Geopolitics

Highlights At 50% Trump’s reelection odds are too high, flagging a risk to equity markets of policy discontinuity. The virus, unemployment, and wages will weigh on him over the year. Trump’s polling is firm because the crisis is still acute. If it remains firm when the dust settles then we will reassess. Trump is competitive in swing states, but not clearly leading. The stock market, as a single variable, is an excellent gauge of reelection odds for ruling parties in US elections going back to 1896. It gives Trump a 16% chance as of today. This is too low, but unemployment and wages also suggest he is an underdog. Michelle Obama and Justin Amash are potential spoilers flying under the radar. The Senate will follow the White House, signaling an understated risk of a total policy reversal and hard left turn in US policy. Massive stimulus motivates our long run risk-on trades: cyber security, infrastructure, Fed-backed corporate bonds, and China reflation plays. Europe and European industrials stand to benefit on a relative basis if Biden wins. Feature Chart 1Recent Poll Shows Trump Leads In Swing States President Donald Trump’s reelection bid is holding up better than we expected so far this year. Trump leads former Vice President Joe Biden in swing states by 52% to 45%, according to a poll taken by CNN from May 7-10 (Chart 1). Our poll of polls below are not as supportive, but this is a strong sign of competitiveness for a sitting president in the midst of a pandemic, recession, social unrest, and controversy over reopening the economy. Naturally several clients have pushed back against our decision to downgrade Trump’s chances of victory from 55% to 35% back in March. We don’t mind the heat – we took the heat for two years while we favored Trump for reelection. Moreover we are not dogmatic. If the facts change, we will change our minds. So far, we are sticking to our view. It is a view that implies risk to corporate earnings and hence supports a tactically bearish or short positioning on the S&P 500. If Trump maintains and builds on his popular support, particularly by August when the Republican and Democratic parties hold their conventions, then we will upgrade his odds, assuming that the economy is improving and the pandemic is abating. At present the market is underrating the challenges facing the president, as we outline in this report. Reopening Poses Downside Risks To Trump Chart 2US Follows The Swedes So far reopening is helping Trump, but it poses a major risk to him down the line this year. The election is five months away – a world away. The new “whistleblower’s complaint” against the Trump administration argues that America faces its “darkest winter in modern history” due to the impending second wave of the virus. However, we rely on the testimony of Anthony Fauci to the Senate this week. Fauci said that states can continue to reopen as long as they adhere to federal guidelines that require 14 days of declining cases in the first phase. June 1 is an acceptable time for most states to open. The trajectory of US deaths per million is deviating from the path of the European Union and moving toward the path charted by Sweden. Swedes have adhered strictly to looser guidelines; Americans have adhered loosely to stricter guidelines. The US death count per million people, a lagging indicator, will rise or at least remain flat in the coming months if states and individuals are not vigilant and compliant (Chart 2). One should assume, however, that governments and individuals will alter their behavior for the sake of self-preservation and in light of new information. Interior American states – those not included in the “COVID confederacy” of western and eastern Democratic states – have seen a tentative drop in deaths (Charts 3A & 3B). While looser restrictions will lead to higher deaths than otherwise, it is not a foregone conclusion that it will be unmanageable for the health system. Chart 3AInterior US Sees Rising COVID Cases … Chart 3B… And Deaths Could Rise From Here From an Electoral College perspective – an absurd way to look at a pandemic, but such are the times – the red states will see an accelerating case count and death toll if they do not actively manage the reopening process (Charts 4A & 4B). This is a political liability. Chart 4ARed States Stable In Case Count … Chart 4B… Yet Deaths Could Tick Up Expectations that Trump is a slam dunk for reelection neglect the obvious fact that interior states shut down before they suffered the full brunt of the pandemic. If new outbreaks spiral out of control, it will have a negative political ramification for those pushing for a quick reopening. That will eventually accrue to the president, with whom the buck stops. A resurgence of infections, whether this summer or this fall, will be met with better preparedness, in terms of non-pharmaceutical intervention (social distancing) and likely pharmaceutical intervention as well (anti-virals, probably not yet a vaccine). But the virus is now underrated as a political risk since President Trump is fully identified with the decision to “liberate” the states yet his polls are firm and online gamblers on sites like PredictIt are giving him a roughly 50% chance of winning reelection. Bottom Line: If outbreaks spiral out of control in swing states then the incumbent president and ruling party will be punished. The evolution of cases and deaths is critical in the near term. Uncertainty over reopening, and understated risks of political change, call for a higher equity risk premium and hence more downside for share prices. Trump’s Approval Gains Are Slight Americans are hitting “peak polarization” this year and the coming years. It is well known that partisanship is affecting voters’ views on objective reality. But notice that all consumers are getting more optimistic about the future, not just Republicans (Chart 5). Chart 5Sentiment Is Polarized But Everyone Sees Improvements On Horizon Uncertainty over reopening and understated risks of political change, call for more downside for share prices. There is a clear bifurcation in voter’s opinions of Trump’s handling of the economy as against the pandemic. Voters approve less and less of his pandemic response; they disapprove less and less of his handling of the economy (Charts 6A & 6B). Chart 6ATrump’s Approval Falling On COVID-19 … Chart 6BYet Supported On Economy Chart 7Voters Wary Of Reopening Too Fast The implication is that if the economy is the single biggest issue in November, then Trump made the right electoral call to reopen fast and focus on presiding over the biggest stimulus in history. Yet a clear majority feels the country is lifting restrictions too quickly. Only a slight majority of Republicans agree with him (Chart 7). Recent Emerson and Marist polls reinforce the point that the economy is the most important issue. Biden is leading Trump on the coronavirus – and notably leading older voters on both issues (Charts 8A & 8B). Chart 8AVoters Still Most Concerned About The Economy Chart 8BYet One Poll Says Biden Gaining Lead On Both Economy And Pandemic Trump’s national approval rating remains underwater, but it has gradually converged with the average of American presidents (Chart 9). A major incident of social unrest – which is possible given active protest movements amid high polarization – would hurt him. The lowest point in his approval rating occurred in August 2017 during the Charlottesville, Virginia protests against taking down a statue of Confederate General Robert E. Lee that turned bloody. Incidents of social unrest will be exploited by both political extremes, but a rise in unrest in general would cause anxiety among middle-of-the-road voters and tend to hurt the ruling party. Chart 9Trump Rising – But Social Unrest A Risk Chart 10Trump Not Yet Clearly On Obama Trajectory Chart 11Trump Gaining Among Hispanics, But Slight Dip Among Elderly Comparing Trump’s approval rating to his immediate predecessors is more realistic because general presidential approval has declined over time due to polarization. On this front, Trump is falling short of President Obama at this stage in 2012. Of course, he could still rally in the lead-up to the campaign, as is typical of sitting presidents (Chart 10). An important caveat is that Trump is making headway in unexpected voting groups. His support is surging among Hispanics, who are disproportionately hurt by economic lockdowns due to the sectoral concentration of their labor, yet less likely to die of COVID-19 (most likely because they are a younger cohort relative to blacks and whites). Moreover this trend began before the coronavirus and coincides with a rise in approval among electorally vital Midwesterners, as well as young people (Chart 11). The implication is that Democrats’ decision to impeach Trump has helped him, just as we argued it would last year, and yet COVID-19 has not reversed his gains. Older people, as mentioned, are a very important exception. They are the critical voting bloc and most susceptible to the virus. They are tentatively becoming less approving of the president. This is according to this Gallup poll, to the CNN poll highlighted at the top of this report, and the aforementioned poll in Chart 8 above. The right-leaning pollster Rasmussen – a proxy for those trying to avoid anti-Trump skews in polling due to any self-censorship or methodological biases – shows that Trump’s approval rating bottomed at a slightly lower level than it did when the Zelensky call appeared last fall, but not as low as during the market plunge and political controversies of late 2018 (Chart 12). This is good news for Trump. Chart 12Trump Reviving From Virus Hit, Shows Rasmussen Polling Chart 13Trump’s Polling Bounce Small Relative To Peers Yet Trump’s polling “bounce,” as the nation rallies around his leadership amid crisis, is small at two percentage points. Other leaders have gotten bigger boosts (Chart 13). More importantly, Trump’s polling bounce is miniscule compared to the average bounce for American presidents during crises that assail the US from the outside (Table 1). Table 1Trump’s Crisis Polling Bounce Compared To Previous Presidential Bounces Bottom Line: Trump is holding up surprisingly well with voters amid the crisis given his past polling. This is an important signal. But it is important to see if it is sustained after the acute phase passes. His polling gains are small relative to US history and contemporary peers. His consistent strong marks on the economy only matter if the economy is the chief issue of the election, but the pandemic creates a major risk that this election could be one of the unusual elections in which a non-economic issue is the most salient. Trump Isn’t Winning In Head-To-Head Polls Earlier we highlighted Trump’s lead in swing states, according to the latest CNN poll. But in our aggregate of polls, Biden is leading in all swing states except Ohio (Chart 14A). Chart 14ABiden Leads Swing State Poll-Of-Polls Except Ohio The lead is within the margin of error in Wisconsin, Florida, and Arizona, meaning the candidates are effectively tied. But that reflects negatively on the sitting president, since incumbents have an advantage over challengers, and Biden is widely known to be a deeply flawed challenger. Trump has taken a big hit in head-to-head polls in critical states. Moreover the year-to-date change in these head-to-head polls suggests that Trump has taken a big hit in critical states: Florida, Arizona, and even Ohio, which should be rock solid for him (Chart 14B). Chart 14BTrump Suffered Blow From Virus In Swing State Poll-Of-Polls The consolation for Trump is that Biden, “Sleepy Joe in the basement,” who is fending off mounting accusations of sexual misconduct against Tara Reade, has either lost ground or made negligible gains. Clients often tell us they do not trust the polls. But post-WWII history shows that polls are fairly accurate and more accurate for sitting presidents than their challengers. Incumbents have averaged 55% of the popular vote, versus 49% for challengers, a clear indication of the incumbent advantage (Chart 15A). Chart 15ASitting Presidents Usually Win The Popular Vote Voter intentions in October and November ahead of the election are usually only 0.8% lower than the sitting president’s actual vote share. However, the same polls tend to underrate challengers by 2.2% (Chart 15B). Chart 15BPolling Is Accurate – Yet Underrates Challengers More Than Incumbent Presidents Chart 16Trump’s Favorability Less Negative, Biden’s Turns Negative Favorability polling is of limited relevance, given that the candidates for president in 2016 and 2020 are the least favorable of all politicians. Polarization makes it so that being hated by the other party is an asset. But it is notable that Trump’s net favorability is not half as negative as it was in 2016, and that he is tied with Biden, whereas Biden has fallen a great distance since the last economic crisis, when he had greater favorability than Barack Obama (Chart 16). Bottom Line: The candidates are virtually tied in the swing states and Biden’s slight lead in our poll-of-polls has not benefited from the crisis. Incumbents tend to outperform their polling by one point, but challengers tend to outperform by two. Biden is manifestly a weak challenger but taking all the evidence together he has a slight lead at present in the swing states. Stock Market And Recession Are Worrisome For Trump Table 2Trump’s Odds 50% At Most Based On Historic Recession/Election Probabilities US elections are a referendum on the incumbent party. Recessions tend to destroy sitting presidents. This is true, but there are important exceptions. A close look at the odds of sitting presidents, as well as sitting parties, and the timing of when the economy resumes expansion, suggests that Trump’s odds of winning are at best 50/50 (Table 2). Our own quantitative election model shows the same thing, and has hovered at 51% all along, although it will flip key states against him once state-level data are updated for the collapse in the economy. Fernando Crupi, of BCA Research Commodity & Energy Strategy, shows what a simple and straightforward look at the S&P 500 implies about Trump’s odds. Together we looked at two variables in elections since 1896: the market performance year to date on October 31 of the election year, and the result of the election for the incumbent party, i.e. victory if the incumbent party is reelected or loss if the new president hails from the opposing party. To estimate the probability of victory we use a logistic model, a widely used statistical tool designed to predict probabilities which can only range between zero and one, never hitting them.1 It is virtually impossible for an election outcome to be certain. The results are as follows: The year-to-date performance of the S&P 500 is a statistically significant variable (at the 5% level) in determining the fate of an incumbent party and has a positive correlation with it. Out of 31 elections, the model correctly predicted the outcome of 77% of the elections in-sample. While this is far from perfect it is remarkable given that we are using the market performance as the only explanatory variable. The effect of an additional percentage point of stock market performance is not linear on the incumbent party’s re-election odds, so two numbers are worthwhile expressing. At