straighten out the affairs of the central bank so as to ensure a cycle of monetary policy tightening, which would stabilize the currency. 3.  Bad Case: Narrow AKP Victory – 15% Odds – A narrow victory would force the AKP to compromise with opposition parties in parliament and pacify social unrest. Foreign adventurism would continue but harmful domestic policies would face obstructionism. 4.  Worst Case: Decisive AKP Victory – 10% Odds – A resounding victory for the ruling party would vindicate Erdoğan and his policies despite their negative economic results, driving Turkey further down the path of authoritarianism, populism, money printing, currency depreciation, and hyper-inflation. He could also be emboldened in his foreign adventurism. Bottom Line: We expect Erdoğan and the AKP to be defeated and replaced. However, Turkey is in the midst of an economic and political crisis and the next 12 months will bring extreme uncertainty. The election could be indecisive, contested, stolen, or overthrown. The aftermath could be chaotic as well as the lead-up. If the AKP stays in power then investors will abandon Turkey and its economy will suffer a historic shock. Therefore investors should underweight Turkey – at least until the next phase in the economic downturn confirms our forecast that the AKP will fall from power. Macro Outlook: Fade The Equity Rally Chart 12Turkish Stock Rally Will Fade Soon; Stay Underweight This Market Versus EM Turkish Stock Rally Will Fade Soon; Stay Underweight This Market Versus EM Turkish Stock Rally Will Fade Soon; Stay Underweight This Market Versus EM The Turkish economy is beset by hyper-inflation. Headline consumer prices are rising at upwards of 80% and core inflation is 65%. Yet Turkish government 10-year bond yields are low and falling: they are down to 11% currently, from a high of 24% at the beginning of the year. Turkish stocks have also outperformed their Emerging Markets counterparts this year in common currency terms even though the lira has been the worst performing EM currency (Chart 12). So, what’s going on in this market? The answer is hidden in the slew of unorthodox policies adopted by the authorities. These measures caused massive distortions in both the economy and the markets. Specifically, late last year, despite very high inflation, the central bank began to cut policy rates encouraging massive loan expansion. As a result, both local currency loans and money supply surged. Which, in turn, completely unhinged inflation (Chart 13). As inflation rose, so did government bond yields. In a bid to keep government borrowing costs low, policymakers changed several bank regulations to force commercial banks to buy government bonds.2  The upshot was that the bond yields stopped tracking inflation and instead began to fall even as inflation skyrocketed. The rampant inflation meant Turkish non-financial firms’ nominal sales skyrocketed. Indeed, sales of all MSCI Turkey non-financials companies have risen by 40% in US dollar terms and 200% in local currency (Chart 14). Chart 13Massive Bank Credit And Money Growth Completely Unhinged The Inflation Massive Bank Credit And Money Growth Completely Unhinged The Inflation Massive Bank Credit And Money Growth Completely Unhinged The Inflation This was at a time when policy rates were being cut. The policy rate has fallen to 12% today from 19% a year earlier. Firms’ local currency real borrowing costs have fallen deeply into negative territory (Chart 15). It helped reduce firms’ costs significantly. Chart 14Surging Sales Amid Deeply Negative Real Borrowing Costs Boosted Firms' Profits Surging Sales Amid Deeply Negative Real Borrowing Costs Boosted Firms' Profits Surging Sales Amid Deeply Negative Real Borrowing Costs Boosted Firms' Profits ​​​​​ Chart 15Policy Rates Are Being Cut Even As The Inflation Reigns Havoc Policy Rates Are Being Cut Even As The Inflation Reigns Havoc Policy Rates Are Being Cut Even As The Inflation Reigns Havoc ​​​​​ Chart 16Wage Costs Have Risen Too, But Not As Much As Inflation Wage Costs Have Risen Too, But Not As Much As Inflation Wage Costs Have Risen Too, But Not As Much As Inflation ​​​​​ Meanwhile, even though wage growth accelerated, it still fell short of inflation, and therefore of nominal sales of the firms (Chart 16). Firms’ wage costs did not rise as much as their prices. All this boosted non-financial firms’ margins. Total profits have risen by 35% in US dollar terms from a year earlier (200% in lira terms). ​​​​​​​ Chart 17The Deluge Of Money Has Led All Kinds Of Asset Prices To Skyrocket The Deluge Of Money Has Led All Kinds Of Asset Prices To Skyrocket The Deluge Of Money Has Led All Kinds Of Asset Prices To Skyrocket ​​​​​​​ On their part, listed financials’ profits have surged by 50% in USD terms and 220% in local currency terms. They benefited both from surging interest income due to rapid loan growth and from massive capital gains on their holding of government securities (see Chart 14 above). All this is reflected in Turkish companies’ earnings per share as well. The spike in EPS has propped up Turkish stocks for past few months. Over the past year, not only have corporate profits and share prices surged, but also house prices have skyrocketed by 170% in local currency terms and 30% in USD terms (Chart 17). In sum, the abnormally low nominal and deeply negative real borrowing costs have produced a money/credit deluge, which has generated a massive inflationary outbreak and has inflated revenues/profits as well as various asset prices. The Lira To Depreciate Further This macro setting is a recipe for a major currency sell-off.  First, Europe – the destination of 90% of Turkish exports – will likely slide into recession over the coming year (Chart 18).  Chart 18A Slowing Europe Will Materially Dent Turkish Growth Too A Slowing Europe Will Materially Dent Turkish Growth Too A Slowing Europe Will Materially Dent Turkish Growth Too A fall in exports will widen Turkey’s current account deficit. Notably, imports will not fall much since the authorities are pursuing easy money policy. Second, the lack of credible macro policies as well as political crisis will assure that foreign capital escapes Turkey. Turkey will find the current account deficit nearly impossible to finance. Third, the country’s net foreign reserves, after adjusting for the central bank’s foreign currency borrowings and commercial banks’ deposits with the central bank, stand at minus 30 billion dollars. In other words, the central bank now has large net US dollar liabilities. As such, it has little wherewithal to defend the currency. There are very high odds that the lira depreciation will accelerate in the months ahead. Fourth, the slew of unorthodox measures taken by the Turkish authorities will encourage banks to buy more government local currency bonds to suppress the government’s borrowing costs. When commercial banks buy government securities from non-banks, they create money “out of thin air.” Hence, the ongoing money supply deluge will continue. This is bearish for the currency. Notably, the economy will likely enter into recession next year – and yet core inflation will stay very high (30% and above). Recent unorthodox bank regulations are meant to encourage a certain kind of lending – loans to farmers, exporters, and small and medium-sized businesses – while discouraging other kinds. Consequently, the overall loan growth will likely slow in nominal terms. There are already signs that credit is decelerating on the margin (Chart 19). Given the very high inflation, slower credit growth will likely lead to a liquidity crunch for many businesses – forcing them to curtail their activity.  Chart 19Bank Credit Will Decelerate Due To Many Unorthodox Bank Regulations Bank Credit Will Decelerate Due To Many Unorthodox Bank Regulations Bank Credit Will Decelerate Due To Many Unorthodox Bank Regulations ​​​​​​ Chart 20Bank Loans Are Already Contracting in Real Terms: Not a Good Omen For Real GDP Bank Loans Are Already Contracting in Real Terms: Not a Good Omen For Real GDP Bank Loans Are Already Contracting in Real Terms: Not a Good Omen For Real GDP ​​​​​​ Indeed, in real terms (deflated by core CPI), local currency loan growth has already slipped into negative territory. This is a bad omen for the overall economy: contracting real loan growth is a harbinger of recession (Chart 20). In short, Turkey is looking into an abyss: a recession amid high inflation (i.e., stagflation) as well as a brewing political crisis (with Erdoğan likely doubling down on unorthodox and populist policies). All this point to another period of a large currency depreciation. While the country will likely change direction to avoid the abyss, investors should wait to allocate capital until after the change in direction is confirmed.    Investment Takeaways The Turkish lira will fall much more vis-à-vis the US dollar in the year ahead. Both Turkish stocks and local currency bonds merit an underweight stance in an EM basket. EM sovereign credit investors, however, should be neutral on Turkish sovereign credit relative to the EM sovereign credit benchmark. Turkey is involved in an economic crisis that will devolve into a political crisis over the election cycle. While Erdoğan and the AKP are likely to fall from power as things stand today, they are heavily entrenched and will be difficult to remove, creating large risks of an indecisive or contested election in 2023 that will increase rather than decrease policy uncertainty and the political risk premium in Turkish assets. As a strongman leader Erdoğan has consolidated political power in his own hands, so there is no one to take the blame for the country’s economic mismanagement – other than foreigners. Hence there is a distinct risk that his foreign policy adventurism will escalate between now and next year, resulting in significant military conflicts or saber-rattling. These will shake out western investors who try to speculate on the likelihood that the election or the military will oust Erdoğan and produce sounder national and economic policies. That outcome is indeed likely but Erdoğan is not going without a fight. Our Geopolitical Strategy also recommends tactically shorting the lira versus the Japanese yen in light of global slowdown, extreme geopolitical risk, and the Bank of Japan’s desire to prevent the yen from falling too far.