United States

Special Report

Highlights COVID-19 shutdowns have intensified the pressure on the original “everything stores,” … : A combination of factors has been weighing on department stores since at least the early 2000s. Pandemic store closures have turned up the heat. … and turned an unwelcome spotlight on the future of shopping malls: Bankruptcy filings by anchor tenants pose an existential threat to already struggling malls. Shelter-at-home orders and universal telecommuting have debilitated the fashion industry, further testing malls’ resilience: Apparel retailers account for an estimated 60% of leased mall space, and their struggles are ramping up the pressure on mall operators. City-to-suburb migration may act to accelerate incumbent malls’ decline: Chester County, Pennsylvania has steadily gained wealth and population since the 1970s, but all the legacy malls within a 15-mile radius of the county seat are dead or dying. Feature Dear Client, US Investment Strategy will take its second summer break next week, so there will be no publication on August 24th. We will return on the 31st with Part 2 of the Mallpocalypse series. Best regards, Doug Peta Come On. How Can It Be That Bad? The July 31st episode of BCA’s Friday Conversations webcast series featured a construction executive who expressed the view that a considerable share of America’s enclosed shopping malls has very little value.1 Many malls, he argued, are no longer viable as originally intended and a daunting mix of financial and zoning obstacles stand in the way of repurposing them for other uses. A client in attendance thought we were laying it on a little thick. “Aren’t you being extreme?” he asked. “Why won’t things go back to normal [for enclosed shopping malls] once there’s a vaccine?” Like casinos, malls created a self-contained environment where customers would spend more the longer they stayed, ...  We confess to a weakness for invented mash-up catchphrases that refer to the patently ridiculous (Sharknado) or relentlessly overhyped (the Snowmageddon build up to potential winter storms). It was with tongue in cheek that we titled the webcast “Mallpocalypse,” but this multi-part Special Report is testament to the dire prognosis for much of the stock of US malls. Malls were under pressure well before COVID-19 emerged and they would remain under pressure even if it were already in full retreat. The pandemic has dramatically accelerated weaker malls’ demise, and few of them appear to have a path back to viability. A Brief History Of The Shopping Mall The fully enclosed, temperature controlled Southdale Center in the Twin Cities suburb of Edina, Minnesota was the world’s first shopping mall. Its 1956 opening was front-page news across the national media, which greeted it with rapturous praise. It was designed by Austrian émigré Victor Gruen, who had made his name by reconfiguring New York City’s retail entryways in a way that lured prospective consumers into stores and helped to keep them there. His mall design achieved the same effect on a much greater scale. Southdale positioned 72 stores across two levels joined by escalators and bookended by two branch department store “anchors.” The open floor plan in the body connecting the anchors allowed for unimpeded views of nearly every storefront. “A ‘garden court’ under a skylight, with a fishpond, enormous sculpted trees, a twenty-one-foot cage filled with bright-colored birds, balconies with hanging plants and a café,”2 meant to evoke the feeling of a town square, was set in the center of the mall, inviting visitors to linger. Vast parking lots stood ready to accommodate thousands of their cars (Box 1). Malls revolved around the department store anchors that promised to deliver foot traffic that their rank-and-file tenants wouldn’t find on the high street or in supermarket-anchored shopping centers. Developers couldn’t get bank funding without contractually committed anchors and most mall leases today contain a provision that automatically resets rent lower, or allows tenants to exit their lease without penalty, if multiple anchors close. Per the 2019 10-K for Simon Property Group, the country’s largest mall owner, the rounded average base minimum rent for anchor tenants with leases expiring between 2020 and 2029 ranges from $4 to $8, while the average base minimum rent for inline tenants ranges from $50 to $65. Anchors are the belle of the ball and malls that lose them risk entering a death spiral. Box 1: The ‘70s: If It Ain’t Broke, Don’t Fix It Other developers faithfully followed Gruen’s initial template during the mall building boom from the mid-fifties to 1990. The three malls within a 15-mile radius of my hometown – Concord Mall (Wilmington, DE, opened 1968), Exton Square Mall (Exton, PA, 1973) and Granite Run Mall (Media, PA, 1974) – had every element but swapped out the bright-colored birds for outsized fountains. Concord Mall meant ICEEs in blue and red cups with a cartoon polar bear, Exton Square was Baskin-Robbins’ mandarin chocolate sherbet and Granite Run was large square floor tiles with a beguiling pattern of cross-sectioned stones, but this elementary schooler’s dominant mall impression was the Niagara-like roar of the fountains, which seemed to fill every cubic foot of the area outside the stores. The Long-Running Department Store Crisis The minimum base rent comparison is not quite apples-to-apples, as anchor tenants often own their own spaces, but anchors are malls’ drawing card. As Simon’s 10-K puts it, “our [properties] rely upon anchor tenants to attract customers.” Ideally, an anchor will comfortably fill the two-level bookend spaces and bring a steady stream of consumers who may spend at the stores they pass on the way. Fit is essential: dollar store customers aren’t likely to pony up for luxury brands or the merchandise on offer at high-end boutiques. Gyms and movie theaters can absorb the space, but shopping may not be on their clientele’s agenda. ... and they counted on department stores to lure them inside it. Before the advent of category-killers in the ‘90s, department stores were an ideal anchor. They were trusted well-known brands that shoppers in their area were conditioned to seek out for a broad range of purchases (Box 2). Despite their struggles, department stores remain the go-to anchors at most malls. High-end brands like Neiman Marcus, Nordstrom or Saks might anchor a mall with luxury tenants, while Dillard’s, JCPenney, Lord & Taylor or the ubiquitous Macy’s might anchor a mall seeking a more general clientele. Box 2: The ‘80s: Best. Purchase. Ever. At 19, I ventured to the massive King of Prussia Mall for a post-Christmas department store sale where I wrote my first check with a comma to purchase a floor model Sony rack system (turntable, amplifier, receiver and dual tape deck) and a CD player. The nearly three-foot-high speakers and cabinet were an early concession to marital comity (reciprocated by the gift of higher-end bookshelf speakers) but the amplifier would keep spreading joy until 2012, when it succumbed just three blocks from BCA’s Montreal office to time and the steady thump of Crazy Horse. Unfortunately for mall operators, department stores have been losing ground for at least 25 years and openly reeling for the last ten. The big-box, category-killer stores, like Home Depot, the late Circuit City, Best Buy, Barnes & Noble, Sports Authority and the late Toys ‘R’ Us, reshaped the retail landscape in the ‘90s, ushering in power centers and stealing business from department stores’ more expensive, less specialized and comparatively thinly stocked individual departments. The steady buildup of e-commerce (Chart 1), the shift in popular appeal from suburbia to urban centers and millennials’ celebrated preference for experiences over things contributed to further erosion. Private equity’s foray into the field exacerbated the other pressures. Its modus operandi of levering its portfolio companies up to the gills left the store chains it acquired dangerously unprepared to contend with falling revenues. Chart 1Perpetual Motion Machine A Rotten Time For A Pandemic Many department stores and other retail chains were staggering before a sick bat straggled into a live animal market in Hubei province. The