the mean S&P 500 YTD performance of the 31 elections, an additional percentage point increase in the market would increase the incumbent party’s odds of winning by 2.8 percentage points, and a decrease would decrease it by the same. By comparison, for all possible values of market performance, the average effect of an additional percentage point increase (or decrease) of the market would increase (or decrease) the probability of an incumbent party re-election by 2.1 percentage points. Chart 17 helps to visualize the model – for any percentage of market performance YTD as of October 31, it shows Trump’s odds of reelection this fall. With the S&P down by 13% this year, Trump’s odds would be 16%. A 10ppt recuperation in the S&P 500 from here would increase his chances to 40% and a 15ppt recuperation would bring him to 55%. Chart 17The Stock Market Says Trump’s Reelection Odds Are 16% Obviously the stock market is likely to rally or sell off for various reasons, for instance, if it thinks that the economy will get worse and the incumbent will lose. A change of government introduces policy uncertainty. Our own electoral model, explained in previous reports, is more robust than this back-of-the-envelope experiment and produces a more favorable outcome for Trump. So while the S&P may be low-balling Trump at 16%, we have no basis either in history or in formal modeling to give him more than a 50% chance as things stand today. And subjectively we think 50% is too high. Presidential approval follows the unemployment rate in the final innings of the campaign. Trump is doomed by this measure. Lastly, to reiterate and update key points we have made in the past: Presidential approval tends to follow the unemployment rate in the final innings of the campaign. Trump is obviously doomed by this measure, as it is the net change over time that matters most (Charts 18A & 18B). Chart 18AUnemployment Rate A Huge Chart 18B… And Tends To Predict Voter turnout is one of the hardest variables to predict, but it follows pretty closely with the change in unemployment over the preceding four years in the swing states. High turnout amid a deep recession is negative for the incumbent president (Chart 19). Chart 19Surge In Unemployment Positive For Turnout, Yet Hurts Incumbent Our subjective probability of reelection, at 35% as of March 24, holds up pretty well in this light. We will adjust this as new evidence comes to light. Bottom Line: To claim that Trump’s odds of reelection are substantially higher than 50% is to argue that “this time is different.” The market should keep falling from its April 29 peak around 2950 not only because of uncertainty about the pandemic and economy but also because of the risk that Trump’s troubles lead to market-negative outcomes. Michelle And Justin As Spoilers With multiple overlapping crises and high polarization, we have highlighted the high potential for extreme events, black swans, and spoilers. These do not include any move of the election date – that would make Trump look weak and would require House Democrats to agree to change a key 1845 statute.2 But they include almost everything else: violent incidents, disputes over voting methods amid the virus, vote recounts, judicial interventions, Electoral College irregularities, congressional intercession, refusals to concede, you name it. We would not be surprised if the Supreme Court took an opportunity currently before it to rule in favor of punishments against “faithless electors” or even to prohibit electors from voting contrary to the popular will in general. On a much less important note, we would also not be surprised if the high court enables President Trump’s personal accounts and tax records to be subpoenaed. Another possible spoiler: Michelle Obama. Chart 20Michelle Obama Objective Best Pick For Vice President Biden is currently mulling his pick for the vice presidential candidate. None of the candidates are magical: Senator Amy Klobuchar makes the most sense of the conventional options as she could improve his standing among women, Midwesterners, white voters, and suburbanites. She hails from Minnesota, he from Pennsylvania, creating a potential pincer movement in the Electoral College. Klobuchar’s favorability is stronger than that of Senators Elizabeth Warren and Kamala Harris, neither of whom can help bring a swing state (Chart 20).3 Yet Warren is well known and could help mend the gap with the progressive wing of the party. Picking her highlights the understated risk to the market of a progressive turn in Biden’s platform. Stacey Abrams could help bring over the black vote but she is sorely lacking in credentials and is reminiscent of the GOP’s desperate and failed bid to reconnect with its base by nominating Sarah Palin in 2008. The obvious choice is Michelle Obama. She has the highest favorability by far, including when her detractors are netted out. She solidifies Biden’s connection with Barack Obama, helps energize progressives, women, and minorities who are needed to turn out. And her power base is in the Midwest. One little problem … Michelle has repeatedly said she does not wish to run. Others have confirmed she has no interest. And a Machiavellian political adviser could advise her to wait until later when there is no incumbent president and then run directly for the top job, free of Biden’s baggage. We held the latter view, until the corona crisis. Trump was heavily favored prior to recession. Now the tables have turned. And a vice presidential role would improve her chances of being the first woman president later. The fact that she apparently does not want to run is obviously a huge problem. But her party needs her and this fact may become increasingly evident as Biden’s weaknesses are exposed. Vice presidential picks seldom make a difference in the campaign. At best they can help bring a swing state. But this election is different. Biden would turn 78 immediately after being elected; he is more likely than the average president to depend upon his VP while ruling, and to pass the baton to the VP early. COVID-19 underscores this risk. In other words, this year is the rare case where the Veep pick is important enough to matter and a charismatic candidate exists who could materially improve the odds of the opposition party’s victory. Would Michelle really help? An argument could be made that the Obama legacy is tarnished and that Trump would relish the chance to run against the Obama brand. However, our reasoning is based on Electoral College scenarios drawn from the best demographic data available, which suggest that the strongest challenge the Democrats can mount in 2020 is to reproduce the 2012 Obama/Biden ticket (Chart 21). Chart 21Electoral College Scenarios Say Biden/Obama 2012 Redux Best Shot For Dems To Beat Trump Chart 22Amash Is Small, But Significant Another important potential spoiler is Justin Amash. Amash is a former Republican who defected from the party due to his opposition to Trump and has since become the nation’s first congressman of the Libertarian Party. Amash could be important because he hails from Michigan, a key swing state, and is a splinter from the right-wing rather than the left-wing, thus potentially threatening President Trump’s thin margins in the battleground states. Currently Amash is winning 3%-5% of the popular vote, according to polls (Chart 22). Historically an extremely elevated third party vote is a threat to the incumbent president and ruling party, regardless of ideological affiliation. This is because it bespeaks general popular discontent, which in turn reflects negatively on the status quo and ruling party. However, so far Amash is not popular enough to hit the extremely elevated threshold. Looking at third party candidacies that have drawn more than 2% of the vote over history, the incumbent party wins 50% of the time. So the historical results are indecisive, but they do show potential for Amash to play the spoiler (Table 3). Table 3How Do Sitting US Presidents And Their Parties Fare When Voters Turn To Third Parties? Furthermore a larger group of Democrats and Democratic-leaning voters are determined not to vote for Biden than Republican and Republican-leaning voters are determined not to vote for Trump (Chart 23). The Republican Party rank and file support Trump enthusiastically, more so than Democrats support Biden, especially in the swing states (Chart 24). This suggests that Amash will fail to get traction among Republicans. Chart 23Left-Leaners Reject Biden More Than Right-Leaners Reject Trump Chart 24GOP More Zealous For Trump Than Dems For Biden We would not rule him out, however. The context of pandemic, deep recession, and extreme polarization is fertile for a third party candidate, as was the case in 2016. If support for Trump wanes due to the mounting death toll and unemployment rate, the weakness of Biden might point to defections from Trump’s camp to Amash. Again, this could be particularly relevant in swing states. Amash may not garner more votes than Gary Johnson, his Libertarian predecessor in 2016, since that year saw an “open election” favorable to third parties, whereas this year there is an incumbent running. But Amash has flown entirely under the radar. He is therefore underrated by markets. And his impact, in the final analysis, will likely prove more negative for the ruling party than Biden, who is very far from a libertarian. Bottom Line: Peak polarization and a historic national crisis will produce black swans. But some spoilers are identifiable. Biden picking Michelle Obama, and a small but significant margin of Republicans defecting to Amash in swing states, are non-negligible risks to Trump’s reelection odds. What About The Senate? Democrats are likely to retain the House of Representatives, unless the positive trends for Trump that we have highlighted start to snowball into massive momentum. Hence the Senate will be decisive to the legislative success of the next administration. It is especially relevant if a Democrat wins, since the implication would be single party control of both legislative and executive branches. By contrast, Trump’s reelection would imply a continuation of today’s balance of power. Online gamblers have finally come around to our long-held view that the Senate will go the way of the White House: currently PredictIt gives the Democrats a 52% chance, up substantially from last year. Republican Senate leaders have openly aired their fears as the election cycle picks up. The risk to Republican control is not merely because the crisis has erased the uptick in Republican Party affiliation (Chart 25), nor is it due to the break in Republican momentum in generic voter party support (Chart 26), though these developments are unwelcome to Republicans. Chart 25Republican Affiliation Of Voters Rolls Over Chart 26Democrats Tick Up Slightly In Generic Congressional Ballot Rather, politics have increasingly become nationalized and more Republican senators are at risk than Democrats due to the windfall Republican senate victory in 2014. Current polling reinforces that the Senate stands on a knife’s edge, as all races are virtually tied, except Colorado, which is a likely shoo-in for Democrats. Arizona is almost as good for them (Chart 27). Democrats need to take four seats plus the White House to win the chamber. Chart 27Close Races In Senate Will Follow The White House Bottom Line: The Senate will go the way of the White House, which means the market is not only underrating a Biden victory but also underrating the probability that he is unconstrained. With peak polarization, and full Democratic control, Biden would not prove a center-left president in office. He would end up governing to the left of the Obama administration. Investment Takeaways Why does the election matter? If Trump loses, the United States will most likely see another total reversal of national policy, as in 2016 and 2008. Yet this time the macroeconomic, political, and demographic backdrop will make it harder for Republicans to stage as effective of resistance as in 2010-16. This is positive for aggregate demand, due to fiscal policy, but negative for corporate earnings. Biden will be pushed to the left by the progressive wing of his party and will face relatively few legislative or judicial constraints. The Democrats will also surprise the market with a tough stance toward China to steal back the mantle of fighting for American workers. Big business will face higher taxes, sweeping re-regulation, and trade restrictions, all at the same time. The S&P 500 has fallen 4% since we recommended investors step back from the rally. We see more downside due to sluggish recoveries, viral outbreaks, hiccups in providing stimulus, and political and geopolitical risks. The S&P’s next support levels are at 2670 and 2250. Chart 28China Faces Protectionism Either Way, But Europe Only With Trump In the short term, Trump’s odds are overrated. We will upgrade him if the stock market, economy, and political indicators improve substantially from what we are seeing today by August when the two parties hold their conventions. What about our view that Trump will crack down on China? A crackdown will cause the S&P to sell. Yet a dramatic selloff that destroys his reelection hopes, or a rally based on massive stimulus, both encourage him to escalate the crisis. Politically, confronting China is positive for him and he cannot let Biden outmaneuver him on workers, trade, and China. This entire dynamic leaves us inclined to be risk-averse. For investors with a long time horizon we recommend selective risk-on investments such as cyber-security, infrastructure, China reflation plays, and investment grade corporate bonds, the latter now backed by the Federal Reserve. A parting thought on industrials. Gargantuan stimulus is positive for cyclical stocks over the long run. But Trump’s reelection raises the prospect of trade war not only with China but also with Europe. It also increases the substantial risk of an expanding conflict with Iran that sows unrest in the Middle East over the next five years. Whereas Biden would seek a united front with Europe against China and would reduce Middle Eastern risks to Europe. Hence over the long run European industrials can benefit disproportionately from a Biden win, on a policy-oriented basis, compared to a Trump win (Chart 28).     Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Fernando Crupi Research Associate fernandoc@bcaresearch.com Footnotes 1 Compared to a simple regression line, the effect of the explanatory variable on the predicted probabilities varies along the curve. An increase (or decrease) in our explanatory variable by one unit has a smaller and smaller effect on the probability of victory as we approach our upper and lower probability bounds of 0 and 1. Obviously this model cannot fully explain the outcome of an election nor establish causality, but it gives us a good indication of how important the market performance is for an incumbent party to be re-elected. 2 Please see Acts of the Twenty-Eight Congress of the United States, Statute II, Library of Congress. www.loc.gov. 3 The only superior scenario mathematically, in which Biden aims solely at winning back the Democrats’ old blue collar white voter base, is much less likely to succeed given that these voters have drifted to the GOP in recent decades and have been galvanized by Trump.