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Andrija Vesic Consulting Editor Footnotes 1      Sinan Ekim and Kemal Kirişci, “The Turkish constitutional referendum, explained,” Brookings Institution, April 13, 2017, brookings.edu. 2     The central bank replaced an existing 20% reserve requirement ratios for credits with a higher 30% treasury bond collateral requirement. Lenders will have to cut interest rates on commercial loans (except for loans to farmers, exporters, and SMEs). Otherwise, banks will have to maintain additional securities. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary Our negative view on the summer rally is coming to fruition, with equities falling back on the negative geopolitical, macro, and monetary environment. China is easing policy ahead of its full return to autocratic government this fall. Yet the Fourth Taiwan Strait Crisis has only just begun. Tensions can still deal nasty surprises to global investors. It is essential to verify that relations will thaw after the US midterm and Chinese party congress is critical. Russia continues to tighten energy supply as predicted. Ukraine’s counter-offensive is pushing back the time frame of a ceasefire deeper into next year. Putin may declare victory and quit while he is ahead – but Russia will not be forced to halt its invasion until commodity prices fall significantly. Sweden’s election will not interfere with its NATO bid; Australia’s new government will not re-engage with China; Malaysia’s election will be a positive catalyst; South Africa’s political risks are reawakening; Brazil’s risks are peaking; Turkey remains a leading candidate for a negative “black swan” event. China’s Confluence Of Domestic And Foreign Political Risk China's Confluence Of Domestic And Foreign Political Risk China's Confluence Of Domestic And Foreign Political Risk Asset Initiation Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 17.4% Bottom Line: Investors should stay defensive in the short run until recession risks and geopolitical tensions abate. Feature Last week we visited clients across South Africa and discussed a broad range of global macro and geopolitical issues. In this month’s GeoRisk Update we relate some of the key points in the context of our market-based quantitative risk indicators. While we were traveling, US-Iran negotiations reached a critical phase. A deal is said to be “closer” but we remain pessimistic (we still give 40/60 odds of a deal). The important point for investors is that the supply side of global oil markets will remain tight even if a deal is somehow agreed, whereas it will get much tighter if a deal is not agreed. China’s rollout of 1 trillion yuan ($146 billion) in new fiscal stimulus and rate cuts (5 bps cut to 1-year Loan Prime Rate and 15 bps cut to 5-year LPR) is positive on the demand side and supports our key view in our 2022 annual outlook that China would ease policy ahead of the twentieth national party congress. However, it is still the case that China is not providing enough stimulus to generate a new cyclical rally. Second quarter US GDP growth was revised slightly upwards but was still negative. Russia tightened control of European energy, as expected, increasing the odds of a European recession. Europeans are getting squeezed by rising energy prices, rising interest rates, and weak external demand. China Eases Policy Ahead Of Return To Autocracy China is facing acute political risk in the short term but it is also delivering more stimulus to try to stabilize the economy ahead of the twentieth national party congress this fall (Chart 1). The People’s Bank of China cut the benchmark lending rate by (1-year LPR) by 5 basis points, while authorities unveiled fiscal spending worth 1 trillion renminbi. Chart 1China's Confluence Of Domestic And Foreign Political Risk China's Confluence Of Domestic And Foreign Political Risk China's Confluence Of Domestic And Foreign Political Risk After the party congress, the regime is likely to “let 100 flowers bloom,” i.e. continue with a broad-based policy easing to secure the recovery from the Covid-19 shock. This will include loosening social restrictions and aggressive regulations against industrial sectors like the tech sector. It should also include some diplomatic improvements, especially with Europe. But it is only a short term (12-month) trend, not a long-term theme. Related Report  Geopolitical StrategyRoulette With A Five-Shooter China’s return to autocratic government under General Secretary Xi Jinping is a new, negative, structural factor and is nearly complete. Xi is highly likely to secure another decade in power and promote his faction of Communist Party stalwarts and national security hawks. The period around the party congress will be uncertain and dangerous. The exact makeup of the next Politburo could bring some surprises but there is very little chance that Xi and his faction will fail to consolidate power. The nomination of an heir-apparent is possible but of limited significance since Xi will not step down anytime soon or in a regular, predictable manner. Larger stimulus combined with power consolidation could spur greater risk appetite around the world, as it would portend a stabilization of growth and policy continuity. However, China’s underlying problems are structural. The manufacturing and property bust can be delayed but not reversed. China’s foreign policy will continue to get more aggressive due to domestic vulnerability, prompting foreign protectionism, export controls, sanctions, saber-rattling, and the potential for military conflict. Bottom Line: Investors should use any rally in Chinese assets over the coming 12 months as an opportunity to sell and reduce exposure to China’s historic confluence of political and geopolitical risk. Fourth Taiwan Strait Crisis Only Beginning The Fourth Taiwan Strait Crisis has only just begun. The previous three crises ranged from four to nine months in duration. The current crisis cannot possibly abate until November at earliest. Taiwan’s political risk will stay high and we would not buy any relief rally until there is a firm basis for believing tensions have fallen (Chart 2). Chart 2Taiwan: The Fourth Taiwan Strait Crisis Taiwan: The Fourth Taiwan Strait Crisis Taiwan: The Fourth Taiwan Strait Crisis If this year’s crisis were driven by US and Chinese domestic politics – the US midterm election and China’s party congress – then both Presidents Biden and Xi Jinping would already have achieved what they want and could proceed to de-escalate tensions by the end of the year – i.e. before somebody really gets hurt. The two leaders could hold a bilateral summit in Asia in November and agree to uphold the one China policy and status quo in the Taiwan Strait. We have given a 40% chance to this scenario, though we would still remain pessimistic about the long-term outlook for Taiwan. But if this year’s crisis is driven by a change in US and Chinese strategic thinking as a result of Russia’s invasion of Ukraine and China’s rising domestic instability, then there will not be a quick resolution on Taiwan. The crisis would grow next year, increasing the risk of aggression or miscalculation. We have given a 60% probability to this scenario, of which full-scale war comprises 20 percentage points. Bottom Line: Our geopolitical risk indicator for Taiwan spiked and Taiwanese equities rolled over relative to global equities as we expected. However, our oldest trade to capture the high long-term risk of a war in the strait – long Korea / short Taiwan – has performed badly despite the crisis. South Korea: China Stimulus A Boon But Not Geopolitics US-China rivalry – and the thawing of Asia’s once-frozen conflicts – is also manifest on the Korean peninsula, where the limited détente between the US and North Korea negotiated by President Donald Trump and Kim Jong Un has fallen apart. South Korea’s situation is not as risky as Taiwan’s but it is nevertheless less stable than it appears (Chart 3). Chart 3South Korea: Lower Geopolitical Risk Than Taiwan South Korea: Lower Geopolitical Risk Than Taiwan South Korea: Lower Geopolitical Risk Than Taiwan South Korea resumed its full-scale joint military exercise with the US, the Ulchi Freedom Shield, from August 22 to September 1. The drills involve amphibious operations and a carrier strike group. Full-scale drills were scaled down or cancelled under the Trump and Moon Jae-In administrations with the hopes of facilitating diplomacy and reducing tensions on the peninsula. North Korea was to discontinue ballistic missile tests and threats to the United States. But after the 2020 election neither Washington nor Pyongyang considered itself bound by this agreement. This year the US went forward with Ulchi Freedom even though regional tensions were sky-high because of House Speaker Nancy Pelosi’s visit to Taiwan and the De-Militarized Zone in Korea. The US is flagging its regional interests and power bases. North Korea is increasing the frequency of missile tests this year and is likely to conduct an eighth nuclear test. On August 17, it fired two cruise missiles towards the Yellow Sea. Pyongyang does not want to be ignored amid so many other geopolitical crises. It is emboldened by the fact that Russia and China will not be voting with the US for another round of sanctions at the United Nations Security Council due to the war in Ukraine and tensions over Taiwan. On August 11, South Korea responded to China’s insistence that the new government should abide by the “Three No’s,” i.e. three negatives that the Moon administration allegedly promised China: no additional deployments of the US’s Terminal High-Altitude Area Defense (THAAD) system, no Korean integration into US-led missile defense, and no trilateral military alliance with the US and Japan. Korea’s Foreign Minister Park Jin told reporters upon his return from China that the three no’s were “neither an agreement nor a promise.” South Korea’s new and conservative President Yoon Suk-yeol is unpopular and gridlocked at home but he is using the opportunity to reassert Korean national interests, including the US military alliance. Tension with the North and cold relations with China are coming at a time when the economy is slowing down. Korean GDP grew by 0.7% in Q2 2022 on a quarter-on-quarter basis, supported by household and government spending, while exports and investments shrank. Roughly a quarter of Korean exports go to China, its biggest trading partner. Korean exports to China have suffered due to China’s economic woes but cold relations could bring new economic sanctions, as China has hit South Korea before over THAAD. With the Yoon administration planning to bring the fiscal deficit back to below 3% of GDP next year, and a broader backdrop of weak Chinese and global demand, it is hard to find bright corners