Turkey

Highlights So What? Key geopolitical risks remain unresolved and most of the improvements are transitory. Maintain a cautious tactical stance toward risk assets. Why? U.S.-China relations remain the preeminent geopolitical risk to investors and President Trump remains a wild card on trade. Japan’s rising assertiveness in the region will also produce clashes with the Koreas and possibly also with China. USMCA ratification is not a red herring for investors. We expect USMCA will pass by year’s end but our conviction level is low. Trump’s threat to withdraw from NAFTA cannot be entirely ruled out. Remain long JPY-USD and overweight Thailand relative to EM equities. Feature Chart 1U.S. And Chinese Policy Growing More Simulative U.S. And Chinese Policy Growing More Simulative U.S. And Chinese Policy Growing More Simulative We maintain our cautious tactical stance toward risk assets despite improvements to the cyclical macro outlook. American and Chinese monetary and fiscal policy are growing more stimulative on the margin – an encouraging sign for the global economy and risk assets. We have frequently predicted this combination as a positive factor for the second half of the year and 2020. With the Federal Reserve likely to deliver a 25 basis point interest rate cut on July 31, the market is pricing in positive policy developments (Chart 1). Yet in the U.S., long-term fiscal and regulatory policies are increasingly uncertain as the Democratic Party primary and 2020 election heat up. And in China, the trade war continues to drag on the effectiveness of the government’s stimulus drive. President Trump remains a wild card on trade: the resumption of U.S.-China talks is precarious and will be accompanied by heightened uncertainty surrounding Mexico, Canada, Japan, and Europe in the near term. Even the USMCA’s ratification is not guaranteed, as we discuss below. Even more pressing are the dramatic events taking place in East Asia: Hong Kong, Japan, the Koreas, Taiwan, and the South and East China Seas. These events each entail near-term uncertainty amid the ongoing slowdown in trade and manufacturing. Our long-running theme of geopolitical risk rotation from the Middle East to East Asia has come to fruition, albeit at the moment geopolitical risk is rising in both regions due to the simultaneous showdown between Iran and the United States and United Kingdom. The market recognizes that geopolitical risks are unresolved, according to this month’s update of our currency- and equity-derived GeoRisk Indicators. This is in keeping with the above points. We regard most of the improvements as transitory – especially the drop in risk in the U.K., where Boris Johnson is now officially prime minister. We are therefore sticking with our cautious trade recommendations despite our agreement with the BCA House View that the cyclical outlook is improving and is positive for global risk assets on a 12-month horizon. What Is Happening To East Asian Stability? A raft of crises has struck East Asia, a region known for political stability and ease of doing business throughout the twenty-first century after its successful recovery from the financial crisis of 1997. The thawing of Asia’s frozen post-WWII conflicts is a paradigm shift with significant long-term consequences for investors. The fundamental drivers are as follows: China’s rise is not peaceful: President Xi Jinping has reasserted Communist Party control while pursuing mercantilist trade policy and aggressive foreign policy. The populations of Hong Kong and Taiwan have reacted negatively to Beijing’s tightening grip, exposing the difficulty of resolving serious political disagreements given unclear constitutional frameworks. Recent protests in Hong Kong are even larger than those in 2014 and 1989 (Table 1). Table 1Hong Kong: Recent Protests The Largest Ever East Asia Risks And The USMCA – GeoRisk Indicators Update: July 26, 2019 East Asia Risks And The USMCA – GeoRisk Indicators Update: July 26, 2019 America’s “pivot” is not peaceful: The United States is determined to respond to China’s rise, but political polarization has prevented a coherent strategy. The Democrats took a gradual, multilateral path emphasizing the Trans-Pacific Partnership while the Republicans have taken an abrupt, unilateral path emphasizing sweeping tariffs. Underlying trade policy is the increased use of “hard power” by both parties – freedom of navigation operations, weapons sales, and alliance-maintenance. America is threatening the strategic containment of China, which China will resist through alliances and relations with Russia and others. Japan’s resurgence is not peaceful: Japan’s “lost decades” culminated in the crises and disasters of 2008-11. Since then, Japan’s institutional ruling party – the Liberal Democrats – have embraced a more proactive vision of Japan in which the country casts off the shackles of its WWII settlement. They set about reflating the economy and “normalizing” the country’s strategic and military posture. The result is rising tension with China and the Koreas. Korean “reunion” is not peaceful: North Korea has seen a successful power transition to Kim Jong Un, who is attempting economic reforms to prolong the regime. South Korea has witnessed a collapse among political conservatives and a new push to make peace with the North and improve relations with China. The prospect of peace – or eventual reunification – increases political risk in both Korean regimes and provokes quarrels between erstwhile allies: the North and China, and the South and Japan. Southeast Asia’s rise is not peaceful: Southeast Asia is the prime beneficiary in a world where supply chains move out of China, due to China’s internal development and American trade policy. But it also suffers when China encroaches on its territory or reacts negatively to American overtures. Higher expectations from the U.S. will increase the political risk to Taiwan, South Korea, Vietnam, and the Philippines. This is the critical context for the mass protests in Hong Kong and the miniature trade war between Japan and South Korea, and other regional risks. Which conflicts are market-relevant? How will they play out? The U.S.-China Conflict The most important dynamic is the strategic conflict between the U.S. and China. Its pace and intensity have ramifications for all the other states in the region. Because the Trump administration is seeking a trade agreement with China, it has held off from unduly antagonizing China over Hong Kong and Taiwan. President Trump has not fanned the flames of unrest in Hong Kong and has maintained only a gradual pace of improvements in the Taiwan relationship.1 But if the trade war escalates dramatically, Beijing will face greater economic pressure, growing more sensitive about dissent within Greater China, and Washington may take more provocative actions. Saber-rattling could ensue, as nearly occurred in October 2018. Currently events are moving in a more market-positive direction. Next week, the U.S. and China are expected to resume face-to-face trade negotiations between principal negotiators for the first time since May. China is reportedly preparing to purchase more farm goods – part of the Osaka G20 ceasefire – while the Trump administration has met with U.S. tech companies and is expected to allow Chinese telecoms firm Huawei to continue purchasing American components (at least those not clearly impacting national security). We are upgrading the odds of a trade agreement by November 2020 to 40% from 32% in mid-June. With this resumption of talks, we are upgrading the odds of a trade agreement by November 2020 to 40%, from 32% in mid-June (Diagram 1). Of this 40%, we still give only a 5% chance to a durable, long-term deal that resolves underlying technological and strategic disputes. The remaining 35% goes to a tenuous deal that enables President Trump to declare victory prior to the election and allows President Xi Jinping to staunch the bleeding in the manufacturing sector. Diagram 1U.S.-China Trade War Decision Tree (Updated July 26, 2019) East Asia Risks And The USMCA – GeoRisk Indicators Update: July 26, 2019 East Asia Risks And The USMCA – GeoRisk Indicators Update: July 26, 2019 Note that these odds still leave a 60% chance for an escalation of the trade war by November 2020. Our conviction level is low when it comes to the two moderate scenarios. Ultimately, Presidents Trump and Xi can agree to a trade agreement at the drop of a hat – no one can stop Xi from ordering large imports from the U.S. or Trump from rolling back tariffs. Our conviction level is much higher in assigning only a 5% chance of a grand compromise and a 36% chance of a cold war-style escalation of tensions. We doubt that China will offer any structural concessions deeper than what they have already offered (new foreign investment law, financial sector opening) prior to finding out who wins the U.S. election in 2020. Beijing is stabilizing the economy even though tariffs have gone up. As long as this remains the case, why would it implement additional painful reforms? This would set a precedent of caving to tariff coercion – and yet Trump could renege on a deal anytime, and the Democrats might take over in 2020 anyway. The one exception might be North Korea, where China could do more to bring about a diplomatic agreement favorable to President Trump as part of an overall deal before November 2020 – and this could excuse China from structural concessions affecting its internal economy. The takeaway is that U.S.