War/Conflict

Highlights The US dollar’s reserve status will remain intact for the foreseeable future. While this privilege is fraying at the edges, there are no viable alternatives just yet. There is an overarching incentive for any country to hold onto its currency’s power. For the US, it is still well within their ability to keep this “exorbitant privilege.” That said, there will be rolling doubts about the ability of the US to maintain its large currency sphere. This will create tidal waves in the currency’s path, providing plenty of trading opportunities for investors. China is on track to surpass the US in economic size, but it is far from dethroning the US in the military realm. However, it is gradually gaining the ability to deny the US access to its immediate offshore areas and may already be capable of winning a war over nearby islands like Taiwan. Watch the RMB over the next few decades. From a macro and cyclical perspective, the dollar is likely to decline as global growth picks up and the Fed lags market expectations in raising rates. From a geopolitical perspective, however, the backdrop is neutral-to-bullish for the dollar over the next three to five years. Feature Having the world’s reserve currency comes with a few advantages, which any governments would be loath to give up. The most important advantage is the ability to settle one’s balance of payments in one’s own currency. This not only facilitates trade for the reserve nation, it also reinforces the turnover of the reserve currency internationally. The value of this privilege is as much symbolic as economic. This “first mover advantage” or adoption of one’s currency internationally automatically ordains the resident central bank as the world’s bank. The primary advantage here is being able to dictate global financial conditions, expanding and contracting money supply to address domestic and global funding pressures. As compensation for this task, the world provides one with non-negligible seigniorage revenue. Being the world’s central bank also comes with another crucial advantage: being able to choose which international projects will be funded, while using cheaply issued local debt to finance these investments. Of course, any sensible society will earn more on its investments than it pays on the debt issued. There is a geopolitical angle to having the world’s reserve currency. A nation’s currency is widely held because of strategic depth—its ability to secure the people who trade in that currency and the property denominated in it. Deposits and transactions can be monitored, secured, or even halted at the behest of the sovereign. Holding the currency means one can maintain one’s purchasing power, given that it is backed by the most powerful country in the world. As the reserve currency becomes the de facto international medium of exchange, having stood the test of time through various crises, this allows the resident country to alter its purchasing power to achieve both national and international goals. Throughout history, having the world’s reserve currency has been the pursuit of many governments and kingdoms. In the current paradigm, the US enjoys this privilege. But could that change? And if so, how and when? Our goal in this report is threefold. First, why would any country want to maintain reserve status? Second, does the US still possess the apparatus to keep the dollar as a reserve asset over the next decade? And finally, are there any identifiable threats to the US dollar reserve status beyond a ten-year horizon? The Imperative To Maintain Status Quo Global trade is still largely conducted in US dollars. According to the BIS triennial central bank survey, 88.3% of transactions globally were in dollars just before the pandemic, a percentage that has been rather resilient over the last two decades (Chart I-1). It is true that currencies such as the Chinese renminbi have been gaining international acceptance, but displacing a currency that dominates almost 90% of global transactions is a herculean task. Surprisingly, the world has been transacting less often in euros and Japanese yen, currencies that also commanded international appeal in recent history. Chart I-1The US Dollar Still Dominates Global Transactions Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? The big benefit for the US comes from being able to settle its balance of payments in dollars. This not only lowers transaction costs (by lowering exchange rate risk), but it also provides the ability to cheaply borrow in your own currency to pay for imports. Having global trade largely denominated in US dollars also establishes a network of systems that make it much easier to settle trade in that currency. It is remarkable that, despite running a persistent current account deficit, the US dollar has tended to appreciate during crises, a privilege other deficit countries do not enjoy (Chart I-2). Strong network effects make the US dollar the currency of choice during crises. Chart I-2Despite Running A Current Account Deficit, The Dollar Tends To Rise During Crises Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Chart I-3The US Generates Non-Negligible Seignorage Revenue The US Generates Non-Negligible Seignorage Revenue The US Generates Non-Negligible Seignorage Revenue Being at the center of the global financial architecture comes with an important benefit beyond trade: the ability to dictate financial conditions both domestically and globally. Consider a scenario in which the US and the global economy are facing a downturn. In this scenario, the Federal Reserve can be instrumental in turning the tide: To stimulate the US economy, the Fed lowers interest rates and/or runs a wider fiscal deficit. The central bank helps finance this fiscal deficit by expanding the monetary base (benefitting from seigniorage revenue). As the Fed drops interest rates, the yield curve steepens. Banks use the positive term structure to borrow at the short end of the curve and lend at the longer end. This boosts the US money supply. As firms borrow to invest, this increases demand for imports (machinery, commodities, consumer goods), widening the US current account deficit. US trade is settled in dollars, increasing the international supply of the greenback. To maintain competitiveness, other central banks purchase these dollars from the private sector, in exchange for their local currency. As global USD reserves rise, they can be reinvested back into Treasuries and held in custody at the Fed. In essence, the US can finance its budget deficit through a strong capital account surplus. The seigniorage revenue that the US enjoys by easing both domestic and international financing conditions is about $100 billion a year or roughly 0.5% of GDP (Chart I-3). But the goodwill from being able to dictate both domestic and international financial conditions is far greater. At BCA, one of our favorite measures of global dollar liquidity is the sum of the Fed’s custody holdings together with the US monetary base. Every time this measure has severely contracted in the past, the shortage of dollars has triggered a financial crisis somewhere, typically among other countries running deficits (Chart I-4), a highlight of the importance of the US as a global financier. Chart I-4US Money Supply And Global Liquidity US Money Supply And Global Liquidity US Money Supply And Global Liquidity Chart I-5Despite A Liability Shortfall, US Assets Generate A Net Profit Despite A Liability Shortfall, US Assets Generate A Net Profit Despite A Liability Shortfall, US Assets Generate A Net Profit Beyond seigniorage revenue, the US enjoys another advantage—being able to earn much more on its international investments than it pays on its liabilities. The US generates an excess return of 1% of GDP from its external assets, despite having a net liability shortfall of 67% of GDP (Chart I-5). The ability to issue debt that will be gobbled up by foreigners, and in part use these proceeds to generate a higher overall return on investments made abroad, does indeed constitute an “exorbitant privilege.” In a nutshell, there is a very strong incentive for the US to keep the dollar as the world’s reserve currency. One short-term implication is that the Fed might only taper asset purchases and/or raise interest rates in an environment in which both global and US growth are strong, or it could otherwise trigger a global liquidity crisis. This will be particularly the case given the Delta variant of COVID-19 is still hemorrhaging global economic activity. An Overreach In The Dollar’s Influence There is a political advantage to the US dollar’s reserve status that is often overlooked: transactions conducted in US dollars anywhere in the world fall under US law. In simple terms, if a company in any country buys energy from Iran and the transaction is done in US dollars, the Treasury has powers to sanction the parties involved. Since most companies across the world cannot afford to be locked out of the US financial system, they will tend to comply with US sanctions. Even companies that operate under the umbrella of great powers, such as China and Russia, still tend to adhere to US sanctions, because they do not want to jeopardize their trade with US allies, such as the European Union. Of course, China, Russia, and Iran are actively seeking alternative transaction systems to bypass the dollar and US sanctions. But they do not yet trust each other’s currencies. Chart I-6A Deep And Liquid Pool Of Treasurys A Deep And Liquid Pool Of Treasurys A Deep And Liquid Pool Of Treasurys The euro is the only viable alternative; however, the euro’s share of global transactions has fallen, despite the EU’s solidification as a monetary union over the past decade and despite the unprecedented deterioration of US relations with China and Russia. The EU could do great damage to the USD’s standing if it joined Russia’s and China’s efforts wholeheartedly, but the EU is still a major trading partner of the US and shares many of the same foreign policy aims. It is also chronically short of aggregate demand and runs trade and current account surpluses, depriving trade partners of euro savings or a debt market to recycle those savings (Chart I-6). Historically, having the world’s reserve currency allows the US to conduct international accords that serve both domestic and foreign interests. The Plaza Accord, signed in the 1980s to depreciate the US dollar, served both US interests in rebalancing the deficit and international interests in financing global trade. The 1980s were golden years for Japan and the Asian tigers on the back of a weak USD, allowing entities to borrow in greenbacks and profitably invest in Asian growth. Once the US dollar had depreciated by a fair amount, threatening its store of value, the US engineered the Louvre Accord to stabilize exchange rates. Ultimately, when various Asian bubbles popped, investors thought of nowhere better to flee than to the safety of the US dollar. The same thing happened after the emerging market boom of the 2000s and the eventual bust of the 2010s. Today, the US may not be able to organize an international intervention, if one should be necessary in the coming years. Past experience shows that countries act unilaterally and coordinated interventions lack staying power. Neither Europe nor Japan is in the position today to allow currency appreciation, as they were in the past. And the US has shown itself unable to combat its trading partners’ depreciation, as in the case of China, whose renminbi remains below 2014 levels. The bottom line is that there is nothing to stop the US from attempting to stretch its overreach too far, which would create a backlash that diminishes the dollar’s status. This is especially the case given trust in the US government is quite low by historical standards, which for now points to a lower dollar cyclically (Chart I-7). Chart I-7Trust In The US Government And The Dollar Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? This is not to say that other countries with reserve aspirations can tolerate sustained appreciation. China has recommitted to manufacturing supremacy in its latest five-year plan, as it fears the political consequences of rapid deindustrialization. As such, the renminbi will be periodically capped to maintain competitiveness. Can The US Maintain Status Quo? Chart I-8A Lifespan Of Reserve Currencies Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Over the last few centuries, reserve currencies have tended to have a lifespan of about 100 years (Chart I-8). The reason is that global wars tend to knock the leading power off its geopolitical pedestal, devaluing its currency and giving rise to a new peace settlement with a new ascendant country whose currency then becomes the basis for international trade. Such was the case for Spain, France, the UK, and the United States in a pattern of war and peace since the sixteenth century. Granting that the US dollar took the baton from sterling in the 1920s and that the post-World War II peace settlement is eroding in the face of escalating geopolitical competition, it is reasonable to ask whether or not the US might lose its grip on this power. To assess this possibility, it is instructive to revisit the anatomy of a reserve currency: Typically, a reserve currency tends to be that of the “greatest” nation. For the same reason, the reserve nation tends to be the wealthiest, which ensures that its currency is a store of value and that it can act as a buyer of last resort during crisis (Chart I-9). This reasoning is straightforward when a global empire is recognizable and unopposed. But in the current context of multipolarity, or great power competition, the paradigm could start to shift. Global trade is slowing globally, but it is accelerating in Asia (Chart I-10). China is a larger trading partner than the US for many emerging markets and is slated to surpass the US economy over the next decade. The renminbi has a long way to go to rival the dollar, but it is gradually rising and its place within the global reserve currency basket is much smaller than its share of global trade or output, implying room for growth (Chart I-11). Chart I-9Wealth And Reserve Currency Status Go Hand-In-Hand Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Chart I-10Trade In Asia Is Booming Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Chart I-11Adoption Of The RMB Has Room To Grow Adoption Of The RMB Has Room To Grow Adoption Of The RMB Has Room To Grow To maintain hegemonic power (especially controlling the vital supply routes of prosperity), the reserve nation needs military might above and beyond everyone else. It helps that US military spending remains the biggest in the world, in part financed by US liabilities (Chart I-12). China is far from dethroning the US in the military realm. But it is gradually gaining the ability to deny the US access to its immediate offshore areas and may already be capable of winning a war over nearby islands like Taiwan. Moreover, its naval power is set to grow substantially between now and 2030 (Table I-1). Already, over the past decade, the US stood helplessly by when Russia and China annexed Crimea and the reefs of the South China Sea. It is possible to imagine a series of events that erode US security guarantees in the region, even as the US loses economic primacy. Chart I-12The US Still Maintains Military Might Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Table I-1China’s Economic And Naval Growth Slated To Reduce American Primacy In Asia Pacific Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? The reserve currency nation needs to run deficits to finance activity in the rest of the world. That requires having deep and liquid capital markets to absorb global savings. There is considerable trust or “goodwill” that makes the US Treasury market the most liquid debt exchange pool in the world. This remains the case today (previously mentioned Chart I-6). Even so, this trend is shifting. The growth in euro- and yen-denominated debt is exploding. This mirrors the gradual shift in the allocation of FX reserves away from dollars into other currencies. If the US began to use the dollar as a geopolitical weapon recklessly, foreign entities may have no other choice but to rally into other currency blocks, including the euro (and perhaps eventually the yuan). This will take years, but it is worth noting that global allocation to FX reserves have fallen from around 80% toward USDs in the 70s to around 60% today (Chart I-13). Chart I-13The Dollar Reserve Status Has Been Ebbing The Dollar Reserve Status Has Been Ebbing The Dollar Reserve Status Has Been Ebbing On the political front, there is some evidence that public opinion on the dollar is fading, although it is far from damning. A Pew survey on the trust in the US government is near decade lows and has tracked the ebb and flow of changes in the dollar (previously shown Chart I-7). Trust in government will probably not get much worse in the coming years, as the pandemic will wane and stimulus will secure the economic recovery, but too much stimulus could conceivably ignite an inflation problem that weighs on trust. True, populism has driven the US government under two administrations into extreme deficit spending. With the pandemic as a catalyst, US deficits have reached WWII levels despite the absence of a war. However, the Biden administration’s $3.5 trillion spending bill will be watered down heavily – and the 2022 midterms will likely restore gridlock in Congress, freezing fiscal policy through at least 2025. In other words, fiscal policy is negative for the dollar in the very near term, but the fiscal outlook is not yet so extravagant as to suggest a loss of reserve currency status. After all, there is some positive news for the US. The US demonstrated its leadership in innovation with the COVID-19 vaccines; it survived its constitutional stress test in the 2020 election; it is now shifting from failed “nation building” abroad to nation building at home; and its companies remain the most innovative and efficient, judging by global equity market capitalization (Chart I-14). China, meanwhile, is facing the most severe test of its political and economic system since it marketized its economy in 1979. Investors should not lose sight of the fact that, since the rise of President Xi Jinping and Russia’s invasion of Ukraine, global policy uncertainty has tended to outpace US policy uncertainty, attracting flows into the dollar (Chart I-15). Given that China and Russia are both pursuing autocratic governments at the expense of the private economy, it would not be surprising to see global policy uncertainty take the lead once again, confirming the decade trend of global flows favoring the US when uncertainty rises. Chart I-14American Primacy Still Clear In Equity Market American Primacy Still Clear In Equity Market American Primacy Still Clear In Equity Market Chart I-15Higher Policy Uncertainty Good For Dollar Higher Policy Uncertainty Good For Dollar Higher Policy Uncertainty Good For Dollar The bottom line is that the US dollar is gradually declining as a share of the global currency reserve basket, just as the US economy and military are gradually declining as a share of global output and defense spending. Yet the US will remain the first or second largest economy and premier military power for a long time, and the dollar still lacks a viable single replacement. A major war or geopolitical crisis is probably necessary to precipitate a major breakdown. The Iranian Revolution and September 11 attacks both had this kind of effect (see 1979 and 2001 in Chart I-13 above). But COVID-19 is less clear. If China and Europe emerge as more stable than the US, then the post-pandemic aftermath will bring more bad news for the dollar. Investment Implications From a geopolitical perspective, the backdrop is neutral for the dollar beyond the next twelve to eighteen months. An escalating conflict with Iran—which is possible in the near term—would echo the early 2000s and weigh on the currency. But a deal with Iran and a strategic pivot to Asia would compound China’s domestic political problems and likely boost the greenback. Chart I-16US Twin Deficits And The Dollar US Twin Deficits And The Dollar US Twin Deficits And The Dollar From a macro and cyclical perspective, however, the view is clearly negative for the dollar. Over the next five years, the U.S. Congressional Budget Office (CBO) estimates that the U.S. budget deficit will shrink and then begin expanding again to -5% of GDP. If one assumes that the current account deficit will widen somewhat, then stabilize, the twin deficits will be pinned at around -10% of GDP. Markets have typically punished the dollar on rising twin deficits (Chart I-16). This suggests near-term pressure on the dollar’s reserve status is to the downside. EM currencies may hold a key to the performance of the dollar. While most EM economies remain hostage to the virus, a coiled-spring rebound cannot be ruled out as populations become vaccinated. China’s Politburo signaled in July that it will no longer tighten monetary and fiscal policy. We would expect policy easing over the next twelve months to ensure the economy is stable in advance of the fall 2022 party congress. If the virus wanes and China’s economy is stimulated, global growth will improve and the dollar will fall.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com

Highlights Commodity markets will face growing supply challenges over the next decade as the US and China prepare for war, if only to deter war. Chinese President Xi Jinping's push for greater self-reliance at home and supply chain security abroad is reinforced by the West’s focus on the same interests. The erosion of a single rules-based global trade system increases the odds of economic and even military conflict. The competition for security is precipitating a reforging of global supply chains and a persistent willingness to use punitive measures, which can escalate into boycotts, embargoes, and even blockades (i.e. not only Huawei). The risk of military engagements will rise, particularly along global chokepoints and sea lanes needed to transport vital commodities. Import dependency and supply chain risk are powerful drivers of decarbonization efforts, especially in China. On net, geopolitical trends will keep the balance of commodity-price risks tilted to the upside. Commodity and Energy Strategy remains long commodity index exposure on a strategic basis via the S&P GSCI and the COMT ETF.  Note: Even in the short term, a higher geopolitical risk premium is warranted in oil prices due to US-Iran conflict. Feature The Chinese Communist Party (CCP) under President Xi Jinping has embarked on a drive toward autarky, or economic self-sufficiency, that has enormous implications, especially for global commodities. Beijing believes it can maintain central control, harness technology, enhance its manufacturing prowess, and grow at a reasonable rate, all while bulking up its national security. The challenge is to maintain social stability and supply security through the transition. China lives in desperate fear of the chaos that reigned throughout most of the twentieth and twenty-first centuries, which also enabled foreign domination (Chart 1). The problem for the rest of the world is that Chinese nationalism and assertive foreign policy are integral aspects of the new national strategy. They are needed to divert the public from social ills and deter foreign powers that might threaten China’s economy and supply security. Chart 1China Fears Any Risk Of Another ‘Century Of Humiliation’ US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand The chief obstacle for China is the United States, which remains the world leader even though its share of global power and wealth is declining over time. The US is formally adopting a policy of confrontation rather than engagement with China. For example, the Biden administration is co-opting much of the Trump administration's agenda. Infrastructure, industrial policy, trade protectionism, and the “pivot to Asia” are now signature policies of Biden as well as Trump (Table 1).1 Table 1US Strategic Competition Act Highlights Return Of Industrial Policy, Confrontation With China US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand Many of these policies are explicitly related to the strategic aim of countering China’s rise, which is seen as vitiating the American economy and global leadership. Biden’s Trump-esque policies are a powerful indication of where the US median voter stands and hence of long-term significance (Chart 2). Thus competition between the US and China for global economic, military, and political leadership is entering a new phase. China’s drive for self-reliance threatens the US-led global trade system, while the US’s still-preeminent geopolitical power threatens China’s vital lines of supply. Chart 2US Public’s Fears Are China-Centric US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand Re-Ordering Global Trade The US’s and China’s demonstrable willingness to use tariffs, non-tariff trade barriers, export controls, and sanctions cannot be expected to abate given that they are locked in great power competition (Chart 3). More than likely, the US and China will independently pursue trade relations with their respective allies and partners, which will replace the mostly ineffective World Trade Organization (WTO) framework. The WTO is the successor to the rules-based and market-oriented system known as the General Agreement on Tariffs and Trade (GATT), which was formed following World War II. The GATT’s founders shared a strong desire to avoid a repeat of the global economic instability brought on by World War I, the Great Crash of 1929, and the retreat into autarky and isolationism that led to WWII. Chart 3US and China Imposing Trade Restrictions US and China Imposing Trade Restrictions US and China Imposing Trade Restrictions This inter-war period saw domestically focused monetary policies and punishing tariffs that spawned ruinous bouts of inflation and deflation. Minimizing tariffs, leveling the playing field in trading markets, and reducing subsidization of state corporate champions were among the GATT's early successes. The WTO, like the GATT before it, has no authority to command a state to change its economy or the way it chooses to organize itself. At its inception the GATT's modus vivendi was directed at establishing a rules-based system free of excessive government intrusion and regulation. If governments agreed to reduce their domestic favoritism, they could all improve their economic efficiency while avoiding a relapse into autarky and the military tensions that go with it.2 The prime mover in the GATT's founding and early evolution – the USA – firmly believed that exclusive trading blocs had created the groundwork for economic collapse and war. These trading blocs had been created by European powers with their respective colonies. During the inter-war years the revival of protectionism killed global trade and exacerbated the Great Depression. After WWII, Washington was willing to use its power as the global hegemon to prevent a similar outcome. Policymakers believed that European and global economic integration would encourage inter-dependency and discourage protectionism and war. The fall of the Soviet Union reinforced this neoliberal Washington Consensus. Countries like India and China adopted market-oriented policies. The WTO was formed along with a range of global trade deals. Ultimately the US and the West cleared the way for China to join the trading bloc, hoping that the transition from communism to capitalism would eventually be coupled with social and even political liberalization. The world took a very different turn as the United States descended into a morass of domestic political divisions and foreign military adventures. China seized the advantage to expand its economy free of interference from the US or West. The West failed to insist that liberal economic reforms keep pace.3 Moreover, when China joined the WTO in 2001, the organization was in a state of "regulatory stalemate," which made it incapable of dealing with the direct challenges presented by China.4 Today President Xi has consolidated control over the Communist Party and directs its key economic, political, and military policymaking bodies. He has deepened party control down to the management level of SOEs – hiring and firing management. SOEs have benefited from Xi’s rule (Chart 4). But now the West is also reasserting the role of the state in the economy and trade, which means that punitive measures can be brought to bear on China’s SOEs. Chart 4State-Owned Enterprises Benefit From Xi Administration State-Owned Enterprises Benefit From Xi Administration State-Owned Enterprises Benefit From Xi Administration What Comes After The WTO? The CCP has shown no interest in coming around to the WTO's founding beliefs of government non-interference in the private sector. For example, it is doubling down on subsidization and party control of SOEs, which compete against firms in other WTO member states. Nor has the party shown any inclination to accept a trade system based on the GATT/WTO founding members' Western understanding of the rule of law. These states represent market-based economies with long histories of case law for settling disputes. Specifically, China’s fourteenth five-year plan and recent policies re-emphasize the need to upgrade the manufacturing sector rather than rebalancing the economy toward household consumption. The latter would reduce imbalances with trade deficit countries like the US but China is wary of the negative social consequences of too rapidly de-industrializing its economy. It wants to retain its strategic and economic advantage in global manufacturing and it fears the social and political consequences of fully adopting consumer culture (Chart 5). Chart 5China’s Economic Plans Re-Emphasize Manufacturing, Not Consumption US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand The US, EU, and Japan have proposed reform measures for the WTO aimed at addressing “severe excess capacity in key sectors exacerbated by government financed and supported capacity expansion, unfair competitive conditions caused by large market-distorting subsidies and state owned enterprises, forced technology transfer, and local content requirements and preferences.”5 But these measures are unlikely to succeed. China disagrees with the West’s characterization. In 2018-19, during the trade war with the US, Beijing contended that WTO members must “respect members’ development models.” China formally opposes “special and discriminatory disciplines against state-owned enterprises in the name of WTO reform.”6 In bilateral negotiations with the US this year, China’s first demand is that the US not to oppose its development model of “socialism with Chinese characteristics” (Table 2). Table 2China’s Three Diplomatic Demands Of The United States (2021) US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand Yet it is hard for the US not to oppose this model because it involves Beijing using the state’s control of the economy to strengthen national security strategy, namely by the fusion of civil and military technology. Going forward, the Biden administration will violate the number one demand that Chinese diplomats have made: it will attempt to galvanize the democracies to put pressure on China’s development