subsequent pandemic has forced a long list of them, including Neiman Marcus, JCPenney and Lord & Taylor, into Chapter 11 to shrink their debt and their cost bases under the protection of the bankruptcy code (Table 1). Several national chains not in bankruptcy are trimming their footprints as well. Nordstrom has announced plans to close a sixth of its locations, and mall stalwart Macy’s (which also owns Bloomingdale’s) wants to shutter 125 of its 850 locations (Table 2). The pandemic has cut a wide swath through apparel retailers, department stores, gyms and restaurants and the toll continues to mount. Table 1Selected Pandemic Retail Bankruptcies Table 2Selected Store Closures Outside Of Bankruptcy Chapter 11 bankruptcy offers struggling businesses a second chance while protecting the interests of senior lenders and secured creditors, but it is cold comfort for unsecured creditors. From a landlord’s perspective at the back of the priority line, the time out that bankruptcy grants an ailing debtor is an excruciating limbo when it is enjoined from initiating eviction proceedings. The landlord collects little, if any, rent and is unable to market the space or spruce it up while the tenant is shielded by the court. The Fashion Industry Was Already A Mess The outlook for department stores is undoubtedly bleak, but the fashion industry, which has relied on department stores’ retail distribution channel, may have it worse. According to a wide-ranging New York Times Magazine cover story,3 the entire fashion ecosystem has been busily devouring itself ever since the financial crisis. Although turmoil in the fashion industry would not typically register with most non-specialist investors, apparel retailers account for around 60% of leased mall space and have become another flash point for mall distress. According to the apparel component of the consumer price index, clothing prices peaked in 1998, rebounded somewhat in 2011 and 2012, and had resumed drifting lower before plunging to 1998 levels in May. The decline in women’s clothing prices has been even more severe, falling 27% from their 1993 peak to slip all the way to 1981 levels (Chart 2). One culprit has been fast fashion. Enabled by social media’s instantaneous dissemination of runway designs, nimble non-luxury retailers like Zara and H&M are able to rush their own versions into production, front-running high-end collections and compelling department stores to discount their own inventory as soon as they receive it. Chart 2Salmon Have It Easier Discounting has been ruinous for the department stores’ apparel margins, as producers’ prices have failed to follow consumer prices lower (Chart 3). Department stores struck back by presenting designers with ridiculously one-sided vendor agreements. Designers reluctantly acquiesced, lest they lose access to the stores’ once-mighty distribution channel and fail to meet their lofty growth targets. Those targets are courtesy of a new breed of investor, eager to discover the next fashion star and ramp his/her operation up to scale immediately. The accelerated timetable pushes fledgling designers to expand well beyond the capacity of their bare-bones organizations and makes an inherently fickle business even more tenuous. Chart 3Rising Production Costs + Falling Prices = A Lot Of Red Ink E-commerce further eroded department stores’ and other brick-and-mortar retailers’ positions, a story with which investors are already familiar. The bottom line is that department stores (Chart 4) and apparel retailers (Chart 5) have been badly lagging the broader market for an extended period. Their relative market performance is consistent with their constituents’ cycling in and out of Chapter 11. Even though they shrink their debt loads and store footprints with every trip to the courthouse, they haven’t been able to do so fast enough to overcome revenue and margin headwinds that show no signs of letting up. Chart 4Gradually, Then Suddenly Chart 5Ex-The Discount Stores, Apparel Retailers Have Gotten Crushed Then the pandemic arrived and nearly the entire white-collar workforce, ex-health care professionals, ceased going to the office or traveling to meet clients in person. For five months and counting, the primary consumers of professional attire have had no reason to wear it, much less buy more. It’s no surprise that Brooks Brothers, Ann Taylor, JoS. A. Bank and Men’s Wearhouse have been among the casualties. Overall sales of clothing fell off a cliff in March, April and May (Chart 6, top panel) but clothing stores fared even worse (Chart 6, bottom panel). Chart 6Apparelocalypse With department store anchors, who occupy approximately 30% of malls’ leasable area, and apparel retailers under siege, mall operators have few places to turn to fill their space. The new breed of anchor stand-ins – fitness centers, movie theaters and entertainment spaces – are not able to open in every state and haven’t been paying rent. Gold’s Gym, 24 Hour Fitness and Chuck E. Cheese have already filed for bankruptcy and the big movie theater chains’ future is deeply uncertain. There’s Gold In Them Thar Hills, But Someone Else Has Already Staked A Claim Green Street Advisors, the leading commercial real estate research and advisory firm, estimates that half of all mall-based department stores will close by the end of 2021. Estimates of the share of malls that will close in the aftermath range from a quarter to a third. If the US has around 1,200 malls, 300 or 400 may soon disappear. Their owners and the entities that have lent to them will recoup only a fraction of their initial investments. If their losses lead to a reduction in the availability of credit, or trigger a self-reinforcing wave of defaults and bankruptcies, they could have a broader macro impact. We will explore the potential macro effects in the next installment of the series. We close this one by noting the sad fate of the ‘70s-era malls within a 15-mile radius of West Chester, Pennsylvania. Granite Run Mall was razed in 2016 and replaced with an open-air mixed-use facility that retained the original mall’s anchor spaces. Concord Mall was sold to a buyer of distressed malls in January, which has yet to disclose its plans for the site. Exton Square Mall, which underwent an ill-fated 2000 expansion that more than doubled its leasable area, is now owned by the ailing publicly traded Pennsylvania Real Estate Trust (PEI). PEI classifies the property as a non-core asset, along with the other two weakest malls in its portfolio. The Chester County mall experience bears on a client question from the July 31st webcast: “People are fleeing cities for the countryside. Isn’t that the opportunity?” Chester County, which has the highest mean household income in Pennsylvania and the 27th highest in the United States, bucks the state’s broader demographic decline. West Chester, the county seat, added a third public high school in 2006; its university has steadily grown enrollment, increasing its share of students in the 14-school State System of Higher Education consortium from 12.1% in 2010-11 to 18.5% in 2019-20; and new highway arteries and commuter rail stations have made it much more feasible for residents to work in Philadelphia, 25 miles to the east, than it was in the ‘70s and ‘80s. Chester County has been a prime suburban development opportunity for 20 or 30 years and commercial and residential developers have been making the most of it, converting acreage formerly devoted to feed corn into high-end housing, office parks, luxury auto dealerships and other commercial uses. It’s not that the market can’t support retail, it’s that it no longer wants 50-year-old spaces that were built to serve a humbler, less affluent constituency. A range of newer open-air options featuring more upscale retailers and restaurants have supplanted Concord, Exton Square and Granite Run. The area has improved; it’s the old nags that couldn’t keep up.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see BCA Research Webcast "Mallpocalypse", from July 31, 2020, available at bcaresearch.com. 2 Gladwell, Malcolm, "The Terrazzo Jungle," The New Yorker, March 15, 2004. 3 Aleksander, Irina. "Sweatpants Forever," The New York Times Magazine, August 9, 2020, pp. 28-33 and 42-43.