-China trade issues are still far from resolved and have a high probability of failure – and this will be a source of strategic tension within the region over the next 16 months, particularly with regard to Taiwan, the Koreas, and the South China Sea. Hong Kong And Taiwan Chart 2 August can be a crucial time period for policy changes as Chinese leaders often meet at the seaside resort of Beidaihe to strategize. This year they need to focus on handling the unrest in Hong Kong, and the Taiwanese election in January, as well as the trade war with the United States. Protests in Hong Kong have continued, driven by underlying socio-economic factors as well as Beijing’s encroachment on traditional political liberties. Even the groups that are least sympathetic to the protesters – political moderates, the elderly, low-income groups, and the least educated – are more or less divided over the controversial extradition bill that prompted the unrest (Chart 2). This reveals that the political establishment is weak on this issue. Chief Executive Carrie Lam is clinging to power, as Beijing does not want to give the impression that popular dissent is a viable mechanism for removing leaders. But she has become closely associated with the extradition bill and will likely have to go in order to satiate the protesters and begin the process of healing. As long as Beijing refrains from rolling in the military and using outright force to crush the Hong Kong protests, the unrest should gradually die down, as the political establishment will draw support for its concessions while the general public will grow weary of the protests – especially as violence spreads. Hong Kong has no alternative to Beijing’s sovereignty. The scene of action will soon turn to Taiwan, where the January 2020 election has the potential to spark the next flashpoint in Xi Jinping’s struggle to consolidate power in Greater China. Chart 3 A large majority of Taiwanese people supports the Hong Kong protests – even most supporters of the pro-mainland Kuomintang (KMT) (Chart 3). This dynamic is now affecting the Taiwanese election slated for January 2020. The relatively pro-mainland KMT has been polling neck-and-neck with the ruling Democratic Progressive Party (DPP), which has struggled to gain traction throughout its term given diplomatic and economic headwinds stemming from the mainland. Similarly, while popular feeling is still largely in favor of eventual independence, pro-unification feeling has regained momentum in an apparent rebuke to the pro-independence ruling party (Chart 4). However, the events in Hong Kong have changed things by energizing the democratic and mainland-skeptic elements in Taiwan. President Tsai Ing-wen is now taking a slight lead in the presidential head-to-head opinion polls despite a long period of lackluster polling (Chart 5). Chart 4 Chart 5 A close election increases the risk that policymakers and activists in Taiwan, mainland China, the United States, and elsewhere will take actions attempting to influence the election outcome. Beijing will presumably heed the lesson of the 1996 election and avoid anything too aggressive so as not to drive voters into the arms of the DPP. However, with Hong Kong boiling, and with Beijing having already conducted intimidating military drills encircling Taiwan in recent years, there is a chance that past lessons will be forgotten. The United States could also play a disruptive role, especially if trade talks deteriorate. If the KMT wins, then anti-Beijing activists will eventually begin gearing up for protests themselves, which in subsequent years could overshadow the Sunflower Movement of 2013. If the DPP prevails, Beijing may resort to tougher tactics in the coming years due to its fear of the province’s political direction and the DPP’s policies. In sum, while the Hong Kong saga is far from over and has negative long-run implications for domestic and foreign investors, Taiwan is the greater risk because it has the potential not only to suffer individually but also to become the epicenter of a larger geopolitical confrontation between China and the U.S. and its allies. This would present a more systemic challenge to global investors. Japan And “Peak Abe” Chart 6 Japan’s House of Councillors election on July 21 confirmed our view that Prime Minister Shinzo Abe has reached the peak of his influence. Abe is still popular and is likely to remain so through the Tokyo summer Olympics next year (Chart 6). But make no mistake, the loss of his two-thirds supermajority in the upper house shows that he has moved beyond the high tide of his influence. Having retained a majority in the upper house, and a supermajority in the much more powerful lower house (House of Representatives), Abe’s government still has the ability to pass regular legislation (Chart 7). If he needs to drive through a bill delaying the consumption tax hike on October 1 due to a deterioration in the global economic and political environment, he can still do so with relative ease. While the Hong Kong saga is far from over ... Taiwan is the greater risk. Chart 7 Clearly, the election loss will not impact Abe’s ability to negotiate a trade deal with the United States, which we expect to happen quickly – even before a China deal – albeit with some risk of tariffs on autos in the interim. Chart 8 The problem is that Abe’s final and greatest aim is to revise Japan’s American-written, pacifist constitution for the first time. This requires a two-thirds vote in both houses and a majority vote in a popular referendum. While Abe can still probably cobble together enough votes in the upper house, the election result makes it less certain – and the dent in popular support implies that the national referendum is less likely to pass. Constitutional revision was always going to be a close vote anyway (Chart 8). If Abe falls short of a majority in that referendum, then he will become a lame duck and markets will have to price in greater policy uncertainty. Even if he succeeds – which is still our low-conviction baseline view – then he will have reached the pinnacle of his career and there will be nowhere to go but down. His tenure as party leader expires in September 2021 and the race to succeed him is already under way. Hence, some degree of uncertainty should begin creeping in immediately. Abe’s departure will leave the Liberal Democrats in charge – and hence Japanese policy continuity will be largely preserved. But the entire arc of events, from now through the constitutional revision process to Abe’s succession, will raise fundamental questions about whether Abe’s post-2012 reflation drive can be sustained. We have a high conviction view that it will be, but Japanese assets will challenge that view. What of the miniature trade war between Japan and South Korea? On July 4, Japan imposed export restrictions on goods critical to South Korea’s semiconductor industry in retaliation for a South Korean court ruling that would set a precedent requiring Japanese companies such as Mitsubishi and Nippon Steel to pay reparations for the use of forced Korean labor during Japanese rule from 1910-45. Chart 9Japan Has A Stronger Hand In The Mini Trade War Japan Has A Stronger Hand In The Mini Trade War Japan Has A Stronger Hand In The Mini Trade War Japan has the stronger hand in this dispute from an economic point of view (Chart 9). While the unusually heavy-handed Japanese trade measures partly reveal the influence of President Trump, who has given a license for U.S. allies to weaponize trade, it also reflects Japan’s growing assertiveness. Abe’s government may have believed that a surge of nationalism would help in the upper house election. And the constitutional referendum will be another reason to stir nationalism and a recurring source of tension with both Koreas (as well as with China). Therefore, Japanese-Korean tensions and punitive economic measures could persist well into 2020. Bottom Line: U.S.-China relations remain the preeminent geopolitical risk to investors, especially if the Taiwan election becomes a lightning rod. Japan’s rising assertiveness in the region will also produce clashes with the Koreas and possibly also with China. We are playing these risks by remaining long JPY-USD and overweight Thailand relative to EM equities, as Thailand is more insulated than other East Asian economies to trade and China risks. Keep An Eye On The USMCA Last week we highlighted U.S. budget negotiations and argued that the result would be greater fiscal accommodation. The results of the just-announced budget deal are depicted in Chart 10. One side effect is an increased likelihood of eventual tariffs on Mexico if the latter fails to staunch the influx of immigrants across the U.S. southern border, since President Trump has largely failed to secure funding for his proposed border wall. Chart 10 Meanwhile, the administration’s legislative and trade focus will turn toward ratifying the U.S.-Mexico-Canada trade agreement (USMCA). There is an increased likelihood of eventual U.S. tariffs on Mexico ... since President Trump has largely failed to secure funding for his proposed border wall.  Ratification is not a red herring for investors, since Trump could give notice of withdrawal from NAFTA in order to hasten USMCA approval, which would induce volatility. Moreover, successful ratification could embolden him to take a strong hand in his other trade disputes, while failure could urge him to concede to a quick deal with China. Chart 11Trade Uncertainty Supports The Dollar Trade Uncertainty Supports The Dollar Trade Uncertainty Supports The Dollar Further, trade policy uncertainty in the Trump era has correlated with a rising trade-weighted dollar (Chart 11), so there is a direct channel for trade tensions (or the lack thereof) to influence the global economy at a time when it badly needs a softer dollar – in addition to the negative effects of trade wars on sentiment. The signing of the USMCA trade agreement by American, Mexican, and Canadian leaders last November effectively shifted negotiations from the international stage to the domestic stage. Last month Mexico became the first to ratify the deal. The delay in the U.S. and Canada reflects their more challenging domestic political environments ahead of elections, especially in the United States. Ratification in the U.S. has been stalled by Speaker of the House Nancy Pelosi, who is locked in stalemate with the Trump administration. She is holding off on giving the green light to present the agreement to Congress until Democrats’ concerns are addressed (Diagram 2). Trump, meanwhile, is threatening to withdraw from NAFTA – a declaration that cannot be entirely ruled out, even though we highly doubt he would actually withdraw at the end of the six-month waiting period. Diagram 2Pelosi Is Stalling USMCA Ratification Process East Asia Risks And The USMCA – GeoRisk Indicators Update: July 26, 2019 East Asia Risks And The USMCA – GeoRisk Indicators Update: July 26, 2019 Republicans are looking to secure the USMCA’s passage before the 2020 campaign goes into full force in order to claim victory on one of Trump’s key 2016 campaign promises. The administration’s May 30 submission of the draft Statement of Administrative Action (SAA) to Congress initiated a 30-day waiting period that must pass before the administration can submit the text to Congress. But the administration is unlikely to put the final bill to Congress before ensuring that House Democrats are ready to cooperate.2 House democrats are in a position of maximum leverage and are using the process to their political advantage. House Democrats are in a position of maximum