in the Korean economy in the near term. With Yoon’s basement level approval rating, he will resort to foreign policy to try to revive his political capital. Saber rattling and tough talk with North Korea and China will increase tensions in an already hot region – geopolitical risk is bound to stay high on the back of the Taiwan crisis. Bottom Line: On a relative basis, due to the ironclad US security guarantee, South Korea is safer than Taiwan. Investors wanting exposure to Chinese economic stimulus, electric vehicles, and semiconductors should go long South Korea. But some volatility is likely because the North’s eighth nuclear test will occur in the context of high and rising regional tensions. Australia: Stimulus Is Positive But No “Thaw” With China Australia is blessed with strong geopolitical fundamentals but it is seeing a drop in national security and economic security due to the deterioration of China relations. Domestic political turmoil is one of the consequences (Chart 4). Most recently Australia has been roiled by the revelation that former Prime Minister Scott Morrison secretly ran five ministries during the pandemic: the ministries of Home, Treasury, Finance, Resources, and Health. Chart 4Australian Geopolitical Risk Limited Australian Geopolitical Risk Limited Australian Geopolitical Risk Limited After an investigation and review by the Solicitor General Stephen Donaghue, Morrison’s action was determined to be legal, although highly inappropriate and inconsistent with the principles of responsible governance. Morrison’s appointments to these ministries were approved by the Governor General but the announcement or publication of appointments has always been the prerogative of the government of the day. One might think that this investigation is merely politically motivated but the Solicitor General is an apolitical position unlike the Attorney General, and Donaghue had been serving with Morrison, guiding him about the constitutionality of a vaccine mandate during the pandemic. The new Labor Party government of Prime Minister Anthony Albanese has vowed to be more transparent and will seek to enshrine a transparency measure into the law. Its political capital will improve, which is helpful for its ability to achieve its chief election promises. With the change of the government, it was hoped that there would be a thaw in the Australia-China relationship. China is Australia’s largest export destination and it erected boycotts against certain Australian exports in 2020 in response to Prime Minister Morrison’s inquiry into the origin of Covid-19. Hence Australia’s new defense minister, Richard Marles, met with his Chinese counterpart, General Wei Fenghe, on the sideline of the Shangri-La Dialogue in Singapore in June, which rekindled the hope that a thaw might happen. Yet a thaw is unlikely for strategic reasons, as highlighted by the Fourth Taiwan Strait Crisis, the Biden administration’s retention of former President Trump’s tariffs, and Australia’s fears of China’s rising influence in the Pacific Islands. The US and Australia are preparing for a long-term policy of containing China’s ambitions. A few days after his election, Prime Minister Albanese flew to Tokyo to attend a meeting of the Quadrilateral Security Dialogue (the Quad), sending a signal that there will be policy continuity with respect to Australian foreign policy. On May 26, Chinese fighter jets flew closely to an Australian surveillance plane on its routine operation and released aluminum chaffs that were ingested by the P8’s engines. An Australian warship, the HMAS Parramatta, was tracked by a People’s Liberation Army nuclear power submarine and multiple aircrafts on its way back from Vietnam, Korea, and Japan as part of its regional presence deployment in June. Currently Australia is hosting the Pitch-Black military exercise, with 17 countries participating. This exercise will last for three weeks – focusing on air defense and aerial refueling. It will also see the German air force with 13 military aircrafts deployed to the Indo-Pacific region for the very first time. They will be stopping in Japan after the exercise. As Australia’s policy towards China is unlikely to change, geopolitical risk will remain elevated. On the economic front, Australia’s misery index is at the highest point since 2000, with an unemployment rate at 3% and inflation at 6%. GDP growth in the first quarter was 0.8% compared to 3.6% in Q4 2021, propped up by government and household consumption while investment and exports contracted. The good news for the government is that it is inheriting this negative backdrop and can benefit from cyclical improvements in the next few years. Since the Labor government lacks a single-party majority in the Senate (where it must rely on the Greens and independents), it will be difficult for the government to raise new taxes. So far, Albanese has indicated that the budget to be tabled in October will focus on pre-election promises, which includes childcare, healthcare, and energy reforms. At worst, Australian government spending will stay flat, but it is unlikely to shrink considering Labor’s narrow control of the House of Representatives. Australian equities have not outperformed those of developed market peers despite high industrial metal prices. The stock market’s weak performance is attributable to the stumbling Chinese economy (Chart 5). Australian exports to China in June are still down 14% from June of last year. Chinese economic woes will be a headwind to Aussie growth and equity markets until next year, when Chinese stimulus efforts reach their full effect. Chart 5Australian Equities Have Yet to Benefit from Industrial Metal Prices Australian Equities Have Yet to Benefit from Industrial Metal Prices Australian Equities Have Yet to Benefit from Industrial Metal Prices On the other hand, the value of Australian natural gas and oil exports in June grew by 118% and 211% respectively (Chart 6), compared to June of last year. Chart 6Geopolitics: A Boon and Bane to Aussie Growth Geopolitics: A Boon and Bane to Aussie Growth Geopolitics: A Boon and Bane to Aussie Growth ​​​​​ Bottom Line: As China will continue stimulating the economy and global energy markets will remain tight, investors should look for opportunities in Aussie energy and materials stocks. Malaysia Closes A Chapter … And Opens A Better One? Rarely do we get to revisit our positive outlook on Malaysia – a Southeast Asian state with an ability to capitalize on the US break-up with China. On August 23, the embattled ex-prime minister of Malaysia, Najib Razak, lost his final appeal at the Federal Court in Putrajaya after being found guilty in 2020 for abuse of power, criminal breach of trust, and money laundering tied to Malaysia’s sovereign wealth fund, 1MDB. The high court instructed that he serves his 12-years prison sentence immediately, becoming the first prime minister to be imprisoned in the country’s 60-years plus of history. Political risk has weighed on the Malaysian economy for almost a decade starting with the contentious 2013 general election, which saw the collapse of non-Malay voter support for the ruling party. Then came the 2015 Wall Street Journal bombshell about 1MDB, and then the 2018 general election that resulted in Malaysia’s first change of government since independence. The pandemic also led to political crisis in 2020. Each crisis resulted in a successive weakening of animal spirits and ever lower investments, resulting in Malaysia’s loss of competitiveness (Chart 7). Malaysia’s cheap currency was unable to increase its competitiveness, due to the low investments in the economy, and reflected higher political risks in the country (Chart 8). Chart 7Political Risk Undermines Competitiveness Political Risk Undermines Competitiveness Political Risk Undermines Competitiveness ​​​​​​ Chart 8Cheap Currency Reflects Political Risk Cheap Currency Reflects Political Risk Cheap Currency Reflects Political Risk ​​​​​​ Nonetheless this entire saga has proved that Malaysia’s legal system is independent and that its political system is capable of holding policymakers accountable. The next general election will come in a matter of months and recent state elections bodes well for the institutional ruling party, the United Malay National Organization (UMNO), and its coalition, Barisan Nasional. The coalition is managing to claw back support from the Malay and non-Malay voters. The opposition had the bad luck of ruling during the pandemic and its rocky aftermath, which has helped to rehabilitate the traditional ruling party. We have long seen Malaysia as a potential opportunity. But we would advise investors to wait until the new election is held and a new government takes power before buying Malaysian equities. With the conclusion of its decade-long 1MDB saga, we would turn more bullish if the next election produces a sizeable and enduring majority, if the use of racial and sectarian rhetoric tones down, and if the governing coalition pursues pro-competitiveness policies. Bottom Line: Structurally, Malaysia is one of the largest exporters of semiconductors and will benefit from the US’s shift away from China and attempt to reconstruct supply chains so they run through the economies of allies and partners. Russia: Escalating To De-Escalate? Russia increased the number of active military personnel in a move that points to an escalation of the conflict with Ukraine and the West, even as Ukraine wages a counter-offensive against Russia in Crimea and elsewhere. The time frame for a ceasefire has been pushed further into next year. As long as the war escalates, European energy relief will be elusive. Our risk indicators will rise again (Chart 9). Chart 9Russia: Geopolitical Risk To Rise Again, Ceasefire Pushed Back Into Next Year Russia: Geopolitical Risk To Rise Again, Ceasefire Pushed Back Into Next Year Russia: Geopolitical Risk To Rise Again, Ceasefire Pushed Back Into Next Year Ukraine will not be able to drive Russians out of territory in which they are entrenched. It would need a coalition of western powers willing to go on the offense, which will not happen. Russia is also threatening to cut off the Zaporizhzhia nuclear power plant, ostensibly removing one-fifth of Ukraine’s electricity. Once the Ukrainian counter-offensive grinds to a halt, a stalemate will ensue, incentivizing ceasefire talks – but not until then. The Europeans will have to support Ukraine now but will become less and less inclined to extend the war as they get hit with recession. Russia says it is prepared for a long war but that kind of