Special Report

Dear Client, With this weekly update on the Chinese economy, we are sending you a Special Report published by BCA Geopolitical Strategy team and authored by my colleague Matt Gertken. Lately we have been getting numerous questions from our clients, on the risk of a significant re-escalation in the US-China conflict. Matt’s report provides timely insights on the topic, and we trust you will find the report very helpful. Best regards, Jing Sima, China Strategist Feature An Update On The Chinese Economy Since mid-April, the speed of resumption in China’s domestic business activity has accelerated. Industrial enterprises appear to be operating at 87% of normal activity levels as of May 11, up from 81.8% one month ago. Small to medium-sized enterprise (SMEs) are estimated to now operate at 87.3% of their normal activity, a vast improvement from 82.3% just two weeks ago. Chart 1Pickup In M1 Still Modest The material easing in monetary conditions and strong flows of local government special-purpose bond issuance in the past two months helped jump start a recovery in the construction sector. But at this early stage of a domestic economic rebound and in the middle of a deep global economy recession, China’s corporate marginal propensity to invest remains muted (Chart 1). Household consumption showed some resilience during last week’s “Golden Week” holiday. The strength in big-ticket item purchases, however, was highly concentrated among consumers in China’s wealthiest urban areas (Chart 2). The COVID-19 pandemic has created a situation resembling a combination of SARS and the global financial crisis. Now the physical constraints on consumption have largely been lifted, consumers’ willingness to spend, after a brief period of compensatory spending, will be suppressed if their expectations of the medium-term job and income security remain pessimistic (Chart 3). Chart 2A Compensatory Rebound In Big-Ticket Item Sales Chart 3The Average Chinese Consumer Remains Cautious Next week we will publish a report, focusing on China’s consumption in a post-pandemic environment. Looking forward, we maintain the view that China’s business activity will pick up momentum in H2, when the massive monetary and fiscal stimuli continue working its way into the economy.  Downside risks to employment and income loom large, which makes it highly unlikely that the authorities will tighten their policy stance any time soon. As such, while we maintain our defensive tactical positioning due to near-term economic and geopolitical uncertainties, our view remains constructive on both the economy and Chinese financial asset prices in the next 6 to 12 months.  (Chart 4). Chart 4Recovery To Gain Traction In H2   Jing Sima China Strategist jings@bcaresearch.com     #WWIII The phrase “World War III” or #WWIII went viral earlier this year in response to a skirmish between the US and Iran (Chart 1). Only four months later, the US and China are escalating a strategic rivalry that makes the Iran conflict look paltry by comparison (Chart 2). Chart 1US-Iran Tensions Were Just A Warm-Up Chart 2The Thucydides Trap Fortunately, the two great powers are constrained by the same mutually assured destruction that constrained the US and the Soviet Union during the Cold War. They are also constrained by the desire to prevent their economies from collapsing further. Unfortunately, the intensity of their rivalry can escalate dramatically before reaching anything truly analogous to the Berlin Airlift or Cuban Missile Crisis – and these kinds of scenarios are not out of the question. Safe haven assets will catch a bid and the recovery in US and global risk assets since the COVID selloff will be halted. We maintain our defensive tactical positioning and will close two strategic trades to book profits and manage risk. In the wake of the pandemic and recession, geopolitics is the next shoe to drop. The War President Over the past 24 hours the White House has taken several steps indicating that President Trump is adopting the “war president” posture in the run-up to the US election: Export controls: Trump has gone forward with new export controls on “dual-purpose” technologies – those that have military as well as civilian applications, in a delayed reaction to China’s policy of civil-military technological fusion. The Commerce Department has wide leeway in whether to grant export licenses under the rule – but it is a consequential rule and would be disruptive if enforced strictly. Supply chain de-risking: Trump is also going forward with new restrictions on the import of foreign parts for US power plants and electricity grid. The purpose is to remove risks from critical US infrastructure. COVID investigation: Trump has hinted that the novel coronavirus that causes the COVID-19 disease may have originated in the Wuhan Institute of Virology. The Director of National Intelligence issued a statement indicating that the Intelligence Community does not view the virus as man-made (not a bio-weapon), but is investigating the potential that the virus transferred to humans at the institute. The State Department had flagged the institute for risky practices long before COVID. Trump avoided the bio-weapon conspiracy theory and is focused on the hypothesis that the laboratory’s investigations into rare coronaviruses led to the outbreak. New tariffs instead of reparations: Director of the National Economic Council Larry Kudlow denied that the US would stop making interest and principal payments on some Chinese holdings of US treasuries. He said that the “full faith and credit of the United States’ debt obligation is sacrosanct. Absolutely sacrosanct.” Trump denied that this form of reparations, first floated by Republican Senator Marsha Blackburn of Tennessee, was under consideration. Instead he suggested that new tariffs would be much more effective, raising the threat for the first time since the Phase One trade deal was agreed in principle in December. Strategic disputes: Tensions have flared up in specific, concrete ways across the range of US-Chinese relations – in the cyber-realm, psychological warfare, Korean peninsula, Taiwan Strait, and South China Sea. These could lead to sanctions. The war president posture is one in which President Trump recognizes that reelection is extremely unlikely in an environment of worse than -4.8% economic growth and likely 16% unemployment. Therefore he shifts the basis of his reelection to an ongoing crisis and appeals to Americans’ patriotism and desire for continuity amid crisis. Bottom Line: Protectionism is not guaranteed to work, and therefore it was not ultimately the path Trump took last year when he still believed a short-term trade deal could boost the economy. Now the bar to protectionism has been lowered. The Decline Of US-China Relations President Trump may still be bluffing, China may take a conciliatory posture, and a massive cold war-style escalation may be avoided. However, it is imprudent to buy risk assets on these reasons today, when the S&P 500’s forward price-to-earnings ratio stands at 20.15. It is more prudent to prepare for a historic escalation of tensions first, buy insurance, then reassess. Why? Because the trajectory of US-China relations is empirically worsening over time. US household deleveraging and the Chinese shift away from export-manufacturing (Chart 3) broke the basis of strong relations during the US’s distractions in Iraq and Afghanistan and China’s “peaceful rise” in the early 2000s. US consumers grew thriftier while Chinese wages rose. Not only has China sought economic self-sufficiency as a strategic objective since General Secretary Xi Jinping took power in 2012, but the Great Recession, Trump trade war, and global pandemic have accelerated the process of decoupling between the two economies. Decoupling is an empirical phenomenon, and it has momentum, however debatable its ultimate destination (Chart 4). Obviously policy at the moment is accelerating decoupling. Chart 3The Great Economic Divorce Chart 4Decoupling Is Empirical The US threat to cease payments on some of China’s Treasury holdings is an inversion of the fear that prevailed in the wake of 2008, that China would sell its treasuries to diversify away from dependence on the US and the greenback. China did end up selling its treasuries, but the US was not punished with higher interest rates because other buyers appeared. The US remains the world’s preponderant power and ultimate safe haven (Chart 5). By the same token, Trump and Kudlow naturally poured water on the threat of arbitrarily stopping payments because that would jeopardize America’s position. Instead Trump is threatening a new round of trade tariffs. Since the US runs a large trade deficit with China, and China is more exposed to trade generally, the US has the upper hand on this front. But it is important to notice that US tariff collections as a share of imports bottomed under President Obama (Chart 6). Chart 5Treasuries Can't Be Weaponized By Either Side... Chart 6... But Tariffs Can And Will Be   The US shift away from free trade toward protectionism occurred in the wake of the 2008 financial crisis. President Trump then popularized and accelerated this policy option in an aggressive and unorthodox way. Trade tariffs are a tool of American statecraft, not the whim of a single person, who may exit the White House in January 2021 anyway. The retreat from globalization is not a passing fancy. Today’s recession also marks the official conclusion of China’s historic 44 year economic boom – and hence a concrete blow to the legitimacy of the ruling Communist Party (Chart 7). The more insular, autarkic shift in the Communist Party’s thinking is not irreversible, but there are no clear signs that Xi Jinping is pivoting toward liberalism after eight years in power. Chart 7Recession Destabilizes The 'G2' Powers China’s unemployment rate has been estimated as high as 20.5% by Zhongtai Securities, which then retracted the estimate (!). It is at least at 10%. Moreover 51 million migrant workers vanished from the job rolls in the first quarter of the year. Maximum employment is the imperative of East Asian governments, especially the Communist Party, which has not dealt with joblessness since the late 1990s. The threat to social and political stability is obvious. The party will take extraordinary measures to maintain stability – not only massive stimulus but also social repression and foreign policy distraction to ensure that people rally around the flag. Xi Jinping has tried to shift the legitimacy of the party from economic growth to nationalism and consumerism, the “China Dream.” But the transition to consumer growth was supposed to be smooth. Financial turmoil, the trade war, and now pandemic and recession have forced the Communist Party off the training wheels well before it intended. Xi’s communist ideology, economic mercantilism, and assertive foreign policy have created an international backlash. The US is obviously indulging in nationalism as well. A stark increase in inequality and political polarization exploded in President Trump’s surprise election on a nationalist and protectionist platform in 2016 (Chart 8). All candidates bashed China on the campaign trail, but Trump was an anti-establishment leader who disrupted corporate interests and followed through with his tariff threats. The result is that the share of Americans who see China’s power and influence as a “major threat” to the United States has grown from around 50% during the halcyon days of cooperation to over 60% today. Those who see it as a minor threat have shrunk to about a quarter of the population (Chart 9). Chart 8A Measure Of Inequality In The US Chart 9US Nationalism On The Rise Chart 10Broad-Based Anti-China Sentiment In US As with US tariff policy, the bipartisan nature of US anger toward China is significant. More than 60% of Democrats and more than 50% of young people have an unfavorable view of China. College graduates have a more negative opinion than the much-discussed non-college-educated populace (Chart 10). Already it is clear, in Joe Biden’s attack ads against Trump, that this election is about who can sound tougher on China. The debate is over who has the better policy to put “America first,” not whether to put America first. Biden will try to steal back the protectionist thunder that enabled Trump to break the blue wall in the electorally pivotal Rust Belt in 2016 (Map 1). Biden will have to win over these voters by convincing them that he understands and empathizes with their Trumpian outlook on jobs, outsourcing, and China’s threats to national security. He will emphasize other crimes – carbon emissions, cyber attacks, human rights violations – but they will still be China’s crimes. He will return to the “Pivot to Asia” foreign policy of his most popular supporter, former President Barack Obama. Map 1US Election: Civil War Lite Bottom Line: Economic slowdown and autocracy in China, unprecedented since the Cultural Revolution, is clashing with the United States. Broad social restlessness in the US that is resolving into bipartisan nationalism against a peer competitor, unprecedented since the struggle with the Soviets in the 1960s, is clashing with China. Now is not the time to assume global stability. Constraints Still Operate, But Buy Insurance The story outlined above is by this time pretty well known. But the “Phase One” trade deal allowed global investors to set aside this secular story at the beginning of the year. Now, as Trump threatens tariffs again, the question is whether he will resort to sweeping, concrete, punitive measures against China that will take on global significance – i.e. that will drive the financial markets this year. Trump is still attempting to restore his bull market and magnificent economy. As long as this is the case, a constraint on conflict operates this year. It is just not as firm or predictable. Therefore we are looking for three things. First, will President Trump’s approval rating benefit so much from his pressure tactics on China that he finds himself driven into greater pressure tactics? This raises the risk of policy mistakes. Second, will Trump’s approval rating fall into the doldrums, stuck beneath 43%, as the toll of the recession wears on him and popular support during the health crisis fades? “Lame duck” status would essentially condemn him to electoral loss and incentivize him to turn the tables by escalating the conflict with China. Chart 11Trump May Seek A Crisis ‘Bounce’ To Popularity Presidents are not very popular these days, but a comparison with Trump’s two predecessors shows that while he can hardly obtain the popularity boost that Obama received just before the 2012 election, he could hope for something at least comparable to what George W. Bush received amid the invasion of Iraq (Chart 11). (Trump has generally been capped at 46% approval, the same as his share of the popular vote in 2016.) The reason this is a real risk, not a Shakespearean play, is outlined above: however cynical Trump’s political calculus, he would be reasserting US grand strategy in the face of a great power that is attempting to set up a regional empire from which, eventually, to mount a global challenge. Thus if he is convinced he cannot win the election anyway, this risk becomes material. Investors should take seriously any credible reports suggesting that Trump is growing increasingly frustrated with his trailing Biden in head-to-head polls in the swing states. Third, will China, under historic internal stress, react in a hostile way that drives Trump down the path of confrontation? China has so far resorted to propaganda, aircraft carrier drills around the island of Taiwan, and maritime encroachments in the South China Sea – none of which is intolerably provocative to Trump. A depreciation of the renminbi, a substantial change to the status quo in the East or South China Seas, or an attempt to vitiate US security guarantees regarding US allies in the region, could trigger a major geopolitical incident. A fourth Taiwan Strait crisis is fully within the realm of possibility, especially given that Taiwan’s “Silicon Shield” is fundamentally at stake. While we dismissed rumors of Kim Jong Un’s death in North Korea, any power vacuum or struggle for influence there is of great consequence in today’s geopolitical context. Aggressive use of tariffs always threatened to disrupt global trade and financial markets, but tariffs function differently in the context of a global economic expansion and bull market, as in 2018-19, than they do in the context of a deep and possibly protracted recession. Trump has a clear political incentive to be tough on China, but an equally clear financial and economic incentive to limit sweeping punitive measures and avoid devastating the stock market and economy. If events lower the economic hurdle, then the political incentive will prevail and financial markets will sell. Bottom Line: However small the risk of Trump enacting sweeping tariffs, the downside is larger than in the 2018-19 period. The stock market might fall by 40%-50% rather than 20% in an all-out trade war this year. Investment Takeaways Go tactically long US 10-year treasuries. Book a 9.7% profit on our long 30-year US TIPS trade. Close long global equities (relative to US) for a loss of 3.8%.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes Cyclical Investment Stance Equity Sector Recommendations