leverage – since they do not need the deal to become law – and are using the process to their political advantage. If the bill is to be ratified through the “fast action” Trade Protection Authority (TPA), which forbids amendments and limits debate in Congress, then now is their only chance to make amendments to the text, which was written without their input. Even in the Democrat-controlled House, there is probably enough support for the USMCA to secure its passage. There are 51 House Democrats who were elected in districts that Trump won or that Republicans held in 2018, and are inclined to pass the deal. Moreover 21 House Democrats have been identified from districts that rely heavily on trade with Canada and Mexico (Chart 12).3 If these Democrats vote along with all 197 Republicans in favor of the bill, it will pass the House. This is a rough calculation, but it shows that passage is achievable. Chart 12 Chart 13 What is more, there is a case to be made for bipartisan support for USMCA. Trump’s trade agenda has some latent sympathy among moderate Democrats, and Democrats within Trump districts, unlike his border wall. Democrats will appear obstructionist if they oppose the bill. Unlike trade with China, American voters are not skeptical of trade with Canada – and the group that thinks Mexico is unfair on trade falls short of a majority (Chart 13). Since enough Democrats have a compelling self-interest in securing the deal, and since Trump and the GOP obviously want it to pass, we expect it to pass eventually. The question is whether it can be done by year’s end. Once the bill is presented to Congress and passes through the TPA process, it will become law within 90 days. Assuming that the bill is presented to the House in early September, when Congress reconvenes after its summer recess, the bill could be ratified before year-end. Otherwise, without the expedited TPA process, the bill will no longer be protected against amendment and filibuster, leaving the timeline of ratification vulnerable to extensive delay. The above timeline may be too late for Canada’s Prime Minister Justin Trudeau, who faces general elections on October 21. The ratification process has already been initiated, as Trudeau would benefit from wrapping up the entire affair prior to the national vote.4 However, the process most recently has been stalled in order to move in tandem with the U.S., so that parliament does not ratify an agreement that the U.S. fails to pass. Canadian Foreign Affairs Minister Chrystia Freeland has indicated that parliament is not likely to be recalled for a vote unless there is progress down south. This leaves the Canadian ratification process at the mercy of progress in the U.S. – and ultimately Speaker Pelosi’s decision. The current government faces few hurdles in getting the bill passed (Chart 14). The next step is a final reading in the House where the bill will either be adopted or rejected. If it is approved, the bill will then proceed to the Senate where it will undergo a similar process. If the bill is passed in the same form in the House and Senate, it will become law. Chart 14 Chart 15...But Trudeau's Party Is At Risk ...But Trudeau's Party Is At Risk ...But Trudeau's Party Is At Risk Failure to ratify the deal before the election means it will be set aside and reintroduced in the next parliament. The Liberal Party is by no means guaranteed to win a majority in the election – our base case has Trudeau forming the next government, but the race is close (Chart 15). A Conservative-led parliament would be likely to pass the bill, but it would likely be delayed to 2021 at that point due to American politics. We suspect that Trudeau will eventually stop delaying and push for Canadian ratification. This would pressure Pelosi and the Democrats to go ahead and ratify, when they are otherwise inclined to reopen negotiations or otherwise delay until after November 2020. If this gambit succeeded, Trudeau would have forced total ratification prior to October 21, which would give him a badly needed boost in the election. He can always go through the frustration of re-ratifying the deal in his second term if the Democrats insist on changes, but not if he does not survive for a second term – so it is worth going forward at home and trying to pressure Pelosi into ratification in September or early October. Bottom Line: In light of Canada’s October election and the U.S. 2020 election cycle, USMCA faces a tight schedule. A delay into next year risks undermining the ratification effort, as we enter a period of hyper-partisan politics amid the 2020 presidential campaigns. This makes the third quarter a sweet spot for USMCA ratification. While we ultimately expect that it will make it through, each passing day raises the odds against it. GeoRisk Indicators Update: July 26, 2019 All ten GeoRisk indicators can be found in the Appendix, with full annotation. Below are the most noteworthy developments this month. U.K.: As expected, Boris Johnson sealed the Conservative party leadership contest. This was largely priced in by the markets and as such did not result in a big shift in our risk indicator. Johnson has stated that he is willing to exit the EU without a deal and it is undeniable that the odds of a no-deal Brexit have increased. Nevertheless, the odds of an election are also rising as Johnson may galvanize Brexit support under the Conservative Party even as Bremain forces are divided between the rising Liberal Democrats and a Labour Party hobbled by Jeremy Corbyn’s leadership. The odds that Johnson is willing to risk his newly cemented position on a snap election – having seen what happened in June 2017 – seem overstated to us, but we place the odds at about 21%. As for a no-deal exit, opinion polling still suggests that the median British voter prefers a soft exit or remaining in the EU. This imposes constraints on Johnson, as he may ultimately be forced to try to push through a plan similar to Theresa May’s, but rebranded with minimal EU concessions to make it more acceptable – or risk a no-confidence vote and potential loss of control. We maintain that GBP will stay weak, gilts will remain well-bid, and risk-off tendencies will be reinforced. France: Our French indicator points toward a significant increase in political risk over the last month. President Macron’s government has recently unveiled the pension system overhaul that he promised during the 2017 campaign. The reform, which is due to take effect in 2025, encourages citizens to work longer, as their full pension will come at the age of 64 – two years later than under current regulations. French reform efforts have historically prompted significant social unrest. Both the 1995 Juppé Plan and the 2006 labor reforms were scrapped as a result of unrest, and the 2010 pension reform strikes forced the government to cut the most controversial parts of the bill. Labor unions have already called for strikes against the current bill in September. However, no pain, no gain. Unrest is a sign that ambitious reforms are being enacted, and Macron’s showdown with protesters thus far is no more dramatic than the unrest faced by the most significant European reform efforts. The 1984-85 U.K. miners’ strike led to over 10,000 arrested and significant violence, but resulted in the closures of most collieries, weakening of trade union power, and allowed the Thatcher government to consolidate its liberal economic program. German labor reforms in the early 2000s led to strikes, but marked a turning point in unemployment and GDP trends (Chart 16), and succeeded in increasing wages and pushing people back into the labor force (Chart 17). And the 2011 Spanish reforms under PM Rajoy led to the rise of Indignados, student protesters occupying public spaces, but ultimately helped kick-start Spain’s recovery. Investors should therefore not fear unrest, and we expect any related uncertainty to abate in the medium term. Chart 16Hartz IV Reforms Were Also Accompanied By Unrest... Hartz IV Reforms Were Also Accompanied By Unrest... Hartz IV Reforms Were Also Accompanied By Unrest... Chart 17...But Were Ultimately Favorable ...But Were Ultimately Favorable ...But Were Ultimately Favorable Note that Macron is doubling down on reforms after the experience of the Yellow Vest protests, just as his favorability has rebounded to pre-protest levels. While Macron’s approval is nearly the lowest compared to other French presidents at this point in their terms (Chart 18), he does not face an election until 2022, so he has the ability to trudge on in hopes that his reform efforts will bear fruit by that time. Chart 18 Spain: Our Spanish indicator is showing signs of increasing tensions as Prime Minister Pedro Sanchez attempts to form a government. After ousting Mariano Rajoy in a vote of no confidence in June 2018, Sanchez struggled to govern with an 84-seat minority in Congress. The Spanish Socialist Workers’ Party’s (PSOE) proposed budget plan was voted down in Congress in February, forcing Sanchez to call a snap election for April 28 in which PSOE secured 123 seats. The PSOE leader failed the first investiture vote on July 23 – and the rerun on July 25 – with less votes in his favor than his predecessor Mariano Rajoy received during the 2015-2016 government formation crisis (Chart 19). In the first investiture vote, Sanchez secured 124 votes out of the 176 he needed to be sworn in as prime minister. This led to a second round of voting in which Sanchez needed a simple majority, which he failed to do with 124 affirmative, 155 opposing votes, and 67 abstentions. Going forward, Sanchez has two months to obtain the confidence of Congress, otherwise the King may dissolve the government, leading to a snap election. Chart 19 Chart 20 The Spanish government is more fragmented today than at any point during the last 30 years (Chart 20). Even if Pedro Sanchez’s PSOE were to successfully negotiate a deal with Podemos and its partner parties, the coalition would still require support from nationalist parties such as Republican Left of Catalonia or Basque Nationalist Party to govern. These will likely require major concessions relating to the handling of Catalonian independence, which, if rejected by PSOE, will result in yet another gridlocked government. The next two months will see a significant increase in political risk, and we assign a non-negligible chance to another election in November, the fourth in four years. Turkey: Investors should avoid becoming complacent on the back of the stream of encouraging news following the Turkey-Russia missile defense system