rhetoric is necessary for propaganda purposes. The truth is that Russia does not have great success with offensive wars. Russia usually suffers social instability in the aftermath. The best indicator for the duration of the war is probably the global oil price: If it collapses for any reason then Russia’s war machine will fall short of funds and the Kremlin will probably have to accept a ceasefire. This what happened in 2014-15 with the Minsk Protocols. Putin will presumably try to quit while he is ahead, i.e. complete the conquest and shift to ceasefire talks, while commodity prices are still supportive and Europe is economically weak. If commodity prices fall, Russia’s treasury dries up while Europe regains strength. So while military setbacks can delay a ceasefire, Russia should be seen as starting to move in that direction. The deal negotiated with Turkey and the United Nations to ship some grain from Odessa is not reliable in the short run but does show the potential for future negotiations. However, a high conviction on the timing is not warranted. Also, the US and Russia could enter a standoff over the US role in the war, or NATO enlargement, at any moment, especially ahead of the US midterm election. Bottom Line: Ukraine’s counteroffensive and Russia’s tightening of natural gas exports increases the risk to global stability and economic growth in the short run, even if it is a case of “escalating tensions in order to de-escalate” later when ceasefire talks begin. Italy: Election Means Pragmatism Toward Russia Italy’s election is the first large crack in the European wall as a result of Russia’s cutoff of energy. The party best positioned for the election – the right-wing, anti-establishment party called the Brothers of Italy – will have to focus on rebooting Italy’s economy once in power. This will require pragmatism toward Russian and its natural gas. Regardless of whether a right-wing coalition obtains a majority or the parliament is hung, Italian political risk will stay high in the short run (Chart 10). Chart 10Italy: Election Brings Uncertainty, Then Economic Stimulus Italy: Election Brings Uncertainty, Then Economic Stimulus Italy: Election Brings Uncertainty, Then Economic Stimulus Although the center-left Democratic Party (PD) is narrowing the gap with the Brothers of Italy in voting intentions, it is struggling to put together an effective front against the right-wing bloc. After its alliance with the centrist Azione party and +Europa party broke down, PD’s chance of winning has become even slimmer. Even if the alliance revives, the center-left bloc still falls short of the conservative parties. Together, the right-wing parties account for just 33% of voting intentions (Democrats at 23%, Greens and Left Alliance at 3%, Azione and +Europa at 7%). By contrast, the right-wing bloc has a significant lead, with 46% of the votes (Brothers of Italy at 24%, Lega at 14%, Forza Italia at 8%). They also have the advantage of anti-incumbency sentiment amid a negative economic backdrop. Unless some sudden surprises occur, a right-wing victory is expected, with Giorgia Meloni becoming the first female prime minister in Italy’s history. This has been our base case scenario for the past several months. But what does a right-wing government mean for the financial markets? In an early election manifesto published in recent weeks, the conservative alliance pledged full adhesion to EU solidarity and dropped their previous euroskepticism. This helps them get elected and is positive for investors. However, there are also clouds on the horizon: In the same manifesto, the right-wing parties pledged to lower taxes for families and firms, increase welfare, and crack down on immigration. These programs will add to Italy’s huge debt pile and eventually lead to conflicts with the ECB and other EU institutions. In the manifesto, they stated that if elected, they would seek to amend conditions of Italy’s entitlement to the EU Recovery Fund, as the Russia-Ukraine war has changed the context and priorities significantly. This could potentially put the EU’s grants and cheap loans at risk. Under the Draghi government, Italy has secured about 67 billion euros of EU funds. According to the schedule, Italy will receive a further 19 billion Euros recovery funds in the second half of 2022, if it meets previously agreed upon targets. The new government will try to accept the funds and then make any controversial policy changes. On Russia, the conservative parties claimed that Italy would not be the weak link within EU. They pledged respect for NATO commitments, including increasing defense spending. Both Meloni and her Brothers of Italy have endorsed sending weapons to support Ukraine. Still, we think that due to Italy’s historical link with Russia and the need to secure energy supplies, the new government would be more pragmatic toward Russia. On China, Meloni has stressed that Italy will look to limit China’s economic expansion if the right-wing alliance wins. She stated that “Russia is louder at present and China is quieter, but [China’s] penetration is reaching everywhere.” China will want to use diplomacy to curb this kind of thinking in Europe. Meloni also stated that she would not seek to pursue the Belt and Road Initiative pact that Italy signed with China in 2019. In short, we stand firm on our recommendation of underweighting Italian assets at least until a new government is formed. Europe Gets Its Arm Twisted Further The United Kingdom is going through a severe energy, water, and inflation crisis – on top of the long backlog at the National Health Service – as it stumbles through the aftermath of Covid-19 and Brexit. The Conservative Party’s leadership contest is a distraction – political risk will not subside after it is resolved. The new Tory leader will lack a direct popular mandate but the party will want to avoid an early election in the current economic context, creating instability. The looming attempt at a second Scottish independence referendum will also keep risks high, as the outcome this time may be too close to call (Chart 11). Chart 11UK: Tory Leaders A Sideshow, Risks Will Stay High UK: Tory Leaders A Sideshow, Risks Will Stay High UK: Tory Leaders A Sideshow, Risks Will Stay High Germany saw Russia halt natural gas flows through Nord Stream 1 as the great energy cutoff continues. As we have argued since April, Russia’s purpose is to pressure the European economies so that they are more conducive to a ceasefire in Ukraine. Germany will evolve quickly and will improve its energy security faster than many skeptics expect but it cannot do it in a single year. The ruling coalition is also fragile, even though elections are not due anytime soon (Chart 12). Chart 12Germany: Geopolitical Risk Still Rising Germany: Geopolitical Risk Still Rising Germany: Geopolitical Risk Still Rising France’s political risk will also remain high (Chart 13), as domestic politics will be reckless while President Emmanuel Macron and his allies only control 43% of the National Assembly in the aftermath of this year’s election (Chart 14). Chart 13France: Lower Geopolitical Risk Than Germany France: Lower Geopolitical Risk Than Germany France: Lower Geopolitical Risk Than Germany Chart 14Macron Will Focus On Foreign Policy Odds And Ends (A GeoRisk Update) Odds And Ends (A GeoRisk Update) Spain is likely to see its coalition destabilized and early elections, much like Italy this year (Chart 15). Chart 15Spain: Early Elections Likely Spain: Early Elections Likely Spain: Early Elections Likely Sweden, along with Finland, will be joining NATO, which became clear back in April. In this sense it is at the center of Russia’s conflict with the West over NATO enlargement, so we should take a quick look at the Swedish general election on September 11. Currently the left-wing and right-wing blocs are neck and neck in the polls. While the current Social Democrat-led government may well fall from power, Sweden’s new pursuit of NATO membership is unlikely to change. The right-wing parties in Sweden are in favor of joining NATO. The two parties that oppose NATO membership are the left-wing Green and Left Party. The Social Democrats were pro-neutrality until the invasion of Ukraine and since May have spearheaded Swedish accession to NATO. The pro-neutrality bloc currently holds 43 seats in the 349-seats Riksdag. It has a supply-and-confidence arrangement with the current government and is currently polling at 13%. If it was willing and able to derail Sweden’s NATO bid, it would already have happened. So the general election in Sweden is unlikely to stop Sweden from joining. However, Russia does not want Sweden to join and the entire pre- and post-election period is ripe for “black swan” risks and negative surprises. One thing that could change with the election is Sweden’s immigration policy. The Social Democrats are pro-immigration (albeit pro-integration), while the right-wing bloc is less so. Sweden has received a great many asylum seekers since the Syrian refugee crisis in 2015 and will be receiving more from Ukraine and Russia (Chart 16). Chart 16Asylum Seekers to Surpass 2015 Refugee Crisis Asylum Seekers to Surpass 2015 Refugee Crisis Asylum Seekers to Surpass 2015 Refugee Crisis Our Foreign Exchange Strategist Chester Ntonifor points out that the increase in asylum seekers could augment Swedish labor force and increase its potential growth in the long run, while in the short run it could increase demand in the domestic economy. But an increase in demand could also exacerbate inflation in Sweden, especially considering how much the Riksbank is behind the curve vis-à-vis the ECB. Our European Investment Strategy recommends shorting EUR/SEK as Sweden is less vulnerable to Russian energy sanctions. Sweden produces most of its energy from renewable sources. Relative to Europe, Canada faces a much more benign political and geopolitical environment (Chart 17). However, within its own context, it will continue to see more contentious domestic politics as interest rates rise on a society with high household debt and property prices. The post-Covid-19 period will undermine the Justin Trudeau government over time, though it is not facing an election anytime soon. Canada continues to benefit from North America’s geopolitical advantage, though quarrels with China will continue, including over Taiwan, and should be taken seriously. Aside from any China shocks we expect Canadian equities to continue to outperform most global bourses. Chart 17Canada: Low Geopolitical Risk But Not Happy Canada: Low Geopolitical Risk But