model. China’s demand itself reflects its violation of the US primary demand that China stop using the state to enhance its economy at the expense of competitors. If a breakdown in global trading rules is replaced by the US and China forming separate trading blocs with their allies and partners, the odds of repeating the mistakes of the inter-bellum years of 1918-39 will significantly increase. Tariff wars, subsidizing national champions, heavy taxation of foreign interests, non-tariff barriers to trade, domestic-focused monetary policies, and currency wars would become more likely. China’s Strategic Vulnerability The CCP has delivered remarkable prosperity and wealth to the average Chinese citizen in the 43 years since it undertook market reforms, and especially since its accession to the WTO in 2001 (Chart 6). China has transformed from an economic backwater into a $15.4 trillion (2020) economy and near-peer competitor to the US militarily and economically.7 This growth has propelled China to the top of commodity-importing and -consuming states globally for base metals and oil. We follow these markets closely, because they are critical to sustaining economic growth, regardless of how states are organized. Production of and access to these commodities, along with natural gas, will be critical over the next decade, as the world decarbonizes its energy sources, and as the US and China address their own growth and social agendas while vying for global hegemony. Decarbonization is part of the strategic race since all major powers now want to increase economic self-sufficiency and technological prowess. Chart 6CCPs Remarkable Success In Growing Chinas Economy CCPs Remarkable Success In Growing Chinas Economy CCPs Remarkable Success In Growing Chinas Economy Over recent decades China has become the largest importer of base metals ores (Chart 7) and the world's top refiner of many of these metals. In addition, it is the top consumer of refined metal (Chart 8). Chart 7China Is World’s Top Ore Importer US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand Chart 8China Is Worlds Top Refined Metal Consumer China Is Worlds Top Refined Metal Consumer China Is Worlds Top Refined Metal Consumer By contrast, the US is not listed among ore importers or metals consumers in the Observatory of Economic Complexity (OEC) databases we used to map these commodities. This reflects not only domestic supplies but also the lack of investment and upgrades to the US's critical infrastructure over 2000-19.8 Going forward, the US is trying to invest in “nation building” at home. An enormous change has taken shape in strategic liabilities. In the oil market, the US went from being the world's largest importer of oil in 2000, accounting for more than 24% of imports globally, to being the largest oil and gas producer by 2019, even though it still accounted for more than 12% of the world's imports (Chart 9). In 2000, China accounted for ~ 3.5% of the world's oil imports and by 2019 it was responsible for nearly 21%. China is far behind per capita US energy consumption, given its large population, but it is gradually closing the gap (Chart 10). Overall energy consumption in China is much higher than in the US (Chart 11). Chart 9US Oil Imports Collapse As Shale Production Grows US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand Chart 10Energy Use Per Capita In China Far From US Levels... Energy Use Per Capita In China Far From US Levels... Energy Use Per Capita In China Far From US Levels... Chart 11China Is World’s Largest Primary Energy Consumer US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand China's impressive GDP growth in the twenty-first century is primarily responsible for China's stunning growth in imports and consumption of oil (Chart 12) and copper (Chart 13), which we track closely as a proxy for the entire base-metals complex. Chart 12Global Oil Demand Forecast Remains Steady Chinas GDP Drives Oil Consumption, Imports Global Oil Demand Forecast Remains Steady Chinas GDP Drives Oil Consumption, Imports Global Oil Demand Forecast Remains Steady Chinas GDP Drives Oil Consumption, Imports Chart 13Global Oil Demand Forecast Remains Steady Chinas GDP Drives Refined Copper Consumption And Ore Imports Global Oil Demand Forecast Remains Steady Chinas GDP Drives Refined Copper Consumption And Ore Imports Global Oil Demand Forecast Remains Steady Chinas GDP Drives Refined Copper Consumption And Ore Imports China’s importance in these markets points to an underlying strategic weakness, which is its dependency on imports. This in turn points to the greatest danger of the breakdown in US-China relations and the global trade system. The Road To War? China is extremely anxious about maintaining supply security in light of these heavy import needs. Its pursuit of economic self-sufficiency, including decarbonization, is driven by its fear of the US’s ability to cut off its key supply lines. China’s first goal in modernizing its military in recent years was to develop a naval force capable of defending the country from foreign attack, particularly in its immediate maritime surroundings. Historically China suffered from invaders across the sea who took advantage of its weak naval power to force open its economy and exploit it. Today China is thought to have achieved this security objective. It is believed to have a high level of capability within the “first island chain” that surrounds the coast, from the Korean peninsula to the Spratly Islands, including southwest Japan and Taiwan (Map 1).9 China’s militarization of the South China Sea, suppression of Hong Kong, and intimidation of Taiwan shows its intention to dominate Greater China, which would put it in a better strategic position relative to other countries. Map 1China’s Navy Likely Achieved Superiority Within The First Island Chain US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand China’s capability can be illustrated by comparing its naval strength to that of the United States, the most powerful navy in the world. While the US is superior, China would be able to combine all three of its fleets within the first island China, while the US navy would be dispersed across the world and divided among a range of interests to defend (Table 3). China would also be able to bring its land-based air force and missile firepower to bear within the first island chain, as opposed to further abroad.10 Table 3China’s Naval Growth Enables Primacy Within First Island Chain US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand In this sense China is militarily capable of conquering Taiwan or other nearby islands. President Xi Jinping had in fact ordered China’s armed forces be capable of doing so by 2020.11 Taiwan continues to be the most significant source of insecurity for the regime. True, a military victory would likely be a pyrrhic victory, as Taiwan’s wealth and tech industry would be destroyed, but China probably has the raw military capability to defeat Taiwan and its allies within this defined space. However, this military capability needs to be weighed against economic capability. If China seized military control of Taiwan, or Okinawa or other neighboring territories, the US, Japan, and their allies would respond by cutting off China’s access to critical supplies. Most obviously oil and natural gas. China’s decarbonization has been impressive but the reliance on foreign oil is still a fatal strategic vulnerability over the next few years (Chart 14). China is rapidly pursuing a Eurasian strategy to diversify away from the Middle East in particular. But it still imports about half its oil from this volatile region (Chart 15). The US navy is capable of interdicting China’s critical oil flows, a major inhibition on China’s military ambitions within the first island chain. Chart 14Chinas Energy Diversification Still Leaves Vulnerabilities Chinas Energy Diversification Still Leaves Vulnerabilities Chinas Energy Diversification Still Leaves Vulnerabilities Of course, if the US and its allies ever blockaded China, or if China feared they would, Beijing could be driven to mount a desperate attack to prevent them from doing so, since its economic, military, and political survival would be on the line. Chart 15China Still Dependent On Middle East Energy Supplies China Still Dependent On Middle East Energy Supplies China Still Dependent On Middle East Energy Supplies The obvious historical analogy is the US-Japan conflict in WWII. Invasions that lead to blockades will lead to larger invasions, as the US and Japan learned.12 However, the lesson from WWII for China is that it should not engage the US navy until its own naval power has progressed much further. In the event of a conflict, the US would be imposing a blockade at a distance from China’s naval and missile forces. When it comes to the far seas, China’s naval capabilities are extremely limited. Military analysts highlight that China lacks a substantial naval presence in the Indian Ocean. China relies on commercial ports, where it has partial equity ownership, for ship supply and maintenance (Table 4). This is no substitute for naval basing, because dedicated military facilities are lacking and host countries may not wish to be drawn into a conflict. Table 4China’s Network Of Part-Owned Ports Across The World: Useful But Not A Substitute For Military Bases US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand Further, Beijing lacks the sea-based air power necessary to defend its fleets should they stray too far. And it lacks the anti-submarine warfare capabilities necessary to defend its ships.13 These capabilities are constantly improving but at the moment they are insufficient to overthrow US naval control of the critical chokepoints like the Strait of Hormuz or Strait of Malacca. While China’s naval power is comparable to the US’s Asia Pacific fleet (the seventh fleet headquartered in Japan), it is much smaller than the US’s global fleet and at a much greater disadvantage when operating far from home. China’s navy is based at home and focused on its near seas, whereas US fleet is designed to operate in the far seas, especially the Persian Gulf, which is precisely the strategic area in question (Chart 16).14 China is gradually expanding its navy and operations around the world, so over time it may gain the ability to prevent the US from cutting off its critical supplies in the Persian Gulf. But not immediately. The implication is that China will have to avoid direct military conflict with the United States until its military and naval buildup has progressed a lot further. Chart 16China’s Navy At Huge Disadvantage In Distant Seas US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand Meanwhile Beijing will continue diversifying its energy sources, decarbonizing, and forging supply chains across Eurasia via the Belt and Road Initiative. What could go wrong? We would highlight a few risks that could cause China to risk war even despite its vulnerability to blockade: Chart 17China’s Surplus Of Males Undergirds Rise In Nationalism US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand Domestic demographic pressure. China is slated to experience a dramatic bulge in the male-to-female ratio over the coming decade (Chart 17).15 A surfeit of young men could lead to an overshoot of nationalism and revanchism. This trend is much more important than the symbolic political anniversaries of 2027, 2035, and 2049, which analysts use to predict when China’s military might launch a major campaign. Domestic economic pressure. China’s turn to nationalism reflects slowing income growth and associated social instability. An economic crisis in China would be worrisome for regional stability for many reasons, but such pressures can lead nations into foreign military adventures. Domestic political pressure. China has shifted from “consensus rule” to “personal rule” under Xi Jinping. This could lead to faulty decision-making or party divisions that affect national policy. A leadership that carefully weighs each strategic risk could decay into a leadership that lacks good information and perspective. The result could be hubris and belligerence abroad. Foreign aggression. Attempts by the US or other powers to arm China’s neighbors or sabotage China’s economy could lead to aggressive reaction. The US’s attempt to build a technological blockade shows that future embargoes and blockades are not impossible. These could prompt a war rather than deter it, as noted above. Foreign weakness. China’s capabilities are improving over time while the US and its allies lack coordination and resolution. An opportunity could arise that China’s strategists believe they cannot afford to miss. Afghanistan is not one of these opportunities, but a US-Iran war or another major conflict with Russia could be. The breakdown in global trade is concerning because without an economic buffer, states may resort to arms to resolve disputes. History shows that military threats intended to discourage aggressive behavior can create dilemmas that incentivize aggression. The behavior of the US and China suggests that they are preparing for war, even if we are generous and assume that they are doing so only to deter war. Both countries are nuclear powers so they face mutually assured destruction in a total war scenario. But they will seek to improve their security within that context, which can lead to naval skirmishes, proxy wars, and even limited wars with associated risks of going nuclear. Investment Takeaways The pursuit of the national interest today involves using fiscal means to create more self-sufficient domestic economies and reduce international supply risks. Both China and the West are engaged in major projects to this end, including high-tech industrialization, domestic manufacturing, and decarbonization. These trends are generally bullish for commodities, even though they include trends like military modernization and naval expansion that could well be a prelude to war. War itself leads to commodity shortages and commodity price inflation, but of course it is disastrous for the people and economies involved. Fortunately, strategic deterrence continues to operate for the time being. The underlying geopolitical trend will put commodity markets under continual pressure. A final urgent update on oil and the Middle East: The US attempt to conduct a strategic “pivot” to Asia Pacific faces a critical juncture. Not because of Afghanistan but because of Iran. The Biden administration will have trouble unilaterally lowering sanctions on Iran after the humiliating Afghanistan pullout. The new administrations in both Iran and Israel are likely to establish red lines and credible threats. A higher geopolitical risk premium is thus warranted immediately in global oil markets. Beyond short-term shows of force, everything depends on whether the US and Iran can find a temporary deal to avoid the path to a larger war. But for now short-term geopolitical risks are commodity-bullish as well as long-term risks.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1     There are also significant differences between Biden and Trump in other areas such as redistribution, immigration, and social policy. 2     See Ravenhill, John (2020), Regional Trade Agreements, Chapter 6 in Global Political Economy, which he edited for Oxford University Press, particularly pp. 156-9. 3    “As time went by, the United States realized that Communism not only did not retreat, but also further advanced in China, with the state-owned economy growing stronger and the rule of the Party further entrenched in the process." See Henry Gao, “WTO Reform and China Defining or Defiling the Multilateral Trading System?” Harvard International Law Journal 62 (2021), p. 28, harvardilj.org.  4    See Mavroidis, Petros C. and Andre Sapir (2021), China and the WTO, Why Multilateralism Still Matters (Princeton University Press) for discussion.  See also Confronting the Challenge of Chinese State Capitalism published by the Center for Strategic & International Studies 22 January 2021. 5    Gao (2021), p. 19. 6    Gao (2021), p. 24. 7     Please see China's GDP tops 100 trln yuan in 2020 published by Xinhuanet 18 January 2021. 8    We excluded 2020 because of the COVID-19 pandemic's effects on supply and demand for these ores, metals and crude oil. 9    See Captain James Fanell, “China’s Global Navy Strategy and Expanding Force Structure: Pathway To Hegemony,” Testimony to the US House of Representatives, May 17, 2018, docs.house.gov. 10   Fanell (2018), p. 13. 11    He has obliquely implied that his vision for national rejuvenation by 2035 would include reunification with Taiwan. Others suggest that the country’s second centenary of 2049 is the likely deadline, or the 100th anniversary of the People’s Liberation Army. 12    The US was a major supplier of oil to Japan, and in 1941 it froze Japan's assets in the US and shut down all oil exports, in response to Japan's military incursion into China in the Second Sino-Japanese War of 1937-45.  Please see Anderson, Irvine H. Jr. (1975), "The 1941 De Facto Embargo on Oil to Japan: A Bureaucratic Reflex," Pacific Historical Review, 44:2, pp. 201-231.  13   See Jeffrey Becker, “Securing China’s Lifelines Across the Indian Ocean,” China Maritime Report No. 11 (Dec 2020), China Maritime Studies Institute, digital-commons.usnwc.edu. 14   See Rear Admiral Michael McDevitt, “Becoming a Great ‘Maritime Power’: A Chinese Dream,” Center for Naval Analyses (June 2016), cna.org. 15   For discussion see Major Tiffany Werner, “China’s Demographic Disaster: Risk And Opportunity,” 2020, Defense Technical Information Center, discover.dtic.mil.  

Highlights The chaotic US withdrawal from Afghanistan is symbolic – the US is conducting a strategic pivot to Asia Pacific to confront China. US-Iran negotiations are the linchpin of this pivot. If they fail, war risk will revive in the Middle East and the US will remain entangled in the region. At the moment, there is no deal, so investors should brace for a geopolitical risk premium in oil prices. That is, as long as global demand holds up despite COVID-19, and as long as the OPEC 2.0 cartel remains disciplined. We think they will in the short run. The US and Iran still have fundamental reasons to agree to a deal. If they do, the US will regain global room for maneuver while China’s and Russia’s window of opportunity will close. The implication is that markets face near-term oil supply risks – and long-term geopolitical risks due to Great Power rivalry in Eastern Europe and East Asia. Feature Events in Afghanistan have little macroeconomic significance but the geopolitical changes underway are profound and should be viewed through the lens of our second key view for 2021: the US strategic pivot to Asia. Chart 1The US Pivot To Asia Runs Through Iran Not Afghanistan The US Pivot To Asia Runs Through Iran Not Afghanistan The US Pivot To Asia Runs Through Iran Not Afghanistan As we go to press the Taliban is reconquering swathes of Afghanistan while US armed forces evacuate embassy staff and civilians. The chaotic scenes are reminiscent of the US’s humiliating flight from Saigon, Vietnam in 1975. As with Vietnam, the immediate image is one of American weakness but the reality over the long run is likely to be different. Over the past decade we have chronicled the US’s efforts to disentangle itself from wars of choice in the Middle East and South Asia. In accordance with US grand strategy, Washington is refocusing its attention on its rivalries with Russia and especially China, the only power capable of supplanting the US as a global leader (Chart 1). The US has struggled to conduct this “pivot to Asia” over the past decade but the underlying trajectory is clear: while trying to manage its strategic interests in the Middle East through naval power, the US will need to devote greater resources and attention to shoring up its economic and military ties in Asia Pacific (Map 1). The Middle East still plays a critical role – notably through China’s energy import needs – but primarily via the Persian Gulf. Map 1The US Seeks Balance In Middle East In Order To Pivot To Asia And Confront China Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China Thus the critical geopolitical risks today stem from Iran and the Middle East on one hand, and China on the other. They do not stem from the US’s belated and messy exit from Afghanistan, which has limited market relevance outside of South Asia. First, however, we will address the political impact in the United States. US Political Implications Chart 2Americans Agree With Biden And Trump On Exit From Afghanistan Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China American popular opinion has long turned against the “forever wars” in Iraq and Afghanistan, which cumulatively have cost $6.4 trillion and about 7,000 American troops dead1 (Chart 2). Three presidents, from two political parties, campaigned and won election on the basis of winding down these wars. The only presidential candidate since Republicans George W. Bush and John McCain who took a hawkish stance for persistent military engagement, Hillary Clinton, nearly lost the Democratic nomination and did lose the general election to a Republican, President Trump, who had reversed his party’s stance to advocate strategic withdrawal. War hawks have been sidelined in both parties. This is notable even if it were not the case that the current President Biden, whose son Beau fought in Afghanistan, had opposed the troop surge there under Obama. True, Biden will use drones, surgical strikes, and limited troop rotations to manage the aftermath in Afghanistan, both militarily and politically. Americans are still concerned about terrorism in general and any sign of a resurgent terrorist threat to the US homeland will be politically potent (Chart 3). But neither Biden nor the US can roll back the Taliban’s latest gains or achieve anything in Afghanistan that has not been achieved over the past twenty years.   Chart 3American Public Cares About Terrorism, Not Afghanistan Per Se Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China True, Biden will suffer a political black eye from Afghanistan. His approval rating has already fallen to 49.6%, slipping beneath 50% for the first time, in the face of the Delta variant of COVID-19 and the Afghan debacle. In both cases his early optimistic statements have now become liabilities. Biden is also 79 years old, which will make the 2024 campaign questionable, and he faces mounting problems in other areas, from lax border security and immigration enforcement to rising domestic crime. Nevertheless, Biden still has sufficient political capital to push through one or both of his major domestic legislative proposals by the end of the year, despite thin majorities in both the House and Senate. Afghanistan will not affect that, for three reasons: 1. The US economy is likely to continue to recover despite hiccups due to the lingering pandemic, since the vaccines so far are effective. The labor market is recovering and business capex and government support are robust. Setbacks, such as volatile consumer confidence, will help Biden pass bills designed to shore up the economy. 2. The public fundamentally agrees with Biden (and Trump) on military withdrawal, as mentioned. Voters will only turn against him if a major attack reinforces an image of weakness on terrorism. A major attack based in Afghanistan is not nearly as likely to succeed as it was prior to the September 11, 2001 attacks. But Biden also faces an imminent increase in tensions in the Middle East that could result in attacks on the US or its allies, or other events that reinforce any image of foreign policy failure. 3. Biden has broad popular support for his infrastructure deal, which also has bipartisan buy-in, with 19 Republican Senators already having voted for it. Further, the Democratic Party has a special fast-track mechanism for passing his social spending agenda, though conviction levels must be modest on this $3.5 trillion bill, which is controversial and will have to be winnowed to pass on a partisan vote in the Senate. If we are correct that Afghanistan will not derail Biden’s legislative efforts then it will not fundamentally affect US fiscal policy or the global macro outlook. Note, however, that a failure of Biden’s bills would be significant for both domestic and global economy and financial markets as it would suggest that US fiscal policy is dysfunctional even under single party rule and would thus help to usher back in a disinflationary context. Might Afghanistan affect the midterm elections and hence the US policy setup post-2022? Not decisively. Republicans are more likely than not to retake at least the House of Representatives regardless. This is a cyclical aspect of US politics driven by voter turnout and other factors. Democrats are partly shielded in public opinion due to the Trump administration’s attempts to pull out of foreign wars. But surely a black eye on terrorism or foreign policy would not help. Similarly, a major failure to manage the Middle East, South Asia, and the pivot to Asia Pacific would marginally hurt the Democrats in 2024, but that is a long way off. Geopolitical Implications The Taliban’s reconquest of Afghanistan has very little if any direct significance for global financial markets. Pakistan and India are the two major markets most likely to be directly affected – and their own geopolitical tensions will escalate as a result – yet both equity markets have been outperforming over the course of the Taliban’s military gains (Chart 4). Afghanistan’s impacts are indirect at best. However, the US withdrawal connects with major geopolitical currents, with both macro and market significance. Afghanistan often marks the tendency of empires to overreach. Russia’s failure in Afghanistan contributed to the collapse of the Soviet Union, though Russia’s command economy was unsustainable anyway. British failures in Afghanistan in the nineteenth and twentieth centuries did not lead to the British empire’s decline – that was due to the world wars – but Afghanistan did accentuate its limitations. Since 9/11 and the US’s wars in Iraq and Afghanistan, the US public’s economic malaise, political polarization, and loss of faith in public institutions have gotten worse. In turn, political divisions have impeded the government’s ability to respond cogently to financial and economic crisis, the resurgence of Russia, the rise of China, nuclear proliferation, constitutional controversies, and the COVID-19 pandemic. Once again Afghanistan marked imperial overreach. It is natural for investors to be concerned about the stability of the United States. And yet the US’s global power has recently stabilized (Chart 5). The US survived the 2020 stress test and innovated new vaccines for the pandemic. It is passing laws to upgrade its domestic technological, manufacturing, and infrastructural base and confronting its global rivals. Chart 4If Indo-Pak Markets Shrug Off Taliban Wins, So Can You If Indo-Pak Markets Shrug Off Taliban Wins, So Can You If Indo-Pak Markets Shrug Off Taliban Wins, So Can You Chart 5US Geopolitical Power Is Stabilizing Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China Chart 6US Not Shrinking From Global Role US Not Shrinking From Global Role US Not Shrinking From Global Role The US is not retreating from its global role, judging by defense spending or trade balances (Chart 6). While the desire to phase out wars could theoretically open the way to defense cuts, the reality is that the great power confrontation with China and Russia will demand continued large defense spending. The US also continues to run large trade deficits, due to its shortage of domestic savings, which gives it influence as a consumer and provider of dollar liquidity across the world. The critical geopolitical problem is Iran, where events have reached a critical juncture: To create a semblance of a balance of power in the Middle East, the US needs an understanding with Iran, which is locked in a struggle with Saudi Arabia over the vulnerable buffer state of Iraq. President Biden was not able to rejoin the 2015 détente with Iran prior to the inauguration of the new president, Ebrahim Raisi, who is a hawk and whose confrontational policies will lead to an escalation of Middle Eastern geopolitical risk in the short term – and, if no US-Iran deal is reached, over the long term. Iran recognizes the US’s war-weariness, as demonstrated by withdrawals from Iraq and Afghanistan. It was also exposed to economic sanctions after the US’s 2018-19 abrogation of the 2015 nuclear deal – it cannot trust the US to hold to a deal across administrations. Still, both the US and Iran face substantial strategic forces pressuring them to conclude a deal. The US needs to pivot to Asia while Iran needs to improve its economy and reduce social unrest prior to its looming leadership succession. But the time frame for negotiation is uncertain. Any failure to agree would revive the risk of a major war that would keep the US entangled in the region. Thus the pivot to Asia could be disrupted again, with major consequences for global politics, not because of Afghanistan but because of a failure to cut a deal with Iran. If the US succeeds in reducing its commitments to the Middle East and South Asia, the window of opportunity that China and Russia have enjoyed since 2001 will close. They will face a United States that has greater room for maneuver on a global scale. This is a threat to their own spheres of influence. But neither Beijing nor Moscow has an interest in a nuclear-armed Iran, so a US-Iran deal is still possible. Unless and until the US and Iran normalize relations, the Middle East is exposed to heightened geopolitical risk and hence oil supply risk. Global oil spare capacity is sufficient to swallow small disturbances but not major risks to stability, such as in Iraq or the Strait of Hormuz. Investment Takeaways Chart 7Near-Term US-Iran Risks Help Oil...Long-Term US-China Risks Help Dollar Near-Term US-Iran Risks Help Oil...Long-Term US-China Risks Help Dollar Near-Term US-Iran Risks Help Oil...Long-Term US-China Risks Help Dollar Back in 2001, the combination of American war spending, and conflict in the Middle East, combined with China’s massive economic opening after joining the WTO, led to a falling US dollar and an oil bull market. Today the US’s massive budget deficits and current account deficits present a structural headwind to the US dollar. Yet the greenback has remained resilient this year. While the pandemic will fade as long as vaccines continue to be effective, China’s potential growth is slowing even as it faces an unprecedented confrontation with the US and its allies. Until the US and Iran normalize relations, geopolitics will tend to threaten Middle Eastern oil supply and put upward pressure on oil prices. However, if the US manages the pivot to Asia, China will face more resolute opposition in its sphere of influence, which will tend to strengthen the dollar. The dollar and oil still tend to move in opposite directions. These geopolitical trends will be influential in determining which direction prevails (Chart 7). Thus geopolitics poses an upward risk to oil prices for now.     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Please see Crawford, Neta, "United States Budgetary Costs and Obligations of Post 9/11 Wars Through FY 2020: $6.4 trillion", Watson Institute, Brown University.