deal. Our indicator is signaling that the market is pricing a decrease in tensions, and President Trump has stated that sanctions will not be immediate. Nevertheless, we would be wary. Congress is taking a much tougher stance on the issue than President Trump: The U.S. administration already excluded Turkey from the F-35 stealth fighter jet program; Senators Scott (R) and Young (R) introduced a resolution calling for sanctions; Senator Menendez (D) stated that merely removing Turkey from the F-35 program would not be enough; The new Defense Secretary nominee Mark Esper said that he was disappointed with Turkey’s “drift from the West”; And U.S. Secretary of State Mike Pompeo expressed confidence that President Trump would impose sanctions. Under CAATSA, a law that targets companies doing business with Russia, the U.S. must impose sanctions on Turkey over the missile deal, but does not have a timeline to do so. The sanctions required are formidable, and the U.S. has already imposed sanctions on China for a similar violation. If President Trump is not going forward with sanctions now, he still could proceed later if Turkey does not improve U.S. relations in some other way. From Turkey’s side, Foreign Minister Mevlut Cavusoglu threatened retaliation if the U.S. were to impose sanctions. Turkey is also facing increasing tensions domestically. Erdogan suffered a stinging rebuke in the re-run of the Istanbul mayoral election. This defeat has left Erdogan even more insecure and unpredictable than before. On July 6, he fired central bank governor Murat Cetinkaya using a presidential decree, which calls the central bank’s independence into question. He may reshuffle his cabinet, which could make matters worse if the appointments are not market-friendly. As domestic tensions continue to escalate, and when the U.S. announces sanctions, we expect the lira to take yet another hit and add to Turkey’s economic woes. Diagram 3Brazil: Pension Reform Timeline East Asia Risks And The USMCA – GeoRisk Indicators Update: July 26, 2019 East Asia Risks And The USMCA – GeoRisk Indicators Update: July 26, 2019 Chart 21Brazil Faces A Fiscal Deficit Despite Pension Reform Brazil Faces A Fiscal Deficit Despite Pension Reform Brazil Faces A Fiscal Deficit Despite Pension Reform Brazil: Brazilian risks are likely to remain elevated as the country faces crunch-time over the controversial pension reform on which its fiscal sustainability depends. Although the Lower House voted overwhelmingly in support of the reform on July 11, the bill needs to make it through another Lower House vote slated for August 6. The bill will then proceed to at least two more rounds of voting in the Senate (by end-September at the earliest), with a three-fifths majority required in each round before being enshrined in Brazil’s constitution (Diagram 3). The whole process will likely be delayed by amendments and negotiations. The estimated savings of the bill in its current form are about 0.9 trillion reals, down from the 1.236 trillion reals originally targeted, which risks undermining the effort to close the fiscal deficit. Our colleagues at BCA’s Emerging Markets Strategy still forecast a primary fiscal deficit in four years’ time (Chart 21).5   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Footnotes 1 For instance, the U.S.’s latest $2.2 billion arms package does not include F-16 fighter jets to Taiwan, and F-35s have entirely been ruled out. The Trump administration sent Paul Ryan, rather than a high-level cabinet member, to inaugurate the new office building of the American Institute in Taiwan for the 40th anniversary of the Taiwan Relations Act. At the same time, the Trump administration is threatening a more substantial upgrade of relations through more frequent arms sales, the Taiwan Travel Act (2018), and the Asia Reassurance Initiative Act (2018). 2 The risk is that history repeats itself. In 2007, then President George W. Bush sent the free-trade agreement with Colombia to Congress prior to securing Pelosi’s approval. She halted the fast-track timeline and the standoff lasted nearly five years. 3 Please see Gary Clyde Hufbauer, “USMCA Needs Democratic Votes: Will They Come Around?” Peterson Institute For International Economics, May 15, 2019, available at piie.com. 4 Bill C-100, as it is known, has already received its second reading in the House of Commons and has been referred to the Standing Committee on International Trade. 5 Please see BCA Research’s Emerging Markets Strategy Weekly Report titled “On Chinese Banks And Brazil,” dated July 18, 2019, available at ems.bcaresearch.com. Appendix Image Image Image Image Image Image Image Image Image Image Image Geopolitical Calendar  

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

Turkish financial assets, and the currency especially, will remain under selling pressure in the coming months. Additional adjustments in the exchange rate and interest rates - as well as in the real economy and current account balance - appear unavoidable. The key imbalance remains the gap between foreign debt obligations (FDOs) and the availability of foreign currency to meet these debt obligations. Turkey’s FDOs in 2019 are equivalent to $180 billion (Chart II-1). FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. This consists of $15 billion in interest payments, $65 billion in debt amortization and $100 billion in maturing short-term (under one year) claims. In theory, these debt obligations can either be rolled over, or the nation should generate current account and capital account surpluses and use these surpluses to pay down FDOs. Even though the current account deficit is shrinking, it is still in a deficit of $18 billion. Net FDI inflows remain weak at US$10 billion. Hence, it appears that Turkey’s only options are either to roll over maturing foreign currency debt or to lure foreign investors into local currency assets and use the surplus in net portfolio inflows to meet these FDOs. However, due to a lack of credibility in the Turkish government’s macro policies - in addition to the ongoing deep economic recession and heightened financial market volatility - external creditors will be unwilling to roll over the debt. In fact, net portfolio flows into government debt and equities have tumbled for the same reason. Typically, when foreign funding dries up temporarily, a country can use its foreign exchange reserves to meet its FDOs. However, Turkey’s foreign exchange reserves have already plummeted to extremely low levels (Chart II-2). The central bank’s foreign currency reserves excluding both commercial banks’ deposits at the Central Bank of Turkey and FX swaps now stand at $13 billion. This is negligible compared with the $180 billion FDO figure due in 2019. Chart II-1Turkey: A Large Foreign Debt Servicing Burden Turkey: A Large Foreign Debt Servicing Burden Turkey: A Large Foreign Debt Servicing Burden Chart II-2Foreign Exchange Reserves Are Too Small Foreign Exchange Reserves Are Too Small Foreign Exchange Reserves Are Too Small   The recent plunge in the central bank’s net foreign exchange reserves excluding swaps (i.e. net international reserves) has put many pertinent metrics at record lows. In particular, net international reserves are at a precarious level relative to both total imports and external debt (Chart II-3). Finally, the net international reserves-to-broad money supply ratio has fallen to 7% (from 15% in 2014) despite the fact that the massive lira depreciation reduced the U.S. dollar measure of broad money supply (Chart II-4). Chart II-3FX Reserves Do Not Cover Imports Or External Debt FX Reserves Do Not Cover Imports Or External Debt FX Reserves Do Not Cover Imports Or External Debt Chart II-4Low Coverage Of Broad Money By International Reserves Low Coverage Of Broad Money By International Reserves Low Coverage Of Broad Money By International Reserves The currency will have to depreciate further and interest rates will have to move higher to shrink domestic demand/imports more. This is needed to generate a current account surplus that could be used to service FDOs, or that otherwise entices foreign creditors to be willing to roll over foreign debt or invest in Turkey.   Finally, while the adjustment in the real economy is advanced, it is unlikely to be over, due to the large foreign debt bubble. Importantly, with large foreign and local currency debt obligations coming due for both companies and households - in addition to the deterioration in economic activity and higher interest rates - NPLs are bound to rise (Chart II-5). This is especially likely to occur because a lot of borrowing has been used in the property market both for construction and purchases. Notably, real estate volumes are shrinking, and prices are deflating in real terms (Chart II-6). Chart II-5NPLs Will Rise A Lot NPLs Will Rise A Lot NPLs Will Rise A Lot Chart II-6Turkey: Real Estate Is In Free Fall Turkey: Real Estate Is In Free Fall Turkey: Real Estate Is In Free Fall   Bottom Line: The macro adjustment in Turkey is not yet complete. The country still lacks foreign currency supply to service its enormous 2019 FDOs. Further currency depreciation and higher interest rates are required to depress domestic demand/imports and push the current account into surplus. Stay put / underweight Turkish financial markets. The authorities are becoming desperate, and the odds of capital control enforcement are not negligible. While such an outcome is not possible to forecast with any certainty or time frame, investors should consider this very real risk. Andrija Vesic, Research Analyst andrijav@bcaresearch.com