Not Happy Canada: Low Geopolitical Risk But Not Happy South Africa: The Calm Before The Storm South Africa’s economy remains in a low growth trap, which is contributing to rising political risk (Chart 18). Electricity shortages continue to dampen economic activity. Other structural issues like 33.9% unemployment, worsening social imbalances, and a split in the ruling party threaten to cause negative policy surprises. Chart 18South Africa: Institutional Ruling Party At Risk South Africa: Institutional Ruling Party At Risk South Africa: Institutional Ruling Party At Risk The South African economy has failed to translate growth outcomes into meaningful economic development, leaving low-income households (the median voter) increasingly disenfranchised, burdened, and constrained. Last year’s civil unrest was fueled by economic hardships that persist today. Without a significant and consistent bump to growth, social and political risks will continue to rise. Low-income households remain largely state dependent. Fiscal austerity has already begun to unwind, well before the 2024 election, in a bid to shore up support and quell rising social pressures (Chart 19). Chart 19South Africa: Fiscal Easing Ahead Of 2024 Vote South Africa: Fiscal Easing Ahead Of 2024 Vote South Africa: Fiscal Easing Ahead Of 2024 Vote The fact that the social scene is relatively quiet for now should not be seen as a sign of underlying stability. For example, two of the largest trade unions led a nationwide labor strike last week – while we visited clients in the country! – but failed to “shut down” the country as advertised. Labor union constituents noted the ANC’s economic failures, demanded immediate economic reform, and advocated for a universal basic income grant. This action blew over but the election cycle is only just beginning. Looking forward to the election, President Cyril Ramaphosa’s ANC is still viewed more favorably than the faction led by ex-President Jacob Zuma, but Ramaphosa has suffered from corruption allegations recently that have detracted attention from his anti-corruption and reform agenda and highlighted the party’s shortcomings once again. The ANC’s true political rival, the far-left Economic Freedom Fighters (EFF), have so far failed to capitalize on the weak economic backdrop. The EFF is struggling with leadership battles, thus failing to attract as many soured ANC voters as otherwise possible. If the Economic Freedom Fighters refocus and install new leadership, namely a leader that better reflects the tribal composition of the country, the party will become a greater threat to the ANC. But the overall macro backdrop is a powerful headwind for the ANC’s ability to retain a parliamentary majority. Global macro tailwinds that supported local assets in the first half of the year are experiencing volatility due to China’s sluggish growth and now stimulus efforts. Cooling metals prices and slowing global growth have weighed on the rand and local equity returns. But now China is enacting more stimulus. China is South Africa’s largest trading partner, so the decision to ease policy is positive for next year, even though China’s underlying structural impediments will return in subsequent years. This makes it hard to predict whether South Africa’s economic context will be stable in the lead-up to the 2024 election. As long as China can at least stabilize in the post-pandemic environment in 2023, the ANC will not face as negative of a macro environment in 2024 as would otherwise be the case. Investors will need to watch the risk of political influence on the central bank. Recently the ANC resolved to nationalize the central bank. Nationalization is mostly about official ownership but a change in the bank’s mandate was also discussed. However, to change the bank’s mandate from an inflation target to an unemployment target, the ANC would need to change the constitution. Constitutional change requires a two-thirds vote in parliament, a margin the ANC does not hold. Constitutional change will become increasingly difficult if the ANC sheds more support in the 2024 general election, as expected. Bottom Line: Stay neutral on South Africa until global and Chinese growth stabilize. Political risk is rising ahead of the 2024 election but it is not necessarily at a tipping point. Brazil And Turkey: Election Uncertainty Prevails We conclude with two brief points on Brazil and Turkey, which both face important elections – Brazil immediately and Turkey by June 2023. Both countries have experienced different forms of instability as emerging middle classes face economic disappointment, which has led to political challenges to liberal democracy. Brazil – President Jair Bolsonaro’s popular support is rallying into the election, as expected, but it would require a large unexpected shift to knock former President Lula da Silva off course for re-election this October (Chart 20). Brazil’s first round vote will be held on October 2. If Lula falls short of the 50% majority threshold, then a second round will be held on October 30. Bolsonaro faces an uphill battle because his general popularity is weak – his support among prospective voters stands at 35% compared to Lula at 44% today and Lula at 47% when he left office in 2010. Meanwhile the macroeconomic backdrop has worsened over the course of his four-year term. Bolsonaro will contest the election if it is close so Brazil could face significant upheaval in the short run. Chart 20Brazil: Risk Will Peak Around The Election Brazil: Risk Will Peak Around The Election Brazil: Risk Will Peak Around The Election Turkey – President Recep Erdogan’s approval rating has fallen to 41%, while his disapproval has risen to 54%. It is a wonder his ratings did not collapse sooner given that the misery index is reaching 88%, with headline inflation at 78%. Having altered the constitution to take on greater presidential powers, Erdogan will do whatever it takes to stay in power, but the tide of public opinion is shifting and his Justice and Development Party is suffering from 21 years in power. Erdogan could interfere with NATO enlargement, the EU, Syria and refugees, Greece and Cyprus, North Africa and Libya, or Israel in a way that causes negative surprises for Turkish or even global investors. Turkey will be a source of “black swan” risks at least until after the general election slated for June 2023 (Chart 21). Chart 21Turkey: A Source Of 'Black Swans' Turkey: A Source Of 'Black Swans' Turkey: A Source Of 'Black Swans' We will revisit each these markets in greater detail soon. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com ​​​​​​​Yushu Ma Research Analyst yushu.ma@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Geopolitical Calendar

Executive Summary Macron Still Favored, But Le Pen Cannot Be Ruled Out Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) Macron is still favored to win the French election but Le Pen’s odds are 45%. Le Pen would halt France’s neoliberal structural reforms, paralyze EU policymaking, and help Russia’s leverage in Ukraine. But she would lack legislative support and would not fatally wound the EU or NATO. European political risk will remain high in Germany, Italy, and Spain. Favor UK equities on a relative basis. Financial markets are complacent about Russian geopolitical risk again. Steer clear of eastern European assets. Do not bottom feed in Chinese stocks. China faces social unrest. North Korean geopolitical risk is back. Australia’s election is an opportunity, not a risk. Stay bullish on Latin America. Prefer Brazil over India. Stay negative on Turkey and Pakistan.   Trade Recommendation Inception Date Return TACTICALLY LONG US 10-YEAR TREASURY 2022-04-14   Bottom Line: Go long the US 10-year Treasury on geopolitical risk and near-term peak in inflation. Feature Last year we declared that European political risk had reached a bottom and had nowhere to go but up. Great power rivalry with Russia primarily drove this view but we also argued that our structural theme of populism and nationalism would feed into it. Related Report  Geopolitical StrategyThe Geopolitical Consequences Of The Ukraine War In other words, the triumph of the center-left political establishment in the aftermath of Covid-19 would be temporary. The narrow French presidential race highlights this trend. President Emmanuel Macron is still favored but Marine Le Pen, his far-right, anti-establishment opponent, could pull off an upset victory on April 24. The one thing investors can be sure of is that France’s ability to pursue neoliberal structural reforms will be limited even if Macron wins, since he will lack the mandate he received in 2017. Our GeoRisk Indicators this month suggest that global political trends are feeding into today’s stagflationary macroeconomic context. Market Complacent About Russia Again Global financial markets are becoming complacent about European security once again. Markets have begun to price a slightly lower geopolitical risk for Russia after it withdrew military forces from around Kyiv in an open admission that it failed to overthrow the government. However, western sanctions are rising, not falling, and Russia’s retreat from Kyiv means it will need to be more aggressive in the south and east (Chart 1). Chart 1Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia has not achieved its core aim of a militarily neutral Ukraine – so it will escalate the military effort to achieve its aim. Any military failure in the east and south would humiliate the Putin regime and make it more unpredictable and dangerous. The West has doubled down on providing Ukraine with arms and hitting Russia with sanctions (e.g. imposing a ban on Russian coal). Germany prevented an overnight ban on Russian oil and natural gas imports but the EU is diversifying away from Russian energy rapidly. Sanctions that eat away at Russia’s export revenues will force it to take a more aggressive posture now, to achieve a favorable ceasefire before funding runs out. Sweden and Finland are reviewing whether to join NATO, with recommendations due by June. Russia will rattle sabers to underscore its red line against NATO enlargement and will continue to threaten “serious military-political repercussions” if these states try to join. We would guess they would remain neutral as a decision to join NATO could lead to a larger war. Bottom Line: Global equities will remain volatile due to a second phase of the war and potential Russian threats against Ukraine’s backers. European equities and currency, especially in emerging Europe, will suffer a persistent risk premium until a