Geopolitics
Highlights The U.S. midterm elections are far less investment-relevant than consensus holds; Trump will increase the pressure on China and Iran regardless of the likely negative election results for the GOP; The Iranian sanctions, civil conflict in Iraq, and other oil supply issues are the real geopolitical risk; Despite the tentative good news on Brexit, political uncertainty in the U.K. makes now a bad time to buy the pound; Go long Brent crude / short S&P 500; long U.S. energy / tech equities; long JPY / short GBP. Feature The U.S. political cycle begins in earnest after Labor Day. Understandably, we have noticed an uptick in client interest, with a steady stream of questions and conference call requests about U.S. politics. Generally, our forecast remains unchanged since our April net assessment of the upcoming midterm election.1 Democrats have a slightly better than 60% probability of winning the House of Representatives, with a solid 45% probability of taking the Senate, and rising. The latter is astounding, given that the "math" of the Senate rotation is against the Democrats. Our bias toward a Democratic victory is based on current polling (Chart 1) and President Trump's woeful approval rating (Chart 2). There are a lot of other moving parts, however, and we will update them next week in detail. Chart 1GOP Trails In Polls, But It Is Still Close Chart 2Trump's Approval Rating Lines The GOP Up For Steep Losses But why, dear client, should you care? Do the midterms really matter for investors? History suggests that they tend to be a bullish catalyst for the stock market (Chart 3). Will this time be any different? The two bearish narratives hanging over markets have to do with the Democrats foiling President Trump's pro-business policy and impeaching him. The former would purportedly have a direct impact on earnings by stymieing Trump's pluto-populist agenda, while the latter would presumably force Trump to seek relevance abroad - through an aggressive foreign policy or trade policy. We think both concerns are without merit. First, by taking over the House of Representatives, the Democrats will not be able to stop or reverse the president's economic agenda. Trump's deregulation will continue, given that regulatory affairs are the sole prerogative of the executive branch of government. Tax cuts will not be reversed, given that Democrats have no chance of gaining a 60-seat, filibuster-proof, majority in the Senate, and would not have a two-thirds majority in each chamber to override Trump's veto. As for fiscal stimulus, it is highly unlikely that the party of the $15 minimum wage and "Medicare for all" would seek to impose fiscal discipline on the nation. As far as the market is concerned, President Trump has accomplished all he needed to accomplish. Gridlock is perfectly fine, which is why a divided Congress has not stopped bull markets in the past (Chart 4). And should the Republicans somehow retain Congress, the result would be a "more of the same" rally. Chart 3Midterm U.S. Elections Tend To Be Bullish... Chart 4... Even Those That Produce Gridlock What about impeachment? Well, what about it? As we have illustrated in our net assessment of the impeachment risk, the Senate is not likely to convict Trump, so markets can look through it, albeit with bouts of volatility (Chart 5A & 5B).2 Chart 5AMarkets Can Rally Through Impeachment... Chart 5B...Despite Volatility To this our clients counter: "But Trump is different!" According to this theory, President Trump would respond to the threat of impeachment by becoming unhinged and seeking relevance abroad through an aggressive foreign and trade policy. But can he be more aggressive than ... Threatening nuclear war with North Korea; Re-imposing an oil embargo against Iran - and thus unraveling the already shaky equilibrium in the Middle East; Imposing tariffs on half, possibly all, U.S. imports from China; Threatening additional tariffs on U.S. allies like Canada, the EU, and Japan? More aggressive than that? We are agnostic towards the upcoming midterm elections. We already have a deeply alarmist view towards U.S. foreign policy posture vis-à-vis Iran3 and U.S. trade policy vis-à-vis China,4 both of which we have articulated at length. The midterm elections factor very little in our analysis of either. As such, they are a non-diagnostic variable. The outcome of the vote is a red herring. President Trump will seek relevance abroad whether or not his Republican Party holds the House and Senate. In fact, we believe that the midterms are a distraction. Investors have already forgotten about Iran (Chart 6), at a time when global oil spare capacity is falling (Chart 7). BCA's Commodity & Energy Strategy is forecasting Brent to average $80/bbl in 2019, but prices would easily reach $120/bbl in a case where all three pernicious scenarios occur (shale production bottlenecks, Venezuela export collapse, and Iran sanctions).5 Chart 6Nobody Is Paying Attention To Iranian Supply Risk! Chart 7Global Spare Capacity Stretched Thin These figures are alarming. But they could become even worse if our Q4 Black Swan - a Shia-on-Shia civil war in Iraq - manifests. The end of the U.S.-Iran détente has put the tenuous geopolitical equilibrium in Iraq on thin ice.6 Since our missive on this topic last week, the violence in Basra has intensified, with rioters setting the Iranian consulate alight. Investors were largely able to ignore the Islamic State insurgency in Iraq because it occurred in areas of the country that do not produce oil. A Shia-on-Shia conflict, however, would take place in Basra. This vital port exports 3.5 bpd. Any damage to its facilities, which is highly likely if Iran gets involved in the conflict, would instantly become the world's largest supply loss since the first Gulf War (Chart 8). Bottom Line: Our message to clients is that midterm elections are far less investment-relevant than is assumed. President Trump has already initiated aggressive foreign and trade policy. We expect the White House to intensify the pressure on Iran and China regardless of the outcome of the midterm election. And we also expect the Democratic Party to be unable to stop President Trump on either front, should it gain a majority in the House of Representatives. The truly underappreciated risk for investors is a massive oil supply shock in 2019 that comes from a combination of instability in Venezuela, aggressive U.S. enforcement of the oil embargo against Iran, and Iran's retaliation against such sanctions via chaos in Iraq. We are initializing a long Brent / short S&P 500 trade, as well as a long energy