Highlights A critical aspect of the diffusion of global geopolitical power – “multipolarity” – is the structural rise of India. India will gain influence in the coming five years as a growing importer of goods, services, oil, and capital. Trade with China is a positive factor in Sino-Indian relations but it will not be enough to offset the build-up of strategic tensions. Indo-Russian relations will also wane. India’s slow transition to green energy will give it greater sway in the Middle East but will not remove its vulnerability if the region destabilizes anew over Iran. Sino-Indian tensions have already affected capital flows, with the US building on its position as a major foreign investor. Feature Chart 1Sino-Pak Alliance’s Geopolitical Power Is Thrice That Of India The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil India’s geopolitical power pales in comparison to that of the China-Pakistan alliance (Chart 1). India is traditionally an independent and “non-aligned” power that has managed conflicts with its neighbors by influencing either Russia or America to display a pro-India tilt. This strategy has held India in good stead as it helps create the illusion of a “balance of power” in the South Asian region. Structural changes are now afoot: Sino-Pakistani assertiveness toward India continues. But in a break from the past India’s Modi-led Bhartiya Janata Party (BJP) has been constrained to adopt a far more assertive stance itself. Russo-Indian relations face new headwinds. Russia has been a close historical partner of India. But Russia under President Vladimir Putin has courted closer ties with China, while the US has tried to warm up with India since President Bush. Under Presidents Trump and Biden, the US is taking a more confrontational approach to Russia and China and will continue to court India. Against this backdrop the key question is this: In a multipolar world, how will India’s relations with the Great Powers evolve over the next five years? Will the alliances of the early 2000s stay the same or will they change? And if they change, what will it mean for global investors? In this special report we provide a helicopter view of India’s relations with key countries. We do so by examining India’s trade and capital flows with the world. A country’s power to a large extent is a function not only of its population and military strength but also of the business interests it represents. India today is the second largest arms importer globally (guns), fifth largest recipient of global FDI flows (capital) and third largest importer of energy (oil). Looking at the trajectory of these business relations, we quantify the magnitude and sources of India’s geopolitical power over the next five years and its investment implications. Trade: India’s Imports Not Enough To Offset China Tensions “The 11th Law of Power - Learn to Keep People Dependent on You. To maintain your independence, you must always be needed and wanted. The more you are relied on, the more freedom you have.” – Robert Greene, The 48 Laws of Power1 A small and closed economy in the 1980s, India today is large and open. Since India lacked industrial capabilities, and was energy-deficient to start with, its import needs grew manifold over this period. India’s current account deficit has increased by nine times from 1980 to 2019. The magnitude of India’s appetite for imports is such that its current account deficit is the fifth largest in the world today (Chart 2). Chart 2India Is The Fifth Largest Importer Of Goods And Services The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Given its lack of domestic energy and industrial capabilities, India’s role as a client of the world will only become more pronounced as it grows. In fact, India appears all set to become the third largest importer of goods and services globally over the next five years (Chart 3). Chart 3India Will Become The Third Largest Net Importer, After US And UK, By 2026 The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Global history suggests that the client is king. The rise and fall of empires have been driven by the strength of their economies and militaries. Great powers import lots of goods and resources – and tend to export arms. The UK’s geopolitical decline over the nineteenth century, and America’s rise over the twentieth, were linked to their respective status as importers within the global economy. India’s rise as a large global importer will prove to be a key source of diplomatic leverage over the next five years. For example, India’s high appetite for imports from China will give India much-needed leverage in bilateral relations. Also, India’s slow transition to green energy continued reliance on oil will strengthen its bargaining power vis-à-vis oil producers. But these trends also bring challenges. Structurally, Sino-Indian tensions are rising and trade will not be enough to prevent them. Meanwhile dependency on the volatile Middle East is a geopolitical vulnerability. China: India’s Growing Might As A Consumer Increases Leverage Vis-à-Vis China China’s rising assertiveness in South Asia and India’s own inclination to adopt an assertive foreign policy stance will lead to structurally higher geopolitical tensions in the region. So, is a full-blooded confrontation between the two nigh? No. First, Sino-Indian wars have always been constrained by geography: they are separated by the Himalayas, which help to keep their territorial disputes contained, driving them toward proxy battles rather than direct and total war. Second, India, Pakistan, and China are nuclear-armed powers which means that war is constrained by the principle of mutually assured destruction. This principle is not absolute – world history is filled with tragedy. There are huge structural tensions lurking in the combination of China’s Eurasian strategy and growing Sino-Indian naval competition that will keep Sino-Indian geopolitical risks elevated. Nevertheless, the bar to a large-scale war remains high. In the meantime, India’s growing might as a consumer could act as a much-needed deterrent to conflict. The last two decades saw America’s share in Chinese exports decline from a peak of 21% to 17% today. With US-China relations expected to remain fraught under Biden and with the US looking to revive its strategic anchor in the Pacific and shore up its domestic manufacturing strength, China’s trade relations with America will continue to deteriorate regardless of which party holds the White House. Against such a backdrop, China will try to build stronger trading ties with countries like India whose share in China’s exports has been growing (Chart 4). After excluding Hong Kong, India today is the eighth-largest exporting destination for China. While it only accounts for 3% of China’s exports, this ratio is comparable to that of larger exporting partners like Vietnam (4% share in China’s exports), South Korea (4%), Germany (3%), Netherlands (3%), and the UK (3%). In other words, China’s need for India is underrated and growing. There are two problems with Sino-Indian trade going forward. First, the strategic tensions mentioned above could prevent trade ties from improving. Over the past decade, Sino-Indian maritime and territorial disputes have escalated while Sino-Indian trade has merely grown in line with that of other emerging markets (Chart 5). China’s rising import dependency has led it to develop both a navy and an overland Eurasian strategy. The Eurasian strategy threatens India’s security in border areas of South Asia, while India’s own naval rise and alliances heighten China’s maritime supply insecurity. These trends may or may not prevent trade from living up to its potential, but they could result in strategic conflict regardless. Chart 4Amongst Top Chinese Export Clients, India’s Importance Has Increased The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 5India’s Imports From China Have Broadly Grown In Line With Peers India's Imports From China Have Broadly Grown In Line With Peers India's Imports From China Have Broadly Grown In Line With Peers Second, the trade relationship itself is imbalanced. India imports heavily from China but sells little into China. China is responsible for more than a third of India’s trade deficit. At the same time, India increasingly shares the western world’s concern about network security in a world where cheap Chinese hardware could become integral to the digital economy. If Sino-Indian diplomacy cannot redress trade imbalances, then trade will generate new geopolitical tensions rather than resolve other ones. One should expect China to court India in the context of rising American and western strategic pressure. Yet China has failed to do so. Why? Because China’s economic transition – falling export orientation and declining potential GDP – is motivating a rise in nationalism and an assertive foreign policy. Meanwhile India’s own economic difficulties – the need to create jobs for a growing population – are generating an opposing wave of nationalism. Thus, while Sino-Indian trade will discourage conflict on the margin, it may not be enough to prevent it over the long run. Oil: As India Lags On Green Transition, Its Significance As An Oil Consumer Will Rise Whilst renewable energy’s share of India’s energy mix is expected to grow, the pace will be slow. Moreover, India’s increased reliance on green energy sources over the next decade will come at the expense of coal and not oil (Chart 6). Consequently, India’s reliance on oil for its energy needs is expected to stay meaningful. Chart 6India’s Reliance On Oil Will Persist For The Next Decade And Beyond The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 7India’s Importance As An Oil Client Has Been Rising The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil The International Energy Agency (IEA) forecasts that India’s net dependence on imported oil for its overall oil needs will increase from 75% today to above 90% by 2040. But India’s relative importance as an oil client will also grow as most large oil consumers will be able to transition to green energy faster than India. In fact, data pertaining to the last decade confirms that this trend is already underway. India’s share of the global oil trade has been rising (Chart 7). In particular, India has taken advantage of Iraq’s rise as a producer after the second Gulf War and has marginally increased imports from Saudi Arabia (Chart 8). Chart 8India’s Importance As A Client Has Been Rising For Top Oil Exporters The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Iran is the country most likely to gain from this dynamic in the coming years – if the US and Iran strike a deal to curb Iran’s nuclear program in exchange for the US lifting economic sanctions. India has maintained stable imports from the Middle East over the past decade despite nominally eliminating imports of oil from Iran (Chart 9). Chart 9India Has Maintained Stable Imports From The Middle East The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil However, while India will have greater bargaining power between OPEC and non-OPEC suppliers, dependency on the unstable Middle East is always a geopolitical liability. If the US and Iran fail to arrive at a deal, a regional conflict is likely, in which case India’s slow green transition and vulnerability to supply disruptions will become a costly liability. Bottom Line: India’s growing importance to both Chinese manufacturers and global oil producers will give it leverage in trade negotiations. However, ultimately, national security will trump economics when it comes to China, while India will remain extremely vulnerable to instability in the Middle East. Guns: Indo-Russian Relations Weaken “When the war broke out [between India & Pakistan in 1971], the Soviet Union cast aside all pretentions of neutrality and non-partisanship… the Russians were in no hurry to terminate the fighting since their interest was better served by the continuation of hostilities leading to an India victory … The factors that decisively determined the outcome of the war were: first, Soviet military assistance to India; secondly the USSR’s role in the UN Security council; and thirdly, Russia strategy to prevent a direct Chinese intervention in the war.” – Zubeida Mustafa, "The USSR and the Indo-Pakistan War"2 The true origins of Russia’s pro-India tilt can be traced back to 1971. The former Soviet Union’s support for India played a critical role in helping India win the Indo-Pakistan war of 1971. Half a century later the Indo-Russia relationship persists, but its intensity has declined and will continue declining over the next few years. We see three reasons: America’s withdrawal from Iraq and Afghanistan will allow the US to focus more intently on its rivalry with China and Russia – a dynamic that is reinforcing China’s and Russia’s move closer together. Meanwhile India’s relationship with the US continues to improve. The China-Pakistan alliance continues to strengthen. Beyond cooperation on China’s ambitious Belt and Road Initiative, Pakistan shares a deep relationship with China based on defense and trade (Chart 10). Hence India is distrustful of closer Russo-Chinese relations. In light of this strategic re-alignment, Russia may see value in developing a closer defense relationship with China. Trading relations between Russia and India are minimal even today. Hence unlike in the case of China, there exists no backstop on weakening of Russo-Indian relations. Less than 1.5% of India’s merchandise imports come from Russia and less than 1% of India’s exports go to Russia. Russia’s share of Indian oil imports has grown in recent years but only to 1.4% of total. Meanwhile the US share of India’s imports has catapulted to 5.7% since the US became an exporter. Any removal of Iran sanctions will come at the cost of other Middle Eastern exporters, not these two alternatives to the risky Persian Gulf, but Russia’s share is still small. Now the backbone of Indo-Russia relations has been their arms trade. However, India’s reliance on Russia for arms could decline over the next five years. India today is Russia’s largest arms client accounting for 23% of its arms sales (Chart 10). However, second in line is China which accounts for 18% of Russia’s arms sales. Given that Russia’s share in global arms exports has been declining (Chart 11), Russia will be keen to reverse or at least halt this trend. Russia can do so most easily by selling more arms to India or to China. Even as China appears to be increasingly focused on developing indigenous arms production capabilities, for reasons of strategy, China appears like a better client for Russia to bank on for the next decade. After all, in 1989, when western countries imposed an arms embargo against China in response to events at Tiananmen Square, Russia became the prime supplier of arms to China. Chart 10India Is A Key Client For Russia, As Is China The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil By contrast, for reasons of strategy India appears like a less promising client to bank on for Russia. India’s import demand for arms has been declining while China’s demand is increasing (Chart 12). India under the Modi-led Bhartiya Janata Party (BJP) has been reducing its reliance on imported arms. Last month, for example, the Indian Ministry of Defense (MoD) said that it has set aside 64% of the defense capital budget for acquisitions from domestic companies.3 This is an increase of 6% over last year, which was the first time such a distinction between domestic and foreign defense expenditure was made. Whilst it will take years for India to develop its domestic arms production capabilities, India’s inward tilt is worrying for traditional suppliers like Russia. Chart 11Among Top Arms Exporters, Russia Is Losing Market Share The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 12India’s Appetite For Arms Imports Is Falling The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Moreover, Russia is aware that the situation is rife for US-India arms trade to strengthen given that India is starting to display a pro-US tilt. Groundwork for a sound defense relationship with India has already been laid out by the US as evinced by: Foundational agreements: India and the US signed the Communications, Compatibility, and Security Agreement (COMCASA) in 2018 and the Basic Exchange and Cooperation Agreement (BECA) in 2020. Sanction exemptions: The US had applied sanctions on Turkey under the Countering America's Adversaries Through Sanctions Act (CAATSA) for Ankara’s purchase of Russia’s S-400 missile defense system in 2020. The US has threatened India with CAATSA sanctions for buying S-400 missile defense systems from Russia but has not applied these sanctions to India (at least not yet). Not applying CAATSA sanctions to India allows the US to strengthen its strategic relations with India that can help further the American goal of creating a counter to China in Asia. Bottom Line: India-Russia relations will remain amicable, but this relationship is bound to fade over the next five years as the US counters China and Russia. Limited backstops exist for Indo-Russia ties. Economic ties between India and Russia are minimal, as India is cutting back on arms imports and only marginally increasing oil imports. Capital: China Investment Down, US Investment Up “America has no permanent friends or enemies, only interests.” – Henry Kissinger, Former US Secretary of State India’s economic growth rates could be higher if it did not have to deal with the paradox of plentiful savings alongside capital scarcity. Even as Indian households are known to be thrifty, only a limited portion of their savings is available for being borrowed by small firms. Almost a quarter of bank deposits are blocked in government securities. More than a third of adjusted net bank credit must be made available for government-directed lending. With what is left, banks prefer lending the residual funds to large top-rated corporates. It is against this backdrop that foreign direct investment (FDI) flows provide much needed succor to Indian corporates, particularly capital-guzzling start-ups. FDI inflows into India have become a key source of funding for Indian corporates over the last decade with annual FDI flows often exceeding new bank credit. Correspondingly, for FDI investors, India provides the promise of high returns on investment in an emerging market that offers political stability. India emerged as the fifth largest FDI destination globally in 2020. Amongst suppliers of FDI into India (excluding tax havens like Cayman Islands), the US and China have been top contributors. Whilst China has been a leading investor into the Indian start-up space, geopolitical tensions have translated into regulatory barriers that prevent Chinese funds from investing in India. Separately, as Indo-US relations improve, the symbiotic relationship between capital-rich US funds and capital-hungry Indian start-ups should strengthen. In fact, in 2020 itself, Chinese private equity (PE) and venture capital (VC) investments into India shrank whilst American investments into India doubled, according to Venture Intelligence (Chart 13). Distinct from Chinese funds’ restrained ability to invest in Indian firms, Indian tech start-ups could potentially benefit from reduced global investor appetite in Chinese tech stocks owing to China’s regulatory crackdown and breakup with the United States. China’s foreign policy assertiveness and domestic policy uncertainty may lead to a reallocation of FDI flows away from China and into India. China (including Hong Kong) has been a top host country for FDI, attracting 4x times more funds than India (Chart 14). However, India’s ability to absorb these reallocated funds over the next five years will be a function of sectoral competencies. For instance, India’s information and communications technology (ICT) sector appears best positioned to benefit from this trend. But the same may not be the case for sectors like manufacturing that traditionally attract large FDI flows in China yet are relatively underdeveloped in India. On the goods’ front, given that India’s comparative advantage lies in the production of capital-light, labor-light and medium-tech intensive products, pharmaceuticals and chemicals could be two other industries that attract FDI flows in India. Chart 13Chinese PE/VC Investments Into India In 2020 Slowed Significantly The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 14China Has Been A Top Host Country For FDI, Attracting 4x More Flows Than India The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Bottom Line: Whilst trade between India and China has not been affected much by geopolitical tensions, capital flows have been. Given that the US historically has been a top FDI contributor in India, and given improving Indo-US relations, FDI investment into India from the US appears set to rise steadily over the next five years, particularly into the ICT sector. Investment Conclusions China-India geopolitical tensions are here to stay and will be a recurring feature of South Asia’s geopolitical landscape. However, a growing trade relationship could discourage conflict, especially if it becomes more balanced. It may not be enough to prevent conflict forever but it is an important constraint to acknowledge. India’s current account deficit will remain vulnerable to swings in oil prices, but it may be able to manage its energy bill better as its bargaining power relative to oil suppliers improves. The problem then will become energy insecurity, particularly if the US and Iran fail to normalize relations. As India and Russia explore new alignments with USA and China respectively, the historic Indo-Russia relationship will weaken. It will not collapse entirely because Russia provides a small but growing alternative to Mideast oil. US-India business interests may deepen as India considers joint ventures with American arms manufacturers and American funds court India’s capital-hungry information and communications technology sector. Against this backdrop we reiterate our constructive strategic view on India. However, for the next 12 months, we remain worried about near-term geopolitical and macro headwinds that India must confront.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 (Viking Press, 1998). 2 Mustafa, Zubeida. "The USSR and the Indo-Pakistan War, 1971" Pakistan Horizon 25, No. 1 (1972): 45-52. 3 Ajai Shukla, "Local procurement for defence to see 6% hike this year: Govt to Parliament" Business Standard, July 2021.

Highlights China’s July Politburo meeting signaled that policy is unlikely to be overtightened. The Biden administration is likely to pass a bipartisan infrastructure deal – as well as a large spending bill by Christmas. Geopolitical risk in the Middle East will rise as Iran’s new hawkish president stakes out an aggressive position. US-Iran talks just got longer and more complicated. Europe’s relatively low political risk is still a boon for regional assets. However, Russia could still deal negative surprises given its restive domestic politics. Japan will see a rise in political turmoil after the Olympic games but national policy is firmly set on the path that Shinzo Abe blazed. Stay long yen as a tactical hedge. Feature Chart 1Rising Hospitalizations Cause Near-Term Jitters, But UK Rolling Over? China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Our key view of 2021, that China would verge on overtightening policy but would retreat from such a mistake to preserve its economic recovery, looks to be confirmed after the Politburo’s July meeting opened the way for easier policy in the coming months. Meanwhile the Biden administration is likely to secure a bipartisan infrastructure package and push through a large expansion of the social safety net, further securing the American recovery. Growth and stimulus have peaked in both the US and China but these government actions should keep growth supported at a reasonable level and dispel disinflationary fears. This backdrop should support our pro-cyclical, reflationary trade recommendations in the second half of the year. Jitters continue over COVID-19 variants but new cases have tentatively peaked in the UK, US vaccinations are picking up, and death rates are a lot lower now than they were last year, that is, prior to widescale vaccination (Chart 1). This week we are taking a pause to address some of the very good client questions we have received in recent weeks, ranging from our key views of the year to our outstanding investment recommendations. We hope you find the answers insightful. Will Biden’s Infrastructure Bill Disappoint? Ten Republicans are now slated to join 50 Democrats in the Senate to pass a $1 trillion infrastructure bill that consists of $550 billion in new spending over a ten-year period (Table 1). The deal is not certain to pass and it is ostensibly smaller than Biden’s proposal. But Democrats still have the ability to pass a mammoth spending bill this fall. So the bipartisan bill should not be seen as a disappointment with regard to US fiscal policy or projections. The Republicans appear to have the votes for this bipartisan deal. Traditional infrastructure – including broadband internet – has large popular support, especially when not coupled with tax hikes, as is the case here. Both Biden and Trump ran on a ticket of big infra spending. However, political polarization is still at historic peaks so it is possible the deal could collapse despite the strong signs in the media that it will pass. Going forward, the sense of crisis will dissipate and Republicans will take a more oppositional stance. The Democratic Congress will pass President Joe Biden’s signature reconciliation bill this fall, another dollop of massive spending, without a single Republican vote (Chart 2). After that, fiscal policy will probably be frozen in place through at least 2025. Campaigning will begin for the 2022 midterm elections, which makes major new legislation unlikely in 2022, and congressional gridlock is the likely result of the midterm. Republicans will revert to belt tightening until they gain full control of government or a new global crisis erupts. Table 1Bipartisan Infrastructure Bill Likely To Pass China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 2Reconciliation Bill Also Likely To Pass China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 3Biden Cannot Spare A Single Vote In Senate China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Hence the legislative battle over the reconciliation bill this fall will be the biggest domestic battle of the Biden presidency. The 2021 budget reconciliation bill, based on a $3.5 trillion budget resolution agreed by Democrats in July, will incorporate parts of the American Jobs Plan that did not pass via bipartisan vote (such as $436 billion in green energy subsidies), plus a large expansion of social welfare, the American Families Plan. This bill will likely pass by Christmas but Democrats have only a one-seat margin in the Senate, which means our conviction level must be medium, or subjectively about 65%. The process will be rocky and uncertain (Chart 3). Moderate Democratic senators will ultimately vote with their party because if they do not they will effectively sink the Biden presidency and fan the flames of populist rebellion. US budget deficit projections in Chart 4 show the current status quo, plus scenarios in which we add the bipartisan infra deal, the reconciliation bill, and the reconciliation bill sans tax hikes. The only significant surprise would be if the reconciliation bill passed shorn of tax hikes, which would reduce the fiscal drag by 1% of GDP next year and in coming years. Chart 4APassing Both A Bipartisan Infrastructure Bill And A Reconciliation Bill Cannot Avoid Fiscal Cliff In 2022 … China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 4B… The Only Major Fiscal Surprise Would Come If Tax Hikes Were Excluded From This Fall’s Reconciliation Bill China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 5Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing There are two implications. First, government support for the economy has taken a significant step up as a result of the pandemic and election in 2020. There is no fiscal austerity, unlike in 2011-16. Second, a fiscal cliff looms in 2022 regardless of whether Biden’s reconciliation bill passes, although the private economy should continue to recover on the back of vaccines and strong consumer sentiment. This is a temporary problem given the first point. Monetary policy has a better chance of normalizing at some point if fiscal policy delivers as expected. But the Federal Reserve will still be exceedingly careful about resuming rate hikes. President Biden could well announce that he will replace Chairman Powell in the coming months, delivering a marginally dovish surprise (otherwise Biden runs the risk that Powell will be too hawkish in 2022-23). Inflation will abate in the short run but remain a risk over the long run. Essentially the outlook for US equities is still positive for H2 but clouds are forming on the horizon due to peak fiscal stimulus, tax hikes in the reconciliation bill, eventual Fed rate hikes (conceivably 2022, likely 2023), and the fact that US and Chinese growth has peaked while global growth is soon to peak as well. All of these factors point toward a transition phase in global financial markets until economies find stable growth in the post-pandemic, post-stimulus era. Investors will buy the rumor and sell the news of Biden’s multi-trillion reconciliation bill in H2. The bill is largely priced out at the moment due to China’s policy tightening (Chart 5). The next section of this report suggests that China’s policy will ease on the margin over the coming 12 months. Bottom Line: US fiscal policy is delivering, not disappointing. Congress is likely to pass a large reconciliation bill by Christmas, despite no buffer in the Senate, because Democratic Senators know that the Biden presidency hangs in the balance. China’s Khodorkovsky Moment? Many clients have asked whether China’s crackdown on private business, from tech to education, is the country’s “Khodorkovsky moment,” i.e. the point at which Beijing converts into a full, autocratic regime where private enterprise is permanently impaired because it is subject to arbitrary seizure and control of the state. The answer is yes, with caveats. Yes, China’s government is taking a more aggressive, nationalist, and illiberal stance that will permanently impair private business and investor sentiment. But no, this process did not begin overnight and will not proceed in a straight line. There is a cyclical aspect that different investors will have to approach differently. First a reminder of the original Khodorkovsky moment. After the Soviet Union’s collapse, extremely wealthy oligarchs emerged who benefited from the privatization of state assets. When President Putin began to reassert the primacy of the state, he arbitrarily imprisoned Khodorkovsky and dismantled his corporate energy empire, Yukos, giving the spoils to state-owned companies. Russia is a petro state so Putin’s control of the energy sector would be critical for government revenues and strategic resurgence, especially at the dawn of a commodity boom. Both the RUB-USD and Russian equity relative performance performed mostly in line with global crude oil prices, as befits Russia’s economy, even though there was a powerful (geo)political risk premium injected during these two decades due to Russia’s centralization of power and clash with the West (Chart 6). Investors could tactically play the rallies after Khodorkovsky but the general trend depended on the commodity cycle and the secular rise of geopolitical risk. Chart 6Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer President Xi Jinping is a strongman and hardliner, like Putin, but his mission is to prevent Communist China from collapsing like the Soviet Union, rather than to revive it from its ashes. To that end he must reassert the state while trying to sustain the country’s current high level of economic competitiveness. Since China is a complex economy, not a petro state, this requires the state-backed pursuit of science, technology, competitiveness, and productivity to avoid collapse. Therefore Beijing wants to control but not smother the tech companies. Hence there is a cyclical factor to China’s regulatory crackdown. A crackdown on President Xi Jinping’s potential rivals or powerful figures was always very likely to occur ahead of the Communist Party’s five-year personnel reshuffle in 2022, as we argued prior to tech exec Jack Ma’s disappearance. Sackings of high-level figures have happened around every five-year leadership rotation. Similarly a crackdown on the media was expected. True, the pre-party congress crackdowns are different this time around as they are targeted at the private sector, innovative businesses, tech, and social media. Nevertheless, as in the past, a policy easing phase will follow the tightening phase so as to preserve the economy and the mobilization of private capital for strategic purposes. The critical cyclical factor for global investors is China’s monetary and credit impulse. For example, the crackdown on the financial sector ahead of the national party congress in 2017 caused a global manufacturing slowdown because it tightened credit for the entire Chinese economy, reducing imports from abroad. One reason Chinese markets sold off so heavily this spring and summer, was that macroeconomic indicators began decelerating, leaving nothing for investors to sink their teeth into except communism. The latest Politburo meeting suggests that monetary, fiscal, and regulatory policy is likely to get easier, or at least stay just as easy, going forward (Table 2). Once again, the month of July has proved an inflection point in central economic policy. Financial markets can now look forward to a cyclical easing in regulation combined with easing in monetary and fiscal policy over the next 12-24 months. Table 2China’s Politburo Prepares To Ease Policy, Secure Recovery China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Despite all of the above, for global investors with a lengthy time horizon, the government’s crackdown points to a secular rise of Communist and Big Government interventionism into the economy, with negative ramifications for China’s private sector, economic freedoms, and attractiveness as a destination for foreign investment. The arbitrary and absolutist nature of its advances will be anathema to long-term global capital. Also, social media, unlike other tech firms, pose potential sociopolitical risks and may not boost productivity much, whereas the government wants to promote new manufacturing, materials, energy, electric vehicles, medicine, and other tradable goods. So while Beijing cannot afford to crush the tech sector, it can afford to crush some social media firms. Chart 7China's Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China's Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China's Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China’s equity market profile looks conspicuously like Russia’s at the time of Khodorkovsky’s arrest (Chart 7). Chinese renminbi has underperformed the dollar on a multi-year basis since Xi Jinping’s rise to power, in line with falling export prices and slowing economic growth, as a result of economic structural change and the administration’s rolling back Deng Xiaoping’s liberal reform era. We expect a cyclical rebound to occur but we do not recommend playing it. Instead we recommend other cyclical plays as China eases policy, particularly in European equities and US-linked emerging markets like Mexico. Bottom Line: The twentieth national party congress in 2022 is a critical political event that is motivating a cyclical crackdown on potential rivals to Communist Party power. Chinese equities will temporarily bounce back, especially with a better prospect for monetary and fiscal easing. But over the long run global investors should stay focused on the secular decline of China’s