Highlights Global stimulus efforts are sufficient thus far, but more will need to be done, especially by Europe and emerging markets. Hiccups will not be well-received by financial markets. The net public wealth of countries helps put debt constraints into perspective in a world of zero and negative interest rates. Insufficient fiscal policy is a bigger risk for Europe in the near term than any Germany-mandated withdrawal of ECB quantitative easing. European states remain locked in a geopolitical predicament that prevents them from abandoning each other despite serious differences over fiscal policy, which will persist. We are tactically long defensive plays and safe havens. Stay long JPY-EUR. Feature This week we focus on two questions: Will global stimulus be enough to fill the gap in demand? And will Germany impose a hard limit on European stimulus efforts? Our answers are yes to the first and no to the second. It is impossible for governments to replace private activity indefinitely, but the resumption of private activity is inevitable one way or another. Governments are continuing to provide massive fiscal and monetary support. The near term is cloudy, however, due to the mismatch between uncertain economic reopening and increasing impediments to new stimulus. Weak spots in the global fiscal stimulus efforts arise in Europe and emerging markets excluding China. Europe, at least, is a temporary catch – as Germany has no choice but to help the rest of the EU prop up aggregate demand. But fiscal policy is a greater near-term risk to peripheral European assets than any cessation of monetary support from the ECB. Will Global Stimulus Be Enough? Yes, Eventually Chart 1 shows the latest update of our global fiscal stimulus chart comparing the size of today’s stimulus to the 2008-10 period. Countries that make up 92% of global GDP are providing about 8% of global GDP in fiscal stimulus. Full calculations can be found in the Appendix. Chart 1US Still Leads In Fiscal Stimulus The chief difference between our calculation and that of others is that we include government loans while excluding government loan guarantees. If a government gives a loan to a business or household, funds are transferred to the receiver’s deposits and can be spent to make necessary purchases or pay fixed costs. A loan guarantee, by contrast, is helpful but does not involve a transfer of funds. Our colleague Jonathan LaBerge, has recently written a Special Report analyzing the size of global fiscal stimulus. He provides an alternative calculation in Chart 2, which focuses on “above the line” measures, i.e. only measures affecting government revenues and expenditures. Government loans, guarantees, and other “below the line” measures are left aside in this conservative definition of stimulus. Chart 2Japan Leads In IMF “Above The Line” Account Of Stimulus Chart 3 shows the discrepancies between Jonathan’s version and our own – they are not very large. The major differences are Japan, China, Germany, Italy, and South Africa. Of these only Germany, Japan, and China are significant.1 Chart 3Geopolitical Strategy Estimates Accord Less Stimulus To Japan, More To Germany And China, Than IMF Does In Japan’s case, we include the stimulus measures that Japan passed at the end of 2019 because even though they were not passed in response to the pandemic, they will take affect at the same time as those that were. We do not include private sector complements to government action, which Japan includes in its account, since private responses are hard to predict and we do not include them for other countries. In China’s case, official estimates underrate the easing of credit policy. Credit is a quasi-fiscal function in China since the Communist Party controls the banks. With a large credit expansion the overall stimulus impact will be larger than expected, as long as borrowers still want to borrow. Data thus far this year suggests that they do, if only to cover expenses and debt payments. Our assessment that China’s stimulus will reach about 10% of GDP follows BCA Research’s China Investment Strategy. The UK and especially Italy, Spain, and France are falling short in their stimulus efforts … Is global stimulus “enough” to plug the gap in demand? Chart 4 shows our colleague Jonathan’s narrower definition of stimulus compared with estimates of the drop in demand from social lockdowns and spillover effects. It assumes a fiscal multiplier of 1.1. The result suggests that the US, China, and Australia are clearly doing enough; Germany, Japan, and Canada are arguably doing enough; other countries including Italy, France, and Spain will likely have to do more. Chart 4Which Countries Have Plugged The Gap In Demand So Far? The latest news confirms this assessment. The US Congress is negotiating another phase of stimulus that will provide a second round of direct payments to households, a third infusion of small business loans, and a large bailout of state and local governments. The current total is $2 trillion, and so far this year these totals are only revised upward. This tendency stems from the political setup: Trump needs to stimulate for the election, GOP senators’ fates ultimately hinge on Trump, while the House Democrats cannot withhold stimulus merely to undermine the Republicans. Similarly, there can be little doubt that China and Japan will provide more stimulus to maintain full employment – their different political systems have always demanded it. We are more concerned about Europe. The UK and especially Italy, Spain, and France are falling short in their stimulus efforts, with the last three ranging from 2%-4% of GDP, according to Chart 4 above. They will add more stimulus, but might they still fall short of what is needed? Assuming that the ECB will provide adequate liquidity, and that low bond yields for a long time will enable debts to be serviced, these countries can service their debts for some time. But what then is the constraint? From a long-term point of view, the UK and peripheral European nations have relatively fewer national assets to weigh against their well-known liabilities. They are closer to their constraints in issuing debt, even if those constraints are nearly impossible to establish and years away from being hit. This is apparent from the IMF’s data series on net public wealth, i.e. total public sector assets and liabilities (Chart 5A). These data, from 2016, are a bit stale, but they are still useful because they take account of assets like natural resources, real estate, state-owned companies, and pension plans that retain value over the long run. It does no good to refer to the large debt loads of countries without considering the vast holdings that they command. By the same token, at some point the debt loads look formidable even relative to these huge realms. Chart 5ANet Public Wealth: A Fuller Picture Of The Debt Story These data tend to underrate the sustainability of developed markets, which are highly indebted but have reserve currencies, safe haven status, and large, liquid credit markets. They overrate the sustainability of emerging markets, with large resource wealth and low-debt, but vulnerable currencies and credit markets. This is not only true for emerging markets with the most negative net worth, like Brazil, or with unsustainable fiscal policies, like Turkey and South Africa. China would look a lot worse in net public wealth, if this could be calculated, than it does on the general government ledger (Chart 5B), due to the liabilities of its state-owned enterprises and local governments. It would look more like the US or Japan in net public wealth – yet without a reserve currency. Chart 5BNet Government Debt: Flatters EM, Not DM Nevertheless the European states have a problem that the other developed markets do not have: the Euro Area’s “constitutional” order is still unsettled. Questions are continually arising about whether countries’ liabilities are backstopped by a single currency authority and the entire assets of the Euro Area. These questions will tend to be settled in favor of European integration. But treaty battles in the context of upcoming elections – in the Netherlands, Germany, France, and likely Italy and Spain – will provide persistent volatility. Bottom Line: Fiscal stimulus passed thus far is only “sufficient” in a few economies; it is insufficient in southern Europe and emerging markets. Uncertainty about the pandemic, and the pace of economic reopening and normalization, combined with any hiccups in providing adequate stimulus will create near-term volatility. Will Germany Halt Quantitative Easing? No, Not Ultimately The questions about Europe highlighted above have come to the fore with the reemergence of the “German question,” which in today’s context means Germany’s and northern Europe’s willingness to conduct fiscal policy to help rebalance the Euro Area and monetary policy to ease conditions for heavily indebted, low productivity southern Europe. We have little doubt that Germany will provide more than its current 10.3% of GDP fiscal stimulus given that it has explicitly stated that state lender KfW has no limit on the amount of loans it can provide to small businesses. This accounts for the difference between our fiscal stimulus estimate and the IMF’s, but the fullest count, including “below the line” measures, would amount to nearly 35% of GDP. A sea change in the German attitude toward fiscal policy has occurred, which we have tracked in reports over the years. This shift gives permission for other European states to loosen their belts as well. We also have little doubt that German leaders will ultimately accept the ECB’s need to take desperate measures to backstop the European financial system: The “dirty little secret” of the Euro Area is that debt is already mutualized through the Target 2 banking imbalance, worth 1.5 trillion euros (Chart 6). As our Chief European Investment Strategist Dhaval Joshi has argued, Germany, as the largest shareholder in the ECB, holds a large quantity of Italian bonds, and Italians have deposited the proceeds of these bond purchases in German banks. All of this is denominated in euros. If Italy redenominates into lira, it can make bond payments in lira and the ECB and Germany will suffer capital losses. Germany would then face Italians withdrawing their deposits from German banks that would still be denominated in euros (or the deutschmark). The cause of this predicament is the ECB’s quantitative easing program (Chart 7). Chart 6Europe’s Gordian Knot Thus Chancellor Angela Merkel’s shift in tone to become more supportive of joint debt issuance belies the fact that European debt is already mutualized through the Gordian knot of Target2 imbalances. This is a politically unpalatable reality for Germans, but they generally accept it because it is in Germany’s national interest to maintain the monetary union and broader European integration. Chart 7Quantitative Easing Puts Germans On Hook For Italy However, the market may need reassurances about “the German question” from time to time, as EU institutional evolution is ongoing. Financial markets did not sell off on the German court’s ruling on May 5, which ostensibly gave the Bundesbank three months before withdrawing from the ECB’s quantitative easing program. Since the sovereign debt crisis, investors have come to recognize that there is more undergirding European integration than mere German preference. Namely, geopolitics – which we have outlined many times, originally in a 2011 Special Report. European nations cannot compete globally without banding together, and Germany is not powerful enough to go it alone. Still, there will be more consequences from this week’s ruling. At issue is the budgetary sovereignty of the European member states as well as Article 123 of the Treaty of Europe, which holds that neither the ECB nor the national central banks of member states can directly purchase public debts. The latter is a prohibition on the monetary financing of deficits. It became controversial in the wake of Mario Draghi’s 2012 declaration that the ECB would do “whatever it takes” to preserve the euro and the ECB’s 2015 Public Sector Purchase Program (PSPP) quantitative easing program, which the European Court of Justice deemed legal on December 11, 2018. The controversy is now implicitly shifting to the new Pandemic Emergency Purchase Program. The other principle concerned is that of “proportionality,” which requires that EU entities not take actions beyond what is necessary to achieve treaty objectives. If the ECB acted without regard to the limits of its mandate, the fiscal supremacy of the states, and the broader economic and fiscal consequences of QE, then its actions would violate the principle of proportionality and would require adjustment by EU authorities or non-participation from member state authorities. The German court did not attempt to overrule or invalidate the European court’s decision in favor of QE, or QE as a whole. Rather, it held that this ruling was not “comprehensible,” hence requiring an independent German ruling, and that the larger question of whether QE violates the prohibition against debt monetization is “not ascertainable.” The reason is that the ECB did not explain its actions adequately and the European Court of Justice did not demand an explanation. Presumably once this is done more decisive determinations can be made. Essentially the German court is demanding “documentation” by the ECB Governing Council that it weighed its monetary decisions against larger economic and fiscal consequences. So will the Bundesbank withdraw from the ECB’s QE operations in three months? Highly unlikely! The ECB, whether directly or indirectly, will provide an assessment of the proportionality of its actions to the Bundesbank and the German court will probably conclude, with limitations, that the ECB’s actions were largely within its mandate. If not, however, markets will plunge. Then the Bundestag or the Bundesbank will have to intervene to ensure that Germany does not in fact withdraw support from the ECB. European nations cannot compete globally without banding together, and Germany is not powerful enough to go it alone. How can we be sure? German opinion. Chancellor Merkel and her ruling Christian Democrats have not suffered this year so far from launching a wartime fiscal expansion and backing the ECB and EU institutions in their emergency actions. On the contrary, they have received one of the biggest bounces in popular opinion polls of any western leaders over the course of the global pandemic. While the bounce will deflate once the acute crisis subsides, this polling signals more than the average rally around the flag (Chart 8). Merkel’s approval rating started to rise when her party embraced more expansive fiscal policy in late 2019 in reaction to malaise revealed in the 2017 election. Germany’s handling of today’s crisis, both the pandemic and the expansive fiscal policy, has put the ruling party in the lead for the 2021 elections (Chart 9). Chart 8Germans See Popular Opinion ‘Bounce’ Amid COVID Chart 9Merkel's CDU Revives Amid Global Crisis Chart 10Germans Support Euro, But Lean On ECB Moreover Germans are enthusiastically in support of the euro and the EU relative to their peers – which makes sense because Germany has been the greatest beneficiary of European integration (Chart 10). The ECB, by contrast, does not have strong support – and is losing altitude. But a crisis provoked by the court and centered on the ECB would quickly become a crisis about the euro and European project as a whole. Opinion has broken in this direction despite Merkel’s and Germany’s many compromises over the years. Remember that Merkel’s capitulation to the Mediterranean states on the European Council in June 2011, which paved the way for Draghi’s famous dictum, was initially seen as a failure by her to defend German interests. Merkel and her party have also recovered from the hit they took when she insisted that Germany take in a huge influx of Syrian refugees in 2015. German popular opinion is relevant when discussing the judicial system and rule of law. No court can ignore popular opinion entirely, no matter how independent and austere, because every court ultimately needs public opinion to maintain its credibility. The European Court’s decision is final, as long as Germany remains committed to the EU. Yet German sovereignty still gives German institutions a say. If the German court persists in attempting to block Bundesbank participation in QE, the result will be a bond market riot that pushes up peripheral debt funding costs. This would eventually risk forcing peripheral states out of the Euro Area, which is against German interests. It is very unlikely things will go so far. Rather, the court will back down after receiving due attention and having its legitimate concerns addressed. The imperatives of European integration are as powerful today as they were in 2011. True, other court challenges will open up against the ECB, particularly the PEPP. But bear in mind that it will be even easier to show that ECB actions are proportional – that broader economic consequences have been weighed – in the case of the pandemic relief emergency than with respect to PSPP prior to COVID. Today it is households and small businesses that need protection from an act of God, not banks and bureaucracies that need protection from the consequences of their excesses. As for the size and duration of QE, the court will try to force some limitations to be acknowledged given the risk to fiscal sovereignty. In this sense, the ECB faces a new constraint, albeit one that we doubt will prove relevant in the near term. Ultimately, the consequence of imposing some limits on central bank policy is to restore authority to member state budgets and European fiscal coordination. In the short term, emergency provision can be provided via the European Stability Mechanism (ESM), whose lending conditions can be relaxed, and by the ECB’s Outright Monetary Transactions (OMT), which can buy bonds amid a market riot. But beyond the immediate crisis the clash over fiscal policy will persist because at some point countries will have to climb down from their extraordinary stimulus and the attempt to restore limits will be contentious. Germany has already made a huge shift in a more fiscally accommodative direction. Italy, Spain, and France are currently not providing enough, but they will add more. Future governments might demand more than even today’s more dovish Germany is willing to accept. Down the road, if these states do not provide more stimulus, then their recoveries will be weaker and political malaise will get worse. An anti-establishment outcome is already likely in Italy in the coming year or two, due to the ability of the League to capitalize on post-COVID voter anger. The big question after that is France in 2022. Macron’s approval rating is holding up, we expect him to win, but his bounce amid the pandemic is not remarkable. From our point of view the peripheral states have a license to spend, so spend they will. But then fiscal conflicts will revive later. Bottom Line: The German constitutional court is not going to try to force the Bundesbank to withdraw from QE, but it is attempting to lay a foundation for the imposition of at least some limits on this policy. The risk to European assets in the short run is not on the monetary side but the fiscal side. Over the long run, the “German question” will never be settled. But the imperatives of European integration are as powerful today as they were in 2011. Each new crisis exposes the weakness of the peripheral states, their need for European institutions. It also exposes Germany’s need to accommodate them when they form a united front. Investment Takeaways Financial markets have no clarity on economic reopening in the face of the virus or how governments will respond to resurgent outbreaks or a second wave in the fall. Taking into consideration the initial shock of the lockdowns plus spillover effects, the cumulative impact to annual GDP rises to 6%-8% by the end of this year for major economies. If another lockdown occurs, the level of GDP would be 10-12% lower at the end of the year depending on the region. This bare risk suggests that global equities face a relapse in the near term. Eventually economic reopening will proceed, as the working age population will demand it. But the path between here and there is rocky and any hiccups in providing stimulus will create even more volatility. Globally, we continue to argue that political and geopolitical risks are rising across the board as the pandemic and recession evolve into a struggle among nations to maintain security amid vulnerabilities and distract from their problems at home. Rumors that China is about to declare an air defense identification zone (ADIZ) in the South China Sea are unverified but we have long expected this to occur and tensions and at least some saber-rattling would ensue. We also expect the US to surprise the market with punitive tech and trade measures against China in the near term and to upgrade relations with Taiwan. We remain long JPY-EUR on a tactical 0-3 month horizon. We are converting our tactical long S&P consumer staples, which is up 6%, to a relative trade against the broad market. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Appendix Table 1The Global Fiscal Stimulus Response To COVID-19 Footnotes 1 In the case of Italy, we assume that parliament will pass the latest proposed increase in stimulus from 1.4% to 3.1% of GDP. In the case of South Africa, we expect the IMF to include these measures soon. Germany is discussed below.