Highlights The US dollar is likely to weaken over the next 12 months as global growth accelerates and the narrowing in real interest rate differentials continues to thwart the greenback. Theoretically, the relationship between exchange rates and budget deficits is indeterminate. Whether or not a larger budget deficit leads to a weaker currency ultimately depends on how the central bank responds and what other countries are doing. Today, the Fed is effectively capping nominal yields through unlimited bond purchases and aggressive forward guidance. As such, the passage of a new US fiscal stimulus package should mitigate deflationary fears, reduce real rates, and put modest downward pressure on the dollar. While a disorderly dollar selloff cannot be ruled out, it is a low-probability scenario at the moment. A major dollar decline would require that realized inflation increases dramatically, which is unlikely at a time when unemployment is still so elevated. Moreover, to the extent that the US economy is operating below its potential, increased fiscal stimulus will lead to higher private-sector savings. Higher private-sector savings, in turn, will limit any deterioration in the current account balance. Investors should remain overweight global equities over a 12-month horizon, favoring cheaper non-US stocks and cyclical sectors. Beep Beep In the classic Road Runner cartoon, Wile E. Coyote has a habit of inadvertently running off a cliff, stopping for a moment in mid-air to look down, only to realize that there is nothing beneath him. Like the coyote, the US economy has gone over the fiscal cliff. The extra $600 a week in emergency federal unemployment benefits have lapsed. The small business Paycheck Protection Program has stopped accepting new applications, while state and local governments face a massive cash crunch. President Trump’s executive orders, if implemented, will mitigate some of the fiscal tightening. However, it is probable that they will be challenged in court. And even if the states are able to get the new unemployment benefit program up and running quickly – which seems doubtful – the $44 billion in federal funding for the program, which was taken from the Department of Homeland Security’s Disaster Relief Fund, will run out in six weeks. The stimulative effect of the adjustment to payroll taxes is also likely to be limited, given that the President’s order only defers tax liabilities until next year, rather than forgiving them altogether. So why hasn’t the stock market reacted negatively to the withdrawal of large-scale fiscal stimulus? The answer is that investors are assuming that Congress will manage to cobble together a deal over the coming days that resolves the shortcomings in Trump’s executive orders. Given that voters favor more stimulus, some sort of a deal is more likely than not (Table 1). However, with the stock market near record highs, the impetus for Trump to seek a compromise with Congress is not yet at hand. Risk assets may need to suffer a setback to catalyze an agreement. Table 1Majority Continues To Support Expanded Unemployment Insurance Still Sticking With Our Overweight 12-Month View On Stocks Despite our near-term concerns, we continue to recommend that investors overweight equities on a 12-month horizon. While stocks are not particularly cheap, they are not expensive either. The MSCI All-Country World index is trading at 18-times calendar 2021 earnings. The forward PE ratio based on projected 2021 earnings is 21 in the US and 15 outside the US. Even if one allows for the likelihood that earnings estimates are overly optimistic – as they usually are – the earnings yield on stocks is about six percentage points above the real yield on bonds. This suggests that the equity risk premium is still quite high, compensating investors for earnings risk (Chart 1). Meanwhile, sentiment towards stocks remains downbeat. Bears outnumbered bulls by 12 percentage points in this week’s American Association of Individual Investors sentiment poll (Chart 2). On average, bulls have exceeded bears by 8 percentage points in the 33-year history of this survey. Stocks are more likely to go up than down when sentiment is bearish. Chart 1Favor Equities Over Bonds Over A 12-Month Horizon Chart 2Many Investors Are Bearish On Stocks   Dollar: Stick With The Herd Chart 3The Dollar Has Started Breaking Down Bears also outnumber bulls in surveys of sentiment towards the dollar (Chart 3). Does that mean that one should position for a stronger greenback? No. The dollar is a high momentum currency (Chart 4). Unlike in the case of equities, being a contrarian has been a losing strategy for trading the dollar. The dollar is more likely to weaken when sentiment is bearish and the currency is trading below its moving averages, as is currently the case (Chart 5).   Chart 4The Dollar Is A High Momentum Currency Chart 5Trading The Dollar: The Trend Is Your Friend The US Dollar Is Normally A Risk-Off Currency Chart 6The US Economy Is Less Cyclical Than Those Of Its Trading Partners What are the implications of a weaker dollar for risk assets? Just like bond yields can either fall for risk-on reasons (i.e., when monetary policy turns dovish) or fall for risk-off reasons (i.e., when deflationary pressures set in), a weakening in the US dollar can either be a risk-on or a risk-off event. Historically, the dollar has traded as a risk-off currency. This is partly because the US Treasury market is one of the most liquid and safest in the world. When investors panic, they flock to Treasuries, which raises the demand for dollars. In contrast, when investors feel emboldened to take on more risk, they tend to sell dollars. The US economy is less cyclical than those of its trading partners (Chart 6). While the US benefits from stronger global growth, the rest of the world benefits even more. Thus, when global growth accelerates, capital tends to flow from the US to other economies, hurting the dollar in the process. Moreover, changes in interest-rate differentials can affect the value of the dollar. For example, at the start of 2019, euro area 2-year real rates were 221 basis points below comparable US rates. Today, they are 19 basis points above US rates, representing a net swing of 240 basis points. If anything, the dollar has fallen less than one would have anticipated based on changes in interest rate differentials (Chart 7). Chart 7AInterest Rate Differentials Do Not Favor The Dollar Chart 7BInterest Rate Differentials Do Not Favor The Dollar   Will Bloated Fiscal Deficits Undermine The Dollar? To the extent that the recent dollar selloff has been driven by stronger global growth and a more dovish Fed, it is not surprising that risk assets have rallied. However, an increasing number of commentators have begun to wonder whether the next leg of the dollar bear market could be less benign than the one that preceded it. The US dollar will weaken over the next 12 months. This weakness will mainly stem from “risk-on” forces, namely stronger global growth and a very dovish Fed. Stephen Roach has argued that soaring budget deficits will push the US current account further into deficit, while America’s disengagement from the rest of the world will undermine the dollar’s reserve status. He reckons that the dollar