economic freedoms and hence productivity. What Happened To The US-Iran Deal? Our second key view for 2021 was the US strategic rotation from the Middle East and South Asia to Asia Pacific. This rotation is visible in the Biden administration’s attempt to withdraw from Iraq and Afghanistan while rejoining the 2015 nuclear deal with Iran. However, Biden here faces challenges that will become very high profile in the coming months. The Biden administration failed to rejoin the 2015 deal under the outgoing leadership of the reformist President Hassan Rouhani. This means a new and much more difficult negotiation process will now begin that could last through Biden’s term or beyond. On August 5, President Ebrahim Raisi will take office with an aggressive flourish. The US is already blaming Iran for an act of sabotage in the Persian Gulf that killed one Romanian and one Briton. Raisi will need to establish that he is not a toady, will not cower before the West. The new Israeli government of Prime Minister Naftali Bennett also needs to demonstrate that despite the fall of his hawkish predecessor Benjamin Netanyahu, Jerusalem is willing and able to uphold Israel’s red lines against Iranian nuclear weaponization and regional terrorism. Hence both Iran and its regional rivals, including Saudi Arabia, will rattle sabers and underscore their red lines. The Persian Gulf and Strait of Hormuz will be subject to threats and attacks in the coming months that could escalate dramatically, posing a risk of oil supply disruptions. Given that the Iranians ultimately do want a deal with the Americans, the pressure should be low-to-medium level and persistent, hence inflationary, as opposed to say a lengthy shutdown of the Strait of Hormuz that would cause a giant spike in prices that ultimately kills global demand. Short term, the US attempt to reduce its commitments in Iraq and Afghanistan will invite US enemies to harass or embarrass the Biden administration. The Taliban is likely to retake control of Afghanistan. The US exit will resemble Saigon in 1975. This will be a black eye for the Biden administration. But public opinion and US grand strategy will urge Biden to be rid of the war. So any delays, or a decision to retain low-key sustained troop presence, will not change the big picture of US withdrawal. Long term, Biden needs to pivot to Asia, while President Raisi is ultimately subject to the Supreme Leader Ali Khamenei, who wants to secure Iran’s domestic stability and his own eventual leadership succession. Rejoining the 2015 nuclear deal leads to sanctions relief, without requiring total abandonment of a nuclear program that could someday be weaponized, so Iran will ultimately agree. The problem will then become the regional rise of Iranian power and the balancing act that the US will have to maintain with its allies to keep Iran contained. Bottom Line: The risk to oil prices lies to the upside until a US-Iran deal comes together. The US and Iran still have a shared interest in rejoining the 2015 deal but the time frame is now delayed for months if not years. We still expect a US-Iran deal eventually but previously we had anticipated a rapid deal that would put downward pressure on oil prices in the second half of the year. What Comes After Biden’s White Flag On Nord Stream II? Our third key view for 2021 highlighted Europe’s positive geopolitical and macro backdrop. This view is correct so far, especially given that China’s policymakers are now more likely to ease policy going forward. But Russia could still upset the view. Italy has been the weak link in European integration over the past decade (excluding the UK). So the national unity coalition that has taken shape under Prime Minister Mario Draghi exemplifies the way in which political risks were overrated. Italy is now the government that has benefited the most from the overall COVID crisis in public opinion (Chart 8). The same chart shows that the German government also improved its public standing, although mostly because outgoing Chancellor Angela Merkel is exiting on a high note. Her Christian Democrat-led coalition has not seen a comparable increase in support. The Greens should outperform their opinion polling in the federal election on September 26. But the same polling suggests that the Greens will be constrained within a ruling coalition (Chart 9). The result will be larger spending without the ability to raise taxes substantially. Markets will cheer a fiscally dovish and pro-European ruling coalition. Chart 8European Political Risk Limited, But Rising, Post-COVID China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients The chief risk to this view of low EU political risk comes from Russia. Russia is a state in long-term decline due to the remorseless fall in fertility and productivity. The result has been foreign policy aggression as President Putin attempts to fortify the country’s strategic position and frontiers ahead of an even bleaker future. Chart 9German Election Polls Point To Gridlock? German Election Polls Point To Gridlock? German Election Polls Point To Gridlock? Now domestic political unrest has grown after a decade of policy austerity and the COVID-19 pandemic. Elections for the Duma will be held on September 19 and will serve as the proximate cause for Russia’s next round of unrest and police repression. Foreign aggressiveness may be used to distract the population from the pandemic and poor economy. We have argued that there would not be a diplomatic reset for the US and Russia on par with the reset of 2009-11. We stand by this view but so far it is facing challenges. Putin did not re-invade Ukraine this spring and Biden did not impose tough sanctions canceling the construction of the Nord Stream II gas pipeline to Germany. Russia is tentatively cooperating on the US’s talks with Iran and withdrawal from Afghanistan. The US gave Germany and Russia a free point by condoning the NordStream II. Now the US will expect Germany to take a tough diplomatic line on Russian and Chinese aggression, while expecting Russia to give the US some goodwill in return. They may not deliver. The makeup of the new German coalition will have some impact on its foreign policy trajectory in the coming years. But the last thing that any German government wants is to be thrust into a new cold war that divides the country down the middle. Exports make up 36% of German output, and exports to the Russian and Chinese spheres account for a substantial share of total exports (Chart 10). The US administration prioritizes multilateralism above transactional benefits so the Germans will not suffer any blowback from the Americans for remaining engaged with Russia and China, at least not anytime soon. Russia, on the other hand, may feel a need to seize the moment and make strategic gains in its region, despite Biden’s diplomatic overtures. If the US wraps up its forever wars, Russia’s window of opportunity closes. So Russia may be forced to act sooner rather than later, whether in suppressing domestic dissent, intimidating or attacking its neighbors, or hacking into US digital networks. In the aftermath of the German and Russian elections, we will reassess the risk from Russia. But our strong conviction is that neither Russian nor American strategy have changed and therefore new conflicts are looming. Therefore we prefer developed market European equities and we do not recommend investors take part in the Russian equity rally. Chart 10Germany Opposes New Cold War With Russia Or China China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Bottom Line: German and European equities should benefit from global vaccination, Biden’s fiscal and foreign policies, and China’s marginal policy easing (Chart 11). Eastern European emerging markets and Russian assets are riskier than they appear because of latent geopolitical tensions that could explode around the time of important elections in September. Chart 11Geopolitical Tailwinds To European Equities Geopolitical Tailwinds To European Equities Geopolitical Tailwinds To European Equities What Comes After The Olympics In Japan? Japan is returning to an era of “revolving door” prime ministers. Prime Minister Yoshihide Suga’s sole purpose was to tie up the loose ends of the Shinzo Abe administration, namely by overseeing the Olympics. After the games end, he will struggle to retain leadership of the Liberal Democratic Party. He will be blamed for spread of Delta variant even if the Olympics were not a major factor. If he somehow retains the party’s helm, the October general election will still be an underwhelming performance by the Liberal Democrats, which will sow the seeds of his downfall within a short time (Chart 12). Suga will need to launch a new fiscal spending package, possibly as an election gimmick, and his party has the strength in the Diet to push it through quickly, which will be favorable for the economy. For the elections the problem is not the Liberal Democrats’ popularity, which is still leagues above the nearest competitor, but rather low enthusiasm and backlash over COVID. Abe’s retirement, and the eventual fall of Abe’s hand-picked deputy, does not entail the loss of Abenomics. The Bank of Japan will retain its ultra-dovish cast at least until Haruhiko Kuroda steps down in 2023. The changes that occurred in Japan from 2008-12 exemplified Japan’s existence as an “earthquake society” that undergoes drastic national changes suddenly and rapidly. The paradigm shift will not be reversed. The drivers were the Great Recession, the LDP’s brief stint in the political wilderness, the Tohoku earthquake and Fukushima nuclear crisis, and the rise of China. The BoJ became ultra-dovish and unorthodox, the LDP became more proactive both at home and abroad. The deflationary economic backdrop and Chinese nationalism are still a powerful impetus for these trends to continue – as highlighted by increasingly alarming rhetoric by Japanese officials, including now Shinzo Abe himself, regarding the Chinese military threat to Taiwan. In other words, Suga’s lack of leadership will not stand even if he somehow stays prime minister into 2022. The Liberal Democrats have several potential leaders waiting in the wings and one of these will emerge, whether Yuriko Koike, Shigeru Ishiba, or Shinjiro Koizumi, or someone else. The popular and geopolitical pressures will force the Liberal Democrats and various institutions to continue providing accommodation to the economy and bulking up the nation’s defenses. This will require the BoJ to stay easier for longer and possibly to roll out new unorthodox policies, as with yield curve control in the 2010s. Japan has some of the highest real rates in the G10 as a result of very low inflation expectations and a deeply negative output gap (Chart 13). Abenomics was bearing fruit, prior to COVID-19, so it will be justified to stay the course given that deflation has reemerged as a threat once again. Chart 12Japan: Back To Revolving Door Of Prime Ministers China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 13Japan To Keep Fighting Deflation Post-Abe Japan To Keep Fighting Deflation Post-Abe Japan To Keep Fighting Deflation Post-Abe Bottom Line: The political and geopolitical backdrop for Japan is clear. The government and BoJ will have to do whatever it takes to stay the course on Abenomics even in the wake of Abe and Suga. Prime ministers will come and go in rapid succession, like in past eras of political turmoil, but the trajectory of national policy is set. We would favor JGBs relative to more high-beta government bonds like American and Canadian. Given deflation, looming Japanese political turmoil, and the secular rise in geopolitical risk, we continue to recommend holding the yen. These views conform with those of BCA’s fixed income and forex strategists. Investment Takeaways China’s policymakers are backing away from the risk of overtightening policy this year. Policy should ease on the margin going forward. Our number one key forecast for 2021 is tentatively confirmed. Base metals are still overextended but global reflation trades should be able to grind higher. The US fiscal spending orgy will continue through the end of the year via Biden’s reconciliation bill, which we expect to pass. Proactive DM fiscal policy will continue to dispel disinflationary fears. Sparks will fly in the Middle East. The US-Iran negotiations will now be long and drawn out with occasional shows of force that highlight the tail risk of war. We expect geopolitics to add a risk premium to oil prices at least until the two countries can rejoin the 2015 nuclear deal. Germany’s Green Party will surprise to the upside in elections, highlighting Europe’s low level of geopolitical risk. China policy easing is positive for European assets. Russia’s outward aggressiveness is the key risk.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

Highlights With geopolitical risks increasing around China, India is attracting greater attention from global investors. India’s youthful demographics also mark a stark contrast with China. While this demographic dividend is real, its benefits should not be overstated. India is young but socially complex, which will create unique social conflicts and policy risks. In particular, the country faces structurally large budget deficits. Regional political differences could slow down reforms. Lastly, competition with China will increase India’s own geopolitical risks. Macroeconomic and (geo)political factors, not youth alone, will determine India’s equity market returns. The bullish long-term view faces near-term challenges. Feature Map 1 PreviewIndia’s Demographic Dividend Can Be Overstated India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details “Independence had come to India like a kind of revolution; now there were many revolutions within that revolution … All over India scores of particularities that had been frozen by foreign rule, or by poverty or lack of opportunity or abjectness, had begun to flow again.” – Sir VS Naipaul, India: A Million Mutinies Now (Vintage, 1990) What is well known is that India is populous, young, and boasts a high GDP growth rate. India is also largely free of internal conflicts. Its democratic framework is seen as a pressure valve that can release social tensions. India’s hefty 58% cross-cycle premium to Emerging Markets (EM) is often attributed to the fact that India is younger than its peers, especially China. In this report we highlight that India’s demographic advantage is real but should not be overstated. For instance, India’s northern region can be likened to a demographic tinderbox. It accounts for about 45% of India’s population and is also younger than the national average. However, per capita incomes in this region are lower than the national average and to complicate matters, this region is crisscrossed by several social fault lines. This heterogeneity and economic backwardness in India’s population is the reason why the trend-line of India’s demographic dividend will not be linear. Its diverse population’s attempt to break out of its poverty will spawn unique policy risks. The North Is A Demographic Tinderbox, The South Is Prosperous But Ageing India will soon be the most populous country in the world (Chart 1). India’s median age is a decade lower than that of China to boot (Chart 2). Some emerging market investors fret about India’s low per capita income but India holds the promise of lifting individual incomes over time. This is because its GDP growth rate has been higher than that of its peers (Chart 3). Chart 1India Will Soon Be The Most Populous Country India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details Chart 2India Is A Decade Younger Than China India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details Chart 3India’s Per Capita Income Is Low, But GDP Growth Rate Is High India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details However, the “demographic dividend” narrative oversimplifies India’s investment case. India is young but also socially heterogenous and its median voter is poor. This complicates India’s development process and makes its demographic dividend trend-line non-linear. India’s social complexity is best understood if India is characterized as an amalgamation of three major regions: the North, the South (which we define to include the western region), and the East. Each of these parts are unique and have distinctive socio-demographic identities. India hence is more comparable to a continent like Europe than a country like the US. Like the European Union, India is a union of multiple social, religious, and ethnic groups. It straddles a vast geography and represents a very wide spectrum of interests. India’s South is more like a middle-income Asian country such as Sri Lanka or Vietnam whilst India’s East is more like a poor Latin American economy with latent social unrest. Understanding the heterogeneity of India’s vast populace is key to get a better sense of why an investment strategy for India must be nuanced and tactical in its approach, even if the overarching strategic view is constructive. The key features of each of these three regions can be summarized as follows: Region #1: The North This region comprises the triangular area between Jammu & Kashmir, Rajasthan and Jharkhand. This is the largest landmass in India stretching from the Himalayas to the fertile Gangetic plains of central India. Ethnically most of the population here is of Indo-Aryan descent. A lion’s share of this region’s population remains engaged in agriculture and allied activities. The North accounts for about 45% of the nation’s total population and is a demographic tinderbox. Per capita incomes are low and one in five persons falls in the age group of 15-24 years. To complicate matters, wage inflation in the farm sector, which employs a large majority of the populace in this region, has been slowing. If job creation in the non-farm sector stays insufficient then it will fan fires of social instability. The North includes states like Uttar Pradesh and Punjab which have seen a steady increase in small but notable socio-political conflicts in the recent past. Issues that triggered social conflict ranged from inter-religious marriages to resistance to amending farmer-friendly laws. Region #2: The South India’s South constitutes the large inverted-triangular region on the map and spans the area between Gujarat, Kerala, and West Bengal. We include India’s western region in this category because of its socio-economic similarities with the southern peninsula. Together the South and West account for the entirety of India’s peninsular coastline and for about 40% of total population. Historically, the South has seen far fewer external invasions and its social fabric is more homogenous than that of the North. This region is characterized by high per capita incomes, balanced gender ratios (Chart 4), and higher literacy ratios (Chart 5). Socio-political conflicts in this region are less common as compared to the North. Chart 4India’s South Has Healthy Gender Ratios Compared To North India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details Chart 5India’s South Is More Educated Than The Rest Of India India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details The state of Kerala is an exception in this region. The social fabric in this state is unusual, with Hindus accounting for only 55% of its population (versus the national average of 80%). The high degree of religious heterogeneity in this southern Indian state could perhaps be the reason why the state has lately seen a rise of small but significant incidences of social conflict. Unlike India’s young North, the median age of the population in India’s South is likely to be higher than the national average. Whilst India’s South is clearly young by global standards, this region will have to deal with problems of an ageing population before India’s North or East. The Southern region in India even today relies on migrant workers from India’s North. Region #3: The East This region is the youngest and the smallest of the three, as it accounts for the remaining 15% of India’s population. The region is young but must contend with low per capita incomes and very high degrees of religious diversity. Muslims, Christians, and other religions account for 20% of India’s population nationally but +50% of the population in India’s East. By virtue of sharing borders with countries like Bangladesh, Nepal, and Myanmar, this region is often the entry point for migration into India. It is historically the least stable of the three regions owing to its heterogeneity and the steady influx of migrants. To conclude, India is young but is also socially complex. Whilst a youthful population yields economic advantages, if this young population lacks economic opportunity then social dissatisfaction and associated risks can be a problem. Furthermore, history suggests that if a region’s populace is young but poor and diverse, then it often spawns the rise of identity politics, which takes policymakers’ attention away from matters of economic development. Social Complexity Index To better represent India’s demographic granularities, we created a Social Complexity Index (SCI), as shown in Map 1. Map 1India’s North Is A Demographic Tinderbox; South Is Prosperous But Ageing India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details The SCI for Indian states is created by adding a layer of socio-economic data over the demographic data. It uses three sets of variables: Economic well-being of a state as proxied by state-level per capita incomes. The lower the incomes, the greater the risk of social instability. This is because India’s per capita income is low to start with and if pockets have incomes that are substantially lower than the national average then the associated economic duress can be significant. Religious diversity in a state as measured by creating a Herfindahl-Hirschman Index of religious diversity in the state. The greater the religious diversity the greater the social complexity is expected to be. Youthfulness of a state as measured by population in the age group of 15-24 years relative to the total population. The greater the youth population ratio, the more complex are the social realities likely to be. If a state is exposed unfavorably to all three of the above stated parameters then such a state is deemed to have a high degree of social complexity and hence could be exposed to a higher risk of social conflicts and/or policy risks. Our Social Complexity Index (SCI) (Map 1) shows how parts of India are young but also socially complex. Why does this matter? This matters because a diverse, young and vast population’s attempt to develop will create policy risks. Policy Impact: Left-Leaning Economics, Right-Leaning Politics To be sure, governments in India will stay focused on creating large-scale jobs, a big concern for India’s median voter (Chart 6). However, given the time involved in building consensus for any major reform, progress on economic reforms (and hence job creation) will remain slow. India’s large population and democratic framework render the reform process more acceptable, but also less nimble. This contrasts with the speed of reforms executed by East Asian countries in the 1970s-90s, which turned them into export powerhouses. Two recent examples illustrate the problem of slow reform in India: Implementation of GST: Goods and services tax (GST) was a major reform that India embraced in 2017. However, the creation of a nation-wide GST was first mooted in 2000 and it took seventeen years for this reform to pass into law. Even in its current form India’s GST does not cover all products. It excludes large categories like petroleum products and electricity owing to resistance from state governments. Industrial sector growth: Despite India’s consistent efforts to grow its industrial sector as a source of large-scale, low-skill jobs, the share of this sector in India’s GDP has remained static for three decades (Chart 7). The services sector has grown rapidly in India over this period but its ability to absorb low-skill workers on a large scale is fundamentally restricted since (1) the sector needs mid-to-high skill workers and (2) the sector generates fewer jobs per unit of GDP owing to high degrees of productivity in the sector. Chart 6India’s Median Voter Worries Greatly About Job Creation India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details Chart 7India’s Industrial Sector Stuck In A Rut, India’s Workforce Is Connected And Aware India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details India’s inability to reform rapidly and create jobs on a large-scale will trigger policy risks. This factor is more relevant now than ever. In the 1990s, India was a small, closed economy that was just opening up. Hence slow reforms were acceptable as they yielded high growth off a low base. By contrast India’s masses today are at the forefront of connectivity (Chart 7). Slow job growth in a young country with high degrees of connectivity will have to be managed in the short term by responding to other needs of India’s median voter. This process might delay painful structural reforms necessary to improve productivity and hence create policy risks in the interim. What policy-risks is India exposed to? We highlight three policy risks that investors must brace for: Policy Risk #1: Structurally Large Budget Deficits Despite being young, India’s fiscal deficit has been large and as such comparable to that of countries that have an older demographic profile (Chart 8). Chart 8Despite India’s Youth, Its Fiscal Deficit Has Been Comparable To That Of Older Countries India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details Chart 9Unlike China, The Majority Of India’s Citizenry Lives On Less Than US$10 A Day India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details Whilst India’s fiscal deficit will rise and fall cyclically, it will remain elevated on a structural basis as India’s median voter is young but poor (Chart 9). This median voter will keep needing government support to tide over her economic duress. These fiscal transfers are likely to assume the form of transfer payments, food subsidies and a large interest burden on the exchequer who will need to borrow funds in the absence of adequate tax revenue growth. Two manifestations of this fiscal quagmire that India must contend with include: Revenue expenditure for India’s central government accounts for 85% of its total expenditure, with only 15% being set aside for more productive capital expenditure. Within central government revenue expenditure, 40% is foreclosed by food-subsidies, transfer payments, and interest payments. Can India’s fiscal deficit be expected to structurally trend lower? Only if India embraces big-ticket tax reforms. This appears unlikely given that India’s central tax revenue to GDP ratio has remained static at 10% of GDP for two decades owing to its inability to widen its tax base. Policy Risk #2: Foreign Policy Will Turn Rightwards India’s northern states are known to harbor unfavorable views of Pakistan. These are more unfavorable than the rest of India (Map 2). Geopolitical tension will persist due to a confluence of factors. Map 2Northern India Views Pakistan Even More Unfavorably Than Rest Of India India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details India may be forced to adopt a far more aggressive foreign policy response and shed its historical stance of neutrality. This will be done to respond to tectonic shifts in geopolitics as well as the preferences of India’s north that accounts for about 45% of India’s population. China’s active involvement in South Asia will accentuate this phenomenon whereby India tilts towards abandoning its historical foreign policy stance of non-alignment. An aggressive foreign policy stance will engender fiscal costs as well as diverting attention away from internal reform. The adoption of a more aggressive foreign policy stance will necessitate the maintenance of high defense spending when these scarce resources could be used for boosting productivity through spends on soft as well as hard infrastructure. Despite having low per capita incomes, India already is the third largest military spender globally. In 2022, India’s central government plans to allocate ~15% of its budget for defense, which is the same allocation that productivity-enhancing capital expenditure as a whole will attract. Since it will be politically untenable to cut social spending, defense spending will simply add to the budget deficit. Policy Risk #3: Regional Differences Could Get Amplified Over Time India’s northern states typically lag on human development indicators (Charts 4 and 5). Owing to their large population, these states have also lagged smaller states in the east more recently on vaccination rates, which could be a symptom of deeper problems of managing public services in highly populous states (Chart 10). Chart 10India’s Northern States Lagging On Vaccinations, Smaller Eastern States Are Leading India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details Whilst such differences between India’s more populous and less populous states are commonplace, these tensions could grow over the next few years. In specific, it is worth noting that a delimitation exercise in India is due in 2026. Delimitation refers to the process of redrawing boundaries for Lok Sabha seats to reflect changes in population. India’s Northern states are likely to receive an increased allocation of seats in India’s lower house (i.e. the Lok Sabha) beginning in 2026, despite poor performance on human development indicators. This is because India’s North accounted for 40% of seats in India’s lower house and accounted for 41% of its population in 1991. Owing rapid population growth, this region’s population share rose to 44% by 2011 and the ratio could rise further. Given that a review of the allocation of Lok Sabha seats is due in 2026, it is highly likely that India’s northern states get allocated more seats at this review. A change in political influence of different regions will have two sets of implications. Firstly, reforms that require a buy-in from all Indian states (such as GST implementation in 2017) could become trickier to implement if states that have delivered improvements in human development have to contend with a decline in political influence. Secondly, the rising political influence of India’s more populous states in the North could reinforce the trend of a less neutral and more aggressive foreign policy stance that we expect India to assume. Investment Conclusions Indian equity markets have historically traded at a hefty premium to Emerging Markets (EMs). This premium is often attributed to India’s youthful demographic structure. However academic literature has shown that realizing benefits associated with a youthful demographic structure is dependent on a country’s institutions and requires the productive employment of potential workers. It has also been shown, both theoretically and empirically, that there is nothing automatic about the link from demographic change to economic growth.1 Country-specific studies have also shown that it is difficult to find a robust relationship between asset returns on stocks, bonds, or bills, and a country’s age structure.2 An analysis of equity market returns generated by young EMs confirms that a youthful demographic structure can aid high equity returns but the geopolitical setting and macroeconomic factors matter too. Moreover, history confirms that each young country spawns a new generation of winners and losers. Fixed patterns in terms of top performing or worst performing sectors are not seen across young and populous EMs. The rest of this section highlights details pertaining to these two findings. Investment Implication#1: Youth Does Not Assure High Equity Market Returns China in the nineties, Indonesia & Brazil in the early noughties and India over the last decade had similar demographic features (see Row 1, 2 and 3 in Table 1). Table 1Leader And Laggard Sectors Can Vary Across Young, Populous Countries India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details However, it is worth noting that these four EMs delivered widely varying returns even when their demographic features were similar (see Row 5, 6 and 7 in Table 1). In real dollarized terms equity returns ranged from a CAGR of -22% to 8% for these four countries. The variation in returns can be attributed to differences in macroeconomic and geopolitical factors. Brazil’s period of political stability in the early 2000s along with its relatively high per capita incomes were potentially responsible for Brazil’s youthful demography translating into high equity market returns. At the other end of the spectrum, equity returns in China were the lowest despite a young demography owing to low per capita incomes and economic restructuring prevalent in the nineties. Investment Implication#2: Each Young Country Spawns A New Generation Of Winners And Losers Given that a young populace is expected to display a higher propensity to consume, sectors like consumer staples, consumer discretionary, and financials are expected to outperform in young countries. However, a cross-country analysis suggests that a young country does not necessarily throw up any consistent patterns of sector performance. Sectoral performance patterns too appear to be affected by demographics along with macroeconomic and geopolitical factors. Similarities in the profile of top performing sectors in India, China, Brazil and Indonesia when these countries were young are few and far between (see Row 9, 10 and 11 in Table 1). No patterns or similarities are evident even in the profile of worst performing sectors in India, China, Brazil and Indonesia when they had similar demographic features (see Row 12, 13 and 14 in Table 1). Even India’s own experience confirms that: There exists no correlation between India’s equity market returns and its demographic structure. India was at its youngest in the nineties and yet its peak equity market returns were achieved in the subsequent decade (see Row 4, 5 & 6 in Table 2). High domestic growth combined with the emergence of political stability potentially allowed India’s youth to translate into high equity market returns over 2000-2010. Table 2Youth Is Not A Sufficient Condition For A Market To Deliver High Returns India’s Demographics: The Devil Is In The Details India’s Demographics: The Devil Is In The Details There exists no pattern in terms of top or worst performing sectors in India as it has aged over the last three decades (see Row 8 to 13 in Table 2). Healthcare for instance was the top performing sector in India in the 1990s when India’s median age was only 21 years. Industrials as a sector have featured as one of the worst performing sectors in India in the 1990s as well as the late noughties despite India’s youthful age structure. This could be attributed to the fact that India’s growth model pivoted off service sector growth while industrial sector development has lagged. Bottom Line: History suggests that a youthful demographic structure is a necessary but not a sufficient condition for an emerging market like India to deliver high equity market returns. Besides demographics, domestic macroeconomic and regional geopolitical factors create a deep imprint on equity returns’ patterns too. India faces a geopolitical tailwind as its economy develops and China’s risks increase. Nevertheless, owing to India’s heterogeneity and poverty, its road to realizing its demographic dividend will be paved with policy risks. Even as India’s lead on the demographic front is expected to continue, tactical underweights on this EM too are warranted from time to time.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 David Bloom et al, "Global demographic change: dimensions and economic significance", NBER Working Paper No. 10817, September 2004, nber.org. 2 James M Poterba, "Demographic Structure and Asset Returns" The Review of Economics and Statistics, Vol. 83, No. 4, November 2001, The MIT Press.