Highlights Our baseline view foresees a U-shaped recovery, as economies slowly relax lockdown measures. There are significant risks to this forecast, however. On the upside, a vaccine or effective treatment could hasten the reopening of economies and recovery in spending. On the downside, containment measures could end up being eased too quickly, leading to a surge in new cases. A persistent spell of high unemployment could also permanently damage economies, especially if fiscal and monetary stimulus is withdrawn too quickly. In addition, geopolitical risks loom large, with the US election likely to be fought on who sounds tougher on China. Earnings estimates have yet to fall as much as we think they will, making global equities vulnerable to a near-term correction. Nevertheless, the spread between earnings yields and bond yields is wide enough to justify a modest overweight to stocks on a 12-month horizon. Is It Safe To Come Down? We published a report two weeks ago entitled Still Stuck In The Tree where we likened the current situation to one where an angry bear has chased a hiker up a tree.1 Having reached a high enough branch to escape immediate danger, the hiker breathes a sigh of relief. As time goes by, however, the hiker starts to get nervous. Rather than disappearing back into the forest, the bear remains at the base of the tree licking its chops. Meanwhile, the hiker is cold, hungry, and late for work. Like the hiker, the investment community breathed a collective sigh of relief when the number of cases in Italy and Spain, the first two major European economies to be hit by the coronavirus, began to trend lower. In New York City, which quickly emerged as the epicentre of the crisis in the United States, more COVID patients have been discharged from hospitals than admitted for the past three weeks (Chart 1). Chart 1Discharges From New York Hospitals Have Exceeded Admissions For The Past Three Weeks Deepest Recession Since The 1930s Yet, this progress has come at a very heavy economic cost. The IMF expects the global economy to shrink by 3% this year (Chart 2). In 2009, global GDP barely contracted. Chart 2Severe Damage To The Global Economy This Year The sudden stop in economic activity has led to a surge in unemployment. According to the Bloomberg consensus estimate, the US unemployment rate rose to 16% in April. The true unemployment rate is probably higher since to be considered unemployed one has to be looking for work, which is difficult if not impossible in the presence of widespread lockdowns. Regardless, even the official unemployment rate is the worst since the Great Depression (Chart 3). Chart 3Unemployment Rate Seen Jumping To Levels Not Reached Since The Great Depression   Unshackling The Economy A key difference from the 1930s is that today’s recession has been self-induced. Policymakers want workers to stay home as much as possible. The hope is that once businesses reopen, most of these workers will return to their jobs. How long will that take? Our baseline scenario envisions a slow but steady reopening of the global economy starting later this month, which should engender a U-shaped economic recovery. Since mid-March, much of the world has been trying to compensate for lost time by taking measures that would not have been necessary if policymakers had acted sooner. As Box 1 explains, some loosening of lockdown measures could be achieved without triggering a second wave of cases once the infection rate has been brought down to a sufficiently low level. To the extent that economic activity tends to move in tandem with the number of interactions that people have, a relaxation of social distancing measures should produce a modest rebound in growth. New technologies and a better understanding of how the virus is transmitted should also allow some of the more economically burdensome measures to be lifted. As we have discussed before, mass testing can go a long way towards reducing the spread of the disease (Chart 4).2 Right now, high-quality tests are in short supply, but that should change over the coming months.  Chart 4Mass Testing Will Help Increased mask production should also help. Early in the pandemic, officials in western nations promulgated the view that masks do not work. At best, this was a noble lie designed to ensure that anxious consumers did not deprive frontline workers of necessary safety equipment. At worst, it needlessly led many people astray. As East Asia’s experience shows, mask wearing saves lives. A recent paper estimated that the virus could be vanquished if 80% of people wore masks that were at least 60% effective, a very low bar that even cloth masks would pass (Chart 5).3  Chart 5Masks On! Recent research has also cast doubt on the merits of closing schools. The China/WHO joint commission could not find a single instance during contact tracing where a child transmitted the virus to an adult. A study by the UK Royal College of Paediatrics provides further support to the claim that children are unlikely to be important vectors of transmission. The evidence includes a case study of a nine year-old boy who contracted the virus in the French Alps but fortunately failed to transmit it to any of the more than 170 people he had contact with in three separate schools.4  Along the same lines, there is evidence that the odds of adults catching the virus indoors is at least one order of magnitude higher than outdoors.5 This calls into question the strategy of states such as California of clearing out prisons of dangerous felons in order to make room for beachgoers.6 Upside Risks To The U: Medical Breakthroughs While a U-shaped economic recovery remains our base case, we see both significant upside and downside risks to this outcome. The best hope for an upside surprise is that a vaccine or effective treatment becomes available soon. There are already eight human vaccine trials underway, with another 100 in the planning stages. In the race to develop a vaccine, Oxford is arguably in the lead. Scientists at the university’s Jenner Institute have developed a genetically modified virus that is harmless to people, but which still prompts the immune system to produce antibodies that may be able to fight off COVID. The vaccine has already worked well on rhesus monkeys. If it proves effective on humans, researchers hope to have several million doses available by September. On the treatment side, Gilead’s remdesivir gained FDA approval for emergency use after early results showed that it helps hasten the recovery of coronavirus patients. Hydroxychloroquine, which President Trump has touted on numerous occasions, is the subject of dozens of clinical trials internationally. While evidence that hydroxychloroquine can treat the virus post-infection is thin, there is some data to suggest that it can work well as a prophylactic.7 Research is also being conducted on nearly 200 other treatments, including an improbable contender: famotidine, the compound found in the heartburn remedy Pepcid.8  Downside Risk: Too Open, Too Soon Chart 6The Lesson From The Spanish Flu: The Second Wave Could Be Worse Than The First As noted above, once the number of new cases drops to sufficiently low levels, some relaxation of containment measures can be achieved without reigniting the pandemic. That said, there is a clear danger that measures will end up being relaxed too aggressively and too soon. This is precisely what happened during the Spanish Flu (Chart 6). It has become customary to talk about the risk of a second wave of infections; however, the reality is that we have not even concluded the first wave. While the number of cases in New York has been falling, it has been rising in many other US states. As a result, the total number of new coronavirus cases nationwide has remained steady for the past five weeks (Chart 7). It is the same story globally: Falling caseloads in western Europe and East Asia have been offset by rising cases in countries such as Russia, India, and Brazil (Chart 8). Chart 7The Spread Of COVID-19 Has Not Been Contained Everywhere (I) Chart 8The Spread Of Covid-19 Has Not Been Contained Everywhere (II)   Chart 9Widespread Social Distancing Has Dampened The Spread Of All Flus And Colds At the heart of the problem is that COVID-19 remains a highly contagious disease. Most studies assign a Reproduction Number, R, of 3-to-4 to the virus. As a point of comparison, the Spanish flu is estimated to have had an R of 1.8. An R of 3.5 would require about 70% of the population to acquire herd immunity to keep the virus at bay.9 As discussed in Box 2, the “true” level of herd immunity may be substantially greater than that. At this point, if you come down with a cough and fever, you should assume you have COVID. As Chart 9 shows, social distancing measures have brought the number of viral respiratory illnesses down to almost zero in the United States. Up to 30% of common cold cases stem from the coronavirus family. Just like it would be foolhardy to assume that the common cold has been banished from the face of the earth, it would be unwise to assume that COVID will not return if containment measures are quickly lifted.   Downside Risk: Permanent Economic Damage Chart 10No Spike In Bankruptcies For Now There are a lot of asymmetries in economics: It is easier to lose a job than to find one; starting a new business is also more difficult than going bankrupt.  The good news so far is that bankruptcies have been limited and most unemployed workers have not been permanently laid off (Chart 10 and Chart 11). Thus, for the most part, the links that bind firms to workers have not been severed.   Chart 11Temporary Layoffs Account For Most Of The Recent Increase In Unemployment   Unfortunately, there is a risk that the economy will suffer permanent damage if unemployment remains high and economic activity stays depressed. For some sectors, such as airlines, long-term damage is nearly assured. It took a decade for real household spending on airlines to return to pre 9/11 levels (Chart 12). It could take even longer for the physiological scars of the pandemic to fade. While businesses outside the travel and hospitality sectors will see a quicker rebound, they could still experience subdued demand for as long as social distancing measures persist. Chart 129/11 Was A Big Shock For US Air Travel There is not much that fiscal policy can do to reverse the immediate hit to GDP from the pandemic. If people cannot work, they cannot produce. What fiscal stimulus can do is push enough money into the hands of households and firms to enable them to meet their financial obligations, while hopefully creating some pent-up demand that can be unleashed when businesses reopen. For now and for the foreseeable future, there is no need to tighten fiscal policy. The private sector in the major economies is generating plenty of savings with which governments can finance budget deficits. Indeed, standard economic theory suggests that if governments tried to “save more” by reducing budget deficits, total national savings would actually decline.10   Nevertheless, just as fiscal policy was prematurely tightened in many countries following the Great Recession, there is a risk that austerity measures will be reintroduced too quickly again. Likewise, calls to tighten monetary policy could grow louder. Just this week, Germany’s constitutional court ruled that the EU Court of Justice had overstepped its powers by failing to require the ECB to conduct an assessment of the “proportionality” of its controversial asset purchase policy. The German high court ordered the Bundesbank to suspend QE in three months unless the ECB Governing Council provides “documentation” showing it meets the criteria of proportionality. Among other things, the ruling could undermine the ECB’s newly launched €750 billion Pandemic Emergency Purchase Programme (PEPP). Downside Risk: Geopolitical Tensions Had the virus originated anywhere else but China, President Trump could have made a political case for further deescalating the Sino-US trade war in an effort to shore up the US economy and stock market. Not only did that not happen, but the likelihood of a new clash between China and the US has gone up dramatically. Antipathy towards China is rising (Chart 13). As our geopolitical team has stressed, the US election is likely to be fought on who can sound tougher on China. With the economy on the ropes, Trump will try to paint Joe Biden as too passive and conflicted to stand up to China. Indeed, running as a “war president” may be Trump’s only chance of getting re-elected. Chart 13US Nationalism Is On The Rise Amid Broad-Based Anti-China Sentiment At the domestic political level, the pandemic has exacerbated already glaringly wide inequalities. While well-paid white-collar workers have been able to work from the comfort of their own homes, poorer blue-collar workers have either been furloughed or asked to continue working in a dangerous environment (in nursing homes or meat-packing plants, for example). It is not clear what the blowback from all this will be, but it is unlikely to be benign. Investment Implications Global equities and credit spreads have tracked the frequency of Google search queries for “coronavirus” remarkably well (Chart 14). As coronavirus queries rose, stocks plunged; as the number of queries subsided, stocks rallied. If there is a second wave of infections, anxiety about the virus is likely to grow again, leading to another sell-off in risk assets. Chart 14Joined At The Hip Chart 15Negative Earnings Revisions Will Weigh On Stocks In The Near Term   Earnings estimates have come down, but are still above where we think they ought to be. This makes global equities vulnerable to a correction (Chart 15). Meanwhile, retail investors have been active buyers, eagerly gobblingup stocks such as American Airlines and Norwegian Cruise Lines that have fallen on hard times recently (Chart 16). They have also been active buyers of the USO oil ETF, which is down 80% year-to-date. When retail investors are trying to catch a falling knife, that is usually an indication that stocks have yet to reach a bottom. As such, we recommend that investors maintain a somewhat cautious stance on the near-term direction of stocks. Chart 16Retail Investors Keen To Buy The Dip   Chart 17Favor Equities Over Bonds Over A 12-Month Horizon   Chart 18USD Is A Countercyclical Currency Looking further out, the spread between earnings yields and bond yields is wide enough to justify a modest overweight to stocks on a 12-month horizon (Chart 17). If global growth does end up rebounding, cyclicals should outperform defensives. As a countercyclical currency, the dollar will probably weaken (Chart 18). A weaker greenback, in turn, will boost commodity prices (Chart 19). Historically, stronger global growth and a softer dollar have translated into outperformance of non-US stocks relative to their US peers (Chart 20). Thus, investors should prepare to add international equity exposure to their portfolios later this year.   Chart 19Commodity Prices Usually Rise When The Dollar Weakens Chart 20Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening   Box 1The Dynamics Of R Box 2Why Herd Immunity Is Not Enough Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Please see Global Investment Strategy Weekly Report, “Still Stuck In The Tree,” dated April 16, 2020. 2 Please see Global Investment Strategy Weekly Report, “Testing Times,” dated April 9, 2020. 3 Philip Anfinrud, Valentyn Stadnytskyi, et al., “Visualizing Speech-Generated Oral Fluid Droplets with Laser Light Scattering,” nejm.org (April 15, 2020); Jeremy Howard, Austin Huang, Li Zhiyuan, Zeynep Tufekci, Vladmir Zdimal, Helene-mari van der Westhuizen, et al., “Face Masks Against COVID-19: An Evidence Review,” Preprints.org, (April 12, 2020); and Liang Tian, Xuefei Li, Fei Qi, Qian-Yuan Tang, Viola Tang, Jiang Liu, Zhiyuan Li, Xingye Cheng, Xuanxuan Li, Yingchen Shi, Haiguang Liu, and Lei-Han Tang, “Calibrated Intervention and Containment of the COVID-19 Pandemic,” arxiv.org (April 2, 2020). 4 “COVID-19 – Research Evidence Summaries,” Royal College of Paediatrics and Child Health; and Alison Boast, Alasdair Munro, and Henry Goldstein, “An evidence summary of Paediatric COVID-19 literature,” Don’t Forget The Bubbles (2020). 5 Hiroshi Nishiura, Hitoshi Oshitani, Tetsuro Kobayashi, Tomoya Saito, Tomimasa Sunagawa, Tamano Matsui, Takaji Wakita, MHLW COVID-19 Response Team, and Motoi Suzuki, “Closed environments facilitate secondary transmission of coronavirus disease 2019 (COVID-19),” medRxiv (April 16, 2020). 6 “Coronavirus: Arrests as California beachgoers defy lockdown,” Skynews (April 26, 2020); and “High-risk sex offender rearrested days after controversial release from OC Jail,” abc7.com (May 1, 2020). 7 Sun Hee Lee, Hyunjin Son, and Kyong Ran Peck, “Can post-exposure prophylaxis for COVID-19 be considered as an outbreak response strategy in long-term care hospitals?” International Journal of Antimicrobial Agents (April 25, 2020). 8 Brendan Borrell, “New York clinical trial quietly tests heartburn remedy against coronavirus,” Science (April 26, 2020). 9 In the simplest models, the herd immunity threshold is reached when P = 1-1/Ro, where P is the proportion of the population which has acquired immunity and Ro is the basic reproductive number. Assuming an Ro of 3.5, heard immunity will be achieved once more than 71.4% of the population has been infected (1-1/3.5). For further discussion on this, please refer to Global Investment Strategy, “Second Quarter 2020 Strategy Outlook: World War V,” dated March 27, 2020. 10 It is easiest to understand this point by considering a closed economy where savings, by definition, equals investment. Savings is the sum of private and public savings. Suppose the economy is depressed and the government increases public savings by either raising taxes or cutting spending. Since this action will further depress the economy, private investment will fall even more. But, since investment must equal total savings, private savings must decline more than proportionately with any increase in public savings. This happens because tighter fiscal policy leads to lower GDP. It is difficult to save if one does not have a job. To the extent that lower GDP reduces employment, it also tends to reduce private-sector savings. Global Investment Strategy View Matrix Current MacroQuant Model Scores