Highlights In Indonesia, investors are ignoring the weakness in global growth, which is an important driver of the country’s financial markets. The Indonesian currency, equities and local currency bonds all remain vulnerable. We continue to recommend underweighting Indonesian assets for now. In Turkey, additional adjustments in the exchange rate and interest rates are unavoidable. Stay put/underweight Turkish financial markets. In the UAE, the economy is set to improve marginally this year. We recommend overweighting UAE equities and corporate spreads within their respective EM portfolios. Feature Indonesia: The Currency And Bank Stocks Are At Risk  Indonesian financial assets have benefited from the Federal Reserve’s dovish turn and corresponding fall in U.S. bond yields (Chart I-1, top panel). Moreover, the market is cheering President Joko Widodo’s lead in the presidential vote tally. Yet investors are ignoring the budding weakness in industrial metals prices, which has historically been an important driver of Indonesia’s exchange rate (Chart I-1, middle panel). Going forward, the Indonesian currency, equities and local currency bonds all remain vulnerable: Falling global growth in general and Chinese imports in particular will intensify Indonesia’s exports contraction and worsen the country’s already wide current account deficit. In turn, the latter will induce currency depreciation, which will then lead to higher interbank rates (Chart I-2). Chart I-1Global Growth Matters For Indonesian Markets Global Growth Matters For Indonesian Markets Global Growth Matters For Indonesian Markets Chart I-2Falling Current Account Deficit = Higher Local Rates Falling Current Account Deficit = Higher Local Rates Falling Current Account Deficit = Higher Local Rates Upward pressure on local interbank rates will cause a slowdown in domestic private loan growth.   The Indonesian central bank – Bank Indonesia (BI) – has been attempting to lower interbank rates, which have been hovering above the central bank's policy rate (Chart I-3). To achieve this, the central bank has substantially increased excess reserves in the banking system (Chart I-4). It has done so by purchasing central bank certificates from commercial banks, conducting foreign exchange swaps and providing repo lending. Chart I-3A Sign Of Liquidity Strains A Sign Of Liquidity Strains A Sign Of Liquidity Strains Chart I-4Bank Indonesia Is Injecting Liquidity Bank Indonesia Is Injecting Liquidity Bank Indonesia Is Injecting Liquidity   Yet by expanding banking system liquidity so aggressively, BI risks renewed currency depreciation. Like any central bank in a country with an open capital account, BI cannot expect to have full control over the exchange rate while simultaneously targeting local interest rates. The Impossibly Trinity dilemma dictates that a central bank needs to choose between controlling the two. Yet investors are ignoring the budding weakness in industrial metals prices, which has historically been an important driver of Indonesia’s exchange rate. Therefore, if BI continues to inject local currency liquidity to cap or bring down interest rates (interbank rates), the resulting excess liquidity could encourage and facilitate speculation against the rupiah. Scratching below the surface, the recent strong outperformance of Indonesian equities has been entirely due to the surge in the country’s bank share prices (Chart I-5, top panel). Remarkably, the performance of Indonesian non-financial as well as small-cap stocks has been especially dismal (Chart I-5, middle and bottom panels). This is an upshot of poor profitability among Indonesia’s non-financial listed companies (Chart I-6). Chart I-5Indonesian Bank Stocks Are The Only Outperformers Indonesian Bank Stocks Are The Only Outperformers Indonesian Bank Stocks Are The Only Outperformers Chart I-6Falling Non-Financial Corporate Profitability Falling Non-Financial Corporate Profitability Falling Non-Financial Corporate Profitability Furthermore, deteriorating financial health of non-financial corporates, especially small companies, will lead to higher NPLs on banks’ books. Notably, Indonesian banks are more heavily exposed to businesses than to households. As NPLs rise anew, Indonesian commercial banks will need to lift their bad-loan provisioning levels, generating a major profit relapse (Chart I-7). Importantly, Indonesian commercial banks have been boosting their profits by reducing NPL provisions since early 2018. Reversing this will materially affect their earnings. Chart I-7Indonesian Bank Share Prices Are Vulnerable Indonesian Bank Share Prices Are Vulnerable Indonesian Bank Share Prices Are Vulnerable Additionally, bank stocks are vulnerable due to falling net interest income margins. Moreover, their share prices are overbought and not cheap. To be clear, we are not negative on Indonesia’s structural outlook. The above-mentioned alarms are more near-to-medium terms issues. Still, foreign ownership of local currency bonds and stocks – at 38% each – are high, and could be a major source of potential outflows if the rupiah depreciates. This would cause Indonesian stocks and local currency bonds to sell off severely. Bottom Line: The global growth slowdown/commodities downturn and the U.S. dollar upturn are not yet over. Consequently, foreign flows into EM will diminish, which will be particularly negative for Indonesian financial markets. We recommend investors continue underweighting Indonesian equities and avoid Indonesian local currency bonds for now. We continue to recommend a short position in the IDR versus USD. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Turkey’s Foreign Debt Bubble: The Worst Is Not Yet Behind Us Turkish financial assets, and the currency especially, will remain under selling pressure in the coming months. Additional adjustments in the exchange rate and interest rates - as well as in the real economy and current account balance - appear unavoidable. The key imbalance remains the gap between foreign debt obligations (FDOs) and the availability of foreign currency to meet these debt obligations. Turkey’s FDOs in 2019 are equivalent to $180 billion (Chart II-1). FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. This consists of $15 billion in interest payments, $65 billion in debt amortization and $100 billion in maturing short-term (under one year) claims. In theory, these debt obligations can either be rolled over, or the nation should generate current account and capital account surpluses and use these surpluses to pay down FDOs. Even though the current account deficit is shrinking, it is still in a deficit of $18 billion. Net FDI inflows remain weak at US$10 billion. Hence, it appears that Turkey’s only options are either to roll over maturing foreign currency debt or to lure foreign investors into local currency assets and use the surplus in net portfolio inflows to meet these FDOs. The central bank’s foreign currency reserves excluding both commercial banks’ deposits at the Central Bank of Turkey and FX swaps now stand at $13 billion. However, due to a lack of credibility in the Turkish government’s macro policies - in addition to the ongoing deep economic recession and heightened financial market volatility - external creditors will be unwilling to roll over the debt. In fact, net portfolio flows into government debt and equities have tumbled for the same reason. Typically, when foreign funding dries up temporarily, a country can use its foreign exchange reserves to meet its FDOs. However, Turkey’s foreign exchange reserves have already plummeted to extremely low levels (Chart II-2). The central bank’s foreign currency reserves excluding both commercial banks’ deposits at the Central Bank of Turkey and FX swaps now stand at $13 billion. This is negligible compared with the $180 billion FDO figure due in 2019. Chart II-1Turkey: A Large Foreign Debt Servicing Burden Turkey: A Large Foreign Debt Servicing Burden Turkey: A Large Foreign Debt Servicing Burden Chart II-2Foreign Exchange Reserves Are Too Small Foreign Exchange Reserves Are Too Small Foreign Exchange Reserves Are Too Small   The recent plunge in the central bank’s net foreign exchange reserves excluding swaps (i.e. net international reserves) has put many pertinent metrics at record lows. In particular, net international reserves are at a precarious level relative to both total imports and external debt (Chart II-3). Finally, the net international reserves-to-broad money supply ratio has fallen to 7% (from 15% in 2014) despite the fact that the massive lira depreciation reduced the U.S. dollar measure of broad money supply (Chart II-4). Chart II-3FX Reserves Do Not Cover Imports Or External Debt FX Reserves Do Not Cover Imports Or External Debt FX Reserves Do Not Cover Imports Or External Debt Chart II-4Low Coverage Of Broad Money By International Reserves Low Coverage Of Broad Money By International Reserves Low Coverage Of Broad Money By International Reserves The currency will have to depreciate further and interest rates will have to move higher to shrink domestic demand/imports more. This is needed to generate a current account surplus that could be used to service FDOs, or that otherwise entices foreign creditors to be willing to roll over foreign debt or invest in Turkey. Finally, while the adjustment in the real economy is advanced, it is unlikely to be over, due to the large foreign debt bubble. Importantly, with large foreign and local currency debt obligations coming due for both companies and households - in addition to the deterioration in economic activity and higher interest rates - NPLs are bound to rise (Chart II-5). This is especially likely to occur because a lot of borrowing has been used in the property market both for construction and purchases. Notably, real estate volumes are shrinking, and prices are deflating in real terms (Chart II-6). Chart II-5NPLs Will Rise A Lot NPLs Will Rise A Lot NPLs Will Rise A Lot Chart II-6Turkey: Real Estate Is In Free Fall Turkey: Real Estate Is In Free Fall Turkey: Real Estate Is In Free Fall     Bottom Line: The macro adjustment in Turkey is not yet complete. The country still lacks foreign currency supply to service its enormous 2019 FDOs. Further currency depreciation and higher interest rates are required to depress domestic demand/imports and push the current account into surplus. Stay put / underweight Turkish financial markets. The authorities are becoming desperate, and the odds of capital control enforcement are not negligible. While such an outcome is not possible to forecast with any certainty or time frame, investors should consider this very real risk. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Overweight UAE Equities And Corporate Bonds Over the next six to nine months, we believe both UAE equities and corporate spreads will outperform their respective emerging market (EM) benchmarks. The UAE economy is set to improve marginally this year (Chart III-1). It will benefit from expansionary fiscal policy, rising oil output, a buoyant tourism sector, a resilient banking sector and less of a drag from the real estate sector. First, sizable fiscal spending will lead to rising non-oil economic growth. The UAE’s federal budget spending for 2019 will increase by 17.3% from a year ago, much higher than the 5.5% year-on-year growth in 2018. Second, UAE oil output could increase by 15% later this year from current levels (Chart III-2). The U.S. announced on April 22 that all Iran sanction waivers will not be extended beyond the early-May expiration date. The U.S. administration also stated that it has secured pledges from Saudi Arabia and the UAE to increase their oil production in order to offset disrupted supply from Iran. Rising oil output will mitigate the negative impact of potentially lower oil prices on the UAE’s economy. Chart III-1Improving UAE Economy Improving UAE Economy Improving UAE Economy Chart III-2Rising Oil Output Rising Oil Output Rising Oil Output   Third, the outlook for the tourism sector is also positive. The number of tourists is set to rise as Expo 2020 approaches. The government is targeting 20 million visitors in 2020, 26% higher than last year’s levels. The UAE is building theme parks, museums, hotels and infrastructure to attract more tourists. The UAE economy is set to improve marginally this year. Fourth, the UAE’s banking sector will enjoy rising credit growth, robust profitability and improved asset quality this year. The banking system has been in consolidation mode since January 2016, with a 15% reduction in branches and a 14% drop in the number of employees. This has improved the banking sector’s profitability by cutting operating costs and increasing efficiency. The improving growth outlook will lift credit growth. The central bank’s most recent Credit Sentiment Survey suggests banks’ lending standards for both business and personal loans are loosening (Chart III-3). In addition, UAE banks enjoy large capital buffers. Despite rising non-performing loans (Chart III-4), UAE banks still reported a Tier-1 capital adequacy ratio of 17% as of December 2018. Chart III-3Credit Growth Is Likely To Increase Credit Growth Is Likely To Increase Credit Growth Is Likely To Increase Chart III-4Rising NPLs, But Still Large Capital Buffers Rising NPLs, But Still Large Capital Buffers Rising NPLs, But Still Large Capital Buffers   Lastly, the real estate markets in both Dubai and Abu Dhabi have suffered from oversupply (from both mushrooming supply and weaker demand) over the past several years. Property prices have already fallen over 20% in both Dubai and Abu Dhabi from their 2014 peaks (Chart III-5). Odds are high that the most dangerous phase of the property market downturn is behind us. Chart III-5Real Estate Adjustment Is Advanced Real Estate Adjustment Is Advanced Real Estate Adjustment Is Advanced In addition, the government’s efforts to attract people to stay in the country longer will somewhat offset the ongoing exodus of expatriates. Last May, the UAE introduced a new visa system that will allow investors, innovators and talented specialists in the medical, scientific, research and technical fields to stay in the country for up to 10 years. Overall, a potential bottom in property demand and restrained supply will likely make the real estate sector less of a drag on this bourse this year. Finally, the authorities are also more open to increasing the foreign ownership cap in the banking sector, albeit not up to 100%. For example, in early April, the largest UAE lender – First Abu Dhabi Bank – obtained regulatory approval to increase its foreign ownership limit to 40% from 25%. This has boosted foreign equity purchases and has supported the equity index. Bottom Line: We recommend an overweight position in UAE equities within an EM portfolio this year (Chart III-6). For fixed income investors, we recommend overweighting UAE corporate credit in an EM corporate credit portfolio. UAE corporate credit is a lower beta market and will outperform as EM corporate spreads widen (Chart III-7). Most UAE-dollar corporate bonds have been issued by banks. Banks in the UAE do not suffer from structural overhangs, and the cyclical downturn in the property market is well advanced. This is why they have been, and will remain, a lower beta sector within an EM corporate credit portfolio. Chart III-6Overweight UAE Equities Within An EM Portfolio Overweight UAE Equities Within An EM Portfolio Overweight UAE Equities Within An EM Portfolio Chart III-7UAE Corporate Credit Will Likely Outperform EM Benchmark UAE Corporate Credit Will Likely Outperform EM Benchmark UAE Corporate Credit Will Likely Outperform EM Benchmark   Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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

Highlights So what? EM elections bring opportunities as well as risks. Why?   Emerging market equities will benefit as long as China’s stimulus does not fizzle. Modi is on track to win India’s election – which is a positive – though risks lie to the downside. Thailand’s next cycle of political instability is beginning, but we are still cyclically overweight. Indonesia will defy the global “strongman” narrative – go overweight tactically. Populism remains a headwind to Philippine and Turkish assets. Wait for Europe to stabilize before pursuing Turkish plays. Feature Chart 1Risks of China's Stimulus Have Shifted To The Upside Risks of China's Stimulus Have Shifted To The Upside Risks of China's Stimulus Have Shifted To The Upside China’s official PMIs in March came at just the right time for jittery emerging market investors awaiting the all-important March credit data. EM equities, unlike the most China-sensitive plays, have fallen back since late January, after outperforming their DM peers since October (Chart 1). This occurred amid a stream of negative economic data and policy uncertainties: China’s mixed signals, prolonged U.S.-China trade negotiations, the Fed’s extended “pause” in rate hikes, the inversion of the yield curve, Brexit, and general European gloom. We have been constructive on EM plays since February 20, when we determined that the risks of China’s stimulus had shifted to the upside. However, several of the EM bourses that are best correlated with Chinese stimulus are already richly valued (the Philippines, Indonesia, Malaysia, etc). The good news is that a series of elections this spring provide a glimpse into the internal politics of several of these countries, which will help determine which ones will outperform if we are correct that global growth will find its footing by Q3.  First, A Word On Turkey … More Monetary Expansion On The Way Local elections in Turkey on March 31 have dealt a black eye to President Recep Tayyip Erdogan. His ruling Justice and Development Party (AKP) has lost control of the capital Ankara for the first time since 2004. Erdogan has also (arguably) conceded the mayoralty of Istanbul, the economic center of the country, where he first rose to power in 1994. Other cities also fell to the opposition. Vote-counting is over and the aftermath will involve a flurry of accusations, investigations, and possibly unrest. Erdogan’s inability to win elections with more than a slim majority is a continual source of insecurity for him and his administration. This weekend’s local elections reinforce the point. The AKP alone failed to cross 45% in terms of popular votes. Combined with its traditional ally – the Nationalist Movement Party (MHP) – it received 51.6% of the total vote (in the 2015 elections, the two parties combined for over 60% of the vote). While losing the local elections will not upset the balance in parliament, it is a rebuke to Erdogan over his economic policy and a warning to the AKP for the future. Erdogan does not face general elections until 2023. But judging by his response to the first serious challenge to his rule – the Gezi Park protests of May 2013 – his reaction will be to double down on unorthodox, populist economic policy. Chart 2Erdogan Will Respond With Populist Politics Erdogan Will Respond With Populist Politics Erdogan Will Respond With Populist Politics Back in 2013, the government responded to the domestic challenge through expansive monetary policy. The central bank gave extraordinary liquidity provisions to the banking system. Chart 2 clearly shows that the liquidity injections began with the Gezi protests. These provisions only paused in 2016-17, when global growth rebounded on the back of Chinese stimulus and EM asset prices rose, supporting Turkey’s currency and enabling the central bank to hold off. Today, the severe contraction in GDP (by 3% in Q4 2018), with a negative global backdrop, will likely end Erdogan’s patience with tight monetary policy.1 To illustrate how tight policy has been, note that bank loan growth denominated in lira is contracting at a rate of 17% in real terms. Given the authorities’ populist track record, rising unemployment will likely lead to further “backdoor” liquidity easing. A new bout of unorthodox monetary policy will be negative for domestic bank equities, local-currency bonds, and the lira. As one of the first EM currencies and bourses to begin outperforming in September 2018, Turkey has been at the forefront of the EM mini-rally over the past six months. But with global growth still tepid, this mini-cycle is likely to come to an end for the time being. Watch for the bottoming in Chinese followed by European growth before seeking new opportunities in Turkish assets. Erdogan’s domestic troubles could also prompt him to renew his foreign combativeness, which raises tail risks to Turkish risk assets, such as through U.S. punitive measures. Last year, Erdogan responded to the economic downswing by toning down his belligerent rhetoric and mending fences with Europe and the U.S. However, a reversion to populism may require him to seek a convenient distraction. The U.S. is withdrawing from Syria and the Middle East, leaving Turkey in a position where it needs other relationships to pursue its interests. Russia is a key example. Currently Erdogan is bickering with the U.S. over the planned purchase of a missile defense system from Russia. But the consequence is that relations with the U.S. could deteriorate further, potentially leading to new sanctions. Bottom Line: Turkey is still in the grip of populist politics and will respond to the recession and domestic discontent with easier monetary policy which would bode ill for the lira and lira-denominated assets. The stabilization of the European economy is necessary before investors attempt to take advantage of the de-rating of Turkish assets. India: Focus On Modi’s Political Capital We have long maintained that Modi is likely to stay in power after India’s general election on April 11-May 19. His coalition has recovered in public opinion polling since the Valentine’s Day attack on Indian security forces in Indian Kashmir (Chart 3). The government responded to the attacks by ordering airstrikes on February 26 against Pakistani targets in Pakistani territory for the first time since 1974. The attack was theatrical but the