stocks / short tech trade, as hedges against this risk (Chart 9). Chart 8Civil Unrest In Basra Would Be Big Chart 9Two Hedges We Recommend Government Shutdown Is The One True Midterm-Related Risk There is a declining possibility of a government shutdown before the midterm - and a much larger possibility afterwards. It is well known that the election odds favor the Democrats, but if there were ever a president who would do something drastic to try to turn the tables, it would be Trump. A majority in the House gives Democrats the ability to impeach. While we think the Senate would acquit Trump of any impeachment articles, this view is based on stout Republican support. A "smoking gun" from Special Counsel Robert Mueller - comparable to Nixon's Watergate tapes - could still change things. Trump would rather avoid impeachment altogether. Trump could still conceivably try to upset the election by insisting on funding his promised "Wall" on the border. The Republicans want to delay the appropriations bill for the Department of Homeland Security, which would include any border security funding increases, until after the election (but before the new House sits in January). Trump has repeatedly threatened to reject his own party's plan, though he has recently backed off these threats. A shutdown ahead of an election would conventionally be political suicide - especially given the likely need for a federal response to Hurricane Florence. Moreover Trump's border wall is opposed by over half the populace. But Trump could reason that the greatest game changer would be a spike in turnout when his supporters hear that he is willing to stake the entire election on this key issue. Turnout is everything. The success of such a kamikaze run would hinge on the Senate. Assuming that Trump retained full Republican support to push through wall funding, as GOP incumbents frantically sought to end the shutdown, there would be 12 Democratic senators, in the broadest measure, who could conceivably be intimidated into voting with them (Table 1). These senators would have to decide on the spot whether they are safer running for office during a government shutdown or after having given Trump his wall. They may decide on the latter. Table 1A Government Shutdown Could Conceivably Intimidate Trump-State Democrats This would total 63 votes in the Senate, enough to invoke "cloture," ending debate, and hence break any Democratic filibuster against proposed wall funding. But this calculation is also extremely generous to Trump. More likely, at least four of the twelve senators would refuse to break rank: Debbie Stabenow of Michigan, Robert Menéndez of New Jersey, Sherrod Brown of Ohio, and Bob Casey of Pennsylvania. They would be averse to defecting from their party on such a consequential vote, even if eight of their colleagues were willing to do so.7 This is presumably why Mick Mulvaney, Trump's budget director, has already gone to Capitol Hill and "personally assured" the leading Republicans that Trump is not going to pursue a government shutdown.8 The legislative math doesn't really work. Nevertheless, there is still some chance that Trump - as opposed to any other president - will try this gambit. Especially as the loss of the House and potentially the Senate begins to appear "inevitable." After the midterm, of course, all bets are off. A lame duck Congress, or worse a Democratic Congress, will give President Trump all the reason he needs to grind things to a halt over his wall, with a view to 2020. The odds of a shutdown will shoot up. Do shutdowns matter for investors? Not really. S&P 500 returns tend to be flat for the first two weeks after a shutdown. Looking at eight past shutdowns, the average return was 1% fifteen days later, and 4.5% two months later. Bottom Line: We give a pre-election shutdown 10% odds due to Trump's unorthodoxy and desperate need to boost turnout among his voter base. Post-midterm election, a government shutdown is inevitable, unless congressional Republicans manage to convince President Trump to sign long-term appropriation bills before the election. Brexit: Is The Pound Pricing In Uncertainty? The U.K.-EU negotiations are entering their final, and thus most uncertain, phase. Our Brexit decision-tree looks messy and complicated (Diagram 1). While we believe that Prime Minister Theresa May has increased the probability of the sanguine "soft Brexit" outcome, there are plenty of pathways that lead to risk-off events. Diagram 1Brexit: Decision Tree And Conditional Probabilities Is the pound sufficiently pricing in this uncertainty? According to BCA's Foreign Exchange Strategy, which recently penned a special report on the subject, the answer is no.9 According to their long-term fair value model, the trade-weighted pound exhibits only a 3% discount - well within its historical norm (Chart 10). Chart 10Pound: A Much Smaller Discount On A Trade-Weighted Basis In order to assess the degree of political risk priced into the pound, one needs to isolate the risk of the U.K. leaving the EU. This is because all fair value models - including that of our FX team - are based on a potentially unrepresentative sample, one where the U.K. is part of the EU! The problem is that the traditional variables used to explain exchange rate movements were also greatly affected by the shock following the Brexit vote in June 2016. For example, looking at the behavior of British gilts, the FTSE, consumer confidence, and business confidence, one can see very abnormal moves occurring in conjunction with large fluctuations in the pound during the summer of 2016 (Chart 11A & 11B). Thus, if one were to regress the pound on these variables, one would not have observed a risk premium, even though the market was clearly very concerned with the geopolitical outlook for the U.K. Chart 11AAbnormal Moves Around The Brexit Vote... Chart 11B...Make It Hard To Spot Geopolitical Risk Our FX team therefore decided to try to explain the pound's normal behavior using variables that did not experience large abnormal moves in the direct aftermath of the British referendum. For GBP/USD (cable), the currency pair was regressed versus the dollar index and the British leading economic indicator (LEI). For EUR/USD, the currency pair was regressed against the trade-weighted euro and U.K. LEI. The reason for using the trade-weighted dollar and euro as explanatory variables is simple: it helps isolate the pound's movements from the impact of fluctuations in the other leg of the pair. Using the U.K. LEI helps incorporate the immediate outlook for U.K. growth and U.K. monetary policy into the pound's