could plunge by 35% “sooner rather than later.” I agree with Stephen that the dollar faces a variety of long-term challenges. However, I do not think these challenges will be the primary drivers of the dollar over the next 12 months or so. A Simple Framework For Thinking About Currencies To understand why, let me describe a simple two-country framework that I have found to be very useful for thinking about currencies’ sensitivity to various macroeconomic forces. This framework, which draws on the seminal work of Rudi Dornbusch in the 1970s,1 relies on two “equilibrium conditions”: A long-run equilibrium condition that says that the price of a comparable basket of goods and services should be the same across countries. This implies, for example, that if the price level in Country A rises relative to Country B by say 10%, then Country A’s currency should eventually depreciate by 10% relative to Country B’s. A short-run equilibrium condition that says that the expected risk-adjusted return on investment assets should be the same across countries. This implies that all excess returns are arbitraged away. Suppose that interest rates and inflation are initially the same in Country A and B, but that A suddenly and unexpectedly decides to run a larger budget deficit for the next ten years. What will happen to the value of A’s currency? The answer depends on how Country A’s central bank reacts; specifically, on whether real interest rates end up going up or down in response to the bigger budget deficit. First, let us consider an extreme situation where investors believe that Country A’s central bank will not hike interest rates at all in response to the larger budget deficit, but that annualized inflation will nevertheless rise by 2% over the following decade due to the additional aggregate demand from easier fiscal policy. In that case, the price level in Country A will end up being 20% higher than previously expected after a decade, implying that A’s currency would have to fall immediately by 20% (Chart 8 – left-hand side column). Chart 8Short- And Long-Run Moves In Currencies Under Various Inflation And Interest Rate Scenarios The reason Country A’s currency has to fall by 20% at once, rather than grinding lower by 2% per year for ten years, is that we are assuming that interest rates in the two countries remain equal. If Country A’s currency were to fall slowly, Country B’s bonds would earn a higher return in common-currency terms during the entire period when Country A’s exchange rate was trending lower. This would violate the second equilibrium condition. Thus, this framework implies that only unanticipated changes to policy can lead to discrete (i.e., step function) changes in exchange rates. Let us now consider a different scenario where the central bank in Country A, rather than accommodating easier fiscal policy, immediately moves to neutralize the stimulative impact of a larger budget deficit by hiking interest rates by two full percentage points. Since there is no net impact on aggregate demand, inflation expectations in Country A do not change.2 Country A’s exchange rate does change, however: it immediately appreciates by 20% (Chart 8 – middle column). This appreciation is necessary to engender the expectation of a subsequent two percentage point per year depreciation in A’s exchange rate. The ensuing slow depreciation in A’s currency offsets the additional two percentage points in interest that A’s bonds pay over B’s bonds. One can easily imagine intermediate cases. For example, suppose Country A’s central bank raises interest rates by only one percentage point, which results in A’s price level rising by 5% over the subsequent decade relative to B’s price level. As the right-hand side column of Chart 8 shows, A’s exchange rate would initially appreciate by 5%, but then depreciate by one percent every year for a decade, ultimately finishing 5% below where it started. An Added Wrinkle: Portfolio Balance Effects Before we apply this framework to the outlook for the US dollar, we need to discuss something that is central to Stephen Roach’s thesis, which is the role of portfolio balance effects. In the discussion above we said nothing about current account deficits, US indebtedness to the rest of the world, or the dollar’s reserve currency status. This is because we assumed that investors would be indifferent between holding Country A's and B’s bonds as long as they offered the same expected returns after accounting for projected exchange rate movements. In reality, financial assets are not perfectly substitutable. Changes in “portfolio balance” – the quantity and composition of assets available to the public – is likely to have an effect on returns. Thus, if Country A’s government issues more debt in order to finance a wider budget deficit, investors may demand a higher return to induce them to hold that additional debt. This extra return is likely to be larger if there is more uncertainty about the path of inflation. In the context of the first example discussed above, Country A’s exchange rate may have to fall by more than 20%. A weakening of Country A’s exchange rate would allow investors in B to purchase the same number of Country A bonds but at a lower cost when measured in B’s currency. Moreover, by undershooting its long-term fair value – and thus creating expectations of an appreciation in its currency – Country A can increase the appeal of its bonds. The expected appreciation of A’s exchange rate following a big depreciation effectively compensates investors with a risk premium for owning A’s bonds. This is why we phrased our second equilibrium condition in terms of “risk-adjusted” returns rather than simply expected returns. What All This Means For The Dollar Chart 9Rising Budget Deficits Do Not Automatically Translate Into A Weaker Dollar The key insight from our analysis is that the relationship between budget deficits and exchange rates is indeterminate. If the Fed adopts a hawkish stance in order to keep inflation from accelerating, like Paul Volcker’s Fed did in the early 1980s, the dollar could rise (Chart 9). In contrast, if the Fed keeps rates on hold in the face of rising budget deficits, the dollar is more likely to weaken. Arguably, this is what happened in the early 2000s following the Bush tax cuts. The downward pressure on the dollar would intensify if, as per our discussion of portfolio balance effects, investors started demanding a higher risk premium to hold US assets. Today, the Fed is effectively capping nominal bond yields through unlimited bond purchases and aggressive forward guidance committing to easy policy for years. Jay Powell has gone as far as to say that “we’re not even thinking about thinking about raising rates.” As such, the passage of a new US fiscal stimulus package would mitigate deflationary fears, reduce real rates, and put modest downward pressure on the dollar. Chart 10Labor Market Slack Will Keep Inflation In Check Chart 11Inflation Expectations Tend To Track Realized Inflation Could further dollar weakness morph into a disorderly dollar selloff which hurts, rather than helps, global equities and other risk assets? While such an outcome cannot be ruled out, it is a low-probability scenario for the moment. For one thing, the US output