Highlights Three distinct forces are likely to make South Asia’s geopolitical risks increasingly relevant to global investors. First, India’s tensions with China stem from China’s growing foreign policy assertiveness and India’s shift away from traditional neutrality toward aligning with the US and its allies. This creates a security dilemma in South Asia, just as in East Asia. Second, India’s economy is sputtering in the wake of the COVID-19 pandemic, adding fuel to nationalism and populism in advance of a series of important elections. India will stimulate the economy but it could also become more reactive on the international scene. Third, the US is withdrawing from Afghanistan and negotiating a deal with Iran in an effort to reduce the US military presence in the Middle East and South Asia. This will create a scramble for influence across both regions and a power vacuum in Afghanistan that is highly likely to yield negative surprises for India and its neighbors. Traditionally geopolitical risks in South Asia have a limited impact on markets. India’s growth slowdown and forthcoming fiscal stimulus are more relevant for investors. However, a sharp rise in geopolitical risk would undermine India’s structural advantages as the West diversifies away from China. Stay short Indian banks. Feature Geopolitical risks in South Asia are slowly but surely rising. India-Pakistan and China-India are well-known “conflict-dyads” or pairings. Historically, these two sets have been fighting each other over their fuzzy Himalayan border with limited global financial market consequences. But now fundamental changes are afoot that are altering the geopolitical setting in the region. Specifically, the coming together of three distinct forces could trigger a significant geopolitical event in South Asia. The three forces are as follow: Force #1: Sino-Indian Tensions Get Real About a year ago, Indian and Chinese troops clashed in Ladakh, a disputed territory in the Kashmir region. Following these clashes China reduced its military presence in the Pangong Tso area but its presence in some neighboring areas remains meaningful. Besides the troop build-up along India’s eastern border, China is building more air combat infrastructure in its India-facing western theatre. China’s major air bases have historically been concentrated in China’s eastern region, away from the Indian border (Map 1). Consequently, India has historically enjoyed an advantage in airpower. But China appears to be working to mitigate this disadvantage. Map 1Most Of China’s Major Aviation Units Are Located Away From India South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown Owing to China’s increased military focus along the Sino-India border, India’s threat perception of China has undergone a fundamental change in recent years. Notably, India has diverted some of its key army units away from its western Indo-Pak border towards its eastern border with China. India could now have nearly 200,000 troops deployed along its border with China, which would mark a 40% increase from last year.1 Turning attention to the Indo-Pak border, India’s problems with Pakistan appear under control for now. This is owing to the ceasefire agreement that was renewed by the two countries in February 2021. However, this peace cannot possibly be expected to last. This is mainly because core problems between the two countries (like Pakistan’s support of militant proxies and India’s control over Kashmir) remain unaddressed. History too suggests that bouts of peace between the two warring neighbors rarely last long. These bouts usually end abruptly when a terrorist attack takes place in India. With both political turbulence and economic distress in Pakistan rising, the fragile ceasefire between India and Pakistan could be upended over the next six months. In fact, two events over the last week point to the fragility of the ceasefire: Two drones carrying explosives entered an Indian air force station located in Jammu and Kashmir (i.e. a northern territory that India recently reorganized, to Pakistan’s chagrin). Even as no casualties were reported, this attack marks a turning point for terrorist activity in India as this was the first-time terrorists used drones to enter an Indian military base. Hours later, another drone attack struck an Indian base at the Ratnuchak-Kaluchak army station, the site of a major terrorist attack in 2002. Chart 1China, Pakistan And India Cumulatively Added 41 Nuclear Warheads Over 2020 South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown Given that the ceasefire was agreed recently, any further increase in terrorist activity in India over the next six months would suggest that a more substantial breakdown in relations is nigh. Distinct from these recent tensions, China’s troop deployment along India’s eastern arm and Pakistan’s presence along India’s western arm creates a strategic “pincer” that increasingly threatens India. India is naturally concerned. China and Pakistan are allies who have been working closely on projects including the strategic China-Pakistan Economic Corridor (CPEC). The CPEC is a collection of infrastructure projects in Pakistan that includes the development of a port in Gwadar where a future presence of the People's Liberation Army Navy (PLAN) is envisaged. Gwadar has the potential of providing China land-based access to the Indian Ocean. Trust in the South Asian region is clearly running low. Distinct from troop build-ups and drone-attacks, China, Pakistan, and India cumulatively added more than 40 nuclear warheads over the last year (Chart 1). China is reputed to be engaged in an even larger increase in its nuclear arsenal than the data show.2 From a structural perspective, too, geopolitical risks in the South Asian peninsula are bound to keep rising. When it comes to the conflicting Indo-Pak dyad, India’s geopolitical power has been rising relative to that of Pakistan in the 2000s. However, the geopolitical muscle of the Sino-Pak alliance is much greater than that of India on a standalone basis (Chart 2). Chart 2India Has Aligned With The QUAD To Counter The Sino-Pak Alliance South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown China’s active involvement in South Asia is responsible for driving India’s increasing desire to abandon its historical foreign policy stance of non-alignment. India’s membership in the Quadrilateral Security Dialogue (also known as the QUAD, whose other members include the US, Japan, and Australia) bears testimony to India’s active effort to develop closer relations with the US and its allies (Chart 2). India’s alignment with the US is deepening China’s and Pakistan’s distrust of India. Conventional and nuclear military deterrence should prevent full-scale war. But the regional balance is increasingly fluid which means geopolitical risks will slowly but surely rise in South Asia over the coming year and years. Force #2: A Growth Slowdown Alongside India’s Loaded Election Calendar The pandemic has hit the economies of South Asia particularly hard. South Asia historically maintained higher real GDP growth rates relative to Emerging Markets (EMs). But in 2021, this region’s growth rate is set to be lower than that of EM peers (Chart 3). History is replete with examples of a rise in economic distress triggering geopolitical events. South Asia is characterized by unusually low per capita incomes (Chart 4) and the latest slowdown could exacerbate the risk of both social unrest and geopolitical incidents materialising. Chart 3South Asian Economies Have Been Hit Hard By The Pandemic South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown Chart 4South Asia Is Characterized By Very Low Per Capita Incomes South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown To complicate matters a busy state elections calendar is coming up in India. Elections will be due in seven Indian states in 2022. These states account for about 25% of India’s population. State elections due in 2022 will amount to a high-stakes political battle. During state elections in 2021, the ruling Bharatiya Janata Party (BJP) was the incumbent in only one of the five states. In 2022, the BJP is the incumbent party in most of the states that are due for elections, which means it has the advantage but also has a lot to lose, especially in a post-pandemic environment. Elections kick off in the crucial state of Uttar Pradesh next February. Last time this state faced elections Prime Minister Narendra Modi was willing to go to great lengths to boost his popularity ahead of time. Specifically, he upset the nation with a large-scale and unprecedented de-monetization program. Given the busy state election calendar in 2022, we expect the BJP-led central government to focus on policy actions that can improve its support among Indian voters. Two policies in particular are likely to come through: Fiscal Stimulus Measures To Provide Economic Relief: India has refrained from administering a large post-pandemic stimulus thus far. As per budget estimates, the Indian central government’s total expenditure in FY22 is set to increase only by 1% on a year-on-year basis. But the expenditure-side restraint shown by India’s central government could change. With elections and a pandemic (which has now claimed over 400,000 lives in India), the central government could consider a meaningful increase in spending closer to February 2022. Map 2Northern India Views Pakistan Even More Unfavorably Than Rest Of India South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown India’s Finance Minister already announced a fiscal stimulus package of $85 billion (amounting to 2.8% of GDP) earlier this week. Whilst this stimulus entails limited fresh spending (amounting to about 0.6% of India’s GDP), we would not be surprised if the government follows it up with more spending closer to February 2022. Assertive Foreign Policy To Ward-Off Unfriendly Neighbors: India’s northern states are known to harbor unfavorable views of Pakistan (Map 2). The roots of this phenomenon can be traced to geography and the bloody civil strife of 1947 that was triggered by the partition of British-ruled India into the two independent dominions of India and Pakistan. Given the north’s unfavorable views of Pakistan and given looming elections, Indian policy makers may be forced to adopt a far more aggressive foreign policy response, to any terrorist strikes from Pakistan or territorial incursions by China. This kind of response was observed most recently ahead of the Indian General Elections in April-May 2019. An Indian military convoy was attacked by a suicide-bomber in early February 2019 and a Pakistan-based terrorist group claimed responsibility. A fortnight later the Indian air force launched unexpected airstrikes across the Line of Control which were then followed by the Pakistan air force conducting air strikes in Jammu and Kashmir. While the next round of Pakistani and Indian general elections is not due until 2023 and 2024, respectively, it is worth noting that of the seven state elections due in India in 2022, four are in the north (Uttar Pradesh, Punjab, Uttarakhand, and Himachal Pradesh). Force #3: Power Vacuum In Afghanistan The final reason to be wary of the South Asian geopolitical dynamic is the change in US policy: both the Iran nuclear deal expected in August and the impending withdrawal from Afghanistan in September. The US public has now elected three presidents on the demand that foreign wars be reduced. In the wake of Trump and populism the political establishment is now responding. Therefore Biden will ultimately implement both the Iran deal and the Afghan withdrawal regardless of delays or hang-ups. But then he will have to do damage control. In the case of Iran, a last-minute flare-up of conflict in the region is likely this summer, as the US, Israel, Saudi Arabia, and Iran underscore their red lines before the US and Iran settle down to a deal. Indeed it is already happening, with recent US attacks against Iran-backed Shia militias in Syria and Iraq. A major incident would push up oil prices, which is negative for India. But the endgame, an Iranian economic opening, is positive for India, since it imports oil and has had close relations with Iran historically. In the case of Afghanistan, the US exit will activate latent terrorist forces. It will also create a scramble for influence over this landlocked country that could lead to negative surprises across the region. The first principle of the peace agreement between the US and Afghanistan states that the latter will make all efforts to ensure that Afghan soil is not used to further terrorist activity. However, the enforceability of such a guarantee is next to impossible. Notably, the US withdrawal from Afghanistan will revive the Taliban’s influence in the region. This poses major risks for India, which has a long history of being targeted by Afghani terrorist groups. The Taliban played a critical role in the release of terrorists into Pakistan following the hijacking of an Indian Airlines flight in 1999. Furthermore, the Haqqani network, which has pledged allegiance to the Taliban, has attacked Indian assets in the past. Any attack on India deriving from the power vacuum in Afghanistan would upset the precarious regional balance. Whilst there are no immediate triggers for Afghani groups to launch a terrorist attack in India, the US withdrawal will trigger a tectonic shift in the region. Negative surprises emanating from Afghanistan should be expected. Investment Conclusions Chart 5Indian Banks Appear To Have Factored In All Positives Indian Banks Appear To Have Factored In All Positives Indian Banks Appear To Have Factored In All Positives We reiterate the need to pare exposure to Indian assets on a tactical basis. India’s growth engine is likely to misfire over the second half of the Indian financial year. Macroeconomic headwinds pose the chief risk for investors, but major geopolitical changes could act as a negative catalyst in the current context. So we urge clients to stay short Indian Banks (Chart 5). Financials account for the lion’s share of India’s benchmark index (26% weight). India could opt for an unexpected expansion in its fiscal deficit soon. Whilst we continue to watch fiscal dynamics closely, we expect the fiscal expansion to materialize closer to February 2022 when India’s most populous state (i.e. Uttar Pradesh) will undergo elections. Over the long run, India’s sense of insecurity will escalate in the context of a more assertive China, stronger Sino-Pakistani ties, and a power vacuum in Afghanistan. For that reason, New Delhi will continue to shed its neutrality and improve relations with the US-led coalition of democratic countries, with an aim to balance China. This process will feed China’s insecurity of being surrounded and contained by a hegemonic American system. This security dilemma is a source of South Asian geopolitical risk that will become more globally relevant over time. China’s conflict with the US and western world should create incentives for India to attract trade and investment. However, its ability to do so will be contingent upon domestic political factors and regional geopolitical factors.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Sudhi Ranjan Sen, ‘India Shifts 50,000 Troops to China Border in Historic Move’, Bloomberg, June 28, 2021, bloomberg.com. 2 Joby Warrick, “China is building more than 100 missile silos in its western desert, analysts say,” Washington Post, June 30, 2021, washingtonpost.com.

Highlights President Biden has called for the US intelligence community to investigate the origins of COVID-19 and one of Biden’s top diplomats has stated the obvious: the era of “engagement” with China is over. This clinches our long-held view that any Democratic president would be a hawk like President Trump. The US-China conflict – and global geopolitical risk – will revive and undermine global risk appetite. China faces a confluence of geopolitical and macroeconomic challenges, suggesting that its equity underperformance will continue. Domestic Chinese investors should stay long government bonds. Foreign investors should sell into the bond rally to reduce exposure to any future sanctions. The impending agreement of a global minimum corporate tax rate has limited concrete implications that are not already known but it symbolizes the return of Big Government in the western world. Our updated GeoRisk Indicators are available in the Appendix, as well as our monthly geopolitical calendar. Feature In our quarterly webcast, “Geopolitics And Bull Markets,” we argued that geopolitical themes matter to investors when they have a demonstrable relationship with the macroeconomic backdrop. When geopolitics and macro are synchronized, a simple yet powerful investment thesis can be discerned. The US war on terror, Russia’s resurgence, the EU debt crisis, and Brexit each provided cases in which a geopolitically informed macro view was both accessible and actionable at an early stage. Investors generally did well if they sold the relevant country’s currency and disfavored its equities on a relative basis. Chart 1China's Decade Of Troubles China's Decade Of Troubles China's Decade Of Troubles Of course, the market takeaway is not always so clear. When geopolitics and macroeconomics are desynchronized, the trick is to determine which framework will prevail over the financial markets and for how long. Sometimes the market moves to its own rhythm. The goal is not to trade on geopolitics but rather to invest with geopolitics. One of our key views for this year – headwinds for China – is an example of synchronization. Two weeks ago we discussed China’s macroeconomic challenge. In this report we discuss China’s foreign policy challenge: geopolitical pressure from the US and its allies. In particular we address President Biden’s call for a deeper intelligence dive into the origins of COVID-19. The takeaway is negative for China’s currency and risk assets. The Great Recession dealt a painful blow to the Chinese version of the East Asian economic miracle. By 2015, China’s financial turmoil and currency devaluation should have convinced even bullish investors to keep their distance from Chinese stocks and the renminbi. If investors stuck with this bearish view despite the post-2016 rally, on fear of trade war, they were rewarded in 2018-19. Only with China’s containment of COVID-19 and large economic stimulus in 2020 has CNY-USD threatened to break out (Chart 1). We expect the renminbi to weaken anew, especially once the Fed begins to taper asset purchases. Our cyclical view is still bullish but US-China relations are unstable so we remain tactically defensive. Forget Biden’s China Review, He’s A Hawk Chinese financial markets face a host of challenges this year, despite the positive factors for China’s manufacturing sector amid the global recovery. At home these challenges consist of a structural economic slowdown, a withdrawal of policy stimulus, bearish sentiment among households, and an ongoing government crackdown on systemic risk. Abroad the Democratic Party’s return to power in Washington means that the US will bring more allies to bear in its attempt to curb China’s rise. This combination of factors presents a headwind for Chinese equities and a tailwind for government bonds (Chart 2). This is true at least until the government should hit its pain threshold and re-stimulate. Chart 2Global Investors Still Wary Global Investors Still Wary Global Investors Still Wary New stimulus may not occur in 2022. The Communist Party’s leadership rotation merely requires economic stability, not rapid growth. While the central government has a record of stimulating when its pain threshold is hit, even under the economically hawkish President Xi Jinping, a financial market riot is usually part of this threshold. This implies near-term downside, particularly for global commodities and metals, which are also facing a Chinese regulatory backlash to deter speculation. In this context, President Biden’s call for a deeper US intelligence investigation into the origin of COVID-19 is an important confirming signal of the US’s hawkish turn toward China. Biden gave 90 days for the intelligence community to report back to him. We will not enter into the debate about COVID-19’s origins. From a geopolitical point of view it is a moot point. The facts of the virus origin may never be established. According to Biden’s statement, at least one US intelligence agency believes the “lab leak theory” is the most likely source of the virus (while two other agencies decided in favor of animal-to-human transmission). Meanwhile Chinese government spokespeople continue to push the theory that the virus originated at the US’s Fort Detrick in Maryland or at a US-affiliated global research center. What is certain is that the first major outbreak of a highly contagious disease occurred in Wuhan. Both sides are demanding greater transparency and will reject each other’s claims based on a lack of transparency. If the US intelligence report concludes that COVID originated from the Wuhan Institute of Virology, the Chinese government and media will reject the report. If the report exonerates the Wuhan laboratory, at least half of the US public will disbelieve it and it will not deter Biden from drawing a hard line on more macro-relevant policy disputes with China. The US’s hawkish bipartisan consensus on China took shape before COVID. Biden’s decision to order the fresh report introduces skepticism regarding the World Health Organization’s narrative, which was until now the mainstream media’s narrative. Previously this skepticism was ghettoized in US public discourse: indeed, until Biden’s announcement on May 26, the social media company Facebook suppressed claims that the virus came from a lab accident or human failure. Thus Biden’s action will ensure that a large swathe of the American public will always tend to support this theory regardless of the next report’s findings. At the same time Biden discontinued a State Department effort to prove the lab leak theory, which shows that it is not a foregone conclusion what his administration will decide. The good news is that even if the report concluded in favor of the lab leak, the Biden administration would remain highly unlikely to demand that China pay “reparations,” like the Trump administration demanded in 2020. This demand, if actualized, would be explosive. The bad news is that a future nationalist administration could conceivably use the investigation as a basis to demand reparations. Nationalism is a force to be reckoned with in both countries and the dispute over COVID’s origin will exacerbate it. Traditionally the presidents of both countries would tamp down nationalism or attempt to keep it harnessed. But in the post-Xi, post-Trump era it is harder to control. The death toll of COVID-19 will be a permanent source of popular grievance around the world and a wedge between the US and China (Chart 3). China’s international image suffered dramatically in 2020. So far in 2021 China has not regained any diplomatic ground. Chart 3Death Toll Of COVID-19 Biden Confirmed As A China Hawk (GeoRisk Update) Biden Confirmed As A China Hawk (GeoRisk Update) The US is repairing its image via a return to multilateralism while the Europeans have put their Comprehensive Agreement on Investment with China on hold due to a spat over sanctions arising from western accusations of genocide (a subject on which China pointedly answered that it did not need to be lectured by Europeans). Notably Biden’s Department of State also endorsed its predecessor’s accusation of genocide in Xinjiang. Any authoritative US intelligence review that solidifies doubts about the WHO’s initial investigation – even if it should not affirm the lab leak theory – would give Biden more ammunition in global opinion to form a democratic alliance to pressure China (for example, in Europe). An important factor that enables the US to remain hawkish on China is fiscal stimulus. While stimulus helps bring about economic recovery, it also lowers the bar to political confrontation (Chart 4). Countries with supercharged domestic demand do not have as much to fear from punitive trade measures. The Biden administration has not taken new punitive measures against China but it is clearly not worried about Chinese retaliation. Chart 4Large Fiscal Stimulus Lowers The Bar To Geopolitical Conflict Biden Confirmed As A China Hawk (GeoRisk Update) Biden Confirmed As A China Hawk (GeoRisk Update) China’s stimulus is underrated in this chart (which excludes non-fiscal measures) but it is still true that China’s policy has been somewhat restrained and it will need to stimulate its economy again in response to any new punitive measures or any global loss of confidence. At least China is limited in its ability to tighten policy due to the threat of US pressure and western trade protectionism. Simultaneous with Biden’s announcement on COVID-19, his administration’s coordinator for Indo-Pacific affairs, Kurt Campbell, proclaimed in a speech that the era of “engagement” with China is officially over and the new paradigm is one of “competition.” By now Campbell is stating the obvious. But this tone is a change both from his tone while serving in President Obama’s Department of State and from his article in Foreign Affairs last year (when he was basically auditioning for his current role in the Biden administration).1 Campbell even said in his latest remarks that the Trump administration was right about the “direction” of China policy (though not the “execution”), which is candid. Campbell was speaking at Stanford University but his comments were obviously aimed for broader consumption. Investors no longer need to wait for the outcome of the Biden administration’s comprehensive review of policy toward China. The answer is known: the Biden administration’s hawkishness is confirmed. The Department of Defense report on China policy, due in June, is very unlikely to strike a more dovish posture than the president’s health policy. Now investors must worry about how rapidly tensions will escalate and put a drag on global sentiment. Bottom Line: US-China relations are unstable and pose an immediate threat to global risk appetite. The fundamental geopolitical assessment of US-China relations has been confirmed yet again. The US is seeking to constrain China’s rise because China is the only country capable of rivaling the US for supremacy in Asia and the world. Meanwhile China is rejecting liberalization in favor of economic self-sufficiency and maintaining an offensive foreign policy as it is wary of US containment and interference. Presidents Biden and Xi Jinping are still capable of stabilizing relations in the medium term but they are unlikely to substantially de-escalate tensions. And at the moment tensions are escalating. China’s Reaction: The Example Of Australia How will China respond to Biden’s new inquiry into COVID’s origins? Obviously Beijing will react negatively but we would not expect anything concrete to occur until the result of the inquiry is released in 90 days. China will be more constrained in its response to the US than it has been with Australia, which called for an international inquiry early last year, as the US is a superior power. Australia was the first to ban Chinese telecom company Huawei from its 5G network (back in 2018) and it was the first to call for a COVID probe. Relations between China and Australia have deteriorated steadily since then, but macro trends have clearly driven the Aussie dollar. The AUD-JPY exchange rate is a good measure for global risk appetite and it is wavering in recent weeks (Chart 5). Chart 5Australian Dollar Follows Macro Trends, Rallies Amid China Trade Spat Australian Dollar Follows Macro Trends, Rallies Amid China Trade Spat Australian Dollar Follows Macro Trends, Rallies Amid China Trade Spat Tensions have also escalated due to China’s dependency on Australian commodity exports at a time of spiking commodity prices. This is a recurring theme going back to the Stern Hu affair. The COVID spat led China to impose a series of sanctions against Australian beef, barley, wine, and coal. But because China cannot replace Australian resources (at least, not in the short term), its punitive measures are limited. It faces rising producer prices as a result of its trade restrictions (Chart 6). This dependency is a bigger problem for China today than it was in previous cycles so China will try to diversify. Chart 6Constraints On China's Tarrifs On Australia Constraints On China's Tarrifs On Australia Constraints On China's Tarrifs On Australia By contrast, China is not likely to impose sanctions on the US in response to Biden’s investigation, unless Biden attacks first. China’s imports from the US are booming and its currency is appreciating sharply. Despite Beijing’s efforts to keep the Phase One trade deal from collapsing, Biden is maintaining Trump’s tariffs and the US-China trade divorce is proceeding (Chart 7). Bilateral tariff rates are still 16-17 percentage points higher than they were in 2018, with US tariffs on China at 19% (versus 3% on the rest of the world) while Chinese tariffs on the US stand at 21% (versus 6% on the rest of the world). The Biden administration timed this week’s hawkish statements to coincide with the first meeting of US trade negotiators with China, which was a more civil affair. Both countries acknowledged that the relationship is important and trade needs to be continued. However, US Trade Representative Katherine Tai’s comments were not overly optimistic (she told Reuters that the relationship is “very, very challenging”). She has also been explicit about maintaining policy continuity with the Trump administration. We highly doubt that China’s share of US imports will ever surpass its pre-Trump peaks. The Biden administration has also refrained so far from loosening export controls on high-tech trade with China. This has caused a bull market in Taiwan while causing problems for Chinese semiconductor stocks’ relative performance (Chart 8). If Biden’s policy review does not lead to any relaxation of export controls on commercial items then it will mark a further escalation in tensions. Chart 7US Tarrifs Reduce China In Trade Deficit US Tarrifs Reduce China In Trade Deficit US Tarrifs Reduce China In Trade Deficit Bottom Line: Until Presidents Biden and Xi stabilize relations at the top, the trade negotiations over implementing the Phase One trade deal – and any new Phase Two talks – cannot bring major positive surprises for financial markets. Chart 8US Export Controls Amid Chip Shortage US Export Controls Amid Chip Shortage US Export Controls Amid Chip Shortage Congress Is More Hawkish Than Biden Biden’s ability to reduce frictions with China, should he seek to, will also be limited by Congress and public opinion. With the US deeply politically divided, and polarization at historically high levels, China has emerged as one of the few areas of agreement. The hawkish consensus is symbolized by new legislation such as the Strategic Competition Act, which is making its way through the Senate rapidly. Congress is also trying to boost US competitiveness through bills such as the Endless Frontier Act. These bills would subject China