movement. The remaining error term was mostly a reflection of geopolitical risk.10 The results of the models are shown in Chart 12A & 12B. While the pound did show a geopolitical discount in the second half of 2016 (as evidenced by the abnormally large discount from the fundamental-based model), today the pound's pricing shows no geopolitical risk premium, whether against the dollar or the euro. This corroborates the message from the economic policy uncertainty index computed by Baker, Bloom, and Davis, which shows a very low level of economic policy uncertainty based on news articles (Chart 13). Chart 12ANo Geopolitical Risk Embedded... Chart 12B...In Today's Pound Sterling Chart 13Policy Uncertainty Index Muted Considering the thin risk premium embedded in the pound against both the dollar and the euro, GBP does not have much maneuvering room through the upcoming busy calendar. The problem for the pound is that the 5% net disapproval of Brexit among the British public remains smaller than the cohort of British voters who remain undecided (Chart 14). This means that domestic politics in the U.K. could remain a source of surprise, especially as Prime Minister Theresa May's polling remains tenuous (Chart 15). This raises the risk that Hard Brexiters end up controlling 10 Downing Street - despite their status as a minority within the ranks of Conservative MPs (Chart 16). Chart 14A Liability For Sterling Chart 15Theresa May's Tenuous Grip Chart 16Hard Brexiters Are A Minority With the global economic outlook already justifying a lower pound, especially versus the dollar, the pound seems to be too risky of an investment at this moment. It is true that positioning and sentiment towards cable are currently very depressed, raising the risk of a short-term rebound (Chart 17). This could particularly occur if the EU meeting in Salzburg in two weeks results in some breakthrough. Such an event would still not resolve May's domestic conundrum, which is why we would be inclined to fade any such rebound. Bottom Line: On a six-to-nine-month basis, it makes sense to short the pound against the dollar and the yen. Slowing global growth hurts the pound but also hurts the euro while benefiting the greenback and the yen. The political environment in Japan, in particular, supports this reasoning. As we have maintained, Shinzo Abe is not going to lose the September 20 leadership election for the ruling party (Chart 18).11 And the Trump administration is not going to wage a full-scale trade war against Japan. However, after the leadership poll, Abe will press ahead with his agenda to revise the constitution, which will initiate a controversial process and stake his fate on a popular referendum that is likely to be held next year. Chart 17Fade Any Short-Term Rebound Chart 18Abe Lives, But Yen Will Rise At the same time, Trump might try throwing some threats or jabs against Japan before his defense secretary and admirals are able to convince him that such actions subvert U.S. strategy against China. Therefore Japan-specific political risks are on the horizon, in addition to the ongoing trade war with China, which is already a boon for the yen. We are therefore initiating a long yen / short pound tactical trade. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Juan Manuel Correa, Senior Analyst juanc@bcaresearch.com Ekaterina Shtrevensky, Research Associate ekaterinas@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "The U.S. And China: Sizing Up The Crisis," dated July 11, 2018, available at gps.bcaresearch.com. 5 Please see BCA Commodity & Energy Strategy Weekly Report, "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," dated August 23, 2018, available at ces.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply," dated September 5, 2018, available at gps.bcaresearch.com. 7 Please see Burgess Everett, "Key red-state Democrat sides with Trump on wall funding," Politico, August 8, 2018, available at www.politico.com, and Ali Vitali, "Vulnerable Senate Democrats embrace Trump's wall," NBC News, August 13, 2018, available at www.nbcnews.com. 8 Please see Niv Elis and Scott Wong, "Trump again threatens shutdown," The Hill, September 5, 2018, available at thehill.com. 9 Please see BCA Foreign Exchange Strategy Special Report, "Assessing The Geopolitical Risk Premium In The Pound," dated September 7, 2018, available at fes.bcaresearch.com. 10 To make sure the exercise was robust, Foreign Exchange Strategy tested the out-of-sample performance of the model. Reassuringly, the GBP/USD and EUR/GBP models showed great predictive power out-of-sample (see Appendix), while remaining significant and explaining 80% and 65% of the pairs' variations respectively. 11 Please see BCA Geopolitical Strategy Special Report, "Japan: Kuroda Or No Kuroda, Reflation Ahead," dated February 7, 2018, available at gps.bcaresearch.com. Appendix: Traditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium Chart 19 Chart 20 Geopolitical Calendar
Highlights President Trump has little to do with the ongoing EM selloff; The macro backdrop is the real culprit behind Turkey's woes, particularly the strong dollar... ... Which is a product of global policy divergence, with the U.S. stimulating while China pursues growth-constraining reforms; Chinese stimulus is important to watch, as it could change the game, but we do not expect China to save EM as it did in 2015; Turkey's troubles are a product of its late-stage populist cycle and will not end with Trump's magnanimity; The positive spin on the EM bloodbath is that it may force the Fed to slow its rate hikes, prolonging the business cycle. Feature Chart 1EM: Bloodbath Markets are selling off in Turkey and the wider EM economies (Chart 1), with the financial media focusing on the actions taken by the U.S. President Donald Trump in the escalating diplomatic spat between the two countries. Investors should be very clear what it means to ascribe the ongoing selloff to President Trump's aggressive posture with Ankara in particular and trade in general. If President Trump started EM's troubles with his tweets, he can then end them with another late-night missive. This is not our view. Turkey is enveloped in a deep morass of populism and weak fundamentals since at least 2013. What is worse, the ongoing selloff is likely going to ensnare at least the other fragile EM economies and potentially take down EM as an asset class. In this Report, we recount the pernicious macro backdrop - both geopolitical and economic - that EM economies face today. We then focus on Turkey itself and show that President Trump has little to do with the current selloff. The