ceasefire is concluded. What If Le Pen Wins In France? By contrast with the war in Ukraine, the French election is a short-term source of political risk. A surprise Le Pen victory would shake up the European political establishment but investors should bear in mind that it would not revolutionize the continent or the world, as Le Pen’s powers would be limited. Unlike President Trump in 2017, she would not take office with her party gaining full control of the legislature. Le Pen rallied into the first round of the election on April 10, garnering 23% of the vote, up from 21% in 2017. This is not a huge increase in support but her odds of winning this time are much better than in 2017 because the country has suffered a series of material shocks to its stability. Voters are less enthusiastic about President Macron and his centrist political platform. Macron, the favorite of the political establishment, received 28% of the first-round vote, up from 24% in 2017. Thus he cannot be said to have disappointed expectations, though he is vulnerable. The euro remains weak against the dollar and unlikely to rally until Russian geopolitical risk and French political risk are decided. The market is not fully pricing French risk as things stand (Chart 2). Chart 2France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator The first-round election results show mixed trends. The political establishment suffered but so did the right-wing parties (Table 1). The main explanation is that left-wing, anti-establishment candidate Jean-Luc Mélenchon beat expectations while the center-right Republicans collapsed. Macron is leading Le Pen by only five percentage points in the second-round opinion polling as we go to press (Chart 3). Macron has maintained this gap throughout the race so far and both candidates are very well known to voters. But Le Pen demonstrated significant momentum in the first round and momentum should never be underestimated. Table 1Results Of France’s First-Round Election Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) ​​​​​​ Chart 3French Election: Macron Maintains Lead French Election: Macron Maintains Lead French Election: Macron Maintains Lead ​​​​​​ Are the polls accurate? Anti-establishment candidates outperformed their polling by 7 percentage points in the first round. Macron, the right-wing candidates, and the pro-establishment candidates all underperformed their March and April polls (Chart 4). Hence investors should expect polls to underrate Le Pen in the second round. Chart 4French Polls Fairly Accurate Versus First-Round Results Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) Given the above points, it is critical to determine which candidate will gather the most support from voters whose first preference got knocked out in the first round. The strength of anti-establishment feeling means that the incumbent is vulnerable while ideological camps may not be as predictable as usual. Mélenchon has asked his voters not to give a single vote to Le Pen but he has not endorsed Macron. About 21% of his supporters say they will vote for Le Pen. Only a little more of them said they would vote for Macron, at 27% (Chart 5). Chart 5To Whom Will Voters Drift? Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) Diagram 1, courtesy of our European Investment Strategy, illustrates that Macron is favored in both scenarios but Le Pen comes within striking distance under certain conservative assumptions about vote switching. Diagram 1Extrapolating France’s First-Round Election To The Second Round Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) Macron’s approval rating has improved since the pandemic. This is unlike the situation in other liberal democracies (Chart 6). Chart 6Macron Handled Pandemic Reasonably Well Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) The pandemic is fading and the economy reviving. Unemployment has fallen from 8.9% to 7.4% over the course of the pandemic. Real wage growth, at 5.8%, is higher than the 3.3% that prevailed when Macron took office in 2017 (Chart 7). Chart 7Real Wages A Boon For Macron Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) But these positives do not rule out a Le Pen surprise. The nation has suffered not one but a series of historic shocks – the pandemic, inflation, and the war in Ukraine. Inflation is rising at 5.1%, pushing the “Misery Index” (inflation plus unemployment) to 12%, higher than when Macron took office, even if lower than the EU average (Chart 8). Chart 8Misery Index The Key Threat To Macron Misery Index The Key Threat To Macron Misery Index The Key Threat To Macron   Le Pen has moderated her populist message and rebranded her party in recent years to better align with the median French voter. She claims that she will not pursue a withdrawal from the European Union or the Euro Area currency union. This puts her on the right side of the one issue that disqualified her from the presidency in the past. Yet French trust in the EU is declining markedly, which suggests that Le Pen is in step with the median voter on wanting greater French autonomy (Chart 9). Le Pen’s well-known sympathy toward Vladimir Putin and Russia is a liability in the context of Russian aggression in Ukraine. Only 35% of French people had a positive opinion of Russia back in 2019, whereas 50% had a favorable view of NATO, and the gap has likely grown as a result of the invasion (Chart 10). However, the historic bout of inflation suggests that economic policy could be the most salient issue for voters rather than foreign policy. Chart 9Le Pen Only Electable Because She Accepted Europe Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) ​​​​​ Chart 10Le Pen’s NATO Stance Not Disqualifying Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) ​​​​​ Le Pen’s economic platform is fiscally liberal and protectionist, which will appeal to voters upset over the rising cost of living and pressures of globalization. She wants to cut the income tax and value-added tax, while reversing Macron’s attempt at raising the retirement age and reforming the pension system. France’s tax rates on income, and on gasoline and diesel, are higher than the OECD average. In other words, Macron is running on painful structural reform while Le Pen is running on fiscal largesse. This is another reason to take seriously the risk of a Le Pen victory. What should investors expect if Le Pen pulls off an upset? France’s attempt at neoliberal structural reforms would grind to a halt. While Le Pen may not be able to pass domestic legislation, she would be able to halt the implementation of Macron’s reforms. Productivity and the fiscal outlook would suffer. Le Pen’s ability to change domestic policy will be limited by the National Assembly, which is due for elections from June 12-19. Her party, the National Rally (formerly the Front National), has never won more than 20% of local elections and performed poorly in the 2017 legislative vote. Investors should wait to see the results of the legislative election before drawing any conclusions about Le Pen’s ability to change domestic policy. France’s foreign policy would diverge from Europe’s. If Le Pen takes the presidency, she will put France at odds with Brussels, Berlin, and Washington, in much the same way that President Trump did. She would paralyze European policymaking. Yet Le Pen alone cannot take France out of the EU. The French public’s negative view of the EU is not the same as a majority desire to leave the bloc – and support for the euro currency stands at 69%. Le Pen does not have the support for “Frexit,” French exit from the EU. Moreover European states face immense pressures to work together in the context of global Great Power Rivalry. Independently they are small compared to the US, Russia, and China. Hence the EU will continue to consolidate as a geopolitical entity over the long run. Russia, however, would benefit from Le Pen’s presidency in the context of Ukraine ceasefire talks. EU sanctions efforts would freeze in place. Le Pen could try to take France out of NATO, though she would face extreme opposition from the military and political establishment. If she succeeded on her own executive authority, the result would be a division among NATO’s ranks in the face of Russia. This cannot be ruled out: if the US and Russia are fighting a new Cold War, then it is not unfathomable that France would revert to its Cold War posture of strategic independence. However, while France withdrew from NATO’s integrated military command from 1966-2009, it never withdrew fully from the alliance and was always still implicated in mutual defense. In today’s context, NATO’s deterrent capability would not be much diminished but Le Pen’s administration would be isolated. Russia would be unable to give any material support to France’s economy or national defense. Bottom Line: Macron is still favored for re-election but investors should upgrade Le Pen’s chances to a subjective 45%. If she wins, the euro will suffer a temporary pullback and French government bond spreads will widen over German bunds. The medium-term view on French equities and bonds will depend on her political capability, which depends on the outcome of the legislative election from June 12-19. She will likely be stymied at home and only capable of tinkering with foreign policy. But if she has legislative support, her agenda is fiscally stimulative and would produce a short-term sugar high for French corporate earnings. However, it would be negative for long-term productivity. UK, Italy, Spain: Who Else Faces Populism? Chart 11Rest Of Europe: GeoRisk Indicators Rest Of Europe: GeoRisk Indicators Rest Of Europe: GeoRisk Indicators Between Russian geopolitical risk and French political risk, other European countries are likely to see their own geopolitical risk premium rise (Chart 11). But these countries have their own domestic political dynamics that contribute to the reemergence of European political risk. Germany’s domestic political risk is relatively low but it faces continued geopolitical risk in the form of Russia tensions, China’s faltering economy, and potentially French populism (Chart 11, top panel). In Italy, the national unity coalition that took shape under Prime Minister Mario Draghi was an expedient undertaken in the face of the pandemic. As the pandemic fades, a backlash will take shape among the large group of voters who oppose the EU and Italian political establishment. The Italian establishment has distributed the EU recovery funds and secured the Italian presidency as a check on future populist governments. But it may not be able