gap – the difference between what the economy can potentially produce and what it is producing now – is very large. Inflation is unlikely to rise significantly if there is still a fair amount of labor market slack (Chart 10). Historically, inflation expectations have tended to track actual inflation (Chart 11). If the latter remains contained for the next few years, so will the former. What about the possibility that bigger budget deficits will produce much larger current account deficits? It is certainly true that if private-sector savings did not change, a bigger budget deficit would reduce national savings, leading to a larger current account deficit. It is also true that US external liabilities now far exceed foreign assets, reflecting the fact that the US has run a current account deficit every year since 1982 (Chart 12). Chart 12Many Decades Of Current Account Deficits Have Led To A Negative Net International Investment Position For The US Fortunately, things are not quite as bleak for the dollar as they seem, at least for now. Despite a net international investment position of negative 56% of GDP, the US still generates substantially more income from its overseas assets than it pays to service its liabilities (Chart 13). This reflects the fact that US foreign liabilities are mainly comprised of low-yielding government bonds, while its assets largely consist of higher-yielding equities and foreign direct investment (Chart 14). Chart 13The US Generates More Income From Its Overseas Assets Than It Pays On Its Liabilities Chart 14A Breakdown Of US Assets And Liabilities   Chart 15Government Transfers Primarily Boosted Personal Savings This Year With Little External Spillovers So Far Moreover, to the extent that the US economy is operating below its potential, fiscal stimulus will lead to higher private-sector savings. Higher private-sector savings, in turn, will reduce the need for the US to source capital from abroad. If the government transfers money to households and they save it, private-sector savings will rise by the same amount that government savings fall. If households spend the money, GDP and national income will rise. The resulting increase in income will boost savings.3 This is precisely what has happened this year: The fiscal deficit has soared, private-sector savings have exploded, and the trade balance has basically gone sideways (Chart 15). Granted, to the extent that some of the spending will be directed towards imports, the current account deficit will widen over the coming months. However, stronger growth will also increase corporate profitability. This could attenuate any capital outflows from the US, thus preventing the dollar from falling as much as it otherwise would have. Investment Conclusions Chart 16Global Equities Tend To Outperform Bonds When Global Growth Is Strengthening And The Dollar Is Weakening The US dollar will weaken over the next 12 months. This weakness will mainly stem from “risk-on” forces, namely stronger global growth and a very dovish Fed. Global equities have generally outperformed bonds when global growth is strengthening, and the dollar is weakening (Chart 16). Non-US stocks, cyclical stocks, value stocks, and small caps all tend to fare best in a weaker dollar environment (Chart 17). These stocks are also quite cheap compared to their counterparts: US stocks, defensive stocks, growth stocks, and large caps (Chart 18). Chart 17ANon-US Stocks, Cyclical Stocks, Value Stocks, And Small Caps Perform Better When The Dollar Is Falling… Chart 17BNon-US Stocks, Cyclical Stocks, Value Stocks, And Small Caps Perform Better When The Dollar Is Falling… Chart 18… And They Are Cheap To Boot Looking further out, the outlook for equities is less rosy. Stagflationary pressures could emerge in 2023 or thereabouts as unemployment falls to pre-pandemic levels and supply-side constraints begin to bite. If that were to happen, profit margins would come under pressure, sending equities lower. It is not clear how the US dollar would perform in that environment. On the one hand, a risk-off environment would tend to favor the greenback. On the other hand, if the Fed is perceived as being too slow to tame inflation, the dollar could sink. Of course, much depends on what is happening in other economies. Exchange rates are relative prices. If inflation rises everywhere, the big winners from higher inflation would not be other fiat currencies, but hard currencies such as gold. That is why we continue to recommend that investors stay long the yellow metal. Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Global Investment Strategy View Matrix Current MacroQuant Model Scores   Footnotes 1 Rudiger Dornbusch, “Expectations And Exchange Rate Dynamics,” The Journal of Political Economy, (84:6), December 1976. return to text 2 We are assuming that the central bank in Country A takes into account the impact that a stronger currency will have on aggregate demand when choosing the appropriate level of interest rates that neutralizes the effect of easier fiscal policy. return to text 3 For example, suppose households spend 75 cents of every dollar the government transfers to them exclusively on domestically-produced goods and services. If a government transfers $100 to households, $25 will be saved while the remaining $75 will be spent, thereby generating an additional $75 in GDP and income for the economy. Of the additional $75 in income, 25% ($18.75) will be saved while 75% ($56.25) will be spent. It is straightforward to show that if this process continues indefinitely, a total of 75+0.75*75+0.75^2*75+0.75^3*75+…=75/(1-0.75)=$300 in GDP and income will be generated. This means that private-sector savings will increase by 25+0.25*300=$100, which is exactly equal to the decline in government savings. Private-sector savings would rise by less than $100 if a portion of the spending was directed to imports. For instance, if households spent 15 cents of every dollar of income on imports, GDP would rise by 60+0.60*60+0.60^2*60+0.60^3*60+…=60/(1/1-0.60)=$150, while private savings would rise by 25+0.25*150=$62.50. return to text

Special Report

Highlights The Beirut blast calls attention to instability in the Shia Crescent. A turbulent push for political change will now ensue in Lebanon. Hezbollah’s and Iran’s political capital in Lebanon will suffer significantly. Lebanon is a red herring, but Iraq is a Black Swan. It is at risk of social unrest contagion. Iran’s financial troubles are weighing on its ability to maintain its sphere of influence. It is adopting a strategy of measured sabotage and deterrence against US interests in Iraq. The double whammy of low oil prices and pandemic is weighing on Saudi Arabia’s finances. Nevertheless it is prioritizing a cooperative relationship with Iraq. Iran could stage a major attack or President Trump’s poor election prospects could force him to “wag the dog.” Massive excess oil capacity will mute the oil market impact of a supply shortfall in Iraq. However, the risk becomes more relevant as demand recovers and markets rebalance in the second half of the year. Stay long Brent crude oil and gold. Feature The August 4 explosion at the Port of Beirut was devastating. It killed more than 220, wounded over 6000, left 300,000 homeless, and damaged