subsequent rally-around-the-flag effect gave Modi and his Bharatiya Janata Party (BJP) a badly needed popular boost. The market rallied on the back of Modi’s higher chances of reelection. Modi is the more business-friendly candidate, as opposed to his chief rival, Rahul Gandhi of the Indian Congress Party. Nevertheless, election risks still lie to the downside: Modi and his party are hardly likely to outperform their current 58% share of seats in the lower house of parliament, since the conditions for a wave election – similar to the one that delivered the BJP a single-party majority in 2014 – do not exist today. While the range of outcomes is extremely broad (Chart 4), the current seat projections shown in Chart 3 put Modi’s coalition right on the majority line. Meanwhile his power is already waning in the state legislatures. Chart 3 Chart 4 Thus Modi’s reform agenda has lost momentum, at least until he can form a new coalition. This will take time and markets may ultimately be disappointed by the insufficiency of the tools at his disposal in his second term. Indian equities are the most expensive in the EM space, and only more so after the sharp rally in March on the back of the Kashmir clash and Modi’s recovering reelection chances (Chart 5). Additional clashes with Pakistan are not unlikely during the election season, despite the current appearance of calm. This is because Modi’s patriotic dividend in the polls could fade. Since even voters who lack confidence in Modi as a leader believe that Pakistan is a serious threat (Chart 6), he could be encouraged to stir up tensions yet again. This would be playing with fire but he may be tempted to do it if his polling relapses or if Pakistan takes additional actions. Chart 5...And Lofty Valuations ...And Lofty Valuations ...And Lofty Valuations Chart 6 Further escalation would be positive for markets only so long as it boosts Modi’s chances of reelection without triggering a wider conflict. Yet the standoff revealed that these two powers continue to run high risks of miscalculation: their signaling is not crystal clear; deterrence could fail. Thus, further escalation could become harder to control and could spook the financial markets.2 Even if Modi eschews any further jingoism, his lead is tenuous. First, the economic slowdown is taking a toll – even the official unemployment rate is rising (Chart 7) and the government has been caught manipulating statistics. There is no time for the economy to recover enough to change voters’ minds. Opinion polls show that even BJP voters are not very happy about the past five years. They care more about jobs and inflation than they do about terrorism, and a majority thinks these factors have deteriorated over Modi’s five-year term (Chart 8). Chart 7Manipulated Stats Can't Hide Deteriorating Economy Manipulated Stats Can't Hide Deteriorating Economy Manipulated Stats Can't Hide Deteriorating Economy   Chart 8 If the polling does not change, Modi will win with a weak mandate at best. A minority government or a hung parliament is possible. A Congress Party-led coalition, which would be a market-negative event, cannot be ruled out. The latter especially would prompt a big selloff, but anything short of a single-party majority for Modi will register as a disappointment. Bottom Line: There may be a relief rally after Modi is seen to survive as prime minister, but his likely weak political capital in parliament will be disappointing for markets. The market will want additional, ambitious structural reforms on top of what Modi has already done, but he will struggle to deliver in the near term. While we are structurally bullish, in the context of this election cycle –  which includes rising oil prices that hinder Indian equity outperformance – we urge readers to remain underweight Indian equities within emerging markets. Thailand: An Outperformer Despite Quasi-Military Rule Chart A new cycle of political instability is beginning in Thailand as the country transitions back into civilian rule after five years under a military junta. However, this is not an immediate problem for investors, who should remain overweight Thai equities relative to other EMs on a cyclical time horizon. The source of Thai instability is inequality – both regional and economic. Regionally, 49% of the population resides in the north, northeast, and center, deprived of full representation by the royalist political and military establishment seated in Bangkok (Map 1). Economically, household wealth is extremely unevenly distributed. Thailand’s mean-to-median wealth ratio is among the highest in the world (Chart 9). Eventually these factors will drive the regional populist movement – embodied by exiled Prime Minister Thaksin Shinawatra and his family and allies – to reassert itself against the elites (the military, the palace, and the civil bureaucracy). New demands will be made for greater representation and a fairer distribution of wealth. The result will be mass street protests and disruptions of business sentiment and activity that will grab headlines sometime in the coming years, as occurred most recently in 2008-10 and 2013-14.   Chart 9 Chart 10Social Spending Did Not Hinder Populism Social Spending Did Not Hinder Populism Social Spending Did Not Hinder Populism The seeds of the next rebellion are apparent in the results of the election on March 24. The junta has sought to undercut the populists by increasing infrastructure spending and social welfare (Chart 10), and controlling rice prices for farmers. Yet the populists have still managed to garner enough seats in the lower house to frustrate the junta’s plans for a seamless transition to “guided” civilian rule. The final vote count is not due until May 9 but unofficial estimates suggest that the opposition parties have won a majority or very nearly a majority in the lower house. This is despite the fact that the junta rewrote the constitution, redesigned the electoral system to be proportional (thus watering down the biggest opposition parties), and hand-picked the 250-seat senate. Such results point to the irrepressible population dynamics of the “Red Shirt” opposition in Thailand, which has won every free election since 2001. Nevertheless, the military and its allies (the “Yellow Shirt” political establishment) are too powerful at present for the opposition to challenge them directly. The junta has several tools to shape the election results to its liking in the short run.3 It would not have gone ahead with the election were this not the case. As a result, the cycle of instability is only likely to pick up over time. Investors should note the silver lining to the period of military rule: it put a halt to the spiral of polarization at a critical time for the country. The unspoken origin of the political crisis was the royal succession. The traditional elites could not tolerate the rise of a populist movement that flirted with revolutionary ideas at the same time that the revered King Bhumibol Adulyadej drew near to passing away. This combination threatened both a succession crisis and possibly the survival of the traditional political system, a constitutional monarchy backed by a powerful army. With the 2014 coup and five-year period of military rule (lengthy even by Thai standards), the military drew a stark red line: there is no alternative to the constitutional monarchy. The royalist faction had its bottom line preserved, at the cost of an erosion of governance and democracy. The result is that going forward, there is a degree of policy certainty. Chart 11Thai Confidence Has Bottomed Thai Confidence Has Bottomed Thai Confidence Has Bottomed Chart 12Strong Demand Sans Risk Of Being Overleveraged Strong Demand Sans Risk Of Being Overleveraged Strong Demand Sans Risk Of Being Overleveraged The long-term trend of Thai consumer confidence tells the story (Chart 11). Optimism surged with the election of populist Thaksin in the wake of the Asian Financial Crisis in 2001. The long national conflict that ensued – in which the elites and generals exiled Thaksin and ousted his successors, and the country dealt with a global financial crisis and natural disasters – saw consumer confidence decline. However, the coup of 2014 and the royal succession (to be completed May 4-6 with the new king’s coronation) has reversed this trend, with confidence trending upward since then. Revolution is foreclosed yet the population is looking up. Military rule is generally disinflationary in Thailand and this time around it initiated a phase of private sector deleveraging. Yet the economy has held up reasonably well. Private consumption has improved along with confidence and investment has followed, albeit sluggishly (Chart 12). The advantage is that Thailand has had slow-burn growth and has avoided becoming overleveraged again, like many EM peers. Chart 13Thailand Outperformed EM Despite Military Interference Thailand Outperformed EM Despite Military Interference Thailand Outperformed EM Despite Military Interference Furthermore, Thailand is not vulnerable to external shocks. It has a 7% current account surplus and ample foreign exchange reserves. It is not too exposed to China, either economically or geopolitically: China makes up only 12% of exports, while Bangkok has no maritime-territorial disputes with Beijing in the South China Sea. In fact, Thailand maintains good diplomatic relations with China and yet has a mutual defense treaty with the United States (the oldest such treaty in Asia). It is perhaps the most secure of any of the Southeast Asian states from the point of view of the secular U.S.