to scrutiny and potential punitive measures over a broad range of issues but most of all they would ignite US industrial policy , STEM education, and R&D, and diversify the US’s supply chains. We would highlight three key points with regard to the global impact of this legislation: Global supply chains are shifting regardless: This trend is fairly well established in tech, defense, and pharmaceuticals. It will continue unless we see a major policy reversal from China to try to court western powers and reduce frictions. The EU and India are less enthusiastic than the US and Australia about removing China from supply chains but they are not opposed. The EU Commission has recommended new defensive economic measures that cover supply chains in batteries, cloud services, hydrogen energy, pharmaceuticals, materials, and semiconductors. As mentioned, the EU is also hesitating to ratify the Comprehensive Agreement on Investment with China. Hence the EU is moving in the US’s direction independently of proposed US laws. After all, China’s rise up the tech value chain (and its decision to stop cutting back the size of its manufacturing sector) ultimately threatens the EU’s comparative advantage. The EU is also aligned with the US on democratic values and network security. India has taken a harder stance on China than usual, which marks an important break with the past. India’s decision to exclude Huawei from its 5G network is not final but it is likely to be at least partially implemented. A working group of democracies is forming regardless. The Strategic Competition Act calls for the creation of a working group of democracies but the truth is that this is already happening through more effective forums like the G7 and bilateral summits. Just as the implementation of the act would will ultimately depend on President Biden, so the willingness of other countries to adopt the recommendations of the working group would depend on their own executives. Allies have leeway as Biden will not use punitive measures against them: Any policy change from the EU, UK, India, and Australia will be independent of the US Congress passing the Strategic Competition Act. These countries will be self-directed. The US would have to devote diplomatic energy to maintaining a sustained effort by these states to counter China in the face of economic costs. This will be limited by the fact that the Biden administration will be very reluctant to impose punitive measures on allies to insist on their cooperation. The allies will set the pace of pressure on China rather than the United States. This gives the EU an important position, particularly Germany. And yet the trends in Germany suggest that the government will be more hawkish on China after the federal elections in September. Bottom Line: The Biden administration is unlikely to use punitive measures against allies so new US laws are less important than overall US diplomacy with each of the allies. Some allies will be less compliant with US policies given their need for trade with China. But so far there appears to be a common position taking shape even with the EU that is prejudicial to China’s involvement in key sectors of emerging technologies. If China does not respond by reducing its foreign policy assertiveness, then China’s economic growth will suffer. That drag would have to be offset by new supply chain construction in Southeast Asia and other countries. Investment Takeaways The foregoing highlights the international risks facing China even at a time when its trend growth is slowing (Chart 9) and its ongoing struggle with domestic financial imbalances is intensifying. China’s debt-service costs have risen sharply and Beijing is putting pressure on corporations and local governments to straighten out their finances (Chart 10), resulting in a wave of defaults. This backdrop is worrisome for investors until policymakers reassure them that government support will continue. Chart 9China's Growth Potential Slowing China's Growth Potential Slowing China's Growth Potential Slowing Chart 10China's Leaders Struggle With Debt China's Leaders Struggle With Debt China's Leaders Struggle With Debt China’s domestic stability is a key indicator of whether geopolitical risks could spiral out of control. In particular we think aggressive action in the Taiwan Strait is likely to be delayed as long as the Chinese economy and regime are stable. China has rattled sabers over the strait this year in a warning to the United States not to cross its red line (Chart 11). It is not yet clear how Biden’s policy continuity with the Trump administration will affect cross-strait stability. We see no basis yet for changing our view that there is a 60% chance of a market-negative geopolitical incident in 2021-22 and a 5% chance of full-scale war in the short run. Chart 11China PLA Flights Over Taiwan Strait Biden Confirmed As A China Hawk (GeoRisk Update) Biden Confirmed As A China Hawk (GeoRisk Update) Putting all of the above together, we see substantial support for two key market-relevant geopolitical risks: Chinese domestic politics (including policy tightening) and persistent US-China tensions (including but not limited to the Taiwan Strait). We remain tactically defensive, a stance supported by several recent turns in global markets: The global stock-to-bond ratio has rolled over. China is a negative factor for global risk appetite (Chart 12). Global cyclical equities are no longer outperforming defensives. There is a stark divergence between Chinese cyclicals and global cyclicals stemming from the painful transition in China’s bloated industrial economy (Chart 13). Global large caps are catching a bid relative to small caps (Chart 14). Chart 12Global Stock-To-Bond Ratio Rolled Over Global Stock-To-Bond Ratio Rolled Over Global Stock-To-Bond Ratio Rolled Over Chart 13Global Cyclicals-To-Defensives Pause Biden Confirmed As A China Hawk (GeoRisk Update) Biden Confirmed As A China Hawk (GeoRisk Update) Chart 14Global Large Caps Catch A Bid Versus Small Caps Global Large Caps Catch A Bid Versus Small Caps Global Large Caps Catch A Bid Versus Small Caps Cyclically the global economic recovery should continue as the pandemic wanes. China will eventually relax policy to prevent too abrupt of a slowdown. Therefore our strategic portfolio reflects our high-conviction view that the current global economic expansion will continue even as it faces hurdles from the secular rise in geopolitical risk, especially US-China cold war. Measurable geopolitical risk and policy uncertainty are likely to rebound sooner rather than later, with a negative impact on high-beta risk assets. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Coda: Global Minimum Tax Symbolizes Return Of Big Government On Thursday, the US Treasury Department released a proposal to set the global minimum corporate tax rate at 15%. The plan is to stop what Treasury Secretary Janet Yellen has referred to as a global “race to the bottom” and create the basis for a rehabilitation of government budgets damaged by pandemic-era stimulus. Although the newly proposed 15% rate is significantly below President Biden’s bid to raise the US Global Intangible Low-Taxed Income (GILTI) rate to 21% from 10.5%, it is the same rate as his proposed minimum tax on corporate book income. Biden is also raising the headline corporate tax rate from 21% to around 25% (or at highest 28%). Negotiators at the OECD were initially discussing a 12.5% global minimum rate. The finance ministers of both France and Germany – where the corporate income tax rates are 32.0% and 29.9%, respectively – both responded positively to the announcement. However, Ireland, which uses low corporate taxes as an economic development strategy, is obviously more comfortable with a minimum closer to its own 12.5% rate. Discussions are likely to occur when G7 finance ministers meet on June 4-5. Countries are hoping to establish a broad outline for the proposal by the G20 meeting in early July. It is highly likely that the OECD will come to an agreement. However, it is not a truly “global” minimum as there will still be tax havens. Compliance and enforcement will vary across countries. A close look at the domestic political capital of the relevant countries shows that while many countries have the raw parliamentary majorities necessary to raise taxes, most countries have substantial conservative contingents capable of preventing stiff corporate tax hikes (Table 1, in the Appendix). Our Geopolitical strategists highlight that the Biden administration’s compromise on the minimum rate reflects its pragmatism as well as emphasis on multilateralism. Any global deal will be non-binding but the two most important low-tax players are already committed to raising corporate rates well above this level: Biden’s plan is noted above, while the UK’s budget for March includes a jump in the business rate to 25% in April 2023 from the current 19%. Ireland and Hungary are the only outliers but they may eventually be forced to yield to such a large coalition of bigger economies (Chart 15). Chart 15Global Minimum Corporate Tax Impact Is Symbolic Rather Than Concrete Biden Confirmed As A China Hawk (GeoRisk Update) Biden Confirmed As A China Hawk (GeoRisk Update) Thus a nominal minimum corporate tax rate is likely to be forged but it will not be truly global and it will not change the corporate rate for most countries. The reality of what companies pay will also depend on loopholes, tax havens, and the effective tax rate. Bottom Line: On a structural horizon, the global minimum corporate tax is significant for showing a paradigm shift in global macro policy: western governments are starting to raise taxes and revenue after decades of cutting taxes. The experiment with limited government has ended and Big Government is making a comeback. On a cyclical horizon, the US concession on global minimum tax is that the Biden administration aims to be pragmatic and “get things done.” Biden is also working with Republicans to pass bills covering some bipartisan aspects of his domestic agenda, such as trade, manufacturing, and China. The takeaway from a global point of view is that Biden may prove to be a compromiser rather than an ideologue, unlike his predecessors.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Roukaya Ibrahim Vice President Daily Insights RoukayaI@bcaresearch.com Footnotes 1 Kurt M. Campbell and Jake Sullivan, "Competition Without Catastrophe," Foreign Affairs, September/October 2019, foreignaffairs.com. Section II: Appendix Table 1OECD: Which Countries Are Willing And Able To Raise Corporate Tax Rates? Biden Confirmed As A China Hawk (GeoRisk Update) Biden Confirmed As A China Hawk (GeoRisk Update) GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan – Province Of China Taiwan-Province of China: GeoRisk Indicator Taiwan-Province of China: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights Biden’s first 100 days are characterized by a liberal spend-and-tax agenda unseen since the 1960s. It is not a “bait and switch,” however. Voters do not care about deficits and debt. At least not for now. The apparent outcome of the populist surge in the US and UK in 2016 is blowout fiscal spending. Yet the US and UK also invented and distributed vaccines faster than others. US growth and equities have outperformed while the US dollar experienced a countertrend bounce. While growth will rotate to other regions, China’s stimulus is on the wane. Of Biden’s three initial geopolitical risks, two are showing signs of subsiding: Russia and Iran. US-China tensions persist, however, and Biden has been hawkish so far. Our new Australia Geopolitical Risk Indicator confirms our other indicators in signaling that China risk, writ large, remains elevated. Cyclically we are optimistic about the Aussie and Australian stocks. Mexico’s midterm elections are likely to curb the ruling party’s majority but only marginally. The macro and geopolitical backdrop is favorable for Mexico. Feature US President Joe Biden gave his first address to the US Congress on April 28. Biden’s first hundred days are significant for his extravagant spending proposals, which will rank alongside those of Lyndon B. Johnson’s Great Society, if not Franklin Delano Roosevelt’s New Deal, in their impact on US history, for better and worse. Chart 1Biden's First 100 Days - The Market's Appraisal Biden's First 100 Days - The Market's Appraisal Biden's First 100 Days - The Market's Appraisal The global financial market appraisal is that Biden’s proposals will turn out for the better. The market has responded to the US’s stimulus overshoot, successful vaccine rollout, and growth outperformance – notably in the pandemic-struck service sector – by bidding up US equities and the dollar (Chart 1). From a macro perspective we share the BCA House View in leaning against both of these trends, preferring international equities and commodity currencies. However, our geopolitical method has made it difficult for us to bet directly against the dollar and US equities. Geopolitics is about not only wars and trade but also the interaction of different countries’ domestic politics. America’s populist spending blowout is occurring alongside a sharp drop in China’s combined credit-and-fiscal impulse, which will eventually weigh on the global economy. This is true even though the rest of the world is beginning to catch up in vaccinations and economic normalization. As for traditional geopolitical risk – wars and alliances – Biden has not yet leaped over the three initial foreign policy hurdles that we have highlighted: China, Russia, and Iran. In this report we will update the view on all three, as there is tentative improvement on the Russian and Iranian fronts. In addition, we will introduce our newest geopolitical risk indicator – for Australia – and update our view on Mexico ahead of its June 6 midterm elections. Biden’s Fiscal Blowout From a macro point of view, Biden’s $1.9 trillion American Rescue Plan Act (ARPA) was much larger than what Republicans would have passed if President Trump had won a second term. His proposed $2.3 trillion American Jobs Plan (AJP) is also larger, though both candidates were likely to pass an infrastructure package. The difference lies in the parts of these packages that relate to social spending and other programs, beyond COVID relief and roads and bridges. The Republican proposal for COVID relief was $618 billion while the Republicans’ current proposal on infrastructure is $568 billion – marking a $3 trillion difference from Biden. In reality Republicans would have proposed larger spending if Trump had remained president – but not enough to close this gap. And Biden is also proposing a $1.8 trillion American Families Plan (AFP). Biden’s praise for handling the vaccinations must be qualified by the Trump administration’s successful preparations, which have been unfairly denigrated. Similarly, Biden’s blame for the migrant surge at the southern border must be qualified by the fact that the surge began last year.1 A comparison with the UK will put Biden’s administration into perspective. The only country comparable to the US in terms of the size of fiscal stimulus over 2019-21 so far – excluding Biden’s AJP and AFP, which are not yet law – is the United Kingdom. Thus the consequence of the flare-up of populism in the Anglo-Saxon world since 2016 is a budget deficit blowout as these countries strive to suppress domestic socio-political conflict by means of government largesse, particularly in industrial and social programs. However, populist dysfunction was also overrated. Both the US and UK retain their advantages in terms of innovation and dynamism, as revealed by the vaccine and its rollout (Chart 2). Chart 2Dysfunctional Anglo-Saxon Populism? Dysfunctional Anglo-Saxon Populism? Dysfunctional Anglo-Saxon Populism? No sharp leftward turn occurred in the UK, where Prime Minister Boris Johnson and his Conservatives had the benefit of a pre-COVID election in December 2019, which they won. By contrast, in the US, President Trump and the Republicans contended an election after the pandemic and recession had virtually doomed them to failure. There a sharp leftward turn is taking place. Going forward the US will reclaim the top rank in terms of fiscal stimulus, as Biden is likely to get his infrastructure plan (AJP) passed. Our updated US budget deficit projections appear in Chart 3. Our sister US Political Strategy gives the AJP an 80% chance of passing in some form and the AFP only a 50% chance of passing, depending on how quickly the AJP is passed. This means the blue dashed line is more likely to occur than the red dashed line. The difference is slight despite the mind-boggling headline numbers of the plans because the spending is spread out over eight-to-ten years and tax hikes over 15 years will partially offset the expenditures. Much will depend on whether Congress is willing to pay for the new spending. In Chart 3 we assume that Biden will get half of the proposed corporate tax hikes in the AJP scenario (and half of the individual tax hikes in the AFP scenario). If spending is watered down, and/or tax hikes surprise to the upside, both of which are possible, then the deficit scenarios will obviously tighten, assuming the economic recovery continues robustly as expected. But in the current political environment it is safest to plan for the most expansive budget deficit scenarios, as populism is the overriding force. Chart 3Biden’s Blowout Spending Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Biden’s campaign plan was even more visionary, so it is not true that Biden pulled a “bait and switch” on voters. Rather, the median voter is comfortable with greater deficits and a larger government role in American life. Bottom Line: The implication of Biden’s spending blowout is reflationary for the global economy, cyclically negative for the US dollar, and positive for global equities. But on a tactical time frame the rotation to other equities and currencies will also depend on China’s fiscal-and-credit deceleration and whether geopolitical risk continues to fall. Russia: Some Improvement But Coast Not Yet Clear US-Russia tensions appeared to fizzle over the past week but the coast is not yet clear. We remain short Russian currency and risk assets as well as European emerging market equities. Tensions fell after President Putin’s State of the Nation address on April 21 in which he warned the West against crossing Russia’s “red lines.” Biden’s sanctions on Russia were underwhelming – he did not insist on halting the final stages of the Nord Stream II pipeline to Germany. Russia declared it would withdraw its roughly 100,000 troops from the Ukrainian border by May 1. Russian dissident Alexei Navalny ended his hunger strike. Putin attended Biden’s Earth Day summit and the two are working on a bilateral summit in June. Chart 4Russia's Domestic Instability Will Continue Russia's Domestic Instability Will Continue Russia's Domestic Instability Will Continue De-escalation is not certain, however. First, some US officials have cast doubt on Russia’s withdrawal of troops and it is known that arms and equipment were left in place for a rapid mobilization and re-escalation if necessary. Second, Russian-backed Ukrainian separatists will be emboldened, which could increase fighting in Ukraine that could eventually provoke Russian intervention. Third, the US has until August or September to prevent Nord Stream from completion. Diplomacy between Russia and the US (and Russia and several eastern European states) has hit a low point on the withdrawal of ambassadors. Fourth, Russian domestic politics was always the chief reason to prepare for a worse geopolitical confrontation and it remains unsettled. Putin’s approval rating still lingers in the relatively low range of 65% and government approval at 49%. The economic recovery is weak and facing an increasingly negative fiscal thrust, along with Europe and China, Russia’s single-largest export destination (Chart 4). Putin’s handouts to households, in anticipation of the September Duma election, only amount to 0.2% of GDP. More measures will probably be announced but the lead-up to the election could still see an international adventure designed to distract the public from its socioeconomic woes. Russia’s geopolitical risk indicators ticked up as anticipated (Chart 5). They may subside if the military drawdown is confirmed and Biden and Putin lower the temperature. But we would not bet on it. Chart 5Russian Geopolitical Risk: Wait For 'All Clear' Signal Russian Geopolitical Risk: Wait For 'All Clear' Signal Russian Geopolitical Risk: Wait For 'All Clear' Signal Bottom Line: It is possible that Biden has passed his first foreign policy test with Russia but it is too soon to sound the “all clear.” We remain short Russian ruble and short EM Europe until de-escalation is confirmed. The Russian (and German) elections in September will mark a time for reassessing this view. Iran: Diplomacy On Track (Hence Jitters Will Rise) While Russia may or may not truly de-escalate tensions in Ukraine, the spring and summer are sure to see an increase in focus on US-Iran nuclear negotiations. Geopolitical risks will remain high prior to the conclusion of a deal and will materialize in kinetic attacks of various kinds. This thesis is confirmed by the alleged Israeli sabotage of Iran’s Natanz nuclear facility this month. The US Navy also fired warning shots at Iranian vessels staging provocations. Sporadic attacks in other parts of the region also continue to flare, most recently with an Iranian tanker getting hit by a drone at a Syrian oil terminal.2 The US and Iran are making progress in the Vienna talks toward rejoining the 2015 nuclear deal from which the US withdrew in 2018. Iran pledged to enrich uranium up to 60% but also said this move was reversible – like all its tentative violations of the Joint Comprehensive Plan of Action (JCPA) so far (Table 1). Iran also offered a prisoner swap with the US. Saudi Arabia appears resigned to a resumption of the JCPA that it cannot prevent, with crown prince Mohammed bin Salman offering diplomatic overtures to both the US and Iran. Table 1Iran’s Nuclear Program And Compliance With JCPA 2015 Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Still, the closer the US and Iran get to a deal the more its opponents will need to either take action or make preparations for the aftermath. The allegation that former US Secretary of State John Kerry’s shared Israeli military plans with Iranian Foreign Minister Javad Zarif is an example of the kind of political brouhaha that will occur as different elements try to support and oppose the normalization of US-Iran ties. More importantly Israel will underscore its red line against nuclear weaponization. Previously Iran was set to reach “breakout” capability of uranium enrichment – a point at which it has enough fissile material to produce a nuclear device – as early as May. Due to sabotage at the Natanz facility the breakout period may have been pushed back to July.3 This compounds the significance of this summer as a deadline for negotiating a reduction in tensions. While the US may be prepared to fudge on Iran’s breakout capabilities, Israel will not, which means a market-relevant showdown should occur this summer before Israel backs down for fear of alienating the United States. Tit-for-tat attacks in May and June could cause negative surprises for oil supply. Then there will be a mad dash by the negotiators to agree to deal before the de facto August deadline, when Iran inaugurates a new president and it becomes much harder to resolve outstanding issues. Chart 6Iran Deal Priced Into Oil Markets? Iran Deal Priced Into Oil Markets? Iran Deal Priced Into Oil Markets? Hence our argument that geopolitics adds upside risk to oil prices in the first half of the year but downside risk in the second half. The market’s expectations seem already to account for this, based on the forward curve for Brent crude oil. The marginal impact of a reconstituted Iran nuclear deal on oil prices is slightly negative over the long run since a deal is more likely to be concluded than not and will open up Iran’s economy and oil exports to the world. However, our Commodity & Energy Strategy expects the Brent price to exceed expectations in the coming years, judging by supply and demand balances and global macro fundamentals (Chart 6). If an Iran deal becomes a fait accompli in July and August the Saudis could abandon their commitment to OPEC 2.0’s production discipline. The Russians and Saudis are not eager to return to a market share war after what happened in March 2020 but we cannot rule it out in the face of Iranian production. Thus we expect oil to be volatile. Oil producers also face the threat of green energy and US shale production which gives them more than one reason to keep up production and prevent prices from getting too lofty. Throughout the post-2015 geopolitical saga between the US and Iran, major incidents have caused an increase in the oil-to-gold ratio. The risk of oil supply disruption affected the price more than the flight to gold due to geopolitical or war risk. The trend generally corresponds with that of the copper-to-gold ratio, though copper-to-gold rose higher when growth boomed and oil outperformed when US-Iran tensions spiked in 2019. Today the copper-to-gold ratio is vastly outperforming the oil-to-gold on the back of the global recovery (Chart 7). This makes sense from the point of view of the likelihood of a US-Iran deal this year. But tensions prior to a deal will push up oil-to-gold in the near term. Chart 7Biden Passes Iran Test? Likely But Not A Done Deal Biden Passes Iran Test? Likely But Not A Done Deal Biden Passes Iran Test? Likely But Not A Done Deal Bottom Line: The US-Iran diplomacy is on track. This means geopolitical risk will escalate in May and June before a short-term or interim deal is agreed in July or August. Geopolitical risk stemming from US-Iran relations will subside thereafter, unless the deadline is missed. The forward curve has largely priced in the oil price downside except for the risk that OPEC 2.0 becomes dysfunctional again. We expect upside price surprises in the near term. Biden, China, And Our Australia GeoRisk Indicator Ostensibly the US and Russia are avoiding a war over Ukraine and the US and Iran are negotiating a return to the 2015 nuclear deal. Only US-China relations utterly lack clarity, with military maneuvering in the Taiwan Strait and South China Sea and tensions simmering over the gamut of other disputes. Chart 8Biden Still Faces China Test Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Biden’s First 100 Days In Foreign Policy (GeoRisk Update) The latest data on global military spending show not only that the US and China continue to build up their militaries but also that all of the regional allies – including Japan! – are bulking up defense spending (Chart 8). This is a substantial confirmation of the secular growth of geopolitical risk, specifically in reaction to China’s rise and US-China competition. The first round of US-China talks under Biden went awry but since then a basis has been laid for cooperation on climate change, with President Xi Jinping attending Biden’s virtual climate change summit (albeit with no bilateral summit between the two). If John Kerry is removed as climate czar over his Iranian controversy it will not have an impact other than to undermine American negotiators’ reliability. The deeper point is that climate is a narrow basis for US-China cooperation and it cannot remotely salvage the relationship if a broader strategic de-escalation is not agreed. Carbon emissions are more likely to become a cudgel with which the US and West pressure China to reform its economy faster. The Department of Defense is not slated to finish its comprehensive review of China policy until June but most US government departments are undertaking their own reviews and some of the conclusions will trickle out in May, whether through Washington’s actions or leaks to the press. Beijing could also take actions that upend the Biden administration’s assessment, such as with the Microsoft hack exposed earlier this year. The Biden administration will soon reveal more about how it intends to handle export controls and sanctions on China. For example, by May 19 the administration is slated to release a licensing process for companies concerned about US export controls on tech trade with China due to the Commerce Department’s interim rule on info tech supply chains. The Biden administration looks to be generally hawkish on China, a view that is now consensus. Any loosening of punitive measures would be a positive surprise for Chinese stocks and financial markets in general. There are other indications that China’s relationship with the West is not about to improve substantially – namely Australia. Australia has become a bellwether of China’s relations with the world. While the US’s defense commitments might be questionable with regard to some of China’s neighbors – namely Taiwan (Province of China) but also possibly South Korea and the Philippines – there can be little doubt that Australia, like Japan, is the US’s red line in the Pacific. Australian politics have been roiled over the past several years by the revelation of Chinese influence operations, state- or military-linked investments in Australia, and propaganda campaigns. A trade war erupted last year when Australia called for an investigation into the origins of COVID-19 and China’s handling of it. Most recently, Victoria state severed ties with China’s Belt and Road Initiative. Despite the rise in Sino-Australian tensions, the economic relationship remains intact. China’s stimulus overweighed the impact of its punitive trade measures against Australia, both by bidding up commodity prices and keeping the bulk of Australia’s exports flowing (Chart 9). As much as China might wish to decouple from Australia, it cannot do so as long as it needs to maintain minimum growth rates for the sake of social stability and these growth rates require resources that Australia provides. For example, global iron ore production excluding Australia only makes up 80% of China’s total iron ore imports, which necessitates an ongoing dependency here (Chart 10). Brazil cannot make up the difference. Chart 9China-Australia Trade Amid Tensions China-Australia Trade Amid Tensions China-Australia Trade Amid Tensions Chart 10China Cannot Replace Australia China Cannot Replace Australia China Cannot Replace Australia This resource dependency does not necessarily reduce geopolitical tension, however, because it increases China’s supply insecurity and vulnerability to the US alliance. The US under Biden explicitly aims to restore its alliances and confront autocratic regimes. This puts Australia at the front lines of an open-ended global conflict. Chart 11Introducing: Australia GeoRisk Indicator (Smoothed) Introducing: Australia GeoRisk Indicator (Smoothed) Introducing: Australia GeoRisk Indicator (Smoothed) Our newly devised Australia GeoRisk Indicator illustrates the point well, as it has continued surging since the trade war with China first broke out last year (Chart 11). This indicator is based on the Australian dollar and its deviation