to do more than that before the next general election in June 2023, which means that populism will reemerge and increase the political risk premium in Italian assets going forward (Chart 11, second panel). Spain is still a “divided nation” susceptible to a rise in political risk ahead of the general election due by December 10, 2023. However, the conservative People’s Party, the chief opposition party, has suffered from renewed infighting, which gives temporary relief to the ruling Socialist Worker’s Party of Prime Minister Pedro Sanchez. The Russia-Ukraine issue caused some minor divisions within the government but they are not yet leading to any major political crisis, as nationwide pro-Ukraine sentiment is largely unified. The Andalusia regional election, which is expected this November, will be a check point for the People’s Party’s new leadership and a test run for next year’s general election. Andalusia is the most populous autonomous community in Spain, consisting about 17% of the seats in the congress (the lower house). The risk for Sanchez and the Socialists is that the opposition has a strong popular base and this fact combined with the stagflationary backdrop will keep political polarization high and undermine the government’s staying power (Chart 11, third panel). While Prime Minister Boris Johnson has survived the scandal over attending social events during Covid lockdowns, as we expected, nevertheless the Labour Party is starting to make a comeback that will gain momentum ahead of the 2024 general election. Labour is unlikely to embrace fiscal austerity or attempt to reverse Brexit anytime soon. Hence the UK’s inflationary backdrop will persist (Chart 11, fourth panel). Bottom Line: European political risk has bottomed and will rise in the coming months and years, although the EU and Eurozone will survive. We still favor UK equities over developed market equities (excluding the US) because they are heavily tilted toward consumer staples and energy sectors. Stay long GBP-CZK. Favor European defense stocks over tech. Prefer Spanish stocks over Italian. China: Social Unrest More Likely China’s historic confluence of internal and external risks continues – and hence it is too soon for global investors to try to bottom-feed on Chinese investable equities (Chart 12). A tactical opportunity might emerge for non-US investors in 2023 but now is not the right time to buy. Chart 12China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator In domestic politics, the reversion to autocracy under Xi is exacerbating the economic slowdown. True, Beijing is stimulating the economy by means of its traditional monetary and fiscal tools. The latest data show that the total social financing impulse is reviving, primarily on the back of local government bonds (Chart 13). Yet overall social financing is weaker because private sector sentiment remains downbeat. The government is pursuing excessively stringent social restrictions in the face of the pandemic. Beijing is doubling down on “Covid Zero” policy by locking down massive cities such as Shanghai. The restrictions will fail to prevent the virus from spreading. They are likely to engender social unrest, which we flagged as our top “Black Swan” risk this year and is looking more likely. Lockdowns will also obstruct production and global supply chains, pushing up global goods inflation. Meanwhile the property sector continues to slump on the back of weak domestic demand, large debt levels, excess capacity, regulatory scrutiny, and negative sentiment. Consumer borrowing appetite and general animal spirits are weak in the face of the pandemic and repressive political environment (Chart 14). Chart 13China's Stimulus Has Clearly Arrived China's Stimulus Has Clearly Arrived China's Stimulus Has Clearly Arrived ​​​​​​ Chart 14Yet Chinese Animal Spirits Still Suffering Yet Chinese Animal Spirits Still Suffering Yet Chinese Animal Spirits Still Suffering ​​​​​​ Hence China will be exporting slow growth and inflation – stagflation – to the rest of the world until after the party congress. At that point President Xi will feel politically secure enough to “let 100 flowers bloom” and try to improve economic sentiment at home and abroad. This will be a temporary phenomenon (as were the original 100 flowers under Chairman Mao) but it will be notable for 2023. In foreign politics, Russia’s attack on Ukraine has accelerated the process of Russo-Chinese alliance formation. This partnership will hasten US containment strategy toward China and impose a much faster economic transition on China as it pursues self-sufficiency. The result will be a revival of US-China tensions. The implications are negative for the rest of Asia Pacific: Taiwanese geopolitical risk will continue rising for reasons we have outlined in previous reports. In addition, Taiwanese equities are finally starting to fall off from the pandemic-induced semiconductor rally (Chart 15). The US and others are also pursuing semiconductor supply security, which will reduce Taiwan’s comparative advantage. Chart 15Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator South Korea faces paralysis and rising tensions with North Korea. The presidential election on May 9 brought the conservatives back into the Blue House. The conservative People Power Party’s candidate, Yoon Suk-yeol, eked out a narrow victory that leaves him without much political capital. His hands are also tied by the National Assembly, at least for the next two years. He will attempt to reorient South Korean foreign policy toward the US alliance and away from China. He will walk away from the “Moonshine” policy of engagement with North Korea, which yielded no fruit over the past five years. North Korea has responded by threatening a nuclear missile test, restarting intercontinental ballistic missile tests for the first time since 2017, and adopting a more aggressive nuclear deterrence policy in which any South Korean attack will ostensibly be punished by a massive nuclear strike. Tensions on the peninsula are set to rise (Chart 16). Three US aircraft carrier groups are around Japan today, despite the war in Europe (where two are placed), suggesting high threat levels. Chart 16South Korea: GeoRisk Indicator South Korea: GeoRisk Indicator South Korea: GeoRisk Indicator Australia’s elections present opportunity rather than risk. Prime Minister Scott Morrison formally scheduled them for May 21. The Australian Labor Party is leading in public opinion and will perform well. The election threatens a change of parties but not a drastic change in national policy – populist parties are weak. No major improvement in China relations should be expected. Any temporary improvement, as with the Biden administration, will be subject to reversal due to China’s long-term challenge to the liberal international order. Cyclically the Australian dollar and equities stand to benefit from the global commodity upcycle as well as relative geopolitical security due to American security guarantees (Chart 17). Chart 17Australia: GeoRisk Indicator Australia: GeoRisk Indicator Australia: GeoRisk Indicator Bottom Line: China’s reversion to autocracy will keep global sentiment negative on Chinese equities until 2023 at earliest. Stay short the renminbi and Taiwanese dollar. Favor the Japanese yen over the Korean won. Favor South Korean over Taiwanese equities. Look favorably on the Australian dollar. Turkey, South Africa, And … Canada Turkish geopolitical risk will remain elevated in the context of a rampant Russia, NATO’s revival and tensions with Russia, the threat of commerce destruction and accidents in the Black Sea region, domestic economic mismanagement, foreign military adventures, and the threat posed to the aging Erdogan regime by the political opposition in the wake of the pandemic and the lead-up to the 2023 elections (Chart 18). Chart 18Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator While we are tactically bullish on South African equities and currency, we expect South African political risk to rise steadily into the 2024 general election. Almost a year has passed since the civil unrest episode of 2021. Covid-19 lockdowns have been lifted and the national state of disaster has ended, which has helped quell social tensions. This is evident in the decline of our South Africa GeoRisk indicator from 2021 highs (Chart 19). While fiscal austerity is under way in South Africa, we have argued that fiscal policy will reverse course in time for the 2024 election. In this year’s fiscal budget, the budget deficit is projected to narrow from -6% to -4.2% over the next two years. Government has increased tax revenue collection through structural reforms that are rooting out corruption and wasteful expenditure. But the ANC will have to tap into government spending to shore up lost support come 2024. Thus South Africa benefits tactically from commodity prices but cyclically the currency is vulnerable. Chart 19South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Canadian political risk will rise but that should not deter investors from favoring Canadian assets that are not exposed to the property bubble. Prime Minister Justin Trudeau has had a net negative approval rating since early 2021 and his government is losing political capital due to inflation, social unrest, and rising difficulties with housing affordability (Chart 20). While he does not face an election until 2025, the Conservative Party is developing more effective messaging. Chart 20Canada: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator India Will Stay Neutral But Lean Toward The West Chart 21Sino-Pak Alliance’s Geopolitical Power Is Thrice That Of India Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) US President Joe Biden has openly expressed his administration’s displeasure regarding India’s response to Russia’s invasion of Ukraine. This has led many to question the strength of Indo-US relations and the direction of India’s geopolitical alignments. To complicate matters, China’s overtures towards India have turned positive lately, leading clients to ask if a realignment in Indo-China relations is nigh. To accurately assess India’s long-term geopolitical propensities, it is important to draw a distinction between ‘cyclical’ and ‘structural’ dynamics that are at play today. Such a distinction yields crystal-clear answers about India’s strategic geopolitical leanings. In specific: Indo-US Relations Will Strengthen On A Strategic Horizon: As the US’s and China’s grand strategies collide, minor and major geopolitical earthquakes are bound to take place in South