buildings as far away as 9km from the site of the explosion. The blast added insult to injury to the country’s already troubled finances. Estimates for the cost of repair range anywhere between $5 billion and $15 billion. Global investors can largely write off the incident as an idiosyncratic shock. Even though emigration is likely to pick up, Lebanon’s population is only a third of Syria’s prior to its civil war. Assuming that a third of Lebanese become displaced abroad – a generous assumption more suitable to Syrian-style civil war than Lebanon’s situation – about 2 million Lebanese will be displaced, half of which will make their way to Europe or elsewhere outside the Middle East. As long as an antagonistic Turkey upholds its agreement with the EU, a mass exodus from Lebanon does not risk an unmanageable migrant crisis for Europe (Chart 1). Political tensions will rise and potentially lead to a populist backlash, given Europe’s battered economy. But Lebanon alone is not enough. The risk is broader Middle Eastern instability, which is a credible risk. Chart 1Middle Eastern Instability Could Fuel European Populism Thus Lebanon in itself is a red herring, but it is a bellwether for further unrest in the Middle East in countries that are not red herrings (Map 1). Map 1Lebanon Is A Red Herring; Iraq And Saudi Arabia Are Relevant A major conflict in Iraq is an underrated risk to global oil supply. The catastrophe calls attention to instability the Shia Crescent – a region in a tug of war between rival sectarian and geopolitical interests. Whereas the 2008 crisis led to the largely Sunni Arab states in the so-called Arab Spring, the 2020 crisis is piling pressure onto already unstable Shia states and regions: Iran, Iraq, Lebanon, Syria, and possibly eastern Saudi Arabia. Of particular significance is the fate of Iraq. Popular grievances are eerily similar to Lebanon’s. Baghdad is on shaky ground, yet the ramp up in US-Iran tensions going into the November US elections makes the threat of instability in Iraq more acute. As OPEC’s second ranked oil producer, a major conflict in Iraq poses an underrated risk to global oil supply. Supply losses are a tailwind to oil prices when market conditions are tight. However OPEC 2.0’s 8.3mm b/d of voluntary cuts means massive spare capacity is available globally to offset potential losses in Iraq, reducing the potential upside to oil prices. Nevertheless, this risk becomes more relevant as markets tighten on the back of a demand-side recovery, i.e. as balance is restored to the oil market and as excess spare capacity is eliminated. With oil markets likely rebalancing in 3Q20, unrest in Iraq poses an upside risk to our Commodity & Energy Strategy service’s expectation that 2H20 Brent prices will average $44/bbl and 2021 prices will average $65/bbl (Chart 2). Even though gold has already rallied 30% since mid-March, geopolitical risks including US-Iran tensions suggest any near-term selloff is a buying opportunity (Chart 3). The bullish gold narrative – geopolitical risks, falling dollar, and low real interest rates for the foreseeable future – remain intact even as the downturn gives way to a cyclical recovery. We continue to recommend gold on a strategic time horizon. Chart 2Oil Price Rally Remains Intact Chart 3Gold Is Due For A Breather Lebanon’s economic collapse highlights risks to other regional economies tied to the oil dependent Arab economies of the Persian Gulf. As the latter grapple with record low oil prices, production cuts, and the pandemic-induced recession, second-order effects will reverberate throughout the region, hitting economies such as Egypt and Jordan whose economic as well as political structures are intimately intertwined with Gulf Cooperation Council finances and policies. Lebanon’s Collapse Was Inevitable Lebanon was already going through an economic and financial meltdown before the explosion (Chart 4). Aside from the humanitarian loss, the economic impact is also profound. The country – highly dependent on imports of basic goods and suffering from food insecurity – must now contend with the loss of its main port and most of its grain reserves, destroyed in the explosion. As the dust settles, grief is morphing into anger on the streets. Regardless of whether the blast was due to happenstance or malice, the immediate cause was 2,750 tons of ammonium nitrate in storage for six years. The government was warned about the risks of the explosive chemicals at least four times this year – with the latest being on the day of the blast. Chart 4Beirut Port Explosion Accelerated Lebanon’s Collapse Mass protests are already taking place, calling on the government to be held accountable for criminal negligence. A controversial petition to return Lebanon to French mandate has gained more than 60,000 signatures. Prime Minister Hassan Diab’s seven-month-old cabinet has resigned. (It was put in place last year amid an earlier bout of unrest.) Official incompetence and neglect are in fact the best-case explanations for the explosion. Many questions remain unanswered. For instance, what triggered the fire? Israel swiftly denied any connection and offered humanitarian aid, while Hezbollah’s leader Hassan Nasrallah claimed to know more about the Port of Haifa than about Beirut Port. Early parliamentary elections and the cabinet’s resignation will not appease the protesters. Photos of Nasrallah, President Aoun, Speaker of Parliament Nabih Berri, and former Prime Minister Saad Hariri were among those hung by protesters in gallows in Martyrs’ Square over the weekend. Berri and Gebran Bassil are known to be the source of the cabinet’s decision-making power.1 They have veto over all decisions, large and small. During the mass protests in October 2019, Nasrallah stated that Hezbollah has two red lines:     Aoun must finish his term, which expires in 2022;     No early elections will be held, i.e. the speaker of the house will not be changed. While early elections have now been promised, these red lines highlight that corruption runs deep in Lebanon and opposition groups face an uphill battle against the establishment. A turbulent push for political change will now ensue. Hezbollah’s and Iran’s political capital in Lebanon will suffer significantly. Another Israeli confrontation with Hezbollah is not the base case but it could occur. Bottom Line: Lebanon is a failed state. As with the Arab Spring, the question is whether popular anger will prove contagious and spread to more market-relevant neighboring countries. The rally in the Israeli shekel in trade weighted terms since mid-March has already started to fizzle and may be tested further as turmoil in Lebanon raises the risk of confrontation. Contagion? In order for a geopolitical event in the Middle East to warrant investors’ attention, it must affect at least two of the following factors : (1) global oil supply, (2) geography of existential significance to a regional power, or (3) sectarian conflict which could lead to contagion. In this context, Lebanon is a red herring, but Iraq is not – therefore investors should watch to see if anything causes destabilization in Iraq. A decline in Iranian funds will weaken Tehran’s sphere of influence. Like Lebanon, Iraq is dominated by a highly corrupt sectarian