Bloodbath Is Afoot, Again Every financial bubble, and every financial bust, begins with a compelling story grounded in solid fundamentals. The now by-gone EM "Goldilocks Era" (2001-2011) was primarily driven by exogenous factors: a generational debt-fueled consumption binge in DM; an investment-fueled double-digit growth rate in China that kicked off a structural commodity bull market; and the unleashing of pent-up EM consumption/credit demand (Chart 2).1 These EM tailwinds petered out by 2011. Subsequently, China and EM economies entered a major downtrend that culminated in a massive commodity rout that began in 2014. But before the bloodbath could motivate policymakers to initiate painful structural reforms, Chinese policymakers stimulated in earnest. In the second half of 2015, Beijing became unnerved and injected enormous amount of credit and fiscal stimulus into the mainland economy (Chart 3). The intervention, however, did not change the pernicious fundamentals driving EM economies but merely caused "a mid-cycle recovery, or hiatus, in an unfinished downtrend," as our EM strategists have recently pointed out (Chart 4).2 Chart 2Goldilocks Era##BR##Is Over For EM Chart 3Is China About To Cause Another##BR##EM Mid-Cycle Recovery? Take Brazil, for example. Instead of using the 2014-2015 generational downturn to double-down on painful fiscal and pension reforms, the country's politicians declared President Dilma Rousseff to be the root-cause of all evil that befell the nation, impeached her in April 2016, and then proceeded to unceremoniously punt all painful reforms until after this year's election (if ever). They were enabled to do so by the "mid-cycle recovery" spurred by Chinese stimulus. In other words, Brazil's policymakers did nothing to actually deserve the recovery in asset prices but got one anyway. The country now will experience "faceoff time" with the markets, with no public support for painful reforms (Chart 5) and hardly an orthodox candidate in sight ahead of the October general election.3 Chart 4Where Are China/EM In The Cycle? Chart 5Brazil's Population Is Not Open To Fiscal Austerity Could Brazilian and Turkish policymakers be in luck, as Chinese policymakers have blinked again?4 Our assessment is that the coming stimulus will not be as stimulative as in 2015. First, President Xi's monetary and fiscal policy, since coming into office in 2012, has been biased towards tightening (Chart 6). Second, Chinese leverage has plateaued (Chart 7). In fact, "debt servicing" is now the third-fastest category of fiscal spending growth since Xi came to power (Table 1). Third, the July 31 Politburo statement pledged to make fiscal policy "more proactive" and "supportive," but also reaffirmed the commitment to continue the campaign against systemic risk. Chart 6Xi Jinping Caps##BR##Government Spending And Credit Chart 7The Rise And Plateau##BR##Of Macro Leverage Whether China's mid-year stimulus will be globally stimulative is now the question for global investors. The key data to watch out of China will be August credit numbers, to be released September 9th through 15th. Is President Trump not to be blamed at all for the EM selloff? What about the trade war against China? If anything, tariffs against China have caused Beijing to "blink" and implement some stimulative measures this summer. If one must find fault in U.S. policy, it is the double dose of fiscal stimulus that has endangered EM economies. A key theme for BCA's Geopolitical Strategy this year has been the idea that global policy divergence would replace the global growth convergence.5 Populist economic stimulus in the U.S. and structural reforms in China would imperil growth in the latter and accelerate it in the former, forming a bullish environment for the U.S. dollar (Chart 8). Table 1Total Government Spending Preferences (Under Leader's General Control) Chart 8U.S. Outperformance Should Be Bullish USD As such, the White House is partly responsible for the EM selloff, but not in any way that can be changed with a tweet or a handshake. Furthermore, we do not see the upcoming U.S. midterm election as somehow capable of altering the global growth dynamics.6 It is highly unlikely that Democrats will seek to spend less, and they cannot raise taxes under Trump. Bottom Line: EM economies have never adjusted to the end of their Goldilocks era. A surge in global liquidity pushed investors further down the risk-curve, propping up EM assets despite poor macro fundamentals. China's massive 2015-2016 stimulus arrested the bear market, giving investors a perception that EM economies had recovered. This mid-cycle hiatus, however, has now been overtaken by the global policy divergence between Washington and Beijing, which is bullish USD. President Trump's trade tariffs and aggressive pressure on Turkey do not help. However, they are merely the catalyst, not the cause, of the selloff. As such, investors should not "buy" EM on a resolution of China-U.S. trade tensions or of the Washington-Ankara diplomatic dispute. Contagion Risk BCA's Emerging Market Strategy is clear: in all episodes of a major EM selloff, the de-coupling between different regions proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside (Chart 9).7 One reason to expect contagion risk among all EM markets is that the primary export market for China and other East Asian exporters are other EM economies, particularly the commodity producers (Chart 10). As such, it is highly unlikely that East Asian EM economies will be able to avoid a downturn. In fact, leading indicators of exports and manufacturing, such as Korea's manufacturing shipments-to-inventory ratio and Taiwan's semiconductor shipments-to-inventory ratio herald further deceleration in their respective export sectors (Chart 11). Chart 9Asian And Latin American Equities:##BR##Unsustainable Divergences Chart 10EM Trades##BR##With EM Chart 11Asia Export##BR##Slowdown Is Afoot In respect of foreign funding requirements of EM economies, our EM strategists have pointed out that there is a substantive amount of foreign currency debt coming due in 2018 (Table 2), with majority EM economies facing much higher foreign debt burdens than in 1996 (Table 3).8 Investors should not, however, rely merely on debt as percent of GDP ratios for their vulnerability assessment. For example, Malaysia's private sector FX debt load stands at 63.7% of GDP, the second highest level after Turkey. But relative to total exports (a source of revenue for its indebted corporates) and FX reserves (which the central bank can use to plug the gap in the balance of payments), Malaysia actually scores