-China conflict. Finally, if our forecast proves wrong and political instability returns sooner than we expect, it is important to remember that Thailand’s domestic political conflicts rarely affect equity prices in a lasting way. Global financial crises and natural disasters have had a greater impact on Thai assets over the past two decades than the long succession crisis. Thailand has outperformed both EM and EM Asia during the period of military interference, though democratic Indonesia has done better (Chart 13). Bottom Line: Thailand’s political risks are domestic and stem from regional and economic inequality, which will result in a revived opposition movement that will clash with the traditional military and political elite. This clash will eventually create policy uncertainty and political risk. But it will need to build up over time, since the military junta has strict control over the current environment. Meanwhile macro fundamentals are positive. Indonesia: Rejecting Strongman Populism We do not expect any major surprises from the Indonesian election. Instead, we expect policy continuity, a marginal positive for the country’s equities. However, stocks are overvalued, overexposed to the financial sector,4 and vulnerable if global growth does not stabilize. Chart 14 The most important trend since the near collapse of Indonesia in the late 1990s has been the stabilization of the secular democratic political system and peaceful transition of power. That trend looks to continue with President Joko Widodo’s likely victory in the election on April 17. President Jokowi defeated former general Prabowo Subianto in the 2014 election and has maintained a double-digit lead over his rival in the intervening years (Chart 14). Prabowo is a nationalist and would-be strongman leader who was accused of human rights violations during the fall of his father-in-law Suharto’s dictatorship in 1998. Emerging market polls are not always reliable but a lead of this size for this long suggests that the public knows Prabowo and does not prefer him to Jokowi. In fact he never polled above 35% support while Jokowi has generally polled above 45%. The incumbent advantage favors Jokowi. Household consumption is perking up slightly and consumer confidence is high (see Chart 11 above). Wages have received a big boost during Jokowi’s term and are now picking up again, in real as well as nominal terms and for rural as well as urban workers. Jokowi’s minimum wage law has not resulted in extravagant windfalls to labor, as was feared, and inflation remains under control (Chart 15). Government spending has been ramped up ahead of the vote (and yet Jokowi is not profligate). All of these factors support the incumbent. Real GDP growth is sluggish but has trended slightly upward for most of Jokowi’s term. Chart 15Favorable Economic Conditions Support Incumbent Jokowi Favorable Economic Conditions Support Incumbent Jokowi Favorable Economic Conditions Support Incumbent Jokowi Chart 16 Jokowi has been building badly needed infrastructure with success and has been attracting FDI to try to improve productivity (Chart 16). This is the most positive feature of his government and is set to continue if he wins. A coalition in parliament has largely supported him after an initial period of drift. The biggest challenge for Jokowi and Indonesia are lackluster macro fundamentals. For instance, twin deficits, which show a lack of savings and invite pressure on the currency, which has been very weak. The twin deficits have worsened since 2012 because China’s economic maturation has forced a painful transition on Indonesia, which it has not yet recovered from. Chart 17 There is some risk to governance as Jokowi has chosen Ma’ruf Amin, the top cleric of the world’s largest Muslim organization, as his running mate. Jokowi wants to counteract criticisms that he is not Islamic enough (or is a hidden Christian), which cost his ally the governorship of Jakarta in 2017. However, Jokowi is not a strongman leader like Erdogan in Turkey, whose combination of Islamism and populism has been disastrous for the country’s economy. As mentioned, Jokowi will be defeating the would-be strongman Prabowo, who has also allied with Islamism. In fact, Indonesia is a relatively secular and modern Muslim-majority country and Amin is the definition of an establishment religious leader. The security forces have succeeded in cracking down on militancy in the past decade, greatly improving Indonesia’s stability and security as a whole (Chart 17). Governance is weak on some measures in Indonesia, but Jokowi is better than the opposition on this front and neither his own policies nor his vice presidential pick signals a shift in a Turkey-like, Islamist, populist direction. Bottom Line: We should see Indonesian equities continue to outperform EM and EM Asia as long as China’s stimulus efforts do not collapse and global growth picks up as expected in the second half of the year. Peaceful democratic transitions and economic policy continuity have been repeatedly demonstrated in Indonesia despite the inherent difficulties of developing a populous, multi-ethnic archipelago. Nationalism is a constant risk but it would be more virulent under Jokowi’s opponent. The Philippines: Embracing Strongman Populism Chart 18 The May 13 midterm elections mark the three-year halfway point in President Rodrigo Duterte’s presidential term. Duterte is still popular, with approval ratings in the 75%-85% range. These numbers likely overstate his support, but it is clearly above 50% and superior to that of his immediate predecessors (Chart 18). Further, his daughter’s party, Faction for Change, has gained national popularity, reinforcing the signal that he can expand his power base in the vote. The senate is the root of opposition to Duterte. His supporters control nine out of 24 seats. But of the twelve senators up for election, only three are Duterte’s supporters. So he could make gains in the senate which would increase his ability to push through controversial constitutional reforms. (He needs 75% of both houses of parliament plus a majority in a national referendum to make constitutional changes.) In terms of the economy, we maintain the view that Duterte is a true “populist” – pursuing nominal GDP growth to the neglect of everything else. His fiscal policy of tax cuts and big spending have supercharged the economy but macro fundamentals have deteriorated (Chart 19). He has broken the budget deficit ceiling of 3%, up from 2.2% in 2017. His reflationary policies have turned the current account surplus into a deficit, weighing heavily on the peso, which peaked against other EM currencies when he came to power in 2016 (Chart 20). Inflation peaked last year but we expect it to remain elevated over the course of Duterte’s leadership. He has appointed a reputed dove, Benjamin Diokno, as his new central banker. Chart 19Reflationary Policies Created Twin Deficits... Reflationary Policies Created Twin Deficits... Reflationary Policies Created Twin Deficits...   Chart 20...And Twin Deficits Weigh On The Peso ...And Twin Deficits Weigh On The Peso ...And Twin Deficits Weigh On The Peso Rule of law has deteriorated, as symbolized by the removal of the chief justice of the Supreme Court for questioning Duterte’s extension of martial law in Mindanao. Duterte also imprisoned his top critic in the senate, Leila de Lima, on trumped-up drug charges. He tried but failed to do so with Senator Antonio Trillanes, a former army officer and quondam coup ring-leader who has substantial support in the military. The army is pushing back against any prosecution of Trillanes, and against Duterte’s ongoing détente with China, prompting Duterte to warn of the risk of a coup.   Duterte’s China policy is to attract Chinese investment while avoiding a conflict in the South China Sea. His administration has failed to downgrade relations with the U.S. thus far, but further attempts could be made. This strategy could make the Philippines a beneficiary of Chinese investment if it succeeds. However, China knows that the Philippine public is very pro-American (more so than most countries) and that Duterte could be replaced by a pro-U.S. president in as little as three years, so it is not blindly pouring money into the country. Pressure to finance the current account deficit will persist. If pro-Duterte parties gain seats in the senate the question will be whether he comes within reach of the 75% threshold required for constitutional changes. His desire to change the country into a federal system has not gained momentum so far. He claims he will stand down at the end of his single six-year term but he could conceivably attempt to use any constitutional change to stay in power longer. If the revision goes forward, it will be a hugely divisive and unproductive use of political capital. Bottom Line: The Philippine equity market is highly coordinated with China’s credit cycle and so should benefit from China’s stimulus measures this year (as well as the Fed’s backing off). Nevertheless, Philippine equities are overvalued and macro fundamentals and quality of governance have all deteriorated. Duterte’s emphasis on building infrastructure and human capital is positive, but the means are ill-matched to the ends: savings are insufficient and inflation will be a persistent problem. We would favor South Korea, Thailand, Indonesia, and Malaysia over the Philippines in the EM space. Investment Implications We expect China’s stimulus to be significant and to generate increasingly positive economic data over the course of the year. China is a key factor in the bottoming of global growth, which in turn will catalyze the conditions for a weaker dollar and outperformance of international equities relative to U.S. equities. Caveat: In the very near term, it is possible that China plays could relapse and EM stocks could fall further due to the fact that Chinese and global growth have not yet clearly bottomed. We are structurally bullish India, but recommend sitting on the sidelines until financial markets discount the disappointment of a Modi government with insufficient political capital to pursue structural reforms as ambitious as the ones undertaken in 2014-19. Go long Thai equities relative to EM on a cyclical basis. Stay long Thai local-currency government bonds relative to their Malaysian counterparts. Go long Indonesian equities relative to EM on a tactical basis. Maintain vigilance regarding Russian and Taiwanese equities: the Ukrainian election, Russia’s involvement in Venezuela, and the unprecedented Taiwanese presidential primary election reinforce our view that Russia and Taiwan are potential geopolitical “black swans” this year.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      See BCA Emerging Markets Strategy, “Turkey: Brewing Policy Reversal?” March 21, 2019, available at www.bcaresearch.com. 2      See Sanjeev Miglani and Drazen Jorgic, “India, Pakistan threatened to unleash missiles at each other: sources,” Reuters, March 16, 2019, available at uk.reuters.com.  3      The junta can disqualify candidates and rerun elections in the same district without that candidate if the candidate is found to have violated a range of very particular laws on campaigning and use of social media. Also, the Election Commission is largely an instrument of the Bangkok establishment and can allocate seats according to the junta’s interests. 4      See BCA Emerging Markets Strategy, “Indonesia: It Is Not All About The Fed,” March 7, 2019, available at www.bcaresearch.com.   Geopolitical Calendar