Highlights Over the past 24 hours the White House has taken several steps indicating that President Trump is adopting the “war president” posture in the run-up to the US election. The intensity of the US-China rivalry can escalate dramatically. We maintain our defensive tactical positioning and are going long US 10-year treasuries. Feature The phrase “World War III” or #WWIII went viral earlier this year in response to a skirmish between the US and Iran (Chart 1). Only four months later, the US and China are escalating a strategic rivalry that makes the Iran conflict look paltry by comparison (Chart 2). Chart 1US-Iran Tensions Were Just A Warm-Up Chart 2The Thucydides Trap Fortunately, the two great powers are constrained by the same mutually assured destruction that constrained the US and the Soviet Union during the Cold War. They are also constrained by the desire to prevent their economies from collapsing further. Unfortunately, the intensity of their rivalry can escalate dramatically before reaching anything truly analogous to the Berlin Airlift or Cuban Missile Crisis – and these kinds of scenarios are not out of the question. Safe haven assets will catch a bid and the recovery in US and global risk assets since the COVID selloff will be halted. We maintain our defensive tactical positioning and will close two strategic trades to book profits and manage risk. In the wake of the pandemic and recession, geopolitics is the next shoe to drop. The War President Over the past 24 hours the White House has taken several steps indicating that President Trump is adopting the “war president” posture in the run-up to the US election: Export controls: Trump has gone forward with new export controls on “dual-purpose” technologies – those that have military as well as civilian applications, in a delayed reaction to China’s policy of civil-military technological fusion. The Commerce Department has wide leeway in whether to grant export licenses under the rule – but it is a consequential rule and would be disruptive if enforced strictly. Supply chain de-risking: Trump is also going forward with new restrictions on the import of foreign parts for US power plants and electricity grid. The purpose is to remove risks from critical US infrastructure. COVID investigation: Trump has hinted that the novel coronavirus that causes the COVID-19 disease may have originated in the Wuhan Institute of Virology. The Director of National Intelligence issued a statement indicating that the Intelligence Community does not view the virus as man-made (not a bio-weapon), but is investigating the potential that the virus transferred to humans at the institute. The State Department had flagged the institute for risky practices long before COVID. Trump avoided the bio-weapon conspiracy theory and is focused on the hypothesis that the laboratory’s investigations into rare coronaviruses led to the outbreak. New tariffs instead of reparations: Director of the National Economic Council Larry Kudlow denied that the US would stop making interest and principal payments on some Chinese holdings of US treasuries. He said that the “full faith and credit of the United States’ debt obligation is sacrosanct. Absolutely sacrosanct.” Trump denied that this form of reparations, first floated by Republican Senator Marsha Blackburn of Tennessee, was under consideration. Instead he suggested that new tariffs would be much more effective, raising the threat for the first time since the Phase One trade deal was agreed in principle in December. Strategic disputes: Tensions have flared up in specific, concrete ways across the range of US-Chinese relations – in the cyber-realm, psychological warfare, Korean peninsula, Taiwan Strait, and South China Sea. These could lead to sanctions. The war president posture is one in which President Trump recognizes that reelection is extremely unlikely in an environment of worse than -4.8% economic growth and likely 16% unemployment. Therefore he shifts the basis of his reelection to an ongoing crisis and appeals to Americans’ patriotism and desire for continuity amid crisis. Bottom Line: Protectionism is not guaranteed to work, and therefore it was not ultimately the path Trump took last year when he still believed a short-term trade deal could boost the economy. Now the bar to protectionism has been lowered. The Decline Of US-China Relations President Trump may still be bluffing, China may take a conciliatory posture, and a massive cold war-style escalation may be avoided. However, it is imprudent to buy risk assets on these reasons today, when the S&P 500’s forward price-to-earnings ratio stands at 20.15. It is more prudent to prepare for a historic escalation of tensions first, buy insurance, then reassess. Why? Because the trajectory of US-China relations is empirically worsening over time. US household deleveraging and the Chinese shift away from export-manufacturing (Chart 3) broke the basis of strong relations during the US’s distractions in Iraq and Afghanistan and China’s “peaceful rise” in the early 2000s. US consumers grew thriftier while Chinese wages rose. Not only has China sought economic self-sufficiency as a strategic objective since General Secretary Xi Jinping took power in 2012, but the Great Recession, Trump trade war, and global pandemic have accelerated the process of decoupling between the two economies. Decoupling is an empirical phenomenon, and it has momentum, however debatable its ultimate destination (Chart 4). Obviously policy at the moment is accelerating decoupling. Chart 3The Great Economic Divorce Chart 4Decoupling Is Empirical The US threat to cease payments on some of China’s Treasury holdings is an inversion of the fear that prevailed in the wake of 2008, that China would sell its treasuries to diversify away from dependence on the US and the greenback. China did end up selling its treasuries, but the US was not punished with higher interest rates because other buyers appeared. The US remains the world’s preponderant power and ultimate safe haven (Chart 5). By the same token, Trump and Kudlow naturally poured water on the threat of arbitrarily stopping payments because that would jeopardize America’s position. Chart 5Treasuries Can't Be Weaponized By Either Side... Chart 6... But Tariffs Can And Will Be Instead Trump is threatening a new round of trade tariffs. Since the US runs a large trade deficit with China, and China is more exposed to trade generally, the US has the upper hand on this front. But it is important to notice that US tariff collections as a share of imports bottomed under President Obama (Chart 6). The US shift away from free trade toward protectionism occurred in the wake of the 2008 financial crisis. President Trump then popularized and accelerated this policy option in an aggressive and unorthodox way. Trade tariffs are a tool of American statecraft, not the whim of a single person, who may exit the White House in January 2021 anyway. The retreat from globalization is not a passing fancy. Today’s recession also marks the official conclusion of China’s historic 44 year economic boom – and hence a concrete blow to the legitimacy of the ruling Communist Party (Chart 7). The more insular, autarkic shift in the Communist Party’s thinking is not irreversible, but there are no clear signs that Xi Jinping is pivoting toward liberalism after eight years in power. Chart 7Recession Destabilizes The 'G2' Powers China’s unemployment rate has been estimated as high as 20.5% by Zhongtai Securities, which then retracted the estimate (!). It is at least at 10%. Moreover 51 million migrant workers vanished from the job rolls in the first quarter of the year. Maximum employment is the imperative of East Asian governments, especially the Communist Party, which has not dealt with joblessness since the late 1990s. The threat to social and political stability is obvious. The party will take extraordinary measures to maintain stability – not only massive stimulus but also social repression and foreign policy distraction to ensure that people rally around the flag. Xi Jinping has tried to shift the legitimacy of the party from economic growth to nationalism and consumerism, the “China Dream.” But the transition to consumer growth was supposed to be smooth. Financial turmoil, the trade war, and now pandemic and recession have forced the Communist Party off the training wheels well before it intended. Xi’s communist ideology, economic mercantilism, and assertive foreign policy have created an international backlash. The US is obviously indulging in nationalism as well. A stark increase in inequality and political polarization exploded in President Trump’s surprise election on a nationalist and protectionist platform in 2016 (Chart 8). All candidates bashed China on the campaign trail, but Trump was an anti-establishment leader who disrupted corporate interests and followed through with his tariff threats. The result is that the share of Americans who see China’s power and influence as a “major threat” to the United States has grown from around 50% during the halcyon days of cooperation to over 60% today. Those who see it as a minor threat have shrunk to about a quarter of the population (Chart 9). Chart 8A Measure Of Inequality In The US Chart 9US Nationalism On The Rise Chart 10Broad-Based Anti-China Sentiment In US As with US tariff policy, the bipartisan nature of US anger toward China is significant. More than 60% of Democrats and more than 50% of young people have an unfavorable view of China. College graduates have a more negative opinion than the much-discussed non-college-educated populace (Chart 10). Already it is clear, in Joe Biden’s attack ads against Trump, that this election is about who can sound tougher on China. The debate is over who has the better policy to put “America first,” not whether to put America first. Biden will try to steal back the protectionist thunder that enabled Trump to break the blue wall in the electorally pivotal Rust Belt in 2016 (Map 1). Biden will have to win over these voters by convincing them that he understands and empathizes with their Trumpian outlook on jobs, outsourcing, and China’s threats to national security. He will emphasize other crimes – carbon emissions, cyber attacks, human rights violations – but they will still be China’s crimes. He will return to the “Pivot to Asia” foreign policy of his most popular supporter, former President Barack Obama. Map 1US Election: Civil War Lite Bottom Line: Economic slowdown and autocracy in China, unprecedented since the Cultural Revolution, is clashing with the United States. Broad social restlessness in the US that is resolving into bipartisan nationalism against a peer competitor, unprecedented since the struggle with the Soviets in the 1960s, is clashing with China. Now is not the time to assume global stability. Constraints Still Operate, But Buy Insurance The story outlined above is by this time pretty well known. But the “Phase One” trade deal allowed global investors to set aside this secular story at the beginning of the year. Now, as Trump threatens tariffs again, the question is whether he will resort to sweeping, concrete, punitive measures against China that will take on global significance – i.e. that will drive the financial markets this year. Trump is still attempting to restore his bull market and magnificent economy. As long as this is the case, a constraint on conflict operates this year. It is just not as firm or predictable. Therefore we are looking for three things. Chart 11Trump May Seek A Crisis ‘Bounce’ To Popularity First, will President Trump’s approval rating benefit so much from his pressure tactics on China that he finds himself driven into greater pressure tactics? This raises the risk of policy mistakes. Second, will Trump’s approval rating fall into the doldrums, stuck beneath 43%, as the toll of the recession wears on him and popular support during the health crisis fades? “Lame duck” status would essentially condemn him to electoral loss and incentivize him to turn the tables by escalating the conflict with China. Presidents are not very popular these days, but a comparison with Trump’s two predecessors shows that while he can hardly obtain the popularity boost that Obama received just before the 2012 election, he could hope for something at least comparable to what George W. Bush received amid the invasion of Iraq (Chart 11). (Trump has generally been capped at 46% approval, the same as his share of the popular vote in 2016.) The reason this is a real risk, not a Shakespearean play, is outlined above: however cynical Trump’s political calculus, he would be reasserting US grand strategy in the face of a great power that is attempting to set up a regional empire from which, eventually, to mount a global challenge. Thus if he is convinced he cannot win the election anyway, this risk becomes material. Investors should take seriously any credible reports suggesting that Trump is growing increasingly frustrated with his trailing Biden in head-to-head polls in the swing states. Third, will China, under historic internal stress, react in a hostile way that drives Trump down the path of confrontation? China has so far resorted to propaganda, aircraft carrier drills around the island of Taiwan, and maritime encroachments in the South China Sea – none of which is intolerably provocative to Trump. A depreciation of the renminbi, a substantial change to the status quo in the East or South China Seas, or an attempt to vitiate US security guarantees regarding US allies in the region, could trigger a major geopolitical incident. A fourth Taiwan Strait crisis is fully within the realm of possibility, especially given that Taiwan’s “Silicon Shield” is fundamentally at stake. While we dismiss rumors of Kim Jong Un’s death in North Korea, any power vacuum or struggle for influence there is of great consequence in today’s geopolitical context. Aggressive use of tariffs always threatened to disrupt global trade and financial markets, but tariffs function differently in the context of a global economic expansion and bull market, as in 2018-19, than they do in the context of a deep and possibly protracted recession. Trump has a clear political incentive to be tough on China, but an equally clear financial and economic incentive to limit sweeping punitive measures and avoid devastating the stock market and economy. If events lower the economic hurdle, then the political incentive will prevail and financial markets will sell. Bottom Line: However small the risk of Trump enacting sweeping tariffs, the downside is larger than in the 2018-19. The stock market might fall by 40%-50% rather than 20% in an all-out trade war this year. Investment Takeaways Go tactically long US 10-year treasuries. Book a 9.7% profit on our long 30-year US TIPS trade. Close long global equities (relative to US) for a loss of 3.8%.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com  

Special Report

Highlights Our COVID Unrest Index reveals that Turkey, the Philippines, Brazil, and South Africa are the major emerging markets most at risk of significant social unrest. China, Russia, Thailand, and Malaysia are the least at risk – in the short run. Stay tactically overweight developed market equities relative to emerging markets. Go tactically short a basket of “EM Strongmen” currencies relative to the EM currency benchmark. Short the rand as well. Feature Chart 1Stimulus-Fueled Markets Ignore Reality With global fiscal stimulus now estimated at 7% of GDP, and central banks in full debt monetization mode, the S&P 500 is at 2940 and rallying toward 3000. It is not only largely ignoring the global pandemic and recession. It is as if the trade war never occurred, China is not shrinking, and WTI crude oil prices have never gone negative (Chart 1). In recent reports we have argued that “geopolitics is the next shoe to drop” – specifically that President Trump’s electoral challenges and the vulnerability of America’s enemies make for a volatile combination. But there are also more mundane geopolitical consequences of the recession that asset allocators must worry about. Such as government change and regime failure. COVID-19 and government lockdowns have exacted a heavy economic toll on households and political systems now face heightened risk of unrest. In many cases emerging market countries were already vulnerable, having witnessed outbreaks of civil unrest in 2019. Fear of contracting the virus, plus various isolation measures, will tend to suppress street movements in the near term. This year’s “May Day” protests will be minor compared to what we will see in coming years. But significant unrest will sprout as the containment measures are relaxed and yet economic problems linger. And bear in mind that the biggest bouts of unrest in the wake of the 2008 crisis did not occur until 2011-13. In this report we introduce our “COVID Unrest Index” for emerging economies, which shows that Turkey, the Philippines, Brazil, and South Africa face substantial unrest that can trigger or follow upon market riots. Introducing The COVID Unrest Index At any point in time, social and political instability depends on economic conditions such as unemployment and inflation, structural problems such as inequality, and governance issues such as corruption. In the post-COVID recessionary environment, additional factors such as health care capacity also carry weight. To identify markets that are most likely to face unrest, we created a COVID Unrest Index (Table 1). The overall ranking is determined by five factors: Table 1Our COVID-19 Social Unrest Index Initial Economic Conditions: A proxy for economic policy’s ability to respond to the crisis. This factor includes the fiscal balance and sovereign debt – which determine "fiscal space" – as well as the current account balance, public foreign currency debt as a percent of GDP, foreign debt obligations as a percent of exports, and foreign funding requirements as a percent of foreign currency reserves. Health Capacity And Vulnerability: A proxy for both a population’s vulnerability to COVID and its health care capabilities. Vulnerability to the pandemic is captured by COVID-19 deaths per million, share of the population over the age of 65, and likelihood of dying from an infectious disease. Health infrastructure is measured by life expectancy at age 60 and health expenditure per capita. Economic Vulnerability To Pandemic: A proxy for the magnitude of the COVID-specific shock to the individual economy. This factor takes into account a country’s dependence on revenue from tourism and its dependence on inflows from remittances. Household Grievances: A proxy for economic hardship faced by households, captured by the GINI index, which measures income inequality, and the “misery index,” which consists of the sum of inflation and unemployment. Governance: A proxy the captures the quality of governance from the World Bank’s World Governance Indicators – specifically the ability to participate in selecting government, likelihood of political instability or politically-motivated violence, and perceptions of corruption. The country ranking for the COVID Unrest Index is constructed by first standardizing the variables, then transforming them such that higher readings are associated with more favorable conditions. Finally, the five factors are averaged for each country to produce individual scores. Turkey: A Shambles On Europe’s Doorstep Turkey is the most likely to face mass discontent in the near future. It has all the ingredients for unrest: poor standing across all factors and the weakest governance score. From an economic standpoint, its foreign currency reserves are critically low while its foreign debt obligations are relatively elevated (Chart 2). This spells trouble for the lira, which will only further add to the grievances of households already burdened by a high misery index. Chart 2AEmerging Markets