system that has been plundering the wealth; people are suffering from rising rates of unemployment; and the regime is in the crosshairs of competing foreign agendas (Chart 5). Chart 5Iraqis And Lebanese Suffer Similar Grievances Iraq is in Iran’s sights because it aspires to establish a land bridge to the Mediterranean through a friendly “Shia Crescent” (Map 2). Iran’s modus operandi is to establish a presence in its neighbors’ domestic politics through Iran-backed factions. Map 2Iraq Essential To Iran’s Aspirational ‘Land Bridge’ To The Mediterranean Given the current state of Iran’s economy, it is not far-fetched to envision a significant drop in the funding of its foreign proxies (Chart 6). Historically these funds have followed the ebbs and flows of oil prices. For instance, in 2009, when faced with declining oil prices and US sanctions Iran’s funds to Hezbollah were estimated to have fallen by 40%. This happened again in 2014-16 and is not too different from today. Thus Iraq is at risk of contagion. Iran’s financial troubles are weighing on its ability to maintain its sphere of influence. Syrian fighters have reported paychecks being slashed, Iranian projects in Syria have stalled, and Hezbollah employees report to have missed paychecks and lost other benefits. Tehran’s finances are essential for Hezbollah’s survival.2 Iran’s proxies in Iraq are facing a similar fate.3 Chart 6Iran Suffering Under "Maximum Pressure" Bottom Line: Iraq faces an uptick in social unrest due to the poor living conditions and possible contagion from Lebanon. Meanwhile, Iran-backed groups there face a decline in funds from Tehran, which will send them searching for replacement funds. If Lebanon falters the world can usually ignore it but if Iraq falters the world will have to take notice. Saudi Arabia Prioritizes Revenue Over Growth Beirut’s foreign policy stances in recent years have been seen as appeasing Iran at the expense of Gulf Arab states.4 This trend coincides with a decline in Gulf Cooperation Council financing to Lebanon. Now the collapse in oil prices and pandemic have weighed on Saudi Arabia’s budget, which still depends on the energy sector for most of its revenues despite efforts to diversify. State revenues were down 49% year-on-year in Q2 pulling the budget deficit down to $29 billion (Chart 7). Riyadh is reassessing its priorities. Opting for revenue at the expense of growth, Riyadh has tightened the screws on its citizens. The government has had to pare back some of the benefits Saudis have long been accustomed to. The value-added-tax rate tripled from 5% to 15%, and a bonus cost-of-living allowance of $266 for public sector employees ended. The kingdom also announced plans to reduce spending on major projects by $26 billion – including some of those associated with Crown Prince Mohammed bin Salman’s reform agenda, Vision 2030. Chart 7Saudi Arabia Under Pressure From Double Whammy Severe economic turmoil poses a risk to the Saudi social contract in which citizens pledge allegiance to the ruling class in exchange for financial and social guarantees. The risk now is that the fiscal challenges dent Saudi citizens’ pocketbooks and thus impact social and political stability. However, oil prices are recovering to levels consistent with the kingdom’s fiscal breakeven oil price next year. The global economic recovery will begin to support the kingdom’s economy in the second half of this year (Chart 8). This will ease pressure on the budget and hence households. Moreover the slowdown is likely to hit foreign workers hardest and thus hasten the Saudization process. Foreign workers are the lowest hanging fruit and will be the first to find themselves jobless. In that sense the crisis is expediting some of Riyadh’s long-term reform targets. That said, there is still some risk of internal instability or even a palace coup. Tehran could incite sectarian tensions in the kingdom’s Eastern Province where an estimated 30-50% of the population is believed to be Shia. This is relevant given that nearly all Saudi oil production is located there. Chart 8KSA Benefits From EM GDP Growth ... Regarding the possibility of a palace coup, Crown Prince Mohammed bin Salman has spent this year cracking down on potential dissidents. Former Crown Prince Mohammed bin Nayef and King Salman’s only surviving full-brother Prince Ahmed bin Abdulaziz – both influential and well-liked – were among those detained in March. The kingdom’s contradictory policies – reform through repression – may eventually culminate in an overt political crisis. Though such a crisis may not occur until the time of royal succession. These economic and political challenges may force Saudi Arabia to adopt an inward stance. Its foreign interventions to date have been costly and come with little benefit – judging by the war in Yemen. It is also possible that Saudi Arabia, which is already the third largest defense spender globally, will try to strengthen its position vis-à-vis Iran. Crown Prince Mohammed bin Salman has already stated that the kingdom will pursue a nuclear program if Iran develops a nuclear bomb. This is relevant in today’s context with Iran no longer complying with restrictions to its nuclear program (Table 1). Saudi Arabia, like Iran, claims its nuclear program is for peaceful purposes – in order to generate nuclear power as part of efforts to diversify its economy.5 Table 1Iran No Longer Complying With 2015 Nuclear Deal Still, low oil prices tend to discourage petro states from engaging in conflict (Chart 9). Arab petro states may show restraint, at least until oil markets recover. Chart 9Low Oil Prices Discourage Petro States From Engaging In Conflict Overall weakness in oil-producing economies will hurt various countries that rely on remittances (Chart 10). The downturn will also hurt countries dependent on remittances from petro states in the region such as Egypt and Jordan. Bottom Line: The collapse in oil prices is forcing Saudi Arabia to reconsider its priorities and is expediting some long-term reforms. For now, it is adopting a pro-revenue rather than a pro-growth stance. This is likely to result in a focus inward for the kingdom. The implication is that countries that are leveraged to the petro-economies of the Gulf for remittances, bilateral aid, and capital flows will take a hit. These include Lebanon, Egypt, and Jordan. Chart 10Egypt And Jordan Also Vulnerable To Petro State Weakness Iraq Is The Prize Not unlike Lebanon, Iraq’s political class has been suffering a legitimacy crisis since protests erupted there last October resulting in the resignation of then-Prime Minister Adel Abdul Mahdi. However unlike Lebanon, Iraq is a significant geography for global investors. It is a major OPEC producer – second only to Saudi Arabia – accounting for 16% of the cartel’s production last year. The Iraqi oil minister’s first foreign trip was to the Saudi capital. This is not surprising. Iraq not only seeks Saudi leniency in OPEC 2.0 cuts, but also needs financial assistance to develop a natural gas field that will allow it to reduce dependence on Iran. Saudi Arabia also hopes to reduce Iraq’s dependence on Iranian natural gas and coax it into its sphere of influence. When it comes to crude oil, the additional 1mm b/d of voluntary cuts in