fairly well. Table 2EM: Short-Term (Due In 2018) FX Debt Table 3EM Private Sector FX Debt: 1996 Versus Today Chart 12 shows the most vulnerable EM economies in terms of foreign currency private sector debt exposure relative to FX reserves and total exports. Unsurprisingly, Turkey stands as the most vulnerable economy, along with Argentina, Brazil, Indonesia, Chile, and Colombia. Chart 12BCA's Emerging Markets Strategy Has Already Pinned Turkey As The Most Vulnerable EM Economy Will the EM selloff eventually ensnare DM economies as well, particularly the U.S.? We think yes. The drawdown in EM will bid up safe-haven assets like the U.S. dollar. The dollar can be thought of as America's second central bank, along with the Fed. If both the greenback and the Fed are tightening monetary conditions, eventually the U.S. economy will feel the burn. As such, it is dangerous to dismiss the ongoing crisis in Turkey as a merely localized problem that could, at its worst, spread to other EM economies. In 1997, Thailand played a similar role to that of Turkey. The Fed tightened rates in early 1997 and largely remained aloof of the developing East Asia crisis that eventually spread to Brazil and Russia, ignoring the tumult abroad until September 1998 when it finally cut rates three times. Fed policy easing at the end of 1998 ushered in the stock market overshoot and dot-com bubble, whose burst caused the end of the economic cycle. The same playbook may be occurring today. The Fed, motivated by the strong U.S. economy and fears of being too close to the zero-bound ahead of the next recession, is proceeding apace with its tightening cycle. It is likely to ignore troubles in the rest of the world until the USD overshoots or U.S. equities are impacted directly. At that point, perhaps later this year or early next year, the Fed will back off from tightening, ushering the one last overshoot phase ahead of the recession in 2020 - or beyond. Bottom Line: Research by BCA's EM strategists shows that EM contagion is almost never contained in just a few vulnerable economies. For investors who have to remain invested in EM economies, we would recommend that they go long Chinese equities relative to EM, given that Beijing policymakers are stimulating the economy to ensure that Chinese growth is stabilized. While this will be positive for China, it is likely to fall short of the 2015 stimulus that also stimulated non-China EM. An alternative play is to go long energy producers vs. the rest of EM - given our fundamentally bullish oil view combined with rising geopolitical risks regarding sanctions against Iran.9 We eventually expect EM risks to spur an appreciation in the USD that the Fed has to lean against by either pausing its tightening cycle, or eventually reversing it as it did in the 1997-1998 scenario. This decision will usher in the final blow-off stage in U.S. equities that investors will not want to miss. What About Turkey? Chart 13Turkey: Volatile Politics, Volatile Stocks In 2013, we called Turkey a "canary in the EM coal mine" arguing that its historically volatile financial markets would mean-revert as domestic politics became turbulent (Chart 13).10 Turkey is a deeply divided society equally split between the secularist cities, which are primarily located on the Mediterranean (Istanbul, Izmir, Bursa, Adana, etc.), and the religiously conservative Anatolian interior. This split dates back to the founding of the modern Turkish Republic in the post-World War I era (and in truth, even before that). The ruling Justice and Development Party (AKP), a religiously conservative but initially pro-free-market party, managed to appeal to the conservative Anatolia while neutering the most powerful secularist institution in Turkey, its military. Investors hailed AKP's dominance because it reduced political volatility and initially promised both pro-market policies and even accession to the EU. However, the AKP has struggled to win more than 50% of the popular vote in a slew of elections and referendums since coming to power (Chart 14), a fact that belies its supposed iron-grip hold on Turkish politics since it came to power in 2002. The vulnerability behind AKP's hold on office has largely motivated President Recep Tayyip Erdogan's attempt to consolidate political power. While we disagree with the consensus view that Erdogan's constitutional changes have turned Turkey into a dictatorship, some of his actions do suggest a deep fear of losing power.11 Populist leadership is characterized by a strategy of "giving people what they want" so that the policymakers in charge remain in office. Erdogan's perpetually slim hold on power has motivated several populist policy decisions that have stretched Turkey's macro fundamentals. First, Turkey's central bank has essentially been conducting quantitative easing since 2013 via net liquidity injections into the banking system (Chart 15). Notably, these injections began at the same time as the May 2013 Gezi Park protests, which saw a huge outpouring of anti-government sentiment across Turkey's large cities. Essentially, politics has been motivating Ankara's monetary policy over the past five years. Chart 14AKP's Stranglehold On Power Is Overstated Chart 15Turkey's Populist Policies Began##BR##With Gezi Park Protests Second, Turkey's current account balance has suffered under the weight of rising energy costs, with no attempt to improve the fiscal balance (Chart 16). The government has done little in terms of structural reforms or fiscal austerity, instead President Erdogan has continued to challenge central bank independence on interest rates, despite a clear sign that the country is experiencing a genuine inflationary breakout (Chart 17). Chart 16Populism Means No Austerity Is In Sight Chart 17Genuine Inflation Breakout Overall, Turkey is a classic example of how populism in a highly divided and polarized country can get out of control. Foreign investors have long assumed that Erdogan's populism was benign, if not even positive, given the presumably ample political capital at the president's disposal. However, with every election or referendum, the government did not double-down on pro-market structural reforms. Instead, the pressure on the central bank only increased while Turkey's expensive and extravagant geopolitical adventures in neighboring Syria accelerated. In this pernicious macro context, it has not taken much to knock Turkey's assets off balance. President Trump's threats to expand sanctions to Turkish trade are largely irrelevant, given that the vast majority of Turkey's exports and FDI sources are non-American (Chart 