Asia and the Indo-Pacific. Against this backdrop, India will strategically align with the US to strengthen its hand in the region (Chart 21). While the Russo-Ukrainian war is a major global geopolitical event, for India this is a side-show at best. True, India will retain aspects of its historic good relations with Russia. Yet countering China’s encirclement of India is a far more fundamental concern for India. Since Russia has broken with Europe, and China cannot reject Russia’s alliance, India will gradually align with the US and its allies. India And China Will End Up As A Conflicting Dyad: Strategic conflict between the two Asian powers is likely because China’s naval development and its Eurasian strategy threaten India’s national security and geopolitical imperatives, while India’s alliances are adding to China’s distrust of India. Thus any improvement in Sino-Indian diplomatic relations will be short-lived. The US will constantly provide leeway for India in its attempts to court India as a key player in the containment strategy against China. The US and its allies are the premier maritime powers and upholders of the liberal world order – India serves its national interest better by joining them rather than joining China in a risky attempt to confront the US navy and revolutionize the world order. Indo-Russian Relations Are Bound To Fade In The Long Run: India will lean towards the US over the next few years for reasons of security and economics. But India’s movement into America’s sphere of influence will be slow – and that is by design. India is testing waters with America through networks like the Quadrilateral Dialogue. It sees its historic relationship with Russia as a matter of necessity in the short run and a useful diversification strategy in the long run. True, India will maintain a trading relationship with Russia for defense goods and cheap oil. But this trade will be transactional and is not reason enough for India to join Russia and China in opposing US global leadership. While these factors will mean that Indo-Russian relations are amicable over a cyclical horizon, this relationship is bound to fade over a strategic horizon as China and Russia grow closer and the US pursues its grand strategy of countering China and Russia. Bottom Line: India may appear to be neutral about the Russo-Ukrainian war but India will shed its historical stance of neutrality and veer towards America’s sphere of influence on a strategic timeframe. India is fully aware of its strategic importance to both the American camp and the Russo-Chinese camp. It thus has the luxury of making its leanings explicit after extracting most from both sides. Long Brazil / Short India Brazil’s equity markets have been on a tear. MSCI Brazil has outperformed MSCI EM by 49% in 2022 YTD. Brazil’s markets have done well because Brazil is a commodity exporter and the war in Ukraine has little bearing on faraway Latin America. This rally will have legs although Brazil’s political risks will likely pick back up in advance of the election (Chart 22). The reduction in Brazil’s geopolitical risk so far this year has been driven mainly by the fact that the currency has bounced on the surge in commodity prices. In addition, former President Lula da Silva is the current favorite to win the 2022 presidential elections – Lula is a known quantity and not repugnant to global financial institutions (Chart 23). Chart 22Brazil's Markets Have Benefitted From Rising Commodity Prices Brazil's Markets Have Benefitted From Rising Commodity Prices Brazil's Markets Have Benefitted From Rising Commodity Prices Chart 23Brazil: Watch Out For Political Impact Of Commodity Prices Brazil: Watch Out For Political Impact Of Commodity Prices Brazil: Watch Out For Political Impact Of Commodity Prices Whilst there is no denying that the first-round effects of the Ukraine war have been positive for Brazil, there is a need to watch out for the second-round effects of the war as Latin America’s largest economy heads towards elections. Surging prices will affect two key constituencies in Brazil: consumers and farmers. Consumer price inflation in Brazil has been ascendant and adding to Brazil’s median voter’s economic miseries. Rising inflation will thus undermine President Jair Bolsonaro’s re-election prospects further. The fact that energy prices are a potent polling issue is evinced by the fact that Bolsonaro recently sacked the chief executive of Petrobras (i.e. Brazil’s largest listed company) over rising fuel costs. Furthermore, Brazil is a leading exporter of farm produce and hence also a large importer of fertilizers. Fertilizer prices have surged since the war broke out. This is problematic for Brazil since Russia and Belarus account for a lion’s share of Brazil’s fertilizer imports. Much like inflation in general, the surge in fertilizer prices will affect the elections because some of the regions that support Bolsonaro also happen to be regions whose reliance on agriculture is meaningful (Map 1). They will suffer from higher input prices. Map 1States That Supported Bolso, Could Be Affected By Fertilizer Price Surge Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) Chart 24Long Brazil Financials / Short India Long Brazil Financials / Short India Long Brazil Financials / Short India Given that Bolsonaro continues to lag Lula on popularity ratings – and given the adverse effect that higher commodity prices will have on Brazil’s voters – we expect Bolsonaro to resort to fiscal populism or attacks on Brazil’s institutions in a last-ditch effort to cling to power. He could even be emboldened by the fact that Sérgio Moro, the former judge and corruption fighter, decided to pull out of the presidential race. This could provide a fillip to Bolso’s popularity. Bottom Line: Brazil currently offers a buying opportunity owing to attractive valuations and high commodity prices. But investors should stay wary of latent political risks in Brazil, which could manifest themselves as presidential elections draw closer. We urge investors to take-on only selective tactical exposure in Brazil for now. Equities appear cheap but political and macro risks abound. To play the rally yet stave off political risk, we suggest a tactical pair trade: Long Brazil Financials / Short India (Chart 24). Whilst we remain constructive on India on a strategic horizon, for the next 12 months we worry about near-term macro and geopolitical headwinds as well as India’s rich valuations. Don’t Buy Into Pakistan’s Government Change Chart 25Pakistan’s Military Is Unusually Influential Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) The newest phase in Pakistan’s endless cycle of political instability has begun. Prime Minister Imran Khan has been ousted. A new coalition government and a new prime minister, Shehbaz Sharif, have assumed power. Prime Minister Sharif’s appointment may make it appear like risks imposed by Pakistan have abated. After all, Sharif is seen as a good administrator and has signaled an interest in mending ties with India. But despite the appearance of a regime change, geopolitical risks imposed by Pakistan remain intact for three sets of reasons: Military Is Still In Charge: Pakistan’s military has been and remains the primary power center in the country (Chart 25). Former Prime Minister Khan’s rise to power was possible owing to the military’s support and he fell for the same reason. Since the military influences the civil administration as well as foreign policy, a lasting improvement in Indo-Pak relations is highly unlikely. Risk Of “Rally Round The Flag” Diversion: General elections are due in Pakistan by October 2023. Sharif is acutely aware of the stiff competition he will face at these elections. His competitors exist outside as well as inside his government. One such contender is Bilawal Bhutto-Zardari of the Pakistan People’s Party (PPP), which is a key coalition partner of the new government that assumed power. Imran Khan himself is still popular and will plot to return to power. Against such a backdrop the newly elected PM is highly unlikely to pursue an improvement in Indo-Pak relations. Such a strategy will adversely affect his popularity and may also upset the military. Hence we highlight the risk of the February 2021 Indo-Pak ceasefire being violated in the run up to Pakistan’s general elections. India’s government has no reason to prevent tensions, given its own political calculations and the benefits of nationalism. Internal Social Instability Poor: Pakistan is young but the country can be likened to a social tinderbox. Many poor youths, a weak economy, and inadequate political valves to release social tensions make for an explosive combination. Pakistan remains a source of geopolitical risk for the South Asian region. Some clients have inquired as to whether the change of government in Pakistan implies closer relations with the United States. The US has less need for Pakistan now that it has withdrawn from Afghanistan. It is focused on countering Russia and China. As such the US has great need of courting India and less need of courting Pakistan. Pakistan will remain China’s ally and will struggle to retain significant US assistance. Bottom Line: We remain strategic sellers of Pakistani equities. Pakistan must contend with high internal social instability, a weak democracy, a weak economy and an unusually influential military. As long as the military remains excessively influential in Pakistan, its foreign policy stance towards India will stay hostile. Yet the military will remain influential because Pakistan exists in a permanent geopolitical competition with India. And until Pakistan’s economy improves structurally and endemically, its alliance with China will stay strong. Investment Takeaways Cyclically go long US 10-year Treasuries. Geopolitical risks are historically high and rising but complacency is returning to markets. Meanwhile inflation is nearing a cyclical peak. Favor US stocks over global. It is too soon to go long euro or European assets, especially emerging Europe. Favor UK equities over developed markets (excluding the US). Stay long GBP-CZK. Favor European defense stocks over European tech. Stay short the Chinese renminbi and Taiwanese dollar. Favor the Japanese yen over the Korean won. Favor South Korean over Taiwanese equities.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Yushu Ma Research Analyst yushu.ma@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com Alice Brocheux Research Associate alice.brocheux@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Section III: Geopolitical Calendar