June announced unilaterally by Saudi Arabia beyond its agreed OPEC 2.0 commitments are also a sign of Saudi willingness to accommodate Iraq and its non-compliance  (Chart 11).6 Saudi Arabia does not want to see Iraq’s newly elected government failing on the back of budgetary strain. In fact, al-Kadhimi is an opportunity for the Saudis. Formerly the director the National Intelligence Service with warm ties to the US, he is a champion of Iraqi sovereignty. Even though Iraq is being forced to compensate for past overproduction of oil in August and September, it was cajoled by the promise of a $500 million “bridging” loan from Saudi Arabia, to be repaid when oil markets recover. While financial assistance shows the kingdom’s commitment to Iraq, more significantly it reflects Riyadh’s desperation to revive oil markets and bring prices closer to its fiscal breakeven oil price amid the still uncertain demand outlook. Chart 11Saudi Arabia Willing To Accommodate Iraq Neither Saudi Arabia’s nor al-Kadhimi’s efforts are guaranteed to succeed in pulling Iraq out of Iran’s sphere. The prime minister received a rude awakening upon his arrest of 14 Kata’ib Hezbollah fighters in June on grounds of a plan to launch a rocket attack on US interest in Baghdad. They were swiftly released, and the case against them dropped. It is hard to curb Iranian influence. For its part, Iran stood behind al-Kadhimi’s nomination despite him being perceived as pro-Western. Tehran needed to avoid an anti-Iranian backlash on the streets of Baghdad if it had stood against him. Instead, Iran’s calculus was that it is in its best interest to swallow the pill and work with the new government at a time when Iraqi anger was targeted against US involvement rather than at Iranian interference. Prior to the US assassination of Qassem al-Suleimani and Abu Mahdi al-Muhandis on Iraqi soil, Iraqis were rebelling against Iran’s influence. That being said, Iran will maintain pressure on Iraq through continued attacks on US interests there (Table A1 in Appendix). This is also reflected in the July assassination of top Iraqi security expert Hisham al-Hashimi, who had previously advised the government on how to curb Iranian control. Iran was looking to make it to the US election in November without an escalation in tensions, hoping the US elections will result in a more dovish Democratic Party leadership averse to conflict with Iran. However, recent cyber-attacks on key Iranian infrastructure raise the likelihood that tensions will escalate ahead of the elections. The US is also threatening to maintain maximum sanctions even if the United Nations Security Council disagrees. As always, Iraq will find itself in the crossfire of any deterioration in relations. Bottom Line: Maintaining a cooperative relationship with Iraq aligns with both of Saudi Arabia’s interests there: limiting Iranian interference and supporting global oil markets through supply-side discipline. Iran will maintain pressure on Iraq’s new government through continued attacks on US interests. However, these attacks are supposed to fall short of killing US citizens and giving President Trump a reason to launch air strikes that could give him a patriotic boost in opinion polls. Nevertheless, tensions in the Gulf could escalate if Iran stages a major attack or if President Trump’s poor election prospects force him to “wag the dog.” In that case Iraqi oil supply would be disrupted. Investment Implications The Shia Crescent remains at heightened risk of instability on the back of Iran’s economic deterioration. Massive excess oil capacity will mute the oil market impact of a supply shortfall in Iraq. However, the risk becomes more relevant as demand recovers and markets rebalance in the second half of the year. Given that the Saudi loan will ensure Iraq’s commitment to compensatory production cuts in August and September, supply-side risks are a tailwind to oil prices in H2. The elevated risk of an escalation in US-Iran tensions also favors holding gold. President Trump’s polling has bottomed, yet he remains the underdog in the election – we maintain his odds of winning reelection are 35%. This raises the risk that he adopts a “war president” posture. Iran could become a target as the financial price of confronting Iran is negligible for Trump, whereas a major China confrontation could sink the stock market. The collapse in oil prices and pandemic have weighed on Saudi Arabia’s budget. It has adopted a revenue over growth posture. While this could be a risk to domestic stability, our base case is that it accelerates the kingdom’s long-term reforms. The oil market rout and economic downturn will hurt other countries in the region that are leveraged to Arab petro states – chiefly Egypt and Jordan. Investors should monitor risks to state stability in the coming years. Lebanon’s crisis will incentivize emigration, but given the relatively small size of its population, the major risk to Europe comes from any broader state failures and Middle Eastern instability rather than from Lebanon’s failure alone. If the Democratic Party wins the US election, as expected, then the US-Iran strategic détente will resume and Iran will get a lifeline. But the immediate transition will still be rocky given the Israeli and Saudi desire to exploit Iran’s extreme vulnerability and build leverage with Washington. The COVID-19 crisis heralds another round of Middle Eastern crisis, much as the 2008 crisis led to the Arab Spring. Stay strategically long Brent crude oil and gold. Also, in the wake of yesterday’s 15% pullback in silver, go strategically long silver (XAGUSD), which will continue benefiting from the same structural trends favoring gold but also outperform gold as the global economy recovers, given its greater industrial utility.     Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com       Appendix Table A1Iran Adopting Deterrence Strategy In Iraq   Footnotes 1     Berri is of the Hezbollah-allied Amal Movement and has been parliamentary speaker since 1992, while Bassil is President Aoun’s son-in-law and president of the Free Patriotic Movement, which has the most seats in parliament. 2     Hezbollah gains legitimacy at home through its charity work that plugs the gap in services normally provided for by the government. 3    According to a commander of an Iran-backed paramilitary group in Iraq, Iran slashed its monthly funding to the top four militias by nearly half this year. Please see “Coronavirus and sanctions hit Iran’s support of proxies in Iraq,” Reuters, July 2, 2020. 4    Hezbollah has gained control over the foreign policy and Lebanon has recently taken stances that are seen as bowing to Iranian pressure. Lebanon did not attend a March 22, 2018 extraordinary Arab League meeting discussing violations committed by Iran. Prior to that, Beirut did not condemn Iranian attacks on a Saudi diplomatic mission in Tehran. 5    However an undisclosed facility for processing uranium ore in the northeast of the kingdom has recently appeared. 6    This is not unlike the US’s decision to extend sanction waivers by four months, allowing Baghdad to import Iranian energy in order to ensure that the new government of Prime Minister Mustafa al-Kadhimi can stand on its own and is not overly dependent on Iran.