18). However, given past behavior - such as after the shadowy Gülen "plot" to take over power or the 2016 coup d'état - markets are by now conditioned to expect that Turkish policymakers will double-down on populist policies in the face of renewed pressure. Chart 18Turkey-U.S. Relationship Is Not Economic What of Turkey's membership in NATO? Should investors fear broader geopolitical instability due to the domestic crisis? No. Ankara has used its membership in NATO, and particularly the U.S. reliance on its Incirlik air base in southern Turkey, as levers in previous negotiations and diplomatic spats with Europe and the U.S. If Ankara were to renege on its commitments to the Western military alliance, it would likely face a united front from Europe and the U.S. As such, we would expect Turkey neither to threaten exit from NATO, which it has not done in the past, nor even to threaten U.S. operations in Incirlik, which Erdogan's government has threatened before. The most likely outcome of the ongoing diplomatic spat, in fact, would be to see Ankara give in to U.S. demands, given the accelerating financial and economic crisis. Such an outcome, however, will not arrest the downturn. Turkey's economy and assets are fundamentally under pressure due to the realization by investors that this year's main macro theme is not the resynchronized global growth recovery, but rather the global policy divergence between the U.S. and China, which has appreciated the U.S. dollar. No amount of kowtowing by Ankara will change this macro trend. Bottom Line: The list of Turkish policy sins is long. Erdogan's reign has been characterized by deep polarization and populism, leading to suboptimal policy choices since at least 2013. The latest U.S.-Turkey spat is therefore merely one of many problems plaguing the country. As such, its resolution will not be a buying opportunity for investors. Investment Implications Our main investment theme in 2018 was that the global policy divergence between the U.S. and China - emblematized by fiscal stimulus in the U.S. and structural reforms in China - would end the global growth resynchronization. As the U.S. economy outperformed the rest of the world, the U.S. greenback would appreciate, imperiling EM economies. The best cognitive roadmap for today is the late 1990s, when the U.S. economy continued to grow apace as the rest of the world suffered from an EM crisis. The problems eventually washed onto American shores in the form of a stronger dollar, forcing the Fed to back off from tightening in mid-1998. Policy easing then led to the overshoot phase in U.S. equities in 1999. Investors should prepare for a similar roadmap by being long DXY relative to EM currencies, long DM equities (particularly U.S.) relative to EM equities, and tactically cautious on all global risk assets. Strategically, however, it makes sense to remain overweight equities as a Fed capitulation would be a boon for risk assets. If the current selloff in EM gets worse, we would expect that the Fed would again back off from tightening as it did in 1998, ushering in a blow-off stage in equities ahead of the next recession. Once the dollar peaks and EM assets bottom, U.S. equities will become the laggard, with global cyclicals outperforming. A secondary conclusion is that President Trump's trade rhetoric in general, and aggressive policies towards Turkey in particular, are merely a catalyst for the selloff. As such, if President Trump changes his mind, we would fade any rally in EM assets. The fundamental policy decisions that have led to the greenback rally have already been taken in 2017 and early 2018. The profligate tax cuts and the two-year stimulative appropriations bill, combined with Chinese policymakers' focus on controlling financial leverage, are the seeds of the current EM imbroglio. Finally, a small bit of housekeeping. We are booking gains on our long Malaysian ringgit / short Turkish lira trade for a gain of 51.2% since May. We are also closing our speculative long Russian equities relative to EM trade for a loss of -0.9% as a result of the persistent headwind from U.S. sanctions. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," dated July 19, 2018, available at ems.bcaresearch.com. 3 Please see BCA Emerging Markets Special Report, "Brazil: Faceoff Time," dated July 27, 2018, available at ems.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "China: How Stimulating Is The Stimulus?" dated August 8, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, and Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018, available at ems.bcaresearch.com. 8 Please see BCA Emerging Markets Strategy Special Report, "A Primer On EM External Debt," dated June 7, 2018, available at ems.bcaresearch.com. 9 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," dated July 19, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Monthly Report, "Turkey: Canary In The EM Coal Mine?" in "The Coming Political Recapitalization Rally," dated June 13, 2013, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Weekly Report, "Turkey: Deceitful Stability," in "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com.
Highlights Editor's Note: I am pleased to return to U.S. Investment Strategy (USIS). I worked with the service when I joined BCA in 2010, and previously led it from August 2013 through September 2014. Sara Porrello, who has been with the team for over 20 years, and I look forward to re-aligning USIS with its original mandate. We hope you will find it consistently insightful. Best regards, Doug Peta U.S. Investment Strategy is getting back to basics: Today's report, plainly stating our position on the near-term direction of interest rates, is the first in an ongoing series meant to stake out our views on the macro issues that are most important to investors. Rates are headed higher, consistent with a booming economy that may well overheat, ... : Assuming trade tensions don't short-circuit the expansion, the U.S. economy is poised to grow above trend well into 2019. ...thanks to a tightening labor market and dubious fiscal spending, ... : Employers will be forced to bid up wages as the pool of idled and under-utilized workers dries up, and the fiscal stimulus package is all but certain to goose inflation pressures. ... and neither tweets nor testy interviews nor other expressions of presidential pique are likely to stay the Fed from its appointed rounds: The Federal Reserve cherishes its independence, and it is extremely unlikely to bow to presidential pressure. Feature U.S. Investment Strategy is meant to provide analyses of the U.S. economy and its future