Face Debt Troubles Even With The Fed’s Help Chart 2BEmerging Markets Face Debt Troubles Even With The Fed’s Help President Erdogan has rejected suggestions of aid from the IMF. Fearing a revival of the main opposition Republican People’s Party (CHP), especially in the wake of his party’s losses in the 2019 municipal elections, he has banned cities that are run by the CHP from raising funds toward virus response efforts. This right is reserved only for cities run by his Justice and Development Party (AKP). Given that Erdogan does not face reelection until 2023, the move to suppress the opposition reflects general weakness and portends a long period of suppression and political conflict. Erdogan’s handling of the outbreak has also seen its share of failures. While he has opted for only a partial lockdown, a 48-hour full lockdown was announced on April 10 only hours in advance, resulting in crowds of people rushing to purchase necessities. Interior minister Suleyman Soylu tried to resign, but was prevented by Erdogan, breeding speculation about Soylu’s motives. Soylu may have sought to distance himself from the president’s handling of the crisis to preserve his image as a potential successor to the president, rivaling Erdogan’s son-in-law, Finance Minister Berat Albayrak. The point is that Erdogan is already facing greater political competition. Former ally and minister of foreign affairs and economy Ali Babacan recently launched a new party, the Democracy and Progress Party (DEVA). He has criticized the government’s stimulus package and decision to hold back on requesting IMF aid. Erdogan is also challenged by his former prime minister Ahmet Davutoglu, who broke away from the AKP to form his own Future Party late last year. The obvious risk to Erdogan is that these opposition groups create a viable political alternative that voters can flock to – and they could form a united front amid national economic collapse. Brazil and South Africa have large twin deficits. Erdogan’s response, repeatedly, has been to harden his stance and double down on populist and unorthodox policies. These have not helped his popular standing, as we have chronicled over the past several years. At home his policies are generating excessive money supply and a large budget deficit (Chart 3). Abroad he has gotten the military more deeply involved in Syria, Libya, and maritime conflicts. The result is stagflation with the potential for negative political surprises both at home and abroad. Chart 3Twin Deficits Flash Red For Emerging Markets Chart 4Turkish Political Risk Has Room To Rise Our GeoRisk Indicator for Turkey shows that risks are rising as the lira falls relative to its underlying economic fundamentals (Chart 4). But it will fall further from here. Positive signs would be accepting IMF aid, cutting off the foreign adventures, selling off government assets, and restoring fiscal and monetary orthodoxy. But it is just as likely that Erdogan resorts to even more desperate moves, including a greater confrontation with Greece and Europe by encouraging more refugee flow-through into Europe. Erdogan has always been more popular than his Justice and Development Party, but after ruling since 2003, and now facing a nationwide crisis, his rule is increasingly in jeopardy. His scramble to survive the election in 2023 will be all the more dangerous to governance. Bottom Line: We booked gains on our short lira trade earlier this year but the fundamental case for the short remains intact, so we include it in our short “EM Strongmen” currency basket discussed at the end of this report. The Philippines: Yes, Governance Matters The Philippines is next at risk of instability. It is particularly vulnerable to a pandemic recession due to its dependence on remittance inflows and tourism for foreign currency (Chart 5) as well as its poor health infrastructure (Chart 6). While it is not in a vulnerable position in terms of foreign currency obligations, its double deficit (see Chart 3) means that significant stimulus will come at the expense of the currency. Chart 5Pandemics Hurt Tourism, Recessions Hurt Remittances Chart 6AEmerging Markets Face COVID-19 Without Developed Market Health Systems Chart 6BEmerging Markets Face COVID-19 Without Developed Market Health Systems President Rodrigo Duterte remains extremely popular even though the Philippines is suffering one of the worst outbreaks in Asia. Socioeconomic Planning Secretary Ernesto Pernia has resigned from his post due to disagreement over containment measures. Pernia’s vision of a partial lockdown contrasted with Duterte’s militarized containment approach – which includes the granting of extraordinary emergency powers.1 Meanwhile the lockdowns imposed on the capital and southern Luzon provinces will remain in place until at least May 15 after which Duterte indicated it will be gradually lifted. While Duterte will in all likelihood remain in power until the end of his term in 2022, he is using his popularity to secure a preferred successor. He is less capable of getting through a constitutional amendment that extends presidential term limits – he has the votes in Congress, but a popular referendum is not a sure bet given the economic crisis. He is widely believed to be grooming his daughter Sara or former aide Senator Bong Go for the presidential post, with speculation that he may run as vice president on the same ticket. Turkey and the Philippines have poor governance, putting them alongside international rogue states. Any hit to his popularity that upends his succession plan poses existential risks to Duterte as he has racked up many influential enemies and could face criminal charges if an opposing administration succeeds him. This risk will likely induce him to tighten control further in an attempt to maintain order and crack down on dissent. Autocratic moves will weigh on the Philippines’ governance score which is already among the poorest in our pool of emerging countries (Chart 7). Chart 7Governance Matters For Investors Over The Long Run Chart 8Duterte Signaled Top In Philippine Equity Outperformance Does governance matter? Yes, at least in the case of strongmen in regimes with weak institutions. Look at Philippine equities relative to emerging market equities since Duterte first rose onto the scene, prompting us to go short (Chart 8). Duterte obliterated the country’s current account surplus just as we expected and its currency has suffered as a result. For now, the Philippines’ misery index is not yet at a level that strongly implies widespread unrest (Chart 9), but the general context does, especially if constitutional maneuvers backfire. At 4% of GDP, the proposed COVID-19 stimulus package comes on top of the fact that Duterte’s “build, build, build” infrastructure plan already required massive fiscal spending. But the weak currency and higher unemployment will increase the misery index and chip away at the president’s popularity. If the people turn against Duterte, they will remove him in a “people power” movement, as with previous leaders. Chart 9Inequality, Unemployment, And Inflation Are A Deadly Brew The Philippines is also highly vulnerable to the emerging cold war between the US and China. Administrations are now flagrantly aligned with one great power or the other. This means that foreign meddling should be expected. Duterte could get Chinese assistance, which erodes Philippine sovereignty and its security alliance with the United States, or he could eventually suffer from anti-Chinese sentiment, which invites Chinese pressure tactics. Either course will inject a risk premium over the long run. The US is popular in the Philippines, especially with the military, and overt Chinese sponsorship will eventually trigger a backlash. Bottom Line: The lack of legislative or popular constraints on Duterte makes it more likely that he will undertake autocratic moves to stay in power – economic orthodoxy will suffer as a result. The Philippines will also see a sharp increase in policy uncertainty directly as a consequence of the secular rise in US-China tensions in the coming months and years. Brazil: Will Bolsonaro Become A Kamikaze Reformer? Chart 10Bolsonaro’s Handling Of Pandemic Gets Panned In Brazil, President Jair Bolsonaro’s “economy first” approach and dismissal of the pandemic as a “little flu” has not improved his popularity (Chart 10). His approval rating is languishing in the 30% range, lower than all modern presidents save the interim government of Michel Temer in the previous episode of the country’s ongoing national political crisis. The pandemic, and Bolsonaro’s response, have fractured his cabinet and precipitated a new episode in the crisis. The clash between the president and the country’s state governors and national health officials, who enjoy popular support, has led to the dismissal of Health Minister Luiz Henrique Mandetta and the resignation of the popular Justice Minister Sergio Moro. We have highlighted Moro as a linchpin of Bolsonaro’s anti-corruption credibility and hence one of the three pillars of his political capital. This pillar is now cracking, making Bolsonaro’s administration less capable going forward. Bolsonaro’s firing of the head of the federal police, Mauricio Valeixo, the catalyst for Moro’s resignation, has led to a Supreme Court authorization for an investigation into whether Valeixo’s dismissal can be attributed to corruption or obstruction of justice. A guilty verdict could force Congress to take up impeachment, an issue on which Brazilians are split. Earlier this week the president was forced to withdraw the appointment of Alexandre Ramagem – a Bolsonaro family friend – as the new head of the federal police after a minister of the supreme federal court blocked the appointment due to his close personal relationship with the president. Brazil’s structural reform and fiscal discipline are on the backburner given the need for massive emergency spending to shore up GDP growth. Reforms are giving way to the “Pro-Brazil Plan,” which seeks to restore the economy through investments in infrastructure. The absence of the economy minister, Paulo Guedes, from the unveiling of this plan has led to speculation over Guedes’ future. Guedes is the key reformer in Bolsonaro’s cabinet and as important for the administration’s economic credibility as Moro was for its anti-corruption credibility. Brazil’s macro context is egregious. Its large public debt load – mostly denominated in local currency – raises the odds that the central bank will monetize the debt at the expense of the exchange rate, which has already weakened since the beginning of the year. Moreover, Brazil’s ability to pay near term debt service obligations is in a precarious position as the pullback in export revenues will weigh on its ability to service debt (see Chart 2). Our Emerging Markets Strategy estimates that Brazil is spending 16% of GDP on fiscal measures that will push gross public debt-to-GDP ratio well above 100% by the end of 2020 (Chart 11). Chart 11Highly Indebted Emerging Markets Have Limited Fiscal Room For Maneuver Given that Brazil already suffers from a relatively elevated misery index (see Chart 9), these macro challenges will translate into greater pain for Brazilian households and hence a political backlash down the road. The three pillars of Bolsonaro’s political capital have cracked: order, anti-corruption, and structural reform. The hope for investors interested in Brazil now rests on Bolsonaro becoming a kamikaze reformer. That is, after the immediate crisis subsides, his low popularity may force him to try painful structural reforms that no leader with political aspirations would attempt. So far he is taking the populist route of short-term measures to try to stay in power. Chart 12Bolsonaro's Meltdown Portends Melt-Up In Brazilian Political Risk Another sign of worsening governance is that military influence in civilian politics is partially reviving. This element of the country’s recent political turmoil has flown under the radar but will become more prominent if the administration falls apart and the only officials with sufficient credibility to fill the vacuum are military officials such as Vice President Hamilton Mourão. Financial markets may force leaders to make tough decisions to stave off a debt crisis, but risk assets will sell in the meantime as the lid on the country’s political risk has blown off and currency depreciation is the most readiest way to boost nominal GDP growth. Our political risk gauge will continue spiking – this reflects currency weakness relative to fundamentals (Chart 12). Bottom Line: Last fall we argued that Brazil was “just above stall speed” and that we would give the Bolsonaro administration the benefit of the doubt if it maintained three pillars of political capital: civil order, corruption crackdown, and structural reform. All three are collapsing amid the current crisis. As yet there is no sign that Bolsonaro is taking the “kamikaze reform” approach – that may be a positive catalyst but would require his administration to break down further. South Africa: Quantitative Easing Comes To EM South Africa faces an 8%-10% contraction in growth for 2020 and President Cyril Ramaphosa has overseen a large monetary and fiscal stimulus. The South African Reserve Bank has committed to quantitative easing in a bid to boost liquidity in the local financial market. South Africa’s highly leveraged households and those who mostly participate in the formal economy will find relief in lower debt-servicing costs and better access to credit. However, the large informal economy, and the rising number of unemployed, will not reap the same benefit from accommodative measures. This last group will benefit more from fiscal policy measures, such as social grants to low-income households. Ramaphosa recently announced a fiscal spending package totaling R500 billion, or 10% of GDP. Social grants to the poor and unemployed are all set to increase, which should help reduce the economic burden low-income households will face over the short term. The problem is that South Africa is extremely vulnerable to this crisis. Well before COVID the country suffered from low growth, persistently high unemployment, rising debt levels, and an increasing cost of social grants. The pandemic has increased dependency on these grants. South Africa is the most unequal society in the world (Chart 9 above) and runs large twin deficits on its fiscal and current accounts (see Chart 3). As the government’s financing needs rise, its ability to keep providing to low-income households will diminish. Yet the ruling African National Congress (ANC) is required to keep up social payments to stave off discontent and maintain its voter base – which consists of poor, mostly rural voters. The ANC must decide whether to implement stricter austerity measures after the immediate crisis to contain the fiscal fallout, which will bring unrest forward, or continue on an unsustainable path and face a market revolt. The latter option is clear from the decision to embrace quantitative easing, which further undermines the currency. Political pressure is mostly stemming from the left-wing – the Economic Freedom Fighters – which prevents Ramaphosa from taking a hard line on economic and fiscal policy. Bottom Line: There have been isolated protests across the country against the government’s draconian lockdown, and social grievances have the potential to boil over in the coming years given the long rule of the ANC and the country’s dire economic straits. Investment Implications It is too soon to buy into risky emerging market assets at a time when a deep recession is spreading across the world, extreme uncertainty persists over the COVID-19 pandemic, and the political and geopolitical fallout is transparently negative for major emerging markets. Remain overweight developed market equities relative to emerging market equities, at least over a tactical (three-to-six month) time horizon. Emerging market losers are countries with poor macro fundamentals, weak health care systems, specific competitive disadvantages during a global pandemic, high levels of inflation and unemployment, and ineffective social and political institutions. Turkey, the Philippines, and Brazil rank high on our list both because of their problems and because they are major markets. Chart 13Short Our 'EM Strongman' Currency Basket Not coincidentally these countries each have “strongman” leaders who have pursued unorthodox polices and ridden roughshod over institutional checks and balances. In each case, the leader is doubling down on populism while exacerbating structural weaknesses that already existed. Apparently greater financial punishment is necessary before policies are adjusted and buying opportunities emerge. Thus we recommend investors short our “EM Strongman Basket” consisting of the Turkish lira, the Brazilian real, and the Philippine peso, relative to the EM currency benchmark, over a tactical horizon. These currencies outperformed the EM benchmark until 2016 when they began to underperform – a trend that looks to continue (Chart 13). These leaders could get away with a lot more during a global bull market than during a bear market. It will take time for Chinese and global growth to revive this year. And their policies suggest bad news will precede good news. We would also recommend tactically shorting the South African rand on the same basis. While Russia, China, and Thailand also have strongman leaders, their countries have much better fundamentals, as our COVID Unrest Index shows. However, we do not have a bright outlook for these countries’ political stability over the long run. Russia, like all oil producers, stands to suffer in this crisis, despite its positive score on our index. In a previous report, “Drowning In Oil,” we highlighted how the petro-states face serious risks of government change, regime failure, and international conflict. This is clear with Iran and Venezuela in the above charts, and also includes Iraq, Algeria, Angola, and Nigeria. Our preferred emerging markets – from the point of view of political risk as well as macro fundamentals – are Thailand, Malaysia, South Korea, and Mexico. We warn against Taiwan due to geopolitical risk, although its fundamentals are positive. We are generally constructive on India, but it is susceptible to unrest, which we will assess in future reports. Roukaya Ibrahim Editor/Strategist Geopolitical Strategy roukayai@bcaresearch.com Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 On April 16, Duterte ordered quarantine violators be arrested without warning. According to the UN, over one hundred thousand people have been arrested for violating curfew orders. The Philippines along with China, South Africa, Sri Lanka, and El Salvador were singled out by the UN High Commissioner for Human Rights are using unnecessary force to enforce the lockdowns and committing human rights violations in the veil of coronavirus restrictions. Duterte’s greenlight on a “shoot to kill” order against those participating in protests in violation of lockdown followed small-scale demonstrations in protest of Duterte’s handling of COVID-19.