from underlying macro variables that should determine its course. These variables are described in Appendix 1. If the Aussie weakens relative to these variables, then an Australian-specific risk premium is apparent. We ascribe that premium to politics and geopolitics writ large. A close examination of the risk indicator’s performance shows that it tracks well with Australia’s recent political history (Chart 12). Previous peaks in risk occurred when President Trump rose to power and Australia, like Canada, found itself beset by negative pressures from both the US and China. In particular, Trump threatened tariffs and the Australian government banned China’s Huawei from its 5G network. Today the rise in geopolitical risk stems almost exclusively from China. There is potential for it to roll over if Biden negotiates a reduction in tensions but that is a risk to our view (an upside risk for Australian and global equities). Chart 12Australian GeoRisk Indicator (Unsmoothed) Australian GeoRisk Indicator (Unsmoothed) Australian GeoRisk Indicator (Unsmoothed) What does this indicator portend for tradable Australian assets? As one would expect, Australian geopolitical risk moves inversely to the country’s equities, currency, and relative equity performance (Chart 13). Australian equities have risen on the back of global growth and the commodity boom despite the rise in geopolitical risk. But any further spike in risk could jeopardize this uptrend. Chart 13Australia Geopolitical Risk And Tradable Assets Australia Geopolitical Risk And Tradable Assets Australia Geopolitical Risk And Tradable Assets An even clearer inverse relationship emerges with the AUD-JPY exchange rate, a standard measure of risk-on / risk-off sentiment in itself. If geopolitical risk rises any further it should cause a reversal in the currency pair. Finally, Australian equities have not outperformed other developed markets excluding the US, which may be due to this elevated risk premium. Bottom Line: China is the most important of Biden’s foreign policy hurdles and unlike Russia and Iran there is no sign of a reduction in tension yet. Our Australian GeoRisk Indicator supports the point that risk remains very elevated in the near term. Moreover China’s credit deceleration is also negative for Australia. Cyclically, however, assuming that China does not overtighten policy, we take a constructive view on the Aussie and Australian equities. Biden’s Border Troubles Distract From Bullish Mexico Story The biggest criticism of Biden’s first 100 days has been his reduction in a range of enforcement measures on the southern border which has encouraged an overflow of immigrants. Customs and Border Patrol have seen a spike in “encounters” from a low point of around 17,000 in 2020 to about 170,000 today. The trend started last year but accelerated sharply after the election and had surpassed the 2019 peak of 144,000. Vice President Kamala Harris has been put in charge of managing the border crisis, both with Mexico and Central American states. She does not have much experience with foreign policy so this is her opportunity to learn on the job. She will not be able to accomplish much given that the Biden administration is unwilling to use punitive measures or deterrence and will not have large fiscal resources available for subsidizing the nations to the south. With the US economy hyper-charged, especially relative to its southern neighbors, the pace of immigration is unlikely to slacken. From a macro point of view the relevance is that the US is not substantially curtailing immigration – quite the opposite – which means that labor force growth will not deviate from its trend. What about Mexico itself? It is not likely that Harris will be able to engage on a broader range of issues with Mexico beyond immigration. As usual Mexico is beset with corruption, lawlessness, and instability. To these can be added the difficulties of the pandemic and vaccine rollout. Tourism and remittances are yet to recover. Cooperation with US federal agents against the drug cartels is deteriorating. Cartels control an estimated 40% of Mexican territory.4 Nevertheless, despite Mexico’s perennial problems, we hold a positive view on Mexican currency and risk assets. The argument rests on five points: Strong macro fundamentals: With China’s fiscal-and-credit impulse slowing sharply, and US stimulus accelerating, Mexico stands to benefit. Mexico has also run orthodox monetary and fiscal policies. It has a demographic tailwind, low wages, and low public debt. The stars are beginning to align for the country’s economy, according to our Emerging Markets Strategy. US and Canadian stimulus: The US and Canada have the second- and third-largest fiscal stimulus of all the major countries over the 2019-21 period, at 9% and 8% of GDP respectively. Mexico, with the new USMCA free trade deal in hand, will benefit. US protectionism fizzled: Even Republican senators blocked President Trump’s attempted tariffs on Mexico. Trump’s aggression resulted in the USMCA, a revised NAFTA, which both US political parties endorsed. Mexico is inured to US protectionism, at least for the short and medium term. Diversification from China: Mexico suffered the greatest opportunity cost from China’s rise as an offshore manufacturer and entrance to the World Trade Organization. Now that the US and other western countries are diversifying away from China, amid geopolitical tensions, Mexico stands to benefit. The US cannot eliminate its trade deficit due to its internal savings/investment imbalance but it can redistribute that trade deficit to countries that cannot compete with it for global hegemony. AMLO faces constraints: A risk factor stemmed from politics where a sweeping left-wing victory in 2018 threatened to introduce anti-market policies. President Andrés Manuel López Obrador (known as AMLO) and his MORENA party gained a majority in both houses of the legislature. Their coalition has a two-thirds majority in the lower house (Chart 14). However, we pointed out that AMLO’s policies have not been radical and, more importantly, that the midterm election would likely constrain his power. Chart 14Mexico’s Midterm Election Looms Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Biden’s First 100 Days In Foreign Policy (GeoRisk Update) These are all solid points but the last item faces a test in the upcoming midterm election. AMLO’s approval rating is strong, at 63%, putting him above all of his predecessors except one (Chart 15). AMLO’s approval has if anything benefited from the COVID-19 crisis despite Mexico’s inability to handle the medical challenge. He has promised to hold a referendum on his leadership in early 2022, more than halfway through his six-year term, and he is currently in good shape for that referendum. For now his popularity is helpful for his party, although he is not on the ballot in 2021 and MORENA’s support is well beneath his own. Chart 15AMLO’s Approval Fairly Strong Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Biden’s First 100 Days In Foreign Policy (GeoRisk Update) MORENA’s support is holding at a 44% rate of popular support and its momentum has slightly improved since the pandemic began. However, MORENA’s lead over other parties is not nearly as strong as it was back in 2018 (Chart 16, top panel). The combined support of the two dominant center-right parties, the Institutional Revolutionary Party and the National Action Party, is almost equal to that of MORENA. And the two center-left parties, the Democratic Revolution Party and Citizen’s Movement, are part of the opposition coalition (Chart 16, bottom panel). The pandemic and economic crisis will motivate the opposition. Chart 16MORENA’s Support Holding Up Despite COVID Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Traditionally the president’s party loses seats in the midterm election (Table 2). Circumstances are different from the US, which also exhibits this trend, because Mexico has more political parties. A loss of seats from MORENA does not necessarily favor the establishment parties. Nevertheless opinion polling shows that about 45% of voters say they would rather see MORENA’s power “checked” compared to 41% who wish to see the party go on unopposed.5 Table 2Mexican President’s Party Tends To Lose Seats In Midterm Election Biden’s First 100 Days In Foreign Policy (GeoRisk Update) Biden’s First 100 Days In Foreign Policy (GeoRisk Update) While the ruling coalition may lose its super-majority, it is not a foregone conclusion that MORENA will lose its majority. Voters have decades of experience of the two dominant parties, both were discredited prior to 2018, and neither has recovered its reputation so quickly. The polling does not suggest that voters regret their decision to give the left wing a try. If anything recent polls slightly push against this idea. If MORENA surprises to the upside then AMLO’s capabilities would increase substantially in the second half of his term – he would have political capital and an improving economy. While the senate is not up for grabs in the midterm, MORENA has a narrow majority and controls a substantial 60% of seats when its allies are taken into account. In this scenario AMLO could pursue his attempts to increase the state’s role in key industries, like energy and power generation, at the expense of private investors. Even then the Supreme Court would continue to act as a check on the government. The 11-seat court is currently made up of five conservatives, two independents, and three liberal or left-leaning judges. A new member, Margarita Ríos Farjat, is close to the government, leaving the conservatives with a one-seat edge over the liberals and putting the two independents in the position of swing voters. Even if AMLO maintains control of the lower house, he will not be able to override the constitutional court, as he has threatened on occasion to do, without a super-majority in the senate. Bottom Line: AMLO will likely lose some ground in the lower house and thus suffer a check on his power. This will only confirm that Mexican political risk is not likely to derail positive underlying macro fundamentals. Continue to overweight Mexican equities relative to Brazilian.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix 1 The market is the greatest machine ever created for gauging the wisdom of the crowd and as such our Geopolitical Risk Indicators were not designed to predict political risk but to answer the question of whether and to what extent markets have priced that risk. Our Australian GeoRisk Indicator (see Chart 11-12 above) uses the same simple methodology used in our other indicators, which avoid the pitfall of regression-based models. We begin with a financial asset that has a daily frequency in price, in this case the AUD, and compare its movement against several fundamental factors – in this case global energy and base metal prices, global metals and mining stock prices, and the Chilean peso. Australia is a commodity-exporting country. It is the largest producer of iron ore and is among the largest producers of coal and natural gas. It is also a major trading partner for China. Due to the nature of its economy the Australian dollar moves with global metal and energy prices and the global metals and mining equity prices. Chile, another major commodity producer also moves with global metal prices, hence our inclusion of the peso in this indicator. The AUD has a high correlation with all of these assets, and if the changes in the value of the AUD lag or lead the changes in the value of these assets, the implication is that geopolitical risk unique to Australia is not priced by the market. We included the peso as Chile is not as affected as Australia by any conflict in the South China Sea or Northeast Asia, which means that a deviation of the AUD from CLP represents a unique East Asia Pacific risk. Our indicator captures the involvement of Australia in a few regional and international conflicts. The indicator climbed as Australia got involved in the East Timor emergency and declined as it exited. It continued declining even as Australia joined the US in the Afghanistan and Iraq wars, which showed that investors were unperturbed by faraway wars, while showing measurable concern in the smaller but closer Timorese conflict. Risks went up again as the nation erupted in labor protests as the Howard government made changes to the labor code. We see the market pricing higher risk again during the 2008 financial crisis, although it was modest and Australia escaped the crisis unscathed due to massive Chinese stimulus. Since then, investors have been climbing a wall of worry as they priced in Northeast Asia-related geopolitical risks. These started with the South Korean Cheonan sinking and continued with the Sino-Japanese clash over the Senkaku islands. They culminated with the Chinese ADIZ declaration in late 2013. In 2016, Australia was shocked again when Donald Trump was elected, and investor fears were evident when the details of Trump-Turnbull spat were made public. The risk indicator reached another peak during the trade wars between the US and the rest of the world. Investors were not worried about COVID-19 as Australia largely contained the pandemic, but the recent Australian-Chinese trade war pushed the risk indicator up, giving investors another wall of worry. If the Biden administration forces Australia into a democratic alliance in confrontation with autocratic China then this risk will persist for some time.   Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com We Read (And Liked) ... The Narrow Corridor: States, Societies, And The Fate Of Liberty This book is a sweeping review of the conditions of liberty essential to steering the world away from the Hobbesian war of all against all. In this unofficial sequel to the 2012 hit, Why Nations Fail: The Origins Of Power, Prosperity, And Poverty, Daron Acemoglu (Professor of Economics at the Massachusetts Institute of Technology) and James A. Robinson (Professor of Global Conflict Studies at the University of Chicago) further explore their thesis that the existence and effectiveness of democratic institutions account for a nation’s general success or failure. The Narrow Corridor6 examines how liberty works. It is not “natural,” not widespread, “is rare in history and is rare today.” Only in peculiar circumstances have states managed to produce free societies. States have to walk a thin line to achieve liberty, passing through what the authors describe as a “narrow corridor.” To encourage freedom, states must be strong enough to enforce laws and provide public services yet also restrained in their actions and checked by a well-organized civil society. For example, from classical history, the Athenian constitutional reforms of Cleisthenes “were helpful for strengthening the political power of Athenian citizens while also battling the cage of norms.” That cage of norms is the informal body of customs replaced by state institutions. Those norms in turn “constrained what the state could do and how far state building could go,” providing a set of checks. Though somewhat fluid in its definition, liberty, as Acemoglu and Robinson show, is expressed differently under various “leviathans,” or states. For starters, the “Shackled Leviathan” is a government dedicated to upholding the rule of law, protecting the weak against the strong, and creating the conditions for broad-based economic opportunity. Meanwhile, the “Paper Leviathan” is a bureaucratic machine favoring the privileged class, serving as both a political and economic brake on development and yielding “fear, violence, and dominance for most of its citizens.” Other examples include: The “American Leviathan” which fails to deal properly with inequality and racial oppression, two enemies of liberty; and a “Despotic Leviathan,” which commands the economy and coerces political conformity – an example from modern China. Although the book indulges in too much jargon, it is provocative and its argument is convincing. The authors say that in most places and at most times, the strong have dominated the weak and human freedom has been quashed by force or by customs and norms. Either states have been too weak to protect individuals from these threats or states have been too strong for people to protect themselves from despotism. Importantly, many states believe that once liberty is achieved, it will remain the status quo. But the authors argue that to uphold liberty, state institutions have to evolve continuously as the nature of conflicts and needs of society change. Thus society's ability to keep state and rulers accountable must intensify in tandem with the capabilities of the state. This struggle between state and society becomes self-reinforcing, inducing both to develop a richer array of capacities just to keep moving forward along the corridor. Yet this struggle also underscores the fragile nature of liberty. It is built on a precarious balance between state and society; between economic, political, and social elites and common citizens; between institutions and norms. If one side of the balance gets too strong, as has often happened in history, liberty begins to wane. The authors central thesis is that the long-run success of states depends on the balance of power between state and society. If states are too strong, you end up with a “Despotic Leviathan” that is good for short-term economic growth but brittle and unstable over the long term. If society is too strong, the “Leviathan” is absent, and societies suffer under a pre-modern war of all against all. The ideal place to be is in the narrow corridor, under a shackled Leviathan that will grow state capacity and individual liberty simultaneously, thus leading to long-term economic growth. In the asset allocation process, investors should always consider the liberty of a state and its people, if a state’s institutions grossly favor the elite or the outright population, whether these institutions are weak or overbearing on society, and whether they signify a balance between interests across the population. Whether you are investing over a short or long horizon, returns can be significantly impacted in the absence of liberty or the excesses of liberty. There should be a preference among investors toward countries that exhibit a balance of power between state and society, setting up a better long-term investment environment, than if a balance of power did not exist.   Guy Russell Research Analyst GuyR@bcaresearch.com GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan – Province Of China Taiwan-Province of China: GeoRisk Indicator Taiwan-Province of China: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator Footnotes 1 "President Biden’s first 100 days as president fact-checked," BBC News, April 29, 2021, bbc.com. 2 "Oil tanker off Syrian coast hit in suspected drone attack," Al Jazeera, April 24, 2021, Aljazeera.com. 3 See Yaakov Lappin, "Natanz blast ‘likely took 5,000 centrifuges offline," Jewish News Syndicate, jns.org. 4 John Daniel Davidson, "Former US Ambassador To Mexico: Cartels Control Up To 40 Percent Of Mexican Territory," The Federalist, April 28, 2021, thefederalist.com. 5 See Alejandro Moreno, "Aprobación de AMLO se encuentra en 61% previo a campañas electorales," El Financiero, April 5, 2021, elfinanciero.com. 6 Penguin Press, New York, NY, 2019, 558 pages. Section III: Geopolitical Calendar

Highlights The Greens are likely to win control of Germany’s government in the September 26 federal elections. At least they will be very influential in the new coalition. Germany has achieved may of its long-term geopolitical goals within the EU. There is consensus on dovish monetary and fiscal policy and hawkish environmental policy. The biggest changes will come from the outside. The US and Germany have a more difficult relationship. While they both oppose Russian and Chinese aggression, Germany will resist American aggression. The Christian Democrats have a 65% chance of remaining in government which would limit the Greens’ controversial and ambitious tax agenda. The 35% chance of a left-wing coalition will frontload fiscal stimulus for the sake of recovery. The economy is looking up and a Green-led fiscal easing would supercharge the recovery. However, coalition politics will likely fail to address Germany’s poor demography, deteriorating productivity, and large excess savings. On a cyclical basis, overweight peripheral European bonds relative to bunds; EUR/USD; and Italian and Spanish stocks relative to German stocks. Feature Chart 1Germans Turn To A Young Woman And A Green Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Germany is set to become the first major country to be led by a green party. At very least the German election on September 26 will see an upset in which the ruling party under-performs and the Greens over-perform (Chart 1). At 30%, online betting markets are underrating the odds that Annalena Baerbock will become the first Green chancellor in 2022 – and the first elected chancellor to hail from a third party (Chart 2). The “German question” – the problem of how to unify Germany yet keep peace with the neighbors – lay at the heart of Europe for the past two centuries but today it appears substantially resolved: a peaceful and unified Germany stands at the center of a peaceful and mostly unified Europe. There are a range of risks on the horizon but this positive backdrop should be acknowledged. Chart 2Market Waking Up To Baerbock’s Bid For Chancellorship Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green All of the likeliest scenarios for the German election will reinforce the current situation by perpetuating policies that aim for Euro Area solidarity. Even the green shift is already well underway, though a Green-led government would supercharge it. Nevertheless this year’s election is important because it heralds a leftward shift in Germany and will shape fiscal, energy, industrial, and trade policy for at least the coming four years. A left-wing sweep would generate equity market excitement in the short run – a positive fiscal surprise to supercharge the post-pandemic rebound – but over the long run it would bring greater policy uncertainty because it would cause a break with the past and possibly a structural economic shift (Chart 3). The Greens are in favor of substantial increases in taxation and regulation as well as big changes in industrial and energy policy. In the absence of a left-wing sweep, coalition politics will be a muddle and Germany’s existing policies will continue. Chart 3German Policy Uncertainty On The Rise German Policy Uncertainty On The Rise German Policy Uncertainty On The Rise Regardless of what happens within Germany, the geopolitical environment is increasingly dangerous. Germany will try to avoid getting drawn into the US’s great power struggles with Russia and China but it may not have a choice. Germany’s Geopolitics The difficulty of German unification stands at the center of modern European history. Because of the large and productive German-speaking population, unification in 1871 posed a security threat to the neighbors, culminating in the world wars. The peaceful German reunification after the Cold War created the potential for the EU to succeed and establish peace and prosperity on the continent. This arrangement has survived recent challenges. Germany’s relationship with the EU came under threat from the financial crisis, the Arab Spring and immigration influx, Brexit, and President Trump’s trade tariffs. But in the end these events cemented the reality that German and Europe are strengthening their bonds in the face of foreign pressures. Germany achieved what it had long sought – preeminence on the continent – by eschewing a military role, sticking to France economically, and avoiding conflict with Russia. Since Germany has achieved many of its long-sought strategic objectives it has not fallen victim to a nationalist backlash over the past ten years like the US and United Kingdom. However, Germany is not immune to populism or anti-establishment sentiment. The two main political blocs, the Christian Democrats and the Democratic Socialists, have suffered a loss of popular support in recent elections, forcing them into a grand coalition together. Anti-establishment feeling in Germany has moved the electorate to the left, in favor of the Greens. The Greens have risen inexorably over the past decade and have now seized the momentum only five months before an election (Chart 4). Yet the Greens in Germany are basically an establishment political party. They participate in 11 out of 16 state governments and currently hold the top position in Baden-Württemberg, Germany’s third most populous and productive state. From 1998-2005 they participated in government, getting their hands dirty with neoliberal structural reforms and overseas military deployments. Moreover the Greens cannot rule alone but will have to rule within a coalition, which will mediate their more controversial policies. Chart 4Greens Surge, Christian Democrats Falter Greens Surge, Christian Democrats Falter Greens Surge, Christian Democrats Falter Today Germany is in lock step with France and the EU by meeting three key conditions: full monetary accommodation (the German constitutional court’s challenges to the European Central Bank are ineffectual), full fiscal accommodation (Chancellor Angela Merkel agreed to joint debt issuance and loose deficit controls amid the COVID-19 crisis as well as robust green energy policies), and full security accommodation (German rearmament exists within the context of NATO and European security aspirations are undertaken in lock-step with the French). These conditions will not change in the 2021 election even assuming that the Greens take power at the head of a left-wing coalition. Bottom Line: Germany has virtually achieved its grand strategic aims of unifying and ruling Europe. No German government will challenge this situation and every German government will strive to solidify it. The greatest risks to this setup stem from abroad rather than at home. The Return Of The German Question? Germany’s geopolitical position can be summarized by Chart 5, which shows popular views toward different countries and institutions. The Germans look positively upon the EU and global institutions like the United Nations and less so NATO. They look unfavorably upon everything else. They take an unfavorable view toward Russia, but not dramatically so, which shows their lack of interest in conflict with Russia – they do not want to be the battleground or the ramparts of another major European war. They dislike the United States and China even more, and equally. Even if attitudes toward the US have improved since the 2020 election the net unfavorability is telling. Chart 5Germany More Favorable Toward Russia Than US? Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Since the global financial crisis, and especially Russia’s invasion of Ukraine in 2014, Germany has built up its military. This buildup is taking place under the prodding of the United States and in step with NATO allies, who are reacting to Russia’s military action to restore its sphere of influence in the former Soviet space (Chart 6). Germany’s military spending still falls short of NATO’s 2% of GDP target, however. It will not be seen as a threat to its neighbors as long as it remains integrated with France and Europe and geared toward deterring Russia. Chart 6Germany And NATO Increase Military Spending Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Chart 7Watch Russo-German Relations For Cracks In Europe’s Edifice Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Russia’s aggressiveness should continue to drive the Germans and Europeans into each other’s arms. This could change if Putin pursues diplomacy over military coercion, for then he could split Germany from eastern Europe. The possibility is clear from Russia’s and Germany’s current insistence on completing the Nord Stream 2 pipeline despite American and eastern European objections. The pipeline is set to be completed by September, right in time for the elections – in no small part because the Greens oppose it. If the US insists on halting the pipeline then a crisis will erupt with Russia that will humiliate Merkel and the Christian Democrats. But the US may refrain from doing so in the face of Russian military threats (odds are 50/50). The Russian positioning over 100,000 troops on the border with Ukraine this year – and now reportedly ordering them to return to base by May 1 – amounts to a test of Russo-German relations. Putin can easily expand the Russian footprint in Ukraine and tensions will remain elevated at least through the Russian legislative elections in September. Germans would respond to another invasion with sanctions, albeit likely watering down tougher sanctions proposed by the Americans. What would truly change the game would be a Russian conquest of all of Ukraine. This is unlikely – precisely because it would unite Germany, the Europeans, and the Americans solidly against Russia, to its economic loss as well as strategic disadvantage (Chart 7). China’s rise should also keep Germany bound up with Europe. The Germans fear China’s technological and manufacturing advancement, including Chinese involvement in digital infrastructure and networks. The Greens are critical of the way that carbon-heavy Chinese goods undercut the prices of carbon-lite German goods. Baerbock favors carbon adjustment fees, a pretty word for tariffs. However, the Germans want to maintain business with China and are not very afraid of China’s military. Hence there is a risk of a US-German split over the question of China. If Germany should consistently side with Russia and China over US objections then it risks attracting hostile attention from the US as well as from fellow Europeans, who will eventually fear that German power is becoming exorbitant by forming relations with giants outside the EU. But this is not the leading risk today. The US is courting Germany and seeking to renew the trans-Atlantic alliance. Meanwhile Germany needs US support against Russia’s military and China’s trade practices. US-German relations will improve unless the US forces Germany into an outright conflict with the autocratic powers. Bottom Line: The US and Germany have a more difficult relationship now than in the past but they share an interest in deterring Russian aggression and Chinese technological and trade ambitions. Biden’s attempt to confront these powers multilaterally is limited by Germany’s risk-aversion. Scenarios For The 2021 Election There are several realistic scenarios for the German election outcome. Our expectation that the Greens will form a government stems from a series of fundamental factors. Opinion polling has now clearly shifted in favor of our view, with the Greens gaining the momentum with only five months to go. Grouping the political parties into ideological blocs shows that the race is a dead heat. Our bet is that momentum will break in favor of the opposition Greens, which we explain below. Meanwhile the Free Democrats should perform well, stealing votes from the Christian Democrats. The right-wing Alternative für Deutschland (AfD), while not performing well, is persistent enough to poach some votes from the Christian Democrats. These are “lost” votes to the conservatives as none of the parties will join it in a coalition (Chart 8). Chart 8Germany's Median Voters Shifts To the Left Germany's Median Voters Shifts To the Left Germany's Median Voters Shifts To the Left The Christian Democrats bear all the signs of a stale and vulnerable government. They have been in power for 16 years and their performance in state and federal elections has eroded recently, including this year (Table 1). The public is susceptible to the powerful idea that it is time for a change. Chancellor Merkel’s approval rating is still around 60%, but in freefall, and her successful legacy is not enough to save her party, which is showing all the signs of panic: succession issues, indecision, infighting, corruption scandals. The Greens will be “tax-and-spend” lefties but the coalition matters in terms of what can actually be legislated (Table 2).1 Table 1AChristian Democrats Fall, Greens Rise, In Recent State Elections Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Table 1BChristian Democrats Fall, Greens Rise, In Recent State Elections Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Table 2Policy Platforms Of The Green Party Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green The fact that Christian Democrats and their Bavarian sister party, the Christian Social Union, saw such a tough race for chancellor candidate is an ill omen. Moreover the party’s elites went for the safe choice of Merkel’s handpicked successor, Armin Laschet, over the more popular Markus Soeder (Chart 9), in a division that will likely haunt the party later this year. Chart 9Christian Democrats And Christian Social Union Divided Ahead Of Election Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Laschet has received a bounce in polls with the nomination but it will be temporary. He has not cut a major figure in any polling prior to now. Chart 10Dissatisfaction Points To Government Change Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green He has quarreled openly with Merkel and the coalition over pandemic management. He was not her first choice of successor anyway – that was Annagret Kramp-Karrenbauer, who fell from grace due to controversy over the faintest hint of cooperation with the AfD. There is a manifest problem filling Merkel’s shoes. Even more important than coalition infighting is the fact that Germany, like the rest of the world, has suffered a historic shock to its economy and society. The pandemic and recession were then aggravated by a botched vaccine rollout. General dissatisfaction is high, another negative sign for the incumbent party (Chart 10). Of course, the election is still five months away. The vaccine will make its way around, the economy will reopen, and consumers will look up – see below for the very positive macro upturn that Germany should expect between now and the election. Voters have largely favored strict pandemic measures and Merkel will have long coattails. This Christian Democrats and Christian Social Union have ruled modern Germany for all but 15 years and have not fallen beneath 33% of the popular vote since reunification. The Greens have frequently aroused more energy in opinion polling than at the voting booth. With these points in mind, we offer the following election scenarios with our subjective probabilities: Green-Red-Red Coalition – Greens rule without Christian Democrats – 35% odds. Green-Black Coalition – Greens rule with Christian Democrats – 30% odds. Black-Green Coalition – Christian Democrats rule with Greens – 25% odds. Grand Coalition (Status Quo) – Christian Democrats rule without Greens – 10% odds. Our subjective probabilities are based on the opinion polls and online betting cited above but adjusted for the Greens’ momentum, the Christian Democrats’ internal divisions, the “time for change” factor, and the presence of a historic exogenous economic and social shock. Geopolitical surprises could occur before the election but they would most likely reinforce the Greens, since they have taken a hawkish line against Russia and China. Bottom Line: The Greens are likely to lead the next German government but at very least they will have a powerful influence. Policy Impacts Of Election Scenarios The makeup of the ruling coalition will determine the parameters of new policy. Fiscal policy will change based on the election outcome – both spending and taxes. The Greens will be “tax-and-spend” lefties but the coalition matters in terms of what can actually be legislated.2 The Greens’ idea is to “steer” the rebuilding process through environmental policy. But if the left lacks a strong majority then the Greens’ more controversial and punitive measures will not get through. Transformative policies will weigh heavily on the lower classes (Chart 11). Chart 11Ambitious Climate Policy Will Face Resistance Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green The policy dispositions of the various chancellor candidates help to illustrate Germany’s high degree of policy consensus. Table 3 looks at the candidates based on whether they are “hawkish” (active or offensive) or “dovish” (passive or defensive) on a given policy area. What stands out is the agreement among the different candidates despite party differences. Nobody is a fiscal or monetary hawk. Only Baerbock can be classified as a hawk on trade.3 Nobody is a hawk on immigration. Nearly everyone is a hawk on fighting climate change. And attitudes are turning more skeptical of Russia and China, though not outright hawkish. Table 3Policy Consensus Among German Chancellor Candidates Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Germany will not abandon its green initiatives even if the Greens underperform. The current grand coalition pursued a climate package due to popular pressure even with the Greens in opposition. Germans are considerably more pro-environment even than other Europeans (Chart 12). The green shift is also happening across the world. The US is now joining the green race while China is doubling down for its own reasons. See the Appendix for current green targets and measures, which have been updated in the wake of a slew of announcements before Biden’s Earth Day climate summit on April 22-23. Chart 12Germans Care Even More About Environment Than Other Europeans Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Any coalition will raise spending more than taxes since it will be focused on post-COVID economic recovery. There has been a long prelude to Germany’s proactive fiscal shift – it has staying power and is not to be dismissed. A Christian Democratic coalition would try to restore fiscal discipline sooner than otherwise but there is only a 5% chance that it will have the power to do so according to the scenarios given above. The rest of Europe will be motivated to spend aggressively while EU fiscal caps are on hold in 2022, especially if the German government is taking a more dovish turn. Even more than the US and UK, Germany is turning away from the neoliberal Washington Consensus. But Germans are not experiencing any kind of US-style surge of polarization and populism. At least not yet. It may be a risk over the long run, depending on the fate of the Christian Democrats, the AfD, and various internal and external developments. Bottom Line: Germany has a national consensus that consists of dovish monetary, fiscal, trade, and immigration policies and hawkish (pro-green) environmental policy. Germany is turning less dovish on geopolitical conflicts with Russia and China. Given that a coalition government is likely, this consensus is likely to determine actual policy in the wake of this year’s election. A few things are clear regardless of the ruling coalition. First, Germany is seeking domestic demand as a new source of growth, to rebalance its economy and deepen EU integration. Second, Germany is accelerating its green energy drive. Third, Germany cannot accept being in the middle of a new cold war with Russia. Fourth, Germany has an ambivalent policy on China. Germany’s Macro Outlook Even before considering the broader fiscal picture, the outlook for German economic activity over the course of the coming 12 to 24 months was already positive. Our base case scenario for the September election, which foresees a coalition government led by the Green Party, only confirms this optimistic view. However, Germany is still facing significant long-term challenges, and, so far, there has not been a political consensus to address these structural headwinds adequately. The Greens offer some solutions but not all of their proposals are constructive and much will depend on their parliamentary strength. Peering Into The Near-Term… Germany’s economy is set to benefit from the continued recovery of the global business cycle, which is a view at the core of BCA Research’s current outlook.4 Germany remains a trading and manufacturing powerhouse, and thus, it will reap a significant dividend from the continued global manufacturing upswing. Manufacturing and trade amount to 20% and 88% of Germany’s GDP, the highest percentage of any major economy. Alternatively, according to the OECD, foreign demand for German goods accounts for nearly 30% of domestic value added, a share even greater than that for a smaller economy like Korea (Chart 13). Moreover, road vehicles, machinery and other transport equipment, as well as chemicals and related products, account for 53% of Germany’s exports. These products are all particularly sensitive to the global business cycle. They will therefore enhance the performance of the German economy over the next two years. Trade with the rest of Europe constitutes another boost to Germany’s economy going forward. Shipments to the euro area and the rest of the EU account for 34% and 23% of Germany’s exports, or 57% overall. Right now, the lagging economy of Europe is a handicap for Germany; however, Europe has more pent-up demand than the US, and the consumption of durable goods will surge once the vaccination campaign progresses further (Chart 14). This will create a significant boon for Germany, since we expect European consumption to pick up meaningfully over the coming 12 to 18 months.5 Chart 13Germany Depends On Global Trade Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Chart 14Europe Has More Pent-Up Demand Than The US Europe Has More Pent-Up Demand Than The US Europe Has More Pent-Up Demand Than The US Chart 15Vaccination Progress Vaccination Progress Vaccination Progress Domestic forces also point toward a strong Germany economy, not just foreign factors. The pace of vaccination is rapidly accelerating in Germany (Chart 15). The recent announcement of 50 million additional doses purchases for the quarter and up to 1.8 billion more doses over the next two years by the EU points to further improvements. A more broad-based vaccination effort will catalyze underlying tailwinds to consumption. German household income will also progress significantly. The Kurzarbeit program was instrumental in containing the unemployment rate during the crisis, which only peaked at 6.4% from 5% in early 2020. However, the program could not prevent a sharp decline in total hours worked of 7%, since by definition, it forced six million employees to work reduced hours (Chart 16). One of the great benefits of the program is that it prevents a rupture of the link between workers and employers. Thus, the economy suffers less frictional unemployment as activity recovers and household income does not suffer long lasting damage. Meanwhile, the German government is likely to extend the support for households and businesses as a result of the delayed use of the debt-brake. The Greens propose revising the debt brake rather than restoring it in 2022 like the conservatives pledge to do. Chart 16Kurtzarbeit Saved The Day Kurtzarbeit Saved The Day Kurtzarbeit Saved The Day The balance-sheet strength of German households means that they will have the wherewithal to spend these growing incomes. Residential real estate prices are rising at an 8% annual pace, which is pushing the asset-to-disposable income ratio to record highs. Meanwhile, the debt-to-assets ratio, and the level of interest rates are also very low, which means that the burden of serving existing liabilities is minimal (Chart 17). In this context, durable goods spending will accelerate, which will lift overall cyclical spending, even if German households do not spend much of the EUR120 billion in excess savings built up over the past year. As Chart 18 shows, while US durable goods spending has already overtaken its pre-COVID highs, Germany’s continues to linger near its long-term trend. Thus, as the economy re-opens this summer, and income and employment increase, the concurrent surge in consumer confidence will allow for a recovery in cyclical spending. Chart 17Strong Household Balance Sheets Strong Household Balance Sheets Strong Household Balance Sheets Chart 18Germany Too Has More Pent-up Demand Than The US Germany Too Has More Pent-up Demand Than The US Germany Too Has More Pent-up Demand Than The US Chart 19Positive Message From Many Indicators Positive Message From Many Indicators Positive Message From Many Indicators Various economic indicators are already pointing toward the coming German economic boom.Manufacturing orders are strong, and economic sentiment confidence is rising across most sectors. Meanwhile, consumer optimism is forming a trough, and new car registrations are climbing rapidly. Most positively, the stocks of finished goods have collapsed, which suggests that production will be ramped up to fulfill future demand (Chart 19). Bottom Line: The German economy is set to accelerate in the second half of the year and into 2022. As usual, Germany will enjoy a healthy dividend from robust global growth, but the expanding vaccination program, as well durable employee-employer relations, strong household balance sheets, and significant pent-up demand for durable goods will also fuel the domestic economy. Our base case scenario that fiscal policy will remain accommodative in the wake of a political shift to the left in Berlin in September will only supercharge this inevitable recovery. … And The Long-Term In contrast to the bright near-term perspective, the long-term outlook for the German economy remains poor. The policies of any new ruling coalition are unlikely to address the problems of Germany’s poor demography, deteriorating productivity, and large excess savings. There is potential for a productivity boost in the context of a global green energy and high-tech race but for now that remains a matter of speculation. The most obvious issue facing Germany is its ageing population, counterbalanced by its fertility rate of only 1.6. Over the course of the next three decades, Germany’s dependency ratio will surge to 80%, driven by an increase in the elderly dependency ratio of 20% (Chart 20). The working age population is set to decline by 18% by 2050, which will curtail potential GDP growth. The outlook for German productivity growth is also poor. Germany’s productivity growth has been in a long-term decline, falling from 5% in 1975 to less than 1% in 2019. Contrary to commonly-held ideas, from 1999 to 2007, German labor productivity growth has only matched that of France or Spain; since 2008, it has lagged behind these two nations, although it has bested Italy. One crucial reason for Germany’s uninspiring productivity performance is a lack of investment. Some of this reflects the country’s austere fiscal policy. For example, in 2019, Germany’s public investment stood at 2.4% of GDP, which compares poorly to the OECD’s average of 3.8%, or even to that of the US, where public investment stood at 3.6% of GDP. This poor statistic does not even account for the depreciation of the German public capital stock. Since the introduction of the euro, net public investment has averaged 0.03% of GDP. The biggest problem remains at the municipal level. From 2012 to 2019, federal and state level net investment averaged 0.2% of GDP, while municipal net investment subtracted 0.2% of GDP on average. Hopefully, the new government will be able to address this deficiency of the German economy. The Greens are most proactive but they will face obstacles. The bigger problem for German productivity is corporate capex. Corporate investments have been low in this country. Since the introduction of the euro, the contribution of capital intensity to productivity in Germany has equaled that of Italy and has underperformed France and Spain. As a result, the age of the German capital stock is at a record high and stands well above the US or Eurozone average (Chart 21). Chart 20Germany Has Poor Demographics Germany Has Poor Demographics Germany Has Poor Demographics Chart 21Germany's Capital Stock Is Ageing Germany's Capital Stock Is Ageing Germany's Capital Stock Is Ageing The make-up of Germany’s capex aggravates the productivity-handicap. According to a Bundesbank study, the contribution to labor productivity from information and communication technology (ICT) capital spending has averaged 0.05 percentage points annually from 2008 to 2012. On this metric, Germany lagged behind France and the US, but still bested Italy. From 2013 to 2017, the contribution of ICT investment to productivity fell to 0.02 percentage points, still below France and the US, but in line with Italy. Looking at the absolute level of ICT or knowledge-based capital (KBC) investment further highlights Germany’s challenge. In 2016, total investment in ICT equipment, software and database, R&D and intellectual property products, and other KBC assets (which include organizational capital and training) represented less than 8% of GDP. In France, the US, or Sweden, these outlays accounted for 11%, 12%, and 13% of GDP, respectively (Chart 22, top panel). This lack of investment directly hurts Germany’s capacity to innovate. The bottom panel of Chart 22 shows that, for the eight most important categories of ICT patents (accounting for 80% of total ICT patents), Germany remarkably lags behind the US, Japan, Korea, or China. Chart 22Germany Lags In ICT investment Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green A major source of Germany’s handicap in ICT and KBC investment comes from small businesses, which have been particularly reluctant to deploy capital. A study by the OECD shows that, between 2010 and 2019, the gap of ICT tools and activities adoption between Germany’s small and large companies deteriorated relative to the OECD average (Chart 23). The lack of venture capital investing probably exacerbates these problems. In 2019, venture capital investing accounted for 0.06% of Germany’s GDP. This is below the level of venture investing in France or the UK (0.08% and 0.1% of GDP, respectively), let alone South Korea, Canada, Israel, or the US (0.16%, 0.2%, 0.4% and 0.65%, respectively). The Greens claim they will create new venture capital funds but their capability in this domain is questionable. Chart 23The Lagging ICT Capabilities Of Small German Businesses Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Since Germany’s productivity growth is likely to remain sub-par compared to rest of the OECD and to lag behind even that of France or the UK, the only way for Germany to protect its competitiveness will be to control costs. This means that Germany cannot allow its recent loss of competitiveness to continue much further (Chart 24). Thus, low productivity growth will limit Germany’s real wages. Chart 24Germany's Competitiveness Is Declining Germany's Competitiveness Is Declining Germany's Competitiveness Is Declining This wage constraint will negatively impact consumption. Beyond a pop over the coming 12 to 24 months, German consumption is likely to remain depressed, as it was in the first decade and a half of the century, following the Hartz IV labor market reforms that also hurt real wages. The Greens for their part aim to boost welfare payments, raise the minimum wage, and reduce enforcement of Hartz IV. Bottom Line: German excess savings will remain wide on a structural basis. Without a meaningful pick-up in capex, German nonfinancial businesses will remain net lenders. Meanwhile, households that were worried about their financial future in a world of low real-wage growth will also continue to save a significant share of their income. Consequently, the excess savings Germany developed since the turn of the millennia are here to stay (Chart 25). In other words, Germany will continue to sport a large current account surplus and exert a deflationary influence on Europe and the rest of the world. The policy prescribed by the various parties contesting the September election will not necessarily result in new laws that will reverse the issues of low capex and low ICT investment. The Greens will worsen the over-regulation of the economy. Barring a policy revolution that succeeds in all its aims (a tall order), we can expect more of the same for Germany – that is, a slowly declining economy. Chart 25Too Much Savings, Not Enough Investments Too Much Savings, Not Enough Investments Too Much Savings, Not Enough Investments Chart 26Germany Scores Well On Renewable Power Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green That being said, some bright spots exist. Germany is becoming a leader in renewable energy, and it can capitalize on the broadening of this trend to enlarge its export market (Chart 26). Investment Implications Bond Markets The economic outlook for Germany and the euro area at large is consistent with the underweighting of German bunds within European fixed-income portfolios. Bunds rank among the most expensive bond markets in the world, which will make them extremely vulnerable to positive economic surprise in Europe later this year, especially if Germany’s fiscal policy loosens up further in the wake of the September election (Chart 27). Moreover, easier German fiscal policy should help European peripheral bonds, especially the inexpensive Italian BTPs that the ECB currently buys aggressively. Thus, we continue to overweight BTPs, and add Greek and Portuguese bonds to the list. Chart 27German Bunds Are Expensive Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Chart 28German Yields Already Embed Plenty Pessimism About Europe German Yields Already Embed Plenty Pessimism About Europe German Yields Already Embed Plenty Pessimism About Europe Relative to US Treasurys, the outlook for Bunds is more complex. On the one hand, the ECB will not tighten policy as much as the Fed later this cycle; moreover, European inflation is likely to remain below US levels this year, as well as through the business cycle. On the other hand, Bunds already embed a significantly lower real terminal rate proxy and term premium than Treasury Notes (Chart 28). Netting it all out, BCA Research Global Fixed Income Strategy service believes Bunds should outperform Treasurys this year, because they have a lower beta, which is a valuable feature in a rising yield environment.6 We will closely monitor risks around this view, because it is likely that the European economic recovery will be the catalyst for the next up leg in global yields, in which case German bunds could temporarily underperform. On a structural basis, as long as Germany’s productivity issues are not addressed by Berlin, German Bunds are likely to remain an anchor for global yields. Germany will remain awash in excess savings, which will act as a deflationary anchor, while also limiting the long-term upside for European real rates. Excess savings results in a large current account surplus; thus, Germany will continue to export its savings abroad and act as a containing factor for global yields. The Euro The medium-term outlook points to significant euro upside. Our expectation of a European and German positive growth surprise over the coming 12 months is consistent with an outperformance of the euro. The fact that investors have been moving funds out of the Eurozone and into the US at an almost constant rate for the past 10 years only lends credence to this argument (Chart 29). Our view on Germany’s fiscal policy contributes to the euro’s luster. Greater German budget deficits help European economic activity and curtail risk premia across the Eurozone. This process is doubly positive for the euro. First, lower risk premia in the periphery invite inflows into the euro area, especially since Greek, Portuguese, Italian, or Spanish yields offer better value than alternatives. Second, stronger growth and lower risk premia relieve pressure on the ECB as the sole reflator for the Eurozone. At the margin, this process should boost the extremely depressed terminal rate proxy for Europe and help EUR/USD. Robust global economic activity adds to the euro’s appeal, beyond the positive domestic forces at play in Europe. The dollar is a countercyclical currency; thus, global business cycle upswings coincide with a weak USD, which increases EUR/USD’s appeal. Nonetheless, if the boost to global activity emanates from the US, then the dollar can strengthen. This phenomenon was at play in the first quarter of 2021. However, the global growth leadership is set to move away from the US over the next 12 months, which implies that the normal inverse relationship between the dollar and global growth will reassert itself to the euro’s benefit. The European balance of payments dynamics will consolidate the attraction of the euro. Germany’s and the Eurozone’s current account surplus will remain wide, especially in comparison to the expanding twin deficit plaguing the US. Beyond the next 12 to 24 months, the lack of structural vigor of Germany’s and Europe’s economy is likely to shift the euro into a safe-haven currency, like the yen and the Swiss franc. A strong balance of payments and low interest rates (all symptoms of excess savings) are the defining features of funding currencies, and will be permanent attributes of the euro area if reforms do not address its productivity malaise. The Eurozone’s net international position is already rising and its low inflation will put a structural upward bias to the Euro’s purchasing power parity estimates (Chart 30). Those developments have all been evident in Japan and Switzerland, and will likely extinguish the euro’s pro-cyclicality as time passes. Chart 29Investors Already Underweight European Assets Investors Already Underweight European Assets Investors Already Underweight European Assets Chart 30Upward Bias In The Euro's Fair Value Upward Bias In The Euro's Fair Value Upward Bias In The Euro's Fair Value Chart 31Germany Has Not Outperformed The Rest Of The Eurozone Germany Has Not Outperformed The Rest Of The Eurozone Germany Has Not Outperformed The Rest Of The Eurozone German Equities In absolute terms, the DAX and German equities still possess ample upside over the next 12 to 24 months. BCA Research is assuming a positive stance on equities, and a high beta market like Germany stands to benefit.7 Moreover, the elevated sensitivity to global economic activity of German equities accentuate their appeal. BCA Research likes European stocks, and German ones are no exception.8 The more complex question is how to position German equities within a European stock portfolio. After massively outperforming from 2003 to 2012, German equities have moved in line with the rest of the Eurozone ever since (Chart 31). Moreover, German equities now trade at a discount on all the major valuation metrics relative to the rest of the Eurozone (Chart 31, bottom panel). The global macro forces that dictate the outlook for German equities relative to the rest of the Eurozone are currently sending conflicting messages. On the one hand, German equities normally outperform when commodity prices rally or when the euro appreciates (Chart 32). On the other hand, however, German equities also underperform when global yields rise, or following periods when Chinese excess reserves fall, such as what we are witnessing today. With this lack of clarity from global forces, the answer to Germany’s relative performance question lies within European economic dynamics. Germany is losing competitiveness relative to the rest of the Eurozone (Chart 24 page 22) which suggests that German stocks will benefit less than their peers from a stronger euro in comparison to their performance in the last decade. Moreover, German equities outperform when the German manufacturing PMI increases relative to that of the broad euro area. The gap between the German and euro area manufacturing PMI stands near record highs and is likely to narrow as the rest of the Eurozone catches up. This should have a bearing on the performance of German stocks (Chart 33). Chart 32Mixed Global Backdrop For Germany's Relative Performance Mixed Global Backdrop For Germany's Relative Performance Mixed Global Backdrop For Germany's Relative Performance Chart 33A European Economic Catch-Up Would Hurt German Equities A European Economic Catch-Up Would Hurt German Equities A European Economic Catch-Up Would Hurt German Equities Finally, sectoral dynamics may prove to be the ultimate arbiter. Table 4 highlights the limited difference in sectoral weightings between Germany and the rest of the Eurozone, which helps explain the stability in the relative performance over the past nine years. However, the variance is greater between Germany and specific European nations. In this approach, BCA’s negative stance on growth stocks correlates with an overweight of Germany relative to the Netherlands. Moreover, our positive outlook on financials and bond yields suggests that Germany should underperform Italian and Spanish stocks. Table 4Sectoral Breakdown Across Europe Major Bourses Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Appendix: Global Climate Policy Commitments Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Winds Of Change: Germany Goes Green Footnotes 1 See Matthew Karnitschnig, "German Conservatives Mired In ‘The Swamp,’" Politico, March 24, 2021, politico.eu. 2 The Greens are interested in a range of taxes, including a carbon tax, a digital services tax, and a financial transactions tax. They are also interested in industrial quotas requiring steel and car makers to sell a certain proportion of carbon-neutral steel and electric vehicles. See an excellent interview with Ms. Baerbock in Ileana Grabitz and Katharina Schuler, "I don’t have to convert the SUV driver in Prenzlauer Berg," Zeit Online, January 2, 2020, zeit.de. 3 See her comments to Zeit Online. 4 Please see BCA Research Global Investment Strategy Strategy Outlook "Second Quarter 2021 Strategy Outlook: Inflation Cometh?", dated March 26, 2021, available at gis.bcareseach.com. 5 Please see BCA Research European Investment Strategy Special Report "A Temporary Decoupling", dated April 5, 2021, available at eis.bcareseach.com. 6 Please see BCA Research Global Fixed Income Strategy Strategy Report "Harder, Better, Faster, Stronger", dated March 16, 2021, available at gfis.bcareseach.com. 7 Please see BCA Research Global Income Strategy Strategy Outlook "Second Quarter 2021 Strategy Outlook: Inflation Cometh?", dated March 26, 2021, available at gis.bcareseach.com. 8 Please see BCA Research European Income Strategy Strategy Report "Time And Attraction", dated April 12, 2021, available at eis.bcareseach.com.