direction for the purpose of helping our clients make asset-allocation decisions. Starting with this report, we are going back to the basics of meeting that mandate. Over the rest of the summer, we intend to outline our positions on the key macro drivers of financial markets: rates, credit, the business cycle, and the state of monetary policy. Laying out our big-picture views, and the rationale underpinning them, will establish a framework for evaluating incoming data. The goal is to allow our clients to think along with us as new information is disseminated, and to distinguish signals from noise. We also want to make it easier for clients to anticipate the evolution of our views. To that end, will make frequent use of checklists highlighting the specific elements that might lead us to change our take on the evolution of the key cycles. The ultimate goal is to stay on top of cyclical inflection points, and to use them to inform asset-allocation decisions. The Fed Gets Its Way On Rates Monetary policy is a blunt instrument that works with indeterminate lags, and its effect has been roundly questioned. At the ends of the armchair-quarterback continuum, the Fed is mocked as a clueless bumbler, turning dials at random like a fumbling Mr. Magoo, or bemoaned as an omnipotent manipulator of financial markets and real-world activity. Strictly speaking, it controls nothing more than short rates. As its post-crisis communications strategy has shown, however, its reach extends well beyond its official policy-rate dominion. Talk of last decade's "conundrum" aside, changes in the fed funds rate reverberate along the entire yield curve. As the Chart Of The Week demonstrates, the aggregate yield on all outstanding Treasury issues is joined at the hip, directionally, with the fed funds rate. Aggregate weighted-average Treasury duration sits squarely in the belly of the curve, and it is a not-quite-perfect proxy for the long end, where the Fed's gravitational pull wanes (Table 1). Its pull is still powerful, though; the 90% correlation between the fed funds rate and the 30-year bond testifies eloquently to the Fed's significant influence at all points of the curve (Chart 2). Chart of the WeekThe Fed Gets Its Way The investment takeaway is that the Fed gets what it wants across the full spectrum of rates the vast majority of the time. Given the FOMC's repeatedly expressed intention to continue on its normalization course, the path of least resistance for rates at all maturities is higher. Despite the money markets' resistance to extrapolate the 25-bps-a-quarter "gradual pace" across the rest of this year and next (Chart 3), six more quarters of that pace is our baseline expectation provided an economic shock does not occur. Investors should be prepared for a higher peak in the fed funds rate than the consensus expects. Table 1Correlation With The Fed Funds##BR##Rate By Bond Maturity Chart 2The Long Arm##BR##Of The Fed Chart 3Rates Have Room To##BR##Surprise To The Upside Bottom Line: The Treasury curve faithfully reflects changes in the fed funds rate. In the absence of a shock that would cause the FOMC's repeatedly expressed plans to change, monetary policy is a catalyst for higher rates. But What About An Inverted Yield Curve? The yield curve typically inverts in the latter stages of a rate-hiking campaign, so it is more correct to say a higher fed funds rate implies higher Treasury yields until the yield curve inverts. An inverted yield curve is a classic recession indicator, albeit often a very early one (Table 2), and it should not be taken as a signal to immediately de-risk portfolios. The yield curve may be prone to invert even earlier than it otherwise would this time around, given that QE1, QE2, and QE3 may well have depressed the term premium on long-term bonds,1 as The Bank Credit Analyst noted in its August edition. The question of how much the Fed's asset purchases have affected the term premium, if at all, is far from settled within either the Fed or BCA, but its potential to impact the signal from the yield curve reinforces our conviction to look to other indicators to confirm its recession message before declaring the end of the bull markets in equities and spread product. Table 2The Yield Curve Is Early The Inflation Outlook As the tepid post-crisis expansion has stretched on and on, investors have grown accustomed to sleepy inflation readings and begun to regard the prospects for a pickup in inflation with skepticism, if not outright disdain. Even within BCA, there has been spirited debate about the relevance of the Phillips Curve - the formalization of the idea that there is an inverse relationship between wage growth and the unemployment rate. Despite the stagflation of the 1970s and the lengthy post-crisis dry spell that have undermined the Phillips Curve's credibility with the rigorously empirically-minded, we do not find it controversial. The relationship between unemployment and compensation may not be perfectly linear, but the Phillips Curve is nothing more than an extension of the laws of supply and demand to wage negotiations. We can accept that the Phillips Curve is kinked - that compensation growth is utterly indifferent to changes in the unemployment rate when labor supply is glutted (as can be seen in Chart 4 when covering all of the observations below 7%), but rather sensitive to its moves when it is in the neighborhood of full employment (as can be seen when covering all of the observations above 5%). We believe the U.S. labor market has reached the point at which employers will have to compete fiercely to attract new talent. After nine years, the economy has finally worked down nearly all of the hidden slack that had padded the broader U-6 unemployment rate.2 The pool of discouraged workers - those who are not counted as officially unemployed because they're not actively looking for a job, but would start tomorrow if offered one - has shrunk below its 2000 and 2007 levels (Chart 5, top panel). Similarly, the share of the labor force that is working part time but would prefer to be working full time is approaching its pre-crisis bottom (Chart 5, bottom panel). The prospects for inflation gained another boost last December upon the passage of the spending package on the coattails of the tax-cut bill. The U.S. economy is poised to receive a substantial dose of fiscal stimulus this year and next (Chart 6). Mainstream macroeconomic thought holds that stimulus injected into an economy that is already operating at full capacity is prone to kindle inflation.3 Chart 4The Phillips Curve Can't Handle Copious Slack ... Chart 5... But