Highlights Kim Jong Un’s sickness or death is a matter of speculation and it is best to remain skeptical for now. If Kim dies or is incapacitated, it is a serious concern for North Korean and hence regional stability – and not only in the medium and long term. A North Korean power vacuum could trigger a major relapse in US-China relations. Even if Kim is healthy, his negotiations with President Trump could affect US-China relations or Trump’s reelection chances this year. US-China tensions could also break down separately this year – watch for yuan depreciation or for Trump to lose public approval. The South China Sea and Taiwan Strait are also non-negligible risks that could derail US-China relations before the US election. Feature If North Korean leader Kim Jong Un dies, it is a risk to global stability. We have no insight on Kim’s health or whereabouts but we do know that North Korea is relevant to global investors – it is no longer a joke – because US-China relations are no longer stable. Korean political risk has been on an uptrend since the second summit between Kim and President Trump in Hanoi, Vietnam was cut short without any agreement (Chart 1). Chart 1Korean Political Risk Already On An Uptrend Due To Pandemic, Recession, US-China Tensions A dispute over North Korea could trigger a relapse in US-China relations that threatens the global equity rebound. Remain Skeptical As we go to press it is still unknown whether Kim is sick, well, living, or dying. What is known is that Kim failed to make a public appearance on Kim Il Sung Day, April 15, a noteworthy absence. China has sent a group of officials from the Communist Party’s Liaison Department, including medical doctors, according to Reuters – the most objective sign yet that something in North Korea has gone amiss. Japan’s Shukan Gendai on April 26 quoted an unnamed Chinese official saying that Kim was in a “vegetative state” after having stents put in his arteries after a heart attack. This corroborates (or repeats) the story that originally broke in South Korean newspaper Daily NK on April 21, saying that Kim was in grave condition after complications from heart surgery. Neither the Daily NK nor the Shukan Gendai are premium papers and the Daily NK also had to correct its original story which it attributed to “multiple” North Korean sources when in fact it only had one source. The US think tank 38 North on April 26 identified Kim’s elite passenger train at Wonsan but neither 38 North nor Reuters can confirm that Kim is actually in Wonsan. Kim was last seen in public on April 11 in Pyongyang, the day before Kim’s alleged surgery on April 12, but North Korean state press has reported on him conducting a range of activities since that date, albeit without video footage or anything that would disprove his incapacity. South Korean officials at the highest levels have repeatedly denied that they have intelligence of anything “special” happening in North Korea. South Korean assets are untroubled by the rumors (Chart 2). US President Donald Trump, and Pentagon officials, have also cast doubt on rumors that Kim is sick or dying – although various White House officials and Senator Lindsey Graham of South Carolina have implied something is wrong. Frequently it occurs that a temporary absence of autocratic leaders like Kim or Chinese President Xi Jinping causes the global media to speculate about illness, death, or intrigue. The lack of transparency of such regimes gives rise to a cottage industry of political watchers who interpret a leader’s every movement. Usually these rumor cycles amount to nothing. Absence of evidence (a leader’s failure to appear at an event) is not evidence of absence (the leader’s death). Still, the longer North Korea goes without offering definitive proof that Kim is alive, the greater the concerns will mount. One thing that we find unusual is the positioning of Kim’s sister, Kim Yo Jong. Kim Yo Jong was removed from the Politburo of the Korean Worker’s Party shortly after the failed Hanoi summit last year. She was reinstated as an alternate member on April 11 this year, in what was probably Kim Jong Un’s last credible public appearance. This gave rise to a surge of interest in her as a rising star, reflected in Google searches on April 12. These searches have spiked much more dramatically now that Kim Jong Un’s health is in question (Chart 3). Chart 2Korean Assets Not Responding Much To Kim Rumors Chart 3Why Was Kim Yo-Jong Rehabilitated Just Before Kim’s Alleged Surgery? The timing of her reinstatement, promptly followed by rumors about Kim’s health, is strange. North Korea’s political legitimacy is based on the Kim family dynasty. Her political recovery and promotion would be necessary to prepare her for any heightened role in the event of Kim’s incapacity or death. The purpose of the Politburo meeting was apparently to address the COVID-19 pandemic and delay a meeting of the legislature, the Supreme People’s Assembly. While rumors have focused on Kim’s cardiac event, we would not rule out the possibility that he has contracted COVID-19. Global leaders certainly are not immune to the disease, as evidenced by UK Prime Minister Boris Johnson. Reports also cite Kim's past periods of illness in 2012-14, although it is doubtful that his previous troubles with gout have any connection to a heart attack this month. What Is At Stake If Kim Exits The Scene For investors, the important thing to recognize is that North Korea is no longer irrelevant, no longer a geopolitical “red herring,” as we outlined in a series of reports in 2016 and 2017. Rather it is a critical moving part in a growing strategic conflict between the US and China. North Korea is a nuclear-armed state and a personalized autocracy with no clear succession plan, a stability risk on China’s border, and a national security risk to the United States and its allies Japan and South Korea. Pyongyang is in the midst of a multi-year, high-stakes diplomatic negotiation with its Northeast Asian neighbors and the United States. Diplomacy has not, thus far, gone off the rails. While Pyongyang has pushed the envelope with minor nuclear and missile activities, and by contesting Trump’s claims of exchanging letters, it has not abandoned negotiations with President Trump since 2017 by testing nuclear devices or intercontinental ballistic missiles, or by threatening to attack the US. South Korea’s legislative election on April 15 reinforced the leadership of President Moon Jae In and his left-leaning Democratic Party, marking a rebound for Moon due to his handling of the pandemic. This marks a boost to his “Moonshine” policy of diplomacy and economic integration with the North, another factor conducive to the continuation of diplomacy (Chart 4). However, any instability now would occur at a time of extreme vulnerability both within North Korea and abroad. North Korean growth is already facing a historic downturn unlike anything since the collapse of the Soviet Union (Chart 5). Chart 4Peaceniks Still Winning In South Korea Chart 5North Korean Instability Is Likely Regardless Of Kim's Health President Trump’s policy of “maximum pressure” sanctions has the North’s economy in a vise (Chart 6). For the past few years China has enforced sanctions on the North to cooperate with the United States. Beijing has reduced fuel exports and coal imports, according to official statistics (Chart 7). Chart 6Sanctions Have Damaged The Regime Chart 7China's Sanctions Enforcement Is Critical Even if China were not enforcing sanctions, North Korea’s economic conditions would be drastically deteriorating due to the COVID-19 pandemic, which has pushed China into what may well be the first recession since the 1970s (Chart 8). Thus if North Korea does end up having a leadership problem, investors should not assume that the regime will remain stable, in the near, medium, or long term. A power struggle broke out in China immediately upon Chairman Mao’s death in 1976. And when Kim Jong Un took power in December 2011, he struggled to consolidate power over the party, state, and military at first. He notoriously executed his uncle in December 2013 amid these internal struggles, which may have involved insubordinate military actions. His older brother Kim Jong Chol, or his sister Kim Yo Jong, would have more trouble consolidating power given that they were not Kim Jong Il’s choice for successor and would enter the supreme office in an extremely unstable time both at home and abroad. A succession process could also lead to external risks relatively quickly. North Korea’s historic surprise attack on the South Korean corvette, the Chonan, occurred in March 2010. Kim Jong Il was known to be preparing for his exit and for Kim Jong Un’s succession, so the regime sought to demonstrate strength while the world was distracted with a global financial crisis. If US-China relations were stable, there would be at least one substantial basis for believing that a North Korean crisis could be prevented from causing a crisis in other foreign relations. But US-China relations are not stable – they have deteriorated since the global financial crisis, as symbolized here by China’s diversifying away from US treasury holdings (Chart 9). The average US tariff rate on Chinese imports has risen from 5% to 15% under President Trump, who is threatening to impose additional punitive measures on China, such as export controls, as the two sides quarrel over the pandemic and recession. Chart 8Chinese Slowdown A Threat To Pyongyang President Trump’s signature foreign policy initiative – as opposed to trade initiative – has consisted of negotiations with North Korea over denuclearization and eventual peace. If these negotiations fall apart, President Trump will suffer in a substantial way that will at least marginally harm his reelection chances on November 3. Chart 9US-China Relations Fundamentally Unstable If the negotiations result in a “magnificent” deal this year, they could help those chances. Negotiations could face a test before that time, if either side abandons negotiations or gets cold feet before agreeing to a deal. Chart 10Brinkmanship Results In US Shows Of Force Testing periods in the current relationship involve shows of US military strength, as in the summer of “fire and fury” in 2017, and as the US also showed in a similar summer of fire and fury with Iran in 2019 (Chart 10). Shows of force typically are a source of passing volatility, at best, in global financial markets. But in this year’s context the risk of broader US-China strategic competition would amplify that impact, even if it is transient. Investment Takeaways For global investors, what matters is if a North Korean crisis destabilizes the region and if US-China relations destabilize for this or any other reason. If Kim dies, we expect instability to ensue in North Korea eventually, if not immediately, and this would entail some degree of instability among the major powers. The US and China would seek to shape the outcome on the peninsula – China has already sent a team of officials. Washington and Beijing have a shared interest in preventing regime collapse, but they have a high level of distrust and different aims for the regime that might emerge in the aftermath. Tensions would get extremely high amid a power vacuum in North Korea. To gauge the durability of the US-China détente, the phase one trade deal signed in January, we are monitoring the CNY-USD exchange rate and President Trump’s approval rating (Chart 11). Renminbi depreciation is possible to ease pressure on China’s weak economy, but it would break the deal entirely, given that most other elements of the deal are either interrupted by the recession (goods purchases) or unverifiable (intellectual property protections). Chart 11Yuan Depreciation Or Falling Trump Approval Threaten Global Equities Meanwhile President Trump only has an incentive to refrain from punitive measures as long as he believes his economy and election chances are salvageable. If this changes, and he is stuck in the 42% approval range or below, he may become a “lame duck” and attempt to turn the tables. Aggressive scapegoating of China, which has attracted widespread American disfavor, is a possible tactic for him to outmaneuver his rival, former Vice President Joe Biden, who is allegedly soft on China. We have long argued that US-China tensions would spill over to strategic disputes in China’s periphery and cause a higher risk-premium in global equities and risk assets exposed to this relationship. The current fragile environment of pandemic and recession makes a risk-off more likely by rendering both the US and China more vulnerable. We have held that the Taiwan Strait was more likely than the Korean peninsula to be the site of a crisis this year, but Kim Jong Un’s death would change that calculation. Two final points. First, North Korea has a long and distinguished history of feigning weakness in order to get foreign aid. If the great powers think it is on the verge of collapse then they will offer aid and possibly sanctions relief. With the pandemic and recession, we could eventually learn that Kim is alive and well, but that North Korea wants assistance with the pandemic. As outlined above, it is still possible that Kim’s health is fine, and yet that a failure of diplomacy with President Trump results in significant saber-rattling this year. Second, all of the above demonstrates the seriousness of geopolitical risk in East Asia stemming from US-China competition. Distrust is growing on a secular level and is seeing a near-term spike due to COVID and the US election. As a consequence, we take any North Korean instability seriously. But we also see potential for conflicts to emerge in the Taiwan Strait or the South China Sea, where a standoff between China, its rival territorial claimants, and the US is already underway. We remain tactically defensive and continue to recommend the Japanese yen as a hedge. We are adding JPY-EUR to this mix. On a longer-term horizon we recommend investors remain long selective international equities and commodities. For now we remain overweight Korean equities relative to Taiwanese, but we will close this trade on any confirmation that Kim is dead or incapacitated. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com