Almost All Of It Has Been Worked Off Chart 6Goosing Inflation Along With Output Bottom Line: The U.S. labor market has tightened considerably and competition between employers to attract scarce talent should soon translate to a pickup in wage growth. Unneeded fiscal stimulus is also likely to push prices higher. There are plenty more inflation green shoots behind the ones that have already begun to emerge. White House-Fed Tension Is Nothing New It is not beyond the realm of possibility that presidential pressure could deter the Fed from following through on its intentions and present a risk to our above-consensus terminal rate estimate. The bond market immediately discounted the potential of a less independent Fed by selling off at the long end after the president stated he was "not thrilled" with ongoing rate hikes in an interview with CNBC. There would seem to be little doubt that a captive Fed would be more reluctant to remove the punch bowl than a Fed which was free to pursue its inflation mandate without outside interference. After all, elected officials would be happy to trade long-term pain for near-term gain (at least through the next campaign). The president may have upended convention by publicly airing his displeasure, but there is a natural tension between the White House and the Fed. There have been dust-ups in the past, and there will be dust-ups in the future for as long as elected officials shudder at the thought of an economic downturn. Alan Greenspan wrote frankly in his memoir about friction with the first Bush administration, which included public criticism from the sitting president. "I do not want to see us move so strongly against inflation that we impede growth," President Bush told the press at the beginning of his term, in response to hawkish congressional testimony from Greenspan.4 By all accounts, however, the conflict between Bush père and Greenspan was of a lower-pressure variety than the conflicts between LBJ and William McChesney Martin, and Nixon and Arthur Burns. The legendarily intimidating LBJ summoned Martin to his ranch following an unwelcome rate hike. According to several accounts (and consistent with his longstanding negotiating practices in the Senate), LBJ backed the smaller Martin up against a wall before giving full voice to his complaints. Martin did not budge, pointing out that the Fed had acted in accordance with the legislation governing its actions.5 If Martin represents the heroic Fed chief, standing his ground in the face of heavy pressure from a larger-than-life figure, Arthur Burns is the poster child for folding like a cheap lawn chair. The Nixon tapes capture Nixon and his proxies repeatedly pressuring Burns to prime the pump ahead of the 1972 election, which Burns ultimately did.6 Our view is that Fed Chair Powell is more likely to follow Martin than Burns. The Fed is more transparent today, and its independence is more firmly established than it was in the 1970s. Even if Powell were amenable to doing the president's bidding, he would be held back by the realization that it would ultimately be self-defeating: any hint of political manipulation in the rate-setting process would risk a bond market riot that would blast rates far beyond the levels where a 3.5% fed funds rate would take them. Bottom Line: We are not concerned that the FOMC will yield to pressure from the White House to back away from their rate hike plans. Attempted influence of the Fed is nothing new, and investors need not worry about it now. Investment Implications If we are correct in our view that rates have not yet peaked, the bond market is likely to face continued headwinds. Long-dated Treasuries will come under more pressure than shorter-maturity issues. Thanks to positive carry, spread product will be less vulnerable to higher rates, but our bond strategists are lukewarm on the risk-reward offered by investment-grade and high-yield bonds given the late stage of the cycle and historically tight spreads. We acknowledge the potential seriousness of the current spate of geopolitical risks, headlined by trade tensions, and advocate temporarily de-risking portfolios in line with the BCA house view (equal weight equities, underweight bonds, overweight cash). We are more constructive than the BCA consensus, however, because we remain constructive on the business cycle, the monetary policy cycle, and the credit cycle. If the key cycles aren't over, the equity bull market probably isn't over, and neither spread widening nor a pickup in defaults is likely to wipe out spread product's excess returns. We will express all of our calls in a basket of ETF recommendations once we have completed our review of the most impactful macro questions, but for now we recommend maintaining below-benchmark positioning in Treasury portfolios while overweighting TIPS at the expense of nominal Treasuries. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Long-term bond yields can be decomposed into the expected path of short-term rates and a term premium, which compensates an investor for the uncertainties that can arise over the extended time period that s/he is locking up his/her money by buying a longer-maturity instrument. 2 In the monthly employment report, the headline unemployment rate, which includes only jobless workers who are actively seeking work, is labeled U-3 unemployment. The U-6 series broadens the definition of unemployment to include the jobless who aren't actively searching and those who are working part time only because they cannot find a full-time position. 3 Please see the November 7, 2016 U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability," available at usis.bcaresearch.com, for a discussion of fiscal multipliers under a range of scenarios. 4 Greenspan, Alan. The Age of Turbulence: Adventures in a New World, Penguin (New York): 2007, p.113. To this day, several members of the G.H.W. Bush administration continue to pin a large measure of blame for its 1992 electoral loss on overly conservative monetary policy. The ex-president himself, in a 1998 television interview, said, "I reappointed him [Greenspan], and he disappointed me." 5 Granville, Kevin. "A President at War With His Fed Chief, 5 Decades Before Trump," New York Times, June 15, 2017, page B3 (updated July 19, 2018). https://www.nytimes.com/2017/06/13/business/economy/a-president-at-war-with-his-fed-chief-5-decades-before-trump.html 6 "How Richard Nixon Pressured Arthur Burns: Evidence from the Nixon Tapes, Vol. 20, No. 4," Journal of Economic Perspectives (Fall 2006). https://fraser.stlouisfed.org/title/1167/item/2388, accessed on July 24, 2018.